Issues in Financial Accounting, 16th Edition By Scott Henderson Solution Manual by Ace Test Banks

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Issues in Financial Accounting, 16th Edition By Scott Henderson

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Chapter 1 INSTITUTIONAL ARRANGEMENTS FOR SETTING ACCOUNTING STANDARDS IN AUSTRALIA LEARNING OBJECTIVES After studying this chapter you should be able to: 1

identify the main sources of regulation of financial reporting;

identify the major developments in the institutional arrangements for accounting standard-setting;

explain the present accounting standard-setting arrangements;

explain the process of developing accounting standards and concepts statements in Australia;

explain the process of developing interpretations; and

explain the process of enforcing accounting standards and interpretations.

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QUESTIONS 1

The three main sources of regulation governing accounting policies and financial reporting practices in Australia are government legislation, the Australian Securities Exchange Ltd (ASX) Listing Rules, and accounting standards and other pronouncements issued by the Australian Accounting Standards Board (AASB). Government Legislation: In the private sector, the most important legislation specifying financial reporting requirements is the Corporations Act 2001. In particular, the Corporations Act specifies general requirements that require the financial report to comply with accounting standards and to present a true and fair view. The form and content of the statement of comprehensive income, statement of financial position, statement of changes in equity and statement of cash flows are considered in accounting standards issued by the Australian Accounting Standards Board (AASB) that are discussed in later chapters of this book. ASX Listing Rules: The listing rules of the ASX apply only to entities whose securities are listed on the ASX. The disclosure requirements of the ASX are contained in Chapter 3 (continuous disclosure), Chapter 4 (periodic disclosure) and Chapter 5 (additional reporting on mining and exploration activities) of the listing rules. The listing rules specify the detailed disclosure of financial information and require the disclosure of some information not required by the Corporations Act (e.g. various disclosures relating to the 20 largest holders of each class of quoted equity securities). If a listed company does not comply with the ASX Listing Rules, it may be delisted. The ASX has also issued Corporate Governance Principles and Recommendations as amended in 2014 through its Corporate Governance Council. There are eight guidelines to which 29 recommendations are attached. The guidelines and associated recommendations are not mandatory. However, the listing rules include two mandatory requirements relating to the corporate governance guidelines. First, ASX Listing Rule 4.10.3 requires listed entities to disclose in their annual reports the extent to which they have followed the guidelines during the reporting period. Second, ASX Listing Rule 12.7 requires that companies included in the S&P/All Ordinaries Index have an audit committee and that companies included in the S&P/ASX 300 Index have an audit committee that is constituted in accordance with the Corporate Governance Principles and Recommendations. Accounting Standards and Other Pronouncements Issued by the AASB: The third source of regulation governing financial reporting is accounting standards and . 2

interpretations prepared by the Australian Accounting Standards Board (AASB). Accounting standards and interpretations are concerned with both accounting measurement and disclosure. Authority is provided to AASB accounting standards by the Corporations Act. The Accounting Professional and Ethical Standards Board (APESB) provides similar authority for Australian accounting standards via APES 205 ‘Conformity with Accounting Standards’ (para. 5). 2

The role of the ASX’s Corporate Governance Principles and Recommendations as amended in 2014 is to provide a voluntary code of best practice corporate governance to guide listed companies. There are eight principles supported by 29 recommendations provided to listed companies. The guidelines and associated recommendations are not mandatory. However, the listing rules include two mandatory requirements relating to the corporate governance guidelines. First, ASX Listing Rule 4.10.3 requires listed entities to disclose in their annual reports the extent to which they have followed the guidelines during the reporting period. Second, ASX Listing Rule 12.7 requires that companies included in the S&P/All Ordinaries Index have an audit committee and that companies included in the S&P/ASX 300 Index have an audit committee that is constituted in accordance with the Corporate Governance Principles and Recommendations. The guidelines are always a ‘work-in-progress’ as their application and relevance need to be monitored as business practices and community expectations change over time.

The Australian Professional and Ethical Standards Board (APESB) was established as an initiative of CPA Australia and the then ICAA (now CAANZ) primarily to develop and issue appropriate professional and ethical standards for their membership. (The IPA has subsequently become a member.) The APESB has reviewed existing professional and ethical standards such as the old Code of Professional Conduct and Miscellaneous Professional Statements (APS series) and guidance notes (GN series). The subsequent APES series of ethical and professional standards approved by the APESB are mandatory for accountants who are members of CPA Australia, the ICAA and the IPA. The specific professional standard and ethical standard APES 205 ‘Conformity with accounting standards’ requires members to comply with accounting standards as follows: 4.3 Members who are involved in, or are responsible for, the preparation and/or presentation of Financial Statements of a Reporting Entity shall take all reasonable steps to ensure that the Reporting Entity prepares General Purpose Financial Statements. . 3

5.1 Members shall take all reasonable steps to apply Australian Accounting Standards when they prepare and/or present General Purpose Financial Statements that purport to comply with the Australian Financial Reporting Framework. 5.2 Where Members are unable to apply Australian Accounting Standards pursuant to paragraph 5.1, they shall take all reasonable steps to ensure that any departure from Australian Accounting Standards, the reasons for such departure, and its financial effects are properly disclosed and explained in the General Purpose Financial Statements. 5.5 Members in Public Practice shall take all reasonable steps to ensure that Clients have complied with Australian Accounting Standards when they perform an Audit or Review Engagement or a compilation Engagement of General Purpose Financial Statements which purport to comply with the Australian Financial Reporting Framework. Compliance with APES 205 is mandatory for members of the professional accounting bodies, and non-compliance represents a breach of the code of ethics issued by the Accounting Professional and Ethical Standards Board. Failure by members to comply with the requirements of APES 205 could result in disciplinary proceedings being brought against them, which could result in the imposition of a fine or expulsion from the professional body. 4

The present institutional arrangements for accounting standard-setting in Australia are summarised in Figure 1.1 in Chapter 1. Financial Reporting Council: The Financial Reporting Council (FRC) is a statutory body under the Australian Securities and Investments Commission Act 2001. It is the peak body responsible for the broad oversight of the accounting and auditing standard-setting process in Australia. The FRC is also responsible for monitoring the effectiveness of auditor independence requirements in Australia and has an oversight function of the Auditing and Assurance Standards Board (AUASB). In general, the FRC has responsibility for oversight of the AASB and for presenting reports and advice on the Australian accounting standard-setting process to the Minister. The role of the FRC includes: • • •

appointment of the members of the AASB (except for the full-time Chair who is appointed by the Minister); approving and monitoring the AASB’s priorities, business plan, budget and staffing arrangements; determining the AASB’s broad strategic direction; . 4

• •

giving the AASB directions, advice or feedback on matters of general policy and the AASB’s procedures; and monitoring the development of international accounting and auditing standards, working to further the development of a single set of accounting and auditing standards for world-wide use and promoting the adoption of these standards.

Although the FRC has wide-ranging powers, the FRC cannot become involved in the technical deliberations of the AASB. For example, the FRC does not have the power to veto a standard formulated or recommended by the AASB, nor direct the AASB in relation to the development or making of a particular standard. Under section 235A of the Australian Securities and Investments Commission Act 2001, members of the FRC are appointed by the Minister and hold office on terms and conditions determined by the Minister. <www.frc.gov.au>. Australian Accounting Standards Board: The Australian Accounting Standards Board (AASB) began operations in 1991, replacing the Australian Accounting Standards Review Board (ASRB). At this time, the ASRB was Australia’s sole standard-setting body for the private sector and its activities were complimented by the Public Sector Accounting Standards Board (PSASB) which developed accounting standards applicable to all other reporting entities. The passage of CLERP in October 1999 resulted in the activities of the PSASB merging into those of the AASB. The reconstituted AASB is an Australian government agency under the Australian Securities and Investments Commission Act. It has responsibility for making accounting standards applicable not only to entities coming under the jurisdiction of the Corporations Act but also for entities in the public sector and the remainder of the noncorporate sector. The AASB’s major functions are specified in section 227(1) of the Australian Securities and Investments Commission Act as follows: 1) to develop a conceptual framework, not having the force of an accounting standard, for the purpose of evaluating proposed accounting standards and international standards; 2) to make accounting standards under section 334 of the Corporations Act 2001 for the purposes of the national scheme laws; 3) to formulate accounting standards for other purposes; 4) to participate in and contribute to the development of a single set of accounting standards for worldwide use; and 5) to advance and promote the main objectives of Part 12 of the Act as set down in section 224, which include reducing the cost of capital, enabling Australian entities

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to compete effectively overseas and maintaining investor confidence in the Australian economy. The Minister appoints the chair of the AASB, and the chair is subsequently accountable to the Minister regarding the operations of the AASB. The AASB comprises nine parttime members plus the full-time chair. Member appointments to the AASB are made by the FRC from nominations received from a number of bodies including CPA Australia, the ICAA, the Business Council of Australia and the ASX. In addition, the AASB presently has one observer – the member of the International Accounting Standards Board, the Australian representative of the IFRS Interpretations Committee. Meetings of the AASB are open to the public. <www.aasb.com.au>. The Office of the AASB: The Governance Review Implementation (AASB and AUASB) Bill 2008 was passed by Parliament in June 2008. Inter alia, the Bill established the Office of the AASB to support the operations of the AASB through the provision of technical and administrative services, information and advice. The chief executive officer of the Office is the chair of the AASB, who is also responsible to the Minister for the financial management of the Office. The Minister: The Minister is one of three Treasury Ministers from the Federal Government. 5

The AASB will typically issue material for public comment and discussion with stakeholders in the form of: • • • •

Discussion Papers (DP) outlining a wide range of possible accounting policies on a particular topic; Exposure Drafts (ED) of a proposed standard or amendment to a standard; Invitations to Comment (ITC) that seek feedback on broad proposals; or Draft Interpretations of a standard.

At present, constituents’ comments on the materials issued by the AASB are obtained from the following avenues: Focus Groups, Project Advisory Panels, Interpretation Advisory Panels, and the Academic Advisory Panel. Focus Groups: There are currently two Focus Groups – the User Focus Group and the Not-for-Profit Focus Group. In general, these groups serve as a resource to the AASB in formulating standard-setting priorities, advising on specific agenda projects and providing feedback to assist on developing standards. The User Focus Group generally comprises eight to

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10 investment and credit professionals and the Not-for-Profit Focus Group comprises eight to 10 professionals with expertise and involvement in charitable and related organisations. Project Advisory Panels: Input is also received from Project Advisory Panels that work with the AASB staff to develop agenda material relating to specific standard-setting projects for consideration by the Board. Invitations are issued to experts in a particular field or topic area to join a Project Advisory Panel. Interpretation Advisory Panels: As part of the process of issuing interpretations, the AASB decides, on a topic-by-topic basis, whether to appoint an Interpretation Advisory Panel. The role of the Advisory Panel is limited to preparing alternate views on a specific issue and, where relevant, recommendations for consideration by the AASB. An Interpretation Advisory Panel normally comprises between four and eight members. These members include the AASB Chair, at least one other AASB member, and other members appointed on the basis of their professional competence and practical experience in the topic area. Members are typically drawn from a register of potential Interpretation Advisory Panel members maintained by the AASB. Academic Advisory Panel: In 2015 the AASB established an Academic Advisory Panel, which is chaired by the academic member of the AASB and consists of six other academics from around Australia. One aim of the Academic Advisory Panel is to increase the level of communication between the AASB and the research community. Standard setters around the world are increasingly seeking objective evidence to inform their deliberations, and the Academic Advisory Panel assists the AASB by bringing relevant research findings to its attention and encouraging researchers to explore topics of mutual interest with the AASB. 6

(a)

The due process used to develop an accounting standard is summarised in Figure 1.2 in Chapter 1. The first step is identification of a technical issue to be added to the AASB’s work program. This can happen in one of three ways: 1) Inclusion in the AASB’s program of issues on the International Accounting Standards Board’s (IASB) and the International Financial Reporting Interpretations Committee’s (IFRIC) work programs; 2) Inclusion in the AASB’s program of issues on the International Public Sector Accounting Board’s (IPSASB) work program; and

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3) Inclusion in the AASB’s work program of issues identified by AASB Board members and staff, as well as Australian organisations and individuals. (Issues relating to for-profit entities are normally referred to the IASB or IFRIC for consideration, while issues relating to not-for-profit entities may be referred to the IPSASB or addressed domestically.) The second step involves the development of a project proposal by the AASB. This contains an assessment of the potential benefits of the project, the potential costs of not undertaking it, resource availability and timing. After reviewing the proposal the AASB makes a decision on whether to place the project on its agenda (and therefore work program). Once an issue is included on the AASB’s agenda, the third step involves the preparation of agenda papers by AASB staff. Agenda papers consider the scope of issues, alternative approaches, and the timing of outputs. They are prepared using material drawn from the IASB, IPSASB, the New Zealand Accounting Standards Board, and other such organisations. The fourth step involves the exposure of the results of the research conducted in step three to facilitate public comment and discussion with stakeholders in the form of: • Discussion Papers (DP) outlining a wide range of possible accounting policies on a particular topic; • Exposure Drafts (ED) of a proposed standard or amendment to a standard; • Invitations to Comment (ITC) that seek feedback on broad proposals; or • Draft Interpretations of a standard. Feedback from the public and stakeholders may be obtained through round-table discussions with stakeholders, Focus Groups, Project Advisory Panels, Interpretation Advisory Panels, and the Academic Advisory Panel. The fifth step involves Board discussion of the results of the feedback received on an agenda item. There are two possible outcomes from this discussion: 1) A standard is not issued. In this situation, the Board notes its view in the minutes of a meeting or in a formal Board agenda decision. 2) An accounting standard is issued.

(b)

Students should visit the Work in Progress page on the AASB website <www.aasb.gov.au>.

(a)

The due process used by the AASB to develop accounting standards is outlined in the answer to Question 6(a). . 8

(b)

Currently, the AASB issues interpretations as a means of providing timely guidance on urgent financial reporting issues. For example, AASB Interpretation 2 ‘Members’ Shares in Co-operative Entities and Similar Instruments’ deals with how to determine the economic substance of ‘shares’ issued by co-operative entities to their members. For example, often a co-operative entity’s constitution requires the entity to buy-back its shares from a member who decides to leave the co-operative. As the entity cannot avoid buying-back the share, this suggests that the share instrument is more in the nature of a liability than an equity instrument (even though it is called a ‘share’). Interpretation 2 provides guidance on how to classify such ‘shares’. The due process used to develop an interpretation has a much shorter timeframe than the due process necessary to develop an accounting standard. To illustrate, the AASB will issue an interpretation as follows: • Interpretation Advisory Panels may be formed, as required on a topic-by-topic basis. The role of a panel is to prepare alternative views on the issue and, where appropriate, make recommendations to the AASB. • The due process will include publishing the composition of each panel and its recommendation on the AASB’s website for an appropriate period. Where the AASB proposes to issue an interpretation, the proposed interpretation will be further exposed on the AASB’s website for an appropriate period before the AASB considers it for formal adoption.

AASB Interpretations are designed to provide timely guidance to preparers of financial statements on various financial reporting issues. For example, sometimes after an accounting standard is issued, problems occur in its implementation where diversity in practice arises because financial statement preparers interpret the requirements of the standard in diverse ways. In addition, financial reporting problems may arise which do not warrant either amendments to an existing standard or the preparation of a new standard. In these cases, it may have been appropriate to resolve the problems by issuing an interpretation to clarify, explain or elaborate upon existing standards. Thus, interpretations have a much narrower scope than accounting standards. They do not introduce ‘new’ requirements, rather they clarify the application of the existing requirements in the relevant accounting standards.

An answer to this question should identify the differences between accounting standards and accounting interpretations as follows: (a) Scope • Accounting standards address much broader issues/topics than interpretations. Accounting standards prescribe accounting and disclosure requirements . 9

relating to a broad area/topic, for example, AASB 137 ‘Provisions, Contingent Liabilities and Contingent Assets’. • Interpretations prescribe accounting and/or disclosure requirements relating to very specific/narrow issues, for example, Interpretation 132 ‘Intangible Assets – Web Site Costs’. (b)

Context/Framework • AASB evaluates proposed accounting standards in the context of the conceptual framework. • Interpretations are prepared in the context of existing accounting standards and the conceptual framework.

(c)

Due Process • Accounting standards are developed by the AASB after an extensive due process, including consultation with a broad range of constituents, and the preparation of discussion papers, exposure drafts and draft standards. • Interpretations are prepared after a much less extensive due process, which does not involve the same level of constituent consultation, or preparation of documents for public comment.

(d)

Approval Process/Veto Power • After an accounting standard is finalised by the AASB, it may be disallowed by Parliament within 15 sitting days of it being tabled in Parliament. • There is no such veto power in relation to interpretations.

(e)

Authority • AASB Accounting Standards: The Corporations Act 2001 requires reporting entities to comply with AASB Accounting Standards and ASIC enforces compliance with those standards. Additional authority is derived from AASB 1057 ‘Application of Australian Accounting Standards’ (accounting standards and interpretations) and AASB 1048 ‘Interpretation of Standards’ (interpretations). • Interpretations: Paragraph 5 of APES 205 ‘Conformity with Accounting Standards’ APS1 requires members of CPA Australia and CAANZ to comply with accounting standards and AASB Interpretations. CPA Australia and CAANZ enforce compliance with Australian Accounting Standards and AASB Interpretations. • The Corporations Act 2001 does not explicitly require compliance with interpretations, but ASIC has indicated support for the interpretations by attending and participating in meetings of the Interpretations Agenda Committee as an observer. Effectively, interpretations have the same authority as accounting standards.

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The AASB’s Interpretations model has been effective since 1 January 2008 and its major features are as follows. 1) Interpretation Advisory Panels may be formed, as required on a topic-by-topic basis. The role of a panel is to prepare alternative views on the issue and, where appropriate, make recommendations to the AASB. 2) A public register of potential Interpretation Advisory Panel members is maintained on the AASB website and it is from this register that Panel members are drawn. 3) Interpretations of IASB accounting standards are made by IFRIC. Where AASB accounting standards are equivalent to IASB accounting standards, the IFRIC Interpretations will be relevant in Australia. Additionally, if an issue arises that relates to the interpretation of an AASB accounting standard that is equivalent to an IASB accounting standard, it will be forwarded to IFRIC for consideration and possible inclusion in its work program. However, if an issue arises in relation to an AASB accounting standard that does not have an IASB equivalent, the issue will be resolved by the AASB. 4) The due process will include publishing the composition of each panel and its recommendation on the AASB’s website for an appropriate period. Where the AASB proposes to issue an interpretation, the proposed interpretation will be further exposed on the AASB’s website for an appropriate period before the AASB considers it for formal adoption.

The reasons for why the AASB would create the Academic Advisory Panel can be determined from examining the role of the Panel as specified in its Charter. The Charter states: The role of the Panel is to contribute to meeting the AASB’s strategies, particularly with regard to influencing the Australian financial reporting framework and influencing international standard setting with evidence-based research. In fulfilling this role, the Panel is to facilitate: • communication with the academic community and contacts with relevant academics on topics of interest to the AASB; • matching up academics with AASB access to data and constituents and, in turn, helping to obtain grants and other resources; • prioritising AASB research projects; • identifying academic papers that could be provided/presented to the AASB, which could be on current projects or possible future projects; • an academic-in-residence program; • AASB staff conducting seminars for students, especially at Graduate and PhD levels; • building relationships with relevant journals; • access to relevant research databases; • participating in relevant AASB liaison; and . 11

• building the relationship with the AFAANZ board. 12

There are three groups responsible for enforcing the accounting standards issued by the AASB. They are: the accounting bodies; the Australian Securities and Investments Commission; and governments. The enforcement mechanisms employed by each of these groups are considered in turn. Accounting Bodies: The profession’s attitude towards accounting standards has changed from regarding them merely as recommendations during the 1960s to making them mandatory in the 1990s. The Australian Professional and Ethical Standards Board (APESB) was established in 2006 as an initiative of CPA Australia and the then ICAA (now CAANZ) primarily to develop and issue appropriate professional and ethical standards for their membership. Of these professional standards and ethical standards, APES 205 ‘Conformity with accounting standards’ requires members to comply with accounting standards as follows. 4.3 Members who are involved in, or are responsible for, the preparation and/or presentation of Financial Statements of a Reporting Entity shall take all reasonable steps to ensure that the Reporting Entity prepares General Purpose Financial Statements. 5.1 Members shall take all reasonable steps to apply Australian Accounting Standards when they prepare and/or present General Purpose Financial Statements that purport to comply with the Australian Financial Reporting Framework. 5.2 Where Members are unable to apply Australian Accounting Standards pursuant to paragraph 5.1, they shall take all reasonable steps to ensure that any departure from Australian Accounting Standards, the reasons for such departure, and its financial effects are properly disclosed and explained in the General Purpose Financial Statements. 5.5 Members in Public Practice shall take all reasonable steps to ensure that Clients have complied with Australian Accounting Standards when they perform an Audit or Review Engagement or a compilation Engagement of General Purpose Financial Statements which purport to comply with the Australian Financial Reporting Framework. Compliance with APES 205 is mandatory for members of CPA Australia and the ICAA, and non-compliance represents a breach of the Code of Professional Conduct of the accounting bodies. Failure by members to comply with the requirements of APES 205

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could result in disciplinary proceedings being brought against those members, which could result in a fine or expulsion from the professional body. Australian Securities and Investments Commission: Accounting standards issued by the AASB are supported by the Corporations Act 2001. This law applies only to those entities required to report under the Corporations Act 2001. Under section 296 of the Corporations Act 2001, the governing board of a company is required to comply with AASB accounting standards in preparing financial reports. Failure to comply is an offence under the Corporations Act which could lead to prosecution by ASIC. Governments: A standard-setting board cannot issue accounting standards that are legally binding on governments. It is the responsibility of the relevant legislatures to require compliance with accounting standards. Various pieces of legislation require the use of accounting standards in the preparation of financial reports by reporting entities in the public sector. For example, Commonwealth statutory authorities and some Commonwealth departmental authorities are required to comply with accounting standards as a result of guidelines issued pursuant to the Audit Act 1902. The various Australian States and Territories have similar pieces of legislation. 13

The objective of this question is simply to allow students to observe a practical example of enforcement in action. ASIC regularly issues media releases drawing attention to various restatements of financial statements and other similar issues and so these should be relatively easy for students to find. For their chosen example, students should clearly identify what is the matter on which ASIC and the relevant company have disagreed and, where sufficient information is available, which accounting treatment the company adopted and which was preferred by ASIC (and why this treatment was preferred). Students might observe that in the majority of cases the companies concerned may continue to suggest that their treatment was the correct or appropriate one but that they will voluntarily restate their accounts as suggested by ASIC. Reasons why ASIC may publish these examples is to demonstrate to companies and the community that it is serious about, and active in, monitoring compliance with accounting standards. Such an approach is a much cheaper and less antagonistic form

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of regulation compared, say, to ASIC seeking to enforce compliance through the courts. 14

(a) ASIC conducts regular reviews of reporting entities’ financial statements to ensure that investors, creditors and other users of those statements are provided with relevant, reliable, and comparable decision useful information. The quality of financial reporting is evaluated by ASIC on the basis of reporting entities’ compliance with Australian accounting standards. The reviews assist ASIC in meeting its legislative obligations and signal to financial statement preparers and users that ASIC takes its responsibilities seriously. The reviews can also serve an educative purpose by assisting entities to understand the application and interpretation of reporting regulations. (b) Accounting for the extractive industries is covered in Chapter 19. However, students can be encouraged to consider how the nature of the mining and renewable energy industries can impact on financial reporting practices. For example, most students are likely to understand that mining is highly risky because of factors such as the uncertainties associated with finding economically recoverable reserves and the fluctuations associated with the market prices for commodities. Consequently, the value of mining companies’ assets can be highly sensitive to these risks and so issues of asset carrying value and potential impairment are of considerable importance to mining companies. For instance, during 2016, many Australian entities that mined iron ore and produced steel were forced to undertake significant impairment of their assets as a result of the collapse of the market price for iron.

(a) Non-IFRS financial information refers to financial information that has not been prepared in accordance with Australian accounting standards. Other names for nonIFRS financial information include ‘non-statutory profits’ and ‘underlying profits’. IFRS financial information (sometimes also called ‘statutory profits’) is financial information prepared in accordance with Australian accounting standards. Typically, non-IFRS financial information is prepared by converting IFRS financial information to what an entity’s management believes is a more appropriate measure of financial performance. Non-IFRS financial information often excludes unusual write-offs and fair value adjustments. The general objective of these adjustments is to provide the users of the financial statements with information about the ‘true’ (as perceived by management) operational performance of the entity. It has become increasingly common for entities to report both IFRS and non-IFRS financial information in their annual reports. (b) As managers determine what items are included in non-IFRS financial information, there is the potential for them to overstate the performance of the entity or to ‘dress up’ performance to represent whatever picture management desires. Usually, profit disclosed using non-IFRS financial information is higher than under IFRS. In addition, . 14

managers across entities are likely to make different choices about how non-IFRS financial information is determined and this risks reducing the comparability of financial information across entities. As noted in the ASIC Regulatory Guide 230, ASIC has been concerned that some entities have given undue prominence to their nonIFRS financial information over the IFRS financial information which has the potential to mislead financial information users. (c) The most significant item of concern to ASIC was the labelling of some items in non-IFRS profit as ‘extraordinary items’. Such terminology is not part of IFRS (although it was used many years ago). Extraordinary items implies that the specific revenue or expense referred to is in some way very unusual in its size or that it occurs highly infrequently. As such, the implication is that extraordinary items should not be considered by financial statement users as being representative of the entity’s performance or financial position. ASIC is right to be concerned because often items that are labelled as ‘extraordinary’ are items such as impairments which are really a common type of expense. The other concern expressed in the media release is that entities should be careful to ensure that non-IFRS financial information is clearly distinguished from IFRS financial information. The reasons for this concern were noted in the answer to (b) above. 16 (a) Continuous disclosure obligations require the Company to keep the market fully informed of information which may have a material effect on the price or value of the company’s securities and to correct any material mistake or misinformation in the market. The Company discharges these obligations by releasing information to the ASX in the form of an ASX release or disclosure in other relevant documents (for example, the Company’s Annual Report). ASX Listing Rule 3.1 is key to the continuous disclosure regime: it stipulates that ‘once an entity is or becomes aware of any information concerning it that a reasonable person would expect to have a material effect on the price or value of the entity’s securities, the entity must immediately tell ASX that information’ (ASX Listing Rule 3.1). There are some exceptions from continuous disclosure that include: • • •

A reasonable person would not expect the information to be disclosed. The information is confidential and ASX has not formed the view that the information has ceased to be confidential. One or more of the following applies: o It would be a breach of law to disclose the information. o The information comprises matters of supposition or is insufficiently definite to warrant disclosure. . 15

o The information concerns an incomplete proposal or negotiation. o The information is generated for internal management purposes. o The information is a trade secret. More recently the ASX has issued Guidance Note 8 to clarify its position on continuous disclosure. GN 8 makes the following clarifications: • • • •

Material information relates to market movements in price rather than earnings; Immediately means promptly and without delay; Confidentiality is lost if the share price moves or trading volume increases; De-emphasise the ‘reasonable person’ test that provides an exception to disclosure.

(b) This question is answered using the compliance report prepared for the month of February 2017. In this period, the ASX made 15 price queries and 21 ‘other continuous disclosure’ queries. A price query is made by the ASX if it detects unusual movements in a listed entity’s security price or trading volume. An ‘other’ query is made when the ASX has concerns that an entity is not in compliance with continuous disclosure requirements following events such as a media report or an announcement lodged with the ASX. (c) The ASX will refer a matter to the ASIC if it has reason to suspect that a person has contravened, is contravening, or is about to commit a significant contravention of the ASX Group Operating Rules or the Corporations Act. It does not automatically follow that because a matter has been referred to ASIC that (1) a contravention has occurred and/or (2) ASIC will take enforcement proceedings in relation to it. The February 2017 Monthly Activity Report shows only one continuous disclosure referral was made to the ASIC. 17 (a) Since 1980, there have been many changes to the institutional arrangements for setting accounting standards in Australia. The following developments may be noted by students: Mid-1978 The Australian Society of Accountants (now CPA Australia) and Institute of Chartered Accountants in Australia decided to reorganise the standard-setting arrangements and the procedures for preparing accounting standards. The Accounting Standards Board (AcSB) was formed under the auspices of the Australian Accounting Research Foundation, a body jointly funded by the professional accounting bodies. 1983 The Public Sector Accounting Standards Board (PSASB) was established. . 16

1984

1988

1990

1991 2000

The AcSB and PSASB, joined by the Accounting Standards Review Board (ASRB), established the Ministerial Council for Companies and Securities with wide powers, including the power to: sponsor the development of accounting standards; review accounting standards referred to it; and approve accounting standards. The AcSB merged with the ASRB. It was agreed by the professional accounting bodies and the Ministerial Council for Companies and Securities that the ASRB should be the sole standard-setting body for the private sector. Proposals for the establishment of an independent Foundation, and the merger of the ASRB and the PSASB, in a report prepared by Professor Graham Peirson (A Report on Institutional Arrangements for Accounting Standard Setting in Australia). The Australian Accounting Standards Board (AASB) was established to replace the ASRB. The Australian Accounting Standards Board was reconstituted as the sole accounting standard-setting body in Australia, absorbing the role of the PSASB.

It is questionable whether the changes in the institutional arrangements for accounting standard setting in the 1980s and 1990s have improved the quality of the standards and the productivity of the standard setters. However, the changes have demonstrated that accounting standard setting has become very much a political process. (b) A review of the institutional arrangements for setting accounting standards by Professor Graham Peirson (A Report on Institutional Arrangements for Accounting Standard Setting in Australia, 1990) made recommendations for change. The proposals were designed to overcome some of the perceived disadvantages of the standard-setting arrangements at that time. Under the Corporations Act 2001, accounting standards developed by the AASB are valid only to the extent that they are consistent with that Act. As a result there was a constraint on the AASB’s ability to issue relevant accounting standards. For example, the accounting standard on consolidated financial reports which was completed by the standard-setting boards in 1989 was not gazetted as an accounting standard (AASB 1024) until the legislation was amended in 1991 to make it consistent with the proposed AASB Accounting Standard. This constraint on the AASB’s activities would be detrimental to the standard-setting process if it resulted in a tendency towards inflexibility and a lack of responsiveness to the needs of users. With the proposed arrangements, the Accounting Standards Board would be free to issue accounting standards on a timely basis for adoption in all jurisdictions. The onus would then be on the authorities in the respective jurisdictions to adopt the standards.

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The AASB’s attention was focused on entities required to report under the Corporations Act 2001 to the exclusion of other reporting entities in the public and non-corporate private sectors that prepare and issue general purpose financial reports. This deficiency has since been rectified. In addition, under the arrangements at the time, there was unnecessary duplication of effort, with the private sector board and the public sector board considering the same issues. This inefficient use of the scarce resources available for standard setting, it was argued, would be avoided with a single standard-setting board. This deficiency has also been rectified. (c)

The following benefits were expected from the proposed new arrangements: i. Accounting standard setting would be independent of interest groups including the accounting profession, business and government and, therefore, the capacity of the proposed AcSB to develop and promulgate accounting standards would not be delayed by any particular interest group or existing legislative requirements. ii. Merging of the AASB and the PSASB would enable more efficient use of the scarce resources available for setting accounting standards. Merging the two boards would also avoid duplication of effort in standard setting. The proposed new arrangements would provide a more cost-effective and efficient mechanism for setting accounting standards. iii. A significant increase in the number of people involved in the standard-setting process was proposed. Users, preparers, auditors and regulators would have the opportunity of being involved in the standard-setting process, particularly as a result of the formation of broadly based consultative groups. iv. There would be a coordinated national approach to setting accounting standards for the public and private sectors. The proposed AcSB would develop accounting standards applicable to all reporting entities. v. Legislative backing for accounting standards would continue through the various jurisdictions responsible for the different groups of reporting entities. vi. The funding of the Foundation would be more broadly based, thereby contributing to its independence. Implementation of broadly based funding was also expected to increase the resources devoted to standard setting with a consequent improvement in the quality and timeliness of accounting standards.

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Chapter 2 THE CONCEPTUAL FRAMEWORK: PURPOSE, REPORTING ENTITY, THE OBJECTIVE OF FINANCIAL REPORTING, AND QUALITATIVE CHARACTERISTICS LEARNING OBJECTIVES 1 After studying this chapter you should be able to: 2 describe the purpose of a conceptual framework; 3 describe the structure of the Australian conceptual framework; 4 describe the reporting entity concept and the role of general purpose financial reporting; 5 describe the objective of general purpose financial reporting; 6 describe the qualitative characteristics of useful financial information; 7 identify the fundamental characteristics of useful financial information; 8 identify the characteristics that enhance the usefulness of financial information; and 9 identify the nature of the cost constraint on the provision of useful information.

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QUESTIONS 1

The role of a conceptual framework is to help provide guidance to accountants and standard setters on how each of the four fundamental issues of definition, recognition, measurement and disclosure is resolved. Framework 2014 has addressed the first three of these issues, but the concept of disclosure has yet to be addressed in a systematic fashion. A conceptual framework is a normative document because it prescribes how accounting policies should be determined. Paragraph 1 of Framework 2014 states that the purpose of the framework is to: (a) assist the AASB in developing new accounting standards and reviewing those that currently exist; (b) assist the AASB in promoting harmonisation of regulations, accounting standards, and procedures relating to the presentation of financial statements; (c) assist preparers of financial statements when they apply accounting standards or deal with topics that are not yet covered by an accounting standard; (d) assist auditors when they form an opinion as to whether financial statements conform with accounting standards; (e) assist users of financial statements in interpreting the information in those statements; and (f) provide those parties who are interested in the AASB’s work to understand its approach to formulating accounting standards. It can be seen from this list of perceived benefits that, although preparers, auditors and users of financial statements are expected to benefit from the development of a conceptual framework, the accounting standard setters should benefit the most. They should be able to use the conceptual framework to: • • • •

develop accounting standards that are more consistent and logical; improve their accountability; improve the process of communication; and save time and money in the development of accounting standards.

The current Australian conceptual framework (Framework 2014) as at May 2016 comprises the following two documents: • •

SAC1 ‘Definition of the Reporting Entity’; and ‘Framework for the Preparation and Presentation of Financial Statements’.

SAC1 was issued in August 1990. It defines a reporting entity and provides a basis for identifying those entities that are reporting entities. Reporting entities are expected to publish general purpose financial statements prepared in accordance with the AASB’s . 2

accounting standards. It should be noted that the IASB has not issued an equivalent document to Australia’s SAC1. Framework 2014 is structured as follows: • The main body of the document specifies the framework’s purpose, status and scope, and sets out the concepts associated with the definition, recognition and measurement of the elements of financial statements. The concepts of capital and capital maintenance are also briefly addressed. • The appendix consists of two chapters. Chapter 1 describes the objective of general purpose financial reporting, and Chapter 3 specifies the qualitative characteristics that financial information should possess if it is to satisfy the objective of general purpose financial reporting. There is currently no Chapter 2, as the IASB has reserved this chapter for the concept of the reporting entity. Australia had already issued SAC1 on the reporting entity concept before the IASB’s framework was adopted. 3

The Australian Accounting Standards Board (AASB) has adopted the International Accounting Standards Board (IASB) conceptual framework which is set out in ‘Framework for the Preparation and Presentation of Financial Statements’. As a result, SAC2 ‘Objective of General Purpose Financial Statements’, SAC3 ‘Qualitative Characteristics of Financial Information’ and SAC4 ‘Elements of Financial Statements’ have been withdrawn. However, SAC1 ‘Definition of the Reporting Entity’ has been retained because these issues are not dealt with adequately in the IASB document. The IASB updated its conceptual framework and these changes have been adopted in the Australian context as ‘Framework for the Preparation and Presentation of Financial Statements’ 2014 (Framework 2014).

(a) The elements of financial statements in the Australian conceptual framework are the fundamental elements of the financial statements and comprise assets, liabilities, equity, income and expenses. The ‘Framework for the Preparation and Presentation of Financial Statements’ establishes the definitions of the elements and specifies criteria for their recognition in financial statements. (b) The qualitative characteristics of financial information are those attributes that financial information should have if it is to serve the objective of general purpose financial reporting, which is to ‘provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’. (c) ‘Recognition’ means reported on, or incorporated in amounts reported on, the face of the financial statements of the entity. Thus, reporting of information about assets, liabilities, equity, income and expenses in financial statements may be by way of recognition and/or by disclosure in notes in the financial statements. However, inclusion . 3

of the effect of a transaction or event only in notes to the financial statements does not constitute recognition. (d) ‘Measurement’ is defined in paragraph 99 of Framework 2014 which states that measurement ‘is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement’. (e) ‘Disclosure’ is the provision of additional information over and above that which is recognised on the face of the financial statements. These disclosures are made because they provide material information that is useful for users’ decision making. 5

SAC1 notes that general purpose financial statements are designed to meet the common information needs of the users of those statements (which differs from Framework 2014 which notes that the objective of general purpose financial reporting is to ‘provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’). There are several potential groups of users of general purpose financial statements, each having different interests and requiring different information. General purpose financial statements ignore the specific information needs of particular groups of users. Instead, the statements attempt to provide information that is of some use to all potential user groups.

SAC1 notes that general purpose financial statements are designed to meet the common information needs of the users of those statements (which differs from Framework 2014 which notes that the objective of general purpose financial reporting is to ‘provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’). General purpose financial statements are designed to meet the common needs of the users of those financial statements, whereas special purpose financial statements are designed to meet the needs of a particular set of users who are requesting those financial statements. Special purpose financial statements are any financial statement other than a general purpose one. Thus, the financial statements accompanying a company’s annual report are general purpose financial statements, while financial statements prepared for taxation purposes would be special purpose financial statements.

In this question, the users are deemed to be external to the entity, which means that general purpose financial statements are not designed to meet the specific information needs of the managers or governing body of the entity. The users are also deemed to be those who cannot prescribe the information they want from an entity. This suggests that general purpose financial statements are prepared for users unable to command information specific to their needs. Users such as small shareholders and small creditors . 4

must rely on general purpose reports, as generally they are not sufficiently influential to enforce demands for the information they need. Other users, such as major shareholders, trade unions, governments, institutional investors, etc., may be able to use their influence to obtain special purpose statements specifically designed to meet their financial information needs. 8

General purpose financial reports are designed to meet the common information needs of all user groups. Common needs include information on: (a) cash position and cash flows; (b) the financing of operations and on funds flows; (c) the earning power of the entity; (d) the financial position of the entity; and (e) the financial risk incurred in investing funds in the entity. However, it is not clear that all external users have common interests as their decision needs may differ. Investors, for example, may be more interested in the earning power of the entity compared to lenders who may be more interested in cash flows and the asset backing of an entity.

There is evidence to suggest that accounting standard setters do not expect financial statements to be prepared that meet the information needs of users with only a limited knowledge and understanding of financial matters. In the US, the Financial Accounting Standards Board (FASB) has adopted the view that financial information should be ‘comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence’. The FASB’s attitude to ‘financially illiterate’ statement users is that they should either acquire the necessary skills or hire experts to help them. If they do not adopt either of these alternatives, then they must suffer the consequences of ignorance. In considering this matter, it should be remembered that the definition of general purpose financial reporting specifies ‘users who generally cannot prescribe the information they want from an organisation’. The assumed users are, therefore, small creditors, small shareholders, small investors, small customers, small suppliers and so on who individually have little bargaining power or influence. It seems reasonable to assume that a significant number and perhaps a majority of these users will have a ‘limited ability’ to interpret financial information. If it is correct that many users of financial statements are financially illiterate, then it makes little sense to provide information which assumes that they have a ‘reasonable understanding of business and economic activity’. It is apparent that the Australian standard-setting bodies have agreed with the FASB and assume that statement users are financially literate. This was first made explicit in AAS5 ‘Materiality in Financial Statements’, which was issued in 1974. Paragraph 6 stated that . 5

‘A necessary assumption ... is that users will understand the information given in financial statements’. This has been confirmed by the AASB in the ‘Framework for the Preparation and Presentation of Financial Statements’. In explaining the characteristic of ‘understandability’, paragraph 25 notes that: ‘... users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence.’ The attitude of the Australian standard-setting bodies to financially illiterate investors is supported by the efficient market hypothesis, which states that all publicly available information is fully reflected in the market prices of securities and that stock markets react instantaneously and without bias to new information. This market efficiency is due to the actions of well-informed professionals who mainly work for institutional investors. However, there is evidence that management feels some responsibility to the financially illiterate investor. Many companies include highlights statements or financial summaries in their annual reports. These statements contain management’s selection of the most important data from the financial statements and, in many cases, financial ratios are calculated. The preparation of highlights statements presumably results from a managerial belief either that many shareholders cannot understand the financial statements, or that they are unwilling to make the effort to understand them. 10 A reporting entity is an entity that has users dependent on general purpose financial statements for information that is useful to them for making and evaluating decisions about the allocation of scarce resources. Users dependent on general purpose financial statements do not have the power/authority to command the information they require for decision-making purposes. 11 The factors identified in SAC1 that might assist managers in determining whether an entity is a reporting entity are: (a) separation of management from economic interest (para. 20); (b) economic or political importance/influence (para. 21); and (c) financial characteristics (para. 22). SAC1 emphasises that these factors are only provided for the guidance of managers and the main factor to consider is whether there are users dependent on general purpose financial statements for information. 12 The definition of a reporting entity and the factors identified in Question 11 can be used to identify whether the entities in (a), (b) and (c) are reporting entities. Note that in each

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case the decision as to whether the entity is a reporting entity could be argued either way. This solution only outlines the most likely decision. (a) Zippo should be classified as a reporting entity. Assuming that the employees are given the information they need, the only separation of economic interest from control that needs to be considered is that in relation to the creditors. Since the amount owed to each creditor is relatively small and there is an ability to switch suppliers at will, it would be reasonable to expect that individual creditors would not be able to command the preparation of financial statements tailored to meet, specifically, their information needs. Accordingly, Zippo should be classified as a reporting entity. (b) X should not be classified as a reporting entity. Individual members of the company will have the power to command the preparation of financial statements tailored to meet their specific information needs. It is also likely that the supplier and the employees will be able to obtain the information they need for decision-making purposes. Although there is a separation of economic interest and control in that members of the banking syndicate are not involved in day-to-day management, nevertheless, the relationship of the syndicate members with the company is probably such that they would be able to command the preparation of special purpose financial statements tailored to meet their specific information needs. (c) LMN should be classified as a reporting entity. The three shareholders/directors have access to the information they need and the bank can presumably demand the preparation of statements to meet its information needs. However, in the case of employees, there is likely to be a separation of economic interest and control. Individual employees are unlikely to be able to command the preparation of financial statements tailored to meet their specific information needs. 13 Zema Pty Ltd The issue is whether Zema has users dependent on general purpose financial statements for information for decision-making purposes. The possible users of Zema’s financial statements identified in the question are: the directors, family members, employees, the bank or banks and the suppliers. In each of these cases it could be argued that the users have access to the information they need for decision making – that is, they are not dependent on general purpose financial statements for their information needs. In that case, the entity is not a reporting entity. 14 Alpha Chemicals Pty Ltd In answering this question, it is necessary to identify whether there are users dependent on general purpose financial statements for information to meet their decision-making needs. The users identified in the question are as follows: . 7

(a) five shareholders, each of whom is involved in the company’s day-to-day operations; (b) 100 employees; (c) customers, mainly in Victoria and South Australia; and (d) a major creditor in the form of a syndicate of banks. The five shareholders and the major creditors are not dependent users. However, the 100 employees and the customers are unlikely to be able to demand the financial information they need for decision-making purposes. As a result, they are likely to be dependent users. If this is the case, Alpha Chemicals Pty Ltd is a reporting entity. 15 The objective of general purpose financial reporting is now set out in Chapter 1 of the Appendix to Framework 2014 and, in Australia, the objective applies to both for-profit and not-for-profit entities. Paragraph OB2 of Framework 2014 states: ‘The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit.’ Understanding the objective of general purpose financial reports provides a basis for identifying the remaining components of the conceptual framework. As decision usefulness for investors and creditors has been set as the objective, accounting standard setters can, at least in principle, address accounting issues in a way that is informed by evidence about what types of definitions, recognition criteria, measurement rules, and disclosure practices are most decision useful to investors and creditors. Of course, in practice, it is much more difficult to observe and agree upon what is decision useful information as users have both common and differing information needs. 16 The choice of ‘decision-usefulness’ as the objective for financial reporting is a relatively recent phenomenon. Many accountants believe that it cannot be achieved with a measurement system that is primarily designed for stewardship or accountability purposes. They believe that the existing historical-cost measurement basis should be abandoned and replaced by a measurement basis specifically designed to meet the decision-usefulness objective. However, the conceptual framework has been developed by the accounting standard setters to be neutral with respect to measurement. No one basis of measurement has been promoted as superior in Framework 2014 which essentially only notes that alternative measurement bases are available. 17 Accountability is a concept that has been defined and understood in many ways. For example, some commentators view accountability as a concept reflecting stewardship . 8

over owners’ contributed assets while others take broader definitions that reflect wider responsibilities of management (e.g., responsibility for environmentally sustainable operations). Over time concepts of accountability have arguably broadened. If standard setters can identify an accepted definition of, and demand for, information about accountability, then this would be decision useful. Therefore, although the objective in Framework 2014 emphasises decision-usefulness, this is not incompatible with a need for accountability depending upon what is generally accepted as the definition of accountability. Indeed, paragraph OB4 of Framework 2014 explicitly notes that useful information includes how effectively and efficiently the management or other governing body has discharged its duties. 18 The arguments presented in the answer to Question 9 could also be applied in answer to this question. 19 It is unclear as to who are the ‘most important group of users of financial statements’ as this is a normative judgement about whose interests should prevail over others. The concept of general purpose financial statements (GPFS) might be interpreted as suggesting that GPFS should serve the information needs that are common across all users of those GPFS. However, in its statement about the objective of GPFS Framework 2014 emphasises the information needs of investors and creditors and it could be argued that the needs of these two groups have been given privileged status relative to other users. This may be because the constitution of the IASB requires it to prepare accounting standards for global capital markets. 20 (a) The objective of general purpose financial reporting in Framework 2014 is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. Users therefore need information assisting them to assess the amount, timing and uncertainty associated with an entity’s future cash flows (para. OB3); and determining the resources available to the entity and the claims on those resources, including information on how effectively and efficiently the management or other governing body has discharged its duties (para. OB4). (b) The objective of general purpose financial reporting is meant to provide a focus for the accounting standard setters. They know that when setting accounting standards they should only be requiring the provision of information that is useful to users for making decisions about the allocation of scarce resources. In this sense, therefore, Karen is correct in saying that the objective provides a starting point for the improvement of financial reporting. The other levels of the conceptual framework provide further guidance for the standard setters when setting accounting standards. . 9

21 Chapter 1 of Framework 2014 identifies the major types of decisions that the primary users make that would be served by general purpose financial statements. In the forprofit sector, these decisions include: • assisting the users to assess the amount, timing and uncertainty associated with an entity’s future cash flows (para. OB3); and • determining the resources available to the entity and the claims on those resources, including information on how effectively and efficiently the management or other governing body has discharged its duties (para. OB4). In the not-for-profit sector the types of decisions of interest to the users of general purpose financial statements would include whether the entity has the ability to achieve the financial and non-financial objectives for which it was created (para. AusOB3.1). With regard to an entity’s stock of economic resources and claims on those resources, paragraphs OB13 and OB14 note that general purpose financial statements should help users to assess how the mix of economic resources might have an impact on the pattern of the entity’s cash flows and also provide information that assists users to understand the entity’s liquidity and solvency. Paragraphs OB15 to OB21 describe how general purpose financial statements should also provide useful information about the changes in an entity’s economic resources and claims on those resources. Such changes could arise from the entity’s operations or from other events, such as contributions by owners or changes in the market value of the entity’s resources. Paragraph OB20 notes that information about the changes in cash flows during a period helps users to understand how the entity’s operating, financing and investing activities impact upon its liquidity and solvency. This information describes the entity’s sources and uses of cash and allows users to assess whether these cash flows are sustainable in the future. A great deal of empirical evidence exists to suggest that these needs will generally be provided by conventional financial statements. For example, capital markets research shows that earnings figures matter to investors. However, students could explore ways in which these reports could be improved. 22 The qualitative characteristics of financial information are the attributes or qualities that the information should have if it is to be useful for decision making. If financial information does not have these characteristics, then the objective of general purpose financial reporting cannot be achieved. According to Framework 2014, the fundamental qualitative characteristics of financial information are relevance and faithful representation. The information also has to meet the materiality test. In addition, there are four enhancing qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. They are: comparability, verifiability, timeliness and understandability. . 10

23 This question relates to the qualitative characteristic of understandability. Whether information is understandable depends on the users of that information. The understandability of financial information may be influenced by the amount of detail, the use of technical language, the format of the financial statements and so on. To make financial information understandable to as many users as possible, accountants may be tempted to present simple, abbreviated, uncomplicated financial statements. However, such a policy may deprive the general purpose financial statements of other desirable qualities such as relevance and faithful representation. Paragraph QC32 of Framework 2014 recognises the complexities associated with understandability in the context of general purpose financial reporting: ‘Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.’ 24 The fundamental characteristics that financial information should have for it to be selected for inclusion in general purpose financial statements are relevance and faithful representation. Relevance and faithful representation are discussed in the IASB’s Conceptual Framework for Financial Reporting 2014 (Framework 2014). The financial information should also pass the materiality test. 25 Framework 2014 specifies that for financial information to be relevant, it should have a confirmatory role and a predictive role (para. QC7). Financial information has a confirmatory role when it is used to confirm or correct decision makers’ expectations (para. QC9). Financial information has a predictive role when it is used to make predictions of, for example, future cash flows or profit (para. QC8). 26 Financial information may be relevant but, if it is not material, the benefits to users from its selection by the reporting entity would be negligible. Paragraph QC 11 of Framework 2014 states that: ‘Information is material if omitting it or misstating it could influence the decisions that users make on the basis of financial information about a specific reporting entity.’ The inclusion of immaterial information could reduce the understandability of financial statements. An item is regarded as material if it is likely to influence the decisions of financial statement users. 27 Paragraph QC 12 of Framework 2014 requires useful information to faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation a depiction would have three characteristics. It would be complete, neutral and free from . 11

error. To be a complete depiction of an item, all information for a user to understand the item must be provided. To be neutral the depiction of an item must be free from bias in the selection or presentation of the item. The depiction of an item must also be largely, but not necessarily completely, free of error. 28 Sometimes it may be necessary to make a trade-off between relevance and faithful representation. For example, while a substantial delay before publication of financial statements may improve the faithful representation of information in those statements, the relevance of the information would be reduced. 29 The qualitative characteristics that enhance the usefulness of financial information are comparability, verifiability, timeliness and understandability. Information about a reporting entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date (para. QC 20). Similarly, financial information is more useful to users if it is verifiable and thereby helps to assure users that the information faithfully represents what it purports to represent. Further, the usefulness of financial information is influenced by its timeliness – this involves both the frequency of reporting and the length of time between the end of a reporting period and the publication of the financial report. Finally, information will only be useful if it is understandable to financial information users – financial information is understandable when users of that information can comprehend its meaning. 30 Meeting the objective of general purpose financial reporting requires accounting standard setters to write standards that reflect users’ information needs. Surprisingly, the needs of users are often not well understood and standard setters have often had to make assumptions about user needs based, in part, on their own experiences. It might seem a simple solution is to ask users what they want but there are some difficulties wish such an approach including: • In answering a question about the information they would like, many users of financial statements are constrained by their experiences. Their decision-making processes are geared to the information already available and they may not see advantages in other information that could be provided. They may not know how useful information that they have never seen might be. • The decision-making process is not the same for all decision makers. Two people making the same decision may rely on different information and process it in different ways. • Users may not consider the costs associated with generating information specific to their particular needs. Some types of information may be impracticable or very costly to obtain. If some users (e.g., investment analysts) don’t have to bear the cost of producing this information, they will happily ask for it. Other users (e.g.,

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shareholders) who bear the costs of information production may be reluctant to provide it! 31 It is acknowledged in Framework 2014 that even though financial information may be relevant and representationally faithful, there may be a cost constraint that prevents it from being provided in general purpose financial statements. Paragraphs QC 35–39 of Framework 2014 consider the importance of the costs and the benefits arising from the provision of some financial information. The measurement of costs and benefits is fraught with difficulties – costs (e.g., information production, compliance) are usually easier to observe than the benefits (e.g., users make better decisions). Note in this context the requirement to prepare a Regulation Impact Statement where the AASB assesses that the standard will involve a medium or significant level of compliance costs. 32 AASB 108 requires accounting policies to be selected and applied in a manner which ensures that the financial information is relevant and reliable. The accounting standard identifies that where substance and form differ, then the substance rather than the form of a transaction or other event must be reported if information is to be relevant and reliable. Reporting the substance of a transaction or other event requires that the information reported reflects its economic effect. For example, a preference share would be classified as a financial liability (even though it is called a ‘share’) if the preference share contained rights that provided for redemption on a specific date. This is because the issuer has an obligation to transfer financial assets to the holder of the preference share (see AASB 132 ‘Financial Instruments: Presentation’, para. AG25).

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Chapter 3 THE CONCEPTUAL FRAMEWORK: DEFINITION, RECOGNITION, AND MEASUREMENT OF THE ELEMENTS IN GENERAL PURPOSE FINANCIAL STATEMENTS LEARNING OBJECTIVES After studying this chapter you should be able to: 1

identify the elements of financial statements;

distinguish between the definition and recognition of the elements of financial statements;

define measurement and identify the alternative measurement scales;

describe measurement in the context of accounting;

define assets and identify their essential characteristics;

identify the recognition criteria for assets and describe the alternative measurement bases that may be employed;

define liabilities and identify their essential characteristics;

identify the recognition criteria for liabilities and describe the alternative measurement bases that may be employed;

define equity and describe the basis for its recognition and measurement;

10 define income and identify its essential characteristics; 11 identify the recognition criteria for income and describe its measurement; 12 define expenses and identify their essential characteristics; 13 identify the recognition criteria for expenses and describe the measurement of expenses; and 14 define profit. . 1

QUESTIONS 1

Paragraph 47 of Framework 2014 states that financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These ‘broad classes’ are the elements of financial statements. For the statement of financial position the elements are assets, liabilities and equity, and for the statement of comprehensive income the elements are income and expenses. As it is a function of income less expenses, the concept of profit is not identified as a financial statement element. In addition, cash receipts and cash payments, the components of the statement of cash flows, are not identified as financial statement elements.

The definition of an element is a statement identifying the characteristics that an item must have if it is to be considered as a member of that class of element. In contrast, recognition is the action or process of recording an item in the entity’s accounting records.

MEASUREMENT 3

This is the definition provided by S.S. Stevens (cited in the text). It is a broad definition that encompasses procedures that are not generally regarded as measurement. According to Stevens, any process that assigns numerals to objects or events according to rules is measurement. He suggested that there are four types of measurement – they are those that use: (a) nominal scales; (b) ordinal scales; (c) interval scales; and (d) ratio scales.

According to Stevens (cited in the text), the use of nominal scales is a form of measurement. Objects or events are classified by assigning numbers to them using rules. For example, a university may assign identification numbers to students. The first two numerals may be the year of first enrolment, the next two may indicate the area of major study. The next two may represent the first letter of the student’s family name and the last four may be the order in which the student first enrolled. A student identification number of 1814034168 may indicate that the student first enrolled in 2018, is majoring in the area 14, has a family name starting with the letter C and was the 4168th student to enrol for the first time in 2018. The numerals have been assigned to students using rules, and according to Stevens’ definition, the process is measurement. Other examples of measurement using nominal scales include the assignment of postcodes to geographical area and the numbering of ledger accounts in a chart of accounts.

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Ordinal scales assign numerals to indicate an order or preference. This type of measurement allows discrimination between objects or events, using terms such as ‘more than’, ‘less than’ and ‘equal to’. The objects or events are ranked. In an interval scale the class intervals are a constant size and that the change in the attribute being measured is reflected in the assigned numeral. With an interval scale, it cannot be assumed that an assigned numeral of ‘0’ means that the attribute being measured is completely absent. A ratio scale has an additional feature beyond the interval scale. It has a natural zero, which is that point at which the measured characteristic is completely absent. Linear measurements involve the use of a ratio scale. If the lengths of two objects are measured and the numerals 3 and 6 are assigned to them, it can be assumed that one object (assigned 6) is twice as long as the other object (assigned 3). The scale has a nonarbitrary zero, and so the relationship between two levels of the characteristic being measured is the same as the relationship between the assigned numerals.

The essential components of the measurement process are: (a) an object or an event; (b)a property, attribute or characteristic to quantify; and (c) a scale or set of units that can be used to quantify the property, attribute or characteristic. Suppose, for example, that we wish to measure a large rock. The rock has many properties that could be measured. For example, there is mass, weight, volume, temperature, specific gravity, ductility and so on. The property that is measured in a particular situation depends on the circumstances. In some cases, volume would be the most appropriate, and in others weight, or some other property, may be more appropriate. The choice of the property to measure depends on the purpose of the measurement. If it is decided that weight is the appropriate property of the rock to measure, then a scale or a set of units must be selected. Assume that the metric weight scale is chosen. This is a ratio scale, as a numeral of zero implies the absence of weight. Provided that a suitable instrument is available for assigning a numeral as a measure of weight to the rock, then measurement is simply a matter of observation.

The ‘quality’ of a measurement can be assessed by replication. The greater the degree of consensus among measurers having similar instruments and constraints who are measuring the same property of the same object, the higher the ‘quality’ of the measurement. In general, replication is easier in the physical sciences and measurement seems to be of a higher quality than measurements in the social sciences where the measured properties are often less tangible and more value laden. Physical scientists attempt to measure properties such as velocity, mass, volume or length, whereas social . 3

scientists attempt to measure properties such as behaviour, literacy, intelligence, wellbeing or value. 8

In accounting, there is general agreement that the measurement scale should be money. The elements of financial statements are measured using a monetary scale, which means that the assigned numerals are accompanied by a dollar sign. Assets, liabilities, revenues and expenses are all measured as amounts of money. Ideally, these amounts of money should be capable of aggregation. They should be amenable to addition, subtraction, multiplication and division. Aggregation is not meaningful if different properties are measured or different scales are used. Suppose, for example, that accountants are measuring assets. In situations where the future economic benefits are associated with physical objects (for example, inventory), accountants choose to measure the cost of acquiring the object. In cases where the benefits come from rights to receive cash (for example, accounts receivable), accountants choose to measure the amount of cash expected to be received in the future. Accountants would then be measuring different properties of two classes of assets. The results cannot be meaningfully aggregated. The simple aggregation: _________________________________________________________________ Non-current assets (at cost) $1 000 Net receivables (at expected cash receipts) $2 000 Total $3 000 _________________________________________________________________ makes little sense because measures of different properties cannot be aggregated even if the same scale is used. It is therefore difficult to attribute meaning to the $3000 total.

The ‘value’ of money varies over time, so that problems of aggregation arise where the same properties are measured using different scales. For example, accountants may agree that the cost of acquiring an asset is the appropriate property to measure. However, measuring the cost incurred in 1997 using 1997 dollars involves a different scale from measuring the cost incurred in 2017 using 2017 dollars. Therefore, the following aggregation makes little sense. _________________________________________________________________ Asset A (1997 dollars) $10 000 Asset B (2017 dollars) $ 6 000 Total $16 000 _________________________________________________________________

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It is therefore difficult to attribute meaning to the total of $16 000 because 1997 and 2017 dollars are not the same. Aggregating them is similar to aggregating Singapore dollars and New Zealand dollars or aggregating metres and feet. ASSETS 10 Assets are defined in paragraph 49(a) of Framework 2014. Their essential characteristics are: (a) the presence of future economic benefits; (b) the existence of control by the entity; and (c) the asset must be the result of a past event. These characteristics are discussed in paragraphs 53 to 59 of Framework 2014. 11 Legal ownership is not an essential characteristic of assets. While ownership is generally synonymous with control of the future economic benefits from an asset, this is not necessarily the case. For example, in the case of a property lease, the lessee controls the future economic benefits without owning the leased property. 12 This is not the case. There are many cases where there are future economic benefits without the asset having been purchased. Two examples are where an asset has been donated and where an asset has been leased. 13 Severability or exchangeability is not an essential characteristic of an asset. The essential characteristics are those identified in the answer to Question 10. An example of an asset that is not severable or exchangeable is goodwill. 14 While agreements that are equally proportionately unperformed have generally not been recognised as assets in accounting, it is no longer appropriate to assume automatically that such agreements do not result in assets. If the definition and recognition criteria of assets are satisfied, an asset should be recognised in the financial statements. Examples of such agreements include leases and firm commitments to purchase assets. 15 This question relates to agreements equally proportionately unperformed. To illustrate this consider the following. Suppose that a football club signed a contract with X for three years, which included payments of $4000 at the end of each month. At the date of signing the contract, the football club has a binding commitment to pay X $144 000 and X has a commitment to play for the club for three years. At the date of signing the contract, the contract is equally proportionately unperformed because both parties have yet to perform 100% of their obligations under it and the view has prevailed that, in such circumstances, no asset . 5

(or liability) exists. Framework 2014 suggests a reinterpretation of this traditional view is possible. If the entity (the football club) controls the service potential or future economic benefits, then the right to those benefits may satisfy the definition of an asset. Consider X in the above example. X has the right to receive $144 000 over the next three years. If the contract is non-cancellable or the penalties for cancellation by X are so severe that cancellation is unlikely, then it could be argued that the entity controls the future economic benefits from recruiting X, and that an asset exists. In other words, it is no longer appropriate to assume automatically that agreements that are equally proportionately unperformed do not result in assets. In each case, the terms of the agreement should be considered to determine whether the benefits from the agreement satisfy the definition of an asset. 16 Framework 2014 provides that the elements of financial statements are recognised only when they are recorded in the body of the financial statements. Inclusion of an element only in notes to the financial statements does not constitute recognition. Paragraph 83 states that: ‘An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefits 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.’ In other words, an asset is recognised only when future economic benefits are probable and a reliable measure of the cost or value of the asset is possible. 17 An asset is defined as future economic benefits controlled by an entity as a result of a past event. Future economic benefits may come from two sources: either from the use of the asset or from its sale. Where the benefits come from use, it is customary to refer to the asset as having ‘value-in-use’, and where the benefits come from sale, the asset is said to have ‘value-in-exchange’. All assets have both a value-in-use and a value-inexchange and these values may be quite different. Consider, for example, a wheat farmer’s harvest. It will have a fairly low value-in-use because the farmer is unlikely to be able to use effectively several hundred tonnes of grain. The harvest would have a much higher value-in-exchange than value-in-use. Value-in-exchange exists, however, because an asset has value-in-use for a prospective buyer. Thus, the value of an asset ultimately depends on it being useful to an entity. 18 It is argued that the measurement of historical cost is relevant to the stewardship objective of financial reporting, but it is probably of less relevance for the decisionusefulness objective of financial reporting. However, there is some doubt whether it is more reliable than other measures. The crucial question in deciding the appropriateness of measuring historical cost is the relative importance attached to the stewardship objective of general purpose financial reporting. If stewardship is relegated to a relatively . 6

minor role in the conceptual framework, then the measurement of historical cost is also likely to be less relevant. 19 The reasons for proposing the measurement of current cost fall into two groups. The first reason is that current cost is a good approximation to value. Revsine (cited in the text), for example, states, ‘At any point in time the replacement cost of an asset is the most objective possible approximation of its discounted present value – the theoretical best measure of asset worth’. The second and predominant reason for using current cost is that its use provides a more relevant measure of profit and financial position than historical cost and is, therefore, more useful for decision makers. 20 The current cash equivalent of an asset is its current selling price (market value) – that is, the amount of cash or cash equivalents that could be obtained by selling the asset. 21 There is a view that multiple measures of an asset are preferable to providing only one measure. In some cases, the proposals for multiple measures are regarded as an interim step while awaiting general agreement on the single characteristic to measure, and in other cases, multiple measures are regarded as the best solution. Multiple measures of an asset are intuitively appealing from a financial position viewpoint. If accountants cannot decide which particular basis of measurement to employ, disclosing several measurement bases is likely to satisfy more statement users than making an incorrect choice of a single measurement basis. Nobody’s interests are ignored. Advocates of using a specific measurement basis are unimpressed by such a compromise solution. Revsine (cited in the text) argues that multiple measures are likely to lead to ‘information overload’ where statement users are ‘so overburdened with data’ that they either ignore much of those data or become confused. It is difficult to believe, however, that providing statement users with, say, the historical cost, the market buying price and the market selling price of an asset, is going to overburden them with data. A more convincing argument against multiple measures of assets is the creation of multiple rates of return and multiple financial ratios which may lead to confusion. In addition, multiple measures of assets will also result in multiple measures of profit which could also be confusing and misleading. LIABILITIES 22 The essential characteristics of a liability are: (a) the existence of a present obligation to another entity; . 7

(b) a future sacrifice of economic benefits; and (c) the liability results from a past event. This question relates to the first of these essential characteristics. Thus, the obligation to the other entity must be legally, equitably or constructively unavoidable. A liability does not exist if it can be avoided by an action other than by future sacrifices of economic benefits by the entity. A legal obligation may arise from a contract or it may be imposed by legally authorised bodies or government statutes. A contractual obligation is knowingly entered into by the reporting entity with another entity and may include agreements to borrow, to pay for purchases, or to pay for services. An imposed obligation could include damages awarded against the entity by a court, payments due under the Income Tax Assessment Act 1936, or workers’ compensation schemes. An equitable obligation arises from social or moral considerations or from custom rather than legal sanctions. An equitable obligation stems from a duty to another entity to do that which an ordinary conscience and sense of justice would deem fair, just and right – to do what one ought to do in the pursuit of one’s objectives rather than what one is legally required to do. An example of an equitable obligation is where a profit-seeking entity, based on moral considerations, undertakes to rectify faults in one of its products even where these become apparent after the warranty period has expired. A constructive obligation is created, inferred or construed from the facts in a particular situation rather than contracted by agreement with another entity or imposed by government. An example of a constructive obligation is the practice of paying periodic bonuses to employees even though the entity is not contractually bound to do so. 23 For there to be a liability, the obligation must be in existence, or present. This means that obligations that will or may arise in the future do not result in liabilities. There must be a present obligation to an external party for a liability to exist. For example, an entity may have decided to commit itself to large maintenance expenditures or to significant capital expenditures in the next reporting period. Because these are not present obligations, but only obligations that will arise in the future, no liability exists. At the end of the reporting period, there is no obligation to pay anything to anyone. There is merely an intention to enter into commitments in the future. However, where there is a firm purchase commitment which cannot be avoided without a significant penalty, then a liability probably exists. If the commitment is firm and it is probable that the obligation under the agreement would be enforced in the event of cancellation and the amount of the obligation can be measured reliably, then the rights

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and obligations under the firm purchase commitment are likely to satisfy the criteria for recognition as an asset and a liability. 24 The issue here is that a liability must be the result of a past transaction or other past event. A liability does not generally result from future obligations. The answer to this question is essentially the same as the answer to Question 23. 25 If an entity guarantees the debt of a third party, the issue to be resolved is whether there is a present obligation. For a present obligation to exist, the entity must have no realistic alternative but to make the future sacrifice of economic benefits to settle the obligation. Providing a guarantee gives rise to a legal obligation. However, at this point in time the future sacrifice of economic benefits is less than probable. As a result, no provision is recognised and the guarantee is disclosed as a contingent liability. For further discussion see AASB 137 ‘Provisions, Contingent Liabilities and Contingent Assets’. 26 This is a true statement. In some cases agreements that are equally proportionately unperformed by both parties may result in obligations that satisfy the definition of a liability. It can no longer be assumed that such agreements do not result in liabilities. The existence of a liability does not necessarily mean that it will be recognised in the financial statements. The liability also has to meet the recognition criteria. 27 In the context of the application of the provisions of Framework 2014, it is necessary to identify the event that gives rise to the present obligation. Two situations are identified in the question. In the case of product warranties, it is the sale of goods that gives rise to the present obligation. It is incorrect to wait for a claim under the warranty before recognising the liability. A claim under the product warranty is the event that requires the vendor to discharge the obligation – but it doesn’t give rise to the obligation. In the case of sick leave, the obligation arises as a result of the provision of services by employees. Again, it is not the claim by the employees that gives rise to the liability. A claim for sick leave is the event that requires the employer to discharge the obligation – but it doesn’t give rise to the obligation. 28 Framework 2014 deals with the criteria for the recognition of liabilities in paragraph 83. Like assets, liabilities are recognised only when the future sacrifice of economic benefits is probable and the amount of the liability is capable of reliable measurement. 29 Framework 2014 provides that a future sacrifice of economic benefits is probable if the sacrifice is more likely rather than less likely. In other words, the liability should be recognised if the probability of the sacrifice of future economic benefits occurring . 9

exceeds 0.5. Assessing probability is, of course, a matter of judgement and provides some scope for creativity. However, if a material liability fails the probability test and is not recognised in the statement of financial position, then it must be disclosed in the notes to the financial statements. 30 If a liability fails either the probability test or the reliability test, it should not be recognised, but should be disclosed in a note to the financial statements. For example, an entity may, at the reporting date, be engaged in litigation in defence of a claim for damages. While it may be probable that a future sacrifice of economic benefits will be required, it may be impossible for it to be reliably measured. Nonetheless, disclosure of the existence of the claim, if material, could assist users in making assessments of the present and expected future financial position of the entity. 31 The historical cost of a liability can be measured in two ways: the contract-price method and the internal-yield method. The contract-price method involves carrying liabilities at their contract price. If an entity agrees to pay $10 000 to a creditor, then the liability is $10 000. The amount of the liability is the cash equivalent of the future sacrifice of economic benefits. The liability is fixed in money terms and does not change as maturity approaches. This is the conventional way to measure a liability. Any interest payable on the debt is treated separately. The internal-yield method recognises the dual obligations to repay the principal and to make the interest payments as they fall due. The amount of the liability shown in the statement of financial position is the present value of interest and principal payments discounted at the internal yield on the debt. The internal yield is the effective rate of interest implicit in the borrowing agreement. These two ways of measuring the historical cost of a liability give the same result. 32 In general, there are two factors that are likely to cause the current yield to differ from the internal yield. In the first place, yield is related to the term. In most circumstances, the longer the term, the higher the yield. Thus, if all other factors remain unchanged, we would normally expect the current yield to decline as maturity approaches. Second, there may be shifts in the general level of interest rates in response to changes in the supply of and demand for money. 33 The current cash equivalent of a liability is the amount necessary to settle the liability at the reporting date. The current cash equivalent of a liability could be measured as either the amount which, if paid to the creditor at the reporting date, would discharge the obligation in full; or as the amount which, if invested at the reporting date, would provide sufficient cash to meet the interest and principal obligations as they fall due. The . 10

effective current cash equivalent would be the lower of these two amounts. No rational person would pay more than was necessary to settle a debt on a specified date. Suppose, for example, that an entity had a debt that could be settled in full by a payment of $10 000 to the lender. The entity could also make an investment of $9800 which would generate sufficient cash to meet the interest payments as they fell due and the principal repayment at maturity. The entity would be foolish to pay $10 000 now when the debt could be effectively settled by a payment of $9800. EQUITY 34 Equity is the residual interest in the assets of the entity after deducting its liabilities. As a result, equity is measured as the difference between the assets and liabilities of the entity. It follows that there are no recognition criteria for equity, only recognition criteria for the assets and liabilities of the entity. The measurement base for equity depends upon the measurement base(s) chosen for assets and liabilities. INCOME 35 Paragraph 70(a) of Framework 2014 defines income as increases in economic benefits during the accounting period in the form of inflows or enhancement of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants. From this definition, we can identify the following essential characteristics of income: (a) it is a flow; (b) that takes the form of increases in assets or decreases in liabilities; and (c) results in an increase in equity. This requires that the inflows or other enhancements in the form of an increase in assets or a decrease in liabilities must increase equity. An increase in assets as a result of an issue of debt securities would not increase equity and would not, therefore, give rise to income. However, note that there are some increases in equity, in particular those resulting from contributions by owners, that do not qualify as income. 36 The answer to this question requires a comparison of the FASB definition of revenues and the AASB definition of income. In the US, this would be a true statement, whereas in Australia this would not be the case. 37 The answer to this question is no. Income can be generated as a result of an enhancement of an asset as would be the case in respect of foreign exchange gains. In some cases, production may also give rise to income.

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38 Under Framework 2014, income would be regarded as ‘probable’ if the probability that the inflow or other enhancement or saving in outflows of economic benefits having occurred is more likely rather than less likely. There are reasons, however, for believing that many accountants would regard a probability of 0.5 as too low. For many years, it has been the conventional practice to delay the recognition of revenues until the inflow of resources is beyond any reasonable doubt. As a general rule, revenues are not recognised until there is a sale which creates a legally enforceable claim to the proceeds of the sale. If, after a sale, there is any doubt that the proceeds will be received, then the revenues are still recognised but an appropriate allowance for doubtful debts is raised. With this conventional practice, the probability is much higher than 0.5 before revenues are recognised. If the 0.5 probability criterion is applied to revenues, accounting practice is likely to be changed with revenues being recognised earlier in the operating cycle than is presently the case. 39 To be recognised, income must meet the recognition criteria specified in Framework 2014 paragraph 83. Realisation, however, is the term applied to the receipt of cash or its equivalent from a revenue transaction. EXPENSES 40 Paragraph 70(b) of Framework 2014 defines expenses as decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or increases of liabilities that will result in decreases in equity, other than those relating to distributions to equity participants. From this definition, we can identify the following essential characteristics of expenses: (a) they are flows; (b) these flows take the form of decreases in assets or increases in liabilities; and (c) these flows result in a decrease in equity. This requires that the decrease in assets or an increase in liabilities must decrease equity. When an entity exchanges one asset for another, as would be the case when it purchases inventory, there would be no reduction in equity and the transaction would not, therefore, give rise to an expense. However, note that there are some decreases in equity, in particular those resulting from distributions to owners, that do not qualify as expenses. 41 This is a true statement. Dividends are regarded as a distribution to owners.

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42 The notion of ‘matching’ has been a traditional basis for recognising expenses but it is not a recognition criterion for expenses in Framework 2014. Paragraph 95 of Framework 2014 notes: ‘Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events. For example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets or liabilities.’ 43 The definition of expenses suggests that they take the form of ‘reductions in assets or increases in liabilities ... during the reporting period’. The measurement of expenses, therefore, depends on how assets and liabilities are measured. The amount of an expense is the reduction in the amount of the asset that is ‘used up’ or the increase in the liability. In many cases, expenses are paid by cash and the amount of the expense is simply the amount of cash paid. Where expenses are an outflow of resources other than cash, the amount of the expense should be the book value of the outflow. For example, if an expense is paid by handing over an asset other than cash, the amount of the expense is the book value of the asset. If an expense results in an increase in a liability, the amount of the expense is the amount of the increase in the liability. 44 Under Framework 2014 a probability of loss of future economic benefits of 0.5 or more is necessary for the recognition of expenses. It has been conventional practice to recognise expenses when the probability of loss of future economic benefits is less than 0.5. For example, as soon as there is a chance of an account receivable not being paid, a doubtful debt expense is usually recognised. Similarly, when the market price of inventory falls below cost, an expense is usually recognised. When the 0.5 probability criterion is applied to expenses, it is likely that they would be recognised later in the operating cycle than is now the case. PROFIT 45 Profit is the difference between income and expenses. Profit exists only because there are income and expenses. There are no recognition criteria for profit, which is recognised in the statement of comprehensive income only when income and expenses are recognised. The presentation of income and expenses in a statement of comprehensive income, and therefore the measurement of profit, is a matter of display in the Australian conceptual framework. . 13

46 Hicks’ definition of a person’s weekly income is ‘the maximum value which he can consume during a week and still expect to be as well-off at the end of the week as he was at the beginning’. Hicks’ definition of personal income has been modified to make it applicable to business profit. For example, Bierman and Davidson (cited in the text) suggest that business profit is ‘the dividend which could be paid and leave the firm well off at the end as it was at the beginning of the period’. 47 The concept of maintaining capital intact is necessary to distinguish between a return of capital and return on capital. Profit can only be measured after maintaining the entity’s capital at the beginning of the period. This issue is considered in paragraphs 102–110 of Framework 2014.

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PROBLEMS 1

Dribnor Ltd This question involves students considering whether the following transactions and events meet the definitions of the elements. In answering these questions students should identify the essential characteristics of assets and liabilities and analyse each transaction or event in light of those characteristics. (a) The payment of 10% deposit would be recognised by the following general journal entry: ______________________________________________________________ Deposit on capital equipment Dr $100 000 Cash at bank Cr $100 000 ______________________________________________________________ The issue is whether it is appropriate to recognise the other $900 000 as an asset and a liability. The answer to this question turns on whether Dribnor controls the future economic benefits from the capital equipment. MMM could fail to perform its part of the contract or Dribnor could change its mind about the purchase. As a result, it can be argued that Dribnor does not control the future economic benefits from the capital equipment and that only the deposit should be recognised as an asset in the accounts. (b) The general journal entry to record this event would be: ______________________________________________________________ Plant and maintenance expense Dr X Provision for plant maintenance Cr X ______________________________________________________________ In the context of the conceptual framework, Dribnor should not recognise the liability (or the expense) because there is no present obligation to an external party. There is merely an intention to carry out the plant maintenance at some time in the future. (c) Legally, preference shares are part of equity. However, in the context of the conceptual framework, the preference shares might meet the definition of a liability if, for example, they were redeemable at the option of the holder (rather than the issuer). (d) The issue in this case is whether to recognise the government grant as an asset and as income. In the context of the conceptual framework, the general journal entry to recognise this event would be: ______________________________________________________________ Government grant receivable Dr X Income Cr X ______________________________________________________________ . 15

Dribnor has been informed that it has been awarded the grant. The recognition of income will revolve around whether Dribnor controls the future economic benefits from the government grant. The available evidence would suggest that the future economic benefits are probable and can be reliably measured. 2

Ramson Retailers This question involves students considering whether the following transactions and events meet the definitions of the elements. In answering these questions students should identify the essential characteristics of assets and liabilities and analyse each transaction or event in light of those characteristics. (a) The general journal entry proposed by the Board would be: ______________________________________________________________ Self-insurance expense Dr $10 000 Third-party claims liability Cr $10 000 ______________________________________________________________ In the context of the conceptual framework, the recognition of a liability would be inappropriate because there is no present obligation to an external party. (b) The general journal entry proposed by the Board would be: ______________________________________________________________ Restrictive covenant Dr $100 000 Cash at bank Cr $100 000 ______________________________________________________________ The issue to be resolved is whether the restrictive covenant gives rise to future economic benefits that are controlled by Ramson. The answer to this question is likely to be yes as the rights are enforceable and it is assumed that Ramson will act within its rights. If the answer is no, then the amount paid would be recognised as an expense rather than as an asset. (c) The general journal entry proposed by the Board would be: ______________________________________________________________ Redundancy expense Dr $3 000 000 Provision for redundancies Cr $3 000 000 ______________________________________________________________ This represents a liability of the entity. The board of directors and the unions representing the employees have agreed on the terms of the redundancy packages, and these items have been made public. There is, therefore, a present obligation for the entity to make payments to its employees if they accept the redundancy package. . 16

There may be some question about the amount to be recognised as a liability, but that is a separate issue. 3

(a) Citizens Insurance Ltd The issue to be resolved in this question is whether Citizens Insurance Ltd should recognise an expense and a corresponding liability for possible future losses attributable to damage to buildings and/or contents. According to Framework 2014, liabilities are the future outflows of economic benefits that the entity is presently obliged to make to other entities as a result of a past event. Based on past experience there will be a future outflow of economic benefits and there has been a past event – the decision by the board to discontinue buildings and contents insurance. However, there is no present obligation to other entities. As a result, there is no liability. It follows that as there has to be an increase in a liability (or a decrease in an asset) for there to be an expense, in this case, there is no expense. (b) It follows from the above that the entity should write off the liability for possible future losses account, which at 30 September 2018 has a balance of $5 428 327. This would require Citizens Insurance Ltd to pass the following general journal entry: ______________________________________________________________ Liability for possible future losses Dr $5 428 327 Income Cr $5 428 327 ______________________________________________________________ The final issue to be considered is the treatment of losses, which apparently were recognised by reducing the relevant asset account and reducing the liability for possible future losses. With the removal of the liability account, the second part of this entry would not be possible. However, reducing the asset account would still be possible, but incorrect. To recognise the loss, the repairs expense account would be debited and cash at bank credited.

Sun Air The issue to be resolved in this question is whether Sun Air should record a provision for losses from discontinuation and transfer to Bass Air of the unprofitable routes. It would be inappropriate to recognise a provision for losses from discontinuation of the unprofitable routes as there are a number of aspects of the transaction that should be dealt with separately. These aspects will be considered in turn: (a) the sale of certain assets at a gain or loss – in this case, the gains or losses on the sale of the assets should be recognised when the sale takes place.

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(b) severance payments to employees and legal fees – in this case, there may be a liability that should be recognised. The issue is whether there is an irrevocable commitment to sell the routes to Bass Air and the ability to reliably measure the amount of the severance payments and legal fees. (c) operating losses before settlement – in this case, this would be in the nature of an impairment of an asset rather than an increase in Sun Air’s liabilities. Only the value of the unprofitable routes has been affected, which has presumably been taken into account in the negotiated price for the sale of those routes to Bass Air. 5

Toy World Ltd (a) A decision by the board of directors does not give rise to a liability because there is no present obligation to an external party. There is merely an announced intention to restructure the company. When the details of the restructure have been formulated and announced to the public, it will then be appropriate to recognise a liability. (b) The answer to this question should canvass the same issues as those addressed in Problem 1(a).

Playfurn Ltd (a) The annual recreation leave entitlement is an expense of the period. If employees take the recreation leave entitlement during the year, there will be a reduction in cash. However, if the employees only take a portion of their recreation leave, then there will be a recreation leave liability for the balance of leave to be taken by the employees in future periods as the entity has a present obligation to provide the leave. (b) The issues are whether an asset of $1 million should be recognised, with a liability for $900 000 also being recognised. Students should approach the answer to this question by using the definition and recognition criteria for assets and liabilities specified in Framework 2014. The answer to the question requires consideration of whether Playfurn controls the future economic benefits and whether it has a present obligation to pay for the equipment. In other words, is there a firm contract which should be recognised? There are insufficient facts to argue that an asset and liability should be recognised and it is expected that students would conclude that only the deposit paid would be recognised as an asset. (c) The amount of the buy-back is 2 000 000 shares at $1.50 per share = $3 000 000. This would result in a reduction in Cash at Bank of $3 000 000. There would be no effect on liabilities, revenues or expenses.

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(d) The issue is whether a ‘Provision for Plant Maintenance’ should be recognised as a liability in the statement of financial position. According to Framework 2014, such provisions should not be recognised as a liability because Playfurn is not required to dispose of future economic benefits to other entities – that is, there is no present obligation to any other entity. (e) The issue here is whether the preference shares should be recognised as a liability or as equity. The issue to be decided, therefore, is whether preference shares meet the definition of and recognition criteria for liabilities. It can be argued that nonparticipating, cumulative and redeemable preference shares satisfy the essential characteristics of liabilities if they are redeemable at the option of the holder or on specified date. It can also be argued that it is probable that settlement of the liability will be required and that the amount of the obligation in terms of dividend payments and repayment of the capital amount can be measured reliably. 7

Windsor Ltd (a) Major Plant Overhaul Windsor’s plant requires a major overhaul every five years. Windsor has entered into a five-year contract with Zappa to undertake those overhauls. The requirement to pay Zappa to undertake the next plant overhaul in 2019 could be recorded as a liability while the right to have the plant overhauled by Zappa could be recorded as an asset. In practice, the corresponding debit is usually treated as an expense (deferred plant maintenance expense). The first task is to determine whether the plant overhaul satisfies the liability definition. This will depend on whether there is a present obligation to Zappa for the future sacrifice of economic benefits. In turn, whether there is a present obligation will depend on the provisions of the agreement with Zappa. If the agreement is firm and enforceable, then Windsor is required to sacrifice economic benefits for Zappa to overhaul the plant. Alternatively, the agreement may be merely a statement of intent which is not enforceable, in which case Windsor is not required to sacrifice economic benefits. If it is concluded that the agreement with Zappa meets the definition of a liability, it will then be necessary to consider whether it meets the liability recognition criteria. As the amount of $500 000 specified in the agreement can be reliably measured, the answer will depend on whether it is probable that the agreement would be enforced in the event of non-performance by Windsor. If it is probable that the agreement would be so enforced, then it is probable that there will be a future sacrifice of economic benefits. It may be concluded, therefore, that if the agreement is firm and enforceable and it is probable that Zappa would enforce the agreement in the event of non-performance . 19

by Windsor, then the agreement should be recognised as a liability by Windsor. If it is not probable that the agreement will be enforced, then the agreement does not satisfy the liability recognition criteria and would not be recognised as a liability. By similar reasoning it may be concluded that an asset, ‘right to plant overhaul’, should be recognised. Students should also consider whether deferred plant maintenance satisfies the expense definition in the Framework. For there to be an expense there should be: • outflow of future economic benefits – as the plant overhaul has not been performed by Zappa, there has been no consumption or loss of future economic benefits. • reduction in assets or increase in liabilities – there has been an increase in liabilities. • decrease in equity – the increase in liabilities is exactly offset by an increase in assets, in the form of the right to have the plant overhauled by Zappa. (b) Tobacco Licence Fee Windsor, a tobacco wholesaler, collects the Tobacco Licence Fee from tobacco retailers each month. In the month following the collection of the fee, the amount collected is paid to the State Government. Windsor, therefore, has an obligation to pay the fees collected to the State Government. This amount should be recorded as a liability. The cash collected by Windsor should be recorded as an asset. Students should analyse the definition of, and recognition criteria for, liabilities and satisfy themselves that the Tobacco Licence Fee satisfies both the definition of, and recognition criteria for, liabilities. In addition, they should satisfy themselves that the asset definition and recognition criteria are satisfied. (c) Early Retirement Packages Windsor has offered an early retirement package to 500 of its employees. The union representing the employees has agreed to the terms of the package and the offer has been made public and communicated to its employees. The issue is whether the early retirement package should be recognised as a liability and an expense in this reporting period. Students should analyse the offer of early retirement packages and conclude that, because the offer has been made public and is therefore unlikely to be withdrawn, the packages satisfy the definition of a liability. In this question, however, the issue is whether the liability can be measured reliably. To measure the liability it will be necessary to estimate the proportion of employees receiving the offer who will accept

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it, the salary levels of those employees who are expected to accept the offer, and the length of service of those employees who accept the offer. If Windsor has no past experience, then it may be difficult to measure the liability reliably. In this case, the early retirement packages should not be recognised as a liability. If Windsor has made an offer of early retirement packages in the past (and the present packages are similar to those offered in the past), then Windsor has the evidence from past experience on which to base the measurement of the liability. Students should then go on to analyse the expense definition and recognition criteria. Their conclusions should be consistent with those they reached in respect of the liability definition and recognition criteria. 8

Airwave Airlines The issue is whether the free tickets are a liability and an expense of Airwave. The general journal entry would be: ______________________________________________________________ Bonus ticket expense Dr Liability for bonus tickets Cr ______________________________________________________________ Students should commence by considering whether there is a liability and then whether the liability meets the recognition criteria. Is there a present obligation to passengers as a result of the flights flown during the year, and perhaps previous years? The answer is yes, and the definition of a liability is satisfied. In respect of the recognition of the liability, the criterion of probable future sacrifice of economic benefits will be met. However, the issue of reliable measurement is much more problematic. Does Airwave have sufficient information to be able to reliably measure the liability? This is the main issue that students should discuss. The same process should be followed in an abbreviated form in considering the recognition of an expense.

University of Southern Australia The issue is whether the vineyard and winery should be recognised as an asset and as income. The general journal entry would be: _______________________________________________________________ Vineyard and winery Dr Income Cr _______________________________________________________________ . 21

The answer should consider whether the vineyard and winery constituted an asset of the university. Once it is decided that it is an asset, the next step is to see whether it satisfies the recognition criteria. The main issue relates to reliable measurement. This could be achieved by an independent valuation. The credit entry is to income, which is broadly defined in Framework 2014 as inflows or other enhancements of future economic benefits in the form of increases in assets, other than contributions by owners, which result in an increase in equity during the period. The definition of income is satisfied. It is necessary then to consider whether the recognition criteria are satisfied. If the asset can be measured reliably it can be concluded that the income can also be measured reliably. 10 Archibald Ltd (a) The replacement cost based measure of profit was lower than the historical cost based measure of profit because of the impact of rising prices for assets over the period. In replacement cost measures, assets at the financial year end would have been measured at their current replacement cost, not their original acquisition cost. This in turn means, for example, that expenses like depreciation will be higher under replacement cost accounting than under historical cost accounting. Similarly cost of goods sold is higher under replacement costs (in times of inflation) because it is measured at the replacement cost of the inventory at reporting date (not the historical cost). (b)

Both of these measures can be viewed as ‘true’ – the historical costs were actually incurred in the past and, assuming active markets, the replacement costs of the various assets can be observed. What matters more is what is the concept of capital and capital maintenance that the users of this information subscribe to? If users are most interested in the ability of the entity to continue in operations, then they may argue that the replacement cost based measures are ‘better’ because they indicate how much capital must be kept in the entity to continue operations. If this is not their desired notion of capital, then historical cost (or for that matter current cash equivalents) might be the ‘better’ measure.

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Chapter 4 FAIR VALUE MEASUREMENT LEARNING OBJECTIVES After studying this chapter you should be able to: 1 describe the importance of fair value measurement; 2 define fair value and describe its various components; 3 describe and apply the fair value measurement process; and 4 describe the main disclosure requirements of AASB 13.

QUESTIONS 1

The purpose of AASB 13 is to ensure consistency across accounting standards on the definition of fair value and to provide guidance on how to measure it. AASB 13 does not specify when fair value should be applied, that is determined via the operation of other accounting standards. Rather, AASB 13 sets out how fair value should be measured when it is specified as a measurement base in other standards.

2 Fair value measurement is a controversial topic for several reasons including: • In the absence of an active market for an asset or liability, fair value measurements may be perceived as being unreliable; • Fair value measurements may be viewed as irrelevant if their use is perceived to conflict with the ‘business model’ associated with an asset or liability. For example, some managers consider that where a financial asset is being held for the purpose of collecting its contractual cash flows, the current fair value of that financial asset does not have anything to do with the economic consequences that will flow from holding that financial asset; • The fair values of many items are volatile and are often outside the control of management. Allowing these volatile fair value measures to impact on reported profits will be unfair to managers whose remuneration is tied to reported profits. That is, managers will be impacted by factors they can’t control and so their performance will not be appropriately reported; and • The volatility of fair value measures may reduce their relevance for use in debt contracts because the fair value movements may not reflect the actual contractual cash flows associated with debt instruments. The chapter provides references to empirical research which suggests that the use of accounting-based profits in management compensation and debt contracts has decreased in those jurisdictions that have adopted IFRS based standards (allegedly because IFRS has a significant adoption of fair value measures). 3

The IASB, FASB and other accounting standards-setters have persisted with advocating the use of fair value measurement notwithstanding significant lobbying efforts from some of their constituents who wished to see the use of fair value wound back (especially during the GFC). It should be remembered that standard-setters have not adopted fair value measures across all standards, nor across all assets and liabilities. Rather they have adopted fair value measures in those circumstances where they believe those measures will promote relevant, decision-useful information for financial statement users. For example, the fair value of financial assets in the context of financial institutions (e.g., banks, insurance entities) is likely to be more relevant than the historical costs of those financial assets because financial statement users want information about the ability of those entities to make payments (e.g., can

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depositors in banks get their funds when required; can an insurance entity pay claims when needed; etc.). In addition, by issuing IFRS 13/AASB 13, standard-setters were prepared to acknowledge that some of the concerns that constituents had about measuring fair value were valid and so standard-setters were proactive in seeking to address those concerns. 4

The statement suggests that the relevance of fair value measurement can be different across types of financial statement users and decision contexts. The statement indicates that fair value measures are likely to be relevant to investors because those fair values may be a better indicator of an entity’s future cash flows which is information that is highly relevant to investors. Although this may be appropriate for certain contexts (e.g., financial institutions, agricultural assets), it is not clear that fair value measures are relevant to all investors. For instance, investors in manufacturing entities may be less interested in fair value measurements of manufacturing assets because such entities generate wealth through the use of those assets in production rather than through the sale of those manufacturing assets. Financial information is not only used in the context of investing decisions. The chapter indicates how financial information is also used for contracting purposes, in particular, management compensation and debt contracts. In these cases, it can be argued that the use of fair value measures adds an unacceptable level of ‘noise’ to the financial information because the volatility and lack of control over market prices will often not reflect the factors that matter in a contracting context. For example, if managers’ remuneration is tied to reported accounting profits, managers are likely to object to being held accountable for changes in fair values that impact on profit (and hence their remuneration) but over which they have no control. Similarly, the cash flows associated with debt contracts will usually be dependent upon contractual terms and conditions. Changes in fair value usually won’t impact on the contractual cash flows but may lead to ‘technical breaches’ of debt contracts to the extent that the accounting numbers are impacted by fair value measures. The chapter provides references to empirical research which suggests that the use of accounting-based profits in management compensation and debt contracts has decreased in those jurisdictions that have adopted IFRS based standards (allegedly because IFRS has a significant adoption of fair value measures). In short, there is some evidence to support the quotation in the question – that is, fair value measures are not universally relevant!

There is no clear understanding about what is the nature of the difference between ‘profit or loss’ and ‘other comprehensive income’ (OCI). This is because the distinction is not addressed in Framework 2014 (nor is it adequately addressed in the IASB’s proposed revisions to the Framework) and the IASB and other standard. 3

setters have not explained the basis on which they decide that some items of income/expense are taken to profit or loss and others are taken to OCI. Nor is the concept of recycling well understood for the same reasons (recycling reflects a requirement for some fair value changes that have previously been recognised in OCI to be transferred to profit or loss on the occurrence of some event (e.g., the sale of the asset to which they relate). Practically, profit or loss is typically the measure most focussed upon by analysts and other users of financial statements on the assumption that profit or loss reflects the entity’s performance from its on-going operations or business model. The important performance statistic Earnings Per Share (EPS) that is commonly used by investors, for example, is calculated using profit or loss (see AASB 133 ‘Earnings per Share’). OCI, on the other hand, typically includes many unrealised fair value changes (e.g., revaluations of property, plant, and equipment). Many contracts contain terms and conditions that are also based on profit or loss rather than total comprehensive income (of which OCI is part). Consequently, what items are included in profit or loss as opposed to OCI matters to both preparers (particularly managers) and users because it is the profit or loss number that is important in reflecting the on-going or underlying performance of an entity. Agency theory suggests that managers would prefer to be able to manage earnings rather than have earnings subject to fluctuation as a result of non-controllable changes in market prices. This is consistent with considerable evidence that managers have often actively lobbied against the adoption of fair value measurements. Over time some standards have required that changes in some fair value measures are included in profit or loss presumably because this is more decision useful and relevant to users. For instance, fair value increments and decrements in investment properties can be recognised in profit or loss (AASB 140 ‘Investment Property’). This can be justified by acknowledging that the business model of investment property holdings includes the objective of obtaining capital gains. Under AASB 116 ‘Property, Plant and Equipment’, however, revaluation increases (unless reversals of previous decrease) are recognised in OCI and revaluation decreases (unless reversals of previous increases) are recognised in profit or loss. Here the justification would be that business model for PPE is that it is held for use rather than for sale and so its fair value is less relevant to the users of financial statements. 6

Paragraph 5 of AASB 13 states that the standard is applied when any other accounting standard requires or permits fair value measurements or disclosures of fair value measurements. The requirements apply to both the initial and subsequent measurement of financial statement elements (para. 8). The only exceptions to the

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application of AASB 13 are set out in paragraphs 6 and 7. With regard to both the measurement and disclosure of fair values, AASB 13 does not apply to: • share-based payment transactions covered by AASB 2 ‘Share-Based Payment’; • leasing transactions covered by AASB 117 ‘Leases’; and • measurements that have some similarities to fair value but which are not fair value. Examples of these are net realisable value in AASB 102 ‘Inventories’ and value-in-use within AASB 136 ‘Impairment of Assets’. With regard to the disclosure of fair values required by AASB 13, these are not required for: • plan assets that are measured at fair value under AASB 119 ‘Employee Benefits’; and • assets for which the recoverable amount under AASB 136 is fair value less costs of disposal. 7

Fair value is defined in paragraph 9 of AASB 13 as: ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.’ Under this definition, fair value is the exit price as at the date that the measurement is made. Paragraphs 57 to 60 of the Standard distinguish fair value as an exit price from the ‘transaction price’ (or entry price) that might arise on the initial recognition of an asset or a liability. It is important to understand that the measurement of fair value is based on a hypothetical transaction for the asset or liability as it would be measured by market participants. Paragraphs 2 to 4 of the Standard state that fair value measurement is a market-based measurement, not a measurement based on the intentions or proposed actions of the entity holding the asset or liability. Such intentions are irrelevant to measuring fair value. Paragraph 2 states that the objective of a fair value measurement is to: ‘estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (i.e. an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability).’ The definition of fair value contains four key characteristics: • the identification of the asset or liability that is being measured at fair value; • the characteristics of the transaction for the purpose of measuring fair value;

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• the characteristics of the assumed market participants (rather than the reporting entity); and • the concept of an exit price. 8

Fair value is defined from the perspective of market participants rather than from the perspective of the entity that holds an asset or liability. An entity specific measurement of an asset, for instance, would reflect any constraints in the use of that asset that might not apply to a market participant who held that asset. In other words, an entity specific measure may not reflect the ‘highest and best use’ of the asset. As fair value is an exit price, an asset’s fair value will be determined by what cash flows market participants would be prepared to pay based on assumptions and risk assessments made by parties external to the firm. A focus on market participants adds a level of independence to the fair value measurement because the entity must obtain external, observable evidence of value as assessed by market participants rather than rely on potentially biased managerial assessments.

It is necessary to distinguish between the concept of unit of account and valuation premise. The unit of account is used to determine what asset or liability is being measured for the purposes of financial reporting and it affects the level of aggregation or disaggregation for the purposes of presentation and disclosure in financial statements. For example, a machine may be reported as an individual asset or as part of a CGU. The unit of account is determined by the relevant accounting standard being applied. The valuation premise applies only to non-financial assets. The purpose of the valuation premise is that once the specific non-financial asset has been identified (e.g. a stand-alone machine or a CGU), the valuation premise states how that non-financial asset generates its maximum value (i.e. by being used by itself, such as with the sale of inventory, or by generating cash flows as part of a group of assets, such as a machine that is integrated into a production line). The valuation premise is determined by the assumptions that are made about the highest and best use of the asset by market participants.

10 The highest and best use of a non-financial asset is defined in Appendix A of AASB 13 as the ‘use of a non-financial asset by market participants that would maximise the value of the asset or the group of assets and liabilities (e.g. a business) within which the asset would be used.’ Paragraph 27 requires as follows: ‘A fair value measurement of a non-financial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use.’ The Standard is clear that the reporting entity’s intentions with regard to the nonfinancial asset are not used for determining highest and best use, because this must be assessed from the point of view of market participants (para. 29). The entity’s use of . 6

the non-financial asset might be constrained or in some other way affected by physical, legal or financial factors that may not apply to a market participant (see for instance Example 4.1 in the chapter). However, there is a presumption that the entity’s current use of the non-financial asset is its highest and best use unless contrary evidence is available that would indicate that market participants could maximise the value of the asset through some other use (para. 29). The role of the concept of highest and best use is to allow the entity to determine the valuation premise that is to be used for measuring the fair value of the non-financial asset (para. 31). The valuation premise describes how a non-financial asset generates its maximum value to market participants (i.e., its highest and best use arises on a stand-alone basis or alternatively it is through the non-financial asset’s use with other assets). 11 Under AASB 13, management assumes that the transaction to sell the asset or transfer the liability takes place in the principal market or, in the absence of a principal market, the most advantageous market (para. 16). The principal market is the market with the greatest volume and level of activity for the asset or liability (Appendix A). In the absence of evidence to the contrary, the market in which an entity would normally enter into a transaction to sell an asset or transfer a liability is presumed to be the principal market or the most advantageous market in the absence of a principal market (para. 17). The most advantageous market is the market that maximises the amount that would be received to sell the asset, or that minimises the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs (Appendix A). The entity must have access to the principal or most advantageous market at the measurement date. As different reporting entities may have access to different markets, the principal or most advantageous market could vary between reporting entities (para. 19). Although an entity must be able to access the market, it does not need to be able to sell the particular asset or transfer the particular liability on the measurement date to be able to measure fair value on the basis of the price in that market (para. 20). AASB 13 prohibits the adjustment of fair value for transaction costs. However, it does require such transaction costs to be considered in determining the most advantageous market. 12 Paragraph 25 of AASB 13 notes that transactions costs are not included in the measurement of fair value because “transaction costs are not a characteristic of an asset or a liability; rather, they are specific to a transaction and will differ depending on how an entity enters into a transaction for the asset or liability.” Paragraph 26, however, indicates that transport costs not normally considered to be transaction costs when location is a characteristic of the asset being measured. In such cases, transport costs must be deducted from the asset’s price in the principal (or most advantageous) market when measuring the asset’s fair value. . 7

13 Observable and unobservable inputs are information that is used to generate fair value measures. Appendix A of AASB 13 defines observable and unobservable inputs as follows: Observable Inputs Inputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability. Unobservable Inputs Inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability. An example of an observable input is the quoted price of a listed company’s shares while an example of an unobservable input would be management’s estimate of the future cash flows associated with a piece of equipment. Observable inputs are preferred to unobservable inputs because the former are likely to be more independent and not subject to any managerial bias and will reflect market participants’ assessments rather than entity specific circumstances. 14 Paragraph 62 of AASB 13 identifies three widely used valuation techniques. They are: • the market approach, which uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities – for example, the use of option pricing models; • the income approach, which converts future amounts to a present value – for example, the use of discounted cash flow methods; and • the cost approach, which uses the current replacement cost of the asset. This assumes that fair value is the cost to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence (paras B5–B11). In some cases, it may be appropriate to use more than one valuation technique – for example, using both an income and a market approach to value a business or CGU. In this case, the reasonableness of the results of the valuation techniques employed will have to be evaluated, and a value chosen that is most representative of fair value in the circumstances (para. 63). Valuation techniques used to measure fair value are to be applied consistently. However, a change in a valuation technique or its application is appropriate if the change results in a measurement that is equally or more representative of fair value (para. 65). This might be necessary where new

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information becomes available, information previously used is no longer available, valuation techniques improve or market conditions change (para. 65). 15 The ‘fair value hierarchy’ is a ranking of the desirability of the inputs to valuation techniques for use in measuring fair value. The hierarchy categorises the various inputs into three different levels (para. 73). The role of the hierarchy is to ensure that fair value measures maximise the use of relevant observable inputs and that the use of unobservable inputs is minimised, as required by paragraph 67. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that management can access at the measurement date (para. 76). Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly (para. 81). Level 2 inputs include: • quoted prices for similar assets or liabilities in active markets; • quoted prices for identical or similar assets or liabilities in markets that are not active; • inputs other than quoted prices that are observable for the asset or liability – for example, interest rates and yield curves observable at commonly quoted intervals; and • market-corroborated inputs. (para. 82) Level 3 inputs are unobservable inputs for the asset or liability (para. 86). This might include future net cash flows that are used to value a business or non-controlling interest in an entity that is not publicly listed. Although fair value measurements based on Level 3 inputs do not use any relevant observable inputs, in making these measurements the entity’s management must still adhere to the objective of AASB 13 – that is, the fair value measure should still reflect the assumptions that market participants would use when pricing the asset or the liability (para. 87). Level 1 inputs are the most preferred inputs to valuation techniques, followed by Level 2 inputs and, finally, Level 3 inputs. Where Level 1 inputs are available for measuring the fair value of an asset or a liability, they must be used without any adjustments (para. 69). 16 The Global Financial Crisis (GFC) was an extraordinary event in which normal market mechanisms for pricing securities failed. As noted in the Chapter, the GFC was an important impetus for the development of IFRS 13 as the IASB and the FASB scrambled to respond to criticisms that fair value measurement was one of the causes of the GFC. There is little, if any, evidence that the GFC was caused by fair value accounting but it has been argued that fair value accounting exacerbated the . 9

downward pressure on prices. However, the quotation in this question does reflect a common criticism of fair value accounting measurements at the time of the GFC. The GFC was an event in which market trading volume/activity significantly decreased and where forced and panic selling resulted in some transactions which were not orderly. IFRS 13/AASB 13 provide guidance on how the impact of a lack of trading volume or disorderly transactions impacts upon fair value measurements. The standard makes it clear that the presence of either or both of these market conditions does not change the underlying principles and objectives of AASB 13. Paragraph B41 reiterates the underlying principle that in such circumstances: ‘the objective of fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (i.e. not a forced liquidation or distress sale) between market participants at the measurement date under current market conditions.’ The implications of a lack of trading volume or disorderly markets are primarily that the measurement of fair value cannot rely on observable inputs and the use of Level 3 inputs may be necessary. The disclosure requirements of AASB 13 will assist financial statement users to identify and understand the extent to which an entity’s fair value measurements are based on unobservable rather than observable inputs. These disclosures were not required at the time of the GFC and may have gone some way towards reducing the perceived negative impacts of fair value accounting measurements. 17 The main objective of the extensive disclosures required by AASB 13 are to ensure that sufficient information is disclosed so that financial statement users can assess: • the valuation techniques and inputs used to develop recurring and non-recurring fair value measurements of assets and liabilities after initial recognition; and • the effect on profit or loss or other comprehensive income of recurring fair value measurements using Level 3 inputs. (para. 91) Recurring fair value measurements of assets and liabilities are those that other Australian accounting standards require or permit in the statement of financial position at the end of each reporting period – for example, financial instruments or biological assets. Non-recurring fair value measurements of assets and liabilities are those that other Australian accounting standards require or permit in the statement of financial position in particular circumstances – for example, noncurrent assets held for sale.

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PROBLEMS 1

As a principal market does not exist, the asset’s fair value would be measured using the price in the most advantageous market. This is the market that maximises the amount that would be received by selling the asset after deducting transport costs and transaction costs. In the case of Carter Ltd, the most advantageous market is Market East, where the net amount that would be received is $23.50. As a result, the fair value of the asset is measured using the price in that market ($27), less transport costs ($2), resulting in a fair value of $25. Note that although transaction costs are taken into account when deciding which market is the most advantageous, the price used to measure the fair value of the asset is not adjusted for those costs.

Under AASB 13, management assumes that the transaction to sell the asset or transfer the liability takes place in the principal market or, in the absence of a principal market, the most advantageous market (para. 16). The principal market is the market with the greatest volume and level of activity for the asset or liability (Appendix A). In the absence of evidence to the contrary, the market in which an entity would normally enter into a transaction to sell an asset or transfer a liability is presumed to be the principal market or the most advantageous market in the absence of a principal market (para. 17). The entity must have access to the principal or most advantageous market at the measurement date. In the case of Lavocah Ltd, the principal market is Market A. Although Lavocah Ltd normally trades in Market C, it is Market A that has the greatest volume and level of activity for the asset. There is nothing in the facts that suggest that Lavocah Ltd could not access Market A, even though that is not its usual trading behaviour. As a result, the fair value of the asset is measured using the price in that market ($100), less transport costs ($6), resulting in a fair value of $94

There is no definitive answer to this question as the answer would depend upon what Mercedes plans to do with the technological advances embodied in the concept car. Students should be encouraged to see this question as an exercise in the application of the fair value measurement process and they can adopt the approach outlined in paragraph B2 of AASB 13 for non-financial assets to address this question. There is an implicit assumption in this question that the research & development expenditures on the concept car have satisfied the criteria of paragraph 57 of AASB 138 Intangible Assets. It is assumed that the technological advances in the car are intended to be, and can feasibly be, used by Mercedes to generate future economic benefits either through use or sale. In addition, for the purposes of this question it is implicitly assumed that Mercedes have chosen the revaluation model for measuring the intangible asset (para. 72, AASB 138). . 11

Step 1. Determine the asset or liability that is the subject of measurement: In this case, the asset is the intellectual property as embodied in the prototype concept car. The technology embodied in the concept car has value in its own right does not need to operate with other assets to generate future economic benefits. The asset can be treated as a ‘stand-alone’ asset which is consistent with the unit of account in AASB 138. Step 2. Determine the valuation premise consistent with the highest and best use (See paras. 27 and 29, AASB 13) To measure the fair value of the asset at initial recognition, the highest and best use of the asset is determined on the basis of its use by market participants (para. 27, 29 or 31 can be cited). We do not know Mercedes’ actual plans for this asset but there are a number of possible uses for the asset: (a) Mercedes-Benz could continue to develop the technology for use in its future production automobiles – the extent to which this can practically be done has yet to be specifically determined. It is likely that Mercedes-Benz believes its employees have the skills to be able to investigate this possibility. The fair value measured would then be based on an in-use valuation premise and would be based on the price that would be received in a current transaction to sell the technology to market participants, assuming that there are other automobile manufacturers that would be able to use the technology in conjunction with their own automobiles. (See para. 29) (b) Mercedes-Benz could decide to cease development of the technology in relation to its applicability to use with its automobiles. In valuing the asset, the assumption is then that other market participants would also lock up the device based upon a defensive competitive strategy, reducing the risk that competitors could achieve a significant marketing edge and so substantially increase market share. The appropriate assumption is then an in-use valuation premise. (See para. 30) (c) Mercedes-Benz could consider that the highest and best use of the asset is to cease development of the project as other market participants would also cease development if they acquired the asset. This may be the case where market participants do not consider that the technology will eventually be able to be practically used with production version automobiles and so the technology will not provide a market rate of return if completed. The fair value would be measured using an in-exchange valuation premise in this scenario. The fair value would be determined by considering what market participants would pay for the rights to use the technology if Mercedes-Benz sold this asset to them (which might be a low figure if no one believes there is much value in the technology). (See para. 31(b)). Step 3. Determine the principal (or most advantageous market) for the assets (see paras 24–26)

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In general, the highest and best use must be determined from the principal market if one exists. Otherwise, the most advantageous market would be determined by considering the three scenarios in part 2 above, and taking into account the transport and transaction costs. Not enough information is provided in the question to be more specific about the answer to this issue but in practice the principal or most advantageous market is likely to be known by Mercedes’ management. Step 4.

Determine the valuation technique

This asset is a unique asset. There are no similar assets on the market. Hence a market valuation approach is not applicable. (See para. 61–62). Students should provide an analysis of what valuation technique they would adopt based on their discussion above of the valuation premise. An income valuation approach could be used based on the expected extra cash flows that could be derived from sales once the technology has proved to be successful. Given that the technology still has to be proved to be useful in relation to production vehicles, this requires a great deal of judgement. The replacement cost approach would require the determination of the costs required to develop similar technology and have the rights to its use. This would be straight-forward for Mercedes-Benz to be able to calculate reliably as it has developed the technology itself. It is expected that the income valuation approach would be the most applicable method. In deciding to incur costs of $10 million, it is assumed that Mercedes-Benz would have investigated the possible effects on its profits and market share of its investment. In other words, it is assumed that Mercedes-Benz was rational in determining the cost it was prepared to pay to develop the concept car. 4

This question identifies a particular type of fire-fighting vehicle for which a fair value measurement is required. Instructors may wish to visit the relevant website given in the question to identify an alternate vehicle for students to fair value measure. Ambulances are also sold on this web site so some variety may be offered by trying to fair value measure these. The notes below are based on a particular set of facts for the Isuzu vehicle that was listed on the web site in 2015. The numbers/facts will need to be modified depending on what is listed on the web site at the date the question is attempted by students. Under AASB 13, there are at least four issues that have to be addressed in determining the fair value of a non-financial asset. Paragraph B2 of AASB 13 provides a very useful structure/set of steps for considering this time of question.

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1. Determine the asset or liability that is the subject of measurement (see paras 11 – 14): In determining the fair value of the fire vehicle it is necessary to take into account its particular characteristics such as its condition and location. It is also necessary to determine whether the fire vehicle is to be measured as a stand-alone asset or as part of a group of assets. The facts of the question are limited about the characteristics of the particular vehicle but do note that it has been specially modified for its duties (and so is unlikely to be equivalent to a commercial Isuzu truck) and it would be safe to assume that it is ‘second-hand’ as it is already part of the assets of the CFS. These characteristics would need to be used in determining the fair value measurement (i.e., it is important to compare ‘like with like’ to the extent that this is possible). The vehicle’s ‘unit of account’ (see para. 14) is likely to be as a stand-alone asset. Although the fire truck is part of a fleet of such vehicles, it can operate independently of any other fire vehicle. This is consistent with AASB 116, ‘Property, Plant and Equipment’. 2. Determine the valuation premise consistent with the highest and best use (See paras. 22, 23, 27–33, AASB 13) The fair value measurement needs to reflect the assumptions that market participants would use in pricing the truck based on their assumptions about the truck’s highest and best use. Some potential uses for the truck would be to continue to use it as a firetruck or convert it for use in general commercial duties. With reference to the factors cited in paragraph 28(c), given the specialised modifications made to the fire truck, modifying it for some other use may be financially prohibitive relative to the cost of purchasing an unmodified vehicle. Paragraph 29 indicates that the current use of an asset is likely to represent its highest and best use in the absence of evidence to the contrary. In this particular case, there is no specific evidence available to suggest that the current use is not the highest and best use of the truck. Consequently, the valuation premise in this case is that the vehicle’s fair value should be determined as a standalone asset which market participants would use as a fire-fighting and rescue vehicle. 3. Determine the principal (or most advantageous market) for the assets (see paras 24–26) On the Fire Trucks Australia website, there would appear to be three geographical markets, namely Adelaide, Brisbane and Perth. Of the 18 fire-fighting vehicles listed on the site (as of 30 March 2015), 5 are listed in Brisbane, 1 is listed in Perth, and 12 are listed in Adelaide. Based on the definition of the ‘principal market’ in Appendix A of AASB 13, it can be concluded that the principal market is that found in Adelaide. There is no need to determine the most advantageous market in this case.

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4. Determine the valuation technique Paragraph 24 requires that the fair value be determined based on the principal market (rather than the most advantageous market) when data for the principal market can be reliably determined. That paragraph also requires the price to be determined in an orderly market – there is no evidence in the question or from the Fire Trucks Australia website that the market for these vehicles is disorderly (i.e., they are not being sold in a ‘fire sale’ – sorry, I couldn’t resist the pun!). Paragraph 61 requires that the valuation technique used to measure the fair value maximises the use of observable inputs (i.e., market data rather than CFS’s managers’ assumptions) and paragraph 62 suggests that three common valuation approaches are the market approach, the cost approach (the replacement price) and the income approach. Given that there is an active market for fire-trucks as demonstrated by the website, the market approach is the best valuation technique in these circumstances (the cost approach assumes that the objective is to replace the service potential of this particular vehicle (which is unstated in the question) and the income approach is not appropriate given that the fire-truck is not used to generate revenues for the CFS except, perhaps, in an indirect way via government grants). The discussion in paras B5 – B11 could be drawn upon here. Based on the information on the Fire Trucks Australia website, one approach would be to note that the same fire-fighting vehicle as that being measured by the CFS is currently priced at $49,000 (as at March 2015). Allowing for the transportation costs of $150, this would suggest that the CFS fire truck should be measured at a fair value of $48,850 (transaction costs do not form part of the fair value measurement, para. 25). Note that if there were any characteristics of the CFS truck that were significantly different to that advertised, then it would be necessary to adjust the website price for the impact of the differences in characteristics (an interesting judgement in itself). If there was a concern that the website price did not reflect an active market for that particular vehicle, an average price of similar vehicles on the site might be used as the starting point for measuring the fair value. 5

The information about fair value measurement provided in Example 4.3 of the chapter falls into the following categories: • Valuation techniques and inputs; • Valuation process; • Sensitivity information; and • Highest and best use information. Valuation Techniques and Inputs The information in this category informs financial statement users about which classes of property are measured at fair value, what the fair value was at 30 June 2015 for . 15

each class, that all the classes of property were measured at Level 3 of the hierarchy, the valuation techniques that were applied using those Level 3 inputs, and specific information about what particular observable and unobservable inputs were used to measure fair value. General information explaining the different valuation techniques is also provided. As Harvey Norman has used Level 3 methods for measuring the fair value of the properties, investors may be wary about the extent to which there is any managerial bias in the valuations. The detailed information about the key facts and assumptions used as the observable and unobservable inputs can be used by informed financial statement users to assess the reasonableness of the Level 3 measurements (e.g., users familiar with the property market may know something about rental costs and discount rates in that market). Valuation Process The information in this category advisers financial statement users about how the measurements were conducted. The Harvey Norman disclosures indicate that property valuations are conducted by a mix of internal management and external independent valuers. Sensitivity Information The information in this part of Harvey Norman’s disclosure note is very generic and simply indicates what would happen to values in general if there were changes up or down in the key unobservable inputs. This sort of high level information is likely to be well known by users familiar with the property market and with valuations more generally and as no numerical sensitivity analysis is undertaken, there is limited value in this disclosure. Highest and Best Use This short disclosure simply indicates that management has judged that the current use of the properties is deemed to be their highest and best use. Although this is presumed in AASB 13, this limited statement does not provide the financial statement users with any basis on which to assess whether market participants would have a different highest and best use (but practically it might be unreasonable or impracticable to determine any such alternative). 6

The solution to this problem would depend upon which company was chosen for the analysis. The solution to problem 5 above could be used as a model for structuring the discussion of the chosen company.

