Chapter 7: Assets THEORY IN ACTION Theory in Action 7.1 Outdated prices blamed in Credit Suisse Error 1. How do European bankers determine the valuations of asset backed securities? The article suggests that models which make use of market values are used by European banks to value asset backed securities. The approach differs to the US where valuation is based directly on market prices. Thus, the models are adjusted as conditions change in the market place in an attempt to approximate true economic value. 2. What is meant by these phrases used in the article: “pretty adverse market conditions” “delinquencies of updating of pricing” “some valuation issues where the pricing did not meet our standards”? (a) The article refers to market conditions in February 2008 when the sub-prime crisis was affecting the value of bank securities. Banks holding such securities were writing down assets, thus reducing the value of their investments, their total equity and shareholder wealth. Credit Suisse had written down debt and loans by 2 billion Swiss Francs in February 2008. The market conditions were adverse in comparison with conditions in earlier years when markets were buoyant, asset prices were rising and banks were posting healthy profits. (b) “delinquencies of updating pricing” appears to be a public relations way of saying that there were errors in the prices used to update valuation models. The article states that it appears that traders used out of date prices. (c) Similar to (b) we have public relations terms for the errors (intentional or otherwise) which fed into the models. The company has admitted that errors occurred and the company discovered them in subsequent checking of valuations of trading positions. The company standards required that certain procedures be followed (presumably the use of current prices) and in this case the appropriate procedures for selecting the correct prices for valuation models inputs were not followed. 3. What are the repercussions of the “errors” at Credit Suisse? Are they reasonable or do they represent an over-reaction? The company is completing an internal review of the trades to ensure that valuations are correct and that other errors are not present. The review is important to demonstrate to stakeholders outside the company that systems and internal controls and sound and can be relied upon to produce appropriate valuations. Uncovering errors in pricing by banks are taken seriously in the market, in case the error has revealed a deeper, previously unknown, problem. Given the vulnerability of banks’ positions and performance to the activities of their traders, the market would be watching closely the outcomes of reviews such as the one being undertaken by Credit Suisse in this situation. The bank would not appreciate the possible credit downgrade by S&P, reflecting S&P’s concerns about (a) internal controls and (b) transparency of operations (i.e. S&P says it is not clear why year to date losses are so much larger than 2007). There are many examples where traders’ unauthorised behaviour has had extremely bad consequences for banks, thus supporting the market sensitivity of any disclosure of errors or irregularities in internal control. These include Sociétè Generale in early 2008, the National Australia Bank unauthorised trading in 2004 and the collapse of Barings Bank in the 1990s. Theory in action 7.2 Agricultural assets: IAS 41 Agriculture Explain what is represented by the items shown in the above table: (a) Assets reclassified from fixed assets € 705.9m IAS 41 requires that agricultural assets are separately recognised in the financial statements (para 41). On adoption of IAS 41 the Stora Enso Group has removed the relevant assets from fixed assets and separately classified them as biological assets. (b) Fair valuation surplus € 855.8m IAS 41 requires that a biological asset is measured at its fair value less point of sale cost at each reporting date (para 12). Thus, the Stora Enso Group has revalued the biological asset on adoption of IAS 41, giving rise to a revaluation surplus, to be included in profit and loss for the year (para 26). (c) Carrying value at 31 December 2003 € 1 587.8m At the end of the first year after adoption of IAS 41, the biological asset is again measured at fair value less point of sale costs (para 12). Net fair value is the carrying value of the asset. (d) Additions € 4.5m and disposals € -1 541.2m During the year ended 31 December 2004 biological assets in the group have increased by € 4.5, presumably through acquisitions of forests (natural increase is possible, but it is more likely to be captured in the year end valuation of the forest rather than as an addition). The disposal € -1 541.2m reflects the large divestment of forest assets noted in the text. (e) Changes in fair value € 37.5m At the end of the second year, the biological asset is again measured at fair value less point of sale costs (para 12). The increase in fair value gives rise to a fair value change which is recorded in profit and loss in the period in which it occurs (para 26). (f) Decrease due to harvest € -30.4m The value of harvested agricultural produce arising from an entity’s biological assets must be measured at fair value less point of sale costs (para 13). The harvesting of agricultural produce (i.e. the felling of trees) leads to a reduction in the value of the forest of € -30.4m. Theory in Action 7.3 Impairment The solution below makes use of material from: Theory in Action 7.2 Impairment Barclays reveals ₤1.7 bn loans write off Patrick Hosking The Times, November 16 2007 1. What is a writedown? In the article, a writedown refers to the process by which a bank reduces the value of assets recognised on its balance sheet. Barclays has written off ₤1.7bn on sub-prime mortgages and buyout loans. A writedown is an unrealised loss (that is, a paper loss) which occurs because the market price or estimated fair value of the asset is less than its carrying amount. In a situation where markets recover, the unrealised loss may not eventuate as the investment may be sold at a profit. 2. At the time of the article, why were banks reporting writedowns? The writedowns were necessary because the value of the bank’s investments declined in value as part of the global financial crisis. The value of investments declined as borrowers in the sub prime mortgage market defaulted, causing loss of liquidity in credit markets. Markets for some assets dried up, making them difficult to value and/or worthless, indicating that writedowns were required. 