2. The Limitations of Financial Accounting

2.1 The two cultures of accounting

Accountants run a close second to lawyers in terms of profession-related jokes. We carry the image of a humorless specialist with an eyeshade and bifocal lenses stooped over a dusty ledger. The private sector image of an accountant is of someone who does the unenviable task of preparing tax returns. The public sector image is of someone who wants to make sure that the last cent of money has been spent as appropriated, and that we returned our used ballpoint pens to the stationery store.

These images are hardly flattering to accountants, and they have been reinforced by the profession itself. The stereotype refers to only one aspect of accounting, however, and that is financial accounting. There is another branch known as management accounting, which is the main concern of this handbook.

Unfortunately the distinction between financial accounting and management accounting is not always made. To illustrate the distinction, we might start with two domestic applications of accounting - preparing a tax return and deciding on replacing a hot water system.

In preparing a tax return the task is to give an accurate account of our previous year's income, nett of allowable deductions. There are detailed rules and standards, which few ordinary citizens would know without reference to published tax guides or the services of a professional tax accountant. There is (or should be) no scope for creativity, and the finished return will be accurate down to the last dollar. That is a domestic example of financial accounting.

When our hot water system blows up, we have to make a decision. How will we replace it? Solar or electric? Solar has high upfront costs, but low operating costs. Electric is low cost to install, but its running costs are high. There are some "knowns" - the installation price of a solar system, the installation price of an electric system for example, but there are many unknowns - the future price of electricity, our future demand for hot water, the life of the panels. We must make a decision which will bind us in the future, with many information gaps. Even after careful deliberation we may make the wrong decision. When we sit down at the kitchen table (or home computer) and do our calculations we are practicing management accounting (although we probably do not use that term). In Chapter 4 we will see what techniques can be brought to bear on problems like this which involve a tradeoff between present outlays and future benefits.

The differences between the two disciplines of accounting are summarized in the table below.

2.2 Financial accounting - precise numbers

Every organization must have some level of financial control and accountability to its stakeholders. Financial accounting is about control and external accountability. It is governed by defined standards; in local government these standards are encapsulated in Australian Accounting Standard AAS 27 Financial Reporting by Local Governments, which, in turn refers to other accounting standards.

The intricacies of financial accounting are best understood by specialist accountants. This section is intended to give a brief introduction to financial accounting to make sure readers understand its assumptions and limitations.

True and accurate figures

Accountants and auditors often use the term "true and accurate" to describe financial statements. This term is much misunderstood. It means that a set of accounts has been prepared in accordance with accepted accounting standards. There has been no serious misappropriation or departure from conventions. It means we can be reasonably assured that two professional accountants working independently on the same set of figures will be guided by the same principles and should develop figures which are close to identical. It means that when we compare the accounts of the Leeton Shire Council and the Port Augusta City Council we can be reasonably confident that they have been prepared on the same basis, even if that basis includes some simplifying assumptions and distortions.

It does not mean, however, that they are unambiguously "accurate" in a managerial sense, for, as we will see, the concept of an "accurate" cost is, in itself, virtually meaningless in both a theoretical and practical sense, and it is almost impossible to place an "accurate" value on many important assets.

Sometimes financial accounting data can give information which is useful for management purposes, but very often it does not. Learning when it does and when it does not is crucial.

As a metaphor, consider Mercator's method of map projection. It is based on projecting, from the center of the planet, a line to a cylinder of paper wrapped around the planet and in contact only at the equator, like a tennis ball in a cylinder.

Mercator's projection gives tolerably good results in mid-latitudes. Its representation of Indonesia is reasonably close. Its representation of Australia is acceptable for a small area, although there are significant scale differences between Darwin and Hobart. Its representation of Greenland is very distorted, and if one is to navigate in polar regions then it is absolutely useless, for by definition it can never project the poles on to a map.

So too, with financial accounting. We need to know something of the concepts and conventions of financial accounting so we can know when it does and does not give useful information to support management decision-making.

2.3 The concepts and conventions of financial accounting

On the following pages are the main concepts and conventions of accounting. They are taken from private sector practice, but all are applicable, often with modification, to government financial accounting. These definitions are mainly from Anthony's text Essentials of Accounting,⁽¹⁾ and the definitions of conservatism and materiality are taken from Horngren and Sumdem Introduction to Management Accounting⁽²⁾. Similar definitions will be found in other texts.

Money Measurement Concept

Accounting records show only facts that can be expressed in monetary terms.