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Chapter 5 THE CHOICE OF ACCOUNTING METHODS LEARNING OBJECTIVES After studying this chapter you should be able to: 1

explain the process used by accounting standard setters to make choices between alternative accounting policies;

discuss the reasons why choices of accounting policies are available to preparers of financial statements and the attempts by Australian accounting standard setters to limit this choice;

explain ‘creative accounting’ by preparers of financial statements;

discuss earnings management and the incentives of preparers of financial statements to engage in earnings management; and

apply agency theory to explain and predict the choice of accounting policies by preparers of financial statements.

QUESTIONS 1

In circumstances where there is not clear support for a particular procedure, the selection of that procedure alone for incorporation in an accounting standard may result in the rejection of the standard by the accounting profession, the business community and regulators. To reduce the risk of rejection, the accounting standard setters may incorporate alternative procedures in the standard. The existence of alternatives is likely to satisfy more people and significantly reduce the risk of rejection of the standard. This is a possible explanation for the choices available, for example, in AASB 102 ‘Inventories’ and AASB 116 ‘Property, Plant and Equipment’. It should be noted, however, that the standard setters have been uncompromising in some cases. For example, the depreciation of buildings required by AASB 116 was opposed when introduced.

The process has been ‘political’ in the sense that standard setters have been anxious to develop acceptable standards, rather than standards that are ‘theoretically’ correct and completely consistent with each other. In most cases, the standards have been compromises and have not been issued until ‘due process’ has ensured that all relevant opinions have been sought and considered. In general, the standards have been agreed rather than imposed. Acceptance by the accounting profession, the business community and regulators has been an important consideration. In this arena, interested stakeholders from the accounting profession, business community and regulators will attempt to exercise power to influence outcomes with respect to standards. The power may be indirect. For example, stakeholders may seek influence through lobbying standard-setters privately and in public, and lobbying other stakeholders to form larger groups to influence standard-setters However, the need for this approach to standard setting has been reduced by legislative backing for accounting standards and the development of a conceptual framework. These developments provide support mechanisms for standard setters who have to make difficult decisions about appropriate (and perhaps controversial) procedures to include in accounting standards.

The changes that may reduce the political nature of the standard-setting process are the introduction of legislative backing for accounting standards and the development of a conceptual framework. The Corporations Act 2001 requires companies to comply with AASB Accounting Standards, even if compliance does not result in the presentation of a ‘true and fair view’. The standard setters can no longer be embarrassed by companies choosing not to comply with standards on the grounds that the results they produce do not present a true and fair view. The development of the conceptual framework means that there is now authoritative support for the principles embodied in the accounting

standards. The authority of the standard setters is enhanced and it can no longer be argued that the standards are based upon ad hoc considerations. 4

The statement is correct. The growing number of standards is closing some opportunities for creativity. However, there are still plenty of opportunities. There are three reasons for these opportunities. First, there are still many aspects of financial reporting that are not yet the subject of an accounting standard. Second, some standards are so imprecise that the scope for creativity is scarcely diminished. The standards rely on indeterminate phrases such as ‘virtually certain’ or ‘in the normal course of operations’. Third, the standards rely heavily on judgements on matters such as an asset’s useful life, the amount of doubtful debts and asset valuations. In these areas and many more, there is scope for using accounting to create the desired result. An additional consideration is the role played by the International Accounting Standards Board (IASB) in developing and issuing International Financial Reporting Standards (IFRS). To date, the IASB has adopted a principle-based approach to developing IFRS in that general principles are prescribed for accounting issues (e.g. determining asset impairment) rather than detailed sets of rules and procedures. As a result, there is scope for ‘creative accounting’ irrespective of the number of accounting standards.

The choice of accounting method in the absence of an explicit accounting standard is dealt with in AASB 108 ‘Accounting Policies, Changes in Accounting Estimates and Errors’. AASB 108 deals with this issue at two levels. First, it prescribes a hierarchy of authorities to which reference should be made (see paras 11 and 12). Second, it specifies the qualitative characteristics that financial information should have. These qualities are taken from Framework 2014. AASB 108 requires that financial information should be relevant and reliable. In this context, relevant means relevant to the decision-making needs of users (para. 10(a)), and reliable means represent faithfully the financial position, financial performance and cash flows of the entity, as well as reflecting the economic substance rather than the legal form of a transaction or event, being neutral, prudent and complete in all material aspects (para. 10(b)).

Accounting standards have had little, if any, impact on the judgements required in accounting. The application of the accounting standards, in fact, relies on the judgement of financial statement preparers. The standards are silent on matters such as the estimation of doubtful debts, the estimation of asset lives or the estimation of the likelihood of future economic benefits. The standards presume that accountants have the ability to make the judgements necessary to apply the standards.

The term ‘creative accounting’ describes a situation where accounting policies are chosen or used in a way that ensures financial statements present the impression of a

reporting entity’s financial performance and financial position desired by the report preparer. The motives for using ‘creative’ techniques are numerous, and include: • • •

maximising reported profits to increase managers’ remuneration (for example, bonus payments tied to reported profits); maximising reported profits in an effort to forestall creditor and shareholder enquiries; and a desire to minimise profits because of the threat of public outcry, employee claims for higher wages or government intervention.

Accounting policies may be used for creative purposes in four general ways: (a) Accountants may be creative in their choice of, or changes in, accounting policies. For example, the choice of an accounting policy that allows capitalisation of expenses will increase both profits and assets, at least in the short run. (b) Accountants may be creative in their judgements. For example, an optimistic assessment of the amount of doubtful debts reduces doubtful debts expense and increases profits and assets, at least in the short run. (c) Accountants may be creative in the way they disclose and present data in the financial statements. For example, they may rely on the concept of materiality not to disclose ‘bad’ news as a separate item. (d) Accountants may change the appearance of an entity’s performance by the timing of transactions or by recording hypothetical or ‘non-arm’s-length transactions’. For example, the deferral of capital maintenance expenditure may change the reported financial position of the entity, or alternatively, a reversible asset sale to a ‘friendly’ outside entity may be used to boost both profit and asset amounts.

Creative accounting arising from capitalising rather than the expensing of costs, and from optimistic judgements that defer the recognition of expenses, do not result in permanent increases in profits and assets. Increases in profits by deferring expenses in one reporting period will be offset exactly by decreases in profits in subsequent periods. This form of creative accounting merely defers ‘bad news’. For example, while capitalising costs may increase the asset amount and profit in that year, profits in subsequent years will be reduced by depreciation charges on the increased asset amount and the book value of the asset will decline. Similarly, a decision to increase profits by underestimating doubtful debts expense merely defers the recording of the expense until those debts are irrevocably bad. These types of creative accounting merely provide an opportunity to decide when the information will be disclosed. If those preparing financial statements are optimistic, they may believe that when the ‘bad news’ is eventually recognised in the statements, it will be overshadowed by emerging ‘good news’.

10 The income-smoothing hypothesis was formally stated by Gordon in 1964. He suggested that, in selecting accounting policies, managers were concerned with maximising their own welfare, which increased with their job security, the level and growth rate of their Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson Issues in Financial Accounting 16e 4

remuneration, and the level and rate of growth in company size. Managers’ welfare, Gordon suggested, was dependent in part upon shareholders’ satisfaction with managerial performance. If the shareholders were pleased, then managers’ job security, salary and perquisites would be increased, and their welfare would also increase. Further, Gordon suggested that managers’ welfare increased by diminishing marginal amounts with increased shareholder satisfaction. In other words, ‘when shareholders are highly dissatisfied with a management, an increase in their satisfaction greatly increases the management’s job security, etc., and hence its utility’ or welfare. Conversely, when shareholders are pleased with management’s performance, an increase in shareholder satisfaction will not add much to managers’ welfare. Finally, Gordon suggested that shareholder satisfaction with management increases with the average rate of growth and the stability of the entity’s reported profit. This is because shareholders believe that a stable profit stream supports a higher level of dividends than a variable profit stream and reduces the perceived riskiness of the entity. If Gordon’s propositions are accepted, it follows that managers should, within the boundaries set by accounting rules, a) smooth reported profit; and b) smooth the rate of growth in profit. This is Gordon’s income or profit-smoothing hypothesis. 11 Recent survey research (Graham, Harvey and Rajgopal, 2005) has found that while an overwhelming majority of the Chief Financial Officers surveyed prefer smooth earnings they are reluctant to achieve this by means of accounting policy choices. Furthermore, the survey found that executives are prepared to smooth earnings by making small or moderate sacrifices in economic value such as by delaying maintenance or advertising expenditure. Graham, Harvey and Rajgopal (2005) suggest that this result may be due to the stigma attached to accounting fraud in the post-Enron environment. 12 (a) Earnings management ‘occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers’ (Healy and Whalen, 1999, p. 368). (b) Earnings management targets include avoiding losses (reporting positive profits), sustaining last year’s (quarter’s) performance (a smooth income stream), and meeting analysts’ earnings forecasts. (c) In answering this question, students can refer to any of the three ways managers could manage earnings upward: (i) choose an accounting policy or change accounting policies to increase revenue and/or decrease expenses; (ii) make estimates or predictions of future events in a way biased towards increasing revenue and/or decreasing expenses; or (iii) timing transactions to increase revenues (e.g. offering significant incentives to move

sales from future periods into the current period; reducing discretionary expenditure on R&D, advertising). (d) As long as the accounting policy choices that managers make which are allowable under existing accounting standards, they are not illegal (i.e. fraudulent). To illustrate, the difference between illegal choices and within-GAAP choices students could compare the following fraudulent choice with the options discussed in (c) above. A manager may inflate sales revenue to manage earnings up to meet an earnings target by fraudulently creating fictitious invoices, and billing customers for non-existent products. 13 In the economics literature, a company is seen as a collection of self-interested individuals who agree to cooperate. This cooperation does not mean that they have abandoned self-interest as an objective, but that they have entered into contracts which provide incentives to gain their cooperation. For example, managers may apparently work hard to achieve a good result for the shareholders. This does not mean that managers are putting the interests of the shareholders ahead of their own. Managers act in this way because there is an agreement that they will receive a higher salary or a bonus if the shareholders do well. Similarly, the company must deal with self-interested parties outside the company. For example, the company must obtain the cooperation of lenders when it borrows money. The company may also find it advantageous to seek the cooperation of governments or an undertaking from governments not to interfere in the company’s activities. In most cases, the securing of cooperation requires either an explicit agreement or an implicit contract between the parties. These contracts are necessary because all parties are self-interested and cooperation must be purchased. The company, then, is an interconnected series of contracts which achieves a level of cooperation between various self-interested parties. These contracts specify the behaviour expected of each party and the reward that each can expect in return for that behaviour. 14 (a) In an agency relationship, one party (the principal) delegates some decision-making authority to another (the agent). For example, there is an agency relationship between a business’s owner (the principal) and its manager (the agent). The manager makes decisions on behalf of the owner. Agreements entered into by the manager are binding on the owner. There is also an agency relationship between an owner-manager (the agent) and a lender (the principal). The lender allows the owner-manager to make decisions that affect the resources of the lender. (b) In these agency relationships, it is often necessary to have a contract between the principal and the agent to ensure that the agent uses the delegated authority in the principal’s best interest rather than in the agent’s best interest. For example, in the absence of a contract, the manager may decide to take excessive perquisites and to Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson Issues in Financial Accounting 16e 6

minimise working hours. A contract would penalise the manager for such self-interested behaviour and encourage (force) decisions more consistent with the owner’s interests. (c) Many contracts include accounting terms such as revenues, profits, assets and liabilities. For example, a contract may provide that a manager will be paid a bonus of 20% of reported profits. A contract may provide that the ratio of liabilities to assets must be no greater than 60%. The definition and measurement of these accounting terms becomes crucial for the interpretation and enforcement of the contract. Unless the terms can be defined and measured objectively, the contract is of little value in restricting opportunistic behaviour. 15 In developing a management remuneration scheme for a large public company, the following would be relevant: • what types of management opportunistic behaviour are likely to occur? • what should be the components of the salary package (cash salary, bonus, share options) which would minimise opportunistic behaviour? • are the salary policies and levels likely to attract and retain the best candidates for the jobs? 16 A number of studies have tested whether companies whose managers have a bonus plan are more likely than other companies to favour accounting policies that increase reported profit. While the results of early tests of this hypothesis were inconsistent, more persuasive evidence was more recently provided by Healy (1985; cited note 34 in the text). The bonus plans studied by Healy specified that a bonus was payable only when profit reached a stated minimum level. Approximately one-third of these plans also placed a ceiling on the amount of the bonus so that when profit exceeded a stated maximum level, the bonus did not increase any further. Profit in excess of the maximum was ‘wasted’ from the managers’ viewpoint because it did not result in a higher bonus. If profit was likely to be below the minimum, management had an incentive to reduce it still further because this would not reduce the current year’s bonus (already zero), but would increase the chance of achieving a bonus in the following year(s). Therefore, management had an incentive to use accruals to manipulate profit from year to year. Healy’s evidence was consistent with this type of profit manipulation. 17 There have been some tests of the hypothesis that the choice of accounting policy was influenced by debt covenants (Smith & Warner, 1979; Smith, 1980). For example, if a company that has agreed to a covenant which specifies a maximum ratio of debt to total tangible assets chooses to treat an expense as an asset by capitalising it, then the company will report lower expenses, higher assets, higher profit and higher equity. The ratio of debt to total tangible assets is reduced and the probability of breaching the covenant is also reduced. Similar opportunities exist in the treatment of advertising costs, research and development costs and the costs of exploration. Another choice arises with Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson Issues in Financial Accounting 16e 7

depreciation. The lower the depreciation expense, the higher are the levels of assets and profits, and the lower is the probability of breaching a covenant. Several US studies have found evidence consistent with accounting choices being influenced by debt covenants (Smith & Warner, 1979; Smith, 1980). Australian evidence is more sparse. It has been suggested that some Australian companies may have refused to depreciate buildings, even to the point of incurring a qualified audit report, to reduce the risk of breaching a debt covenant (Whittred & Zimmer, 1986). However, a later study suggested that these results were due to factors such as firm size and industry grouping (Stokes & Leong, 1988). When these factors were controlled for, there was no apparent link between the existence of debt covenants and the depreciation of buildings. 18 Political costs are contracting costs arising from the relationship between an entity and governments or government instrumentalities. In these relationships, there is not usually a formal contract. For example, an entity reporting large profits may risk a government investigation to determine whether the entity has earned large profits because of unfair practices, because of monopoly power or because of breaches of socially accepted rules of conduct. The entity may also incur political costs in the form of lobbying the government or in the form of action against it by the government. In general, it is believed that the likelihood of incurring political costs is directly related to the size of the entity. A very profitable large company is more likely to be subjected to public scrutiny than a very profitable small company. It is hypothesised that companies likely to incur political costs will choose accounting policies that reduce profits. 19 Large companies would be expected to use profit-reducing techniques because they are more likely to incur political costs if they make large profits. Large companies are regarded as having the power to make decisions that are not in the public interest and for the result of those decisions to have a significant effect on the community. Large profits by large companies are sometimes seen as prima facie evidence of anti-social behaviour by the company. Although small companies also may behave in anti-social ways, the impact on the community is likely to be much less. Large companies, therefore, have an incentive to use profit-reducing accounting policies to minimise profits to avoid attracting the attention of governments. Most US empirical studies have found a relationship between large companies and the use of profit-reducing accounting policies. This relationship seems to be particularly strong for companies in the oil and gas industry. In Australia, company size has been used as a proxy for political costs in a study of the choice of accounting method used to report foreign currency translation gains and losses. It was found that larger companies were more likely to treat these gains and losses as movements in reserves.

However, these results should be viewed with caution because asset value is only a proxy for political costs. It may also be a proxy for a number of other variables. Company size may be correlated with, for example, competitive advantage, industry grouping and management ability. PROBLEMS 1

Many investors and creditors are wary of amounts assigned to intangible assets, especially goodwill. Intangible assets are viewed as being of a lower quality than tangible assets. Thus, a creditor may be able to take possession of a physical asset and sell it to cover an outstanding debt. However, it is impossible to take possession of, for example, goodwill. Consequently, intangibles are sometimes deducted from assets (or equity) before leverage ratios are calculated. Secured lenders wish to minimise their credit risks. A covenant specifying secured borrowings as a percentage of ‘tangible assets’ will help to achieve this goal.

A management remuneration contract could explain the ‘big bath’ taken by CSR. Suppose a new CEO or management team was aware of poorly performing or overvalued non-current assets. An immediate write-down would be considered ‘prudent’ in these circumstances. It would also increase some performance measures in later years. Consider, for example, the ratio of profit as a percentage of total assets. A write-down of non-current assets will possibly reduce depreciation in future years and the total asset base will be lower. The ‘bath’ is possible as long as debt covenants (such as, liabilities as a percentage of assets or equity) are not breached.

Chapter 6 THE STATEMENT OF FINANCIAL POSITION: AN OVERVIEW LEARNING OBJECTIVES After studying this chapter you should be able to: 1

discuss how the information disclosed in a statement of financial position may be employed;

compare and contrast a fixed-format with a flexible-format statement of financial position;

discuss the different ways in which investor and investee entities interrelate;

explain the accounting for equity investments when there is no special relationship between the investor and the investee;

define and identify the components of equity;

Identify and record share capital, including share buybacks;

discuss the requirements of AASB 101 ‘Presentation of Financial Statements’ as they relate to the classification and disclosure of equity;

identify the bases of classification for assets and liabilities required by AASB 101 ‘Presentation of Financial Statements’; and

explain and apply the requirements of AASB 101 ‘Presentation of Financial Statements’ relating to disclosures of assets, liabilities and equity on the face of the statement of financial position and in the notes.

QUESTIONS 1

The purpose of preparing a statement of financial position is to provide information about the financial position of a reporting entity. Report users can use this information to understand the financial position of an entity at reporting date and to assist them in predicting future financial performance and financial position. Information about an entity’s financial position may be used to assess the resources controlled by the entity, the financial structure of the entity, the entity’s capacity for adaptation and its solvency.

The statement of financial position provides a listing of all assets, liabilities and the equity of the reporting entity, appropriately classified. This information may be used to assess the resources controlled by the entity, the financial structure of the entity, the entity’s capacity for adaptation and its solvency.

A fixed format for a statement of financial position is typified by clause 7(1) of Schedule 5 of the Corporations Regulations (now repealed). It required the preparation of a statement of financial position with a balanced, fixed format with net assets equal to shareholders’ equity. The fixed format is not consistent with the requirements of AASB 101. Instead AASB 101 allows a flexible format whereby it specifies the information to be included in a statement of financial position and notes, but not the format of the presentation.

Clause 7(1) of Schedule 5 of the Corporations Regulations (now repealed) required the preparation of a statement of financial position with a balanced, fixed format with net assets equal to shareholders’ equity. In contrast, AASB 101 does not require a fixed format for the statement of financial position, but rather allows entities some flexibility in presentation. Specifically, AASB 101 ‘Presentation of Financial Statements’ permits entities to present information in either a current/non-current presentation format or an order of liquidity presentation format. However, an entity with diverse operations may use a combination of the current/non-current and liquidity presentation formats. Additionally, some specification of information to be disclosed is found in AASB 101 (para. 54), which are discussed in section 6.4.3 of the chapter. However, it is noted in paragraph 57 of AASB 101 that this is merely a list of items that warrant separate presentation on the face of the statement of financial position – the order and format of disclosure is not prescribed. The presentation of that information is a decision for management.

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Opinions differ as to whether a fixed-format statement of financial position is preferable to a flexible-format statement. A fixed-format statement enhances understandability and comparability of the information on financial position between entities, and makes it easier for report users to locate information. A flexible-format statement permits the selection and presentation of information that is relevant to the users of a reporting entity’s statement of financial position. The current situation is that AASB 101 does not require a fixed format for the statement of financial position, but rather allows entities some flexibility in presentation. Specifically, AASB 101 ‘Presentation of Financial Statements’ permits entities to present information in either a current/non-current presentation format or an order of liquidity presentation format. However, an entity with diverse operations may use a combination of the current/non-current and liquidity presentation formats. Thus, an entity could present some of its assets and liabilities using a current/non-current classification and others in order of liquidity. Some specification of information to be disclosed is found in AASB 101 (para. 54), which are discussed in section 6.4.3 of the chapter. However, it is noted in paragraph 57 of AASB 101 that this is merely a list of items that warrant separate presentation on the face of the statement of financial position – the order and format of disclosure is not prescribed. The presentation of that information is a decision for management.

Small holdings of shares in other companies are those in which the investor cannot control or influence the operations of the investee. It is generally accepted that a holding of less than 20% of the outstanding shares of a company is a small holding.

AASB 128 ‘Investments in Associates and Joint Ventures’ defines significant influence as ‘the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies’. Control, on the other hand, is defined in AASB 10 as ‘An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee’. Significant influence therefore falls short of control. If control is established the entity must be consolidated in accordance with the requirements of AASB 10 ‘Consolidated Financial Statements’. If significant influence is established the entity must be accounted for using the equity method of accounting in accordance with the requirements of AASB 128.

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Paragraph 6 of AASB 128 ‘Investments in Associates and Joint Ventures’ lists the factors that may indicate the existence of significant influence by an investor. They are: • representation on the investee’s board of directors; • participation in policy-making processes; • material transactions between the investor and the investee; • interchange of managerial personnel; and • provision of essential technical information.

Joint arrangements are contractual arrangements between operators or venturers. The contract specifies joint control by the operators or venturers over the operating and financial decisions of the operation or venture and how expenses and income from the operation and venture should be allocated between the operators/venturers. In a jointly controlled operation the joint operators use their own assets, raise their own finance and incur their own expenses and liabilities. There is no separate entity and no jointly owned assets or liabilities. In contrast, jointly controlled entities exist when the joint venturers contribute to a separate entity to pursue the objectives of the joint venture agreement. AASB 11 ‘Joint Arrangements’ requires an operator in a jointly controlled operation to recognise the assets it controls and the liabilities it incurs as well as the expenses it incurs and its share of the income it earns from the sale of goods or services by the venture. In contrast, AASB 11 requires a venturer in a jointly controlled entity to apply the equity method of accounting to recognise its interest in the joint venture entity.

10 The ‘mark-to-market’ method of accounting for investments requires that, at the end of each reporting period, investments are revalued to fair value with changes in fair value being recognised either as income or expenses. AASB 13 ‘Fair Value Measurement’ defines ‘fair value’ as the ‘price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’ (para. 9). AASB 9 ‘Financial Instruments’ governs the recognition and measurement of financial assets (among other things). Paragraph 4.1.1 requires that after initial recognition, financial assets should subsequently be classified as being measured at either amortised cost or at fair value. An entity is required to determine the appropriate classification of the financial asset by considering both (para. 4.1.1): (a) the entity’s business model for managing the financial assets; and

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(b) the contractual cash flow characteristics of the financial asset. These criteria are designed to try to match the accounting treatment of particular financial assets with the purpose for which they are held. For example, paragraph 4.1.2 of AASB 9 states that: A financial asset shall be measured at amortised cost if both of the following conditions are met: a) The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows. b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. This paragraph indicates that the amortised cost method is appropriate because this measurement method, which is based on the cash flows to be received, matches the benefits expected to be collected from a financial asset when it is being held with the purpose of generating a readily determinable set of cash receipts. Paragraph 4.1.4 of AASB 9 requires that all financial assets will be measured at fair value unless paragraph 4.1.2 applies. Once an entity has classified its financial assets as either amortised cost or fair value, it can only change the way its financial assets are classified if its business model for holding those financial assets changes (para. 4.4.1). Under the amortised cost classification, any gains or losses on financial assets are recognised in the profit and loss only when a financial asset is derecognised (e.g. sold) or impaired or reclassified to fair value and through the amortisation process (para. 5.7.2). Paragraph 5.7.1 requires that under the fair value model, any gains or losses on financial assets are recognised in profit and loss. This form of accounting is sometimes described as ‘mark-to-market’. Although the fair value classification results in gains and losses on financial assets being recognised in profit and loss, paragraph 5.7.1(b) contains one exception to this which is that where the financial asset is an equity instrument, the entity can make an irrevocable choice to recognise the gains and losses on that equity instrument in other comprehensive income provided that the equity instrument is not held for trading purposes (para. 5.7.5). This choice must be made when the equity instrument is initially recognised (para. 5.7.5). Any dividends associated with the investment in equity instruments is treated as revenue in profit and loss no matter how the equity instruments are classified (para. 5.7.6). In summary, the requirements of AASB 9 mean that investments that are equity instruments (e.g. shares in other companies) are normally going to be classified as ‘fair value’ because the cash flows to be received from them do not satisfy the criteria given in paragraph 4.1.2 of AASB 9. Provided that the business model for financial assets of the investor is not to hold the equity instruments for trading

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purposes, then the investor has the option to recognise any gains or losses in other comprehensive income but once this choice is made it cannot be reversed. In Australia, property investments are subject to the requirements of AASB 140 ‘Investment Property’ which allows the use of a fair value model or the cost model of AASB 116. The fair value model in AASB 140 is akin to ‘mark to market’. 11 Framework 2014 defines equity as ‘the residual interest in the assets of the entity after deducting its liabilities’ (para. 49(c)). Defining equity as a residual has a number of implications: (a) Equity cannot be identified, recognised and measured until assets and liabilities are identified, recognised and measured. It follows that the measurement of equity depends on the concept of capital employed and the consequent measurement rules applied to assets and liabilities. This can be illustrated by reference to the discussion in Chapter 3. (b) The residual interest in the net assets of an entity belongs to some other entity or entities. For companies, these other entities are the shareholders. (c) Equity holders are exposed to the risks and benefits of ownership in both the continuing operations of the entity and in the event of the entity being wound up. 12 Assets and liabilities can be individually identified and measured. Under the Framework 2014’s definition of equity, equity can only be identified and measured in total as the value of the net assets of the entity. It follows that there is a close relationship between the concept of capital employed and the consequent measurement rules applied to assets and liabilities. 13 Retained earnings are accumulated profits and represent the balance of profits and losses that the company has made since incorporation. Reserves represent transfers of accumulated profits. For example, a firm may decide to allocate a proportion of retained earnings to general reserve to permit the issue of bonus shares to the shareholders of the company. In addition, reserves may also be capital in nature; for example, the asset revaluation reserve. Capital reserves usually arise from movements in other comprehensive income. 14 The ‘applications’ account is a liability account. Section 722 of the Corporations Act (2001) requires that money subscribed with an application for shares is to be held in trust for the applicant until either: (1) the shares are issued, or (2) the money is refunded. Therefore, the applications account represents the company’s liability to perform either (1) or (2). . 6

15 (a) Strict conditions are imposed on companies that wish to engage in a share buyback scheme. These conditions are necessary to protect creditors and shareholders. For example, the Board of Directors of a company in financial difficulties may authorise a share buyback in order to effect a return of capital to shareholders. This is unlikely to be in the best interest of creditors because the interests of shareholders will no longer be subordinate to the interests of creditors, thus prejudicing the company’s ability to pay its debts. The main conditions specified in the Corporations Act 2001 are as follows. 1) A company may buy back its own shares. 2) The buyback must not materially prejudice the company’s ability to pay its creditors. 3) The company must follow the procedures laid down in the Corporations Act. 4) Shareholders’ approval is required if a company wishes to buy back more than 10% of its shares in a 12-month period. (b) The ability of companies to buy back their own shares provides them with the opportunity to manage their capital structures more efficiently. For example, if a company wants to manage and maintain its financial leverage at a level appropriate to its capital structure – that is, its ratio of debt to equity – it may borrow and use the proceeds or use existing credit facilities, to buy back some of its shares. Also, a company may be liquid but not have sufficient profitable future investment opportunities. In such a case, the company may wish to return capital to participating shareholders via a share buyback. (c) Students should locate a similar announcement to that featured made by Perpetual Ltd in the Accounting in Focus box, and identify the possible motivation. In the case of Perpetual, the share buyback appears to have occurred because the company lacked sufficient profitable investment opportunities for the capital. 16 (a) Share capital consists of shares in a company, comprising at least one class of ordinary shares. It may have been issued when the company was incorporated, or at a later date in various ways such as offers to existing shareholder (rights issue), private placements with institutional investors, employee share plans and dividend reinvestment plans. (b) This answer is based on the 2015 Annual Report of Wesfarmers Ltd. Note 12 contains details of equity and reserves. The answers are as follows: (i) $ 21 844 million (from statement of financial position) . 7

(ii) Yes, Wesfarmers has used a share buyback scheme and describes the repurchased shares as ‘reserved shares’. Basically, these shares have been repurchased by the company. (iii) From note 12, Wesfarmers has restructure, tax, capital, foreign currency translation, cash flow hedge, financial assets and share-based payments reserves. Students should be able to explain the accounting process resulting in the following reserves which are discussed in the following chapters: • Foreign currency translation reserve (chapter 24); • Cash flow hedge (chapters 13 and 24); • Financial assets reserve (chapter 13); and • Share-based payments reserve (chapter 12). 17 (a) AASB 101 (para. 7) classifies equity into two broad categories: 1) owner changes in equity – for example, equity contributions, dividends and the buyback of an entity’s own equity instruments (para. 9(e)); 2) non-owner changes in equity – that is, those items recognised as ‘other comprehensive income’ in the determination of ‘total comprehensive income’ (e.g. translation differences relating to foreign operations, changes in revaluation surplus). (b) The underlying reasoning is that the separate presentation of owner changes in equity from non-owner changes in equity provides better information to users. That is, owner changes in equity provide information to users about items that do not change the entity’s net assets, whereas non-owner changes in equity provide users with information about items that can increase or decrease the entity’s net assets. 18 (a) The statement of changes in equity includes on its face (para. 106): (1) total comprehensive income for the period; (2) for each component of equity, the effects of retrospective changes in accounting policies and corrections of errors; and (3) for each component of equity, a reconciliation between the carrying amount at the beginning and end of the period (with separate disclosure of each change resulting from profit or loss, other comprehensive income and transactions with owners in their capacity as owners). (b) This question is answered using the 2015 Annual Report of Wesfarmers Ltd. Two examples of each change are provided. (i) exchange differences on translation of foreign operations; change in fair value of cash flow hedges (ii) acquisition of own shares; equity dividends . 8

(iii) The net increase (decrease) in total equity is as follows: • $2 440 million increase resulting from net profit; • $(192) million decrease resulting from changes in other comprehensive income; and • $(3 454) million decrease resulting from changes in other components of equity. 19 When a current/non-current presentation format is adopted, all assets and liabilities are classified as either current or non-current and presented separately on the face of the statement of financial position (para. 60). An asset is to be classified as current if it satisfies any one of the following four criteria specified in paragraph 66: (a) It is expected to be realised, sold or consumed during the entity’s normal operating cycle. An entity’s operating cycle is the time between acquiring the assets for ‘processing and their realisation in cash or cash equivalents’ (para. 68). If the operating cycle is not determinable, a 12-month duration is assumed (para. 68). (b) It is held primarily for the purpose of being traded. (c) It is expected to be realised within 12 months after the end of the reporting period. (d) It is cash or cash equivalent in accordance with AASB 107 ‘Statement of Cash Flows’ providing there is no restriction on its use in exchange or for settlement of liabilities for at least 12 months after the reporting date. Non-current assets are those that do not meet any of the criteria for classification as current assets. Current and non-current liabilities are categorised in a similar way. Thus, current liabilities are those that satisfy any of the following criteria specified in paragraph 69: (a) It is expected to be settled in an entity’s normal operating cycle (within a 12-month period, assumed where a normal operating cycle is not clearly identifiable). (b) It is held primarily for the purpose of being traded. (c) It is due to be settled within 12 months after the reporting date. (d) No conditional right exists to defer settlement of the liability for at least 12 months after the reporting date. Non-current liabilities are those that do not meet the criteria for classification as current liabilities. 20 The minimum requirements for separate disclosure of items on the face of the statement of financial position are as follows: the separate disclosure of the following items on the face of the statement of financial position: (a)

property, plant and equipment; . 9

(b) investment property; (c)

intangible assets;

(d) financial assets (excluding amounts shown under (e), (h) and (i)); (e)

investments accounted for using the equity method;

(f)

biological assets;

(g) inventories; (h) trade and other receivables; (i)

cash and cash equivalents;

(j)

the total of assets classified as held for sale and assets included in disposal groups classified as held for sale in accordance with AASB 5 ‘Non-current Assets Held for Sale and Discontinued Operations’;

(k) trade and other payables; (l)

provisions;

(m) financial liabilities (excluding amounts shown under (k) and (l)); (n) liabilities and assets for current tax, as defined in AASB 112 ‘Income Taxes’; (o) deferred tax liabilities and deferred tax assets, as defined in AASB 112; (p) liabilities included in disposal groups classified as held for sale in accordance with AASB 5; (q) non-controlling interests, presented within equity; and (r)

issued capital and reserves attributable to owners of the parent.

The order or format of disclosure of these items is not prescribed. Paragraph 57 notes that they are simply a list of items that are sufficiently different in nature or function to warrant separate presentation on the face of the statement of financial position. Where relevant, further sub-classifications of these amounts must be disclosed on the face of the statement of financial position or in the notes (para. 77). Additional line items to those disclosed in accordance with paragraph 54 may be included on the face of the statement of financial position when the size, nature or function of an item or the aggregation of similar items is assessed as relevant to an understanding of the entity’s financial position (para. 57). One final point to note is that the requirements of AASB 101 are subject to a materiality override. That is, ‘[i]f a line item is not individually material, it is aggregated with other items either in the statement of financial position or in the notes’ (para. 30).

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PROBLEMS 1

The format selected is the current/non-current presentation format of AASB 101 ‘Presentation of Financial Statements’. This has been selected because there is no evidence that an order of liquidity presentation format would provide more relevant and reliable information. It should be noted that comparative amounts for previous years should be provided and numbers referencing notes in the financial report should be shown. In this case, no data are available to prepare comparatives or the notes. Company Name Limited and its controlled entities Statement of financial position as at 30 June 2018 Current assets Cash and cash equivalents Accounts receivables Other receivables Inventories Other current assets Non-current assets classified as held for sale Total current assets

$ 80 200 184 900 69 700 412 380 62 170 114 000 923 350

Non-current assets Property, plant and equipment (net) Goodwill Total non-current assets Total assets

1 647 040 ___47 300 1 694 340 2 617 690

Current liabilities Accounts payables Other payables* Short-term borrowings Current tax payable Short-term provisions Other current liabilities

335 800 62 750 600 000 53 500 212 000 ___84 100

Total liabilities Net assets

1 348 150 1 269 540

Share capital Other reserves Retained earnings

400 000 348 800 520 740 1 269 540

Equity

* Other payables includes accrued wages payable, accrued commissions payable and interest payable. . 11

2 (a)

It would be classified as current. AASB 101 (paras 72 and 73) require that a financial liability that is due within 12 months after the reporting date, and for which an entity does not have an unconditional right to defer its settlement for at least 12 months after the reporting date, is classified as current. In this case, the loan is due on 6 February 2019 (less than 12 months from reporting date), and although negotiations are promising, no unconditional right exists to defer its settlement for at least 12 months after the reporting date (30 June 2018).

(b) It would remain as a current liability. Paragraph 72 states that even if an agreement to refinance or reschedule payments over the long term is secured after the reporting date, but before the financial report is authorised for issue, the loan remains classified as current. In this situation, Mit has renegotiated the finance period to extend the repayment for more than 12 months after 30 June 2018. The agreement was reached on 4 July 2018, which is after the reporting date (30 June 2018) and before the financial report is authorised for issue (28 August 2018). (c) It would be classified as non-current. A loan liability that is due no more than 12 months after the reporting date would normally be classified as current regardless of its original form. However, if the entity has discretion to refinance, or roll over the obligation for at least 12 months after the reporting date, the obligation should be classified as non-current (para. 73). In this case Mit has the capacity to roll over its obligations for an additional 18 months. (d) It would be classified as current. Magg Ltd has breached the loan agreement with the effect that the liability becomes payable on demand and thus a current liability (para. 74). (e) It would be classified as non-current. If an entity breaches a loan agreement and repayment can be demanded by the lender, it is usual to classify the loan as a current liability. However, if by the reporting date the entity secures the lender’s agreement to extend the repayment date at least 12 months after reporting date, paragraph 75 states the obligation would be classified as non-current because the lender can no longer demand immediate repayment. In this case, Magg has negotiated such an extension on the loan repayment (and future repayments to be made) over 12 months from the reporting date.

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Note: these solutions are prepared in the context of the 2015 Statement of Financial Position.

(a)

The presentation format is a flexible current/non-current format in accordance with the requirements of AASB 101 ‘Presentation of Financial Statements’.

(b)

From the 2015 Statement of Financial Position, it is noted in note 13 ‘Receivables’ that the average credit period is 60 days. In accordance with AASB 101, an asset is to be classified as a current asset if it satisfies any one of the following four criteria specified in paragraph 66. (a)

It is expected to be realised, sold or consumed during the entity’s normal operating cycle. An entity’s operating cycle is the time between acquiring the assets for ‘processing and their realisation in cash or cash equivalents’ (para. 68). If the operating cycle is not determinable, a 12-month duration is assumed (para. 68). The average credit period is 60 days, so it is reasonable to assume that the company’s operating cycle is not going to exceed more than several months. There is no disclosure in the financial statements to indicate that the accounts receivable are not expected to be realised as cash during the normal operating cycle of the company (i.e. within several months). (Blackmores Ltd has taken into account the possibility some overdue accounts remain unpaid (e.g. of the 327 accounts outstanding at 30 June 2012, 710 accounts are past 90 days overdue) by creating an allowance for doubtful debts. This does not preclude accounts receivable being disclosed as a current asset.) CONCLUSION – SATISFIES (a).

(b)

It is held primarily for the purpose of being traded. NO, DOES NOT SATISFY.

(c)

It is expected to be realised within 12 months after the end of the reporting period. CONCLUSION – ON AVERAGE SATISFIES (c). The average credit period is 60 days, so it is reasonable to assume that the company’s operating cycle is not going to exceed more than several months. There is no disclosure in the financial statements to indicate that the accounts receivable are not expected to be realised as cash during the normal operating cycle of the company (i.e. within 12 months).

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(d) Is cash or a cash equivalent in accordance with AASB 107 ‘Statement of Cash Flows’ providing there is no restriction on its use in exchange or for settlement of liabilities for at least 12 months after the end of the reporting period. NO – DOES NOT SATISFY In summary, the accounts receivable are correctly disclosed as a current asset. The asset actually satisfies (a) and (c) when in fact satisfying only one criterion is necessary for classification as a current asset. (c)

Interest bearing liabilities of $44 000 000 are disclosed as non-current liabilities in the 2015 Statement of Financial Position. This indicates that the borrowings do not satisfy the definition of a current liability. That is, the borrowings do not meet any of the following four criteria (para. 69, AASB 101): (a)

It is expected to be settled in an entity’s normal operating cycle (with a 12month period assumed where a normal operating cycle is not clearly identifiable).

(b)

It is held primarily for the purpose of being traded.

(c)

It is due to be settled within 12 months after the end of the reporting period.

(d)

No unconditional right exists to defer settlement of the liability for at least 12 months after the end of the reporting period.

(d)

No, this statement is not correct. Paragraph 54 (l) of AASB 101 requires, as a minimum, the separate disclosure of provisions on the face of the Statement of Financial Position. In addition, paragraphs 77 and 78 require a sub-classification either on the face of the statement or in the notes of particular items that include employee benefits. Therefore, Blackmores has complied with these disclosure requirements.

(e)

No, this statement is not correct. Paragraph 54 of AASB 101 requires as a minimum the disclosure of particular items on the face of the Statement of Financial Position. Deferred tax assets and deferred tax liabilities are specifically required to be disclosed (para. 54 (o) ‘deferred tax liabilities and deferred tax assets, as defined in AASB 112 “Income Taxes”’).

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4 Bright Limited and its controlled entities Statement of financial position as at 30 June 2018 Current assets Cash and cash equivalents Accounts receivables Inventories1, 2 Investments (shares) Total current assets

$ 670 2 868 48 320 68 700 120 558

Non-current assets Property, plant and equipment (net) Total non-current assets Total assets

540 000 540 000 660 558

Current liabilities Accounts payables Other payables3 Total current liabilities

970 5 674 6 644

Non-current liabilities Deferred tax liability Provisions Loan payable4 Total non-current liabilities Total liabilities Net assets

1 200 14 500 40 000 55 700 62 344 598 214

Equity Share capital Reserves Retained earnings Capital and reserves attributable to owners Non-controlling interest

412 000 30 000 100 214 542 214 56 000 598 214

1. Bright Ltd is a fashion retailer. Therefore, it is reasonable to expect that its inventory of clothes will be sold within a normal operating cycle (e.g. winter fashions are sold by the end of winter, summer fashions are sold by the end of summer). This expectation is applicable even though one quarter of the inventory comprises last season’s fashions. 2. Assume the shares are held for trading. This means that they would be measured at fair value, and they would likely be sold within 12 months of the reporting date (i.e. current assets). 3. Other payables includes accrued rental payable, accrued wages payable, and accrued commissions payable.

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4. A loan liability that is due no more than 12 months after the reporting date would normally be classified as current regardless of its original form. However, if the entity has discretion to refinance or roll over the obligation for at least 12 months after the reporting date, the obligation should be classified as non-current (para. 73).

Revenge Company (a) Able Company Baker Company Charlie Company Delta Company Epsilen Company

2018 $1 000 1 200 1 450 1 375 1 109 $6 134

2019 $1 200 1 150 1 200 1 500 1 075 $6 125

Loss for year ended 30 June 2015 Loss on shares held for year Loss on shares sold in year Gain on shares purchased in year Loss on investments

$(9) (675) 130 $(554)

(b) 1 November 2018 ______________________________________________________________ Investment in shares of Good Company Dr $1 380 Cash at bank Cr $1 380 ______________________________________________________________ 1 April 2019 ______________________________________________________________ Cash at bank Dr $800 Loss on sale of shares Dr 675 Investment in shares of Fair Co Cr $1 475 ______________________________________________________________ 30 June 2019 _____________________________________________________________ Shares in Able Company Dr $200 Shares in Delta Company Dr 125 Shares in Good Company Dr 130 Shares in Baker Company Cr $50 Shares in Charlie Company Cr 250 Shares in Epsilon Company Cr 34 Gain on investments Cr 121 ______________________________________________________________ . 16

Twain Ltd 15 April 2018 (Purchase of shares) _________________________________________________________________ Investment in shares of Barlow Dr $81 000 Cash at bank Cr $81 000 _________________________________________________________________

1 August 2018 (Receipt of dividend) _________________________________________________________________ Cash at bank Dr $4 500 Dividend revenue Cr $4 500 _________________________________________________________________ 7

Weller Ltd

30 June 2018 Shares in A Shares in C Shares in B Other Comprehensive Income

Dr Dr Cr Cr

$2 000 1 000

Loss on Investments Shares in E Shares in D

Dr Dr Cr

2 000 1 000

$1 000 2 000

3 000

30 June 2019 _________________________________________________________________ Shares in A Dr $500 Other comprehensive income Dr 1 000 Shares in B Cr $1 000 Shares in C Cr 500 Loss on investments Dr $2 000 Shares in D Cr 1 000 Shares in E Cr 1 000 _________________________________________________________________

8 Hammond Ltd (a) Shares issued at 80 cents per share: ______________________________________________________________ Trust bank account Dr $52 000 Applications Cr $52 000 ______________________________________________________________ Applications Dr $52 000 Share capital Cr $52 000 _____________________________________________________________ Cash at bank Dr $52 000 Trust bank account Cr $52 000 ______________________________________________________________ (b) Shares issued at $1.25 per share: ______________________________________________________________ Trust bank account Dr $81 250 Applications Cr $81 250 ______________________________________________________________ Applications Dr $81 250 Share capital Cr $81 250 ______________________________________________________________ Cash at bank Dr $81 250 Trust bank account Cr $81 250 ______________________________________________________________ 9

Twain Ltd Recording the issue of shares on incorporation: 1 July 2016 _________________________________________________________________ Trust bank account Dr $1 980 000 Applications Cr $1 980 000 _________________________________________________________________ 1 July 2016 _________________________________________________________________ Applications Dr $1 980 000 Share capital Cr $1 980 000 _________________________________________________________________ 1 July 2016 _________________________________________________________________ Cash at bank Dr $1 980 000 Trust bank account Cr $1 980 000 Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson, Issues in Financial Accounting 16e 18

Recording the buy-back of shares: 30 June 2020 _________________________________________________________________ Share capital Dr $715 000 Cash at bank Cr $715 000 _________________________________________________________________ AASB 132 ‘Financial Instruments: Presentation’ states that consideration paid or received shall be recognised directly in equity.

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Chapter 7 ACCOUNTING FOR CURRENT ASSETS LEARNING OBJECTIVES After studying this chapter you should be able to: 1

explain the basis for distinguishing between current and non-current assets;

describe the nature of accounts receivable and the procedure for initial recognition and subsequent measurement of accounts receivable;

identify the ways in which inventories may be classified;

explain and apply the requirements of AASB 102 ‘Inventories’;

explain the purposes of accounting for inventory;

identify the components of the cost of inventory;

describe the effects of the choice of cost-flow assumption in measuring inventory and cost of goods sold; and

apply the lower of cost and net realisable value rule.

QUESTIONS 1

AASB 101 ‘Presentation of Financial Statements’ indicates that an asset shall be classified as current when: a) it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle; b) it holds the asset primarily for trading purposes; c) it expects to realise the asset within twelve months after the reporting period; or d) the asset is cash or a cash equivalent (as defined in AASB 107 ) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date (para. 66). Hence, assets should be classed as ‘current’ when they meet the above definition. For some assets, however, the statement may be correct. For example, inventory is rarely classified as a non-current asset even if it does not satisfy the definition of current assets. Similarly, land and buildings are usually classified as non-current even if it is intended to sell them in the next financial year.

Accounts receivable are amounts owed to a seller as a result of having sold goods or services on credit.

The Framework for the Preparation and Presentation of Financial Statements (Framework 2014) recognition rules for assets apply to accounts receivable. They are not recognised unless it is probable that the amount owing will be paid and they have an amount that can be measured with reliability (Framework 2014, para. 83). Accounts receivable are measured at the undiscounted amount that it is expected the entity will ultimately receive. If, after initial recognition, the receipt of an account receivable is considered doubtful, it must be reported as doubtful debts expense. It is conventional practice, however, not to reduce the gross carrying amount of the receivable asset but to create a contra-asset called ‘allowance for doubtful debts’. The general journal entry to allow for doubtful debts, requires a debit to bad and doubtful debts expense and a credit to allowance for doubtful debts. The amount is normally based on an age analysis of outstanding debts with larger percentage losses anticipated for those debts that have been outstanding longer. If and when a debt is finally determined to be uncollectable, the debt is written off by debiting the allowance for doubtful debts and crediting the accounts receivable control account and the individual debtors account in the subsidiary accounts receivable ledger. . 2

Allowing for doubtful debts is an accounting estimate. The amount allowed in any period is most unlikely to be accurate. This will be reflected in the balance of the allowance for doubtful debts at the end of the next reporting period. If there is a credit balance in the allowance for doubtful debts that indicates that the previous estimate was excessive. If there is a debit balance this indicates that the previous estimate was insufficient. When determining the amount to be allowed in the current reporting period, the existing balance in the allowance for doubtful debts is taken into account. Thus if the previous estimate was excessive (credit balance in the allowance for doubtful debts) then the amount of the doubtful debts expense this period will be reduced. If the previous estimate was insufficient (debit balance in the allowance for doubtful debts) then the amount of the doubtful debts expense for this period will be increased. Thus past under or over estimates are corrected prospectively, as required by AASB108. 4

This statement is correct. Possession is not a relevant consideration in determining whether an item of merchandise should be included in inventory. To be recognised as inventory, the future economic benefits from merchandise must be ‘controlled by the entity’. Possession of the merchandise is not always an indication of control. For example, an entity may possess goods that are held on consignment or for sale on commission but have no control over the future economic benefits arising from the goods. Similarly, the absence of possession does not necessarily mean a lack of control of the future economic benefits. For example, the owner of merchandise may have placed it in the hands of another entity for sale on commission or on consignment. The owner still controls the future economic benefits from the goods.

Goods in transit should be included in the inventory of the entity which at that time controls the future economic benefits from those goods. In these circumstances, control is usually evidenced by ownership. The ownership of goods in transit is determined by the contractual terms of the shipping agreement. If the merchandise is shipped Free on Board (FOB) destination, then the ownership remains with the seller until the buyer receives it from the common carrier. The merchandise is included in the seller’s inventory. If the merchandise is shipped FOB shipping point, then the ownership passes to the buyer when the goods are delivered to the common carrier. The merchandise in transit is included in the buyer’s inventory.

As a matter of accounting practice, merchandise being acquired by means of a commercial hire purchase agreement is regarded as part of the inventory of the buyer. This reflects the perception that a hire purchase ‘sale’ is to all intents a genuine sale and . 3

that control of the future economic benefits from the goods passes to the buyer. There is an assumption that ownership and control pass with possession of the merchandise. This assumption does not accord with the legal position and is a result of the tendency of accountants to prefer the substance, or reality, of a transaction over its legal form in determining the most appropriate accounting treatment. 7

In general terms, inventories are goods that are controlled by a business and are held specifically for future sale or for use in the manufacture of goods for sale. Specifically, AASB102 ‘Inventories’ defines inventories as: Inventories are assets: a) held for sale in the ordinary course of business; b) in the process of production for such sale; or c) in the form of materials or supplies to be consumed in the production process or in the rendering of services (para. 6). Everything that is bought and sold is, at some time, part of some entity’s inventory. Thus, a building under construction by a contractor is part of the inventory of the contractor, and land developed for sale by a property developer is part of the inventory of the property developer.

Accounting for inventory has two interrelated purposes. The first is to measure the amount of the asset ‘inventory’ for the purposes of preparing a statement of financial position, and the second is to measure the amount of expense for the purpose of preparing a statement of comprehensive income. The amount of the asset is calculated by determining the number of units of merchandise on hand at the end of the period and multiplying it by the appropriate unit dollar amount. The expense recognised in the statement of comprehensive income generally consists of two components ─ the ‘cost of goods sold’ (usually measured as the number of units sold × the appropriate dollar amount per unit) and the ‘inventory loss expense’ resulting from the destruction, loss or theft of inventory. Under the periodic, or physical inventory recording method, the two components of expense cannot be separated and are measured together as cost of goods sold. This is achieved by deducting the amount of inventory at end from the sum of opening inventory and purchases. Periodic inventory effectively assumes that ‘What is not on hand has been sold’. This illustrates the relationship between the two purposes of accounting for inventory. When the perpetual inventory recording method is used in conjunction with a . 4

stocktake, the cost of goods sold and the inventory loss expense are able to be separately measured and recorded. Arguably, both the asset measurement and expense measurement purposes of accounting for inventory are equally important. However, in practical terms the measurement of inventory on hand tends to dominate (especially if the periodic inventory method is being used). 9

The statement is correct. The cost principle requires that all costs incurred in acquiring, installing and preparing an asset for its ultimate use by an entity should be capitalised as that asset’s carrying amount. In the case of inventory, those costs would include the purchase price, freight inwards, insurance during transit, unpacking, checking and perhaps displaying the goods for sale. In practice, however, many of these costs are not capitalised but are recognised as expenses as they are incurred. The main reason for this departure from strict adherence to the cost principle is that the cost of tracing these costs to individual items of inventory is greater than the benefits from so doing. In many cases, the cost per unit of the costs other than purchase price are very small and the benefits from allocating them to inventory are virtually non-existent.

10 Cash discounts are frequently offered to encourage early payment for purchases made on credit. Whether or not the ‘settlement discount’ is taken should not affect the cost of acquiring inventory. If the discount is taken, the price paid does not include the discount. If the discount is not taken, the amount of the forgone discount should be regarded as a financing expense rather than as part of the inventory’s cost. Presumably, the discount was not taken either because of an oversight or because of a decision to defer payment of the account. In either case, the discount lost cannot be regarded as part of the cost of inventory. Inventory should be recorded, therefore, at a price net of settlement discount. Discounts for prompt payment are not mentioned in AASB102 and, presumably, are not deducted from the purchase price. By not mentioning settlement discounts we are assuming AASB102 supports conventional accounting practice which defines the cost of inventory excluding any settlement discount 11 The advantages of LIFO compared to FIFO are as follows: a) it provides a better matching of current costs and current revenues; b) it is counter cyclical; and c) there are taxation advantages in the United States. The disadvantages of LIFO compared to FIFO are as follows: . 5

a) when prices are rising, LIFO undervalues inventory, the extent of the under-valuation depending upon the rate of inflation and the period for which LIFO has been used; b) profit can be manipulated by changing the pattern of purchases; and c) there may be involuntary stock liquidations, which will result in large holding gains being included in reported profit. The advantages are simply reversed for FIFO compared to LIFO. 12 The statement is correct if reported profits are fully distributed. If it is recognised that profits include some holding gains, and these gains are not distributed, then there should not be consequent liquidity problems. A holding gain on inventory arises if the replacement cost of inventory increases during the period that the inventory is held. The amount of the holding gain is the increase in the replacement cost. It may be realised by sale or remain unrealised if the inventory is still on hand. The situation can best be illustrated with a simple example. A business began a period with the following statement of financial position: ________________________________________________________________ Assets Cash Inventory 100 @ $2.00

0 $200 200 100 $100

Liabilities Equity

_________________________________________________________________ During the period, the inventory was sold for $300 ($3.00 per unit) and the profit of $100 was fully distributed. At the end of the period, the statement of financial position would be as follows: ________________________________________________________________ Assets Cash Inventory

$200 200 Liabilities 100 Equity $100 _________________________________________________________________

The business has $200 cash to restore its inventory. If, however, the replacement cost had risen to $2.50 per unit, the business could buy only 80 units and its operating capability would be impaired. The holding gain realised during the period was 100  ($2.50 – $2.00) or $50. If $50 had been retained, the business would have had $250 in

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cash that would have been sufficient to acquire 100 units of inventory and maintain its operating capability. 13 When prices are changing, the use of LIFO may result in profit manipulation through the pattern of purchases. By restricting purchases to force sales from the old base stock, a business will bring holding gains into reported profit. Consider the following two businesses, both of which used LIFO and made sales of 1000 units. One (A), however, purchased 1000 units at $3.00, while the other (B) purchased only 500 units at $3.00. Both began the period with inventories of 700 at $2.00. ________________________________________________________________ Business A Sales revenue, 1 000 @ 5.00 $5 000 less Cost of goods sold: 1 000 at $3.00 3 000 Profit $2 000 Business B Sales revenue, 1 000 @ $5.00 $5 000 less Cost of goods sold: 500 @ $2.00 and 500 @ $3.00 2 500 Profit $2 500 _________________________________________________________________ By restricting its purchases, business B has increased its profit by recognising holding gains of $500. 14 In some circumstances, a FIFO assumption may be realistic. Goods may actually be sold on a first-in-first-out basis. For example, supermarkets put the freshest milk at the back so that customers take the oldest in stock. In some cases, an average cost assumption may be appropriate. For example, an inventory of fluids may be topped-up by simply pouring the addition in the stock. The inventory is mixed and the customer gets an average. In other cases, LIFO may be a more realistic assumption. For example, bins of hardware may be topped up in a way that means that customers take the most recent addition. The quotation in the question is not always true. In some cases, an assumption of FIFO may be unrealistic. Even if the quote were always true, it would remain essentially irrelevant to the choice of cost flow method. That is, choice of cost flow method is NOT driven by the physical flow of goods through the business. 15 IFRS do not permit the use of LIFO for financial reporting purposes, US GAAP does permit use of LIFO for financial reporting purposes. Convergence of US GAAP with IFRS would require removal of this difference. On the face of it, this difference is just one of many financial reporting differences that would disappear if US GAAP and IFRS

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are converged. What complicates this issue is that is that removing LIFO from financial reporting options may cost some US firms real dollars! US tax laws require that firms using LIFO for income tax purposes must also use it for financial reporting purposes. If LIFO is not available for financial reporting purposes this would presumably prevent firms from using LIFO for income tax purposes. LIFO results in substantial tax savings for some US firms (for example, it is reported that Exxon Mobil’s 2007 income tax bill would increase by US$9 billion if it changed from LIFO). Those firms currently using LIFO are likely to lobby strongly for LIFO to be retained as a financial reporting option in the US. Inventory method remains as a fundamental difference between US GAAP and IFRS with some proponents requesting a carve-out of the LIFO provisions should the US adopt IFRS. The issue remains unresolved. [See, e.g., comment letter of TLIFOC (the LIFO Coalition) on the 2011 May Staff Paper. The commenter noted that if U.S. issuers adopt IFRS they would be forced to violate the IRS conformity requirements. The LIFO Coalition requested the SEC to provide a carve-out for LIFO accounting, in the event the SEC decides to require U.S. issuers to adopt IFRS. For an update on the SEC Work Plan on IFRS adoption, please visit the following website: http://www.sec.gov/spotlight/globalaccountingstandards.shtml. For a further discussion on this issue, refer to the reading by Hoffman and McKenzie (2009), referencing detailed of which are available in Note 3 at the end of this chapter. 16 AASB 102 does not allow the use of LIFO. It identifies the use of first-in, first-out (FIFO) or weighted average cost formula for items of inventory that are ordinarily interchangeable (para. 25), and specific identification for inventory that are not ordinarily interchangeable (para. 23). There is no explanation for the prohibition. It is sometimes argued that LIFO is not a realistic assumption about the flow of merchandise through an entity and that it was devised to decrease profits in periods when prices were rising and (in the United States) to reduce taxable income. The argument about taxable income is not relevant to Australia as there is no requirement to use the same inventory method for tax and accounting purposes. There may be circumstances when LIFO is a realistic assumption and it could be argued that the method should be available in these circumstances. 17 Paragraph 23 of AASB102 requires ‘the cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs.’ The term ‘ordinarily interchangeable’ is not defined or expanded on, however, it would appear that many (if not all) items sold in retail outlets are interchangeable, thus preventing the use of specific identification in this industry. Paragraph 24 goes on to explain that use of . 8

specific identification when items are interchangeable may encourage management to manipulate the selection of inventory items for sale so as to increase or reduce reported profits. This danger is obviously considered to outweigh the advantages of specific identification (information is objective and does not rely on assumptions about when goods are sold). With appropriate technology (bar codes and scanners), specific identification could be used for a very wide range of ‘interchangeable’ items. 18 The question requires students to prepare a memorandum addressed to the CEO. In professional correspondence, including briefing notes or internal memorandums (‘memos’), the contents should be brief and to the point (concise). No manager likes to read pages of information. Your memo should cover the requirements of AASB 102 paragraphs 28 to 33 but should not be a ‘replication’ or ‘copy’ of the standard. It would not be appropriate to provide your CEO with a replication of the standard. The skill of writing correspondence for internal purposes or for your clients is a learned and practiced skill. Your answer should provide a discussion, preferably illustrated by an example, of the possible options when applying the lower of cost and net realisable value rule. The options will include applying the rule: • • •

on an item-by-item basis (para. 29), by each class of inventory grouping similar or related items of the same product line or similar purpose or end use (para. 29); or on the total inventory where maybe it is not practicable to evaluate separately from other items or classes of items.

Example 7.4 demonstrates these choices. Your briefing note should highlight the impact on: • •

the statement of financial position – i.e. on the value of the closing inventory the statement of comprehensive income – i.e. on the profit i.e. COGS.

19 AASB 102 prefers that the lower of cost and net realisable value should be applied on an item-by-item basis (para. 29). The Standard offers no rationale for this requirement. The item-by-item basis gives the lowest inventory valuation and it is likely that the requirement is a residual influence of the principle of conservatism. 20 The lower of cost and net realisable value rule is a direct result of the traditional doctrine of conservatism. Its application means that potential losses when the expected selling price of inventory falls below its cost are recognised, but potential profits when expected selling price is above cost are ignored until the profits are realised by sale. The arguments for the lower of cost and net realisable value rule are, therefore, the arguments . 9

for conservatism. Basically, these arguments are that statement users are best served by financial statements that understate rather than overstate profit and net worth. These arguments have been generally accepted. The argument against the rule is that potential losses and potential profits should be treated in the same way. The asymmetric approach of conservatism introduces a pessimistic bias into the accounts. Note that conservatism is not a qualitative characteristic of financial information in the Framework 2014. Also, Framework 2014 applies the same probability of occurrence for recognising income and expenses in the accounts. 21 The change of related inventory policies could easily influence the reported profit. These are some of the possible alternatives. •

Change in cost flow methodology. Changes in cost flow choice could result in higher profits particularly in an environment of rising prices. Whilst LIFO not allowed in Australia, the entity could move to a weighted average price as opposed to FIFO basis particular in a perpetual inventory system. This is likely to reduce the value of COGS thereby increasing gross profit and all else equal, reported profits. This would have the effect of also increasing the value of the closing stock at the end of the period

•

Change in determining the cost base of inventory. The company could consider capitalising the directly attributable costs associated with getting the stock into the condition and location available for sale and costs incurred in the manufacturing process. This will elevate the level of closing inventory value of stock and decrease reported profits.

Changes in accounting policies are permitted but must be performed in accord with AASB 108 Accounting Policies, changes in Accounting Estimates and Errors. AASB 108 requires that an entity shall select and apply its accounting policies consistently for similar transactions over time (see paras 13, 15). Paragraph 14 requires that an entity shall change an accounting policy only if the change: (b) results in the financial statements providing reliable and more relevant information about the effect of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows. Hence, such changes must be driven by more reliable and relevant information for users not for purposes of altering profit in a period to achieve performance target. The manipulation of inventory has a multiplicative effect. Changes in one period are likely to result in reducing effects on profit in the following period when the closing inventory of the current period becomes opening inventory of the next period. The change in profit and change in asset value through closing inventory is also likely to have . 10

an impact of ratios such as the current ratio and return on assets which may influence users. It would seem that management’s intention is not motivated by providing reliable and more relevant information but self-interest (increasing their performance bonuses). The management team should consider an alternative method, such as cost minimisation to achieve the targets. 22

Howard Company (a) As the merchandise inventory was shipped FOB shipping point on 30 June 2017, ownership passed to Howard Company when the supplier delivered the merchandise to the common carrier on that date. Therefore, Howard Company should have included the merchandise in its inventory. (b) The merchandise inventory is still at the premises of Howard Company, it has not been delivered to the common carrier and, therefore, ownership has not passed to the customer. Hence, Howard Company should have included this merchandise in its inventory for the year ended 30 June 2017. (c) Assuming FOB shipping point, ownership will only pass to the customer when the company delivers the merchandise to the common carrier. The merchandise was still in the shipping room on the 30 June 2017. At that date, ownership had not passed to the customer because delivery of the merchandise by the common carrier had yet to take place. Therefore, the merchandise should have been included in inventory for the year ended 30 June 2017. (d) The merchandise should be excluded from Howard Company’s inventory because although it is possessed by Howard, the merchandise is on consignment from another company. This means that it is owned by the other company and not by Howard, which is only acting as a type of sales agent for the owner of the goods. (e) The merchandise should not be included in inventory because it was shipped FOB destination which means that ownership does not pass until the merchandise is received by Howard Company. As the merchandise was received on 3 July 2017, it should be excluded from inventory as at 30 June 2017 because, at that date, ownership had not yet passed to the company.

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PROBLEMS 1

(a) Drysdale Ltd – FIFO - perpetual inventory record

# 5 000

16 000

Purchases Unit $ Cost $ 8.15

8.20

Sales Unit $

Cost $

8 000 2 000

8.10 8.15

64 800 16 300

3 000 8 000

8.15 8.20

24 450 65 600

40 750

131 200

4 000

8.30

33 200

7 000

8.20

57 400

8 000 4 000 2 000 5 000

8.10

37 000

8.20 8.30 8.20

65 600 33 200 16 400

40 500 $303 050

35 000

$286 350

Inventory on-hand # Unit $ Cost $ 8 000 8.10 64 800 8 000 8.10 64 800 5 000 8.15 40 750 3 000 3 000 16 000

8.15 8.15 8.20

24 450 24 450 131 200

8 000 8 000 4 000 8 000 4 000 7 000

8.20 8.20 8.30 8.20 8.30 8.20

65 600 65 600 33 200 65 600 33 200 57 400

5 000 5 000 5 000 10 000

8.20 8.20 8.10

41 000 41 000 40 500

Total Total $ 64 800 105 550 24 450 155 650 65 600 98 800

156 200

41 000 81 500 $81 500

(b) Drysdale Ltd - Journal entries Inventory Dr Cash at bank Cr (To record purchases of merchandise)

$303 050 $303 050

Cash at bank Dr $700 000 Sales revenue Cr $700 000 (To record sales of merchandise inventory [35 000 units  $20.00]) Cost of goods sold Dr $286 350 Inventory Cr $286 350 (To record the cost of goods sold and related reduction in inventory) Inventory loss Inventory

Dr Cr

$8 200 $8 200

(To record the inventory loss [10 000 units – 9 000 units counted]. Assume that the inventory loss is from the inventory on hand which was the earliest acquired – that is, 1000 units  $8.20 = $8 200.) Note: For simplicity, the totals have been used rather than journals for each transaction. However, in practice, each transaction would be recorded on the date of the event.

Lower of cost and net realisable value: Cost 4 000 units  $8.20 5 000 units  $8.10

Lower of cost and net realisable

32 800 40 500 $73 300

Market @ $15.00 60 000 75 000 $135 000

$73 300

No inventory write-down is required as inventory will continue to be carried at cost. (c) Statement of Comprehensive Income for the product Sales revenue (35 000 units  $20.00) less Cost of goods sold Inventory loss Gross profit

$700 000 286 350 8 200 $405 450

Note: An alternative method of calculation would be as follows given the assumption of perpetual inventory and with a FIFO cost flow assumption. (The result will be the same for the period method with FIFO). Statement of Comprehensive Income for the product Sales Revenue (35 000 units x $20.00) less Cost of goods sold (35,000 8 000 x $8.10 64 800 5 000 x $8.15 40 750 16 000 x $8.20 131 200 4 000 x $8.30 33 200 2 000 x $8.20 16 400 less Inventory loss 1 000 x $8.20 Gross Profit

$700 000

$286 350 8 200 $405 450

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(d) Closing Inventory On-hand less Inventory loss

5 000 x $8.20 5 000 x $8.10 1 000 x $8.20

41 000 40 500

Inventory at Lower of Cost and Net Realisable Value 2

$81 500 8 200 73 300 $73 300

SupaFresh Ltd (a) How SupaFresh Ltd determines the purchase price per kilo by grade In this question it is not sufficient to simply determine the average price per kilo of oranges as the total costs $35 200 (purchase price $34 300 plus sorting costs $900) divided by kilos purchases 24 000 as the oranges are of differing quality (grades). Therefore to determine purchases, calculate the average unit price per kilo by grade of oranges by allocating the cost of purchases as a percentage of the total expected value determined by the expected selling price by grade. This percentage is then used to determine the relative purchase price per kilo per grade. The following table provides the calculated costs based on the allocation method described above and also shows the calculation for sale, costs of sales and on-hand inventory.

Grades of Oranges A B C D E Total Purchases - kgs 3 000 4 000 10 000 6 000 1 000 24 000 Selling price (per kg) - $ $4.00 $3.00 $1.50 $0.75 $0.50 Selling value - $ $12 000 $12 000 $15 000 $4 500 $500 $44 000 % of total value 27.27% 27.27% 34.09% 10.23% 1.14% 100% Allocated purchase cost $1 $9 600 $9 600 $12 000 $3 600 $400 $35 200 Allocated cost per kg - $2 $3.20 $2.40 $1.20 $0.60 $0.40 Sales - kgs 2 000 3 000 8 000 4 000 900 17 900 Sales - $ $8 000 $9 000 $12 000 $3 000 $450 $32 450 Cost of Sales - $ $6 400 $7 200 $9 600 $2 400 $360 $25 960 On-hand - kgs 1 000 1 000 2 000 2 000 100 6 100 On-hand - $ $3 200 $2 400 $2 400 $1 200 $40 $9 240 1 The allocated purchase cost is determined by multiplying the total purchase price $35 200 ($34 300 + $900) by the allocated % of total value. 2 The allocated cost per kg is determined by dividing the allocated purchase cost $ by the kgs purchases.

Grade A Sales revenue less Cost of goods sold Purchases On hand

9 600 (3 200)

6 400

2 000 @ $4.00 3 000 @ $3.20 1 000 @ $3.20

$ 8 000

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Grade B Sales revenue less Cost of goods sold Purchases On hand Grade C Sales revenue less Cost of goods sold Purchases On hand

3 000 @ $300 4 000 @ $2.40 1 000 @ $2.40

9 000 9 600 (2 400)

7 200

8 000 @ $1.50 10 000 @ $1.20 2 000 @ $1.20

Grade D Sales revenue less Cost of goods sold Purchases On hand Grade E Sales revenue less Cost of goods sold Purchases On hand

12 000 12 000 (2 400)

9 600

4 000 @ $0.75 6 000 @ $0.60 2 000 @ $0.60

3 000 3 600 (1 200)

2 400

900 @ $0.50 1 000 @ $0.40 100 @ $0.40

450 400 (40)

Total

360 $25 960

$32 450

(b) To record inventory purchase. Inventory Dr Cash Cr (To record purchase of inventory)

$35 200 $35 200

(c) To record sales and cost of goods sold. Cash /Accounts Receivable Sales revenue Cost of Goods Sold Inventory (To record sale of inventory)

Dr Cr Dr Cr

$32 450 $32 450 25 960 25 960

(d) To determine inventory loss: Inventory Loss Grade A Grade B Grade C -

Loss on inventory Inventory (To record loss on inventory)

50 @ $3.20 60 @ $2.40 80 @ $1.20

Dr Cr

160 144 96 400 $400 $400

(e) To determine the value of closing inventory in accordance with AASB 102 Closing inventory Grade A Grade B Grade C Grade D Grade E less Losses Inventory value 3

$3 200 2 400 2 400 1 200 40

9 240 400 $8 840

Power Motors (Australia) Ltd (a) The value of closing inventory is determined with reference to the provisions of AASB 102. o Principle of inventory valuation: lower of cost and net realisable value: AASB 102, para. 9 o Determination of cost: components of cost: costs of purchase, costs of conversion and all other costs of bringing the inventory to its present location and condition (AASB 102, para. 10). Cost of purchase is A$ purchase price The cost of bringing the inventory to its present location would include freight and therefore freight etc of $25 per unit is to be included in cost (AASB 102, para. 11). o Determination of cost: cost flow assumptions: specific identification is one method, but the information in part (b) implies that the individual mowers cannot be specifically identified. Arguably, AASB 102 prohibits the use of this method as the mowers are ‘ordinarily interchangeable’. That is, each model is the same and can be readily interchanged for one another. Assuming specific identification is not permitted, which cost flow assumption should be used? AASB 102 permits either FIFO or weighted average cost (WAC). The fact that the US manufacturer uses LIFO has no bearing on this choice. As this is the first year of operations, there is no basis for consistency of choice, so the choice between FIFO and WAC is completely arbitrary. . 16

FIFO – On hand 140 units Shipment 3 - 100 unit @ $335 Shipment 2 - 40 units @ $265 Total

$33 500 10 600 $44 100

WAC – On hand 140 units Average costs/unit $84,500/300 140 units @ $282

$282 $39 480

o Determination of net realisable value: the most recent sale value provides the most reliable evidence of expected selling price. There is no indication of costs to sell, but these would have to be deducted to arrive at NRV. NRV for all units is $360. Therefore the NRV of the inventory on hand is 140 units @ $360 = $50 400. o Application of lower of cost and NRV rule: AASB 102 paragraph 29 expresses a preference for applying this rule item-by-item. As the NRV exceeds cost for all units in inventory, the inventory amount is $44 100 (if using FIFO) or $39 480 (if using WAC). (b)

Accounting policy for 2018 AASB102 paragraph 23 prohibits the use of specific identification when the items are ordinarily interchangeable. In the case of the mowers this clearly seems to be the case. Hence specific identification is not an acceptable method of determining the cost of inventories.

Irrigation (Australia) Ltd (a)

Determine the value of closing inventory in accordance with AASB102. AASB102 requires inventory to be measured at lower of cost and net realisable value (para. 9). In determining the cost of inventories the following issues need to be considered: • What costs are to be included? AASB102 paragraph 10 indicates that cost includes all cost of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. On this basis, the freight and handling charges of $1000 per unit should be included in cost. In practice, where these associated costs are not large, they are often expensed immediately rather than being allocated to inventory. In this case, these costs represent from 3 to 4% of purchase price, hence are not likely to be determined to be material. Hence these will be expensed rather than be allocated to each unit.

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•

Assigning costs to items of inventory: AASB102 requires the specific identification method to be used to assign costs to inventory if the items are ‘not ordinarily interchangeable’. Paragraph 24 of AASB102 explains that use of specific identification for interchangeable items can be used to obtain predetermined effects on profit or loss. The standard does not give any explain further explanation of what ‘ordinarily interchangeable’ means. We assume that these goods are interchangeable, hence specific identification is not available. Paragraph 25, of AASB102 allows the use of FIFO or weighted average methods to items that are ordinarily interchangeable. The standard is silent on how the choice between these two cost flows assumptions is to be made. Presumably, AASB108 ‘Accounting Policies, Changes in Accounting Estimates and Errors’ requires any cost flow method adopted to be consistently applied. As this is the first period of operation of the company, this also provides no guidance on the choice between FIFO and weighted average. We assume use of FIFO. Calculation of cost: 12 units on hand are initially assumed to come from the last purchase (Shipment 3 - 10 units @ cost $30 000 each), any remaining units coming from the next to last purchase (Shipment 2 - 2 units @ $27 000) Total value of closing inventory being $354,000. FIFO – On hand 12 units Shipment 3 - 10 unit @ $30 000 Shipment 2 - 2 units @ $27 000 Total

$300 000 54 000 $354 000

However, if selection WAC WAC – On hand 12 units Average costs/unit $820 000/30 12 units @ $27 333.33

$27 333.33 $328 000

Determination of net realisable value: the recommended selling price of $40 000 per unit fails to take account of current market conditions. The price achieved on the most recent sale better reflects prevailing market conditions and will be used as the measure of net realisable value for those units that remain in showroom condition. For the unit used at field days, the estimated realisable value is $19 000. There is no indication of any costs to sell the inventory; hence these have not been deducted. Comparison of cost and net realisable value: AASB102 para. 29 indicates that ‘inventories are usually written down to net realisable value item by item.’ Adopting the item by item approach, the question arises as to whether the inventory unit used at field days is from shipment 2 (cost $27 000) or shipment 3 (cost $30 000)? Since the units are assumed to be ordinarily . 18

interchangeable there would appear to be no way to tell which shipment a particular unit came from. Logic might suggest the demonstration unit came from the earlier shipment, but AASB102 does not specify that. Cost Shipment 2 (1 unit) $27 000 Shipment 2 (1 unit) $27 000 Shipment 3 (10 units) $30 000 Total

NRV $30 000 $19 000 $30 000

Lower $27 000 $19 000 $300 000 $346 000

The inventory write-down to net realisable value expense would be $8 000. (b)

The value of the closing inventory required to be disclosed. In accordance with paragraph 36 AASB 102, the closing inventory would be recorded at the Net Realisable Value of $346,000.

(c)

Subsequent treatment of the demonstration unit: The circumstances described in the question (a unit of inventory that was written down to net realisable value is still on hand at a subsequent balance date and has gone up in estimated net realisable value) are discussed in paragraph 33 of AASB102. Paragraph 33 requires that the initial write-down should be reversed (although the item cannot be carried at a figure above original cost). Before preparing the relevant journal entry, it should be noted that the following treatment essentially assumes that, at least after the write-down, the item of inventory is NOT ordinarily interchangeable and that the specific identification method has been used. If we assume periodic inventory, the closing inventory of 31 December would include the demonstration unit at net realisable value of $24 000 which is higher than the ‘cost’ assigned on 30 June of $19 000. The higher amount would be included in the overall inventory. The journal entry to record the change at 31 December 2017 is: Inventory Dr $5 000 Inventory gain Cr $5 000 (To record reversal of previous write-down of inventory from NRV of $19,000 to $24,000)

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Feather Ltd (a) Determine the cost per unit using direct costing and absorption costing. Direct Absorption Costs per unit Costing Costing Direct materials $12 $12 Direct labour 22 22 Variable production overhead 15 15 Fixed production overhead* 15 Total $49 $64 *(fixed overhead $1 500 000 ÷ normal production capacity 100 000 units) (b)

Cost per unit using AASB 102: AASB 102 requires that costs of conversion include systematic allocation of fixed production overheads. This is to be done based on normal operating capacity. Hence the absorption costing method is required by AASB 102 giving production costs of $64 per unit. What about the fixed and variable selling costs and the fixed administrative costs? Paragraph 16 of AASB 102 excludes administrative overheads and selling costs from the cost of inventories. Cost per unit under AASB 102 = $64.

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Chapter 8 ACCOUNTING FOR PROPERTY, PLANT AND EQUIPMENT LEARNING OBJECTIVES After studying this chapter you should be able to: 1

identify the issues involved in the initial recognition and measurement of property, plant and equipment and apply the relevant requirements of AASB 116 ‘Property, Plant and Equipment’;

assess the issues in accounting for infrastructure and heritage assets and the accounting treatment required by AASB 116 ‘Property, Plant and Equipment’;

analyse the controversy regarding accounting for land under roads and apply the relevant requirements of AASB 116 ‘Property, Plant and Equipment’;

explain the issues in accounting for borrowing costs during asset construction and implement the relevant requirements in AASB 123 ‘Borrowing Costs’;

evaluate the role of revaluation in accounting for property, plant and equipment and apply the relevant requirements in AASB 116 ‘Property, Plant and Equipment;

explain asset impairment and implement the requirements of AASB 136 ‘Impairment of Assets’;

explain the nature of depreciation;

discuss the practical problems in accounting for depreciation expense and how they are dealt with in AASB 116 ‘Property, Plant and Equipment’; and

explain the nature of investment properties and apply the requirements of AASB 140 ‘Investment Property’.

QUESTIONS 1

(a) AASB 116 ‘Property, Plant and Equipment’ requires that where there is an acquisition, the acquired assets must be measured at the acquisition date at cost. Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire the asset. The components of the cost of an item of property, plant and equipment are discussed in paragraphs 16–22 of AASB 116. (b) The principal requirements of AASB 116 regarding the measurement of property, plant and equipment subsequent to acquisition are as follows: • Property, plant and equipment must be accounted for using either the cost model or the revaluation model. • All assets in the same class must be accounted for on the same basis but different bases may be used for different classes. • If the revaluation model is chosen for a class of assets, the assets must be revalued with sufficient frequency to keep fair values ‘up to date’. • A revaluation increment for an asset must be credited to the revaluation surplus unless it reverses a revaluation decrement that was recognised as an expense in an earlier period, in which case, the revaluation increment should be recognised as revenue. • A revaluation decrement for an asset must be recognised as an expense unless it reverses a revaluation increment that was credited to the revaluation surplus, in which case, the revaluation decrement must be debited to the revaluation surplus. • AASB 116 does not comment on the ability of an entity to change the measurement model of a class of assets (e.g. change from cost model to revaluation model). Instead, any change in accounting policy is governed by AASB 108 ‘Accounting Policies, Changes in Accounting Estimates and Errors’.

In relation to for-profit entities, this statement is correct, as paragraph 15 of AASB 116 requires an asset to be initially recognised at cost. However, there is an exception to this general rule. In particular, for not-for-profit entities, paragraph Aus15.1 requires that where an asset is acquired at no cost, or for a nominal cost – as is the case with a donated asset – the cost is its fair value as at the date of acquisition. In this case, the asset would be depreciated over its estimated useful life.

As a general rule, the cost of an asset should include the fair value of all assets surrendered or used up in its acquisition and construction. If overhead is incurred in the . 2

construction of an asset, then the cost of that asset should include an amount for that overhead. There are, however, some problems with fixed factory overhead. It is generally agreed that where normal production is curtailed to provide the capacity to construct the asset, a portion of fixed factory overhead should be included in the cost and depreciable amount of the constructed asset. This allocation should leave the unit cost of the product that is usually manufactured the same as before the construction commenced. However, where there is excess capacity, the position is less clear. With excess capacity, the asset can be constructed with no change in the output of the usual product. If the constructed asset is charged with some fixed factory overhead, the unit cost of the usual product will fall and profits will rise. This does not seem to be a sensible outcome. If fixed factory overhead is not charged to the constructed asset, the unit cost of the usual product will remain unchanged, but the depreciable amount of the constructed asset will be less. Which of these alternatives is the most desirable is a matter of opinion? We prefer not charging fixed factory overhead to the constructed asset to avoid variations in the cost of goods manufactured and sold. 4

Infrastructure assets are those with very long lives that provide services to the community. They include assets such as roads, sewerage systems, water delivery systems, ports, bridges and electricity generation and delivery systems. They are normally very expensive and long-lasting. Heritage assets are assets that should be preserved regardless of their utility. They include historic buildings, monuments, museum collections and works of art. As a general rule, they are irreplaceable. Community assets are assets owned and enjoyed by the community in which they are located. They include parks and gardens, beaches, sporting facilities and libraries.

(a) Infrastructure and heritage assets are not to be treated differently from other property, plant and equipment under AASB 116. They may be accounted for either in accordance with the cost model or the revaluation model. (b) In AASB 116 ‘Property, Plant and Equipment’ assets acquired at no cost or for a nominal cost are required to be initially recognised at fair value. In these cases, fair value is deemed to be the cost and the assets would be depreciated and tested for impairment in accordance with the requirements of AASB 116 and AASB 136. An alternative would be to record a zero or nominal cost for assets that may be expected to generate significant

. 3

future economic benefits. To record such assets at a zero or nominal value is regarded by many as misleading. 6

It has been argued that infrastructure, heritage and community assets should either be omitted from the accounting records of government entities or be given special treatment. This argument is based on a belief that these assets are so different from ‘ordinary’ assets that ‘ordinary’ accounting methods are inappropriate. This difference arises from their long lives, the difficulty of identifying and/or measuring their benefits and their large initial costs. It is also suggested that few, if any, private sector entities have assets comparable to infrastructure, heritage and community assets and that private sector accounting methods are, therefore, inappropriate. The counter-argument is that these assets are not different in nature from any other assets. They have a cost, they have useful lives (which may be long), and they provide future economic benefits (which may be difficult to measure). The differences are ones of degree, rather than in the nature of the asset, and omitting such important and valuable assets from the balance sheet of a government entity cannot be regarded as presenting relevant information. It can also be argued that some private sector entities have assets corresponding to infrastructure, heritage and community assets; for example, many mining companies in Northern Western Australia have substantial investments in ports, railway systems and mining town infrastructure. The private sector seems to have no difficulty in applying accrual accounting procedures to these assets.

Like buildings, where the land on which a building is constructed is treated as a separate asset from the building, roads also have two components – ‘roadworks’ and ‘land under roads’. Roadworks are all road construction works, including the road bed and pavement. Land under roads is the land under roadways and road reserves. While many of the same issues could apply to other infrastructure assets, such as railways and water storages, most of the debate has focused on the recognition of land under roads. This is probably because of the number of entities that would be affected by a requirement to recognise land under roads. The main concerns that have been raised about the recognition of land under roads have been: • uncertainty about which entities control land under roads; • that land under roads cannot be measured reliably; and • that the costs of recognising land under roads would exceed the benefits.

8 There are two options: (1) Do not recognise the land under roads as an asset because it was acquired prior to 31 . 4

December 2018 (para. 8 AASB 1051) but disclose the accounting policy. (2) Recognise the land under roads as an asset at deemed cost. The state government authority may use as deemed cost: (a) fair value at the date of the recognition; (b) an earlier revaluation of land under roads; or (c) an earlier deemed costs (para. 14, AASB 1051). After initial recognition, the entity would apply the requirements of AASB 116). 9

If interest is a cost necessarily incurred during a construction period and it can be traced unequivocally to the project, then it should be capitalised as part of the cost of that project. It is argued that interest is as much a cost of construction as labour or materials and provided it is directly traceable to the project, it should be capitalised. The counter argument, that interest during the construction period should not be capitalised, falls into two categories. The first is that not all projects are financed by borrowing with interest as a cost. Some projects are financed by equity and some from retained profits. These sources of finance are not costless although they do not involve an obvious cash outflow, such as interest. If it is appropriate to capitalise interest, then it should also be appropriate to capitalise the cost of equity. However, the idea seems to be only to capitalise interest. This is not so much an argument against interest capitalisation but an argument to extend it to capitalising the cost of all sources of finance. The second and more substantive argument is that it is not possible to trace the cost of particular sources of finance to particular projects. It is argued that finance should be regarded as a pool comprised of debt and equity from which all projects are financed. There is an optimum composition for this pool of finance which determines whether it is augmented by debt or equity when there is a need to enlarge the pool. If there is too much debt in the pool, it will be augmented by a new equity issue or by restricting dividends. Projects are not financed by the addition to the pool of finance but by the pool itself in the proportions of debt and equity in that pool. This argument does not say that, in some circumstances, the cost of finance should not be capitalised. Rather, it says that if it is capitalised, then it should be at the current weighted average cost of the pool of capital rather than at the cost of the marginal addition to the pool.

10 AASB 123 defines a qualifying asset as: ‘an asset that necessarily takes a substantial period of time to get ready for its intended use or sale’. (para. 5) Deciding whether an asset is a qualifying asset is not simply a matter of the time taken to get it ready for its intended use or sale. For example, if an asset took a long time to . 5

construct merely because of inefficiencies, labour disputes or the allocation of resources to other projects, it would not be a qualifying asset because it did not ‘necessarily’ take a substantial period of time to get ready for its intended use or sale. For an asset to be a qualifying asset, its nature must require a ‘substantial period of time to get ready for its intended use or sale’ even if it is constructed or produced in the shortest possible period of time. Qualifying assets include long-term construction projects, such as the construction of ships, dams, roads, power generation plants and buildings. 11 Paragraph 11 of AASB 123 provides examples of when such difficulties may occur. These situations include when the financing activity of an entity is co-ordinated centrally. Difficulties also arise when a group uses a range of debt instruments to borrow funds at varying rates of interest, and lends those funds on various bases to other entities in the group. Other complications arise through the use of loans denominated in or linked to foreign currencies, when the group operates in highly inflationary economies, and from fluctuations in exchange rates. As a result, the determination of the amount of borrowing costs that are directly attributable to the acquisition of a qualifying asset is difficult and the exercise of judgement is required. 12 The standard is silent on the reasons for the different treatments of revaluations upwards and downwards. The difference is probably a residual of the doctrine of conservatism which did not allow the recognition of revenue until it was virtually certain. An increase in the value of an asset did not guarantee that revenue would eventually be realised. The value may fall and the revenue may never be realised. The doctrine of conservatism would not allow the recognition of revenue in these circumstances. This conservative approach is reflected in the inclusion of revaluation increases in other comprehensive income rather than profit after tax in the statement of comprehensive income. On the other hand, the doctrine of conservatism required that expenses should be recognised as soon as there was a chance that they would be incurred. A fall in the value of an asset would be interpreted as a clear indication that an expense could be incurred and conservatism would require that it should be recognised. This conservative approach is reflected by the inclusion of any revaluation expense in the profit after tax in the statement of comprehensive income. 13 There is the potential for managers to selectively revalue items of property, plant and equipment to achieve desired financial outcomes. To limit opportunistic revaluations,

. 6

paragraph 36 requires that ‘if an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued’. Thus, the increments and decrements of all items within a class of assets will likely balance each other out, making it more difficult for managers to manage the balance sheet and/or income statement to achieve a desired result. AASB 116 requires property, plant and equipment to be recognised initially at cost. Subsequent to initial recognition, management may choose either the cost model or the revaluation model to measure property, plant and equipment. The revaluation model is to be applied to an item of property, plant and equipment only if its fair value can be measured reliably. This implies that management may revert to the cost method in the event that the item’s fair value in some future period cannot be measured reliably. In any event, there is no prohibition in AASB 116 on changing the measurement model. In fact, AASB 116 provides no comment on the ability of an entity to change the measurement model of a class of assets (e.g. change from cost model to revaluation model). Instead, any change in accounting policy is governed by AASB 108 ‘Accounting Policies, Changes in Accounting Estimates and Errors’. Specifically, paragraph 14 of AASB 108 allows a change in measurement model only if it results in financial statements that provide ‘reliable and more relevant’ financial information. 14 (a) AASB 136 defines the recoverable amount of an asset or cash-generating unit as ‘the

higher of its fair value less costs of disposal and its value-in-use’ (para. 6). Fair value less costs of disposal to sell is determined as: ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’ (para. 6). The determination of fair value less costs of disposal is elaborated in AASB 13 ‘Fair Value Measurement’. Value-in-use is defined as ‘the present value of the future cash flows expected to be derived from an asset or cash-generating unit’ (para. 6). Estimating an asset’s value-inuse is a two-step process requiring first, the estimation of net future cash flows from the continued use and disposal of an asset, and second, application of an appropriate discount rate. The elements to be included in the calculation of an asset’s value-in-use are listed in paragraph 30 as follows: •

the expected future cash flows derived from the asset; . 7

• • • •

the expected variations in the amount and timing of future cash flows; the time value of money (represented by current market risk-free rate of interest); the price for bearing the uncertainty inherent in the asset; and other relevant factors for pricing the future cash flows such as illiquidity.

(b) No. If either of these amounts (i.e. fair value less costs of disposal or value-in-use) exceeds the asset’s carrying amount, the asset is not impaired and it is not necessary to estimate the other amount (para. 19, AASB 136). (c) This will often be the case for an asset that is held for disposal (para. 21, AASB 136). This is because the value-in-use of an asset held for disposal will consist mainly of the net disposal proceeds, as the future cash flows from continuing use of the asset until its disposal are likely to be negligible. 15 (a) AASB 116 describes a reduction in the carrying amount of a non-current asset to its fair value as a ‘revaluation decrement’. AASB 116 refers to a reduction in the carrying amount of an asset to its recoverable amount as ‘an impairment loss’. Paragraph 5 of AASB 136 requires that the revaluation requirements of AASB 116 are first applied before an entity applies AASB 136 to determine whether the asset may be impaired. (b) AASB 116 requires that assets are carried at revalued amount (i.e. fair value). Fair value does not take account of the costs of disposal which are defined in paragraph 28 of AASB 136 to include ‘legal costs, stamp duty and similar transaction costs, costs of removing the asset, and direct incremental costs to bring the asset into condition for its sale’. Thus, if an asset’s fair value is its market value, disposal costs are the only difference between fair value (required by AASB 116) and fair value less costs of disposal (required by AASB 136). (i) If disposal costs are immaterial, it is unlikely that a revalued asset will be impaired since the recoverable amount of the revalued asset will be close to its revalued amount (para. 5, AASB 136). (ii) If disposal costs are material, the fair value less costs of disposal of the revalued asset is necessarily smaller than its fair value (para. 5, AASB 136). Therefore, the revalued asset will only be impaired if its value-in-use is less than its revalued amount (i.e. fair value). 16 Similar to individual assets, an entity must assess whether any indicators of impairment exist at reporting date for a cash-generating unit. If there is an indication that a cash. 8

generating unit is impaired, the recoverable amount of the unit must be determined (para. 66). For cash-generating units to which goodwill has been allocated, impairment testing must be conducted annually, or more often if there is an indication of impairment (para. 90). Testing for impairment involves comparing the carrying amount of the unit (including any allocated goodwill), with the recoverable amount of the unit. An impairment loss must be recognised if the carrying amount of the cash-generating unit exceeds the recoverable amount of the unit (paras 90, 104). Recognition of an impairment loss for a cash-generating unit is governed by paragraph 104. If there is any allocated goodwill, this asset is first written down and the remaining impairment loss is allocated to the other assets in proportion to their carrying amounts. If there is no allocated goodwill, the impairment loss is allocated to the assets in proportion to their carrying amounts. There is a limit to the write-down on assets within a cashgenerating unit. Paragraph 105 stipulates that in allocating an impairment loss, the carrying amount of an asset shall not be reduced below the highest of: its fair value less costs to sell, its value-in-use, or zero. 17 A subsequent reversal of an impairment loss for a cash-generating unit is dealt with in

the same way as for an individual asset with the exception of goodwill allocated to the unit. An impairment loss previously recognised for goodwill cannot be reversed in subsequent periods (para. 124). The rationale is that any increase in goodwill in subsequent periods following the recognition of an impairment loss is likely to be the result of an increase in internally generated goodwill rather than a reversal of the impairment loss for externally purchased goodwill (para. 125). For the remaining assets in a cash-generating unit, the reversal of impairment is allocated to these assets in proportion to their carrying amounts (para. 122). The reversal is to be recognised immediately in profit or loss unless the unit is carried at revalued amounts in accordance with AASB 116. In this case, the reversal is treated as a revaluation increase (paras 122, 119). Paragraph 123 imposes a ceiling on impairment reversals – the carrying amounts of asset units shall not be increased above the lower of (a) recoverable amount (if determinable), and (b) the carrying amount that would have been determined had not impairment loss been recognised for the asset in prior periods. 18 The word ‘depreciation’ has an everyday non-accounting usage with a variety of meanings. In some uses of the word, it means a physical deterioration in an object or

. 9

property and, in other uses, it means a fall in the object’s value. The distinction between these two uses is, in many cases, blurred or indistinct. An expression such as ‘If you leave your car in the rain it will depreciate,’ has some components of both meanings of the word. The car will depreciate in the sense that it will physically deteriorate (for example, it may rust) and, as a consequence, it will lose value-in-exchange. In general usage, the word ‘depreciate’ means both a physical deterioration and a fall in expected selling price. 19 Depreciation is a word in common usage meaning physical deterioration or a fall in expected selling price. Accountants use the word in a completely different sense; as an allocation of an asset’s depreciable amount over its useful life to recognise the consumption of the asset’s future economic benefits. Non-accountants have difficulty in appreciating that accountants use the word ‘depreciation’ in a narrow technical sense. As a result, financial reports may be misunderstood. The significance of depreciation expense is misinterpreted. Some of this confusion could perhaps be reduced if accountants used a term without common usage. The term ‘amortisation’ has been suggested. It is already used for some intangible assets and its use could be extended to all depreciable, or amortisable, assets. 20 The annual report justifies the non-depreciation of the buildings on grounds that are not acceptable. The fact that the buildings have increased in value is irrelevant for accounting depreciation. The argument is probably based on an impression that depreciation means a fall in expected selling price. While this is a common usage of the word, it is not the accounting meaning. It should be noted that an increase in value may mean an increase in the building’s residual value at the end of its useful life. Such an increase may reduce depreciable amount and depreciation expense, but it cannot be used as an excuse for not recognising depreciation. Resorting to materiality to justify the non-depreciation of buildings is also unacceptable. Even if depreciation of buildings is not material, it should still be recorded. However, it may be reported as an indistinguishable part of total depreciation expense. The tax deductibility of depreciation on the buildings is also an irrelevant consideration. If the service potential of the buildings has been reduced during the period, then the accounts should recognise this reduction. Even where expenses are not allowable deductions for tax purposes, this does not justify their non-recognition for accounting purposes.

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21 (a) The managing director probably believes that depreciation is a valuation adjustment. This leads to his/her view that depreciation expense should be increased to reduce book value to expected realisable value. While this is a widely held non-accounting interpretation of depreciation, it is not the accounting meaning of the word. Accounting uses the word to mean the allocation of an asset’s depreciable amount over its estimated useful life to record the consumption of the asset’s future economic benefits. It is apparent that the managing director has confused everyday usage of the word with its accounting meaning. The production manager has also misunderstood the accounting meaning of the word depreciation. He/she has interpreted it as physical deterioration. While this is a common everyday usage of the word, it is not the accounting meaning. The physical condition of the asset is not a consideration for accounting depreciation. However, if the maintenance of the asset has extended its useful life beyond that originally expected, then this may be a valid reason for a reduced depreciation charge. (b) Market value may be a relevant consideration in determining depreciation expense only to the extent that it influences the depreciable amount or useful life. A change in current market value may mean a change in the expected residual value at the end of the asset’s useful life. This will change depreciable amount and depreciation expense. There is also a possibility that changes in market value may influence the period during which the entity will use the asset. For example, an increase in valuein-exchange (net market value) above value-in-use may encourage the entity to sell the asset rather than to use it. (c) A reduction in the efficiency of an asset may change depreciation expense if the reduction was not expected when the useful life was initially estimated. An unexpected reduction in efficiency may reduce the anticipated useful life of the asset and consequently increase depreciation expense. However, if the reduction in efficiency was anticipated, it should already be incorporated into the original estimate of useful life. 22 This statement must be interpreted with some caution. In a strict historical cost accounting system, the statement is incorrect. The cash flow occurs when the asset is acquired and prepared for use, and when ‘betterment’ expenditures are made. The asset is basically a prepaid expense and depreciation is an allocation of that cash flow to the periods when the service potential of the asset is used. However, under a modified historical cost accounting system where the depreciable amount includes a revaluation increment, depreciation of that increment is not an allocation of an earlier cash outflow . 11

and is an expense ‘which does not involve a cash flow’. In some circumstances, therefore, depreciation expense may not be associated with a cash flow. It should be noted that the statement implies that all other expenses involve cash flows. In some cases, the expenses are an allocation of previously incurred cash outflows. In other cases, the expenses are in anticipation of cash outflows. While it is wise to be suspicious of dogmatic, all-inclusive assertions, it is difficult to think of an expense that is not associated with a past, present or a future cash outflow. 23 There are differing opinions on this topic. It may be argued that investment properties are no different from owner-occupied buildings and should be accounted for in the same way. In both cases, they are acquired with an expectation of future economic benefits, which may be from occupancy (saving rental payments), or rental revenue and capital gains. As there is no difference in the motive for acquiring owner-occupied buildings or investment properties, they should be accounted for in the same way. The alternative view is that investment properties are essentially different from owneroccupied buildings and should, therefore, be treated in a different way. Occupied property is held until it has reached the end of its useful life or its value-in-exchange exceeds its value-in-use. The benefits are not cash flows but savings in the form of saving rental payments. Investment property is held until the rate of return from rent falls below the opportunity cost of selling and investing elsewhere. The benefits are rental income and capital gains. Those holding the view that the two assets are different would also probably argue that those differences warrant different accounting procedures. An analogy might be made with the adoption of the ‘business model’ approach that underlies AASB 9 ‘Financial Instruments’. In that standard, the entity’s intentions with regard to the use of the investment asset drive the accounting method and a similar argument might be made in the case of investment properties. As investment properties are held, at least in part, for sale (based on favourable movements in market prices), the fair value model, it could be argued, is therefore a more decision-useful measurement method for such properties. 24 The statement is incorrect. The revaluation model in AASB 116 requires that an asset be carried at its fair value less any subsequent accumulated depreciation and subsequent accumulated impairment losses. The fair value model in AASB 140 makes no reference to depreciation or impairment.

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25 The ‘mark-to-market’ method of accounting for investments requires that, at the end of each reporting period, investments are revalued to fair value with changes in fair value being recognised either as income or expenses. AASB 13 ‘Fair Value Measurement’ defines ‘fair value’ as the ‘price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’ (para. 9). AASB 9 ‘Financial Instruments’ governs the recognition and measurement of financial assets (among other things). Paragraph 4.1.1 requires that after initial recognition, financial assets should subsequently be classified as being measured at either amortised cost or at fair value. An entity is required to determine the appropriate classification of the financial asset by considering both (para. 4.1.1): (a) the entity’s business model for managing the financial assets; and (b) the contractual cash flow characteristics of the financial asset. These criteria are designed to try to match the accounting treatment of particular financial assets with the purpose for which they are held. For example, paragraph 4.1.2 of AASB 9 states that: ‘A financial asset shall be measured at amortised cost if both of the following conditions are met: a) The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows. b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.’ This paragraph indicates that the amortised cost method is appropriate because this measurement method, which is based on the cash flows to be received, matches the benefits expected to be collected from a financial asset when it is being held with the purpose of generating a readily determinable set of cash receipts. Paragraph 4.1.4 of AASB 9 requires that all financial assets will be measured at fair value unless paragraph 4.1.2 applies. Once an entity has classified its financial assets as either amortised cost or fair value, it can only change the way its financial assets are classified if its business model for holding those financial assets changes (para. 4.4.1). Under the amortised cost classification, any gains or losses on financial assets are recognised in the profit and loss only when a financial asset is derecognised (e.g. sold) or impaired or reclassified to fair value and through the amortisation process (para. 5.7.2). . 13

Paragraph 5.7.1 requires that under the fair value model, any gains or losses on financial assets are recognised in profit and loss following the guidance given in paragraph 48 of AASB 139 (namely, remeasurement of the financial asset at each reporting date). This form of accounting is sometimes described as ‘mark-to-market’. Although the fair value classification results in gains and losses on financial assets being recognised in profit and loss, paragraph 5.7.1(b) contains one exception to this which is that where the financial asset is an equity instrument, the entity can make an irrevocable choice to recognise the gains and losses on that equity instrument in other comprehensive income provided that the equity instrument is not held for trading purposes (para. 5.7.5). This choice must be made when the equity instrument is initially recognised (para. 5.7.5). Any dividends associated with the investment in equity instruments is treated as revenue in profit and loss no matter how the equity instruments are classified (para. 5.7.6). In summary, the requirements of AASB 9 mean that investments that are equity instruments (e.g. shares in other companies) are normally going to be classified as ‘fair value’ because the cash flows to be received from them do not satisfy the criteria given in paragraph 4.1.2 of AASB 9. Provided that the business model for financial assets of the investor is not to hold the equity instruments for trading purposes, then the investor has the option to recognise any gains or losses in other comprehensive income but once this choice is made it cannot be reversed. In Australia, property investments are subject to the requirements of AASB 140 ‘Investment Property’ which allows the use of a fair value model or the cost model of AASB 116. The fair value model in AASB 140 is akin to ‘mark to market’.

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PROBLEMS 1

(a) Chelmer Ltd Irrespective of whether the cost model or revaluation model is used to measure the item of PP&E, the equipment will be initially recorded at cost. Cost = Purchase price (incl. import duties) (para. 16(a) AASB 116) Installation and assembly costs (para. 17(d) AASB 116) Testing costs net of proceeds from selling any items produced while bringing the asset to that location and condition ($2 000 – $500) (para. 17(e), AASB 116)

$60 000 $1 300 $1 500 $62 800

By 16 October 2018 Property plant and equipment Dr $62 800 Cash, payables etc. Cr $62 800 Cash Dr $6 000 Car park fee income Cr $6 000 (Para. 21, AASB 116 – Incidental operations are not necessary to bring the PP&E to the location and condition necessary for it to be capable of operating in the manner intended by management. Thus, income and expenses from incidental operations are recognised in profit and loss as per normal.) Training expense Dr $3 200 Advertising expense Dr 1 400 Cash, payables etc. Cr $4 600 (Para. 19(c) costs of staff training necessary to deal with a new class of customer is not an item of PP&E; para 19(b) advertising costs to market the new product to be produced from the equipment are not an item of PP&E.) (b) Two years later Property, plant and equipment Dr $20 000 Cash, payables etc. Cr $20 000 (Para. 11, AASB 116 – such an item of PP&E qualifies for recognition as an asset because it enables Chelmer Ltd to derive future economic benefits from related assets in excess of what could be derived had it not been acquired.)

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Graceville Ltd Irrespective of whether the cost model or revaluation model is used to measure the item of PP&E, the equipment will be initially recorded at cost. Cost = Purchase price (para. 23 AASB 116) Delivery and handling costs (para.17(c) AASB 116) Engineering fees (17(f) AASB 116)

1 November 2018 Property plant and equipment Accounts payable

Dr Cr

$50 000

Property plant and equipment Accounts payable, cash etc.

Dr Cr

$5 200

$50 000 $4 000 $1 200 $55 200

$50 000

$5 200

During January 2019 Repairs and maintenance expense Dr 900 Accounts payable, cash etc. Cr 900 (Para. 12 AASB 116 – not included as part of the carrying amount of PP&E.) The holding costs of $5 000 were incurred because the asset was operating at less than full capacity. Since the asset is in the location and condition necessary for it to be capable of operating in the manner intended by management, the holding costs of $5 000 are not included in the carrying amount of PP&E (para. 20, AASB 116). 1 November 2019 Accounts payable Dr 50 000 Interest expense Dr 15 000 Cash at bank Cr 65 000 (Para 23, AASB 116 – where payment is extended beyond normal credit terms, the difference between the cash equivalent and total payment is recognised as interest over the period of credit.)

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3 (a) Clayfield Company Details of interest paid and received on this borrowing in each of the years during which the bridge is constructed are as follows: Year ended: Interest paid Interest received Net interest paid 30 June 2016 $900 000* $220 000 $680 000 30 June 2017 900 000 160 000 740 000 30 June 2018 900 000 90 000 810 000 30 September 225 000** 15 000 210 000 2018 *[$15 000 000  6%] ** [$15 000 000  6%]  3/12mths = $225 000

(b) AASB 123 requires that borrowing costs be recognised as expenses when they are incurred, except where they are attributable to the acquisition, construction or production of a qualifying asset. In the latter case, the borrowing costs are to be capitalised. Is the bridge a qualifying asset? Yes, since the bridge will take three years to construct it is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale (para. 4, AASB 123). Are the borrowing costs directly attributable to the acquisition, construction or production of the bridge? Yes, borrowing was undertaken to construct the bridge. That is, the costs would have been avoided had the bridge not been constructed (para. 13) Therefore, the borrowings costs are to be capitalised as part of the cost of the bridge during its construction. What amount of borrowing costs should be capitalised? Paragraph 15 requires capitalisation of the actual borrowing costs incurred on the borrowing undertaken specifically for the purpose of obtaining a qualifying asset less any investment income on the temporary investment of those borrowings. The borrowing costs incurred during the delay in construction due to high water levels amount to $225 000 ([$15 000 000  6%] x 3/12mths). Paragraph 23 of AASB 123 requires that capitalisation of borrowing costs be suspended during extended . 17

periods in which active development is interrupted. However, paragraph 24 provides an exception to this general rule. Capitalisation of borrowing costs is not suspended when a temporary delay is a necessary part of getting an asset ready for its intended use – e.g. if high water levels delay construction and this is common during the construction period in the geographic region involved. This is the case for Clayfield Company since the high water levels during the rainy season are consistent with the long-term weather patterns rather than the recent period of drought. Therefore, the $225 000 borrowing costs incurred between December and January are still to be capitalised as part of the cost of the qualifying asset. Year ended: 1 Interest paid Interest expense Cash at bank Building under construction Interest expense 2 Interest received Cash at bank Interest revenue Interest revenue Building under construction

Dr Cr Dr

30 June 2016

30 June 2017

$900 000

$900 000 $900 000

900 000

Cr Dr Cr Dr Cr

$900 000 900 000

900 000 $220 000

900 000 $160 000

$220 000 220 000

$160 000 160 000

220 000

160 000

Year ended 30 June 2018 The borrowing costs would continue to be capitalised for the building until substantially all the activities necessary to prepare the qualifying asset for its intended used or sale are complete (para. 25, AASB 123). In the absence of any information provided in the question, and since the project was delayed by three months due to high water levels, it is argued that ‘substantially all the activities necessary’ to complete the bridge are yet to be completed. Thus, the borrowing costs for the year ended 30 June 2018 will be capitalised. 1 Interest paid Interest expense Cash at bank Building under construction Interest expense 2 Interest received Cash at bank

Dr Cr Dr Cr

$900 000

$90 000

$900 000 900 000 900 000

. 18

Interest revenue Interest revenue Building under construction

Cr Dr Cr

$90 000 90 000 90 000

30 September 2018 Any outstanding interest is received and paid on the date construction is completed. At this point, since ‘substantially all the activities necessary’ to complete the bridge are completed, the borrowing costs will not be capitalised. 30 September 2018 1 Interest paid Interest expense Cash at bank 2 Interest received Cash at bank Interest revenue 4

Dr Cr

$225 000

Dr Cr

$15 000

$225 000

$15 000

Durango Ltd 1 July 2014 ______________________________________________________________ Plant and equipment Dr $100 000 Cash at bank Cr $100 000 ______________________________________________________________ 30 June 2015 ______________________________________________________________ Depreciation expense Dr $5000 Accumulated depreciation Cr $5000 ($100 000/20 years = $5 000 p.a.) ______________________________________________________________ 30 June 2016 ______________________________________________________________ Depreciation expense Dr $5 000 Accumulated depreciation Cr $5 000 Accumulated depreciation Plant and equipment

Dr Cr

Plant and equipment Dr Revaluation surplus (OCI) Cr (Fair value ($180 000) – carrying amount ($90 000) = $90 000 revaluation increment)

10 000 10 000 90 000 90 000

. 19

______________________________________________________________ 30 June 2017 ______________________________________________________________ Depreciation expense Dr $10 000 Accumulated depreciation Cr $10 000 ($180 000/18 years = $10 000 p.a.) ______________________________________________________________ 30 June 2018 ______________________________________________________________ Depreciation expense Dr $10 000 Accumulated depreciation Cr $10 000 Accumulated depreciation Plant and equipment

Dr Cr

20 000 20 000

Revaluation surplus (OCI) Dr 90 000 Revaluation expense Dr 20 000 Plant and equipment Cr 110 000 (Fair value ($50 000) – carrying amount ($160 000) = $110 000 revaluation decrement) ______________________________________________________________ 1 July 2018 ______________________________________________________________ Cash at bank Dr $60 000 Plant and equipment Cr $50 000 Gain on sale Cr $10 000 ______________________________________________________________ 5 Ajax Ltd (a) Year

Asset revalued

Asset not revalued

Difference

1–5

Depreciation expense

($500 000)a

($500 000)

Nil

6–7

Depreciation expense

(320 000)b

(200 000)c

$(120 000)

Gain on sale

120 000d

300 000e

(180 000)

$(700 000)

$(400 000)

$(300 000)

Total effect on income

. 20

5 years x $100 000 depreciation per annum.

2 years x$160 000 ($800 000/5 years) depreciation per annum.

2 years x $100 000 depreciation per annum.

$600 000 – carrying amount, where the carrying amount = $480 000 = $800 000 – 2($160 000).

e $600 000 – carrying amount, where the carrying amount = $300 000 = $1 000 000 – 7($100 000).

(b) Over the final two years of the asset’s useful life, revaluation has reduced reported profit by the increase in depreciation of $60 000 per annum, or a total of $120 000; when the asset was sold the effect of the revaluation was to reduce the reported profit by $180 000 ($300 000 gain less $120 000 gain). Revaluation has, therefore, reduced Ajax’s aggregate reported profit by $300 000. This is the amount of the revaluation increment. The amount of the revaluation increment has found its way into equity via the revaluation surplus. If the asset had not been depreciable, profit would still be reduced by the amount of the revaluation increment, but the reduction would occur when the asset was sold and would be reflected in the gain on the sale of the asset. In addition to the reduction in reported profit, the rates of return on both assets and equity would be reduced. These ratios would fall because of the reduction in reported profit and the increase in assets and equity. 6

(a)

Clayton Corporation 30 June 2016 – Record revaluation ______________________________________________________________ Accumulated depreciation Dr $500 000 Asset Cr $500 000 (5 years  [$1 000 000/ 10 years]) Asset

Dr 300 000 Revaluation surplus Cr 300 000 (Fair value ($800 000) – carrying amount ($500 000) = $300 000 revaluation increment) Carrying amount now $800 000 Annual depreciation $800 000 / 5 years = $160 000 ______________________________________________________________ 30 June 2018 – Record depreciation, revaluation and sale ______________________________________________________________ . 21

Depreciation expense Accumulated depreciation

Dr Cr

$160 000 $160 000

The asset would be revalued prior to sale because its carrying amount must not be materially different from fair value: Accumulated depreciation Dr Asset Cr (Carrying amount is $800 000 – 320 000 = $480 000)

320 000

Asset

Dr Cr

120 000

Dr Cr

600 000

Revaluation surplus (FV – CA = $600 000 – $480 000) Cash at bank Asset

320 000

120 000

600 000

Revaluation surplus Dr 420 000 Retained earnings Cr 420 000 ($120 000 + $300 000) ______________________________________________________________ Summary of financial statement impact (30 June 2018): Effect on comprehensive statement of income: Increase expense ($160 000) Increase income Nil Net decrease in profit ($160 000) Effect on statement of financial position: Increase in cash $600 000 Decrease in PPE $(480 000) Increase retained earnings $260 000 (b) No, the answer remains the same. At 30 June 2016, there is an indicator of impairment (para. 12, AASB 136) in that an adverse technological change is expected to impact the plant. This means that the recoverable amount of the plant should be estimated. It is $800 000 (the higher of fair value less costs to sell ($800 000 – $0) and value-in-use ($600 000)). The recoverable amount must be compared with the plant’s carrying amount. After the revaluation the carrying amount is $800 000. Since the carrying amount is equal to the recoverable amount, there is no impairment of the plant to be recognised. . 22

Vanguard Company Cost Basis 1 July 2015 Acquisition of the asset _________________________________________________________________ Asset Dr $500 000 Cash at bank Cr $500 000 _________________________________________________________________ 30 June 2016 Recording depreciation _________________________________________________________________ Depreciation expense Dr $50 000 Accumulated depreciation Cr $50 000 ($500 000/10 years = $50 000 p.a.) _________________________________________________________________ * Indicators of impairment are present * Comparison of carrying amount ($450 000) and recoverable amount ($360 000) reveals an impairment loss of $90 000 Recording Impairment Loss _________________________________________________________________ Impairment loss Dr 90 000 Accumulated impairment losses Cr 90 000 _________________________________________________________________ 30 June 2017 Recording depreciation _________________________________________________________________ Depreciation expense Dr $40 000 Accumulated depreciation Cr $40 000 ($360 000/9yrs = $40 000 p.a.) _________________________________________________________________ * Indicators of impairment reversal are present Carrying amount $320 000 Recoverable amount $340 000 Potential reversal $20 000

Ceiling on reversal = $400 000 ($500 000 − $100 000(2yrs x $50 000p.a.) Recoverable amount = $340 000 The recoverable amount is below the ceiling therefore the full reversal may be recorded. Reversal of impairment _________________________________________________________________ Accumulated impairment losses Dr $20 000 Reversal of impairment loss Cr $20 000 _________________________________________________________________ 30 June 2018 Recording depreciation _________________________________________________________________ Depreciation expense Dr $42 500 Accumulated depreciation Cr $42 500 ($340 000/8 years) _________________________________________________________________ * Indicators of impairment are present * Comparison of carrying amount of $297 500($340 000 – 42 500) and recoverable amount ($245 000) reveals that there is an impairment loss of $52 500 to be recognised. Recording impairment loss _________________________________________________________________ Impairment loss Dr $52 500 Accumulated impairment losses Cr $52 500 _________________________________________________________________ 31 December 2018 Recording six months’ depreciation _________________________________________________________________ Depreciation expense Dr $17 500 Accumulated depreciation Cr $17 500 ($245 000 / 7 years = $35 000 p.a. For ½ year = $17 500) _________________________________________________________________ Recording asset sale . 24

_________________________________________________________________ Cash at bank Dr $235 000 Accumulated depreciation Dr 150 000 Accumulated impairment losses Dr 122 500 Asset Cr $500 000 Gain on sale Cr 7 500 8

Atropos Company The carrying amount of the asset in the absence of any impairment losses would be as follows: Cost 30 June 2015 30 June 2016 30 June 2017 30 June 2018

$1 200 000 1 200 000 1 200 000 1 200 000

Accumulated depreciation

Carrying amount

$100 000 200 000 300 000 400 000

$1 100 000 1 000 000 900 000 800 000

1 July 2014 Acquisition of the asset _________________________________________________________________ Asset Dr $1 200 000 Cash at bank Cr $1 200 000 _________________________________________________________________ 30 June 2015 Recognising depreciation _________________________________________________________________ Depreciation expense Dr $100 000 Accumulated depreciation Cr $100 000 ($1 200 000/12 years = $100 000 p.a.) _________________________________________________________________ Recognise asset impairment ▪ Indicators of impairment are present. ▪ Comparison of carrying amount of $1 100 000 ($1 200 000 − $100 000) and recoverable amount ($1 000 000) reveals that there is an impairment loss ($100 000) to be recognised.