3. What guidance is there about how to calculate the writedown? IAS 39 provides guidance relating to the recognition and measurement of financial instruments. Managers classify financial instruments into one of four categories (see Chapter 7) and follow measurement methods based on these categories. The way in which a decline in value is to be treated is also specified according to category. Financial instruments at fair value through profit and loss will reflect any loss in value as market price (or an approximation of market price) is used to value the instrument. In determining impairment, market value must be used if it is available. For an asset with no market value, banks can use models to estimate fair value, making assumptions about interest rates and default rates relating to the assets underlying the securities. For loans and receivables and held to maturity investments held at amortised cost, and impairment loss is recorded (in profit and loss) when the asset’s carrying amount is less than the present value of estimated future cash flows (IAS 39, para 63). When there is objective evidence that an available for sale investment is impaired, the impairment losses will be recognised in profit and loss (not in equity) (IAS 39, para 67). Impairment losses which subsequently decrease may be reversed if there is objective evidence e.g. improvement in the debtor’s credit rating. The reversal will be recorded in profit and loss. At the date of the reversal, the value of the asset will not result in a carrying value in excess of the amortised cost applicable at that date had the impairment not occurred (IAS 39, para 65). 4. Do all banks use the same model to calculate a writedown? No. Although they all follow the same accounting standard IAS 39, the way the standard is applied varies between banks. Hosking (2007) describes the valuation process in this way: “Each bank values its assets in-house. First, the bank’s traders put a price on their books. Then its product or business unit control departments test the traders’ pricing. Finally, external auditors review the models and the underlying assumptions used by the bank to ensure they are in line with good accounting principles. But auditors sign off only on year end figures. For quarterly updates, the auditors discuss the figures with the banks, but do not sign off on them. Because there are no fixed rules on factors used in valuation models, and each banks’ investments are structured differently – with different weightings for each security for example, writedowns are not calculated in a uniform way….In turbulent times, valuations are highly judgemental.” Source: The Times, 16 November 2007 Theory in action 7.4 Class action targets ABC and auditors By Nabila Ahmed Australian Financial Review 16 October 2008 p. 6 1. The article states that ‘the auditors allowed them to book those guarantee payments as revenue’. What are the implications of this action for assets? Booking something as revenue means that there is a credit entry to the revenue account. There must also be a debit entry; in this case it seems to have been made to an account receivable or another asset. The debit to assets gives the impression that the business has more assets. The revenue entry increases profits, and thereby increasing shareholders equity. The lawyer bringing the new action refers to ‘inflated profits and inflated values’. The inflated values appear to be the assets recognised as part of the transaction to recognise revenue. 2. What is a class action? Why is it being brought against the auditors? A class action has many plaintiffs acting together to sue another party or parties. They collectively bring an action to court. In this case the class action is being brought against both the auditors and the company ABC. (Note that the article refers to two class actions brought by different law firms.) Auditors could be targeted because the lawyers expect that the company will try to shift blame to the auditors (rightly or wrongly), meaning that shareholders will not be able to recover damages from the company or its directors. If auditors are targeted, then shifting blame between the various parties will not defeat the shareholders’ action. Another reason auditors could be targeted is that they are often regarded as having ‘deep pockets’. This means that if the audit firm is found responsible it is likely to be able to pay the damages, either from the partners’ own resources or from the firm’s insurance coverage. Many possible legal actions do not proceed if it is likely that the defendant would not be able to pay, even if the plaintiff won. 3. What do you think the auditor’s legal defence will be? A third auditor, KPMG, (the original auditor is Pitcher Partners and the new auditor is Ernst & Young) provided an independent opinion that both types of accounting treatments were defensible. This opinion was sought by the ABC Board but seems to protect both Pitcher Partners and Ernst & Young from the class action. However, simply receiving a favourable third opinion does not mean that the court will accept the auditors’ views. The court will determine if the auditors’ actions were ‘reasonable’. CASE STUDIES Case Study 7.1: Heritage assets Answer the following questions in relation to the issue of recognising the value of heritage assets in the financial statements of the organisations which are responsible for the assets. 1. In what ways are heritage assets similar to the assets of for-profit entities and in what ways are they different? Consider the conceptual framework definition of an asset (Framework, para 49): “..a resource controlled by the entity as a result of past events and from which future economic benefits can be expected to flow to the entity.” The definition can be applied to assets held by for-profit businesses but it is difficult to apply to many heritage assets because of the special features of these assets. Do custodial entities have control of the heritage asset? This point can be debated by students. The custodial entity may manage and care for a park, but it cannot sell it. Art galleries can buy and sell assets, but purchases are scrutinised by external stakeholders (e.g. the public, for whom the managers are trustees in an equitable and/or legal sense). Is there a past event? The purchase of a painting is a past event, but the creation of the Great Barrier Reef is an event possibly beyond the scope of accounting. Do future economic benefits flow to the entity? Art galleries often do not charge for admission to view collections. Parks may charge admission, but to contribute to costs rather than make a profit. Heritage assets are often not held to make future economic benefit but rather have social, psychological and community benefits. Students should discuss the difficulty of applying concepts of ‘future economic benefit’ to heritage assets. 