CH-10 Regulation and the Conceptual Framework – Accounting : Book Guide

Chapter 10: Regulation and the Conceptual Framework Questions and solutions which have a GST version: • Problem 10.16 Please note: GST versions of the end-of-chapter questions are not appropriate for this chapter. Discussion questions 1. Outline the regulatory process in Australia in relation to accounting standard setting and discuss the influence of international bodies in the standard-setting process. The answer to this question requires a full coverage of the material covered in Learning Objective 1 of the chapter. Regarding international influence, refer to the discussion of the roles played by the IASB and the FASB. See also discussion of the Asian–Oceanian Standard Setters Group. 2. What is meant by an entity’s financial position and performance? To whom and for what purpose are the financial position and performance appropriate sources of information? Information about an entity’s financial position, in the IASB’s Conceptual Framework, represents information about the entity’s resources and claims against those resources. The IASB states that information about an entity’s economic resources and the claims on them—its financial position—can provide users of the entity’s financial reports with a good deal of insight into the amount, timing and uncertainty of its future cash flows. That information helps users (present and potential investors, lenders and other creditors) to identify the entity’s financial strengths and weaknesses and to assess its liquidity and solvency, its needs for additional financing and how successful it is likely to be in obtaining that financing. Financial performance, according to paragraph the IASB’s Conceptual Framework, an entity’s financial performance provides information about the return it has produced on its economic resources. In the long run, an entity must produce a positive return on its economic resources if it is to generate net cash inflows and thus provide a return to its capital providers. Such information provides an indication as to how well management has discharged its responsibilities to make efficient and effective use of the reporting entity’s resources. Information about a reporting entity’s past financial performance and how its management discharged its responsibilities is usually helpful in predicting the entity’s future returns on its economic resources and future cash flows. 3. ‘One of the major changes in both corporations legislation and accounting standards is the adoption of the reporting entity concept.’ This comment was made in a presentation at an accounting conference. One of the directors of your entity, a Brisbane-based company that is a wholly owned subsidiary of a Sydney-based company, was at the presentation and was concerned at his lack of knowledge of this concept. Explain to the director what is meant by the ‘reporting entity’ concept, the steps the company needs to take to determine whether it is a reporting entity, and the potential impact of this concept on financial reporting. Discuss as well whether or not the reporting entity concept should be abandoned. Currently, a reporting entity is defined in SAC 1 as an entity in which it is reasonable to expect the existence of users who depend on general purpose financial reports for information to enable them to make decisions about the allocation of scarce resources, i.e. economic decisions. Note that these users do not have power to command that the entity supply them with information. Hence, they are not entitled to special purpose financial reports. The users that are expected to exist are in three categories. 1. Resource providers. This category includes employees, lenders, creditors, suppliers and investors. In the case of non-business entities, the category includes donors, members of clubs, taxpayers and ratepayers. 2. Recipients or consumers of goods and services, i.e. customers, beneficiaries, taxpayers and ratepayers. 3. Parties performing a review or overseeing function. These include parliaments, governments, regulatory agencies, labour unions, employer groups, media, and special-interest community groups, e.g. environmental and conservation groups. SAC 1 provides certain guidelines to be used to assess whether an entity is or is not a reporting entity. These are as follows. i. separation of management from economic interest ii. economic or political importance/influence iii. financial characteristics. See section 10.3 of the chapter for further discussion of these guidelines. The consequences of being a reporting entity is that the entity must prepare a general purpose financial report which must comply with accounting standards issued by the AASB. Should the reporting entity concept be abandoned? In 2007, proposals were put forward to do away with the reporting entity concept in favour of using a size and public accountability test for determining which entities should prepare a general purpose financial report. If an entity is publicly accountable and satisfies the size test, it must prepare general purpose financial reports which comply fully with the Australian equivalents of full IFRSs. If an entity is not publicly accountable and does not satisfy a size test, then it should use merely the Australian equivalents to the IFRS for small and medium entities (SMEs). Following negative feedback on the IASB’s proposals, the AASB has tackled the problem differently by issuing AASB 1053, Application of Tiers of Australian Accounting Standards in June 2010, which has adopted a Tier 1 and Tier 2 system of financial reporting, to be applied on or after 1 July 2013. When preparing general purpose financial statements, those entities in Tier 1 shall apply full International Financial Reporting Standards (IFRSs) as adopted in Australia, and those in Tier 2 can adopt Reduced Disclosure Requirements (RDR). The RDR involves compliance