_________________________________________________________________ Impairment loss Dr 100 000 Accumulated impairment losses Cr 100 000 _________________________________________________________________ 30 June 2016 Recognising depreciation _________________________________________________________________ Depreciation expense Dr $90 909 Accumulated depreciation Cr $90 909 ($1 000 000  11 years) _________________________________________________________________ Recognise asset impairment ▪ Indicators of impairment are present. ▪ Comparison of carrying amount of $909 091 ($1 200 000 – $190 909 accum. depreciation – 100 000 accum. impairment losses) and recoverable amount ($900 000) reveals that there is an impairment loss ($9 091) to be recognised. _________________________________________________________________ Impairment loss Dr 9 091 Accumulated impairment losses Cr 9 091 _________________________________________________________________ 30 June 2017 Recognising depreciation _________________________________________________________________ Depreciation expense Dr $90 000 Accumulated depreciation Cr $90 000 ($900 000  10 years) _________________________________________________________________ Recognise asset impairment ▪ Indicators of impairment are present. ▪ Comparison of carrying amount of $810 000 ($1 200 000 – 280 909 accum. dep’n – $109 091 accum. impairment losses) and recoverable amount ($800 000) reveals that there is an impairment loss ($10 000) to be recognised.

. 26

_________________________________________________________________ Impairment loss Dr 10 000 Accumulated impairment losses Cr 10 000 _________________________________________________________________ 30 June 2018 Recognising depreciation _________________________________________________________________ Depreciation expense Dr $88 889 Accumulated depreciation Cr $88 889 ($800 000  9 years) _________________________________________________________________ Recognise reversal of impairment loss ▪ Indicators of a reversal of impairment are present. ▪ Comparison of carrying amount of $711 111 ($1 200 000 – 369 798 accumulated depreciation – 119 091 accumulated impairment losses) and recoverable amount ($850 000) reveals that there is a potential reversal of impairment ($138 889) to be recognised. ▪ The impairment reversal exceeds the ceiling imposed by AASB 136 – the carrying amount of the asset had no previous impairment been recognised ($800 000) – so only an $88 889 reversal can be recognised ($800 000 – $711 111). _________________________________________________________________ Accumulated impairment losses Dr 88 889 Reversal of impairment loss Cr 88 889 _________________________________________________________________ Recognise sale of asset _________________________________________________________________ Cash at bank Dr $860 000 Accumulated depreciation Dr 369 798 Accumulated impairment losses Dr 30 202 Asset Cr $1 200 000 Gain on sale Cr 60 000 _________________________________________________________________

. 27

Watson Ltd 1 June 2016 – Purchase _________________________________________________________________ Industry Land Parcel Dr $3 000 000 Cash Cr $3 000 000 Beach Land Parcel Dr 2 350 000 Cash Cr 2 350 000 _________________________________________________________________ 30 June 2017 – Revaluation increment Industry Land _________________________________________________________________ Industry Land Parcel Dr 500 000 Revaluation surplus Cr 500 000 ($3 500 000 − $3 000 000 = $500 000) _________________________________________________________________ 30 June 2017 – Impairment loss Beach Land Is there any indication of impairment of the asset? There are indicators of asset impairment (para. 12, AASB 136): 1. There is decline in the market value of the land greater than would be expected as a result of normal wear and tear; and 2. There is evidence of physical damage (landslides). Therefore, need to test for impairment. This involves estimating recoverable amount and comparing it with the carrying amount of the asset. What is the recoverable amount? Recoverable amount is defined in paragraph 6 as the higher of its fair value less costs of disposal ($1 900 000) and its value-in-use ($500 000), and in this case the asset’s recoverable amount is equal to $1 900 000. Is there an impairment loss? If the carrying amount of the asset is greater than its recoverable amount, the asset shall be reduced to its recoverable amount. That reduction is an impairment loss (para. 59). In this case the carrying amount of the asset ($2 350 000) is greater than its recoverable amount ($1 900 000), so there is an impairment loss of $450 000.

. 28

Recognition of the impairment loss Since the cost model is used, any impairment loss is recognised immediately in profit or loss (para. 60). _________________________________________________________________ Impairment loss Dr $450 000 Accumulated impairment losses Cr $450 000 _________________________________________________________________ 30 June 2018 – Revaluation of Industry Land Para. 5 of AASB 136 requires that the revaluation requirements of AASB 116 be applied before applying the requirements of AASB 136. Is the carrying amount of Industry Land different to fair value? Yes, the carrying amount ($3 500 000) is greater than fair value ($2 900 000), so a revaluation decrement ($600 000) must be recorded. _________________________________________________________________ Revaluation surplus Dr $500 000 Loss on revaluation Dr 100 000 Industry Land Parcel Cr $600 000 _________________________________________________________________ Impairment of Industry Land Is there any indication of impairment of the asset? There is an indicator of asset impairment (para. 12, AASB 136): 1. Restructuring of Watson Ltd which will likely lead to the closure of its manufacturing division which is located on the Industry land parcel. Therefore, need to test for impairment. This involves estimating recoverable amount and comparing it with the carrying amount of the asset. What is the recoverable amount? Recoverable amount is defined in paragraph 6 as the higher of its fair value less costs of disposal ($2 400 000) and its value-in-use ($2 500 000), and in this case the asset’s recoverable amount is equal to $2 500 000. Is there an impairment loss? If the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss (para. 59). In this case the carrying amount of the asset ($2 900 000) is

. 29

greater than its recoverable amount ($2 500 000), so there is an impairment loss of $400 000. Recognition of the impairment loss Since the revaluation model is used, any impairment loss is accounted for as a revaluation decrement. _________________________________________________________________ Impairment loss Dr $400 000 Accumulated impairment losses Cr $400 000 _________________________________________________________________ 30 June 2018 – Reversal of Impairment of Beachside Land Is there an indication of reversal of impairment? Yes − the assumption is provided in the question that there are indicators for a potential reversal of any prior impairment losses recognised for the Beach land parcel. What is the recoverable amount? Recoverable amount is defined in paragraph 6 as the higher of its fair value less costs of disposal ($2 500 000) and its value-in-use ($500 000), and in this case the asset’s recoverable amount is equal to $2 500 000. Is there a potential reversal of impairment? If the recoverable amount of an asset is greater than its carrying amount, there is a potential reversal. In this case the carrying amount of the asset ($1 900 000) is less than its recoverable amount ($2 500 000), so there is a potential reversal of an impairment loss of $600 000. Does the reversal exceed the ceiling imposed by AASB 136? The revised carrying amount of an asset cannot exceed the carrying amount had no previous impairment loss been recognised. In this case, the ceiling was $2 350 000. Therefore, only $450 000 of the potential impairment reversal can be recognised. _________________________________________________________________ Accumulated impairment losses Dr 450 000 Reversal of impairment loss (revenue) Cr 450 000 _________________________________________________________________

. 30

10 1 July 2015 Acquisition of asset Equipment Cash

Dr Cr

30 June 2016 Record depreciation Depreciation Expense ($4M/4 years) Dr Accumulated depreciation Cr ($4 000 000/4 years = $1 000 000 p.a.) Revalue asset Accumulated Depreciation Equipment

Dr Cr

4,000,000 4,000,000

1,000,000 1,000,000

Revaluation expense/loss Dr 90,000 Equipment Cr 90,000 (carrying amount $3 000 000 – fair value $2 910 000 = $90 000). After the revaluation, the carrying amount is now $2 910 000 Impairment loss? Indicators of impairment are present, therefore calculate recoverable amount: Value-in-use $2 950 000 FV – costs to sell $2 910 000 – $50 000 $2 860 000 Value-in-use > FV less costs to sell Recoverable amount $2 950 000 > CA $2 910 000, therefore no impairment is recognised 30 June 2017 Record depreciation Depreciation Expense ($2.91M/3 years) Dr Accumulated depreciation Cr

970 000 970 000

Revaluation? Carrying amount = $2 910 000 – $970 000 (accum. dep’n) = $1 940 000 = fair value. Therefore, no revaluation is required.

Impairment loss? Indicators of impairment are present, therefore calculate recoverable amount: Value-in-use $1 880 000 FV – costs to sell $1 940 000 – $80 000 $1 860 000 Value-in-use > FV less costs to sell RA$1 880 000 < CA $1 940 000, therefore an impairment loss of $60 000 should be recognised. Record impairment loss Impairment loss Accumulated impairment

Dr Cr

60 000 60 000

Statement of Financial Position 30 June 2013: Equipment (revalued amount) Less Accumulated depreciation ($970 000) Less Accumulated impairment (60 000) Equipment carrying amount

$2 910 000 (1 030 000) $1 880 000

30 June 2018 Record depreciation Depreciation expense ($1.88M/2 years) 940 000 Accumulated Depreciation 940 000 The carrying amount now $940 000 ($1 880 000 – 940 000 current addition to accum. dep’n) Impairment reversal? Indicators of impairment reversal, calculate recoverable amount: Value-in-use $1 160 000 FV – costs to sell $1 140 000 – $40 000 $1 110 000 Value-in-use > FV less costs to sell RA of $1 160 000 > CA $940 000, potential increase $220 000 The ceiling = fair value so maximum asset increase: FV ($1 140 000 – CA $940 000)

200 000

. 32

Record impairment reversal of $200 000: (1) Write back accumulated depreciation/impairment Accum. Depreciation (970 000 + 940 000) Dr 1 910 000 Accumulated impairment Dr 60 000 Equipment Cr 1 970 000 (2) Recognise impairment reversal Equipment now recorded at carrying amount $940 000 Equipment Dr 200 000 Revenue (reversal of impairment loss) Cr 60 000 Revenue (reverse revaluation expense) Cr 90 000 Revaluation surplus Cr 50 000 Balance sheet measurement 30 June 2014: Equipment at fair value $1 140 000 11 Yerongapilly Ltd (a) Is there an indication of impairment? Yes, there is an increase in interest rates that will reduce fair value calculations involving future cash flows of the cash-generating unit. What is the recoverable amount? It is provided in the question and is equal to $510 000. Is there an impairment of the assets? Yes, the carrying amount of the cash-generating unit ($530 000) is greater than its recoverable amount ($510 000). There is an impairment loss of $20 000. Recognition of impairment loss? The impairment loss of $20 000 is apportioned over the assets by reference to their carrying amounts. Asset 1 $4 528 120/530  $20 000) Asset 2 $6 792 (180/530  $20 000) Asset 3 $8 680 (230/530  $20 000) $20 000 30 June 2018 Impairment loss Accumulated impairment losses – Asset 1 Accumulated impairment losses – Asset 2 Accumulated impairment losses – Asset 3

Dr Cr Cr Cr

$20 000 $4528 6792 8680

. 33

(b) Yes, the answer changes. The allocated goodwill is first written down and the remaining impairment loss is allocated to the other assets in proportion to their carrying amounts. Asset 1 $2 264 (120/530  $10 000) Asset 2 $3 396 (180/530  $10 000) Asset 3 $4 340 (230/530  $10 000) $10 000 30 June 2018 Impairment loss Goodwill Accumulated impairment losses – Asset A Accumulated impairment losses – Asset B Accumulated impairment losses – Asset C

Dr Cr Cr Cr Cr

$20 000 $10 000 2264 3396 4340

12 Petersham Ltd Period ended 30 June 2016 There are indicators of impairment, so calculate recoverable amount. The recoverable amount is $171 831 and the carrying amount is $220 000, therefore recognised an impairment loss of $48 169. Recoverable amount: Fair value < value-in-use $78 000 < $171 831 Year 2017 2018 2019 2020 2021

Future cash flows $44 300 42 900 41 100 49 450 50 650

Impairment loss Accumulated impairment losses

Discounted cash flows (10%) $40 273 35 454 30 879 33 775 31 450 $171 831 Dr Cr

48 169 48 169

Period ended 30 June 2017 No indicators of impairment. Depreciation expense Accumulated depreciation ($171 831/ 5 years = $34 366 p.a.)

Dr Cr

34 366 34 366

Period ended 30 June 2018 Capitalise the betterment expenditure of $50 000 since it is enhancing the future economic benefits of the asset. Machinery Dr 50 000 Cash, payables etc. Cr 50 000 End of period Depreciation expense Dr Accumulated depreciation Cr ($171 831 carrying amount Less 34 366 accum. depreciation Plus 50 000 betterment expenditure Equals $187 465 $187 465/4 years = $46 866 depreciation expense)

46 866 46 866

The enhancement expenditure has increased the expected future cash flows from the machinery, so the recoverable amount of the machine must be recalculated (para. 110 and para. 111 of AASB 136). The recoverable amount ($162 839) is greater than the carrying amount of $140 599 ($187 465 less $46 866 accum. depreciation), therefore there is a potential reversal of impairment equal to $22 240. Recoverable amount: Fair value < value-in-use $80 000 < $162 839 Year 2019 2020 2021

Future cash flows $69 900 66 100 59 450

Discounted cash flows (10%) $63 545 54 628 44 666 $162 839

. 35

The reversal cannot result in a carrying amount of the machinery that exceeds the carrying amount had it not previously been impaired (i.e. depreciated historical cost). Date 30/06/2017 30/06/2018

Cost $220 000 176 000 + 50 000 226 000

Accum. Dep’n $44 000

Carrying Amount $176 000

56 500

$169 500

The recoverable amount of $162 839 does not exceed the depreciated historical cost of $169 500, therefore the full reversal of impairment can be recorded as follows: Accumulated impairment losses Reversal of impairment loss (income)

Dr Cr

22 240 22 240

13 Radiant Ltd (a) Revaluation model and the gross method for recording accumulated depreciation: Machinery Asset (Cost of Acquisition 1/7/2015) Accumulated depreciation $4 800 000/8 years × 2 years Carrying amount 30 June 2017

$4 800 000 (1 200 000) 3 600 000

Ratio fair value/carrying amount 30/6/17: $4 680 000/$3 600 000 = 1.30 Gross asset, accumulated depreciation and carrying amount must be 130% of present recorded amounts after the revaluation. Must increase each recorded amount by 30%. 30 June 2017 Machinery ($4 800 000 × 30%) 1 440 000 Accumulated depreciation ($1 200 000 × 30%) 360 000 Revaluation surplus (FV $4 680 000 – $3 600 000 CA) 1 080 000 Revalue to fair value use gross method for accumulated depreciation. Remaining life now 6 years. 30/6/2017 Revalued carrying amount Machinery (cost $4 800 000 × 130%) OR ($4 800 000 + $1 440 000) Accumulated Depreciation $1 200 000 × 130% OR ($1 200 000 + $360 000) Carrying amount (fair value)

$6 240 000 (1 560 000) 4 680 000

Annual depreciation recorded in 2017–2018 EITHER $6 240 000/8 yrs. original life** = $780 000 OR Revalued CA $4 680 000/6 yrs. Remaining life = $780 000 ** This will not work if there is a residual value that does not change proportionately. (b) Revaluation model and the net method for recording accumulated depreciation: Machinery Asset (Cost of Acquisition 1/7/2015) Accumulated depreciation $4 800 000/8 years × 2 years Carrying amount 30 June 2017 30 June 2017 Accumulated depreciation Machinery Write back existing accumulated depreciation

$4 800 000 (1 200 000) 3 600 000

1 200 000 1 200 000

Machinery FV $4 680 000 – CA $3 600 000 Revaluation reserve

1 080 000 1 080 000

Depreciation expense 2017–2018 $4 680 000/6 yrs remaining life = $780 000 14 Reliable Company (a) 1972–1981 ______________________________________________________________ Depreciation expense Dr $48 500 Accumulated depreciation Cr $48 500 ($2 000 000 – 60 000)/40 years = $48 500 p.a. ______________________________________________________________ (b) 1982–1999 ______________________________________________________________ Depreciation expense Dr $64 500 Accumulated depreciation Cr $64 500 Carrying amount at 31/12/81 = $1 515 000 = $2 000 000 – 485 000 (48 500  10 years) C.A. $1 515 000 Addition $500 000 $2 015 000 Annual depreciation expense = $64 500 [($2 015 000 – $80 000)/30 years)] ______________________________________________________________ . 37

(c) 2000–2031 ______________________________________________________________ Depreciation expense Dr $24 188 Accumulated depreciation Cr $24 188 Carrying amount at 31/12/99 = $854 000 = $2 015 000 – $1 161 000 (64 500 × 18 years) Annual depreciation expense = $24 188 [($854 000 – $80 000)/32 years)] ______________________________________________________________ 15 Currawong Ltd 1 July 2015 Acquisition of assets Land Equipment Cash at bank

Dr Dr Cr

$3 000 000 2 000 000 $5 000 000

30 June 2016 Depreciation of equipment Depreciation expense ($2 000 000 ÷ 4 years) Accumulated depreciation

Dr Cr

$500 000 $500 000

Impairment of equipment Indicators of impairment exist. Therefore, the recoverable amount of the equipment must be determined. Recoverable amount is $1 200 000 (the higher of fair value less costs of disposal and value-in-use). Since the recoverable amount of $1 200 000 is less than the carrying amount of the equipment of $1 500 000 ($2 000 000 – 500 000 accumulated depreciation), an impairment loss of $300 000 is recognised as follows: Impairment loss Accumulated impairment losses

Dr Cr

$300 000 $300 000

Revaluation of land The fair value of the land is $2 500 000 and its carrying amount is $3 000 000. Therefore, a revaluation expense of $500 000 must be recognised as follows:

. 38

Revaluation expense Land

Dr Cr

$500 000 $500 000

Impairment of land Indicators of impairment exist. Therefore, the recoverable amount of land must be determined. Recoverable amount is equal to $2 400 000 (the higher of fair value less costs of disposal and value-in-use). Since the recoverable amount of $2 400 000 is less than the carrying amount of $2 500 000, an impairment loss of $100 000 is recognised as follows: Impairment loss Accumulated impairment losses

Dr Cr

$100 000 $100 000

30 June 2017 Depreciation of equipment Depreciation expense ($1 200 000 ÷ 3 years) Accumulated depreciation

Dr Cr

$400 000 $400 000

Impairment of equipment Indicators of impairment exist. Therefore, the recoverable amount of equipment must be determined. Recoverable amount is $750 000 (the higher of fair value less costs of disposal and value-in-use). Since the recoverable amount of $750 000 is less than the carrying amount of $800 000 ($2 000 000 – (500 000 + 400 000) accumulated depreciation – 300 000 accumulated impairment losses), an impairment loss of $50 000 is recognised as follows: Impairment loss Accumulated impairment losses

Dr Cr

$50 000 $50 000

Revaluation and impairment of land The carrying amount of land of $2 400 000 ($2 500 000 – $100 000 accumulated impairment losses) is equal to fair value at 30 June 2017. Therefore, the land is not revalued. Indicators of impairment exist. Therefore, the recoverable amount of land must be determined. Recoverable amount is $2 400 000 (the higher of fair value less costs of disposal and value-in-use). Since the recoverable amount of $2 400 000 equals the carrying amount of land, no impairment is recognised.

. 39

30 June 2018 Depreciation of equipment Depreciation expense ($750 000 ÷ 2 years) Accumulated depreciation

Dr Cr

$375 000 $375 000

Reversal of impairment of equipment Indicators of an impairment reversal exist. Therefore, the recoverable amount of equipment must be determined. Recoverable amount is $600 000 (the higher of fair value less costs of disposal and value-in-use). Since the recoverable amount of $600 000 is greater than the carrying amount of $375 000 ($2 000 000 – (500 000 + 400 000 + 375 000) accumulated depreciation – ($300 000 + 50 000) accumulated impairment losses), a potential reversal of impairment of $225 000 is possible. The ceiling on reversal needs to be considered – that is, the carrying amount of the equipment had no impairment previously been recognised. The ceiling is $500 000 ($2 000 000 – ($500 000 depreciation expense 3 3 years)), which is less than the recoverable amount of $600 000. Thus, the maximum impairment reversal is $125 000 ($500 000 ceiling – $375 000 carrying amount). The reversal would be recognised as follows: Accumulated impairment losses Reversal of impairment losses

Dr Cr

$125 000 $125 000

Reversal of impairment of land Indicators of an impairment reversal exist. Therefore, the recoverable amount of land must be determined. Recoverable amount is $3 000 000 (the higher of fair value less costs to sell and value-in-use). Since the recoverable amount of $3 000 000 is greater than the carrying amount of land of $2 400 000, a potential reversal of impairment of $600 000 is possible. However, the ceiling on reversal needs to be considered – that is, the carrying amount of the land had no impairment previously been recognised. The ceiling is $2 800 000 (fair value at 30 June 2018). Thus, an impairment reversal of $400 000 is recognised ($2 800 000 – $2 400 000). This is, in effect, a partial reversal of the revaluation on 30 June 2012. The general journal entries to record the reversal are as follows. Write back accumulated impairment losses recorded on 30 June 2016: Accumulated impairment losses Land

Dr Cr

$100 000 $100 000

. 40

Recognise $400 000 impairment reversal to increase carrying amount to fair value: Land Gain on reversal of the revaluation

Dr Cr

$400 000 $400 000

16 Carter Property Ltd Fair value model ______________________________________________________________ 1 July 2016 Investment property Dr $1 400 000 Cash/payable Cr $1 400 000 ______________________________________________________________ 30 June 2017 Investment property Dr $162 000 Investment revenue Cr $162 000 ______________________________________________________________ 30 June 2018 Investment property Dr $71 000 Investment revenue Cr $71 000 ______________________________________________________________ 31 December 2018 Investment property Dr $227 000 Investment revenue Cr $227 000 Cash/receivables Dr $1 860 000 Investment property Cr 1 860 000 ______________________________________________________________ 17 Greenfields Ltd Investment property ______________________________________________________________ 1 July 2016 Investment property Dr $800 000 Cash/payables Cr $800 000 _______________________________________________________________________________________

30 June 2017 Investment property Dr $180 000 Investment revenue Cr $180 000 30 June 2018 Investment property Dr $270 000 Investment revenue Cr $270 000 ______________________________________________________________ 31 December 2018 . 41

Investment losses Investment property

Dr Cr

$50 000 $50 000

Cash/receivables Dr $1 200 000 Investment property Cr 1 200 000 ______________________________________________________________ 18 The answer to this question will be based on the AMP Annual Report for the year chosen by the student. Students should be encouraged to bring copies of the relevant financial statements and notes to class. However, the following observations are provided to help facilitate discussion based on the 2015 annual report. (a) Investments held by AMP include: • Investments in financial assets at fair value (see note 10) • Investments in financial assets at amortised cost (see note 10) • Investment properties (see note 11) • Investments in associates (measured using equity method – see note 30(a)) • Investments in controlled entities (see statement of financial position). (b) Methods of accounting for AMP’s investments and are they in accordance with accounting standards? Information regarding the accounting treatment for each of these can be found in Note 1(b), (g), (h) and (i) and the notes mentioned in part (a) above. The relevant standards include AASB 9 and AASB 10. It should be noted that, in the case of the 2015 financial statements, AMP and other companies are dealing with the transition period between the old relevant standards (e.g. AASB 139, AASB 127) and new standards that are going to be operational from 2018 (e.g. AASB 9). In AMP’s case, many of these new standards had not been adopted in 2015.

. 42

Chapter 9 ACCOUNTING FOR COMPANY INCOME TAX LEARNING OBJECTIVES After studying this chapter you should be able to: 1

identify the major differences between tax and accounting treatments;

identify and explain the tax-payable method of accounting for income tax;

explain the perceived benefits of and problems with the tax-payable method;

identify and explain the statement of financial position approach to tax allocation;

explain the perceived benefits of and problems with the statement of financial position approach to tax allocation;

identify and apply the requirements of AASB 112 ‘Income Taxes’; and

explain the results of research on tax-effect accounting.

QUESTIONS 1

Refer to Table 9.1 of the text for more information on differences between tax and accounting requirements. Three possible examples of differences between tax and accounting requirements are outlined below: (a) Depreciation of non-current assets: companies often use higher depreciation rates or accelerated depreciation methods for tax compared to accounting. This initially results in higher tax depreciation deductions than accounting depreciation expense; hence the taxable profit will be lower than accounting profit. This leads to the accounting carrying amount of non-current assets being greater than the tax base of those same assets. Later in the asset’s life, the accounting depreciation methods may result in higher depreciation charges than for tax. (b) Provision for long service leave: The tax treatment provides a deduction for long service leave when the long service leave is paid. The accounting treatment permits the recognition of an expense when the long service leave is accrued with any unpaid amount recognised as a liability. These differences typically result in accounting profit being lower than taxable income and the carrying amount of provision for long service leave liability for accounting purposes being greater than the tax base (= nil) for tax purposes. (c) Bad and doubtful debts: the tax treatment provides a deduction only for bad debts written off. Doubtful debts are not tax deductible. The accounting process typically recognises an expense for doubtful debts. The typical result of this difference is that accounting profit is lower than taxable income and the carrying amount of accounts receivable is lower for accounting purposes than for tax purposes. The effect depends on the relationship between bad debts written off and doubtful debts expense.

The tax treatment provides a deduction only for bad debts written off. Doubtful debts are not tax deductible. The accounting process typically recognises an expense for doubtful debts. The typical result of this difference is that accounting profit is lower than taxable income and the carrying amount of accounts receivable is lower for accounting purposes than for tax purposes. The effect depends on the relationship between bad debts written off and doubtful debts expense.

The statement would probably have been accepted in the 1950s when income tax was viewed as a distribution of profit to the government. Tax was paid because a profit had been made. It was an appropriation of profit and was similar to dividends. It is now widely agreed that there are at least three significant differences between income tax and dividends that are sufficient to warrant different accounting treatments. First, dividends . 2

are a voluntary payment made by directors. The amount of a dividend is determined by several factors including the level of profits, the available cash, alternative uses for the cash, share prices and expectations of future profits and cash needs. Tax, however, is not paid voluntarily by directors. It is compulsorily taken by the government. It is expropriated rather than appropriated. The amount of dividends is determined by the payer; the amount of tax is determined by the payee. Second, current tax liability is not influenced at all by reported profits, cash needs or cash availability. It is determined solely by tax laws. Although there is a superficial similarity between taxable income and accounting profit, they are derived from different sets of rules. It is usual for there to be considerable differences between taxable income and accounting profit. Third, dividends are a return to shareholders from the provision of equity capital. Taxation is simply a convenient way for the government to raise revenue from companies. 4

Current tax liability is the amount due and payable to the government. It is a liability. Income tax expense is the amount shown in the income statement as an expense. These are different financial reporting elements and the double-entry recording process requires that a distinction be made between these elements in journal and ledger recording. The major issue in contemporary accounting practice is whether the amount recorded for each element should be the same. Whether the distinction between the amount of income tax expense and the amount of current tax liability is sensible is a matter of opinion. Some would argue that there should be no distinction. The amount payable to the government should be the expense for the period. This is the situation for most other expenses. For example, the wages expense, the interest expense and the rent expense for a period are the same as the amounts paid or payable for that period. The alternative viewpoint is that income tax expense is an accounting measure and should be related to pre-tax accounting profit. Current tax liability, on the other hand, is determined by an assessment related to taxable income. This viewpoint is based on a belief that income tax expense and current tax liability are different concepts. The amount of income tax expense is determined by reference to accounting profit. Current tax liability is the amount that is payable based on taxable income. The distinction has been justified on grounds such as that: income tax expense is matched with accounting profit; income tax expense should be based on accrual accounting principles; and it results in a smoother after-tax reported profit than if tax expense and current tax liability were the same.

The tax payable method of accounting for income tax assumes that the amount recorded for current tax liability and tax expense are identical. For each reporting period, the following general journal entry is made: _________________________________________________________________ . 3

Income tax expense Dr $X Current tax liability Cr $X _________________________________________________________________ When the tax is paid, the general journal entry is: _________________________________________________________________ Current tax liability Dr $X Cash at bank Cr $X _________________________________________________________________ Income tax expense and current tax liability are determined by the tax assessment based on taxable income. 6

Under the tax payable method (which is not the method required by current Australian accounting standards), income tax expense and the current tax liability are always the same amount. Using this method there are no circumstances in which the income tax expense and current tax liability would be different.

The advantages of the tax payable method are its common sense simplicity and the similarity of the treatment to that for many other costs that are recognised as expenses in the period in which they are incurred. The main disadvantage is that it may lead to volatile after-tax reported profits because of vagaries of the tax laws. For example, government policies may result in substantial differences in income tax payable between reporting periods. Differences in after-tax reported profits may not reflect differences in operating performance, but be due to peculiarities in the income tax legislation. Whether the tax payable method should be used in Australia is a matter of opinion. Those who support its use justify their position by reference to the advantages listed above.

The answer to this question is a matter of opinion. Those who believe that smoothing is a sufficient justification will argue that without tax allocation, differences in reported aftertax profit may be as much due to peculiarities in the income tax legislation as they are to operating performance. They would argue that where pre-tax operating results are similar, the after-tax results should also be similar. Profit smoothing by the use of income tax allocation makes after-tax reported profit a more meaningful basis for assessing corporate performance. Those who do not believe that profit smoothing is sufficient justification would argue that it is management’s job to arrange the affairs of the reporting entity to manage the impact of the taxation system. The financial statements should allow an assessment of management’s achievements in this area. Smoothing denies such an assessment. They . 4

would probably also argue that the payment of tax is part of the environment in which business operates. The financial statements should report on the success of the entity in that environment. A further issue is whether the benefits of profit smoothing outweigh the costs of creating deferred tax assets and/or deferred tax liabilities that, arguably, do not meet the definition and recognition criteria for assets and/or liabilities in Framework 2014. 9

The statement of financial position approach to tax allocation was developed to allow smoothing of after-tax profit in a way that was conceptually justifiable. It places the emphasis on the measurement of the tax assets and tax liabilities, with the income tax expense becoming the ‘leftover’. Statement of financial position approach is a process in which the current income tax expenses and current tax liability are measured by reference to the taxable income. Differences between the carrying amount of assets and liabilities for accounting purposes and the tax base for tax purposes require the recognition of a deferred tax asset and/or a deferred tax liability. Income tax expense has two components; the current component and the deferred component. The deferred component is determined by the movement in the balances of the deferred tax asset and deferred tax liability balances during the reporting period.

10 Under the statement of financial position approach, a temporary difference is a difference between the carrying amount of an asset or liability in the statement of financial position and its tax base. Temporary differences are either deductible or taxable depending on whether the difference results in a future deductible amount or a future assessable amount. Under the statement of financial position approach, a permanent difference is the difference between the carrying amount and the tax base of an asset or liability that will never become zero. For example, if a firm has acquired another resulting in the recognition of goodwill, assuming no impairment, the goodwill will remain on the statement of financial position forever. From a tax point of view, goodwill is never recognised hence the carrying amount and the tax base of goodwill will always be different. A temporary difference, on the other hand, is the difference between the carrying amount and the tax base of an asset or a liability that will disappear over time. For example, the difference between the carrying amount and the tax base of a depreciable asset will disappear when the aggregate of the depreciation expense becomes equal to the aggregate of the depreciation claimed for taxation purposes.

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11 Under the statement of financial position approach to income tax allocation income tax expense has two components; the current component and the deferred component. Similar to the tax payable method, the current income tax expenses and current tax liability are measured by reference to the taxable income. However, the additional deferred component is determined by the movement in the balances of the deferred tax asset and deferred tax liability balances during the reporting period. Differences between the carrying amount of assets and liabilities for accounting purposes and the tax base for tax purposes require the recognition of a deferred tax asset and/or a deferred tax liability. Therefore, whenever there are temporary differences between the carrying amount and the tax base of assets and liabilities giving rise to either a deferred tax asset or deferred tax liability, a movement in these balances will give rise to a deferred tax expense and cause the income tax expense to comprise a deferred tax component. This will mean that the income tax expense will be different to the current tax liability. 12 The main advantage of the statement of financial position approach to tax allocation is that it overcomes the main disadvantage of the tax payable method and results in smoother after-tax reported profits. However, the main disadvantage is its complexity and requirement for detailed internal record keeping. There is also some criticism of the statement of financial position approach in respect of the recognition of deferred tax assets and deferred tax liabilities that, arguably, do not meet the definition and recognition criteria for assets and/or liabilities in Framework 2014. 13 In paragraph 49(b) of the Framework 2014, liabilities are defined 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 future economic benefits’. Whether a deferred tax liability (DTL) is a liability in accordance with this definition is a matter for debate. A case can be made that it is not a liability as that element is defined in Framework 2014. The entity does not have a ‘present obligation’ to pay the tax nor is it the result of a ‘past event’. 14 In paragraph 49(a) of Framework 2014 assets are defined 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’.

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Whether a deferred tax asset (DTA) is an asset under this definition is a matter of debate. There is little doubt that it represents ‘future economic benefits’ in the form of lower taxes payable in the future. There is more doubt whether it is ‘controlled by the entity’. The benefits can only be enjoyed if the entity makes taxable income in the future sufficient to take advantage of the future income tax benefit. AASB 112 does not permit the recognition of a DTA unless it is probable that the benefit will be realised. It could be argued that those requirements ensure that a DTA will be recognised only if it is controlled by the entity. Framework 2014 definition also requires that an asset must be ‘a result of past events’. In the case of a DTA arising from a tax loss, it would be argued that the tax loss is the ‘past event’ and that the DTA satisfies this part of the asset definition. The position is less clear for a DTA arising from a temporary difference. If it does not arise from an identifiable ‘past event’, then it probably does not satisfy the definition of an asset. It could perhaps be argued that the temporary difference giving rise to the DTA is the past event. 15 The previous standard (AASB1020; now withdrawn) used the terms deductible amount and assessable amount to determine the tax base. This is not done in the current standard but the method employed in AASB1020 helps in understanding how the tax base is arrived at. (a) The carrying amount of an asset is the amount at which it is recorded in the accounting records as at a particular date. In the case of depreciable assets, it is the amount after deducting accumulated depreciation and accumulated impairment loss. In the case of accounts receivable, it is the amount after deducting the allowance for doubtful debts. (b) The deductible amount of an asset is the future allowable deductions arising from the asset under income tax law. For example, deductible amounts include future depreciation to be allowed for tax purposes. (c) The assessable amount of an asset is the assessable income expected to arise from the asset under income tax law. Assessable income arises from the use and/or sale of the asset. For assets that represent costs carried forward, there is an expectation that these assets will generate sufficient future revenue to cover their carrying amount. For most assets, assessable amount will be equal to their carrying amount. (d) AASB 112 defines tax base as the amount that is attributed to that asset for tax purposes. According to AASB 1020 (now withdrawn), the tax base of an asset can be determined as its carrying amount minus assessable amounts plus deductible amounts.

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16 Under the statement of financial position approach, a temporary difference is a difference between the carrying amount of an asset or liability in the statement of financial position and its tax base. Temporary differences are either deductible or taxable depending on whether the difference results in a future deductible amount or a future taxable amount. The difference between the carrying amount and the tax base of an asset or a liability will disappear over time, hence the title ‘temporary difference’. AASB 112 specifies that taxable temporary differences give rise to deferred tax liabilities (DTL) and deductible temporary differences give rise to deferred tax assets (DTA). AASB 112 offers some examples (paras 7 and 8) to illustrate this difference. The previous standard (AASB 1020; now withdrawn) included formulae for deriving the tax base from the carrying amount of both assets and liabilities. Whether the resultant difference gives rise to a DTA or a DTL can then be determined by comparing the deductible amount with the assessable amount used to derive the item’s tax base. If the assessable amount exceeds the deductible amount, then future assessable income for this item exceeds future deductible amounts for this item hence leading to higher future taxes thus indicating a DTL. If the deductible amount exceeds the assessable amount, then future deductions for this item exceed future assessable income for this item hence leading to lower future taxes thus indicating a DTA. 17 The previous standard (AASB1020; now withdrawn) used the terms deductible amount and assessable amount to determine the tax base. This is not done in the current standard but the method employed in AASB1020 helps in understanding how the tax base is arrived at. (a) The carrying amount of a liability is the amount at which it is recorded in the accounting records at a particular date. (b) The deductible amount of a liability is the future allowable deductions arising from the liability. For example, in the case of the provision for long-service leave, the taxation deduction can be claimed only when the leave is taken and the payment made. The deductible amount will be equal to the liability’s carrying amount. (c) The assessable amount of a liability is the assessable income expected to arise from the liability under income tax law. It will be equal to any assessable amount that is expected to arise from selling the liability’s carrying amount as at the reporting date. In most cases, the assessable amount will be zero. (d) AASB 112 defines tax base as the amount that is attributed to that liability for tax purposes. According to AASB1020, the tax base of a liability is its carrying amount plus assessable amount minus deductible amount. . 8

18 A provision for long-service leave will result in a temporary difference and a deferred tax asset. The carrying amount of the liability is the amount that has been recognised as an expense but not yet paid to the employees (say $100). This amount is tax deductible when the leave is taken and the amount is paid. Paragraph 8 of AASB 112 states the tax base of a liability is: ‘its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods. In the case of revenue which is received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods.’ The tax base of the liability is, therefore: Carrying amount $100 less Future Deductible amount 100 plus Future Assessable amount nil Tax base nil The carrying amount of the liability is $100 and its tax base is nil. There is, therefore, a deductible temporary difference of $100. The carrying amount of the liability is greater than its tax base (deductible amount > assessable amount) and there is, therefore, a deferred tax asset. 19 AASB 112 defines deferred tax liabilities as: ‘the amounts of income taxes payable in future periods in respect of taxable temporary differences’. In other words, a deferred tax liability is an obligation to pay taxes in future reporting periods; that is, it is a noncurrent liability. Current tax liability is a current liability for taxes owing to the government. It is an amount currently due that is not contingent on any future event. 20 Outlined below is the effect of an asset revaluation on: (a) Carrying amount: a revaluation changes the asset’s carrying amount (usually upward). (b) Deductible amount: generally, an asset revaluation does not change the amount related to the asset that can be deducted for tax purposes. (c) Assessable amount: for assets measured on the fair value basis, an upward asset revaluation is required where the fair value of the asset is materially below the asset’s carrying amount. It is assumed that the increased fair value reflects additional benefits that will be taxable when they arise, hence the assets assessable amount is increased by an asset revaluation. . 9

(d) Tax base: AASB 112 paragraph 7 indicates the tax base of an asset is ‘the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset’. Since the asset’s tax base is equal to its carrying amount plus its deductible amount minus its assessable amount, the asset revaluation does not change the asset’s tax base. The effect of an upward asset revaluation is outlined below: (a) Deferred tax asset/liability: an upward asset revaluation will normally create or increase the asset’s taxable temporary difference resulting in creation of/increase in the deferred tax liability. (b) Deferred tax expense: paragraph 61A of AASB 112 requires that the deferred tax expense arising from an upward asset revaluation should not be charged to current or deferred tax expense in the profit or loss. As the revaluation is recognised in other comprehensive income (and ultimately accumulated to the revaluation surplus in equity) the tax effect relating to the revaluation should be also be recognised in other comprehensive income. (para. 62). (c) Revaluation surplus: the after deferred tax expense effect of the asset revaluation is credited to the revaluation surplus and, as noted in (b) above, the deferred tax expense is debited to the revaluation surplus, so that the net after deferred tax benefit is recognised as an increase in equity. 21 Other things being equal, the upward revaluation of a depreciable non-current asset results in higher depreciation in subsequent reporting periods. This higher depreciation will (eventually) reduce the taxable temporary difference created (increased) by the asset revaluation (see the answer to question 20). The effects are outlined below: (a) Deferred tax asset/liability: will continue to be measured in terms of the taxable temporary difference between the revalued carrying amount of the asset and its tax base. As mentioned above, this temporary difference will reduce over time with the higher depreciation. (b) Deferred tax expense: adjustments to deferred tax expense resulting from changes in the deferred tax liability are to be taken to deferred tax expense in other comprehensive income and ultimately through to the revaluation surplus. This is indicated in paragraph 61A of AASB 112. (c) Revaluation surplus: although logic might suggest that part of the reversal of the taxable temporary difference be taken back to the revaluation surplus, this is not the required treatment. In effect, the tax benefit of reversing the taxable temporary

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difference created by the asset revaluation is used to reduce tax expense in the statement of comprehensive income. 22 According to AASB 112 the statement is incorrect. AASB 112 paragraph 7 indicates the tax base of an asset is ‘the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset’. The statement presumes that the tax depreciation rate is higher than the accounting depreciation rate. The result of this situation is that the tax base of the asset will be less in the early years of the asset than the carrying amount of the asset. The difference gives rise to a DTL which reverses over the life of the asset. Refer to the example below where the asset cost of $1 200 with a zero salvage value is depreciated over 3 years for tax purposes but 4 years for accounting purposes.

Accounting depreciation Tax depreciation

Year 1 300 400

Year 2 300 400

Year 3 300 400

Year 4 300 Nil

Carrying amount Cost Accumulated depreciation Carrying amount

1 200 300 900

1 200 600 600

1 200 900 300

1 200 1 200 Nil

900 800 900 800

600 400 600 400

300 Nil 300 Nil

Nil Nil Nil Nil

Tax base Carrying amount Add Future deductible amount Less Future assessable amount Tax base

Taxable temporary difference 100 200 300 Nil DTL (30% of TTD) 30 60 90 Nil • Future deductible amount is the remaining depreciation available for claiming as a deduction for income tax purposes. • Future assessable amount is the amount that could be recovered from use which equals the carrying amount of the asset. If the situation were reversed and the tax depreciation rate allowed depreciation over 4 years and the entity was depreciating the asset for accounting purposes over 3 years then the reverse situation would apply as indicated in the table below. . 11

Accounting deprecation Tax deprecation

Year 1 400 300

Year 2 400 300

Year 3 400 300

Year 4 Nil 300

Carrying amount Cost Accumulated depreciation Carrying amount

1 200 400 800

1 200 800 400

1 200 1 200 Nil

800 900 800 900

400 600 400 600

Nil 300 Nil 300

Nil Nil Nil Nil

Tax base Carrying amount Add Future deductible amount Less Future assessable amount Tax base

Deductible temporary difference 100 200 300 Nil DTA (30% of DTD) 0 60 90 Nil • Future deductible amount is the remaining depreciation available for claiming as a deduction for income tax purposes. • Future assessable amount is the amount that could be recovered from use which equals the carrying amount of the asset. This situation would give rise to a deductible temporary difference and accordingly a deferred tax asset. On the basis of the indications above the statement is incorrect and the individual situation would need to be assessed to determine whether a deferred asset or liability existed. 23 If a company makes a tax loss – that is, it has negative taxable income – the income tax legislation allows the tax loss to be offset against future taxable income. In other words, the current period’s tax loss saves tax in future periods when there is taxable income. For example, Acme made a loss during year 0 and its taxable income was assessed as ($100 000). If the company tax rate is 30%, then provided it was probable that Acme would have taxable income in subsequent years the following general journal entry would be passed: _________________________________________________________________ Deferred tax asset Dr $30 000 Deferred income tax expense/revenue Cr $30 000 _________________________________________________________________

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The after-tax loss would be reduced by $30 000 and the deferred tax asset would be recognised as an asset. If, during the next year, Acme had taxable income and pre-tax accounting profit of $150 000 before allowing for the tax loss, it would pay income tax only on $50 000. That is the $150 000 minus the $100 000 loss carried forward from the prior year. The prior year loss is utilised/recouped through the DTA ($100,000 @ 30% = $30 000) and the current tax is recognised ($50 000 @ 30% = 15 000). ____________________________________________________________________ Deferred income tax expense Dr $30 000 Deferred tax asset Cr $30 000 Current income tax expense Dr 15 000 Current tax liability Cr 15 000 _________________________________________________________________ A deferred tax asset may also arise from a deductible temporary difference. This can arise due to the excess of an asset or liability’s deductible amount over its assessable amount that results in current tax liability exceeding income tax expense. The difference multiplied by the tax rate is accumulated in the statement of financial position as an asset. As noted above a deferred tax asset can arise from either a deductible temporary difference or from the carry-forward of unused tax losses and unused tax credits. However AASB 112 paragraphs 24 and 34 provides that a deferred tax asset ‘shall be recognised for all deductible temporary differences, carry-forward of unused tax losses and unused tax credits to the extent that it is probable that taxable profit will be available against which the deductible temporary difference, unused tax losses and unused tax credits can be utilised’. 24 It would probably seem unusual to a non-accountant that a company could reduce its after-tax loss in a particular reporting period simply by assuming that it will earn taxable income in future years. On the face of it, it seems to provide an opportunity to improve a bad result by asserting that it will get better in future periods. However, it must be understood that AASB 112 does not permit the recognition of the deferred tax asset from a tax loss unless realisation of the benefit is probable. There is no opportunity to improve the after-tax loss by unbridled optimism or wishful thinking. It should also be remembered that there is usually adequate disclosure of the effect of tax losses on future tax benefits. Hence a DTA may not be recognised if the conditions are not met. Thus the statement is not entirely correct.

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25 The carrying amount of goodwill is determined as the costs recorded less any accumulated impairment. The carrying amount as at 30 June 2018 would be: Cost less accumulated impairment carrying amount

$3 500 000 500 000 $3 000 000

Goodwill arising in a business combination is essentially measured as the excess of the cost of the combination over the acquirer’s interest in the net fair value of the acquirer’s identifiable assets, liabilities and contingent liabilities (refer AASB 112 para. 21 for details). The treatment of goodwill under AASB 112 is set down in paragraph 21 as follows: ‘Many taxation authorities do not allow reductions in the carrying amount of goodwill as a deductible expense in determining taxable profit. Moreover, in such jurisdictions, the cost of goodwill is often not deductible when a subsidiary disposes of its underlying business. In such jurisdictions, goodwill has a tax base of nil. Any difference between the carrying amount of goodwill and its tax base of nil is a taxable temporary difference. However, this Standard does not permit the recognition of the resulting deferred tax liability because goodwill is measured as a residual and the recognition of the deferred tax liability would increase the carrying amount of goodwill’. The tax base of Argonaut’s goodwill is zero. carrying amount $3 000 000

+ deductible amount + $Nil

- assessable amount - $3 000 000

= tax base = $nil

The carrying amount of the asset goodwill exceeds its tax base by $3 000 000. If this amount was a taxable temporary difference, there would be a deferred tax liability of $3 000 000  30% = $900 000. However, under AASB 112 the difference is not permitted to be recognised as a deferred tax liability (paragraph 21). The resultant deferred tax liability is not able to be recognised by Argonaut. In relation to goodwill impairment, Paragraph 21A indicates that any subsequent impairment of the goodwill will result in a reduction to the unrecognised deferred tax liability. Impairment of goodwill is not an allowable deduction for tax purposes. In essence, the initial recognition and any subsequent impairment of goodwill are treated as permanent (or exempt) differences and no deferred tax liability recognised. 26 Offsetting of deferred tax assets (DTA) and deferred tax liabilities (DTL) is an issue of presentation. Offsetting deals with cases where one entity or group of entities simultaneously has both DTAs and DTLs. Paragraph 74 of AASB 112 deals with

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offsetting and essentially requires that DTAs and DTLs relating to the same taxable entity and the same taxing authority, where the entity has a legally enforceable right to set off current tax assets against current tax liabilities shall be offset for presentation purposes. Thus, only the net DTA or DTL is presented in the statement of financial position. Thus the statement is not correct. 27 Changes in tax rates are automatically accommodated in the statement of financial position approach to tax allocation. Suppose, for example, that Redoubtable Ltd had an asset in year 1 with a carrying amount of $114 000 and a tax base of $84 000. The tax rate is 36%. There would be a deferred tax liability of $30 000  0.36 = $10 800. In the second year, the carrying amount of the asset had fallen to $100 000 and the tax base was $75 000. The tax rate had been increased to 38%. The deferred tax liability would now be $25 000  0.38 = $9 500. If we assume that current tax liability was $100 000, the income tax expense would be: Current tax liability Adjustment to deferred tax liability (10 800 – 9 500) Income tax expense

$100 000 (1 300) $98 700

The general journal entry would be as follows: _________________________________________________________________ Income tax expense Dr $98 700 Deferred tax liability Dr 1 300 Current tax liability Cr $100 000 _________________________________________________________________ The decline in the deferred tax liability is due to: 1 the changes in the carrying amount and the tax base; and 2 the change in the tax rate. Both of these components of the change are included in income tax expense. The amounts of the two components of the change can be calculated as follows: Change due to change in tax rate $30 000  (0.38 – 0.36) $600 Change due to changes in carrying amount and tax base ($30 000 – 25 000)  0.38 (1 900) Net change in deferred tax liability ($1 300)

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28 The presentation and disclosure requirements relating to income taxes are detailed in paragraphs 71 to 88 of AASB 112. The key provisions are as follows: Paragraph 79 of AASB 112 requires the separate disclosure of ‘the major components of tax expense (income)’. Paragraph 80 indicates that these components may include: (a) current tax expense (income); (b) any adjustments recognised in the period for current tax of prior periods; (c) the amount of deferred tax expense (income) relating to the origination and reversal of temporary differences; (d) the amount of deferred tax expense (income) relating to changes in tax rates or the imposition of new taxes; (e) the amount of the benefit arising from a previously unrecognised tax loss, tax credit or temporary difference of a prior period that is used to reduce current tax expense; (f) the amount of the benefit from a previously unrecognised tax loss, tax credit or temporary difference of a prior period that is used to reduce deferred tax expense; (g) deferred tax expense arising from the write-down, or reversal of a previous writedown, of a deferred tax asset in accordance with paragraph 56; and (h) the amount of tax expense (income) relating to those changes in accounting policies and errors that are included in profit or loss in accordance with AASB 108, because they cannot be accounted for retrospectively. Paragraph 81 requires the separate disclosure of other information, including a reconciliation between ‘tax expense (income) and the product of accounting profit multiplied by the applicable tax rate(s), disclosing also the basis on which the tax rate(s) is (are) computed.’ (para. 81(c)(i)). Paragraph 82 requires the separate disclosure of a deferred tax asset and the nature of evidence support its recognition. 29 The empirical research evidence on the usefulness of tax allocation focuses on the relationship between tax-effect related accounting numbers and share prices and returns. Early research (for example, Beaver and Dukes, 1972) is consistent with the view that investors perceive deferred tax liabilities (DTLs) to be “real” liabilities. Later research which investigated the effects of tax rate changes in the US found a positive relationship between the size of the company’s DTLs and share prices effect following announcement of large reductions in US company tax rates. (Givoly and Hayn, 1992). More recent research looks at whether investors correctly interpret information in the reconciliation

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between income tax expense and prima facie income tax expense. Hanlon (2005) finds that investors fail to fully and correctly interpret the effects of large, negative tax reconciliation items. 30 Accounting treatments are established by accounting standard setters. In theory, the deliberations of accounting standard setters are driven by the decision-usefulness objective of financial reporting, the qualitative characteristics of financial information and the definitions of financial statement elements. In practice, the views of the accounting profession, public accounting firms and companies may influence the deliberations of the AASB and IASB. Tax treatments are decided by the government and tax authorities such as the ATO. They are determined by government policy, the need to raise sufficient funds to meet the government’s spending and principles such as fairness and equity. Book-tax conformity requires uniform policies to be adopted for both accounting and tax purposes. Such conformity would remove the need for tax effect accounting and for many of the disclosures currently required by AASB 112. However, it hardly seems likely that Governments are going to hand over control of tax policy to accounting standard setters, hence book-tax conformity would require accounting standard setters to cede authority over financial reporting to tax authorities. While this had been the traditional approach in some countries such as France and Germany, in the U. S., U. K. and Australia there is a substantial history of development of financial reporting principles separate from tax principles. It seems unlikely that this will change. Indeed, the increasing importance of the IASB and development of international financial reporting standards suggest that book-tax conformity is unlikely to be found in any country. 31 A US study by Hanlon (2005) finds evidence consistent with the view that large book-tax differences identify firms whose future reported earnings are more variable and less persistent than firms whose book-tax differences are small. She further notes that, while investors seem to interpret correctly the implications for future profitability of large, positive book-tax differences – that is, book profit in excess of taxable income – they fail to utilise the information fully and correctly in cases where there are large, negative book-tax differences. 32 An Australian study by Herbohn, Khor and Tutticci (2010) finds evidence that managers use income increasing accruals for tax losses where companies are below an important earnings benchmark – analysts’ consensus forecast of earnings. The evidence is consistent with the view that managers use accounting choices opportunistically. . 17

PROBLEMS 1

Cameron Ltd Income tax using the Tax payable approach. Income tax expense = (taxable income  tax rate) a. Instalment sales: from a tax perspective $20 000 collected is assessable so must be added. b. Depreciation: from a tax perspective $150 000 is deductible and must be deducted. Taxable income = $500 000 + 20 000 ─ 150 000 = $370 000 Tax rate = 30% Income tax expense = $111 000 Journal entry: _________________________________________________________________ Income tax expense Dr $111 000 Current tax liability Cr $111 000 __________________________________________________________________ The fact that accounting treatment differ from tax treatment is ignored in the tax payable method.

Lourens Ltd (a) Calculate taxable income and current record income tax expense Initial profit figure less: tax deduction for depreciation (500 000 x 30%) tax deduction for warranty payments tax deduction for bad debts tax deduction for employee benefits paid1 Taxable Income @ tax rate 30%

$300 000 150 000 5 000 2 500 4 000 $138 500 $41 550

Employee benefits expense = $25 000, liability at end $21 000, liability at beginning nil, therefore, cash paid is $4 000. General journal entry as at 30 June 2018: _________________________________________________________________ Current income tax expense Dr $41 550 Current tax liability Cr $41 550 _________________________________________________________________ Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson, Issues in Financial Accounting 16e 18

(b)

Calculate temporary differences, deferred tax assets/liabilities and record deferred income tax expenses Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 Carrying amount

Tax base

Taxable Temporary Difference (TTD)

Deductible Temporary Differences (DTD)

Deferred Tax Liability (DTL)a

Deferred Tax Asset (DTA)b

Property, plant and equipment

500 000

less accumulated depreciation

(100 000)

(150 000)

PPE - net

400 000

350 000

Accounts receivable

300 000

less allowance for doubtful debts

(15 000)

(0)

Accounts receivable - net

285 000

300 000

15 000

4 500

Provision for warranty

20 000

6 000

Provision for employee benefit

21 000

6 300

Assets

50 000

15 000

Liability

Closing balances 30/6/2018

50 000

56 000

15 000

16 800

∆↑ 15 000

∆↑ 16 800

DTA/DTL cf – 1/7/2017c Change in DTA/DTL a

The amount of the DTL is calculated by multiplying the TTD by the relevant tax rate. For 2018: $50 000 x 30% = $15 000.

The amount of the DTA is calculated by multiplying the DTD by the relevant tax rate. For 2018: $56 000 x 30% = $16 800.

As there are no DTAs or DTLs balances carried forward, the total of the closing balance is the amount recorded in the general journal entry. General journal entries as at 30 June 2018: _________________________________________________________________ Deferred tax asset Dr $16 800 Deferred tax liability Cr $15 000 Deferred income tax expense Cr 1 800 ________________________________________________________________ . 19

Note that set-off of DTA and DTL may occur in presenting the statement of financial position, but is not permitted at the journal entry (recognition) stage. Non-current assets/depreciation: The accounting depreciation is based on 20% straight line $500 000 x 20% pa = $100 000 pa. The depreciation for tax purposes is based on 30% reducing balance $500 000 x 30% pa = $150 000. To determine the tax base using the mathematical relationship previously provided in AASB 1020: carrying amount $400 000

+ deductible amount + $350 000

- assessable amount = tax base $400 000 = $350 000

Accounts receivable/ doubtful debts: The allowance for doubtful debt is $15 000. The bad debts written off during the period assumed to be a direct write-off as no allowance would have been available for write-off during the year. To determine the tax base using the mathematical relationship previously provided in AASB 1020: carrying amount $285 000

+ deductible amount + $15 000

- assessable amount $nil

= tax base = $300 000

Provision for warranty: The opening balance is NIL plus the expense recorded for the period $25,000 less warranty payments made $5,000 = $20,000. To determine the tax base using the mathematical relationship previously provided in AASB 1020: carrying amount

- deductible amount

+ assessable amount

= tax base

$20 000

- $20 000

+ $nil

= $0

Provision for employee benefits: The liability at end of period is given as $21 000. To determine the tax base using the mathematical relationship previously provided in AASB 1020: carrying amount $21 000 3

- deductible amount - $21 000

+ assessable amount $nil

= tax base = $0

Process Ltd Calculate taxable income and record current income tax expense Profit add back accounting expenses not deductible depreciation (1 000 000 x 20%) doubtful debts expense employee benefits expense

500 000 200 000 12 000 85 000

297 000

. 20

less tax deduction for depreciation (1 000 000  30%) bad debts written off employee benefits paid Taxable income  tax rate 30%

(300 000) (10 000) (45 000)

(355 000) 442 000 132 600

General journal entries as at 30 June 2018: _________________________________________________________________ Current income tax expense Dr $132 600 Current tax liability Cr $132 600 ________________________________________________________________ Allowance for doubtful debts: The opening balance of the allowance was $6 000. During the year, bad debts of $10 000 were written off leaving the balance at $4 000 debit. The closing balance is required to be $400 000 x 2% = $8 000 (credit). Therefore the increase in doubtful debts expense for the period is $12 000. Employee benefits expense: $85 000, yet provision for employee benefits increases by only $40 000 ($200 000 to $240 000), this can only occur if payments of employee benefits are $85 000 ─ $40 000. Calculate temporary differences, deferred tax assets/liabilities and record deferred income tax expenses Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 For Financial Year Ended 30 June 2018

Carrying amount

Tax base

Property, plant and equipment

1 000 000

less accumulated depreciation

(600 000)

(900 000)

PPE - net

400 000

100 000

Accounts receivable

400 000

less allowance for doubtful debts

(8 000)

(0)

Accounts receivable - net

392 000

400 000

Taxable Temporary Difference (TTD)

Deductible Temporary Differences (DTD)

Deferred Tax Liability (DTL)

Deferred Tax Asset (DTA)

Assets

300 000

90 000

8 000

2 400

Liability

. 21

Provision for employee benefit Closing balances 30/6/2018

240 000

240 000 300 000

248 000

72 000 90 000

74 400

For Financial Year Ended 30 June 2017 PPE - net

600 000

400 000

Accounts receivable - net

404 000

410 000

6 000

1 800

Provision for employee benefit

200 000

60 000

Closing balances 30/6/2017

200 000

60 000

206 000

Change in DTA/DTL

60 000

61 800

∆↑ 30 000

∆↑ 12 600

General journal entry as at 30 June 2018: _________________________________________________________________ Deferred tax asset Dr $12 600 Deferred income tax expense Dr 17 400 Deferred tax liability Cr $30 000 ________________________________________________________________ Note that set-off of DTA and DTL may occur in presenting the statement of financial position, but is not permitted at the journal entry (recognition) stage. Non-current assets/depreciation: The accounting depreciation is based on 20% straight line $1 000 000 x 20% pa = $200 000 pa. The depreciation for tax purposes is based on 30% straight line $1 000 000 x 30% pa = $300 000. There has been three years since acquisition (1/7/2015) therefore accumulated depreciation for accounting purposes is $600 000 and for tax purposes is $900 000. To determine the tax base using the mathematical relationship previously provided in AASB 1020: Year 2018 2017

carrying amount $400 000 $600 000

+ deductible amount + $100 000 + $400 000

- assessable amount - $400 000 - $600 000

= tax base = $100 000 = $400 000

Accounts receivable/doubtful debts: The closing balance of accounts receivable is $400 000. During the year a bad debt of $10 000 was written off. The opening balance of accounts receivable is $410 000. The allowance for doubtful debt closing balance is $8 000. The opening balance of the allowance was $6 000. To determine the tax base using the mathematical relationship previously provided in AASB 1020: Year 2018

carrying amount $392 000

+ deductible amount + $8 000

- assessable amount - $nil

= tax base = $400 000

. 22

2017

$404 000

+ $6 000

- $nil

= $410 000

Provision for employee benefits: The liability at the beginning and end of period is given. To determine the tax base using the mathematical relationship previously provided in AASB 1020:

Year

carrying amount

- deductible amount

+ assessable amount

= tax base

2018 2017

$240 000 $200 000

- $240 000 - $200 000

+ $nil + $nil

= $0 = $0

Effingham Company (a) and (b) - Carrying amount, temporary difference, tax base and deferred liability Carrying Tax Taxable Deferred 30/6/18 - Y1 Amount Base Temporary Tax Difference Liability Cost 1 200 000 1 200 000 less acc dep 120 000 200 000 1 080 000 1 000 000 80 000 24 000 The carrying amount of the asset exceeds its tax bases giving rise to a taxable temporary difference and therefore a deferred tax liability. This is as a result of the tax depreciation rate being higher than the accounting depreciation rate. 30/6/2019 - Y2 Cost less acc dep 30/6/2020 - Y3 Cost less acc dep 30/6/2021 - Y4 Cost less acc dep 30/6/2022 - Y5 Cost less acc dep 30/6/2023 - Y6 Cost less acc dep

1 200 000 240 000 960 000

1 200 000 400 000 800 000

160 000

48 000

1 200 000 360 000 840 000

1 200 000 600 000 600 000

240 000

72 000

1 200 000 480 000 720 000

1 200 000 800 000 400 000

320 000

96 000

1 200 000 600 000 600 000

1 200 000 1 000 000 200 000

400 000

120 000

1 200 000 720 000

1 200 000 1 200 000 . 23

30/6/2024 – Y7 Cost less acc dep

480 000

144 000

1 200 000 840 000 360 000

1 200 000 1 200 000 0

360 000

108 000

30 June 2019

30 June 2020

30 June 2021

30 June 2022

30 June 2023

30 June 2024

Deferred income tax expense Dr Deferred tax liability Cr (increase in DTL from $0 to $24 000)

$24 000 $24 000

Deferred income tax expense Dr $24 000 Deferred tax liability Cr (increase in DTL from $24 000 to $48 000)

$24 000

Deferred income tax expense Dr $24 000 Deferred tax liability Cr (increase in DTL from $48 000 to $72 000)

$24 000

Deferred income tax expense Dr $24 000 Deferred tax liability Cr (increase in DTL from $72 000 to $96 000)

$24 000

Deferred income tax expense Dr $24 000 Deferred tax liability Cr (increase in DTL from $96 000 to $120 000)

$24 000

Deferred income tax expense Dr $24 000 Deferred tax liability Cr (increase in DTL from $120 000 to $144 000)

$24 000

Deferred tax liability Dr $36 000 Deferred income tax expenses Cr (decrease in DTL from $144 000 to $108 000)

$36 000

Note: In year 7, the DTL reversal will commence as the asset is now fully depreciation for tax purposes. . 24

Damon Ltd (a) and (b) - Carrying amount, temporary difference, tax base and deferred asset Carrying Tax Deductible Deferred 30/6/2018 - Y1 Amount Base Temporary Tax Difference Asset Cost 1 200 000 1 200 000 less acc dep 300 000 200 000 900 000 1 000 000 100 000 30 000 The carrying amount of the asset is below its tax base giving rise to a deductible temporary difference and therefore a deferred tax asset. This is as a result of the tax depreciation rate being lower than the accounting depreciation rate. 30/6/2019 - Y2 Cost less acc dep 30/6/2020 - Y3 Cost less acc dep 30/6/2021 - Y4 Cost less acc dep 30/6/2022 - Y5 Cost less acc dep 30/6/2023 - Y6 Cost less acc dep

1 200 000 600 000 600 000

1 200 000 400 000 800 000

200 000

60 000

1 200 000 900 000 300 000

1 200 000 600 000 600 000

300 000

90 000

1 200 000 1 200 000 Nil

1 200 000 800 000 400 000

400 000

120 000

1 200 000 1 200 000 Nil

1 200 000 1 000 000 200 000

200 000

60 000

1 200 000 1 200 000 Nil

1 200 000 1 200 000 0

Nil

30 June 2019

Deferred tax asset Dr Deferred income tax expense Cr (increase in DTA from $0 to $30 000)

$30 000

Deferred tax asset Dr $30 000 Deferred income tax expense Cr (increase in DTA from $30 000 to $60 000)

$30 000

30 June 2020

30 June 2021

Deferred tax asset Dr $30 000 Deferred income tax expense Cr (increase in DTL from $60 000 to $90 000)

$30 000

Deferred tax asset Dr $30 000 Deferred income tax expense Cr (increase in DTL from $90 000 to $120 000)

$30 000

30 June 2022

Deferred income tax expense Dr $60 000 Deferred tax asset Cr $60 000 (decrease in DTA from $120 000 to $60 000 – reversing previously recognised DTA)

30 June 2023

Deferred income tax expense Dr Deferred tax asset Cr (decrease in DTA from $60 000 to Nil)

$60 000 $60 000

Note: In year 5, the DTA reversal will commence as the asset is now fully depreciated for accounting purposes. 6

Dido Ltd (a)

The revaluation occurred on 1 July 2018, three years after acquisition of the asset. Depreciation for accounting purposes $600 000/6 = $100 000 pa Depreciation for tax purposes $600 000/4 = $150 000 pa. The deferred tax liability as at 30 June 2018 = $45 000 calculated as follows: Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 Carrying amount

Tax base

Asset

600 000

less accumulated depreciation

(200 000)

(300 000)

Asset - net

400 000

300 000

TTD

DTL @ TR 30%

For financial year ended 30/6/2017

Closing balances as at 30/6/2017

100 000

30 000 30 000

For financial year ended 30/6/2018 Asset

600 000

less accumulated depreciation

(300 000)

(450 000)

Asset - net

300 000

150 000

45 000

Closing balances as at 30/6/2018

45 000 ∆↑15 000

Change in DTL At date of revaluation 1/7/2018 Asset less accumulated depreciation Asset - net

500 000

600 000

(0)

(450 000)

500 000

150 000

350 000

105 000

Closing balances as at 1/7/2018

105 000

Change in DTL

∆↑60 000

(b) General journal entries as at 1 July 2018 for revaluation

Accumulated depreciation Dr $300 000 Asset Cr $300 000 (to write-back the accumulated depreciation at date of revaluation) Asset Dr $200 000 Revaluation surplus (OCI) Cr $200 000 (to revalue asset to fair value of $500 000 from carrying amount of $300 000 through OCI) Income tax expense on revaluation (OCI) Dr $60 000 Deferred tax liability Cr $60 000 (to record deferred tax effect from asset revaluation increasing DTL from $45,000 to $105,000) Revaluation surplus (OCI) Dr $200 000 Income tax expense on revaluation (OCI) Cr $60 000 Revaluation surplus (equity) Cr $140 000 (to accumulate/transfer from OCI to revaluation surplus in equity with tax effects)

Koala Ltd (a) Carrying amount, tax base and deferred tax for revalued asset. The revaluation occurred on 1 July 2018, one year after acquisition of the asset. Depreciation prior to revaluation: Depreciation for accounting $500 000/4 = $125 000 pa Depreciation for tax $500 000 x 40% reducing balance = $200 000 (y1) Depreciation after revaluation: Depreciation for accounting $420 000/3 = $140 000 pa Depreciation for tax $500 000 - $200,000 = $300 000 x 40% = $120 000 (y2) Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 Carrying amount

Tax base

Asset

500 000

less accumulated depreciation

(125 000)

(200 000)

Asset - net

375 000

300 000

TTD

DTL @ TR 30%

For financial year ended 30/6/2018

75 000

22 500

Closing balances as at 30/6/2018

22 500

Closing balance as at 30/6/2017

0 ∆↑22 500

Change in DTL as at 30 June 2018 At date of revaluation 1/7/2018 Asset less accumulated depreciation Asset - net

420 000

500 000

(0)

(200 000)

420 000

300 000

120 000

36 000

Closing balances as at 1/7/2018

36 000

Closing balance as at 30/6/2018

22 500 ∆↑13 500

Change in DTL at 1/7/2018 For financial year ended 30/6/2019 Asset

420 000

500 000

less accumulated depreciation

(140 000)

(320 000)

Asset - net

280 000

180 000

100 000

30 000

Closing balances as at 30/6/2019

30 000

Closing balance as at 30/6/2018

22 500

Revaluation 1/7/2018

adjustment

13 500 ∆↓6 000

Change in DTL at 30/6/2019

(b) General journal entries: income tax effect and asset revaluation.

30 June 2018 Current income tax expense Dr $75 000 Current tax liability Cr $75 000 (to record current income tax expense and tax payable for taxable income $250,000 x 30%) Deferred income tax expense Dr $22 500 Deferred tax liability Cr (to record increase in DTL on Asset from $0 to $22 500)

$22 500

1 July 2018 Accumulated depreciation Dr $125 000 Asset Cr $125 000 (to write-back the accumulated depreciation at date of revaluation) Asset Dr $45 000 Revaluation surplus (OCI) Cr $45 000 (to revalue asset to fair value of $420 000 from carrying amount of $375 000 through OCI) Income tax expense on revaluation (OCI) Dr Deferred tax liability Cr (to record deferred tax effect from asset revaluation)

$13 500 $13 500

Revaluation surplus (OCI) Dr $45 000 Income tax expense on revaluation (OCI) Cr $13 500 Revaluation surplus (equity) Cr $31 500 (to accumulate/transfer from OCI to revaluation surplus in equity with tax effects) 30 June 2019 Current income tax expense Current tax liability

Dr Cr

$96 000 $96 000

. 29

(to record current income tax expense and tax payable for taxable income $320 000 x 30%) Deferred tax liability Dr Deferred income tax expense Cr (to record deferred tax effect on depreciable asset)

$6 000 $6 000

Cash at bank Accumulated depreciation Loss on sale of asset Asset (to record sale of asset)

Dr Dr Dr Cr

$125 000 140 000 155 000 $420 000

Revaluation surplus Dr $31 500 Retained earnings Cr $31 500 (to transfer the net revaluation surplus to retained earnings on sale of asset)

The net effect of the asset sale is a loss of $155 000. Paragraph 68 of AASB 116 requires the gain or loss on sale to be included in the profit and loss element of the statement of comprehensive income. The net revaluation surplus is $45 000 – $13 500 tax effect = $31 500. On sale of an asset, hence derecognition, AASB 116 paragraph 41 indicates the revaluation surplus may be transferred to retained earnings. The transfers from the revaluation surplus to retained earnings are not made through the profit and loss. 8

Alexander Ltd (a) The carrying amount of the liability on 30 June 2018 is $18 000. (b) Paragraph 8 of AASB 112 requires that the tax base in these circumstances be measured as ‘the liability’s carrying amount less any amount of the revenue that will not be taxable in future periods’ In this question, the full amount has been assessed as taxable in the current year. carrying amount $18 000

- amount of revenue that will not be taxable in future periods - $18 000

= tax base = $nil

. 30

(c) The carrying amount of the liability exceeds its tax base by $18 000. There is, therefore, a deductible temporary difference giving rise to a deferred tax asset of $18 000  0.3 = $5 400. (d) The carrying amount would be unchanged but none of the revenue has been included in assessable income. As the carrying amount equals the tax base of the liability, there will be no deferred tax asset. carrying amount - amount of revenue that will not be taxable = tax base in future periods $18 000 - $nil = $18 000 9

Leander Company (a) The carrying amount of the liability is $214 000. (b) The deductible amount of the liability is nil as the full amount has already been claimed for tax purposes. However, if the liability was settled for $214 000, the exchange gain of $11 000 would be assessable income. The liability does not arise from revenue received in advance. carrying amount $214 000

- deductible amount - $nil

+ assessable amount + $11 000

= tax base = $225 000

(c) The tax base of the liability exceeds its carrying amount. There will, therefore, be a taxable temporary difference which gives rise to a deferred tax liability of $11 000  0.30 = $3 300. (d) If the exchange gains are assessable in the same period they are recognised, then there is no difference between the accounting and tax treatment. Hence, the carrying amount remains at $214 000. The deductible amount of the liability remains nil, however, the exchange gain of $11 000 has already been assessed, therefore there is no assessable amount. The tax base and carrying amount are equal, hence no DTL.

carrying amount

- deductible amount

+ assessable amount

= tax base

$214 000

- $nil

+ $nil

= $214 000

Swiftsure Ltd (a) The carrying amount of the assets exceeds their tax base by $491 000. There is, therefore, a taxable temporary difference which gives rise to a deferred tax liability of $491 000  0.30 = $147 300. The deferred tax liability must be reduced from $170 000 to $147 300 or $22 700.

. 31

Asset

Carrying amount

Tax base

142 000

108 000

541 000

340 000

820 000

610 000

86 000

40 000

1 589 000

1 098 000

Balance as 30 June 2018

TTD

DTL @TR 30%

491 000

147 300

C/F Balance as at 30 June 2017

170 000

Change in DTL

∆↓22 700

The general journal entries to record the income tax expense as at 30 June 2018

Current income tax expense Dr $840 000 Current tax liability Cr $840 000 (to record current income tax expense and current tax liability for taxable income) Deferred tax liability Dr $22 700 Deferred income tax expense Cr (to record deferred tax effect on depreciable asset)

$22 700

(b) If the deferred tax liability as at 30 June 2017 was $122 000, the DTL would have to be increased by $25 300 to bring it to the required balance of $147 300. The general journal entry would be:

Current income tax expense Dr $840 000 Current tax liability Cr $840 000 (to record current income tax expense and current tax liability for taxable income) Deferred income tax expense Dr $25 300 Deferred tax liability Cr (to record deferred tax effect on depreciable asset)

$25 300

Audacious Ltd The unused tax losses were $300 000  0.30 = $1 000 000. The taxable income for the year ended 30 June 2018 would, therefore, be $2 250 000 – $1 000 000 = $1 250 000

and current tax liability would be $1 250 000  0.3 = $375 000. As the unused tax loss has new been fully utilised, the deferred tax asset must be reduced to zero. The general journal entries to record income tax expense as at 30 June 2018:

Deferred income tax expense Dr Deferred tax asset Cr (to utilisation of unused tax losses)

$300 000 $300 000

Current income tax expense Dr $375 000 Current tax liability Cr $375 000 (to record current income tax expense and current tax liability for taxable income)

Challenger Ltd (a) Current and deferred income tax general journal entries Calculate taxable income/loss and record current income tax expense. Loss for the period add income assessable in the current period add back accounting expenses not deductible doubtful debts expense depreciation expense warranty expense legal fees less tax deduction for bad debts written off depreciation warranty payments rent paid in advance Taxable income/(loss)  tax rate 30%

(500 000) 200 000 85 000 325 000 104 000 20 000 (62 000) (306 000) (67 000) (65 000)

534 000

(500 000) (266 000) (79 800)

General journal entry as at 30 June 2018: _________________________________________________________________ Deferred tax asset Dr $79 800 Deferred income tax expense Cr $79 800 (to record tax loss carried forward) ________________________________________________________________

Calculate temporary differences, deferred tax assets/liabilities using a tax worksheet and record deferred income tax expenses. Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 Carrying amount

Tax base

Accounts receivable

2 000 000

less allowance for doubtful debts

(90 000)

(0)

Accounts receivable - net

1 910 000

2 000 000

PPE - net

1 860 000

1 619 000

241 000

72 300

Prepaid rent

65 000

19 500

Provision for warranty

164 000

49 200

Revenue received in advance

200 000

60 000

Closing balances 30/6/2018

TTD

DTD

DTL @TR 30%

DTA @TR 30%

90 000

306 000

454 000

27 000

91 800

136 200

For Financial Year Ended 30 June 2017 Accounts receivable – net *

1 995 000

2 062 000

PPE - net

2 185 000

1 925 000

127 000

Provision for warranty

67 000 260 000

20 100 78 000

127 000

38 100

Closing balances 30/6/2017

260 000

194 000

78 000

58 200

Closing balances 30/6/2018

306 000

454 000

91 800

136 200

∆↑ 13 800

∆↑ 78 000

Change in DTA/DTL

To determine the balance at the end of 30 June 2017, we need to consider the balance at the commencement of 2018. Absent other information, the opening balance of Accounts receivable is $2 000 000 + $62 000 which was written off in 2018 therefore the tax base is $2 062 000 000. The allowance for doubtful debts opening balance

. 34

would be $90,000 - $85 000 + $62 000 = $67,000 therefore the carrying amount is $2 062 000 - $67 000 = $1 995 000 The general journal entry as at 30 June 2018:

Deferred tax asset Deferred income tax expense Deferred tax liability

Dr Cr Cr

$78 000 $64 200 13 800

Note that set-off of DTA and DTL may occur in presenting the statement of financial position, but is not permitted at the journal entry (recognition) stage. (b) Possible implications of a subsequent loss • Recognition criteria for DTA arising from tax losses? Is the requirement still “probable” or does the AASB 112 requirement that where there is a history of tax losses, there is a need for ‘convincing other evidence’ (para. 35) before recognising DTAs arising from tax losses kick in? What is meant by convincing evidence? Disclosure of supporting evidence is to be disclosed (para. 82). • Recognition of other DTAs from deductible temporary differences – is it still ‘probable’ that these benefits will be received if losses continue? • Derecognition of any existing taxable temporary differences (DTLs) is certainly the first step in recognising the tax benefit of tax losses. 13

Spring Time Limited

Calculate the tax bases and deferred tax asset and liability balances Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 For Financial Year Ended 30 June 2018

Carrying amount

Tax base

TTD

DTD

DTL @TR 30%

Cash

60 000

Accounts receivable - net

106 000

120 000

6 000

Nil

6 000

1 800

Land

300 000

320 000

20 000

6 000

Furniture

252 000

315 000

Accounts payable

45 000

Accrued expenses

16 000

Prepaid insurance

DTA @TR 30%

14 000

4 200

63 000

18 900

16 000

4 800

. 35

Provision for warranty

25 000

7 500

Provision for long service leave

32 000

9 600

Loan

112 000

Closing balances 30/6/2018

26 000

150 000

7 800

45 000

Opening 1/7/2018

Nil

∆↑ 7 800

∆↑ 45 000

balances

Change in DTA/DTL

The general journal entry as at 30 June 2018:

Deferred tax asset Deferred income tax expense Deferred tax liability

Dr Cr Cr

$45 000 $37 200 7 800

Note that set-off of DTA and DTL may occur in presenting the statement of financial position, but is not permitted at the journal entry (recognition) stage. Workings: • Cash: The tax base will always equal the carrying amount for this assets therefore resulting in neither a taxable temporary difference nor deductible temporary difference. Accounts receivable net: The difference arises from allowance for doubtful debts which are deductible temporary difference. • Prepaid insurance: the deduction for the payment of insurance is available generally when the insurance is paid i.e. in the current period therefore there is no deducible temporary difference, but rather a taxable temporary difference through use of the asset or recover through refund. • Land: Land is not subject to depreciation therefore any difference between the carrying amount and the tax base is a result of revaluation. In this case the land has decreased in value. It should be noted that unlike a revaluation increase which is recognised in other comprehensive income and accumulated in equity to the revaluation surplus with resulting tax effects (see AASB 116, para. 39); a decrease in the carrying amount as a result of revaluation is recognised in profit or loss to the extent that it is not a reversal of a prior increase (see AASB 116, para 40). • Furniture: the difference is likely to be a result of the difference tax and depreciation rates. As the tax base exceeds the carrying amount, the deductible amount ($314 000) exceed the assessable amounts ($252 000), resulting in a deductible temporary difference.

. 36

•

• •

•

Accounts payable: payables are generally recognised and taxed on an accrual basis and therefore there are no temporary differences. Thus, the carrying amount of the liability is equity to its tax base. This would not be the case if accounts payable were taxed on a cash basis rather than accrual similar to accrued expenses. Accrued expenses: the deduction for accrued expenses is generally when the expense is paid. In this case, the expense has not been paid in this period, thus there is a future deductible amount when paid. This gives rises to a deductible temporary difference. Provision for warranty: the deduction for warranty is available when the warranty claim is paid. In this case, the expense has not been paid in this period, hence the provision, and results in a future deductible amount when paid. This gives rises to a deductible temporary difference. Loan: Like cash, the carrying amount and the tax base of the loan will be the same and therefore resulting in neither a taxable temporary difference nor deductible temporary difference. Bamboo Ltd (a) Calculate taxable income with carried forward tax losses and record income tax expense Profit before tax add back accounting expenses not deductible doubtful debts expense 60 000 long service leave expense 17 000 less tax deduction for bad debts written off (50 000) long service leave paid* (57 000) Taxable income/(loss) before prior tax losses c/f tax loss $2 000 000 from FYE 30 June 2016 (part) Taxable income Prior tax loss consumed in current year $1 470 000 x 30%

1 500 000

77 000

(107 000) 1 470 000 (1 470 000) $0 $441 000

The general journal entry as at 30 June 2018: _________________________________________________________________ Deferred income tax expense Dr $441 000 Deferred tax asset Cr $441 000 (to record utilisation of prior year tax loss carried forward) _______________________________________________________________ *Long service leave paid = Opening balance $120 000 + expenses $17 000 – closing balance $80 000 = $57 000 Note: Unused tax losses as at 30 June 2018. . 37

Financial year 30/6/2016 = $530 000 ($2 000 000 - $1 470 000) Financial year 30/6/2017 = $500 000 (b) Calculate temporary differences, deferred tax assets/liabilities using a tax worksheet and record deferred income tax expenses Deferred Tax Worksheet for the Financial Year Ended 30 June 2018

Accounts receivable

380 000

less allowance for doubtful debts

(30 000)

(0)

Accounts receivable - net

350 000

380 000

30 000

9 000

Provision for long-service leave

80 000

24 000

110 000

33 000

DTD

DTA1

Closing balances 30/6/2018

TTD

DTL1

Financial Year Ended 30 June 2017 Accounts receivable

320 000

less allowance for doubtful debts

(20 000)

(0)

Accounts receivable - net

300 000

320 000

20 000

6 000

Provision for long-service leave

120 000

36 000

Closing balances 30/6/2017

140 000

42 000

Closing balances 30/6/2018

110 000

33 000

Change in DTA/DTL 1

∆↓ 9 000

Tax rate of 30% applied. The general journal entry as at 30 June 2018: _________________________________________________________________ Deferred income tax expense Dr $9 000 Deferred tax asset Cr $9 000 (to record change in deferred tax expense and DTA) _______________________________________________________________ (c) Note disclosure: Major components of income tax expense: Current tax expense

Deferred tax expense Origination and reversal of temporary differences Benefit of tax losses recognised Total income tax expense 15

9 000 441 000 $450 000

Zealous Ltd (a) Calculate taxable income with carried forward tax losses, calculate temporary differences, deferred tax assets/liabilities using a tax worksheet and record general journal entries for income tax. The unused tax losses are $375 000/30% = $1 250 000. The taxable income for the year ended 30 June 2018 would be nil but the deferred tax asset associated with the unused tax losses would be reduced to ($1 250 000 - $680 000) x 30% = $171 000. The reduction in the deferred tax asset arising from unused tax losses is, therefore $204 000. Taxable income before adjustments for prior tax losses c/f tax loss Taxable income Prior tax loss consumed in current year $680 000 x 30%

680 000 (680 000) $0 $204 000

Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 CA

TTD

PPE – net

910 000

850 000

60 000

Provision for long-service leave

450 000

Financial Year Ended 30 June 2018

Closing balances as at 30/6/2018 Financial Year Ended 30 June 2017 PPE – net

DTL1

TTD

DTA1

18 000 450 000

60 000 CA

DTD

450 000 DTD

135 000 18 000 1

DTL

135 000 DTA1

25 000

Provision for long-service leave

120 000

Closing balances as at 30/6/2017

25 000

120 000

Closing balances as at 30/6/2018

18 000

135 000

Change in DTA/DTL 1 Tax rate of 30% applied.

∆↓7 000

∆↑15 000

The general journal entry as at 30 June 2018: ____________________________________________________________ Deferred income tax expense Dr $204 000 Deferred tax asset Cr $204 000 (to record utilisation of prior year tax loss carried forward) Deferred tax liability Dr $7 000 Deferred tax asset Dr 15 000 Deferred income tax expense Cr $22 000 (to record change in deferred tax expense and DTA/DTLs) _______________________________________________________________ (b) Note disclosure: Deferred tax asset Arising from unused tax losses Origination and reversal of temporary differences Deferred tax liability Net deferred tax asset

$171 000 $135 000 $306 000 $18 000 $288 000

Presuming the conditions necessary for offsetting are met (AASB 112, para. 74), the statement of financial position would, therefore, show a deferred tax asset of $288 000. 16

Kirk Ltd (a) Current income tax expense, carrying amount, tax base, temporary difference and amount of any DTA and DTL. Profit before tax add back accounting expenses not deductible doubtful debts expense depreciation less tax deduction for bad debts written off depreciation Taxable income x 30% tax rate

$720 000 60 000 75 000 (40 000) (90 000)

135 000

(130 000) $725 000 $217 500

. 40

Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 CA

Accounts receivable

1 460 000

less allowance for doubtful debts

(70 000)

(0)

Accounts receivable – net

1 390 000

1 460 000

Non-current assets

750 000

less accumulated depreciation

(300 000)

(405 000)

Non-current assets - net

450 000

345 000

Financial Year Ended 30 June 2018

Closing balances 30/6/2018

TTD

DTD

70 000

105 000

TTD

Accounts receivable

1 000 000

less allowance for doubtful debts

(50 000)

(0)

Accounts receivable – net

950 000

1 000 000

Non-current assets

750 000

less accumulated depreciation

(225 000)

(315 000)

Non-current assets - net

525 000

435 000

17 500

DTD

26 250

17 500

DTL2

DTA2

50 000

90 000

DTA1

26 250

Financial Year Ended 30 June 2017

DTL1

15 000

27 000

Closing balances 30/6/2017

27 000

15 000

Closing balances 30/6/2018

26 250

17 500

∆↓750

∆↑2 500

Change in DTA/DTL 1

Tax rate of 25% applied. The change in tax rate will be applicable for balances from 1 July 2018 and therefore applied as at 30 June 2018. 2 Tax rate of 30% applied. The change in tax rate will be applicable for balances from 1 July 2018 and therefore applied as at 30 June 2018.

. 41

(b) The general journal entries as at 30 June 2018: ____________________________________________________________ Current income tax expense Dr $217 500 Current tax liability Cr $217 500 (to record current tax expense and current tax liability) Deferred tax asset Dr $2 500 Deferred tax liability Dr 750 Deferred tax expense Cr $3 250 (to record change in deferred tax expense and DTA/DTLs taking account of new tax rate effective from 1 July 2018) _______________________________________________________________ 17

Hilfiger Ltd Current income tax expense, carried forward tax losses, carrying amount, tax base, temporary difference, amount of any DTA and DTL with change in tax rate. Profit before tax add back accounting expenses not deductible doubtful debts expense less tax deduction for bad debts written off Taxable income before tax loss recoupment Tax loss carried forward from 2017 Taxable income x 30% tax rate

$500 000 11 000

11 000

(10 000)

(10 000) $501 000 ($200 000) $301 000 $90 300

Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 CA

Accounts receivable

450 000

less allowance for doubtful debts

(9 000)

(0)

Accounts receivable – net

441 000

450 000

Financial Year Ended 30 June 2018

Closing balances as at 30/6/2018

DTD

DTA1

9 000

2 250

9 000

2 250

. 42

Accounts receivable

460 000

less allowance for doubtful debts

(8 000)

(0)

Accounts receivable – net

452 000

460 000

Financial Year Ended 30 June 2017

Closing balances as at 30/6/2017

DTD

DTA2

8 000

2 400

8 000

2 400

Closing balances as at 30/6/2018

2 250

Change in DTA/DTL

∆↓150

Tax rate of 25% applied. The change in tax rate will be applicable for balances from 1 July 2018 and therefore applied as at 30 June 2018. 2 Tax rate of 30% applied. The general journal entries as at 30 June 2018: ____________________________________________________________ Deferred income tax expense Dr $60 000 Deferred tax asset Cr $60,000 (to record utilisation of prior period tax loss carried forward $200 000 x 30%) Current income tax expense Dr $90 300 Current tax liability Cr $90 300 (to record current period income tax expense and current tax liability) Deferred tax expense Dr $150 Deferred tax asset Cr $150 (to record change in deferred tax expense and DTLs taking account of new tax rate effective from 1 July 2018) _______________________________________________________________

Orion Ltd Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 CA

Allowance for doubtful debts

TTD

250 000

2 450 000

1 940 000

Revenue received in advance

80 000

Prepaid rent

48 000

Accounts payable

532 000

Non-current assets - net

Closing balances 30/6/2018

Closing balances 30/6/2017

DTD

DTL1

250 000 510 000

510 000

DTA1 75 000

153 000

250 000

Change in DTA/DTL

153 000

75 000

180 000

80,000

∆↓ 27 000

∆↓ 5 000

1 At tax rate of 30%

Revenue received in advance: The revenue received in advance has not been included in taxable income or revenue in the income statement and therefore the carrying amount is equal to the tax base. As a result, there is no temporary difference. carrying amount $80 000

- amount of revenue that will not be taxable in future periods - $nil

= tax base = $80 000

Prepaid rent: The rent has not been yet been deducted as either an accounting expense or tax deduction and therefore the carrying amount is equal to the tax base. As a result there is no temporary difference. The general journal entries as at 30 June 2018: ____________________________________________________________ Current income tax expense Dr $765 000 Current tax liability Cr $765 000 (to record current tax expense and current tax liability on taxable income $2 550 000 x 30%) Deferred tax liability Dr $27 000 Deferred tax asset Cr $5 000 Deferred income tax expense Cr $22 000 (to record change in deferred tax expense and DTLs/DTA’s) _______________________________________________________________ . 44

Renown Ltd Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 CA

Accounts receivable

8 250 000

less allowance for doubtful debts

(600 000)

(0)

Accounts receivable – net

7 650 000

8 250 000

210 000

Property plant and equipment

14 000 000

less accumulated depreciation

(7 000 000)

(14 000 000)

PPE – net

7 000 000

Provision for long-service leave

2 400 000

Revenue received in advance

400 000

Financial Year Ended 30 June 2018

Prepaid rent

Closing balances as at 30/6/2018

TTD

DTD

DTL1

600 000

180 000

210 000

63 000

7 000 000

2 100 000 2 400 000

3 000 000

720 000

2 163 000

900 000

Closing balances as at 30/6/2017

2 500 000

1 200 000

Change in DTA/DTL

∆↓ 337 000

∆↓ 300 000

7 210 000

DTA1

At tax rate of 30% Property, plant and equipment: Five years since acquisition Accounting depreciation $14 000 000/10 = $1 400 000 pa x 5 years = $7 000 000 Tax depreciation $14 000 000/5 = $2 800 000 pa x 5 years = $14 000 000 carrying amount $7 000 000

+ deductible amount + $nil

- assessable amount - $7 000 000

= tax base = $nil

Note: the PPE is now fully depreciated for tax purposes hence the deductible amount is nil. Accounts receivable/Allowance for doubtful debts: The allowance for doubtful debts is deductible in the future when then debts are written-off. carrying amount $7 650 000

+ deductible amount + $600 000

- assessable amount - $nil

= tax base = $8 250 000

Prepaid rent: The rent has been claimed as a tax deduction but not as an accounting expense. carrying amount $210 000

+ deductible amount + $nil

- assessable amount - $210 000

= tax base = $nil

Goodwill: The treatment of goodwill under AASB 112 is set down in paragraph 21. This Standard does not permit the recognition of the resulting deferred tax liability because goodwill arising on the acquisition of a subsidiary is a residual and the recognition of the deferred tax liability would increase the carrying amount of goodwill. In essence, the initial recognition and any subsequent impairment of goodwill are treated as permanent differences. Provision for long-service leave: The tax deduction for long-service leave will be available when the leave is taken thus a future deduction will be available. carrying amount

- deductible amount

+ assessable amount

= tax base

$2 400 000

- $2 400 000

+ $nil

= $nil

Revenue received in advance: The revenue received in advance has not been included in taxable income or revenue in the income statement and will be taxable in future periods. Therefore the carrying amount is equal to the tax base. As a result, there is no temporary difference. carrying amount $400 000

- amount of revenue that will not be taxable in future periods - $nil

= tax base = $400 000

Inventory, Investment and Accounts payable: There are no timing differences associated with these accounts. Thus the carrying amount is equal to the tax base and therefore no temporary difference. The general journal entries as at 30 June 2018: Current income tax expense Dr $6 747 000 Current tax liability Cr $6 747 000 (to record current tax expense and current tax liability on taxable income $22 490 000 x 30%) Deferred tax liability Deferred tax asset Deferred income tax expense

Dr Cr Cr

$337 000 $300 000 $37 000 . 46

(to record change in deferred tax expense and DTLs/DTA’s)

Valiant Ltd Profit before tax add back accounting expenses not deductible doubtful debts expense long-service leave expense goodwill impairment expense depreciation ($800 000/8yrs) less tax deduction for bad debts written off long-service leave taken prepaid rent depreciation ($800 000/5yrs) Taxable income before tax loss recoupment Tax loss carried forward/recouped from 2017 Taxable income x 30% tax rate

$5 000 000 10 400 18 000 50 000 100 000 (12 200) (8 000) (30 000) (160 000)

178 400

(210 200) $4 968 200 ($300 000) $4 668 200 $1 400 460

Deferred Tax Worksheet for the Financial Year Ended 30 June 2018 Financial Year Ended 30 June 2018

Carrying amount

Tax base

TTD

Accounts receivable

202 000

less allowance for doubtful debts

(16 000)

(0)

Accounts receivable – net

186 000

202 000

Prepaid rent

30 000

Property plant and equipment

800 000

less accumulated depreciation

(300 000)

(480 000)

PPE – net

500 000

320 000

Provision for long-service leave

40 000

Revenue received in advance

40 000

Closing balances as at 30/6/2018 Closing balances as at 30/6/2017

DTD

DTL1

16 000

4 800

30 000

9 000

180 000

54 000 40 000

210 000

56 000

DTA1

12 000

63 000

16 800

41 660

110 000

(90 000)

period.2 ∆↑ 21 340

Change in DTA/DTL 1

At tax rate of 30% Note: The balance of the DTA as at 30 June 2017 was $110 000. However, $90,000 of the DTA from unused tax losses was utilised during the period. The general journal entries as at 30 June 2018: ____________________________________________________________ Deferred income tax expense Dr $90 000 Deferred tax asset Cr $90,000 (to record utilisation of prior period tax loss carried forward $300 000 x 30%) Current income tax expense Dr $1 400 460 Current tax liability Cr $1 400 460 (to record current tax expense and current tax liability on taxable income $4 668 200 x 30%) Deferred income tax expense Dr $24 540 Deferred tax liability Cr $21 340 Deferred tax asset Cr $3 200 (to record change in deferred tax expense and DTLs/DTA’s) _______________________________________________________________ Additional workings: Property, plant and equipment: Five years since acquisition. Accounting depreciation $800 000/8 = $100 000 pa x 3 years = $300 000. Tax depreciation $800 000/5 = $160 000 pa x 3 years = $480 000. The carrying amount of property, plant and equipment exceeds its tax base by $180 000 giving a taxable temporary difference x 30% = $54 000 deferred tax liability. carrying amount $500 000

+ deductible amount + $320 000

- assessable amount - $500 000

= tax base = $320 000

Accounts receivable/Allowance for doubtful debts: The allowance for doubtful debts is deductible in the future when then debts are written-off. The tax base exceeds the carrying amount by $16,000 giving a deductible temporary difference x 30% = $4 800 deferred tax asset. carrying amount $186 000

+ deductible amount + $16 000

- assessable amount - $nil

= tax base = $202 000

. 48

∆↓ 3 200

Prepaid rent: The rent has been claimed as a tax deduction but not as an accounting expense. The carrying amount of the asset is greater than the tax base by $30 000 giving a taxable temporary difference x 30% = $9 000 deferred tax liability. carrying amount $30 000

+ deductible amount + $nil

- assessable amount - $30 000

= tax base = $nil

Provision for long-service leave: The tax deduction for long-service leave will be available when the leave is taken thus a future deduction will be available. The carrying amount of the liability exceeds its tax base by $40,000 giving a deductible temporary difference x 30% = $12 000 deferred tax asset. carrying amount - deductible amount + assessable amount = tax base $40 000 - $40 000 + $nil = $nil Revenue received in advance: The revenue received in advance has not been included in taxable income or revenue in the income statement and therefore the carrying amount is equal to the tax base. As a result, there is no temporary difference. carrying amount $40 000

- amount of revenue that will not be taxable in future periods - $nil

= tax base = $40 000

. 49

TJ Ltd

Deferred Tax Worksheet for the Financial Year Ended 30 June 2017 and 30 June 2018 TTD

DTA1

Accounts receivable – net

100 000

123 000

Prepaid rent

26 000

Land

420 000

Equipment – net

240 000

180 000

Plant - net

332 800

442 000

109 200

32 760

Accrued expenses

20 000

6 000

Commission received in advance

18 000

5 400

Provision for long-service leave

6 000

1 800

Closing balances as at 30/6/2017

DTD

DTL1

30 June 2017

23 000

6 900

26 000

7 800

60 000

18 000

86 000

176 200

Closing balances as at 30/6/2016 Change in DTA/DTL - 2017

25 800

52 860

18 000

23 400

∆↑ 7 800

∆↑ 29 460

30 June 2018 Accounts receivable – net

200 000

241 000

Prepaid rent

32 000

9 600

Land2

440 000

420 000

20 000

6 000*

Equipment – net

210 000

120 000

90 000

27 000

Plant – net

270 400

416 000

145 600

43 680

Accrued expenses

30 000

9 000

Commission received in advance

8 000

2 400

Provision for long-service leave

5 000

1 500

41 000

12 300

Closing balances as at 30/6/2018

142 000

229 600

42 600

68 880

Closing balances as at 30/6/2017

86 000

176 200

25 800

52 860

Adjust from revaluation made to DTL and revaluation surplus (OCI) during the period Change in DTA/DTL - 2018

1 2

(6 000) ∆↑ 10 800

∆↑ 16 020

Tax rate of 30% Note: When the land was revalued in 2018, the resulting tax effect would be recognised.

The general journal entries as at 30 June 2017:

Current income tax expense Dr $253 680 Current tax liability Cr $253 680 (to record current tax expense and current tax liability on taxable income $845 600 x 30%) Deferred tax asset Dr $29 460 Deferred tax liability Cr Deferred income tax expense Cr (to record change in deferred tax expense and DTLs/DTA’s)

$7 800 $21 660

The general journal entries as at 30 June 2018:

Current income tax expense Dr $290 490 Current tax liability Cr $290 490 (to record current tax expense and current tax liability on taxable income $968 300 x 30%) Land Dr $20 000 Revaluation surplus (OCI) Cr $20 000 (to revalue asset to fair value of $440 000 from carrying amount of $420 000 through OCI) Income tax expense on revaluation (OCI) Dr $6 000 Deferred tax liability Cr $6 000 (to record deferred tax effect from asset revaluation increasing DTL $20 000 @ 30%) Revaluation surplus (OCI) Dr $20 000 Income tax expense on revaluation (OCI) Cr $6 000 Revaluation surplus (equity) Cr $14 000 (to accumulate/transfer from OCI to revaluation surplus in equity with tax effects) Deferred tax asset Dr 16 020 Deferred tax liability Cr Deferred income tax expense Cr (to record change in deferred tax expense and DTLs/DTA’s)

$10 800 5 220

Workings: . 51

Accounts receivable/Allowance for doubtful debts: The allowance for doubtful debts is deductible in the future when then debts are written-off. The tax base exceeds the carrying amount giving rise to a deductible temporary difference and a deferred tax asset. 2017 2018 Accounts receivable $123 000 $241 000 less allowance for doubtful debts (23 000) (41 000) Accounts receivable net $100 000 $200 000 Year 2017 2018

carrying amount $100 000 $200 000

+ deductible amount + $23 000 + $41 000

- assessable amount - $nil - $nil

= tax base = $123 000 = $241 000

Prepaid rent: The rent has been claimed as a tax deduction but not as an accounting expense. The carrying amount of the asset is greater than the tax base giving rise to a taxable temporary difference and a deferred tax liability. Year

carrying amount

+ deductible amount

- assessable amount

= tax base

2017 2018

$26 000 $32000

+ $nil + $nil

- $26 000 - $32 000

= $nil = $nil

Equipment: Accounting depreciation $300 000 x 10% = $30 000 pa. Tax depreciation $300 000 x 20% = $60 000. The carrying amount of equipment exceeds its tax base by giving rise to a taxable temporary difference and therefore a deferred tax liability.

Asset Equipment less accum. depreciation Equipment - net

2017 Accounting Tax 300 000 300 000 (60 000) (120 000) 240 000 180 000

2018 Accounting Tax 300 000 300 000 (90 000) (180 000) 210 000 120 000

Year

carrying amount

+ deductible amount

- assessable amount

= tax base

2017 2018

$240 000 $210 000

+ $180 000 + $120 000

- $240 000 - $210 000

= $180 000 = $120 000

Plant: Accounting depreciation $520 000 x 12% = $62 400 pa. Tax depreciation $520 000 x 5% = $26 000. The tax base of the Plant exceeds its carrying amount giving rise to a deductible temporary difference and therefore a deferred tax asset. This is the case because the asset is being depreciated using a greater rate under accounting (12%) than tax rate (5%).

. 52

Asset Plant less accum. depreciation Plant - net

2017 Accounting 520 000 (187 200) 332 800

Year 2017 2018

+ deductible amount + $442 000 + $416 000

carrying amount $332 800 $270 400

Tax 520 000 (78 000) 442 000

2018 Accounting Tax 520 000 520 000 (249 600) (104 000) 270 400 416 000

- assessable amount - $332 800 - $270 400

= tax base = $442 000 = $416 000

Accrued expense: Expenses are deductible when paid. The carrying amount of the liability exceeds its tax base giving rise to a deductible temporary difference and therefore a deferred tax asset. Year 2017 2018

carrying amount $20 000 $30 000

- deductible amount - $20 000 - $30 000

+ assessable amount +$nil + $nil

= tax base = $nil = $nil

Commission received in advance: The commission received in advance has been taxed when cash received. The carrying amount of the liability is greater than the tax base giving rise to a deductible temporary difference and therefore a deferred tax asset. Year

carrying amount

2017 2018

$18 000 $8 000

- amount of revenue that will not be taxable in future periods - $18 000 - $8 000

= tax base = $nil = $nil

carrying amount $6 000 $5 000

- deductible amount - $6 000 - $5 000

+ assessable amount +$nil + $nil

= tax base = $nil = $nil

Land: The taxable temporary difference arises as the carry amount of the asset is greater than the tax base. The revaluation increase must go recognised in OCI with relevant tax and accumulated to the revaluation surplus.

. 53

Disclosure and Harvey Norman Limited (a) Outline the main disclosure requirements of AASB112 Paragraph 79 of AASB 112 requires the separate disclosure of ‘the major components of tax expense (income)’. Paragraph 80 indicates that these components may include: (a) current tax expense (income) (b) any adjustments recognised in the period for current tax of prior periods; (c) the amount of deferred tax expense (income) relating to the origination and reversal of temporary differences (d) the amount of deferred tax expense (income) relating to changes in tax rates or the imposition of new taxes; (e) the amount of the benefit arising from a previously unrecognised tax loss, tax credit or temporary difference of a prior period that is used to reduce current tax expense; (f) the amount of the benefit from a previously unrecognised tax loss, tax credit or temporary difference of a prior period that is used to reduce deferred tax expense; (g) deferred tax expense arising from the write-down, or reversal of a previous writedown, of a deferred tax asset in accordance with paragraph 56; and the amount of tax expense (income) relating to those changes in accounting policies and errors that are included in profit or loss in accordance with AASB 108, because they cannot be accounted for retrospectively. Paragraph 81 requires the separate disclosure of other information, including reconciliation between tax expense (income) and the product of accounting profit multiplied by the applicable tax rate(s), disclosing also the basis on which the tax rate(s) is (are) computed (para. 81 (c)(i)) . Paragraph 81(e) requires disclosure of the amount of deductible temporary differences, unused tax losses, and unused tax credits for which no deferred tax asset is recognised in the statement of financial position. (b) Review of Harvey Norman Limited Note 5 to the financial statements is the note for income tax expense. Disclosure Requirement Harvey Norman reference Fulfilled? Paragraph 80 (a) current tax expense Note 5 (a) - $109 186 000 Yes (income) reconciled as disclosed in Income Statement (b) current tax of prior Note 5 (a) - $632 000 Yes periods (c) the amount of deferred Note 5 (a) - $9 046 000

Yes

tax expense (income) . 54

relating to the origination and reversal of temporary differences (d) changes in tax rates

Not applicable

Yes

(e) to (h)

Note 5 (c) some included in the reconciliation noted in para. 81 (c) (i) and also words indicating deferred tax assets not recognised re tax losses of $207m

Some disclosure of unrecognised tax losses $4 169 000 and utilisation of tax losses $182 000.

Paragraph 81 (a) aggregate current and deferred tax relating to items charged directly credited to equity

Note 5(b) Charges noted for Yes revaluation of cash flow hedges ($1 406 000) and land and buildings ($2 055 000)

(ab) amount of income tax Statement of Comprehensive relating to each component Income highlights the above of comprehensive income amounts in arriving at Other Comprehensive Income (b) Deleted Not applicable (c) Numerical reconciliation tax expense and accounting profit multiplied by tax rate (d) Change in tax rates

Note 5 (c) Report for profit Yes and loss of $109 186 000 reconciled to accounting profit $378, 100 000 multiplied by tax rate of 30% = $113 430 000. Not applicable

(e) Unrecognised deferred Note 5 (c) deferred tax assets Yes tax assets not recognised re tax losses of $207 million (f) Deferred income tax Note 5 (c) no recognised or Yes liability not recognised unrecognised deferred tax liability (g) Details of each type of Note 5 (d) highlights the temporary difference in different types of deferred tax deferred tax assets and assets $23 670 000 and liabilities liabilities $222 398 000 - net . 55

offset to deferred tax liability position of $198 728 000 as per the Statement of Financial Position. The reconciliation in Note 5 (c) between tax expense and pre-tax profit shows that prima facie tax exceeds income tax expense by approximately $4.2 million mainly due to income not assessable for income tax purposes ($4 169 000), support payments under an agreement with the ATO ($2 160 000) and tax concessions related to research and development expenses ($1 268 000). The major offset to these was the unrecognised tax losses of $4 169 000. Based on the review outlined above, the financial statements of Harvey Norman Limited appear to have fulfilled disclosure requirements as set out by AASB 112.

. 56

Chapter 10 ACCOUNTING FOR INTANGIBLE ASSETS LEARNING OBJECTIVES After studying this chapter you should be able to: 1

describe the nature of intangible assets;

distinguish between purchased and internally generated intangible assets;

apply the requirements of AASB 138 ‘Intangible Assets’ to the initial recognition and subsequent measurement of intangible assets;

distinguish between research and development, and explain the alternative methods of accounting for research and development;

apply the requirements of AASB 138 ‘Intangible Assets’ to research and development;

distinguish between intangible assets and goodwill;

explain the alternative methods that have been suggested to account for goodwill or excess on acquisition; and

apply the requirements of AASB 3 ‘Business Combinations’, AASB 136 ‘Impairment of Assets’ and AASB 138 ‘Intangible Assets’ to accounting for goodwill.

QUESTIONS Intangible assets: 1 AASB 138 ‘Intangible Assets’ refers to three factors necessary for the existence of an intangible asset. They are identifiability, control and the existence of future economic benefits. These are discussed below in relation to the Framework 2014 definition of assets. Framework 2014 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’ (para. 49). According to the Framework definition, intangibles qualify as assets when they represent future economic benefits controlled by an entity. These rights to future economic benefits are controlled by the entity because they are normally in the possession of, or are owned by, the entity deriving the benefits, which means that the entity can benefit from the asset and deny or regulate the access of others to the benefit. These rights also exist because of some past transaction or event, such as the purchase or internal generation of the intangible asset. The requirement for control and the existence of future economic benefits are common to both the Framework 2014 definition of assets and the AASB 138 definition of intangible assets. The AASB 138 definition of intangible assets also requires that intangible assets be identifiable – ‘An intangible asset is an identifiable non-monetary asset without physical substance’ (para 8). The term ‘non-monetary’ is not defined in AASB 138. However, referring to the nature of assets, a non-monetary asset is an asset for which there is no right to receive, or an obligation to deliver, a fixed or determinable number of units of currency. Non-monetary assets include inventory and PPE while monetary assets include cash and receivables. The term ‘without physical substance’ relates to the tangibility of the assets. The term ‘identifiable’ is not used in the Framework definition of assets. Framework 2014 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’ (para. 49). AASB 138 discusses identifiability and indicates that an asset is considered identifiable if it is separable (capable of being separated from the entity and sold or transferred), or if the asset arises from contractual or other rights. Neither the current Framework nor its predecessors (including SAC4) identify separability as an essential characteristic of assets. Given this, it is hard to explain why the definition of intangible assets requires that these assets (but not others) must be identifiable. Inclusion of this requirement ensures that goodwill is excluded from the definition of intangible assets. . 2

Intangibles such as brands, business processes and systems have become more important in creating and maintaining a business’s success. This is indicated by the increasing business expenditure on intangibles. Coupled with increased reliance on intangibles is recognition that intangibles are essentially inert—that is, by and of themselves they neither create value nor generate growth. Intangibles need support and enhancement systems to create value. Without effective support the value of intangibles dissipates very quickly—far more quickly than the value of tangible assets! This is illustrated by the billions of dollars of lost intangibles in companies such as One-Tel, AOL Time Warner Co. and Enron. The reasons for the rapid gains or losses in value of intangibles are not well understood and are difficult for accounting systems to capture. Including separability as a necessary characteristic of intangibles is contrary to Lev (2002) who argues that intangible assets are inherently inert and only contribute to firm value where embedded in appropriate systems and procedures. Assets such as brand names can be legally sold and therefore appear to be separable. However, once removed from the systems and procedures that support them, the value of such assets may quickly dissipate. In practice, drawing a distinction between intangible assets (which are separable) and components of goodwill (which are not separable) may be difficult.

Brand names are an intangible asset – they may be acquired (purchased) or internally generated. Trademarks, patents and many other intangible assets may also be purchased or internally generated. Where such assets are acquired in an arm’s-length transaction, the transaction may result in a reliable measure of the amount of the asset. Where such assets are internally generated there may be some minor cost involved (for example, in registering a trademark) but this is unlikely to represent the full cost of developing the asset. Is the distinction: (i) consistent with Framework 2014? – the definition of assets makes no distinction between assets that are internally generated and those that are acquired. The key elements of control, future economic benefits and past event may be satisfied for both acquired and internally-generated intangible assets. The recognition criteria for assets, especially the reliable measurement criterion, may provide a reason for distinguishing between acquired and internally-generated intangible assets. A purchase transaction provides reliable evidence of the amount of the asset. Note, however, that expert valuations are also accepted as reliable measurements (for example, for asset . 3

revaluations) and thus may provide a basis for reliable measurement of internally generated intangible assets. (ii) a useful basis for financial reporting differences? – basing financial reporting requirements on the acquired/internally generated distinction provides an implementable and practical basis to differentiate different financial reporting requirements for different categories of items. But, the distinction has no conceptual or theoretical basis hence it is unlikely to result in conceptually sound and theoretically defensible financial reporting. 4

In many cases, Framework 2014 and AASB 138 ‘Intangible Assets’ would lead to the same conclusion – internally-generated brands, mastheads etc should not be recognised as assets. However, AASB 138 requires this conclusion no matter what the circumstances. Framework 2014 allows the possibility that there may be circumstances where internallygenerated brands, mastheads etc do satisfy the definition of and recognition criteria for assets and hence would be recognised as assets. Paragraph 64 of AASB 138 indicates that ‘expenditure on internally generated brands, mastheads, publishing titles, customer lists and items similar in substance cannot be distinguished from the cost of developing the business as a whole. Therefore, such items are not recognised as intangible assets.’ The reason for the AASB 138 prohibition is likely to be pragmatic rather than conceptual. Such a policy gives certainty and is easily enforced. Framework 2014 is conceptually sound, but would be difficult to police and might open up opportunities for aggressive and misleading financial reporting.

The immediate expensing of the cost of intangibles is usually justified on three grounds: (i) The cost of some intangibles is an allowable deduction for income tax purposes in the period in which the cost is incurred. While it may be convenient to use the same treatment for both taxation and financial reporting purposes, it may not be appropriate to do so. Accounting profit should be measured using accounting concepts and standards. There is no expectation that taxable income and accounting profit should be the same. (ii) Accountants sometimes suggest that recognising the cost of intangible assets as expenses in the period in which the cost is incurred is justified because of uncertainty about the amount and timing of the future economic benefits from them. The Framework 2014 provides that assets should be recognised in the financial statements when the receipt of future economic benefits is probable and the cost or other value of the asset can be measured reliably. In the case of intangible assets acquired in an arm’s-length transaction, there is no reason to believe that the probability of receiving future economic benefits is consistently lower than the . 4

probability of receiving future economic benefits from acquired tangible assets, or that the measurement of the cost or other value is consistently more unreliable. However, in the case where intangible assets are developed internally, there may be more uncertainty about the recovery of future economic benefits and the amount that should be recognised as the cost of the asset. This higher level of uncertainty may be used to justify prohibiting the recognition of (some) internally-generated intangible assets. (iii) Another reason for the immediate expensing of the cost of intangible assets is that the amount is frequently immaterial. If the cost of an intangible asset is not material, then the immediate expensing of the cost would be justified. However, this argument would not support immediate expensing in all cases, but only in those cases where expenditure on intangibles was immaterial. Further, as noted in the answer to question 2, businesses appear to be spending more, not less, on intangibles hence the materiality argument may apply less and less. 6

The initial recognition of purchased intangible assets should not involve a great deal of judgement, but the subsequent measurement of purchased intangible assets requires judgements about the use of the cost model or revaluation model and whether the assets have finite or indefinite useful lives. To the extent that entities adopt a policy of capitalising internally-developed intangibles, considerable judgement will be necessary in deciding whether future economic benefits are expected to be generated. If such assets are capitalised the issues of subsequent measurement again come to the fore. However, requiring entities to expense all intangibles would be inappropriate where the expenditure on such assets gives rise to future economic benefits. In the context of Framework 2014, it is inevitable, therefore, that an appropriate accounting policy for intangibles assets such as research and development costs will require the application of professional judgement.

(a) The financial reporting requirements for initial recognition of intangible assets are summarised in Table 10.1:

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Table 10.1 Requirements for initial recognition and measurement of intangible assets under AASB 138 ‘Intangible Assets’ Accounting issue

1. Initial recognition

2. Initial measurement

Method of acquisition of intangible asset Acquired Internally generated Separately Part of business Research phase Development phase combination Meet definition Meet definition No intangible Meet definition of of intangible of intangible assets may be intangible asset (para. asset (para. 8asset (para. 8recognised as 8-17) and recognition 17) and 17) and arising from criteria (paras 21-23) recognition recognition research or the in AASB138 AND criteria (para. criteria (para. research phase meet six additional 21-23) in 21-23) in of a project criteria from para 57. AASB138. AASB138. (para. 54). Specific prohibition on recognition of Note: The Note: The internally generated probability probability brands, mastheads, recognition recognition publishing titles etc criterion is criterion is (para. 63). always always considered to considered to be satisfied for be satisfied as separately is the reliable acquired measurement intangible criterion (para. assets (para. 33). 25). Measured at Measured at Not applicable. Measured at cost cost (para. 24). cost (para. 24). (para. 24). Cost is Cost is Cost is measured as the sum measured as measured as of expenditure purchase price fair value at incurred from the date plus costs acquisition the intangible asset directly date. first meets the attributable to recognition criteria preparing the (para 65). asset for its intended use (para 27-28).