2. Is it appropriate to recognise a heritage asset in the financial statements of the entity which has custody of and responsibility for the asset? Consider the IASB Framework recognition criteria (para 89) it is probable that future economic benefits will flow to the entity and it has a cost or value that can be measured reliably. Students should discuss if future economic benefits are likely in relation to holding heritage assets. In many cases such assets are held for social, political and community reasons rather than economic reasons. Future economic benefits are unlikely in many cases as the assets are not held for the purpose of wealth creation. Further, future benefits (of any kind) are difficult to measure with any reliability in relation to heritage assets which are often unique (one of a kind) and thus lacking in a market value. Where market values are available, such as for works of art or buildings, they are may not be relevant to stakeholders since the assets are not held for trading or sale. 3. Are there users for the information about the value of heritage assets? Students should discuss whether the cost benefit requirement is satisfied in relation to the valuation of heritage assets. For example, is the cost of determining a valuation of a gallery’s art collection justified when the collection is not for sale? It can be argued that the collection must be valued for insurance purposes and that insurance is necessary to protect the asset. Since a value is available it should be communicated to stakeholders, to assess the stewardship of management in maintaining, protecting and expanding the community asset. It has been suggested that “businesses manage what they measure.” Should not-for-profit entities also measure their assets as part of an accountability and stewardship process? While there is some merit in this argument, it should be noted that heritage assets are not held to generate income in a manner similar to the assets of commercial enterprises. 4. Can a financial value be assigned to a heritage asset? It can be argued that heritage assets are priceless, that they belong to future generations, that they are not for sale and market values or financial values are academic and meaningless. It would appear that for many heritage assets financial value in no way represents their ‘real’ value or future value. Some assets have no ‘market value’ because they are unique and irreplaceable. The value of the assets is determined by reference to community values and may vary according to the stakeholders consulted. There may not be agreement about the financial value or even the social or cultural value. For example, we can determine both a purchase price and a current market value for Jackson Pollack’s Blue Poles owned by the Australian National Gallery. However, does the financial value represent the value of the painting to the community? Is the increase in financial value over the time it has been owned related to ‘income’ for the community? The answers to these question is likely to be no and can be discussed with students to explore the relevance of financial values to determining worth of heritage assets. Case Study 7.2: Intangible assets 1. Explain the valuation methodology and key considerations for intangible assets such as brands and trademarks using the relief from royalty approach. What are the main challenges in determining the royalty rate and how can they be addressed? 2. How does the relief from royalty approach differ in valuing patents compared to brands and trademarks? What factors contribute to this difference? 3. Describe the indirect approach to valuing customer contracts. What assets are considered in this approach, and how are charges calculated against cash flows generated by the contract? 4. Discuss the cost approach for valuing internally generated computer software. Why is this method considered suitable for unique software? What challenges are involved in estimating development costs? Intangible asset Valuation methodology Valuation issues Brands and trade marks Relief from royalty approach The valuer needs to know: (1) royalty rate, expressed as percentage of sales (2) the forecast sales of the intangible (3) the terminal value of an intangible with definite life (4) the cost of capital. The most difficult item is (1) which requires qualitative and quantitative input from financial and marketing personnel. However, all model inputs are subjective and require experience and judgement in estimation. Patents Relief from royalty approach As above, but the patent may have a definite life so an assumption is not necessary. Customer contract Indirect approach Relevant assets which contribute to the valuation of the customer contract include fixed assets, working capital and the brand. A charge is made for the use of these assets against the cash flows generated over the forecast life of each contract. The residual cashflows after making the charges are then discounted at the appropriate cost of capital. Internally generated computer software Cost approach. Considered the only method which can approximate the cost of a unique set of software not available in the wider market place. Forecast costs must be discounted at appropriate cost of capital. The key issue is sourcing the data for costs of development of the software. Note: market method is rarely used as outright sales and purchases of intangible assets are infrequent and details are rarely fully disclosed. There is no assurance that the intangible asset to be valued is the same as that in the market transaction. Case study 7.3: Fair Value Activity: Based on material presented in this article and in the chapter, compare and contrast views about the fair value measurement model and the mixed attribute measurement model. Full fair value would require all financial instruments to be measured at balance date at fair value. Bankers consider that this would lead to negative consequences. They state that it will lead to volatility (an understatement and overstatement of net assets) and unrealised (or ‘paper’) losses. In addition, opponents claim fair value measurement is misleading and does not provide a faithful representation of an entity’s business model and how it generates earnings. For example, a loan at