Solutions Manual
to
accompany
Understanding Australian Accounting Standards
Janice Loftus, Ken Leo, Ruth Picker, Victoria Wise,
Kerry Clark
By Janice Loftus
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John Wiley & Sons
Australia, Ltd 2013
Chapter
1 – Accounting regulation and the Conceptual
Framework
Comprehension
questions
1. What are they key
sources of regulation in Australia for a listed company?
The key sources of regulation
for a listed company in Australia are:
Ÿ The
Corporations Act, which is administered by the Australian Securities and
Investments Commission
Ÿ Australian
Accounting Standards and the Conceptual
Framework, issued by the Australian Accounting Standards Board
Ÿ Australian
Securities Exchange Listing Rules.
2. Describe the standard-setting
process of the AASB.
Technical issues may be
identified sources within Australia, such as members or staff of the Australian
Accounting Standards Board or other stakeholders, or by international sources,
such as the International Accounting Standards Board. If an item is added to
the Board’s agenda, it may research the issue, consider solutions, and consult
with stakeholders. Then the AASB may proceed with the issue of exposure drafts,
invitations to comment, draft interpretations and discussion papers. For
standards intended for profit-seeking entities, the exposure drafts issued by
the AASB typically incorporate exposure drafts issued by the IASB, along with
Australian-specific matters for comment as applicable. The consultation process
may involve focus groups and roundtable discussions with stakeholders and
responses to exposure drafts. The AASB may also draw on project advisory panels
and interpretation advisory panels.
3. Distinguish between the
roles of the FRC and the AASB.
Both the FRC and the AASB are
involved in standard setting. The AASB is responsible for developing a
conceptual framework and issuing accounting standards. Another function of the
AASB is to participate in and contribute to the development of a global set of
accounting standards. The FRC’s role in standard setting is essentially a broad
oversight function; it oversees the processes for setting accounting standards.
The FRC’s oversight function also extends to the auditing standard setting
process, including monitoring the effectiveness of auditor independence
requirements in Australia.
4. How does the IASB
influence financial reporting in Australia?
One of the functions of the
AASB is to participate in and contribute to the development of a global set of
accounting standards, effectively, IFRS. The AASB may formulate an accounting
standard by issuing the text of an international accounting standard (s.
227(4)). In fact the issue of an accounting standard by the IASB would result
in a corresponding and consistent standard being issued by the AASB. The text
of the international accounting standard may be modified to the extent
necessary to take account of the Australian legal or institutional environment
and, in particular, to ensure that any disclosure and transparency provisions
in the standard are appropriate to the Australian legal or institutional
environment. This is often reflected in modifications to standards for
application by not-for-profit entities in Australia.
5. Explain the potential
benefits and problems that can result from the adoption of IFRSs in Australia.
The adoption of Australian
Accounting Standards that are equivalent of IFRSs may be viewed as implementing
development of a global set of accounting standards. It also reflects the view
that doing so is, on the whole, in the best interests of the Australian
economy. These benefits may manifest in reduce cost of capital and reduced
reporting costs for Australian companies that seek finance in global capital
markets. It also may make listing in Australian more attractive to
multinational corporations because Australian investors’ will have greater
understanding of financial statements prepared in accordance with IFRSs, to the
extent that multinationals report under IFRSs, which is increasing a requirement
or option in securities exchanges around the world.
6. What
is the difference between Australian Accounting Standards and IFRSs?
While IFRSs are developed for
application by profit-seeking entities, Australian Accounting Standards are
also applied by not-for-profit entities in the public and private sectors. Accordingly
Australian Accounting Standards may include additional or different
requirements or exemptions for not-for-profit entities. Australian Accounting
Standards also cover additional matters, such as disclosure requirements
(typically in a separate standard) on matters not covered by IFRSs.
7. Specify
the objectives of general purpose financial reporting, the nature of users, and
the information to be provided to users to achieve the objectives as provided
in the Conceptual Framework.
SAC 2 and the Conceptual Framework specify the
objectives of general purpose financial reporting as
being financial reports which are intended to meet the information needs
common to a range of users who are unable to command the preparation of reports
tailored to satisfy their own particular needs.
8. One
of the functions of the FRC is to ensure that the Australian Accounting
Standards are ‘in the best interests of both the private and public sectors in
the Australian economy’. How might they assess this?
The FRC is required under the
ASIC Act to promote the adoption international best practice, provided doing so
would be in the best interests of both the private and public sectors in the
Australian economy. The success of this mandate may be assessed by considering
the reduction in the cost of capital and reporting costs for Australian
companies that seek finance in global capital markets, the attractiveness to multinational
corporations of listing in Australia. Feedback obtained
via various stakeholder mechanisms may also be assessed. For example,
stakeholder groups represented on the FRC will be consulted regularly by the
FRC member they have nominated, and stakeholder views will be brought to FRC
meetings, as appropriate.
9. Discuss
the role of ASIC in interpreting accounting standards, particularly with the
assistance of the FRP.
In Australia, companies are required to comply with
the Corporations Act 2001. Section
296 of the Corporations Act requires that a financial report must comply with
accounting standards. ASIC has general administration of the Corporations Act
(s. 5B). As such, ASIC is required to administer the law effectively and
enforce and give effect to the law. This includes the investigation of suspected
breaches of the law and in so doing require people to produce books or answer
questions at an examination. This may include interpretation of the application
of accounting standards.