with the recognition and measurement requirements of IFRSs, as already adopted in Australia, but with disclosures substantially reduced compared with those that would be required under full IFRSs. Figure 10.4 illustrates the key elements of the standard: In the meantime, rather than abandoning the reporting entity concept, the IASB has proposed a new definition of the reporting entity, namely: • a circumscribed area of economic activities whose financial information has the potential to be useful to existing and potential equity investors, lenders and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity and in assessing whether management and the governing board of that entity have made efficient and effective use of the resources provided. The focus is on equity investors, lenders and creditors, who are unable to obtain the information necessary to make an economic decision, nor to assess the accountability of the entity’s management. A reporting entity is seen as having three features. (a) the conduct of economic activities (b) the economic activities can be objectively distinguished from those of other entities and from the economic environment in which the entity exists; and (c) financial information about those economic activities is potentially useful in making economic decisions and in assessing whether the management have made efficient and effective use of the resources provided. 4. Briefly explain the nature of the Conceptual Framework for Financial Reporting, and discuss the perceived advantages and disadvantages of having a conceptual framework. A conceptual framework of accounting theory should enable standard setters to develop standards which are consistent and logically formulated, provide guidance to accountants in areas of accounting where standards have not been established, and enable standard users to better understand standards and proposed standards. The IASB and FASB are currently undertaking a joint project to amend the conceptual framework. The overall objective of this joint project is to develop a common conceptual framework that is both complete and internally consistent. The Boards want to develop a framework which will provide a sound foundation for developing future accounting standards that are principles-based, internally consistent, internationally converged, and that lead to financial reporting which provides the information needed for investment, credit, and similar decisions. That framework, which will deal with a wide range of issues, will build on the existing IASB and FASB frameworks. Are there any disadvantages in having a conceptual framework? Consider the cost of developing the framework versus the benefits. Also, since it is not compulsory for standard setters to follow the conclusions of the conceptual framework, will it be ignored? 5. Specify the objectives of general purpose financial reporting, the nature of users, and the information to be provided to users in order to achieve the objectives, as provided in the Conceptual Framework. The IASB’s Framework specify the objectives of general purpose financial reporting as being financial reports which are intended to meet the information needs common to a range of users who are unable to command the preparation of reports tailored to satisfy their own particular needs. The purpose of the Framework is to: (a) assist the AASB in the development of future Australian Accounting Standards and in its review of existing Australian Accounting Standards, including evaluating proposed International Accounting Standards Board pronouncements; (b) assist the AASB in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by Australian Accounting Standards; (c) [deleted by the AASB]; (d) assist preparers of financial statements in applying Australian Accounting Standards and in dealing with topics that have yet to form the subject of an Australian Accounting Standard; (e) assist auditors in forming an opinion as to whether financial statements conform with Australian Accounting Standards; (f) assist users of financial statements in interpreting the information contained in financial statements prepared in conformity with Australian Accounting Standards; and (g) provide those who are interested in the work of the AASB with information about its approach to the formulation of Australian Accounting Standards. The IASB and FASB have adopted the ‘entity perspective’, i.e. it is the entity, not its owners and others having an interest in it, which is the object of general purpose financial reporting. In other words, the focus is placed on reporting the entity’s resources (assets), the claims to the entity’s resources (liabilities and equity) and the changes in them. Shareholders are seen not so much as owners of the entity but merely as providers of resources to the entity, in much the same way as liabilities. Both present and potential equity investors, lenders and other creditors are seen as constituting a single primary user group. This group makes decisions about the allocation of resources as well as decisions relating to protecting or enhancing their claim on the entity’s resources. Other potential user groups e.g. government and other regulatory bodies, customers, employees and their representatives, are not the focus of the objective. Hence, it seems that the objective in the IASB’s and FASB’s Conceptual Framework is narrowly focussed on the needs of the primary user group. It also appears odd that in times when environmental and social issues are of great importance to society, and the desire for triple-bottom line reporting is growing, that these issues are ignored in the revised Conceptual Framework. 