Accounting in

Organisations and Society

Module 5: Analysis of organisations’ external reports

Topic Notes

Module 5: Analysis of organisations’ external reports

By Craig Deegan

RMIT University
Accounting in Organisations and Society
Module 5: Analysis of organisations’ external reports
 Accounting in Organisations and Society

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Table of Contents
Learning objectives .................................................................................................... 1
How this module links with previous modules in this course ...................................... 1
Financial statement analysis - some initial ‘scene setting’ issues .............................. 2
How do we do financial statement analysis ................................................................ 3
Ideally be aware of the existence of organisation’s contracts that rely upon
accounting numbers ................................................................................................... 4
Further reflections about the assets that appear - and do not appear on the balance
sheet .......................................................................................................................... 5
Accounting policies..................................................................................................... 6
Broad classification of accounting ratios .................................................................... 7
Profitability ratio – return on assets ............................................................................ 8
Profitability ratio – return on owners’ equity................................................................ 9
Profitability ration – profit margin .............................................................................. 10
Profitability ratio – gross profit margin ...................................................................... 10
Efficiency ratio – inventory turnover ......................................................................... 10
Efficiency ratio – debtors turnover ............................................................................ 10
Efficiency ratio – operating cash flow margin ........................................................... 11
Capital structure ratios – debt to assets ratio ........................................................... 11
Capital structure ratios – debt to equity ratio ............................................................ 11
Liquidity ratios – current ratio ................................................................................... 12
Liquidity ratios – quick ratio ...................................................................................... 12
Liquidity ratios – interest coverage ratio ................................................................... 12
Liquidity ratios – cash flows from operations to current liabilities ............................. 13
Market based ratios – price earnings info................................................................. 13
Changing focus ........................................................................................................ 13
Let’s move to different ‘accounts’ ............................................................................. 20
Analysis of social and environmental (sustainability) reports ................................... 20
Further considerations.............................................................................................. 22
The organisation context .......................................................................................... 22
Independent review .................................................................................................. 25
Concluding comments .............................................................................................. 26
References ............................................................................................................... 41

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Learning objectives
By the end of this Module, you should be able to:
• Understand the nature of financial statement analysis (FSA) in terms of:
– Who should do it?
– Why we might do it? and
– How we might do it?
• Understand why we should have knowledge of financial accounting rules and
conventions before we attempt to perform FSA.
• Explain that financial accounting numbers are used in many contractual arrangements
and that knowledge of such arrangements is useful prior to undertaking FSA.
• Understand that financial ratios are often used in FSA, and understand that different
ratios provide information about different aspects of an organisation.
– For example, about profitability, efficiency, and ability to pay debts as and when due.
• Be able to explain that there is also very important information within the notes to the
financial statements that should also be analysed.
– For example, information about events after the end of the reporting period and
information about contingent liabilities.
• Explain how we need to have knowledge about an organisation’s specific social and
environmental context before we can attribute proper meaning to organisational social
and environmental disclosures.
• Understand that once we have information about organisational context (for example,
where it is operating, with whom it is operating) then that in turn, informs us about what
types of social and environmental information we might expect to find in a report.
• Briefly explain the insights provided by some of the research that explores the objectivity,
or otherwise, of social and environmental disclosures.
• Understand that reports prepared by managers will not always be objective and therefore
appreciate the role and value provided by third party audits/assurances of financial
reports and social and environmental reports.

How this module links with previous modules

in this course
• In this course, we have discussed how organisations produce various ‘accounts’ that are
used by a variety of ‘stakeholders’.
• We have learned that ‘accounts’ are produced by an organisation for external use (which
might also be referred to as ‘reports’) will be influenced by a variety of factors, including:
– Management’s and stakeholders’ beliefs about the responsibilities of the
organisation.

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– Related beliefs about the ‘accountabilities’ of the organisation in respect of what

aspects of performance should be measured, managed, and reported.
– Related beliefs about to whom (which stakeholders?) the ‘accounts’ should be
provided.
– Related beliefs about which reporting frameworks should be used to generate the
reports/accounts and where such reports should be sent/displayed.
• We have learned that the external accounts being prepared by an organisation might be
financial (Module 3), social, or environmental (Module 4) in nature.
– We have also learned that financial reports – the preparation of which tends to be
highly regulated - typically ignore many social and environmental aspects of
performance.
– Further, ‘accounts’ of ‘performance’ do not necessarily need to focus on monetary
calculations.
• In this module we will explore various factors to consider when reviewing/analysing
external reports produced by organisations.
• We will start the module by focusing on the analysis of financial statements and then we
will move our focus on analysing social and environmental accounts/reports.

Financial statement analysis - some initial

‘scene setting’ issues
• Who would (or ‘should’) perform financial statement analysis?
– Requires some reasonable knowledge of financial accounting in terms of the
current rules and conventions (and remember, accounting standards are frequently
changing). People with limited financial accounting knowledge would be unwise to
rely upon their own analysis of financial statements.
• Why would somebody do financial statement analysis?
– There could be various reasons. People analysing the reports might be thinking of
investing in an organisation, advising others about whether to invest, working for an
organisation, loaning money to the organisation, selling goods on credit to the
organisation, and so forth.
For these various purposes they might want to know how efficiently the organisation
is using its resources, how profitable the organisation is relative to other
organisations, and the ability of the organisation to pay its debts as and when
they fall due. FSA can provide such insights.
• Financial accounting numbers are everywhere and they are part of common
communication.
– The media often focuses on corporate profitability and changes therein, and uses this
as some form of comprehensive performance assessment – something we know it is
not.
• Financial accounting numbers are used in many agreements between an organisation
and different stakeholders.

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– Many stakeholders want information from annual reports, as their own wealth might
be influenced by such numbers.
– For example: managers might be receiving bonuses tied to accounting profits;
lenders might have negotiated debt to asset restrictions; employees want to know the
security of their employment.
• Financial accounting numbers create various social impacts.
– For example: if reported profits are falling then staff might be sacked so as to save
on ‘expenses’; labour unions might use high reported profits as an excuse to call for
increased wages.

How do we do financial statement analysis

• A simple comparison of this year’s figure (perhaps particular expenses or revenues)
with the previous year figure (sometimes referred to as horizontal analysis) – but we
need to ensure there is nothing fundamentally different about the organisation from one
year to the next (or that the accounting rules being used haven’t changed since last year
in a way that might hamper our comparison).
• Ratio analysis
– Within ratio analysis, particular line items in financial statements are compared to
other line items. It is used to evaluate various aspects of a company, for example its
profitability, efficiency, liquidity, or solvency.
– We will consider a number of accounting ratios.
• Trend analysis
– Look at various financial indicators – perhaps ratios – over time to see if there is a
pattern of improvement or deterioration.
• Comparison to benchmarks
– Different performance measures – which might be encapsulated in ratios - might be
compared to other organisations to determine how the organisation is performing
relative to others.
– But be careful when comparing financial accounting numbers with similar
organisations. Different organisations in different industries are subject to different
risks and therefore simply comparing their profitability might not be appropriate. Also,
we must consider size (for example, is it sensible to compare the performance of
Coles with that of a corner store?) and geographical location (for example, different
countries can pose different risks and different costs of operation making comparison
problematic).
• There is also other information accompanying financial statements that might also
require consideration, for example:
– Is there an auditor’s report? What does it say about the report? Should the report be
relied upon?
– Are there any significant events that have occurred after the end of the reporting
period?

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– Are there some potentially significant contingent liabilities (these are not shown in the
financial statements – and hence are not reflected in the numbers we are using - but
are in the accompanying notes)?
– What are the accounting policies of the organisation?