10. Outline
the fundamental qualitative characteristics of financial reporting information
to be included in general purpose financial statements.
The fundamental qualitative
characteristics of financial information are relevance and faithful
representation.
• it is capable of making a difference in the
decisions made by the capital providers as users of financial information
• it has predictive value, confirmatory value
or both. Predictive value occurs where the information is useful as an input
into the users’ decision models and affects their expectations about the
future. Confirmatory value arises where the information provides feedback that
confirms or changes past or present expectations based on previous evaluations.
• it is capable of making a difference whether
the users use it or not. It is not necessary that the information has actually
made a difference in the past or will make a difference in the future.
Ÿ complete. A
complete depiction includes all information necessary for a user to understand
the phenomenon being depicted, including all necessary descriptions and
explanations. (QC13)
Ÿ neutral A
neutral depiction is without bias in the selection or presentation of financial
information. (QC14)
Ÿ free from
error. Free from error means there are no errors or omissions in the
description of the phenomenon, and the process used to produce the reported
information has been selected and applied with no errors in the process. (QC15)
11. Discuss
the importance of the going concern assumption to the practice of accounting.
Financial statements are prepared under the
assumption that an entity will continue to operate in the foreseeable future.
This going concern assumption is important as it may be used to justify the use
of historical costs in accounting for liabilities and assets and, in the case
of non-current assets, for the systematic allocation of their costs to
depreciation expense over their useful lives. As such the assumption is made
that current market values of assets are sometimes of little importance. It
also ensures that the financial statements are not prepared on the basis of
expected liquidation or forced sale values.
12. Discuss
the essential characteristics of an asset as contained in the Conceptual Framework.
Discussion of essential
characteristics of asset:
Ÿ resource must
contain future economic benefits
Ÿ control,
requiring a capacity to benefit from the asset in the pursuit of the entity’s
objectives, and an ability to deny or regulate the access of others to those
benefits.
Ÿ past event,
giving rise to the entity’s control over future economic benefits.
Non-essential characteristics:
Ÿ purchased at a
cost
Ÿ tangibility
Ÿ exchangeability.
13. Discuss
the essential characteristics of a liability as described in the Conceptual Framework.
A liability is defined in the current Conceptual Framework as ‘a
present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources
embodying economic benefits’. Important aspects of this definition:
· A legal debt
constitutes a liability, but a liability is not restricted to being a legal
debt. Its essential characteristic is the existence of a present obligation,
being a duty or responsibility of the entity to act or perform in a certain
way. A present obligation may arise as a legal obligation and also as an
obligation imposed by custom or normal business practices (referred to as a
‘constructive’ obligation). For example, an entity may decide as a matter of
normal business policy to rectify faults in its products even after the warranty
period has expired. Hence, the amounts that are expected to be spent in respect
of goods already sold are liabilities.
· A present
obligation needs to be distinguished from a future commitment. A decision by
management to buy an asset in the future does not give rise to a present
obligation.
· A liability
must result in the giving up of resources embodying economic benefits, which
requires settlement in the future. The entity has little, if any, discretion in
avoiding this sacrifice. This settlement in the future may be required on
demand, at a specified date, or on the occurrence of a specified event.
· A liability is
must have resulted from a past event. For example, wages to be paid to staff
for work they will do in the future is not a liability as there is no past
event and no present obligation.
14. A
government gives a piece of land to a company at no charge. The company builds
a factory on the land and employs people at the factory to produce jam that is
sold in local and interstate markets. Considering the definition of income in
the Conceptual Framework, do you
think the receipt of the land is income to the company? Would your answer
depend on how the land is measured.
The fair value of the land
should be a direct credit to equity.
(a) Under the Conceptual Framework, income is defined as follows:
Income is increases in
economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in
equity, other than those relating to contributions from equity participants.
(b) Arguments for direct credit to
equity
Ÿ Those who
would argue that the government’s contribution of land to the company is not
income say that the government is not an equity participant in the business –
that is, the government does not own shares of stock and is not entitled to
dividends or other return on its contribution of the land.
Ÿ They also
argue that the grant is not earned in the same way as income from the sales of
goods and services is earned. Rather, it is simply an incentive provided by the
government without any related costs.
Ÿ Therefore the
land should be recognised as a direct credit to equity. It would be reported in
the statement of financial position as a capital contribution from government. Sometimes
this is described as ‘donated capital’.
(c) Arguments for income
recognition:
Ÿ On the other
hand, some accountants argue that it is income because the land is owned by the
company, that it increases the assets attributable to the shareholders of the
company, and that after the company meets its obligations to employ the
specified number of people for the specified period of time, the company can
sell the land and distribute the proceeds to shareholders.
Ÿ Also, while
the land is held, it helps to generate profits (benefits) for the company, and
those profits benefit the shareholders in the form of increased dividends
and/or share value.
Ÿ Additionally,
grants come with ‘strings attached’ — in this case the company must employ a
certain number of people for a specified time. This involves a cost. The grant
is income to be matched against that cost.