6. From the current Conceptual Framework, outline the qualitative characteristics of financial information to be included in general purpose financial reports. The Conceptual Framework 2010, issued by the IASB and the FASB, has divided qualitative characteristics into two categories, namely, fundamental characteristics (relevance and faithful representation) and enhancing characteristics (comparability, understandability, verifiability and timeliness). See Learning objective 5 in the chapter for a discussion of each characteristic. 7. The Conceptual Framework discusses ‘essential’ and ‘non-essential’ characteristics of an asset. Consider which characteristics of an asset are ‘essential’, explaining why you regard other characteristics as being non-essential. How would these characteristics change as a result of the proposed asset definition put forward by the IASB and the FASB? Discussion of essential characteristics of asset: • resource must contain future economic benefits • control, requiring a capacity to benefit from the asset in the pursuit of the entity’s objectives, and an ability to deny or regulate the access of others to those benefits. • past event, giving rise to the entity’s control over future economic benefits. Non-essential characteristics: • purchased at a cost • tangibility • exchangeability. With the proposed definition of an asset, namely ‘An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have,’ there will be less focus on ‘future economic benefits’ and more on ‘present resource’; and less on ‘control’, with more on the existence of rights that limit the access of others to that resource. 8. ‘To determine whether an entity should classify its costs either as an asset or an expense, accounting standards must contain definitions of these terms.’ With reference to the above statement, discuss the concept of an asset and an expense provided in the Conceptual Framework. Provide also a discussion of the IASB’s and FASB’s alternative suggestion for amending the definition of an asset. Do you agree with the above statement? Why or why not? An asset is defined in the current Framework 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’. Expenses are defined in the Framework as ‘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’. Note that the definition of an expense is driven by the definitions of assets and liabilities. For a cost incurred to qualify as an asset, the cost must result in future economic benefits which the entity controls. If this is not the case, then the cost automatically qualifies as an expense, as there is a reduction in an asset or an increase in a liability which has the effect of decreasing the entity’s equity. The purchase of an asset does not decrease equity and therefore does not create an expense. An expense also arises whenever the economic benefits in the asset are consumed, expired or lost. The proposed definition of an asset in the Framework is that ‘an asset of an entity is a present economic resource to which the entity has a right or other access that others do not have.’ This means that when a cost is incurred, the questions to be asked will be, has a present economic resource come into existence? and does the entity have rights to that resource that others do not have? It is important that accounting standards contain definitions of assets and expenses in order to provide a mechanism by which preparers of financial statements can determine which costs are assets and which are expenses. 9. Outline the definitions of a liability and equity as provided in the current Conceptual Framework. Provide and discuss examples of situations where there is confusion in determining whether a liability exists as opposed to equity. A liability is defined in the current Framework as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. Important aspects of this definition are below. A legal debt constitutes a liability, but a liability is not restricted to being a legal debt. Its essential characteristic is the existence of a present obligation, being a duty or responsibility of the entity to act or perform in a certain way. A present obligation may arise as a legal obligation and also as an obligation imposed by custom or normal business practices (referred to as a ‘constructive’ obligation). For example, an entity may decide as a matter of normal business policy to rectify faults in its products even after the warranty period has expired. Hence, the amounts that are expected to be spent in respect of goods already sold are liabilities. A present obligation needs to be distinguished from a future commitment. A decision by management to buy an asset in the future does not give rise to a present obligation. A liability must result in the giving up of resources embodying economic benefits which requires settlement in the future. The entity has little, if any, discretion in avoiding this sacrifice. This settlement in the future may be required on demand, at a specified date, or on the occurrence of a specified event. A liability is that it must have resulted from a past event. For example, wages to be paid to staff for work they will do in the future is not a liability as there is no past event and no present obligation. The current Framework defines equity as ‘the residual interest in the assets of the entity after deducting all its liabilities’. Equity cannot be identified independently of the other elements in the statement of financial position/balance sheet. The characteristics of equity are that equity is a residual, i.e. something left over after the entity has determined its assets and liabilities. In other words: Equity = Assets – Liabilities. The IASB and FASB have proposed to change the definition of a liability by focusing on a liability as a ‘present economic obligation’ rather than an expected future sacrifice of economic benefits. Furthermore, the reference to past events is to be replaced by a focus on the present. A further essential attribute in the proposed definition is that the entity is the ‘obligor’. An entity is the obligor if the entity is required to bear the economic obligation and its requirement to bear the economic obligation is enforceable by legal or equivalent means. Examples of items which cause problems in determining whether they are liabilities or equity are financial instruments such as: • convertible debt • redeemable preference shares. 