ACC00712: Reflective Journal - Prudence in Caltex Company - Assessment Answer

Reflective Journal Assignment

Assignment Task

You should select a company listed on the Australian Stock Exchange (ASX) and find a copy of 2014/2015 or 2015/2016 annual report of the chosen company.

According to Australian Conceptual Framework Paragraph 37 (2009 version), it states:

‘Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.’

You need to answers following questions:

1. You are required to discuss and evaluate the concept of Prudence.
2. Explain why Prudence is very important in financial reporting.
3. Give TWO (2) examples when Prudence is applied in the annual report of the chosen company. Discuss how Prudence is applied. ).
4. Using the examples you discussed in part c) explore the implications of Prudence for financial statements in future financial year.

The quality of the essay will be assessed based on the following four areas:

1. Demonstrate and identify the accounting concepts and principles applied clearly.
2. Provide examples from the annual report of a chosen company to illustrate the implementation of the concept.
3. Use paragraphs from the Australian Conceptual Framework as a guideline to support your discussion. You may need to use other references as well.
4. Demonstrate effective communication, logical presentation and integrated evaluation.

The escalating number of corporate scandals and the need to uphold the corporate social responsibility to company stakeholders has pushed firms to encourage a culture of moral and ethical practices. Ethics as a risk management strategy continues to remain widespread among accounting departments in organizations. The primary application of accounting ethics is through the standards set by the accounting boards which set a blueprint for companies to base their principles and estimates. There are different accounting standards and principals, but the value of prudent accounting is mostly prioritized my most of the companies. According to Corlos et.al (2010), mark prudence is the ability to uphold practical wisdom in accounting practices which facilitate in making sound judgments concerning the business entity. The preparation of accounting statements requires that companies make the soundest decisions and judgment concerning the value of their assets and liabilities to give the real financial position of the firm and protect stakeholder’s interests. Such misrepresentation is common in a competitive business world whereby ethics are termed as a luxury. Companies want to be viewed as more profitable than they are so as to improve their public image thus enhancing their competitive position. According to Corlos (2010), the principle ensures that incomes and value of assets are not overstated and that the liabilities and expenses are not understated. The Australian stock exchange issued instructions to all companies stating that they must include their accounting standards and principles in their accounting reports so as to control unhealthy competition and also promote ethics in business.

Importance of prudence in financial reporting

According to Dang (2011), the Australian stock exchange recommends that all companies apply the practice of prudence in accounting as it facilitates accountability and sustainability of business finances. Operating or governing a business is always about the cognitive capabilities of an individual and how well they can analyze a situation and make a decision based on critical judgment. According to Hlaciuc.et al. (2013), prudence is all about enhancing the ability of a manager of a member of staff to judge and make wise decisions that will improve productivity boosting the company’s performance. It allows managers to make decisions which enable the going concern of a company since it allows managers to think more about the future gain as opposed to the present gain. By making prudent decisions, the organization does not have to worry about the uncertainties which are brought about by the dynamic business environment (Manea, 2013). When teams are known to be open and honest, they may improve their value of goodwill which in turn enhances the quality of the business operations and thus improves a good public image. A good public image results in an excellent market position and also translates in ensuring more investors place their Prudence as a virtue in business which helps to avoid extreme and unhealthy competition which may be unethical and cause the company not to run in an efficient manner. If a company does not seek to falsify profits, then it means that they are more inclined towards supporting the welfare of stakeholders. Such acts promote trust to the management, and since management trust is an essential ingredient for motivation, it will mean better performance.

The Application of prudence in the accounting reports of the Caltex Company

The high known virtue of prudence helps in the recognition of revenues and also in the realization of expenses in their actual value to avoid overstating or understating any numbers. Caltex is an oil company in Australia whose stock is sold in the stock market in Australia. The company recorded an increase in plant, property, and equipment of 427 million dollars which was later offset by a depreciation value of 178 million dollars. Another separate 20 million was offset from the books of account due to the value of disposed assets. The purpose of Caltex Company accounting for depreciation is to avoid overstating the actual value of the property as compared to the benefit a firm receives from it. An asset loses value with time due to usage and obsoleteness. By deducting the lost value, this is known as upholding the matching concept which makes it possible for the company to match the real value of the asset with its depreciation expense (Nolan, 2005). The company uses the straight-line method of accounting for depreciation. Prudence is practiced at the Caltex Company in Australia and allows the accounting managers to make good decisions as to which way will bring out the best representation of the asset usage. The stakeholders of a company may observe the books and therefore be able to estimate the period which the company will purchase a new asset. By accounting for the depreciation, expense companies benefit from the fact that their taxable income has reduced, and this means a higher value of tax savings for the company

The Caltex Company allows for individual uncertainties like the allowance for doubtful debts. According to Manea (2013), the provision for doubtful debts reduces the number of accounts receivables represented on the balance sheet and ensures that future uncertainties are mitigated. This refers to an amount of money which is accounted for in the business as an expense so that in case some of the debtors don’t honour their debts; then it is possible for the company to absorb such risks more efficiently. The value of provision for doubtful debts for the year 2014 stood at 100 million and managers apply prudence to make right decisions of whether or not the rule is favourable for the business. This allowance is then adjusted to the value of accounts receivable so as to understate the asset value of receivables so as to mitigate adverse effects of lack of payments by debtors (Nolan, 2005). Some of the debtors have a history of not paying their debts while some of the debtors are declared bankrupt making it impossible for them to meet their credit obligations. The value of receivables is hard to quantify, and so some borrowers is achieved in the balance sheet of the company while a provision for doubtful debts is made in the income statement. The allowance for doubtful debts is made to ensure that the income is not overstated and that also the obligations which seem un-payable are considered avoiding a likely overstatement of assets and earnings. By including the allowance for doubtful debts in their books a company makes sure they don’t overstate the value of their property and also ensure that they provide the right information to commercial users. Investors will always want to check the provision of doubtful doubts so as to ensure a company is not likely to suffer liquidation.

Implications of prudence for financial statements in future

Caution is essential to ensure that the going concern of a group is protected making it easier for management and investment decision making. A company is likely to survive for the longest time possible if the company takes care of their expenses and observes the prudence concept. Some of the accounting standards in some countries do not support the virtue of prudence stating that it may also be a way of misinterpreting the profits of a company and thus prevent the business from growing. One of the typical implications of the prudence principle on the Caltex Company is that it reduces the uncertainties which occur from understating the value of revenues and understanding the outflows of cash to seem profitable. According to Nolan (2013), since prudence ensures that everything is represented in the most favourable amount, the users of financial information will be able to base their decisions on the available reports.

Some of the contenders who are against prudence application in financial reporting, usually state that recording assets when they are understated and overstating liabilities at another point, defeats the whole purpose of presenting an uncertainty-independent organization (Hlaciuc, 2013). The truth is that once the assets value and responsibility value are not exact, and then there is still some degree of uncertainty. If the manager is faced by optimal balance they may be tempted to use a little,

Again the assets and liabilities would not have any neutrality since the value of assets can be estimated at any value and that of liabilities at any value thus the implications are that in future, there may still be uncertainty which may have adverse effects on the company (Nolan, 2013). Once the investors and other stakeholders notice some difficulties, not only will they look for greener pastures but they will also cause a drastic fall in the prices of shares. There is no clear basis for how the prudent judgment should be made, and so some of the managers will affect the businesses in future by understating the value of depreciation by too far and overstating the value of assets leading to the wrong representation of the financial health of the company.