Ÿ Also,
government grants are like a ‘reverse income tax’ — where the government gives
something to the taxpayer rather than the taxpayer giving something to the
government. Grants, like taxes, are determined based on a country’s fiscal and
social policies. When a company pays taxes, it recognises tax expense. When a
company receives a grant, it should recognise grant income.
(d) Under AASB 120
Accounting for Government Grants and Disclosure of Government Assistance:
7. Government
grants, including non-monetary grants at fair value, shall not be recognised
until there is reasonable assurance that:
(a) the
entity will comply with the conditions attaching to them; and
(b) the
grants will be received.
12. Government
grants shall be recognised as income over the periods necessary to match them
with the related costs, which they are intended to compensate, on a systematic
basis. They shall not be credited directly to shareholders’ interests.
15. Discuss
the difference, if any, between income, revenue and gains.
The Conceptual Framework defines income
as ‘increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity
participants.’
16. Describe
the qualitative characteristics of financial information according to the Conceptual Framework, distinguishing
between fundamental and enhancing characteristics.
Chapter 3 of the Conceptual
Framework for Financial Reporting (the Conceptual
Framework) discusses the qualitative characteristics of useful financial
information. For financial information to be useful (e.g. to existing and
potential investors, lenders and other creditors for making decisions about the
reporting entity on the basis of information in its financial report), it must
be relevant and faithfully represent what it purports to represent. Therefore,
the fundamental qualitative characteristics are relevance and faithful representation.
• it is capable of making a difference in the
decisions made by the capital providers as users of financial information
• it has predictive value, confirmatory value
or both. Predictive value occurs where the information is useful as an input
into the users’ decision models and affects their expectations about the
future. Confirmatory value arises where the information provides feedback that
confirms or changes past or present expectations based on previous evaluations.
• it is capable of making a difference whether
the users use it or not. It is not necessary that the information has actually
made a difference in the past or will make a difference in the future.
Ÿ complete. A
complete depiction includes all information necessary for a user to understand
the phenomenon being depicted, including all necessary descriptions and
explanations. (QC13)
Ÿ neutral A
neutral depiction is without bias in the selection or presentation of financial
information. (QC14)
Ÿ free from
error. Free from error means there are no errors or omissions in the
description of the phenomenon, and the process used to produce the reported
information has been selected and applied with no errors in the process. (QC15)
Comparability (QC20–QC25)
Financial information is comparable if it:
Ÿ can be
compared with similar information about other entities or the same entity
across for another period or another date.
Ÿ enables users
to identify and understand similarities in, and differences among, items.
Verifiability (QC26–QC28)
Financial information is verifiable if:
Ÿ different
knowledgeable and independent observers could reach consensus different
knowledgeable and independent observers could reach consensus, although not
necessarily complete agreement, that a particular depiction is a faithful representation.
Ÿ can be
directly or indirectly verified. Direct verification means verifying an amount
or other representation through direct observation, for example, by counting
cash. Indirect verification means checking the inputs to a model, formula or
other technique and recalculating the outputs using the same methodology.
Timeliness (QC29)
Timeliness means having information available to
decision-makers in time to be capable of influencing their decisions.
Understandability (QC30–QC32)
Financial information is understandable if it is classified,
characterised and presented clearly.
17. Define
‘equity’, and explain why the Conceptual
Framework does not prescribe any recognition criteria for equity.
The Conceptual
Framework defines equity as ‘the residual
interest in the assets of the entity after deducting all its liabilities’.
Equity cannot be identified independently of the other elements in the
statement of financial position/balance sheet.
18. Multiple
choice questions:
(a) (i) is incorrect. Materiality is not a
constraint
(b) Only (iii) is correct
(c) Only (iv) is correct
(d) (ii) is correct.
Application and analysis
exercises
Exercise 1.1 RELEVANT
INFORMATION FOR AN INVESTMENT COMPANY
a. What financial information about the
investment company’s holdings would be most relevant to you?
b. The investment company earns
profits from appreciation of its investment securities and from dividends
received. How would the concepts of recognition in the Conceptual Framework apply here?
a. The performance of an
investment company results from income earned on its investments (dividends and
interest) and changes in the fair values of its investments while they are
held. I would like to know:
Ÿ Fair values of
the securities that the investment company holds.
Ÿ How those fair
values changed during the year. It would not matter much to me whether the
investment company actually sold the investments (in which case they would have
to replace them with other investments) or held on to the investments. Either
way, the fair value changes represent gains and losses to the investment
company and, therefore, to me as an investor in the investment company.
Ÿ How the fair
value changes of investments managed by this investment company compared to
changes in similar investments in the market as a whole.
Ÿ Turnover of the
portfolio, and related transaction costs such as commissions.
Ÿ Interest and
dividends earned.
Ÿ Information
about risks in the portfolio.
Ÿ Income taxes
are usually only based on those fair value changes that have been ‘confirmed’
by a sale transaction. If that is the case with this investment company, I
might want to know how the fair value changes were split between ‘realised’
(relating to investments that have been sold) and ‘unrealised’ (relating to investments
that are still held). In many countries, investment companies that distribute
their earnings rapidly to the investors do not themselves pay taxes — only the
investors pay the taxes on realised gains and dividend and interest income.
b. Under the Conceptual Framework, an item that meets the definition of an
asset, liability, income, or expense should be recognised if:
(a) it is
probable that any future economic benefit associated with the item will flow to
or from the entity; and
(b) the item
has a cost or value that can be measured with reliability.