amortised cost shows the expected cash flows, which are contractual and can be measured reliably. A fair value calculation based on periodic marking to market of the loan can provide less predictive value because expected future cash flows are not represented. Bankers express a preference for a mixed attribute measurement model, where held-for-trading financial instruments are measured at fair value while other financial instruments (loans, deposits and receivables) are measured at amortised cost. The standard setters rebut the claims of bankers in relation to fair value. Herz argues that loans are financial instruments and should be covered by any overarching rule adopted for financial instruments. He notes that loans are not always held to maturity; they are often parcelled up in securitisation, which gives them a short term nature. David Tweedie (Chairman, IASB) argues that fair value measurement has a disciplining effect on an institution’s lending and investing decisions. He points to the example of Japanese banks in the 1990s when stating that historical cost accounting for financial instruments can delude investors that all is well. For derivatives, cost is often zero, making historical cost measurement irrelevant. Tweedie also notes that much of the ‘pain’ attributed to fair value accounting in the 2008-2009 financial crisis would still have been reported under historical cost accounting, because impairment principles, which are fundamental in the mixed attribute model, would have led to asset write downs. Investors favour more fair value measurement, stating that, in their view, fair value improves transparency and assists risk assessment. This is in spite of the fact that fair value measurement can involve subjective management assessments of value. Nevertheless, some analysts favour full fair value and argue that the mixed attribute model is a burden. The CFA Institute (an organisation representing analysts) argues that fair values are useful for calculating whether loans will be repaid “because they are likely to reflect the most up to date assessments of that probability”. The CFA Institute argues that the mixed attribute model unduly burdens investors that rely on fair values to make decisions. Such investors rely on disclosures about fair values which may vary in quality. Arguments in favour of fair value: The use of fair value provides relevant information for decision making. The use of historical cost for items such as financial instruments is misleading and potentially dangerous as it underestimates the risk of instruments. See for example the collapse of Australian miner, Sons of Gwalia, in 2005. Losses on hedge contracts were not recognised in the financial statements, making the financial statements misleading. Standard setters argue that assets and liabilities should be carried in the balance sheet at fair value to provide relevant information for decision making. Fair value can be determined in exchange or by referring to the existing value of a comparable item in the market place. FAS 157 provides guidance on how to calculate fair value. Arguments against the use of fair value: Fair values are not available for all assets. In some cases, fair values have to be estimated. Therefore they are costly to obtain and are subjective. In the case of some financial instruments standard setters require the use of mathematical models to calculate the hypothetical market price. Fair values may be misleading when they are based on estimation. Fair values may be subject to intentional and unintentional measurement error. Valuations are sensitive to the assumptions underpinning the models which may be wrong or may be manipulated in line with management incentives (see for example pricing of stock options). Small changes in the assumptions and predictions used in the models can change the value of an item. Costs and gains shown in the income statements could vary widely, depending on the assumptions in the model. The fluctuations as a result of ‘mark to model’ may bear little or no relation to cash flows. Thus some fair value measurements are subjective, raising questions about their reliability and usefulness. Fair value remeasurements introduce volatility into the accounts, which may influence investors’ views. Preparers may be concerned that the volatility is hard for investors to understand. Some preparers argue that fair value measurement requires firms to follow rules which do not reflect a firm’s economic view of the asset. Thus financial reporting and management reporting do not correspond. For example, IAS 39 requires that an available-for-sale security be marked to market, but the firm may intend to hold the security indefinitely and not trade it in the current market, making current market value irrelevant (according to the managers’ perspective). QUESTIONS What attributes must something possess in order to be defined as an asset? Why? For something to be defined as an asset, it must possess the following attributes: future economic benefits or services will flow to the entity from it it must be controlled by the entity it must be the result of a past transaction or event. These attributes ensure that whatever is defined as an asset is of economic value to the entity and is an asset of the entity itself rather than some other organisation that controls it. The Framework defines assets, liabilities and equity by reference to economic benefits. What are the economic benefits that would be assets for AlexCorp, a government business enterprise that constructs the physical infrastructure (roads, bridges, etc.) for the city of Huntersville? Must economic benefits be revenue-generating, or can parks, roads or statues provide economic benefits? (a) An economic benefit is ‘scarce’ and has ‘utility’. Utility pertains to the future economic benefits or services. Because the resource is scarce and has future benefits, it has economic value in generating future cash flows (including reducing future cash outflows). AlexCorp — a government business enterprise constructing physical infrastructure for the city of Huntersville — would have assets comprising productivity resources to build the infrastructure (that is, equipment) and claims to receive money associated with contracts and money. If AlexCorp retains ownership of the infrastructure assets and they are leased to the city of Huntersville, the infrastructure assets provide economic resources to AlexCorp (that is, lease receipts) and constitute assets. (b) Examples of economic benefits include: Cash inflows from sales of products