Many of the important aspects of an enterprise are very hard to measure at all, and even if they can be measured it is often hard to translate those measures to money terms. For example in the private sector it would be difficult to measure the ethical standards of the board and senior mangers. In the public sector it is very hard to measure the reputation of a school. It may be possible to measure its academic achievement, but it is not easy to translate to money terms. In private enterprise, when a company changes hands, there is often a component called goodwill, which is the difference between the purchase price of an enterprise and the tangible value of the assets purchased. For example, a restaurant may have only a few physical assets, but will have an excellent reputation with its customers, and this is reflected in the selling price when the restaurant changes hands. Because public sector entities very rarely change hands, goodwill is very hard to measure or even to conceptualise in monetary terms. Even when there is privatization, such as with the sale of Telstra, there is difficulty because privatization is often accompanied by changes in the regulatory environment. For example, if Telstra were allowed to operate as a monopoly its shares would be worth much more than if it is subject to open slather competition.

Valuation of intangible assets, like goodwill, presents major problems. Banks are willing to lend against tangible assets like buildings, land and machinery, but are much more nervous about considering assets like intellectual property. When governments account to the public should they include goodwill? Perhaps they should err on the side of caution and not try to include it. But when there is a re-organization, involving closure of a library or a swimming pool, or breaking up a functioning work team, should not governments be called to account for writing off an asset, which, even if hard to measure, is still real? The money measurement concept means that only the physical assets will be brought to account, but, as the cliché goes in many organization, "people are our greatest asset".

'Going Concern' and Cost Concepts

Accounting assumes that a business will continue indefinitely and is not about to be sold. Assets are normally entered on the accounting records at the price paid to acquire them.

This means, in fact, that accurate asset valuation is not very important; what is important is to have an unambiguous and objective base of valuation. The most objective source of values of assets is their purchase price. These assets will then be depreciated at standard rates. The alternative concept, not usually accepted in the preparation of financial statements, is that assets are recorded on an immediate liquidation value, that is, what we could get in an immediate sale. In essence that's an opportunity cost basis of valuation. (We cover the opportunity cost concept in Chapter 3.)

Neither concept is entirely satisfactory. In times of even moderate inflation the purchase price of assets rapidly becomes meaningless. Assets subject to rapid technological change can lose value rapidly. What is the value of a 486 computer for which you paid $5 000 five years ago?

In the public sector these problems are compounded because of the long life of certain assets and their often specialized functions. The cost concept yields absurd figures when we apply it to an asset like the Trans Australia Railroad, completed in 1917. So too does the immediate liquidation concept. Who wants a railroad? How do we establish a market price when there hasn't been a railroad sold in recent history? For a less commercial asset, like a collection of archives, the problem is even more marked. For buildings and land, market valuation is often dependent on zoning regulations. In Canberra the old hospital on Acton Peninsula, a peninsula jutting into Lake Burley Griffin, was closed in 1992. The site was zoned for use as health care. It would be worth much more if it were zoned as commercial, for example, and those who follow the debates about betterment tax in the ACT will be familiar with the way in which governments can create or destroy land value through regulation. The opportunity cost of assets is very hard to measure. John Mikesell talks about the problems of valuing St Michael's Church, a 12th century church on the outskirts of London where a new airport was planned.⁽³⁾

In fact heritage assets such as St Michael's Church or an aboriginal bora ground present special problems. To the community they may be very valuable, to the government entity, responsible with a specific function, they may not be worth much at all. Sydney's General Post Office obviously has heritage value, but, being designed in a different era, it is not particularly suitable for mail handling. Lofty ceilings make heating and air conditioning expensive, confined access at the rear of the building makes it difficult to handle fork lift trucks. Many local governments have magnificent old buildings which are functionally difficult to use. One possible approach to heritage assets is to use deprival value; that is, what would the entity lose if deprived of this asset? A heritage lighthouse, for example, could be replaced functionally by a light on a steel pole; the cost of such a hypothetical structure would represent the deprival value.

Another possible basis of valuation is to use replacement cost. The problem is that after the lapse of any time it is unlikely that a similar asset would be installed in place of the existing one. A 1995 Sydney Harbor Bridge would be very different from the 1932 bridge; a single Canberra hospital would be constructed more centrally than Woden. It would be very costly for government agencies to obtain continuous updates on the cost of replacing their assets.

Accrual Concept

Income (or earning) is measured as the difference between revenue and expense rather than the difference between cash receipts and disbursements.

This leads to a consideration of the difference between the accrual concepts of revenue and expense and the cash concepts of receipts and disbursements. Revenue and expense are defined in accounting texts as transactions which change the owners' equity. For example, a farmer sells 50 cattle off her farm for $300 each; these had been valued in the books at $20 each. Her recorded expense in this transaction is $1 000 (= 50 x 20), her revenue is $15 000, and her income is therefore $14 000. She does not write a check for $1 000, however. Neither does she necessarily get a check for $15 000; that may simply be credited to an account with a firm of stock and station agents, but it is still counted as revenue.

