Chapter 3 Accounting

Overview of the chapter. This chapter introduces the reader to the basics of accounting and explores its relevance for the law and practice relating to closely held companies. The adviser can no longer understand or apply the law relating to closely held businesses without some knowledge of accounting and accounting practice. Accounting terminology figures in many rules of company law and is increasingly the preferred mode of expressing the tax law rules which, in many situations, drive the structure of corporate transactions. The chapter focuses on financial statements, some of the principal issues involved in their preparation and the relevance of these issues for business planning. The concepts and techniques presented in this chapter are used throughout the text, particularly in the analysis of the specific transactions provided in the examples. The chapter is recommended reading for students and practitioners without formal training in accounting. The most important lesson of the chapter is a general one: despite its use of numbers and numerical techniques, accounting is anything but an exact science.

What is accounting? Accounting is the application of standardised techniques for depicting, in financial terms, the activity and condition of business entities. To a large extent, accounting concerns the content and the preparation of three documents, called financial statements. These are the statement of financial position (the “balance sheet”), the statement of financial performance (the “income statement”), and the statement of cash flows. All three documents figure significantly in the law and practice concerning closely held companies. On the one hand, the financial statements provide the information for investment decisions by both creditors and shareholders. The principals of closely held companies are primarily concerned with objectives expressed in accounting terms, ie profit and loss and cash flow, rather than ones expressed in legal terminology. On the other hand, the financial statements or information from those statements figure in the company law rules governing capital maintenance and director accountability. As illustrated by teaching materials and accounting standards¹, accounting is a discipline in its own right and one of considerable complexity. However, the basic concepts and techniques can be comprehended without formal training.

The balance sheet

The statement of financial position – “balance sheet”. The balance sheet is a snap shot of the financial position of an entity at a given point in time. The entity is defined according to the informational needs of the user of the financial statement. The entity can be a person, a family, a political entity, a governmental department, a particular business owned by a person, a company, a division of a company, etc. The financial position is described by reference to the assets and liabilities of the entity. Assets refers to property that is owned by the entity and liabilities to debts owed by the entity. For example, consider the economic entity comprised of the Jones family comprised of the two spouses and their two children. On a given date, the one indicated at the top of the balance sheet, the familys assets and liabilities might be as follows:

Jones family Balance sheet 1.1.99

Assets Cash on hand 100 Cheque account balance 900 Savings account balance 1,000 Shares ABC Ltd 50,000 Vehicles 12,000 Other chattels 6,000 House 280,000 Total assets 350,000

Liabilities Credit cards 2,000 Vehicle hire purchase 7,000 Misc bills 1,000 House mortgage 250,000 Total liabilities 260,000

Net worth/Equity 90.000

The difference between assets and liabilities is called net worth or owner’s equity. It refers to the amount of funds which would be left to the Jones family if the assets were realised at the value shown on the balance sheet [their book value] and the liabilities were paid.

The fundamental accounting identity. The relationship between assets, liabilities and net worth or equity is called the fundamental accounting identity. It can be expressed in a number of ways:

(1) Assets = Liabilities +Equity

(2) Equity = Assets - Liabilities

(3) Liabilities = Assets - Equity

It is an identity in the sense that, at any given point in time, it always hold true. This is, intuitively, most apparent in the second expression of the identity. A person’s wealth is, at any given time, the difference between their assets and their liabilities. The first alternative can be viewed in terms of the source and destination of the accounting entity’s assets. By reference to their source, the acquisition of assets is funded either out of the entity’s own wealth (equity) or by borrowing. By reference to their destination, proceeds from the realisation of assets are, in the event of insolvency, distributed first to the lenders and then to the owners.

Another illustration. In the preceding example, one of the assets owned by the Jones family consisted of shares in ABC Ltd. Suppose ABC Ltd is the family’s wholly owned company, ie, all the shares are held by the two spouses. Assume that the company operates a small retail business. At any given time, the firm’s financial condition can also be described by a balance sheet. At the date of the family’s balance sheet, 1 January l999, the company’s balance sheet might appear as follows:

Balance Sheet ABC Ltd 1.1.99

Assets Cash on hand 5,000 Receivables 55,000 Trading stock 50,000 Equipment 40,000 Building 100,000 Total assets 250,000

Liabilities Overdraft 30,000 Trade creditors 50,000 Hire purchase 30,000 Mortgage 90,000 Total liabilities 200,000

Equity/shareholder funds 50,000

The company’s balance sheet has the same format as that for the Jones family. In the case of a company, it is usual practice to use the expression shareholder funds to refer to the net worth or equity. It designates the amount of funds which would be left to the shareholders if the assets of the firm were realised at their book value and the debts were paid. As such, it provides one possible measure for the value of the shares in the company. It is this value at which the shares in ABC Ltd appear in the family's balance sheet at the same date. There are other techniques for valuing shares. For instance, the shares in ABC Ltd could be also valued as the difference between the market value [as opposed to book value] of the company's assets and the amount of the company's liabilities. A share in a listed company is frequently valued at its quoted price. The capitalisation of a company's anticipated income or cash flows will also yield a figure for the value of the shares in the company. The valuation of shares and other assets is the subject of chapter XX.

Alternative formats for the balance sheet. Alternative formats are available for the balance sheet. The foregoing balance sheets for ABC Ltd and the Jones family employ a vertically presented subtractional format which reflects the second version of the accounting identity.

Assets xxx less Liabilities yyy Equity xxx

Another common format, which reflects the first version of the accounting identity, places assets on one side and liabilities and equity on the other. In this format the balance sheet of the company appears as follows:

In this format, North American practice puts the assets on the left side and liabilities and equity on the right side. In Commonwealth jurisdictions, the placement is often reversed. Another commonly used format collects and aggregates assets and liabilities according to whether they are current or long term.

Balance sheet ABC Ltd 1.1.99 Current assets Cash 5,000 Receivables 55,000 Trading stock 50,000 110,000 Less current liabilities Overdraft 30,000 Trade creditors 50,000 80,000 Net current assets 30,000 Term assets Equipment 40,000 Building 100,000 140,000 Less term liabilities Hire purchase 30,000 Mortgage 90,000 120,000 Net term assets 20,000 Equity Shares 50,000

In this layout, the fundamental accounting identity is not so obvious as in the other layouts On the other hand, the concatenation and netting of assets and liabilities makes apparent to the user information about the short term and long term position of the entity.

Three fundamental issues. Preparation of a balance sheet, whatever its format, involves three fundamental issues: selection of the entity, identification of assets and liabilities and quantification of the entries. In any situation, there will be a number of ways to deal with each of these issues. The content of the balance sheet will vary, sometimes quite dramatically, from one alternative treatment to the next. In many common situations, there can be a reasonable difference of opinion concerning which treatment is the most appropriate. In these cases, the resulting balance sheet is only one of several possible depictions of the entity’s financial condition and reflects the result of a judgment and/or negotiation respecting the most appropriate accounting procedure. The leeway possible in the resolution of these three issues significantly impedes the usefulness of the balance sheet for comparing the financial condition of different entities, a matter of considerable concern to investors.