The requirements for subsequent measurement are summarised in Table 10.2:

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Table 10.2 Requirements for subsequent measurement of intangible assets under AASB 138 ‘Intangible Assets’ Measurement base Cost model Revaluation model Carrying amount Intangible asset carried at cost Intangible assets revalued to fair value less accumulated amortisation less any subsequent accumulated and any accumulated impairment amortisation and any accumulated losses (para. 74). impairment losses (para. 75). This basis is only permitted if there is an active market for the asset. Subsequent Test for impairment in Test for impairment in accordance with impairment accordance with AASB 136. AASB 136. If useful life is finite: tested when If useful life is finite: tested when there there are indicators of are indicators of impairment. impairment. If useful life is indefinite: tested at least If useful life is indefinite: tested annually and when there are indicators of at least annually and when there impairment. are indicators of impairment. Subsequent Required if Not required if Required if Not required if useful amortisation useful life is useful life is useful life is life is indefinite. finite. Use zero indefinite. finite. residual value, unless an active market exists.1 1

Residual value shall be assumed to be zero unless a) there is a third-party commitment to purchase the asset at the end of its useful life or b) there is an active market for the asset as defined in AASB 13 and the residual value can be determined by reference to that market and it is probably that such a market will exist at the end of the asset’s useful life. (AASB 138: para. 100).

(b) The following points may be relevant: • Australia is less conservative than the US in that some internally-generated development assets may be recognised, subject to meeting quite strict conditions as specified in AASB 138 paragraph 57. However, comparatively few Australian companies capitalise research and development costs; • Australian reporting requirements do require recognition of acquired identifiable intangibles. The purchase price is a reliable measure of the future expected benefits from the asset. • Post IFRS adoption, however, the recognition of intangible assets is far more restrictive and more conservative that Australian financial reporting practices preIFRS adoption.

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Regulators (ASIC) and standard setters used to be more concerned about amortisation than recognition/measurement of identifiable intangibles. Under current standards, amortisation is not required if the intangible has an indefinite useful life. The collapse in share values of many 'new economy' companies calls into question Lev and Zarowin’s assertions about the importance of this issue.

Paragraph 88 of AASB 138 ‘Intangible Assets’ states ‘an intangible asset shall be regarded by the entity as having an indefinite useful life when, based on an analysis of all the relevant factors, there is no foreseeable limit on the period over which the asset is expected to generate net cash inflows for the entity.’ Paragraph 90 identifies a number of factors that should be considered in making this decision. These include: assessment of typical product life cycles; technical, technological and commercial obsolescence; the stability of the industry in which the asset is used; the expected actions of competitors; the period of the entity’s control over the asset. Paragraph 92 indicates that, given rapid changes in technology etc, the useful lives of most intangible assets should be short. If an intangible asset has a finite life, it is to be amortised over that useful life. If an intangible asset has an indefinite useful life, it is not to be amortised. Both classes of intangible asset are subject to an impairment test at least annually.

Paragraph 111 of AASB 138 indicates that impairment testing is to be carried out in accordance with the provisions of AASB 136. First, intangible assets with indefinite lives have to be tested for impairment annually and when there are indicators of impairment. Second, recoverable amount is the higher of fair value less costs to sell and value-in-use. AASB 136 identifies three sources of measurement of fair value. The best measure is price in a binding sale agreement, the next best is bid prices in an active market and finally the price that willing, knowledgeable parties would agree in an arm’s length transaction. As noted above, very few intangible assets trade in active markets, hence in measuring fair value, reliance is likely to be placed on estimates of market prices. However, the unreliability of estimated market prices for intangible assets is one of the main reasons why revaluation of intangible assets is not permitted by AASB 138 (unless they trade in active markets). Measurement of value-in-use requires an estimate of the future cash flows the entity expects to derive from the asset (AASB 136, para. 30). For intangible assets, estimating future cash flows is extremely difficult, especially in light of Lev’s (2002) argument that intangibles are essentially inert and their capacity to generate cash flows depends on them being embedded in appropriate systems and procedures. While this may be accommodated by measuring value-in-use for cash generating units rather than individual intangible assets, the point remains that estimating recoverable . 8

amount for the purposes of impairment testing will involve significant judgement. Arguably, this requires a greater amount of judgement than would be required to recognise and measure internally generated brand names based on estimated fair values between willing, knowledgeable parties. Yet the latter procedure is not permitted by AASB 138. 10 Research is defined as ‘original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding’ (para. 8). Research is seen as the pursuit of knowledge, without any defined commercial objective. Development is defined as ‘the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services before the start of commercial production or use’ (para. 8). Development is focused on commercial application prior to production. Selective capitalisation of internally generated research and development costs is required by AASB 138. All research costs must be recognised as expenses in the period of outlay. Development costs, on the other hand, may be recognised as intangible assets, provided they meet the definition of intangible assets (paras 8–17 of AASB 138), the recognition criteria for intangible assets (paras 21–23 of AASB 138) and the six additional conditions specified in paragraph 57 of AASB 138. The six additional conditions to be met are as follows: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale; (b) the company’s intention to complete the intangible asset and use or sell it; (c) the company’s ability to use or sell the intangible asset; (d) how the intangible asset will generate probable future economic benefits. Among other things, the company must demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself, or, if it is to be used internally, the usefulness of the intangible asset; (e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and (f) the company’s ability to measure reliably the expenditure attributable to the intangible asset during its development. The expensing of all research costs and the specification of strict criteria for the capitalisation of internally generated development costs are justified because of uncertainty about the receipt of future economic benefits. It is notable that paragraph 34 . 9

of AASB 138 permits the recognition of research and development purchased in a business combination when it ‘meets the definition of an intangible asset and its fair value can measured reliably’. Purchased research and development is not specifically required to meet the probable future economic benefits recognition criterion for asset recognition in the Framework, nor is it required to meet the six conditions outlined above. This is presumably because fair value reflects the future economic benefits expected from the research and development. 11 The Framework 2014 approach is to determine the accounting treatment of research and development expenditure based on whether it satisfies the definition and recognition criteria for assets. It seems apparent that any blanket policy of expensing or capitalising is likely to be inconsistent with the requirements of Framework 2014. 12 The major costs of discovering a patentable product or process will be research and development costs. However, AASB 138 ‘Intangible Assets’ prohibits the capitalisation of costs arising from the research phase of a project. Thus, only development costs may be included in costs capitalised as patents and these may only be included if six conditions are satisfied (AASB 138, para. 57). In addition, there will be legal costs, administration costs and registration fees associated with securing a patent, but these are likely to be small relative to the research and development costs. Having established the cost of the patented product or process, it will be necessary to estimate the useful life of the patent. Normally the life of the patent would be finite (term of patent and any period of renewal) and thus the provisions of AASB 138 in relation to indefinite lives are unlikely to apply. However, the intention or likelihood of renewal must be consistent in the decision making and therefore the life may be restricted by the term of the patent. Paragraph 94 of AASB 138 indicates that the life of intangible assets arising from legal rights shall not exceed the period of the legal rights, but may be shorter. 13 Arguably, the definition of intangible assets in AASB 138 encompasses computer software. The key elements of the definition of intangible assets are identifiability, control and future economic benefits. Computer software is able to meet all these requirements. Purchased computer software is thus likely to be recognised as an asset and recorded at cost. The rapid technological change referred to is an important issue in determining the useful life of this asset, but is not a reason for failing to recognise it as an asset when it is purchased.

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14 AASB 138 ‘Intangible Assets’ distinguishes intangible assets from goodwill by requiring that intangible assets be identifiable. Intangible assets are therefore identifiable assets and include patents, copyrights, research and development, trademarks, brand names, newspaper mastheads, television and radio licenses and franchises. Goodwill represents future economic benefits from assets that are not capable of being individually identified and separately recognised (AASB 3 Business Combinations - Definitions). As goodwill lacks the characteristic of identifiability, in accordance with the AASB 138 definition, it is not an intangible asset. An entity may have a number of ‘assets’, such as loyal and efficient employees, an established clientele and good image. Collectively, these are referred to as goodwill. Although unidentifiable, these ‘assets’ make an entity’s value as a going concern greater than the sum of the fair values of its identifiable net assets. Thus, the earning power of most entities cannot be attributed solely to identifiable assets. The identifiability criterion allows a clear distinction to be drawn between intangible assets and goodwill, but identifiability is not part of the Framework 2014 definition of assets. A possible explanation of the need to distinguish between intangible assets and goodwill is that, by convention, goodwill is only recognised when it is acquired as part of an arm’s-length acquisition of one entity or a business by another entity. Except in these circumstances, goodwill is omitted from the accounting records, whereas, intangible assets may be recognised irrespective of whether they have been acquired or internally generated. It is argued that a reliable measure of goodwill is available only when one entity purchases another entity or a business. 15 In accounting, the term ‘goodwill’ has been used to describe an entity’s unidentifiable intangible assets. AASB 138 ‘Intangible Assets’ now requires that intangible assets be identifiable. As goodwill is not identifiable, according to AASB 138, it is not an intangible asset. Goodwill can only be sold or purchased as a part of the entity as a whole. It is not a separate vendible asset. Consequently, it is generally agreed by accountants that goodwill should not be recognised in the accounts unless there is an arm’s-length purchase of one entity or business by another entity. The policy adopted by SmithCo is clearly contrary to this requirement. Advertising costs would be recognised as an expense in the period in which those costs were incurred, unless they are expected to give rise to future economic benefits in which case they should be recognised as an asset provided they meet the asset recognition criteria of Framework 2014. 16 The main argument for the systematic amortisation of goodwill is that given the cost or other value of long-lived tangible assets is required to be systematically depreciated, why should goodwill be any different? The allocation process results in smoother, less . 11

volatile reported profits. The main arguments against systematic amortisation are the difficulties of estimating the useful life of goodwill and determining the pattern of consumption of future economic benefits. Any allocation is bound to be arbitrary. Arguably, impairment is better able to capture the unpredictable changes in value that goodwill is likely to suffer. However, measuring the recoverable amount of goodwill is likely to be extremely subjective (measurement difficulties and the lack of identifiability are the main reasons for prohibiting the recognition of internally-generated goodwill, presumably both arguments apply equally to the impairment testing of goodwill). AASB 3 gives no reason for requiring impairment but not systematic amortisation. 17 A number of methods of accounting for goodwill have been suggested including: (a) goodwill is written-off immediately, preferably against retained earnings or reserves; (b) goodwill is recognised as an asset and remains in the statement of financial position unamortised and not subject to an impairment test; (c) goodwill is recognised as an asset and is amortised systematically; and (d) goodwill is reported not as an asset but as a separate deduction from equity. A number of methods have also been suggested to account for excess on acquisition (negative goodwill or discount on acquisition), including: (a) negative goodwill is recognised as a deferred credit which is amortised systematically to the statement of comprehensive income; (b) negative goodwill is credited immediately to retained earnings; (c) negative goodwill is recognised as an item of income in the statement of comprehensive income in the year of acquisition; and (d) negative goodwill is allocated to the identifiable net assets purchased so that the carrying amounts of those net assets represent their ‘cost’ to the purchaser. Students are required to consider these alternatives in answering the question, reach a conclusion and give reasons for their conclusion. 18 The reasons for recognising goodwill only if there is an arm’s-length transaction are as follows: (a) recognition of internally-generated goodwill would not conform to the historicalcost basis of accounting for assets, because the measurement of internally-generated goodwill is not transaction based and, of necessity, involves a valuation process, However this is a weak argument as, under existing accounting standards, internallygenerated, identifiable intangibles may be recognised without an arm’s-length . 12

transaction and the option to measure assets under the revaluation model means that many assets are not measured using historical cost. (b) if there is an arm’s-length transaction, then the measurement of goodwill is more reliable. AASB 138 justifies the prohibition on recognising internally-generated goodwill on the grounds that internally-generated goodwill is not identifiable. However, as identifiability is not a requirement of the Framework 2014 definition of or recognition criteria for assets, it is hard to see that this argument has much substance. 19 Note that AASB138 deals with intangible assets which are defined so as to exclude goodwill. Apart from paragraph 48 which prohibits the recognition of internally generated goodwill, AASB138 has virtually nothing to say about goodwill and does not require impairment testing of goodwill. AASB 3 requires the subsequent measurement of assets acquired in a business combination to be in accord with the requirements of relevant accounting standards (AASB136). AASB 136 requires goodwill to be tested for impairment at least annually. In general, an asset is impaired when the carrying amount of the asset exceeds its recoverable amount. For the purposes of measuring goodwill impairment, goodwill must be allocated to the cash-generating units to which it relates. To measure the amount of goodwill impairment it is necessary to measure the difference between the recoverable amount of the cash-generating unit (defined as the higher of the fair value less costs of disposal and value-in-use of the cash-generating unit) and the net fair value of the identifiable assets, liabilities and contingent liabilities the entity would recognise if it acquired the cash-generating unit at that date. If this amount is less than the carrying amount of goodwill the goodwill must be written down to the lower amount. Impairment testing of goodwill thus requires estimates of the expected net cash flows to be generated by cash generating units and the discounting of these net cash flows to present value using a discount rate that reflects both the time value of money (current market risk-free rate of interest) and the risks specific to those assets. Given the difficulties and complexities of measuring the recoverable amount of cash generating units and the residual nature of the measurement of goodwill, the impairment testing of goodwill is an extremely subjective process. Arguably, impairment testing is at least as difficult and probably as reliable as measuring internally generated goodwill or revaluing purchased goodwill. However, both of the latter procedures are not permitted under current Australian accounting standards.

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20 Goodwill is measured at cost less accumulated impairment losses. This is different to the subsequent measurement of intangible assets in two respects: (a) AASB 3 ‘Business Combinations’ does not permit the use of the revaluation model for goodwill. AASB 138 ‘Intangible Assets’ allows both the revaluation model and the cost model for subsequent measurement of intangible assets. However, the revaluation model is restricted to intangible assets traded in active markets. As very few intangible assets trade in active markets, there is little real difference between goodwill and intangible assets on this point; (b) AASB 3 does not permit systematic allocation of goodwill. AASB 138 requires that intangible assets must be systematically amortised, except where they have indefinite useful lives (in which case, no amortisation is required). Arguably, very few intangible assets have indefinite lives, hence this difference is a substantive one. 21 An accounting policy for goodwill consistent with Framework 2014 would differ from the requirements of AASB138 and AASB3 in two main respects: •

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the prohibition on the recognition of internally-generated goodwill contained in paragraph 48 of AASB 138: under Framework 2014 if goodwill satisfies the definition of assets and the recognition criteria for assets, then it should be recognised as an asset irrespective of whether the goodwill is purchased or internally generated. systematic amortisation versus impairment testing for goodwill: arguably, when compared to impairment testing, systematic amortisation of goodwill leads to smoother, less volatile reported profits. Smoother profits are arguably more relevant to users, hence it might be argued that under Framework 2014, systematic amortisation is to be preferred. Ultimately, this is an empirical question. A further point is that both systematic amortisation and impairment are required for intangible assets (other than those with indefinite lives), and arguably both should be required for goodwill.

If intangible assets are considered more strictly, then AASB 138 is the relevant authority. Several aspects of AASB 138 appear contrary to Framework 2014. For example, the prohibition on recognising internally-generated brands, mastheads etc as assets. Also, the insistence that ‘research’ activities cannot give rise to assets but ‘development’ activities can, seems arbitrary and potentially in conflict with Framework 2014.

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PROBLEMS INTANGIBLE ASSETS 1 Techplus Ltd Report on managing director’s views:

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The managing director wants to capitalise all non-capital spending on the grounds that it contributes to development of intellectual capital. There is no precise definition of what intellectual capital is. Some elements of intellectual capital (for example, staff loyalty) may be considered to be part of goodwill. Recognition of internally-generated goodwill is not permitted. This was the view taken by ASIC when it prevented OneTel Ltd from capitalising staff training and other costs. AASB 138 requires that intangible assets must be ‘identifiable’. For ‘intellectual capital’ to be an intangible asset it must be capable of being separated from the entity and sold or transferred to another party or arise from contractual or other legal rights regardless of whether those rights are transferable or separable. It seems highly unlikely that ‘intellectual capital’ satisfies this test. The managing director’s proposal to capitalise these items fails immediately as they don’t qualify as intangible assets.

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AASB 138 prohibits capitalisation of ‘research’ expenditure. Only ‘development’ expenditure can be capitalised. Given that the company seems to be at an early stage with its projects, it seems likely that all (or a very large part) of the expenditure is ‘research’ and hence cannot be capitalised. AASB 138 defines research as ‘original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding’

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AASB 138 allows ‘development’ expenditure to be capitalised if six conditions outlined in paragraph 57 are satisfied. Even if some of the project expenditure qualifies as ‘development’, there seems to be no indication that these six conditions could be satisfied. There is insufficient information provided to debate whether the six conditions could be met and hence any consideration required to be given to requirements for assessment of amortisation or impairment of development expenditure. Again, the managing director’s proposals would fail under AASB 138.

New Motor Ltd (a) Students would be expected to outline an appropriate accounting policy for research and development. This policy should include a prohibition on recognition of research expenditure as an asset, the requirement that development expenditure is only capitalised when six conditions are satisfied, the initial recognition of any development assets at cost, the inability to apply the revaluation model due to the lack of active markets for the . 15

assets, the cost of such assets to be systematically allocated over their useful life, the life of such assets, the amortisation method used, the impairment testing of the carrying amount of such assets at least annually. (b) New Motor Ltd Statement of Comprehensive Income for the year ended 30 June 2018 ______________________________________________________________ $ $ Sales revenue 15 000 000 less Cost of goods sold Production costs 9 000 000 Amortisation of R&D 300 0001 Depreciation: Plant 500 0002 9 800 000 less Closing inventory 2 450 0003 7 350 000 Gross profit 7 650 000 less Expenses Administration 800 000 Selling 600 000 Advertising 400 000 1 800 000 Profit before income tax 5 850 000 Income tax expense 2 500 000 Profit for the period $3 350 000 Other comprehensive income 0 Total comprehensive income $3 350 000 _______________________________________________________________

All the costs incurred in developing the engine have been assumed to have been capitalised (total $6m). Management has decided to amortise the development costs over the same period as the life of the plant. The company has capitalised $6 million which will be amortised over 10 years. Given six months of operations, only six months’ amortisation is charged.

Depreciation is calculated as $10 000 000 / 10 year x ½ year = $500 000

Closing inventory is equal to ¼ (5/20) of total production cost. ($9 800 000 x ¼) Optimistic Ltd AASB 138 prohibits the capitalisation of research costs, thus to the extent that any of the $1 250 000 spent in 2016-17 is research expenditure, it must be recognised as an expense. The question is not clear on this point, but implies that the product is nearly complete, hence it would be expected that the expenditures are development costs. . 16

Development costs can be capitalised only if six conditions are met: The question gives little information relevant to assessing whether these conditions are satisfied. Considerable doubt must exist over conditions (d) and (e). Does the company have a clear plan as to how the probable future benefits will be derived? Does the company have the resources to ensure these plans are met? Hence there seems good reason to suggest that the expenditures should not be capitalised. The following general journal entry would therefore be passed: _________________________________________________________________ 30 June 2017 Research expense Dr $1 250 000 Various accounts Cr $1 250 000 _________________________________________________________________ Profit before tax and research and development expense is $25 000. Research and development is not deductible for tax purposes. (Note: Research expenditure, whilst not deductible, is available as a tax credit. For the purposes of this question, the implication of tax credits for research expenditure is ignored). AASB 112 ‘Income Taxes’ requires that there be probable future economic benefits before a deferred tax asset arising from a tax loss can be recognised. Provided the obtaining of tax benefits is probable, the deferred tax asset would be recognised. The same reasoning would apply to the priorperiod losses. Based on tax losses of $1 975 000 ($750 000 prior period loss + $1 225 000 current period loss), a deferred tax asset would be recognised as follows: _________________________________________________________________ 30 June 2017 Deferred tax asset Dr $592 500 Deferred income tax expense Cr $592 500 (to record DTA arising from unused tax losses for 2017 and 2016) ________________________________________________________________ The deferred tax asset is recognised at the tax rate expected to apply (i.e. 30%). Note that where the firm has a history of recent tax losses, the tax benefit of tax losses can be recognised only if there is convincing other evidence that sufficient taxable income will be earned. 4

Aerial Survey Ltd (a) Initial recognition and subsequent measurement of intangibles: AASB 138 is the relevant accounting standard. AASB 138 requires intangible assets that are purchased to be recorded as assets initially using the cost basis. Internally-generated intangibles other than mastheads, brand names etc may be recognised as assets and . 17

initially measured on the cost basis. However, costs incurred in the research phase cannot be capitalised and costs incurred in the development phase may only be capitalised if six conditions are met. As the trade names were purchased they must be recognised as an intangible asset and initially measured at cost. Subsequent measurement of intangibles may be under the cost model or the revaluation model. However, the revaluation model may only be applied if there is an active market. As most intangibles do not have active markets, effectively intangible assets cannot be revalued. For the purposes of amortisation of intangibles, the standard classifies intangible assets into: • those with finite useful lives, which are to be amortised over their expected useful lives; and • those with indefinite useful lives, which are not to be amortised. The expected life of trade names would be difficult to estimate. There are examples of trade names that appear to have indefinite lives. However, this would not apply to most trade names. It seems likely that AASB 138 requires amortisation of trade names. The CEO’s estimate of a 10 year life seems reasonable but there is no indication of how that figure was arrived at. (b) Capitalisation of the Aerodata Database AASB 138: capitalisation is justified if the costs are development costs and if the six conditions set down in AASB 138 are satisfied. It seems clear that expenditure on the Aerodata database is not ‘research’ as defined in AASB 138. It is less clear whether the six conditions are satisfied. However, this is a product that is already being sold and these are further enhancements to an existing, successful product. Hence it seems highly likely that there are strong arguments to suggest that the six conditions set out in AASB 138 would be satisfied. AASB 138 also imposes an impairment test for intangible assets. (c) Define recoverable amount The relevant existing standard is AASB 136 ‘Impairment of Assets’ which defines recoverable amount as ‘the higher of its fair value less costs of disposal and its value in use’. Value in use is defined as ‘the present value of the future cash flows expected to be derived’. Value in use is determined by applying present value techniques using a company specific discount rate. Thus, discounting is required under current accounting

. 18

standards. The question contains no information about the fair value less costs of disposal, so it is impossible to say whether a write-down is required. However, the estimate of value in use given in the question ($11 100 000) is below the asset’s carrying amount (12 250 000 + 2 140 000 – 1 820 000 = $12 570 000), hence unless fair value less costs of disposal exceeds carrying amount, a write down will be required. 5

Builders Supplies Ltd (a) Apply the provisions of AASB 138 Amount of research expenditure recognised as an expense AASB 138 defines research as ‘… original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding’ The on-line sales team project seems to have much more specific objectives and would not be classified as research. Therefore, there is no research expenditure recognised as an expense. (b) The amount of development expenditure recognised as an expense Development is defined as ‘the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services before the start of commercial production or use’ The cost incurred in the on-line sales project all appear to be development costs. The components of development cost for 2017 are: •

•

the amortisation of the computer equipment ($200 000, based on straight-line method over a five-year life with zero residual value. Note that the total cost of the computers would be capitalised as plant and equipment), the software: while it could be argued that this should be capitalised and only the amortisation treated as a research and development cost, the approach taken is to treat the whole amount as a research and development cost = $380 000; and the consultants’ fees of $620 000

In order for these costs to be capitalised, the six conditions set out in paragraph 57 of AASB 138 would need to be satisfied. The question lacks details about the technical feasibility of the project and about the existence of a market for the output of the intangible asset. While there seems to be reliable measurement of the development costs incurred, in the absence of further information, recognising these costs as expenses seems the only sensible choice. . 19

CSL Limited Annual Report - Accounting policies and disclosures (a) The principal activities of the entity are the research, development manufacture, marketing and distribution of biopharmaceutical and allied products (Directors report note 4). The nature of intangibles reported by CSL Limited (Note 7 to the Financial Report 89-90) include goodwill, intellectual property, software and intangibles capital work in progress. Goodwill is defined as any excess of the fair value of the purchase consideration over the fair value of identifiable nets assets. Intellectual Property is not explained however additions for the year indicated as being related to a distribution agreement. Software includes capitalised costs incurred in developing or acquiring software, licences or systems that will contribute to future financial benefits. No details are provided as to the nature of the capitalised costs ‘Intangible capital work in progress’. Note 6 of the accounts identify that research and development expenditures are expensed as incurred as uncertainty exists until the point of regulatory approval as to whether that research and development project will be successful. At the point of approval the total cost of development has largely been incurred. On this basis CSL does not consider capitalisation is available for the development costs. (b) Initial recognition and subsequent measurement of intangibles identified Intangible item Research and development Goodwill (unidentifiable intangible)

Initial Recognition and Measurement Cost - expensed Cost in accord with earlier definition part (a)

Intellectual property

Subsequent Measurement Not applicable Goodwill is allocated to CGUs, is not amortised, but is tested annually for impairment Cost less accumulated amortisation and impairment, asset has a finite life and is amortised Cost less accumulated amortisation and impairment, assets have finite life 3-10 years and are amortised

Cost arising from acquisition or business combination - not internally generated Software Cost - including external and some internal direct costs and only in respect of development phase on completion of technical feasibility Intangible capital work in No separate policy provided No details provided progress .

Intangibles are assessed to have finite or indefinite lives where finite the costs amortised over the useful life with amortisation period and method reviewed at reporting date. Indefinite life assets are not amortised but the assessment of the indefinite life is reviewed at reporting date and assessment of impairment is also conducted. A conservative approach is adopted by CSL on capitalisation of development costs due to particular nature of the business environment in which the company operates. No details are provided to the user on the ‘Intangible capital work in progress’ category which makes it difficult to complete a full evaluation of CSL’s policies on all intangibles. The policies disclosed and adopted by CSL appear to be consistent with AASB 138 in respect of the various categories of intangible assets as outlined above. (c) The main disclosures required by AASB 138 in relation to intangible assets are outlined in paragraph 118. For each class of intangible asset the entity must distinguish between internally generated and other intangibles and indicate whether their useful lives are indefinite or finite and, if finite, the estimated length of life and the amortisation method used. The main disclosures also include a detailed reconciliation showing opening and closing balances, any additions during the period, the amount of any amortisation and/or impairment. (d) CSL Limited - Disclosures Evaluation Disclosure required in CSL Note reference accord AAS 138 Useful life - finite/infinite Note 7 - by type of asset (para. 118 (a)) Amortisation methods for Note 7 - by type of asset finite life assets (para. 118 (b)) Gross carrying amount beginning and end of period (para. 118 ( c)) Line items of comprehensive income in which amortisation of intangible is shown (para. 118 (d))

Meets Requirements

Yes - except Intangible Capital Work in Progress Software - straight line basis. Intellectual property and Intangible Capital Work in Progress not clear Note 7 - by type of asset Net carrying amounts are provided in the table page 89. Gross carrying amounts can be calculated. Statement of Amortisation is not Comprehensive Income separately identified in Note 2 Revenue and Statement of Expenses Comprehensive income Note 7 - by type of asset where expenses are classified by function. . 21

Reconciliation of carrying Note 7 - by type of asset amount at beginning and end of period (para. 118 (e))

Note 2 discloses amortisation amount which agrees to Note 7 amount. There is no indication of allocation of amortisation across functions. Yes / No Additions not separate internally generated from acquired. No impairment losses noted. Amortisation by type provided. Exchange differences provided. Transfers between classes noted.

The intangible asset Note 7 table does not distinguish in the case of software those assets that have been internally generated and those that have been acquired or are other intangible assets. The information shown in Note 7 of CSL Limited financial statements includes goodwill as part of intangible assets. This is inconsistent with AASB138 which argues that goodwill is not an intangible asset as it is not separable and hence not identifiable. In summary, there are some inconsistencies as highlighted in the table above in meeting the required disclosures but many seem consistent with the requirements of paragraph 118. 7

Global Innovator Project 1 – Product Rosehip • development costs incurred to 30 June 2017 – capitalised $1 600 000 • development costs incurred July – December 2017 capitalised $1 100 000 • production commenced 1 Jan 2018 – expected benefit 6 years. • Amortisation of development costs $2 700 000/6 = $450 000 pa Project 2 – Research • costs incurred to 2016/2017 - expensed • costs incurred to 2017/2018 – expensed • further research required – development to commence in 2019

$500 000 $400 000

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Project 3 – Product Jasmine • research costs incurred 2015/2016 - expensed • applied research costs incurred 2016/2017 - expensed • development costs 2017/2018 – capitalised • commercial production commencing December 2018 • no amortisation in 2017/2018 as production not commenced. (Amortisation will commence when asset is available for use in December 2018 (AASB 138 para. 97).) Project 4 – Product Apple • research costs incurred 2016/2017 – expenses • development costs 2017/2018 • May 2018 – project abandoned – write-off development costs

$300 000 $400 000 $600 000

$900 000 $500 000

(a) Statement of Comprehensive Income - extract Research and development costs recognised as expenses in the statement of comprehensive income are: Amortisation of development costs – project one (½ year only) 225 000 Research costs – project 2 400 000 Written of development costs – project 4 500 000 $1 125 000 (b) Statement of Financial Position as at 30 June 2017 and 30 June 2018 - extract Development costs recognised as an asset in the statement of financial position are 2017 2018 Development asset – project 1 $1 600 000 $2 700 000 less accumulated amortisation 0 (225 000) 1 600 000 2 475 000 Development asset – project 3 -600 000 Total $1 600 000 $3 075 000

Systex Telco Ltd First step is to calculate the amount of expenditure that might be considered to be research and/or development cost. •

Calculation of long-service leave expense

Stephanie – commencement date: 1 July 2011 Date 30 June 2017 30 June 2018

Years of Service 6 7

Projected Salary $168 000 x 13/52 x 6/15 $171 000 x 13/52 x 7/15

Discount Rate (1.065)-9 (1.065)-8

Prob.

Projected Salary

Discount Rate

Prob.

$159 000 x 13/52 x 3/15 $164 000 x 13/52 x 4/15

(1.065)-12 (1.065)-11

0.25 0.35

0.62 0.72

LSL Liability $5 910 $8 708

LSL Expense

LSL Liability

LSL Expense

$2 799

Nicholas – commencement date: 1 July 2014 Date

Years of Service

30 June 2017 30 June 2018

3 4

Stephanie

Current salary Long-service leave

$152 000 2 799 $154 799

Nicholas

Current salary Long-service leave

$132 000 885 $132 885

•

$ 933 $1 818

$ 885

Depreciation of building On 1 January 2018, when building revalued, the remaining useful life is 30 years – 10 years = 20 years. Depreciation July – Dec 2017

2 000 000 1  30 2

= $33 333

Depreciation Jan – June 2018

3 500 000 1  20 2

= $87 500 $120 833

•

Allocation of costs to each project

Cost Item Stephanie – $154,799 Nicholas – $132,885 Depreciation - $120,833 Materials - $300 000 Total - $708 517

Project 1 $30,960 ($154 799 x 20%) -

Project 3 $92,879 ($154 799 x 60%) -

Admin $15,480 ($154 799 x 10%) -

$36,250 ($120 833 x 30%) $150 000

Project 2 $15,480 ($154 799 x 10%) $132,885 ($132 885 x 100%) $24,167 ($120 833 x 20%) $90 000

$12,083 ($120 833 x 10%) $60 000

$48,333 ($120 833 x 40%)

$217 210

$262 532

$164 962

$63 813

Electricity charges should not be allocated to projects because there is no reasonable basis for allocating those costs to projects. •

Capitalise or expense research and development?

AASB 138 requires all research costs to be expensed, whereas, development costs may be capitalised if six conditions are met. Project 1 - $217,210 Systex has completely developed the technology required for visual telephones and a market survey has established that there is a large market. This project seems to have the best chance of meeting the conditions for capitalisation. The market survey seems to satisfy test (d), but there is nothing said about the availability of adequate financial and other resources to complete the development (e). The amount of development expenditure seems to be reliably measurable hence, despite the above concern, it could be argued that all costs associated with Project 1 are to be capitalised. Project 2 - $262,532 In this case, while the expenditures are all arguably development expenditures, they do not meet the conditions for capitalisation. While the project appears to be technically feasible, it is hard to see that all six conditions for capitalisation are met. Therefore, Project 2 development costs must be recognised as expenses. Project 3 - $164,963 Some of the expenditure on this project may be classed as research expenditure, which must be expensed. For those expenditures that would be classed as development expenditure, as the chance of successfully developing a new type of telecommunications cable is low, it is clear that this project does not yet satisfy the condition of technical feasibility; hence the Project 3 development costs must be recognised as expenses.

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Conclusion Research and development costs recognised as expenses in the statement of comprehensive income are: $262 532 + $164 963 = $427 494. Development costs recognised as an asset in the statement of financial position are: $217 210. 9

Sugarcube Drug and Chemical Ltd (a) Research and development costs incurred on a specific project in the current reporting period should be deferred to future periods, only to the extent that any development costs meet the six conditions set down in paragraph 57 of AASB 138. Thus to be recognised as an intangible asset, the costs must be development costs (not research) and must satisfy all six conditions set out in paragraph 57. Amounts carried forward as research and development asset are subject to an impairment test, such that if the recoverable amount falls below the asset’s carrying amount an impairment expense and accumulated impairment are recognised. (b) Project A It could be argued that the costs incurred in Project A are likely to be considered costs incurred in the development phase and therefore development costs. These costs could be capitalised as an intangible asset provided the conditions set out in paragraph 57 are met. Given there is considerable doubt about whether Sugarcube will successfully solve the problem of unacceptably high levels of the drug remaining in the chicken meat, condition (a), technical feasibility must be considered to be not satisfied, hence the costs associated with Project A cannot be recognised as an intangible asset. If any development costs incurred on Project A in previous periods were recognised as intangible assets, they should also be recognised as expenses in the current period, because they no longer meet the criteria for deferral. Project B Costs incurred in Project B appear to be development costs and hence may be capitalised if all six conditions set down in paragraph 57 of AASB 138 are satisfied. Sugarcube is confident that it will: i ii

develop the techniques required to economically mass produce the new fertiliser; and obtain large sales of the new fertiliser.

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Condition (a), technical feasibility, seems satisfied. However, condition (d) requires that the entity can demonstrate the existence of a market for the product. There is nothing in the question to suggest that Sugarcube has tested the market. It is unclear from the information whether all six conditions are satisfied. Therefore, all development costs incurred on Project B in the current period should be recognised as an expense. Any development costs incurred on Project B in previous periods, which were deferred in those previous periods, should be expensed. Project C Sugarcube has completed development of a new spray and is currently establishing production facilities for the new product. Sugarcube is confident of obtaining future economic benefits of $20 000 000. The costs incurred are all development costs and may be capitalised if all six conditions are satisfied. In this case, technical issues seem to be solved and production and sales issues also seem to be satisfied, hence it is appropriate to recognise the $5m incurred on this project as an intangible asset. Development costs of $1 200 000 incurred on Project C in previous periods, and deferred in those previous periods should continue to be carried forward, because they continue to meet the criteria for deferral. An issue to be considered is whether the sum of the development costs incurred in the current and previous periods exceed the recoverable amount of the asset. Figures provided indicate that the product will generate a ‘surplus’ of only $3m over its future (undiscounted?) costs. Thus, based on the impairment test, it is not possible to carry forward more than $3m as an intangible asset. In fact, if information were available to allow the calculation of the present value of the future cash flows (value in use), it is likely to be below $3m.The table below summarises the situation. ______________________________________________________________ Confident sales $20 000 000 Future costs 17 000 000 Undiscounted value in use 3 000 000 Development costs incurred 5 000 000 Previously deferred 1 200 000 Total intangible asset $6 200 000 ______________________________________________________________ While the $3 200 000 difference between $6 200 000 and $3 000 000 meets the criteria for recognition as an intangible asset, it fails the impairment test and would be recognised as an impairment loss. The impairment loss may be reversed in future periods

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if the conditions for impairment reversal in AASB 136 ‘Impairment of Assets’ are satisfied. 10 Eradication Laboratories Ltd (a) AASB 138 defines research as ‘… original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.’ Development is defined as ‘the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services before the start of commercial production or use’ A characteristic which helps distinguish development activities from research activities is that development activities have commercial objectives, whereas research activities do not. Research The activities undertaken during 2014 that are concerned with identifying a radically different poison useful for controlling pests would be classified as research. These activities were concerned with obtaining new knowledge. They did not have a particular practical aim or application, because the activities were not focused on identifying any particular chemical form of poison nor were they concerned with controlling any particular type of pest. Development The activities undertaken during 2015 and 2016 were concerned with developing a poison to eradicate mice. Initially the focus was on technical feasibility (finding a more concentrated form of the new poison so that the quantities of poison required to kill significant mice populations could be reduced). The activities undertaken during 2015 and 2016, were concerned with determining how to economically mass produce the new poison. (b) During 2014, research was undertaken. AASB 138 prohibits any expenditure on research from being recognised as an intangible asset. Hence the $1m incurred must be recognised as an expense. During 2015, the focus shifted to developing a specific mouse poison, and the activities undertaken could be classified as development. Development costs may be recognised as an intangible asset provided all six conditions set out in paragraph 57 of AASB 138 are . 28

satisfied. It is clear that during 2015 the technical feasibility requirement (a), was not satisfied. Hence costs on $3 500 000 incurred in 2015 must also be recognised as an expense. During 2016, further development was undertaken. Under AASB 138 development costs may be recognised as intangible assets, but all six conditions must be satisfied before that can occur. At this time the focus shifted to finding ways to economically produce the poison and to establishing that a viable market existed for the product. It seems that at the end of 2016 not all of the six conditions were met. While market research had established demand for the product, there were still issues of mass production (technical feasibility) to be solved. Based on this assessment, the $6 000 000 of development costs incurred would again be expensed. The research and development costs incurred on the mice poison project in 2014, 2015 and 2016, and recognised as expenses in those years, cannot be included in the amount of intangible assets carried forward to future periods (AASB 138 para. 71). During 2017, Eradication had completed development of the mice poison, and market research had established that there is a large market in Australia for a chemically more efficient mice poison. Therefore, Eradication could demonstrate that all six conditions are now satisfied and the development costs incurred in 2017 ($2 000 000) can be recognised as an intangible asset. The cost of establishing production facilities for the new poison is not included as an intangible asset, rather it is recognised as an asset: property, plant and equipment in accordance with the requirements of AASB 116 ‘Property, Plant and Equipment’. GOODWILL 11 Eastern Management Ltd (a) Calculate goodwill Goodwill is initially measured, in accord with AASB 3 para. 32, as the difference between (a) the aggregate of (i) the consideration transferred measured in accordance with this Standard, which generally requires acquisition date fair value (see para.37); (ii) the amount of any non-controlling interest in the acquire measured in accordance with this Standard; and (iii) in a business acquisition achieved in stages (see paras 41 and 42), the acquisition-date fair value of the acquirer’s previously held equity interest in the acquire; . 29

(b) the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed in accordance with this Standard. Essentially goodwill is measured as the excess of the purchase price paid for acquisition over the fair value of the identifiable assets acquired (net of liabilities assumed). Paragraph 53 requires the acquisition related costs of $100,000 in a Business Combination to be expensed in the period incurred. Cost of the business combination Purchase price The fair value of identifiable assets is: Accounts receivable $720 000 Inventory 1 440 000 Property, plant and equipment 1 560 000 1 Brand names 500 000 Total 4 220 000 The fair value of liabilities and contingent liabilities is: Accounts payable (680 000) Provision for employee benefits (220 000) Contingent liabilities (150 000) Total (1 050 000) Net fair value Goodwill

$4 800 000

$3 170 000 $1 630 000

Note that the AASB 138 prohibition on the recognition of internally-generated brand names does not apply to purchased or acquired brand names. (b) Subsequent measurement of goodwill Paragraph 54 of AASB 3 indicates that the subsequent measurement of and accounting for assets acquired in a business combination should be in accordance with the provisions of other applicable Australian Accounting Standards. Paragraph B63(a) of the Application Guidance in Appendix B accompanying AASB 3 states that ‘the acquirer measures goodwill at the amount recognised at the acquisition date less any accumulated impairment losses.’ Note also that: • • •

the revaluation model is not permitted for goodwill, only the cost model; systematic amortisation of goodwill is not permitted; and goodwill is to be tested for impairment, at least annually (AASB 136 para. 10).

Note that impairment testing of goodwill requires measurement of the recoverable amount of goodwill, yet revaluation of goodwill is not permitted. Reversal of impairment loss for goodwill is prohibited (AASB 136, para. 124). . 30

(c) Bargain Purchase Paragraph 34 of AASB 3 indicates ‘occasionally an acquirer will make a bargain purchase, which is a business combination in which the amount in paragraph 32(b) exceeds the aggregate of the amounts specified in paragraph 32(a)’. The bargain purchase arises essentially when the consideration paid is less than the fair value of the net identifiable assets acquired. Paragraph 34 of AASB 3 further indicates ‘If that excess remains after applying the requirements in paragraph 36, the acquirer shall recognise the resulting gain in profit and loss on the acquisition date’. Paragraph 36 of AASB 3 requires the acquirer to undertake a review to assess whether the acquirer has correctly identified all assets acquired and liabilities assumed as well as their related measurements. ‘The objective of the review is to ensure that the measurements appropriately reflect consideration of all available information as of the acquisition date’ (AASB 3 para. 36). Cost of the business combination Purchase price The fair value of identifiable assets is: Accounts receivable $720 000 Inventory 1 440 000 Property, plant and equipment 1 560 000 Brand names1 500 000 Total 4 220 000 The fair value of liabilities and contingent liabilities is: Accounts payable (680 000) Provision for employee benefits (220 000) Contingent liabilities (150 000) Total (1 050 000) Net fair value Excess on acquisition/Gain on bargain purchase

$3 000 000

$3 170 000 $(170 000)

The excess on acquisition of $170,000 would be recognised as a gain on bargain purchase in the profit and loss of Eastern Management in accord with requirements of paragraph 34 of AASB 3. 12 Alan Pond On acquisition, the assets and liabilities acquired, stated at fair value, would be included in the statement of financial position of Pond Ltd. Any excess of the purchase price over the fair value of the identifiable net assets is to be recorded as a non-current asset labelled goodwill. Paragraph 53 (AASB 3) require the acquisition-related costs in a Business Combination to be expensed in the period incurred.

. 31

On the basis of the information provided, the following items would be included in the appropriate sections of Pond’s statement of financial position. _________________________________________________________________ Assets Cash at bank $ 254 000 Accounts receivable 359 000 Inventories 337 000(1) Land and buildings 6 650 000(2) Plant and equipment 939 500 Patents 1 000 000(3) Deferred tax asset ($750 000  0.30) 225 000(4) Brand name 200 000(5) Goodwill 367 500(6) Liabilities Creditors and borrowings 322 000 Other current liabilities 210 000 Mortgage 4 000 000 _________________________________________________________________ Notes: (1) Reduced to fair value by deducting $65 000 for obsolete stock. (2) The recorded value of the land is increased by $200 000. (3) Recording at fair value an identifiable asset acquired. (4) As it is probable that the benefit of the tax losses will be realised, the deferred tax asset should be recognised in accordance with AASB 112. This then becomes an identifiable asset at the date of acquisition. (5) The proportion of the existing goodwill acquired, which comprises identifiable intangibles in the form of brand names should be recognised in the accounts at the date of acquisition. The residual goodwill of $290 000 ($490 000 - $200 000) cannot be recorded as an identifiable intangible. (6) The difference between the fair value of the identifiable net assets acquired and the cost of acquisition calculated as follows: Purchase consideration Fair value of identifiable net assets (9 964 500 – 4 532 000) Purchased goodwill

5 800 000 5 432 500 $ 367 500

Implications for future reporting periods 1

Purchased goodwill must be tested for impairment annually in future periods in accordance with AASB 136. In addition, the intangible assets, patent and brand name will also be subject to impairment testing (AASB 138), as will the land and buildings and plant and equipment acquired. The patent will have a finite life and must therefore be amortised systematically over this useful life in a manner that . 32

reflects the pattern of expected future economic benefits. Whether the brand name has an indefinite life is not clear. If it has, then no systematic amortisation is required. If the life is finite, the same treatment as for patents is required. The tangible non-current assets (with the exception of land) will also have to be systematically depreciated over their useful lives. 2

Deferred tax asset. When Beer Bottles Ltd. returns to profitability and earns taxable income, it will claim the accumulated tax losses as a tax deduction. This will reduce the asset, deferred tax asset, by the amount of the tax losses claimed as a deduction multiplied by the tax rate.

COMPREHENSIVE PROBLEM 13 Market to Book Ratio and Indicative Existence of Unrecorded Intangible Assets (a) The market value of an ASX listed entity can readily be observed/estimated by multiplying the current share price by the number of ordinary shares on issues. The statement of financial position of the same listed entity will provide the net asset (book) value of the entity. The difference between these two assessments of ‘value’ of the organisation can be significantly different. For example, Morningstar report the Facebook Inc. historic market-to-book valuation for 2016 at 6.1 whilst the S&P500 is 2.8. (Source: See http://financials.morningstar.com/valuation/price-ratio.html?t=FB). So why are the market to book ratios so large. There are a number of observations that can be made. The numerator is based on market value and therefore reflects the future potential (growth options) of the company and is not bound by the convention of accounting recognition and measurement principles. A low denominator relative to the numerator will result in a high ratio. Support for unrecorded or under-recorded intangible asset values: The market to book ratio is also likely to reflect some industry and entity related factors including the level of research and development expenditure undertaken. This type of expenditure can be an indicator of future prospects of the company. However, governed by accounting standards, many of the intangibles would not be reflected in the book value. Other rationale for differences in market and book value: The statement of financial position adopt a number of different methodologies in valuing the assets and liabilities of the entity. Some assets are likely to be measured using historical cost (and then adjusted for depreciation, amortisation and impairment) whilst some may reflect fair value where application and adopted by the relevant entity. For instance land or other . 33

assets which increase in value may be carried at historical cost as opposed to their current market value. (b) It is true that the market-to-book ratio may be an indicator of unrecorded or underrecorded intangible assets, however, the ratio may also be indicative of other factors influencing either book or market value. Students should be able to identify a number of factors which will influence the reliability of ratios based on accounting numbers. For example, the company may have elected to measure property, plant and equipment at cost rather than fair value and hence the book value will be understated. However, fair values are based on judgement and subject to bias, therefore assets measured at fair value may be over- or understated, hence the market-to-book ratio is measured with error. Factors unrelated to intangible assets may influence stock price which will, in turn, influence the measure in the numerator. Hence, the market-tobook ratio is a noisy measure for unrecorded or under-recorded intangible assets.

. 34

Chapter 11 ACCOUNTING FOR LEASES LEARNING OBJECTIVES After studying this chapter you should be able to: 1

describe the nature of leases;

explain the implications of lease accounting for assessment of operating performance and financial risk;

explain and apply the requirements of AASB 16 ‘Leases’ to identify a lease;

explain and apply the requirements of AASB 16 ‘Leases’ to accounting for leases by the lessee;

explain and apply the requirements of AASB 16 ‘Leases’ to accounting for finance leases by the lessor;

explain and apply the requirements of AASB 16 ‘Leases’ to accounting for operating leases by the lessor; and

explain and apply the requirements of AASB 16 ‘Leases’ to accounting for sale-andleaseback transactions.

QUESTIONS Leases 1 Leases are agreements which, in exchange for lease payments, convey to one party (the lessee) the right to possess and to use an asset owned by another party (the lessor) for a stated period of time. Five key provisions likely to be included in a lease agreement are: • • • •

•

the term of the lease given that in all lease agreements the lessee acquires the right to use the asset during the term of the lease; the amount and timing of lease payments; whether the lease is cancellable by either party (and, if so, under what conditions); what happens to the asset at the end of the lease for example; in some leases, the lessor retains the right to use or dispose of the asset at the end of the lease term, in other leases ownership is passed to the lessee on payment of a guaranteed residual value or payment of a ‘bargain purchase’ price. In still other leases, the lessee has the option to make a further additional payment to acquire the leased asset; and whether the lessor or the lessee is responsible for certain costs – e.g. payment of maintenance and repair costs, insurance, taxes and other operating costs.

The advantages of leasing from the lessee’s point of view are that leases provide a mechanism whereby lessees can obtain the use of a resource without having to own it and pay for it at the time of acquisition. Leases are sufficiently flexible to allow shortterm rental-type agreements or long-term finance leases that allow the lessee to use and then acquire the resource. Leases may also provide tax advantages to lessees who can claim the full amount of the lease payments as a tax deduction. The cost of leasing may be greater than other sources of bank funding which may be a disadvantage. Further, for leases recognised on-balance sheet (as is mostly now the case under AASB 16), the leased asset and lease liability are recognised in the statement of financial position and therefore have an effect on leverage and return on assets.

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Managers will not be indifferent between the alternative treatments of leases. Capitalisation treatment will result in an increased debt ratio (implying higher financial risk, an increase in the rates of interest on debt, and a reduced credit rating) and lower return on total assets (implying inferior operating performance and possibly reduced management incentives such as bonuses). Thus, managers have strong incentives to favour the expense treatment and to ensure that leases remain off balance sheet. Empirical evidence supports this conclusion. Such evidence also indicates that following the introduction of accounting standards mandating the operating/finance lease distinction, many leases were re-negotiated to allow them to be classified as operating. This is not the same as saying that the classification criteria were so vague as to allow either conclusion to be drawn. Indeed, the former Australian standard on leases included precise numeric guidelines to operationalise the lease term and present value tests. However, slight changes in lease terms may be sufficient to ensure that the leases fail the numeric guidelines yet the underlying economic substance remains unchanged. The most recent changes as a result of AASB 16 will reduce significantly the flexibility of previous standards with lessee requiring capitalisation of all leases with few exceptions (i.e. shortterm and low-value asset leases).

The leasing project, which commenced in 2005 as a joint project of the FASB and IASB, culminated with the issue of AASB 16 in January 2016. The project was undertaken because of the dissatisfaction with the existing lease accounting standard which resulted in quite often substantial leasing obligations to remain off-balance sheet. Hence, the perceived lack of transparency of information relating to lease obligations was the key motivator for the new standard. Students are encouraged to review the Accounting in Focus in section 11.2.

Empirical evidence indicates that following the introduction of accounting standards mandating the operating/finance lease distinction, many leases were re-negotiated to allow them to be classified as operating. However, evidence provided by Bratten et al. (2013) suggests that capital market participants (i.e. lenders and equity investors) generally treat off-balance sheet lease commitments equivalent to on-balance sheet debt. Thus, disclosed items are not processed differently from recognised items when the disclosures are reliable (see also Bowman, 1980, Imhoff et al 1991). This would suggest that the issue of transparency is resolved with salient and reliable disclosure requirements, rather than necessarily changing the recognition requirements. However,

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the IASB has chosen, after extensive consultation (see section 11.2) to change the recognition requirements. 7

The report should include the following: Entering into an off-balance sheet lease will have no effect on interest expense but the lease rental payment will reduce profit before tax. Interest coverage is calculated as follows: Profit before interest and tax/Interest expense. Therefore, entering into an offbalance sheet lease will lower the numerator without changing the denominator. As a result, the interest coverage will fall (this ignores any positive effects the availability of the leased resource may have on profit). In the case of an on-balance sheet lease, the interest expense will increase as part of each lease payment is recognised as lease interest expense. In addition, the profit before interest and tax will decrease as the amortisation of the asset ‘lease rights’ is recognised in the statement of comprehensive income. Thus, the numerator will decrease and the denominator will increase causing interest coverage to fall. Comparing the two treatments, in most circumstances, the interest cover will fall by a larger amount if the lease is treated as a finance lease than with an off-balance sheet lease because of the effect on both the numerator and denominator in the case of the onbalance sheet lease. In relation to return on total assets, entering into an off-balance sheet lease will not change total assets, but will reduce profits by the amount of the lease payments (ignoring any positive effects on profit from the use of the leased resource). Thus a reduction in return on assets is expected. Entering into on-balance sheet lease increases total assets (and interest bearing liabilities) and reduces profit by the sum of the interest component of the lease payments, plus the amount of the depreciation on the leased asset. Again, a reduction in return on total assets is expected. In comparative terms both off-balance sheet and on-balance sheet leases have similar effects on profit, but on-balance sheet lease increase total assets and hence must result in a lower return on total assets.

AASB 16 Leases requires the lessee to capitalise all leases recognising a right-of-use asset and lease liability, essentially bringing all leases on-balance sheet. The only exceptions to this being for short-term leases (12 month or less lease term) or leases of low-value assets. This is a substantial departure from the former leasing standards, AASB 117, whereby the lessee was required to determine if the lease was an operating lease or a finance lease. Operating leases were expenses whilst finance leases were capitalised.

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The new requirements in AASB 16 for accounting for leases by lessees eliminates the finance/operating lease distinction. For all lease agreements (except for short-term or low-value asset leases), lessees will be required to recognise the right-of-use asset and lease obligation-liability. Opinions about whether these proposals will overcome the problems experienced with the operating/finance lease distinction vary. On the one hand, bringing all leases on-balance sheet should remove most of the problems created by having lease obligations off-balance sheet, which is clearly the opinion shared by accounting standard setters. On the other hand, capitalising short-term rental agreements is likely to create costs for lessees with few if any benefits for financial statement users. Time will tell if the standards setters have been successful in achieving their desired goal of getting all leasing obligations on balance sheet. Leasing has a very long history of ‘working around’ the accounting standards to achieve the desired outcomes for management. It remains to be seen as to how management (and lease financing organisations) will use the exemptions in lease structuring to enable lessees to avoid lease capitalization. However, the opportunity to structure lease agreements to remain off-balance sheet has been significantly reduced.

10 AASB 16 requires entities to identify, at the inception of a contract, whether the contract contains a lease. AASB 16 para. 9 notes that ‘a contract is, or contains a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Paragraphs B9–B31 set out guidance on the assessment of where a contact is, or contains a lease.’ Thus there are two key aspects of this requires are: 1 the asset that is the subject of a lease must be specifically identified (i.e. identified asset) [see paras B13–B20] 2 the lease must convey the right to control the use of that identified asset for a period of time requiring the customer to have both: a) the right to obtain substantially all of the economic benefits from used; AND b) the right to direct the use of the identifiable asset. [see paras B21–B30) 11 The statement is essentially correct. The customer’s right to control the use of the identified asset must not be subject to substantive substitution. This is, the customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset through the period of use. Substantive substitution rights are discussed in paragraphs B14 to B18. Paragraph B14 indicates that a supplier’s right to substitute an asset is substantive if both the following conditions are met. First, if the supplier has the practical ability to substitute alternative assets throughout the period of . 5

use. Second, the supplier would benefit economically from the exercise of its right to substitute the asset (i.e. the benefits exceed the costs incurred in substituting). 12 The right to control the use of an identified asset for a period of time is evident when the customer has both: a) the right to obtain substantially all of the economic benefits from used (paras B21– B23); AND b) the right to direct the use of the identifiable asset. [see paras B24–B30) Thus, the right to control has two elements: benefit and power. The benefits can be obtained directly or indirectly by using, holding or sub-leasing the asset, and include the primary output and by-products, including potential cash flows, derived from use. However, the benefits must be derived from use of the asset within the scope of the customer’s right to use the asset. The power element is derived by the right to direct the use of the identified asset through-out the period of use. The customer will only have the power to direct the use if either of the following conditions are meet: a) the customer has the right to direct how and for what purpose the asset is used throughout the period of use; OR b) the relevant decision about how and for what purpose the asset is used are predetermined and i.

ii.

the customer has the right to operate the asset or direct others to operate the asset in a manner that it determines, throughout the period of use, without the supplier having the right to change those operating instructions the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

The requirements are presented in a flowchart provided in paragraph B31 of AASB 16. See Figure 11.1 of the text. 13 Once the entity has identifies that the contract contains a lease, it is then necessary to separate the components of the contract into any lease and non-lease components. Paragraph 12 of AASB 16 requires that ‘for a contract this is, or contains, a lease, an entity shall account for each lease component within the contract as a lease separately . 6

from non-lease components of the contract, unless the entity applies the practical expedient in paragraph 15.’ Allocation by the Lessee: The lessee allocates the consideration in the contract to the components based on the relative stand-alone price the lessor, or a similar supplier, would charge an entity for that component or a similar component. If the stand-alone similar price is not observable, then the lessee will estimate the stand-alone price maximizing the use of observable information (paras 13 and 14). Example 11.2 demonstrates the allocation of consideration across the lease and non-lease components of the contact. The lessee may elect, by class of underlying asset, not to separate nonlease components from lease components, but rather account for each lease component and any associated non-lease component as a single lease component (para. 15). Allocation by the Lessor: The lessor is required to allocate the consideration in the contract applying the provisions of AASB 15 ‘Revenue from Contracts with Customers’, paragraphs 73–90. For a further discussion on revenue recognition, please refer to Chapter 15. 14 This statement is not correct. As a practical expedient, the lessee may elect, by class of underlying asset, not to separate non-lease components from lease components, but rather account for each lease component and any associated non-lease component as a single lease component (para. 15). 15 Paragraph 22 of AASB 16 required that ‘at the commencement date, a lessee shall recognise a right-of-use asset and a lease liability’. The only exception is provided by virtue of paragraph 5 of AASB 16, which provides that a lessee may elect not to apply the requirements to short-term leases and leases for which the underlying asset is of low value. Summarised below are the key provisions in relation to the initial and subsequent measurement of the lease liability and right-of-use asset.

Initial measurement

Lease liability Net present value (using the interest rate implicit in the lease) of the: • ﬁxed payments not paid at commencement date less lessor incentive • variable payments (indexed) • expected guaranteed residual value

Right-of-use asset Lease liability + lessee’s initial direct costs + payments at/before commencement date less incentives received + estimated cost of dismantling/restoring asset

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termination penalty if reasonably certain • exercise price of reasonably certain purchase option Subsequent the lessee shall measure the • Measured using the cost measurement lease liability by: model# (a) increasing the carrying • Depreciate the asset in amount to reflect interest on accordance with the provision the lease liability; of AASB 116 PPE (b) reducing the carrying amount o If the lease transfers to reflect the lease payment ownership of the made; and underlying asset to the (c) remeasuring the carrying lessee, or if there is a amount to reflect any purchase option that the reassessment or lease lessee intends to exercise, modifications. the lessee depreciation the asset over the useful life of the underlying asset; o Otherwise depreciation over the earlier of the useful life or term of the lease. # Unless the right-of-use asset meets the definition of an investment property in AASB 140, then applies the fair value model. •

16 The statement is not correct. By virtue of paragraph 5 of AASB 16, the lessee may elect not to apply the requirements of paragraph 22 (i.e. to capitalise all leases) to short-term leases and leases for which the underlying asset is of low value. A short-term lease is defined as a lease with a term of 12 months or less (Appendix A). However, AASB 16 does not define low-value underlying assets but gives examples including leases of tablets, personal computers, small items of office furniture and telephones (para. B8). Further, AASB 16 does not provide a threshold amount to quality as a low-value underlying asset. For guidance on this, we turn to IFRS 16 ‘Basis for Conclusions’ which indicates the IASB has in mind leases of underlying asset with a value, when new, in the order of magnitude of USE $5,000 or less’(BC100). Given the long-term attempts by lessees to avoid bringing lease commitments on balance sheet, it is likely that the exemptions for short-term leases and leases of low-value underlying assets provides discretion to structure some leases so as to keep them off balance sheet. Example 11.4 provides an illustration of the lessee accounting for short-term and low-value asset leases.

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17 This statement is not correct. The interest rate implicit in the lease is the interest rate that causes the present value of the lease payments, as defined by paragraph 27 of AASB 16, and the unguaranteed residual value to equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor. The lease payments defined in paragraph 27 would include any residual value guaranteed by the lessee. Thus whether the residual value is guaranteed by the lessee or not, the amount is included in the determination of the interest rate implicit in the lease. 18 Fast Freddie Finance has submitted a proposal to Redeye that is based on the requirements of the previous leasing standard - AASB 117 to determine whether the lease is a finance lease. That is, paragraph 10 of AASB 117 identifies five examples of situations that would normally indicate the existence of a finance lease. Two of these are (c) Lease term is for a major part of the economic life of the asset: is 74% a ‘major part’? (d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all the fair value of the leased asset, is 89% ‘at least substantially all’? These were issues of judgement under AASB 117. However, under the provisions of the new leasing standard, AASB 16, irrespective of these provisions, Redeye (lessee) would be required to capitalise the lease (see para. 22) unless availing of the exemption for a short-term leases or lease for which the underlying asset is of low value. 19 This statement is not correct. The lessee is required to capitalise all leases (except as provided by para. 5). However, the lessor must classify the lease as either an operating lease or a finance lease (para. 61). Hence the treatment is not symmetrical. 20 The lessor classifies a lease as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. A lease is classified as an operating lease if it does not transfer substantially all the risk and rewards incidental to ownership of an underlying asset (AASB 16, para. 62). This requirement is consistent with the former accounting standard, AASB 117’s determination of finance and operating leases. The essential characteristic of a lease which determines whether it should be capitalised is whether the lease transfers substantially all the risks and rewards incidental to ownership to the lessee. If the risks and rewards of ownership remain with the lessor, the transaction is an operating lease which need not be capitalised. If the risks and rewards of

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ownership pass to the lessee, then the transaction is a finance lease which should be capitalised. Paragraph 63 indicates that the classification as either a finance or operating lease will depend on the substance of the transaction rather than the form of the contract. The following situations, either individually or in combination would normally lease to a lease being classified as a finance lease: (a) The lease transfers ownership of the underlying asset to the lessee by the end of the lease term; (b) The lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonable certain, at the inception date, that he option will be exercises (i.e. a bargain purchase option); (c) The lease term is for the major part of the economic life of the underlying asset even if the title is not transferred; (d) At the inception date, the present value of lease payments amounts to at least substantial all of the fair value of the underlying assets; and (e) The underlying asset is of such a specialised nature that only the lessor can use it without major modification. (para. 63). (f) Further indicators that individually or in combination could also lead to a lease being classified as a finance lease are: (g) If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee; (h) Gains or losses form the fluctuation in the fair value of the residual accrue to the lessee; (i) The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than the market rent. All of these indicators must be considered and are not always conclusive. It is a matter of judgement. However, if it is clear from other features that the lease does not transfer substantially all the risk and rewards incidental to ownership, then the lease is an operating lease. 21 For a contract that contains a lease component and one or more additional lease or nonlease components, a lessor is required to allocate the consideration in the contract applying the provisions of AASB 15 ‘Revenue from Contracts with Customers’,

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paragraphs 73–90. For a further discussion on revenue recognition, please refer to Chapter 15. 22 For finance leases, the lessor shall recognise assets held under a finance lease in its statement of financial position and present them as a receivable at an amount equal to the net investment in the lease. For operating leases, the lessor shall recognise lease payments from operating leases as income on either a straight-line bases or another systematic basis. The lessor will continue to depreciate or amortise the assets in accordance with the provisions of AASB 116 or AASB 138 (para. 84). The asset will also be subject to impairment in accordance with AASB 136 (para. 85). 23 For finance leases, the lessor shall recognise assets held under a finance lease in its statement of financial position and present them as a receivable at an amount equal to the net investment in the lease. The net investment in the lease is defined in AASB 16, Appendix A as the gross investment in the lease discounted at the interest rate implicit in the lease. The lease payments included in the net investment in the lease are identified in paragraph 70 of AASB 16 as follows: (a) fixed payments, less any lease incentives payable; (b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date; (c) any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor …; (d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and (e) payment of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease. Subsequent to initial measurement the lessor is required to recognise finance income over the lease term, based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease (para. 75). The lease receivable will be subject to impairment requirements of AASB 9. 24 AASB 16 does not directly define manufacturer or dealer leases. Paragraph 72 of AASB 16 says manufacturers or dealers often offer their customers the choice of either buying or leasing an asset. A finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income: first, profit or loss on the sale of the asset; and second, finance income over the lease term. In a direct finance lease, there is no profit on the sale . 11

of the asset and only finance income exists. Thus, the additional issue for manufacturer or dealer lessors is how to account for the profit on the sale of the asset. Paragraph 71 of AASB 16 requires that the selling profit or loss is to be recognised by the dealer in accordance with their policy for recognising profit on outright sales to which AASB 15 applies. A particular difficulty is that the dealer may offer lower than market interest rates on the finance lease to induce the customer to buy. Discounting the lease receipts at a lower interest rate will result in a higher amount being recognised for the lease receivable and potentially inflating the apparent profit. Paragraph 73 of AASB 16 requires that market rates of interest be used in discounting the lease receivables in a dealer lease. 25 For operating leases, the lessor shall recognise lease payments from operating leases as income on either a straight-line bases or another systematic basis (para. 81). The lessor will continue to depreciate or amortise the assets in accordance with the provisions of AASB 116 or AASB 138 (para. 84). The asset will also be subject to impairment in accordance with AASB 136 (para. 85). 26 A sale-and-leaseback agreement involves the owner selling the property to another entity and, at the same time, agreeing to lease it back from the new owner. The use of the property continues without interruption and the original owner (now the lessee) usually pays all costs such as maintenance, insurance and local government rates as if ownership of the property had not passed to the lessor. A sale-and-leaseback transaction is usually prompted by a need to raise cash. It is an alternative to using the property as security for a loan. 27 In the first instance, it is necessary to determine whether the transfer of an asset is accounted for as a sale of that asset by reference to whether a performance obligation is satisfied in accordance with AASB 15 (para. 99). See Chapter 15. 28 In a sale-and-leaseback transaction, Paragraph 101 of AASB 16 requires that if the transfer of an asset by the seller/lessee satisfies the requirements of AASB 15 to be accounted for as a sale, then the accounting treatment for the seller/lessee and buyer/lessor are summarised as follows:

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TRANSFER OF THE ASSET IS A SALE Seller/lessee • Derecognise the underlying asset • Recognise the right-of-use asset (proportion of previous carrying amount) • Recognise the lease liability • Record the gain/loss on sale of rights transferred. o Where Sales Price (SP) > Fair Value (FV), the above-market terms shall be accounted for as additional financing provided by the buyer/lessor to the seller/lessee. (para. 101(a)) o Where SP < FV, the below-market terms shall be accounted for as a prepayment of lease payment. (para. 101(a)) Buyer/lessor • Recognise the purchase of the asset applying applicable accounting standards • Recognise the lease contract under lessor accounting as required by AASB 16. Example 11.10 illustrates the requirements for a sale and leaseback arrangement which transfer of the asset is considered a sale. 29 In a sale-and-leaseback transaction, if the transfer of the asset does not satisfy the requirements of AASB 15 to be accounted for as a sale, then the accounting treatment for the seller/lessee and buyer/lessor are summarised as follows: TRANSFER OF THE ASSET IS NOT A SALE Seller/lessee • Continue to recognise the asset • Recognise a financial liability applying AASB 9 Buyer/lessor • Do not recognise the asset • Recognise a financial asset applying AASB 9

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PROBLEMS 1

Fly High – Determining if contract contains a lease To determine if the contract between Fly High (customer) and Goeing (seller) contains a lease in accordance with AASB 16, it is necessary to establish: 1 an identified asset 2 the lease must convey, to the customer, the right to control the use of that identified asset for a period of time. Identified asset The aircraft is explicitly specified with detailed specifications for the interior and exterior. Whilst Goeing (supplier) may substitute the aircraft at any time during the two-year period, the substitution right is not substantive because of the significant costs incurred by the supplier to ensure the substituted aircraft is of the exact specifications. Given the significant cost to the supplier, one of the two conditions identified in paragraph B14 has not been meet; that is, whilst the supplier has the practical ability to substitute (para. B14(a)), the condition that the supplier would benefit economically from the exercise of its right of substitution (para. B14(b)) has not. The supplier obligation to substitute the aircraft for repairs and maintenance when it is not working does not preclude the customer from having the right to use an identified asset (para. B18). Therefore it can be concluded there is an identified asset. Right to control the use of that identified asset Two aspects must be evident to establish the right to control the use. 1 The right to obtain substantially all of the economic benefit (benefit) 2 The right to direct the use of the identified asset (power) Benefit Fly High (customer) has the right to obtain substantially all of the economic benefit for the two year period as Fly High has exclusive use of the aircraft. Power Whilst Goeing (supplier) is the exclusive operator of the aircraft, the operations are directed by the customer. Fly High determines which passengers and cargo will be transported and where and when the aircraft will fly. The customer therefore has the right to direct the use of the aircraft because the relevant decisions about how and for what purpose the asset is used are predetermined and the customer has the right to operate the asset, or direct others to operate the asset in a manner that it determines, throughout the period of use, without the supplier having the right to change those operating instructions (para. B24 (b)(i))

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Therefore it can be concluded that the customer has the right to control the use of the identified asset. Given there is an identified asset and the customer has the right to control the use of the identified asset (i.e. both conditions are satisfied), it is evident that the contract contains a lease. (Note: this example is drawn from Example 7 of IFRS 16 Leases – Illustrative Examples) 2

Paperbark Ltd – determining if contract contains a lease This example is drawn from Example 8 of IFRS 16 Leases – Illustrative Examples. For a solution to this problem, please refer to the pronouncement which is available on the AASB website.

Lessee – determining if contract contains one or more leases This problem is similar to Example 11.2. (a) In the absence of information to the contrary, it would seems that the contact does contain a lease given that the items of equipment are identified assets and the lessee has right to control the use of the identified items. However, it is necessary to determine if each item of equipment constitutes a separate lease component. Paragraph B32 of AASB 16 indicates that the right to use an underlying asset is a separate lease component if both of the following conditions are evident: (a) The lessee can benefit from use of each of the three items of equipment on its own or together with other readily available resources. (b) The underlying asset is neither highly dependent on, not highly interrelated with, the other underlying assets in the contract. Although the lessee is leasing all three items of equipment to engage in mining operations, the machines are neither highly dependent on, not highly interrelated with, each other (see para. B32(a)(b)). The leasee’s ability to derive benefit from the lease of each items of equipment is not significantly affected by its decision to lease, or not lease, the other equipment items. As such, the contract contains three lease components and effectively, three non-lease components for the service and maintenance contracts (para. 12). (b) The lessee must allocate the fixed consideration based on the observable standalone price the lessor, or a similar supplier, would charge an entity for component – i.e. each item of lease equipment and each maintenance and service contract (paras 13 and 14). If an observable stand-alone price is not readily available, the lessee shall estimate the stand-alone price, maximising the use of observable information. The lessee would have to estimate the price of the maintenance component for the excavator. The allocation made by lessee, based on observable . 15

stand-alone prices for each item of equipment and maintenance contact would be as follows: Components Lease Non-lease Total consideration

Crane 180 000 35 000

Truck 150 000 15 000

Excavator 290 000 50 000

Total $620 000 $100 000 $720 000

The annual lease payment of $180 000 will be allocated in the relative proportions as follows: The proportion of the lease payment attributable to: lease component $620 000/$720 000 x $180 000 non-lease component $100 000/$720 000 x $180 000

The proportionate allocation of the lease components to each item: Crane $180 000/$620 000 x $155 000 Truck $150 000/$620 000 x $155 000 Excavator $290 000/$620 000 x $155 000

The proportionate allocation of the non-lease components to each item: Crane $35 000/$100 000 x $25 000 Truck $15 000/$100 000 x $25 000 Excavator $50 000/$100 000 x $25 000

Components Lease Non-lease Total consideration 4

Crane 45 000 8 750

Truck 37 500 3 750

Excavator 72 500 12 500

$155 000 $25 000 $180 000

$45 000 $37 500 $72 500 $155 000

$8 750 $3 750 $12 500 $25 000 Total 155 000 25 000 180 000

Cubic-Haul – Accounting for a Lease by Lessee On 1 January 2019, Cubic Haul (Lessee) entered into a lease contract with Lessor Ltd under the following conditions: • Term: 5 years • Annual payment of $12 000 commencing 1 January 2019 • Unguaranteed residual value $4,000. • Interest rate implicit in the lease 8% The lessee must account for the lease by recognising the right-of-use asset and lease liability (para. 22). Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson, Issues in Financial Accounting 16e 16

Determine the lease liability (para. 26) Net present value (using the interest rate implicit in the lease) of the: • ﬁxed payments not paid at commencement date less lessor incentive 4 remaining payments @ $12 000 pa • variable payments (indexed) Nil • expected guaranteed residual value Nil • termination penalty if reasonably certain Nil • exercise price of reasonably certain purchase option Nil NPV =

 $12 000  1 1 −  = $39 746 0.08  (1 + 0.08)4 

Determine the right-of-use asset (para. 24) Lease liability + lessee’s initial direct costs + payments at/before commencement date less incentives received + estimated cost of dismantling/restoring asset

$39 746 12 000 $51 746

Subsequent measurement of lease liability (para. 36). Paragraph 36 requires that the lease liability first be increased to reflect the interest and then reduced to reflect the lease payment. As such, the interest is accrued at year end (31 December) and the carrying amount of the lease liability is increased. The lease liability is reduced for the payment on the 1 January each year. The interest as determined as indicated in the lessee’s schedule of lease payments Schedule of lease payments: Lessee Period Lease Lease After Interest @ Lease Liability payment# Payment 8% Liability Opening Closing Bal. Bal. a 31 December 39 746 39 746 3 180 42 926b 2019 31 December 42 926 12 000 30 926 c 2 474d 33 400 2020 31 December 33 400 12 000 21 400 1 712 23 112 2021 31 December 23 112 12 000 11 112 888 12 000 2022 31 December 12 000 12 000 0 2023 # Note: Lease payments will be made at the commencement of each year on 1 January a $39 746 x 8% = $3 180 . 17

b c d

$39 746 + 3 180 = $42 926 $42 926 – 12 000 = $30 926 $30 926 x 8% = $2 474

Subsequent measurement of right-of-use asset (paras 31 and 32). To determine the depreciation expense for the subsequent measurement of the right-ofuse asset, the asset is depreciated over the term of the lease which is also equal to the useful life. $51,746/5 years = $10 349 pa. The general journal entries to reflect the initial and subsequent measurement of the lease liability and the right-of-use assets by Cubic Haul (lessee) over the term of the lease are as follows: Date 1 Jan 2019

31 Dec 2019

1 Jan 2020

31 Dec 2020

1 Jan 2021

31 Dec 2021

1 Jan 2022

Details Dr/Cr Debit $ Credit $ Right-of-use asset - Truck Dr 51 746 Lease liability Cr 39 746 Cash at bank Cr 12 000 (to recognise right-of-use asset, lease liability and initial payment on commencement of the lease – para. 22) Interest expense Dr 3 180 Lease liability Cr 3 180 (to recognise interest on lease liability para. 36) Depreciation expense Dr 10 349 Accumulated depreciation Cr 10 349 (to depreciate right-of-use asset over five year term) Lease liability Dr 12 000 Cash at bank Cr 12 000 (to record lease payment) Interest expense Dr 2 474 Lease liability Cr 2 474 (to recognise interest on lease liability para. 36) Depreciation expense Dr 10 349 Accumulated depreciation Cr 10 349 (to depreciate right-of-use asset) Lease liability Dr 12 000 Cash at bank Cr 12 000 (to record lease payment) Interest expense Dr 1 712 Lease liability Cr 1 712 (to recognise interest on lease liability para. 36) Depreciation expense Dr 10 349 Accumulated depreciation Cr 10 349 (to depreciate right-of-use asset) Lease liability Dr 12 000 Cash at bank Cr 12 000

31 Dec 2022

1 Jan 2023

31 Dec 2023

(to record lease payment) Interest expense Dr Lease liability Cr (to recognise interest on lease liability para. 36) Depreciation expense Dr Accumulated depreciation Cr (to depreciate right-of-use asset) Lease liability Dr Cash at bank Cr (to record lease payment) Depreciation expense Dr Accumulated depreciation Cr (to depreciate right-of-use asset)

888 888 10 349 10 349 12 000 12 000 10 349 10 349

Rose Ltd – Accounting for a short-term/low-value lease by Lessee Rose Ltd has entered into a lease of office equipment for a period of five year. Given the lease is for office equipment with a total value of $5 000, the lease it likely to qualify for recognition exemption as a lease for asset of low value (para. 5(b)) as paragraph 8 specifically identifies office furniture as example of low-value underlying assets. Whilst AASB 16 provides no indication of amount constituting a low-value underlying asset, IFRS 16 Basis of Conclusion BC100 indicates that the IASB has a value, when new, in the order of magnitude of USD$5 000 or less. The office equipment is within this order of magnitude. Paragraph 6 requires the lessee to recognise the lease payments associated with the lease as an expense on either straightline basis over the lease term or another systematic basis if that basis is more representative of the patter of the lessee’s benefits. The total lease payments are recognised on a straight-line basis as the benefits to the lessee under the lease are expected to arise on a straight-line basis over the term of the lease. The annual lease expense is calculated as the total payments/term of the lease as follows: [$1 500 + ($1400 x 2) + ($1 500 x 2) – $600]/5 years = $1 340 pa. The general journal entries to recognise the annual lease expense would be: Date Details Dr/Cr Debit $ Credit $ 30 June 2019 Lease expense Dr 1 340 Cash at bank Cr 1 340 (to recognise lease expense straight-line over the term of lease for lease of low-value underlying asset – para. 5b)

Tasman Ltd (a) Accounting for a Lease by Lessee

. 19

The lessee must account for the lease by recognising the right-of-use asset and lease liability (para. 22). On 1 July 2019, Tasman Ltd (Lessee) entered into a lease contract with Lessor under the following conditions: • Term: 5 years • Annual payment of $20,000 commencing 1 July 2019 • Interest rate implicit in the lease 12% Determine the lease liability (para. 26) Net present value (using the interest rate implicit in the lease) of the ﬁxed payments not paid at commencement date less lessor incentive. There are four remaining payments of $20 000.

NPV =

 $20 000  1 1 −  = $60 747 0.12  (1 + 0.12)4 

$60 747 20 000 $80 747

The general journal entry to reflect the initial measurement of the lease liability and the right-of-use asset by Tasman Ltd (Lessee) at 1 July 2019 is as follows: Date 1 July 2019

Details Dr/Cr Debit $ Credit $ Right-of-use asset - equipment Dr 80 747 Lease liability Cr 60 747 Cash at bank Cr 20 000 (to recognise right-of-use asset, lease liability and initial payment on commencement of the lease – para. 22)

(b) Subsequent measurement of lease liability (para. 36). Paragraph 36 requires that the lease liability first be increased to reflect the interest and then reduced to reflect the lease payment. As such, the interest is accrued at year end (30 June) and the carrying amount of the lease liability is increased. The lease liability is reduced for the payment on the 1 July each year. The interest as determined as indicated in the lessee’s schedule of lease payments

. 20

Schedule of lease payments: Lessee Period

Lease Lease After Liability payment# payment Opening Bal. $ $ 30 June 2020 60 747 30 June 2021 68 037 20 000 48 037c 30 June 2022 53 801 20 000 33 801 30 June 2023 37 857 20 000 17 857 30 June 2024 20 000 20 000 # Note: Lease payments will be made on 1 July each year. a $60 747 x 12% = $7 290 b $60 747 + 7 290 = $68 037 c $68 037 – 20 000 = $48 037 d $48 037 x 12% = $5 764

Interest @ 12% $ 7 290a 5 764d 4 056 2 143 -

Lease Liability Closing Bal. $ 68 037b 53 801 37 857 20 000 -

(c) Subsequent measurement of right-of-use asset (para. 31, 32). To determine the depreciation expense for the subsequent measurement of the right-ofuse asset, the asset is depreciated over the term of the lease. . Depreciation Schedule: Lessee Depreciation Accumulated Carrying Period Cost $ charge $ depreciation $ Amount $ 30 June 2020 80 747 16 149 16 149 64 598 30 June 2021 80 747 16 149 32 298 48 449 30 June 2022 80 747 16 149 48 447 32 300 30 June 2023 80 747 16 149 64 596 16 151 30 June 2024 80 747 16 151 80 747 (d) The general journal entries to reflect the subsequent measurement of the lease liability and the right-of-use assets by Tasman Ltd (Lessee) over the term of the lease are as follows: Date 30 Jun 2020

1 Jul 2020

Details Dr/Cr Debit $ Interest expense Dr 7 290 Lease liability Cr (to recognise interest on lease liability para. 36) Depreciation expense Dr 16 149 Accumulated depreciation Cr (to depreciate right-of-use asset over five year term) Lease liability Dr 20 000 Cash at bank Cr (to record lease payment)

Credit $ 7 290

16 149

20 000

30 Jun 2021

1 Jul 2021

30 Jun 2022

1 Jul 2022

30 Jun 2023

1 Jul 2023

30 Jun 2024

Interest expense Dr Lease liability Cr (to recognise interest on lease liability para. 36) Depreciation expense Dr Accumulated depreciation Cr (to depreciate right-of-use asset) Lease liability Dr Cash at bank Cr (to record lease payment) Interest expense Dr Lease liability Cr (to recognise interest on lease liability para. 36) Depreciation expense Dr Accumulated depreciation Cr (to depreciate right-of-use asset) Lease liability Dr Cash at bank Cr (to record lease payment) Interest expense Dr Lease liability Cr (to recognise interest on lease liability para. 36) Depreciation expense Dr Accumulated depreciation Cr (to depreciate right-of-use asset) Lease liability Dr Cash at bank Cr (to record lease payment) Depreciation expense Dr Accumulated depreciation Cr (to depreciate right-of-use asset)

5 764 5 764 16 149 16 149 20 000 20 000 4 056 4 056 16 149 16 149 20 000 20 000 2 143 2 143 16 149 16 149 20 000 20 000 16 151 16 151

(e) Accounting for a Finance Lease by Lessor For finance leases, the lessor shall recognise assets held under a finance lease in its statement of financial position and present them as a receivable at an amount equal to the new investment in the lease. The net investment in the lease is defined in AASB 16, Appendix A as the gross investment in the lease discounted at the interest rate implicit in the lease. The lease payments included in the net investment in the lease are identified in paragraph 70 of AASB 16 as follows: (a) fixed payments, less any lease incentives payable; (b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date; (c) any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor …; . 22

(d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and (e) payment of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease. NPV is determined as: 20 000 + (

 $20000  1 1 − 4  ) = $80 747. 0.12  (1 + 0.12) 

Schedule of lessor’s receipts Date of Rent Interest Principal Lease receivable payment Received $ revenue $ recovery $ Closing Bal. $ 1 July 2019 80 747 1 July 2019 20 000 20 000 60 747 1 July 2020 20 000 7 290 12 710 48 037 1 July 2021 20 000 5 764 14 236 33 801 1 July 2022 20 000 4 056 15 944 17 857 1 July 2023 20 000 2 143 17 857 The general journal entries for a finance lease for the Lessor for the period 1 July 2019 to 30 June 2021 are as follows. Date 1 July 2019

1 July 2020

30 June 2021

Details Dr/Cr Debit $ Lease receivable Dr 80 747 Equipment Cr (to record the lease receivable at commencement ) Cash at bank Dr 20 000 Lease receivable Cr (to record receipt of the first lease payment ) Cash at bank Dr 20 000 Unearned lease revenue Cr Lease receivable Cr (to record receipt of the lease payment ) Unearned lease revenue Dr 7 290 Interest revenue Cr (to record revenue from lease interest )

Credit $ 80 747

20 000

7 290 12 710

7 290

(f) Accounting for an Operating Lease by Lessor For operating leases, the lessor shall recognise lease payments as income on either a straight-line basis or another systematic basis (para. 81). The general journal entries for an operating lease for the Lessor for the period 1 July 2019 to 30 June 2021 are as follows. Date 1 July 2019

Details Dr/Cr Cash at bank Dr Lease rental received in adv Cr (to record the initial lease payment )

Debit $ 20 000

Credit $ 20 000

30 June 2020

1 July 2020

30 June 2021

Lease rental received in adv Dr 20 000 Lease rental revenue Cr (to record revenue from receipt of the first lease payment ) Depreciation expense Dr ? Accum. Depreciation Cr (to record depreciation on underlying leased asset over useful life) Cash at bank Dr 20 000 Lease rental received in adv Cr (to record lease payment received ) Lease rental received in adv Dr 20 000 Lease rental revenue Cr (to record revenue from receipt of the lease payment ) Depreciation expense Dr ? Accum. Depreciation Cr (to record depreciation on underlying leased asset over useful life)

20 000

The asset would be depreciated by the lessor according to the requirements of AASB 116. Insufficient details are provided to enable calculation of depreciation. 7

Box Ltd and GEC Ltd - Accounting for leases by Lessee and Lessor (a)GEC Ltd – Accounting for a finance lease by Lessor For finance leases, the lessor shall recognise assets held under a finance lease in its statement of financial position and present them as a receivable at an amount equal to the new investment in the lease. The net investment in the lease is defined in AASB 16, Appendix A as the gross investment in the lease discounted at the interest rate implicit in the lease. The lease payments included in the net investment in the lease are identified in paragraph 70 of AASB 16 as follows: (a) fixed payments, less any lease incentives payable; (b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date; (c) any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor …; (d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and (e) payment of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.  $2000  1 NPV of lease payments = $4 000 + = $78 707 1 − 47  0.01  (1 + 0.01)  The general journal entries for a finance lease for the Lessor at commencement of the lease: . 24

Date Details Dr/Cr Commencement Lease receivable Dr date Asset Cr (to record the lease receivable at commencement ) Cash at bank Dr Lease receivable Cr (to record receipt of the first lease payment )

Debit $ 78 707

Credit $

78 707 4 000 4 000

The general journal entries for a finance lease for the Lessor at the end of the first month: Date First month

Details Dr/Cr Debit $ Credit $ Cash at bank Dr 2 000 Lease receivable Cr 1 253 Interest revenue Cr 747 (to record receipt of the monthly lease payment and recognise interest revenue as $78 707 - $4 000 = $74 707 x 1% = $747 interest revenue)

(b) Box Ltd – Accounting for lease by Lessee The lessee must account for the lease by recognising the right-of-use asset and lease liability (para. 22). Determine the lease liability (para. 26) Net present value (using the interest rate implicit in the lease) of the ﬁxed payments not paid at commencement date less lessor incentive. There are four remaining payments of $20 000.

NPV =

 $2 000  1 1 −  = $74 707 0.01  (1 + 0.01)47   

$74 707 4 000 $78 707

The general journal entries for a lease for the Lessee at commencement of the lease: Date Details Dr/Cr Debit $ Credit $ Commencement Right-of-use asset - equipment Dr 78 707 date Lease liability Cr 74 707 Cash at bank Cr 4 000 (to recognise right-of-use asset, lease liability and initial payment on commencement of the lease – para. 22) Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson, Issues in Financial Accounting 16e 25

The general journal entries for a lease for the Lessee at the end of the first month: Date First month

Details Dr/Cr Debit $ Credit $ Interest expense Dr 747 Lease liability Cr 747 Lease liability Cr 2 000 Cash at bank Cr 2 000 (to recognise monthly payment and interest expense) Depreciation expense Dr 1 640 Accumulated depreciation Cr 1 640 (to recognise monthly depreciation of right-of-use asset $78 707/48 = $1640 )

Lessee’s Books: ABC Company The lessee must account for the lease by recognising the right-of-use asset and lease liability (para. 22). Determine the lease liability (para. 26) Net present value (using the interest rate implicit in the lease) of the ﬁxed payments not paid at commencement date less lessor incentive. There are five remaining payments of $15 000.

NPV =

 $15000  1 1 −  = $56 862 0.10  (1 + 0.10)5   

Schedule of lease payments: Lessee Period Lease Liability Opening Bal. $ 30 June 2020 56 862 30 June 2021 62 548

Lease payment# $ 15 000

$56 862 15 000 $71 862

Interest @ 10%

Lease Liability Closing Bal. $ $ 5 686 62 548 4 755 41 033

The general journal entries to reflect the initial and subsequent measurement of the lease liability and the right-of-use assets by ABC Company (lessee) for the first two years: Date 1 July 2019

Details Right-of-use asset - Machine Lease liability Cash at bank

Dr/Cr Dr Cr Cr

Debit $ 71 862

Credit $ 56 862 15 000

30 June 2020

1 July 2020

30 June 2021

(to recognise right-of-use asset, lease liability and initial payment para. 22) Interest expense Dr 5 686 Lease liability Cr 5 686 (to recognise interest on lease liability para. 36) Depreciation expense Dr 11 977 Accumulated depreciation Cr 11 977 (to depreciate right-of-use asset $71 862/six year term ) Lease liability Dr 15 000 Cash at bank Cr 15 000 (to record lease payment) Interest expense Dr 4 755 Lease liability Cr 4 755 (to recognise interest on lease liability para. 36) Depreciation expense Dr 11 977 Accumulated depreciation Cr 11 977 (to depreciate right-of-use asset)

Lessor’s Books: XYZ Company (Manufacturer/Dealer Lease) This is a dealer or manufacturer lease, and therefore we assume that 10% is the market rate of interest, and there is no unguaranteed residual. Based on these assumptions, the journal entries would be as follows: Lease receivable = $71 862 Is the net investment in the lease = $15 000 +

 $15 000  1 = $71 862 1 − 5 0.10  (1 + 0.1) 

Sales revenue = $71 862 The sales revenue is the fair value of $72 000, or if lower, the present value of lease payments at the market rate of interest = $71 862. PV of lease payments = $15 000 +

 $15 000  1 = $71 862 1 − 5 0.10  (1 + 0.1) 

Cost of goods sold = $52 000 The COGS is the cost of $52 000 or if lower, the carrying amount $52 000 of the item sold less the PV of any unguaranteed residual value 0. Inventory = $52 000 Is the carrying amount of the item sold. The general journal entries to reflect the initial and subsequent measurement of the lease receivable by XYZ Company (lessor) for the first two years: . 27

Date 1 July 2019

30 June 2020

1 July 2020

30 June 2021

Details Dr/Cr Debit $ Lease receivable Dr 71 862 Cost of goods sold Dr 52 000 Inventory Cr Sales revenue Cr (to recognise a manufacturer/dealer lease para. 22) Cash at bank Dr 15 000 Lease receivable Cr (to recognise receipt of first lease payment) Cash at bank Dr 15 000 Unearned lease revenue Cr Lease receivable Cr (to record lease payment) Unearned lease revenue Dr 5 686 Interest revenue Cr (to record revenue from lease interest )

Credit $

52 000 71 862

15 000

5 686 9 314

5 686

Manufacturer/Dealer Lessor This is a dealer or manufacturer lease, and therefore we assume that 10% is the market rate of interest. The lease payments included in the net investment in the lease are identified in paragraph 70 of AASB 16 as follows: (a) fixed payments, less any lease incentives payable; (b) … (c) any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor …; (d) …. (e) ….. Lease receivable (net investment in the lease) = $18 853  $4000  1 = $4 000 + + $3 500(1.01)-5 = $18 853 1 − 4 0.10  (1 + 0.1)  Sales revenue = $18 853 The sales revenue is the fair value of $18 853, or if lower, the present value of lease payments at the market rate of interest = $18 853  $4000  1 = $4 000 + + $3 500(1.10)-5 = $18 853 1 − 4 0.10  (1 + 0.10)  Cost of goods sold = $14 000 The COGS is the cost of $14 000 or if lower, the carrying amount $14 000 of the item sold less the PV of any unguaranteed residual value 0. . 28

Inventory = $14 000 Is the carrying amount of the item sold. The general journal entries to reflect the initial and subsequent measurement of the lease receivable by the manufacturer/dealer Lessor to the 1 July 2020: Date 1 July 2019

1 July 2019

1 July 2020

30 June 2021

Date 1 July 2019 1 July 2019 1 July 2020 1 July 2021 1 July 2022 1 July 2023 30 June 2024

Details Dr/Cr Debit $ Lease receivable Dr 18 853 Cost of goods sold Dr 14 000 Inventory Cr Sales revenue Cr (to recognise a manufacturer/dealer lease para. 22) Cash at bank Dr 4 000 Lease receivable Cr (to recognise receipt of first lease payment) Cash at bank Dr 4 000 Unearned lease revenue Cr Lease receivable Cr (to record lease payment) Unearned lease revenue Dr 1 485 Interest revenue Cr (to record revenue from lease interest )

Rent received 4 000 4 000 4 000 4 000 4 000 3 500 $23 500

Interest Revenue 10%

1 485 1 234 957 653 318 $4 647

Principal recovery 4 000 2 515 2 767 3 043 3 348 3 182 $18 853

Credit $

14 000 18 853

4 000

1 485 2 515

1 485

Balance of Lease receivable $18 853 14 853 12 338 9 572 6 529 3 182 --

Ruapehu Ltd – Lessor lease classification The lessor (Ruapehu Ltd) must classify the lease as either an operating lease or a finance lease. Guided by AASB 16, paragraph 61: The lease is classified a finance lease if substantially all of the risks and rewards incidental to ownership of an underlying asset pass from the lessor to the lessee. The following indicators individually or in combination would normally lead to the lease being classified a finance lease (para. 63). Each will be assessed relevant to the facts provided.

(a) The lease transfers ownership of the underlying asset to the lessee by the end of the lease term; • No transfer of title indicated. (b) The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonable certain, at the inception of the lease, that the option will be exercised; • No bargain purchase option. (c) The lease term is for a major part of the economic life of the assess even if title is not transferred; • 5/8 years if lease not renewed= 62.5% which is unlikely to be considered to be a major part of the assets life. • 7/8 years if lease renewed = 87.5% if the lessee exercises the option to extend, which may be considered to be a major part of the assets life, however, this is contingent on the extension which is not certain. (d) At the inception of the lease, the PV of MLP amounts to at least substantially all of the fair value of the leased asset; • Turoa Ltd did not guarantee the residual value, equal to 25% of the fair value of the lease asset. This risk is borne, legally, by an insurance company not related to either Turoa Ltd or the lessor. This would suggest, looking at the legal form of the contract, that the present value of minimum lease payments can be no more than 75% of the fair value of the leased asset and therefore difficult to suggest that the PV of MLP is ‘at least substantially all’ of the fair value of the leased asset. However, insurance premiums are normally set to compensate for risk which would be reflected in the premiums charged by the insurance company and paid by Turoa Ltd. In substance, Turoa Ltd has guaranteed the residual value and in substance this lease has a residual guaranteed by the lessee ensuring that the present value of the minimum lease payment is 100% of the fair value of the leased asset. The substance of the arrangement with the PV of MLP strongly suggests that this is a finance lease. • Further, AASB 16 defines a residual value guarantee as a guarantee made to a lessor by a party unrelated to the lessor that the value (or part of the value) of an underlying asset at the end of a lease will be at least a specified amount. Effectively, the residual value is therefore guaranteed. (e) The lease assets are of such a specialised nature that only the lessee can use them without major modification; • No indication of specialised equipment. Turning now to paragraph 64: (a) If lessee can cancel the lease, the lessor’s losses from cancellation are borne by the lessee; • It is not certain that the lessee is able to cancel the lease and not possible to decide on this point.

. 30

(b) Gains or losses from the fluctuations in the fair value of the residual accrue to the lessee; • There cannot be changes in the fair value of the residual for the lessor as the lessor will receive the contract amount (25% of the fair value). (c) The lessee may continue the lease for a second term at a rent substantially lower than the market rate; • The second lease term does not have lease rentals at lower than market rate. Conclusion: A decision must be made on the duration of the lease term – is it 7 years (indicating a finance lease) or 5 years (possibly indicating an operating lease). The point that must be settled is whether, at inception of the lease, it is reasonably certain that the lessee will exercise its option to renew the lease for a further two years. It is considered that the present value of minimum lease payments equals 100% of the fair value of the lease asset at inception since, in substance; the lessee has fully guaranteed the residual. This may well tip the classification decision in favour of a finance lease. Ruapehu Ltd would need to exercise judgement in making this decision. It should be noted, that under AASB 16, Turoa Ltd is required to capitalise the lease and therefore the classification is irrelevant to the lessee. 11

Compak Finance Ltd (a) Operating lease in the books of the lessor Date 30 June 2020

Details Cash at bank Lease revenue (to record lease payment) Depreciation expense Accumulated depreciation

Dr/Cr Dr Cr

Debit $ 20 000

Dr Cr

15 086

Credit $ 20 000

15 086

(to (depreciation of leased asset over 4 year useful life and $5 000 residual value $65 343 – 5 000 = 60 343/4 = $15 086) (b) Finance lease in the books of the lessor For the lessor, the unguaranteed residual must be included in the calculation of the net investment in the lease. Net receivable PV =

 $20000  1 + 5 000 (1 + 0.11)-4= $65 343. 1 − 4 0.11  (1 + 0.11) 

. 31

Date 1 July 2019

30 June 2020

Details Lease receivable Equipment (to recognise finance lease receivable) Cash at bank Lease interest revenue Lease receivable (to record lease payment)

Dr/Cr Dr Cr

Debit $ 65 343

Dr Cr Cr

20 000

Credit $ 65 343

7 188 12 812

Rent received

1 July 2019 30 June 2020 30 June 2021 30 June 2022 30 June 2023 30 June 2017

Interest Revenue 11%

20 000 20 000 20 000 20 000 5 000 $85 000

7 188 5 778 4 214 2 477 0 $19 657

Principal recovery

12 812 14 222 15 786 17 523 5 000

Balance of Lease receivable $65 343 52 530 38 309 22 523 5 000 -

Sale and leaseback The question states that the transfer of the asset constitutes a sale in accordance with AASB 15. (a) Hawthorne Ltd (seller/lessee) • Derecognise the underlying asset (carrying amount) • Recognise the right-of-use asset (proportion of previous carrying amount) • Recognise the lease liability • Record the gain/loss on sale of rights transferred Because the consideration for the sale of the building is not at fair value, Hawthorne Ltd and Kew Ltd must make the necessary adjustments to measure the sale proceeds at fair value. The amount of the excess sale price of $300 000 ($3 500 000 – $3 200 000) is recognised as additional financing provided by Kew Ltd to Hawthorne Ltd. The present value of the annual payments (10 payments of $500 000, discounted at 10 per cent per annum) amounts to $3 072 284.

 $500000  1 = $3 072 284 1 − 10  0.10  (1 + 0.10)  This is separated as $300 000 which relates to the additional financing non-lease component and $2 772 284 which relates to the lease component. The lease payment of PV =

. 32

$500 000 is allocated between the lease component and the non-lease component relating to the additional financing based on the relative proportions of the NPV as follows: $300 000 For the non-lease component $500 000 x $3 072 284 = $48 824 For the lease component

$2 772 284

$500 000 x $3 072 284 = $451 176

Hawthorne Ltd measures the right-of-use asset arising from the leaseback of the building at the proportion of the previous carrying amount of the building that relates to the right of use retained by Hawthorne Ltd. This is calculated as the carrying amount divided by the fair value multiplied by the PV of discounted lease payments for the right-of-use asset as follows: $2 800 000 $3 200 000

x $2 772 284 = $2 425 748.

Hawthorne Ltd recognises only the amount of the gain that relates to the rights transferred to Kew Ltd. The gain on sale of building of $400 000 ($3 200 000 - $2 800 000) is: (i) The right to use the building retained by Hawthorne Ltd (seller/lessee) = $346 535 ($400 000 ÷ $3 200,000 × $2 772 284.); and (ii) The rights transferred to Kew Ltd (buyer/lessor) = $53 465 ($400 000 ÷ $3 200 000 × ($3 200 000 – $2 772 284)). At commencement date, the general journal entry to record the transactions by Hawthorne Ltd is as follows: Date 1 July 2019

Details Cash at banka Right-of-use assetb Buildingc Financial liabilityd Gain on rights transfere (to recognise sale of building)

Dr/Cr Dr Dr Cr Cr Cr

Debit $ 3 500 000 2 425 748

Credit $

2 800 000 3 072 284 53 464

(a) cash received by seller/lessee on transfer of the building (b) right-of-use asset is recognised at the proportion of the previous carrying amount of the building that relates to the right of use retained by lessee (c) derecognition of the building on sale to the buyer/lessor at the carrying amount (d) financial liability is equal to the present value of lease payments discounted at lease implicit rate (e) gain on sale of the building as the rights transferred to the buyer/lessor

. 33

(b) Kew Ltd (buyer/lessor) At commencement date, the general journal entry to record the transactions by Kew Ltd is as follows: Date 1 July 2019

Details Buildinga Financial assetb Cashc

Dr/Cr Dr Dr Cr

Debit $ 3 200 000 300 000

Credit $

3 500 000

(a) fair value of the building transferred to the buyer/lessor (b) financial asset is equal to the non-lease component being 10 payments of $48 824 discounted at 10% per annum =

 $48824  1 = $300000 1 − 10  0.10  (1 + 0.10) 

After the commencement date, Kew Ltd accounts for the lease by recording $451 176 of the annual payments of $500 000 as lease payments. The remaining $48 824 of annual payments received from Hawthorne Ltd are accounted for as (a) payments received to settle the financial asset of $300 000 and (b) interest revenue recognised on financial asset balance at 10 per cent per annum. The general journal entry to record the transactions by Kew Ltd is as follows: Date 30 June 2020

Details Cash at banka Lease rental revenueb Interest revenuec Financial assetb

Dr/Cr Dr Cr Cr

Debit $ 500 000

Credit $ 451 176 30 000

Cr 18 824 (a) annual payment (b) represents the component allocated to the lease (c) interest revenue is calculated as the opening balance of the financial asset of $300 000 x 10% = $30 000. (d) the reduction in the financial asset is calculated as the non-lease component payment of $48 824 – allocation to interest revenue of $30 000 = $18 824

Evolve Ltd – Sale-and-leaseback The question states that the transfer of the asset constitutes a sale in accordance with AASB 15. (a) Evolve Ltd (seller/lessee) • Derecognise the underlying asset (carrying amount) • Recognise the right-of-use asset (proportion of previous carrying amount) • Recognise the lease liability • Record the gain/loss on sale of rights transferred The sale of the building is at fair value.  $2475000  1 PV of annual payments = 1 −  = $20 843 818 0.11  (1 + 0.11)25  . 34

Evolve Ltd measures the right-of-use asset arising from the leaseback of the building at the proportion of the previous carrying amount of the building that relates to the right of use retained by Evolve Ltd. This is calculated as the carrying amount divided by the fair value multiplied by the PV of discounted lease payments for the right-of-use asset as follows: $18 000 000 x $20 843 818 = $17 054 033 $22 000 000

Evolve Ltd recognises only the amount of the gain that relates to the rights transferred to Bank. The gain on sale of building of $4 000 000 ($22 000 000 - $18 000 000) is: (i) The right to use the building retained by Evolve Ltd (seller/lessee) = $3 789 785 ($4 000 000 ÷ $22 000 000 × $20 843 818.); and (ii) The rights transferred to Bank (buyer/lessor) = $210 215 ($4 000 000 ÷ $22 000 000 × ($22 000 000 – $20 843 818)). At commencement date, the general journal entry to record the transactions by Evolve Ltd is as follows: Date 1 July 2019

Details Cash at banka Right-of-use assetb Buildingc Financial liabilityd Gain on rights transfere (to recognise sale of building)

Dr/Cr Dr Dr Cr Cr Cr

Debit $ 22 000 000 17 054 033

Credit $

18 000 000 20 843 818 210 215

(b) Bank (buyer/lessor) At commencement date, the general journal entry to record the transaction by the Bank is as follows: Date 1 July 2019

Details Building Cash

Dr/Cr Dr Cr

Debit $ 22 000 000

Credit $ 22 000 000

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Chapter 12 ACCOUNTING FOR EMPLOYEE BENEFITS LEARNING OBJECTIVES After studying this chapter you should be able to: 1 explain the reasons for salary packaging; 2 discuss the accounting regulations governing employee benefits; 3 apply the requirements of AASB 119 ‘Employee Benefits’ to wages and salaries; 4 identify the issues in accounting for annual leave and apply the requirements of AASB 119 ‘Employee Benefits’; 5 distinguish between accumulating and non-accumulating sick leave and implement the requirements of AASB 119 ‘Employee Benefits’ to account for sick leave; 6 explain the issues in measuring long-service leave obligations and implement the requirements of AASB 119 ‘Employee Benefits’ to account for long service leave; 7 identify the issues in accounting for profit-sharing and bonus plans and apply the requirements of AASB 119 ‘Employee Benefits’; 8 explain the issues in accounting for termination benefits and apply the requirements of AASB 119 ‘Employee Benefits’; 9 explain the measurement and recognition of the remuneration resulting from share-based payment transactions in accordance with AASB 2 ‘Share-based Payment’, distinguishing between equity-settled share-based payment transactions, cash-settled share-based payment transactions and share-based payment transactions with cash alternatives; and 10 identify the issues in accounting for post-employment benefits and apply the requirements of AASB 119 ‘Employee Benefits’ to post-employment benefits, distinguishing between defined contribution and defined benefit plans.

QUESTIONS 1

(a) A remuneration package is the set of benefits comprising the remuneration of an employee. A remuneration package may include benefits such as cash, a motor vehicle, low-interest loans, the payment of school and club fees, an expense account, an entertainment allowance, long-service leave, sick leave, contributions to a superannuation plan and an employee share option plan. (b) Remuneration packages have become widespread in Australia because they are ‘tax effective’. Where personal income tax rates are greater than the company income tax rate, a fully taxed salary means that the after-tax cost to the employer is greater than the after-tax benefits to the employee. Making part of the remuneration package tax free in the hands of the employee increases the after-tax benefits to the employee with no change in the after-tax cost to the employer. For example, where the company tax rate is 30 cents in the dollar and the average personal tax rate is 45 cents in the dollar, a cash salary of $50 000 provides an after-tax benefit to the employee of ($50 000 [1 – 0.45]) or $27 500 and an after-tax cost to the employer of ($50 000 [1 – 0.30]) or $35 000. If the remuneration package was changed to $40 000 cash and a $10 000 non-taxable component, the after-tax benefit to the employee would be $10 000 + $40 000 (1 – 0.45) or $32 000. The employee has had an after-tax salary increase at no cost to the employer. (c) The fringe benefits tax (FBT) is designed to reduce the tax revenue losses to the government from the non-taxed components of a remuneration package. The employer is taxed instead. FBT reduces the attractiveness of remuneration packages from the employer’s viewpoint.

The statement is correct for many employees. Sick leave is a conditional benefit because it is paid only if the employee becomes sick. Superannuation is a benefit, which is deferred until the employee retires. It is usually conditional on the employee being eligible under the superannuation plan. Long-service leave is also both conditional and deferred until a future period. The benefit is paid only if the employee satisfies the conditions of the long-service leave scheme and the employee is not paid until a future period. The presence of both conditional and deferred benefits creates problems for measuring salary expense in the current reporting period. The benefits are earned by the employees in the current reporting period, but the payments are conditional on future events, which are uncertain.

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If it is assumed that ‘accrued’ means ‘owing’ or ‘due and payable on reporting date’, then this statement is inconsistent with the definitions of liabilities in the Framework (2014) and AASB 119. The statement implies that a liability exists only if it is actually payable at reporting date. This could be regarded as an old-fashioned view. The more modern view is reflected by AASB 119 which requires a ‘present obligation’ arising from a ‘past transaction’ to be recognised in the statement of financial position. Such a liability may not be presently payable. For example, long-service leave earned in a period constitutes a ‘present obligation’ to pay in the future. A successful claim may not be made by an employee on reporting date because the conditions giving rise to the payment may not have been met. For example, the employee may have to provide services to the employer for several more years before being entitled to take the leave. According to the Framework (2014) and AASB 119, however, a liability should be recognised provided that it can be measured reliably and its ultimate payment is probable.

AASB 119 specifies that the nominal basis of measurement must be used for short-term employee benefits (para. 9). Paragraph 8 defines short-term employee benefits as ‘employee benefits (other than termination benefits) that are expected to be settled wholly before twelve months after the end of the annual reporting period in which the employees render the related service’. Therefore, the nominal basis or an undiscounted basis should be used. If on the other hand, the employee benefits are expected to be settled after 12 months of the end of the annual reporting period, they are to be measured at a discounted amount. Paragraph 83 of AASB 119 requires that ‘market yields as at the reporting date on high quantity corporate bonds must be used to discount estimated future cash flows. The currency and term of the bonds must, to the extent practicable, be consistent with the currency in which the employee benefit obligations are to be settled and the estimated term of the employee benefit obligations’. This means that: • • •

a pre-tax bond rate must be used; the bonds must be those of the nation whose currency will be used to settle the obligation; and the term of the bonds is usually the weighted average of the term to expected settlement.

Recent research suggests that Australia has a deep market in such bonds and so the corporate bond rate would be appropriate for discounting benefits in Australian currency. . 3

In countries without a deep market for corporate bonds, the market yields (at the reporting date) on government bonds shall be used’ (para. 83). 5

The following explanation is provided in Deloitte (2012), ‘Amendments to AASB 119 – Employee Benefits: The Implications for Employers’, Actuaries and Consultants (p. 4): ‘The inclusion of “expected” and “wholly” in the definition of short-term employee benefits might lead to a change in classification from short-term to long-term employee benefits. For example, for annual leave in Australia it is generally not required (or “expected”) that the accrued annual leave is wholly used (settled) before the end of the next reporting period … The impact of this would be that annual leave classified as long term would need to be discounted allowing for expected salary levels in the future period when the leave is expected to be taken.’

(a) Non-cumulative sick leave is an annual entitlement. If it is not taken, it lapses and a new entitlement begins. Cumulative sick leave allows an employee to carry forward unused sick leave entitlements for use in subsequent periods. (b) Vesting sick leave entitlements give an employee the right to be paid the full amount of the accumulated entitlement, if the employee resigns or retires. Non-vesting sick leave entitlements become claimable only when an employee makes a valid claim for sick leave. Non-vesting accumulated sick leave entitlements are lost by an employee on retirement or resignation. (c) The eventual payment of vesting sick leave entitlements is certain. It will be paid as sick leave or in cash on retirement or resignation. The eventual payment of non-vesting sick leave entitlements is less certain. If sick leave is not taken, it will be lost by the employee on retirement or resignation. There will be some incentive for an employee to use up accumulated sick leave by taking ‘sickies’ as resignation or retirement approaches. With non-vesting sick leave entitlements, the expense and liability calculation should include an estimate based on past experience of the probability that the leave will be taken. With vesting sick leave, the probability of it being taken is 1. The two methods are identical in principle. They simply involve different probability inputs.

Sick leave is a short-term compensated absence for the purposes of AASB 119. The standard essentially adopts the conventional practice in recognising accumulating sick

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leave. For this reason, it seems reasonable and most students would be expected to support the required treatment of sick leave. In particular, AASB 119 requires that a liability is recognised as employees provide service that increases their entitlement to future paid sick leave (para. 13(a), para. 15). The liability is equal to ‘the amount of short-term benefits expected to be paid in exchange for that service’ (para. 11). For vesting sick leave, the amount of the entitlement is equal to 100 per cent of the sick leave accumulated. For non-vesting benefits, past experience should be used to recognise only that portion of the accumulated sick leave expected to be used in the future by employee (para. 16). Sick leave entitlements are usually settled within 12 months after the end of the period in which employees provide the related services. As such, paragraph 11 requires any liability for sick leave entitlements to be measured on a nominal basis at the anticipated pay rates when it is expected that the leave will be taken. 8

(a) Long-service leave allows extended paid leave to employees as a reward for uninterrupted service to the same employer. It is in addition to annual leave. In a few cases, long-service leave is ‘portable’ which means that accumulated long-service leave entitlements may be taken to a new employer. Long-service leave provisions vary between industrial awards. However, they nearly all have similar conditions. The early periods of employment (usually up to five or seven years) provide no long-service entitlement. If employment ceases during this period, the employee receives nothing. During the next period (five or three years depending on the length of the pre-conditional period), long-service leave accumulates from the beginning of employment. While employees cannot take leave during this period, if they resign they are usually entitled to a cash payment. When the second period has expired, the employee continues to accumulate long-service leave and is eligible to take accumulated leave entitlements. On resignation or retirement, there is usually an entitlement to a cash payment for any accumulated leave. (b) The pre-conditional period is the early years of employment when an employee has no entitlement to long-service leave. If the employee resigns or retires during this period, there is no entitlement to long-service leave. The pre-conditional period (usually up to five or seven years) differs between industrial awards.

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The conditional period follows the pre-conditional period. At the beginning of the conditional period, long-service leave entitlements accruing from the beginning of the pre-conditional period are available. An employee is not entitled to take long-service leave during this period (usually five or three years depending on the length of the preconditional period). However, employees are entitled to a cash payment in lieu of longservice leave if they resign or retire during the conditional period. The unconditional period follows the conditional period. During the unconditional period, long-service leave continues to accrue and an employee may take the accumulated leave or the equivalent cash on resignation or retirement. 9

It could be argued that using the wages or salaries payable when the leave is expected to be taken and discounting those amounts to a present value may offset each other so that the net change in the long-service leave liability is negligible. While it is true that the former will increase the liability and the latter will reduce it, there is no assurance that their combined effect will have only a small net effect on the liability. It is much more likely that the liability will be materially changed by applying the method in AASB 119. The statement must, therefore, be viewed with caution. It is possible that the effect on the liability would be small, but this is unlikely.

10 (a) Yes, AASB 119 draws a distinction between termination benefits and other employee benefits because the event that gives rise to the benefit is the termination rather than an employee’s service (para. 159). (b) Termination benefits arise when an entity is committed, by legislation, by contractual or other agreements with employees or their representatives (e.g. unions) or by a constructive obligation based on business practice, custom or a desire to act equitably, to make payments (or provide other benefits) to employees when it terminates their employment. Such payments are called ‘termination benefits’ (AASB 119, para. 163). (c) Your friend is incorrect because involuntary redundancies are covered by AASB 119. Section 12.5 contains further discussion of accounting for involuntary redundancies. 11 (a) Yes, the receipt of 6 months’ wages plus sick leave and annual leave entitlements satisfies the definition of termination benefits in AASB 119 (i.e. wages until the end of a specified notice period if the employee renders no further service that provides economic benefits to the entity).

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(b) Bison Ltd should recognise the termination benefits on 9 December 2019. In accordance with AASB 119, the date of recognition of termination benefits is the date when Bison can no longer withdraw from the offer of termination benefits (para. 165). This date is the earlier date of when: (i) Employees accept the offer (by 31 December 2019) and (ii) There are restrictions on Bison’s ability to withdraw the offer of termination benefits (para. 166). To determine if there are restrictions on Bison’s ability to withdraw the offer, the following criteria must be met (para. 167): • •

•

It is unlikely to change the plan (YES – there is no evidence to suggest that change is envisaged); The expected completion date, number of employees and their functions and location have been identified (Yes – all of this detail has been communicated); and There is enough detail of the type and amount of the termination benefit payments (YES – this detail has been provided).