Ideally be aware of the existence of

organisation’s contracts that rely upon
accounting numbers
• Ideally, when (or perhaps, before) undertaking financial statement analysis, we should
be aware of the accounting-based contracts the organisation has entered into. For
example:
• When borrowing funds, an organisation will often agree to various accounting-based
covenants so as to reduce the risks of the lenders and therefore reduce the cost of the
funding.
– For example, there might be negotiated debt to asset restrictions or minimum interest
coverage requirements.
• Managers might be rewarded in terms of accounting numbers.
– For example, managers might receive bonuses based upon reported profits, reported
sales, or return on assets.
• Having such accounting based contracts can provide incentives for managers to use
accounting methods that are income increasing/asset increasing –so we should factor
this into our analysis.
• Also, because an organisation can potentially be wound up if it defaults on its
accounting-based lending agreements (often referred to as being in ‘technical default’)
knowledge of such lending agreements is useful in assessing the future of the
organisation.
• Auditors should certainly make efforts to be aware of the accounting-based contracts in
place as this will provide a possible indication of when management might have been
motivated to manipulate the accounting numbers – in those situations when they appear
close to breaching the debt covenants.
• Research evidence does actually indicate that organisations that are close to breaching
accounting-based debt contracts are indeed more likely to opportunistically adopt.
– Accounting methods which are asset increasing.
– Accounting methods which is income increasing.
– Action that is taken to generate financial statements that are more favourable to
management is often referred to as ‘creative accounting’. For students who would
like to consider the topic of creative accounting in more depth they might like to refer
to: https://www.slideshare.net/Ziela87/creative-accounting-15779257

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– The point to be made here is that because of the way accounting numbers are used
within society, and how they are used in various contractual arrangements, we need
to accept that the numbers will not always be prepared objectively. To assume
otherwise is naïve. It is sensible to have an element of ‘healthy scepticism’.

Further reflections about the assets that

appear - and do not appear on the balance
sheet
• As we would know from Module 3, reported ‘total assets’ – a fairly central number for
financial accounting purposes – does not represent the fair value of all the assets, or the
cost, or replacement value of them. Rather it is the sum of various different
measurement bases of those assets that we are permitted to recognise.
• Therefore, ‘total assets’ needs to be reviewed/used with much care.
• As we should also appreciate, ‘total assets’ does not include many valuable assets. For
example, most internally generated intangible assets – which might have great value –
are not recognised within financial accounting (because the accounting standards
prohibit their recognition), and hence do not appear on the balance sheet. Analysts need
to remember this.
• Also, many other key resources of the organisation – such as its labour force, key
intellectual capital, valuable customer and supplier networks and so forth are not
reported on the balance sheet.
• Therefore, the total ‘resources’ of the organisation, and its reported ‘total assets’ (as
determined by the financial accountants) can be quite different.
• So be careful with how you use financial accounting reports such as balance sheets
when undertaking financial statement analysis – many valuable resources are not there,
or if they are there they might be reported at a historical cost that is quite different to their
fair value.
– So we often need to supplement our FSA with other information.
• As a general (and sensible) principle, if we do not understand the rules of financial
accounting (including knowledge about what assets do not appear, and the mixed
measurement requirements for different categories of assets) then the balance sheet can
actually be a rather misleading, and perhaps dangerous, document to deal with!!!
– For example, uninformed users of financial statements might incorrectly believe that
‘total assets’ reflects the current fair value of all assets held by the organisation. As
we know, this IS NOT the case.
– You should reflect on how you would have previously interpreted the meaning of
‘total assets’. Has that belief now changed?

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Accounting policies
• Accounting policies are the specific principles, bases, conventions, rules and practices
applied by an entity in preparing and presenting financial statements
• Whilst often very difficult to understand (even for experienced accountants), the first
notes that accompany financial statements generally are the ‘accounting policy notes’. In
this regard, the International Accounting Standard IAS 1 (in Australia, AASB 101)
Presentation of Financial Statements states (at paragraph 117):
An entity shall disclose its significant accounting policies comprising:
a. The measurement basis (or bases) used in preparing the financial statements; and
b. The other accounting policies used that are relevant to an understanding of the
financial statements.
• Because for some assets and liabilities there can be a choice between measurement
bases it is important to ensure that if two or more organisations are being compared then
they should be applying the same policies, else the comparison can be misleading.
• Organisations will also change accounting policies over time. Often this could be
because new accounting standards have been released, or because previously used
accounting methods no longer provide ‘relevant’ information for the organisation.
• 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– rules that can frequently change.
– So there is a need to be careful when comparing accounting numbers (and therefore,
ratios that have been calculated from those numbers) across time as there is a very
real chance that the underlying rules for calculating those numbers has changed. It
would actually be very misleading to compare a profitability measure from this year –
such as return on assets – with the same measure ten years ago for the same
organisation as the rules for measuring various assets, liabilities, income and
expenses have changed a lot in that time making comparison somewhat
meaningless.
• This brings into question much of the (naïve) analysis that can often be seen, which
charts aspects of financial position or financial performance over an extended and
sometimes lengthy period of analysis. People that do such analysis often really do not
understand financial accounting, particularly the fact that the recognition and
measurement rules for various expenses, revenues, assets and liabilities often change.

Example
An example of an accounting policy for measuring assets:

An accounting policy note within the BHP 2016 Annual Report states:
Property, plant and equipment (PPE)
Property, plant and equipment are recorded at cost less accumulated
depreciation and impairment charges. Cost is the fair value of

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consideration given to acquire the asset at the time of its acquisition or

construction and includes the direct costs of bringing the asset to the
location and the condition necessary for operation and the estimated
future costs of closure and rehabilitation of the facility.
As we can see, BHP does not measure its PPE at fair value (which is an
option it has available). Rather, it has elected to use historical cost as the
basis for measurement. This would mean in general that, relative to
organisations that measure their PPE at fair value, BHP’s depreciation
costs would be lower, and profit on sale of PPE would be higher. That is,
reported profit would be higher than had fair value been used to measure
PPE.
Ratios such as return on assets might also look relatively better as the
asset base (the denominator) would be lower.
Therefore, we can hopefully see that it would be problematic to compare
BHP’s performance with another organisation that measured its PPE at
fair value.
So, we need to make sure that - if we are comparing organisations when
doing financial statement analysis - the organisations are using the same
accounting policies in respect of important measurement decisions.
Otherwise we might need to make some adjustments
Hence, reviewing accounting policies is an important first step in
financial statement analysis – again, many analysts miss this VERY
IMPORTANT step!

Broad classification of accounting ratios

As already noted, much financial statement analysis is undertaken using ratios. A ratio is a
relationship between two quantities, normally expressed as one divided by the other. We
can calculate a variety of accounting ratios and they can be broadly categorised into:
• Profitability ratios
– Looks at the ability of an organisation to make a profit (but remember, here we are
looking at organisations that are established to make profits. Such analysis might not
be relevant for not-for-profit entities). Determined by comparing profits against bases
such as sales, assets or owners’ equity.
– For example, return on assets ratio, return on owners’ equity, net profit margin, gross
profit margin.
• Efficiency ratios
– Provides insight into how an organisation is managing its assets and liabilities.
– For example, inventory turnover, debtors turnover and operating cash flow margin.
• Capital structure ratios

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– Provides an insight into how the organisation is being funded (from owners or
through debt) and therefore provides some indicator of risk.
– For example, the debt to assets ratio, debt to equity ratio.
• Liquidity ratios
– Provides insights into the ability of an organisation to pay its debts as and when they
fall due.
– For example, the current ratio, the quick ratio, interest coverage ratio, cash flows
from operations to current liabilities.
• Market based ratios
– Provides an insight into how the market values an organisation.
– For example, price earnings ratio.