Entity selection. The information contained in a balance sheet depends, as a threshold matter, on the selection of the entity. The first balance sheet takes the Jones family as the entity and the second one takes the family’s wholly owned company. A third possible balance sheet would be one for the economic unit comprised of the family and the company which would show the assets and liabilities of the family and the company in a single document. It should be noted that the company is a separate legal entity owning its assets and having sole legal responsibility for its debts. Selection of the entity is determined largely by the information needs of the user of the balance sheet. A potential investor in the family's business would be primarily interested in a balance sheet which takes the company as the relevant entity. The family’s balance sheet would be the more relevant one for a bank that was approached for a loan to finance the construction of an extension on the Jones’ residence. Neither balance sheet would be entirely appropriate for the bank which was considering a loan to Ms Jones for the purchase of shares on her own account. That bank would insist on a balance sheet which took Ms Jones as the relevant entity and showed the extent of her personal assets and liabilities.

Quantification of liabilities. The integrity of a balance sheet or other financial statement is only as good as the reliability of the figures. The techniques for quantifying asset entries are quite different from those used in respect of entries for liabilities and equity. Most liabilities represent amounts owing to creditors under contracts which spell out, often in great detail, the extent of the liability. This would be true for the liabilities which appear on the balance sheets for the Jones family and ABC Ltd. For example, the amount owned by ABC Ltd to trade creditors will be fixed by bilateral contacts which fix the price of the goods and services delivered by the creditors. In these cases, the amount of the liability will be fixed by the terms of the contract. It is generally an accurate figure to the extent that the contract is legally enforceable.

Contingent liabilities. Contingent liabilities are ones in respect of which there is uncertainty about the existence and/or amount of the debt. For instance, in respect of the Jones family and ABC Ltd, the following situations would give rise to contingent liabilities:

• A close friend of Mr Jones borrows $50,000 from XYZ Bank. Mr Jones guarantees the loan.

• ABC Ltd orders trading stock from Supplier Ltd. When the goods are delivered, Mr Jones finds that some of the items to be defective, returns them to the supplier and refuses to pay for them. The supplier insists that the goods are as specified and demands payment in full.

• Mr Jones instructs a towing company to remove X’s auto from the street outside the premises of ABC Ltd. During the removal operation, X’s vehicle suffers serious damage. Claiming that the vehicle was rightfully parked, X seeks compensation from Mr Jones, ABC Ltd and the towing company.

The liability in the first case is contingent in respect of amount, whilst the liability in the second and third situations is uncertain in respect of both existence and amount. Almost every business will have one or more contingent liabilities. For such businesses, the balance sheet figures for liabilities and net worth will depend significantly upon whether the contingent liabilities are taken into account and, if so, at what amount. Also Mr Jones’ claim to indemnification, which arises upon performance of the guarantee, is an example of a contingent asset. The operation of several key rules in the 1993 Act¹ depend critically upon the recognition and valuation of contingent assets and liabilities. The valuation problems are discussed in greater detail in chapter XX.

Quantification of asset value - the lower of historical cost or market value. In general, the quantification of assets is more problematic than the quantification of liabilities. As noted, liabilities can generally be quantified by reference to the bilateral contract between the entity and the creditor. Most assets can also be related to a bilateral contract, ie the contract of purchase under which the entity acquired the asset. There is a long tradition in accounting that assets should be carried on the books at the lower of their historical cost, ie purchase price, or their market value. There are two problems with this quantification standard. First, it understates the value of assets in times of inflation. For example, although the Joneses may have purchased their residence for $100,000 five years ago and still owe the bank $90,000 on the purchase money loan, the bank will be happy to lend another $20,000 against the house if the identical house next door just sold for $150,000. The second problem concerns the determination of market value.

Market value - willing buyer/willing seller standard. It is accepted wisdom that the value of an asset is the price that a willing but not anxious buyer would pay a willing but not anxious seller in an arm’s length transaction. If such a transaction actually occurs, then the price fetched by the asset is, at the time of transaction, a reliable indicator of its value. However, the standard does not take us very far in respect to the problem faced by the preparer or user of a balance sheet. The reason why the entity’s assets appear on the balance sheet is that they have not been sold by the entity and converted into cash. In the absence of an actual transaction, the willing buyer/willing seller standard refers to a hypothetical transaction. To apply the standard, one must identify the components of the hypothetical transaction, particularly, the factors which the hypothetical participants will take into account when setting the offer price and asking price.

Price relevant factors. In respect to any given asset, there are usually a number of price relevant factors. This can be easily illustrated by considering two assets from the previous balance sheet, the Jones’ residence on the family’s balance sheet and the accounts receivable on the balance sheet of ABC Ltd. In setting the offer and asking prices of the home, the hypothetical buyer and seller would look at the seller’s cost of the property and any improvements, the time of purchase, the current government valuation, the recent sale prices of similar properties, and the potential rental value. The value of ABC Ltd’s receivables would be considered in view of the solvency of the debtors, the age of the receivables, the price paid for similar receivables and the likely cost of collecting the receivables. The value associated with some factors will not be open to question. For instance, there is only one government valuation of a particular parcel of real estate. However, there will be a range of values associated with other referents, eg the prices obtained in recent sales of similar properties. The value associated with one referent will seldom be the same as the value associated with another referent. For instance, the government valuation of a property will usually be higher or lower than the value associated with the property’s rental potential. Finally, where the values associated with different factors diverge, there is invariably room for disagreement about the weight to be attached to a particular factor in setting the figure eventually taken as the value of the asset on the balance sheet.

The business of asset valuation. During the last fifty years, asset valuation has become big business. As of November l999, there were around 1800 registered valuers in New Zealand who, in that year, had an estimated income of $105m from their services.² This attests to the role of financial statements in decision making, the significance of asset valuation for the accuracy of those financial statements, the complexity of asset valuation and the room for honest disagreement. Disputes over asset valuation regularly feature in the financial press and in litigation.³ Where there are reputable and skilled valuers on both sides of the dispute it is not unusual to find that the higher valuation is at least twice the lower valuation.⁴ Such is the leeway for uncertainty in relation to the valuation of most assets.