We can accrue expenses without any cash outlay in the short term. Our staff accrue long service leave entitlements, and that should be carried in our books as an expense and an unfunded liability. Similarly we can accrue revenue without any immediate cash receipt; a purchaser may take 30 days to pay, for example.

Another way to think of accrual is in terms of economists' concepts of value-added as the difference between resources used and resources produced. It's an attempt to align accounting with economics.

The most contentious accrual concept is depreciation. When we buy an asset it is not immediately used up, but we draw down on its value over its lifetime. Depreciation is an accrued expense, but without any cash outlay. It is nearly impossible to determine how quickly we 'use' an asset; that is why we usually use standard depreciation rates.

To illustrate some of the difficulties in using standard depreciation rates, consider a works area which takes very good care of its vehicles. A utility is bought for $25 000, and is depreciated for three years at 20 percent straight line, so that its book value is $10 000 at the end of that period. But the vehicle, having been kept in good condition, is sold for $13 000. The $3 000 difference between the book value is known as a profit on disposal of an asset. In many instances it will be credited to consolidated revenue. The works area which has "used" only $12 000 of this vehicle, will have been debited with $15 000 of vehicle use.

Accrual accounting may involve more transactions than cash accounting, but one approach to accrual accounting often used in small agencies is to use cash accounting throughout the year, but to present accrual statements for external reporting. This is known as accrual reporting, or modified accrual accounting. An agency with few or regular transactions may simply keep its books on a cash basis - an expense is written into the accounts when a check is written and a revenue is written into the accounts when money is received. Throughout the year there are no accounts payable or accounts receivable in the agency's books. Only at the end of the financial year are these accrual-based accounts brought into temporary existence, for the sake of presenting a balance sheet and an income statement. The advantage is that each transaction requires only one pair of ledger entries, rather than two pairs which are used in full accrual. The disadvantage is that it is hard to keep track of accruals if there are many transactions - for example there is no ongoing trace of accounts receivable. But if there are few transactions this does not matter. Most farmers use modified accrual accounting; they have no difficulty in remembering who owes them money!

Realization Concept

Revenue is recognized at the time it is realized.

This sounds almost tautological, but it relates to the accrual concept, and the 'real' transaction that takes place, such as the delivery of the good or performance of the service, rather than the payment of the account. Similarly for expenses; they are recognized once they are incurred, not when we get around to paying the bill.

Two other concepts used particularly in the public sector are those of commitment and obligation. If, in June council appropriates funds to paint a building for $100 000, then that is a commitment. In January of the following year it may sign a contract to paint the building for $100 000. That is an obligation (conditional on the work being completed), but is not at that stage an expense. The painter completes the job in March. At that stage an expense is incurred, which is offset against a liability to pay the account (accounts payable). The painter is paid in May, at which stage there is a cash outlay, and the liability is erased. The forward estimate process is an attempt to encapsulate commitments in projections, and to overcome the bureaucratic convention of wedging (incurring a small outlay now but with escalating commitments down the track - see the section on sunk costs in the next Chapter). The commitment process can also be used to tie up funds as a deliberate means of limiting flexibility.

Conservatism Convention

The conservatism convention means selecting the method of measurement that yields the gloomiest immediate results.

Horngren and Sumdem elaborate on this convention "Anticipate no gains, but provide for all possible losses, and if in doubt, write it off." Anthony refers to recording an event at a value such that the owners' equity is lower than it would be under any other basis of recording.

This can clash with the cost concept, and there are debates over which should be the overriding concept. Should we record our 486 computer at cost less depreciation, or should we write it off and record it as an extraordinary loss?

In the private sector, application of the conservatism convention can lead to undervaluation of corporate assets, thus leading to low corporate valuation, low share prices and the threat of takeover.

In the public sector the problems are more to do with accountability. Should the City of Tinned Dog adopt the conservatism convention, reporting the airport at Tinned Dog to be worth only $100 000, which was the price of land and buildings in 1952? If so, is it misleading the community by understating the value of assets under its control and reporting a high rate of return? What is a reasonable benchmark for a return on the Tinned Dog airport? There is a good public policy argument that the Tinned Dog airport should be valued at least at its opportunity cost.

Materiality Convention

An item is material if it is sufficiently large that its omission or mis-statement would tend to mislead the user of the financial statements under consideration.

Accountants often quote their favorite Latin phrase: De minimus ne curat lax - "Of trivia the law cares not". This is not an excuse to dip into the petty cash, but it does justify a degree of what would otherwise be called 'misappropriation'. For example, under the accrual and realization conventions, if we buy $90 worth of postage stamps, these should be treated as inventory, and should become an expense only as we use them. Thus the purchase would see a credit to cash of $90, and a balancing debit to inventory of $90. Each time we use a stamp we should credit inventory with 45 cents, and debit postage with 45 cents.