Profitability ratio – return on assets

• Calculated as PROFIT ÷ TOTAL ASSETS × 100
• It is a measure of profitability as it gives an indication of how much profit is being
generated for every dollar of assets controlled by the organisation.
• But care must be taken in undertaking such analysis, for example:
– Must be careful comparing such measures across different firms, as different firms
will have different risk profiles (depending upon the type of industry, financial
structure, country of operation, etc.), and all things being equal, the great the risk the
higher the expected rate of return.
– Also, we know that many ‘assets’ of the organisation do not get recognised on the
balance sheet.
– Further, and as we have already discussed, some organisations might report their
non-current assets at cost, whilst another comparable organisation might report their
non-current assets at fair value, which would typically be higher.
– Meaning that the return on assets of the revaluing organisation would be biased
downwards. The point is that different organisations might have different
accounting policies thereby making financial performance comparisons
problematic.
– Further, the age of the assets also will influence the number. Assets measured
at cost which were acquired many years ago will tend to be lower in cost and
have higher accumulated depreciation and this will have the effect of improving
return on assets (unless they are old and inefficient).
– Again we need to emphasise that across time accounting policies will change (for
example, an organisation might switch from the cost model to the revaluation model).
– Further, accounting standards will change (for example, in 2005 the accounting rules
changed in Australia in respect of accounting for intangible assets with the result that
billions of dollars of intangible assets were removed from corporate balance sheets).
Therefore, and as we have explained, comparing financial accounting results across

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multiple periods for one organisation can also be misleading as, for example, the way
we might measure assets can change from one year to the next.
– The point being made is that although we have only considered one ratio so far, the
general rule is that financial statement analysis should be undertaken with care. If the
numbers themselves are somewhat questionable then the analysis must also be
questionable.
– Garbage in, garbage out!
Adjusted measure of return on assets
• The ratio just discussed, whilst widely used, does not take into account the sources of
funding.
• As we know:
– For equity funding, owners are paid dividends which are not an expense and
therefore do not reduce profits.
– For debt funding, lenders are paid interest, which is an expense and therefore does
reduce profits.
• By adding back interest expense we are removing the influences of where the funds are
sourced, and therefore efficiency of asset use might be better assessed.
• The adjusted measure becomes:
• (Profit + interest expense) ÷ total assets x 100
• Some analysts also add back tax so as to remove the effects of such things as different
tax regimes and other arrangements.

Profitability ratio – return on owners’ equity

• Return on owners’ equity (ROE) = Profit ÷ average owners’ equity x 100
• Average owners’ equity can simply be calculated as opening owners’ equity plus closing
owners’ equity divided by 2.
• The ROE provides a measure of the profit being generated – which ultimately might go
to owners in the form of dividends – for each dollar of equity the owners have in the
organisation.
• Provides an indicator of how effectively an organisation has used owners’ capital to
generate profits.
• Generally, the larger the number the better and an improving trend across time is
preferred.
• Provides a basis for investors to compare to other investment opportunities
– The rate of return certainly should be higher than low risk returns, such as returns on
bank deposits.
• There is no absolute ‘right’ percentage. There is a need to compare with benchmarks,
such as:
– ROE from previous periods

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– Budgeted ROE
– ROE of similar organisations

Profitability ration – profit margin

• Profit margin = profit ÷ sales x 100
• Provides an indication of the extent to which each dollar of sales contributes to profits.
• A measure of say 18% means that for every dollar of sales the organisation generated a
profit of 18 cents.
• Can be compared to other similar organisations, previous periods, and to budgets to
determine whether the costs being incurred relative to sales are higher or lower thereby
providing an indication of cost efficiency/control.

Profitability ratio – gross profit margin

• Gross profit margin = (sales – cost of goods sold) ÷ sales x 100
• One cost that is particularly significant to many organisations is their cost of goods sold.
• Gives an indication of pricing strategy (mark ups), which can be compared to similar
organisations in similar industries.
• Organisations with high turnover will generally survive on the basis of relatively lower
gross profit margins and robust cashflow.

Efficiency ratio – inventory turnover

• Inventory turnover = cost of goods sold ÷ average inventory
• Provides an indication of how many times in the accounting period the organisation
turned over (sold) its inventory.
• Provides a basis of comparison with other organisations.
• A lower inventory turnover is a potential sign of inefficiency and also exposes the
organisation to various risks, such as risk of spoilage or obsolescence.
– But again remember this tends to be industry specific. A retailer of expensive luxury
cars would be expected to have a lower inventory turnover that a fruit and vegetable
shop.
• A higher inventory turnover is reflective of greater efficiency in both purchasing and sales
activities and potentially the need for less cash for acquiring inventory.

Efficiency ratio – debtors turnover

• Debtors turnover = sales ÷ average accounts receivable

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• When an organisation sells inventory on credit it needs to collect the amounts due from
debtors so as to complete the operating cycle.
• Provides an indication of the number of times during the period that debtors turn over
(pay).
• The higher the number the less the amount of cash tied up with debtors.
• Average collection period (365 / debtors turnover) provide a measure of how many days
it takes to collect cash from debtors.
• Provides an indication of the effectiveness of credit granting policies and debtor follow-
ups.
• The longer amounts owing stay with debtors the lower the probability of payment and the
greater potential liquidity problems.

Efficiency ratio – operating cash flow margin

• Operating cash flow margin = cash flows from operating activities ÷ sales
• Provides a measure of how much cash is generated from each dollar of sales.
• The higher the better.

Capital structure ratios – debt to assets ratio

• Debt to assets ratio:
Total liabilities ÷ total assets x 100
• Is a measure of the extent to which an organisation’s assets have been funded by
lenders/creditors?
• All things being equal, the greater the percentage the greater the risk of an organisation
given that debt needs to be repaid and attracts interest expense (as opposed to
organisations that are funded primarily by equity).
• However, different organisations/industries have different abilities to support debt.
– For example, industries with high variability in earnings could have greater trouble
servicing debt in some periods.
• But as with all such analysis, we need to consider how organisational choices can
influence the measurement of assets and liabilities and also that ‘total assets’ does tend
to understate the actual resources that are controlled by the organisation.

Capital structure ratios – debt to equity ratio

• Debt to equity ratio = total liabilities ÷ total owners’ equity x 100
• Provides an indication of how much liability there are per dollar of equity.
• Shows the extent to which an organisation is dependent upon equity financing.

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• If this amount is in excess of 50% then this indicates that the organisation is more reliant
on funding from lenders than from owners.
• All things being equal, the greater the relative level of debt financing the riskier the
organisation.
• This is because for debt there are legal requirements for payments in terms of principal
and interest. For equity there is generally no legal requirements to pay dividends.
• Different types of organisations can tend to absorb different levels of debt.
• Organisations with high variability in cash flows (meaning there might often be periods of
no profits) will find it relatively risky to have higher levels of debt relative to equity.

Liquidity ratios – current ratio

• To assess whether an organisation will be able to pay its debts as and when they fall due
it is common to compare current assets to current liabilities by way of the ‘current ratio’.
Current ratio = current assets ÷ current liabilities
• There is a VERY general rule that this number should not fall below 1. The lower this
number gets the greater the difficulty an organisation would have in meeting its short-
term liabilities.
• However a high number might indicate inefficiencies with too much funds being held in
cash, accounts receivable, and inventory.
– A ‘balancing act’

Liquidity ratios – quick ratio

• Another ratio known as the quick ratio (or acid-test) ratio is also used to assess the
ability of an organisation to pay its debts as and when they are due.
– This measure typically excludes inventory from the current asset balance because
inventory can take a long period of time to turn to cash (for example, the inventory
needs to be sold and then further time needs to pass before debtors pay the amount
due).
– Also often excludes bank overdraft because banks often allow the overdraft to stay in
place indefinitely even though in principle it could be demanded at short notice.
– A number below 1.0 can indicate potentially high financial risk.
Quick ratio = (current asset – inventory) ÷ (current liabilities – bank overdraft)

Liquidity ratios – interest coverage ratio

• Interest coverage ratio = earnings before interest and taxes ÷ finance costs
• Provides an indication of an organisation’s ability to service debt requirements.
• A number below 1 would represent a financially unsustainable situation.

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• All things being equal, the greater the amount of times an organisation can cover its
interest payment requirements, the better.
• Interest coverage clauses are often included within borrowing agreements wherein a
minimum number of times is stipulated.

Liquidity ratios – cash flows from operations to

current liabilities
• Cash flows from operations to current liabilities = cash flows from operating
activities ÷ current liabilities
• In Module 3 we discussed the statement of cash flows and noted that one classification
of cash flows was cash flows from operating activities (the other classifications being
cash flows from financing activities and cash flows from investing activities).
• This measure provides an indication of the ability of an organisation to cover its financial
obligations as a result of its operating activities, rather than having a reliance on cash
flows from financing or investing.
• Generally, the bigger this ratio is, the better.