These three criteria are satisfied on 9 December 2019 when the plan is first communicated to Bison Ltd’s employees. (c) The lack of detail provided in the call for expressions of interest means that it is still possible for Bison Ltd to withdraw from the termination benefits offer. Thus, recognition of the termination benefits is not possible. 12 A compensated absence refers to circumstances in which employees continue to be paid even though they are absent. Compensated absences include annual leave, sick leave and long-service leave. A profit-sharing and bonus plan is a component of wages and salaries that is determined on the basis of the entity’s profit level, share price level or on a subjective assessment of the employee’s worth. It is important to emphasise that the term covers only cash payments. Where the benefits are in the form of equity they are called ‘equity settled share-based payments’. There are a wide variety of these schemes. For example,

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employees may be paid an annual cash bonus determined by the level of entity profit and the employer’s assessment of the contribution of the employee to that profit. Another example is a cash payment to an employee that is related to profit if they remain with the entity for a specified period or meet other criteria during subsequent periods. Termination benefits are benefits paid to employees as a consequence of their employment being terminated or upon them accepting a voluntary separation package. These benefits arise when an entity is committed by legislation, by contractual or other agreements with employees, or by a constructive obligation based on business practice, custom or desire to act equitably to make payments (or to provide other benefits) to employees when it terminates their employment (para. 163). Termination benefits are typically lump sum payments, but sometimes also include enhancement of retirement benefits, and salary until the end of a specified period. Post-employment benefits are employee benefits (other than termination benefits) which are payable to an employee after the completion of employment. Examples are free or subsidised air or train travel, office accommodation, superannuation pensions, and post-employment medical care. Post-employment benefits usually accrue over time and are not payable until a specified employment period has passed. 13 AASB 2 requires the recognition of an expense as employees provide services in sharebased payment transactions (para. 8). The general assumption is that services provided by employees to an entity as part of such a transaction are consumed immediately, which gives rise to an expense. AASB 2 also requires entities to recognise a corresponding increase in equity from granting share options (para. 7). That is: ________________________________________________________________ Remuneration expense Dr Employee options (equity) Cr _________________________________________________________________ AASB 2 requires the measurement of share-based payments at fair value. These transactions are recognised at the time the goods or services are received or acquired (para. 7, AASB 2), and the way in which such transactions are recognised depends upon whether the share-based transaction is equity-settled, cash-settled or a combination of both. • If the goods or services are acquired in an equity-settled share-based payment transaction, an increase in equity is recognised with a corresponding increase in . 8

expenses (if the goods or services are consumed immediately), or a corresponding increase in assets (if the goods or services are yet to be consumed). • If the goods or services are acquired in a cash-settled share-based payment transaction, an increase in liabilities is recorded with a corresponding increase in either expenses or assets as appropriate. • For share-based payments with cash alternatives, recognition depends upon whether the company settles the transaction in cash (in which case an increase in liabilities and expenses or assets is required), or by issuing equity instruments (in which case an increase in equity and expenses or assets is required). 14 AASB 2 requires that for cash-settled share-based payment transactions the goods or services acquired and the liability incurred are measured at the fair value of the liability (para. 30). Additionally, the liability is to be remeasured to fair value at the end of each reporting period until it is settled. Any changes in fair value are recognised in profit or loss for the period (para. 30). The timing of recognition depends on when the rights vest. If the rights to payment vest immediately, the reporting entity is to immediately recognise the services received and the liability incurred to pay for them (para. 32). Alternatively, if the rights vest after a specified period of service to be completed by employees, the services rendered by the employees and the associated liability incurred to pay for them are recognised over the vesting period as the services are provided (para. 32). 15 For employee share-based payment transactions which provide employees with a choice of cash payment or equity instruments, AASB 2 requires that the reporting entity estimates the fair value of the compound instrument (i.e. a financial instrument which contains a debt and equity component) by initially measuring the fair value of the debt component and then the fair value of the equity component (para. 37). The components of the compound instruments are to be accounted for separately (para. 38). That is, the debt component is accounted for as a cash-settled share-based payment transaction and any equity component is accounted for as an equity-settled share-based payment transaction. 16 The required accounting treatment for employee share options has been the subject of much debate in many countries. Various reasons have been advanced as to why share options should not be recognised in financial statements in this way. For example, opponents have claimed the recognition of share options as an expense in a similar

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manner to other forms of employee remuneration is inappropriate. Unlike other forms of remuneration, it was argued that the granting of options does not require an entity to sacrifice cash or other assets so there is no cost. Also, there have been concerns expressed about recognising an expense because the provisional allocation of shares and options may have no value since they may never vest. Accounting standard setters have rejected these arguments. They have noted, for example, that although some companies have argued that share options have no value until exercised, the share options do have value because they provide an incentive to employees to improve operating performance (and so, the cost of the options should be recognised earlier than the date on which they are exercised). In addition, the expense element arises because the services provided by employees are immediately consumed as created (i.e. an asset produced by their services is immediately decreased). Although it has been difficult in the past to measure a number of these option schemes because of their unique terms and conditions, advances in financial mathematics over recent years have increased the reliability of the measurement of the cost of share options. 17 A past service cost arises when there is a change in the defined benefit obligation for employee service provided in prior periods. This occurs when a defined benefit plan is introduced by an established employer or when the plan is amended (e.g. benefits are increased). For example, if a superannuation plan with benefits dependent on years of service is introduced by an employer, then the employer has an obligation to its present employees as well as to those who are subsequently employed. The benefits for existing employees are usually backdated to the date when their employment began. The employer must bear a ‘one-off’ cost to provide for the benefits arising from this past service. This ‘one-off’ cost is called a past-service cost. The ‘current service cost’ is the periodic charge borne by the employer to cover the superannuation benefits earned during the current period in the case of a defined benefit plan, and in the case of a defined contribution plan, it is the periodic amount (specified in the plan) to be paid by the employer to the plan. 18 AASB 119 sets out different accounting and reporting requirements for defined contribution and defined benefit plans to reflect the economic substance of the arrangements. Under defined contribution plans, an employer’s legal or constructive obligation is limited to the amount that it agrees to pay to the plan. Consequently, the risks of lower than expected benefits are borne by employees (para. 27). When an

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employee provides services during a period, paragraph 51 requires the employing entity to recognise any contributions payable as a liability and an expense after deducting any contributions already paid. If excess contributions have been paid, an asset is to be recognised (prepaid expense). The prescribed treatment is similar to accounting for wages and salaries. The only liability for post-employment benefits is for the accrued contributions payable as at the reporting date. In contrast, an employer effectively underwrites the actuarial and investment risks of a defined benefit plan. Ultimately the payment of benefits depends on the plan’s financial position, investment performance and the ability (and willingness) of an employer to fund any shortfall in plan assets. Consequently, the risk of lower than expected benefits falls, in substance, on the employer (para. 56). The treatment prescribed in AASB 119 reflects the substance of this arrangement. It is based on the assumption that the employer has an obligation when the fair value of the plan assets is less than the present value of the defined benefit obligation under the plan. The difference is a liability because the employer intends to ensure that the post-employment benefits are paid. In circumstances where the fair value of the plan assets exceeds the present value of the defined benefit obligation, the employer shows the difference as an asset. This amount is an asset because it either reduces the obligation of the employer to make contributions to the plan in the future or represents an amount that the employer may ‘claw back’. 19 (Note that the answer to Question 15 above in relation to defined benefit plans is also relevant.) Under defined benefit post-employment plans, an employer effectively underwrites the actuarial and investment risks of a defined benefit plan. Ultimately the payment of benefits depends on the plan’s financial position, investment performance and the ability (and willingness) of an employer to fund any shortfall in plan assets. The assumption underlying the treatment prescribed in AASB 119 is that the risk of lower than expected benefits falls, in substance, on the employer. The method of accounting for defined benefit post-employment plans in AASB 119 attempts to reflect this position. It is based on an assumption that the employer has an obligation when the fair value of the plan assets is less than the present value of the defined benefit obligation under the plan. (Remember that the defined benefit obligation is the expected future payments required to settle the obligation resulting from employee service in current and prior periods).

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A deficit between plan assets and the defined benefit obligation is considered to be a liability because the employer intends to ensure that the superannuation benefits are paid. In circumstances where the fair value of the plan assets exceeds the present value of the defined benefit obligation, the employer shows the surplus as an asset. This amount is considered an asset because it is controlled by the entity as a result of past transactions and represents future economic benefits in the form of reductions in future contributions or an amount that the employer may ‘claw back’ as a cash refund (para. 65). 20 AASB 119 (para. 120) requires the recognition of a defined benefits cost comprising the following components: (a) service cost (current and past) in profit or loss; (b) net interest on the net defined benefit liability (asset) in profit or loss; and (c) re-measurements of the net defined benefit liability (asset) in other comprehensive income. Service cost: The current and past service costs are to be recognised immediately in profit and loss (paras 103, 120), and are to be determined using the Projected Unit Credit Method (para. 64). This calculation is usually performed by an actuary.

Net interest cost: The net interest cost is the change in the net defined benefit liability (asset) during the period that arises from the passage of time (para. 8). It is determined by multiplying the net defined liability (asset) by the discount rate specified in paragraph 83 (i.e. the yield on corporate bonds) at the beginning of the reporting period, taking into account contributions made and benefits paid (para. 123). Specifically, it comprises the interest cost on the defined benefit obligation after adjusting for interest income on plan assets and interest on the effect of the asset ceiling (paras 123, 124). Re-measurements of the net defined benefit liability (asset): Re-measurements of the net defined benefit liability (asset) are to be recognised in other comprehensive income (para. 120). Re-measurements are defined in paragraph 8 as: (a) actuarial gains and losses; (b) the return on plan assets, excluding amounts included in net interest on the net defined benefit liability (asset); and

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(c) any change in the effect of the asset ceiling, excluding amounts included in net interest on the net defined benefit liability (asset)’. Actuarial gains and losses are defined in paragraph 8 as changes in the present value of the defined benefit obligation due to experience adjustments and changes in actuarial assumptions. Examples of experience adjustments include unexpectedly high or low employee turnover rates and mortality, and increases in salaries (para. 128). Examples of changes in assumptions include changes in the discount rate, changes in estimates of employee turnover and changes in assumptions regarding benefit payment options (para. 128).

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PROBLEMS 1

Spring Ltd When an employee purchases at cost goods that the employer produces, the amount of the employee benefit is the cost of the goods sold. The acquisition of $1000 worth of goods by the production manager would be recorded by Spring Ltd as follows: 30 June 2020 Cash at bank Employee benefits expense Inventory Sales revenue

Dr Dr Cr Cr

$1 000 1 000 $1 000 1 000

Where an employee is entitled to low-interest loans, the amount of the employee benefit is the net marginal cost to the employer. If Spring Ltd borrows at a rate of interest of 8% (interest = $8000) but makes a loan to an employee at a rate of interest of 5% (interest = $5000), the general journal entry for the loan of $100 000 would be as follows:

Loan receivable Cash

Dr Cr

$100 000

Cash Employee benefit expense Cash/interest payable

Dr Dr Cr

$5 000 3 000

$100 000

$8 000

Annual leave is paid at the wage rates current when the leave is taken. If there is a change in wage rates during the reporting period, there should be a change in the liability and the expense. The increased salary means that the cost of Jones’ leave rises to $60 000 × 4/52 × 1.175, or $5423.08, which is $104.29 per week. The annual leave expense and the annual leave payable should be $104.29 per week × 15 weeks, or $1564.35. The following general journal entry adjusts these accounts to reflect the new rate of pay: Annual leave expense Annual leave payable

Dr Cr

$208.65* $208.65

*(104.29 – 90.38) per week × 15 weeks = $208.65

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The general journal entry to record the accrual of Jones’ leave entitlement from the time of the salary increase would be as follows: Annual leave expense Dr $104.29 Annual leave payable Cr $104.29 3

Addison Ltd Employees are entitled to 13 weeks of leave after 15 years of continuous service. Use the corporate bond rate as the discount rate. For example, for the group of employees with 4 years of continuous service, there are 11 years remaining until they are unconditionally entitled to long-service leave. The appropriate discount rate is therefore the yield on corporate bonds with a period to maturity of 11 years – that is, 6.5%. 4 years’ service 13 4  15  52  940 000 0.35 (1.065 )11

$10 971.32

32 068.43

33 137.76

21 333.33

8 years’ service 13 8  15  52  340 000 0.90 (1.035 )7

12 years’ service 12 13  15  52  180 000 1.00   3 (1.03 )

16 years’ service 16 13  15  52  80 000  1  

Long-service leave liability as at 30/6/2020

$97 510.84

The journal entry would be as follows: _________________________________________________________________ 30 June 2020 Long-service leave expense Dr $25 140 Provision for long-service leave Cr $25 140 ($97 511 – 72 360 = 25 140) _________________________________________________________________ . 15

Sea Ltd Use the yield on corporate bonds as the appropriate discount rate. For example, for Jones with 3 years of continuous service, there are 7 years remaining of the vesting period. The appropriate discount rate is therefore the yield on corporate bonds with a period to maturity of 7 years – that is, 7.0%. The liability for Jones on 30 June 2020 is calculated as follows: 13  3   10  52  48 500  0.22 = $498.36 (1.07 )7

The liability for Kall on 30 June 2020 is calculated as follows: 13  6    10 52  57 000  0.73 = $5545.49 (1.03 )4

The liability for Blewitt on 30 June 2020 is calculated as follows:  10 13   10  52  85 000   1.0  

= $21250

The total LSL liability is equal to $27293.85 ($498.36 + 5545.49 + 21250). The total LSL liability that should appear in the statement of financial position prepared for Sea Ltd for the year ended 30 June 2020 is $27 293.85. The following general journal entry would be passed by Sea Ltd. _________________________________________________________________ LSL expense Dr $7694 Provision for LSL Cr $7694 (Increase in LSL provision = $27 294 − $19 600) _________________________________________________________________ 5

Regg Ltd Vesting sick leave entitlement = $14 000. This amount would be reflected as an outstanding liability of Regg Ltd because there is 100% certainty that this sick leave entitlement will be paid to the employees.

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Non-vesting entitlements – the amount of the liability is determined by past experience. The average amount of accumulated sick leave is 4 days per employee at 30 June 2020. This is lost if it is not taken during the year ending 30 June 2021. 45 employees: Based on past experience, 45 employees will take no more than 10 days. This is adequately met by next year’s entitlement of 10 working days of sick leave. Thus, the accumulated 4 days of sick leave is not carried forward as an asset for the 45 employees. 15 employees: There are 15 employees who are expected to take 12 days of sick leave during the year ending 30 June 2021, when next year’s entitlement is only 10 working days. As a result, 2 working days of the leave accumulating during the period ended 30 June 2020 will be accrued to meet the expected 12 days of sick leave. That is: 15 employees × 2 days’ sick leave/5 working days × $24 000 weekly payroll = $9 600 Total provision for sick leave reported in Regg Ltd’s statement of financial position as at 30 June 2020 = $23 600 = $14 000 (vesting) + $9 600 (non-vesting) 6

Fortuna Ltd Profit-sharing plan expense Dr 1 495 000 Profit-sharing plan obligation Cr 1 495 000 (2.3% x $65 000 000) As soon as the performance hurdle has been cleared, an obligation is created (para. 19). Its measurement should reflect the possibility that some employees will not have remained with Fortuna Ltd for the specified period of time (para. 20), therefore the obligation is recognised at 2.3% of net profit after tax rather than 2.7% of net profit after tax. Since it is to be paid within 3 months it is measured at its nominal amount.

Meadow Ltd Paragraph 160 of AASB 119 requires that Meadow Ltd accounts for benefits provide in exchange for termination of employment as termination benefits and accounts for benefits provided in exchange for services as short-term employee benefits.

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Termination benefits: Recognition of a liability for termination benefits occurs at the earlier of when the plan of termination is announced and when Meadow Ltd recognises the restructuring costs associated with the closure of the factory. There is not enough detail in the question to identify when the restricting costs have been recognised, so it is not possible to identify a specific date. Students should be able to identify the two possibilities from which to choose a date of recognition. The liability is measured as the amount that Meadow would have to pay for terminating the employment regardless of whether the employees stay and render service or they leave before closure. Therefore, the termination benefit liability is $1 800 000 or 120 employees x $15 0000. Benefits provided in exchange for service (short-term benefits) These are the incremental benefits employees receive if they provide services for the full 10-month period in exchange for services provided over that period. The amount is recognised as a short-term employee benefits with an increase in expense and liability recognised in each month during the service period of 10 months. The total amount is therefore $4 000 000 or 100 employees x $40 000. Allocated to each month is $400 000 per month for 10 months ($4 000 000/10 months). 8

(a) Moonlight Ltd 1 July 2018 No entry is recorded because the service vesting condition of three years of service has not been completed. 30 June 2019 Remuneration expense Dr $275 000 Employee options (equity) Cr $275 000 (100 options x 550 (700-80-70) executives x $15 x 1/3 years) 30 June 2020 Remuneration expense Dr $255 000 Employee options (equity) Cr $255 000 (Cumulative remuneration expense is $530 000 which is estimated as:

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100 options x 530 (700-80-40-50) executives x $15 x 2/3 years The remuneration expense for the year is equal to $255 000 or $530 000 - $275 500) 30 June 2021 Remuneration expense Dr $257 500 Employee options (equity) Cr $257 500 (Cumulative remuneration expense if $787 500 which is estimated as: 100 options x 525 (700-80-40-55) executives remaining x $15 x 3/3 years The remuneration expense for the year is equal to $257 500 or $787 500 – $530 000) (b) The modification to terms and conditions of the share options is not beneficial to the employees because the fair value has decreased. As a result, Moonlight Ltd is to continue to account for the arrangement ‘as if that modification had not occurred’ (para. B44, Appendix B). Therefore the answer to (a) is unchanged. (c) 30 June 2019 No change to the answer for part (a). That is: Remuneration expense Dr $275 000 Employee options (equity) Cr $275 000 (100 options x 550 (700-80-70) executives x $15 x 1/3 years) 30 June 2020 Remuneration expense Dr Employee options (equity) Cr

$308 000 $308 000

The repricing of the options is beneficial to the employee because it increases their fair value from $9 to $11 per option. Therefore, it is to be recognised (para. 27). Specifically, the increase in fair value per option of $2 ($11-$9) is recognised over the remaining two years, together with the remuneration expense based on the original option value of $15 (para. B43 (a), Appendix B). The cumulative remuneration expense for the period equals $583 000. This is calculated as 100 options x 530 (700-80-40-50) employees expected to remain until the end of year 3 x [($15 x 2/3 years) original issue + ($2 ($11-$9) x 1 out of 2 years) modification] The remuneration expense for the year is $335 500 or $583 000 - $247 500.

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30 June 2021 Remuneration expense Dr $309 500 Employee options (equity) Cr $309 500 The cumulative remuneration expense for the period equals $892 500. This is calculated as 100 options x 525 (700-80-40-55) employees x [($15 x 3/3 years) original issue + ($2 ($11-$9) x 2/2 years) modification] The remuneration expense for the year is $309 500 or $892 500 - $583 000. 9

Fly Fishing Ltd (a) In the case of the share options of Fly Fishing Ltd, this means that the exercise price (or strike price) is greater than the share price of Fly Fishing Ltd. That is, the share option has no intrinsic value because the employees would lose money on the trade if they exercised the option. (b) AASB 2 requires that when a grant of share options is cancelled during the vesting period, Fly Fishing Ltd is to apply an acceleration of vesting and immediately recognise the outstanding amount that would otherwise have been recognised over the remaining vesting period (para. 28). (c) 30 June 2019 Remuneration expense Dr $5 700 Employee options (equity) Cr $5 700 (60 options x 300 employees x 95% x $7 x 1/3 years) 30 June 2020 Remuneration expense Dr $11 400 Employee options (equity) Cr $11 400 The vesting period is accelerated and any outstanding balance is recognised. The cumulative remuneration expense is $17 100 estimated as: 60 options x 300 employees x 95% x $7. Therefore the outstanding balance to be recognised is equal to $11 400 or $17 100 less $5 700.

10 (a) These examples are drawn from AASB 2. Grant of share appreciation rights to employees as part of their remuneration whereby the employees will become entitled to a future cash payment (rather than equity instruments) based on the increase in the company’s share price from a specified level over a specified period of time.

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Employer grants employees a right to receive a future cash payment by granting them a right to shares that are redeemable, either mandatorily (e.g. upon cessation of employment) or at the employee’s option. (b) Saddle Ridge Ltd This is a share-based payment transaction with cash alternatives since the executive has a choice of settlement. 30 June 2019 Remuneration expense Dr $5 000 Share-based payment liability Cr $5 000 (500 shares x $20 x 1/2 years) 30 June 2020 Remuneration expense Dr $6 500 Share-based payment liability Cr $6 500 Cumulative expense and liability is $11 500 or 500 shares x $23 x 2/2 years Expense for the year is $6 500 or $11 500 – $5 000 11 Alexander Ltd Defined contribution plans are (para. 8): Defined contribution superannuation plans are plans for which an employer pays fixed contributions into a separate entity (a fund) and has no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods (para. 8, AASB 119). For defined contribution plans, AASB 119 requires that only accrued contributions payable as at the reporting date are recognised by an employer as a liability. The shortfall in funding of members’ superannuation benefits does not give rise to a liability in the employer’s financial statements and is ignored. The general journal entry recorded at the end of the financial year to record Alexander Ltd’s post-employment benefit obligation is: Superannuation expense Dr Accrued superannuation contributions payable Cr

$80 000 $80 000

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12 Rizz Ltd (a) What is the amount of net defined benefit liability (asset) recognised by Rizz Ltd? Present value of defined benefit obligation (30 June 2020) $34 464 000 Less: Fair value of plan assets (30 June 2020) (31 944 000) Deficit (para. 64) $2 520 000 Thus, Rizz Ltd will recognise a net defined benefit liability equal to the amount of the $2 520 000 deficit (para. 57). (b) What is the defined benefit cost recognised by Rizz Ltd in profit and loss and in other comprehensive income? Step 1: Determine the defined benefit cost recognised in profit or loss Service cost Current service cost $4 032 000 Past service cost 2 304 000 $6 336 000 Plus: Net interest on net defined benefit liability Interest cost on defined benefit obligation 1 643 100 (5% × $32 862 000) Interest income on plan assets (1 572 600) (5% × $31 452 000) Interest on effect of asset ceiling --$70 500 Defined benefit cost recognised in profit and loss $6 406 500 Step 2: Determine the defined benefit cost recognised in other comprehensive income Re-measurement of net defined benefit liability: Actuarial gain $(2 101 980) Return on assets Return on assets $1 887 120 Less: Interest income (1 572 600) 314 520 Defined benefit cost (income) $(2 416 500) Actuarial gain or loss – defined benefit obligation Present value of defined benefit obligation (1 July 2019) Plus: Interest cost (5% × $32 862 000) 1 643 100

$32 862 000

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Current service cost 4 032000 Past-service cost 2 304 000 6 336 000 Minus: Benefits paid (5 184 000) Actuarial (gain) loss (1 193 100)1 Present value of defined benefit obligation (30 June 2020) 1

This is a balancing amount.

Actuarial gain or loss – plan assets Fair value of plan assets (1 July 2019) Plus: Return on plan assets (6% × $31 452 000) Contributions 2 880 000 Minus: Benefits paid (5 184 000) Actuarial gain (loss) 908 8801 Fair value of plan assets (30 June 2020) 1

$34 464 000

$31 452 000 1 887 120

$31 944 000

This is a balancing amount.

Total amount of re-measurements of the net defined benefit liability The total defined benefit cost due to re-measurements of $405 480 that will be recognised by Rizz in other comprehensive income is calculated as follows: Re-measurement of net defined benefit liability: Actuarial gain $(353 000) Return on assets Return on assets $369 000 Less: Interest income 314 520 (52 480) Defined benefit cost (income) $(405 480) Step 3: Determine the total defined benefit cost to Rizz Ltd The total defined benefit cost recognised by Rizz Ltd is $3 990 000 comprising a defined benefit cost recognised in profit and loss of $6 406 500 and DB income of $2 416 500 recognised in other comprehensive income.

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13 Mosh Ltd Defined Contribution Plan (parts (a) and (b)): The general journal entries recorded in the books of Mosh Ltd during the period would be: Contributions expense Dr Contributions payable Cr

300 000

Contributions payable Cash

240 000

Dr Cr

300 000

240 000

Therefore the superannuation expense is $300 000 in superannuation contributions and the liability for outstanding contributions is $60 000 ($300 000 – $240 000). Defined Benefit (DB) Plan (parts (a) and (b)): Net defined benefit liability: Present value of defined benefit obligation (30 June 2020) $46 700 000 Less: Fair value of plan assets (30 June 2020) (32 560 000) Deficit (para. 64) $14 140 000 Thus, Mosh Ltd will recognise a net defined benefit liability equal to the amount of the $14 140 000 deficit (para. 57). The total defined benefits cost recognised by Mosh Ltd is calculated as follows: Service cost $1 900 000 Net interest on DB obligation Interest on DB obligation $2 613 600 (6% × $43 560 000) Less: Interest income on plan assets (2 208 000) (6% × $36 800 000) Defined benefit cost recognised in profit and loss

405 600 $2 305 6 00

Re-measurement of defined benefit liability Actuarial losses $7 222 400 Return on assets $2 576 000 (7% × $36 800 000) Less: interest income (2 208 000) (548 000) Defined benefit cost recognised in other comprehensive income

$6 674 400

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Actuarial gain or loss – defined benefit obligation Present value of defined benefit obligation (1 July 2019) Plus: Interest cost (6% × $43 560 000) 2 613 600 Service cost 1 900 000 Minus: Benefits paid (2 300 000) Actuarial (gain) loss 926 4001 Present value of defined benefit obligation (30 June 2020) 1

$46 700 000

This is a balancing amount.

Actuarial gain or loss – plan assets Fair value of plan assets (1 July 2019) Plus: Return on plan assets (7% × $36 800 000) Contributions 1 780 000 Minus: Benefits paid (2 300 000) Actuarial gain (loss) (6 296 000)1 Fair value of plan assets (30 June 2020) 1

$43 560 000

$36 800 000 2 576 000

$32 560 000

This is a balancing amount.

14 (a) The relevant accounting standard is AASB 119. Specifically, paragraph 64 of AASB 119 requires the recognition of a defined benefit liability for post-employment benefits in employers’ statement of financial position that is the net total of: Present value of the defined benefit obligation at the reporting date minus the fair value at the reporting date of plan assets (if any) out of which the obligations are to be settled directly. Thus, any ‘funding shortfall’ will be disclosed. This was the case for Qantas which is featured in an ‘Accounting in Focus’ box in section 12.7. (b) Yes, this is a reasonable comment to make. The defined benefit superannuation liability is an actuarial estimate of the total superannuation liability that is due to current . 25

plan members in the future. Events that would result in the liability vesting include retirement, death or disability, or rolling over the superannuation entitlement into another superannuation fund. It does not represent the current obligation of a superannuation plan to pay out members’ superannuation benefits. On this basis, it has often been argued that it is potentially misleading to members to compare the defined benefit obligation with plan assets currently held. A more accurate insight into funding shortfalls would be provided by an actuarial review of the funding of the plan. Also, the vested benefits index is argued to provide a more accurate insight into current superannuation obligations.

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Chapter 13 ACCOUNTING FOR FINANCIAL INSTRUMENTS LEARNING OBJECTIVES After studying this chapter, you should be able to: 1

define ‘financial instrument’ and distinguish between primary and derivative financial instruments, and between simple and compound financial instruments;

explain the approach for distinguishing financial liabilities from equity;

explain and apply the principles in AASB 132 ‘Financial Instruments: Presentation’ to distinguish between ordinary shares and preference shares;

explain the nature of compound financial instruments and how to account for them;

apply the requirements of AASB 132 ‘Financial Instruments: Presentation’ as they relate to accounting for convertible notes;

explain the recognition and measurement of financial assets and financial liabilities in AASB 9 ‘Financial Instruments’;

demonstrate an understanding of hedge accounting as applied in AASB 9 ‘Financial Instruments’;

explain the nature of futures contracts and how to account for them;

explain the nature of option contracts and how to account for them;

10 explain the nature of swaps and how to account for them; and 11 explain the purpose of, and identify the main disclosure requirements in, AASB 7 ‘Financial Instruments: Disclosures’ and AASB 132 ‘Financial Instruments: Presentation’.

QUESTIONS 1

(a) Financial instruments may be classified as primary, such as accounts receivable, accounts payable, loans receivable, loans payable and equity securities, or as derivative (secondary) financial instruments, such as forward contracts, futures contracts, options, and interest rate and currency swaps. Derivative financial instruments have been defined as those that ‘create rights and obligations that have the effect of transferring one or more of the financial risks inherent in an underlying primary financial instrument, and the value of the contract normally reflects changes in the value of the underlying financial instrument’. For example, an entity with accounts payable in a foreign currency may take out a forward rate agreement to reduce the risk from fluctuations in currency exchange rates. Derivative financial instruments do not result in a transfer of the underlying primary financial instruments when the agreement is entered into, nor do they necessarily result in a transfer of the underlying primary financial instruments when the derivative financial instruments mature. (b) Simple financial instruments comprise a single financial asset, financial liability or equity instrument, such as a loan receivable, loan payable or ordinary share, whereas compound financial instruments comprise a combination of characteristics of financial assets, financial liabilities and equity instruments. For example, a debt security convertible into ordinary shares comprises two components. They are an arrangement to deliver cash or other financial assets and an option granting the holder the right, for a specified period, to convert the debt security into the ordinary shares of the issuer.

This is not true as it is the substance of the arrangement and not the legal form which is most important as indicated in paragraphs 15 and 18 of AASB 132.

A 5% non-cumulative, non-redeemable preference share is similar to an ordinary share because there is no obligation of the issuer to pay a dividend or redeem the instruments. Hence it is classified as equity.

The probability of the holder converting note into ordinary shares has no bearing on the classification of the convertible notes. Generally convertible notes are classified as compound instruments.

The residual approach is where the value of the debt component of the instrument is measured first and then this amount is deducted from the nominal value of the notes and this residual is the value of the equity option to convert the notes to ordinary shares. An Copyright © 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442561175, Henderson, Issues in Financial Accounting 16e 2

alternative approach would be to measure the value of the option to convert the notes to ordinary shares and derive the value of the debt component but this is not permitted by AASB 132. 6

Views differ on this question. The IASC exposure drafts, E48 and E40, and the Australian exposure draft, ED59, proposed that different accounting methods are appropriate depending on the purpose for which a financial instrument is used. For example, a hedging financial instrument will be accounted for on the same basis as the underlying position being hedged. Thus, if inventory is measured at cost, a forward rate agreement used to hedge an overseas purchase of inventory would also be measured at cost. In contrast, a financial instrument used for trading or speculative purposes will be measured at market value. However, some would argue that market value is the appropriate basis of measurement for all financial instruments.

Hancock in Discussion Paper No. 14 considers that financial instruments should be accounted for at net market value (fair value), irrespective of the purpose for which financial instruments are used. This differs from the proposals in E48, E40 and ED59 which argued for a purpose-led approach to the measurement of financial instruments. As it has turned out, AASB 9 ‘Financial Instruments’ has adopted an approach that has similarities to the purpose-led approach of the earlier exposure drafts. Students should consider the arguments for these different approaches to measuring financial instruments.

(a) The purpose of hedge accounting is to recognise the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item. (b) The three types of hedging arrangements identified in paragraph 86 of AASB 9 are: (i) fair value hedge, which is a hedge of an exposure to the changes in the fair value of an asset, liability or unrecognised firm commitment. (ii) cash flow hedge, which is a hedge of an exposure to variability in the cash flows of a recognised asset or liability, or a highly probable forecast transaction. (iii) hedge of a net investment in a foreign operation as defined in AASB 121 ‘The Effects of Changes in Foreign Exchange Rates’. The same hedging arrangements are identified in AASB 9.

It is not generally accepted accounting practice in Australia to recognise the financial asset (futures receivable) and the financial liability (futures payable) relating to a futures contract. In practice, it is assumed that futures contracts are agreements equally

proportionately unperformed, which is based on the argument that the liability of one entity is contingent on the performance of another entity. In the US, however, SFAS 133 ‘Accounting for Derivative Instruments and Hedging Activities’, which requires derivative financial instruments, including futures contracts, to be carried in a statement of financial position as assets and liabilities and measured at fair value, is inconsistent with this generally accepted accounting practice. The SFAS 133 approach is consistent with the conceptual framework, in that a futures contract is not equally proportionately unperformed because it is a firm contract with substantial penalties for non-performance. 10 The answer to this question should canvass the same issues that were referred to in the answer to Question 7. 11 Accounting standards that require entities to account for financial instruments at fair value were heavily criticised during the global financial crisis (2007–09) because application of the standards resulted in entities recording very large losses on those financial instruments. A consequence of the global financial crisis was that entities had difficulty in raising funds and, therefore, the large losses on financial instruments would have exacerbated this situation. As a result, the IASB came under intense pressure to change the requirement for financial instruments to be accounted for at fair value in certain circumstances. 12 (a) A futures contract is an agreement to sell (or buy) something in the future at an agreed price which is decided today. A futures contract is similar to a forward contract. Forward contracts are discussed in the context of currency exchange rates in Chapter 24. A forward exchange contract is a contract under which a foreign exchange dealer (such as a bank) agrees to buy from or sell to a customer a fixed amount of an overseas currency on a fixed future date at the rate of exchange specified in the contract. The main difference between a forward contract and a futures contract is that the latter is a standardised contract that can be traded on a futures exchange. This facilitates the opening and closing of positions without the necessity of delivering or taking delivery of the underlying financial instrument. In some cases, the underlying instrument, such as a share price index, may not be capable of delivery. (b) It is important to distinguish between option contracts and futures contracts. Although both types of contract may involve the delivery of some underlying asset at a future date and at a predetermined price, there is a significant difference between them. Copyright © 2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442561175, Henderson, Issues in Financial Accounting 16e 4

A futures contract requires the delivery of the underlying asset, whereas delivery under an option contract is a matter of choice for the option holder. Holders of futures contracts have an obligation to buy; whereas holders of, say, call options have the right to buy if they so choose. Therefore, if holders of futures contracts take no action to cancel their positions, they will be required to buy the underlying asset at the expiry of the contract. If buyers of call or put options take no action to cancel their positions, then the options simply expire and there are no subsequent transactions. Another difference concerns payment. When a futures contract is written, the payment of the futures price is not required until the expiry date, but when an option contract is written, the buyer must immediately pay to the writer the option price. If the option is subsequently exercised, then there is a further transaction when the exercise (strike) price is paid. 13 An option is the right to force a transaction to occur at some future time on terms and conditions agreed to now. A call option allows the buyer of that option to buy the item (frequently shares) from the seller of the call at a price determined now. Similarly, the buyer of a put option has the right to sell the item in the future to the seller of the option at a predetermined price. 14 The basic idea of a swap is that two borrowers agree to repay each other’s loan – that is, they swap loan commitments. The two principal forms of swap are the interest rate swap and the currency swap. With a currency swap, future cash flows calculated using an interest rate in one currency are swapped for future cash flows calculated using an interest rate in another currency. Such an agreement mimics the effect of exchanging a loan in one currency for a loan in another currency. In providing an example, it is likely that students will use an example similar to (or the same as) Example 13.6. Currency swaps have been undertaken in order to achieve interest cost savings. Currency swaps have also been used as tools in structuring contracts that exploit tax advantages, or that reduce the effect of government regulations. For example, US companies have used currency swaps as part of a method to exploit some tax advantages of borrowing Japanese yen. In addition, currency swaps may be used as an exchange rate hedging device that need not have any implications for interest costs.

15 The purpose of the disclosure requirements of AASB 7 is to provide information that enables users of the financial statements to evaluate the significance of financial instruments to an entity’s financial position and performance. The disclosures also enable users to evaluate the nature and the extent of the risks arising from financial instruments and the way in which the entity manages those risks.

PROBLEMS 1

(a) To record the issue under the Framework 2010, Glenelg Ltd must assess the probability of note conversion or note redemption at reporting date. If conversion to equity is probable, the notes would be recognised as equity whereas if redemption at maturity is probable, the notes would be recognised as a liability. (b) To record the issue under AASB 132 ‘Financial Instruments: Presentation’, Glenelg Ltd must separate the notes into equity and debt components. The value of the liability component is first determined by measuring the fair value of a similar liability without the equity component. This amount is then deducted from the fair value of the compound instrument as a whole to arrive at the carrying amount of the equity component.

Zest Ltd (a)In this case, the liability is measured as the present value of the annual coupon payments ($1 809 000) and principal repayment ($27 000 000) in four years’ time: Using Present Value Tables (4 years, 10%): $1 809 000 × 3.1698 = $27 000 000 × 0.68301 = $24 175 438

$5 734 168 $18 441 270

The conversion option has a value of $27 000 000 – 24 175 438 = $2 824 562. At the time the notes were issued, the following journal entry would be passed: ______________________________________________________________ 30 June 2016 Cash at bank Dr $27 000 000 Convertible note liability Cr $24 175 438 Convertible note option Cr 2 824 562 ______________________________________________________________ (b) 30 June 2017 – Interest payment Interest expense Dr Cash Cr Convertible note liability Cr ($24 175 438 @ 10% = $2 417 544) Cash = $27 000 000 @ 6.7% = $1 809 000

$2 417 544 $1 809 000 608 544

[Note: If the bonds were not converted at the end of year one, but held for the four-year term, the amount in the convertible note liability account would be equal to $27 000 000. Students can record the remaining three years of journal entries to prove this is the case.] 30 June 2017 – Conversion of notes Convertible note liability Dr $24 783 982 Convertible note option Dr 2 824 562 Share capital Cr $27 608 544 ($24 175 438 + $608 544 = $24 783 982 liability component) 3

(a) In this case, the liability is measured as the present value of the annual coupon payments ($4 400 000) and principal repayment ($55 000 000) in five years’ time:

Using Present Value Tables (5 years, 12%): $4 400 000 × 3.1698 = $55 000 000 × 0.56743 =

$15 861 120 $31 208 650 $47 069 770

The conversion option has a value of $55 000 000 – $47 069 770 = $7 930 230. At the time the notes were issued, the following journal entry would be passed: ______________________________________________________________ 30 June 2017 Cash at bank Dr $55 000 000 Convertible note liability Cr $47 069 770 Convertible note option Cr 7 930 230 ______________________________________________________________ The following effective interest schedule is prepared to identify the fair value of the convertible notes liability outstanding at each reporting period during the term of the convertible note issue.

Effective Interest Schedule 1

date

payment ($55m × 8%)

interest exp (col 4 × 12%)

30-Jun-12 30-Jun-13 4 400 000 30-Jun-14 4 400 000 30-Jun-15 4 400 000 30-Jun-16 4 400 000 30-Jun-17 4 400 000 * Rounding error

5 648 372 5 798 177 5 965 958 6 153 873 6 364 338

4 fair value adjustment (interest expense – interest payment) 1 248 372 1 398 177 1 565 958 1 753 873 1964 338

5 convertible notes liability ((col 3 – col 2) + col 5 op. bal) 47 069 770 48 318 142 49 716 319 51 282 277 53 036 150 55 000 488*

(b) Assuming that the non-exercise of the conversion options occurs on 30 June 2018: Convertible note liability Dr $55 000 000 Cash Cr $55 000 000 Convertible note option Dr 7 930 230 Retained earnings Cr 7 930 230 ___________________________________________________________ 4

NAB classified both notes as debt securities despite the fact that both are only redeemable at its discretion. Perpetual notes create the impression of equity because they lack a present obligation, as the holder can't insist on repayment but in fact the returns earned by the holders of such notes over the period equate to the returns payable to a debt holder and NAB has no discretion but to pay this amount. As the return received by holders of the notes represents in substance a return of capital and interest, they are classified as debt. Why would anyone invest in such instruments if this wasn’t the case as the holders of such notes do not have any residual interest in the assets of the bank unlike an equity holder.

Blair Ltd 1 September 2016 Deposit on futures contract Dr 30 000 Cash at bank Cr 30 000 (To record deposit) _________________________________________________________________ 30 September 2016 Deposit on futures contract Dr $1361 Gain on futures contract Cr $1361 (To record gain on futures contract)

So at 87.5 the Price = 365 + ( 12.5 x 90) 100 =

1 000 000 x365

So at 88 the Price

1 000 000 x365 365 + ( 12 x 90)

100 =

$970 100

$971 261

Cash at bank Dr 1361 Deposit on futures contract Cr 1361 (To record withdrawal of cash from margin account) _________________________________________________________________ 31 October 2016 Deposit on futures contract Gain on futures contract (To record gain on futures contract)

Dr Cr

$627 $627

So at 88.2 the Price = 1 000 000 x365 365 + ( 11.8 x 90) 100 = $971 727 ________________________________________________________________ It is assumed that Blair does not withdraw cash from the margin account in October.

30 November 2016 Cash at bank Loss on futures contract Deposit on futures contract (To close out futures contract) So at 87.8 the Price = 365 + (12.2 x 90) 100 =

Dr Dr Cr

$29 696 931 $30 627

1 000 000 x365

$970 796

For purposes of illustration, it is assumed that Blair does not withdraw cash from the margin account in October. Alternatively, students may assume that the gains in September and October are withdrawn or continue to be held in the deposit account. 6

The price of B Ltd futures is $4.85 when A Ltd enters into the futures contracts and, regardless of what happens to the market price of the futures contract, A has ‘locked in’ that amount as the price it will ultimately receive. After one month, the price of B Ltd shares has risen to $6.05 and the futures price has risen to $6.15. A Ltd has made a loss on the futures contract as it has a contract to sell the futures at $4.85 which is well below their current market price. The loss on the futures is ($6.15 − $4.85)  100 000 = $130 000. This loss offsets the gain that A Ltd has made on the shares in B ($6.05 − $4.80)  100 000 = $125 000. A Ltd has therefore effectively hedged the amount that it would ultimately have received. Note that, in this case, A Ltd would have been better off not to have entered into the futures contract. The amount received by A Ltd is: From shares in B Ltd Amount payable to broker to cover losses Net amount received

$605 000 130 000 $475 000

7 Company ZZZ Note: Please instruct students that the problem should say that the swap started on July 1, 2015 and not July 1, 2016 1 July 2016 No entry as the fair value of the swap is zero as the market rates for fixed and variable interest are both 12%. In the general journal entry on 30 June 2017 ZZZ no cash is exchanged as the variable rate is still 12% 30 June 2017 Swap receivablea Dr $40 562 b Swap payable Cr $37 182 Gain on swap Cr 3 380 (To record the swap of interest payment and the fair value of the swap receivable and swap payables) a The swap receivable is equal to the present value of the fixed-rate interest payments ($24 000) at 12% for two years, or $40 562. b The swap payable is equal to the present value of the variable-rate interest payments ($22 000) at 12% for two years, or $37 182. In the general journal entry on 30 June 2018, ZZZ receives $2000 cash ($200 000 x [0.120.11] to AA because the floating rate of interest is 11%. 30 June 2018 Swap payableb Dr $17 360 Cash at bank Dr $2 000 a Swap receivable Cr $19 132 Gain on swap Cr $228 (To record the restatement of the swap payable and receivable) a The swap receivable is equal to the present value of the fixed-rate interest payments ($24 000) at 12% for one year, or $21 430. The credit entry is therefore $40 562 – $21 430 or $19 132. b The swap payable is equal to the present value of the variable-rate interest payments ($22 000) at 11% for one year, or $19 822. The debit entry is therefore $37 182 – $19 822, or $17 360.

The general journal entry to close out the swap on 30 June 2019 is as follows: 30 June 2019 Swap payableb Dr $19 822 Loss on swap Dr $3 608 A Swap receivable Cr $21 430 Cash at bank Cr $2 000 (To close out the swap agreement) a, b The journal entry closes the swap payable and swap receivable accounts of ZZZ. Also ZZZ has to pay $2000 ($200 000 [0.13 – 0.12]) to AA because the variable-rate of interest is 13%. Note The net amount for the swap contract which would be reported at the end of each year is: 30 June 2017= Swap asset $3 380 30 June 2018= Swap asset $1 608 30 June 2019= Nil _________________________________________________________________ 8

Using the residual valuation of equity component approach shown in AASB 132, the liability is measured first, and the difference between the proceeds of the note issue and the liability is assigned to the equity component. The following calculations use financial mathematics tables. Present value $ Principal:

Interest:

$8m payable at the end of 4 years at 10% per annum

5 464 080

$640 000 payable annually in arrears for 4 years at 10% per annum

2 028 672

Total liability component Equity component Proceeds of note issue

7 489 752 510 248 8 000 000

1 July 2016 ______________________________________________________________ Cash at bank Dr $8 000 000 Note liabilities Cr $7 489 752 Conversion options Cr 510 248 (Issue of convertible notes) ______________________________________________________________

The answer to this problem is available by reference to the Qantas annual report.

The answer to this problem is available by reference to the 2015 Annual Report of Brambles Limited

Financial assets are measured at fair value through profit or loss if they are not held within a business model whose objective is to hold assets to collect contractual cash flows or within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. Hence it is clear that Portfolio A must be accounted for at fair value through profit or loss. Portfolio B can be accounted for at amortised cost as the selling of assets is limited to specific circumstances and so the principal reason for holding assets in Portfolio B is to receive the contractual cash flows and principal.

(a)Where the company had made no plan to redeem the shares the instruments are equity as redemption is at the discretion of the issuer. (b) The official announcement by the company that its intention was to redeem the shares can be reversed although unlikely and hence would remain as equity. (c) Once the company had written to the holders of the preference shares informing them that the company intended to redeem the shares then the instruments become a liability.

(a) As redemption is at the discretion of the holder then the instruments are a liability even where it was probable the holders would seek redemption of the shares. (b) The instruments are classified as a liability even if it was not probable the holders would seek redemption of the shares. (c) The holders had requested that the company redeem the shares. The instruments become equity when they are redeemed.

Chapter 14 THE STATEMENT OF COMPREHENSIVE INCOME LEARNING OBJECTIVES After studying this chapter you should be able to: 1

explain different approaches to profit measurement;

explain the approach to profit measurement adopted in Australia;

apply the requirements for the preparation of a statement of comprehensive income in AASB 101 ‘Presentation of Financial Statements’;

apply the requirements of AASB 101 ‘Presentation of Financial Statements’ to revenue and the classification of expenses;

identify and apply the requirements of AASB 101 ‘Presentation of Financial Statements’ to other comprehensive income;

apply the required treatment of unusual items in AASB 101 ‘Presentation of Financial Statements’;

explain the use of non-statutory profit measures; and

explain the information disclosed in a statement of value added.

QUESTIONS 1

(a) Profit measurement has traditionally been regarded as a process of matching the revenues for a period with the expenses of earning those revenues. In brief, revenues for a period are identified, the expenses incurred in generating those revenues are then identified and the two are matched to measure profit. However, following changes made in Framework 2010, Framework 2014, does not rely on the concept of matching for profit measurement. Instead, accounting problems related to the measurement of profit are resolved by reference to the definitions and recognition criteria for financial statement elements. Framework 2014 identifies the two financial statement elements related to the measurement of profit as income and expenses. This is more than a simple change in labelling as Framework 2014 notes that both income and expenses consist of two components. Income is made up of revenue and gains. Revenue arises in the course of the ordinary activities of the entity, whereas gains may be within or outside the ordinary activities of the entity and are often reported net of related expenses. Likewise, expenses consist of expenses and losses. Expenses arise in the course of the ordinary activities of the entity, whereas losses may be within or outside the ordinary activities of the entity and are often reported net of related income. Framework 2014 does not require the association of particular expenses with income. Periodic income and periodic expenses are identified and recognised independently. Profit is then measured as the difference between the income and expenses for the reporting period. (b) Measuring periodic profit is a vital aspect of general purpose financial reporting. Framework 2014 paragraph OB2 indicates that the objective of financial reporting is to ‘provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity’. Framework 2014 paragraph QC4 indicates information useful for such decisions will have the qualitative characteristics of relevance and faithful representation, whilst the usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable. These are the characteristics used to evaluate possible approaches to measuring periodic profit.

In answering this question it is helpful to start from the broadest profit measure: comprehensive income. The comprehensive income approach to profit measurement includes all changes in net assets, other than transactions with owners – that is, it includes items the meet Framework 2014 definitions of income and expense and the recognition criteria. Thus, . 2

under this approach, items that have traditionally been taken directly to equity, such as increases in the value of non-current assets are included in comprehensive income. Comprehensive income also includes all items of income and expense whether they relate to this or other periods and whether they arise from within or outside the firms operations. The all-inclusive approach to profit measurement includes income and expenses arising from the current period’s ordinary operations, as well as income and expenses relating to prior periods, the effects of some accounting policy changes and extraordinary items. What is not included are items that that are recognised in equity such as unrealised increases to non-current asset values. The operating-profit approach to profit measurement includes only income and expenses that relate to the operations for the reporting period. Under this approach, income and expenses relating to prior periods and those arising from extraordinary items and unrealised increases to non-current assets will bypass the statement of comprehensive income. 3

The all-inclusive approach is supported on several grounds. First, it is argued that allowing extraordinary and prior period items to bypass the statement of comprehensive income may lead to profit manipulation. Second, it has been asserted that extraordinary expenses, over a period of years, are likely to exceed extraordinary revenues. If this is correct, even if there is no deliberate manipulation, reported profit would be consistently higher from the use of the operating-profit approach than from the use of the all-inclusive approach. Third, the all-inclusive statement of comprehensive income is easier to prepare because it avoids the need for the accountant to exercise judgement in deciding whether an item is extraordinary. As the classification of items as extraordinary is dependent, at least to some extent, on the professional judgement of the accountant there is a possibility that transactions and other events classified as operating by one company may be classified as extraordinary by another. There is also the possibility that transactions and other events classified as extraordinary in one year may be classified as operating by the same company in later years. This may make both inter-firm and inter-period comparisons difficult. However, if all revenues and expenses for this and prior periods are included in the calculation of profit, this problem is avoided. The arguments against the all-inclusive approach are as follows. First, the inclusion of extraordinary and prior period items in profit may cause statement users to reach unwarranted conclusions about the future earning capacity of the entity. In other words, . 3

the inclusion of extraordinary and prior period items in the measurement of profit or loss conceals the operating result, which is the proper basis for assessing past performance and predicting future performance. Second, the inclusion of extraordinary and prior period items in the measurement of profit may destroy the utility of inter-period and inter-company comparisons. Extraordinary items could materially affect the results of some companies in some periods, making inter-company comparisons difficult. Third, some changes in net assets (for example, the effect of asset revaluations) still bypass the statement of comprehensive income. 4

The arguments against the operating profit approach are as follows. First, it is argued that allowing extraordinary and prior period items to bypass the statement of comprehensive income may lead to profit manipulation. Second, it has been asserted that extraordinary expenses, over a period of years, are likely to exceed extraordinary revenues. If this is correct, even if there is no deliberate manipulation, reported profit would be consistently higher from the use of the operating-profit approach than from the use of other approaches. Third, the operating profit statement of comprehensive income is more difficult to prepare because it requires the accountant to exercise judgement in deciding whether an item is extraordinary. As the classification of items as extraordinary is dependent, at least to some extent, on the professional judgement of the accountant there is a possibility that transactions and other events classified as operating by one company may be classified as extraordinary by another. There is also the possibility that transactions and other events classified as extraordinary in one year may be classified as operating by the same company in later years. This may make both inter-firm and interperiod comparisons difficult.

It is suggested the International Accounting Standards Board have adopted the comprehensive income approach to profit measurement although no conceptual notion of income is provided in Framework 2014. The comprehensive income approach to profit measurement includes all changes in net assets, other than transactions with owners – that is, it includes items the meet the Framework 2014 definitions of income and expense and the recognition criteria. Thus, under this approach, items that have traditionally been taken directly to equity, such as increases in the value of non-current assets are included in comprehensive income. Comprehensive income also includes all items of income and expense whether they relate to this or other periods and whether they arise from within or outside the firms operations. This approach is consistent with the definitions and recognition criteria in Framework 2014 and results in a statement of comprehensive income whose contents is determined conceptually, not arbitrarily. Students may agree or disagree with the merits of a conceptual approach. . 4

However, the International accounting standard governing the preparation of the income statement (IAS 1 Presentation of Financial Statements and consequently Australian’s equivalent AASB 101 Presentation of Financial Statements) do not fit neatly into any of the approaches. The approach adopted AASB 101 bears some resemblance to the allinclusive approach in that all items of income and expense recognised in the period are included in profit or loss. This is so whether the items of income or expense arise from ordinary activities or from outside ordinary activities. However, contrary to expectations under an all-inclusive approach, AASB 101 forbids the use of the term ‘extraordinary’ to describe items of income or expense that arise outside of ordinary activities. Further, many prior period adjustments (such as, the effects of errors and accounting policy changes) by-pass the income statement and are taken directly to equity. The approach in AASB 101 is similar to the comprehensive income approach in that revaluations of property, plant and equipment are included in the statement of comprehensive income. However, prior period adjustments (such as, the effects of errors and accounting policy changes) by-pass the income statement and are taken directly to equity. 6

Under AASB 101, the items that by-pass the statement of comprehensive income are included in the statement of changes in equity. Paragraph 110 of AASB 101 identifies retrospective adjustments to effect changes in accounting policies and retrospective restatements to correct prior period errors (both of which arise from AASB 108) as the main items to by-pass the statement of comprehensive income. The comprehensive income approach arguably includes all recognised items of income and expense whether within or outside operations, whether relating to this period or prior periods. Hence allowing these items to by-pass the statement of comprehensive income is inconsistent with the comprehensive income approach. In general, there are two ways in which prior-period items could be treated. Suppose, for example, that it is discovered in 2018 that depreciation expense for 2016 was understated by $10 000. The $10 000 adjustment, together with the usual depreciation charge of say $80 000, could be included in the 2018 income statement. The general journal entry would be as follows: Date Details 30/6/2018 Depreciation expense Accumulated depreciation

Dr Cr

Debit $ $90 000

Credit $ $90 000

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Alternatively, the adjustment could be made through retained earnings in the statement of changes in equity, leaving the 2018 profit unaffected. In this case, the general journal entry would be as follows: Date Details 30/6/2018 Depreciation expense Retained earnings 1/7/2017 Accumulated depreciation

Dr Dr Cr

Debit $ $80 000 10 000

Credit $

$90 000

There are arguments in favour of each approach. If a prior-period adjustment is passed through the current period’s statement of comprehensive income, there is ‘bad’ matching of income and expenses both in the period in which the item should have been recognised and in the period in which it is recognised. In our example, profit was overstated by $10 000 in 2016 and understated by $10 000 in 2018. The inclusion of prior-period adjustments in the current period’s statement of comprehensive income is, therefore, misleading. There are, however, risks associated with making the adjustment to retained earnings. It leaves the door open for the manipulation of reported profit. For example, a company could deliberately understate an expense in 2017 to inflate reported profit in that year and in 2018 pass an adjustment directly to retained earnings, leaving that year’s profit unaffected. Or perhaps a company may incorrectly classify an item as a prior-period adjustment to avoid including it in the current period’s profit. In addition, where errors in one period can be corrected by adjustments to retained earnings in a subsequent period, the incentive to avoid errors may be reduced. 7

Paragraph 10A of AASB 101 gives entities the option to present a single statement of comprehensive income or two statements: a statement displaying components of profit or loss (separate statement of profit or loss) and a second statement beginning with profit or loss and displaying components of other comprehensive income (statement of comprehensive income). Note also that paragraph 10 indicates that an entity may use titles for the statements other than those used in AASB 101.

Paragraph 81B and paragraph 82 provide the minimum disclosure requirements for the profit and loss section of the statement of comprehensive income. Paragraph 81B states that an entity shall present the following items, in addition to the profit or loss and other comprehensive income sections, as allocation of profit or loss and other comprehensive income for the period:

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(a)

(b)

profit or loss for the period attributable to: (i) non-controlling interest, and (ii) owners of the parent; comprehensive income for the period attributable to: (i) non-controlling interest, and (ii) owners of the parent.

If an entity presents profit or loss in a separate statement it shall present (a) in that statement. Paragraph 82 states that, in addition to items required by other Australian accounting standards, the profit or loss section shall include line items that present the following amounts for the period: (a)

revenue, presenting separately interest revenue calculated using the effective interest method; (aa) gains and losses arising from the derecognition of financial assets measured at amortised cost; (b) finance costs; (ba) impairment losses (including reversals of impairment losses or impairment gains determined in accordance with Section 5.5 of AASB 9); (c) share of the profit or loss of associates and joint ventures accounted for using the equity method; (ca) if a financial asset is reclassified so that it is measured at fair value, any gain or loss arising from a difference between the previous carrying amount and its fair value at the reclassification date (as defined in AASB 9); (cb) if a financial asset is reclassified out of the fair value through other comprehensive income measurement category so that it is measured at fair value through profit or loss, any cumulative gain or loss previously recognised in other comprehensive income that is reclassified to profit or loss; (d) tax expense; (e) [deleted by the IASB]; (ea) a single amount for the total discontinued operations (see AASB 5 ); (f) – (i) [deleted by the IASB]. 9

(a) Income and revenue: The term income is used as a broader concept and encompasses both revenue and gains. Framework 2014 paragraph 70 defines Income as ‘increases in economic benefits during the accounting period in the form of inflows or enhancements

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of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants’, whilst revenues ‘arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent’ (Framework 2014, para. 74). (b) Revenue and gains: Revenue and gains are subsets of Income. Revenue arises in the course of the ordinary activities of the entity, whereas gains represent other items that meet the definition of income and may, or may not, arise in the course of ordinary activities of an entity (Framework 2014, para. 74). Gains are also often reported net of related expenses. Examples of revenue include revenue from sales, interest, dividend, royalties and rent. Examples of gains include a gain on the sale of property, plant and equipment. (c) Expenses and losses: Expenses are ‘decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants’ (Framework 2014, para. 70). The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity (Framework 2014, para. 78). Losses represent ‘other items that meet the definition of expenses and may, or may not, arise in the course of the ordinary activities of the entity’ (Framework 2014, para. 79). Examples of expenses include cost of goods sold, wages, rent expense or advertising expense. Examples of losses include a loss on the sale of property, plant and equipment. 10 The term ‘ordinary activities’ is not defined in or further explained in Framework 2014. However, the term ‘ordinary activities’ has been used extensively in previous Australian accounting standards. For example, AASB 1018 ‘Statement of Financial Performance’ defined ‘ordinary activities’ as ‘activities undertaken by an entity as part of its business or to meet its objectives and related activities in which the entity engages in furtherance of, incidental to, or arising from activities undertaken to meet its objectives’ (para. 8.1). This is an extremely broad definition and it is unclear whether such a broad definition is intended in Framework 2014. 11 AASB 101 requires that expenses (other than finance costs which are required to be classified by nature) be ‘classified’ according to either their nature or their function. An analysis of expenses based on one of these classifications must be presented (para. 99). Classification by nature might involve expense categories such as depreciation, purchases of raw materials and employee benefits. These would not be reallocated across . 8

the various functions within the entity. The benefit of this method is that it is simple and does not require arbitrary allocations of expenses. An example of a classification using the nature of expense method is given in paragraph 102. Classification by function (cost of sales method) might involve expense categories such as cost of sales, cost of distribution, and cost of administration. At a minimum, an entity that sells goods and uses a functional classification would disclose the cost of sales separate from other expenses. Classification by function can provide more relevant information, but may require arbitrary allocations of expenses across functional categories. An example of a classification using the function of expense method is given in paragraph 103. Companies adopting a functional classification are required to also disclose information on expenses classified by nature for depreciation and amortisation expense and employee benefits expense (para. 104). Companies are required to choose the basis of classification that is reliable and more relevant (para. 99). Typically, what is more relevant will depend on historical and industry factors as well as the nature of the entity (para. 105). Paragraph 100 encourages companies to present this analysis on the face of the statement of comprehensive income. 12 Other comprehensive income is defined in AASB 101 as ‘items of income and expense (including classification adjustments) that are not recognised in profit or loss as required or permitted by other Australian Accounting Standards.’ (para. 7) This definition tells us little about the fundamental nature and character of these items. Paragraph 7 goes on to list a number of examples including changes in revaluation surplus, remeasurement of defined benefits plans, gains and losses arising from translating the financial statements of a foreign operation, gains and losses from investments in equity instruments measured at fair value through other comprehensive income. 13 AASB 101 defines a reclassification adjustment as ‘amounts reclassified to profit or loss in the current period that were recognised in other comprehensive income in the current or previous periods.’ (para. 7) Paragraph 95 of AASB 101 gives two examples of reclassified adjustments arising from the disposal of a foreign operation and when a hedged forecast transaction affects profit or loss. Any part of the realised gain included in profit or loss in the current period, that was recognised in other comprehensive income as unrealised gain in the current or prior periods, must be deducted from the other comprehensive income in the current period. This deduction is a reclassification adjustment. It is suggested that the reclassification adjustment is needed to ensure that amounts are not double counted. Such reclassification adjustments are not required for (say) gains or losses on disposal of property, plant and equipment that has been revalued . 9

because the realised gain included in profit or loss is measured as the difference between book value (latest revalued amount) and amount received on disposal. Thus the realised gain does not include any amounts previously included in other comprehensive income. (See para. 96) 14 Research evidence: These questions provide students with an opportunity to think more deeply about the financial reporting issues and the consequences of regulation and disclosure. Students are encouraged to form their own thoughts and opinions on these questions. Summative guidance is provided below. The solution provides a starting point in the discussion rather than an all-inclusive answer. (a)

Bamber, Jiang, Petroni and Wang (2010) investigate factors that may influence managers’ choice for the reporting location of comprehensive income. Whilst US regulators allow for the reporting choice, their preferred position is to report comprehensive income in the performance statement. Rationally, managers should be indifferent to reporting comprehensive income in the performance statement (i.e. the income statement) or in the statement of changes in equity. However, Bamber et al (2010) find that mangers with strong equity-based incentives or less job security are more likely to choose to report comprehensive income in the statement of changes in equity rather than the performance statement. The evidence in Bamber et al (2010) could be relevant to Australian listed companies, because it indicates that where there is choice; location is perceived to matter to managers. Whilst the regulation in Australia is slightly different in that AASB 101 requires comprehensive income to be reported in the performance statement rather than the statement of changes in equity, it allows a choice between presenting one performance statement including comprehensive income or two statements. It is plausible that, for similar reasons, managers may choose to use the two statement option. Students are encouraged to form their own thoughts and opinions.

(b)

In a study of 16 European countries, Goncharov and Hodgson (2011) examine the impact of the aggregation/disaggregation and reporting of operating and comprehensive income. They find evidence supporting the separate reporting of operating net income from comprehensive income. This would suggest two separate statements rather than a single statement of comprehensive income where there is aggregation of the components. They also find evidence suggesting comprehensive income should be delineated on the basis of realised and unrealised income. . 10

(c)

Kanagaretnam, Mathieu and Shehata (2009) examine whether reporting comprehensive income and its components provides the incremental valuerelevant information to the securities market. They find the components of other comprehensive income are associated with price and market returns and that aggregate comprehensive income is more strongly associated with both stock price and returns compared to net income. Whilst comprehensive income is found to be more strongly associated with price and return, net income is a better predictor of future net income relative to the predictive ability of comprehensive income.

(d)

Hodgson and Russell (2014) provides an overview of the historical debate surrounding comprehensive income and a synopsis of the relevant research results and therefore is a good summary article for students to get a sense with the debate. Hodgson and Russell (2014) suggest there is academic research support for the IASB’s treatment of disaggregating income. However, they do identify that the differential posting of OCI to equity and recycling to P&L creates avenues for further research in order to ‘understand the incremental information content of equity adjustments and the persistence and predictability impact of recycling, and where information content now resides in equity rather than CI’ (p. 107)

(e)

Students’ letters to the AASB will vary and therefore it is not appropriate to provide a ‘template answer’. Any answer should contain the following features: A summary of the research evidence; how each study is potentially applicable to the Australian setting with specific reference to the issues of measurement and the implication of an ‘all-inclusive’ comprehensive income approach and reporting choice available in AASB 101.

15 There are no specific categories of ‘unusual items’ identified for disclosure in the current accounting standard. Earlier standards such as AASB 1018 contained requirements for the separate disclosure of extraordinary items, abnormal items and subsequently significant items. None of these categories is included in AASB 101. However, AASB 101 does have requirements for the identification and disclosure of important items of income and expense. Paragraph 97 requires that ‘when items of income and expense are material, their nature and amount shall be disclosed separately’. Paragraph 98 identifies some examples of circumstances where separate disclosure would be required. They include write-downs of inventory or property, plant and equipment; restructuring of the activities of the entity; disposal of property, plant and equipment, discontinued operations, and litigation settlements. Some of these could be regarded as ‘unusual’ items. . 11

Advantages of identifying and disclosing ‘unusual’ items in the statement of comprehensive income are that this allows for more accurate evaluation of current performance and more accurate forecasting of future performance. By definition, ‘unusual’ items are often random in occurrence and the direction of their effect. Separating these from on-going components of performance should make it easier to forecast future profit. The disadvantage is the potential for manipulation. There is evidence that some financial statement preparers may deliberately classify items with a negative effect on profit as ‘unusual’ in order to present a more optimistic picture to statement users about the reporting entity’s profit. 16 AASB 101 requires material items of income and expense to be disclosed separately presented in the statement or in the notes. The term ‘unusual’ is not used (see question 15). AASB 108 sets out the requirements for the treatment of prior period errors. Material prior-period errors must be corrected retrospectively with restatement of the comparative amounts (para. 42). AASB 108 does not allow correction of a prior-period error to be included in profit or loss for the period in which the error is discovered, thus bypassing comprehensive income. 17 AASB 101 does not adopt the term ‘extraordinary items’ in relation to revenue and expenses. However the former standard, AASB 1018, defined extraordinary items as ‘items of revenue and expense that are attributable to transactions or other events of a type that are outside the ordinary activities of the entity and are not of a recurring nature’ (para. 8.1). The definition of extraordinary items in AASB 1018 specifies two conditions that must be satisfied if an item is to be considered extraordinary. These conditions are that transactions must: 1

Be outside the ordinary activities of the entity: the definition of ordinary activities in AASB 1018 was extremely broad. As a result, virtually all items of revenue and expense arise in the course of ordinary activities of the entity. Hence, items will rarely satisfy the definition of extraordinary items.

Not be of a recurring nature: an event that is outside ordinary activities but is likely to recur is not extraordinary.

The cost of classifying items as extraordinary is the potential for manipulation. There is evidence that some financial statement preparers may deliberately classify items as extraordinary in order to present a more optimistic picture to statement users about the reporting entity’s profit. Accounting standard setters have responded to the perceived . 12

creative use of extraordinary items. They progressively narrowed the definition of extraordinary items to the point where the current standard completely prohibits any entity from presenting any item of income or expense as ‘extraordinary’. Whilst AASB 101 paragraph 87 indicates that an entity shall not present any items of income or expense as extraordinary items (either on the face of the statement or in the notes), paragraph 97 indicates that that when items of income or expense are material, an entity shall disclose their nature and amount separately (either on the face of the statement or in the notes). Paragraph 98 provides a list of items that would give rise to separate disclosure. Some of these items may previously have been identified as extraordinary – for example: litigation settlements. Another example may be a material loss arising from uninsured inventory as a result of flooding or fire. Under AASB 1018, this is likely to have been classified as extraordinary and is also likely to be material warranting separate disclosure by virtue of AASB 101 paragraph 97. 18 The term ‘underlying profit’ is one of a growing number of terms used entities to describe their reported profits. Underlying profit (and others like underlying earnings, non-GAAP, pro forma earnings, street earnings, normalised earnings) and measures of profit that do not equate to the profit figure determined through compliance with accounting standards – i.e. statutory profit. These terms can generically be referred to as non-statutory profit measures. 19 The obligations for the reporting of non-statutory profit measures can be found in the Australian Securities and Investments Commission’s (ASIC) Regulatory Guide 230 ‘Disclosing non-IFRS financial information’ (RG 230) issued in December 2011. Whilst ASIC acknowledges that financial information presented other than in accordance with accounting standards can be useful it can be potentially misleading. As such, RG 230 sets out the principles for disclosing non-IFRS (non-statutory) financial information. Whilst there are very specific requirements, the overriding principle is that IFRS information should be given equal or greater prominence compared to non-IFRS information and that the financial statements must not include non-IFRS information. Further, non-IFRS information should be explained and reconciled to the IFRS financial information, be calculated consistently from period to period; and be unbiased and not used to remove ‘bad news’. As suggested by the 2015 KPMG survey (See the Accounting in Focus), the use of nonIFRS financial information ‘continues to play a key role in how top companies communicate and analyse their financial performance’. As indicated by the KPMG . 13

survey of the ASX200, ‘86% of companies reported at least one non-IFRS performance measure in their annual reports and 69% of these companies reported a 2015 non-IFRS measure that implied ‘better performance than the relevant statutory measure.’ The proliferation of non-statutory performance metrics raises questions as to the motive for entities to report these numbers and the implications for information quality. 20 Whilst not used in the four statutory statements, the use of underlying profits and other non-statutory (non-IFRS) financial measures in the 2015 Annual Report by Qantas Airways Limited can only be described as extensive. The first line of the CEO’s report on page 4 indicates ‘Qantas’ underlying profit before tax of $975 million was a turnaround of $1.6 billion compared with 2013/2014.’ Students will have varying opinions as to if this extensive use of non-IFRS is within the ‘spirit’ of RG 230. 21 The difference between a statement of comprehensive income and a statement of value added is essentially one of emphasis. The statement of comprehensive income shows what has been earned for the company’s shareholders while the statement of value added shows what has been earned for groups with a stake in the company’s performance. Although the main difference is one of emphasis, companies that published a statement of value added in Australia voluntarily disclosed information that is not professionally or legally required to be disclosed elsewhere in the financial statements. This information relates to labour costs and the costs of bought-in materials and services. The information usually disclosed in a statement of value added is shown in Table 14.2 of the textbook. 22 The arguments supporting the preparation of a statement of value added are: • It is suggested that, for those who are ‘financially illiterate’, the statement of value added is much easier to understand than the statement of comprehensive income. It is for this reason that it has frequently been used in Britain as a means of reporting to employees. • As the statement of value added reflects a broader view of a company’s objectives and responsibilities than the statement of comprehensive income, it is claimed that it will facilitate changes in the attitudes of employees. It is suggested that the statement of comprehensive income has little interest or motivational value for employees, as profit is the reward of shareholders and not employees. In contrast, the statement of value added shows the wealth created by the company to which employees contribute and the distribution to them of a portion of that wealth. It is hoped as a result that reporting value added distributed to employees will improve their attitudes to work and reduce industrial disputation. There is no empirical evidence to support this argument. . 14

• A statement of value added will facilitate the evaluation of a company’s performance. For example, the calculation of new ratios such as payroll to value added and taxation to value added may be useful in inter-period and inter-company comparisons. • Value added is an alternative to sales revenue and assets as a measure of company size. 23 The arguments against the preparation of a statement of value added are: •

•

Including the statement of value added in an annual report could cause confusion with the statement of comprehensive income. For example, what implication would users draw from the fact that a company had made a loss but had a positive value added? This is possible, as the following example shows. Suppose that a company has sales revenue of $10 000, bought-in costs of $7 000 and wages of $5 000. In this case, the value added would be $10 000 - $7 000 = $3 000, although the company would report a loss of $2 000. These results reflect the different emphases of the two financial statements. As is often the case with new proposals, it is argued that the costs will exceed the benefits of providing the new data. However, as the new statement largely involves recasting data already contained in the statement of comprehensive income, the additional costs should be minimal. The Corporate Report suggested that the statement of value added ‘elaborates on the profit and loss account and in time may come to be regarded as a preferable way of describing performance’ The danger is that it may also come to be expected that management should seek to maximise value added rather than profit. This could result in an erosion of equity and the eventual liquidation of the company.

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PROBLEMS 1

Mossman Enterprises The draft statement of comprehensive income differs from the requirements of AASB 101 in the following ways: • Aggregate expenses (excluding finance costs) should be classified by nature or function. • A number of line items required to be included by paragraph 82 of AASB 101 have been omitted. For example, profit or loss from discontinued operations, other comprehensive income, and total comprehensive income. • The errors corrected by adjustments to retained earnings are correct in terms of AASB 108, but should be shown in a separate statement of changes in equity, not the statement of comprehensive income. Statement of Comprehensive Income of Mossman Enterprises for the year ended 30 June, 2017 Revenue $500 000 Expenses, excluding finance costs1 (405 000) Finance costs (50 000) Profit before income tax 45 000 Income tax expense 25 000 Profit from continuing operations 20 000 Profit from discontinued operations 0 Profit for the period $20 000 Other comprehensive income 0 Total comprehensive income $20 000 Statement of Changes in Equity of Mossman Enterprises for the year ended 30 June, 2017 Total comprehensive income for the period $20 000 Effect of correction of errors (3 000) Balance of retained earnings at beginning 8 000 Balance of retained earnings at end $25 000 1

Expenses $400 000, plus depreciation of building and loss on sale of non-current assets. The notes would need to show the classification of these expenses by nature or function. There is insufficient information in the question to allow that to be done.

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Cairns Company Ltd The statement of comprehensive income and statement of changes in equity differ from the requirements of AASB 101 in the following ways: • The statement of comprehensive income must disclose aggregate revenues and aggregate expenses with details in the notes. • Expenses are to be classified by nature or function. • Finance costs expense must be separately disclosed on the face of the statement of comprehensive income. • AASB 101 prohibits the identification of items as ‘extraordinary’. • Amortisation of goodwill is no longer permitted by Australian Accounting Standards. • Identification of items as ‘significant’ is not required by AASB 101. However, assuming these ‘significant’ items are material, paragraph 97 of AASB 101 requires the nature and amount of these items to be separately disclosed. • The items identified as extraordinary are unlikely to warrant separate disclosure as they are unlikely to be classified as material. • Line items required by AASB 101 have been omitted. These include profit or loss from discontinued operations, profit or loss for the period, other comprehensive income, and total comprehensive income. • The prior-period adjustments include the effects of changes in accounting estimates (under-provision for tax and understatement of depreciation). The correction of these must be done prospectively through the current period’s statement of comprehensive income and disclosed if material. Based on the nature and amount they don’t appear to be material. The correction of the prior-period error in relation to the legal expense must be done retrospectively through the statement of changes in equity. Statement of Comprehensive Income of Cairns Company Ltd for the year ended 30 June, 2017 $’000 Revenue $????? Expenses, excluding finance costs1 (???) Finance costs (???) Profit before income tax 11 8352 Income tax expense 3 567 Profit from continuing operations 8 268 Profit from discontinued operations 0 Profit for the period $8 268 Other comprehensive income 0 Total comprehensive income $8 268

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Statement of Changes in Equity of Cairns Company Ltd for the year ended 30 June, 2017 $’000 Total comprehensive income for the period $8 268 Effect of correction of errors (131) Balance of retained earnings at beginning 12 845 20 982 Transfers to reserves (500) Dividends paid (10 000) Balance of retained earnings at end $10 482 Notes: 1 Expenses to be classified by nature or function. Items identified as ‘significant’ are presumably material and would be separately disclosed using a more descriptive name. 2 Profit before tax as given = $12 222, plus gain on sale of fixed assets 64, less depreciation of buildings 142, bad debts 64, effects of changes in estimates (assumed to be depreciation adjustments 140 and under provision for tax 105). Under current standards, amortisation of goodwill is not to be charged.

Atherton Ltd Is the lottery winning revenue? Framework 2014 defines revenue as ‘inflow of economic benefits during the period arising in the course of the ordinary activities of an entity…’ Is a lottery ticket part of the ordinary activities of the entity? If not the lottery winnings would be classified as gains and, according to para.4.30 of Framework 2014, are normally displayed separately. AASB 101 paragraph 97 requires material items to be disclosed separately, the lottery winnings are clearly material. Conclusion: lottery winnings are included in profit and should be separately disclosed. The below is a mixed classification of expenses, COGS being a functional classification but depreciation, wages and finance costs being classified by nature. Paragraph 99 of AASB 101 requires expenses to be classified based on ‘either the nature of expenses or their function’. Calculate accounting profit before tax Income Sales revenue Lottery winnings Expenses COGS Depreciation, Vans Doubtful debts Interest (finance costs) Marketing expense Long service leave expense Wages Profit before tax

500 000 905 000 1 405 000 350 000 25 000 375 7 500 1 600 850 105 000

490 325 914 675

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Income tax expense is determines based on the requirements of AASB 112 as the sum of the current and deferred income tax Calculation of Taxable income to determine current income tax expense Accounting Profit 914 675 Accounting adjustments add Doubtful debts 375 add Long service leave expense 850 add Accounting depreciation 25 000 Adjustments for Tax treatment deduct Lottery winnings (not assessable income) (905 000) deduct Bad debts written off 0 deduct LSL payments (7 500) deduct Tax depreciation (27 000) Taxable Income 1 400 Multiplied by 30% current tax rate expected to apply 420 Calculation of the Deferred tax expense

Deferred Tax Worksheet FYE 30 June 2017

Carrying amount 37 500

Tax base 37 500

less allowance for doubtful debts

(375)

Accounts receivable - net

37 125

37 500

Depreciable asset – van

250 000

Less accumulated depreciation

(120 000)

(132 000)

Depreciable asset – net

130 000

118 000

1 500

Accounts receivable

Provision for long service leave Closing balances as at 30/6/2017

TTD

DTD

DTL @30%

375

12 000

112.5

3 600 1 500

12 000

DTA @30%

1 875

450 3 600

562.5

Closing balances as at 30/6/2016

3 000

2 445

Change in DTA/DTL

∆↑ 600

∆↓ 1 882.5

The general journal entry to record the current income tax expense would be as follows: Date Details Debit $ Credit $ 30/6/2017 Current income tax expense Dr $420 Current tax liability Cr $420 (to record current income tax expense on taxable income $1 400 @ 30%) Deferred tax expense Dr 2 482.5 Deferred tax asset Cr 1 882.5 Deferred tax liability Cr 600 (to record deferred tax expense and change in DTA and DTL) Calculation of Income tax expense (for presentation in the SCI) Current income tax expense Deferred income tax expense Total Income tax expense

420 2 482.5 2 902.5

After Reporting date event: The loss of the permit is an after reporting date event that does not relate to conditions existing at reporting date. Given this will result in a 20% drop in sales (100 000 out of a total sales figure of 500 000), it is material in nature. Thus under AASB110, paragraph 10 this is a non-adjusting event, but, as it is material, paragraph 21 requires us to disclose in the notes the nature of the event and an estimate of its financial effect. It seems unlikely that the event threatens the going concern status of Atherton, so paragraph 14 is considered not to apply. _____________________________________________________________ Atherton Ltd Statement of Comprehensive Income for the financial year ended 30 June 2017 notes

$ Sales revenue 500 000 para. 82(b) Other income 2 905 000 Expenses from ordinary activities excluding finance costs 3 482 825 Finance costs 7 500 para. 82(b) Profit before income tax 914 675 Income tax expense 2 903 para. 82(d) Profit from continuing operations 911 772 para. 81(f) Profit from discontinued operations 0 Profit for the period $911 772 para. 81A(a) Other comprehensive income 0 Total comprehensive income $911 772 _____________________________________________________________ Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson, Issues in Financial Accounting 16e 20

Notes Note 1 should be the statement of significant accounting policies. Note 2 in this example is the note outlining the nature and amount of other income i.e. the lottery winnings. Note 3 in this example is the expense note and should disclose expenses by nature or by function as this has not been done on the face of the report (AASB 101 para. 99). Separate line items are required for material expenses under AASB 101 paragraph 97 There are also specific requirements for disclosure e.g. AASB 101 paragraph 104 that may be relevant. Note 4 in this example is the tax note and should include: (a) AASB 112 paragraph 79 requires the major components of income tax expense be disclosed separately. This would include (para. 80) current tax expense, the amount of deferred tax expense relating to temporary differences, the amount of deferred tax expense related to changes in tax rate; (b) a numerical reconciliation between income tax expense and the product of pretax net profit multiplied by the tax rate, including the basis by which the tax rate is determined; and (c) an explanation of changes in the applicable tax rate(s) (para. 81(d)). Note 5 There should also be a note for the Type 2 after reporting date event relating to the loss of the permit. 4

Daintree Ltd In this question it is necessary to calculate ‘other expense’ as they has not been listed separately in the additional information. On the information provided, it can be determined that the net profit before tax and before extraordinary items is $6 581 250 ($4 300 000 + $2 281 250). Gross profit is $11 000 000 therefore total expenses would be $4 418 750. Expenses listed in other information total $3 700 000, therefore other expense are $718 750. _____________________________________________________________ Daintree Ltd Statement of comprehensive income for the year ended 30 June 2017 _____________________________________________________________ $ Sales revenue 23 000 000 Cost of sales 12 000 000 Gross profit 11 000 000 Other expenses [note 1] 4 318 750 Finance costs 500 000 Profit before income tax expense 6 181 250 Income tax expense (incl. under-provision in 2015) 2 481 250 Profit from the period 3 700 000 Other comprehensive income Items that may be reclassified . 21

Foreign currency translation loss (net of tax) (400 000) Items that will not to be reclassified Gain on revaluation of property (net of tax) 100 000 Total other comprehensive income (net of tax) (300 000) Total comprehensive income 3 400 000 ______________________________________________________________ Note: 1 Other Expenses Paragraph 97 of AASB 101 requires disclosure of material expenses and depreciation. It would not be necessary to list all of these items however other expenses consist of: Director’s emoluments 300 000 Auditor’s remuneration 150 000 Depreciation 2 500 000 Bad and doubtful debts 250 000 Other expenses 718 750 Loss on sale of PPE 400 000 Total 4 318 750 Expenses are to be classified by nature or function. The foreign currency losses qualify as an item of other comprehensive income and are included in the statement of comprehensive income. The under-provision for income tax in 2015 is the correction of an accounting estimate and is accounted for prospectively and included in the current period statement of comprehensive income, along with the rest of the income tax expense. It is not the correction of a prior period error. 5

Cubic Ltd _________________________________________________________________ Cubic Ltd Statement of comprehensive income for the year ended 30 June 2017 _________________________________________________________________ Note $ Revenues from service activities 3 500 000 Other income* 1 1 000 000 Expenses 2 2 355 000 Finance costs** 49 790 Profit before income tax expense 2 095 210 Income tax expense 394 276 Profit for the period 1 700 934 Other comprehensive income Items that may not be reclassified Gain on revaluation of property 600 000 Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson, Issues in Financial Accounting 16e 22

Income tax on revaluation of property (180 000) Total other comprehensive income net of tax 420 000 Total comprehensive income $2 120 934 _________________________________________________________________ Cubic Ltd Statement of changes in equity for the year ended 30 June 2017 _______________________________________________________________ Total comprehensive income for the period $2 120 934 Balance of retained earnings at beginning 1 301 577 3 422 511 Dividends paid (800 000) Balance of retained earnings at end $2 622 511 _________________________________________________________________ Notes: 1 Other Income: Gain on sale of land 1 000 000 2 Expenses, classified by function Labour costs 800 000 Occupancy costs ($100,000 + $50,000) 150 000 Selling expenses 200 000 Administration expenses 400 000 Other expenses 80 000 Depreciation and amortisation expense*** 465 000 Bad debts expense 260 000 2 355 000 Calculations and assumptions ** lease The lease payment is $8333 per month ($100 000  12). The lease is capitalised as per the requirements of AASB 16. The lease liability is determined as the present value of remaining minimum lease payments after initial payment: [$8333/0.016 x [1 – (1.016– 59 )] = $316 661. The borrowing cost figure of $49 790 is calculated from the lease schedule. See below. *** Depreciation and Amortisation expense Goodwill: AASB 3 does not permit amortisation of goodwill, it is assumed that there is no impairment of goodwill at balance date. Depreciation of leased asset: Lease asset = $316 661 + 8337 = $325 000 (rounded) therefore the depreciation for the period is $325 000/5 = $65 000. It is assumed that the life of the trucks is the lease term – 5 years. This is added to the other depreciation figure of $400 000.

. 23

Schedule of payments under the finance lease Period end 2015/2016

30/09/2015 31/10/2015 30/11/2015 31/12/2015 31/01/2016 29/02/2016 31/03/2016 30/04/2016 31/05/2016 30/06/2016 2016/2017 31/07/2016 31/08/2016 30/09/2016 31/10/2016 30/11/2016 31/12/2016 31/01/2017 28/02/2017 31/03/2017 30/04/2017 31/05/2017 30/06/2017

Lease liability beginning

Lease payment

Interest @ 1.6%

Lease Liability ending

316 661 313 395 310 076 306 704 303 278 299 798 296 262 292 669 289 018 285 310

8 333 8 333 8 333 8 333 8 333 8 333 8 333 8 333 8 333 8 333

5 067 5 014 4 961 4 907 4 852 4 797 4 740 4 683 4 624 4 550

313 395 310 076 306 704 303 278 299 798 296 262 292 669 289 018 285 310 281 542

281 542

8 333 8 333 8 333 8 333 8 333 8 333 8 333 8 333 8 333 8 333 8 333 8 337 $100 000

4 478 4 406 4 335 4 266 4 198 4 131 4 064 3 999 3 935 3 873 3 811 3 774 $49 790

277 713 273 824 269 872 265 857 261 778 257 633 253 422 249 144 244 797 240 381 235 894 231 331

277 713 273 824 269 872 265 857 261 778 257 633 253 422 249 144 244 797 240 381 235 894

Mackay Ltd _________________________________________________________________ Mackay Ltd Statement of comprehensive income for the year ended 30 June 2017 _________________________________________________________________ Note $ Sales revenue 16 000 000 Cost of sales (5 000 000) Gross profit 11 000 000 Other income 1 226 000 Labour costs (5 492 000) Selling expenses (2 500 000) Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson, Issues in Financial Accounting 16e 24

Occupancy expenses (480 000) Administration expenses (100 000) Other expenses 2 (960 667) Finance costs (480 000) Profit before income tax expense 1 213 333 Income tax expense 218 640 Profit for the period 994 693 Other comprehensive income Items that may be reclassified Foreign currency translation loss (60 000) Items that will not to be reclassified Gain on revaluation of PPE (net tax) 120 000 Total other comprehensive income 60 000 Total comprehensive income $1 054 693 _________________________________________________________________ Mackay Ltd Statement of changes in equity for the year ended 30 June 2017 _________________________________________________________________ Total comprehensive income for the period $1 054 693 Balance of retained earnings at beginning 567 040 Balance of retained earnings at end $1 621 733 _________________________________________________________________ Notes: 1 Other income Gain on sale of land 200 000 Dividends received 26 000 $226 000 2 Other expenses from ordinary activities Includes the following material expenses: Bad debts 200 000 Loss on destruction of plant 320 000 Other expenses 440 667 7

Black Ltd (a) Revenues and gain are both components of income. Whilst expenses and losses are both components of expenses. AASB 15 paragraph 46 requires revenue to be measured at the transaction price. The transaction price is the ‘amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, sale sales taxes)’ paragraph 47. Therefore revenue is reported on a net basis. Gains (losses) are the net outcome of a transaction, For example, in relation to the sale of nonCopyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson, Issues in Financial Accounting 16e 25

current assets, the proceeds of sale are the gross flow whereas the overall gain or loss is equal to the proceeds – carrying value of asset sold. The gains/losses will also be reported on a net basis. (b)

(c)

Classification of Expenses: (i) Paragraph 99 of AASB 101 requires that the entity present an analysis of expenses using a classification based on either nature or function. The choice between these bases is to be decided based on whichever provides information that is reliable and more relevant. (ii) Given the information provided, a functional classification seems most feasible. Function classification enhances relevance, but may create difficulties in the need to allocate expenses across different functions. The allocation of expenses for this purpose may be arbitrary and hence unreliable. Other comprehensive income Other comprehensive income is ‘items of income and expense that are not recognised in profit or loss as required or permitted by other Australian Accounting Standards.’ (AASB 101, para. 7). The loss on discontinued stock, loss on sale of building, and loss on sale of marketable securities are not items of other comprehensive income and are recognised through profit or loss. The prior-period depreciation error is dealt with in AASB 108, not AASB 101. Essentially, errors arising in prior periods are to be dealt with retrospectively. That is, prior period comparative figures are adjusted as if the error never occurred. The effects of correcting the error are not recognised as revenue or expense of the current period, rather they are adjusted through the statement of changes in equity (i.e. through retained earnings). Paragraph 49 of AASB 108 requires disclosure of the nature of the prior period error and, to the extent practicable, the amount of each error correction.

(d)

Sample Statement of comprehensive income It should also be noted that the term extraordinary items cannot be used. Black Ltd Statement of comprehensive income for the year ended 30 June 2017 ________________________________________________________________ Notes $ Sales revenue 8 581 000 Cost of sales (4 159 000) Gross profit 4 422 000 Other income 1 441 000 Wages and salaries 605 000

. 26

Administration expenses 34 000 Occupancy costs 100 000 Other expenses 2 1 902 000 Finance costs 91 000 Profit before income tax expense 2 131 000 Income tax expense* 639 300 Profit for the period 1 491 700 Other comprehensive income Total other comprehensive income 0 Total comprehensive income 1 491 700 ________________________________________________________________ * For simplicity, income tax expense is determined at 30% Notes: 1 Other income Dividend and interest received Bad debt recoveries 2 Other expenses including losses Bad and doubtful debts expense Loss on discontinued stock Loss on sale of marketable securities Loss on sale of building 8

302 500 138 500 441 000 278 000 370 000 390 000 864 000 1 902 000

Travel Centre Ltd The first point to make clear is that the failure of Travel Centre Ltd to earn as much revenue as last year or as much as it expected is not an item that will appear directly in the company’s statement of comprehensive income. The financial reporting system is an historical one and does not report on opportunities foregone. Clearly, the airline attacks and the collapse of Ansett would be major factors that management would use to explain Travel Centre’s poor financial performance, but these items would not appear in the company’s financial statements. Notwithstanding this, the discussion of materiality in AASB 108 indicates that items may be material because they deviate significantly from what they have been in prior years. This is clearly the case here with commission revenues that will be well below levels achieved in previous years. Under AASB 101 for items that are material, their nature and amount must be disclosed. Hence identification of a material fall in commission revenues and the reasons for this would be included in the notes to the Statement of comprehensive income. Note that AASB 101 prohibits any item from being classified as extraordinary.

. 27

Wesfarmers Limited and Woolworths Limited – Comparison of 2015 Annual Reports Students may have varying opinions on differences and similarities on the disclosure of each of the company’s performance statements and will have varying opinions of the readability of each report. The following items may be noted: • Both companies present performance using the two-statement format. • The income statement for Wesfarmers is far more disaggregated than Woolworths. It seems both have classified expenses by function with Wesfarmers providing the additional line item disclosures on the face rather than in the notes. • Woolworths’ expense disclosures (on the face and in the note 5) are very brief. Essentially only three functions are identified – cost of sales, branch expenses and administration expenses. In note 5, as required, depreciation/amortisation and employee related expenses are disclosed separately. However in note 3 (pg 65) Woolworths has listed at note 3 individually significant items which is quite detailed. • The cost of sales is reported on the face of the SCI for Woolworths but not reported separately (on the face or in the expense note 2, pg 98) for Wesfarmers. • Wesfarmers provides more information in relation to their operating segments (pg 95 & 96) including a discussion on seasonality. • Students may come up with various other differences.

. 28

Chapter 15 REVENUE LEARNING OBJECTIVES After studying this chapter you should be able to: 1 describe the importance of accounting for revenue; 2 describe the objective, core principle and scope of AASB 15 ‘Revenue from Contracts with Customers’; 3 describe and apply the five-step model for revenue recognition in AASB 15 ‘Revenue from Contracts with Customers’; 4 describe and apply the treatment of contract costs in AASB 15 ‘Revenue from Contracts with Customers’; and 5 describe the objective of the disclosure requirements in AASB 15 ‘Revenue from Contracts with Customers’

QUESTIONS 1

Income is defined in paragraph 70(a) of Framework 2014 as: ‘increases in economic benefits during the accounting 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 contributions from equity participants.’ Framework 2014 states that income is recognised when it is probable that an increase in economic benefits has occurred which has a cost or value that can be measured reliably (para. 83). The approach adopted in Framework 2014 links income and its recognition to movements in assets and liabilities. In other words, income is dependent upon movements in assets and liabilities (other than those resulting from contributions from equity participants). This notion of income is sometimes known as the ‘balance sheet approach’ (or the ‘asset and liability approach’). A traditional definition of revenue is: ‘Generally, revenue is the sum of the selling prices (or fees) of all products sold and services provided to customers during the current period – whether or not the sales are cash sales or “credit sales”.’ Revenue is defined in Appendix A of AASB 15 ‘Revenue from Contracts with Customers’ as income arising in the course of an entity’s ordinary activities, although ‘ordinary activities’ is not defined in the standard. Revenue is thus a sub-set of income.

dependent upon movements in assets and liabilities (other than those resulting from contributions from equity participants). This notion of income is sometimes known as the ‘balance sheet approach’ (or the ‘asset and liability approach’). A traditional definition of revenue is: ‘Generally, revenue is the sum of the selling prices (or fees) of all products sold and services provided to customers during the current period – whether or not the sales are cash sales or “credit sales”.’ That is, this traditional approach first identified income/revenue and then determined which assets or liabilities were affected as a result of the recognition of income. This approach is often known as the ‘income statement approach’ (or the ‘revenues and expenses approach’). The income statement approach relies on some notion of realisation or ‘earning’ in which revenue emerges as the entity performs its obligations. Expenses are ‘matched’ to revenue as revenue is recognised. It has been argued that the income statement approach is subject to too much risk of manipulation by opportunistic managers. Note that although Framework 2014 adopts a balance sheet approach, AASB 15 (and its international equivalent) has been criticised for adopting more of a hybrid income statement approach because its satisfaction of performance obligations model seems to be based on an income realisation model (see note 6 in the chapter). 3

Recognising revenue at the time of production but before receipt of orders would usually be viewed as being inconsistent with the revenue realisation principle that drove the income statement approach. In the past, some gold mining companies recognised revenue at the time of production based on the argument that gold will always be in demand and the amounts could be reliably estimated because of quoted prices. Such revenue recognition was rare however. Adoption of different revenue recognition points across entities does negatively impact on the comparability of financial statements and could be subject to manipulation to manage reported earnings. However, disclosures of accounting policies for revenue recognition might go some way to assisting users of financial statements.

(a) Revenue from the sale of goods can be recognised when the following conditions have been satisfied (para. 14, AASB 118): (a)

The entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

(b)

The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; (c) The amount can be reliably estimated (d) It is probable the economic benefits associated with the transaction will flow to the entity; and (e) The costs incurred or to be incurred in respect of the transaction can be measured reliably. On the other hand, the revenue from a service transaction can be recognised when all of the following conditions are satisfied (para. 20, AASB 118): (a) (b) (c) (d)

The amount of revenue can be measured reliably; It is probable that the economic benefits associated with the transaction will flow to the entity; The stage of completion of the transaction at the end of the reporting period can be measured reliably; and The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

Only paragraphs (a) and (b) of the recognition criteria for the sale of services are the same as for the sale of goods (paras (c) and (d)). (b) Under AASB 15, there are no separate recognition criteria for goods and services. Rather the five step process must be applied to all contracts with customers. Most relevant to this question is the identification of all the performance obligations within a contract and the timing of the recognition of when each of those performance obligations are satisfied. In particular, para. 31 of AASB 15 requires that: ‘An entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e., an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.’ As paragraph 32 notes, this transfer of control might occur by satisfying the performance obligation over a period of time or by satisfying the performance obligation at a point in time. In assessing which of these two possible timings is relevant, an assessment of whether the performance is satisfied over time is made first. Paragraph 35 sets out the criteria which indicates if performance over time is appropriate (only one of these criteria have to be satisfied). If none of the criteria are satisfied, then the revenue is recognised at the point in time when control passes to the

customer (para. 38 specifies indicators of when control has transferred. These must be assessed on the basis of the particular facts). 5

AASB 15 adopts the following five-step model for determining the recognition of revenue from contracts with customers: 1. Identify the contract with the customer (para. 9). 2. Identify the performance obligations in the contract (para. 22). 3. Determine the transaction price (para. 47). 4. Allocate the transaction price to the performance obligations (para. 73). 5. Recognise revenue when (or as) a performance obligation is satisfied (paras 31 and 46). Each of these five steps must be applied to each contract with a customer (or, where practically expedient, a portfolio of contracts with similar characteristics).

Variable consideration is the projected impact of any discounts, rebates, refunds, incentives, performance bonuses or penalties and other similar variations to the consideration (paras 51 and 52). These modifications to the contract price may arise from terms in the contract (and the entity’s expected performance under the contract) or from any factor such as the entity’s customary business practices that may create a valid expectation in the customer that the consideration will be different from the price stated in the contract (para. 52(a)). Although variable consideration must be taken into account (subject to the constraints mentioned below), paragraph 49 notes that the entity can assume that the goods or services will be transferred to the customer and that the contract will not be modified, cancelled or renewed for the purposes of determining the transaction price. When estimating the impact of variable consideration on the transaction price, not all possible sources of variation need to be adjusted for. Paragraph 56 indicates that variable consideration is included in determining the transaction price “only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.” When calculating the effect of variable consideration on the transaction price (after allowing for any constraints), paragraph 53 states that an entity should use either an expected value method (the sum of probability weighted amounts of possible consideration) or the most likely amount method (the single most likely consideration from the contract). The choice of method must be that which the entity expects to be the better predictor of the consideration (para. 53) and the method chosen must be

applied consistently throughout the period of the contract (para. 54). Paragraph 53 suggests that the expected value method is likely to be the appropriate method in situations where the entity has a large number of similar contracts, whereas the most likely amount method would be appropriate when there are only two possible outcomes (e.g. the entity may incur a penalty if it does not achieve a performance target). Paragraph 55 requires that when an entity has received consideration from a customer but expects to have to refund some or all of the consideration, then it should recognise a refund liability. 7

Revenue that is allocated to a performance obligation is recognised when (or as) the performance obligation is satisfied (para. 46). Paragraph 31 states that an entity satisfies a performance obligation by transferring a promised good or service to the customer. The good or service is transferred when (or as) the customer obtains control of that good or service. To discover when control has passed to the customer the entity must determine at the start of the contract whether the entity satisfies a performance obligation over time or at a point in time (para. 32). A performance obligation must first be assessed to see if it is satisfied over time and, if not, it is necessary to determine the point in time at which it is satisfied. Paragraph 35 states that an entity transfers control of a good or service over time, and thus satisfies the performance obligation over time, if any one of the following tests are met: (a) the customer simultaneously receives and consumes the benefits provided as the entity performs; (b) the entity’s performance creates or enhances an asset (for example, work-inprogress) that the customer controls as the asset is created or enhanced; or (c) the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. Paragraphs B3 and B4 provide guidance on paragraph 35(a). Paragraph B3 notes that routine and repeating services would satisfy this test – for example, a contract in which daily office cleaning services are provided by the entity to a customer. Where it is less obvious that the customer receives and consumes the benefits as the entity performs, paragraph B4 provides that a performance obligation would be satisfied over time if the entity is of the view that ‘another entity would not need to substantially re-perform the work that the entity has completed to date if that other entity were to fulfil the remaining performance obligation to the customer’.

In circumstances where it is decided that a performance obligation is not satisfied over time, the entity is deemed to satisfy the performance obligation at a point in time (para. 38). Revenue is recognised at that point in time at which a customer obtains control of a promised good or service and the entity satisfies a performance obligation (para. 38). In addition to the definition and criteria for control provided in paragraphs 31 to 34, other indicators of the transfer of control of a good or service to a customer include (para. 38): (a) the entity has a present right to payment for the asset; (b) the customer has legal title to the asset (control is still deemed to pass to the customer in those cases where the entity retains legal title only as a protective right in case of non-payment by the customer); (c) the entity has transferred physical possession of the asset to the customer (although care must be taken in situations where a party holds a good on consignment or in a bill-and-hold arrangement, or where there is a repurchase agreement. See section 15.4.6 in the chapter for discussion of some of these situations); (d) the customer has the significant risks and rewards of ownership of the asset (an entity must exclude any risks that give rise to separate performance obligations. For example, one risk of asset ownership is the need to maintain the asset. If the entity has contracted to provide maintenance services after the delivery of the asset to the customer, it still has a performance obligation to satisfy); and (e) the customer has accepted the asset (e.g. a contract might state that a customer must first certify that the goods delivered to it by the entity are the ones it contracted for). Such certification would be a form of customer acceptance. Where the entity can objectively determine that it is delivering what was contracted for (e.g. by counting the number of goods delivered or observing other key characteristics), then lack of formal customer acceptance would not stop the entity deciding that control had passed to the customer (para. B84). However, where goods are delivered to a customer on a trial-and-evaluation basis and the customer does not have to pay until the trial period ends, control of the goods is not transferred until the customer accepts the goods or the trial period finishes. (para. B86). 8

Paragraph 60 of AASB 15 requires an entity to assess whether a contract with a customer contains a significant financing component and, if so, the transaction price must be adjusted. This involves separating the consideration into the portion that

represents the transaction price for the promised transfer of goods or services and the portion that represents the interest revenue or interest expense from the financing component. The objective of this adjustment is the need: ‘for an entity to recognise revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer (i.e., the cash selling price).’ (para. 61) An entity is required to consider all relevant facts in determining whether a significant financing component exists within a contract including both: (a) the difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services; and (b) the combined effect of both of the following: (i) the expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services; and (ii) the prevailing interest rates in the relevant market. (para. 61) The characteristics in paragraph 61 reflect the typical characteristics in a contract with a financing component. However, these characteristics are not essential in determining the presence of a financing component. Paragraph 62 notes that a contract would not have a significant financing component if any of the following circumstances were present: (a) the customer paid for the goods or services in advance and the timing of the transfer of those goods or services is at the discretion of the customer; (b) a substantial amount of the consideration promised by the customer is variable and the amount or timing of that consideration varies on the basis of the occurrence or non-occurrence of a future event that is not substantially within the control of the customer or the entity (for example, if the consideration is a sales-based royalty); or (c) the difference between the promised consideration and the cash selling price of the good or service (as described in para. 61) arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract.

Notwithstanding paragraphs 61 and 62, the Standard does not require that the consideration needs to be adjusted for a financing component if the period between the transfer of a promised good or service and the receipt of the consideration is for a period of 12 months or less (para. 63). When calculating the interest component, the entity is required to use a discount rate that would be used if a separate financing transaction had been entered into with the customer at the start of the contract. This rate must reflect the credit risk of whichever party is being financed (i.e. the entity or the customer) as well as any collateral (para. 64). 9

Entities may incur a variety of costs in their efforts to win contracts with customers. Examples of such costs include selling and marketing costs, costs incurred in developing and presenting a bid to a customer, sales commissions and various legal fees. Some of these costs will be incurred whether or not the entity obtains the contract – for example, the selling and marketing costs and the costs to develop and present a bid will be incurred whether or not the entity wins the bid. Other costs, such as sales commissions, are called ‘incremental costs’ and are only incurred if the entity is successful in obtaining the contract – for example, sales commissions are only paid if the entity wins the contract (para. 92). Paragraph 91 of AASB 15 requires an entity to recognise these incremental costs of obtaining a contract with a customer as an asset if the entity expects to recover the incremental costs either directly or indirectly from the contract. Costs incurred to obtain a contract that would have been incurred whether or not the contract was obtained must be recognised as an expense as incurred, except where the entity can charge the customer to recoup those costs (para. 93). Any incremental costs incurred to obtain the contract must be amortised and monitored for impairment as required by paragraphs 99–101 (see section 15.5.3 below), unless the amortisation period is one year or less, in which case the entity can choose to recognise those costs as an expense (para. 94). Once an entity obtains a contract, it incurs costs to satisfy the requirements of the contract. Paragraphs 95 and 96 note that where those costs are subject to standards other than AASB 15, then they must be accounted for using the relevant standards. For example, such costs might be subject to AASB 102 ‘Inventories’, AASB 116 ‘Property, Plant and Equipment’ or AASB 138 ‘Intangible Assets’. Where such costs are not subject to another standard, then paragraph 95 of AASB 15 requires that they must be recognised as an asset subject to the costs satisfying all of the following criteria: (a) the costs relate directly to a contract or to an anticipated contract that the entity can specifically identify – for example, costs relating to services to be

provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved; (b) the costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future; and (c) the costs are expected to be recovered. Paragraph 97 provides examples of costs that would be likely to satisfy these criteria, including: (a) direct labour – for example, salaries and wages of employees who provide the promised services directly to the customer; (b) direct materials – for example, supplies used in providing the promised services to a customer; (c) allocations of costs that relate directly to the contract or to contract activities – for example, costs of contract management and supervision, insurance and depreciation of tools and equipment used in fulfilling the contract; (d) costs that are explicitly chargeable to the customer under the contract; and (e) other costs that are incurred only because an entity entered into the contract – for example, payments to subcontractors. Paragraph 98 explicitly excludes the following types of costs from being assets: (a) general and administrative costs (unless those costs are explicitly chargeable to the customer under the contract, in which case an entity shall evaluate those costs in accordance with paragraph 97); (b) costs of wasted materials, labour or other resources to fulfil the contract that were not reflected in the price of the contract; (c) costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (i.e. costs that relate to past performance); and (d) costs for which an entity cannot identify whether the costs relate to unsatisfied performance obligations or to satisfied performance obligations (or partially satisfied performance obligations). Paragraph 98 requires that such costs must be recognised as expenses when they are incurred. 10 Paragraphs 107 and 108 of AASB 15 distinguish between a ‘contract asset’ and ‘a receivable’. A contract asset arises when an entity performs under the contract by Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442561175, Henderson, Issues in Financial Accounting 16e 10

transferring goods or services to the customer before the consideration has been paid or is due. The contract asset is recorded net of any receivables and it should be assessed for impairment as governed by AASB 9 ‘Financial Instruments’ (para. 107). Paragraph 108 states that ‘a receivable’ is the entity’s unconditional right to consideration. A right to consideration is deemed to be unconditional ‘if only the passage of time is required before payment of that consideration is due’. An entity would not have an unconditional right to consideration, for instance, if it still had to transfer another good or service to the customer. The receivable is to be accounted for in accordance with AASB 9 (para. 108). 11 Paragraph 107 of AASB 15 states that a contract asset arises when an entity performs under the contract by transferring goods or services to the customer before the consideration has been paid or is due. The contract asset is recorded net of any receivables and it should be assessed for impairment as governed by AASB 9 ‘Financial Instruments’ (para. 107). Paragraph 106 states that the entity recognises a contract liability in those circumstances where the customer pays consideration (or the entity obtains a right to an unconditional amount of consideration) before the entity has transferred a good or service to the customer. The entity presents a contract as a liability at the time the payment is made or the payment is due (whichever is earlier).

PROBLEMS 1

The example seeks to demonstrate how some entities try to enter into complex finance arrangements disguised as revenue. The economic substance of this transaction appears to be more in the nature of a financing arrangement than a sales arrangement. Indicators that this arrangement is not in substance revenue include: •

• •

The fair value of the inventory sold by Cole Ltd to Porter Ltd is $900,000 at the time of the sale but the ‘selling price’ is substantially ($1,300,000) above the fair value; There is no physical transfer of the inventory from Cole Ltd to Porter Ltd; Most significantly, Cole Ltd must repurchase the inventory in one year’s time at a price higher ($1,550,000) than the original ‘selling price’ and at an amount likely to be significantly higher than the fair value of the inventory (although the facts are silent on this). The higher repurchase amount has the form of a return of principal plus interest.

Cole Ltd by treating the initial transaction as a ‘sale’ it will (1) be able to record a substantial revenue item to boost its reported profits and (2) obtain cash flows necessary to fund its operations without showing any liabilities on the statement of financial position. The facts suggest that Cole Ltd is entering into this arrangement because its sales have been falling and it is facing difficulties paying its debts as they fall due. The company is trying to avoid breaching its debt covenants and wants to pay management bonuses. As these two objectives are dependent upon the numbers reported in the financial statements, treating the transaction as a ‘sale’ would greatly assist in achieving the desired objectives. The accounting treatment of the arrangement would be governed by AASB 9 ‘Financial Instruments’ because the arrangement is likely to meet the definition of a financial liability. Cole Ltd would be required to record a liability rather than a sale at the date of the initial transaction and to recognise interest expense/payable over the life of the arrangement.

2 Fair value of each component if sold separately Connection fee Access fee Troubleshooting Total

5 000 12 000 23 000 40 000

At inception of the agreement: Cash Revenue – connection fee Unearned revenue – access Unearned revenue – troubleshooting

Allocation of fair value to total consideration

Allocated amount

5 000/40 000 x 35 000 12 000/40 000 x 35 000 23 000/40 000 x 35 000

DR CR CR CR

4 375 10 500 20 125 35 000

35 000 4 375 10 500 20 125

Under AASB 118 the connection fee component can be recognised immediately because the criteria in paragraph 20 are satisfied (e.g., the amount can be measured reliably as per the calculation above, the benefits have been received because the payment has been made, and the connection to the network has been completed). The unearned revenue for each of the undelivered elements (i.e., the ongoing access and on-call troubleshooting) will be recognised when those services are delivered. Because these are available to Arthur Ltd continuously over the period of the agreement the revenue should be recognised in accordance with paragraph 25 of AASB 118 – i.e., on a straight-line basis. Since this agreement is for 1 year Ernst Ltd would record the following over the year ended 30 June 2017: Unearned revenue – access Unearned revenue – troubleshooting Revenue 3

DR DR CR

10 500 20 125 30 625

Paragraphs 18–21 cover modifications of contract. Essentially the issue here is whether the modification represents a change to the existing contract or whether it is an entirely separate new contract. The facts suggest that the two parties have approved the modification as per paragraph 18. Paragraph 20 requires the modification to be

treated as a separate contract if both (a) distinct promised goods or services have been added and (b) the price has increased by an amount that reflects the entity’s standalone selling prices of the additional goods/services. The facts are silent on whether criterion (b) is satisfied but criterion (a) is probably not satisfied based on the available facts. There is nothing explicit in the facts that suggests that additional distinct goods and services have been added – modifying the original design suggests that something like the layout of the facility is changing and so there is no distinct goods or services being added. In other words, the same single performance obligation remains after the contract modification [note: I’m happy if students want to argue the other way given that the facts can be open to interpretation. However, they would need to explain why new goods/services are being added]. As paragraph 20 is not satisfied, paragraph 21 outlines alternative possible treatments of the modification. As I’ve argued above that the modifications do not seem to give rise to distinct goods and services paragraph 20(b) seems the most appropriate response. This treats the modification as part of the existing contract and requires the change in price, costs, and extent of completion of the performance obligation to be used to recognise an adjustment to revenue at the date of the modification. 4

See the answer to Question 4(b) above as to the rules underlying this question. Determination of whether the transfer of control over the desks occurs over time must be made first by way of reference to the criteria in paragraph 35 (only one of these criteria have to be met). In this particular case, none of these three criteria are satisfied: i. Castor does not simultaneously receive and consume the benefits of the desks (among other things, they are physical assets that have a long life); ii. Although WDL’s performance creates WIP as the desks are made, Castor does not control that WIP because legal title and physical possession to the WIP remains with WDL; and iii. WDL’s performance creates an asset with an alternative use – the desks can be sold to other customers and if Castor cancels the contract it only has to pay a penalty clause which is unlikely to bear any relationship to the work completed to date. Consequently, WDL should recognise revenue when the desks are delivered to Castor because control is transferred and the performance obligation is satisfied at that point in time. The terms of the contract indicate that control of the desks is not transferred as they are built. In particular, Castor does not retain the work in process if the contract is cancelled and WDL can sell the completed goods to another customer. The

timing of payments does not determine whether WDL has met the criteria for revenue recognition over time. 5

1. Identify the contract In the absence of any other information, we are told that the two parties enter into a contract. We would expect that this contract will be enforceable in the courts. There is nothing to suggest that Sail Ahoy will be unable to collect the consideration or fail to satisfy any of the other criteria in paragraph 9 (you could briefly run through each of these with the students). 2. Identify the performance obligations There are two performance obligations here – the delivery of the boat and the provision of mooring services are distinct goods and services as per paragraph 27. Captain Ahab’s purchase of the boat is not interrelated or dependent upon the mooring services – (e.g., he could moor the boat somewhere else) 3. Estimate the transaction price. The transaction price of is given in the contract as $35 275. There are no variations or other factors impacting upon that price (para. 47). 4. Allocate the transaction price. Sail Ahoy should allocate the transaction price of $35,275 to the boat and the mooring services based on their relative standalone selling prices as follows (paras 73 and 76): Boat: Mooring services:

$29 750 $5 525

($35 275 x ($35 000 / $41 500)) ($35 275 x ($6 500 / $41 500))

The allocation results in the $6,225 discount being allocated proportionately to the two performance obligations. 5. Recognition of Revenue Recognition of revenue must be separately assessed for each performance obligation. Boat: Determination of whether the transfer of control over the boat occurs over time must be made first by way of reference to the criteria in paragraph 35 (only one of these criteria have to be met). In this particular case, none of these three criteria are satisfied:

Ahab does not simultaneously receive and consume the benefits of the boat (among other things, the boat is a physical asset that has a long life); ii. Legal title and physical possession to the boat remains with Ship Ahoy until settlement; and iii. Ship Ahoy’s performance creates an asset with an alternative use – the boat can be sold to other customers if Ahab cancels the contract and there is no mention that Ahab has to pay anything if he cancels the contract. Consequently, the revenue for the boat cannot be recognised over time. The point of time that revenue can be recognised depends on when control has passed (para. 38). The available facts suggest that legal title passes when the cash consideration is received by Ship Ahoy – this would suggest that items (a) to (e) in paragraph 38 are satisfied at this time, that is, revenue can be recognised at the time the cash is received. Mooring Rights: Determination of whether the transfer of control over the mooring rights occurs over time must be made first by way of reference to the criteria in paragraph 35 (only one of these criteria have to be met). In this particular case, criterion (i) appears to be satisfied: i.

Ahab does simultaneously receive and consume the benefits of the mooring rights; ii. No work-in-progress or other asset is being created; and iii. Ship Ahoy’s performance creates an asset with an alternative use – the mooring can be rented to other customers if Ahab cancels the contract and there is no mention that Ahab has to pay anything if he cancels the contract. Consequently, a period of time approach should be adopted to recognise revenue from the mooring rental. As the benefits of the rental are consumed equally over time, a straight-line method of recognition (outputs based) would seem appropriate. 6 (a) Step 1 – Identify the contract A contract exists between MM and A. Wimp. This is because the customer is essentially committed to the contract (e.g., they have paid the non-refundable fee, the contract would be enforced at law, the terms of the contract are well specified, etc.). Step 2 – Identify the Performance Obligations

There are three performance obligations here – the access to the gym facilities, the use of a personal trainer for 3 months, and the acquisition of some weights. Each good/service is distinct because there is nothing in the terms of the contract that make the use of these three things interdependent e.g., there is evidence that MM sells them separately). Step 3 – Identify the transaction price. The three performance obligations are sold as part of one package and the price of $900 is specified in the contract. Step 4 – Allocate the transaction price The transaction price must be allocated across the three performance obligations on the basis of their relative stand-alone prices.

Gym Access Personal Trainer Weights Total

Stand-Alone Price $960 420 80 $1 460

Allocation 0.67 0.28 0.05 1.00

Allocated Price $603 252 45 $900

Step 5 – Recognise revenue as performance obligation is satisfied. Gym access – should be recognised over 12 months (customer receives and consumes benefit simultaneously (i.e., as gym access goes by month by month) Personal trainer – should be recognised over 3 months (customer receives and consumes benefit simultaneously (i.e., as personal trainer sessions go by month by month) Weights – should be recognised at end of 2 months (i.e., at a point of time). Control passes on physical delivery. (b) 1 July 2017 Cash Unearned Revenue

DR CR

900

179.25

900

31 August 2017 Unearned Revenue

Gym Membership Revenue Personal Trainer Services Revenue Sales

CR CR CR

100.50 168.00 45.00

Revenue for gym membership and personal trainer services is recognised monthly (e.g., $603/12 = $50.25) and the sale of the weights occurs entirely at the end of the second month. 7

Span Constructions Ltd should expense the costs incurred during the proposal and contract negotiations as incurred. The costs are not incremental because they would have been incurred even if the contract was not obtained (AASB 15, para. 93). The costs incurred during contract negotiations could be recognized as an asset if they are explicitly chargeable to the customer regardless of whether the contract is obtained but the facts are silent on this. Even though the costs incurred for the initial design of the bridge are not incremental costs to obtain a contract, it is possible that some of those costs might be costs to fulfil a contract and recognized as an asset provided the criteria in paragraph 95 are met.

ICL would apply the requirements of paragraphs 95–98 of AASB 15. ICL should recognize an asset for the mobilisation costs as these costs (1) relate directly to the contract, (2) enhance the resources of the entity to perform under the contract and relate to satisfying a future performance obligation, and (3) are expected to be recovered. The direct costs incurred during the build phase are accounted for in accordance with other standards if those costs are in the scope of those standards. Certain supplies and materials, for example, might be capitalized in accordance with AASB 102 ‘Inventory’. The equipment might be capitalized in accordance with AASB 116 ‘Property, Plant, and Equipment’. Any other direct costs associated with the contract that relate to satisfying performance obligations in the future and are expected to be recovered are recognized as an asset. ICL should expense the abnormal costs as incurred.

Students’ responses will depend on which company’s disclosures they have studied. In general students should be encouraged to discuss how the company’s disclosures satisfied the objectives in paragraph 110 of AASB 15 by providing both quantitative and qualitative disclosures about: (a) the entity’s contracts with customers;

(b) the significant judgements and changes to judgements that the entity has made in applying AASB 15 to its contracts with customers; and (c) any assets that have been recognised as a result of incurring costs to obtain or fulfil a contract with a customer.

Chapter 16 THE STATEMENT OF CASH FLOWS LEARNING OBJECTIVES After studying this chapter you should be able to: 1

discuss the purpose of a statement of cash flows;

define and distinguish between three concepts of funds: cash, working capital and total resources;

assess the advantages of cash flow information;

discuss the requirements of AASB 107 ‘Statement of Cash Flows’ and use them to prepare a statement of cash flows; and

compare and contrast the direct and indirect methods of calculating cash flows from operating activities.