produced by an entity using resources such as raw materials, equipment, patents, or contractual rights to the use of resources of other entities money claims to receive money ownership interests in other enterprises. Monuments, parks and/or roads provide service potential to the authorities providing and maintaining them because they enable those authorities to pursue their objectives. To the extent that the monuments, parks, and/or roads generate inflows (e.g. indirectly from increased rates or donations, etc.) or reduce outflows of cash, (e.g. because other community resources do not need to be acquired in their stead) they contribute economic benefits. The Framework definition of assets requires future economic benefits to be controlled by an entity before they can be regarded as an asset. How does ownership differ from control? Which criterion (ownership or control) do you think should be applied in defining assets? Why? The term ‘ownership’ means different things to different people. Ownership is usually associated with legal ownership or entitlement. For accounting purposes, the criterion to meet the asset definition is that the entity controls the future economic benefits. The term ‘control’ is associated with the right to regulate access to, and use of, the future economic benefits. This implies that the entity has a legal or moral/equitable right to receive the benefits. For example, for an operating lease, the lessee does not legally ‘own’ the asset, but it does have the legal right to receive the benefits or services of the asset. Students should debate whether legal ownership or control is the preferable criterion. All sensible arguments should be entertained, but in the final analysis, what ‘should’ be done depends upon the opinions and assumptions of those developing the theory of accounting to be applied. According to the Framework, assets do not exist unless they result from past transactions or events. Determining whether a past transaction or event has occurred to give rise to an asset is not always straightforward. Explain the past transaction or event that triggers the existence of the following assets: (a) accounts receivable (b) prepaid insurance (c) inventory of work-in-process (d) inventory of raw materials (e) finance lease of manufacturing plant (f) goodwill (internally generated or purchased). (a) accounts receivable — sale of the product or service (b) prepaid insurance — purchase of the insurance policy (c) inventory of work-in-process — production activity (d) inventory of raw materials — purchase of the inventory (e) finance lease of manufacturing equipment — the signing of the lease agreement; or if the equipment is to be constructed, when the construction is completed (f) goodwill — the purchase of a company (purchased goodwill); the activity/activities generating reputation (internally generated goodwill, which is not recognised, anyway). Instructors might discuss the ‘reasonableness’ of the accepted past transaction or event for each of the assets mentioned above. For example, the relevant event for inventory could be the physical receipt of the inventory, especially because the timing of order, invoicing, receipt and payment, can vary in order and separation. It is also worth mentioning that the presence of an asset does not necessarily imply that the asset will be recognised in the financial statements (e.g. internally generated goodwill). What is an agreement equally proportionately unperformed (AEPU)? According to strict interpretations of the Framework definitions of assets, liabilities and equity, should AEPUs be reported on the statement of financial position? Why or why not? Wholly executory contracts (agreements equally proportionately unperformed, or AEPUs) are not recorded because they involve only an exchange of promises. There is no performance yet to give ‘economic substance’ to the contract. That is to say, the signing of the contract is not regarded as the relevant past transaction or event to give rise to an asset or liability. Yet they are in question (4) above. The instructor may wish to discuss the reasons why. For a financial lease, there is a transfer of the asset to the lessee for his or her use. For a forward exchange contract, the contract may be sold and therefore the contract itself has value. In both cases, as far as accountants are concerned, something of value has been exchanged, not just promises. Most wholly executory contracts would be recorded by firms complying with the Framework, because the statement requires the recognition of both the asset and liability involved in such contracts. In practice many AEPUs are not recognised. Proposals to recognise AEPUs in Australia under SAC4 were vigorously opposed by preparer groups certain AEPUs were excluded from its scope. Under some market-based systems of accounting, asset definitions require that to be defined as an asset, an economic benefit must be both ‘severable and saleable’, sometimes described as ‘exchangeability’. Is that a requirement in the Framework definition of assets? Why or why not? Do you think that severability is necessary to a definition of assets? Why or why not? Those who favour exchangeability believe an asset should be ‘separable’, and have value of its own. They argue that the entity should be able to sell it, and an asset should be capable of separate identification in order that it can be measured (valued). Such a condition would exclude certain intangible assets (such as goodwill) and deferred charges (such as deferred income taxes) from assets. Using this approach, the purpose of financial accounting and of the statement of financial position is to report the value (cost) of a firm’s assets, not to report the value of the business as a whole. To value a business involves predicting its future earnings (or net cash flows) and is a function of the combination of resources rather than individual items. Those who oppose exchangeability as a necessary feature of assets believe that this unduly emphasises a single way (exchange) of obtaining benefits from assets, and depends on a misguided view of ‘economic value’. They argue that value is only through their use rather than exchange. Assets are used jointly, and therefore in most cases their benefits cannot be precisely identified. There is no reason to believe that the contributions of certain intangible assets are proportionately less than tangible assets, or that they are less because there is no market to sell them separately. Because benefits received from using resources are unaffected by