Asset valuation and the reliability of the balance sheet. The ambiguity about asset values obviously bears upon the integrity of the balance sheet. The user of a balance sheet should bear in mind that asset figures are inherently less reliable than liability figures. In relation to liabilities, the greatest area for uncertainty involves contingent liabilities. However, similar uncertainties arise in respect of contingent assets. In most cases, the user can assume that the figure associated with non-contingent liabilities designates the amount of funds that the entity must pay to discharge the debt. In contrast, it is only by accident that the figures associated with non-contingent assets would equal their realisation value. In most cases, it is probably safe to assume that the figure would overstate or understate the realisation value by at least 50%.² This fact must obviously be born in mind by anyone who uses the balance sheet as the basis for contracting with the entity, eg, as lender, credit supplier or equity investor.

Quantification of the equity entry. The equity entry on a balance sheet is quantified in a manner quite different from that used in relation to assets and liabilities. The quantification technique follows from the function served by the equity entry. As its primary function, the equity entry represents the difference between the assets and liabilities of the entity. .This is most obvious where the balance sheet is presented as a statement of net worth. The equity entry is the subtractional difference between the asset figure and the liability figure. Where assets exceed liabilities, the figure is positive and where assets are less than liabilities, the figure is negative. As a balancing entry, the equity figure carries forward the techniques used to quantify the assets and liabilities. The equity figure inherits all the uncertainties, ie associated with contingent liabilities and asset valuations, which detract from the reliability of asset and liability figures.

A common misconception concerning the equity entry. In most balance sheets, the equity segment is comprised of a number of entries which appear to have an independent existence and bear no obvious relation to the balancing function. For instance, it would not be surprising to find the shareholder funds portion of the balance sheet for ABC Ltd comprised as follows:⁵

Shares [100] $4,000 Retained earnings 16,000 Asset revaluation reserve 30,000 Total 50,000

In the case of larger companies, the equity segment of a balance sheet may be far more complex. There will be entries for multiple classes of shares, various reserve accounts, share premium accounts, etc.⁶ These accounts are frequently referred as capital accounts and the total of funds in this segment of the balance sheet as the capital of the company. When so used, the expression capital is often understood to designate an identifiable pool of assets. This misconceives the function and significance of the equity segment of the balance sheet. The assets of the entity are only those shown in the assets segment of the balance sheet. Neither the individual equity entries nor their sum refers to an asset of the company. The total of the equity entries refers to the amount of money which, if the assets were realised at their book value and the liabilities paid, would be left to the owners. The strictly residual nature of the entry is not altered by the fact that the equity segment is comprised of individual entries [in the instant case: three]. These entries refer, not to assets of the company, but to the source and form of the residual wealth attributable to the owners of the business. In the above example, if the assets were indeed realised at their book value and $50,000 distributed to the owners, $4,000 would be attributable to their original investment, ie, the price they paid for the shares, $16,000 would represent undistributed earnings; and $30,000 attributable to appreciation of fixed assets.

Recognition of assets and liabilities. The third fundamental issue involved in preparation of the balance sheet involves the recognition of assets and liabilities. In respect of the vast majority of assets and liabilities appearing on a balance sheet, there is no dispute about identification and recognition. There will, however, be instances where there is a question whether the rights and obligations which characterise the asset or liability are sufficiently ascertainable as to warrant recognition in the balance sheet. Examples of common contingent assets and liabilities were discussed in an earlier paragraph. Particularly significant for many companies is whether the balance sheet should reflect a liability entry for amounts eventually payable by the company under superannuation schemes.⁷ A problem also arises where the reporting entity exerts substantial control over an asset with something less than full ownership rights. For instance, the balance sheet of ABC Ltd shows asset and liability entries for equipment acquired under hire purchase. The company will not, as a matter of law, own the equipment until it makes payment in full and exercises the purchase option if any. Despite the lack of complete ownership rights, good accounting practice requires that the transaction be reflected in the balance sheet. However, the equipment would not appear on the balance sheet if the company had simply hired the equipment under an operating lease, ie, one from week to week, even if the lease continued for the same period as the hire purchase agreement and resulted in eventual acquisition of the equipment.⁸ In that event, both the asset and the liability would be off balance sheet. Recognition problems also arise in relation to intangible assets which are not the subject of fixed legal rights. The most common example is good will, ie, capitalised earning potential related to location or reputation.⁹

The income statement

The statement of financial performance – “income statement”. The balance sheet, as noted above, describes the financial condition of the reporting entity at a particular point in time. During the ensuing period—be it a week, month or year—the entity will engage in activity which alters its assets and liabilities. The balance sheet at the end of the period will be different from that at the beginning of the period. The statement of financial performance or, as it is more commonly known, the income statement relates the opening and closing balance sheet in that it explains some of the differences between the two balance sheets. Whereas the balance sheet describes the entity at a particular point in time, the income statement views the entity over a period of time. The period is usually a year, ie, the financial year of the entity. However, it is possible to compile an income statement for a day, week, month or any other period. For example, listed companies are required to publicise semi-annual financial statements.¹⁰ The statement of financial performance presents a tightly constrained view of the entity’s performance. As its alternative name indicates, performance is measured in terms of income. There are other, often more relevant measures of performance such as change in market share, turnover and cash flow.

Post balance date transactions. The construction of the statement of financial performance and the concept of accounting income can be illustrated by focusing on the effect of individual transactions upon the entity’s balance sheet. Assume that the following balance sheet describes the financial position of ABC Ltd at the beginning of the financial year.

Now consider the impact of four transactions during the period 1 January to 8 January 1999:

Transaction 1: Acquisition of new trading stock. The company purchases 100 units of trading stock at a price of $40 per unit and pays cash for the goods on delivery.

As the accounting identity must hold true before and after this transaction, the preceding balance sheet no longer accurately describes the condition of the company following the acquisition of the trading stock. The transaction reduces cash by $4,000, the amount paid for the trading stock. It increases trading stock by a corresponding amount. Immediately following the transaction, the company’s balance sheet will show cash at $6,000 and trading stock at $54,000.

The transaction changes the composition of the assets but leaves unchanged the total of assets, the company’s liability and its net worth.

Transaction 2: Purchase of equipment on credit. The company buys a new computer for $11,000. It makes a $1,000 cash payment and finances the balance on hire purchase.

This transaction will have three consequences for the balance sheet. The purchase results in the acquisition of a new asset [computer] which will be booked at its acquisition price of $11,000. The cash deposit reduces the entry for cash by $1,000. The balance owing on the hire purchase increases the company’s hire purchase liabilities by the amount of $10,000. These changes would result in the following balance sheet:

Like the purchase of trading stock, the acquisition of the computer changes the composition of the assets. However, it also increases the total assets and total liabilities by $10,000. This reflects the fact that $10,000 of the $11,000 acquisition price was financed by additional borrowing. Had the vendor taken shares for the balance of the purchase price, the transaction would have resulted in the same increase in assets and an increase of $10,000 in the equity segment.