Exercise
1.2 MEASURING INVENTORIES OF GOLD AND
SILVER
AASB 102 Inventories allows producers of gold and silver to measure
inventories of those commodities at selling price, even before they have sold them,
which means income is recognised at production. In nearly all other industries,
however, income is recognised only when the inventories are sold to outside
customers. What concept(s) in the Conceptual
Framework might the standard setters have looked to with regard to
accounting for gold and silver production?
(a) Unlike other ordinary goods, there is a ready
liquid market with quoted prices, minimal transaction costs, minimal selling
effort, minimal after-costs, and immediate cash settlement.
(b) Under the Conceptual
Framework, an item that meets the definition of an asset, liability,
income, or expense should be recognised if:
(a) it is probable that any future economic
benefit associated with the item will flow to or from the entity; and
(b) the item has a cost or value that can be
measured with reliability.
(c) The AASB concluded that because of the nature
of the market in which gold and silver are bought and sold, the conditions for
income recognition are met at the time of production.
Exercise
1.3 RECOGNISING A LOSS FROM A LAWSUIT
The law in your community requires
store owners to shovel snow and ice from the pavement in front of their shops.
You failed to do that, and a pedestrian slipped and fell, resulting in serious
and costly injury. The pedestrian has sued you. Your attorney says that while
he will vigorously defend you in the lawsuit, you should expect to lose
$25 000 to cover the injured party’s costs. A court decision, however, is
not expected for at least a year. What aspects of the Conceptual Framework might help you in deciding the appropriate
accounting for this situation?
(a) The
definition of liability can help decide the accounting treatment of the
situation. Under the Conceptual Framework
a liability is a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits. In this case, the past event is the fall
and injury to the pedestrian.
(b) Present
obligation depends on the probability of payment. The attorney has advised that
a $25 000 loss is probable. Therefore appropriate accounting involves
recognising a liability for the probable payment. An expense would also be
recognised.
(c) Expenses are
decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities. In this case,
the expense arises at the time the pedestrian is injured because a liability
has also arisen at that time.
Exercise 1.4 FINANCIAL
STATEMENTS OF A REAL ESTATE INVESTOR
An entity purchases a rental
property for $10 000 000 as an investment. The building is fully
rented, and is in a good area. At the end of the current year, the enterprise
hires an appraiser who reports that the fair value of the building is $15 000 000
plus or minus 10%. Depreciating the building over 50 years would reduce
the carrying amount to $9 800 000.
(a) What are the relevance and faithful
representation accounting considerations in deciding how to measure the
building in the entity’s financial statements?
(b) Does the Conceptual
Framework lead to measuring the building at $15 000 000? Or at $9 800 000?
Or at some other amount?
(a) Is the fair
value relevant to stakeholders’ decisions? Whether the stakeholders care about
the fair value of the building should be considered.
Relevance
Ÿ Information in financial statements is relevant when it influences
the economic decisions of users. It can do that both by (a) helping them
evaluate past, present, or future events relating to an enterprise and by (b)
confirming or correcting past evaluations they have made.
Ÿ Materiality is a component of relevance. Information is material
if its omission or misstatement could influence the economic decisions of
users.
Ÿ Timeliness is another component of relevance. To be useful,
information must be provided to users within the time period in which it is
most likely to bear on their decisions.
Faithful
representation
Ÿ Information in financial statements is a faithful representation
if it is complete, neutral and free from material error and bias and can be
depended upon by users to represent events and transactions faithfully.
Information is not a faithful representation when it is purposely designed to
influence users’ decisions in a particular direction.
Ÿ There is sometimes a trade-off between relevance and faithful
representation — and judgement is required to provide the appropriate balance.
Ÿ Faithful representation is affected by the use of estimates and by
uncertainties associated with items recognised and measured in financial
statements. These uncertainties are dealt with, in part, by disclosure and, in
part, by exercising prudence in preparing financial statements. 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.
However, prudence can only be exercised within the context of the other
qualitative characteristics in the Conceptual
Framework, particularly relevance and the faithful representation of
transactions in financial statements. Prudence does not justify deliberate
overstatement of liabilities or expenses or deliberate understatement of assets
or income, because the financial statements would not be neutral and,
therefore, not have the quality of reliability.
Analysis
Ÿ The fair value of the property is relevant to the investors in the
enterprise. The enterprise — and therefore its owners — are better off because
the value of the property has gone up. Better off means that their wealth
increased.
Ÿ Is the fair value reported by the appraiser reliable? Certainly,
appraisals involve judgements, and different valuation methods and different
assumptions can generate different valuations. The objectivity and other
qualifications of the appraiser should be considered. The Conceptual Framework acknowledges that accounting information can
be reliable even if it is not precise. The appraiser acknowledged that there is
a potential for error of plus or minus 10%. That does not mean that the value
information is not reliable.
(b) The Conceptual Framework does not include
concepts or principles for selecting which measurement basis should be used for
particular elements of financial statements or in particular circumstances. The
qualitative characteristics do provide some guidance, particularly the
characteristics of relevance and reliability.