Market based ratios – price earnings ratio

• Price earnings ratio = market price per ordinary share ÷ earnings per share
• For example, if a share is trading at $20 and the earnings per share (which is calculated
as profit divided by the average number of shares on issue for the period) is $2, then the
price earnings ratio is 10.
• The PE ratio provides an indication of how many times earnings the 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 has relatively lower risk
and/or it has good growth prospects – so a higher number seems a good thing.
• But ……sometimes these numbers can get very high to the point they seem to defy
explanation and are potentially indicative of an ‘overheated market’.

Changing focus
• Moving our attention away from the financial statements themselves, we can also find
some very important information in the notes that accompany the financial statements
(and remember we have already discussed the accounting policy notes).
• So, as well as reviewing the financial statements we also should spend time looking at
the accompanying notes.
• The notes that accompany financial statements can sometimes make up 50 to 100
pages of an annual report.

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• Within these notes, there are many important issues addressed. We will consider 3
issues, but please remember there will be many other items of important information in
the notes as well.
• The three specific topics we can consider are:
– Notes about events occurring after the end of the reporting period.
– Notes about contingent liabilities.
– Notes about how senior managers/executives are being paid – what type of
incentives are there?
• We will consider these issues now.

Events occurring after the end of the reporting

period
• As we learned in Module 3, the balance sheet is prepared as at a certain point in time
(typically either 30 June or 31 December) and the income statement (and statement of
cash flows and statement of changes in equity) is prepared for a period of time (perhaps
12 months to 30 June).
• If, for example, the reporting date is 30 June then the financial statements need time to
be prepared, auditors need time to do their audit, reports need to be formatted, ‘nice
photos’ included, and so forth.
• The result is that the annual report (which includes the financial statements, notes, and
some other reports) would typically be released sometime in September, which is up to
three months after the reporting period ended.
• Whilst the financial statements will reflect the transactions and events that occurred to
the reporting date (for example, 30 June) many important things might happen in the
period between the end of the reporting period and the date of release of the financial
statements.
• These transactions and events will not be recorded to the extent they are outside the
reporting period.
• With this in mind there is a requirement in the accounting standards that states that in
respect of events that occur after the end of the reporting period, but before the financial
statements have been authorised for issue, the organisation shall disclose in the notes to
the financial statements:
a. The nature of the event; and
b. An estimate of its financial effect or a statement that such an estimate cannot be
made.
• Therefore, when reviewing financial reports we should always remember to look through
the notes for information about such events as they might create material impacts to
future financial performance and financial position. Such notes are often found towards
the end of the annual report – so we need to know to look for them.

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Example
Examples of notes describing events occurring after the end of the
reporting period.
From Commonwealth Bank Annual Report 2016 (reporting period
ending 30 June 2016)
Note 44 Subsequent Events
The Bank expects the DRP for the final dividend for the year ended 30
June 2016 will be satisfied by the issue of shares of approximately $628
million.
The Directors are not aware of any other matter or circumstance that has
occurred since the end of the financial year that has significantly affected
or may significantly affect the operations of the Group, the results of
those operations or the state of affairs of the Group in subsequent
financial years.

From ANZ Bank Annual Report 2016 (reporting period ending 30

September 2016)
Note 44: Events Since the End of the Financial Year
On 31 October 2016 the Group announced it had entered into an
agreement to sell its Retail and Wealth businesses in Singapore, China,
Hong Kong, Taiwan, and Indonesia to DBS Bank Limited for a premium
of approximately $110 million over the book value of net assets, which
principally comprised approximately $11 billion of gross lending assets
and $17 billion of deposits as at 30 September 2016. The final purchase
price will be based on the net assets at completion. The transaction is
subject to regulatory approval in each country, with completion occurring
on a rolling country by country basis from mid financial year 2017 with all
countries expected to be completed with 18 months. The Group
anticipates the transaction will generate a net loss of approximately $265
million (post-tax) including write-downs of software, goodwill and fixed
assets, as well as separation and transaction costs.
The assets associated with the Retail Asia and Wealth businesses were
assessed for impairment as at 30 September 2016 on the basis of the
businesses being a continuing operation and no impairment was
identified. Additionally, the assets did not meet the conditions for ‘held for
sale’ classification under AASB 5 – Non-Current Assets Held for Sale and
Discontinued Operations. Other than this matter, no other material events
have occurred between the end of the reporting period (30 September
2016) and the date of this report.

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Contingent liabilities
• As we know from Module 3, a contingent liability is:
An obligation that is payable contingent upon a future event or an obligation that is not
probable (in terms of resource outflows) or is not measurable with sufficient reliability
• As we also know, contingent liabilities are not recorded within the financial. statements
and hence will not be reflected within our ratio analysis.
• Rather, we need to look at the notes accompanying the financial statements to find them.
– And again such notes are often found towards the end of the annual report.
• As part of our financial statement analysis we should review the notes and see if there
are any significant contingent liabilities.
• At the extreme, contingent liabilities can potential threaten the ongoing existence of an
organisation – so it is very important to be aware of them.

Example
Extracts from the contingent liabilities note within the ANZ Group Annual
Report 2016
Bank fees litigation
Litigation funder IMF Bentham Limited commenced a class action against
ANZ in 2010, followed by a second similar class action in March 2013.
The applicants contended that certain exception fees (honour, dishonour
and non-payment fees on transaction accounts and late payment and
overlimit fees on credit cards) were unenforceable penalties (at law and
in equity) and that various of the fees were also unenforceable under
statutory provisions governing unconscionable conduct, unfair contract
terms and unjust transactions. In August 2014, IMF Bentham Limited
commenced a separate class action against ANZ challenging late
payment fees charged to ANZ customers in respect of commercial credit
cards and other ANZ products (at this stage not specified). This action is
expressed to apply to all relevant customers, rather than being limited to
those who have signed up with IMF Bentham Limited. In the second
class action, all the applicants' claims have failed. The claims in relation
to all fees were dismissed by the Full Federal Court. That decision was
appealed to the High Court only in relation to credit card late payment
fees (the other claims were not appealed). On 27 July 2016 the High
Court dismissed the appeal and upheld the judgment in favour of ANZ in
respect of credit card late payment fees. The applicants are presently
considering the implications of the High Court's decision for the
remaining class actions, which have been on hold pending the outcome
of the second class action. ANZ believes that the remaining class actions
are likely to be discontinued or dismissed.
Proceedings in relation to Bank Bill Swap Rate (BBSW)
On 4 March 2016, ASIC commenced court proceedings against ANZ.

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ASIC is seeking declarations and civil penalties for alleged market

manipulation, unconscionable conduct, misleading or deceptive conduct,
and alleged breaches by ANZ of certain statutory obligations as a
financial services licensee. ASIC has subsequently initiated similar
proceedings against two other Australian banks. ASIC’s case against
ANZ concerns transactions in the Australian interbank BBSW market in
the period from March 2010 to May 2012. ANZ is defending the
proceedings. The potential civil penalty or other financial impact is
uncertain.
In August 2016, a class action complaint was brought in the United
States District Court against two international broking houses and 17
banks, including ANZ. The class action is brought by two US-based
investment funds and an individual derivatives trader. The action is
expressed to apply to persons and entities that engaged in US-based
transactions in financial instruments that were priced, benchmarked,
and/or settled based on BBSW, from 1 January 2003 onwards. The
claimants seek damages or compensation in amounts not specified, and
allege that the defendant banks, including ANZ, violated US anti-trust
laws, anti-racketeering laws, the Commodity Exchange Act, and unjust
enrichment principles. ANZ is defending the proceedings. The action is at
an early stage.
Regulator investigations into foreign exchange trading
Since 2014, each of ASIC and the Australian Competition and Consumer
Commission (ACCC) have been investigating foreign exchange trading
conduct of various banks including ANZ. ASIC’s and the ACCC’s
investigations are ongoing and the range of potential outcomes include
civil penalties and other actions under the relevant legislation.
Other regulatory reviews
In recent years there have been significant increases in the nature and
scale of regulatory investigations and reviews, enforcement actions
(whether by court action or otherwise) and the quantum of fines issued by
regulators, particularly against financial institutions both in Australia and
globally. The nature of these investigations and reviews can be wide
ranging and, for example, currently include a range of matters including
responsible lending practices, wealth advice and product suitability,
conduct in financial markets and capital market transactions. During the
year, ANZ has received various notices and requests for information from
its regulators as part of both industry-wide and ANZspecific reviews. The
outcomes and total costs associated with such reviews remain uncertain.