Debits and credits. The adjustments associated with a particular transaction are, in accounting terminology, called debits and credits. A debit refers to an increase in an asset account or a decrease in a liability or equity account. A credit refers to a decrease in an asset account or an increase in a liability or equity account. As so defined, the credits and debits associated with a particular transaction must always be equal if the fundamental accounting identity is to be maintained.

Income in the accounting sense The following transaction illustrates the concept of income in the accounting sense and demonstrates how this income emerges in the adjustments required to maintain the accounting identity.

Transaction 3: Sale of trading stock. The company sells for cash 200 units of trading stock for $100 per unit. The trading stock was carried on the books at its acquisition price of $40 per unit.

The transaction decreases trading stock by $8,000 and increases cash by $20,000. However, these two changes to the balance sheet do not maintain the accounting identity. They leave the company with an excess of $12,000 in assets over the sum of liabilities and equity. This excess represents profit on the transaction. If, following the transaction, the company was liquidated at book value, a total of $62,000 would be paid to the owners, ie, they would receive the profit on the transaction. Accordingly, the $12,000 difference is, as an adjustment to the balance sheet, accounted for by an increase in the equity account. Prior to transaction 3, that segment contains only the $50,000 entry for shares. The required adjustment could be effected by increasing the entry for shares from $50,000 to $62,000. This would be consistent with the fact that, if the company were liquidated at book value, the shareholders would receive $62,000 in respect of their shares. However, as a matter of convention in New Zealand and a matter of law in some other jurisdictions, shares must be carried on the balance sheet at their issue price. Accordingly, the offsetting entry for profit must be effected by an increase in some other account in the equity segment. The equity segment is expanded to include a line for earnings/losses. The sale of trading stock results in a $20,000 increase (debit) to cash, an $8,000 decrease (credit) in trading stock and a $12,000 increase (credit) in earnings. After the transaction, the company would have the following balance sheet:

This transaction demonstrates two other noteworthy points in addition to the emergence of income in the accounting sense. First, the appearance of the earnings entry illustrates the need for and significance of other components in the equity portion of the balance sheet. Secondly, taken together, the second and third transactions demonstrate how an increase in assets can be financed by either external credit or internally generated profits.

Expenses in the accounting sense. In terms of the accounting identity, depicted by the balance sheet, income is represented as an increase to the equity account. By similar reasoning, an expense in the accounting sense is represented by a decrease in the earnings segment of that account.

Transaction 4: Hire purchase instalment. The company makes a payment due under one of its hire purchase contracts. The amount of the payment is $4,000 comprised of $1,000 of interest and $3,000 reduction of the debt.

The payment reduces cash by $4,000 and the amount of hire purchase debt by $3,000. This leaves the accounting identity out of balance by $1,000, the amount of the interest component of the instalment. Were the company liquidated immediately after the transaction, the $1,000 interest payment would result in the owners receiving $1,000 less than otherwise. As its economic function, the payment is incurred in the production of income, ie, for the privilege of paying the price over a period of time rather than by cash upon delivery. As such, it is appropriately charged to the earnings line of the equity account. Such charges are characterised as expenses. The changes associated with the instalment result in the following balance sheet:

The payment results in a $4000 reduction in assets which is represented by a $3000 reduction in liabilities and a $1000 reduction in earnings.

The income statement. The income statement comprises a summary of the increases and decreases to the earnings line of the equity account during the period. If the four transactions were the only ones undertaken by ABC Ltd in the period, this would result in the following income statement:

Statement of change in financial position ABC Ltd 1 January to 8 January l999

Revenue sales $20,000 Less Cost of goods sold 8,000 Interest 1,000 Expenses 9,000 Income 11,000

Note how the income statement provides a partial link between the opening and closing balance sheets. It explains the increase in the shareholder funds account but not the changes in the entries for cash, trading stock or hire purchase liability. As true for the balance sheet, preparation of the income statement involves a number of specialised accounting techniques. In this basic survey of accounting practice, the two matters of singular importance are timing conventions and the distinction between incomings and revenue and outgoings and expenses.

Incomings and revenue; outgoings and expenses. Fundamental to preparation of the income statement are the distinctions between incomings and revenue on the one hand and between outgoings and expenses on the other.¹¹ For instance, in transaction 3 above, sale of the trading stock resulted in an incoming of $20,000 but in revenue of $12,000. Payment of the hire purchase instalment resulted in an outgoing of $4,000 but in an expense of $1,000. Whereas incomings and outgoings refer to changes in the asset cash, revenue and expenses refer to changes in the earnings line of the equity segment of the balance sheet. Most small businesses receive incomings from the sale of goods or services. Receipts from sales of services are booked in their entirety as revenue. Receipts from sales of goods are usually netted with the cost of goods sold and the difference is booked as revenue.¹² An inevitable but less common incoming comprises proceeds from financing transactions in the form of borrowings and issue of shares. These incomings do not result in revenue or income as they do not increase the net worth of the business. In terms of the fundamental accounting identity, they are taken to book by an increase to the asset cash and offsetting increase to a liability borrowings or to the issued shares line of the equity account. Common outgoings which give rise to an expense include wages, taxes, interest, and utilities. Outgoings not constituting an expense are those made in reduction of a liability or acquisition of an asset, neither of which increase the net worth of the entity. As noted, revenue and expenses are summarised by the income statement; incomings and outgoings are summarised by the cash flow statement discussed below.

Nature of outgoing/incoming as controlled by contract. As demonstrated by the examples, income in the accounting sense emerges from the process of charging incomings and outgoings to various accounts. There are two distinct aspects to this process. At the most elemental level, the process comprises a purely mechanical adjustment of the fundamental accounting identity. The second aspect, contained within the first, involves selection of the accounts to be credited and debited. This step determines whether an incoming or an outgoing impacts upon the income of the entity. The selection is determined, very largely, by the contractual relationship which occasions and comprises the basis for the incoming or outgoing. This is most clearly illustrated by the payment to the hire purchase vendor in transaction 4 above.. The contract and associated law determined that and the extent to which the outgoing was charged as interest [an expense] and reduction of principal [not an expense]. If the contractual relationship were one of lease only, the entire outgoing would be an expense.

Payments to principals of closely held companies. The role of contractual relationships for income accounting is particularly apparent and significant in the case of payments to principals of one person companies, by far the most common type of company registered in New Zealand. In addition to serving as the sole shareholder, the principal can arrange to be the company’s sole director, a full or part time employee, a lender to or borrower from the company, a landlord of the company, etc. Each of these relationships can serve as the basis for the outgoings required by the principal. In each case, the payment will result in a credit to the asset cash. The offsetting entry and its impact upon the company’s income statement will depend upon the underlying contractual relationship. The following table sets forth the possible offsetting entries and their impact on the income statement.