QUESTIONS 1

Early in the twentieth century, it was realised that the statement of financial position and statement of comprehensive income did not present a complete picture of the operations of a business. The statement of financial position summarised an entity’s financial position at a point in time and, while the statement of comprehensive income summarised the operating transactions of a business, there was no summary of investing and financing transactions during the reporting period. Information about such important events as new share issues, new borrowing, loan repayments, and the acquisition and disposition of non-current assets was not readily available to the users of financial statements. To overcome this perceived deficiency, an additional financial statement was developed to summarise the funds flows associated with operating, investing and financing transactions. This became known as a funds statement. The purpose of a statement of cash flows is essentially the same as that of the funds statement – that is, to summarise the cash flows associated with the operating, investing and financing transactions of an entity.

The basic argument for the preparation of a statement of cash flows is that the statement of comprehensive income and statement of financial position do not present a complete picture of the operations of an entity. The statement of cash flows shows an entity’s cash flows for a reporting period, and contains verifiable (reliable) data. An argument against the publication of a statement of cash flows is that it is focused on only one aspect of business activities for the period – that is, on cash flows.

A widely used interpretation of funds is working capital which is usually measured as current assets less current liabilities. An increase in working capital (source of funds) occurs when there is an increase in total current assets without a corresponding increase in total current liabilities (for example, an issue of shares for cash) or a decrease in total current liabilities without a corresponding decrease in current assets (for example, refinancing a short-term loan into a long-term loan). A decrease in working capital (application of funds) occurs in the opposite circumstances. In total, the difference between sources and uses of working capital will be equal to the change in working capital between successive statements of financial position. The use of working capital as the basis for the preparation of a funds statement is related to liquidity considerations. Additions to working capital presumably increase liquidity and reductions in working capital reduce liquidity. Funds statements which show movements in working capital suffer from a similar defect to statements of cash flows. They omit the effects of some transactions which may be very important. These omissions are of two types. The first type of omission is intraCopyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson Issues in Financial Accounting 16e 2

working capital transactions which affect components of working capital but which leave total working capital unchanged. Transactions of this type include the purchase of inventory, the receipt of cash from debtors, the payment of cash to creditors, the use of cash to settle a short-term loan, and the short-term investment of cash in marketable securities. All of these transactions leave working capital unchanged and are, therefore, not disclosed in the funds statement. The second type of omission from working capital-based funds statements is transactions that have no effect on the components of working capital. Transactions of this type include refinancing of long-term loans, the acquisition of assets in exchange for shares or on long-term credit, the exchange of non-current assets and the conversion of a convertible note issue. 4

The total resources concept of funds is based on an interpretation of the statement of financial position as a statement that shows the sources of an entity’s resources and how those resources have been used. The equities side of the statement of financial position is a summary of the sources of resources that have been entrusted to the entity by lenders and shareholders. At the same time, the assets side of the statement of financial position shows how those resources have been employed. Some resources have been used to acquire assets, some have been used to provide credit and some remain as cash. The statement of financial position shows how management has used the resources entrusted to it by outsiders. Any transaction that increases liabilities or equity is a source of funds. Conversely, any transaction that reduces liabilities or equity is a use of funds. Any transaction that increases assets is a use of funds and any transaction that reduces assets is a source of funds which are now ‘free’ for some new use. Since all transactions affect the statement of financial position, a total resources funds statement summarises all transactions. Only the total resources approach, therefore, is consistent with the notion of a funds statement as a summary of all operating, investing and financing transactions of an entity. An argument against the total resources concept is that it is only a selection, reclassification and summarisation of information already contained in the statement of financial position and statement of comprehensive income.

If funds are defined as cash, then any transaction that increases cash is a source of funds and any transaction that reduces cash is an application of funds. The reasons for defining funds as cash are set out in paragraph 4 of AASB 107: ‘A statement of cash flows, when used in conjunction with the rest of the financial report, provides information that enables users to evaluate the changes in net assets of an entity, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson Issues in Financial Accounting 16e 3

cash flows in order to adapt to changing circumstances and opportunities … It also enhances the comparability of the reporting of operating performance by different entities because it eliminates the effects of using different accounting treatments for the same transactions and events.’ However, because the statement only summarises transactions with immediate effects on cash, many important transactions are omitted. For example, credit sales or purchases, the acquisition of assets in exchange for shares or on extended payment terms, writing off bad debts, exchanges of non-cash assets, refinancing a loan and so on are important transactions that would not be included in a statement of cash flows. The omission of transactions such as these reduces the comprehensiveness and therefore the usefulness of a statement based upon cash. It has also been argued that showing only transactions with an immediate impact on cash is inconsistent with accrual accounting.

When evaluating this comment, students should discuss the differences between accounting profit data and cash flow data. In particular, the statement of comprehensive income summarises the operating transactions of a business, including both accrual and cash based transactions. However, it is quite difficult to ‘undo’ the accounting accruals reflected in accounting profit data (e.g. accruing revenue before cash is received, recognising expense prior to the payment of cash) to identify the cash flows within the business (e.g. new share issues, new borrowing, loan repayments, and the acquisition and disposition of non-current assets). Having information on cash flows assist investors and other statement users in understanding issues such as a firm’s ability to generate cash flows from its core operational activities, and the net flows from investing and financing activities which might not otherwise be evident from accounting profit data.

There are many examples of the arbitrariness of these classifications. For example, transactions relating to the sale of non-current assets are included as income in the statement of comprehensive income, but are classed as relating to investing activities in the statement of cash flows. Similarly, the proceeds of share issues and the dividends on those shares are treated as financing cash flows, but cash borrowed from lenders and interest on those borrowings are treated as financing and operating cash flows respectively. This is strictly not correct. In general, AASB 107 requires that gross cash flows be shown (para. 21). However, there are some exceptions to this general requirement. Paragraph 22 provides that cash flows may be reported on a net basis for: a) items where the entity is, in substance, holding or disbursing cash on behalf of its customers; and

b) items where the turnover is quick, the amounts are large, and the maturities are short. Examples include the acceptance and repayment of demand deposits of a bank, or rents collected on behalf of, and paid over to, the owners of properties (para. 23). Paragraph 24 also allows the disclosure of net cash flows for some transactions of financial institutions. Examples include cash advances and loans made to customers and the repayment of those advances and loans.

9 (a) The direct method involves reporting the major classes of gross operating cash receipts and gross operating cash payments. This presentation shows the cash flow equivalent of profit after tax, hence the name direct method. The scope of cash flows from operating activities is narrower than the scope of profit after tax. Cash flows from operating activities focus on the provision of goods and services, while profit after tax encompasses all operating activities including investment activities. In contrast, under the indirect method, reported profit is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing activities. Hence, the name indirect method is used to describe how profit is adjusted to indirectly provide cash flows from operating activities. This method provides a reconciliation of the cash flows from operating activities with the profit from ordinary activities after tax shown in the statement of comprehensive income. (b) AASB 107 allows an entity to report cash flows from operating activities using either the direct method (para. 18(a)) or the indirect method (para. 18(b)). However, entities are ‘encouraged’ to report cash flows from operating activities using the direct method (para. 19). This decision may have been based on the two criticism that have been made of the indirect method has been criticised on two grounds. First, there is a complaint that showing the ‘adding back’ of expenses such as depreciation suggests that such expenses are sources of cash. Second, relative to the direct method, the indirect method is not as useful for forecasting future cash flows and earnings. For example, the direct method cash flow component of cash collected from customers is identified as the most important direct cash flow number for investors and a primary indicator of a company’s cash-generating ability. These assertions are supported by empirical evidence which suggests that data from statements prepared using the direct method are incrementally more informative beyond indirect method disclosures when predicting future cash flows from operations and earnings (e.g. Orpurt and Zang, 2009). 10 (a) The indirect method of presenting cash flows from operating activities is used. Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson Issues in Financial Accounting 16e 5

(b) Under the indirect method, profit before tax is adjusted for various accounting items in order to calculate net cash flows from operating activities. Accrual-based expenses such as depreciation, amortisation and impairment expenses which have been deducted from accounting profit are not cash-based expenses. As a result, they are added back to accounting profit before tax in order to calculate cash flows. Changes in assets such as accounts receivable also reflect cash inflows/outflows. To illustrate, if accounts receivable decreases, this suggests that cash received from customers exceeds sales revenue recorded in profit or loss (i.e. ignoring discounts, accounts receivable decreases when cash collections occur). Thus, the increase in accounts receivable is added to sales revenue to calculate total cash collections from customers. 11

This question can be used to illustrate on of the criticisms of the indirect method of presenting cash flows from operating activities. That is, “adding back” depreciation and amortisation expenses to accounting profit suggests that they are sources of cash. Clearly, this is not correct. The adjustment is made because the depreciation and amortisation expenses are non-cash expenses and the objective is to adjust operating profit to make it equal to operating cash flows. Thus, all non-cash accruals contained in operating profit are ‘undone’ or ‘reversed’.

PROBLEMS 1

Hermes Ltd Statement of cash flows for the year ended 30 June 2018 _________________________________________________________________ Cash flows from operating activities Cash receipts from customers Payment to suppliers and employees Income tax paid Interest paid Net cash provided by operating activities

$ 260 000 (210 000) (25 000) (5 000) 20 000

Cash flows from investing activities Interest received Proceeds from selling land Proceeds from selling equipment Purchase of property and equipment Net cash used in investing activities

16 000 21 000 30 000 (69 000) (2 000)

Cash flows from financing activities Proceeds from issuing debt Proceeds from issuing preference shares Dividends paid Repayment of debt Net cash used in financing activities Net decrease in cash held Cash at 1 July 2017

36 000 15 000 (26 000) (46 000) (21 000) (3 000) 34 000

Cash at 30 June 2018 $31 000 _________________________________________________________________

Sturman Ltd This question requires a thorough understanding of accrual and cash flow accounting. It assumes that there were no sales of depreciable assets during the year. (a) Extract from the statement of comprehensive income for year ended 30 June 2018 $ $ Sales Cash Credit

24 000 270 400

294 400

Cost of sales Opening inventory Purchases less Closing inventory Gross Profit

38 200 175 040 213 240 (40 800)

172 440 121 960

Expenses Operating expenses Interest Depreciation

84 000 1 000 14 000

99 000

Profit before tax 22 960 ______________________________________________________________ Credit sales

= cash received from debtors + the increase in accounts receivable = 260 000 + 10 400 Purchases = payments to creditors + the increase in accounts payable = 149 840 + 25 200 Depreciation = 86 000 + 16 000 (purchases) – 88 000 Profit is the increase in retained profits plus dividends paid. (b) Statement of cash flows for the year ended 30 June 2018 Operating cash flows (before tax): Receipts from customers Payments to suppliers and employees Interest paid Net operating cash flows

284 000 (233 840) (1 000) 49 160

Cash flows from investing activities: Purchase of depreciable assets

(16 000)

Borrowings: Proceeds Repayments Dividends paid Net financing cash flows

8 000 (17 000) (20 000) (29 000)

Net increase in cash held Cash balance at beginning of year Cash balance at end of year

4 160 50 000 54 160

22 960 14 000 36 960

add (deduct) Changes in working capital, not including cash: Increase in accounts receivable* Increase in merchandise inventory* Increase in accounts payable Net operating cash flows

(10 400) (2 600) 25 200 49 160

* These are equivalent to a use (decrease) in cash during the year. 3 Windsor Ltd Additional information to the question: Assume that at the beginning of the year, Windsor Ltd held $760 000 in on-call deposits at XYZ Bank. _________________________________________________________________ Windsor Ltd Statement of cash flows for the year ended 30 June 2018 Cash flow from operating activities Cash inflows: Receipts from customers Cash outflows: Payments to suppliers and employees Payments for other operating expenses Interest paid Income tax paid Net cash provided by operating activities

$1 400 000

(775 000) (290 000) (22 000) (135 000) $178 000

Proceeds from sale of shares Dividend received Interest received Cash outflows: Payments for purchases of shares Purchase of plant and equipment Net cash used in investing activities

130 000 15 000 28 000

(591 000) (1 024 000) ($1 442 000)

Cash flow from financing activities Cash inflows: Issue of shares 200 000 Issue of debentures 425 000 Cash outflows: Dividend paid (120 000) Net cash provided by financing activities Net change in cash Cash balance at beginning of year Cash balance at end of year * ($760 000 on call deposits + $2 000 beginning cash on hand)

505 000 (759 000) 762 000* ($3 000)

4 The answers to this question are based on the 2015 Annual Financial Statements of Wesfamers Ltd. (a) Yes, the company has generated positive cash flows. The information is contained in the cash flows from the operations section of the statement. In 2015, Wesfarmers generated $3,791 million cash flows from its operations. (b) No, the cash flows from investing activities are negative. From the statement of cash flows for 2015, the investing cash flows are $(1 898) million. This suggests that Wesfarmers is in a period of expansion (i.e. cash outflows on investments), with the largest investment being the purchase of property, plant, equipment and intangibles ($2 239 million outlay). (c) No, the cash flows from financing activities are negative. From the statement of cash flows for 2015, the financing cash flows are $(3 249) million. Overall, this suggests that the company is repaying it sources of finance. In particular, Wesfarmers Ltd repaid borrowings of $722 million, returned capital of $864 million and paid equity dividends of $2 597 million. At the same time, it borrowed $930 million which reduced its deficit position on financing cash flows. (d) The reported net profit after tax from continuing operations is $2 440 million and the cash flows from operations are $3 791 million. The difference between these two Copyright © 2017 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781488611643, Henderson Issues in Financial Accounting 16e 10

figures can be attributed to the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing activities. From Note 4 ‘Reconciliation of Net Profit After Tax and Cash Flows from Operations’ (2015 Financial Statements), the two most significant items are: • Depreciation and amortisation $1 219 million; and • Increase in trade and other payables of $219 million. Both items are added back to the net profit after tax to reconcile it with cash flows from operations.

Chapter 17 FINANCIAL REPORTING: SEGMENT REPORTING AND HIGHLIGHTS STATEMENTS LEARNING OBJECTIVES After studying this chapter you should be able to: 1

explain the arguments for and against providing segment information;

understand and apply the requirements of AASB 8 ‘Operating Segments’;

explain the arguments for and against the preparation of a highlights statement;

apply the requirements of AASB 133 ‘Earnings per Share’; and

calculate other performance indicators.

QUESTIONS 1

The main arguments for and against segment reporting are set out in sections 17.2.1. and 17.2.2. The case supporting segment reporting rests on two arguments. 1) Segment reporting will result in improved managerial performance. Segment reporting will reveal in more detail how well management have performed. Management will find it more difficult to hide its failures behind it successes if disaggregated information is disclosed. In addition, disclosure of segment results may encourage management to be more careful in making investment decisions and more decisive in correcting mistakes. 2) Data provided by segment reporting will be useful for decision making by financial statement users. Disaggregated information will enable users to better asses the risks relating to investments. Research evidence provides support for these arguments (as discussed in section 17.2.1).

The arguments against segment reporting hinges on consideration of cost and reliability. If the benefits of providing the information exceed the costs, then the disclosure is desirable. However, the comparison of the benefits and costs are difficult because the benefits are enjoyed by the users whilst the costs are incurred by preparers. Miller and Scott argue that the five specific objections to the disclosure of segment date are as follows. 1) Investors invest in a company and not in individual segments. 2) The data is difficult to interpret and may confuse readers or be misunderstood with inappropriate inferences being drawn. 3) It is argued that segment data are not sufficiently reliable to justify their disclosure and it is beyond the scope of external financial reporting to provide such analytical or interpretive data. The unreliability arises from the need to make arbitrary allocations of costs and revenues among segments of the business. The degree of arbitrariness will depend on the nature and size of the reporting segments and the amount of detail disclosed. 4) It may have a negative impact on corporate innovation and experimentation. To avoid poor performance in a particular segment, management may be inclined to minimise risk with a consequent decline in innovation. This argument is difficult to assess. In the long run, of course, a lack of innovation will lead to poor performance and dissatisfaction with management. However, it seems likely that investors will be sufficiently sophisticated to realise that continued success requires innovation, which means that some risks must be taken. . 2

5) The costs of providing segment information are too high. This would include the direct costs incurred in preparing the information and the indirect costs associated with disclosure of proprietary information to competitor entities. (See for example the Accounting in Focus box in section 17.2.2.) 3

This is true. Including the segment data in the financial statements and making these data subject to audit is costly but results in data that the FASB describes as meeting ‘the objective of verifiability in reasonable degree’. Excluding segment data from the financial statements but including them in the directors’ report or elsewhere in the annual report would avoid audit costs, but, as a consequence, would make them less reliable.

Paragraph 5 of AASB 8 ‘Operating Segments’ defines an operating segment as a component of an entity: (a) that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity); (b) whose operating results are regularly reviewed by the chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance; and (c) for which discrete financial information is available.

The answer to this question should be largely guided by the student’s own perceptions after studying AASB 8. The first shortcoming is likely to be around the approach taken in determining reportable segments. AASB 8 adopts a ‘management approach’ to identify operating segments and therefore leads to considerable discretion by management. Whilst the decision is to be based on internal reporting function, this information is unobservable to external users and therefore is not verifiable. Second, given that the nature of the required disclosures is based around management reporting and considerable discretion existing in the implementation of the requirements, there are likely to be variations in the disclosures made by different entities making comparability for decision making more difficult.

A highlights statement or financial summary summarises a company’s performance and financial position usually for a period of 5–10 years. In general, highlights statements include two types of data. First, there are data that are simply extracted from the financial statements. Data in this category include turnover (sales), total assets, profit and equity. Second, there are data that result from computations performed on financial statement data. This category of data includes ratios such as earnings per share, net tangible assets

. 3

per share, rates of return on total assets or equity, dividends per share and the dividend payout ratio. This class of data is frequently termed ‘performance indicators’ and it involves an analysis of the data in the financial statements. Companies include a highlights statement in order to present in a simple way data from the financial statements that management believes are the most important indicators of performance and financial position. 7

Three arguments are advanced against the publication of highlights statements: 1) A highlights statement contains management’s selection of the most important indicators or performance and financial position. There is, therefore, a risk of conscious or unconscious bias. Management may be tempted to include ‘good’ news and exclude ‘bad news’. 2) There is frequently no indication of how performance indicators are calculation and therefore inter-company or intra-year comparisons are made more difficult. 3) Performance indicators use data that are already available to report users and the calculation of such measures would normally be regarded as analysis of the results. There is disagreement about whether the scope of published financial statement should include financial statement analysis.

AASB 133 requires that an entity shall present basic and diluted earnings per share on the face of the statement of comprehensive income (see para. 66).

Basic earnings per share is calculated as follows: Profit or loss (after tax) from continuing operations attributable to ordinary equity holders of the parent Weighted average number of ordinary shares outstanding during the period. Diluted earnings per share is the basic earnings per share adjusted for the effect of all dilutive potential ordinary shares. Paragraph 5 indicates that potential ordinary shares are defined as ‘a financial instrument or other contract that may entitle its holder to ordinary shares. Examples would include convertible debt instruments, convertible preference shares, uncalled shares, partly paid ordinary shares that are not entitled to participate in dividends and options.

10 A reason for including earnings per share figures in highlights statements is that they provide data for statement users in a way that is more readily understood than in conventional financial statements. Earnings per share data are useful for inter-period comparisons. There are, however, some arguments against their inclusion in published financial reports. . 4

(a) The calculation of earnings per share adds arbitrariness and estimates beyond those already contained in the published profit figure. In spite of this increased subjectivity, earnings per share figures are usually shown ‘accurate’ to the nearest hundredth of a cent. This combination of more estimation and more apparent accuracy may not be in the best interests of some statement users who do not appreciate the judgements involved. (b) Earnings per share figures may be useful for comparisons over time of the performance of a particular company, but they are no improvement on profit for comparing the performance of different companies. Earnings per share figures are independent of both the market and nominal value of the shares. For example, two similar companies, with shares trading at widely differing prices, could have identical earnings per share but they would have different earnings yields. (c) Earnings per share figures are often included in financial statement analysis through the price-earnings ratio or the earnings yield. There is a risk that accounting support for earnings per share calculations may imply support for the price-earnings ratio. It would be dangerous if implicit support for the price-earnings ratio detracted from other measures of corporate performance. (d) Also, there is some doubt about the usefulness of the price-earnings ratio. It is widely used as an indication of the reasonableness of a company’s share price compared with the industry average. Such a use implies that earnings alone determine share prices. Clearly, there are many other factors such as dividends, growth and expectations about future performance that are relevant. 11 The answer should consider the arguments for and against the publication of performance indicators. Arguments that could be raised include: (a) usefulness of such information in the absence of an accepted methodology for selecting and calculating the performance indicators; (b) the reasons against the publication of EPS outlined in Question 10; and (c) the fact that the performance indicators have not been audited (or independently reviewed) may also lead to them being considered of questionable value.

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PROBLEMS 1

A – Woolworths Limited 2015 Annual Report (a) Note 4 pg 66 & 67 (b) Reportable segments are identified on the basis of internal reports on the business units of the Group that are regularly reviewed by the Board of Directors in order to allocate resources to the segment and assess its performance. (c) The Group has five reportable segments. These business units offer different products and services and are managed separately because they require different technology and marketing strategies. The Group’s reportable segments are as follows: (a) Australian Food, Liquor and Petrol – procurement of food, liquor and petroleum products for resale to customers in Australia (b) New Zealand Supermarkets – procurement of food and liquor products for resale to customers in New Zealand (c) General Merchandise – procurement of discount general merchandise products for resale to customers predominantly in Australia (d) Hotels – provision of leisure and hospitality services including food and alcohol, accommodation, entertainment and gaming in Australia (e) Home Improvement – procurement of home improvement products for resale to customers in Australia (d) Performance of each segment Woolworths’ segment disclosures are quite brief and they do not disclose the profit after tax by segment but report only to earnings before interest, tax and significant items. Woolworths also do not provide segment asset disclosures. Operating Segment

Revenue $m

% of Consolidated Revenue 78.4%

EBITSI* $m

% of EBITSI

ROA#

Australian Food, 47 944.6 3439.8 91.8% 13.6% Liquor and Petrol New Zealand 5 475.2 9.0% 303.2 8.1% 1.2% Supermarkets General Merchandise 4 106.5 6.7% 114.2 3.0% 0.5% Hotels 1 475.0 2.4% 234.5 6.3% 0.9% Home Improvements 1 867.1 3.1% (224.7) -6.0% -0.9% Consolidated 61 149.4 100% 3 748.4 100% 12.4%^ * Earnings before interest, tax and significant items. # ROA has been estimated based on available information as EBITSI/Total Assets $25,336.8M ^ Consolidated ROA is calculated as PBT $3067.7m/Average Total Assets $40 064.5m (from financial statements)

. 6

Little can be gleaned from the segment information other than the Australian Food, Liquor and Petrol is the most significant segment and Home Improvements has had a negative impact on the Group’s performance (which is well known through the popular press). It would be more interesting to see the break-down within the operating segment of ‘Australian Food, Liquor and Petrol’ to see the relative contributions of each of the components. B – Wesfarmers Limited 2015 Annual Report (a) Pg 95 & 96 (b) The Group’s operating segments are organised and managed separately according to the nature of the products and services provided. Each segment represents a strategic business unit that offers different products and operates in different industries and markets. The Board and executive management team (the chief operating decision-makers) monitor the operating results of the business units separately for the purpose of making decisions about resource allocation and performance assessment. (c) The Group identifies the following operating segments under the main categories of Retail, Industrial and Other: • Retail o Coles o Home Improvements and Office Supplies (HIOS) o Kmart o Target • Industrial o Resources o Industrial and Safety (WIS) o Chemical, Energy and Fertilisers (WesCEF) • Other includes Forest productions, Property, Investment banking, Private equity investment and Corporate. (d) Performance of each segment Wesfarmers provides significantly more information than Woolworths. Operating Segment Coles HIOS Kmart Target Resources WIS WesCEF Consolidated

Revenue $m 38 201 11 248 4 553 3 438 1 374 1 772 1 839 62 447

% of Consolidated Revenue 61.2% 18.0% 7.3% 5.5% 2.2% 2.8% 2.9%

Segment Result

% of Result

Segment Assets

1 783 1 206 432 90 50 70 233 3 759

47.4% 32.1% 11.5% 2.4% 1.3% 1.9% 6.2%

21 533 5 959 2 182 3 021 1 892 1 626 1 732 39 282

% of Segment Assets 54.8% 15.2% 5.6% 7.7% 4.8% 4.1% 4.4%

ROA#

4.0% 3.0% 1.1% 0.2% 0.1% 0.2% 0.6% 8.6%^

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# ROA has been estimated based on available information as Segment result/Total Assets $40 402M ^ Consolidated ROA is calculated as PBT $3,444m/Average Total Assets $40 064.5m from the financial statements.

Like for Woolworths, it is difficult to glean much from these disclosures. 2

Uluru Ltd Determining Reportable Segments North

South

East

West

City

Country

Total

1 500

1 800

5 340

6 920

1 200

25 160

AASB 8: para. 13(a) Revenue analysis External sales

8 400

Intersegment sales

480

440

920

Other segment revenues

160

140

300

Total revenue

9 040

1 500

2 240

5 480

6 920

1 200

Segment % of Total

34.3%

5.7%

8.5%

20.8%

26.2%

4.5%

Exceed 10% threshold

YES

640

790

320

26 380

AASB 8:para. 13(b): Reported profit/loss analysis Segment profit/ (loss)

2,100

240

4 005

Unallocated revenue*

5 200

Unallocated expenses

2 300

Profit before income tax

11 505

Income tax expense

3 452

Profit (loss) for period

8 054

sum of profit

2 100

240

sum of loss

640

790

320

4 090

Segment % of Total

51.3%

5.9%

2.1%

15.6%

19.3%

7.8%

Exceed 10% threshold

YES

6 840

175

2 680

7 400

960

100.0%

AASB8: para. 13(c) Asset analysis Segment assets

12 400

30 455

Unallocated assets

490

Segment % of Total

40.7%

22.5%

0.6%

8.8%

24.3%

3.2%

30 945

Exceed 10% threshold

YES

Overall

YES

North, South, West and City are identified as reportable segments of Uluru Ltd as each passes at least one of the quantitative thresholds identified in paragraph 13 of AASB 8. To determine if Uluru has identified sufficient reportable segments, it is necessary to

undertake the test identified in paragraph 15. Does the total external revenue of reportable segments represent at least 75% of the total external revenue? AASB 8: para 15

North

South

West

City

Total

Segment revenue

9 040

1 500

5 480

6 920

22 940

Less Intersegment sales

(480)

External segment revenue

22 460 Total revenue ($25,160 + $300)

25 460

+ Unallocated external rev

4 100

Total External

29 560

% External Revenue

76%

The identified reportable segments of Uluru Ltd report more than 75% of external revenue and therefore meet the quantitative threshold specified in paragraph 15 of AASB 8. No further reportable segments need be identified. 3

Uluru Ltd North, South, West and City are identified as reportable segments of Uluru Ltd as each passes at least one of the quantitative thresholds identified in paragraph 13 of AASB 8 (See Problem 2). To determine if Uluru has identified sufficient reportable segments, it is necessary to undertake the test identified in paragraph 15. Does the total external revenue of reportable segments represent at least 75% of the total external revenue? AASB 8: para. 15

North

South

West

City

Total

Segment revenue

9 040

1 500

5 480

6 920

22 940

Less Intersegment sales

(480)

External segment revenue

22 460

Total revenue ($25,160 + $300)

25 460

+ Unallocated external rev

5 200

Total External

30 660

% External Revenue

73%

If all of the unallocated revenue is external, only 73% of external revenue is reported by segments North, South, West and City. It is therefore necessary for Uluru to select another operating segment as reportable to satisfy the test. The decision to select either East or Country is an arbitrary one given that neither has satisfied any of quantitative threshold tests. In fact, either could be selected as either will achieve in excess of 75%. If East is selected, the reported external revenues will be 79.1% and if Country is selected, 77.2%. . 9

LMN Company Ltd (a) Basic earnings per share Profit less Preference dividends Basic earnings

$2 000 000 56 000 $1 944 000

Weighted average number of ordinary shares outstanding during the reporting period Outstanding at beginning of period 562 500 Bonus issue 31/12/17 (562 500 ÷ 3) 187 500 Rights issue 31/3/18 (500 000  3/12) 125 000 Basic number of shares 875 000 To calculate the number of shares outstanding at the beginning of the period it is necessary to deduct the effects of the rights issue (500 000 shares) and the bonus issue (187 000 shares). Basic earnings per share $1 944 000  875 000 = $2.222 (b) Diluted earnings per share ‘Trigger Test’ Profit from continuing operations per share ($2 000 000 – 56 000)  875 000 = $2.222 (i) Convertible notes If the convertible notes were converted, 375 000 new ordinary shares would be issued (750 000  100  50). Interest after tax of ($750 000  0.08) (1 – 0.30) = $42 000 would be saved. The profit after tax per incremental share as a result of the conversion is therefore: $42 000  375 000 = $0.112 (ii)

Options If the options were exercised, there would be 10 000 new ordinary shares issued. The exercise of those options would yield $10 000  $3.50 or $35 000. 7 000 ordinary shares could be issued at the current market price to yield $35 000 (35 000  5). It is assumed that 3 000 shares are issued for no consideration. Therefore, the conversion of the notes and the exercise of the options are both dilutive and diluted earnings per share must be calculated and discussed. Profit Initial position Exercise of options Conversion of notes

$1 944 000 – 1 944 000 42 000 $1 986 000

Number of shares 875 000 3 000 878 000 375 000 1 253 000

EPS $2.222 2.214 1.585

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Diluted earnings per share $1 986 000  1 253 000 = $1.585 5

Brisbane Ltd (a) Basic earnings per share Profit less Preference dividends Basic earnings

$4 000 000 80 000 $3 920 000

Weighted average number of ordinary shares outstanding during the reporting period Outstanding at beginning of period 10 000 000 Basic earnings per share 3 920 000  10 000 000 = $0.392 (b) Diluted earnings per share ‘Trigger Test’ Profit from continuing operations per share 3 920 000  10 000 000 = $0.392 (i) Convertible notes If the convertible notes were converted, 300 000 new ordinary shares would be issued (500 000  100  60). Interest after tax of (500 000  0.10) (1 – 0.30) = $35 000 would be saved. The profit after tax per incremental share as a result of the conversion is, therefore: 35 000  300 000 = $0.117 (ii) Options If the options were exercised, there would be 100 000 new ordinary shares issued. The exercise of those options would yield $200 000. 80 000 ordinary shares could be issued at the current market price of $2.50 to yield $200 000. Therefore, 20 000 ordinary shares are assumed to be issued for no consideration. Therefore, the conversion of the notes and the exercise of the options are both dilutive and diluted earnings per share must be calculated and discussed.

Initial position Exercise of options Conversion of notes

Profit

Number of shares

EPS

$3 920 000 – 3 920 000 35 000 $3 955 000

10 000 000 20 000 10 020 000 300 000 10 320 000

0.392 0.391 0.383

Diluted earnings per share $3 955 000  10 320 000 = $0.383 . 11

Relive Ltd (a)Basic earnings per share Profit $6 250 000 less Preference dividends 60 000 Basic earnings $6 190 000 Weighted average number of ordinary shares outstanding during the reporting period On 31/12/17 after the bonus issue, there must have been 25 000 000 – 10 000 000 = 15 000 000 shares issued. Let x be the number of shares outstanding on 1/7/17 1 x + x = 15 000 000 3 4 x = 15 000 000 3 x = 11 250 000 Weighted average number of shares Outstanding for full year 11 250 000 Bonus issue 3 750 000 Rights issue (1/3 of 10 000 000) 3 333 333 Basic weighted average number of shares 18 333 333 Basic earnings per share $6 190 000  18 333 333 = $0.338 (b) Diluted earnings per share ‘Trigger Test’ Profit from continuing operations per share $6 190 000  18 333 333 = $0.338 (i) Convertible preference shares If the preference shares were converted, 1 000 000 new ordinary shares would be issued. Preference dividends of $60 000 would be saved. The profit after tax per incremental share as a result of conversion is therefore: $60 000  1 000 000 = $0.06 (ii)

Convertible notes If the convertible notes were converted to ordinary shares, 5 000 000 new shares would be issued (100 000  50). Interest after tax of (100 000  100  0.08) (1 – 0.30) = $560 000 would be saved. The profit after tax per incremental share as a result of conversion is therefore: $560 000  5 000 000 = $0.112

(iii) Options If the options were exercised, there would be 150 000 new ordinary shares issued. The exercise of those options would yield $600 000. The same yield could be achieved by issuing 120 000 shares at the current market price (600 000  5). Therefore, 30 000 shares are assumed to be issued for no consideration. . 12

Therefore, the conversion of the preference shares and notes and the exercise of the options are all dilutive and diluted earnings per share must be calculated and discussed. Profit Initial position Exercise of options

$6 190 000 – 6 190 000 Conversion of preference shares 60 000 6 250 000 Conversion of notes 560 000 $6 810 000

Number of shares 18 333 333 30 000 18 363 333 1 000 000 19 363 333 5 000 000 24 363 333

EPS 0.338 0. 337 0. 323 0.280

Diluted earnings per share $6 810 000  24 363 333 = $0.280

Dayboro Ltd (a) Basic earnings per share Profit less Preference dividends Basic earnings Ordinary shares outstanding for year Rights issue (1 000 000  0.75) Basic number of shares

$2 400 000 100 000 $2 300 000 3 000 000 750 000 3 750 000

Basic earnings per share $2 300 000  3 750 000 = $0.613 (b) Diluted earnings per share ‘Trigger Test’ Profit from continuing operations per share ($2 400 000 – 100 000)  3 750 000 = $0.613 (i)

Options If the options were exercised there would be 1 000 000 new ordinary shares issued (500 000  2) which would yield (1 000 000  2) $2 000 000. The same amount could have been raised by issuing 800 000 shares at the market price of $2.50 (2 000 000  2.50). It is assumed that 200 000 shares are issued for no consideration. This is dilutive and diluted earnings per share must be calculated.

Profit

Number of shares

EPS

Initial position $1 950 000 Exercise of options – $1 950 000

3 750 000 200 000 3 950 000

$0.52 0.494

Diluted earnings per share $1 950 000  3 950 000 = $0.494 8

Boral Ltd – Performance indicators Ratio 2015 Current ratio 1741.3 1.9 current assets 923.2 current liabilities Debt-to-asset ratio 1322.6 22.5% 1 total debt x 100 5865.4 total assets Debt-to-equity ratio 1322.6 37.5% total debt1 x 100 3524.1 total equity Times interest earned 352.2 5.5 PBIT 63.7 times interest expense2 Rate of return on total asset (ROA) 352.2 6.2% PBIT 5712.25 average total assets Rate of return on equity (ROE) 257 7.5% earnings available to ordinary shareholders 3436.1 average ordinary equity Times dividends earned 257 2.0 earnings available to ordinary shareholders 129.1 ordinary dividend 1 total debt is the sum of current and non-current loans and borrowings 2 net finance costs have been used.

2014 1664.5 1170.2

1.4

1101.5 5559.1

19.8%

1101.5 5559.1

32.9%

158.9 64.4

2.5 times

158.9

2.7%

176.2 3370.8

5.2%

176.2 100.9

1.7

Bearing in mind the limitation of only looking at two years, the following observations can be made. • Boral’s solvency and liquidity has improved as indicated by the improvement in current ratio • There has been an increase in the reliance on debt as indicated by the debt-to-asset and debt-to-equity ratio.

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• •

Increased profitability has resulting in the increased ability to service debt interest. The ROA and ROE have both increased indicated improved efficiency in use of assets and generating return from equity funding.

. 15

Chapter 18 FURTHER FINANCIAL REPORTING ISSUES LEARNING OBJECTIVES After studying this chapter you should be able to: 1

explain differential reporting and apply the requirements of AASB 1053 ‘Application of Tiers of Australian Accounting Standards’ in the preparation of financial statements;

explain the concept of materiality and apply the requirements of AASB 108 ‘Accounting Policies, Changes in Accounting Estimates and Errors’ in the preparation of financial statements;

explain the nature of events occurring after the end of the reporting period and apply the requirements of AASB 110 ‘Events after the Reporting Period’ in the preparation of financial statements;

explain the reasons for the disclosure of accounting policies and apply the requirements of AASB 108 ‘Accounting Policies, Changes in Accounting Estimates and Errors’ to the selection, application and modification of accounting policies in the preparation of financial statements;

explain the nature of prior-period adjustments and apply the requirements of AASB 108 ‘Accounting Policies, Changes in Accounting Estimates and Errors’ to the treatment of changes in accounting estimates and the correction of errors in the preparation of financial statements;

explain the nature of related-party transactions and apply the requirements of AASB 124 ‘Related Party Disclosures’ in the preparation of financial statements;

explain continuous and interim reporting and apply the requirements of AASB 134 ‘Interim Financial Reporting’ in the preparation of financial statements;

explain the purpose of concise financial reports and apply the requirements of AASB 1039 ‘Concise Financial Reports’ in the preparation of financial statements; and

apply the requirements of AASB 1054 ‘Australian Additional Disclosures’ in the preparation of financial statements.

QUESTIONS 1

In the simplest terms, ‘differential reporting’ means that some entities do not have to comply with either some or all of the AASB Accounting Standards. The expression can also be used to describe the circumstances in which some companies are excused from complying with some aspects of the Corporations Act 2001.

Legislation already allows some differential reporting. For example, the Corporations Act 2001 distinguishes between small and large proprietary companies. Large proprietary companies must prepare annual reports in accordance with accounting standards (s296). In some cases, small proprietary companies are required to prepare financial reports (see s292(2)). Further, AASB 1057 requires certain accounting standards to be applied by entities that are required to report under the Corporations Act and that are preparing special purpose financial statements because they are not reporting entities. See also ASIC Regulatory Guide 85. Some AASB Accounting Standards also apply only to some entities. For example, some recent AASB Accounting Standards apply only to ‘reporting entities’. For example, AASB 1039 ‘Concise Financial Reports’ (para.1) states that the Standard applies to a concise financial report prepared by an entity in accordance with paragraph 314(2) in Part 2M.3 of the Corporations Act 2001. AASB 133 ‘Earnings per Share’ restricts the application to entities whose shares or potential shares are traded in a public market (or in the process of filing for listing) (para. 2). Paragraph 1 of AASB 134 ‘Interim Financial Reporting’ does not mandate which entities should be required to publish interim financial reporting, how frequently, or how soon after the end of an interim period. Further, AASB 1053 ‘Application of Tiers of Australian Accounting Standards’ sets out differential disclosure requires based on two tiers. (See question 9).

The basic argument in favour of differential reporting is that the information needs of the users of financial statements are likely to be related to the nature of the entity and the nature of the users. Providing all users with the same data in the same format may not meet their information needs. If it is agreed that the objective of accounting is to provide users with relevant and reliable information, then some account should be taken of differences between reporting entities and between users. In general, it has been argued that differences in the size and the ownership of entities, and in the ability of users to demand and to obtain information relevant to their needs are the critical issues. In summary, there are three justifications for differential reporting: . 2

(a) The cost of complying with accounting standards is much the same for all companies. The cost of designing and installing the accounting system is, therefore, likely to be a more significant amount for smaller than for larger companies. The costs of compliance are therefore likely to be proportionately greater for small companies. (b) The information needs of the users of the financial statements of small companies are likely to be different from those of larger companies. Owners of small companies are usually intimately involved in their day-to-day operations. They do not need elaborate financial statements to provide them with information about the results of the entity’s operating activities or its financial position. (c) The users of the financial statements of small companies are usually able to obtain special purpose financial information to meet their particular needs. They do not need to rely on general purpose financial statements, as is the usual situation with shareholders in large companies. Acceptance of these arguments is a matter of personal opinion. It seems, however, that, in the great majority of cases, these arguments are accepted. It could be argued, however, that providing some degree of choice to financial statements preparers allows scope for more creativity and introduces room for conflict between the preparers, auditors and users of financial statements. 4

If an entity is determined to be a reporting entity, then it must prepare general purposes financial statements in accordance compliance the Accounting Standards. 5

SAC1 ‘Definition of the Reporting Entity’ defines a ‘reporting entity’ as an entity for which ‘it is reasonable to expect the existence of users dependent on general purpose financial statements for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources’ (para. 40). In other words, a reporting entity has financial statements users who cannot force the entity to produce information to meet their specific needs, even though they have a right to be kept informed. Three factors that suggest whether dependent users exist include: a separation of management from economic interest; the ability of the entity to influence the welfare of others through economic or political importance or influence; and financial characteristics of the entity, such as size and indebtedness. (See Question 4.) (a) This is likely to be a small proprietary company is not likely to be a reporting entity – that is, there are not generally dependent users since there is no separation of ownership, the company does not appear to have the ability to influence the welfare of others in society, and its financial characteristics are small with no debt. (b) This small proprietary company is not likely to be a reporting entity – that is, there is little separation of ownership from management (two working shareholders/ directors), the level of indebtedness is small ($30 000 bank overdraft), and although the company employs 70 workers it is unlikely that these individuals rely on general purpose financial statements to make decisions regarding their employment with the company. (c) A public company with 250 shareholders is most likely a reporting entity – there is a greater separation of ownership from management (e.g. 250 shareholders not involved in the day to day operations of the company), and the company employs a significant number of people (360 employees) and owes what is described as ‘substantial’ amounts of money to financial institutions. (d) This small proprietary company is not likely to be a reporting entity – there is no separation of ownership from management (managed by family shareholders) and the company has no external borrowings. It could be argued that since it has 120 employees and operates in a sensitive industry of waste and toxic chemical disposal, it has the ability to impact on society. However, on balance it is not likely to be a reporting entity.

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A public company that is not a reporting entity is required under the Corporations Act 2001 to prepare an annual financial report (statements of comprehensive income, financial position cash flows, changes in equity and accompanying notes) that give a true and fair view of the company’s financial position and performance. As the company is not a reporting entity, it does not have to apply accounting standards unless the company prepares financial statements that are held out to be general purpose financial statements and are required by virtue of the application of AASB 1057 ‘Application of Australian Accounting Standards’. (AASB 1057 requires certain accounting standards to be applied by entities that are required to report under the Corporations Act 2001 and that are preparing special purpose financial statements because they are not reporting entities. See also ASIC Regulatory Guide 85.)

Special purpose financial statements are prepared to meet specific rather than general, information needs of users. This type of reporting is tailored to meet the specialised needs of users who have the ability and power to command the form and content of such reports. The reports may or may not comply with AASB series of accounting standards. AASB 1057 requires certain accounting standards to be applied by entities that are required to report under the Corporations Act and that are preparing special purpose financial statements because they are not reporting entities. See also ASIC Regulatory Guide 85.

When the IASB issued IFRS for SMEs in 2009, Australia did not adopt the standard. Whilst the AASB supported the thrust of the IASB standard, it did not agree with the IASB’s decision to modify some of the recognition and measurement requirements. Following an extensive consultative process, the AASB first issued AASB 1053 ‘Application of Tiers of Australian Accounting Standards’ in June 2010. AASB 1053 was revised in February 2015, applicable to annual reporting periods beginning on or after 1 July 2014 but before 1 January 2017. Under AASB 1053, reporting entities have the same recognition and measurement requirements however it implements reduced disclosure requirements for tier 2 entities. See question 9 for a discussion of the reporting framework.

In June 2010, the AASB issued, AASB 1053 ‘Application of Tiers of Australian Accounting Standards’ and AASB 2010-2 ‘Amendments to Australian Accounting Standards arising from Reduced Disclosure Requirements’ applicable to annual reporting periods beginning on or after 1 July 2013. The most recent version of AASB 1053 incorporating amendments up to 28 January 2015 (including AASB 2010-2) was issued in February 2015 and applied to annual reporting periods beginning on or after 1 July 2015. . 5

AASB 1053 establish a differential reporting framework consisting of two tiers of reporting requirements for entities preparing general purpose ﬁnancial statements:  

Tier 1: full IFRSs as adopted in Australia (Australian Accounting Standards); and Tier 2: the Reduced Disclosure Requirements (RDR), which as the name suggests, would require fewer disclosures than those required under the full IFRSs as adopted in Australia.

Tier 2 therefore comprises the recognition and measurement requirements of Tier 1 but substantially reduced disclosure requirements. AASB 1053 notes that ‘the disclosures required by Tier 2 and the disclosures required by IFRS for SMEs are highly similar. However, Tier 2 requirements and the IFRS for SMEs are not directly comparable as a consequence of Tier 2 including recognition and measurement requirements corresponding to those in IFRSs, whereas the IFRS for SMEs includes limited modifications to those requirements.’ Future amendments to Tier 2 reporting requirements are the responsibility of the AASB rather than IASB. Paragraph 11 of AASB 1053 requires Tier 1 reporting requirements to be applied to general purpose financial statements of: (a) for-profit private sector entities that have public accountability; and (b) the Australian Government and State, Territory and Local Governments. Paragraph 13 identifies the following entities that shall, as a minimum, apply Tier 2 reporting requirements: (a) for-profit private sector entities that do not have public accountability; (b) not-for-profit private sector entities; and (c) public sector entities, whether for-profit or not-for-profit, other than the Australian Government and State, Territory and Local Governments. Like IFRS for SMEs, the AASB’s differential reporting standards are based on the principle of public accountability. Public accountability is defined in Appendix A of AASB 1053 as: ‘accountability to those existing and potential resource providers and others external to the entity who make economic decisions but are not in a position to demand reports tailored to meet their particular information needs.’ Further, a for-profit private sector entity has public accountability if: . 6

(a) its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market; or (b) it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. This is typically the case for banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks. Appendix B identifies the for-profit entities deemed to have public accountability: (a) disclosing entities, even if their debt or equity instruments are not traded in a public market or are not in the process of being issued for trading in a public market; (b) co-operatives that issue debentures; (c) registered managed investment schemes; (d) superannuation plans regulated by the Australian Prudential Regulation Authority (APRA) other than Small APRA Funds; and (e) authorised deposit-taking institutions (para. B2). Many of the Australian Accounting Standards include reduced disclosure requirements (RDR) provisions that exempt Tier 2 entities from complying with certain disclosure requirements. The RDR provisions are described in an Aus paragraph and highlighted in grey in the relevant accounting standard. 10 In accounting, the term ‘materiality’ refers to the relative importance of a transaction or event. A transaction or event is judged to be material if its ‘omission, misstatement or non-disclosure’ in the financial statements could influence the economic decisions of users taken on the basis of the financial statements. It is a basic principle of accounting that all material items should be accounted for and separately disclosed in the reports. In determining the materiality of an item its nature and size is assessed. An item can be judged to be material either on the basis of its nature, size or a consideration of both. Thus, accountants are required to exercise professional judgement in determining materiality. The materiality concept does not mean that non-material items need not be recorded or disclosed in the financial statements. All items and events should be recorded and their effects included in the financial statements. All material items, however, should be reported separately and in accordance with the requirements of Australian accounting standards.

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Materiality would also be a relevant consideration in designing a chart of accounts. Separate ledger accounts are usually required only for material items. For example, the amount spent on postage stamps may be judged to be immaterial. A separate account for postage stamps would not be needed and postage costs would be charged to a broader class of items such as office expenses, which would be judged to be material. 11 Framework 2014 notes in paragraph QC11 that materiality is an entity-specific aspect of the qualitative characteristic of relevance based on the nature or magnitude, or both, of the item. Framework 2014 takes that position that given materiality is entity-specific in nature; it cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. 12 Size is an important aspect of materiality, but it is not the only consideration. Materiality also depends on the nature of the item. Some items are material regardless of their size. Paragraph 5 of AASB 108 states that materiality ‘depends on the size and nature of the omissions or misstatements judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. Neither Framework 2014 nor AASB 108 provides any further guidance on materiality. 13 The materiality of an item affects whether an item is required to be recognised, or disclosed separately in accordance with the requirements of an Australian accounting standard. If a transaction has occurred, then it would need to be recorded. For example, if the entity purchases postage stamps, it would not have a separate account for postage stamps as it is likely to not be material, however, the purchase would routinely be recorded as part of office supplies. Various accounting standards require the separate disclosure of material items. 14 In September 2010, the IASB issued its revised Conceptual Framework for Financial Reporting 2010 (Framework 2010). In Framework 2010, it is noted that ‘materiality is an entity-specific aspect of the qualitative characteristic of relevance [emphasis added] based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report’. This means that an assessment of the materiality of information is based on whether its omission or misstatement could influence the economic decisions of users taken on the basis of financial information about a specific reporting entity (Framework 2010, QC11). As a result the IASB regards uniform quantitative thresholds to be inconsistent with the entity-specific nature of materiality. AASB 1031 includes quantitative thresholds for . 8

materiality. At the AASB’s February 2012 meeting it was decided that in light of the IASB’s concept of materiality the AASB would issue an exposure draft proposing the withdrawal of AASB 1031. The effect of the withdrawal of AASB 1031 is a matter of opinion. As indicated in chapter 18, the AASB’s decision to withdraw AASB 1031 was not without its critics. In the Accounting in Focus box on page 669, the article for the Charter is provided. Students are encourage to form their opinions regarding the potential consequences of the withdrawal of AASB 1031 based on the information provided in this article. 15 It is generally accepted that financial statements should be prepared on the basis of knowledge at the end of the reporting period. As the financial statements are presented at that date, and summarise transactions and events during the reporting period, it is reasonable to base the reports on knowledge at that date. Paragraph 8 of AASB 110 ‘Events after the Reporting Period’ requires this general principle to be applied in accounting for adjusting events. However, where information relevant to the reporting period becomes known after the end of the reporting period but before the financial statements is finalised and failure to include the new information could be misleading, then common sense suggests that the new information should be included in the report. This is required by paragraph 10 of AASB 110. This requirement of AASB 110 reduces opportunities for avoiding disclosure by denying that the news was known at the end of the reporting period. 16 AASB 101 states that when preparing financial statements, management is required to assess the entity’s ability to continue as a going concern (para. 25). AASB 110 states that an entity shall not prepare its financial statements as a going concern if management determines that the entity is unable to continue as a going concern after the end of the reporting period (para 14). AASB 110 ensures that the assessment of the entity’s ability to continue as a going concern, considers events that can arise between the end of the reporting period and the date when the financial statements are authorised for issue. 17 AASB 110 ‘Events after the Reporting Period’ distinguishes between two types of event after the end of the reporting period. The first type of event is that which provides evidence of conditions that existed at the end of the reporting period (adjusting events). This type may either correct or clarify transactions or events that are already incorporated in the accounts at the end of the reporting period or they may reveal for the first time transactions or events that apply to . 9

that reporting period. For example, new knowledge may allow a better measure of doubtful debts than was possible at the end of the reporting period or a retrospective change in legislation may make a company liable to a new type of government charge. AASB 110 requires the amounts recognised in the financial statements to be adjusted to reflect the first type of event (i.e. adjusting events). The second type of event is that which is indicative of conditions that arose after the end of the reporting period (non-adjusting events). For example, part of the entity’s facilities may be destroyed by fire, a major legal action may be launched against the entity or there may be a new issue of equity or increased borrowing. AASB 110 prohibits the amounts recognised in the financial statements from being adjusted to reflect the second type of event (non-adjusting events) and instead requires specific disclosures about the second type of event to be made in the financial statements. Finally, AASB 110 prohibits the preparation of financial statements on a going concern basis when events of the first or second type indicate that the going concern assumption is no longer appropriate. 18 ‘Creative accounting’ is a term used to describe the use of accounting policies to create the desired reported profit or financial position. There are several ways in which accounting may be used creatively: (a) Desired reported results may be obtained by the choice of accounting policies or by a change in policy. For example, net worth may be increased by an accounting policy to capitalise whenever there is a choice between capitalising or expensing costs. Similarly, reported profits may be increased in a particular period by a change in accounting method, such as a switch from reducing-balance depreciation to straightline depreciation. (b) Even in areas where there are specific accounting standards, choice is still possible because of the reliance on judgement. For example, even if straight-line depreciation is used, judgement is still necessary to determine the estimated useful life and the estimated residual value of each depreciable asset. Similarly, even if there is a consistent policy of creating a provision for doubtful debts, judgement is still necessary to determine the amount of the provision. This judgement may be exercised ‘creatively’. 19 The statement is incorrect for several reasons. It implicitly assumes that the disclosure of accounting policies will allow statement users to adjust the published financial . 10

statements to allow for differences in accounting method. In fact, it is unlikely that enough information will be disclosed to allow such an adjustment. Even if the information was made available, it is probable that only a small percentage of users would have the technical skills necessary to make the adjustments. Disclosure of accounting policies does not reveal anything about judgements, the timing of transactions or bogus transactions, the first of which is likely to be the major vehicle for creative accounting. 20 Accounting policies are defined as ‘the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements’ (para. 5, AASB 108). For example, an entity may have developed an accounting policy on the treatment of borrowing costs that requires these costs to be expensed as finance costs rather than capitalised as part of the cost of an associated construction project. The selection and application of accounting policies is to be guided by the relevant Australian accounting standard(s) and implementation guidance that are applicable to the particular issue under consideration (para. 7). If there is no Australian accounting standard that is applicable, AASB 108 requires that statement preparers draw from the Framework’s qualitative characteristics of financial information. Specifically, paragraph 10 directs preparers to use judgement in developing and applying an accounting policy that results in information that is reliable and relevant to the economic decision-making needs of users. In making this judgement, paragraph 11 refers statement preparers to first, the requirements of Australian accounting standards on similar issues and second, the definition, recognition criteria and measurement concepts for assets, liabilities, income and expenses in Framework. 21 AASB 108 limits the ability of an entity to change accounting policies. These restrictions are in place because it is important for statement users to be able to compare the financial statements of an entity over time to identify trends in financial position, financial performance and cash flows. Such comparisons are only possible if the same accounting policies are applied within each accounting period and over time. A change in accounting policy is only permitted in either of the following circumstances identified in paragraph 14 of AASB 108: (a) the change is required by an Australian accounting standard; or

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(b) the change results in the financial statements providing reliable and more relevant information on the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows. 22 The answer is probably that changes in accounting policies have been used creatively to hide bad news or to defer such news in the hope that when it is disclosed it will be offset by some compensating good news. A requirement to disclose the nature of, the reason for, and financial effect of changes in accounting policies should reduce any benefits from the creative use of changes in accounting policies. 23 A mandatory change in accounting policy is a change that is required by an Australian accounting standard. Paragraph 19 requires that the change be accounted for in accordance with any transitional provisions contained in the relevant standard. Where there are no such provisions, the change is to be retrospectively applied unless it is impractical to do so. In this sense, an entity must have made every reasonable effort to do so before a situation can be assessed as impracticable (para. 5, AASB 108). Retrospective application means applying the new accounting policy as if that policy had always been applied (para. 5). This involves making adjustments to the opening balance of each affected component of equity for the earliest period presented (para. 22). Usually the adjustment will be to retained earnings (para. 26). Also, adjustments are to be made to other comparative amounts disclosed for each prior period such as historical summaries of financial data (para. 22). Retrospective application of a change in accounting policy is not required if it is impracticable to determine either the period specific effects or the cumulative effect of a change in accounting policy (para. 23, AASB 108). For example, an entity may change its accounting policy for depreciating property, plant and equipment, so that individual components of this asset class are separately depreciated. However, its prior asset records may not provide a sufficient basis for reliably estimating the cost of the individual components that had not previously been accounted for on a separate basis. As a result, prior data has not been collected in a way that allows retrospective application of the new depreciation policy. 24 A voluntary change is to be retrospectively applied unless it is impractical to do so (para. 19, AASB 108). In this sense, an entity must have made every reasonable effort to do so before a situation can be assessed as impracticable (para. 5). The accounting treatment of a voluntary change in accounting policy is the same as for a change that is required by an Australian accounting standard that contains no transitional provisions. . 12

Retrospective application means applying the new accounting policy as if that policy had always been applied (para. 5). This involves making adjustments to the opening balance of each affected component of equity for the earliest period presented (para. 22). Usually the adjustment will be to retained earnings (para. 26). Also, adjustments are to be made to other comparative amounts disclosed for each prior period, such as historical summaries of financial data (para. 22). Retrospective application of a change in accounting policy is not required if it is impracticable to determine either the period specific effects or the cumulative effect of a change in accounting policy (para. 23). For example, an entity may change its accounting policy for depreciating property, plant and equipment, so that individual components of this asset class are separately depreciated. However, its prior asset records may not provide a sufficient basis for reliably estimating the cost of the individual components that had not previously been accounted for on a separate basis. As a result, prior period data has not been collected in a way that allows retrospective application of the new depreciation policy. 25 Retrospective application means applying the new accounting policy as if that policy had always been applied (para. 5, AASB 108). This involves making adjustments to the opening balance of each affected component of equity for the earliest period presented (para. 22). Usually the adjustment will be to retained earnings (para. 26). Also, adjustments are to be made to other comparative amounts disclosed for each prior period such as historical summaries of financial data (para. 22). Retrospective application of a change in accounting policy is not required if it is impracticable to determine either the period specific effects or the cumulative effect of a change in accounting policy (para. 23). For example, an entity may change its accounting policy for depreciating property, plant and equipment, so that individual components of this asset class are separately depreciated. However, its prior asset records may not provide a sufficient basis for reliably estimating the cost of the individual components that had not previously been accounted for on a separate basis. As a result, prior period data has not been collected in a way that allows retrospective application of the new depreciation policy. Retrospective application of a change in accounting policy is required for either (1) a change in policy made in accordance with an Australian accounting standard which contains no transitional provisions or (2) a voluntary change in accounting policy . 13

permitted by AASB 108 (that is, the change will result in more relevant and reliable financial information). Retrospective application of a new accounting policy is not required if it is impracticable to do so. Paragraph 52 contains guidance on how to determine whether retrospective application of a new accounting policy is impracticable: ‘...retrospectively applying a new accounting policy... requires distinguishing information that: (a) provides evidence of circumstances that existed on the date(s) as at which the transaction, other event or condition occurred; and (b) would have been available when the financial statements for that prior period were authorised for issue; from other information…When retrospective application or restatement would require making a significant estimate for which it is impossible to distinguish between these two types of information, it is impracticable to apply the new accounting policy...retrospectively.’ Retrospective application of a new accounting policy is also impracticable if it either requires assumptions to be made about what management’s intent would have been in that period, or the effects of the retrospective application are not determinable (para. 5.) 26 A ‘retrospective application’ under AASB 108 refers to changes made in the financial statements as a result of changes in accounting policy in the current reporting period (paras 19–22), whereas ‘retrospective restatement’ under AASB 108 refers to the correction of prior period errors by restating the comparative amounts for the prior period(s) or the earlier prior period(s) in which the error occurred (paras 41, 42). 27 In general, there are two ways in which prior-period items could be treated. The first is to include any adjustment in the current period’s statement of comprehensive income. For example, assume that it is discovered in 2018 that depreciation expense for 2015 was understated by $10 000. The $10 000 adjustment, together with the usual depreciation charge of, say, $80 000, could be included in the 2018 statement of comprehensive income. The general journal entry would be as follows: ______________________________________________________________________ Depreciation expense Dr $90 000 Accumulated depreciation Cr $90 000

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The second way is to adjust retained earnings. In the example outlined above, the adjustment for the depreciation expense could be made through retained earnings leaving the 2018 profit unaffected. In this case, the general journal entry would be as follows: ______________________________________________________________________ Depreciation expense Dr $80 000 Retained earnings (1/7/2017) Dr 10 000 Accumulated depreciation Cr $90 000 There are arguments in favour of each approach. If a prior-period adjustment is passed through the current period’s statement of comprehensive income, there is inappropriate matching of revenues and expenses, both in the period when the item should have been recognised and in the current period when it is recognised. In our example, profit was overstated by $10 000 in 2015 and understated by $10 000 in 2018. The inclusion of prior-period adjustments in the current period’s statement of comprehensive income is, therefore, misleading. There are, however, risks associated with making the adjustment to retained earnings. It leaves the door open for the manipulation of reported profit. For example, a company could deliberately understate an expense in 2018 to inflate reported profit in that year and in 2019 pass an adjustment directly to retained earnings, leaving that year’s profit unaffected. Or perhaps a company may incorrectly classify an item as a prior-period adjustment to avoid including it in the current period’s profit. In addition, where errors in one period can be corrected by adjustments to retained earnings in a subsequent period, the incentive to avoid errors may be reduced. 28 Paragraph 5 of AASB 108 defines a change in an accounting estimate as: ‘...an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities.’ For example, an entity may change its estimate of bad and doubtful debts, its estimate of warranty claims and its estimate of the useful life of a depreciable asset. 29 The required treatment of changes in accounting estimates in AASB 108 paragraph 36 is that the effect of a change in an estimate is to be recognised in the profit or loss in:

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(a) the period of the change, if the change affects that period only; or (b) the period of the change and future periods, if the change affects both. In addition, if the change in estimate results in changes in assets, liabilities or an item of equity, an adjustment is required to the carrying amount of the affected asset, liability or equity item (para. 37). Note that the recognition of changes in accounting estimates is ‘prospective’. That is, the change in estimate is only applied from the date of the change in estimate (para. 38). For example, a revision of bad and doubtful debts expense due to an economic downturn affects only the current period’s profit or loss and therefore is recognised in the current period. 30 Errors occur due to ‘omissions from, and misstatements in, the entity’s financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that: (a) was available when the financial statements for those periods were authorised for issue; and (b) could reasonably be expected to have been obtained and taken into account in the preparation and presentation of the financial statements’ (para. 5, AASB 108). Examples of errors include mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretation of facts, and fraud. 31 If an error is discovered before the financial statements are authorised for issue, the error relates to the current period error would be corrected before the financial statements are issued. If the error is not discovered until after the financial statements are authorised for issue, the error relates to a prior reporting period and AASB 108 applies. Material prior period errors must be corrected in the first financial statements authorised for issue after their discovery (para. 42, AASB 108). The correction is to be retrospective, with restatement of the comparative amounts for the prior period(s) in which the error occurred. If the error occurred before the earliest period presented in the financial statements, the opening balances of affected assets, liabilities and equity are to be restated for the earliest period presented (para. 42, AASB 108). Thus, AASB 108 does not allow correction of a prior period error to be included in profit or loss for the period in which the error is discovered.

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The correction of a prior period error through retrospective restatement of comparative amounts or opening balance of affected assets, liabilities and items of equity is not required by AASB 108 where it is impracticable to determine either the period-specific effects or the cumulative effect of the error (para. 43). In these cases, paragraphs 44 and 45 permit the restatements for the earliest period practicable. To illustrate, assume that it was discovered in 2018 that $160 000 of inventory was omitted from the annual stock take performed for Lucia Ltd in 2017. A general journal entry would be required in 2018 to correct this prior period error because this is when the error was first discovered. Note that in the entry shown below the adjustment for the prior period error is made to retained earnings and is not included in 2018 profit and loss. ______________________________________________________________________ Inventory Dr $160 000 Retained earnings Cr $160 000 In addition, Lucia Ltd would have to restate the comparative figures provided in the statement of comprehensive income prepared for the period ended 2018. Specifically, for 2017 comparative figures closing inventory, cost of goods sold expense, profit or loss and income tax expense would need to be restated. Restatement is necessary because closing inventory was understated by $160 000, causing cost of goods sold to be overstated and profit and any associated income tax expense to be understated. 32 In accounting, the term ‘related party’ refers to an entity that is able to influence the operating, financing and investing decisions of another entity. The term also extends to an entity whose operating, financing and investing decisions can be influenced by another entity. Related parties of a reporting entity include its parent and subsidiary entities, subsidiaries in the same group, directors, senior employees and probably major debtors and creditors. The notion of a related party also includes relatives of directors and senior executives. Parties are related if one has the ability to control or significantly influence the activities of the other or if both are under the common control or significant influence of another part. 33 A related-party relationship exposes an entity to risks or provides opportunities that may not have existed without that relationship. A closer relationship than a normal arm’slength business relationship may enable one entity to gain sales orders at attractive prices or to receive the benefit of technological developments, which are not available to the general community. However, it may also expose a related party to pressures which

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disadvantage its competitive position more than would apply in an arm’s-length relationship. 34 Because related parties can influence the behaviour of each other, there is a possibility that one related party may persuade or coerce the other to enter into transactions that favour the interests of the stronger party. These transactions may not be the result of arm’s-length negotiations or subject to market forces. For example:    

a director may sell real estate to the reporting entity at a price exceeding market value. a director may be granted a loan by the reporting entity on terms far better than would normally be available. a director may encourage the reporting entity to enter into an unfavourable agreement with another company of which he/she is a director. a senior executive may award a valuable contract to a business run by a spouse without proper tendering.

In all these cases, because the related party has benefited from the transactions, the reporting entity must suffer. In other words, there is conflict of interest for the related party which may be resolved in a way not in the best interest of the reporting entity and its shareholders. 35 There are several ways in which related parties may be used to create or manipulate profit. Two possibilities are as follows: 



One entity may sell an asset to a non-consolidated related party at a book profit on the understanding that the transaction will be reversed in a subsequent reporting period. The effect is that there is an increase in the asset carrying amount and the reported profit of the original ‘vendor’. Another possibility is that one entity may ‘buy’ assets from another entity at bargain prices. The former can make profits by subsequently selling the assets while the vendor entity incurs losses. This transaction may be fraudulent or it may be with the full knowledge and acceptance of both entities.

36 There are two possible ways of disclosing related-party transactions. The first is to disclose the fact of the transaction, and to estimate and disclose the financial effect on the reporting entity of that transaction compared to a ‘normal’ arm’s-length transaction. The second possibility is simply to disclose the existence and details of any related-party

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transactions, without making an attempt to quantify the financial implications of the fact that the transaction was with a related party and not at arm’s length. The second approach is advocated by AASB 124. The main reason is that it is the approach advocated by IAS 24 and AASB 124 is based on IAS 24 as a result of the AASB’s policy of adopting Australian equivalents to IFRS. More generally, the first approach to the disclosures of related-party transactions – the restatement of related-party transactions to the amount which would have been involved had the transaction been at arm’s length – is not usually favoured by accountants for practical reasons. In many cases, no comparable arm’s-length transaction may have been possible or may not have occurred at all if the reporting entity had been forced into the open market. 37 This question is relevant because AASB 124 requires that related-party relationships be disclosed even though no related-party transactions occurred. It could be argued that such disclosure is unnecessary because it carried no information relevant to the performance and the financial position of the entity. The only time when the existence of related-party relationships may be important is when there are transactions between the parties. Disclosing the relationship when there are no transactions is cluttering the financial statements with data that are not relevant or material. On the other hand, disclosure of related-party relationships does indicate a potential for non-arm’s-length transactions. Such a disclosure may be to the detriment of the reporting entity. Acceptance of those arguments is a matter of opinion. Our attitude is that disclosure of too much is better than disclosing too little. The information overload argument is difficult to sustain given the assumption of contemporary accounting that report users understand the information contained in financial statements. 38 The requirements for related party transactions are contained in AASB 124 ‘Related Party Disclosures’. The objective of AASB 124 is to: ‘...ensure that an entity’s financial statements contains the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances with such parties’ (para. 1, AASB 124).

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There are two key components of AASB 124. The first is concerned with setting out a comprehensive definition of the related parties of an entity. The second details disclosures to be made about transactions between an entity and its related parties (paras 1–22). Hence, the focus of AASB 124 is on requiring an entity to make specific disclosures regarding its related parties, with additional disclosure requirements imposed on disclosing entities. 39 AASB 124 requires the disclosure of money amounts for compensation and related party transactions. Specifically, the compensation received by key management personnel must be disclosed in total and for each of the following categories: (a) short-term employee benefits; (b) post-employment benefits; (c) other long-term benefits; (d) termination benefits; and (e) share-based payment (para. 17). Information about transactions with related parties is also to be disclosed. It includes: (a) the amount of the transactions; (b) the amount of outstanding balances, including commitments, and: (i) their terms and conditions, including whether they are secured, and the nature of the consideration to be provided in settlement; and (ii) details of any guarantees given or received; (c) provisions for doubtful debts related to the amount of outstanding balances; and (d) the expense recognised during the period in respect of bad or doubtful debts due from related parties’ (para. 18). Whether or not disclosure of amounts is desirable is a matter of opinion. Our opinion is that this quantitative disclosure is essential if report users are to reach any meaningful conclusions and the materiality of related-party transactions. The importance of drawing related party transaction to report users’ attention is illustrated in the earlier discussion for questions 33, 34 and 35. 40 The relatives of key management personnel are classed as related parties to limit the practice of management receiving benefits from related-party transactions with their relatives. For example, an executive may encourage a transaction with an entity controlled by a son. This type of transaction is disclosed by classifying executives as ‘related parties’. . 20

41 Yes, there is section 300A of the Corporations Act 2001. In brief, s. 300A requires the following disclosures to be made in a separate remuneration report included in the Director’s Report. 



Quantitative and qualitative details of the remuneration policy for directors, secretaries and senior managers of the listed company, as well as the top five highest-paid executives of the listed company, and if consolidated financial statements are required, of the consolidated entity. Disclosure of the structure of remuneration – for example, the mix of fixed and variable pay, the value of options granted, exercised and lapsed during the financial year, details of duration of contract, notice periods and termination payments. Disclosure of details of performance hurdles – for example, a summary of the performance conditions, why they were chosen, the methods used to assess whether the condition is satisfied and any external factors that are considered. Discussion of the relationship between the remuneration policy and company performance, specifically considering company earnings and shareholder wealth impacts.

Clearly, there are many similarities between the requirements of s.300A and the requirements of AASB 124 regarding the disclosure of information re: key management personnel by disclosing entities. 42 Continuous reporting is the on-going dissemination to users of financial statements of relevant financial and other information. It includes quarterly and half-yearly reporting in traditional formats (statements of financial position, comprehensive income, changes in equity and cash flows). It also includes the timely reporting to securities exchanges by public companies of material and important transactions and events, such as a change in shareholdings or a major asset purchase. 43 Continuous disclosure refers to the on-going disclosure of material information by the reporting entity as soon as it is known. For example, the listing rules of the Australian Securities Exchange require that companies disclose information that could influence price or value immediately. The preparation of more frequent financial statements refers to a requirement for entities to prepare interim reports either on a quarterly or half-yearly basis as well as annually. 44 The advantages of continuous reporting are as follows: . 21

(a) Participants in the stock market respond quickly to new information so that frequent financial statements may improve the efficiency of the stock market by keeping participants informed on a more timely basis. (b) Seasonal patterns in the operations of a reporting entity are revealed by more frequent reporting. This will improve users’ understanding of the nature of the business. In this context, Foster examined the time-series properties of quarterly profit announcements for a sample of Unite States companies. He found that, in certain circumstances, quarterly profits in period t are related to quarterly profits in period t+4. In other words, quarterly profit amounts may reveal a seasonal pattern over time in certain industries such as agriculture and retailing. Foster found that there were seasonal patterns in sales, expenses and profit amounts. Arguments against continuous reporting are related to the reliability of the data and the cost associated with the process. The arguments include the following: (a) The reliability of quarterly reports for determining seasonal patterns has been questioned when there are large adjustments to the values of assets and liabilities in the fourth quarter. The fourth-quarter entries required by auditors to adjust for errors of judgement in previous quarters could make the quarterly reporting process unreliable and potentially misleading. One solution could be to provide fourthquarter results prior to the end-of-year adjustments. (b) The cost of continuous reporting includes additional audit costs, publication and mailing costs, and the time spent on completing the reports. However, management should be using quarterly and monthly financial data for internal purposes and the additional costs of continuous reporting for external purposes are likely to be minimal. On the other hand, entities making frequent disclosures may be at a competitive disadvantage compared with non-disclosing entities, which could use the disclosures for competitive purposes. As the cost of continuous reporting for small entities is likely to be large relative to the cost for larger entities, some commentators favour a form of differential reporting in which only the largest entities would be required to report continuously. Comparisons of the costs and benefits of continuous reporting are difficult because the costs are borne by the disclosing entities and the benefits are enjoyed by the report users. The ASX and government regulatory bodies appear to have concluded that the benefits enjoyed by users are greater than the costs incurred by the preparers.

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45 ASX Listing Rule 3.1 requires a listed company to immediately notify the ASX of ‘any information concerning it that a reasonable person would expect to have a material effect on price or value of the entity’s securities.’ The cost of information gathering and monitoring by companies continues to increase, especially now that information sources are so widespread and information technologies have made the information delivery immediate. For example, market speculation, chat room rumours and analyst commentary. Companies must monitor all these sources for the potential effect on the entity’s securities. 46 AASB 134 ‘Interim Financial Reporting’ applies to entities preparing general purpose interim financial statements, including those that are required to prepare half-yearly financial statements in accordance with Part 2M.3 of the Corporations Act 2001. The purpose of the standard is to prescribe the minimum content of interim financial statements, and the criteria for recognising the bases for measuring the elements of financial statements in interim financial statements. Paragraph 8 of AASB 134 requires that interim financial statements include, as a minimum: (a) a condensed statement of financial position, (b) a condensed statement of comprehensive income, (c) a condensed statement of changes in equity, (d) a condensed statement of cash flows and (e) selected explanatory notes as required in paragraph 15–18. An entity’s condensed financial statements provide less information at interim dates compared with its complete set of financial statements. Such condensed interim financial statements may be prepared in the interest of timeliness, cost consideration and to avoid the repetition of information previously reported (para. 6). Paragraphs 9 to 14 specify the form and content of interim financial statements. If an entity issues a complete set of financial statements as its interim financial statements, it must comply with the requirements of AASB 101 ‘Presentation of Financial Statements’ (para.10). If an entity publishes condensed financial statements as its interim financial statements, the condensed report shall include, as a minimum, ‘each of the headings and subtotals that were included in its most recent annual report and the selected explanatory notes. Additional line items may be added if their omission would make the condensed financial statements misleading’ (para. 10). . 23

Irrespective of whether a complete or condensed statement of comprehensive income is prepared, basic and diluted earnings per share are to be presented in the face of the statement of comprehensive income (para. 11). Explanatory notes, must be included in the interim financial statements. They must include:           

a statement that the same accounting policies are used in the interim financial statements as those used in the most recent annual financial statements; where the interim financial statements does not include notes of the type normally included, that fact must be disclosed; explanatory comments about the ‘seasonality or cyclicality’ of interim operations; items that impact on assets, liabilities, equity and income that are unusual due to their size, nature or incidence; material revisions of estimates reported in prior periods; details of transactions affecting debt and equity securities; the amount of dividends in aggregate or per share that were paid, proposed or recognised; segment revenues and segment result; material events subsequent to the end of the interim period that have not been recognised in interim financial statements; details of changes in the composition of entity as a result, for example, of the acquisition or disposal of entities; and changes in contingent liabilities or contingent assets since the last annual reporting date.

47 This statement is not correct. Paragraph 28 of AASB 134 requires an entity to use the same accounting policies in its interim financial statements as in its most recent annual report. This requires the application of the same recognition criteria and measurement bases for assets, liabilities, income and expenses in the annual and interim financial statements. Since assumptions and forecasts are generally not part of annual financial statements, they are also not part of interim financial statements. Further, AASB 134 requires each interim period to be treated as a discrete reporting period. This means that the interim report reflects the economic activity of that reporting period, there is no need to make any more estimates that would usually be made in preparing the financial statements.

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A common example is the reversal of impairment losses between the interim reporting date and annual reporting date. The question has recently arisen as to whether an entity should reverse an impairment loss recognized in an interim period for goodwill, or an investment in an equity instrument, or a financial loss carried at cost, if the losses would not have been recognized, or smaller losses would have been recognized, had impairment assessments been made only at a subsequent reporting date? The AASB released Interpretation 10 ‘Interim Financial statements’ which applies to annual reporting periods beginning on or after 1 November 2006. It stipulates that short-term impairment losses recognised in interim financial statements cannot be reversed in the preparation of annual financial statements should the circumstances that gave rise to the impairment improve. 48 Concise financial reports are prepared in order to reduce the costs of financial reporting by entities required to report under the Corporations Act 2001. The concise financial reports are also expected to be more readily understood by users of those reports. 49 The relevance and usefulness of concise financial reports is questionable given that technological advances allow shareholders and investors to access and quickly search voluminous company reports on the internet. The Parliamentary Joint Committee on Corporations and Financial Services (PJC) has recommended the amendment of section 314 of the Corporations Act 2001 to remove the requirement for entities to produce concise financial reports. The PJC is of the view that this would ‘encourage companies to produce a plain comprehensible statement of company performance and direction that is better suited to the requirements of shareholders’. At the time of writing, section 314 of the Corporations Act has not been repealed. However, the Corporations Amendment (Corporate Reporting Reform Act 2010) Bill removed the use of concise financial reports as an option for companies limited by guarantee (section 314(1AAA)). 50 (a) A concise financial reports must include a statement of comprehensive income, a statement of financial position, a statement of cash flows and a statement of changes in equity for the annual reporting period as presented in the financial statements. AASB 1039 ‘Concise Financial Reports’ also requires specific disclosures derived from the financial statements. (b) The Standard also requires the financial statements to be accompanied by a management discussion and analysis to facilitate users’ understanding of the concise financial report (para. 24). AASB 1039 requires the financial statements to be accompanied by a management discussion and analysis because all the notes to the . 25

financial statements required by other accounting standards are not required in the concise financial report. (c) Yes, listed companies are exempt from the requirement to include a management discussion and analysis of the content of the financial statements in the concise financial report. This has occurred in order to avoid duplication of information in the operational and financial report included in the Directors’ Report (as part of CLERP 9), and the concise financial report. 51 AASB 1054 ‘Australian Additional Disclosures’ sets out Australian-specific disclosures required that are in addition to disclosure required by IFRS. The following disclosures must be explicitly made:      

the statutory basis or framework under which the statements have been prepared; if the entity is a for-profit or not-for-profit entity; identification if general purpose or special purpose financial statements prepared; audit fees; imputation (franking) credit information; and reconciliation of net cash flow from operating activities to profit/(loss).

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PROBLEMS 1

Paragraph 5 of AASB 108 states material omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. No further guidance is provided and therefore each of the following will be a matter of professional judgement. (a) The misstatement of sales revenue is equal to 12% of total sales revenue for the period ($180 000/$1 500 000). There are no additional facts provided to assist in determining materiality. By virtue of its size it is likely to be material. (b) The item is unlikely to be material judged on size however; an item may be material because of its nature. In this case, MattCom Ltd has a high likelihood of breaching its loan agreement with Portsmith Bank because of the issue of the debentures. On this basis, the debentures are likely to be material in accordance with AASB 108. (c) The answer to (b) is likely to be different since the debentures would no longer be material in accordance with AASB 108. The debentures are not likely to be material judged on their amount. Also, now there is no evidence that the nature of the debentures contributes to their materiality – that is, there is no likelihood that MattCom Ltd will be in breach of its loan agreement with Portsmith Bank. (d) Whilst the revaluation is not likely to be material by size, consideration needs to be given to the size and nature. In this case, MattCom’s financial situation has worsened over the period ended 30 June 2018, but its directors’ revalued equipment upward. Therefore, in this situation the revaluation is material.

Paragraph 5 of AASB 108 states Material Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. No further guidance is provided and therefore each of the following will be a matter of professional judgement. (a) The investment of $170 000 in assets is material. Irrespective of the size of the investment of $170 000 assets in China ($170 000/$3 564 612 = 4.77%), it is likely that the expansion of a company into a new industry or geographical area as an item that is material because of its nature.

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(b) The understatement of inventory by $10 000 is not likely to be material. The nature of the item is not unusual and its size is small ($10 000/$240 000 = 4.17%). (c) The potential threat to the plant with a carrying amount of $420 000 renders the plant and its circumstances material. The restrictions on the powers and operations of a company and the risk that the plant will be seized without compensation, by nature, would be considered to be material. (d) A transaction with a related party (i.e. director) is material. Irrespective of the size of the expense of $20 000 for air travel ($20 000/ $1 890 000 = 1.06%) transactions between the company and parties who have a fiduciary responsibility in relation to that company are material. 3

Montford Ltd (a) This is a non-adjusting event as it refers to a condition (the effect of the fire) that did not exist at the end of the reporting period, but which arose subsequently. The damage is material ($950 000/$1 600 000 = 59.4%) by virtue of its size and nature (particularly if the company is not insured for fire damage). As the information about the fire is likely to be material, details of the fire loss should be disclosed in a note making it clear that the effect of the loss is not included in the financial statements, disclosing the date of the fire and the financial effect, if known. (b) Presumably knowledge of the claim was available on 30 June so this is an adjusting event. It refers to conditions existing at the end of the reporting period and allows a more exact recording of a liability, which was probably disclosed in the notes as a contingent liability. The liability of $275 000 should be recorded in the accounts and included in the financial statements by means of the following general journal entry: ___________________________________________________________________ Legal claim expense Dr $275 000 Liability for legal claim Cr $275 000 ___________________________________________________________________ If this is judged to be material, then it should be separately disclosed as an expense and a liability. It is not material by virtue of its size ($275 000/$12 000 000 = 2.3%) The nature of the judgement handed down would need to be considered. For example, it may have been a test case that paves the way for many more law suits to be brought against Montford Ltd. In such a situation the liability would be material.

Holloways Ltd The issue date of the financial statements is the date that the directors sign off on the statements – 14 September 2018 (para. 6, AASB 110). It is not the date that shareholders . 28

approve the financial statements (para. 5, AASB 110), nor is it the date that the profit and other financial information is made public. Thus, AASB 110 will only apply to events occurring between the end of the reporting period on 30 June 2018 and the date of issue of the report on 14 September 2018. (a) The 3% increase in corporate tax rates arose after the end of the reporting period of 30 June 2018. It is therefore a non-adjusting event (para. 3). No adjustment to the amounts recognised in the financial statements is allowed (para. 10). Instead, there should be note disclosure of (a) the nature of the event, and (b) an estimate of its financial effect (this would include the increase in the deferred tax liabilities that would occur) (para. 21). (b) The error in recording the cost of the equipment purchased is an adjusting event. The purchase was made on 25 June 2018 and was therefore already recorded in Holloway’s books at the balance date. The discovery of the error on 13 August 2018 provided further evidence of conditions that existed at the balance date (para. 3). Any amounts recognised in the financial statements must be amended to reflect the adjusting event (para. 8). Consequently, the following general journal entry would be required: _________________________________________________________________ Equipment Dr $27 000 Accounts payable Cr $27 000 (c) This is an adjusting event. The directors made a decision to close the Queensland operation before the end of the reporting period and recorded the estimated costs of closure as a provision on 30 June 2018. The event concerns a liability existing at the end of the reporting period and replaces an estimate with an actual giving greater certainty to the measurement of a liability. As an adjusting event for the amount of $500 000 ($2 300 000-$1 800 000), is recognised in the financial statements. Record increase in provision as follows: _________________________________________________________________ Closure of QLD Division (expense) Dr $500 000 Provision for costs of closure (L) Cr $500 000 (d) This event falls outside the period between reporting date (30 June 2018) and the date for authorisation of the issue of the financial statements (14 September 2018). Thus, it falls outside the scope of AASB 110. There would be no adjustments to the amounts recognised and no note disclosures in accordance with AASB 110 and would be dealt with in the following financial year.

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(e) AASB 110 specifically prohibits dividends declared after the end of the reporting period (30 June 2018), but before the date the financial statements are authorised for issue (14 September 2018) from being recognised as a liability (para. 12) – that is, from being treated as an adjusting event. Instead, the dividends would be treated arising from a non-adjusting event and note disclosures would be made. The note disclosures are specified in AASB 101 (para. 125) and include the amount of the dividends and the related amount per share. 5

Fraser Ltd (a) This is a non-adjusting event (para. 11, AASB 110). The decline in market value would not normally relate to the condition of the investments at the end of the reporting period (30 June), but reflects circumstances that have arisen subsequently. Thus, the amount of the investments recognised in the statement of financial position are not adjusted down by $87 000. Since the amount is material, additional note disclosures on the nature of the event and estimated financial effect ($87 000) would be made (para. 21, AASB 110). (b) This is a non-adjusting event (para. 22(f) specifically identifies share issues as an example of a non-adjusting event). Since the issue of shares is material, Additional note disclosures on the nature of the event and estimated financial effect ($150 000) would be made (para. 21, AASB 110). (c) This is a non-adjusting event; entering into significant commitments or contingent liabilities (such as issuing significant guarantees) is specifically identified in para. 22(i) as a non-adjusting event. Since the guarantees are material, additional note disclosures on the nature of the event and estimated financial effect ($45 000) would be made (para. 21, AASB 110). (d) This is an adjusting event. Paragraph 9(b) of AASB 110 identifies the receipt of information after the end of the reporting period indicating that an asset was impaired at the end of the reporting period as an adjusting entry. Bankruptcy of a customer that occurs after balance date usually confirms that a loss already existed at the end of the reporting period on a trade receivable and that the entity needs to adjust the carrying amount of the trade receivable (para. 9(b)(i). As a result, Fraser Ltd is required to adjust the amounts recognised in its financial statements as follows: _________________________________________________________________ Allowance for doubtful debts Dr $98 000 Accounts receivable Cr $98 000 ($120 000 - $22 000 = $98 000 decrease in accounts receivable)

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(e) This is an adjusting event. Paragraph 9(b) of AASB 110 identifies the receipt of information after the end of the reporting period that the amount of a previously recognised impairment loss for that asset needs to be adjusted. The sale of inventories after the end of the reporting period may give evidence about their net realisable value at the end of the reporting period (para. 9(b)(ii). As a result, Fraser Ltd is required to adjust the amounts recognised in its financial statements as follows: _________________________________________________________________ Inventory Dr $25 000 Reversal of inventory write-down Cr $25 000 (reversal of write-down of inventory by $25 000. $165 000 - $140 000) 6

Jean Ltd In accordance with paragraph 14 of AASB 108, a voluntary change in accounting policy is permitted if the change results in the financial statements providing reliable and more relevant information on the effects of transactions on the entity’s financial position, financial performance or cash flows. The management of Jean Ltd suggest the change in depreciation policy will result in more relevant and reliable information in the financial statements. On this basis, the change would be permitted. Retrospective application of the new accounting policy is required by paragraph 19 unless it is impracticable to do so. There is no evidence to suggest that this is the case. Thus, Jean Ltd must retrospectively apply the change in policy. That is, the opening balances for the year ended 30 June 2017 should be adjusted to reflect the position as if the new policy had always been applied. General journal entries: 30 June 2018 – The year in which the accounting policy is changed __________________________________________________________________ Retained earnings 1/7/2017 Dr $310 000 Accumulated depreciation Cr $310 000 (Restatement of opening balances of retained earnings and accumulated depreciation at 30 June 2017 reflect the position as if the new policy had always been applied. Retained earnings is an after-tax figure, so the adjustment is for $310 000 ($442,857 × 70%). Note that for simplicity we are ignoring the implications of AASB 112. As a result, the adjustment to accumulated depreciation is also for $310 000). After these adjustments, the comparative figures for the year ended 30 June 2017 that are presented in the financial statements for the year ended 30 June 2018 would reflect the position as if the new policy had always been applied. In an extract from the statement of

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comprehensive income for Jean Ltd for the period ended 30 June 2018, the comparative figures would be shown as follows for 2017. Extract from Statement of Comprehensive Income for the period ended 30 June: 2018 2017 (restated) Profit before depreciation and tax $793 000 Depreciation expense 40 000 Profit before tax 753 000 Tax expense (30%) 225 900 Profit after tax $527 100 Statement of Changes in Equity for the period ended 30 June: 2018

2017 (restated) --$527 100 $527 100 $(310 000)

2018

2017 (restated) $1 281 600 (310 000) 971 600 527 100 $1 498 700 ----$1 498 700

Net income recognised directly in equity Profit after tax Total comprehensive income for the period Effect of retrospective application included in retained earnings Note – Movements in equity Retained earnings Balance at start of period Changes in accounting policy Restated balance Profit for the period Total for the period Dividends Balance at end of period

These balances for the year ended 30 June 2017 are now the starting point for the financial statements for the year ended 30 June 2018. The new policy is applied in 2018. The general journal entry to record the depreciation for the year ended 30 June 2018 would be: __________________________________________________________________ Depreciation expense Dr $42 000 Accumulated depreciation Cr $42 000 The inclusion of financial information for the year ended 30 June 2018 within the extract from the statement of comprehensive income, statement of changes in equity and the note in movements in equity would be as follows:

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(b) Extract from Statement of Comprehensive Income for period ended 30 June: 2018 2017 (restated) Profit before depreciation and tax $912 000 $793 000 Depreciation expense 42 000 40 000 Profit before tax 870 000 753 000 Tax expense (30%) 261 000 225 900 Profit after tax $609 000 $527 100 Statement of Changes in Equity for the period ended 30 June: 2018 Net income recognised directly in equity Profit after tax Total recognised income and expense for the period Effect of retrospective application included in retained earnings

---$609 000 $609 000

2017 (restated) ----$527 100 $527 100

------

$(310 000)

2018

2017 (restated) $1 281 600 (310 000) 971 600 527 100 1 498 700 ----$1 498 700

Note – Movements in equity Retained earnings Balance at start of period Changes in accounting policy Restated balance Profit for the period Total for the period Dividends Balance at the end of period

$1 498 700 ----1 498 700 609 000 2 107 700 ----$2 107 000

(c) Paragraph 14 of AASB 108 requires that a voluntary change in accounting policy must result in the financial statements providing reliable and more relevant information on the effects of transactions on the entity’s financial position, financial performance or cash flows. If the management of Jean Ltd provides no reasons for the change in the depreciation policy, it is difficult to argue that AASB 108 would permit such a change. On this basis, the change would not be permitted. 7

Yandoit Ltd (a) Paragraph 5 of AASB 108 defines a change in an accounting estimate as: ‘...an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the

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present status of, and expected future benefits and obligations associated with, assets and liabilities.’ Whereas paragraph 5 of AASB 108 defines prior period errors as: ‘Omissions from, and misstatements in, the entity’s financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that: (a) was available when the financial statements for those periods were authorised for issue; and (b) could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements’ (para. 5). Examples of errors include mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretation of facts, and fraud. Clearly, the prior-period understatement of the provision for doubtful debts equal to $86 667 is not an error. The estimate of the provision for doubtful debts was based on prior experience. There is no indication of mathematical error, a mistake in applying the policy, oversight or fraud. Thus, there is nothing to indicate an error. Rather, the revision is part of the estimation process inherent in preparing periodic financial statements, that is, it is a change in an accounting estimate. (b) The required treatment of changes in accounting estimates is that the effect of change in an estimate is to be recognised in the profit or loss in: (a) the period of the change, if the change affects that period only; or (b) the period of the change and future periods, if the change affects both’ (para. 36 ). In addition, if the change in estimate results in changes in assets, liabilities or an item of equity, an adjustment is required to the carrying amount of the affected asset, liability or equity item (para. 37, AASB 108). The statement of comprehensive income must recognise as an expense in the current reporting period both the current period’s bad debt and doubtful debts expense and the expense arising from the prior-period understatement of the provision for doubtful debts. From paragraph 36 of AASB 108, a revision of accounting estimate is to be recognised in the reporting period in which the estimate is revised. The bad and doubtful debts expense

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to be recognised in the statement of comprehensive income of Fraser Ltd for the reporting period ended 30 June 2018 is: 2018 sales $6 000 000 × 0.05 = $300 000 Plus Understatement of bad and doubtful debts expense from 2017 = $ 86 667 Bad and doubtful debts expense for 2018 = $386 667 The general journal entry to recognise this expense would be as follows: ______________________________________________________________________ Bad and doubtful debts expense Dr $386 667 Allowance for doubtful debts Cr $386 667 (c) Paragraph 39 of AASB 108 requires entities to disclose the nature and amount of a change in an accounting estimate that has an effect in the current period or is expected to have an effect in future periods. However, if it is impracticable to estimate effects on future periods, an entity must disclosure this fact (para. 40). The amount of the revision of accounting estimate is $206 667 calculated as follows: Bad and doubtful debts expense recognised less amount that would have been recognised under the previous method of estimating the provision (sales $6 000 000 × 0.03)

$386 667 (180 000) $ 206 667

Of this amount $86 667 relates to a prior period. Assuming a tax rate of 30%, the after-tax effect of the revision of estimate is ($206 667 × (1 – 0.3) = $144 667. This amount is clearly material in relation to the expected after-tax profit of $400 000. Thus, the nature and amount of the revision of accounting estimate must be disclosed in the notes accompanying the statement of comprehensive income. 8

Douglas Ltd (a) Paragraph 35 of AASB 108 states that ‘a change in the measurement basis applied is a change in an accounting policy, and is not a change in an accounting estimate’. Consequently, the change from fair value basis to cost basis for property, plant and equipment is a change in an accounting policy and would be covered by AASB 108. (b) The initial application of a policy to revalue assets in accordance with AASB 116 ‘Property, Plant and Equipment’ is a change in accounting policy as per the answer to (a). However, AASB 108 does not apply as was the case in (a) above. Instead, paragraph 16 of AASB 108 states that this is ‘a change in accounting policy to be dealt with as a revaluation in accordance with AASB 116 and AASB 138, rather than in accordance with this standard (AASB 108).’ . 35

(c) Paragraph 35 of AASB 108 states that ‘When it is difficult to distinguish a change in accounting policy from a change in an accounting estimate, the change is treated as a change in an accounting estimate.’ 9

Cootha Ltd (a) The error has been discovered on 30 June 2018 and relates to the prior reporting period ending 30 June 2017. The error occurred due to the inadvertent omission of a group of employees from the calculation of the sick leave liability. Thus, the $33 000 understatement of the sick leave liability is caught by the definition of prior period errors in paragraph 5 of AASB 108. The understatement is material when compared to total liabilities ($33 000/$260 000). Paragraph 42 of AASB 108 requires that material prior period errors be corrected in the first financial statements authorised for issue after their discovery. The correction is to be retrospective, with restatement of the comparative amounts for the prior periods(s) in which the error occurred. If the error occurred before the earliest period presented in the financial statements, the opening balances of affected assets, liabilities and equity items are to be restated for the earliest period presented (para. 42, AASB 108). The understatement of the sick leave liability would be corrected on 30 June 2018 as follows. __________________________________________________________________ Retained earnings Dr $33 000 Sick leave liability Cr $33 000 In addition, Cootha Ltd would have to restate the comparative figures provided in the statement of comprehensive income prepared for the period ended 2017. Specifically, for 2017 comparative figures: sick leave expense would have to be increased by $33 000, profit or loss would decrease by $33 000 and income tax expense would decrease by $9900 ($33 000 × 30%). (b) No, the answer remains unchanged. Paragraph 53 of AASB 108 states that hindsight should not be used when correcting amounts for a prior period. In this case, the information about the bird flu outbreak did not become available until after the financial statements for the year ended 30 June 2018 are authorised for issue on 22 September 2018. Consequently, it is disregarded when correcting the prior period error.

10 The definition of a related party contained in paragraph 9 of AASB 124 needs to be applied to each individual and entity associated with Chelmer Ltd. . 36

Chelmer directly controls Brighton Chelmer has direct significant over Sandgate Chelmer indirectly, through its control over Brighton, has significant influence over Gatton The intermediary controlled by Chelmer, Brighton, has only 10% ownership of Noosa, so there is not significant influence Directors of Chelmer, C1, C2, C3 and C4 are key management personnel of Chelmer G1 is the spouse of C3 N1 is the son of C2 Both of these persons are close family members of an individual referred to in para. 9(d) G1 owns Clayfield (i.e. controls Clayfield) and G1 is a person identified in para. 9(e) The remaining persons – B1, B2, B3, G2, N2, N3, S1 and S2 – are not covered by any paragraphs in AASB 124

AASB124, paragraphs(s) 9(a)(i)

Related Party Yes Brighton

9(a)(ii)

Sandgate

9(a)(ii)

Gatton

Related Party No

Noosa

9(d)

C1, C2, C3, C4

9(e)

G1, N1

9(f)

Clayfield

None

B1, B2, B3, G2, N2, N3, S1 and S2

11 The definition of a related party contained in paragraph 9 of AASB 124 needs to be applied to each individual and entity. A Ltd is a related party because it controls (100% ownership) B Ltd (para. 9(a)(i) AASB 124). Since A controls D Ltd (90% ownership), D Ltd and B Ltd are fellow subsidiaries under the control of one parent entity. That is, they are under common control. This means that D is a related party of B Ltd (para. 9(a)(i), AASB 124).

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B Ltd has significant influence over C Ltd (34% ownership). C Ltd is deemed to be a related party of B Ltd (para. 9(b), AASB 124). A1, A2, B1, B2 and B3 as directors of B Ltd and its parent A Ltd, are key management personnel of B Ltd and its parent A Ltd. Consequently, they would be related parties of B Ltd (para. 9(d), AASB 124). The remaining directors listed are not related parties of B because they are not part of the key management personnel of either B Ltd or C Ltd. The wife and two children of B1 are close family members of B1, who in turn is a related party of B Ltd. Thus, the wife and children are related parties of B Ltd under paragraph 9(e) of AASB 124. B1 controls F Ltd (100% ownership). Paragraph 9(f) deems F Ltd to be a related party of B Ltd because it is controlled by B1. The superannuation plan is to provide postemployment benefits to employees of F Ltd. Since F Ltd is a related party of B Ltd, paragraph 9(g) deems the superannuation plan to be a related party of B Ltd. To summarise, the related parties of B Ltd include: A Ltd, C Ltd, D Ltd, A1, A2, B1, B2, B3, wife and children of B1, F Ltd, superannuation plan. Parties not related to B Ltd include: D1, D2, D3, C1, C2, wife and children of D2. 12 Over recent years company directors and ofﬁcers seem to have become more prone to charges of breaches/potential breaches of ASX continuous disclosure rules. The following cases highlight the significant and growing implication of the continuous disclosure obligations. (a) In Kim Riley AFT the KER trust v Jubilee Mines NL (Supreme Court of Western Australia, 6 September 2006). In September 1994, Jubilee Mines (a gold miner) received the results of drilling that had been inadvertently carried out on one of Jubilee’s mining tenements by Western Mining Corporation. The result from one drill hole indicated nickel deposits. Being a gold miner, the results were shelved and Jubilee did not report to ASX until 2006. In the interim, Riley sold shares held in the company that would not have been sold had he known about the drilling results. Essentially, the company was found to be in contravention of its duty to notify the ASX of information that may affect the value of the shares and ordered to pay Riley damages. The Riley case was, at the time, the first successful case of its kind in Australia.

. 38

The case of Sons of Gwalia Ltd v Margaretic has had wide ranging implications for continuous disclosure and insolvency administration. On the 18 August 2004, Mr Margaretic purchased 20,000 shares at a cost of $26,200 in Sons of Gwalia. Eleven days later, on the 28 August 2004, administrators were appointed to the company. Margaretic alleged that the company had failed in its obligations under ASX’s continuous disclosure requirements in that its gold reserves were insufficient to meet its gold delivery contracts and it could not continue as a going concern. Because the company was found to have failed in its obligations and mislead the investor, the High Court decision allowed Margaretic, an investing shareholder, to rank equally with the general creditors in a winding-up. This is contrary to the general principle of shareholders ranking after general creditors. The decision has been the subject of extensive legal, academic and parliamentary attention and fuelled intense debate about the need for law reform. Within one week of the decision being handed down the Commonwealth Government announced that it had asked the Corporations and Markets Advisory Committee to advise on whether changes would be made to the law in regard to: (i) The priority of shareholder’s claims in an insolvency; (ii) The efficient administration of insolvency proceeding where shareholders make claims of misleading and deceptive conduct; and (iii)The protection of shareholder from the risk of acquiring shares on the basis of misleading information. In December 2010, legislation was passed by the Australian Parliament in the form of the Corporations Amendment (Sons of Gwalia) Act 2010 (Cth) which amends the Corporations Act 2001 (Cth) and means that in future all such shareholder claims will once again be subordinated. (b) In ASIC v Fortescue Metals Group Limited [2011] FCAFC 19, ASIC prosecuted Fortescue for alleged breaches of its continuous disclosure obligations under section 674 of the Corporations Act and for misleading and deceptive conduct. In early 2004, FMG and Forrest commenced negotiations with three Chinese entities for the construction, financing and transfer of mine, rail and port infrastructure in the Pilbara region of WA. Three substantially similar framework agreements were executed in the second half of 2004. The agreements made clear that the parties intended to create certain binding obligations but left a number of matters to be negotiated, including detailed specifications for the scope of the construction work and price. In August through to November 2004, FMG made a series of announcements to ASX concerning the nature of the framework agreements under

. 39

Listing Rule 3.1. FMG ASX announcements indicated that it had entered into ‘binding agreements’. In March 2005 an article in the Australian Financial Review claimed that the agreements were not binding and were in fact merely agreements to negotiate and not enforceable. The company’s share price fell significant. In the first instance, the decision dismissed ASIC’s claim the FMG had mislead the market on the basis that FMG’s board and Mr Forrest has reasonably and honestly held the opinion that the framework agreements were binding. However, on appeal, Full Court of the Federal Court of Australia found in favour of ASIC and concluded that Fortescue had misled the market about having secured binding contracts. The Full Court decided that it did not matter what the intentions of FMG or Mr Forrest were, what mattered was the effect that the announcement had on those to whom they were published. Finally, on appeal in Forrest v Australian Securities and Investments Commission and Fortescue Metals Group Ltd v Australian Securities and Investments Commission [2012] HCA 39 (2 October 2012), the High Court of Australia set aside the decision and found Fortescue had not misled the market. The decision underlines that listed companies and their directors must pay close and careful attention to the content of the announcement being made and the likely viewpoint of investors. (c) On 17 October 2012, the ASX released a media statement announcing consultation on a new draft Guidance Note on continuous disclosure. In the media announcement, the ASX indicates: The draft revisions to Guidance Note 8 reﬂect industry feedback that aspects of the continuous disclosure rules would beneﬁt from updated guidance. They also take into consideration recent legal and market developments. The ASX has worked closely and cooperatively with ASIC to develop the revised guidance. The draft Guidance Note 8 seeks to provide more information on a number of areas, including:      

a test for determining what constitutes material or ‘market sensitive’ information; clarifying that ‘immediately’ does not mean ‘instantaneously’ but rather ‘promptly and without delay’; how to use trading halts to manage disclosure issues; exceptions to the requirement to release information immediately; the meaning of ‘false market’; managing ‘earnings surprises’; . 40

  

responding to market and media speculation and analyst commentary; how the continue disclosure requirements apply to conﬁdential offers to enter into control transactions; and ASX enforcement practices, including an explanation of the role of ‘price query’ and ‘aware’ letters.

ASX Guidance Note 8 was revised in 2013 and in March 2015. The updated ASX Guidance Note 8 came into effect on 1 July 2015 containing expanded guidance on analyst and investor briefings, consensus estimates, analyst forecasts and earnings surprises.

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Chapter 19 ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES LEARNING OBJECTIVES After studying this chapter you should be able to: 1 describe the nature of extractive industries; 2 explain the nature of the accounting issue in the extractive industries; 3 apply AASB 6 ‘Exploration for and Evaluation of Mineral Resources’ to accounting for exploration and evaluation costs; 4 apply AASB 6 ‘Exploration for and Evaluation of Mineral Resources’ to measuring exploration and evaluation costs; 5 apply the relevant accounting standards to accounting for development and construction costs; 6 explain how to account for stripping costs, and removal and restoration costs; 7 explain how to account for the costs carried forward once production commences; 8 identify four methods of accounting for exploration and evaluation costs; and 9 explain the application of reserve recognition accounting.

QUESTIONS 1

It has been suggested that there are five identifiable phases in the discovery and recovery of minerals, oil and natural gas. Four of these phases are ‘pre-production’ phases, which means that they occur before production begins. The pre-production phases are exploration, evaluation, development and construction. The exploration phase covers the process of finding the deposit. It includes the geological, geophysical and geochemical studies made over wide areas to obtain information and the acquisition of exploration rights in the most promising areas. Evaluation is work undertaken to determine whether the prospect is commercially viable. It includes evaluation of the extent and quality of the deposit, and a consideration of the technical feasibility of extracting and selling it economically. Development involves the establishment of access roads, drilling wells, driving shafts, the removal of overburden, and the supply of water and power. Construction is a separate phase in which facilities are constructed for the extraction, treatment and transportation of product from the production areas. The fifth phase is production. This covers extraction and processing before sale. The costs of production also include the amortisation of any capitalised pre-production costs.

2 (a) The main issue is how to account for the significant costs incurred during both the pre-production and production phases. Should the costs be recognised as expenses or as an asset? What criteria should be used in answering this question? Conceptually, Framework 2014 should be applied to see if the expenditures give rise to assets. Differences in opinion relate mainly to the treatment of preproduction costs and in particular exploration and evaluation costs. By the time development commences, the deposit is obviously considered by management to be worth exploiting. Variations in opinions on how to account for these costs are likely due primarily to differing interpretations of the degree of risk inherent in the extractive industries. (b) Broadly speaking, there are four approaches to accounting for pre-production costs: 1 the expense (or costs written-off) method, which recognises the costs as expenses in the period in which they are incurred; 2 the expense-and-reinstate method, which recognises the costs as expenses in . 2

the period in which they are incurred, but reinstates them as assets if subsequently those costs give rise to economically recoverable reserves; 3 the full-cost method, which recognises the costs as an asset irrespective of the likely success of the exploration program; and 4 the successful-efforts method, which limits asset recognition to those costs that are likely to result in the discovery of economically recoverable reserves (the other costs are recognised as expenses). The current approach advocated in AASB 6, the area of interest method, is a special case of the successful-efforts method. 3

The primary difference between AASB 6 and its predecessor (AASB 1022) relates to the scope of the accounting standards. AASB 6 is an activity-based accounting standard that deals only with the exploration for and evaluation of mineral resources. In contrast, AASB 1022 was an industry-based accounting standard that applied to all phases of extractive industry operations. Therefore, to account for all phases of activities under AASB 6 will require the application of other AASB accounting standards in addition to AASB 6.

The statement seems to envisage changes in the area of interest. AASB 6, however, requires that all costs associated with an area of interest should be capitalised for so long as the whole area is not abandoned. In such cases, if particular costs incurred in an area are unproductive, they are capitalised because they apply to the area. AASB 6 requires the identification of areas of interest at the outset of exploration. Areas may be redefined at irregular intervals, but AASB 6 does not indicate that they should be progressively narrowed or concentrated on the successful parts of the area with costs incurred on unsuccessful parts recognised as expenses. There are several ways in which pre-production costs could be accounted for. The four most frequently suggested ways are that they should be: • • •

recognised as expenses in the period in which they are incurred (the expense method); capitalised until there is revenue against which they are amortised (the full-cost method); capitalised only to the extent that the costs are expected to provide future economic benefits (the successful-efforts and area-of-interest methods); and

. 3

•

recognised as expenses and reinstated if the costs subsequently give rise to future economic benefits.

In the pre-production period, the expense method probably understates profits and the full-cost method probably overstates profits. The intermediate methods produce results that lie between these extremes. If AASB 6 were to be amended to be consistent with Framework 2014, the expense and reinstate method would probably be selected. 5

The statement supports the expense method. It relies on an assertion that the risk associated with mining operations is so great that all exploration and evaluation costs should be recognised as expenses in the period in which they are incurred. It implies that the probability of success from the costs of exploration and evaluation in any period is less than 0.5, which means that, given Framework 2014, no asset can be recognised when the costs are incurred. This is a persuasive argument. The probability of a commercially viable discovery is very low, particularly in the exploration and evaluation phases of the process. In the later pre-production phases, a viable deposit is likely to yield benefits and so capitalisation is appropriate. However, this does not mean that exploration and evaluation costs should never be capitalised. If a viable deposit is eventually discovered, then the pre-production costs associated with its discovery, which were recognised as expenses in previous reporting periods, should be reinstated and recognised as an asset.

Stripping Activities Costs In the Basis for Conclusions of Interpretation 20, paragraph BC6 states that stripping activity gives rise to an asset because it generates one of two possible benefits to the entity – either the extraction of saleable ore which constitutes inventory or improved access to the ore body for a future period (which the Interpretation notes is expected to normally be a non-current asset). Paragraph BC 7 notes that although these benefits meet the definition of an asset, the usual recognition criteria still apply.

Northern Mining Ltd (NML) (a) NML should recognise the estimated costs of restoration in its statement of financial position as at 30 June 2017. The restoration will require an outflow of economic benefits to those undertaking the restoration. NML has a constructive obligation to restore the company’s mine sites based on community expectation and company policy, and the need for restoration has arisen because of site development work. Assuming that the $1 million of future work is necessitated . 4

by development at the mine site that has already occurred, the need for restoration is probable and the costs can be measured reliably. The obligation would be measured at either: (i) face value of expected future outlays = $1 million or (ii) present value of expected future outlays =

$1 000 000 = $385 543 (1.1)10

As Framework 2014 is effectively silent on the choice of an appropriate measurement base, students may prefer to measure restoration costs either in accordance with option i or to recognise that restoration is deferred for a considerable time (option ii). (b) The need for restoration has arisen as a result of development activities. Because AASB 6 only deals with exploration and evaluation, the accounting standard does not specify requirements in relation to this issue. Instead, the obligation for restoration costs would be recognised in accordance with AASB 137 ‘Provisions, Contingent Liabilities and Contingent Assets’. Also, consistent with the treatment in AASB 6, the $1 million should be included in development costs and amortised over the life of the deposit once production commences. In brief, AASB 137 requires that a provision for removal and restoration to be recognised when ‘(a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation’ (para. 14). As discussed in the answer to part (a) of this question, these three recognition criteria have been met. Therefore, the provision for restoration costs would be recognised as follows: Development assets Provision for restoration costs

Dr Cr

Paragraph 36 of AASB 137 requires that a provision be measured as ‘the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.’ In addition, if the effect of the time value of money is material, the amount of the provision is measured as the present value of the expected future expenditures (para. 45). The appropriate discount rate is a pre-tax

. 5

rate that reflects the current market assessment ‘of the time value of money and the risks specific to the liability’ (para. 47). Since the time value of money is likely to be material in the extractive industries, the provision for provision for restoration costs should be reported at net present value, i.e.:

Mine removal and mine site restoration costs can arise during pre-production and production activities. In fact, the quantum of such costs is likely higher once development and construction activities commence as well as during production. Thus, it is not correct to state that restoration costs arise largely during exploration and evaluation activities. An obligation for restoration costs is recognised in accordance with AASB 137 ‘Provisions, Contingent Liabilities and Contingent Assets’ (and also AASB 6 for exploration and evaluation activities). AASB 137 requires that a present obligation exists as a result of a past event, it is probable that an outflow of economic benefits will be necessary to settle the obligation, and a reliable estimate can be made of the obligation (para. 14). The present obligation may be legal (e.g. required by legislation, required by mine leasing agreement) or constructive (i.e. arising due to community expectations, or corporate policy). Thus, it is not correct to state that an obligation for restoration costs is always a legal obligation. It is not correct to state that GAAP requires the undiscounted amount of restoration costs to be included as part of the carrying amount of development assets. Firstly, AASB 137 requires that if the time value of money is material, as is the case in the extractive industries, the amount of the restoration costs obligation is measured as the present value of expected future expenditures. Secondly, the statement that restoration costs are only capitalised as part of development assets is not entirely correct. The following explanation illustrates why this is the case. Restoration costs that arise as part of exploration and evaluation will initially be capitalised as part of exploration and evaluation assets. That is: Exploration and Evaluation assets Provision for restoration costs

Dr Cr

$XXX $XXX

. 6

Once a commercially viable mineral deposit is found for an area of interest, the balance of exploration and evaluation costs (including restoration costs) is transferred/reclassified to/as development assets. If any further obligation arises for restoration costs during the development and construction phases, these costs are capitalised as part of development costs as follows: Development assets Provision for restoration costs

Dr Cr

$XXX $XXX

Finally, any restoration costs that arise as a result of production activities are included as part of production costs as follows: Production costs Provision for restoration costs 9

Dr Cr

$XXX $XXX

The requirements of AASB 6 are based on the costs of finding deposits. The assets are the capitalised costs; the expenses are the writing-off of costs associated with unsuccessful exploration and evaluation and the amortisation of the capitalised preproduction costs associated with successful exploration and evaluation. No effort is made to value the deposit for financial position purposes or to include changes in the value of the deposit in the income statement, except to the extent that development and construction costs can only remain capitalised as long as they are expected to be recovered. The Reserve Recognition Accounting (RRA) method that was proposed by the Securities and Exchange Commission in the United States requires that deposits be periodically revalued for the purposes of preparing a balance sheet, with any changes in value being recognised as income or expenses. This means that changes in estimates of the size of the deposit, the quality of the ore and price measurements will all affect the profit or loss figure. The preferred method is a matter of opinion. Advocates of RRA argue that it results in the disclosure of relevant data. An entity in the extractive industry is better off if it makes a significant discovery, increases its estimate of the size or quality of a deposit and sees the price of its output rising. This ‘better-offness’ should be disclosed in the financial report. Similarly, the cost of finding and developing a deposit is of relatively less interest to a financial report user compared to the value of the deposit. The balance sheet should show the value of the discovery because this is what statement users want to know. The opposing point of view is that while the RRA information may be relevant, it is unlikely to be reliable and may mislead statement users. It is . 7

notoriously difficult to estimate the size and quality of deposits and the selling price of many minerals is volatile. In addition, RRA is a significant departure from contemporary accounting practices and its adoption may set a precedent for further radical reforms. Financial statements are prepared by experts for experts. They know that cost does not represent value. 10 Provision for Restoration Costs 30 June 2018: The best estimate of the restoration costs arising from total oil extraction is $285 500 or 10% x $2 855 000. The portion of the obligation for restoration costs recognised for the year ended 30 June 2018 is the portion of $285 500 that arises through the extraction of oil for the year. The portion of restoration costs to be recognised is $33 318 or 11.67% x $285 500, where 11.67% is equal to 1 400 000 barrels extracted/ 12 000 000 barrels over the term of the licensing agreement. The present value of the obligation for restoration costs would be measured by discounting $33 318 using a discount rate of 5% over 7 years. That is: Production cost

$33 318 x 1.05-7

$23 678

The general journal entry to recognise the restoration costs arising from the current year’s oil extraction would be: 30 June 2018 Production costs Provision for restoration costs

Dr Cr

$23 678 $23 678

A further adjustment to the provision for restoration costs is required at 30 June 2018. This adjustment reflects the due date for the obligation becoming one year closer (i.e. the ‘unwinding of the discount’). It is calculated by restating any prior balances in the provision to present value as at 30 June 2018. In this case the obligation for restoration costs arising from development activities is restated as follows: Development cost (recalculated) Production cost Total provision balance

(90% x $2 855 000) x 1.05-7

Existing provision balance Increase in provision

($1 739 139 + $16 103)

$1 826 096 $23 678 $1 849 774 $ 1 755 242 $94 532

The increase in the provision of $94 532 is recorded as a finance cost in accordance with paragraph 8 of Interpretation 1. The general journal entry would be: . 8

30 June 2018 Finance costs Provision for restoration costs

Dr Cr

$94 532 $94 532

11 The treatment of pre-production costs is a crucial element of accounting for the extractive industries. There are various opinions about the most appropriate way of accounting for pre-production costs. One view is that all pre-production costs should be recognised as expenses in the period in which they are incurred. This view is supported by an assertion that the probability of a successful outcome from preproduction costs is so low that capitalisation cannot be justified. While this may be a justifiable argument for exploration and evaluation costs, it is difficult to justify for development and construction costs. The immediate expensing treatment has also been supported by other arguments including that the costs of finding new deposits should be charged against the revenue from existing deposits and that, in a steady state, expensing is a simpler procedure than capitalisation with the same profit or loss effect. At the other extreme, it is argued that all pre-production costs should be recognised as an asset to be amortised systematically as soon as the mineral deposit generates revenues. This view is supported by an argument that all pre-production costs are part of the effort to find a viable deposit. Unsuccessful exploration is as much a part of the process of finding the deposit as successful exploration. It is also argued, not very persuasively, that a policy of capitalising all pre-production costs will result in a carrying amount for the asset closer to its ‘value’ than a policy of recognising all preproduction costs as expenses. Support for these practices is a matter of judgement about which approach best reflects the economic reality of the situation. However, an expense and reinstate policy is likely to be more consistent with the conceptual framework than either of the policies discussed above. 12 With the area-of-interest method, the choice of a cost centre is a critical determinant of profit during the pre-production and production phases. If the cost centre is defined very narrowly, then the costs associated with unsuccessful exploration will be recognised as expenses very early in the process. If cost centres are broadly defined, then more costs associated with unsuccessful exploration will be carried forward until the whole area is abandoned. In the first case, expenses will be higher in earlier

. 9

periods and hence, profits will be lower than those where broad cost centres are employed. In later periods, when there is revenue, the narrow cost centres will result in higher profits than broad cost centres. Consider the following simple example. Two companies each drill two exploratory shafts in a year at a cost of $1 million per shaft. One defines its area of interest as a single shaft, the other as both shafts. In both cases, the first shaft is abandoned but the second produces revenues of $2 million per year as from the beginning of year 2. Capitalised costs are amortised at 10% per year. Area of interest defined as Single shaft Both shafts Year 1 Amount capitalised Amount expensed Reported loss Year 2

$1m $1m $1m

$2m – –

Amount expensed Reported profit

$100 000 $1 900 000

$200 000 $1 800 000

13 The most frequently used method of amortising the pre-production costs carried forward is the units-of-production method. An amortisation rate is calculated by relating the costs carried forward to the ‘reserve base’ considered to be the most appropriate in the circumstances. The reserve base is the estimated quantity of minerals, oil or natural gas that can be recovered from the deposit, and in AASB 6 is referred to as ‘economically recoverable reserves’. A straight-line approach would charge depreciation based on the estimated life of the recoverable reserves. Such a time-based methods may be criticised on the ground that the exhaustion of reserves is related to physical effort and output rather than the passage of time. In other words, a straight-line method would not reflect the relative depletion of the reserves that was generated in any particular period. 14 These arguments have been used to justify the use of the full-cost method. The first argument is that recognising as expenses all exploration costs will result in reported losses during the exploration period even though some of the exploration activity may be successful and lead to future revenue. Other things being equal, the expensing of . 10

all costs also means that the reported net assets of the entity declines over the exploration period. Advocates of the full-cost method argue that expensing all costs understates reported profits because it fails to indicate that there will probably be some future economic benefits as a consequence of those costs. The low reported profits and falling net assets make the entity an unattractive investment opportunity and will impede any efforts to raise new capital. It is argued that this is not in the best interests of the entity, the industry or the country’s economy. The contrary argument is that it is not the purpose of accounting to attract capital into an entity. Its purpose is to report an entity’s performance and financial position so as to give a ‘true and fair’ view. The full-cost method overstates profits and net assets with a possible misallocation of scarce resources to the mining industry. To the extent that exploration costs are unproductive, they should be recognised as expenses. The second argument is that all exploration costs add to the general expertise and knowledge of the entity, thereby increasing the probability of successful exploration outcomes in the future. The entity’s management learns from its mistakes. A variation of this argument is that looking in the wrong place is a necessary prerequisite for looking in the right place. In very few cases is a deposit found at the site where exploration is first commenced. Looking in the wrong place eliminates it as a possible site. These arguments lead to the conclusion that while the costs of unsuccessful exploration may appear to be wasted, they do provide significant benefits which should be shown as assets in the balance sheet. The counter argument is that these vague benefits do not satisfy the definition of and recognition criteria for assets as specified in Framework 2014 and therefore they should not be recognised as assets. 15 The Securities and Exchange Commission (SEC) in the United States has argued, in essence, that statement users are not interested in the cost of finding deposits, but in their value. It also argued that changes in the value of a deposit change the ‘welloffness’ of the miner and these changes ought to be reflected in the income statement. The SEC’s arguments are based on an assessment of the information needs of financial report users. They are based on a ‘decision usefulness’ interpretation of accounting. The need for reserve recognition accounting is a matter of opinion. It seems reasonable to argue that the value of a deposit and changes in that value are relevant provided that they can be measured reliably. Supporters of the SEC view would argue that miners periodically estimate the value of deposits as part of the process of deciding whether to close or continue operations. If these data can be provided to managers and are relied on by them, then these data should also be

. 11

available to financial report users. Critics of the SEC view would probably argue that many report users would not realise that the data are based on estimates and may be misled by them. The adoption of reserve recognition accounting may also provide opportunities for creativity in financial reporting.