Exercise 1.5 NEED
FOR THE CONCEPTUAL FRAMEWORK VS. INTERPRETATIONS
Applying the Conceptual Framework is subjective and requires judgement. Would
the AASB be better off to abandon the Conceptual
Framework entirely and, instead, rely on a very active interpretations
committee that develops detailed guidance in response to requests from
constituents?
(a) No. The fact
that the Conceptual Framework
involves judgement does not mean that it should be abandoned.
(b) The guidance
developed by the interpretations committee would be ad hoc – that is, developed
case by case without the foundation of the framework to look to. The standards
themselves would suffer from the same problem if there were no framework.
(c) The Conceptual Framework provides guidance
and direction to the standard setters, and therefore will lead to consistency
among the standards.
(d) But it
is a set of concepts. It provides a boundary for the exercise of judgement by
the standard setter and the interpretive body.
Exercise 1.6 MEANING OF
‘DECISION USEFUL’
What is meant by saying that accounting information should be
‘decision-useful’? Provide examples.
(a) The Conceptual Framework identifies the
principal classes of users of general purpose financial statements as:
Ÿ present and potential investors,
Ÿ lenders,
Ÿ suppliers and other trade creditors,
Ÿ employees,
Ÿ customers,
Ÿ governments and their agencies; and
Ÿ the general public.
(b) All of these
categories of users rely on financial statements to help them in making various
kinds of economic and public policy decisions. Investors need to decide whether
to buy, sell, or hold shares. Lenders need to decide whether to lend and at
what price. Suppliers need to decide whether to extend credit. Employees need
to make rational career decisions, and so on. Information is decision-useful if
it helps these people make their decisions.
(c) Because
investors are providers of risk capital to the enterprise, financial statements
that meet their needs will also meet most of the general financial information
needs of the other classes of users. Common to all of these user groups is
their interest in the ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of those future cash flows. Therefore,
the Conceptual Framework regards
investors as the primary, overriding user group.
(d) The Conceptual Framework notes that
financial statements cannot provide all the information that users may need to
make economic decisions. For one thing, financial statements show the financial
effects of past events and transactions, whereas the decisions that most users
of financial statements have to make relate to the future. Further, financial
statements provide only a limited amount of the non-financial information
needed by users of financial statements.
(e) Financial
statements cannot meet all of the diverse information needs of these user
groups. However, there are information needs that are common to all users, and
general purpose financial statements focus on meeting those needs.
(f) While the
concepts in the Conceptual Framework
are likely to lead to information that is useful to the management of a
business enterprise in running the business, the Conceptual Framework does not purport to address their information
needs. The same can be said for the Standards and Interpretations themselves.
Exercise 1.7 PERFORMANCE OF A BUSINESS ENTITY
A financial analyst says: ‘I advise
my clients to invest for the long term. Buy good shares and hang on to them.
Therefore, I am interested in a company’s long-term earning power. Accounting
standards that result in earnings volatility obscure long-term earning power.
Accounting should report earning power by deferring and amortising costs and revenues.’
Is this analyst’s view consistent with the fundamental characteristics of
financial information established in the Conceptual
Framework?
(a) Accounting
standards should help provide relevant and faithfully represented financial
information.
(b) Companies
that operate in risky business environments or that enter into risky kinds of
transactions are likely to experience real ups and downs in their performance. In
such cases, volatility of reported earnings results from the real transactions
and activities of the company.
(c) In other
words, the statement of profit or loss and other comprehensive income reflects
the underlying risks. It is not the role of financial accounting and reporting
to try to smooth the company’s earnings by, say, deferring profits in good
years and deferring expenses in bad years. The amounts reported in the
financial statements would not be faithfully represented because they do not
reflect real phenomena.
Exercise 1.8 GOING CONCERN
What measurement principles might be
most appropriate for a company that has ceased to be a going concern (e.g.
creditors have appointed a receiver who is seeking buyers for the company’s
assets)?
(a) Net
realisable value is an asset’s selling price or a liability’s settlement amount
less disposal or settlement costs. If a company ceases to be a going concern,
that means it is either being wound up or sold.
(b) Either way,
the relevant measurements to users of financial statements would be the net
realisable value of the company’s net assets.
Exercise 1.9 ASSESSING PROBABILITIES IN ACCOUNTING RECOGNITION
The Conceptual Framework defines an asset as a resource from which
future economic benefits are expected to flow. ‘Expected’ means it is
not certain, and involves some degree of probability. At the same time, the Conceptual Framework establishes, as a
criterion for recognising an asset, that ‘it is probable that any future
economic benefit associated with the item will flow to or from the entity’.
Again, an assessment of probability is required. Is there a redundancy, or
possibly some type of inconsistency, in including the notion of probability in
both the asset definition and recognition criteria?
(a) It is not an
inconsistency to include the notion of probability both in the definition of an
asset and in the recognition criteria. However, it may be a redundancy.
Exercise
1.10 PURCHASE ORDERS
An airline places a non-cancellable
order for a new aeroplane with one of the major commercial aircraft
manufacturers at a fixed price, with delivery in 30 months and payment in full
to be made on delivery.
(a) Under the Conceptual
Framework, do you think the airline should recognise any asset or liability
at the time it places the order?