whether or not they are exchangeable, the condition of exchangeability is irrelevant in deciding whether an item is an asset. Economic value depends on scarcity and utility, not exchangeability. To include as assets certain intangibles, such as goodwill, is not an attempt to value the firm as a whole, but an attempt to include in total assets the future benefits obtainable by the firm as a result of past transactions or events. The Framework does not regard exchangeability as a criterion to apply in defining an asset. It recognises that if something is exchangeable for something else of value, then it has future economic benefit and is presumably an asset. However, it recognises that some assets may not be exchangeable. For example, roads and monuments may be unsaleable, but they have service potential for the organisation controlling them and are therefore assets under the Framework. Are the following assets? If so, whose assets, and why? (a) Members of the Australian hockey team (b) A 9-month lease agreement to rent a business office (c) Expenditure on research and development (d) An unsigned, documented contractual agreement to build specialised equipment for a client (e) A building bequeathed to a firm (f) A 5-year option to acquire property, where the option was purchased by the company a year ago (a) Human resources arguably meet the definition of assets of the Australian government, or the Australian Institute of Sport (depending upon whether it is accepted that they can be controlled to act in the interests of the reporting entity). However, even if they are regarded as meeting the definition, because of the difficulty of placing a value on them they are not recognised. (A question to debate in class is: If the team is on a losing streak, are the players still assets? As long as they generate future economic benefits, they remain assets whose measurement and probability may not warrant capitalisation as assets.) (b) Operating lease. For the lessee (tenant), the future benefits that he or she has control over are the benefits under a contract specifying the rights to benefits, e.g. the right to use a motor vehicle for a month. According to AASB 117, there is no intent by the lessor to transfer substantially all ownership benefits and risks to the lessee. Nonetheless, once a contract is in place there is a right to control the inflow of economic benefits, and an obligation to pay for them. As such, both an asset and a liability do exist under the Framework definitions. (c) Research and development. AASB 138 does not allow intangible assets arising from research phase to be recognised by the firm paying for the R&D, as the existence of intangible assets that will generate future economic benefits cannot be demonstrated. AASB 138 only allows intangible assets arising from development to be recognised if the technical feasibility of the product or process that they relate to has been demonstrated, and there is a clear indication of a future market for the product; or if the item is to be used internally, its usefulness can be demonstrated. Students should debate whether the R&D is controllable by an organisation and gives rise to economic benefits. An important question to ask in this debate is why an organisation would undertake R&D if it did not give rise to future economic benefits under the control of the entity? (d) An unsigned contract. There is no basis for believing future economic benefits exist. Because the contract has not been signed, it is possible that the buyer (client) may get out of the contract. The law does not recognise a sale for custom-made goods unless performance has begun. In this case, the contract for performance has not even been signed. There is no asset. (e) Bequest. An asset does not need to have a cost. The land is now under the control of the company, it has future benefits, and it arose from a past transaction (the donation) — therefore, by definition it is an asset. The company should record it at fair market value. (f) Option. At the time the option is purchased, it should be considered an asset of the holder. It gives the company the right to purchase the building and therefore has future benefit. If the building is actually purchased, whether the option should be considered part of the cost of the building is another issue. It can be argued that the option was purchased as part of an integrated plan to acquire an appropriate building, and therefore it is part of the cost of the building. On the other hand, does the purchase of the option make the building more valuable than the actual bargained price of the building? If the option lapses, it should be expensed. PROBLEMS Problem 7.1 1. What criteria should be considered to determine whether a deferred tax asset can be recorded based on the realisation of tax benefits from future income? 2. When should an entry be made for a transaction where there is no performance? 3. How should a situation be handled where there is insufficient evidence to determine whether a liability has been incurred? 4. In what circumstances should a liability be recognized, even if there is a possibility of the decision being reversed in the future? 5. When should an entry be made for a contract that has been signed but no performance has occurred yet? 6. Can firm policy be the basis for recognizing a liability, even if it is not a legal obligation? Provide an example. This problem demonstrates the difficulty of determining whether an asset or liability exists. There is an asset if the realisation of the tax benefits will occur because of future income. AASB 112 and the Framework are relevant. The reason for the loss can be identified as an isolated incident. The firm has been continuously profitable over a long period of time, and assuming that it is more probable than not there will be sufficient taxable income in the future that the benefit will be realised, and an asset can be recorded. Deferred tax asset $144 000 Income tax benefit from loss carry forward $144 000 2. No entry should be made since there is no performance. 3. The Framework is pertinent. At this point, there is insufficient evidence to say that it is ‘probable’ a liability has been incurred. There is no entry to record. Footnote only. 4. Is there a liability? Su Lamp Ltd plans to appeal, and there is a possibility the decision could be reversed. However, there is presently an obligation as a result of past events, the payment is probable, and the amount is reliably determinable. As such, there is sufficient evidence to say it is ‘probable’ a liability has been incurred, and the amount can be reasonably estimated. Loss from lawsuit $400 000 Lawsuit liability $400 000 On the other hand, if the outcome of the appeal is favourable with more than 50% probability, then a liability should not be reported, although a contingency should be disclosed. Overall, the decision must be made exercising prudence, a concept under the Framework, whereby caution is exercised to ensure that assets are not overstated or liabilities understated. 