Remuneration policies
• Organisations – particularly larger organisations – often include several pages of
information about how senior managers in an organisation are paid and remunerated.
• This is a corporation’s law requirement within many countries.

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• Managers in organisations typically receive bonuses (referred to commonly as

‘performance-based rewards’ or ‘at risk rewards’).
– That is, it is virtually never the case that senior managers simply receive a ‘fixed
salary’.
• Such bonuses could be linked to various performance indicators.
• Some performance indicators might be linked to financial accounting numbers.
– For example, the senior manager might receive a bonus, which is a specific
percentage of profits, return on assets, or sales.
• The bonus could also be linked to various measures of social and environmental
performance.
– For example senior managers might receive a bonus if there are no instances of non-
compliance with environmental laws or if there are no instances of work place
injuries.
• The central idea behind such bonuses is that they motivate certain behaviours.
– The assumption being that managers prefer higher pay.
• The disclosures about bonuses inform the reader/analyst about certain priorities of the
organisation and what types of performance the organisation appears particularly intent
on improving.
• The information 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 publicly promoted a view that environmental
sustainability is as important as being profitable but we find, within the notes, that the
remuneration plans only link rewards to measures of financial performance (and not
social and environmental performance) then we would rightly question the
statements being made by the organisation and we might question whether the
organisation is actually operating in a socially responsible manner.

There would appear to be a ‘decoupling’ between their ‘public face’ and their actual
behaviour. – and that would be a reason for concern. What else can we also not
believe?
– If an organisation is rewarding its managers in terms of yearly accounting profits, and
nothing else, then this might motivate them to be short term in focus which creates
various risks for the organisation and its stakeholders. Its also something the
financial statement auditors would want to be aware of.
– So, knowing about how managers are being paid is important in assessing the
direction an organisation might be going.

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Discussion
Qantas 2016 annual report
https://www.qantas.com/infodetail/about/corporateGovernance/2016Direc
torsReport.pdf
1. Review Qantas’ 2016 remuneration report provided within its
annual report on page 30-48. Discuss:
• If the managers are being rewarded with bonuses linked to
performance then what type of performance is the bonus being
linked to?
• As a reader of the report and with knowledge of the bonus
plans, what aspects of performance do you believe are being
encouraged?
• To what extent is social and environmental performance being
addressed by the bonus plans?
• Do you think enough weight is being place on social and
environmental performance?

2. Review Qantas’ 2016 financial report provided within its

annual report on page 51-104. Use the material provided so
far in this Module to make an assessment of:
• The financial performance of the organisation
• The efficiency of the organisation
• The solvency of the organisation
• Did the organisation have any significant events occurring after
the end of the reporting period?
• Are there any contingent liabilities that are of potential
concern? Why are they of concern?
If the organisation produces a ‘remuneration report’, what aspects of
performance are being included within the remuneration plans? Does the
way senior managers/executives are being paid create any concerns for
you? Why? (Hints: Link back to measurement of performance.)

Suggested Reading
Deegan & Islam 2012, Corporate Commitment to Sustainability–Is it All
Hot Air? An Australian Review of the Linkage between Executive Pay
and Sustainable Performance, Australian Accounting Review 22 (4),
pp384-397.

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Let’s move to different ‘accounts’

• The discussion in this Module has so far been directed towards financial accounting –
which reports information about the financial performance and position of an organisation
as calculated using the financial accounting rules and conventions in place at that point
in time.
• We will now turn our attention to analysing external reports, which address important
issues to do with the social and environmental performance of organisations.

Analysis of social and environmental

(sustainability) reports
• As we would probably appreciate by now, the practice of financial reporting is highly
regulated particularly as it relates to medium sized and large organisations. Financial
reporting requirements are included with accounting standards, corporation law, and
securities exchange requirements.
• By contrast, and as explained in Module 4, the preparation of publicly available social
and environmental (sustainability) reports is predominantly unregulated. This means
managers have many choices about what to disclose, how to disclose, and where to
disclose. This means there is much variability in reporting practice.
• As such, and given the voluntary nature of the reporting, when reviewing a sustainability
report it is important to firstly try to understand:
– Why management has prepared the report (motivation)?
– Why they have decided to disclose the particular social and environmental
information that they have disclosed?
– What stakeholders does it seem to be directed towards?
• There are many social and environmental impacts that could be discussed so it is
important to a report user that they understand why particular information has been
selected for disclosure.
• Also, why were particular reporting frameworks adopted?
– For example, if the organisation has used the GRI Framework has it used the
framework objectively, or has it decided only to disclose those items within the
Framework which project a favourable image of the organisation
• Again, it needs to be remembered that such considerations are not generally relevant
when reviewing financial disclosures as most of the disclosures are mandated –
management does not have a choice in respect of many aspects of financial
performance and disclosure. However they do for social and environmental disclosures.
• When analysing a sustainability report it is also important for the reader to understand
the context of the organisation. For example:

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– Where is the organisation located and what are the significant environmental aspects
of the location?
– What are the significant social implications of its operations on employees?
– What are the significant social implications of its operation on customers?
• Once we have some background information about the organisation, and the social and
environmental risks and opportunities associated with its operations, we are then in a
better position to determine whether the report addresses our information needs. In
many instances we might need to look beyond the organisation’s reports and review
other publicly available information.

Reflection
1. Assume you were set the task of reviewing the social and
environmental disclosures made by Crown Resorts Ltd – an
organisation that runs various gambling venues.
a. What aspects of performance would you be particularly
interested in and expect to find in a report prepared by the
organisation?
b. Would your interest be the same as other stakeholders (for
example, investors, anti-gambling campaigners, government,
employees, and local communities)?
c. What would your thoughts be if the information you expected
was not disclosed?
Its 2016 Corporate Social Responsibility Report can be found at:
http://www.crownresorts.com.au/CrownResorts/files/34/34c3a60d-6c86-
4733-9f48-7840199f2d0a.pdf

2. Assume that you were also set the task of reviewing the
social and environmental disclosures of British American
Tobacco Australia.
a. Can a producer of tobacco products ever really be considered
to be “socially responsible”?
b. Can it be a sustainable organisation?
c. Should it actually produce a sustainability report?
d. Why would it produce a sustainability report?
e. What items of information would you be particularly interested
in? (Of course, the answers to these questions are very much
a matter of personal opinion).
Its Sustainable Focus Report 2016 can be found at:
http://www.bata.com.au/group/sites/bat_9rnflh.nsf/vwPagesWebLive/DO9
RNMLG/$FILE/medMDADJ5Y4.pdf?openelement

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Further considerations
Why is the report being prepared?
• Because of the predominantly voluntary nature of public social and environmental
reporting many accounting researchers have considered the question of ‘why
organisations voluntarily report?’
• A lot of the research has shown that social and environmental disclosure has tended to:
– Highlight positive aspects of an organisation’s social and environmental
performance whilst downplaying negative aspects
– be particularly responsive to ‘legitimacy threatening’ events
– For example, if an organisation is linked to a particular social or environmental
crisis/catastrophe then it has been common to find firms responding by making
disclosures which highlight positive aspects of their performance as well as
highlighting the introduction of governance policies which will address such
crises in the future.
– be used as means for managing ‘powerful’ stakeholders whilst neglecting the
information needs of less powerful stakeholders.
– For example, if an organisation is particularly dependent on certain customers
then managers will typically ensure that the organisation is reporting the
information such stakeholders want/need.
– Therefore, evidence clearly seems to show that we need to be careful when
reviewing such voluntarily prepared reports.
– We need to place the report within the context of the events occurring around that
point in time and also within the context of changing stakeholder expectations.
– The evidence to date suggests that much social and environmental disclosure
appears to be motivated by profitability and survival considerations rather than being
reflective of management accepting an accountability for their social and
environmental performance.
– Hence we must not be naïve and necessarily believe/trust everything we read!