As illustrated by the table, the impact of the payment upon the company’s income varies with the character of the outgoing. All the payments result in a reduction in the asset cash. The payment will reduce the income of the company if it is characterised as interest, salary, director’s fee or rentals. However, it will have no impact on income if characterised as dividends, share repurchase, loan proceeds or loan repayment. As a loan repayment, it will reduce the liabilities of the company. As a dividend or proceeds of a share buy-back, it will reduce the equity segment of the balance sheet. As loan proceeds, it results in creation of a new asset or increase in an existing asset. The character of the payment and therewith the impact on income is determined according to which of the several contractual relationships the payment is attributed.

Company income within discretion of the principal. In most closely held companies, particularly one-person entities, payments from the company will comprise the main source of financial support for the principal and their family. The nature of the payments will depend upon the underlying contractual relationship. Although in law the principal and the company are separate entities, the principal will stand on both sides of any payment relationship. Accordingly, the principal has almost unlimited freedom to enter several legal relationships with the company, determine the terms of those legal relationships and then allocate a particular outgoing to one or more of the contracts. If the principal desires to receive the payment in the form of dividends, the principal will, in their capacity as director, resolve that the company shall pay a dividend of a specified amount. In many cases, the principal could instead elect to receive the payments in the form of salary, director’s fee, buyback proceeds, interest, or loan repayment. In view of the differential accounting treatment of these outgoings, control over the payment relationships places the bottom line of the income statement under the control of the principal. In addition to their differential impact upon the company’s income statement, the various payments have widely differing consequences under both company law and tax law. These ramifications are explored in later chapters.

Timing conventions. Whilst the income statement tracks activity over one fixed period, many of the processes which give rise to incomings and outgoings extend over two or more periods.

Example. ABC Ltd sells trading stock on credit. The contract for sale is concluded in week 1; the goods are delivered in week 2; the purchaser is billed in week 3; the bill calls for payment no later than the end of week 4; payment is finally received in week 5. The company’s accountant prepares weekly income statements for the board of directors.

The example raises the obvious question whether the income associated with the sale should be reported in the income statement for week 1 or in the income statement for a subsequent week. The same question can arise where, as is more common, the relevant reporting period is a year rather than a week. There will be a significant number of transactions which are concluded in one year and performed wholly or partially in a subsequent year. Similar timing issues also arise in respect of outgoings.

Example. The financial year of ABC Ltd runs from 1 April to 31 March. On 15 March, the company purchases trading stock for $20,000 and a new vehicle for $30,000. It is anticipated that the trading stock will be sold during the following financial year and that the vehicle will have a useful life of three years.

The company’s income for a particular period will be significantly affected by whether the outgoings are expensed in the year of acquisition or are expensed in one or more subsequent financial periods. Accounting practice recognises certain conventions which guide this determination. The conventions seek to ensure that the income statement accurately reflects economic performance for the period covered by the income statement.

Timing: the realisation convention. As a general rule, revenue is not taken to book in the absence of an enforceable legal transaction. This convention prevents an entity from reporting as income the appreciation in property such as corporate securities and real estate until the property is sold. The convention is opposed by investment companies which wish to include as income unrealised gains on their property holdings. In New Zealand, the convention has been relaxed by accounting standards which permit limited recognition of unrealised gains.¹³ This could be unacceptable accounting practice under the standards in other jurisdictions.¹⁴ By way of contrast, decreases in asset values can be booked as losses in the absence of a realisation transaction.

Timing: cash or accrual accounting. As illustrated by example XX, the realisation transaction may span several periods. In such cases, the timing problem is frequently dealt with by reference to the distinction between cash accounting and accrual accounting. A cash basis entity will book expense or revenue only in the period when it is paid or received. An accrual basis entity will book the items when all events have occurred which are necessary to fix both the fact and the amount of liability. In cash basis accounting, salary will be expensed when paid, ie, result in a credit to asset cash and debit to income. For an accrual basis entity, salary expenses would entail two sets of entries. When the salary obligation accrues, eg at the end of a week, this is reflected in a credit to liability salaries owing and a debit to income. Payment of the salary would entail a credit to asset cash and a debit to liability salaries owing. Whether an entity accounts on a cash basis or accrual basis, it can often control, eg through arrangements with the other party to the transaction, the period in which the expense or revenue is taken to book and therewith the amount of income reported in the period. Today, as required by both accepted accounting practice and tax law, mercantile enterprises must generally account on an accrual basis. Cash accounting is limited to households and certain service professions such as lawyers and doctors.¹⁵

Timing: prepaid expenses. The salary example typifies the common situation where the entity pays for services or goods after their receipt. Timing problems also arise where, as less frequently happens, payment is made before receipt of the services. For instance, under some loan agreements, all or part of the interest is paid at the outset, ie, deducted from the loan proceeds. Subscriptions to periodicals and club memberships are often paid in advance of receipt of the goods or services. Insurance premiums are generally paid at the beginning of the coverage period. In most instances, the performance period will not coincide with the accounting period.

Example. On 1 January 1999, ABC Ltd pays $6,000 to an insurance company for one calendar year’s insurance cover. ABC Ltd has a 1 April/31 March financial year.

If ABC Ltd accounts for the expense on a cash basis, the premium will be reflected as a $6,000 expense on the company’s 1998 income statement. Alternatively, the company can seek to match the expense with the coverage periods. In this event, at the time of payment, the company would credit asset cash by $6,000 and debit earnings:insurance premiums 1998 by $15,00, the prorata cost of cover for the three months remaining in the current [1998] financial year. The $4,500 difference would be debited to asset:prepaid insurance cover and appear as such on the balance sheet for the period ending 31 March 2000. The asset:prepaid insurance cover is then used up in the 1999 financial year, constituting an expense of $4,500.

Timing: acquisition of long lived assets. Up to this point, the discussion has involved goods and services whose contribution to income exhausts itself in the year of payment. In this situation, expensing the outgoing in the year of payment accurately reflects the relationship between the outgoing and the production of income. However, the production of income also employs assets, eg plant and equipment, whose lives extend over several reporting periods. Unless the costs of these assets can be absorbed as expenses, the income statements will overstate the entity’s performance. On the other hand, expensing these costs in the period of acquisition would result in an understatement of income in the year of acquisition and overstatement in successive years. Further, if the asset were expensed in the year of acquisition, the balance sheet would not reflect the asset’s continued existence or reflect it at only a zero value. There would be no problem if the period of the income statement coincided or exceeded the period over which the equipment or building contributed to production of income. However, in the case of a building this would require an income accounting period of fifty years or more, which far exceeds the life of the typical small business.

Depreciation and amortisation. These are the techniques used to expense the costs of assets which contribute to production of income over a period which is longer than the period covered by the income statement. Both techniques allocate the acquisition cost over the life of the asset.