5. No entry is to be made. The contract has only been signed. The fact that the contract is with the city hall and is a cost-plus contract makes no difference. Some performance needs to occur before there is an actual obligation under the contract. 6. A liability does not have to be a ‘legal’ liability. Firm policy can be the basis of an obligation. The bonus is based on past services rendered by the sales manager, and therefore an expense should be accrued. Salaries and wages expense $15 000 Salaries and wages payable $15 000 Problem 7.2 1. How should internally generated research and development (R&D) costs be accounted for under AIFRS? 2. When a company purchases another company and absorbs its assets and liabilities, what accounting treatment should be applied, and why is goodwill recorded in such transactions? 3. According to AASB 3 Business Combinations, how should an excess of market value over cost be treated in a business combination? 4. Under what conditions would a secret formula meet the definition of an asset, and when would it not be recorded as an asset? 5. How should a lease be classified as operating or capital under AASB 117, and what factors determine this classification? 6. Why are executive contracts not recorded as assets on the balance sheet, even though they represent future economic benefits to the firm? 1. Internally generated R&D is to be expensed under AIFRS. Research and development expense $250 000 Cash or Accounts payable $250 000 2. This is a 100% purchase of Austin Power Ltd. Austin Power Ltd will be merged with Zanadriana Ltd, and therefore Zanadriana Ltd absorbs the former’s assets and liabilities. Because the transaction is a ‘purchase’, there is a new basis of accountability. Current assets $ 140 000 Land and buildings 1 700 000 Goodwill 310 000 Liabilities $ 150 000 Cash 2 000 000 It should be noted that goodwill is recorded. The accounting principle is that it can only be recorded when it is paid for. It may be interesting to discuss why. One reason is the cost principle. Another is the problem of measurability. It is difficult to know what the value of goodwill is until there is an actual transaction. 3. Cost of purchase $1 900 000 Market value of net assets acquired 1 990 000 Excess of market value over cost $ 90 000 According to AASB 3 Business Combinations, paragraph 56, if the acquirer’s interest in the net fair value of the recognised identifiable assets, liabilities and contingent liabilities exceeds the cost of the business combination, the acquirer shall: (a) reassess the identification and measurement of the acquiree’s identifiable assets, liabilities and contingent liabilities and the measurement of the cost of the combination; and (b) recognise immediately in profit or loss any excess remaining after that reassessment. As such, the assets and liabilities should be recognised at their fair values, and $90 000 written off, immediately, as an expense. 4. The secret formula appears to meet the definition of an asset. But it will not be recorded, unless (a) a patent is taken out, and (b) a reliable measure can be obtained. This is because it was not purchased and the research and development costs have been expensed. A reliable measure needs to be obtained, and control ascertained. 5. According to AASB 117, this is a capital lease if there is a transfer of the rights and obligations of ownership, otherwise it is an operating lease. It is not possible to tell from the information given whether the lease is operating or capital, because the life of the machinery is not given, nor is the normal price of the machinery. Thus, it is impossible to tell whether the machinery can be acquired at a bargain purchase price at the end of three years, or whether the machinery is leased for a significant portion of its useful economic life. If the machine is leased under an operating lease: Lease expense $50 000 Cash $50 000 If the machine is leased under a capital lease: Leasehold asset (PV of $50 000 @ (12√1.08)% for 35 periods + $50 000 + PV of 5 y3a4 annuity of $3000 per month or $40 000, whichever yields the lower amount) Lease liability (PV of $50 000 @ (12√1.08)% for 35 periods + $50 000 + PV of 5 y3a4 annuity of $3000 per month or $40 000, whichever yields the lower amount) Note that the tables at the back of the text do not offer the appropriate monthly compound interest rate to yield an 8% annual return, which is assumed at the start of this problem. 6. The executives obviously represent future economic benefits to the firm. However, the economic benefits to be derived are difficult, if not impossible to measure. Despite the contracts being in place, the firm does not control the executives in a total sense, and when the services are received by the firm an expense will be recorded. Unless the salaries are prepaid, there is no asset to record. Problem 7.3 1. How should Kalmers & Meehan account for the taxation advice provided to Steph’s Tennis World Ltd, considering the change in the probability of receiving payment and the recognition of doubtful debts? 2. How should Kalmers & Meehan account for the taxation advice provided to Ranch Vineyards Ltd, considering the probability of receiving payment in the form of wine and the subsequent recognition of revenue and assets? 