(b) One
year later, the price of this aeroplane model has risen by 5%, but the airline
had locked in a fixed, lower price. Under the Conceptual Framework, do you think the airline should recognise any
asset (and gain) at the time when the price of the aeroplane rises? If the
price fell by 5%, instead of rising, do you think the airline should recognise
a liability (and loss) under the Conceptual
Framework?
(a) Under current
accounting, the airline should not recognise any asset or liability at the time
it places the order, because the transaction has not taken place. Accounting
recognises purchase transactions when delivery takes place, and title passes. At
this point the airline, and not the manufacturer, has assumed the risks and rewards
of owning the airplane.
(b) Nonetheless,
the airline has made an important and irrevocable commitment. Generally, major
capital spending commitments are disclosed in the notes to the financial
statements.
(c) The airline
is better off for having locked in the price than if it had not done so.
Conversely, if the price had fallen, it would be worse off for having signed
the non-cancellable fixed price order. Nonetheless, under current accounting
standards, such gains and losses are not recognised.
(d) Accounting
treats commitments to purchase financial assets differently from commitments to
purchase property. If the airline had agreed to purchase a foreign currency at
a fixed price for delivery at a future date, and the exchange rate goes up or
down, it is required to recognise a gain or loss.
Exercise 1.11 DEFINITIONS
OF ELEMENTS
Explain how Q Ltd should account for the
following items/situations, justifying your answer by reference to the Conceptual Framework’s definitions and
recognition criteria:
a. A trinket of sentimental value
only.
b. Q Ltd is guarantor for an
employee’s bank loan:
(i) You have no reason to
believe the employee will default on the loan.
(ii) As the employee is in
serious financial difficulties, you think it likely that he will default on the
loan.
c. Q Ltd receives 1000 shares in
X Ltd, trading at $4 each, as a gift from a grateful client.
d. The panoramic view of the
coast from Q Ltd’s café windows, which you are convinced attracts customers to the
café.
e. The court has ordered Q Ltd to
repair the environmental damage it caused to the local river system. You have
no idea how much this repair work will cost.
(a) Trinket of sentimental
value
Ÿ Fails the para. 49(a) asset definition as it does not constitute
future economic benefits, defined in para. 53 as the potential to contribute,
directly or indirectly, to the flow of cash and cash equivalents to the entity.
Ÿ Recognition criteria are irrelevant, as there is no asset to
recognise.
(b) Guarantor for an employee’s
loan
(i) Employee
unlikely to default on his/her loan
Ÿ Meets the para. 49(b) liability definition: (1) present obligation
— legal obligation via the guarantor contract; (2) past event — signing the
guarantor contract; (3) settlement involving outflow of economic benefits —
payment of the guarantee.
Ÿ Fails probability recognition criterion, as it is not likely that Q
Ltd will be required to pay on the guarantee. Hence, no liability can be
recognised. However, note disclosure of the guarantee may be warranted (para.
88).
(ii) Employee likely to default on his loan
Ÿ Again, meets the liability definition as per (i) above.
Ÿ Meets both recognition criteria — probable that outflow of
economic benefits will be required, and settlement amount can be reliably
measured (amount owing). Hence, a liability should be recognised.
Ÿ Also meets the expense definition and recognition criteria.
Definition: (1) decrease in economic benefits in the form of a liability
increase — Q Ltd now owes the amount of the employee’s loan; (2) during period
— the liability increase arose during period; (3) results in equity decrease —
if liabilities increase and assets do not change, equity decreases. Recognition
criteria: The decrease in future economic benefits has arisen, as Q Ltd now owes
the amount of the employee’s loan. The bank can advise exactly how much the
employee owes and so it can be reliably measured.
(c) Receipt of 1000 shares in X Ltd, trading at
$4 each, as a gift from a grateful client.
Ÿ The receipt of the shares meets the asset definition: (1)
represent FEBs (via future sales or dividend stream); (2) controlled by Q Ltd
(only Q Ltd can benefit from either selling them or receiving dividends); (3)
past event (their receipt).
Ÿ They also meet the asset recognition criteria: probable that FEBs
will eventuate (via sale or dividend stream); and the shares have a value (they
are trading at $4 each) that can be reliably measured (this value can be
verified via securities exchange and so on).
Ÿ The shares also meet the income definition and recognition
criteria. Definition: (1) increase in EBs in the form of an asset increase — Q
Ltd now owns the shares; (2) during period — the shares were received during
period; (3) results in equity increase — if assets increase and liabilities do
not change, equity increases. Recognition criteria: The increase in FEBs has
arisen, as Q Ltd now owns the shares (asset). The shares’ value is known and so
can be reliably measured.
(d) Café’s panoramic view
Ÿ The view fails the definition as the entity does not control the
FEBs that are expected to flow from the view — the entity cannot deny or
regulate access by others to the view.
Ÿ Recognition criteria are irrelevant, as there is no asset to
recognise.
(e) Court
order to repair environmental damage caused to the local river system. You have
no idea how much this repair work will cost.
Ÿ The court order meets the liability definition: (1) present
obligation — legal obligation; (2) past event — order has been made; (3)
settlement will involve outflow of EBs — future payment for repair of damage.
Ÿ Fails reliable measurement recognition criterion, as you have no
idea as yet how much the repair work will cost. Hence, no liability can be
recognised. However, note disclosure of the court order may be warranted (para.