The organisation context

• As already emphasised, to understand whether an organisation is ‘performing well’ from
a social or environmental perspective we need to know something about the
environment in which it is operating within.
• That is, we need to be able to understand the social and environmental context of an
organisation before we can give meaning to many social and environmental metrics
being disclosed.
• A well prepared social and environmental report will be clear about the context of the
organisation. Interested stakeholders must also undertake their own research to
understand organisational context and associated risks.

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• For example, management should be very clear about issues such as :

– Is the organisation operating within an area of important bio-diversity?
– If so, why is it important? What are the particular risks that the organisation
creates by being there? How are these being managed? A good report should
explain such things.
– Is the organisation operating within an area that is close to, or above,
important water catchments/water tables?
– An organisation should be clear about where it is located and what risks it
creates to the environment from being there. If it is near important aquifers then
a reader/reviewer of the report should want to know what efforts are being made
to ensure that important water sources are not being contaminated.
– Related to the above point, is the organisation operating in an area with
minimal water?
– Organisations often provide information about their water use, and water saving
measures, without placing it within context. So why is the information there? If
the organisation is operating in very high rainfall areas, is this information
relevant? If it is operating in low water environments, then it might be very
important (consider the case of Coke as described in Module 4). Again, as a
reader of a report, we need to be able to place context on measures such as
water usage. Managers need to be clear about why they are, or are not,
providing information about water consumption.
– Is the organisation operating in an industry with many unskilled, ‘low power’
employees?
– If so, is their health and safety being properly attended to and being accounted
for?
– Is the organisation operating within a carbon intensive industry?
– As described in Module 4, Climate change is a major risk confronting the planet.
Organisations with high carbon emissions arguably should be accountable for
this, however, if emissions are very small we might question the relative
importance of disclosure (again, because organisations have many social and
environmental impacts some prioritisation is necessary).
– Further, with various initiatives being implemented around the world, carbon
intensive manufacturers will be at higher risk in turns of being a ‘going concern’ –
so we need to know what they are doing to address the issue.
– Is the organisation operating in a dangerous industry?
– Some industries – for example mining and construction – are more dangerous
than others. For such organisations it might be particularly important to note
relevant governance practices as they pertain to health and safety. An absence
of relevant disclosures might indicate that the organisation does not accept an
accountability for ensuring safe work practices.
– Is the organisation sourcing or making products in countries known to have
poor labour practices?

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– Creates many issues in terms of accountability for workers within the supply
chain. An absence of disclosures indicates a lack of accountability for people in
the supply chain. As recent experience has indicated (eg Rana Plaza) that poor
accountability can lead to high levels of criticism of an organisation – and
potentially large scale consumer boycotts with direct implications for profitability.
– Does the organisation source animal-based products from different countries?
– Different countries have different standards for animal treatment. If we know an
organisation is sourcing animal products from different countries, and if we are
concerned about the welfare of animals, then we should review the report to see
what information, if any, is provided. Failure to be accountable for proper
treatment of animals (whilst simply being morally wrong) also exposes the
organisation to many risks.

Web Resources
This article shoes how animals have been treated in China.
http://www.peta.org/issues/animals-used-for-clothing/fur/chinese-fur-
industry/

Reflection
Can you understand the social or environmental context of Puma (which
is necessary in order to ‘make sense’ of the various social and
environmental disclosures being made)?
Review Puma’s 2010 Environmental Profit and Loss Account, and discuss
• If they provide information about water use then why is that
important in that context? Do they tell us?
• If they are providing information about particular emissions, do
they explain why that is important?
• Does it report on its supply chain? What does it report?
• Do you think it provides an ‘objective’ perspective of the
organisation’s social and environmental performance? Why?
• What are the implications of providing/not providing an
objective account of the organisation’s social and
environmental performance?
Puma’s 2010 Environmental Profit and Loss Account can be found at
http://about.puma.com/damfiles/default/sustainability/environment/e-p-
l/EPL080212final-3cdfc1bdca0821c6ec1cf4b89935bb5f.pdf

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Independent review
• We will conclude this module with a brief discussion of independent (third party)
reviews/audits of external reports.
• This discussion applies to all reports prepared by managers – both financial reports as
well as social and environmental reports.
• Earlier we said that we need to be careful not to believe everything we read, particularly
where the information is being prepared voluntarily.
– We need to have a healthy dose of scepticism.
• As a general principle, if reports are prepared by management then there will perhaps be
incentives, at times, for them to be less than objective when preparing the reports.
– Why might they be less than objective?
– Remember the idea of ‘creative accounting’ discussed earlier wherein managers
might use various accounting techniques so as to project the best picture of the
organisation.
– An independent expert review of a report will tend to add credibility and ‘value’ to
the report.
– Because it acts to reduce the risks of external stakeholders when assessing
such things as whether to invest in the organisation, loan to the organisation, or
sell on credit to the organisation it is actually in the organisation’s interest to pay
for the third party review.
• So something to consider when reviewing the reports produced by organisations is:
– Who prepared the financial reports or the social and environmental reports
(typically managers, but for some reports it might also be a public relations
organisation)? and
– Who reviewed/audited them?
• When reviewing an external audit/assurance report there are a few questions we should
consider before considering whether we might rely upon the independent third party
opinion, including:
– What is the purpose of the third party review? For example, was it to check
conformity with particular standards? Was it for the whole report or part thereof?
– Who is the intended audience of the assurance report?
– Against what standards was the audit/assurance undertaken and what form of
testing/risk assessment was undertaken?
– Who did the audit? What is their reputation? What are their relevant
qualifications?
– Did it provide a clear unambiguous opinion about the report?
• If the opinion provided was that the reports were poorly prepared perhaps breaching
particular standards and guidelines then we might actually be wasting our time reviewing
them. Again, garbage in, garbage out!

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• If the independent review was performed by individuals who have no clear expertise then
its value would be questionable.
• We now provide some examples of independent third party reviews/audits. One from a
financial statement audit and one from a sustainability report.

Example
Examples of independent reviews of reports

BHP Independent auditors report to the 2016 BHP Annual Report

http://www.bhpbilliton.com/-/media/bhp/documents/investors/annual-
reports/2016/bhpbillitonannualreport2016_interactive.pdf
(See page 220)

Independent assurance report to the 2016 BHP Sustainability Report

http://www.bhpbilliton.com/-/media/bhp/documents/investors/annual-
reports/2016/bhpbillitonsustainabilityreport2016.pdf
(See page 64)

Concluding comments
• We have now concluded our final topic and we hope you have enjoyed this course, as
well as having various prior beliefs about accounting challenged!
• Hopefully your understanding of ‘accounting’ has grown significantly.
• You would now understand that ‘accounts’ can take many forms and can address
various aspects or organisational activities.
• We can also now appreciate that ‘accounting’ seems to be everywhere and the practice
of ‘accounting’ can – perhaps surprisingly – be extremely interesting and thought
provoking.
• We all make choices about what to consume, what resources to use when producing
items, where to work, who to support, where to invest, and so forth.
• Information is central to many of these decisions and information – accounting
information (!) – provides us with power to make informed decisions.
• Because ‘accountants’ generate much of the information that is used to make important
decisions with various social and environmental impacts then accountants are indeed
very powerful people!! Indeed, arguably accountants are amongst the most powerful
people within all of society. Who knew?!