3. How should Kalmers & Meehan account for the cost of a walkway, considering the firm's belief that it will increase revenues and the treatment of the walkway as an asset? At the time that Kalmers & Meehan provided taxation advice to Steph’s Tennis World Ltd, Kalmers & Meehan would have deemed it probable that there would be an inflow of $70 000 for taxation advice. As such, there was a probable inflow of economic benefits as a result of a past transaction (taxation advice provision), and revenue would have been recognised. It is only now that the firm realises that the inflow is unlikely. As such, there is a reduction in probable future economic benefits as a consequence of the debate about the appropriateness of the advice offered by Kalmers & Meehan (this is the past event, along with Steph’s Tennis World Ltd’s refusal to pay). The firm should recognise a reduction in the revenue receivable asset, and recognise an expense (doubtful debts) to offset against the previously recognised revenue. Possibly, the expense should be bad debts rather than doubtful: When advice was provided and it appeared probable that Steph’s Tennis World Ltd would pay: Dr Accounts receivable 70 000 Cr Taxation advice revenue 70 000 30 June 2005 Dr Doubtful debts expense 70 000 Cr Accounts receivable 70000 2. The fact that Ranch Vineyards Ltd has not yet delivered the wine does not mean that it is unlikely that the firm will do so. If Kalmers & Meehan deem it probable that the wine will be delivered, they have an asset in the future economic benefits: the wine can either be used within the firm, or sold. Furthermore, it is measurable. If it is deemed probable that the wine will be delivered, the asset and associated revenue should be recorded. When advice was provided and it appeared probable that Ranch Vineyards Ltd would pay (whether in money or in wine): Dr Accounts receivable 5000 Cr Taxation advice revenue 5000 The fact that the accounts are being prepared six weeks after the invoicing and the wine has not been received is not necessarily unusual, and should not necessarily trigger doubts about receiving the wine. However, it if is deemed improbable that the wine will be delivered, then no revenue or asset should be recorded. If they have already been recorded, they should be written-down or written-off, in the same manner as the entries recorded for part 1 of this problem (Steph’s Tennis World Ltd). 3. The fact that Kalmers & Meehan was prepared to pay the cost of a walkway indicates that the firm deems it likely that the walkway will increase revenues (perhaps because it provides a more sophisticated/successful image). As such, it would be deemed an asset. Dr Land & buildings 3000 Cr Bank/Loan payable/… 3000 Problem 7.4 The purpose of this problem is to discuss what constitutes a liability, and when it is recorded. Given historical trends, it is likely that there should be a liability recorded for probable future outflows of economic benefits related to labour, parts, etc. As such, option (a) below is the preferable answer. Option (b) is shown for comparative purposes only. (a) Accrual method entries for 2009 year: Warranty expense $500 000 Estimated liability on product warranty $500 000 Estimated liability on product warranty $800 000 Cash, Parts inventory etc. $800 000 For ease of accounting, each year a warranty liability is increased for the probable warranty expenses based on the period’s sales. This liability is reduced as costs are incurred so that the balance should always be somewhere close to the expected cost of warranty repairs for the last two years’ worth of sales. There is no point reversing the warranty expense entry each year and starting afresh if warranty expense estimates are reasonably accurate. (b) Cash-basis method for 2009: During year Warranty expense $800 000 Cash, Parts inventory, etc. $800 000 The cash basis can be used if the amount of the warranty cost is not material, or the two criteria mentioned in the Framework — probability of incurrence of a liability and ability to estimate the amount — are not met. In this case, the firm should be using the accrual method. At least to a limited degree, both methods are acceptable. The question is: Why does one method yield a liability, and for the other, there is none? The circumstances of giving customers a warranty are substantially the same, so that the condition of the Framework should be met. If there is a liability, then only the accrual method should be used, and the cash method should be declared unacceptable. Problem 7.5 1. How should a firm account for self-insurance appropriations and actual losses, considering the requirements of AASB 137 regarding impairment of assets or incurred liabilities? 2. How should a firm account for salary expenses related to bonuses, and what entry should be made to reflect this transaction? 3. How should a firm account for labour strikes as a general risk contingency, and is disclosure required in the balance sheet for such events? 4. How should a firm account for a probable liability that is reasonably determinable, such as a demand for refund due to overcharging, and what entry should be made in such a situation? 5. How should a firm account for the impairment of asset values due to expropriation, considering the notice of intent to expropriate by a foreign government and the subsequent recording of a loss and allowance for expropriation? 1. As of the balance sheet date, there is no particular event to cause the firm to believe that an asset has been impaired or a liability has been incurred. Expected losses, even if subject to reasonable estimation, do not satisfy the requirements of AASB 137. The firm may record an appropriation for self-insurance. Retained earnings $500 000 Retained earnings appropriation – self-insurance $500 000 When the loss actually occurs, then the following entry is to be made: Loss from casualty x Asset (specific asset damaged) x The appropriation should not be debited for the actual loss. 2. Salary expense (bonus) $500 000 Paid up capital $500 000 3. Labour strikes are considered a general risk contingency inherent in business operations. Although negotiations have terminated at present, they will probably continue at a later date. The threats and bluster of labour negotiations are common. No entry should be recorded. Disclosure is not necessary in the balance sheet. 4. It is probable that a liability has been incurred, and the amount is reasonably determinable. The firm knows the cause of the demand for refund (for example, overcharging of items). Therefore, the following entry should be made. Loss from Danlon & Dolland contract $75 000 Liability on Danlon & Dolland Contract $75 000 5. There is sufficient evidence of impairment of asset values at the balance sheet date, because the foreign government has actually given notice of intent to expropriate. The amount is subject to reasonable estimation. Therefore, according to the Framework, a loss should be recorded. At the time of actual expropriation, the specific assets would be written against the allowance for expropriation account. Book value of subsidiary $12 900 000 Expected amount from government 9 000 000 Loss $ 3 900 000 Loss from expropriation $03 900 000 Allowance for expropriation $3 900 000 Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152
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