88).
Ÿ However, if you know a minimum amount that Q Ltd will have to pay,
then the reliable measurement criterion is met for this amount. The probability
criterion is met as it is certain (given that Q Ltd has been ordered by the
court) that Q Ltd will have to pay the repair cost. Again, note disclosure may
still be warranted advising that the cost may be well in excess of this amount.
Exercise 1.12 DEFINITIONS
AND RECOGNITION CRITERIA
Explain how T Ltd should
account for the following items, justifying your answer by reference to the
definitions and recognition criteria in the Conceptual Framework. Also state, where
appropriate, which ledger accounts should be debited and credited.
(a) Photographs
of the company’s founders, which are of great sentimental value.
(b)(i) T
Ltd has been sued for negligence — likely it will lose the case.
(b)(ii) T Ltd has been sued for
negligence — likely it will win the case.
(c) Obsolete
plant now retired from use.
(d) T
Ltd receives a donation of $10 000.
(a) Photographs
of the company’s founders, which are of great sentimental value.
Ÿ The asset definition is failed as the photographs do not represent
future economic benefits (para. 49(a)). Future economic benefits constitute the
potential to contribute, directly or indirectly, to the flow of cash and cash
equivalents to an entity (para. 53).
Ÿ Recognition criteria are thus irrelevant, as there is no asset to
recognise.
(b)(i) T
Ltd has been sued for negligence — likely it will lose the case.
Ÿ The liability definition (para. 49(b)) is met as all 3
characteristics are present.
– Past event: The act of negligence or the act
of being sued.
– Present obligation: Para 60 states that an obligation is a duty
or responsibility to act or perform in a certain way. The key question here is
whether there is a present obligation. Does the lawsuit create a present
obligation? Or will the obligation only arise when a court decision against you
is handed down? The definition requires the existence of a present, not a
future, obligation (para. 61). I believe that the lawsuit (arising from being
sued) gives rise to a present obligation.
– Settlement involves the outflow of economic
benefits: If a present obligation is accepted as existing, its settlement will
involve the outflow of economic benefits, namely cash.
Ÿ The liability recognition criteria (para. 91) are met, as it is
probable that an outflow of economic benefits (cash) will result from settling
the liability, and the amount ($20 000 minimum) can be reliably measured.
Ÿ Therefore, at this stage a liability of $20 000 must be
recognised. If the damages firm up to another amount as the case progresses,
the amount must be adjusted.
Ÿ The expense definition (para. 70(b)) is met as all 3
characteristics are present.
– Decrease in economic benefits during the period:
The loss of at least $20 000 represents a decrease in economic benefits
and T Ltd was sued during the period.
– In the form of a liability increase: See
above liability discussion — T Ltd now owes $20 000 minimum.
– Results in a decrease in equity: If
liabilities increase and assets remain unchanged, equity decreases.
Ÿ The expense recognition criteria (para. 94) are met, as the
decrease in economic benefits has arisen, as T Ltd now owes $20 000
minimum, and the amount ($20 000 minimum) can be reliably measured.
Ÿ Therefore, at this stage an expense of $20 000 must also be
recognised. If the damages firm up to another amount as the case progresses,
the amount must be adjusted accordingly.
Ÿ Note that in this case the recognition of a liability has resulted
in the simultaneous recognition of an expense (paras. 91 and 98).
(b)(ii) T
Ltd has been sued for negligence — likely it will win the case.
Ÿ The liability definition (para. 49(b)) is met
as all 3 characteristics are present. See discussion in (b) (i) above.
Ÿ However, the liability probability recognition
criterion (para. 91) is failed, as it is not probable that an outflow of
economic benefits will result from settling the liability. As T Ltd is likely
to win the case, it is unlikely that it will have to pay damages.
Ÿ Therefore, the liability cannot be recognised.
However, if material, the lawsuit should be disclosed in the notes.
(c) Obsolete
plant now retired from use.
Ÿ The asset definition is failed as the plant no
longer represents future economic benefits (para. 49(a)).
Ÿ The plant must now be written off from the
accounts.
Ÿ Recognition criteria are thus irrelevant, as
there is no asset to recognise.
(d) Donation
of $10 000.
Ÿ The asset definition (para. 49(a)) is met as
all 3 characteristics are present.
– Past
event: The receipt of the donation.
– Flow
of future economic benefits: The donation represents an inflow of $10 000
cash into T Ltd.
– Control
over the future economic benefits: T Ltd will benefit from this $10 000
cash inflow and can deny or regulate the access of others to this cash inflow.
Ÿ The asset recognition criteria (para. 89) are
met, as it is probable (actually, it is certain) that an inflow of economic
benefits (cash) will flow to the entity, and the amount ($10 000) can be
reliably measured as it is known.
Ÿ Therefore, an asset of $10 000 must be
recognised.
Ÿ The income definition (para. 70(a)) is met as
all 3 characteristics are present.
– Increase
in economic benefits during the period: The inflow of $10 000 cash
represents an increase in economic benefits, and T Ltd received and cleared the
donation during this period.
– In
the form of an asset increase: See above asset discussion — T Ltd now has
additional cash of $10 000.
– Results
in an increase in equity: If assets increase and liabilities remain unchanged,
equity increases.