. 12

PROBLEMS 1

Archer Mining Limited _________________________________________________________________ Archer Mining Limited Extract from the Statement of Comprehensive Income for year ended 31 December 2019 $ $ Sales revenue (490 000 tonnes @ $4.15 per tonne) 2 033 500 less Cost of goods sold: Opening inventory Nil Production costs 1 160 000 Stripping activity costs 180 000 Restoration costs 100 640 Amortisation of exploration, evaluation and development costs (524 000 tones @ $0.39424) 206 582 Depreciation of improvements (524 000 tonnes @ $0.102) 53 448 Depreciation of equipment 32 500 Total production costs 1 733 170 less Closing inventory (34/524  1 733 170) 112 458 1 620 712 Gross profit 412 788 less Administration expenses 115 000 Finance costs 21 230 Selling expenses 64 000 200 230 Profit before tax 212 558 less Income tax expense 120 000 Profit $92 558 _________________________________________________________________ Calculations: Pre-production costs capitalised: Acquisition cost Exploratory drilling Trenching and sampling Mine restoration costsa Development cost Total less Residual value Cost to be amortised Estimated deposit (tonnes)

$3 720 000 180 000 92 000 353 848 405 000 $4 750 848 20 000 $4 730 848 12 000 000

Amortisation rate per tonne a

$0.39424 cents

On 31 December 2018, mine site restoration costs of $1 010 000 are estimated to have been incurred as a result of development and construction activities. The present value of these costs is included as part of pre-production costs capitalised with a corresponding increase recognised in a provision for restoration costs. The present value is $353 848 or ($1 010 000 x (1.06)-18)

Improvements with a service life related to the life of the mine (physical life greater than or equal to life of mine and items cannot be economically moved from mine location): Mine buildings Railroad and associated equipment Total

$415 000 810 000 $1 225 000

Depreciation per tonne of ore $1 225 000/12 000 000 = $0.102 per tonne Other mine equipment: Depreciation: 260 000/8 years = $32 500 (This item is depreciated over its estimated useful life since this is independent of the life of the mine.) Restoration costs incurred as a result of production: On 31 December 2019, mine site restoration costs of $271 000 are estimated to have been incurred as a result of production. The present value of these costs is included as part of production costs. The present value is $100 640 or ($271 000 x (1.06)-17) Finance costs (unwinding of the discount on restoration costs): Recalculated balance of provision for restoration costs Development ($1 010 000 x (1.06)-17) Production ($271 000 x (1.06)-17) Existing balance of provision for restoration costs ($100 640 + $353 848) Increase in provision recognising as a finance cost

$375 078 100 640

$475 718 454 488 $21 230

. 14

2 Oxford Copper Limited _________________________________________________________________ Oxford Copper Limited Extract from the Statement of Comprehensive Income for the year ended 31 December 2019 $ $ Sales revenue 13 200 000 less Cost of goods sold Opening inventory Production costs Restoration costs Amortisation of exploration, evaluation and development costs (a) Depreciation of improvements (b) Depreciation of equipment (c) Closing inventory 140/1460) Gross profit less Expenses: Administration expenses Finance costs Selling expenses Profit before tax

Nil 2 120 000 211 439 1 001 560 87 600 42 000 3 462 599 332 030

215 000 38 123 136 000

3 130 569 $10 069 431

389 123 9 680 308

less Income tax expense 1 180 000 Profit $ 8 500 308 _________________________________________________________________ Calculations a

Amortisation of exploration, evaluation and development costs Pre-production costs capitalised: Mining property Geological studies Exploratory drilling Sampling Restoration costsi Development cost

$13 500 000 65 000 345 000 192 000 476 537 675 000 15 253 537 . 15

less Residual value Cost to be amortised Estimated deposit (tonnes)

160 000 15 093 537 22 000 000

Amortisation rate per tonne Amortisation charge

= $0.686 = 1 460 000  $0.686 = $1 001 560

On 31 December 2018, mine site restoration costs of $1 200 000 are estimated to have been incurred as a result of development and construction activities. The present value of these costs is included as part of pre-production costs capitalised with a corresponding increase recognised in a provision for restoration costs. The present value is $476 537 or ($1 200 000 x (1.08)-12) Depreciation of improvements Depreciated on a units of production basis because their estimated life is longer than the estimated mine life and they cannot be economically removed Mine buildings Railroad and associated equipment

421 000 905 000 $1 326 000

Depreciation rate per tonne

Depreciation

= $1 326 000/22 000 000 = $0.060 per tonne = 1 460 000 tonnes  $0.060 per tonne = $87 600

Depreciation of equipment $420 000 / 10 years

= $42 000 per year

Restoration costs incurred as a result of production: On 31 December 2019, mine site restoration costs of $493 000 are estimated to have been incurred as a result of production. The present value of these costs is included as part of production costs. The present value is $2119 439 or ($493 000 x (1.08)-11) Finance costs (unwinding of the discount on restoration costs): Recalculated balance of provision for restoration costs Development ($1 200 000 x (1.08)-11 Production ($493 000 x (1.08)-11) Existing balance of provision for restoration costs ($476 537 + 211 439) Increase in provision recognising as a finance cost

$514 660 211 439

$726 099 687 976 $38 123

. 16

3 Grace NL _________________________________________________________________ Grace NL Extract from the Statement of Comprehensive Income for the year ended 31 December 2018 $ $ Sales revenue (a) 4 960 000 Other revenue – gain on sale of property 120 000 Total revenue 5 080 000 less Cost of goods sold Production costs 780 000 Amortisation charge (b) 305 000 Depreciation of mine plant and equipment (c)(d) 169 167 Restoration costs (j) 53 271 1 307 438 Closing inventory (g) 261 488 1 045 950 Gross profit 4 034 050 less Expenses: Administration expenses Selling expenses Depreciation of other fixed assets (e) Pre-production expenditure written off (f) less Foreign exchange loss (h) Profit before tax

225 000 120 000 37 500 250 000 155 000

less Income tax expense (i)

787 500 3 246 550 973 965

Profit $2 272 585 _________________________________________________________________ Calculations: a

Sales revenue: 800 000 tonnes sold at $6.20 per tonne = $4 960 000.

Amortisation rate: Pre-production costs capitalised: exploration costs 2016 and 2018 (450 000 + 150 000) evaluation costs 2017 development costs 2017 – access road

600 000 640 000 1 200 000 $2 440 000

. 17

Amortisation rate = $2 440 000/8 000 000 tonnes = $0.305 per tonne ii

Amortisation charge: Amortisation charge for 2018 = 1 000 000 tonnes  $0.305 per tonne = $305 000.

Depreciation: mine buildings The buildings cannot be economically removed and so are depreciated on a units of production basis: Depreciation rate

= $420 000/8 000 000 tonnes = $0.0525 per tonne

Depreciation expense = $0.0526 per tonne x 1 000 000 tonnes = $52 500

Depreciation: mine plant and equipment Mine plant and equipment can be economically removed and have alternative uses. Depreciate on time basis as life is independent of the life of the mine. $1 750 000/15 years = $116 667 per annum

Depreciation: other fixed assets: The assets are used for administrative purposes, can be moved and have alternative uses. Therefore, depreciate over their useful life $300 000/8 years = $37 500 per annum

Exploratory drilling: Assume that expenditure is capitalised until the exploratory drilling is found to be unsuccessful. The 2017 expenditure in Victoria was capitalised in 2017 and expensed in 2018.

Closing inventory: 200 000/1 000 000  $1 307 438 = $261 488

Exchange gain/loss: 50% of total sales = $2 480 000 Invoice amount at time of sale = $A2 480 000  0.90 Invoice amount at settlement = US$ 2 232 000/0.96 Therefore, exchange loss

= US$ 2 232 000 = $A 2 325 000 = $A 2 480 000

. 18

less

2 325 000 $A 155 000

Calculation of tax expense: Profit before tax Tax rate 30 cents Tax expense

$3 245 550 $973 965

Restoration costs incurred as part of production: When production begins in 2018, the company decided to provide an amount of $90 000 per annum for mine site restoration costs. The present value of these costs is included as part of production costs. The present value is $53 271 or ($90 000  (1.06)-9)

Bling NL An area of interest is an individual geological area that is considered to constitute a favourable environment for the presence of a mineral deposit, or an oil or natural gas field. Lease A and Lease B are neighbouring mining leases in the Bendigo area. It is implicit in the question that the company acquired Lease B because it believed that the gold deposit in Lease A extended into Lease B. Therefore, leases A and B constitute one area of interest. Assume that Bling capitalises exploration and evaluation costs when permitted by AASB 6. Leases A and B:

Exploration, evaluation and development costs

2016 Geological survey Purchase of mining lease Exploratory drilling program

$110 000 180 000 260 000

2017 Feasibility study

560 000

2018 Access road Transportation cost of portable office building Lease B purchase Exploratory drilling

660 000 16 000 1 000 000 250 000

2019 Total

450 000 $3 486 000

Feasibility study

. 19

Amortisation charge: Economically recoverable reserves Output

220 000 ozs 10 000 ozs

Therefore, amortisation of pre-production costs is ($3 486 000  10 000)/220 000 = $158 454

Construction costs 2018: Estimate of useful life of Bendigo area of interest = 20 years

Processing plant Mining equipment

Cost $

Life

Depreciation $

1 100 000 500 000

Mine life 10 years

55 000 50 000 $105 000

Leased asset: Assume this is classified as a finance lease that is treated as per AASB 117 and the buildings are expected to be retained at the end of the lease. PV = $25 000 +

25 000  1  100 000 = $363 300 1 − + 0.07  (1.07)39  (1.07 )40

Payment schedule: Date

Rental $

Interest $

Principal $

Liability $

31.12.2018 30.06.2019 31.12.2019

25 000 25 000 25 000

– 23 680 23 590 $47 270

25 000 1 320 1 410

338 300 336 980 335 570

Amortisation of leased asset. (Cost – SV)/Useful life = ($363 300 – 0)/40 = $9 082

Bond NL Extract from the Statement of Comprehensive Income for year ended 31 December 2019 ______________________________________________________________ Sales revenue less Cost of goods sold: Production costs $2 100 000 Amortisation of pre-production costs 158 454 Amortisation of portable office buildings 9 082 Depreciation 105 000 2 372 536 Closing inventory 189 803

$5 566 000

2 182 733 3 383 267

Gross profit less Expenses: Selling expenses Administration expenses Interest expense Advertising Research and development

110 000 215 000 47 270 80 000 215 000 667 270

Profit before tax 2 715 997 less Income tax expense 710 000 Profit $2 005 997 ______________________________________________________________ a.

b. c. d. e. f.

The gold production plant is accounted for as a non-current asset and depreciated over its useful life. Its useful life is the life of the mine because its estimated life is greater than the estimated life of the mine and it will be abandoned when operations cease. The lease is treated as a finance lease. It is assumed that the risks and benefits of ownership are transferred to the lessee. The mining equipment is depreciated over its useful life because it is a construction cost rather than a development cost. Lease B is the same area of interest as Lease A. The costs of the research program were expensed in accordance with AASB 138 ‘Intangible Assets’. Advertising was expensed because the future economic benefits were not probable. . 21

Milicent Mining Company (a) ______________________________________________________________ Milicent Mining Company Extract from the Statement of Comprehensive Income for the year ended 30 June 2018 Sales revenues (i) less Cost of goods sold Production costs Restoration costs (ii) Amortisation expense (iii) Depreciation expense (iv)

$2 160 000 $510 000 93 358 827 255 198 865 1 629 478 211 832

Closing inventory (v) 1 417 646 Gross profit 742 354 less Expenses: Administration expenses 90 000 Finance costs 29 391 Selling expenses 205 000 324 391 Profit before income tax 417 963 Income tax expense 150 000 Profit $ 267 963 ______________________________________________________________ Extract from Statement of Financial Position as at 30 June 2018 ______________________________________________________________ Assets Inventory

$ 211 832

Mining properties (at cost) less Amortisation

$6 417 383 827 255 $7 456 470

Property, plant and equipment (at cost) less Accumulated depreciation

$1 580 000 198 865 $1 381 135

Liabilities Provision for restoration costs $490 132 ______________________________________________________________

. 22

Calculations: i. Sales revenue 4800 ounces @ $450/ounce = $2 160 000 ii. Restoration costs incurred as a result of production: On 30 June 2018, mine site restoration costs of $160 000 are estimated to have been incurred as a result of production. The present value of these costs is included as part of production costs. The present value is $93 358 or ($160 000 x (1.08)-7) iii. Amortisation expense Capitalised costs: Acquisition cost Restoration costsa Development costs

$5 600 000 367 383 450 000 $6 417 383

Amortisation charge per ounce: ($6 417 383 – $100 000) / 42 000 Amortisation expense: 5500 ounces  $150.41 a

= $150.41 per ounce = $827 255

On 30 June 2017, mine site restoration costs of $680 000 are estimated to have been incurred as a result of development and construction activities. The present value of these costs is included as part of pre-production costs capitalised with a corresponding increase recognised in a provision for restoration costs. The present value is $367 383or ($680 000 x (1.08)-8) iv. Depreciation expense Units of production method (cannot be economically removed): Mine buildings $500 000 Mine life $ 62 500 Mining equipment 820 000 Mine life 102 500 $1 320 000 Depreciation rate per ounce: = $1 320 000/42 000 ounces = $31.43 per ounce Depreciation = 5 500 ounces  $31.43 per ounce = $172 865

. 23

Depreciation over useful life (can be economically removed and used elsewhere) Processing equipment $260 000/10 years = $26 000 depreciation expense Total depreciation expense = $198 865 ($172 865 + $26 000) v.

Closing inventory Total production cost $1 629 478. 87% sold: 13% on hand Closing inventory = $1 629 478  0.13 = $211 832. vi. Finance costs (unwinding of the discount on restoration costs): Recalculated balance of provision for restoration costs Development ($680 000 x (1.08)-7) $396 774 Production ($160 000 x (1.08)-7) 93 358 Existing balance of provision for restoration costs ($367 383 + $93 358) Increase in provision recognising as a finance cost

$490 132 460 741 $29 391

(b) If reserve recognition accounting is used, the “Mining Properties” asset would be carried at the present value of the estimated economically recoverable reserves of gold and not at its historical cost less amortisation. Changes in the present value are recognised as revenues and expenses. 6

Della NL Assume Della capitalises all pre-production costs when permitted by AASB 6. Pre-production costs – Western Australia: 2016

Exploration

2017 2018

Evaluation Development

2019

Geological survey 2 700 000 Kimberley lease 11 000 000 Exploratory drilling 4 500 000 Feasibility study 16 000 000 a Railway 8 500 000 Depreciation of locomotive/ Wagonsb 562 500 Removal of overburden 4 000 000 Restoration costsc 751 077 Further drilling 8 000 000 . 24

Pre-production costs – end 2019 2020

56 013 577

Further feasibility study Costs to be amortised

10 000 000 66 013 577

The railway could also be depreciated separately over the life of the Kimberley area on a production basis because the estimated life of the railway (16 years) is greater than the estimated life of the Kimberley area (15 years); and the railway will be abandoned when mining operations cease in the Kimberley area. For expedience it is capitalised with preproduction costs and amortised. The end result (i.e. charge against revenue) is the same irrespective of whether the railway is depreciated or amortised.

Since the locomotive and wagons are used in the second half of 2018 to remove the overburden in preparation for production, ½ year of depreciation or $562 500 is capitalised as part of pre-production costs (annual depreciation is $1 125 000 ($18 000 000/16years), therefore ½ year is $562 500 ($1 125 000/2).

On 31 December 2018, mine site restoration costs of $1 800 000 are estimated to have been incurred as a result of mine site preparation (i.e. a development cost). The present value of these costs is included as part of pre-production costs capitalised with a corresponding increase recognised in a provision for restoration costs. The present value is $751 077 or ($1 800 000 x (1.06)-15)

Amortisation of pre-production costs – 2019 Pre-production costs to be amortised Amortisation of pre-production costs

= $66 013 577 = $66 013 577 x 3 500 000/36 000 000 = $6 417 985

Amortisation of pre-production costs – 2020 Pre-production costs to be amortised

= =

Economically recoverable reserves

Amortisation of pre-production costs

$66 013 577 – 6 417 985 59 595 592

36 000 000 + 24 000 000 – 3 500 000 = 56 500 000 = $59 595 592 x 4 200 000/56 500 000 = $4 430 110 . 25

Locomotive engine and wagons Locomotive engine and wagons should be depreciated over their useful life on a time basis because they are portable. Depreciation = $1 250 000

Diamond processing plant The diamond processing plant is depreciated over the life of the Kimberley area on a production basis because the estimated life of the diamond processing plant (25 years) is greater than the estimated life of the Kimberley area (15 years); and the diamond processing plant will be abandoned when mining operations cease in the Kimberley area. 3 500 000 Depreciation – 2019 = $21 000 000  = $2 041 666 36 000 000 Depreciation – 2020 Depreciable amount = 21 000 000 – 2 041 666 = $18 958 334 Economically recoverable reserves = 56 000 000 carats 4 200 000 Depreciation = $18 958 334  = $1 409 290 56 500000 Mining equipment The mining equipment is depreciated over its useful life, because the estimated life of the mining equipment (7 years) is less than the estimated life of the Kimberley area (15 years). $10 500 000 Depreciation of mining equipment = = $1 500 000 7 Restoration costs – 2020 At the end of 2020, Della has estimates that mine site restoration costs of $720 000 have been incurred as a result of production during the year. The present value of these costs is included as part of production costs. The present value is $337 564 or ($720 000 x (1.06)-13) Finance costs (unwinding of the discount on restoration costs): Recalculated balance of provision for restoration costs Development ($1 800 000 x (1.06)-13 ) Production ($720 000 x (1.06)-13)

$843 910 337 564

$1 181 474

. 26

Existing balance of provision for restoration costs ($751 077 + 337 564) Increase in provision recognising as a finance cost

1 088 641 $92 833

Sales revenue 3 300 000  $A13 Sales to Japanese company:

= 42 900 000

1 000 000  US$9.20 = US$9 200 000  1/0.88

= 10 454 545

Total sales revenue

$53 354 545

Foreign exchange gain/loss US$5 million paid on 1 December 2020: US$5 000 000  1/0.88 = US$5 000 000  1/0.91

$A5 681 818 $A5 494 505 (187 313)

(loss)

US$4.2 million outstanding on reporting date: US$4 200 000  1/0.88

$A4 772 727

US$4 200 000  1/0.92

$A4 565 217 (207 510)

Total foreign exchange loss

(loss) $394 823

Della NL Extract from the Statement of Comprehensive Income for the year ended 31 December 2020 Sales revenue 53 354 545 Cost of goods sold: Opening inventory 3 300 000 Production costs: Amortisation of pre-production costs 4 430 110 Depreciation – locomotive engine and wagons 1 250 000 – diamond processing plant 1 409 290 – mining equipment 1 500 000 Restoration costs 337 564 Other production costs 20 000 000 28 926 964 . 27

Costs of diamonds available for sale Closing inventory ($32 226 964 x 900000/4200000)

32 226 964 6 905 778

Cost of goods sold

25 321 186

Gross profit Foreign exchange loss Head office administration expenses Finance costs Selling expenses

$28 033 359 394 823 1 800 000 92 833 800 000 3 087 656 $24 945 703 2 700 000 $22 245 703

Profit before tax Income tax expense Profit after tax 7

Burke NL Assume that Burke capitalises pre-production costs when permitted by AASB 6

. Pre-production costs – Smile 2016

Leases (single area of interest) Geological survey Depreciation –drilling equipment Drilling program

$12 000 000 770 000 183 333 5 000 000

2017

Feasibility study Depreciation - drilling equipment

7 500 000 366 667

2018

Road Excavations Restorationa

7 000 000 11 000 000 1 350 672 $45 170 672

On 31 December 2018, mine site restoration costs of $2 500 000 are estimated to have been incurred as a result of mine site preparation activities. The present value of these costs is included as part of preproduction costs capitalised with a corresponding increase recognised in a provision for restoration costs. The present value is $1 350 672 or ($2 500 000 x (1.08)-8)

Amortisation 2019 = $45 170 672  18/144 = $5 646 334 . 28

Pre-production costs – Strahan

2017

Geological survey Mining lease

300 000 3 400 000

2018

Freight – drilling equipment Depreciation - drilling equipment Drilling program

22 000 366 667 1 980 000

2019

Depreciation – drilling equipment Feasibility study

366 667 2 700 000 $9 135 334

Assets – Smile Treatment plant Mining equipment a

Cost Useful life $36 000 000 Mine life (8yrs) $ 8 000 000 6 years

Depreciation $4 500 000a 1 333 333 $5 833 333

The treatment plant has a useful life (18 years) greater than the Smile area of interest (8 years). However, the treatment plant will be abandoned when the copper reserves have been exhausted. As a result, the treatment plant should be depreciated over the life of the mine using the units of production method as follows: $36 000 000 x 18 000/144 000 tonnes = $4 500 000 depreciation expense Burke NL Extract from the Statement of Comprehensive Income for the year ended 31 December 2019 Sales revenue less cost of goods sold Production costs $3 200 000 Amortisation of pre-production costs 5 646 334 Depreciation 5 833 333 Administration 1 300 000 15 979 667 Closing inventorya 2 663 278

$34 500 000

Gross profit less Expenses

21 183 611

13 316 389

. 29

Administration Selling Write-off Strahan Profit before tax Taxation

750 000 450 000 9 135 334

Profit after tax a

10 335 335 $10 848 276 2 100 000 $8 748 276

3 000/18 000 x $15 979 667

These questions are answered in the context of the 2015 Annual Financial Statements of Australian Mines Limited. (a) The current balance of exploration and evaluation assets carried forward as an asset is: $1 935 892 (Note 14, 2015 Financial Statements). Yes there is a possible issue about the current tenure of the areas of interest that relates to potential Native Title claims. However, the company cannot determine the existence or quantum of such claims at the time of issuing the financial statements. Note 24: (p. 56, 2015 Annual Financial Statements). ‘The Company’s mining tenements are subject to native title applications. At this stage it is not possible to quantify the impact (if any) that native title may have on the operations of the Company.’

(b) (i) From note 3(d) (p. 332), indicates that impairment is assessed at the level of cash generating units (CGUs). Extract from Note 3(d), p. 332 of 2015 Annual Financial Statements ‘Exploration and evaluation assets are assessed for impairment if sufficient data exists to determine technical feasibility and commercial viability, and facts and circumstances suggest that the carrying amount exceeds the recoverable amount (see impairment note, accounting policy note 3(f)). For the purposes of impairment testing, exploration and evaluation assets are allocated to cash-generating units to which the exploration activity relates. The cash generating unit shall not be larger than the area of interest.’

(ii) Yes, following a detailed technical review of the Nigerian assets, the Company concluded that the tenement would not be a commercially viable . 30

gold mining operation. The tenements however did contain economic grade manganese mineralisation. Due to a drop in the price of manganese during the period the Nigerian assets were impaired to zero as at 31 December 2014. In addition to the impairment the Company signed a Share Sale Agreement on 22 January 2015 for the sale of its shares in Mines Geotechniques Limited. (See Note 14, page 46.) (c) The company is silent on how it amortises economically recoverable reserves for mine property (which includes exploration, evaluation and developments costs carried forward in accordance with AASB 6 and other relevant standards). See the following extract from note 3(c)(iv) (p. 32, 2015 Annual Financial Statements) Extract: Note 3(c) (iv): ‘Exploration and development costs for reserves not yet in production are not amortised.’

The straight-line method of depreciation over the estimated useful lives of depreciable assets is used for all assets other than mine property ((which includes exploration, evaluation and developments costs carried forward in accordance with AASB 6 and other relevant standards). See the following extract from note 3(c)(iv) (p. 32, 2015 Annual Financial Statements). Extract: Note 3(c) (iv): ‘With the exception of freehold land and mining property and development assets, depreciation is charged to the Statement of Profit or Loss and Other Comprehensive Income on a straight-line basis over the estimated life of the asset, using rates per annum as set out below:

Buildings Plant & equipment Leased plant & equipment

2015 33% 33% 25%

2014 33% 33% 25%

Land is not depreciated, while buildings on mining tenements are given a short life. Exploration and development costs for reserves not yet in production are not amortised. The residual value, the useful life and the depreciation method applied to an asset are reassessed at least annually.’

. 31

(d) The current balance of the provision for mine rehabilitation is $0. Despite having an accounting policy for mine rehabilitation, the company does not yet appear to have recognised any provision. The company does not undertake comprehensive disclosure of any underlying assumptions used to measure the provision. The only information disclosed is shown in note 3(h) (2015 Annual Financial Statements, p. 36). Note 3(h), p.36: ‘Provisions are made for the estimated cost of rehabilitation relating to areas disturbed during the mine’s operation up to reporting date but not yet rehabilitated. Provision has been made in full for all disturbed areas at the reporting date based on current estimates of costs to rehabilitate such areas, discounted to their present value based on expected future cash flows. The estimated cost of rehabilitation includes the current cost of re-contouring, topsoiling and revegetation employing legislative requirements. Changes in estimates are dealt with on a prospective basis as they arise. Significant uncertainty exists as to the amount of rehabilitation obligations which will be incurred due to the impact of changes in environmental legislation. The amount of the provision relating to rehabilitation of mine infrastructure and dismantling obligations is recognised at the commencement of the mining project and/or construction of the assets where a legal or constructive obligation exists at that time. The provision is recognised as a non-current liability with a corresponding asset included in mining property and development assets. ‘At each reporting date the rehabilitation liability is re-measured in line with changes in discount rates, and timing or amount of the costs to be incurred. Changes in the liability relating to rehabilitation of mine infrastructure and dismantling obligations are added to or deducted from the related asset, other than the unwinding of the discount, which is recognised as a finance cost in the Statement of Profit or Loss and Other Comprehensive Income as it occurs. ‘If the change in the liability results in a decrease in the liability that exceeds the carrying amount of the asset, the asset is written-down to nil and the excess is recognised immediately in the Statement of Profit or Loss and Other Comprehensive Income. If the change in the liability results in an addition to the cost of the asset, the recoverability of the new carrying amount is considered. Where there is an indication that the new carrying amount is not

. 32

fully recoverable, an impairment test is performed with the write-down recognised in the Statement of Profit or Loss and Other Comprehensive Income in the period in which it occurs. ‘The amount of the provision relating to rehabilitation of environmental disturbance caused by on-going production and extraction activities is recognised in the Statement of Profit or Loss and Other Comprehensive Income as incurred. Changes in the liability are charged to the Statement of Profit or Loss and Other Comprehensive Income as rehabilitation expense, other than the unwinding of the discount which is recognised as a finance cost.’

. 33

Chapter 20 ACCOUNTING FOR AGRICULTURAL ACTIVITY LEARNING OBJECTIVES After studying this chapter you should be able to: 1

define biological assets;

identify the appropriate accounting classification for biological assets;

analyse the alternative methods of measuring biological assets;

discuss the issues in accounting for changes in the carrying amount of biological assets;

explain and apply the requirements of AASB 141 ‘Agriculture’ to the measurement of biological assets; and

explain and apply the requirements of AASB 141 ‘Agriculture’ to agricultural produce.

QUESTIONS 1

Biological assets are living animals or plants and include consumables with both longterm and short-term production cycles.

Bearer biological assets produce revenues more than once. Animal bearer biological assets include sheep used for wool production and cattle used for breeding or milk production. Plant bearers include orchards and grape vines. Consumable biological assets produce revenues only once, i.e. when they are harvested or slaughtered. Animal consumable biological assets include sheep and cattle bred for meat production. Plant consumable biological assets include vegetables, flowers and cereal crops. However, flowers may be bearers if the plants continue to produce blooms over an extended period.

Biological assets can be broadly classified as animals and plants. Each of these categories can be subdivided into ‘bearers or consumables’. Bearers are biological assets that generate revenue by producing output. Animal bearers include sheep used for wool production, cattle used for milk production and animals used for breeding. Consumables produce revenues only once when they are slaughtered or harvested. Animal consumables include animals that provide revenue as a result of them being slaughtered. Plant bearers include orchards and vineyards. Plant consumables include vegetables and flowers. Consumables may be further classified as ‘short term’ or ‘long term’. Short-term consumables generate revenue in the immediate future. Animal short-term consumables would include cattle awaiting slaughter. Animal long-term consumables would include cattle being fattened for slaughter. Plant short-term consumables would include vegetables and flowers. Plant long-term consumables would include forests.

Consumable biological assets generate revenue when they are slaughtered or harvested. Whether they should be classified as current or non-current assets is not straightforward. Short-term consumables are probably inventories. They satisfy the AASB 102 definition of inventories. Biological assets such as growing cereal or vegetable crops and cattle awaiting slaughter are in the process of production for sale, or in the form of material or supplies to be consumed in the production process. They should be included among current assets as the future economic benefits from them are likely to be realised within twelve months of the reporting date.

. 2

The treatment of long-term consumables depends on the criteria used to classify assets as current or non-current. The ‘traditional’ criterion is that assets that are expected to be realised ‘within twelve months of the reporting date’ should be classified as current. Using this criterion, long-term consumable biological assets should be classified as noncurrent assets until the end of the growth period is less than twelve months away. At this point they should become current assets. AASB 101 ‘Presentation of Financial Statements’ defines a current asset as one that is: ‘(a) expected to be realised in, or is intended for sale or consumption in, the normal course of the entity’s operating cycle …’ (para. 57). An operating cycle is defined as ‘the time between the acquisition of assets for processing and their realisation in cash or cash equivalents’. Adoption of the AASB 101 definition is likely to result in long-term consumable biological assets being classified as current assets. 5

The cost of an asset is the value of the consideration surrendered to acquire it. The use of cost to measure animal biological assets is, however, of limited use. In many cases animals are not purchased. They are the progeny of breeding stock owned by the entity. While these animals have a cost, it is very difficult to measure it with any degree of confidence. These costs include joint costs such as fencing, fertilising, feeding, labour and, perhaps, ‘depreciation’ of the breeding stock. These costs can be allocated to individual animals by, at best, crude arbitrary allocation procedures. The cost of an individual animal depends on a series of arbitrary estimates, which probably would not satisfy the Framework (2014)’s recognition criterion of reliability. There is also a belief that cost is an irrelevant measure of animals. For animals, which take a long time to grow to maturity, value is much more dependent upon growth than upon costs incurred, even if they could be reliably measured.

The discounted-market-value method of measuring animal biological assets is the net market value reduced by an amount to provide for possible future reductions in market price. It is a conservative variation of net market value.

Many would agree with this statement. The prices of livestock may change significantly over time. The use of net market values for animals could result in significant fluctuations in the carrying amount of assets. It is argued, however, that any volatility in carrying amount reflects reality and provides relevant information to statement users. . 3

Significant changes in the net market value of animals are relevant information for report users and the financial reports should disclose this information. 8

Roberts, Staunton and Hagan suggest that there are three possible cost-based methods for measuring forestry biological assets. They are: (a) historical cost (b) compounded historical cost; and (c) replacement cost. There is an opinion that these approaches are inappropriate, primarily because they do not provide information that is relevant for financial report users.

The first sentence in the quotation is correct. The second is a matter of opinion. It is correct to argue that changes in the net market value of a biological asset are due to two factors: (a) growth in the asset; and (b) changes in the selling price of the asset. For example, during a year a tree may increase in value because it grows and because the price of timber increases. It has been traditional to regard increases in the value of a non-current asset as increments to equity rather than as income. There is, however, a shift towards recognising increases in the value of investments as income. For example, AASB 139 ‘Financial Instruments: Recognition and Measurement’, AASB 9 ‘Financial Instruments’ and AASB 1023 ‘General Insurance Contracts’ require ‘mark-to-market’ accounting for particular investments, with all changes in value being recognised in the statement of comprehensive income. The reluctance to recognise increases in value as income was a result of the fact that they are not necessarily certain. They may be reversed in subsequent periods if prices fall. The traditional notion of conservatism required a high degree of certainty before income was recognised. It has been argued that, in the case of biological assets, the increase in value due to growth is irreversible and that the traditional strictures of conservatism do not apply. Thus, while there may be hesitancy about recognising as income changes in value due to price changes (which could be reversed), changes in value due to growth should be recognised as income because they are not reversible. Acceptance of this argument is a matter of opinion.

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10 This is a matter of opinion. The conservative view represented by this statement is that the income is not realised until it is virtually certain. Increases in value are not certain as they can be reversed. Gains in value in one period may be lost in a subsequent period. The traditional view is that income is not earned until it is realised by sale. A contrary point of view is reflected by the Framework (2014), which lowers the probability for the recognition of income from virtual certainty to more likely than less likely. With this interpretation, an increase in value may be recognised as a gain provided the Framework’s definition of income is satisfied and the inflow of resources is ‘probable’. 11 The statement is incorrect. AASB 141 requires that biological assets must be measured at fair value less costs to sell (AASB 141.12), except where fair value cannot be reliably measured (AASB 141.12 – see below). However, where there are no market-determined prices or values available for a biological asset in its present condition, cost may approximate fair value (AASB 141.24). In some cases, little biological transformation may have occurred since initial recognition (e.g. tree seedlings recently planted in a plantation forest). Alternatively, the impact of biological transformation on price may not be material (e.g. initial growth of a pine plantation on a 30-year production cycle). Where market prices are unavailable, it may also be the case that estimates of fair value on initial recognition of a biological asset are unreliable (e.g. foals of racing horses – at the point of initial recognition, it would be impossible to determine the potential quality of the foals and world prices when the foals are mature). In this situation, the biological asset is measured at cost until such time as it is possible to reliably estimate its fair value. 12 The statement is incorrect. No distinction is made between value changes due to growth and price changes. All changes in value, regardless of their origin, are treated as gains or losses. For biological assets with a production cycle of greater than one year, disclosure of the change in fair value less costs to sell due to growth and due to price changes is encouraged in paragraph 51 of AASB 141. However, this disclosure is not mandatory. 13 Fall within the Scope of AASB 141? Pearl oysters fit the definition of biological assets as living animals. They are also managed as part of agricultural activity (i.e. the biological transformation of the pearl oysters into agricultural produce (i.e. pearls) is managed by Atlas Pacific). Thus, they fall within the scope of AASB 141.

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Measurement at Cost? There is a presumption in AASB 141 that fair value can be measured reliably. However, this presumption can be rebutted upon initial recognition of a biological asset for which ‘market-determined prices or values are not available and for which alternative estimates of fair value are determined to be clearly unreliable’ (para. 30). In this situation, the biological asset is measured at its cost less accumulated depreciation and any accumulated impairment losses. Given the uncertainty and risk that exists in the process of producing a pearl it seems reasonable to argue that fair value cannot be reliably estimated. In this situation, the biological asset is measured at its cost less accumulated depreciation and any accumulated impairment losses. This is the measurement basis employed by Atlas Pacific. 14 AASB 141 requires that the agricultural produce of biological assets must be accounted for in accordance with AASB 102 ‘Inventories’. For the purposes of AASB 102, the cost of the agricultural produce is deemed to be its fair value less costs to sell at the time of harvest. For example, the ‘cost’ of felled logs for the purposes of AASB 141 is the fair value of the logs immediately after felling, determined by reference to the most likely market for the felled logs. Any relevant estimated costs to sell are deducted from the fair value of felled logs. These costs may include brokerage commissions, levies by regulatory agencies, transfer taxes and duties.

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PROBLEMS 1

(a) The fish are live finfish (salmon) which are biological assets. They are consumable biological assets taking approximately 16 months to grow from juveniles to harvest. They are disclosed as current assets because they are in the nature of inventory (i.e. expected to be consumed during the course of an operating cycle of 16 months). Disclosures would appear in the balance sheet, notes to the accounts (i.e. note on accounting policy and note on biological assets), and as part of profit or loss in the statement of comprehensive income. (b) An increase in fish size can improve operating earnings forecasts because of biological transformation which is a feature of biological assets. The fish have changed through the process of growth – i.e. their volume has increased with the same incurrence of variable costs (e.g. nutrients) and fixed costs (e.g. maintenance of cages). Thus, a greater volume of biomass (i.e. fish) has been produced for the same cost which has the effect of decreasing the average fish costs and therefore increasing current and future earnings.

Splinter Timber Corporation Ltd (a) The company would record a loss of $400 000 in the current financial year. The general journal entries would be as follows: i Revalue the forest to net realisable value __________________________________________________________ Revaluation loss Dr $400 000 Forest Cr $400 000 __________________________________________________________ ii Sell the forest for cash __________________________________________________________ Cash at bank Dr $5 000 000 Forest Cr $5 000 000 __________________________________________________________ (b) Over the forest’s life, the company would record a profit of $4 800 000 – $400 000, or $4 400 000. These profits were recognised as valuation adjustments.

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The Radiata Company Ltd (a) (i) 30 November 2019 _________________________________________________________ Inventory of logs Dr $2 400 000 Value of inventory recognised as a gain Cr $2 400 000 Harvesting costs Dr 480 000 Cash at bank Cr 480 000 __________________________________________________________ (ii)

15 February 2020 __________________________________________________________ Sales revenue Dr $2 000 000 Cash at bank Cr $2 000 000 __________________________________________________________ Cost of logs sold Dr $2 400 000 Inventory of logs Cr $2 400 000 __________________________________________________________ Revaluation loss on forest Dr $2 100 000 Forest Cr $2 100 000 __________________________________________________________

(b) Gain recognised in log inventory ($2 400 000 – 480 000) $1 920 000 Revenues from sale of logs 2 000 000 Cost of logs sold (2400 000) Revaluation increment (4 600 000 – 2 500 000) (2100 000) Profit (loss) from operations $ (580 000) 4 Fibre Company Ltd (a) The underlying rationale for the exclusion of bearer biological assets which are capable of biological transformation from the scope of AASB 141 is that mature bearer biological assets are similar to an item of plant. That is: • when mature the primary biological transformation associated with bearer biological assets such as almond trees in an orchard is due to the produce growing (e.g. almonds); and • the only purpose of the bearer biological assets is to produce agricultural produce. In light of these two characteristics, it is argued that bearer biological assets are in the nature of property, plant and equipment and are therefore to be accounting for in accordance with AASB 116.

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(b) (i) Knocking of the almonds ________________________________________________________ Inventory of almonds Dr $300 000 Value of inventory recognised as a gain Cr $300 000 Harvesting costs Dr 70 000 Cash at bank, payable Cr 70 000 __________________________________________________________ (ii) Sale of the almonds __________________________________________________________ Cash at bank Dr $260 000 Sales revenue Cr $260 000 __________________________________________________________ Cost of almonds sold Dr $300 000 Inventory of almonds Cr $300 000 __________________________________________________________ (iii) Other costs Depreciation expense Dr $150 000 Accum. depreciation – almonds Cr $150 000 _________________________________________________________ (c) Revenue in almond inventory (300 000 – 70 000) Revenue from sale of almonds Cost of almonds sold Depreciation of trees Profit from operations

$230 000 260 000 (300 000) (150 000) $40 000

Stock Enterprises Ltd (a) (i) _________________________________________________________ Biological asset – cattle Gain on biological asset

Dr Cr

42 000 42 000

(AASB 141, para. 27: 3000 calves @ $14 = $42 000) _________________________________________________________

(ii) _________________________________________________________ Cash at bank Dr 30 000 Brokerage fees and taxes payable Cr 4 500 Biological asset – cattle Cr 25 500 _________________________________________________________ (The answer assumes that Stock Enterprises does not measure the net realisable value of biological assets on hand immediately before sale. The decrement in biological assets will be recognised at the year end when the difference in opening and ending carrying amounts is recognised as a gain or loss and included in the statement of comprehensive income.) (iii) _________________________________________________________ Inventory – carcasses Dr 80 000 Gain on inventory of carcasses Cr 80 000 Slaughter costs Dr 13 000 Slaughter costs payable Cr 13 000 _________________________________________________________ (b) and (c) Carrying amount before revaluation* = $516 500 Carrying amount after revaluation** = $600 000 * Carrying amount before revaluation: Opening balance $500 000 + Natural increase 42 000 – Sale 25 500 Carrying amount $516 500 ** Carrying amount after revaluation: The biological asset is required to be held at fair value less costs to sell (given as $600 000). The following general journal entry would be passed to record the revaluation increment: 30 June 2020 _______________________________________________________________ Biological asset – cattle Dr 83 500 Revaluation increment (gain) Cr 83 500 ($600 000 – 516 500 = $83 500) _______________________________________________________________ . 10

(d) Gain recognised on natural increase Gain recognised in inventory of carcasses (80 000 – 13 000) Revaluation increment Less: veterinary and other expenses Profit from livestock operations

$ 42 000 67 000 83 500 $192 500 90 000 $102 500

Airlie Ltd During the year – Harvest of fruit _________________________________________________________________ Inventory of fruit Dr $13 900 000 Value of inventory harv’d (gain) Cr 13 900 000 Harvesting costs Dr 7 000 000 Cash at bank Cr $7 000 000 _________________________________________________________________ (The fair value less selling costs less transportation costs is equal to $13 900 000 ($15 200 000 – $900 000 – $400 000) During the year – Transportation of fruit to market The transportation costs to markets totalling $300 000 are specifically excluded from costs to sell in AASB 141 and are to be recognised as period costs. _________________________________________________________________ Transportation costs (expense) Dr $300 000 Cash at bank Cr $300 000 _________________________________________________________________ During the year – Sale of fruit _________________________________________________________________ Cash at bank Dr $14 200 000 Sales revenue Cr $14 200 000 Cost of fruit sold Dr 13 900 000 Inventory of fruit Cr 13 900 000 _________________________________________________________________

30 June 2020 – Recognise depreciation of fruit trees in the orchard _________________________________________________________________ Depreciation expense Dr $400 000 Accum. depreciation Cr $400 000 _________________________________________________________________ 7

Sustainable Forest Company October – December 2019 (at the time of harvest) The inventory of logs is carried at its fair value less selling costs: $8 400 000 fair value (60 000) transportation costs (adjust fair value as per AASB 13) (235 000) state government levy (cost to sell) $8 105 000 fair value less costs to sell Paragraph 5 of AASB 141 defines costs to sell as incremental costs directly attributable to the disposal of an asset. Since the harvesting costs of $460 000 are not directly attributable to the disposal of the logs harvested, they are recognised as a period cost. Inventory of logs Dr Value of inventory recognised as a gain Cr

Harvesting costs Cash at bank, payable

$8 105 000 $8 105 000

Dr Cr

460 000

Cash at bank Sales revenue

Dr Cr

$9 900 000

Cost of logs sold Inventory of logs

Dr Cr

$8 105 000

State government levy expense Dr Selling expenses payable Cr

240 000

Transportation costs Cash, payables

80 000

460 000

31 December 2019 (sale of logs)

Dr Cr

$9 900 000

$8 105 000

240 000

80 000

30 June 2020 (end of the annual reporting period) Revaluation decrement (loss) Biological asset – Forest

Dr Cr

$10 000 000 $10 000 000

($14 000 000 – $24 000 000 = $10 000 000 decrement) 8

Almonds Galore Ltd During year ended 30 June 2020 – Harvest of agricultural produce The estimated fair value of the almonds less costs to sell is calculated as follows: $1 400 000 fair value (13 000) transportation costs (AASB 13) (60 000) selling costs (sales commission) $1 327 000 Paragraph 5 of AASB 141 defines costs to sell as incremental costs directly attributable to the disposal of an asset. Since the harvesting and packaging costs of $350 000 are not directly attributable to the disposal of the almonds picked, they are recognised as a period cost. Inventory of almonds Dr Value of inventory recognised as a gain Cr

$1 327 000

Harvesting and packaging costs Dr Cash at bank Cr

350 000

$1 327 000 350 000

2 May 2020 – Sale of almonds Cash at bank Sales revenue

Dr Cr

$1 500 000

Cost of almonds sold Inventory of apples

Dr Cr

$1 327 000

Sales commission expense Sales commission payable

Dr Cr

$65 000

Transportation expense Transportation costs payable

Dr Cr

$15 000

$1 500 000

$1 327 000

$65 000

$15 000

30 June 2020 – depreciation charge recognised Depreciation expense Accumulated depreciation

9 (a)

Dr Cr

$800 000 $800 000

This phrase is referring to the requirement of AASB 141 (para. 12) to measure biological assets at fair value less cost. Any subsequent increments or decrements in fair value less costs to sell are included in profit or loss in the statement of comprehensive income (para. 26). Since the fair value of beef cattle is typically determined by market prices the term ‘mark-to-market’ is used. The lack of appreciation in cattle value is most likely attributable to the drought leading to producers selling more cattle stock during the period which forced the market value of cattle down for the quarter.

(b)

The value of biological assets such as cattle is determined by two factors: (a) changes in the price of the cattle and (b) biological transformation which results in growth of the beef cattle (i.e. an increase in volume). In this case, for the period ended 30 September 2003 beef producers had been forced to sell their beef cattle due to the drought (and therefore an inability to maintain the cattle). This meant that there was a decrease in the price of the cattle due to the increased quantity of beef cattle for sale. There would also be volume decreases because the drought would mean less feed, and thus leaner cattle. AASB 141 (para. 26) requires that any changes in the fair value less costs to sell of consumable biological assets are included in profit or loss. For AACo, in the corresponding last quarter, the market value of cattle increased by 7.5% (thereby resulting in an increase in income and ultimately profit). In contrast, during the current quarter the increased sales volume of cattle due to the drought resulted in a decrease in the price of cattle and so no appreciation of the cattles’ market value occurred. The general journal entry to give effect to a decrement in value is: Revaluation increment (loss)

Biological assets (cattle)

Thus if this is what is being alluded to in the announcement, then profit for the quarter has been decreased by a direct expense charged to profit or loss. . 14

Alternatively, if there was no decrement recorded by the company but simply no increase in value (i.e. no appreciation in cattle value), then in previous periods the following general journal entry would have been recorded resulting in an increase in profit. Biological assets (cattle)

Revaluation increment (gain)

This entry has not been recorded in the current quarter (i.e. ‘no appreciation in cattle value) and so there is no gain included in profit or loss. Thus, AACo is suggesting that the inability to recognise increases in the fair value of beef cattle as a gain in the current quarter ending 30 September 2003 led to the loss of $3.2m compared with the prior period profit of $7.7m. (c)

It is for the student to arrive at an opinion on the validity of this statement. In so doing the following arguments for and against the use of fair value less costs to sell should be discussed. On the one hand, the main difficulty of using fair value less costs to sell is volatility. The prices of livestock may change significantly over time due to climatic conditions, disease and natural disasters. The use of fair value less costs to sell for animals could result in significant fluctuations in the carrying amount of assets. On the other hand, it is argued, that any volatility in carrying amount reflects reality and provides relevant information to statement users. It reflects the inherent risk of an investment in livestock, and it provides a relevant basis for assessment of the effects of management’s decisions to buy, sell or hold livestock for a period of time. Significant changes in the net realisable value of animals is relevant information for report users, and the financial statements should disclose them. An additional consideration is that AASB 141 requires changes in the fair value less costs to sell of biological assets to be recognised as income or expense in profit or loss. This also introduces volatility into operating profit. On the one hand, it has been argued that the recognition of unrealised income or expense will cause unnecessary earnings volatility (with these increments/decrements likely to reverse in future periods anyway); and may erode capital as unrealised profits are distributed as dividends. On the other hand, it has been argued that the earnings volatility reflects the nature of an investment in agriculture.

These solutions are based on the 2015 Annual Financial Statements of Webster Ltd. Note that Webster Ltd has not elected to early adopt the revised AASB 141 which excludes

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bearer biological assets such as walnut orchards from its scope. As a result, these trees are still included as part of biological assets. (a) See Note 11, p. 59 Biological assets totalled $33 964 000 at 30 June 2015. This comprised walnut orchards and nursery walnut trees. The company also produces onions but at 30 June 2015, there was no crop of onions (just an inventory of agricultural produce (i.e. onions) from the last crop). (b) See Note 1(e) p. 44 Growing walnut trees are valued at their growing cost until they bear their first commercial crop. After this time, they are valued using a discounted cash flow methodology. The growing crop is valued at current selling prices and current costs of growing, processing and selling; and this amount is discounted which takes into account (1) the crops immaturity and (2) agricultural risk. (c) See Note 11, p. 59 and Statement of Comprehensive Income (p. 36) Total change in fair value less estimated selling costs is $0. (d) See Note 11, p. 59 The company has a total of 1995 hectares of orchard area. A total of 5835 tonnes of walnuts were harvested; and 50 220 tonnes of onions were grown.

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Chapter 21 ACCOUNTING FOR SUPERANNUATION ENTITIES LEARNING OBJECTIVES After studying this chapter you should be able to: 1

explain the nature of superannuation;

discuss the reports prepared by superannuation entities;

explain the need for the preparation of general purpose financial statements by superannuation entities;

identify the issues in accounting for the assets and liabilities of superannuation entities and apply the requirements of AASB 1056 ‘Superannuation Entities’;

discuss the issues in preparing financial statements for superannuation entities and apply the requirements of AASB 1056 ‘Superannuation Entities’; and

compare and contrast the requirements of AASB 1056 ‘Superannuation Entities’ with the requirements of AAS 25 ‘Financial reporting by Superannuation Plans’.

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QUESTIONS 1

A superannuation plan is a scheme to provide retirement benefits to a specified group of employees. Money contributed by the employer(s) and/or the employees is paid to a trust fund administered by trustees. The trustees invest this money to earn sufficient revenue to provide the employees with a lump sum payment or a pension on retirement or a combination of lump sum payment and pension.

A defined benefit superannuation plan specifies the benefits that will be received by members of the plan. The trustees must ensure that contributions to the plan and the investment performance of the plan are sufficient to meet the defined benefits. A defined contribution superannuation plan specifies the contributions that must be made by the employees and the employer. The trustees then determine the amount of the benefits from time to time, depending on the financial position of the plan.

A self-managed superannuation plan is managed by the trustees of the plan who make the investment and all other decisions associated with the plan. With an externally managed plan, the trustees employ professional managers to manage the plan’s investments. These professional managers are usually banks, life insurance companies, trustee companies or investment consultants. The trustees are, of course, ultimately responsible for externally managed plans. A superannuation plan is contributory if employees bear part of the cost of the benefits. The employees of a contributory plan usually make periodic payments to the trustees of the plan during their years of employment. A non-contributory plan exists if all the contributions are made by the employer with the employees paying nothing to the plan.

(a) Students can nominate to discuss: • the ‘Stronger Super’ legislation which has been progressively introduced since 2011 in the form of Superannuation Legislation Amendment (Further My Super and Transparency Measures) Act 2012 and the Superannuation Legislation Amendment Act (My Super Core Provisions) Act 2012; • the Financial Services Reform (FSR) Act 2001; or • the Superannuation Industry (Supervision) (SIS) Act 1993. Details of each are as follows. The Stronger Super legislation arose from the Cooper Review of the superannuation industry. Its aim is to create a low-cost default superannuation product called ‘My Super’ and to strengthen the governance, integrity and regulatory settings of superannuation plans. To this end, a register of selfmanaged superannuation fund auditors has been established, plan trustees are required to disclose the total portfolio of holdings of their plan biannually on the plan’s . 2

website, and the remuneration of executive officers and trustees is to be disclosed on the plan’s website. The Financial Services Reform Act is designed to provide standardisation within the financial services industry. Under the FSR Act a trustee of a superannuation plan must have a licence as a provider of financial products and services. The FSR Act also stipulates the information to be provided on any financial products to plan members (existing and prospective), and sets out the requirements that determine good conduct and misconduct rules for superannuation plans. Compliance with the FSR Act is monitored by the ASIC. (a) and (b) The Superannuation Industry (Supervision) (SIS) Act 1993 regulates the operations of superannuation plans, and includes financial and reporting standards. In summary, the SIS Act 1993 in conjunction with APRA’s relevant Prudential Standards and Reporting Forms require the preparation of general purpose financial statements by superannuation plans without specifying the content of such statements. Specifically, section 35A of the Act requires self-managed superannuation entities to prepare a statement of financial position. Section 35B of the Act requires registerable superannuation entities to maintain data to allow the preparation of reports referred to in section 13 of the Financial Sector (Collection of Data) Act 2001, and specified by APRA. In particular, APRA requires the presentation of a statement of financial position (Reporting Form SRF 320) and a statement of financial performance (Reporting Form SRF 330) that are audited in accordance with Prudential Standard SPS 310 ‘Audit and Related Matters’. Additionally, a triennial actuarial investigation for defined benefit superannuation plans is required in accordance with section 34C of the SIS Act and Prudential Standard SPS 160 ‘Defined Benefit Matters’. The detail of these reports has been left to accounting standard setters. They have addressed this task via AASB 1056 ‘Superannuation Entities’ (and previously AAS 25). 5

An actuarial report provides information about the current and future solvency of a superannuation plan. Thus it is necessary for effective management because it alerts trustees to any significant issues surrounding the ability of the superannuation entity to provide member benefits. An actuarial report is prepared by an actuary, and would typically read as follows: The last actuarial valuation of the scheme was made on 30 June 2017. In that report, an employer contribution of 10 per cent of members’ salaries (twice members’ contributions) was recommended payable until the issue of the next report on 30 June 2020 unless reviewed earlier. This recommendation was based on aggregate funding without distinction between future and past service.

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It is confirmed that the scheme is expected to be able to meet its obligations provided that the recommended employer contributions are maintained. If the scheme had been terminated at the valuation date, the value of the termination benefits would have exceeded the market value of its assets by 12 per cent. 6

There is general agreement that individuals need some information about their individual rights and obligations under the plan and some reassurance that the plan is solvent, well managed and that their individual benefits are likely to be paid. While there are varying opinions on what should be disclosed, the following information would probably be regarded as adequate: (a) total member contributions; (b) total employer contributions; (c) the amount payable now on the death of the member either as a lump sum or as a pension to the surviving spouse; (d) the amount payable now on the resignation of the member; (e) the amount payable on retirement at various ages either as a lump sum or as a pension; and (f) the average rate of return on plan assets. In addition, members of superannuation plans would probably need a statement from the trustees and actuaries that the plan is solvent and that their individual benefits will probably be paid.

The basis for this statement is an assumption that members generally are likely to be less financially literate than shareholders because of the compulsory nature of superannuation. The financial reports of companies are prepared on the assumption that the users of those reports have a reasonable knowledge of business and economic activities and who review and analyse the information diligently (Framework 2014). Because it cannot be assumed that members of superannuation plans have these skills, the assumption underlying the preparation of general purpose financial reports is less likely to be valid. Members of superannuation plans, therefore, need simpler reports than shareholders. The acceptability of the statement is a matter of opinion. While some may accept that a different class of users requires a different type of financial report, others may see the statement as an insult to members of superannuation plans. An alternate interpretation of the quote may be that the members of superannuation plans may have different information needs than those of individuals who invest in or lend to for-profit entities. The former may be most interested in the ability of the superannuation plan to pay benefits as they fall due and so may have a greater interest in, say, measuring all assets at fair values. Although investors and creditors are also

. 4

interested in liquidity, they also have other information needs that are broader than those of plan members. 8

In accordance with Statement of Accounting Concept (SAC) 1, general purpose financial reports are prepared for users who do not have the influence to demand special purpose financial reports. General purpose financial reports are not designed for any particular user group. They contain information that should be useful to most potential users but which are not presented to meet the needs of a dominant group. The trustees of superannuation plans should prepare general purpose financial reports only if there are potential users who do not have the power to demand ‘tailor-made’ financial statements. The primary users are likely to be plan members and beneficiaries, but that other potential users would be potential members, employers, trustees and plan administrators, trade unions, regulators and the general public. Clearly, judgement will need to be exercised by the trustees in determining whether there are groups who lack the influence to obtain special purpose financial reports and therefore must rely upon general purpose financial reports. Additionally, the AASB argues that financial statements play an important role by providing a basis for information reported in trustees’ annual reports to members and members individual benefit statements (which are not subject to audit or the same level of disclosure (Basis for Conclusions, para. BC248).

This is a matter of opinion. A persuasive case could be made that for many employees, their superannuation benefits are a major asset and that they should be given all the information they need to plan their retirement. A failure to provide adequate information may result in false expectations of a large superannuation benefit for some and others may curtail their consumption expenditures because they are unaware of their net worth. Alternatively, it could be argued that general information about the financial position and performance of the plan is sufficient. Such information could enable individual members to assess the health of the superannuation plan which has a direct impact on the plan’s ability to pay individual benefits. Thus, individual member benefit statements are not necessary.

10 General purpose financial reports should provide information to help answer three questions: (a) Is the plan solvent? (b) Will the plan remain solvent? and (c) Are the trustees diligently performing their responsibilities? Answering the first question may be helped by listing plan assets at their current realisable amounts and by listing the amounts owing as at the reporting date. . 5

Answering the second question may be helped by estimating future contributions, earnings and payments. Answering the third question may be helped by providing general purpose financial reports supported by an auditor’s opinion as to their truth and fairness. The Association of Superannuation Funds of Australia (ASFA) also recommended the inclusion of an actuarial report, and a trustees’ report which should ‘disclose matters not directly relevant to the annual accounts … but important enough to be drawn to the attention of interested members’. It is suggested that the trustees’ report should cover matters such as: (a) details of the scope of the plan; (b) names of the trustees and the basis of their appointment; (c) names of any professional advisers; (d) details of membership; (e) basis of employer contributions; (f) details of any material indebtedness to or investment in the employer; (g) an outline of the rules and any changes which have been made to the rules; and (h) a description of investment policies and rates of return. The actuarial report recommended by ASFA provides information about the current and future solvency of the plan. The actuarial report should include: (a) the date of the last full investigation and valuation; (b) the funding method assumed; (c) whether current rates of employer contributions are likely to vary materially in the future; (d) any contingent liability in the event of plan termination; and (e) the date of the next full investigation and valuation. 11 Paragraph 13 of AASB 1056 requires superannuation plan assets to be measured at fair value at each reporting date, with the exception of tax assets, acquired goodwill, insurance assets and employer-sponsored receivables. Changes in fair value are to be recognised through the income statement. No specific guidance is provided on the determination of fair value, and so the relevant principles and requirements of other accounting standards such as AASB 13 ‘Fair Value Measurement’ are to be applied. Acquired goodwill, tax assets, insurance assets and employer-sponsored receivables are excluded from measurement at fair value on the grounds that it is inappropriate, the costs of so doing outweigh the benefits, and it will not provide users with additional understanding of the superannuation entities’ financial statements (Basis for Conclusions, para. BC145, BC153). Instead, acquired goodwill is measured in accordance with the requirements of AASB 3 ‘Business Combinations’, tax assets are measured in accordance with the requirements of AASB 112 ‘Income Taxes’ and employer-sponsored receivables and insurance assets are measured in accordance with . 6

the requirements of AASB 1056. In particular, employer sponsored receivables are as the difference between a defined member benefit liability and the fair value of assets available to meet the liability (para. 18). Insurance assets are only recognised and measured when a superannuation entity takes on insurance risk. In this case the assets are measured using the approach specified in AASB 119 ‘Employee Benefits’ for defined benefit member liabilities. The AASB’s rationale for requiring plan assets to be measured at fair value is explained in Basis for Conclusions (para. BC47). That is, • the measurement of assets at fair value through profit or loss provides members of superannuation entities with useful information about an entity’s capacity to pay defined contribution and defined benefit member benefits. The primary function of superannuation plans is to act as a vehicle for the accumulation of assets to pay benefits to members and beneficiaries. Measuring assets at fair value as at the reporting date provides more relevant information to users about the resources available to pay benefits than does the cost basis of measurement. • Additionally, the use of fair value enhances the comparability of the financial statement of superannuation entities with other entities. Students can express an opinion that coincides with that of the AASB expressed above. The alternate view is that measuring the fair value of many assets is too subjective, that this measure gives rise to too much volatility in earnings, and that taking value changes to profit or loss results in recognising profits which may never be realised. These are, of course, the traditional arguments against a departure from historical cost. An additional consideration is that all assets (bar the few exceptions discussed above) are required to be measured at fair value. Thus, while the use of fair value may be justified for investments, it cannot be sustained for operating assets that are held for use and not to earn revenue directly. As the operating assets are held for use, perhaps historical cost is a more appropriate valuation basis. 12 The requirement of AASB 1056 to measure most assets at fair value does represent a departure from the approach adopted in other Australian accounting standards where several measurement bases are allowed. For example, AASB 116 ‘Property, Plant and Equipment’ allows property, plant and equipment to be measured at cost or fair value. In contrast, AASB 1056 eliminates this choice and requires that property, plant and equipment held by superannuation entities are measured at fair value with changes in fair value recognised in income. Another example is provided by AASB 9 ‘Financial Instruments’ which allows financial assets to be measured at fair value through profit or loss, fair value through other comprehensive income and in rare cases at cost. In contrast, AASB 1056 requires that all financial assets are measured at fair value with re-measurement changes recognised in profit or loss. . 7

Standard setters argue that the measurement of assets at fair value through profit or loss provides members of superannuation entities with useful information about an entity’s capacity to pay defined contribution and defined benefit member benefits, and enhances the comparability of the financial statement of superannuation entities with other entities (Basis for Conclusions, para. BC47). 13 In discussing the difference between the approach adopted in AASB 1056 and that of AASB 116, students should discuss two interrelated issues – why superannuation entities are not required to prepare a statement of comprehensive income and why changes in fair value of property, plant and equipment are recognised in profit and loss for each reporting period. AASB 1056 does not require a statement of comprehensive income to be prepared by superannuation entities because the statement encompasses items that would not be recognised in equity in a superannuation context. (Students should review Example 21.1 and the two components of equity for a superannuation entity – operational risk reserve and an investment fluctuation reserve). Instead, only an income statement is required to overcome the issue of ‘other comprehensive income’ not being relevant. Equally importantly, AASB 1056 requires that all changes in the fair value of assets, labelled re-measurement changes in assets, should be recognised in profit or loss (i.e. in the income statement) for the period. The reasoning is provided in the Basis for Conclusions (para. BC 47, BC78 and BC81). The re-measurement changes appear in income to provide a clear presentation of a superannuation entity’s financial performance. The purpose of holding plan assets is to generate sufficient returns to provide defined contribution and defined benefit member benefits. Thus, showing remeasurement changes directly affecting the operating result of a superannuation entity highlights this aspect. Finally, it is noted in paragraph BC81 that this treatment of re-measurement changes in assets is consistent with prudential reporting. Thus, having a comparable reporting requirement in AASB 1056 reduces the reporting costs for superannuation entities. 14 (a) Generally, insurance arrangements provide cover which is: ‘(a) offered to members, with the entity only acting as an agent; (b) offered to members, with the entity accepting insurance risk; or (c) provided to defined benefit members in relation to their projected retirement benefit’ (AASB 1056, Basis for Conclusions, para. BC 147).

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Paragraphs AG41 to AG42 provide factors to consider in determining whether a superannuation entity is acting as an agent (arrangement (a)) or as an insurer (arrangements (b) and (c)). These include: ‘i. members (or their beneficiaries) only receive insurance benefits if the external insurer/reinsurer pays claims; ii. insurance premiums are only paid through the superannuation entity for administrative reasons; and iii. insurance premiums are effectively set directly by reference to premiums set by an external insurer’ (AASB1056, para. AG41) (b) This is not correct. The extent to which these insurance arrangements are reflected in the financial statements of superannuation entities depends on whether the superannuation entity is exposed to insurance risk. The most common type of insurance arrangement (arrangement (a) above) does not expose the superannuation entity to significant insurance risk, since its members would generally not have recourse against the superannuation assets, even if the insurer fails (AASB 1056, Basis for Conclusions para. BC155). Therefore, no insurance assets and liabilities in relation to such arrangements are required to be recognised by AASB 1056. In contrast, arrangements (b) and (c) above which are less common for superannuation entities do expose the superannuation entity to significant insurance risk. As a result, AASB 1056 requires the recognition of insurance assets and liabilities in relation to these arrangements. 15 (a) For defined contribution member liabilities, the member liability is ‘measured as the amount of member account balances as at the reporting date’ (para. 17). This measurement requirement reflects the nature of defined contribution member benefits which ‘are determined by reference to accumulated contributions made on their behalf and /or by them, together with investment earnings thereon (Appendix A). It is difficult for a student to argue otherwise. (b) Defined benefit member liabilities are measured using the principle specified in paragraph 17 – that is, ‘the amount of a portfolio of investments that would be needed as at the reporting date to yield future net cash inflows that would be sufficient to meet accrued benefits as at that date when they are expected to fall due’. Accrued benefits are the benefits the ‘superannuation entity is presently obliged to transfer to members of their beneficiaries in the future as a result of membership up to the end of the reporting period’ (Appendix A). To implement this principle, a superannuation entity is required to ‘measure its defined benefit member liabilities in accordance with the approach in AASB 119 (without modification) for defined benefit member liabilities’ (Basis for Conclusions, para. BC126).

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The measurement approach of AASB 119 does reflect the nature of these benefits which ‘are specified, or are determined, at least in part, by reference to a formula based on their years of membership and/or salary level (Appendix A). That is, the AASB 119 measurement approach requires: • an estimate of expected cash flows from members’ service up to the reporting date under the assumption that the superannuation entity will fund the liability and taking into account the timing and probability of factors such as: ‘expected mortality; rates of member turnover, disability and early retirement; salaries and rates of salary adjustment; member choices of available options, such as lump sum or pension options; and any other risks specific to the liability’ (Basis for Conclusions, para BC129). • Expected cash flows are to be discounted by a rate ‘that reflects the expected notional returns, including fair value changes, on a portfolio of investments that is judged by the trustees to be the optimal way to generate the net cash inflows needed to meet benefit payments’ (Basis for Conclusions, para. BC129). Thus, it is difficult for students to argue that the measurement approach does not at the very least attempt to reflect the nature of defined benefit member liabilities. 16 Students should discuss the rationale of AASB 1056 in requiring this treatment, and note that it is possible that a gain is recognised (and not just a loss as suggested in the statement. Specifically, recognition of re-measurement changes in the defined contribution member liabilities in profit or loss is required by AASB 1056. That is, increases in the liability for defined contribution members’ accrued benefits is to be recognised as a loss for defined contribution plans and a decrease in the liability is to be recognised as a gain. This treatment is: • consistent with other Australian accounting standards that permit or require liabilities to be remeasured with any re-measurement changes to be recognised as gains or losses in profit or loss in the period in which they occur; and • consistent with the approach adopted in AASB 1056 to require most of a superannuation plan’s assets and other liabilities to be measured at fair value less transaction costs with re-measurement changes in these assets and liabilities recognised as gains or losses in the income statement (Basis for Conclusions, para. BC86, BC87). Recognition of re-measurement changes in the defined benefit member liabilities in profit or loss is also required by AASB 1056. The rationale for this requirement is as follows.

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• •

It facilitates the provision of comparable information on all types of superannuation entities. It is consistent with other accounting standards that permit or require liabilities to be re-measured, with re-measurement changes to be recognised in profit or loss in the period they occur (Basis for Conclusions, para. BC89).

17 The statement is the statement of changes in member benefits. This statement is unique to superannuation entities, which reflects the significance of member benefits from superannuation entities to statement users. Its purpose is to provide users with information useful in evaluating the significance of contributions, rollovers of benefits, transfers and benefits to members in relation to their superannuation’s financial position, as well as understanding changes in member liabilities (Basis for Conclusions, para. BC92). 18 (a) AAS25 required a defined contribution plan and permitted a defined benefit plan to present a statement of financial position, operating statement, and statement of cash flows. Defined benefit plans which did not elect to use this format were permitted to present a statement of net assets and a statement of changes in net assets. (b) AASB 1056 does not permit a differential reporting requirement for defined benefits plans compared to defined contribution plans. That is, both plan types must prepare in each reporting period a: • statement of financial position; • income statement; • statement of changes in equity/reserves; • statement of cash flows; • statement of changes in member benefits; and • notes to the financial statements (para. 8). (c) The AASB did not support differential reporting because the financial statements would not be comparable between superannuation entities and differential reporting did not accommodate hybrid superannuation entities with both defined contribution and defined benefit members (Basis for Conclusions, para. BC63). 19 Specifically, AAS25 required a defined contribution plan to recognise its members’ accrued benefits as a liability whereas a defined benefit superannuation plan could choose either to disclose its members’ accrued benefits in a note or recognise them as a liability of the plan. In contrast, AASB 1056 requires that both defined contribution and defined benefit member liabilities are recognised and measured as the amount of accrued benefits, and that the accrued member benefits of both defined contribution and defined benefit plans are recognised as a liability of a superannuation plan. This . 11

proposed approach is consistent with the requirements of existing Australian standards such as AASB 9 and AASB 119. 20 AAS25 permitted (but did not require) the re-measurement change in members’ accrued benefits for a period to be recognised as an expense in the statement of comprehensive income by defined benefit plans measuring members’ accrued benefits at the end of each reporting period, whereas defined benefit plans not measuring members’ accrued benefits at the end of each reporting period could provide a note disclosing the amount of members’ accrued benefits at the most recent measurement date. In contrast, AASB 1056 requires that a superannuation plan recognises the net change in defined benefit members’ accrued benefits for each reporting period as a gain or loss in the income statement for the period. This change is to provide users with information on a timely basis and is consistent with the treatment of similar types of obligations in AASB 1056 and other Australian accounting standards (Basis for Conclusions, para. BC89, BC90). AASB 1056 allows computational shortcuts, estimates and averages to be used in measuring defined benefit member liabilities in the intervening periods between triennial actuarial reviews if an actuary is not engaged. The use of such abbreviated computations is allowed as long as the estimates are not likely to be materially different to those derived from a comprehensive measurement technique.

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PROBLEMS 1 Over the Hill Ltd (a) The superannuation plan is a defined benefit plan. This can be determined by the inclusion of the equity item ‘defined benefits that are underfunded’ in the statement of financial position. For a defined contribution plan, there is no such item since member benefits are not over- or under-funded. Instead, they are determined by reference to accumulated contributions made, together with the investment earnings thereon. (b)(i) For a defined benefit plan, there are two scenarios. (1) The net assets attributable to defined benefit members exceed members’ accrued benefits, or (2) The net assets attributable to defined benefit members are less than members’ accrued benefits. Scenario (1) above may arise when the trust deed of the superannuation plan or the relevant legislation is silent with respect to surplus assets, and there is no established practice (e.g. the plan has a history of increasing member benefits when there are surplus assets). In this case, it is argued that the residual interest in the net assets is equity because the superannuation entity has no present obligation with respect to surplus assets (Basis for Conclusions, para. BC67). In scenario (2) above, unless there is a specific contractual arrangement between the superannuation entity and employer-sponsor, the deficit would not in itself give rise to a receivable controlled by the entity (i.e. in the absence of a contract, the payment of any future contributions by the employer-sponsor to reduce the deficit do not meet the definition of a financial instrument under AASB 132, and would not be ‘virtually certain to be received as required to recognise a reimbursement under AASB 137). Thus, the deficit residual interest in net assets is in the nature of equity. (ii) A superannuation entity recognises a difference between total assets and total liabilities when it has an operational risk reserve and the amount of net assets attributable to defined benefit members is greater or less than such members’ accrued benefits (Basis for Conclusions, para. BC65). We discuss the operational risk reserve in (iii) below. The item ‘defined benefits underfunded arises because when there are differences between actual experiences and assumed experiences. For example, employer turnover rates may have been lower than predicted resulting in defined benefits being underfunded; or salaries may have been higher than expected resulting in defined benefits that are underfunded. (iii) An operational risk reserve is maintained in accordance with Prudential Standard SPS 114 ‘Operational Risk Financial Requirement’. Operating risk is defined as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or . 13

from external events. [It] includes legal risk…’ (SPS 114, para. 6). To illustrate, operational risk may arise when there is an error made in allocating investment earnings or excesses to be met which have arisen from insurance arrangements. The rationale for maintaining this reserve is to spread potential costs across different ‘generations’ of fund members. It is argued that it provides a more equitable way of meeting the cost of rectifying operational errors than charging the full cost to people who are members of the fund at the time the errors are detected or rectified. 2 Gone Fishing Superannuation Plan (a) It is a defined contribution plan. This can be determined by the inclusion of the loss item ‘net benefits allocated to members’ accounts’ in the statement of comprehensive income (see para. 9(c) of AASB 1056). For a defined benefit plan this loss item would be ‘net change in members’ accrued benefits’. (b) AASB 1056 does not require a statement of comprehensive income to be prepared by superannuation entities because the statement encompasses items that would not be recognised in equity in a superannuation context. (Students should review Example 21.1 and the two components of equity for a superannuation entity – operational risk reserve and an investment fluctuation reserve). Instead, only an income statement is required to overcome the issue of ‘other comprehensive income’ not being relevant. Equally importantly, AASB 1056 requires that all changes in the fair value of assets, labelled re-measurement changes in assets, should be recognised in profit or loss (i.e. in the income statement) for the period. The reasoning is provided in the Basis for Conclusions (para. BC 47, BC78 and BC81). The re-measurement changes appear in income to provide a clear presentation of a superannuation entity’s financial performance. The purpose of holding plan assets is to generate sufficient returns to provide defined contribution and defined benefit member benefits. Thus, showing remeasurement changes directly affecting the operating result of a superannuation entity highlights this aspect. (c) The approach adopted in AASB 1056 is to require recognition of defined contribution members’ accrued benefits as a liability of a superannuation plan (Basis for Conclusions, para. BC85-BC87). In arriving at this conclusion the AASB reviewed the characteristics of defined contribution benefits and identified the following characteristics: (a) Member contributions and transfers into a superannuation entity fully vest upon receipt by the entity; (b) Employer contributions on behalf of a defined contribution member fully vest with the member upon receipt by the superannuation entity; and

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(c) Most defined contribution members are entitled to transfer their vested benefits to other regulated superannuation entities under the Superannuation Guarantee (Administration) Act (Basis for Conclusions, para. BC103). (d) As such, the defined contribution benefits are similar to a financial liability with a demand feature under AASB 139. Recognition of re-measurement changes in the defined contribution member liabilities in profit or loss is required by AASB 1056. That is, increases in the liability for defined contribution members’ accrued benefits is to be recognised as a loss for defined contribution plans and a decrease in the liability is to be recognised as a gain. This treatment is: •

•

consistent with other Australian accounting standards that permit or require liabilities to be remeasure with any re-measurement changes to be recognised as gains or losses in profit or loss in the period in which they occur; and consistent with the approach adopted in AASB 1056 to require most of a superannuation plan’s assets and other liabilities to be measured at fair value less transaction costs with re-measurement changes in these assets and liabilities recognised as gains or losses in the income statement.

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Chapter 22 ACCOUNTING FOR INSURANCE LEARNING OBJECTIVES After studying this chapter, you should be able to: 1

explain the nature and categories of insurance;

explain the nature of fixed-fee service contracts;

explain the nature of general insurance and the accounting issues associated with a general insurer’s underwriting activities;

explain the accounting issues associated with the investments of a general insurer;

identify and apply the requirements of AASB 1023 ‘General Insurance Contracts’;

describe the nature and business model of the life insurance industry; and

identify and apply the requirements of AASB 1038 ‘Life Insurance Contracts’.

QUESTIONS 1

(a) An ‘insurable interest’ exists if the insured would suffer a loss when the insured property is damaged by a ‘specific event’. As a general rule, an insurer will not enter an insurance contract unless the insured has an ‘insurable interest’. (b) An ‘insurable risk’ exists if the probability of a loss can be determined. The amount of a possible loss should be measurable and the risk spread over a sufficient number of similar cases.

A fixed-fee service contract is the simplest form of insurance contracts. It is a contract where the insured pays a premium to an insurer in exchange for an undertaking to perform an agreed service if a specified event occurs. Examples would include undertakings to repair specified items of machinery should they break-down or to provide roadside assistance and/or towing services in the case of vehicle breakdown.

Premium revenue under a fixed-fee service contract is governed by the requirements of AASB 4 Insurance Contracts. Premiums must be recognised as revenue when services are transferred to the customer (AASB 4, para. B7(b)). In other word, the revenue is recognised on an accrual basis. If the premiums have been received in advance, premiums received in advance (or unearned premium revenue) are recognised. The Accounting in Focus on in section 22.2.2 of the textbook demonstrates related premium revenue disclosures typical of fixed-fee service contracts.

The insurer must recognise a liability for the estimated amount of obligation when the insurance contract is signed. The liability would be reduced on an accrual basis as time passes. The liability adequacy test, which must be undertaken by the insurer at the end of each reporting period (AASB 4, para. 15), is an assessment of whether the carrying amount of an insurance liability needs to be increased (or the carrying amount of related deferred acquisition costs or related intangible assets decreased), based on a review of future cash flows (AASB 4, Appendix A).

General insurance covers the risk of loss or damage to property as a result of events such as fire, flood, theft and motor vehicle accidents. It also includes losses of profits or income arising from property damage, and losses arising from compensation claims for injuries arising from professional negligence or work-related and motor vehicle accidents. General insurance does not include life insurance, medical insurance or insurance that provides annuities. . 2

‘Short-tail business’ is general insurance business under which claims are typically settled within one year of the occurrence of the events giving rise to those claims. ‘Longtail business’ is general insurance business under which claims are typically not settled within one year of the occurrence of the events giving rise to those claims. There is no difference in principle in accounting for short-tail business and long-tail business. There are, however, greater difficulties in measuring claims liabilities arising from long-tail business. They require much more estimation. They are also likely to be ‘inflated’, to allow for changes in circumstances between the event giving rise to the claim and settlement, and then discounted to present value. These adjustments are not necessary for short-tail business.

All of the premiums collected by an insurer are not necessarily income. They include some amounts that the insurance company collects as an agent for others. These amounts are subsequently passed on to the final recipients. Stamp duty included in the premium is, therefore, not income because it is collected on behalf of a State or Territory government. The premium may also include levies and charges such as licence fees, fire brigade charges and workers’ compensation levies. It is frequently argued that these levies and charges are imposed on the insurance company and are costs of operations. In this case, levies and charges would be included in income because they are not simply collected for somebody else but are collected to cover expenses of operations.

Most would agree with this statement. Where premiums are allocated to revenue on a monthly basis, the amount allocated in a month should reflect the probability of a claim in that month. For example, if the probability of a bushfire claim in February is five times as large as the probability in July, then the revenue allocated to February should be five times the revenue allocated to July. While this may be an ideal treatment, in practice it is likely to be assumed that there is no seasonal pattern to claims and therefore premiums will be spread evenly over the term of the contract.

Paragraph 19 of AASB 1023 defines the ‘attachment date’ as: ‘... the date as from which the insurer accepts risk from the insured under an insurance policy or endorsement or, for a reinsurer, the date from which the reinsurer accepts risks from the direct insurer or another reinsurer under a reinsurance arrangement.’ The attachment date defines the beginning of the period for which the insurer is liable for claims under the policy. The premium for the policy should be allocated from that date over the term of the policy. . 3

10 A premium deficiency is the difference between contingent claims obligations and unearned premium revenue. Suppose, for example, that the premium for a twelve-month insurance cover is $1000. After six months, the unearned premium revenue would be $500. It is estimated that the probability of a claim in the remaining period of the policy is 0.006 and that the claim would be approximately $100 000. The contingent claim obligation would be 0.006  $100 000 = $600. The premium deficiency is $600 – $500 = $100. The unearned premium revenue is usually shown as a liability and it is sometimes argued that the premium deficiency should also be shown as a liability. This means that the total liability is equal to the contingent claim obligation. It is not presently Australian practice to record premium deficiencies as liabilities, probably because they do not satisfy the definition of, and recognition criteria for, liabilities. 11 The statement is correct. As payouts resulting from claims depend on many factors, such as estimates of court determined damages and the amount of losses arising from property damage, the amount of claims liabilities appearing in a statement of financial position are simply an informed estimate. 12 Most insurers would agree that this statement is incorrect. The estimation of the discount rate and the inflation rate is a matter of judgement. The major difficulty is to estimate the likely payout on long-tail business. In many cases, this amount will be influenced by negotiation and by decisions of a court. Although insurers have much experience in this estimation process, no two claims are identical and the decisions of courts are often unpredictable. The major area of estimation is, therefore, the size of the likely payout. As such, it is necessary for insurers to employ actuarial techniques in estimating the claims liability, which will include the effect of inflating and discounting the amount of the likely payout. 13 Investments are held to generate income in the form of interest, dividends, rentals and capital profits. They consist of property, listed and unlisted shares and fixed interest securities. The investments of insurance companies are carried at their fair value and changes in that value during a period are included in profit or loss for that period (AASB 1023). Operating assets are used by an insurer in the process of generating underwriting and investment income. They consist of land and buildings occupied by the insurer, plant and equipment, motor vehicles and inventories of consumables. Operating assets are measured using either the cost model or the revaluation model (AASB 116 ‘Property, . 4

Plant and Equipment’) and subject to impairment requirements of AASB 136 ‘Impairment of Assets’. Financial assets are cash or claims to cash. They include accounts receivable, premiums receivable, and bank deposits that are used for operating purposes. Financial assets are measured at fair value through profit or loss in accordance with AASB 9 (AASB 1023, para. 15.2). 14 This is a matter of some controversy. The logical approach would seem to be that property occupied by the insurer is an operating asset and that all other property is an investment. There is a view, however, that all property is an investment even if it is occupied by the insurer. This view is supported by an argument that owner-occupied property has a yield in the form of rent savings and that, at an appropriate time, the property will be sold in the same way as any other investment property. There is a third view that all property should be treated as operating assets. According to Lamble and Minehan in Discussion Paper No. 11 ‘Accounting for the General Insurance Industry’ (AARF, 1987) this was the usual Australian accounting treatment prior to the issue of AASB 1023. Such a practice is difficult to justify on logical grounds but may be supported on grounds of ‘conventional practice’. 15 ‘Acquisition costs’ are the costs incurred by an insurer in obtaining business. They include commissions to agents and brokers, costs associated with the preparation and issue of policies, the salaries of field staff and premium collection costs. These costs are usually incurred ‘up front’. There are two possible ways in which acquisition costs could be accounted for. They could be recognised as expenses in the period in which they are incurred or they could be capitalised and amortised over the term of the associated policies. Capitalising and then amortising these costs over the period of the consequent benefits is probably the most logically satisfying approach. However, recognising acquisition costs as expenses in the period in which they are incurred has been justified on the practical grounds that if the acquisition costs are incurred steadily over time, then it would result in virtually the same periodic profit figure as capitalising and then amortising them. Recognising acquisition costs as expenses in the period in which they are incurred, of course, would not result in the recognition of an asset, deferred acquisition costs. This approach is also supported on the grounds that if the insurance policy was subsequently cancelled, no asset would exist.

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Paragraph 8.1 of AASB 1023 requires that acquisition costs be deferred and amortised systematically over the reporting periods expected to benefit from the acquisition costs incurred provided that they can be reliably measured and it is probable that they will give rise to premium income that will be recognised in the statement of comprehensive income in subsequent reporting periods. 16 ‘Reinsurance’ involves insurers insuring a portion of the risks that they accept. For example, an Australian insurer with a large number of household policies in an area with a high risk of earthquake would face a large payout if there was an earthquake in the area. To reduce the risk, the insurer may reinsure with other insurers who accept part or all of the risk. Outwards reinsurance is where an insurer pays premiums to another insurer to reduce its exposure to risk. Inwards reinsurance is where an insurer accepts premiums from another insurer and agrees to indemnify the latter for losses arising from business that it has written. Accounting for inwards reinsurance is the same as for any other insurance. From the reinsurer’s point of view, the reinsurance business does not differ from any other direct insurance business. Accounting for outwards reinsurance is a little more controversial. There are two broad approaches which could be used. One treats outwards reinsurance as a modification or an adjustment to the initial direct insurance. Outwards reinsurance premiums are then regarded as a reduction in premium income and claims recovered from reinsurance are treated as a reduction in claims expenses. The alternative approach is that the initial direct insurance and the reinsurance are two separate transactions of the insurer. The outwards insurance premium is treated as an expense and any claim recoveries are regarded as income. AASB 1023 ‘General Insurance Contracts’ adopts this approach (see paras 10.1, 11.1). 17 There are two possible ways in which outwards reinsurance premiums and recoveries could be accounted for. The first assumes that outwards reinsurance is simply a passing on of direct insurance premiums to the reinsurer and that claims recoveries are a reimbursement of claims expenses by the reinsurer. If this approach is adopted, outwards reinsurance premiums are shown as a deduction from premium revenues and claims recoveries are shown as a deduction from claims expenses. The alternative approach is to regard reinsurance transactions as quite separate from the original direct insurance. If this approach is adopted, then claims recoveries will be shown as income and outwards reinsurance premiums will be shown as expenses. Paragraph 10.1 of AASB 1023 requires that outwards reinsurance premiums will need to be recognised as an expense of the

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direct insurer and paragraph 11.1 of AASB 1023 requires that reinsurance recoveries will need to be recognised by the direct insurer as income. 18 The view expressed in this statement is that the act of reinsurance passes the risk to a reinsurer. The original direct insurer retains no risk. In other words, the insurer is merely an agent for the reinsurer. The insurer collects the premiums on behalf of the reinsurer. The reinsurer is an intermediary between the original insured and the insurer. If this view is held, then outwards reinsurance premiums should be deducted from direct premiums as the latter are not income but are merely sums collected on behalf of the reinsurer. An alternative view is that the decision to reinsure is a separate transaction and should be treated as such in the accounts. AASB 1023 describes the accounting treatment in the question as a ‘net method’. The insurer shows as income only the difference between direct premium revenues and outwards reinsurance premiums. AASB 1023 rejects the net method and requires full disclosure of the total premium revenues and outwards reinsurance premiums. 19 The investment activities of an insurer make use of the available cash balances that exist because of the time between the collection of premiums and the payment of claims. Investment is a crucial component of the insurance industry. Without investment, premiums would be much higher and insurance would be much less attractive to insurers. Thus, although investment is a different activity from underwriting, it is still an integral component of the insurance industry. The purpose of investment is to use cash balances in a way that maintains liquidity, solvency and profitability. The results of underwriting activities and investments may be shown separately. While this separation may be useful, there is a risk that some may conclude that underwriting operations resulted in a loss while investing activities were profitable. It is possible, however, that management sets premiums at levels that result in underwriting losses with a clear understanding that these losses will be more than covered by investment profits. Lower premiums attract underwriting business and provide the cash for investment. In other words, the results of underwriting and investment should be considered together. They are like the blades of a pair of scissors. Together they achieve the result. It cannot be argued that one is more important than the other. 20 The objectives of managing the investment portfolio of an insurance company are liquidity, solvency and profitability. The investments must be managed in a way that ensures that cash is available to meet obligations as they fall due. Under legislation, insurance companies must remain solvent. The insurance company also wishes to make . 7

as much profit as possible from its investments. The three objectives of liquidity, solvency and profitability are not always compatible. For example, an overemphasis on liquidity may mean investing a large proportion of the portfolio in short-term low yielding investments at the expense of more profitable long-term investments. 21 The treatment of owner-occupied buildings as an investment may be justified on the grounds that owner occupancy yields profit in the same way as occupancy by tenants. Tenants provide an income stream by way of rent payments, whereas owner occupancy provides an equal amount of rent savings. Cost reductions are a return on investment in the same way as rental revenue. In addition, owner occupancy does not mean that the property cannot be sold at a profit in the future. Sale and lease-back arrangements are frequently used to realise capital profits. In other words, owner-occupied buildings are held for the same reasons as tenanted buildings. They provide a return on investment while they are held and they may be sold at a profit in the future. 22 The case for showing investments at fair value has been summarised in paragraph 15.1.1 of AASB 1023: ‘The fair value approach to the measurement of assets backing general insurance liabilities ... is consistent with the present value measurement approach for general insurance liabilities ...’ In other words, investments are held for solvency and liquidity purposes and the fair value of the investments is the only measurement that meets these two objectives. It indicates how much the investments could be sold for in order to meet the obligations to pay claims as they fall due. It also provides a meaningful measure of solvency. Rates of return calculated on the fair value of investments also provide a useful measure of the opportunity cost of holding the assets. If the rates of return become too low, this may indicate that the investments should be sold and the proceeds reinvested to earn a higher return. 23 AASB 116 ‘Property, Plant and Equipment’ allows that non-current assets may be revalued upwards but that the revaluation increase should be recognised in other comprehensive income (rather than profit or loss) and accumulated in equity as a revaluation surplus (except where the increase reverses a previous decrease recognised in profit or loss). When the asset is sold, the revaluation surplus associated with that asset is not recycled into the statement of comprehensive income. The effect of AASB 116 is, therefore, that where assets are revalued upwards, the gain is excluded from profit even after it is realised.

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The assessment of solvency requires the use of fair values for investments. If AASB 116 is applied, this means that capital profits are not reported. The provisions of AASB 116 are not appropriate where there is a need to report on both solvency and profitability. 24 Ideally, premium revenue should be allocated to reporting periods in accordance with the pattern of risk. Before this allocation is undertaken, the costs and the benefits of doing so should be estimated and compared. The costs may be considerable as the pattern of risk for each type of claim needs to be assessed. Many policies cover several risks (for example, fire and flood) where the apportioning of risk is quite different. In these circumstances, the premium should first be allocated to different risks and the result should then be allocated to different periods. The benefits from such allocations do not appear to be significant. If there is an annual pattern of risk, an annual reporting period and annual premiums, then there appears to be very little benefit from allocation on a prospective risk basis. Most insurers assume that the risks are spread evenly over the term of the policy and allocate the premiums on a straight-line basis. 25 There are general five main types of traditional activities of life insurance. (i) Whole-of-life insurance – where benefits are paid on the death of the insurer person. (ii) Endowment insurance – where benefits are provided at the end of a specified period or on the earlier death of the insured person. (iii)Term insurance – where benefits are generally only paid if the insured person dies within a specified period, though the policy may be convertible at any time during the period to a whole-of-life or endowment policy. (iv) Annuity contracts – where benefits are provided as a future stream of payment generally commencing on a specific date. (v) Disability insurance – where benefits are paid when the insured person in unable to carry on gainful employment because of sickness or accident. However, over the past few decades, a significant array of products available from life insurers that are investment-linked insurance policies (ILPs) have development. ILPs have both life insurance and investment components. In general terms, the insurer contracts to pay a sum on the expiration of the policy or on death of the insured. The amount that is payable, is determined by the amount of the premiums paid and the accumulated investment earnings on those premiums less a management fee. 26 Paragraph 8.1 of AASB 1038 requires the obligations arising from life insurance contract (life insurance liabilities) shall be recognised as liabilities and shall be measured at the end of each reporting period as: . 9

(a) the net present value of future receipts from and payments to policyholders, including participating benefits, allowing for the possibility of discontinuance before the end of insurance contact periods, plus planned margins of revenue over expenses relating to services yet to be provided to policy holders, on a basis of assumptions that are best estimates and using a discount rate determined in accordance with paragraphs 8.7 or 8.8; or (b) the accumulated benefits to policyholders after allowing for the portion of acquisition costs expected to bed recouped when the result would not be materially different from paragraph (a) above. 27 AASB 1038 does not explicitly explain this phrase. It probably means investment assets available to cover possible adverse results or support anticipated growth in insurance activities. The measurement approach of the asset depends on the nature of the asset. AASB 1038 requires that financial assets within the scope of AASB 139 that back life insurance liabilities or life investment contract liabilities shall be designated as ‘at fair value through profit or loss’ (para. 10.2). Investment property that is within the scope of AASB 140 ‘Investment Property’ and that backs life insurance liabilities or life investment contract liabilities shall be measured at fair value using the fair value model under AASB 140 and AASB 13 Fair value Measurement (para. 10.3). Property, plant and equipment that is within the scope of AASB 116 ‘Property, Plant and Equipment’ and that backs life insurance liabilities or life investment contract liabilities shall be measured using the revaluation model under AASB 116 (para. 10.4). Investments in associates as defined by AASB 128 Investments in Associates and Joint Ventures and venturers’ interest in joint ventures as defined by AASB 11 ‘Joint Arrangements’ and that backs life insurance liabilities or life investment contract liabilities shall be designated as ‘at fair value through profit or loss’ under AASB 139 (paras 10.5, 10.6).

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PROBLEMS 1

Diad Insurance Company Limited Receipt of income: _________________________________________________________________ Cash at bank Dr $70 000 000 Payable to State Government Cr $1 500 000 Premium income Cr 68 500 000 _________________________________________________________________ Payment of levies: _________________________________________________________________ Levies and charges expenses Dr $10 000 000 Cash at bank Cr $10 000 000 _________________________________________________________________ Unclosed business: _________________________________________________________________ Accrued premiums receivable Dr $2 000 000 Premium income Cr $2 000 000 _________________________________________________________________ Unearned premiums: _________________________________________________________________ Premium income Dr $5 000 000 Unearned premium income Cr $5 000 000 _________________________________________________________________

Festival Insurance Company Ltd (a) Receipt of revenue from investments: ________________________________________________________________ Cash at bank Dr $17 000 000 Investment income Cr $17 000 000 _________________________________________________________________ Acquisition of new investments: _________________________________________________________________ Investments Dr $35 000 000 Cash at bank Cr $35 000 000 _________________________________________________________________

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Sale of investments: _________________________________________________________________ Cash at bank Dr $41 000 000 Investments Cr $36 000 000 Gain on sale Cr 5 000 000 _________________________________________________________________ Accrued revenue receivable: _________________________________________________________________ Investment revenue receivable Dr $3 000 000 Investment income Cr $3 000 000 _________________________________________________________________ Value of investments, 30 June 2017 Investments acquired during the year Investments sold during the year

$175 000 000 35 000 000 210 000 000 36 000 000 $174 000 000

These investments have a fair value of $180 000 000. The revenues from the increase in fair value is, therefore: $180 000 000 – 174 000 000 = $6 000 000. Revenues from changes in fair value of investments: _________________________________________________________________ Investments Dr $6 000 000 Investment income Cr $6 000 000 _________________________________________________________________ (b)

Investment revenues for the year ended 30 June 2018 would be: Income received Income receivable Gain on sale of investments Increase in value of investments

$17 000 000 3 000 000 5 000 000 6 000 000 $31 000 000

Chapter 23 INTERNATIONAL ACCOUNTING STANDARDS, HARMONISATION AND CONVERGENCE LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 describe how the institutional arrangements for international accounting standard setting have evolved; 2 describe the development of international financial reporting standards; 3 identify alternative approaches to the harmonisation of accounting standards; 4 describe the internationalisation policy adopted by the Australian Accounting Standards Board; 5 describe the convergence and harmonisation policy adopted by the Australian Accounting Standards Board; 6 outline the benefits resulting from the convergence process; 7 outline the costs resulting from the convergence process; 8 outline the arguments for and against principles-based accounting standards.

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QUESTIONS 1

Prior to the FRC directive the AASB independently set its own technical agenda and was an active participant on the international accounting stage via its involvement in the IASC (it was a founding member) and the G4+1 group of standard setters. As such the AASB developed and set its own standards but (as described in more detail in question 7), it sought to ensure that its standards were consistent with those produced by the IASC/IASB. Where there were differences between the two sets of standards, these differences were identified as a note in the AASB standards.

The IASC, was established in 1973 following the Tenth Congress of the International Congress of Accountants held in Sydney in 1972. At the Congress, representatives of the professional accounting bodies in Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the UK and Ireland, and the US agreed to form the IASC. It grew considerably after its establishment in 1973 and, at the time of its replacement by the IASB, the IASC had 143 members representing professional accounting bodies in 104 countries. The size of the IASC made it an inefficient and ineffective standard setter because getting everyone to agree on a proposed standard took a long time and required numerous compromises. The IASB was formed to overcome these limitations. The initial structure of the IASB was modelled on that of the Financial Accounting Standards Board and membership of the IASB was initially focussed on those people who had accounting/standard setting expertise rather than necessarily geographical representation. The current structure of the IASB is set out in Figure 23.1. The new structure was developed to promote efficiency, expertise, and effectiveness in international accounting standards setting. In addition, the oversight bodies of the IFRS Foundation Trustees and IFRS Foundation Monitoring Board were created to maximise the independence of the operations of the IASB.

The structure depicted in Figure 23.1 identifies three main components: the IFRS Foundation (within which is the IASB and IFRS Interpretations Committee); The IFRS Foundation Trustees and the IFRS Foundation Monitoring Board. These bodies are supported by the ASAF and the IFRS Advisory Council. The IASB is the primary standard setting board. The IASB comprises up to 16 members (as of early 2016, there were 14 full-time members), initially appointed for five-year terms that are renewable for a further three years. Of the 16 members, up to three may be

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part-time. They are appointed by the trustees of the IFRS Foundation. To ensure broad international diversity on the Board, there would normally be four members from the Asia/Oceania region, four from Europe, four from North America, one each from Africa and South America, and two appointed from any area, subject to maintaining overall geographical balance. The IFRS Interpretations Committee (IFRIC), consists of 14 members appointed by the trustees of the IFRS Foundation for three-year terms. The role of the IFRIC is to interpret the application of international accounting standards and provide timely guidance on financial reporting issues not covered in international accounting standards in the context of the IASB’s conceptual framework. From 2009, the IFRIC also assumed responsibility for the annual process of making relatively minor improvements to IFRSs. The Interpretations require the approval of the IASB before they can be issued. The Accounting Standards Advisory Forum (ASAF) was formed in 2013. It was established to facilitate a cooperative relationship between the IASB and national accounting standard setters. The ASAF consists of 12 members (representing national accounting standard-setting bodies from around the world) plus a chair from the IASB. As an advisory group, the objectives of the ASAF are to: • •

•

provide support to the IFRS Foundation in the objective of developing a single set of high-quality global financial reporting standards; promote the effectiveness of the IASB’s engagement with national standard setters to ensure that wide-ranging national and regional input on major technical issues is considered; and ensure productive technical discussions on standard-setting issues.

The IFRS Advisory Council assists the IASB in its work by providing a broad crosssection of groups with an interest in international financial reporting. The role of the IFRS Advisory Council is to discuss with the Board a range of issues, including input on the IASB’s agenda, the relative importance of topics on the work program, and advice on projects, with particular emphasis on practical application and implementation issues. Advisory committees may also be established to provide guidance on technical issues relating to topics on the Board’s work program. Oversight roles are provided by the IFRS Foundation Trustees and the IFRS Foundation Monitoring Board. There are 22 IFRS Foundation Trustees whose main role is to independently appoint the members of the IASB. The IFRS Foundation Monitoring Board has oversight responsibilities in relation to the trustees of the IFRS Foundation. In particular, the responsibilities of the Monitoring Board include involvement in the

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appointment process for, and approval of, trustees of the IFRS Foundation, as well as the review of the trustees’ fulfilment of their responsibilities. This structure was developed to promote efficiency, expertise, and effectiveness in international accounting standards setting. In addition, the oversight bodies of the IFRS Foundation Trustees and IFRS Foundation Monitoring Board were created to maximise the independence of the operations of the IASB. 4

The United States (US) has the world’s largest capital market and considerable economic and political power. At present the US allows foreign companies that are listed on a US stock exchange to use IFRSs, but domestic companies must use US accounting standards as promulgated by the Financial Accounting Standards Board (FASB). The FASB and the Securities and Exchange Commission (SEC) have tended to adopt a policy of ‘convergence’, rather than adoption of IFRSs; that is, the US has worked with the IASB in trying to reduce the differences between FASB and IASB accounting standards. In particular, the IASB and the FASB have been working towards convergence of IFRSs and US generally accepted accounting principles (GAAP) since the Norwalk Agreement (2002) in which they ‘each acknowledged their commitment to the development of high quality, compatible accounting standards that could be used for both domestic and crossborder financial reporting’. This commitment was reaffirmed in the Memorandum of Understanding between the IASB and the FASB, which was originally issued in 2006 and updated in 2008. The Memorandum of Understanding identified short-term and longer-term convergence projects with the aim of improving US GAAP and IFRSs, and eliminating differences between them. By the end of 2013, the formal convergence arrangements between the IASB and the FASB had come to an end as major projects identified in the Norwalk Agreement were finalised. However, the IASB and the FASB continue to work cooperatively on projects where their mutual interests align. The SEC commissioned and published three reports examining methods of incorporating IFRSs into US GAAP, the differences between IFRSs and US GAAP, and the application of IFRSs in practice. These reports culminated in a final SEC staff report, which was published in 2012. The staff report on the possible use of IFRSs within the US has served to confuse rather than elucidate the US position on one set of global standards. It does not outline a recommended action plan on convergence for the SEC, which was the aim of the work plan, but rather reiterates the likely issues to result from a transition from US GAAP to IFRSs. As of early 2016, the SEC has yet to make a formal statement about the domestic adoption of IFRSs, but a speech given by the Chief Accountant of the SEC in May 2015 (see the Accounting in

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Focus box in the chapter) suggests that the use of IFRSs by US companies is very unlikely for the foreseeable future. When a major economic power such as the US does not commit to adoption of IFRS for domestic purposes, this weakens the ability of the IASB to promote IFRS to other countries. Although well over 100 countries have adopted IFRS in some form, very few of these countries are economically or politically significant relative to the US. When other major countries see that the US can opt out of IFRS, it is more difficult for them to perceive the benefits of IFRS adoption. As a result, it is unlikely that the world will achieve in the foreseeable future a single set of global accounting standards. Some commentators have suggested that this is a good outcome because competition between standard setters could lead to better quality standards. 5

The three broad approaches that may be taken to reduce the diversity in accounting standards are as follows: (a) global harmonisation, which would involve the adoption of a single set of accounting standards throughout the world; (b) harmonisation of Australian accounting standards, which would involve Australia adopting accounting standards developed in another jurisdiction; and (c) internationalisation, which would involve the Australian standard setters developing local accounting standards based on a detailed examination of accounting standards and practices in other jurisdictions, including the US and the IASB.

When the FRC issued its directive for Australia to adopt IFRS this significantly changed the role and international influence of the AASB. For the purposes of setting standards for private sector entities, the AASB essentially became as ‘standards taker’ rather than a standards maker because the AASB adopts the content and wording of IASB standards. Given its policy of transaction neutrality, the AASB has been able to further develop its work in standard setting for the not-for-profit and public sectors because as part of its activities it adds ‘Aus’ paragraphs to standards which provide guidance on how the standards are to be applied in those sectors. Once the AASB had to adopt IFRS, it found itself with a loss of international influence which it has had to rebuild since 2005. The key challenge for the Australian Accounting Standards Board (AASB) was to ensure that Australia continued to have representation and influence on international boards and committees. This is particularly the case with the European Union and the US looking to influence the development of IFRS as they move closer to full adoption. As Hicks (2009) comments: ‘There is a risk that when the US adopt IFRS, Australia will be left out in the cold as Europe and the US battle for supremacy. It is therefore important for our

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AASB to be seen as a high quality national standard setter, so it can participate in and influence directions in global accounting standard setting.’ A similar view was expressed by Ms Kris Peach (a then member of the AASB and now its Chair): ‘Australia needs to make sure it is involved in the standard-setting process. Having members on IFRIC and the IASB, making submissions at an early stage and having a strong and active Australian Accounting Standards Board ensures that we continue to punch above our weight with influence of the IASB.’ One mechanism which the AASB has adopted as a means of regaining an international presence has been its active involvement in the Asian-Oceanian Standard Setters Group (AOSSG) which is regional group of standard setters who have banded together to increase their influence at the IASB. 7

(a) Following the establishment of the new international standard-setting arrangements in March 2001, the AASB revised its internationalisation policy. In April 2002 it issued Policy Statement PS4 ‘International Convergence and Harmonisation Policy’, which stated the AASB’s intention to pursue policies of ‘international convergence’ and ‘international harmonisation’. International convergence refers to a policy of working with other standard-setting bodies to develop new or revised accounting standards that will contribute to the development of a single set of standards for worldwide use, while international harmonisation refers to a process that leads to Australian accounting standards being made compatible with the standards of international standard-setting bodies to the extent that this would result in high-quality standards (para. 2, Policy Statement PS4). The main objectives of the AASB’s convergence and harmonisation policy are described in paragraphs 5 and 6 of Policy Statement PS4 ‘International Convergence and Harmonisation Policy’ as follows: 5 The AASB’s international convergence objective is to pursue, through the participation in the activities of the IASB and the PSC (now the International Public Sector Accounting Standards Board), the development of an internationally accepted single set of accounting standards which can be adopted in Australia and elsewhere for both domestic and world-wide use in order to achieve the benefits set forth is paragraph 7 of this Policy Statement. 6 A single set of internationally accepted accounting standards is not likely to be achievable in the short term. Accordingly, the AASB’s international

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harmonisation objective is to work towards the development of accounting standards in Australia that harmonise with IFRSs and International Public Sector Accounting Standards (IPSASs) issued by the PSC, where the AASB concludes that such standards are likely to be in the best interests of both the private and public sectors in the Australian economy. Where IFRSs and/or IPSASs are considered by the AASB to not represent best international practice, the interim objective is to work towards adopting standards that are considered by the AASB to be best international practice and to endeavour to influence the deliberation of the IASB and the PSC to adopt what the AASB considers to be the best international practice. (b) Prior to the issue of PS4 by the AASB in April 2002, the proposed policy was endorsed by the Financial Reporting Council (FRC) at its meeting in March 2002. Despite its apparent support for the AASB’s policy, the FRC announced less than two months later, following its June 2002 meeting, ‘that the FRC has formalised its support for the adoption by Australia of international accounting standards by 1 January 2005’ (Bulletin of the Financial Reporting Council 2002/4 – 3 July 2002). The announcement went on to say that: ‘Subject to the Government’s support at the appropriate time for any necessary amendments of the Corporations Act, this will mean that, from 1 January 2005, the accounting standards applicable to reporting entities under the Act will be the standards issued by the International Accounting Standards Board (IASB). After that date, audit reports will refer to companies’ compliance with IASB standards.’ Thus, the policy of international convergence and harmonisation had, in effect, been replaced by the adoption of IFRSs. Thus, practically international convergence and harmonisation are no longer in effect. 8

This quote is suggesting that IFRS adoption is not going to bring benefits to a jurisdiction. (The benefits and costs of international convergence are set out in question 9). The quote does not offer any reasons for its conclusion and students should be encouraged to speculate as to why such a conclusion might be valid. Many of the alleged benefits of IFRS adoption relate to increasing confidence of investors in a local market – e.g., more transparency leads to better information for investors who then are more confident and more prepared to invest in that market. However, as discussed in the chapter, these benefits may not be experienced equally by all jurisdictions. Some reasons for this include:

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•

• •

An adopting jurisdiction, already has high quality accounting standards (Australian would be a good example) so the marginal benefit of IFRS adoption is small; Counties can ‘adopt’ IFRS but not actually consistently apply them; and IFRS may not be adequately enforced in a jurisdiction.

The chapter refers to an ICAEW research report which summaries evidence that, with regard to the European Union (EU), a number of the alleged benefits of IFRS adoption have been achieved but not equally among EU members due to some of the reasons noted above. 9

Some benefits of international convergence include: • Better ability for investors to compare entities across global capital markets; • Increased quality of financial reporting leading to more financial transparency; • Increased transparency should lead to lower cost of capital; • Increased liquidity of global capital markets; and • Reduction in financial reporting production costs. Some costs of international convergence include: • • •

Short-term learning and information systems costs associated with the introduction of IFRS; Loss of national sovereignty and power over rules that impact on a particular jurisdiction; and Potential to move to lower quality financial reporting (e.g., some consider that one of the reasons that the US has not adopted IFRS is because there is a view that the FASB’s standards are the “best” in the world.

It is noted in the chapter that it is expected (and some research shows) that these benefits and costs are not equally distributed across jurisdictions. 10 Principles-based standards ‘refer to fundamental understandings that inform transactions and economic events … accounting standards of the principles persuasion do not address every controversial issue at hand but keep considerable ambiguity about such major processes as record keeping and measurement’ (Carmona and Trombetta, 2008, p. 456). They can be contrasted with so-called rules-based standards, which include ‘specific criteria, “bright line” thresholds, examples, scope restrictions, exceptions, subsequent precedents, implementation guidance etc.’ (Nelson, 2003, p. 91). Any AASB standard based on an IFRS could be used to support your answer. For example, AASB 136 ‘Impairment of Assets’ is based on the equivalent IFRS and so is . 8

largely a principles-based standard. As a result, AASB 136 does not outline specific rules to determine whether an asset is impaired. Instead, paragraph 12 of AASB 136 provides a non-exhaustive list of generic indicators of impairment – for example, if there are observable indicators of declines in the asset’s value greater than would be expected from normal wear and tear, it is impaired. To contrast this principles-based approach, a rules-based standard may contain a specific impairment rule that if an asset’s book value is less than or equal to 75 per cent of its fair value it is considered to be impaired. It is unlikely that any single set of accounting standards can be purely principles-based or purely rules-based. One reason is that in litigious societies, accountants, managers and others will demand more black/white rules so that they can minimise the likelihood that they will suffer legal consequences. Schipper (2003) has argued that even though the US is frequently categorised as possessing rules-based accounting standards, those standards are derived, at least in part, from the principles in the FASB’s Conceptual Framework. 11 The arguments in favour of a principles-based approach include: i) A reduction in excessive complexity in accounting standards. ii) The generic nature of principles-based standards has allowed the adoption of IFRS in so many different countries. That is, the flexibility of principles-based standards can accommodate diverse institutional setting and traditions (Carmona and Trombetta, 2008). iii) Principles-based standards are more likely to remain applicable when the economic environment changes (Benston, Bromwich and Wagenhofer, 2006). iv) Principles-based standards do not ‘provide a roadmap to avoidance of the accounting objectives inherent in the standards’ (SEC, 2003). v) Principles-based systems require professional judgement, which will lead to the continued growth of the accounting profession beyond merely technical skills and compliance with rules-based accounting standards. The arguments against principles-based standards include: i) They typically require preparers and auditors to exercise judgement in accounting for transactions and events without providing a sufficient structure to frame that judgement. ii) There will likely be a loss of comparability between reporting entities since preparers will exercise judgement in the absence of implementation guidance such as illustrative practical examples. iii) The existence of principles rather than rules will make it more difficult to successfully seek legal remedies against managers who have selected accounting policies in bad faith to further their own reporting objectives.

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Students should be encouraged to reflect on the respective pros and cons of each approach and, as discussed in question 10 whether any standard can really be either entirely principles-based or entirely rules-based. One view is that principles are the starting point from which we derive rules.

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Chapter 24 FOREIGN CURRENCY TRANSLATION LEARNING OBJECTIVES After studying this chapter you should be able to: 1

compare and contrast functional currency with presentation currency;

discuss the process of foreign currency translation;

apply the requirements of AASB 121 ‘The Effects of Changes in Foreign Exchange Rates’ to account for foreign currency transactions, distinguishing between monetary and non-monetary items;

apply the requirements of AASB 121 ‘The Effects of Changes in Foreign Exchange Rates’ in accounting for foreign operations;

explain the nature of hedging transactions; and

apply the requirements of AASB 9 ‘Financial Instruments’ in accounting for hedging transactions.

QUESTIONS 1

Functional currency is the currency in which an entity is required to measure its financial performance and financial position, including impacts of any foreign currency items, while its presentation currency is used to present its report in (AASB 121 paras 17 and 18). (a) In determining functional currency of an entity (i.e. the currency of the primary economic environment in which the entity operates), a key identifying factor is the environment in which an entity primarily generates and expends cash (para. 9). Paragraphs 9, 10 and 11 set down indicators to assist in determining an entity’s functional currency. The requirements of paragraph 9 have priority, and the requirements of paragraphs 10 and 11 only apply if the results from an application of paragraph 9 are mixed. From paragraph 9, indicators of functional currency include the currency in which sales prices for its goods and services are denominated and settled, the currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services, and the currency in which such costs are denominated and settled. From paragraph 10, additional considerations are the currency in which financing is generated, and the currency in which receipts from operating activities are retained. For foreign operations that are a subsidiary, branch, associate or joint venture, factors to consider include whether the activities of the foreign operation are carried out with any degree of autonomy from the reporting entity, the proportion of transactions with the reporting entity, the impact of the foreign operation’s cash flows on the cash flows of the reporting entity, and the ability of the foreign operation to service debt independent of the reporting entity (para. 11). (b) The presentation currency is ‘the currency in which the financial report is presented’ (para. 8). AASB 121 permits the presentation currency of a reporting entity to be any currency (para. 38), and it may differ from the functional currency. The one restriction on selection of a presentation currency is that for the purposes of reporting under the Corporations Act 2001, only one presentation currency is permitted (para. Aus38.1).

Sheets Ltd It is NZ dollars. There are mixed indicators of functional currency identified in accordance with paragraphs 9 to 11, AASB 121. For example: •

HK dollars as the functional currency – suggested by the source of debt

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•

financing from a Hong Kong Bank (para. 10). Australian dollars as the functional currency – suggested by equity financing from two share issues on ASX (para. 10); the functional currency of parent Beds Ltd (para. 11). NZ dollars – suggested by cash collections from operations in NZ dollars (para. 10); NZ dollars are used by customers to settle accounts and NZ dollars are used by Sheets Ltd to pay suppliers of labour and goods (para. 9).