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Case Study

DC Surf Co.
Download Video:
https://smoovivideov1.s3.amazonaws.com/11fce144-8af0-e234_7452.mp4

Background
De and Claire studied a business course together 5 year ago. De majored in
Marketing and Claire majored in International Business. They met through
the University Surfing Club.
De works full-time as a marketing Assistant for a major retailer. On the
weekends he shapes surfboards in his shed. It started out as a hobby but he
has now started selling his boards in a few local surf shops. Claire works
part-time for a graphic design firm. She also designs her own t-shirts and
sells them online. She currently ships her t-shirts to 7 different countries
throughout South East Asia as well as the US.
De and Claire surf together a couple of times a month and often talk about
starting a business together. Finally, they have decided to take the plunge
and have set up ‘DC Surf Co’ with the vision of supplying high quality surfing
equipment and apparel. They have decided to start small but have plans to
grow quickly. For now, they are operating from a small home office in De’s
lounge room.
De and Claire decided to set up their business as a partnership. They
employed De’s neighbour Johnny on a part-time basis to assist with setting
up the website and other administrative tasks so that De and Claire can
focus on growing the business. De already had a relationship with a few of
the local surf shops and they have agreed to stock the full range of DC Surf
Co boards and apparel. They have also started selling their goods online
through their website. They have made a few bulk purchases of materials
(fibreglass, cotton, fabric) and are storing these in De’s lounge room. They
realise that they are quickly running out of space and expect to either rent or
purchase commercial premises within the next 6 months.
De and Claire considered restructuring the business from a partnership to a
company. They initially set up the business as a partnership because it
seemed to be the easiest and least expensive option but they then wondered
if perhaps they made the decision in haste and should have researched
business structures more thoroughly before making their choice. After further
consideration, they restructured the partnership into a company.

A large surfboard manufacturer has recently received negative media

attention for importing their surfboards into Australia from China where the
workers are subject to unsafe working and poor wage conditions. DC Surf
Co have noticed that a lot of potential customers are now enquiring as to
how and where DC Surf Co makes their boards. De is still manufacturing his

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boards locally and has now employed one experienced staff member and
one trainee to assist him. Prior to the recent media attention, no-one really
asked about the origins of the boards and De has never made an effort to
voluntarily provide this information.
De decided to label his locally made boards with a sticker which says
“designed and made locally in Australia”. Since promoting his boards as
locally made, De has noticed a significant increase in sales but is finding that
most of this extra money is being used to purchase materials and pay staff
wages. De isn’t sure how well the business is performing and how he should
best go about improving the performance of the business. He came across
this article about how to make a living as a surfboard maker and has decided
that he and Claire should develop a business plan for their business. De also
thinks that they should hire an accountant to assist them in their business but
Claire isn’t convinced that this is necessary and is worried about the extra
cost. They decide on a compromise which is to advertise a position for a
part-time accountant to work in the business 2-3 days per week.
Congratulations, you got the job!
With your help De and Claire have prepared and implemented a business
plan which they hope will increase sales, reduce costs and help their
business to perform better overall. Their vision is to become an emerging
leader in the surfing industry with a reputation for high quality products and
great service. It has now been six months since the plan was put into place
and from De and Claire’s perspective, the business seems to be going well.
DC Surf Co’s surfboards are currently stocked by 22 different surf shops. In
order to keep up with the demand, De and Claire have hired an additional
two trainees and one experienced staff member to assist with the surfboard
manufacturing. A great deal of time has gone into training the new trainees
and while they were learning they made some mistakes in the manufacturing
process that were not detected until the boards were purchased and used by
customers. In total, out of 192 board produced, 16 boards were returned to
DC Surf Co. The business replaced 12 of these boards and issued refunds
for the remaining 4 boards. DC Surf Co. retained the faulty boards so that
the current and any future trainees could use these boards to practice their
board shaping skills.
The apparel line is also growing. The business produces t-shirt which are
also stocked by the 22 surf-shops and are sold online both in Australia and
overseas. A celebrity was recently photographed in one of the t-shirts and
since then the t-shirts sales have tripled and the business has temporarily
sold out of some of the most popular styles and has been unable to fulfil
some customer orders. Whilst customer reviews on Facebook initially spiked
at 4.8 stars, since running out of stock, some customers have become
frustrated and their current rating has decreased to 4.1.
In order to leverage from the popularity of their t-shirts, De is keen to add
board shorts to their apparel line. Claire is not convinced that this is a good
idea and is concerned that board shorts are a very seasonal item and that
people do not buy shorts all year round. T-shirts on the other hand are
purchased by customers even during the winter time to wear underneath
warmer clothing. Before taking a risk on the new board short line, De and

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Claire want to have a clear understanding of how the business is currently

performing.
With your help De and Claire make the decision to proceed with the board
short line and it is a huge success. It is now 3 years on and the business
now stocks a full range of both men’s and women’s apparel including
hoodies, tracksuit pants and hats. They have also decided to expand their
line into beach towels which they will manufacture themselves.
After preparing an analysing a number of budgets, De and Claire discovered
that they would be unable to continue growing at such a rapid rate without
obtaining the additional funds necessary to expand. They considered
borrowing funds from the bank but did not feel comfortable taking on such a
substantial amount of debt. Instead, they decide to list DC Surf Co on the
Australian Stock Exchange. They are now a publicly listed company and
have raised several million dollars through the initial public offering (IPO) in
order to further expand the business.
During the month of April 2017 they DC Surf Co experienced the following
transactions and events:

3 April 2017 DC Surf Co paid staff wages of $13,000

5 April 2017 DC Surf Co purchased $18,000 of materials to

manufacture their beach towels. Payment is not due for
14 days.

7 April 2017 Johnny resigned from DC Surf Co in order to take up a

new job opportunity in Canada. His final day will be 21
April 2017. Due to operating efficiencies, De and Claire
decided that they will not need to replace Johnny and
so expect to save $36,000 in wages per year.

13 April 2017 DC Surf Co made a large sale worth $85,000 to a new

retailer who has agreed to stock their entire range. This
new customer is required to make payment in 14 days.

19 April 2017 DC Surf Co makes the payment of $18,000 related to

the materials purchase on 5 April 2017.

19 April 2017 De discovers that the one of the surfboard shapers has
been incorrectly disposing of potentially hazardous
waste. The employee has been storing the waste
behind an old shed and after recent storms, much of
this waste has been washed into the nearby waterways
and estuaries.

24 April 2017 DC Surf Co was named in a damaging post on

Facebook and had to apply to Facebook to have the
review removed. On 26 April the post was removed.
During the period 24 April -26 April, 3 retailers
contacted DC Surf Co to advise that they will not

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purchase any further goods from the company. These

lost future sales are estimated to total $100,000 per
year.

26 April 2017 DC Surf Co is temporarily running low on cash and

takes out a small bank loan of $30,000 in order to pay
the warehouse rent for the month.

26 April 2017 Claire decides to switch cotton suppliers after learning

that the offshore supplier they had been using was not
providing safe working conditions for staff. It has been
reported that 3 cotton-pickers died from heat
exhaustion in the past 4 weeks.

27 April 2017 DC Surf Co receives the $85,000 from the sale made
on 13 April 2017. They use $30,000 of this money in
order to pay back their bank loan.

De and Claire have decided to purchase new equipment that will allow them
to manufacture surfboards more efficiently and with fewer faults. The
equipment cost $180,000 with a further $15,000 of installation costs. It was
fully installed and ready to use on 1 July 2017. The useful life of the
equipment is 10 years with a residual value of $25,000.
It is now the end of the 2017 financial year and after a number of years
working for DC Surf Co you have been promoted to a senior accounting role.
Well done! You have been very busy supervising Megan the assistant
accountant to prepare the 2017 financial statements and have also been
busy assisting De and Claire to understand and improve their cash flow.
The 2017 financial statements are almost ready to be released to the public.
De and Claire are considering what other information they might provide to
the public regarding the operations and performance of DC Surf Co. As part
of this process they have reviewed the annual reports and websites of their
key competitors and have noticed that many of these organisations have
reported information in relation to their social and environmental
performance.

Additional Information:
De and Claire have been wanting to introduce wetsuits into their product line
for some time but have been reluctant to do so as there is a lot of skill
involved in designing wetsuits and there are already a number of well
established brands on the market that DC Surf Co would struggle to compete
with. While reviewing the annual reports of other companies in the surfing
industry, De and Claire looked at the 2016 annual report of a company called
TJ Wetsuits Ltd. They had heard many good things about TJ branded
wetsuits and in fact, Claire has recently purchased one for herself and is very
impressed. De and Claire are now considering significantly investing in this
company with the view that one day they may wish to acquire it.