In fact any sensible accounting system simply treats the whole purchase of stamps as an expense, with one pair of ledger entries.

The public sector often applies tougher standards of materiality than the private sector. Many agencies apply the concept of "attractiveness and portability" to decide whether items should be entered on an asset register. A $50 coffee percolator may be "attractive and portable", a $500 collection of legal texts may fail on both tests. Even items which have been fully depreciated should be maintained on an asset register.

While the public sector may have tight rules on materiality, it does not always have rigid controls on program expenditure; program misappropriation is still easy in many agencies, especially of administrative costs which are not appropriated by program.

Application of these concepts and conventions results in the data in financial accounting systems and the data in consolidated reports having little connection with reality.

Those who place too much faith in the accuracy of financial accounting would do well to consider how the private sector values public companies. Consider, for example, a firm such as Coca Cola Amatil, for which a balance sheet is shown below.

Given that the balance sheet, prepared in accordance with Australian accounting standards, recorded equity of $2 677 million, and that there were 546 million issued shares, then the balance sheet valuation of shares was $4.90. In fact in early 1996 the market price of shares in Coca Cola Amatil was around $15.00.

Where does the difference lie? Generally not in liabilities, which are records of amounts owing to creditors. And generally not in current assets, which record cash and amounts owing from debtors. Of course there can be bad debts, foreign exchange losses and gains etc, but these aren't going to affect these values greatly. The difference lies in the valuation of non-current assets, many of which are not even recorded on the balance sheet, or are recorded at nominal amounts. For example the market rights to the Coke brand in the Czech Republic and Indonesia are not recorded on the balance sheet of Coca-Cola Amatil. The goodwill the firm has in the reputation of its product, does not appear as an "asset".

Coca Cola Amatil is not an isolated example. It would be coincidental if the owners of a firm accepted balance sheet valuation. Some other examples of the spread between balance sheet and market valuation are shown below.

In theory the market value of a share is determined by investors' perception of the firm's future earnings. In financial terms it is the net present value of the future earnings of the company (a concept which we'll re-visit in Chapter 4.)

2.4 Management accounting - complexity and uncertainty

If financial accounting cannot be relied on to give us information useful for supporting decision-making (such as whether to buy Coca Cola Amatil shares), where can we get useful information?

The bad news is that such information is never available "off the shelf". You can go to a software supplier and buy many good financial accounting packages, but you cannot go out and buy a package to handle management accounting. Unfortunately there has been something of an oversell of financial accounting, at the expense of management accounting. There have been missionaries claiming that they have found the "perfect" system, and that a more finely tuned accrual accounting system will provide "true and accurate" data. It doesn't.

Management accounting requires the exercise of judgement, gathering whatever data is available from a variety of sources, using whatever tools of analysis fit the situation under consideration, and, above, all accepting ambiguity. If someone says "It costs us $2.18 to collect each domestic rubbish bin", treat that advice with the same degree of skepticism that you may treat a forecast that earth will be wiped out on 22 September 2003. If someone says "It costs between $1.50 and $2.50 per bin, depending on our assumptions ...." then that is useful advice. You may be able to refine the range of estimates with more research but there will come a point when you have to make a judgement based on limited information.

A pen and paper, a computer spreadsheet, some mental arithmetic, experience and a capacity to use informed judgement are the basic tools of management accounting. We will, however, illustrate some techniques and concepts under the headings of costing, pricing and investment analysis. These are covered in the following three Chapters.

Exercises

1. Australian Accounting Standard AAS 27 requires local governments to value assets. How might the relevant local government go about valuing the following assets?

a road to a new subdivision

a busy road passing through the main street

the Shehan Bridge at Gundagai - a 110 year old wooden heritage structure, now by-passed by a more modern bridge

George Street, Sydney

a dam which is surplus to immediate requirements

a garbage truck

a rubbish tip

a vacant lot in prime location but with toxic chemical contamination

a commercial pine plantation

a grove of shady trees in a park

an explorer's grave blocking a proposed road widening

a public lavatory which has been taken over by drug dealers

a 100 year old sewer pipe

a railroad once owned by the state government, handed over to the local government for $1, now used for recreational steam train rides.

works of art in the local gallery by an artist who has gone out of fashion, and others by an artist who has become more famous?

2. For the above assets, how would the relevant local government go about establishing measures of depreciation?

3. In light of your responses to (1) and (2), what information is conveyed by a local government balance sheet and financial ratios such as the return on assets?

Notes

1. Robert N Anthony Essentials of Accounting (Addison Wesley - Various editions 1963 to 1997).

2. Charles Horngren and Gary Sumdem Introduction to Management Accounting (Prentice Hall 1990).

3. John Mikesell Fiscal Administration - Analysis and Applications for the Public Sector (Brooks/Cole 1991).

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