10. ‘Accounting profit is determined by recognising the income earned by the entity, and associating with that income the costs incurred in generating it.’ This statement describes the way in which accountants have determined profit in practice for many years under the historical cost system. Is the statement an accurate reflection of the requirements of the Conceptual Framework for general purpose financial reporting? If not, explain any differences. Under the Conceptual Framework, while most income e.g. revenue, is ‘earned’, an earnings process is not an essential criterion for income to exist or be recognised. Secondly, the idea of ‘associating’ costs against income in order to recognise expenses does not appear in the expense recognition principle of the Conceptual Framework. Expense recognition occurs if it is probable that economic benefits have been consumed and when the associated decrease in an asset or increase in a liability can be reliably measured (a verifiable, faithfully representative measure). Nevertheless, the ‘matching’ process, used in the past for determining when to recognise expenses by associating them with revenues, appears to be used in practice. Application of the Conceptual Framework is not mandatory. 11. ‘I find the distinction between income, revenue and gains confusing.’ This is a student’s statement overheard in a corridor. Help this student by discussing the major issues involved. The Framework defines income as ‘increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.’ This definition of income is linked to the definitions of assets and liabilities. The definition is wide in its scope, in that income in the form of inflows or enhancements of assets can arise from the provision of goods or services, the investment in or lending to another entity, the holding and disposing of assets, and the receipt of contributions such as grants and donations. To qualify as income, the inflows or enhancements of assets must have the effect of increasing the equity, excluding capital contributions by owners. Income can exist as well through a reduction in liabilities that increase the entity’s equity. An example of a liability reduction is if a liability of the entity is ‘forgiven’. Income arises as a result of that forgiveness, unless the forgiveness of the debt constitutes a contribution by equity holders. Under the current Framework, income encompasses both revenue and gains. A more precise definition of revenue arises in accounting standard IAS 18/AASB 118 Revenue as follows: ‘the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.’ Revenue therefore represents income which has arisen from ‘the ordinary activities of an entity’. On the other hand, gains represent income which does not necessarily arise from the ordinary activities of the entity, e.g. gains on the disposal of non-current assets or on the revaluation of marketable securities. Gains are usually disclosed in the income statement (statement of profit or loss and other comprehensive income) net of any related expenses, whereas revenues are reported at a gross amount. Revenues arise from the ‘ordinary activities’ of the entity and gains may or may not be from ordinary activities. What ‘ordinary activities’ means in any particular context is unclear; hence the distinction between revenues and gains is unclear. Would we be better off abandoning the distinction? 12. Outline and compare the revenue recognition criteria required by accounting standards for the sale of goods, the provision of services, contributions, and government grants. Are there any inconsistencies in these requirements? If so, discuss. In accordance with the Framework, income (of which revenue is a part) is recognised when an increase in future economic benefits related to an increase in an asset or decrease of a liability can be measured reliably. However, the standard setters have provided further requirements for the recognition of revenues in accounting standard IFRS 15/AASB 15 Revenue from Contracts with Customers, which deals with the recognition of different types of revenue. Revenue from sale of goods, rendering of services and contributions now require identification and satisfaction of obligations in accordance with the guidance provided in IFRS 15/AASB 15. Government grants Under IAS 20/AASB 120, government grants are divided into two categories: • grants related to assets, whose main condition is that an entity qualifying for them should purchase, construct or otherwise acquire long-term assets • grants related to income, which are grants other than those related to assets. According to the standard, government grants of both categories, including non-monetary grants at fair value, cannot be recognised until there is reasonable assurance that: • the entity will comply with the conditions attaching to them • the grants will be received. Government grants related to income are to be recognised as income systematically over the periods necessary to match them with the related costs which they are intended to compensate, on a systematic basis. They are not to be credited directly to equity. Under this policy, the recognition of the income depends on a knowledge of the related costs, and income recognition is then tied to cost and expense recognition. However, government grants related to assets are to be debited to assets but cannot be credited directly to income or to equity. Instead, they must be credited to an account called ‘deferred income’ and presented on the statement of financial position/balance sheet as such. Alternatively, a grant related to assets may be presented as a reduction of the carrying amount of the asset concerned. 