Example. ABC Ltd purchases for $10,000 cash an item of equipment which has a life of ten years. The equipment makes the same contribution to income production for each of those years, declines in value at the rate of $1,000 per year and at the end of period will be worthless and can be replaced by a similar piece of equipment at the same price.

The contribution of the asset to the generation of income is accounted for by taking as an expense in the calculation of each year’s income a portion of the acquisition cost. Under the circumstances, it would be appropriate to prorate the cost over a ten year period. Acquisition of the asset would result in a decrease in asset:cash and an offsetting increase in asset:equipment. At the end of first year, the asset:equipment would be credited $1,000 and expense:depreciation debited in a like amount. The opening balance sheet for the second year would show the asset:equipment at a value of $9,000. In each of the following nine years, $1,000 of the acquisition cost would be taken as a depreciation expense in preparation of the income statement and a corresponding reduction made in the value of the asset in preparation of the balance sheet. Amortisation is the term used to describe similar proration techniques in respect of non tangible assets such as patents, trademarks or goodwill.

Proration factors. In any given case, the amount of the depreciation expense turns on four variables: the cost of the asset, the useful life, the residual value and the proration technique. The cost of the asset [$10,000 in the example] is fixed exogenously by the purchase transaction. The useful life [10 years] and residual value [zero] are estimates made in view of the circumstances and industry experience. The most straightforward proration technique, straight line depreciation, allocates an equal portion [$1,000 in the example] of the difference between acquisition cost and residual value to each of the years of useful life. Accounting practice and tax law also recognise the use of various accelerated proration techniques which allow a greater portion of the acquisition cost to be expensed in the earlier years of the asset’s life.¹⁶

Uncertainties in depreciation. The depreciation technique applied to the previous example is entirely appropriate in view of the assumed facts. However, the assumptions will not be realistic ones in most situations. There is no way to measure exactly the contribution of equipment or a fixed asset to the income stream of a business. The decline in value is equally uncertain. It can be measured only by successive valuations of the asset with all the uncertainties which, as described earlier, attend any valuation. It is also difficult to estimate accurately an asset’s useful life. Few assets are used until they have no value whatsoever. Buildings may appreciate in value even when subject to severe wear and tear and not properly maintained. In light of these uncertainties, there is in most cases considerable room for discretion in specifying both the useful life and residual value of the asset. Coupled with the choice of proration technique, this places the amount of the depreciation deduction, to a large extent, within the discretion of the reporting entity. It is probably fair to say that the highest defensible figure is generally two or three times the lowest defensible figure. Thus, in the case of a building acquired for $500,000, the depreciation expense would be $10,000 if computed on a straight line basis over 50 years, and $40,000 if computed on a double declining balance method over 25 years. There would be a corresponding variation in the bottom line of the income statement.

Extraordinary items. Every firm will experience non recurring events, the financial consequences of which cannot be sensibly absorbed into the income statement by proration techniques.

.Example After three years, ABC Ltd decides to replace the equipment described in example XX above. The equipment, which has a book value of $7,000, is sold for $9,000 or, alternatively, $5,000.

The disposition generates a profit of $2,000 at sale price of $9,000 and a book loss of $2,000 at sale price of $5,000. The profit or loss reflects that the variables used in computing the depreciation adjustment did not accurately track the changes in market value of the asset. While the profit or loss contributes to the firm’s income, it results from a one off transaction unrelated to the usual income producing activity of the firm. So that the firm’s income from its usual operations is not distorted, such transactions are reported separately on the income statement as an extraordinary profit or loss. The amount of the loss or profit will be a figure which results from netting all of the outgoings and incomings associated with the particular transaction, ie, expenses of the sale are netted against the proceeds rather than taken as an expense.

Non cash expenses and hidden reserves. Where an expense entails a cash outgoing equal to the amount of the expense, as in the case of wages or rentals, the expense reflects an actual diminution in the assets of the entity. This is not so in respect of non cash expenses, such as depreciation, which are not accompanied by a cash outlay. In such cases, the expense will reflect a diminution in the assets of the business only where the expense equals the decline the asset’s value. However, it is not unusual, particularly in times of inflation, for the amount booked for depreciation to exceed, sometimes far to exceed, the actual decline in value of the asset. In such situations, after a number of accounting periods, the balance sheet will significantly understate the market value of the company’s assets and therewith its net worth. The discrepancy is further aggravated by the realisation principle, discussed above, which prevents adjustments for systemic increases in asset values, eg, due to inflation or market changes. Such hidden reserves are a significant factor in takeovers and insider trading, even in the case of closely held companies.

Cash flow statement

The cash flow statement. Like the income statement, and in contrast to the balance sheet, the cash flow statement reflects activity over a period of time rather than the condition of the business at a particular time. The statement tracks the changes in asset:cash for the accounting period. For the accounting period covered by the four transactions described earlier, the cash flow statement would be as follows:

ABC Ltd Cash flow statement 1 Jan to 8 Jan 1999

Opening balance $10,000 Plus Incomings Sale of trading stock 20,000 Less outgoings Purchase trading stock 4,000 Purchase computer 1,000 Hire purchase loan 4,000 Closing balance 21,000

As we have seen, preparation of both the income statement and balance sheet involves a large number of discretionary if not arbitrary decisions concerning both the making of the entry and its amount. The information contained in the cash flow statement is more accurate in the sense there is less discretion involved in its preparation. For example, where an entity purchases goods or services towards the end of an accounting period, it may have the choice to pay the account in the current period or following one. But whatever it decides, there is no leeway as to whether and how the matter is presented in the cash flow statement.

Hard information not necessarily useful or reliable. The information contained in the cash flow statement, while marginally harder than that in the balance sheet or income statement, is neither particularly informative nor reliable. It reflects movements in only one asset, namely cash. For most companies that asset comprises less than XX% of the total assets. The statement aims to provide information on the liquidity of a business. A business can be highly profitable and have a healthy balance sheet but still be financially stressed if it does not have sufficient cash for daily needs. Many otherwise healthy businesses have collapsed for lack of cash.¹⁷ However, cash movements are only one measure, albeit an important one, or liquidity. Even small businesses have access to assets which, although they are not cash, resemble cash in the sense that they can be readily converted into cash. These assets include short term receivables, short term deposit accounts, certificates of deposit etc. Because the cash flow statement ignores changes in these assets it does not always provide a very accurate picture of the liquidity of a business.¹⁸ Further, insofar as an entity can, to a large degree, choose the mix of cash and near cash assets, the information presented by the cash flow statement lies within its control.