Paragraph 12 of AASB 121 requires that priority is given to the indicators in paragraph 9 in the event that the functional currency is not clear. In this situation, the indicators from paragraph 9 suggest that NZ dollars are the functional currency, and paragraphs 10 and 11 are not required (they have been included only to demonstrate their application). 3

Magnolia Ltd (a) Paragraph 12 should be applied in determining functional currency because there are mixed signals from paragraph 9. That is: • • • •

Labour and raw materials are sourced from the Philippines (peso) (para. 9(b)); Markets of relatively equal size are located in Australia (A$) and the UK (£) (para. 9(a)); Sales are invoiced in Australian dollars (para. 9a); and Company is listed on the Australian Securities Exchange, so capital was raised in Australia at some point.

If paragraph 12 is applied with weight given to paragraph 9 indicators then the functional currency is likely to be Australian dollars because the sales are invoiced in Australian dollars (para. 9(a)). The British pound is also a consideration because capital was raised in the UK (£) (para. 10) but the tipping point is that the sales are invoiced in Australian dollars. (b) The presentation currency is determined/selected at management’s discretion (para. 38). It can be different to an entity’s functional currency. In this case it would likely be a choice of the Australian dollar (AUD) or British pound due to the cross-listing on the ASX and the London Stock Exchange. However, any currency is permitted by AASB 121. 4

ABC Company (a) At the date of purchase, the exchange rate for FC was A$1 = FC6.10. Two months later, at the date of settlement, the exchange rate was A$1 = FC6.50. In the books of the

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company, the account would have a balance of: FC100 000/6.10 = A$16 393. At the date of settlement, however, FC100 000 – that is, the amount shown on the invoice – was worth: FC100 000/6.50 = A$15 385. An exchange gain of A$1 008 has been made. The devaluation of the FC meant that fewer Australian dollars were required to purchase the FC100 000 and this is, therefore, a gain to the company. (b)If the invoice had been in Australian dollars, then the company would not have gained anything as a result of the devaluation of the FC. The invoice for the goods would have shown an amount equalling A$16 393. This is the amount that would have to be paid in two months’ time, regardless of the fact that the FC was devalued during that time. FC would have worn a foreign exchange loss. 5

A buying rate of exchange is the rate (or price) at which units of the local currency can be purchased with units of a foreign currency. For example, a buying rate of exchange of $A1 = US$0.88 means that 88 US cents would purchase $A1. If an Australian exporter or an Australian lender was paid in US dollars, then those dollars could be exchanged for Australian dollars at that rate. A selling rate of exchange is the rate (or price) at which units of a foreign currency can be purchased with units of the local currency. For example, a selling rate of exchange of $A1 = US$0.79 means that an entity would receive US$0.79 for $A1. If an Australian importer had to purchase US dollars to settle an account or an Australian borrower had to repay a US dollar loan, the selling rate would be used to exchange Australian dollars for US dollars. The word ‘selling’ is used because Australian dollars are exchanged or ‘sold’ to purchase US dollars. The difference or spread between the two exchange rates is the foreign currency dealer’s profit margin.

A spot rate of exchange is the rate applicable on that day. For example, a spot buying rate of exchange of $A1 = US$0.72 means that Australian dollars could be purchased

. 4

with US dollars at that rate on that day. A spot rate is used to translate foreign currency transactions at a particular point in time – e.g. when a purchase of inventory is recognised, when a sale is recognised, when financial statement elements need to be revalued at the reporting date. A forward rate of exchange is the rate at which currency can be bought and sold on a specified future date. For example, if on 1 March, a bank quoted a 60-day forward selling rate of $A1 = US$0.74, then this means that the bank undertakes to sell Australian dollars for US dollars at that rate on 1 May of the same year. Forward exchange rates can be incorporated into arrangements such as forward exchange contracts. For such arrangements, forward exchange rates can be used to measure changes in the fair value of forward exchange contracts. 7 (a) and (b) The ‘translation process’ involves expressing: (i)

(ii)

(iii)

transactions expressed in a foreign currency into the domestic currency by translating one currency into an equivalent amount of another by applying the appropriate foreign exchange rate (e.g. a credit sales transaction invoiced in foreign currency); expressing the statements (e.g. statement of comprehensive income, statement of financial position) of a foreign operation expressed in one currency into equivalent statements expressed in another currency by applying appropriate foreign exchange rates. so that the foreign operation can be included in the financial statements of the reporting entity via consolidation or the equity method (para. 44, AASB 121). An example includes the translation of the financial statements of a foreign operation expressed in a particular functional currency (e.g. NZ$) into the reporting entity’s functional currency (e.g. A$); or expressing the financial statements of an entity in a presentation currency (e.g. US$) that is different from its functional currency (e.g. A$).

AASB 121 requires that receivables and payables that are to be settled in a foreign currency should be translated initially at the spot rate current at that time (para. 21). Outstanding receivables and payables should be retranslated on succeeding reporting dates using the spot rate current on those dates (para. 23). The unrealised gains or losses should be recognised in the statement of comprehensive income (para. 28). On settlement, the difference between the foreign currency amount translated at the spot rate on that date and the carrying amount should be recognised in the statement of comprehensive income.

. 5

Agreement with these procedures is a matter of opinion. Those who agree with the recommended treatment would probably argue that the statement of financial position should be translated at the current spot rate because this provides more relevant and understandable information than any other exchange rate. They would also probably argue that gains or losses should be reported in the period in which they arise. These exchange differences arise because of changes in exchange rates and the differences should be recorded in the period in which the exchange rates changed. Those who do not support the requirements of AASB 121 would probably argue that the unrealised exchange differences will be realised only if the exchange rates remain stable until the date of settlement. This is unlikely and the probability that the unrealised exchange differences will be realised is too low to recognise them on reporting date. An alternative argument may rely on prudence or conservatism and suggest that while recording unrealised exchange losses is acceptable, the recording of unrealised exchange gains is unacceptable. Others may argue that the probability of the unrealised exchange gains or losses being realised is related to time to maturity. If that time is short, the probability of realisation is high, and the unrealised gains or losses should be reported in the periods in which the exchange rates changed. If that time is long, the probability of realisation is low and the unrealised exchange gains or losses should be deferred until the probability of realisation reaches an acceptable level. 9

Upon initial recognition, a non-monetary item that is measured in a foreign currency is recorded at the spot rate at the date of the transaction (para. 21). At subsequent reporting dates, paragraph 23 requires that non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated using the exchange rate at the date of the transaction; and non-monetary items that are measured at fair value in a foreign currency shall be translated using the exchange rates at the date when the fair value was determined. For inventory and assets to be tested for impairment, paragraph 25 of AASB 121 outlines how to ascertain carrying amount. From paragraph 25, the carrying amount is determined by comparing the cost or carrying amount, as appropriate, translated at the exchange rate at the date when that amount was determined (i.e. the rate at the date of the transaction for an item measured in terms of historical cost); and the net realisable value (for inventory) or recoverable amount (for asset tested for impairment), as appropriate,

. 6

translated at the exchange rate at the date when that value was determined (e.g. the closing rate at the reporting date). The implication of this approach is that translation may result in an impairment loss or inventory write-down that is recognised in the functional currency but not in the foreign currency. 10 (a) Translation of the financial statements of foreign-based operations is necessary in two circumstances: (1) If the functional currency of the foreign operation is not the same as the functional currency of the parent, then its financial statements must be translated into the parent’s functional currency for consolidation in the economic entity’s financial statements; or (2) the functional currency of the economic entity is not its presentation currency, then its financial statements must be translated into the presentation currency. Suppose, for example, the functional currency of a parent is Australian dollars and the functional currency of a foreign operation is New Zealand dollars. The financial statements of the foreign operation must be translated from New Zealand dollars to Australian dollars. The financial statements of the foreign operation can now be consolidated with those of the parent entity to create the Australian currency financial statements of the economic entity. However, if the economic entity’s presentation currency is US dollars, the Australian currency financial statements must be translated into US dollars. In most cases, the functional and presentation currencies of the parent will be the same and a second translation of the financial statements of the economic entity will be unnecessary. The financial statements of foreign-based operations must be translated from the foreign currency into the domestic currency so that they can be consolidated with or incorporated in the financial statements of the parent or head office. (b) The approach required in AASB 121 for the translation of foreign-based operations is similar to the current rate method. AASB 121 requires the translation of all statement of financial position items at the rate current on reporting date and all statement of comprehensive income items at the spot rate when the transaction occurred. The translation gain or loss is not taken to the statement of comprehensive income but is accumulated in the equity section of the statement of financial position as a ‘foreign currency translation reserve’. 11 As translation methods use different rates for different statement of financial position and statement of comprehensive income items, the relationship between those items is changed simply by altering the choice of translation method. Profitability, rates of return, liquidity and solvency are changed by translation. The performance of the branch or subsidiary should be assessed using the foreign currency financial statements. The

. 7

managers of the branches and subsidiaries should be responsible only for matters that they control. As they cannot control exchange rate changes or the translation process, their perceived performance should not be affected by those factors. 12 (a) A parent company would be justified in not consolidating the translated accounts of a foreign subsidiary when it does not control that subsidiary. Control would be lost, if restrictions or regulations in the host country limited the repatriation of profits or made the expropriation of the subsidiary’s assets without compensation probable. It would also be appropriate if it was judged probable that the subsidiary’s assets would be destroyed by war or by civil strife. (b) If the accounts of the foreign subsidiary are not consolidated with the parent company’s accounts, the latter should explain the reason for the non-consolidation and present the translated subsidiary’s accounts in a note to the financial report. 13 (a) Basically, AASB 121 requires the use of the current-rate method for translating the financial statements of all foreign operations. From paragraph 39, the basic procedures for translating financial statements from functional currency to presentation currency are: (a)

(b)

(c)

assets and liabilities for each statement of financial position presented (i.e. including comparatives) shall be translated at the closing rate at the date of that statement of financial position; income and expenses for each statement of comprehensive income (i.e. including comparatives) shall be translated at exchange rates at the dates of the transactions; and all resulting exchange differences shall be recognised as a separate component of equity.

For practical reasons, an average rate for the period can be used to translate income and expense items (para. 40). A summary of the procedures are provided in Table 24.2. (b) The exchange differences arising from translation referred to in paragraph 39(c) are due to translating (a) income and expense items at average rates, (b) closing assets and liabilities at the closing rate, and (c) opening net assets at a closing rate that differs from the previous closing rate. Since the changes in exchange rates have little or no effect on the current and future operational cash flows, such exchange differences are closed to equity rather than being recognised in profit or loss (para. 41). 14 A hedging transaction is an action taken, whether by entering into a forward exchange

. 8

contract or otherwise, with the objective of mitigating possible adverse financial effects of movements in exchange rates. The adverse financial effects are felt if there are changes between the date of the initial transaction and the date of settlement, or an intervening reporting date. The objective of the hedge is to offset such adverse changes. In general terms, there are three types of hedging transactions to remove uncertainty from foreign currency operations. They are: (a) Buy (or sell) foreign currency at the date of the initial transaction in anticipation of a future payment. • E.g. an entity may purchase goods and agrees to pay US$10 000 in 30 days’ time. At the same time, the purchasing entity could acquire US$10 000 for A$14 285 and place it on deposit in a US bank. On settlement of the accounts payable arising from the purchase, the Australian purchaser would draw a cheque for US$10 000 on the US bank and send it to the US creditor. (b) A neutralising transaction. • E.g. if an Australian entity sells goods to a US customer for US$10 000, it could enter into another transaction to purchase goods for US$10 000 with a settlement date as close as possible to that of the first transaction. Any exchange gains or losses on one transaction would be offset by losses or gains on the other. (c) A foreign currency or forward exchange contract. • E.g. an Australian importer must pay US$100 000 in 90 days’ time. The importer could approach a bank for a 90-day forward exchange contract. The bank agrees to sell US$100 000 in 90 days to the importer at a guaranteed exchange rate of, say, A$1 = US$0.60. This is the 90-day forward rate. If this offer is accepted, the bank sells US$100 000 in 90 days’ time for US$100 000/0.6, or A$166 667, regardless of the spot rate on the settlement date. From the importer’s point of view, the uncertainty about exchange gains or losses is removed. 15 The statement is correct. A hedging contract determines in advance the outcome of a foreign currency transaction. The rate is specified and the eventual domestic currency cash payment or receipt is certain. Although uncertainty is removed, there is still a risk that the entity would have been better off not entering into a hedging contract. Any chance of an unexpected gain from a favourable exchange rate movement is lost. The entity must balance the benefits of a certain outcome and no chance of an unexpected exchange loss, and the loss of any chance of an unexpected gain. There is a possibility that the loss of the gain may be greater than the benefit of certainty.

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16 (a) Hedge accounting is used to account for a hedging relationship between a hedged item and a hedging instrument (both of which are designated in accordance with AASB 9). If a designated hedging relationship satisfies specified qualifying criteria, the entity applies hedge accounting – that is, ‘account[s] for the gain or loss on the hedging instrument and the hedged item in accordance with paragraphs 6.5.1–6.5.14 and B6.5.1– B6.5.28’ (AASB 9, para. 6.1.2). The aim of hedge accounting is to: … represent, in the financial statements, the effect of an entity’s risk management activities that use financial instruments to manage exposures from particular risks that could affect profit or loss … This approach aims to convey the context of hedging instruments for which hedge accounting is applied in order to allow insight into their purpose and effect (AASB 9, para. 6.1.1) (b) There are three criteria that must be met by a hedging relationship for it to qualify for hedge accounting. They are specified in paragraph 6.4.1 of AASB 9 as follows: (a) The hedging relationship consists of only eligible hedging instruments and eligible hedged items. (b) At the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge … (c) The hedging relationship meets … hedge effectiveness requirements … In terms of criterion (a), paragraph 6.2.1 of AASB 9 states that a derivative measured at fair value through profit or loss qualifies as a hedging instrument. An example of such a derivative is a commodity forward contract or a forward rate contract to acquire foreign currency. Qualifying hedged items include a recognised asset or liability (e.g. inventory items purchased for a foreign supplier), an unrecognised firm commitment (e.g. a standing purchase order with a foreign supplier), a forecast transaction (e.g. an expected future sale to be invoiced in foreign currency) or a net investment in a foreign operation (para. 6.3.1, AASB 9). Criterion (b) requires documentation that identifies the hedging instrument, the hedged item, the risk being hedged and how the entity will assess whether the hedge is effective. Criterion (c) requires that an entity demonstrates hedge effectiveness by showing an economic relationship between the hedged item and hedging instrument, that credit risk is not dominating the value changes from the relationship and that the proposed hedge ratio is the same as the actual hedge ratio. The hedge ratio is equal to the quantity of the . 10

hedging instrument and the quantity of the hedged item. (c) When an entity has designated the hedging relationship and it qualifies for hedge accounting, it is classified as one of three types of relationships. They are a: a) fair value hedge; b) cash flow hedge; or c) the hedge of a net investment in a foreign operation as defined in AASB 121 (para. 86). Type (c) is self-explanatory, but (a) and (b) require some further discussion. In particular, a fair value hedge is: ‘a hedge of the exposure to changes in fair value of a recognised asset or liability, or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss’ (para. 6.5.2, AASB 9). For example, a company may use a benchmark commodity forward contract to hedge a coffee purchase in foreign currency. The forward contract would reduce its exposure to fluctuations of the spot price or fair value of the coffee in foreign currency (para. IE8, Implementation Guidance to IFRS 9). A cash flow hedge is: ‘a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of a recognised asset or liability … or a highly probable forecast transaction, and could affect profit or loss’ (para. 6.5.2, AASB 9). An example of a cash flow hedge is a hedge of the amount payable to a supplier that is invoiced in foreign currency. (d) In general, a fair value hedge is accounted for by (para. 6.5.8, AASB 9): (a) recognising the gain or loss on the hedging instrument in profit or loss; and (b) recognising the hedging gain or loss on the hedged items in profit or loss. The exception to this occurs if the hedged item is an unrecognised firm commitment. In this case: (a) the cumulative change in the fair value of it is recognised as an asset or . 11

liability with a corresponding gain or loss recognised in profit (para. 6.5.8, AASB 9); and (b) when the firm meets the commitment, the initial carrying amount of the asset or liability is adjusted to include the cumulative change in fair value described in (a) above (para. 6.5.9, AASB 9). The requirements of accounting for a cash flow hedge are summarised below. (a) Hedged item – upon initial recognition a hedged item such as an amount owing to a foreign supplier would be classified as subsequently measured at fair value with gains or losses recognised in profit or loss. (b) Cash flow hedge reserve – this is a separate component of equity associated with the hedged item. It is adjusted to the lower (in absolute terms) of the cumulative gain or loss on the hedging instrument from the inception of the hedge and the cumulative change in fair value of the hedged item from inception of the hedge (para. 6.5.11, AASB 9). (c) Hedging instrument – the hedging instrument is classified as subsequently measured at fair value. However, the portion of the gain or loss on the hedging instrument that is determined to be effective is recognised in other comprehensive income as an adjustment to the ‘cash flow hedge reserve’. The remaining portion of the gain or loss that is due to hedge ineffectiveness is recognised in profit or loss (para. 6.5.11, AASB 9). In the period when the expected future cash flows that are hedged affect profit – for example, when acquired inventory is sold – the accumulated balance of the cash flow hedge reserve is reclassified to profit or loss as a ‘reclassification adjustment’. Also, if the balance of the cash flow hedge reserve is a loss that is not expected to be recovered, it must be immediately reclassified into profit or loss as a ‘reclassification adjustment’. Finally, if a hedged forecast transaction has resulted in the recognition of a non-financial asset or liability (e.g. forecast purchase of inventory from a supplier), the balance of the cash flow hedge reserve shall be included in the initial cost or other carrying amount of the asset or liability (para. 6.5.11, AASB 9). 17 The designated hedging instrument and hedged item must qualify under AASB 9 to be part of the hedging relationship. Paragraph 6.2.1 of AASB 9 states that a derivative measured at fair value through profit or loss qualifies as a hedging instrument. An example of such a derivative is a commodity forward contract or a forward rate contract to acquire foreign currency. Qualifying hedged items include a recognised asset or liability (e.g. inventory items purchased for a foreign supplier), an unrecognised firm

. 12

commitment (e.g. a standing purchase order with a foreign supplier), a forecast transaction (e.g. an expected future sale to be invoiced in foreign currency) or a net investment in a foreign operation (para. 6.3.1, AASB 9). To illustrate a hedging instrument in the context of foreign currency transactions, suppose that an entity borrows US$1 000 000. At the same time, the entity takes out a forward exchange contract to cover the risk of changes in the exchange rate between the date of negotiation of the loan and the date of its settlement. The loan payable is the hedged item and the forward exchange contract is the hedging instrument, providing both are designated as such. 18 Megatron Ltd Note: Please replace the first sentence in the question with the following: ‘Megatron is likely to borrow US$230 000 within the next two weeks which will be payable in six months’ time.’ AASB 9 allows that a hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or a cash flow hedge. Thus, AASB 9 would allow (i) a fair value hedge, or (ii) a cash flow hedge designation for the loan commitment of US$230 000. For a fair value hedge, the description of the accounting treatment is correct. Paragraph 6.5.8 of AASB 9 requires that the gain or loss on the hedging instrument is recognised in profit or loss; and the hedging gain or loss on the hedged items is recognised in profit or loss. The exception to this occurs if the hedged item is an unrecognised firm commitment. In this case: (a) the cumulative change in the fair value of it is recognised as an asset or liability with a corresponding gain or loss recognised in profit (para. 6.5.8, AASB 9); and (b) when the firm meets the commitment, the initial carrying amount of the asset or liability is adjusted to include the cumulative change in fair value described in (a) above (para. 6.5.9, AASB 9). The described accounting treatment of a cash flow hedge is not completely correct. Paragraph 6.5.11 of AASB 9 requires that any gains or losses on the hedging instrument (the forward rate contract) are recognised in other comprehensive income as an adjustment to the ‘cash flow hedge reserve’. However, once the forecast transaction (i.e. . 13

the repayment of the commitment) results in the recognition of a financial liability (i.e. the loan commitment), the gains and losses previously accumulated in other comprehensive income as part of the cash flow hedge reserve equity are reclassified into profit or loss in the periods when the liability affects profit or loss. The loan commitment affects profit or loss whenever it is remeasured; for example, this may happen if the reporting date fell between now and the settlement in six months’ time. 19 Litra Ltd No. To have a designated hedging arrangement for the purposes of AASB 9, the hedge is designated as such at its inception. That is, hedge accounting can only be applied prospectively (not retrospectively) from the date the hedging arrangement qualifies for hedge accounting in accordance with AASB 9. 20 There are three criteria that must all be met by a hedging relationship for it to qualify for hedge accounting. They are specified in paragraph 6.4.1 of AASB 9 as follows: (a) The hedging relationship consists of only qualifying hedging instruments and qualifying hedged items. (b) At the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge. (c) The hedging relationship meets hedge effectiveness requirements. (a) Qualifying Hedge Instruments and Items Paragraphs 6.2.1 to 6.2.3 of AASB 9 govern qualifying hedging instruments. Qualifying hedging instruments include derivatives measured at fair value through profit or loss, and non-derivative financial assets or non-derivative financial liabilities measured at fair value through profit or loss. An example of a qualifying hedging instrument is a commodity forward contract, or a forward exchange rate contract to acquire foreign currency. Qualifying hedged items are covered by paragraphs 6.3.1 to 6.3.6. They include a recognised asset or liability (e.g. inventory items purchased from a foreign supplier), an unrecognised firm commitment (e.g. a standing purchase order with a foreign supplier), a forecast transaction (e.g. an expected future sale to be invoiced in foreign currency) or a net investment in a foreign operation. (b) Formal Designation and Documentation Criterion (b) requires documentation that identifies the hedging instrument, the hedged

. 14

item, the nature of the risk being hedged and how the entity will assess whether the hedge is effective. (c) Hedge Effectiveness Hedge effectiveness is defined as: ‘the extent to which change in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item … Hedge ineffectiveness is the extent to which the changes in the fair value or cash flows of the hedging instrument are greater or less than those on the hedged item’ (para. B6.4.1, AASB 7). However, AASB 9 does not specify a method for assessing whether a hedging relationship is effective. Instead, the following principle is provided: ‘[A]n entity shall use a method that captures the relevant characteristics of the hedging relationship including the sources of hedge ineffectiveness. Depending on those factors, the method can be a qualitative or a quantitative assessment’ (para. B6.4.12, AASB 9). Supporting this principle, there are three hedge effectiveness requirements outlined in paragraph 6.4.1, all of which must be met for a hedge to be effective: • There must be an economic relationship between the hedged item and the hedging instrument. This means that the hedging instrument and hedged item have values that generally move in the opposite direction because of the same risk, which is the hedged risk (para. B6.4.3). For example, there is an economic relationship between a US$100 000 payable owed to a supplier and a forward exchange rate contract to receive US$100 000 on the date settlement of the payable is due. The hedged risk, fluctuations in foreign currency exchange rates, will result in a gain (loss) on the payable that is offset by a loss (gain) on the forward rate contract. • The effect of credit risk does not dominate the value changes that result from the economic relationship. An example of credit risk is when an Australian company sells its product to international buyers and there is the risk of potential financial losses should some international buyers default on their obligations. • The proposed hedge ratio is the same as the actual hedge ratio. The hedge ratio is equal to the quantity of the hedging instrument and the quantity of the hedged item (Appendix A, AASB 9). For example, assume a company hedges a purchase of 400 tonnes of coffee using standard coffee futures contracts. The . 15

standard coffee futures contract size covers 16.74 tonnes of coffee (para. B6.4.10). Since it will take 24 futures contracts which cover 401.76 tonnes of coffee (24 contracts × 16.74 tonnes per contract), the company nominates 24 coffee futures contracts as the hedging instruments. Therefore, the hedge ratio for this hedging relationship is equal to 1.00044 or 401.76 tonnes/400 tonnes. Thus, the hedged item – the purchase of 400 tonnes of coffee – is hedged at 100.44 per cent by the coffee futures contracts. Assessment of hedge effectiveness is required on an ongoing basis, at least annually and sooner if there is a significant change in the circumstances surrounding the hedge effectiveness (para. B6.4.11).

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PROBLEMS 1

(a)

Australian company’s journal ______________________________________________________________ 3 November Accounts receivable – NZ Dr $52 000 Sales revenue Cr $52 000

Sold merchandise to NZ company for $NZ52 000 when the exchange rate was $A1 = $NZ1. ______________________________________________________________ 10 December Cash at bank Dr $43 333 Exchange loss Dr 8 667 Accounts receivable – NZ Cr $52 000 NZ debtors pay $NZ52 000 which is now worth

52 000 = $43 333. 1.20

______________________________________________________________ (b) Assuming that the Australian company’s financial year closes on 31 December and the NZ company settles its account with the Australian company on 10 January, when the exchange rate, for example, is $A1 = $NZ1.10, the journal entries would be: ______________________________________________________________ 31 December Exchange loss Dr $8 667 Accounts receivable – NZ Cr $8 667 Providing for the loss associated with $NZ devaluation. ______________________________________________________________ 10 January Cash at bank Dr $47 273 Exchange gain Dr 3 940 Accounts receivable – NZ Cr $43 333 NZ debtors pay $NZ52 000 which is now worth

52 000 = $A47 273. 1.10

____________________________________________________________ . 17

Assuming that the Australian company’s financial year closes on 31 December. Journal entries in Australian company’s books: _________________________________________________________________ 30 September Cash at bank Dr $75 000 Accounts receivable Dr 75 000 Sales revenue Cr $150 000 _________________________________________________________________ 30 September Inventory Dr $16 618 Cash at bank Cr $8 309 Accounts payable Cr 8 309 _________________________________________________________________ 31 December Exchange loss Dr $3 125 Accounts receivable Cr $3 125 _________________________________________________________________ 31 December Accounts payable Dr $346 Exchange gain Cr $346 _________________________________________________________________

3 Exchange rate $A = Asset $A =

01.07.18

30.06.19

30.06.20

$NZ1.13 2 212 389

$NZ1.09 $NZ1.02 2 293 578 2 450 980

Initial recording of loan on 1 July 2018 _________________________________________________________________ Loan to subsidiary Dr $2 212 389 Cash at bank Cr $2 212 389 _________________________________________________________________ Adjustment of loan to current rate on 30 June 2019 _________________________________________________________________ Loan to subsidiary Dr $81 189 Exchange gain Cr $81 189 _________________________________________________________________ Adjustment of loan to current rate on 30 June 2020 _________________________________________________________________ Loan to subsidiary Dr $157 402 Exchange gain Cr $157 402 _________________________________________________________________

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Mornington Ltd The Australian head office should have recorded the long-term loan to its New Zealand subsidiary on 1 April 2019 as follows: _________________________________________________________________ Loan to NZ subsidiary Dr $50 000 Cash at bank Cr $50 000 _________________________________________________________________ The New Zealand subsidiary would have recorded at the same time the following entry in NZ dollars: _________________________________________________________________ Cash at bank Dr $52 500 Loan from Australian head office Cr $52 500 _________________________________________________________________ On 30 March 2020, as the loan is repayable in Australian dollars, the Australian head office would not adjust its accounts. The New Zealand subsidiary would adjust its liability to reflect current exchange rates. _________________________________________________________________ Loss on Australian dollar borrowing Dr $2 500 Loan from Australian head office Cr $2 500 _________________________________________________________________ 1/04/2019 A$50 000 = NZ$52 500 30/03/2020 A$50 000 = NZ$55 000 Therefore, there is a loss on the liability of $2500 due to adverse exchange rate changes for the NZ subsidiary. The New Zealand subsidiary would show a liability to head office of $NZ55 000. This would be eliminated on consolidation against the loan to subsidiary in the head office accounts.

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Clayton Ltd 11 June 2020 – Purchase of inventory _________________________________________________________________ Inventory Dr A$1 086 957 Accounts payable Cr $1 086 957 (£500 000/0.46 = A$1 086 957) _________________________________________________________________ 30 June 2020 – Balance date _________________________________________________________________ Exchange loss Dr $49 407 Accounts payable Cr $49 407 (£500 000/0.46 = A$1 086 957 book value (£500 000/0.44 = A$1 136 364 fair value Exchange loss = A$49 407) _________________________________________________________________ Settlement of the accounts payable is due in 30 days’ time. This will occur after 30 June 2020 and so is not recorded in the current period.

6 Translation of financial statements of subsidiary from functional currency (FC) to presentation currency (Australian dollars). For ease of setting the exchange rates are expressed as follows: A$1= FC3.00 = 0.33 A$1 = FC4.00 = 0.25 A$1 = FC2.00 = 0.50 Extract from the statement of comprehensive income FC rate Sales revenue less Cost of goods sold: Purchases Closing inventory Gross profit Wages Depreciation Profit/(loss)

2 100 000

0.33

693 0001

(860 000) 350 000 1 590 000 (550 000) (80 000) 960 000

0.33 0.29 --0.33 0.33

(283 800)1 101 5002 510 7003 (181 500)1 (26 400)1 302 800

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Statement of financial position Cash at bank 2 390 000 Inventory 350 000 Fixed assets 800 000 less Accumulated depreciation (80 000) Total assets $3 460 000 Loan 500 000 Share capital 2 000 000 Profit 960 000 Foreign currency translation reserve – Total equities $3 460 000

0.25 0.25 0.25 0.25

597 5004 87 5004 200 0004 (20 000) $865 000

0.25 0.50

125 0004 1 000 0005 302 8006 (562 800)7 $865000

Notes: 1 Translated at the average rate for the year. 2 Translated at the average for June to December of the year. 3 The result of addition and subtraction of translated amounts. 4 Translated at the closing rate. 5 Translated at the historical rate. 6 From the translated statement of comprehensive income. 7 A balancing item or it can be calculated in accordance with paragraph 41 of AASB 121 as follows:

The total translation loss shown in the foreign currency translation reserve is equal to (i) plus (ii) or A$562 800 (62 800 loss + 500 000 loss). (i) A$ profit FC profit × closing rate (FC960 000  0.25) Translation loss (ii) Opening net assets × opening rate (FC2 000 000  0.5) Opening net assets × closing rate (FC2 000 000  0.25) Translation loss

A$302 800 A$240 000 A$(62 800) A$1 000 000 A$500 000 A$(500 000)

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Drover Ltd Translation of net assets from foreign currency into functional currency Drover Ltd (a) Statement of financial position Extract – Functional currency $US Cash at bank 69 000 0.79 Inventory 112 000 0.81 Land 130 000 0.75 Buildings 250 000 0.78 less Accumulated depreciation (80 000) 0.78 Equipment* 28 000 0.71 less Accumulated depreciation (13 000) 0.71 Total assets $496 000

A$ 87 342 138 272 173 333 320 513 (102 564) 39 437 (18 310) $638 023

Accounts payable Income tax payable Borrowings Total liabilities

45 000 34 000 250 000 329 000

56 962 43 038 316 456 $416 456

Net Assets

167 000

0.79 0.79 0.79

$221 567

* Indicators of impairment are present for the equipment (i.e. physical damage to the asset). Impairment is tested for as follows: Asset Equipment less Accumulated depreciation Carrying amount Recoverable amount

US$ 28 000 (13 000) $15 000 17 600

0.71 0.71 0.79

A$ 39 437 (18 310) $21 127 22 278

There is no impairment because recoverable amount (A$22 278) is greater than carrying amount (A$21 127). (b)Statement of financial position Extract – Presentation currency $A Cash at bank 87 342 1.12 Inventory 138 272 1.12

NZ$ $97 823 154 865

Land Buildings less Accumulated depreciation Equipment less Accumulated depreciation Total assets

173 333 320 513 (102 564) 39 437 (18 310) $638 023

1.12 1.12 1.12 1.12 1.12

194 133 358 975 (114 872) 44 169 (20 507) $714 586

Accounts payable Income tax payable Borrowings Total liabilities Net Assets

56 962 43 038 316 456 $416 456 $221 567

1.12 1.12 1.12

63 797 48 203 354 431 $466 431 $248 155

Meggs Ltd Extract from the statement of comprehensive income for year ended 30 June 2020

Sales revenue Less: Cost of goods sold Opening inventory Purchases Closing inventory

Gross profit

FC FC1 600 000

Rate 0.33a

A$ $533 333

--920 000 (320 000) 600 000

0.33

200 000 333 333 133 333 133 333 26 667 $40 000

1 000 000

Wages and salaries

400 000

0.33

Depreciation

400 000

0.33

Interest

80 000

0.33

Profit before tax a

FC120 000

A$1=FC3 is equivalent to an exchange rate of 0.33

Meggs Ltd Statement of Financial Position as at 30 June 2020 Assets Cash Inventory Non-current assets Less: accumulated depreciation

Liabilities Loan Equity Share capital Retained earnings Foreign currency translation reserve

Rate

FC1 400 000 320 000 1 200 000 (400 000) FC2 520 000

0.25a 0.25 0.25

$350 000 80 000 300 000

0.25

(100 000)

FC400 000

0.25

100 000

2 000 000 b

0.50b

1 000 000

---

$630 000

40 000c (510 000)d

FC2 520 000 $630 000 A$1=FC4 is equivalent to an exchange rate of 0.25 b A$1 million contributed by Australian company on 1 January 2020 when the exchange rate was A$1=FC2 or 0.5 c From the statement of comprehensive income d The total translation loss in the foreign currency translation reserve is A$510 000 ($10 000 loss + $500 000 loss) calculated as follows: (i) A$ profit A$40 000 FC profit × closing rate (FC120 000  0.25) A$30 000 Translation loss A$10 000 (ii) Opening net assets*  opening rate (FC2 000 000  0.50) A$1 000 000 Opening net asset  closing rate (FC2 000 000  0.25) A$500 000 Translation loss A$500 000 a

* Opening net assets = A – L. Using the accounting equation, A – L = E, and since opening equity was equal to FC2 000 000 share capital, opening net asset is equal to FC2 000 000.

ALH Ltd In effect, ALH Ltd has locked in the receipt of €250 000 at the forward rate of A$1=€0.55 from JLH Bank when the customer account is settled on 3 May 2020. This amounts to A$454 545 (€250 000/0.55). Thus, ALH will not be exposed to any risk that the amount it will receive will decrease (or increase) with movements in the exchange rate. As part of the contract, JLH Bank charges ALH for the reduction in risk. The charge is the difference between the spot rate at the date of the transaction and the forward rate which is equal to A$26 224 or A$480 769 (€250 000/0.52) less A$454 545 (€250 000/0.55).

10 Soas Company (a) (1) Measure Fair Value of Hedged Item and Hedging Instrument Hedged item – Liability to pay the foreign supplier The inventory order is placed on 1 July 2020 at which time legal title passes to Soas and the purchase is recorded. The fair value of the liability arising from the purchase of inventory is measured using the spot exchange rate and any changes in fair value are recognised in profit or loss. The calculations of fair value are as follows:

Accounts payable at prevailing spot rate (A$) Change in fair value recognised in profit or loss as gain (loss)

Fair value (A$) 30 1 July June --$125 000 (US$100 000/ 0.80) ---

1 August

1 October

(Not relevant to part (a) of question)

$120 482 (US$100 000/ 0.83) $4 518 ($120 481 – $125 000)

. 25

Hedging Instrument – Forward Exchange Rate Contract The calculations of fair value are as follows: (A$)

Forward exchange rate contract at prevailing forward exchange rate (A$) Fair value of forward contract

Change in fair value recognised in profit or loss as gain (loss)

Dates 30 June ---

---

1 July

1 August

1 October

$133 333 (US$100 000/ 0.75)

(Not relevant to part (a) of question)

$120 482 (US$100 000/ 0.83)

$0 (There is no change in the forward exchange rate) $0

---

$12 851 ($120 482 – $133 333)

$(12 851)

(2) Record General Journal Entries 2020: 30 June No entries since there is no purchase and no forward exchange rate contract. 1 July The legal title to the inventory has passed to Soas and the inventory and liability to the supplier are recognised at fair value measured using the spot rate. Inventory Accounts payable

Dr Cr

$125 000 $125 000

No entry is recorded for the forward exchange rate contract. Although the contract has

. 26

been entered into on this date, its fair value is zero because there has been no change in the forward exchange rate. 1 October Settlement of the accounts payable and the forward exchange rate contract both occur at this date. Prior to settlement the forward exchange rate contract and accounts payable are remeasured at fair value, and any changes in fair value are recognised in profit or loss. Foreign exchange loss Forward exchange rate contract Accounts payable Foreign exchange gain

Dr Cr Dr Cr

$12 851 $12 851 $4 518 $4 518

The settlement of the forward contract with the Bank of South Australia requires Soas to pay the bank A$133 333 and in return the bank delivers A$120 482. Therefore, there is a net outflow of cash to the Bank of $12 852 ($133 333 – $120 482). This would be recognised as follows: Forward exchange rate contract Cash at bank

Dr Cr

$12 851 $12 851

The settlement of the liability owed to the foreign supplier would be recorded as follows: Accounts payable Cash at bank

Dr $120 482 Cr

$120 482

In this case, Soas has made a loss on the transaction and the other party to the forward rate agreement – the Bank of South Australia – has made a gain. The total amount of cash paid by Soas of $133 333 ($12 851 + $120 482) is equal to the fixed commitment that Soas had under the forward rate contract. (b) Soas Co. has designated the hedging arrangement as a cash flow hedge. Both the hedging instrument (forward exchange rate contract) and the hedged item (highly probable liability to pay the supplier) must be recorded at fair value. Changes in the fair value of the hedged item are recognised in profit or loss, and changes in the fair value of the hedging instrument are recognised in other comprehensive income as an adjustment to the cash flow hedge reserve because the hedge is assumed to be 100% effective. Therefore, the first step is to measure the fair value of the hedged item and hedging

. 27

instrument, and the second step is to record the general journal entries. (1) Measure Fair Value of Hedged Item and Hedging Instrument Hedged item – Liability to pay the foreign supplier There is a highly probable purchase of inventory on 1 July 2020, but an order is not placed until 1 August 2020 at which time legal title passes to Soas and the purchase is recorded. The fair value of the liability arising from the purchase of inventory is measured using the spot exchange rate and any changes in fair value are recognised in profit or loss. The calculations of fair value are as follows: Fair value (A$) 30 1 July June -----

Accounts payable at prevailing spot rate (A$) Change in fair value recognised in profit or loss as gain (loss)

---

1 August

1 October

$123 457 (US$100 000/ 0.81) $0

$120 482 (US$100 000/ 0.83) $2 975 ($120 482 – $123 457)

Hedging Instrument – Forward Exchange Rate Contract The calculations of fair value are as follows: (A$)

Forward exchange rate contract at prevailing forward exchange rate (A$) Fair value of forward contract

Change value

fair

Dates 30 June ---

---

1 July

1 August

1 October

$133 333 (US$100 000/ 0.75)

$126 582 ($US100 000/ 0.79

$120 482 (US$100 000/ 0.83)

$0 (There is no change in the forward exchange rate) $0

$(6 751) ($126 582 – $133 333)

$(12 851) ($120 482 – $133 333)

$(6 751)

$(6 100)

. 28

Recognised in: - cash flow hedge reserve - profit or loss as gain (loss)

$(6 751) $(6 100)

(2) Record General Journal Entries 2020: 30 June This is a reporting date, but both transactions do not occur/are not considered until 1 July. No entries are recorded. 1 July The forward exchange rate contract has been entered into by Soas Ltd but its fair value is zero, so no entry is recorded. Legal title to the inventory has not passed, so there is no entry to record the highly probable purchase transaction. 1 August The legal title to the inventory has passed to Soas and the inventory and liability to the supplier are recognised at fair value. Inventory Accounts payable

Dr Cr

$123 457 $123 457

The hedged forecast purchase has resulted in a non-financial asset, the inventory. Paragraph 6.5.11 of AASB 9 requires that the balance of the cash flow hedge reserve is included in the cost of the inventory. Prior to this transfer, any change in the fair value of the forward exchange rate contract is recognised. In this case, the loss on the forward contract reduced the asset ‘Forward Contract’ and reduces the cash flow hedge reserve. Cash flow hedge reserve Forward exchange rate contract (Change in fair value of forward exchange rate contract)

Dr Cr

$6 751 $6 751

Inventory Dr $6 751 Cash flow hedge reserve Cr $6 751 (Transfer as per para. 6.5.11 of AASB 9. The loss on the forward exchange rate contract increases the cost of the inventory) . 29

1 October 2020 Settlement of the accounts payable and the forward exchange rate contract both occur at this date. Prior to settlement, the forward exchange rate contract and accounts payable are remeasured at fair value. Since the purchase of the inventory has been recognised, any changes in the fair value of the forward exchange rate contract are no longer accumulated in the cash flow hedge reserve in other comprehensive income. Instead, the changes in fair value are recognised in profit or loss. Accounts payable Foreign exchange gain Foreign exchange loss Forward exchange rate contract

Dr Cr Dr Cr

$2 975 $2 975 $6 100 $6 100

The settlement of the forward exchange rate contract with the Bank of South Australia requires Soas to pay the bank A$133 333 and in return the bank delivers A$120 482 (US$100 000/0.83). Therefore, there is a net outflow of cash from Soas of $12 851 ($133 333 – $120 482). This would be recognised as follows: Cash at bank Forward exchange rate contract

Dr Cr

$12 851 12 851

The settlement of the liability owed to the foreign supplier would be recorded as follows: Accounts payable Cash at bank

Dr Cr

$120 482 120 482

In this case, Soas has made a loss on the transaction and the other party to the forward exchange rate agreement – the Bank of South Australia – has made a gain. The total amount of cash paid by Soas of $133 333 ($12 851 + $120 482) is equal to the fixed commitment that Soas had under the forward exchange rate contract. 11 SA Company SA Co. has designated the hedging relationship as a cash flow hedge for the purposes of AASB 9 and it is assumed that the hedge qualifies for hedge accounting. The forward exchange rate contract is the hedging instrument and the hedged item is the highly probable credit purchase from the foreign supplier. The first step is to measure the fair value of the hedged item and hedging instrument, and the second step is to record the general journal entries. . 30

(1) Measure Fair Value of Hedged Item and Hedging Instrument Hedged item – Liability to pay the foreign supplier The inventory order is placed on 1 July 2020 at which time legal title to the goods passes to SA Co. The forward exchange rate contract is entered into 1 June 2014 and 30 June is the annual reporting date. The fair value of the liability arising from the purchase of inventory is measured using the spot exchange rate and any changes in fair value are recognised in profit or loss. The calculations of fair value are as follows: Fair value

Accounts payable at prevailing spot rate (A$) Change in fair value recognised in profit or loss as gain (loss)

Dates 1 June ---

30 June ---

---

1 July

1 September

$103 093 (US$100 000/ 0.97) $0

$100 000 (US$100 000/ 1.00) $3 093 ($103 093 – $100 000)

Hedging Instrument – Forward Exchange Rate Contract The forward exchange rate contract is entered into on 1 June 2020. At this time, SA Co has a liability to pay the ABC Bank $108 696 on 1 September 2020 in exchange for the right to receive US$100 000 translated at the spot exchange rate on 1 October 2020 from the ABC Bank. The calculations of fair value are as follows: (A$) Forward exchange rate contract at prevailing forward exchange rate (A$) Fair value of forward contract

1 June $108 696 (US$100 000/ 0.92)

30 June $105 263 (US$100 000/ 0.95

Dates 1 July $104 167 (US$100 000/ 0.96)

1 September $100 000 (US$100 000/ 1.00)

$0 (There has been no

$(3433) ($105 263 – $108 696)

$(4 529) ($104 267 – $108 696)

$(8 696) ($100 000 – $108 696)

. 31

Change in fair value

change in the forward exchange rate) $0

Recognised in: - cash flow hedge reserve -

profit or loss

$(3 433) ($3 433 – $0)

$(1 096) ($4 529 – $3 433)

$(3 433)

$(4 167) ($8 696 – $4 529) ---

$(1 096) ---

$(4 167)

(2) Record General Journal Entries 2020: 1 June The forward exchange rate contract has been entered into by SA Co. but its fair value is zero, so no entry is recorded. 30 June This is the reporting date. Therefore, the forward exchange rate contract’s fair value must be measured and any change recognised in other comprehensive income as an adjustment to the cash flow hedge reserve. Note, the 1 June forward contract represents an asset to SA Co. – that is, the right to receive US$100 000 on 1 September 2020 from the ABC Bank. The loss on the forward exchange rate contract reduced the asset ‘Forward Contract’ and reduces the cash flow hedge reserve. Cash flow hedge reserve Forward contract

Dr Cr

$3 433 $3 433

1 July The legal title to the inventory has passed to SA Co. and the inventory and liability to the supplier are recognised at fair value. Inventory Accounts payable

Dr Cr

$103 093 $103 093

. 32

the forward exchange rate contract is recognised. Cash flow hedge reserve Forward exchange rate contract (Change in fair value of forward contract)

Dr Cr

$1 096 $1 096

Inventory Dr $4 529 Cash flow hedge reserve Cr $4 529 (Transfer as per para. 6.5.11of AASB 9 ($3 433 + 1 096). The two losses on the forward exchange rate contract increased the cost of the inventory) 1 September 2020 Settlement of the accounts payable and the forward exchange rate contract both occur at this date. Prior to settlement, the forward contract and accounts payable are remeasured at fair value. Since the purchase of the inventory has been recognised, any changes in the fair value of the forward contract are no longer accumulated in the cash flow hedge reserve in other comprehensive income. Instead, the changes in fair value are recognised in profit or loss. Accounts payable Foreign exchange gain Foreign exchange loss Forward exchange rate contract

Dr Cr Dr Cr

$3 093 $3 093 $4 167 $4 167

The settlement of the forward exchange rate contract with the Bank of Commerce requires Montlake to pay the bank A$108 696 and in return the bank delivers A$100 000 (US$100 000/1.00). Therefore, there is a net outflow of cash from SA Co. of $8696 ($108 696 – $100 000). This net outflow would be recognised as follows: Forward exchange rate contract Cash at bank

Dr Cr

$8 696 $8 696

The settlement of the liability owed to the foreign supplier would be recorded as follows: Accounts payable Cash at bank

Dr Cr

$100 000 100 000

. 33

In this case, SA Co. has made a loss on the transaction and the other party to the forward exchange rate agreement – the ABC Bank – has made a gain. The total amount of cash paid by SA Co. of $108 696 ($8 696 + $100 000) is equal to the fixed commitment that Soas had under the forward exchange rate contract. 12 These questions are answered based on the most recent financial statements of Cochlear Ltd at the time of writing – in this case, the 2015 financial statements. (a) The answer can be found in Note 6 ‘Financial Risk Management’, p. 85 of the 2015 Financial Statements. That is: ‘Cochlear is exposed to currencies other than the respective functional currencies of the controlled entities, primarily AUD, USD, EUR, GBP, Swedish Kroner (SEK), JPY and Swiss Francs (CHF). ‘Over 90% of Cochlear’s revenues and over 50% of costs are determined in currencies other than AUD. Currency risk is hedged in accordance with treasury risk policy. Risk resulting from the translation of assets and liabilities of foreign operations into Cochlear’s reporting currency is not hedged. ‘ (b) Yes, Cochlear has hedges of foreign currency risk. The hedging arrangements take the form of derivative financial instruments. (This information is available in Note 6, p. 86) An example of a derivative financial instrument used by Cochlear to hedge foreign currency risk is a forward exchange contract to hedge anticipated sales and purchases in USD, EUR and JPY. (c) (i) The hedges meet the requirements for hedge accounting. This is stated in Note 6, p. 86. (ii) The hedges have been designated as cash flow hedges (see Note 6, p. 86). They are hedges of forecast future transactions to manage the currency risk arising from exchange rate fluctuations,. The hedged items were highly probable foreign currency transactions. (d) Yes, it is noted in note 1.1(c) that the functional and presentation currency of Cochlear Ltd is Australian dollars (AUD). Further, Note 6 (a) (p. 87) lists the significant exchange rates (average and spot rates) applied to Cochlear during the reporting period.

. 34

In particular, the average exchange rates are used for income and expense items for each statement of comprehensive income. While paragraph 39 of AASB 121 requires that income and expense items shall be translated at exchange rates at the dates of the transactions, for practical reasons paragraph 40 of AASB 121 allows the use of an average rate for the period to be used for translation. Further, assets and liabilities are translated at the spot rate at the end of the reporting period.

. 35

Chapter 25 ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITIES LEARNING OBJECTIVES After studying this chapter you should be able to: 1

define social responsibility and assess the role of corporate social responsibilities in the context of the corporate objective of maximising shareholders’ wealth;

explain the different motivations for corporate social responsibility reporting;

describe the extent of reporting by entities on their corporate social responsibilities;

identify some proposed methods of accounting for corporate social responsibilities and understand how these methods may be implemented;

explain sustainability reporting;

explain integrated reporting; and

discuss developments in accounting for carbon.

QUESTIONS 1

In the book we introduce the notion of ‘corporate social responsibility’ as follows. Some companies in the US and in other countries have been criticised in recent decades for their apparent lack of ‘social responsibility’. The meaning of ‘corporate social responsibility’ has been interpreted very broadly, and may be thought of as the impact of a company’s activities on the welfare of society. There have been complaints, for example, about the pollution of the environment, about products which are unsafe or . 1

faulty, and about health and safety issues in the workplace. A company which does not pollute the environment, does not produce unsafe or faulty products, and provides a healthy and safe workplace would, therefore, be classified as ‘socially responsible’. Students would be expected to consider such issues in answering this question. More formally, we draw from the United Nations Industrial Development Organisation which defined corporate social responsibility whereby ‘companies integrate social and environmental concerns in their business operations and interactions with their stakeholders. Corporate social responsibility is generally understood as being the way in which a company achieves a balance of economic, environmental and social imperatives…, while at the same time addressing the expectations of shareholders and stakeholders.’ Thus, corporate social responsibility has evolved to include a focus on the economic, environmental and social impacts of an organisation’s activities with an emphasis on stakeholder engagement to identify issues of concern so as to meet expectations. 2

(a) The costs imposed on society by an entity that have to be met out of the public purse are referred to as ‘externalities’. Many examples can be found from any newspaper. A hypothetical example of an externality is a detergent manufacturer that is considering whether to manufacture its product at a new site. In making the decision, the manufacturer’s managers compare the extra revenues and the extra costs of producing the detergent at the new location. The managers are aware that the production of detergent at the new location will cause a serious pollution problem as effluent from the production process will contaminate a waterway into which it will be discharged. This will reduce the suitability of the waterway for recreation purposes. In other words, the release of the effluent into the waterway will result in costs to society in general. The costs imposed on society are not met by the manufacturer. Costs incurred by, say, a local authority in ridding the waterway of the contamination are borne by the community as a whole and not by the detergent manufacturer. Because they are external costs, they are ignored by the company’s managers in their decision-making processes. (b) Governments may take the initiative in ensuring that companies act in a socially responsible manner in a number of ways. (1) They may legislate to establish environmental and other standards to which all entities must conform. For example, the quality of exhaust emissions from motor vehicles can be controlled by imposing the same level of permissible emissions on the products of all motor vehicle manufacturers. (2) They may impose penalties on those who damage the environment. For example, a detergent manufacturer releasing effluent into a waterway may be required to pay a tax. The magnitude of the tax should be equal to the sum of the damage to all other . 2

members of society that results from the manufacturer’s pollution of the waterway. The manufacturer would then be free to choose whether to continue to pollute the waterway and pay the tax or whether to act in a more socially responsible manner and control the release of effluent into the waterway. However, the practical difficulties of adopting this solution are significant. In many cases, it is impossible to measure the social costs in dollar terms, and, even if measurement were possible, the government still has the practical problem of taxing a particular manufacturer in a manner proportional to the unfavourable effects that it is causing. (3) They may provide subsidies to encourage companies to produce the desired social goods and services. For example, the detergent manufacturer may be given a subsidy to control the discharge of effluent into the waterway. (4) Governments may respond to concerns about climate change by adopting any of the following three mechanisms to limit greenhouse gas emissions: • clean development mechanisms (reducing emissions via investment in emissions reduction projects in developing countries for which carbon credits can be obtained);

•

joint implementation (similar to clean development mechanisms but also enables investment in emissions reduction projects in other industrialised countries); and

•

Kyoto emissions trading mechanism (allows countries to purchase emissions permits from other signatory countries to contribute to their domestic reduction targets).

If, for example, a company installs pollution abatement equipment, then, compared with companies that have not installed the equipment, the effect on its financial statement will be to increase its assets and its periodic expenses in the form of depreciation. Another example may be a company that is investing in research and development aimed at innovative new technology to reduce carbon emissions. The effect on its financial statement will be to increase expenses and reduce earnings. In short, the short-term effect for the worst polluters (i.e. companies focused on externalising the cost of pollution) is that they do appear more profitable with fewer expenses and capital investments.

There seems to be ample support for the contention that unless the benefits of a socially responsible activity flow to the company and exceed the costs, then, from the entity’s point of view, there are economic reasons for failing to act in a socially responsible manner. The result is that, if social costs result from an entity’s activities, they will be borne by the rest of the community when ideally they should be borne by the entity

. 3

whose activities cause them. The ‘internalisation’ of these social costs would force the management of a company to include them with other costs in making its decisions. Governments may take the initiative in ensuring that companies act in a socially responsible manner. One way in which they may achieve this result is to legislate to establish environmental and other standards to which all entities must conform. For example, the quality of exhaust emissions from motor vehicles can be controlled by imposing the same level of permissible emissions on the products of all motor vehicle manufacturers. 5

Advocates for maximising shareholders’ wealth suggest that socially responsible activities, such as pollution abatement, should not be undertaken unless they are consistent with the shareholders’ best interests. They suggest that management should confine itself to ensuring the efficient operation of the company in the interests of shareholders. If a detergent manufacturer installed expensive equipment to reduce pollution, the benefits would accrue largely to outsiders. From society’s point of view, the benefits may be substantial. However, from the company’s point of view, unless it can recover the costs of pollution abatement from its customers by charging higher prices, the costs are unlikely to be justified. It will not be in the shareholders’ best interest because, other things being equal, the costs of pollution abatement will result in a lower market price for the company’s shares. The possibility of a reduction in share price will be reinforced if competitors fail to take similar action to reduce pollution and, consequently, have superior profitability. There is, therefore, apparently very little incentive for the detergent manufacturer to install pollution-abatement equipment. This does not mean that the manufacturer will fail to install the equipment. If, for example, the manufacturer knows of impending legislation to impose large penalties on polluters, it may install the equipment now in order to avoid having to do so at a later date, probably at a greater cost and with disruption to production.

This contention may be illustrated as follows. A motor vehicle manufacturer would be unlikely to voluntarily install a device on its products to reduce exhaust emissions because this would place it at a disadvantage compared to its competitors who do not install the device on their products. Society cannot reasonably expect a particular manufacturer to shoulder the extra costs voluntarily, if its competitors are not doing the same. In these situations, there is conflict between the decision that serves the best interest of shareholders and the decision that serves the best interest of society. It is for this reason that governments find it necessary to compel companies to meet minimum standards of pollution control.

In many instances, management will find it difficult to justify on purely economic grounds the costs of socially desirable projects. However, incurring such costs is . 4

frequently justified by companies on the ground of ‘enlightened self-interest’. This phrase describes costs that appear to be motivated by a desire to promote society’s best interest, but which are really incurred in the hope of generating benefits for the company that exceed those costs. For instance, corporate philanthropy such as allowing employees to take one day per year to work for any charitable organisation and making donations to universities would be expected to flow to activities that the donor company believes will serve its own interest. Also, incorporating elements of corporate social responsibility into a company’s products may reinforce product differentiation and allow access to new customers and therefore future revenue growth. In addition, where a company makes donations to universities, its own interests would include the promotion of good public relations and the possibility that graduates may seek employment with the company. However, a general grant to a university does not guarantee either good public relations or that superior graduates will seek employment exclusively with the donor. In the latter case, more graduates will also become available to other companies, including competitors of the philanthropist. Indeed, it is possible that competitors may pay higher salaries to new graduates with the funds that would otherwise have been used for donations to universities, with the result that the donor may have difficulty recruiting any of the graduates who have benefited from its donations. Thus, it may be argued that companies which make donations to universities may not be acting in their own selfinterest because it is usually impossible to ensure that the benefits will flow exclusively to the donors. However, the philanthropy may still be justified if the perceived benefits exceed the costs. 8

Stakeholder theory extends the traditional view of stakeholders to include groups and individuals such as environmentalists, consumer advocates, media, governments and global competitors. Under this perspective, the behaviour of stakeholders is viewed as a potential constraint on strategies to match corporate resources with the environment. Stakeholder theory suggests that a major role of management is to assess the importance of meeting stakeholder demands in order to achieve the strategic objectives of the company. Companies have a certain degree of discretion on how to fulfil these various external demands, and accordingly prioritise the management of the demands of powerful stakeholder groups. Stakeholders’ importance derives from their power to control critical resources required by the company to remain viable. Consequently, the company will strategically manage relationships with important stakeholders to ensure continued survival. Publicly disclosed information, including corporate social responsibility disclosures, is viewed as part of a strategy to negotiate stakeholder relationships. In short, corporate . 5

social responsibility reporting is undertaken as part of a stakeholder management strategy. 9

Legitimacy theory suggests that the relationship between a company and society, viewed as a collection of individuals, is subject to a social contract. The implied social contract provides that as long as the activities of a company are consistent with society’s values, the company’s legitimacy and ultimately its continued survival is assured. The legitimacy of a company is called into question when the expectations of society do not match corporate behaviour. This disparity creates threats to corporate legitimacy, referred to as legitimacy gaps. Examples of failures in corporate performance that give rise to legitimacy gaps include negative social and environmental impacts such as a serious accident, a major pollution leak or a financial scandal. The managers of a company seek to close legitimacy gaps because the members of society may react by imposing legal, economic and other social sanctions on the company. There are various corporate strategies to close a legitimacy gap, one of which is to use various forms of communication to direct attention from the legitimacy gap, or to reinforce the community’s perception of management’s responsiveness to particular social or environmental issues. One channel of communication is financial statements. There is empirical evidence to suggest that managers make strategic and environmental disclosures in financial statements. The disclosures tend to be self-laudatory with positive news emphasised over negative news, particularly in response to specific social and environmental issues. Any search of The Australian or Australian Financial Review will turn up examples of companies ‘breaching’ their social contract via negative environmental impacts or detrimental social impacts (e.g. impacts on local communities, outsourcing of local jobs, fatalities to employees). The examples selected should include an element of societal pressure in the form of local community pressure, or political pressure to ‘do what is expected’.

10 This statement is incorrect. While there are no Australian accounting standards requiring companies to report on their environmental and social performance, two legal requirements in Australia are applicable to reporting CSR: 1) Section 299(1)(f) of the Corporations Act which stipulates that companies include in their Directors’ Report information about whether the entity’s operations are subject to any particular and significant regulation and, if so, details of the entity’s performance in relation to the regulation. In addition, sections 1013(A) to (F) of the . 6

Act require providers of financial products with an investment component to disclose the extent to which labour standards and environmental, social or ethical considerations are taken into account in investment decision making. Regulatory Guide 65 ‘Section 1013DA disclosure guidelines’ provides additional guidance on how issuers can meet their obligations under s1013DA to disclose in product statements how labour standards or environmental, social or ethical considerations are taken into account in selectin, retaining or realising an investment. 2) The NGER Act (2007) requires that liable entities report their annual greenhouse gas emissions and energy usage to the Clean Energy Regulator. 11 Drugs For Life Drugs for Life Ltd would be required to comply with Section 299(1)(f) of the Corporations Act which stipulates that companies include in their Directors’ Report information about whether the entity’s operations are subject to any particular and significant regulation and, if so, details of the entity’s performance in relation to the regulation. In addition, as a large chemical manufacturer Drugs for Life would likely exceed the mandated emission thresholds under the NGER Act (2007) for reporting their greenhouse gas emissions, energy production and consumption to the Clean Energy Regulator. Currently, the reporting threshold for corporate groups (individual facilities) is 50 000 kilotonnes (kt) (25 000 kt) of CO2-e (scope 1 and scope 2 emissions)53, producing or consuming more than 200 terajoules (TJ) (100TJ) of energy in a financial year. Once registered, controlling corporations are required to report by 31 October following the reporting year, and must submit an NGER Report every subsequent year that it remains registered. . 12 This statement is incorrect. While there are no Australian accounting standards requiring companies to report on their environmental and social performance, section 299(1)(f) of the Corporations Act stipulates that companies include in their Directors’ Report information about whether the entity’s operations are subject to any particular and significant regulation and, if so, details of the entity’s performance in relation to the regulation. Thus, a breach of the regulations would be reported in the Directors’ Report of the company. 13 This is the most frequent method of disclosing activities that could be included under the umbrella of corporate social responsibility. An advantage of this approach is that it is simple to prepare and does not involve the necessity of attributing costs to particular activities. A difficulty with this approach is to keep the list within realistic limits. Also, it would be virtually impossible to make inter-company comparisons as there is no . 7

standard that can be used in association with the list to measure a company’s social responsibility. 14 Quantitative corporate social responsibility reporting attempts to quantify a company’s social and environmental interactions. This approach is based on a more systemic view of a company’s interaction with the environment than descriptive performance reporting. For example, a company may attempt to quantify the environmental impacts of one of its products over its life cycle, which can also be expanded to apply to a division or to the entire company. Of interest are the resources used and the efficacy of their usage over the life cycle of a company’s products. The Ricoh Group introduced the concept of Eco Balance in 1998 to identify the overall environmental impacts of its businesses, as well as its individual business sites in such a way. Students may access the latest Eco Balance from the Ricoh Group’s website (www.ricoh.com/environment/management/eco.html). In this report, the company discloses the physical inputs to its operations including the amounts of chemical substances (tonnes), water (cubic metres), fossil fuels (kilolitres) and electric power (KWh) used, and the subsequent outputs such as greenhouse gases (carbon dioxide equivalents), landfill waste (tonnes) and water discharged (cubic metres). 15 Full cost reporting systems attempt to allow accounting and economic numbers to incorporate all potential/actual costs and benefits including environmental (and perhaps social) externalities. More often than not, reported income is adjusted for the estimated social and environmental impacts of a company’s operations to provide a performance measure that reflects financial and social responsibility performance. The motivation for full cost accounting for corporate social responsibility is that managers and stakeholders often assess the performance of companies in terms of conventional profit, with little or no attention given to any externalities or social costs imposed on the community. If there is no link between financial performance and corporate social responsibility performance, the social and environmental impacts of companies will most likely not be recognised. There was early experimentation with full cost reporting in the 1970s (e.g. Linowes, 1972), and most recently in the 1990s. There are three basic approaches – maintenance cost, asset valuation and damage cost reporting systems. Maintenance cost approaches focus on the maintenance of natural capital to ensure the sustainability of a company’s operations. Reporting on the sustainability of a company’s operations is done by estimating the ‘sustainable cost’ associated with negative . 8

externalities resulting from its activities and adjusting the conventional profit figure accordingly. A company’s ‘sustainable cost’ is equal to the additional costs to be borne by it if its activities are not to leave the planet worse off. This may be estimated by considering the cost of purchasing the most sustainable alternative on the market, and the cost of remediation of environmental effects arising from operations. Asset valuation approaches to full cost accounting focus on valuation of environmental assets and changes therein. To illustrate, consider the ‘Supplementary Economic Accounts’ experiment (1995–1998) of Earth Sanctuaries. A supplementary economic statement of financial position was prepared that included three types of natural assets – vegetation, wildlife and habitat. An economic statement of comprehensive income was also prepared in which increases in the value of these natural assets were included in economic profit, and then transferred from profit to an economic valuation reserve. Damage cost reporting systems are concerned with communicating estimates of external environmental costs from a company’s operations. The basic assumption is that externalities are non-monetary infusions of capital provided by the environment to be accounted for in a similar manner. To illustrate, consider the most recent ‘Environmental Profit and Loss Account’ (EP&L) prepared by Kering (the French parent company of PUMA Corporation) which can be accessed from the group’s website (www.kering.com/en/sustainability/results). The aim of the EP&L project is to report on the cost of all types of capital used to produce its goods, from raw materials right through to the retail transaction. To obtain these estimates of the cost of capital used, Kering/PUMA Corporation engaged external consultants to apply environmental economic modelling techniques. The aim of Kering’s damage cost approach is not to reduce earnings by the environmental cost, but rather to use the metrics to focus managers within the company on where to mitigate the environmental footprint of PUMA’s operations across all supply levels. The ability to measure the financial value of social and environmental impacts is one of the most significant impediments to full cost reporting, even after nearly four decades of experimentation. Practical measurement issues include data availability, and the reliability and suitability of estimates of social and environmental impacts. In addition, there are problems with ‘additivity’. That is, different measurement bases are usually incorporated within the one report, making a sensible financial result impossible. Put simply, these financial environmental reporting experiments are like adding possible apples to approximate pears and subtracting the results from hypothetical oranges. There have also been questions about the validity of attempting to value the environmental and social dimensions of corporate activities.

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16 This is a provocative statement, addressing the role of regulation in improving accountability. Voluntary disclosures are made by Australian companies, but these disclosures vary in format and content. Some students may agree that environmental disclosures should be enforced through specific accounting standards, ASX listing requirements, or the Corporations Act 2001. They should be prepared to comment on the nature of these disclosures including format and content. 17 Sustainability reporting is corporate disclosure that provides information on a company’s economic, environmental and social activities. The Group of 100’s Guide to TBL Reporting contains the following definition of sustainability reporting. ‘… as corporate communication with stakeholders that describes the company’s approach to managing one or more of the economic, environmental and/or social dimensions of its activities and through providing information on these dimensions … In its purest sense, the concept of TBL reporting refers to the publication of economic, environmental and social information in an integrated manner that reflects activities and outcomes across these three dimensions of a company’s performance.’ Another definition comes from the Global Reporting Initiative (GRI) Sustainability Reporting Guidelines which define sustainability reporting as: ‘the practice of measuring, disclosing and being accountable to internal and external stakeholders for organisational performance toward the goal of sustainable development’. Sustainability reporting is in an early stage of development. There is no accepted national or international framework for sustainability reporting. Instead, in many countries government and industry are developing guidelines to assist interested companies with the implementation of sustainability reporting. Sustainability reporting involves the communication of a range of qualitative, quantitative and financial information about a company’s social, environmental and economic performance to key stakeholder groups. To assist in this communication process, there has been a focus on the development of performance indicators. The idea is that accepted performance indicators provide a means of benchmarking a broad range of information on economic, social and environmental performance over time and between entities. The Sustainability Reporting Guidelines – the GRI G4 Guidelines – developed by the Global Reporting Initiative (GRI) provide suggestions for performance indicators. •

A company only reports on areas of performance that are important to its stakeholders. As part of sustainability reporting, companies must prioritise . 10

•

amongst these stakeholder groups and communicate about areas of performance that are significant to key stakeholders. There are many possible formats for sustainability reporting that range from stand-alone reports, to sections in a company’s annual report, to disclosures on a company’s website. The content of a sustainability report/section is tailored to an individual company’s context and its stakeholders’ requirements. (Some companies have applied the GRI G4 Guidelines on what should be included in a sustainability report.) Implementation of a sustainability reporting approach by a company is an incremental process, occurring over a period of several years.

A key issue that arises is how users of reports assess the reliability of information reported in a sustainability report. Recently, this has led to a focus on verification of the reports/sections. There are two general options available for independent verification of sustainability reporting reports/sections. Assistance can be sought from large international chartered accounting firms or major engineering consultancies that have consulting practices specialising in verification of sustainability reporting. Alternatively, the expertise of smaller boutique environmental and social consultancies or individuals with strong social credentials can be sought. 18 This statement is incorrect. One of the most common misconceptions regarding sustainability reporting is that social, environmental and economic impacts are combined into a single bottom line performance measure. This is not the case. Instead, sustainability reporting involves the communication of a range of qualitative, quantitative and financial information about a company’s social, environmental and economic performance to key stakeholder groups. 19 There are no legislative requirements, nor generally accepted standards in relation to the preparation and attestation of sustainability reports. Some voluntary guidelines on the verification process have been issued, one of the most prominent examples being the ‘AA1000 Assurance Standard Guiding Principles’ issued by AccountAbility <www.accountability.org/standards/index.html>. The absence of any generally accepted verification procedures means that: ‘… a customised approach is usually adopted, based upon agreed procedures between the reporting company and the company or individuals providing independent verification. Such agreed upon procedures vary from verification of

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specific data and underlying processes through to substantiation of material facts and assertions or a combination of both.’ There are two general options available for independent verification of sustainability reports/sections. Assistance can be sought from large international chartered accounting firms or major engineering consultancies that have consulting practices specialising in verification of sustainability reporting/sustainability reporting. Alternatively, the expertise of smaller boutique environmental and social consultancies or individuals with strong social credentials can be sought. Students’ opinions on the importance of verification of sustainability report/sections will vary. However, there should be discussion of the broad range and volume of descriptive, quantitative and in some cases financial data that are disclosed in a sustainability report. (Rio Tinto can be used as an example.) With this type and quantity of data being reported, a key issue that arises is how users of reports assess the reliability of the information. 20 (a) The Global Reporting Initiative (GRI) was established in 1997 following the Exxon Valdez oil spill. It was a joint initiative of the Coalition for Environmentally Responsible Economies (CERES) (a US-based organisation) and the United Nations Environment Programme (UNEP). Its focus was on environmental and then social and economic issues. Since this time it has become an independent organisation based in Amsterdam that works closely with the UNEP. The GRI produced an initial version of its sustainability reporting guidelines in 1999, revised them in 2002 and October 2006 and again in May 2013 as the G4 Guidelines. These reporting guidelines are for voluntary use by organisations for reporting on the economic, environmental and social dimensions of their activities, products and services. The suggested disclosures of a GRI-based report can be split into standard disclosures aimed at providing an organisation context (e.g. strategy, governance, stakeholder engagement, ethics and integrity) and specific disclosures which outline performance. The specific disclosures include information on managers’ approach to management of economic, environmental and social impacts relating to material aspects of operation are managed; and indicators and aspect-specific disclosures to assess performance on material aspects of operations. The Accounting in Focus box in section 25.3.3 provides an overview of the categories and aspects covered in the G4 Guidelines. (b) The GRI database can be searched for Australian companies. Using Brambles 2015 Sustainability Review as an example: (i) The adherence level is comprehensive. . 12

(ii) the report is assured by KPMG (although no accepted assurances standards have been applied) (iii) Brambles (see summary p. 4 of 2015 Sustainability Review) achieved its target to have supply chain collaboration by joining the Consumer Goods Forum. (iv) Brambles is working toward a people engagement score of 75% (in 2015 it achieved a score of 72%). 21 Integrated reporting is defined in the International <IR> Framework as ‘a process founded on integrated thinking that results in a periodic integrated report by an organization about value creation over time and related communications regarding aspects of value creation. An integrated report is a concise communication about how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term.’ <www.integratedreporting.org/the-iitc-2/>. The Integrated Reporting Committee (IRC) of South Africa suggests that integrated reporting is based on the concept of value creation which stems from changes in the value of six types of capital over time. The types of capitals are: • • • • • •

financial capital (e.g. debt and equity capital); manufactured capital (e.g. equipment, public infrastructure); intellectual capital (e.g. patents, research and development, internally developed technological systems); human capital (e.g. employees’ skill base); social and relationship capital (e.g. stakeholder and community relationships) and natural capital (e.g. natural resources). (Integrated Reporting Committee (IRC) of South Africa (2014), Preparing an Integrated Report: A Starter’s Guide, p. 3)

Examples can be found on the website under ‘recognised reports’. Using the filters ‘Australasian Reporting Awards’ and ‘2015’, CPA Australia 2014 is identified. From p. 51 The section ‘How we do business’ (pp. 47-63) provides a good example of overlaying CPA Australia’s business model with the resources at its disposal. 22

Integrated reporting presents a more comprehensive view of how the organisation creates value (in the short-, medium- and long-term) from interactions between its strategy, governance, performance and prospects and its capital (i.e. financial, manufactured, intellectual, human, social and relationship and natural). In contrast, sustainability reporting focusses on economic, environmental and social performance. As such sustainability reporting can be viewed as an intrinsic part (or subset) of integrated reporting.

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23 Yes, it is an accurate statement. The underlying rationale of integrated reporting is to integrate or converge the annual and corporate social responsibility (CSR) reports. Simply including CSR information in the annual report is not sufficient to be an integrated report. In fact, the impetus for integrated reporting came from the increasingly complex CSR disclosures being made in stand-alone sustainability reports. 24

(a) Students should form their own opinion. However, the obvious answer is yes there are few mandated carbon-related disclosures. The only mandated requirement applies to organisations which exceed the reporting thresholds set under the NGER Act (2007). These organisations are required to report their greenhouse gas emissions, energy production and consumption during a financial year to the Clean Energy Regulator. Currently, the reporting threshold for corporate groups (individual facilities) is 50 000 kt (25 000 kt) of CO2-e, or producing or consuming more than 200 TJ (100TJ) of energy in a financial year. Once registered, controlling corporations are required to report by 31 October following the reporting year, and must submit an NGER Report every subsequent year that it remains registered. The NGERS also provides for greenhouse and energy audits of NGER reporting companies and the establishment of a register of such auditors. The aim of a greenhouse and energy audit is to determine the extent of compliance by a company caught by the NGER Act. Companies may elect to self-audit using greenhouse and energy auditors from the register, or the Clean Energy Regulator may initiate such an audit when there are reasonable grounds to suspect that a registered company is contravening the NGER Act and Regulations, or there are other grounds. Note that this type of assurance is ‘after the fact’ assurance. It is similar to an audit undertaken by the Australian Taxation Office, rather than assurance of the lodged reported information such as is required for financial statements lodged with regulators like the Australian Securities Exchange or the Australian Securities and Investments Commission. (b) No it does not. Surveys of voluntary carbon disclosure prior to the mandated reporting of carbon emissions for companies meeting NGERS’s reporting thresholds, reveal an increase in carbon-related disclosures. Specifically, in carbon-intensive industries carbon footprint-related disclosures have increased in volume and detail. (Haque and Deegan, 2010; Hrasky, 2012; Choi, Lee and Psaros, 2013). This general trend in voluntary carbon disclosures is also evident internationally (Kim and Lyon, 2011; Luo and Tang 2014).

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Students may wish to speculate on why these disclosures have increased. For example, legitimacy theory would suggest that the mandated disclosure of carbon emissions under NGERS reveals an organisation’s historical carbon emissions to society. To attempt to legitimise this impost on society, the organisations may increase the volume of voluntary carbon-related disclosures. Clarkson et al. (2008) would suggest that poor performers increase the level of ‘soft’ disclosure (i.e. cannot be verified) whilst better carbon performers will increase the level of ‘hard’ disclosure (i.e. objective, can be verified). 25

(a) Organisations which exceed the reporting thresholds set under the NGER Act (2007). These organisations are required to report their greenhouse gas emissions, energy production and consumption to the Clean Energy Regulator during that financial year. Currently, the reporting threshold for corporate groups (individual facilities) is 50 000 kt (25 000 kt) of CO2-e, or producing or consuming more than 200 TJ (100TJ) of energy in a financial year. Once registered, controlling corporations are required to report by 31 October following the reporting year, and must submit an NGER Report every subsequent year that it remains registered. The greenhouse gases to be reported under the NGER Scheme include carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), sulphur hexafluoride (SF6) and specified kinds of hydro fluorocarbons and perfluorocarbons. Scope 1 and scope 2 emissions are to be reported (but not scope 3). In particular, scope 1 greenhouse gas emissions (or direct emissions) are the emissions released to the atmosphere as a direct result of an activity, or series of activities at a facility level. Scope 1 emissions are sometimes referred to as direct emissions. Examples are: emissions produced from manufacturing processes, such as from the manufacture of cement; emissions from the burning of diesel fuel in trucks, fugitive emissions, such as methane emissions from coal mines, or production of electricity by burning coal. Scope 2 greenhouse gas emissions are the emissions released to the atmosphere from the indirect consumption of an energy commodity For example, 'indirect emissions' come from the use of electricity produced by the burning of coal in another facility. The NGERS also provides for greenhouse and energy audits of NGER reporting corporations and the establishment of a register of such auditors. The aim of a greenhouse and energy audit is to determine the extent of compliance by a company caught by the NGER Act. Corporations may elect to self-audit using greenhouse and energy auditors from the register, or the Clean Energy Regulator may initiate such an audit when there are reasonable grounds to suspect that a registered company is contravening the NGER Act and Regulations, or there are other grounds. Note that this . 15

type of assurance is ‘after the fact’ assurance. It is similar to an audit undertaken by the Australian Taxation Office, rather than assurance of the lodged reported information such as is required for financial statements lodged with regulators like the Australian Securities Exchange or the Australian Securities and Investments Commission. (b) ABC Tissue Products Ltd – For the 2013/2014 period its carbon emissions reported under NGERS were as follows: Total scope 1 emission = 25 660t CO2-e; total scope 2 emissions = 61 440 CO2-e. 26

(a) In a cap and trade emissions trading scheme, a limit or cap is set on the total amount of carbon pollution allowed by sectors. Each organisation in the sector is issued with permits or allowances up to the cap for a year. Typically, the permits are either allocated free of charge and/or auctioned to businesses. A permit or allowances represents a right for its holder to emit a specified amount of greenhouse gas emissions during a specified period of time. The options available to organisations at the end of the year are as follows: 1) If an entity’s net emissions are likely to be less than the permits they hold, the entity can: bank them for future use; or sell them to other entities. 2) If the net emissions are likely to be more than the emission permits held allow, the liable entity can: reduce their emissions (e.g. use more energy-efficient technology); and/or purchase unused emission permits from other entities. 3) If the liable entity is still unable to reduce its net emissions using the strategies outlined above, it will have to pay an emissions fee to the government. (b) There are two general approaches to accounting for the rights and obligations arising from an emissions trading scheme: the gross approach and the net approach (Clarkson, Li, Pinnuck and Richardson, 2015). The gross approach requires firms to record carbon emission allowances as assets measured at their fair value, which reflects the view that emission allowances are rights to emit a quota of pollutants. Similarly, as emissions are released firms are required to accrue the associated carbon liabilities. Thus, there is no offsetting of carbon assets and obligations arising from the emissions trading scheme. Instead, gross assets and liabilities are reported. In contrast, under the net approach, allocated allowances are viewed as having a zero cost and there no asset is recorded. In addition, carbon liabilities are only recorded when carbon emissions exceed allocated allowances. Thus, there is an offset of rights to emit pollutants against actual emissions.

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(c) The IASB advocated a gross approach to accounting for the carbon-related rights and obligations arising from the EU ETS in Interpretation 3 ‘Emission Rights’. Interpretation 3 required emission allowances to be recognised as intangible assets and to be measured at fair value, and carbon obligations to be recognised as accrued. The asset and liability were not to be offset but rather disclosed at their gross amounts.

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PROBLEMS 1 Mega Dump Ltd 1 July 2019 (receipt of permits free of charge) Interpretation 3 states that permits are to be accounted for as intangible assets in accordance with AASB 138 (para. 6). Where permits are issued for less than fair value, they are to be measured initially at fair value (i.e. $900 000) and any difference between the amount paid and fair value is a government grant (i.e. $900 000 fair value - $0 amount paid). The general journal entry would be: Permits (intangible asset) Government grant (deferred income) (36 000 permits x $25 per tonne)

Dr Cr

$900 000 $900 000

31 March 2020 (emission of 24 000 tonnes of carbon dioxide) The deferred income of $900 000 is recognised as income on a systematic basis over the compliance period for which the permits were issued (para. 6). Mega Dump amortises the deferred income using the proportion of actual emissions to estimated total emissions as follows: Government grant (deferred income) Dr $600 000 Income Cr (24 000 actual emissions /36 000 estimated emissions x $900 000)

$600 000

As emissions are made, a liability is recognised for the obligation to deliver permits equal to emissions that have been made. It is measured as the best estimate of the expenditure required to settle the present obligation at the end of the reporting period (para. 8). Thus, the liability would be equal to 24 000 x $27 per tonne, or $648 000, which is the fair value of a permit. The general journal entry would be: Emissions expense Provision for delivery of permits

Dr Cr

$648 000 $648 000

30 June 2020 (end of the first compliance period and financial reporting period) The remaining balance of the deferred income of $300 000 is recognised as income. The general journal entry would be:

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Government grant (deferred income) Income

Dr Cr

$300 000 $300 000

The company measures its total emissions for the period at 37 000 tonnes, when the market price of a permit is now $33 per tonne. Thus, the fair value of Mega Dump Ltd’s obligation to deliver permits equal to emissions is $1 221 000 (37 000 tonnes x $33 per tonne). On 31 March 2020, the estimated obligation was estimated at $648 000. The increase in the obligation would be recorded as follows: Emissions expense Provision for delivery of permits ($1 221 000 - $648 000)

Dr Cr

$573 000 $573 000

Also, the company has emitted an additional 1000 tonnes of carbon dioxide than it expected, and it purchases 1000 permits to cover these unexpected emissions. The addition to the intangible asset ‘permits’ is recorded as follows of $5500, or 500 permits x $11 per tonne. The general journal entry would be: Permits (intangible asset) Cash, payables (1000 tonnes x $33 per tonne)

Dr Cr

$33 000 $33 000

Delivery of permits to regulator at future date in settlement of obligation Assuming there have been no further changes to the provision, the following general journal entry would be recorded upon settlement of its emissions obligation: Provision for delivery of permits Permits (intangible asset) Income

Dr Cr Cr

$1 221 000 $933 000 288 000

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Chapter 26 ETHICS IN ACCOUNTING LEARNING OBJECTIVES After studying this chapter you should be able to: 1 explain the nature of ethics; 2 distinguish between rules-based and values-based approaches to ethics; 3 describe the nature and limitations of ethical relativism; 4 describe the foundational ethical principles and their application; 5 describe the three core skills in applied ethics; 6 describe the fundamental ethical principles of the accounting profession; 7 incorporate ethics into decision making in a systematic and justifiable manner; 8 describe how rules can be set in organisations in a way that reflects ethics in a systematic and justifiable manner; and 9 describe some of the ethical issues facing Australian accountants.

QUESTIONS 1

Ethics is concerned with what is good and right for human beings. In particular, it is an exploration of what factors promote human flourishing and well-being. When we discuss ethics we seek to determine what conditions, attributes and characteristics are required to enable us to be the very best at what we do or to achieve the best outcome in a particular situation or context. As such, ethics is about achieving excellence. Although ethics is frequently seen as an issue only for the individual, ethical issues, in fact, are much more widespread. Thus, ethics is a concern of ‘communities’ whether those communities are, for example, students and teachers in a course, a project team in a business, an accounting professional association like CPA Australia or the Chartered Accountants Australia New Zealand, or society as a whole. As discussed in other questions in this chapter, ethical behaviour is not limited to compliance with the law or other rules but also involves individuals or communities making sometimes difficult choices on the basis of their values. Although different communities often exhibit different values, there is also considerable commonly shared ethical principles as well; these foundational ethical principles allow different people and communities to engage in rational debate about ethical problems.

Some philosophers would accept this statement as correct. It describes what is known as ‘ethical relativism’ or ‘situational ethics’ in which it is argued that ethical standards and behaviour may differ among individual people and among different communities. Although it is clear that people do have differences in their values, care must be taken not to overstress these differences between people. This is because there are also common foundational principles that enable us to often reach agreement with people from different backgrounds despite the cultural differences (e.g. international trade would not be possible if ethical relativism was taken to its extreme).

This question is designed to encourage students to relate to the importance of ethics based on their own experiences to date. A concern for ethics is just as relevant to people in their role as students as it will be in their future professional lives. Students should be asked to identify experiences they have encountered as students for which they believe had important ethical dimensions. Some common examples that could be discussed included perceptions of fairness associated with matters like the marking of assessments, or what are appropriate grounds for granting extensions on assignments, etc. Students should explore the ethics of these issues from the perspective of the fundamental ethical principles.

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This question is designed to encourage students to understand that ethics is not simply about proscribing behaviour. As ethics is about what actions and factors promote human flourishing, it also has a positive perspective. That is, ethics is also about how do people achieve excellence in what they do? In accounting, for instance, ethics is not only about complying with rules and standards but understanding how accountant’s behaviour and practices can, for instance, promote the public interest and benefit clients.

The quote suggests that bribery in a particular country is ethically okay if bribery is commonly encountered in that country. This is a form of ethical relativism based loosely on the idea that one should respect the ‘ethics’ of others. However, bribery is morally unacceptable even if it is commonly practice in some locations. Typically bribery occurs due to poor economic circumstances or where appropriate governance mechanisms are lacking. Bribery is unacceptable because it breaches the ethical principle of justice – only those who can afford to pay the bribe are advantaged over those who cannot. In addition, it breaches the principle of respect for persons because the practice is dishonest.

Some philosophers would accept this statement as correct. It describes what is known as ‘ethical relativism’ or ‘situational ethics’. It means that ethical behaviour may differ among different communities. For example, in a community where family loyalty is of paramount importance, reporting a relative to the police would be unethical. In a community where family loyalty was less important, not reporting a relative to the police may be unethical. Ethical behaviour in times of war may differ from that in times of peace; ethical behaviour on public transport may differ from that on a football field, and so on. Care must be taken not to overstress the differences between communities because there is also common foundational principles that enable us to often reach agreement with people from different backgrounds despite the cultural differences (e.g. international trade would not be possible if ethical relativism was taken to its extreme).

Financial reporting standards are associated with ethics because those standards represent ‘best’ practice in financial reporting. Compliance with AASB standards is required to ensure that all financial statement users receive decision useful information and that an adequate level of information is provided. One example is the issue of the disclosure of ‘underlying profits’ versus ‘statutory profits’ in many companies’ financial reports. The Australian Securities and Investments Commission has been concerned that some companies have given too much prominence to their ‘underlying profits’ results instead of the ‘statutory profits’. Statutory profits are in principle comparable because they have been produced in accordance with the one set . 3

of AASB standards but underlying profits are based on whatever a company’s management think are relevant to users. As different management teams, will make different judgements about what should be in/out of underlying profits, there is a potential for financial statement users to be misled by underlying profit calculations. 8

Ethics is important to accountants for several reasons. As a recognised profession, accountants enjoy benefits such as high social status and relatively high incomes. These benefits are obtained only because the community trusts that accountants will use their specialised expertise in the public interest. If accountants behave unethically, then that trust is broken and accountants risk being constrained by more and more regulation. Their status in the community also suffers as a result. A related reason why ethics is important to accountants is that their high standing and specialised knowledge and expertise often places them in more powerful positions relative to their clients. The public expectation is that that power should not be exploited at the expense of clients or to the selfish benefit of the accountant.

Codes of ethics are often presented as signals of high ethical standards by professions and organisations. Codes of ethics can have an important role to play in communicating and clarifying an entity’s expectations about the conduct of its members. However, the presence of codes of ethics is not enough to ensure ethical behaviour. Such codes need to be ‘owned’ by those who are expected to comply with them and need to be enforced. Top management and other senior leaders in an organisation also need to ‘walk the talk’ and demonstrate to everyone that they act in accordance with the code. Ultimately, relying on rules to achieve ethical behaviour is unlikely to be successful because behaviour is driven by additional factors such as values, economic factors, etc.

10 Professional associations have codes of ethics for four reasons. First, they can be used to pre-empt externally imposed regulation, usually by a government agency. Second, codes of ethics are devised by the profession and not ‘outsiders’, such as public servants or legislators. The rules will be proposed by people who understand the practice of the profession and therefore will not be ‘unreasonable’ or ‘unattainable’. Third, the profession can control the disciplining of its members. This discipline can be applied bearing in mind the ‘realities’ of the profession. Fourth, a profession’s code of ethics can perform an aspirational role by signalling to the profession’s members’ expectations about the service ideal and standards of professional behaviour. 11 A code of ethics is a necessary but not sufficient condition for maintaining public trust in a profession. The code is an important vehicle for communicating the values and . 4

expectations of proper behaviour of members of the profession. However, the public will lose trust in the profession if the members of that profession are perceived to act in ways that are not in accordance with the code. Public displays of the enforcement of the code is one way of demonstrating that the profession is serious about good practice. One reason that APES 110 includes the principle of ‘professional behaviour’ is to acknowledge the importance of maintaining public trust in the accounting profession. Codes of ethics, however, can never be so specific that they cover every possible ethical challenge that an accountant might encounter. Consequently, accountants must be trained in tools of practical ethics such as values clarification and decision making so that they can appropriately exercise their professional judgement in cases where the code does not apply or where it gives ambiguous signals. 12 A reason why ethics is important to accountants is that their high standing and specialised knowledge and expertise often places them in more powerful positions relative to their clients. The public expectation is that that power should not be exploited at the expense of clients or to the selfish benefit of the accountant. In any given situation the accountant and client may have different relevant amounts of power and each situation may make correspondingly different ethical demands on the accountant. Example 26.1 in the chapter illustrates these different power relationships and their ethical implications for the accountant. 13 The three core skills in applied ethics are values clarification, ethical decision making and ethical policy setting. Values clarification requires the accountant to understand what are the values that matter to her and that consequently guide her actions. The accountant will have her own personal values but also have to identify the values that are held by the organisation she works for and those of the profession. Values clarification requires the accountant to acknowledge and resolve any conflicts that may arise between these sets of values. Skills in decision making are those associated with developing a systematic process by which the accountant uses her values to make decisions in specific situations in a justifiable and defensible way. Quality decision making skills reduce the risk of capricious and negligent behaviour. The AAA decision model is one example of a process for developing skills in ethical decision making. Organisations and professions make rules about how they operate and how members should behave. Rule-making requires systematic processes that employee the entity’s

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values to develop and deploy rules which will be owned by all members and which will promote excellence in operations and behaviour. 14 A ‘dilemma’ is defined in the Oxford Dictionary as “argument forcing opponent to choose one of two alternatives both unfavourable to him”. The media and textbooks frequently describe all ethical issues as ‘dilemmas’ which tends to reinforce the view that ethical issues cannot be satisfactorily resolved (given the definition of the word). However, not all ethical issues are necessarily irresolvable. It would be more helpful to describe ethical issues as ‘problems’ because that reinforces the view that ethical issues can be solved by the application of typical problem solving tools such as the AAA decision making model. This is not to say that such tools make all ethical decisions resolvable or simple but the use of these problem solving methods offers more possibility for an acceptable resolution than simply viewing all issues as ‘dilemmas’. 15 A person who undertakes unethical behaviour may not know that it is unethical because they have failed to reflect adequately on the appropriateness of their behaviour. One reason that the chapter makes reference to skills in ethical decision making, for example, is to help students develop appropriate awareness of the ethical dimensions of their behaviour. However, a practicing member of the profession should know the code of ethics with which he/she should comply, should be aware of society’s expectations, and should understand the law, at least in general terms. In these circumstances, a decision to behave unethically is made by persons fully aware that they are risking the consequences of being discovered and incurring the cost. It is unlikely that a member of the profession will unconsciously behave unethically and, even if he/she does behave unethically, ignorance is no excuse and will not be a reason to avoid the consequences of the behaviour. 16 Values define an entity’s goals and ideals. Values are derived from experience of what factors lead to that entity’s flourishing. The principles of integrity, objectivity, etc. in sections 100 - 150 of APES 110 are values (notwithstanding that the Code uses the terminology of ‘principles’) which are then used to inform the rules found in later sections of the Code. For example, the principle of ‘integrity’ is a value of the profession that is derived from the profession’s experience that if accountant’s act honestly (i.e., with integrity), then that will generate public trust in the profession’s services and members. 17 For an accountant in public practice, a conflict of interest may arise in two circumstances. The conflict of interest may be between the interests of two or more clients or between a client and the accountant. A conflict of interest for an accountant . 6

could arise if two clients came into conflict or were negotiating (e.g. advising both the acquirer and acquiree in a business purchase). An accountant could obtain information from one client that would be of great benefit to the other. The conflict arises because the accountant must choose the client whose interests he/she will safeguard. Such a choice would mean that the accountant is not safeguarding the interests of one client. A conflict could also arise where safeguarding the interests of a client would harm the accountant. For example, the accountant may have made an error in some work done for the client, which places the client at a disadvantage in some negotiations. The accountant would be torn between admitting the error and possibly losing the client, or keeping quiet and allowing the client to incur a loss. A number of common ethical challenges for accountants can be found in section 26.6 of the chapter. 18 Section 130 of the Code considers professional competence and due care. In effect, it provides that performing tasks for which an accountant is not competent is unethical. An incompetent accountant cannot be safeguarding the interests of clients or employers nor is incompetence consistent with the requirement to exercise due care and diligence. Incompetence can, of course, result in real harm if the client acts on the accountant’s poor advice (e.g. fines for taxation errors, loss on investments). 19 Section 140 of the Code makes confidentiality of information provided by a client or an employer an ethical requirement. However, this is not unconditional. The Code provides exceptions such as where there is a legal duty to disclose information (section 140.7). Accountants are not expected to go to jail to protect the confidentiality of information provided by a client or employer. 20 Paragraph 100.5(e) defines ‘professional behaviour’ as being “to comply with relevant laws and regulations and avoid any action that discredits the profession.” Section 150 elaborates on this principle: “150.1 The principle of professional behaviour imposes an obligation on all Members to comply with relevant laws and regulations and avoid any action or omission that the Member knows or should know may discredit the profession. This includes actions or omissions that a reasonable and informed third party, weighing all the specific facts and circumstances available to the Member at that time, would be likely to conclude adversely affects the good reputation of the profession.” “150.2 In marketing and promoting themselves and their work, Members shall not bring the profession into disrepute. Members shall be honest and truthful and not: (a) . 7

Make exaggerated claims for the services they are able to offer, the qualifications they possess, or experience they have gained; or (b) Make disparaging references or unsubstantiated comparisons to the work of others.” This principle is important as it acts as a general ‘catch-all’ reminder that accountants must consider their obligations to act ethically – that is, there may be acts that are not explicitly discussed in the Code but which could, nonetheless, be perceived as unethical by the community. As such, accountants must always be mindful of maintaining the highest standards of behaviour as poor behaviour by one accountant has a reputational impact on the whole profession. 21 The disciplinary procedures begin with a complaint about a member. The complaint may come from a client, another member, or a member of another profession. In most cases, the complaint is instigated by a telephone call to a senior staff member of the professional body. If the matter cannot be resolved on the spot, the complainant will be asked to put the complaint in writing so that it can be considered by the body’s disciplinary procedures. In the great majority of the cases, the complaints are about the behaviour of members in public practice, usually in small firms. In CPA Australia, written complaints are referred to the relevant state’s Investigation Committee, which considers the matter. The Investigation Committee comprises senior experienced members of the profession. The Committee usually interviews the complainant to get a clear picture of the nature of the complaint. The member being complained about is also given an opportunity to appear before the Committee. The Investigation Committee will often seek a resolution of the matter. If the Committee reaches a conclusion that the complaint is groundless or trivial, the matter is concluded. If the Investigation Committee believes that the member has a case to answer, the complaint is referred to the Disciplinary Committee. The role of the Investigation Committee is very similar to that of a magistrate who considers whether a person has a case to answer and refers the matter for trial. The Disciplinary Committee also comprises senior experienced members of the profession but includes at least one person who is not a member of the profession. This person is always a respected member of the community. The independent member’s role is to ensure that the Disciplinary Committee is neither too harsh nor too lenient on its members. The independent member gives a community perspective to the proceedings. The case against the member is presented by a member of the Investigation Committee who usually provides a written summary of the basis of the complaint and . 8

the reasons the Investigation Committee concluded that there was a case to answer. The written summary is also made available to the member who is the subject of the inquiry. In most cases, the member attends the disciplinary hearing, sometimes accompanied by a ‘friend’ who is frequently a solicitor. The member is given the opportunity to reply to the charges. Members of the Disciplinary Committee may ask questions of both the member and the ‘prosecuting’ member of the Investigation Committee. When it is satisfied that it understands the issues, the Disciplinary Committee will ask the ‘prosecution’ and the ‘accused’ to leave the room. In considering the matter, the Disciplinary Committee is concerned only with breaches of the code of ethics. It must decide whether a breach has occurred and if there is a breach, what is the appropriate penalty. The Regulations provide for several different penalties including fines, censure, reprimand, suspension, expulsion and publicity about the case. When the Disciplinary Committee has reached a decision, the ‘prosecution’ and the ‘accused’ return to the room and the chairperson of the Committee announces the decision and the penalty if any. The decision can be appealed to a National Disciplinary Appeals Committee. 22 It is usual for Disciplinary Committees to have at least one lay-person as a member. There are two reasons based on the concept of independence for a lay-member to be present at disciplinary hearings. First, it provides an external perspective on the disciplinary process and gives some assurance that the system is neither too easy nor too hard on members of the profession. Second, it goes some way to reassuring outsiders that disciplinary procedures are not simply ‘whitewashes’ of members to protect the image and reputation of the profession. 23 Publication of a breach of the code of ethics by a member can have a significant effect on the member. His/her reputation is publicly brought into question. This may affect the member’s ability to get work and may have a significant effect on their income and wealth. 24 Part C of APES 110 applies to ‘members in business’. That part of the Code makes it clear that, although members may be employees and subject to direction from higher level managers, they are as equally bound by the principles and requirements of the Code as any other member of the relevant professional body. For example, even though a member in business may be under pressure by a higher level manager to act in a way contrary to, say, accounting standards, the accountant must still maintain their integrity, objectivity, and professional competence and not comply with the unethical suggestion.

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25 Policies or rules are created by companies to provide guidance on how their employees should behave. In section 26.3, we note that rules are an efficient means by which a company expresses the values which it believes promote its wellbeing and that of its stakeholders. Clear policies help achieve efficiency and effectiveness in operations and also assist in corporate governance by providing a basis for assessing and monitoring accountability. 26 Just as with decision making, policy development can be conducted using systematic processes that allow an organisation to ensure that its rules are informed by its values. Sound policy setting assists in promoting the operations and governance of an organisation. Opinions are divided as to whether organisational rules should be set only by top levels of management. How rules are set might depend on the particular policy issue and who in the organisation is most informed about the issue that requires a policy. The point of this question, however, is to sensitise students to the point that policy implementation and conformity will be much easier if those affected by the policy ‘own’ it. That is, those affected by the policy understand it and see it as useful and helpful. This is more likely to happen if they have some involvement in the development of the policy.

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PROBLEMS Teaching Note: A number of these problems ask students to apply the AAA ethical decision model. The purpose of using such a model is to assist students to structure their thinking and address ethical problems in a systematic and justifiable manner. Our experience shows that, although the decision-making model is a process for addressing ethical problems, many students often use the model in a very mechanistic way by working through each stage of the model as though the stages were independent of each other (e.g. they can arrive at suggested courses of action that weren’t even evaluated in the earlier stages of the model!). It is helpful to initially mentor students in the use of the model by stressing how the later stages must be informed by the analysis undertaken in earlier stages (e.g. each of the suggested courses of action should be evaluated by the relevant ethical principles identified in the analysis). Students should be encouraged to use the model to justify their decisions and to identify and evaluate ‘practical’ and realistic plans of action. Due to the variety of interpretations and judgements that might be made about any particular case, the suggested solutions below simply provide some starting points for the in-class discussions and do not represent definitive solutions. 1 Determine the Facts • Armstrong is a public practitioner in a small practice largely reliant on servicing clients from the medical profession. • The clients are generally aggressive with regard to their taxation affairs. • One client, Roberts, has demanded that Armstrong implement a tax avoidance scheme that is allegedly currently being adopted by other individuals. • Roberts threatens to take his business to another accountant and will encourage other clients to do likewise unless Armstrong applies the scheme to Roberts’s tax affairs. Define the Ethical Issue Key stakeholders include: Armstrong, Roberts, other clients, Australian Taxation Office/the public. The immediate decision that Armstrong faces is whether he will implement the tax avoidance scheme on behalf of Roberts. Identify the Major Principles, Rules and Values Major professional ethical principles are integrity (Armstrong and his clients should be honest in their taxation affairs); objectivity (Armstrong should not let his behaviour be influenced by his financial reliance on his clients); and professional behaviour (actively promoting suspect tax avoidance schemes is likely to bring disrepute to the profession).

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Students can refer to APES 110, Section 100, paragraph 100.5, Section 110 (Integrity), Section 120 (Objectivity), and Section 150 (Professional Behaviour).

Specify the Alternatives Students may identify several options. These could include: a) Comply with Roberts’s request and manage his tax affairs in accordance with the avoidance scheme. b) Refuse to comply with Roberts’s request. c) Try to convince Roberts as to the potential risks and ethical concerns associated with the tax avoidance scheme. Compare Values and Alternatives – See if a Clear Decision Emerges Option (a) – given the suspect legality of the scheme, complying with the request to implement the scheme is likely to breach all of the ethical principles identified above. Option (b) – refusing to implement the scheme satisfies the ethical principles identified above. Option (c) – trying to persuade Roberts not to implement the scheme would be consistent with the ethical principles identified above. Assess the Consequences Option (a) – compliance with the request is likely to result in Armstrong’s high value clients staying with him, thus assisting in the profitability of his practice in the short term. However, accepting the proposal does compromise his ability to resist similar potentially illegal proposals in the future. In addition, should the scheme be deemed illegal in the future, Armstrong may face high penalties from the taxation office and from his professional accounting association for promoting illegal schemes. This would also bring his personal reputation and that of the profession into disrepute. Option (b) – Armstrong risks losing high value clients which could significantly impact on the profitability of his practice. On the other hand, he may develop a reputation for high ethical standards which attracts less aggressive tax payers to his practice. Option (c) – trying to persuade Roberts to change his mind does allow Roberts the opportunity to reflect upon the potential risks (e.g. penalties) and ethical considerations associated with the scheme.

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Make Your Decision Based on the analysis above, Armstrong should first try to convince Roberts that adopting the scheme would be inappropriate and, if Roberts does not change his mind, then Armstrong should stop providing services to Roberts. This plan is consistent with upholding the relevant ethical principles and emphasises the importance of the long-term consequences for Armstrong’s reputation which is fundamental to his ability to generate revenue from his accounting practice. 2 (a)

This is a clear case of conflict of interest (see section 220.1 of the Code). Donovan should not advise both Wolfgang and Heidi. She should choose one and recommend that the other go to a different adviser. Donovan could, with care, recommend and introduce the client to an appropriate alternative adviser. An alternative option is to decide that she withdraws completely and does not act as an adviser for either party.

(b)

Donovan should advise only one party and recommend that the other seek advice from an independent adviser. See sections 220.3 and 220.6 which detail the accountant’s requirements to notify the two parties.

(c)

(i) No. The conflict of interest remains as it is not the friendship that creates the clash of interests. (ii) No. Donovan must maintain professional independence.

3 Determine the Facts Pham is an accountant in business being Chief Accountant at the Bank of Australia. The bank’s loan portfolio appears to have become too heavily weighted with high-risk loans. Pham has formed the view that the bank’s bad debts provision should be substantially increased to reflect the higher risk, but her recommendation has been emphatically rejected by the managing director. An appeal to the bank’s auditor has also been unsuccessful because the auditor has favoured the more extensive experience of the managing director. Define the Ethical Issue Key stakeholders include Pham, the managing director, the auditors, the bank’s shareholders and the bank’s depositors. The most immediate decision problem for Pham is how should she respond to the rejection of her recommendation. Identify the Major Principles, Rules and Values Major professional ethical principles are integrity (Pham should promote honesty with regard to the bank’s financial statements); objectivity (Pham should not be influenced by . 13

the fact she is employed by the bank); competence and due care (Pham should ensure that the calculation of the provision reflects appropriate accounting practices, calculations, etc.); and confidentiality (Pham should not disclose the private information of the bank without permission). Students can refer to APES 110, Section 100, paragraph 100.5, Section 110 (Integrity), Section 120 (Objectivity), Section 130 (Professional Competence and Due Care) and Section 150 (Professional Behaviour). Specify the Alternatives Students may identify several options. Having already tried to persuade the managing director and the auditors, options could include:1 a) Document her concerns within the bank’s systems and present these to the board/audit committee. b) Document her concerns within the bank’s systems and present these to a regulator (e.g. ASIC). c) Document her concerns within the bank’s systems and resign. Compare Values and Alternatives – See if a Clear Decision Emerges Option (a) – informing the board/audit committee is in compliance with all of the ethical principles identified above. One strength is that it respects the bank’s right to confidentiality. Option (b) – going to the outside regulator may satisfy most of the ethical principles identified above but does breach the general duty of confidentiality to Pham’s employer. Option (c) – documenting the information and resigning is in compliance with all of the ethical principles identified above but might seem to be lacking in courage as it leaves the alleged problems within the bank unresolved (perhaps leading to even greater costs later). Assess the Consequences Each of the options stresses the need for Pham to formally document what her concerns are and that she lodges them within the records of the bank. Apart from allowing her to clearly demonstrate the available evidence that supports her concerns, it also makes those in the bank with greater authority the responsible parties if the bank does not act on the advice and Pham’s concerns ultimately prove to be correct. Option (a) – going to the board/audit committee keeps the alleged problem confidential and so may minimise any reputation cost to the bank if the concerns turn out to be valid. If the board or audit committee is dominated by a managing director with a strong 1

Other options not reviewed here might include gathering more evidence to provide stronger support for her concerns which might then be used to persuade the managing director and/or auditor as to the seriousness of the risks. . 14

personality, then appealing to those two committees may be ineffectual and Pham faces a strong risk of being sacked from her job. Option (b) – going to the outside regulator leads to potential risks to Pham’s reputation if she fails to convince the regulator as to the validity of her concerns or could have serious reputation effects for the bank if her concerns are made public (e.g. the share price might drop and/or depositors at the bank may lose confidence and try to take all their money out). These risks might be managed by the regulator depending upon how it chooses to respond to Pham’s claims. Option (c) – resigning leaves the alleged problems unresolved, potentially letting the problem get worse over time. In addition, Pham loses her livelihood in the short run for no clear benefit. Make Your Decision Pham should ensure the validity of her evidence and approach the board or audit committee to persuade them to allow the changes to the provision. If this is unsuccessful and there is a very significant risk to the public interest, Pham should consider whistle blowing to the regulator. (Seeking legal advice first would be appropriate.) 4 Determine the Facts McEwin is an accountant in business working for Mammoth Constructions Ltd. McEwin is having personal financial difficulties and is under threat of having his home repossessed to cover his debts. He has been approached by Prather, a stockbroker, who is seeking to have McEwin provide him with what would appear to be non-public information (the facts are somewhat ambiguous about the nature of the information to be passed on) about Mammoth in return for a weekly fee of $500. McEwin is also under pressure from his parents to assist Prather. Define the Ethical Issue Key stakeholders include McEwin, Prather, Mammoth Ltd (and its shareholders). The general public and the accounting profession might also be seen to have a more general interest in the situation due to the potential impact on market confidence and the reputation of the profession. The most immediate decision for McEwin is whether he will accept Prather’s offer and pass on the information on a weekly basis. Identify the Major Principles, Rules and Values Major professional ethical principles are confidentiality (McEwin should not exploit his position by revealing confidential information about Mammoth without permission or a . 15

legal obligation to do so); objectivity (McEwan should not let his behaviour be influenced by his personal financial situation or the family relationships with Prather); and professional behaviour (active involvement in some form of insider trading is likely to bring disrepute to the profession). Students can refer to APES 110, Section 100, paragraph 100.5, Section 120 (Objectivity), Section 140 (Confidentiality) and Section 150 (Professional Behaviour). Specify the Alternatives Students may identify several options. These could include: a) Provide Prather with the information and take the money. b) Refuse to provide the information. c) Refuse to provide the information but inform Mammoth of the approach. Compare Values and Alternatives – See if a Clear Decision Emerges Option (a) – given the potential illegal insider trading nature of the proposal, complying with the request to provide the information is likely to breach all of the ethical principles identified above. Option (b) – refusing to implement the scheme satisfies the ethical principles identified above. Option (c) – this would be consistent with the ethical principles identified above. Assess the Consequences Option (a) – compliance with the request is likely to result in assisting McEwen to avoid his financial problems at least in the short term. However, accepting the proposal does compromise his ability to resist similar potentially illegal proposals in the future. In addition, if Mammoth discover he has been passing information on to outsiders, it is very likely that he would be sacked from the company. This could make it very difficult for him to get another job as he would be unable to access a positive reference from Mammoth and Mammoth may complain about his behaviour to the relevant accounting professional body with the possibility that McEwen loses his membership. Public revelations about the behaviour also risks bringing the profession’s reputation into disrepute. Option (b) – McEwen is likely to face continued financial problems and risk losing his home. His parents would also be very disappointed in him and think that he has been disloyal. On the other hand, his professional reputation will be intact, which has longerterm positive implications for his ability to generate salary.

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Option (c) – there will be similar consequences to those of option (b) but the sense of disloyalty from his parents may be much stronger. It is unclear what Mammoth might be able to do about Prather, however, although the facts imply that Prather has other sources of information about the company that it may wish to investigate. Make Your Decision On balance, McEwen should refuse to assist Prather given that this option fits best with the relevant ethical principles and although the financial consequences may be very serious in the short run, in the longer term the protection of his professional reputation helps his ability to improve his financial situation. (Of course, on paper this is easier to write than it may be to implement in practice – the feelings of loyalty to his parents and a family friend and the stress caused by his financial situation will be very powerful influences. Although not discussed in the options above, the classroom discussion might also consider other options such as McEwen looking for another job or selling his oversized home for something that is more financially manageable.) 5 Determine the Facts The decision maker is the financial controller of a not-for-profit entity, Safe Haven. Safe Haven has incurred certain costs associated with advertising activities. These costs have previously been classified as ‘administrative expenses’ but the CEO has suggested that these costs should be reclassified in this year’s financial statements as ‘program’ expenses. She believes this would be more appropriate as donors expect only a maximum of 30% of Safe Haven’s costs should be administrative. She claims that if the costs are not reclassified many needy children will be left without support. Define the Ethical Issue Key stakeholders include the donors, the recipients of Safe Haven’s services, the CEO, and the decision maker. The most immediate decision problem for the decision maker is to resolve the classification of the brochure and advertising costs. Identify the Major Principles, Rules and Values Major professional ethical principles are integrity (Safe Have should promote honesty with regard to its financial statements); objectivity (the decision maker should not be influenced by the emotional threats of the CEO); competence and due care (the decision maker should ensure that the financial statements comply with relevant industry regulations and accounting standards); and professional behaviour (public knowledge that the financial controller sought to ‘manage’ the treatment of the costs would bring disrepute to the profession). Students can refer to APES 110, Section 100, paragraph 100.5, Section 110 . 17

(Integrity), Section 120 (Objectivity), Section 130 (Professional Competence and Due Care), and Section 150 (Professional Behaviour). Specify the Alternatives Students may identify several options. These could include: a)

Comply with the CEO’s request and reclassify the costs as ‘program’ expenses.

b) Comply with the CEO’s request and reclassify the costs as ‘program expenses’ but try to ensure that the financial statements include a note that describes the change in accounting policy as per AASB 108. c)

Refuse to make the change in the classification of the expenses.

Compare Values and Alternatives – See if a Clear Decision Emerges Option (a) – this option does not seem to satisfy any of the ethical principles identified above. As the expenses don’t seem to be associated with the actual delivery of the entity’s services, it is dishonest to claim that they do. The CEO’s comments re the children are a form of emotional blackmail and the reclassification would not seem to satisfy the requirements of AASB 108, paragraph 14 as to when a change in accounting policy is acceptable. The profession would not be viewed as ethical if it became known that the objective of the change was to mislead donors. Option (b) – applying the disclosures in AASB 108 would at least mean that readers of the financial statements would be made aware of the reclassification but the majority of the ethical principles would not be satisfied. Option (c) – this option seems to satisfy the ethical principles identified above. Based on an analysis of the ethical principles, option (c) would seem to be the most satisfactory. Assess the Consequences Option (a) – this option may, at least in the short-run, have the result the CEO desires in keeping Safe Haven attractive to donors. However, it is high risk because if the entity’s auditor objects to the change or the change becomes known publicly, this could destroy donors’ trust in the entity with a much more significantly negative impact on funding than that which might arise by being 2% over the general expectation about administrative expenses. Also, giving in to the CEO on this occasion, provides her with more leverage for further questionable behaviour in the future. Option (b) – providing some sort of note disclosure explaining the change and its financial impact would at least inform donors about what has been done. It is unknown how donors . 18

would react but they are likely to be suspicious of such a change and may lose trust in the entity. Option (c) – the decision maker will not have compromised themselves with the CEO. Correct financial reporting will help to maintain donor trust in Safe Haven. It is unknown how donors will react to the knowledge that administrative expenses are 32% rather than 30% but the relatively small difference suggests that any negative impacts are likely to be small. The CEO may view the decision maker as lacking loyalty but loyalty is not owed to people who seek to improperly exploit it. Make Your Decision Option (c) would seem to be the best of these three options in that it upholds the relevant ethical principles and it least likely to have negative consequences for Safe Haven. 6 (a) Acceptance of large gifts may create an obligation to look after a client’s interests to a level beyond that required in Section 260 of the Code. In other words, it may lead to a loss of independence. The client may expect that the accountant will return favours. (b) This is a difficult issue. As the old man will not be a client in the future, it should not lead to a loss of independence. However, it could be perceived as evidence that independence has already been lost. It is a payment for services already rendered. The safest course would be not to accept the car. (c) Boumas should ensure that her files are complete and up-to-date showing fully the calculation and assumptions she made in helping the old man to value the business. She could seek a legal opinion about her position, lodging documentary evidence of her non-complicity with the lawyer. 7 Determine the Facts Howard is an accountant in business who is suspicious about certain cheque payments. Inquiries to his supervisor and to the auditor have received responses that ‘all is okay’ and, indeed, that further questioning about these transactions could result in his dismissal. He has recently been told by a junior member of staff that a scheme to steal money from the company has been discovered by the junior staff member. Define the Ethical Issue Key stakeholders include Howard, his supervisor, the auditor (and his/her firm), Howard’s employer. The immediate decision question for Howard is what to do about the information he has received from the junior staff member.

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Identify the Major Principles, Rules and Values Major professional ethical principles are integrity (Howard should promote honesty with regard to his work and the company’s affairs); objectivity (Howard should not let his behaviour be influenced by the threat from his supervisor); confidentiality (Howard should maintain confidentiality about the company’s affairs unless there is a legal duty to disclose); and professional behaviour (failure to address malfeasance is likely to bring disrepute to the profession). Students can refer to APES 110, Section 100, paragraph 100.5, Section 110 (Integrity), Section 120 (Objectivity), Section 140 (Confidentiality) and Section 150 (Professional Behaviour). Specify the Alternatives Students may identify several options. These could include: a) Howard could confront the supervisor and auditor with the new evidence. b) Howard could check the reliability and validity of the evidence allegedly uncovered by the junior staff member. c) Howard could seek legal advice about the matter. d) Howard could disclose what he knows to the directors or the audit committee. e) Howard could disclose what he knows to a regulator such as ASIC. Compare Values and Alternatives – See if a Clear Decision Emerges Option (a) – this option is consistent with the ethical principles identified above. Option (b) – this option is consistent with the ethical principles identified above. In addition, it might be argued that it is also consistent with the principle of competence and due care because Howard would first be checking that the facts are correct. Option (c) – this could breach the principle of confidentiality. Option (d) – this option is consistent with the ethical principles identified above. Option (e) – this could breach the principle of confidentiality. Assess the Consequences Option (a) – this option is unlikely to be successful in itself. Without checking the evidence first, Howard may risk making untrue allegations. Even if true, the supervisor and auditor may try to take actions to stop Howard providing the information to others. Option (b) – this option is valid as it allows Howard to be more accurately informed about the nature, if any, of the scheme. The junior may have insufficient experience to know . 20

exactly what evidence they think they have discovered. However, by itself it won’t resolve the issue because Howard will still need to make a decision about what to do subsequent to his investigation. Option (c) – this option would allow Howard to be more informed about what are the legal consequences of whistle blowing but, again, by itself it won’t resolve the issue because Howard will still need to make a decision about what to do subsequent to his meeting with the lawyer. Option (d) – this option may allow corrective action to be taken by those with authority provided that the directors are not also involved in the scheme. If they were in the scheme, they too might take actions to ensure that Howard’s information is not revealed further. Option (e) – this option by itself would not allow the company the opportunity to take its own corrective action and to manage any ‘fallout’ from having the scheme made public. Howard would have to have a strong documented case before the regulator would be prepared to investigate. If it did, however, then corrective action might be taken but this would be very public and likely to have a negative impact on the company’s shareholders among others. Make Your Decision Howard should first check the new evidence to ensure that it is valid. Depending on what is discovered, he might then present the information to the directors or chair of the audit committee (e.g. if it was discovered that the directors were also in on the scheme, then raising the matter with them is unlikely to be effective!). If these options are not viable, then, as a last resort, Howard could present his documented evidence to ASIC.

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