13. A major step in the framework project being undertaken by the regulators is the measurement of assets and liabilities. Some accountants argue that this will lead to a re-emergence of the current value debate. Why is measurement such an important issue? What alternatives for measurement have been put forward by the Conceptual Framework? What role does capital maintenance have in selecting an appropriate measurement system? Since the basic objective of general purpose financial reports is to provide relevant, verifiable and faithfully representative information to users for making economic decisions, selection of the most appropriate financial measurement(s) of an entity’s assets and liabilities is(are) essential in order to provide such information. Some measures may be more relevant than others. The Framework points out that a number of different measurement bases which may be used for assets, liabilities, income and expenses in varying degrees and in varying combinations in financial statements. They include the following: • Historical cost. Under the historical cost measurement basis, an asset is recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire it at its acquisition date. Liabilities are recorded at the amount of the proceeds received in exchange for an obligation, or at the amount of cash to be paid out in order to satisfy the liability in the normal course of business. • Current cost. For an asset, current cost represents the amount of cash or cash equivalents that would be paid if the same or equivalent asset was acquired currently. A liability is recorded at the amount of cash or cash equivalents needed to settle the obligation currently. • Realisable or settlement value. For an asset, the realisable value is the amount of cash or cash equivalents that could be obtained currently by selling the asset in an orderly disposal, or in the normal course of business. A liability is measured as the amount of cash or cash equivalents expected to be paid to satisfy the obligation in the normal course of business. • Present value. The present value of an asset means the discounted future net cash inflows or net cash savings that are expected to arise in the normal course of business. The present value of a liability is the discounted future net cash outflows that are expected to settle the obligation in the normal course of business. The measurement basis most commonly adopted by entities is the historical cost basis. Nevertheless, other bases are used from time to time in accounting standards. For example, in order to comply with IAS 2/AASB 102 Inventories, inventories are to be measured at the lower of cost and net realisable value. Non-current assets may be measured under the cost basis or revalued to fair value, which for an asset is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date, as per the requirements of IFRS 13. Fair value is basically a measure of an item’s selling market value on a particular date in the normal course of business. The topic of measurement is part of the joint project of the IASB and FASB to amend and expand the conceptual framework. Exercises Exercise 10.1 Violation of reporting requirements Several independent situations are described below. 1. The owner of the business included his personal dental expenses in the entity’s income statement. 2. The company spent $40 000 on computer software development and recorded the cost as an asset. As yet it is impossible to predict whether this cost will result in future economic benefits. 3. Depreciation expense was not recorded because to do so would result in a loss for the period. 4. The cost of three books (cost $110 each) was charged to expense when purchased even though they had a useful life of several years. 5. A major lawsuit has been filed against the company for environmental damage, and the com¬pany’s solicitors believe there is a high probability of losing the suit. However, nothing is recorded in the accounts. 6. Land was reported at its estimated selling price, which is substantially higher than its cost. The increase in value was included on the income statement. 7. The company received a government grant of $60 000 to continue its research program into finding a cure for diabetes. The company recognised the grant as an addition to capital. Required (a) Indicate for each situation the accounting principle(s) or reporting characteristics (if any) that are violated. (LO5, LO6 and LO7) (a) 1. Entity assumption. General purpose financial reports are to be prepared using an ‘entity perspective’, separate from owners and other investors and creditors. 2. The definition of an asset, and, even if there are future economic benefits which means that an asset exists, there would be violation of the asset recognition criteria in that the future benefits are not ‘probable’. 3. Expense recognition, plus relevance and reliability (faithful representation). 4. Probably none. The items are probably not material in the company context. 5. The liability and expense recognition criteria are violated if a reliable estimate can be made of the probable damages. But is there a liability? 6. Violation of IAS 16/AASB 116 if the land is held as a non-current asset (see the previous chapter which requires such revaluation adjustments to be placed in a reserve rather than in income). Consider also revenue recognition criteria under IAS 18/AASB 118, which may be violated. 7. Violation of income recognition. Note the discussion in the text regarding the appropriate treatment of government grants related to income under IAS 20/AASB 120. Such grants must not be credited to equity (such as ‘capital’) but are to be recognised as income systematically over the periods necessary to associate them to the related costs for which they are intended to compensate. How is this to be done in practice? Explain the debit and credit entries necessary. Exercise 10.2 Income recognition Described below are several transactions and events for Chisholm Insurance Ltd for the year ended 30 June 2019. 