Relationship between the three financial statements. It is important to understand how the three financial statement complement each other. Standing alone, any one of the statements provides useful but limited information about an entity. For instance, a current balance sheet provides a prospective trade creditor with useful information, eg about the excess of assets over liabilities which will comprise the so called equity cushion for its claim against the business. Where the current assets and liabilities are segregated and netted, the balance sheet will also provide the creditor with information about the liquidity of the business and therewith its ability to pay debts in ordinary course. On the other hand, a single balance sheet says little about the profitability of the business, a matter also of concern to creditors and investors. Access to preceding balance sheets only partially fills this information gap. For example, identical opening and closing balance sheets would result where a company has done absolutely nothing during the period. They could also result where a company has been extremely profitable and distributed all the earnings to the shareholders. The income statement complements the opening and closing balance sheets by providing otherwise unavailable information about the performance of the business during the period. However, as the income statement is confined to transactions which impact upon the earnings line of equity account, its information value is also limited. It will not show net cash flows, financing transactions or management’s husbandry of liquid assets—all matters of considerable concern to certain investors. This information is provided by the cash flow statement.

Reliability of financial statements. The three financial statements are intended to provide information about different aspects of an entity’s finances. The balance sheet purports to be a snap shot of the entity’s financial state at particular time. The income statement and cash flow statement view different aspects of the entity’s activity over a period. The information would be reliable if it were determined solely or largely by the subject matter of the statements, ie, the rights and liabilities of the company in the case of the balance sheet and the economic activity of the entity in the case of the income statement. However, this is far from being the case, particularly in respect of the balance sheet and income statement. The entries in those statements reflect not only underlying economic transactions but the techniques for accounting for those transactions. The balance sheet entry for any given asset as well as the bottom line of the income statement typically reflect the result of half a dozen decisions by the preparer of the statement. In respect of any given decision, the preparer can choose from a range of values or different options. Accordingly, in respect of an entity and its performance for a particular period, there is a whole range of possible financial statements. As a result, the content of the financial statements lies largely within the control of the person who makes the various decisions.

Financial statements as under control of the board of directors. In a closely held company, financial statements are generally prepared by the same person or firm who is responsible for maintaining the accounting records of the company. This accountant is employed by the entity and, as such, must take orders from the board of directors which is responsible for management of the company. The accountant can recommend that certain practices be followed in relation to the many decisions which arise in preparation of the financial statements. For example, the accountant can recommend that a prepaid expense be prorated over several financial years, that a specific life and depreciation method be adopted in respect of a particular asset, or that a particular contingent liability be recognised and quantified at a particular amount. However, if the board directs otherwise, the accountant has no choice but to either comply with instruction or resign. In most cases, the board will accept the advice of the accountant. Without more, there is no way that a user of the financial statements can know whether the information was prepared in accordance with the advice of the accountant or the instructions of the board. Further, as an employee of the company, the accountant who prepares the financial statements has access only to that information provided by the board. Although the financial statements may look regular on their face, there is no way for the user to know whether they in fact reflect reality. For instance, the figure for trading stock on the balance sheet represents the difference between (i) the value of the trading stock at the beginning of the period plus inventory purchases during the period and (ii) value of the trading stock on hand at the end of the period. In respect of the figure for trading stock on the balance sheet, the user does not know whether the preparer actually sighted the purchase invoices and conducted inventories. In view of management’s obvious self interest in the content of the firm’s financial statements, its control over their preparation must surely detract from their reliability.

Financial statements as stale information. Preparation of financial statements requires decisions to be struck and services to be performed by a range of individuals. For instance, finalisation of an entry for trading stock on a balance sheet requires that an inventory be taken. The entry for accounts requires a decision about which accounts should be written off as bad debts. It may be necessary to get a current valuation on certain fixed assets. The existence and amount of contingent liabilities may require a legal opinion. Professionals must be engaged to perform these services. In the case of public issuers, eg listed companies, the financial statements cannot be released until they have been scrutinised by an auditor. All of these matters take time. For closely held companies, as permitted by statute, the annual financial statements (balance sheet and income statement) are generally not completed until towards the end of the nine-month period following the close of the financial year.¹⁹ This means that the most recent financial statement of such a company will, towards the end of the current financial year, be based on information which is up to 21 months old. This delay necessarily detracts from the value of the statements.

Regulation of accounting and accounting practice

Legislative regulation. In the last two decades, accounting practice and the use of accounting information has, increasingly, been the subject of legislative regulation. This reflects the commercial need for reliable financial information and the real or perceived opportunity for manipulation of financial statements by reporting entities. In relation to New Zealand companies, the relevant legislation is found largely in the Financial Reporting Act 1993, the Companies Act 1993 and the Securities Act 1978.

Differentiation of accounting entities. The extent and content of the regulation varies according to the entity involved. The Financial Reporting Act 1993 distinguishes between—

• an issuer, ie a person [any individual or entity] who offers securities to the public,

• an exempt company, ie one with no more than $450,000 in assets and annual turnover not more than $1m,

• a reporting entity, eg an issuer and a company other than an exempt one and

• an overseas company, ie one incorporated overseas but carrying on business in New Zealand.

Issuers and overseas companies are subject to a heavier degree of regulation than exempt companies. In many, but certainly not all cases, a closely held company will qualify as an exempt company. In view of the steady appreciation of real estate values, the asset threshold will be easily exceeded, particularly in the larger urban markets, by ownership of the business premises. However, a company can easily avoid triggering this condition. The business premises should be left titled in the name of the principal or trustee and then leased by the company.

Financial statements and accounting records required by law. Section 194 of the Companies Act l993 requires all companies registered under the statute to maintain certain accounting records, eg, records of assets and liabilities, monies paid and received, stock held at the end of the year etc. This requirement applies of course only to companies registered under the 1993 Act. However, companies as well as other persons conducting a business are subject to similar record keeping requirements under s 22 of the Tax Administration Act 1994. Whichever Act requires them, these records provide the information necessary for preparation of financial statements. Section 10 of the Financial Reporting Act l993 requires the directors of every reporting entity to ensure that, within five months after balance date, financial statements are prepared. Under s 208(2) of the 1993 Act, the board of an exempt company must within nine months of balance date prepare an annual report which, under s 211(1), must contain the financial statements. Reporting entities must prepare a statement of financial position, a statement of financial performance and, where required by an applicable financial reporting standard, a statement of cash flows. Only the first two financial statements are required in the case of an exempt company. The definition of reporting entity includes any company registered under the Companies Act 1993 (other than an exempt on) but does not include other business forms such as partnerships, trusts or sole proprietorships unless they qualify as an issuer, ie, offer securities to the public.

Content of financial statements. If the company is not an exempt one, the financial statements must, under s 11(1) of the Financial Reporting Act 1993, comply with generally accepted accounting practice. Under s 3, this requires compliance with applicable financial reporting standards released by the Financial Standards Accounting Board or, in the absence of such a standard, policies that are appropriate to the circumstances and enjoy authoritative support within the New Zealand accounting profession. As of December 1998, the Board had promulgated twenty standards dealing with, eg disclosure of accounting policies (FRS 1), accounting for construction contracts (FRS 14) and life insurance business (FRS 34). The primary source of practices not regulated by standards is found in the Statements of Standard Accounting Practice promulgated by the New Zealand Society of Accountants. The financial statements of exempt companies need not comply with generally accepted accounting practice. Section 12 requires only that they be in the form and contain such particulars as are prescribed by the regulations under the Act. The Securities Act 1978 imposes several specific requirements applicable only to the financial disclosures under that statute.²⁰.