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They have asked you to keep an eye out for the release of the 2017 annual
report and once available they would you like you to analyse the profitability
and the efficiency of the business. They noticed in the 2016 financial reports
that the company was funded partly through bank loans and there were a
number of covenants associated these loans. They have asked you to look
into these also.
The 2017 annual report and the 2017 sustainability report have been
released. Extracts from the reports are included below. You have also
ascertained the following account balances from the 2015 annual report of
TJ Wetsuits Ltd:
• Inventory: $528,000
• Accounts Receivable: $791,000
• Total Equity: $3,929,000

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Income Statement
For the year ended 30 June 2017
2017 2016
$'000 $'000
Continuing Operations
Revenue from the sale of goods 11,245 8,650
Total operating revenue 11,245 8,650
Cost of goods sold (4,377) (3,979)
Gross profit 6,868 4,671
Depreciation (1,298) (865)
Employee benefits expenses (273) (260)
Lease expenses (234) (260)
Other expenses (571) (519)
Earnings before interest and tax 4,492 2,767
Interest expense (519) (519)
Profit before tax 3,973 2,248
Income tax expense (1,271) (674)
Profit for the period from continuing operations 2,702 1,574

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TJ Wetsuits Ltd
Statement of Financial Position
As at 30 June 2017
2017 2016
$'000 $'000
Current assets
Cash 2,990 304
Accounts receivable 913 507
Inventories 1,330 760
Total current assets 5,233 1,571
Non-current assets
Property, plant and equipment 5,016 3,344
Intangible assets 152 152
Total non-current assets 5,168 3,496
Total assets 10,401 5,067
Current liabilities
Accounts payable 221 245
Income tax payable 318 169
Accrued expenses 131 145
Total current liabilities 670 559
Non-current liabilities
Bank loans 1,590 636
Provisions 107 89
Total non-current liabilities 1,697 725
Total liabilities 2,367 1,284
Net assets 8,034 3,783
Equity
Share capital 1,135 946
Reserves 1,700 340
Retained earnings 5,199 2,497
Total Equity 8,034 3,783

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TJ Wetsuits Ltd
Statement of Cash Flows
For the year ended 30 June 2017
2017 2016
$'000 $'000
Cash Flows from Operating Activities
Receipts from customers 10,839 6,340
Payment to suppliers and employees (6,045) (3,872)
Interest paid (519) (493)
Income tax paid (1,122) (708)
Net cash provided by operating activities 3,153 1,760
Cash Flows from Investing Activities
Purchase of property, plant and equipment (1,610) (1,150)
Net cash used in operating activities (1,610) (6,135)
Cash Flows from Financing Activities
Proceeds from share issue 189 -
Proceeds from loan 954 4,681
Net cash used in financing activities 1,143 4,681
Net (decrease)/increase in cash 2,686 306
Cash at the beginning of the period 304 (2)
Cash at the end of the period 2,990 304

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TJ Wetsuits Ltd
Statement of Changes in Equity
For the year ended 30 June 2017
Share Reserves Retained Total
Capital Asset Revaluation General Earnings Equity
$'000 $'000 $'000 $'000 $'000
Balance at start of period 946 272 68 2,497 3,783
Comprehensive income for the year 4,062
Gain of revaluation - 1,360 - -
Profit for the period - - - 2,702
Issue of share capital 189 - - - 189
Balance at the end of the period 1,135 1,632 68 5,199 8,034

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Notes to the financial statements (extract)

Note 23: Change in accounting policy

During the year, the company changed its accounting policy with respect to the valuation of
property, plant and equipment. The company now applies the fair value method in order to
value such assets. Prior to this change in policy, the company measured these assets at
historical value (less accumulated depreciation).

The company believes that this new method is preferable as it more accurately reflects the
current market value of property, plant and equipment assets. The impact of this voluntary
change in accounting policy on the statement of financial position is an upward revaluation
of property, plant and equipment assets of $1.36 million thus increasing non-current assets,
total assets and net assets by this amount. A corresponding increase has been made to
equity via the company’s asset revaluation reserve.

Note 36: Debt restrictions

The bank loans of $1,590,000 are subject to the following conditions:

The company will not exceed a debt to equity ratio of 30%

The company will maintain an interest coverage ratio (calculated as earnings before
interest and taxes/interest expense) of no less than 3:1

If a breach of these conditions occurs, the lender may demand payment of all outstanding
debts due immediately. Should payment not be made within 5 business days, the lender
may commence legal action to recover the debt including exercising their right to take
physical possession of secured assets.

The loans are currently secured against property, plant and equipment.

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TJ Wetsuits Ltd

Sustainability Report

2017

Extracts from the sustainability report for the year ended 30 June 2017

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Sustainability at TJ Wetsuits Ltd

We understand that our customers expect more from us than just a great wetsuit. By
purchasing a TJ Wetsuit you are investing in the future of our sport. We are proud to invest
in social and environmental initiatives to help secure the sustainability of our business, our
industry and our planet.

Giving back to the community

TJ Wetsuits is a proud sponsor of the Australia wide KidSwim initiative which provide water
safety education to primary school children across Australia. In 2017, we donated over
$50,000 to this initiative which contributed to KidSwim being able to educate more than
$5,000 kids in over 100 schools in 2017.

Our Carbon Footprint

We aim to reduce our carbon footprint by 20% over
the 3 year period commencing 1 July 2017 and
ending 30 June 2020.

We aim to do this through greater use of efficient

technologies and renewable energy.

20%
REDUCTION TARGET
Reduce, re-use, recycle
 8.3 tonnes of shredded paper recycled and implemented paperless filing systems
 20% decrease in neoprene wastage with offcuts donated to charity to make pencil
cases
 6.2 tonnes of shipping materials recycled externally and reused within the
organisation
 Recycled 8kg of office equipment (mobile phones, computer accessories,
electricals etc.)

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Our playground – our responsibility

We take our responsibility for the ocean

seriously. We want to make sure that
future generations are able to enjoy our
oceans the way that we have. That is why
we support marine clean-up programs
around the Australian coastlines. In 2017,
with the help of our customers, we
donated a whopping

$100,000
to this important cause. We are incredibly
proud of this effort and would like to give
our customers a high-five for their
awesomeness in achieving this goal.
Continuing to grow
At TJ Wetsuits we aim to continually grow and improve the way we do business.
This means improving the way we interact with customers, suppliers, communities
and the environment. It is important that we continue to identify ways to be more
sustainable in everything that we do. Not only does it make good business sense
but it helps secure the future of our industry, our sport and most importantly our
planet.

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References

References
Australian Accounting Standards Board, 2016, Framework for preparation
and presentation of financial statements, viewed on 22 March 2017
http://www.aasb.gov.au/admin/file/content105/c9/Framework_07-
04_COMPjun14_07-14.pdf

Australian Accounting Standards Board, 2015, Presentation of Financial

Statements, AASB 101, viewed on 22 March 2017
http://www.aasb.gov.au/admin/file/content105/c9/AASB101_07-15.pdf

ANZ Bank, 2016, ANZ Bank Annual Report 2016

BHP, 2016, BHP 2016 Annual Report

British American Tobacco Australia, 2016, British American Tobacco

Australia Sustainable Focus Report 2016

Commonwealth Bank, 2016, Commonwealth Bank Annual Report 2016

Crown Resorts, 2016, Crown Resorts Corporate Social Responsibility

Report

Deegan & Islam 2012, Corporate Commitment to Sustainability–Is it All

Hot Air? An Australian Review of the Linkage between Executive Pay and
Sustainable Performance, Australian Accounting Review 22 (4), pp384-
397.

Peta, 2017, Then Chinese Fur Industry, viewed on 1 May

<http://www.peta.org/issues/animals-used-for-clothing/fur/chinese-fur-
industry/>

Puma, 2010, Puma 2010 Environmental Profit and Loss Account

Qantas, 2016, Qantas Annual Report 2016

Wesfarmers 2016 annual report, 2016

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