Ÿ The income recognition criteria (para. 92) are met, as the
increase in economic benefits has arisen (as T Ltd now has additional cash), and
the amount ($10 000) is known.
Ÿ Therefore, income of $10 000 must also be recognised.
Ÿ Note that in this case the recognition of an asset has resulted in
the simultaneous recognition of income (paras. 84 and 92).
Exercise 1.13 DEFINITIONS
AND RECOGNITION CRITERIA
Glenelg Accounting
Services has just invoiced one of its clients $3600 for accounting services
provided to the client. Explain how Glenelg Accounting Services should
recognise this event, justifying your answer by reference to relevant Conceptual Framework definitions and
recognition criteria. Would your answer be different if the services had not
yet been provided; that is, the payment is in advance?
Ÿ The Conceptual Framework
defines an asset as a resource controlled by the entity as a result of past
events and from which future economic benefits are expected to flow to the
entity.
Ÿ Invoicing the client gives rise to an asset as all 3
characteristics are present:
– Flow of future economic benefits: The invoice
represents a future cash inflow to the firm;
– Control: The firm has control over the
economic benefits via its contractual right to the future cash inflow; and
– Past event: The issuing of the invoice or the
provision of the services for which the invoice was issued.
Ÿ Under the Conceptual
Framework an asset must be recognised when it is probable that the future
economic benefits will flow to the entity, and the asset has a cost or value
that can be reliably measured.
Ÿ These recognition criteria are met as:
– It is more than 50% likely (probably certain)
that the firm will receive the cash (otherwise it would not have provided the
services); and
– The value ($3600) can be reliably measured as
it is known.
Ÿ Therefore, an asset (receivable) of $3600 must be recognised.
Ÿ The Conceptual Framework
defines income as increases in economic benefits during the period in the form
of inflows or enhancements of assets or decreases in liabilities that result in
increases in equity, other than those relating to owners’ contributions.
Ÿ Invoicing gives rise to income as all 3 characteristics are
present:
– Increase in economic benefits during the
period: The right to a future cash inflow arose during the period;
– Increase in assets or decrease in
liabilities: The increase is in the form of an asset increase as the receivable
meets the asset definition and recognition criteria; and
– Increase in equity: As assets have increased
and liabilities have not changed, equity has increased.
Ÿ Under the Conceptual
Framework income must be recognised when an increase in future economic
benefits, related to an asset increase or liability decrease, has arisen that
can be measured reliably.
Ÿ These recognition criteria are met as:
– The asset increase has arisen (on issue of
the invoice); and
– The increase ($3600) can be reliably measured
as it is known.
Ÿ Therefore, income (fee revenue) of $3600 must be recognised.
Exercise 1.14 ASSETS
Glam Cosmetics has
spent $220 000 this year on a project to develop a new range of chemical-free
cosmetics. As yet it is too early for Glam Cosmetics’ management to be able to
predict whether this project will prove to be commercially successful.
Explain whether Glam
Cosmetics should recognise this expenditure as an asset, justifying your answer
by reference to the Conceptual Framework
asset definition and recognition criteria.
Ÿ The Conceptual Framework
defines an asset as a resource controlled by the entity as a result of past
events and from which future economic benefits are expected to flow to the
entity.
Ÿ The expenditure of developing a new line of chemical-free
cosmetics meets this definition as: (1) it represents future economic benefits
via sale of the new line of cosmetics; (2) the benefits are controlled, as the
company will enjoy the economic benefits flowing from the new line; and (3)
there is a past event, as the company has already spent the $220 000.
Ÿ Under the Conceptual
Framework an asset is recognised only when it is probable that the future
economic benefits will flow to the entity and the asset has a cost or value
that can be reliably measured.
Ÿ The expenditure fails the probability criterion, as it is not yet
possible to predict whether the project will prove to be commercially relevant.
Ÿ Accordingly, the company cannot (yet) recognise the expenditure as
an asset.
Exercise 1.15 ASSET
DEFINITION AND RECOGNITION
On 28 May 2013, $20 000 cash was stolen from Fremantle Ltd’s night safe.
Explain how Fremantle should account for this event, justifying your answer by
reference to relevant Conceptual
Framework definitions and recognition criteria.
Ÿ The Conceptual Framework
defines expenses as decreases in economic benefits during the period in the
form of asset decreases or liability increases that result in decreases in
equity, other than those relating to distributions to owners.
Ÿ The theft of the $20 000 cash satisfies the expense definition as:
– It is a decrease in economic benefits during
the period, as cash (economic benefits) has decreased;
– The decrease in economic benefits is in the
form of an asset decrease, as cash (an asset) has decreased; and
– It has resulted in a decrease in equity, as
assets have decreased and liabilities have not changed.
Ÿ In accordance with the Conceptual
Framework an expense must be recognised when:
– A decrease in economic benefits related to an
asset increase or a liability decrease has arisen; and
– The decrease can be reliably measured.
Ÿ The theft of the cash satisfies both recognition criteria as:
– The decrease in economic benefits related to
an asset decrease (a decrease in cash) has occurred; and
– The decrease can be reliably measured, as the
amount of cash lost is known (i.e. $20 000).
Ÿ Accordingly, an expense (Dr) and asset decrease (Cr) of $20 000
must be recognised.