Disclosure of the financial statements. Various statutes require that financial statements be disclosed to specific persons. Most significant for closely held companies is the requirement in ss 209 and 210 of the 1993 Act which requires that the financial statements be furnished to the shareholders of exempt companies not later that the tenth month from the balance date and to shareholders of non exempt companies not later than the sixth month from the balance date. The Securities Act l978 requires and regulates the disclosure of financial statements by those who offer securities to the public. Additional disclosure requirements are imposed upon listed companies by the rules of the New Zealand Stock Exchange.

The audit requirement. The financial statements of some entities are subject to an audit requirement. For instance, s 15 of the Financial Reporting Act 1993 requires that the directors of an issuer ensure that the issuer’s financial statements be audited. Under section 196 of the Companies Act 1993, an auditor must be appointed at the annual general meeting of any company subject to that Act unless all shareholders agree otherwise. The audit requirement is the primary mechanism used to guard against the risks associated with management’s control over the maintenance of accounting records and preparation of financial statements. The requirement seeks to ensure that financial statements reflect reality and comply with the accounting standards imposed by statute.

Qualifications of the auditor. Section 199 of the Companies Act 1993 sets forth the qualifications for an auditor which aim at insuring both competence and independence. For instance, the auditor must be a member of the New Zealand Society of Accountants or an officer of the Audit Department. The auditor must be independent of the audited entity. The auditor may not, for instance, be a director or employee of the company. Thus the accounting firm which performs the ongoing accounting services for a company may not also serve as auditor of the company’s financial statements.

Role of the auditor. It is the responsibility of the auditor to prepare a report on the entity’s financial statements. The content of the report is controlled, in most cases, by s 16 of the Financial Reporting Act 1993. The report addresses the various uncertainties otherwise associated with the financial statements The report must state, among other things, the scope and limitations of the audit, the existence of any relationship with the reporting entity, whether the auditor recovered the information that he or she has required, and whether proper accounting records have been kept. In the case of issuers, the report must also state whether the financial statements comply with generally accepted accounting practice and give a true and fair view of the matters to which they relate. In the case of exempt companies, the report must state whether the financial statements comply with the applicable regulations. The report must be distributed along with the financial statements.

Sanctions. Serious consequences attend the failure to comply with the accounting and reporting practices arising under these various statutes. In the main, the consequences are criminal ones. For instance, failure to complete the financial statements required by the Financial Reporting Act 1993 constitutes an offence by every director of the entity. The offending director is liable to a fine of up to $100,000 in the case of a reporting entity and up to $10,000 in the case of an exempt company.²¹ The failure to keep accounting records, to prepare an annual report or to send the report to the shareholders as required by the Companies Act 1993 amounts to an offence by every director of the board and is subject to a fine up to $10,000. The failure to keep accounting records also attracts civil liability. In the event of liquidation, the directors of the company can, under s 300, be held personally responsible for all or any part of the company’s debts. This is probably the most common ground for imposing personal liability on directors of closely held companies.²² Failure to keep accounting records as required by s 22 of the Tax Administration Act l994 constitutes an offence under s 199(1)(f) of the same statute, which is punishable under s 222(4) by a fine up to $25,000. Failure to make the financial disclosures required by the Securities Act 1978 also attracts both criminal and civil liability.³ Accountants and auditors face civil liability under the common law for negligence in the performance of their services.²³

Efficacy of regulation. The statutory requirement for maintenance of accounting records is defensible as a corollary of the limited liability nature of corporate entities. The requirement insures that management of such entities have access to the financial information needed for rational decisions. This operates to protect creditors who, due to the limited liability feature of the corporate form, will bear the brunt of bad business decisions. Whilst listed and large unlisted companies would likely keep accounting records in absence of a statutory requirement, the volume of reported litigation under s 300 of the Companies Act 1993 indicates that many closely held companies would not do so, probably in order to save costs. However, there is reason to doubt the efficacy other features of the statutory regime governing accounting practice as it relates to closely held companies. As compared with the requirement for maintenance of accounting records, the many rules governing preparation and dissemination of financial reports serve little useful purpose in relation to small closely held companies. These requirements aim to protect creditors and shareholders. However, most closely held companies have only one or two shareholders who, due their involvement in the business, have first hand knowledge of the financial condition of the company and have no need for the disclosure required by the statute. Nor are company creditors well served by the requirements. In practice, the financial statements are not finalised until nine months after balance date, by which time the information is far too stale to be reliable. The information required of exempt entities under the Financial Reporting Act is notional and not subject to generally accepted accounting standards. Also, the shareholders of closely held companies will usually agree under s 196(2) of the Companies Act 1993 that the financial statements need not be audited. The differential treatment of exempt companies under the Financial Reporting Act 1993 is also dubious as a matter of regulatory policy. To the extent that the Act aims at shareholder protection, the distinction based on asset value and turnover obviously do not differentiate accurately between situations where disclosure is required and those where it is redundant. Where a company has only a single shareholder, there is no reason to require the financial statements to comply with generally accepted accounting practice simply because the value of the assets is $500,000 rather than $400,000. Nor is the distinction sensible in view of creditor protection policy. Even though a company must, because of its turnover or asset value, comply with generally accepted accounting practice, the shareholders will usually opt out of the audit requirement. Accordingly, the application of generally accepted accounting practice only marginally increases the reliability of financial statements. It does not to overcome the problem of staleness.

Conclusion

Significance of accounting revisited. Accounting terminology and techniques are now firmly established as a fundamental component of the law and practice relating to closely held companies. This development reflects, at least in part, a drive for information and precision. Indeed, the public face of accounting practice comprises financial statements which, often abjuring the rounding of cents, appear as the very epitome of accuracy. The infusion of accounting terminology into company and tax law, often accompanied by flow charts and algebraic formulae, give an unmistakable impression of mechanical exactitude. However, it is the single most important lesson of this chapter that precision is largely if not completely illusory. Accounting terminology shares the same ambiguity as ordinary language. There is not a single number in a financial statements which does not reflect one or more significant value judgments on the part of the preparer of the statement. In most all instances, the preparer, in making the judgment, has recourse to two or more equally defensible options. As a consequence, the financial statements comprise one of several possible stories about the affairs of a business. Statutes couched in accounting terminology cannot be applied without confronting the same ambiguities and making the same value judgments.²⁴