1. The company issued a 1-year insurance policy to Boronia Ltd on 1 March 2019, costing $8000, received in advance. 2. The company leased premises to Red Hill Ltd for a period of 3 years, beginning on 1 January 2019. Red Hill Ltd paid $35 000 on this date, and is required to pay further instalments of $35 000 in 2020 and 2021. 3. The company has been a generous sponsor of the Clean-Up Australia Campaign in past years. In recognition of its support, an anonymous donor sent the company a cheque for $20 000, with a letter stating, ‘keep up the good work!’ 4. On 30 January 2019, the company sold a non-current asset to another organisation for $20 000. The asset originally cost Chisholm Insurance Ltd $50 000 and had been depreciated to a carrying amount of $15 000. Required (a) For each transaction or event, determine the appropriate amount to be recognised as income in the current year. Ignore GST. (LO6 and LO7) (a) 1. The amount of $8000 has come from the rendering of insurance services. Whether the whole $8000 should be recognised as income in the year ended 30 June 2019 is determined by the revenue recognition criteria for the rendering of services as per IAS 18/AASB 118, as shown in the text. In this case the entity does satisfy criteria (a) as the cash is already received, and (b) as the amount is known with certainty, and (c) as the stage of completion of the insurance services is easily measured at 4 months as at 30 June. However, criterion (c) is satisfied only to the extent of the services rendered up to 30 June. Revenue from services such as insurance is normally recognised as the services are performed. Since only 4 months’ services have been provided, the amount of revenue is $8000  4/12 = $2667. The company also has a liability (present obligation) to perform insurance services in the following year, equivalent to the amount of $5333. 2. Rental agreement is for 3 years with $105 000 total income. The total income to be recognised by Chisholm Insurance Ltd for the first 6 months up to 30 June 2019 = 1/6 of $105 000 = $17 500. This amount satisfies the IAS 18/AASB 118 revenue recognition criteria for services as shown in the text. (ignoring present value calculations) 3. The full amount of cash received as a donation can be recorded as income (a contribution) as it satisfies the AASB 1004 Contributions recognition criteria for income from contributions, as discussed in the text. However, AASB 1004 applies only to not-for-profit organisations. It is considered here that such a donation received should also be treated as income in business organisations, even though there appears to be no standard on this for businesses. 4. The proceeds on the disposal of other assets, do not qualify as revenue under IAS 18/AASB 118, hence, the recognition criteria for revenue as discussed in the text do not apply. The Framework generally specifies recognition criteria for income as satisfaction of a probability test and a reliable measurement test. Nevertheless, under IAS 16/AASB 116, the proceeds, less the carrying amount of the asset sold, would be described as an item of other income, called a gain. The gain on disposal of the asset is $5000 (= $20 000 – $15 000) and is recognised as part of current income. Exercise 10.3 Assets and asset recognition Explain whether you would recognise each item below as an asset, justifying your answer by ref¬erence to the Conceptual Framework’s asset definition and recognition criteria: (a) a trinket of sentimental value only (b) discovery (at insignificant cost) of evidence of mineral reserves (c) specialised equipment with zero disposal value, which now, because of downsizing, is surplus to requirements and has thus been retired from use (d) your staff (e) goods held on consignment for another entity. (LO6 and LO7) (a) Fails the asset definition as it does not constitute future economic benefits. Oxford English Dictionary defines ‘economic’ as maintained for profit, on a business footing. Recognition criteria are thus irrelevant, as there is not asset under the Framework to recognise. (b) Definition is satisfied — Future economic benefits (assuming the mineral can be extracted and there is a market for this mineral!), control (assuming the entity has rights over the site/claim, etc.); and past event (the exploration has already been done). Probability Recognition Criteria may be a problem — it may not be possible as yet to establish that it is probable that future economic benefits will eventuate (cost of extraction may render extraction not viable, market price of mineral may currently be depressed, etc.). There is also a problem with reliable measurement — the extent of the find or its value may not yet be known. Unless and until both recognition criteria are satisfied, this asset cannot be recognised under the Framework. (c) Fails definition as it does not constitute future economic benefits — it no longer can help generate profits as it is surplus to requirements. Recognition criteria are thus irrelevant, as there is no asset to recognise. (d) Definition is satisfied — Future economic benefits, control (at least during work hours!), and past event (employment contract). Probability recognition criterion is satisfied — if future economic benefits were not probable, would you sack the staff? Reliable (faithfully representative) measurement is the problem — how does one place a dollar figure on a human being? Human resources cannot be recognised as assets if no reliable measure is possible. (e) Not an asset of the entity as the entity does not have control of the goods. See Chapter 6 for further discussion. Exercise 10.4 Asset definition and recognition Randwick Medical Laboratory Ltd, RMLL, a medical research entity, has discovered a cure for a previously incurable disease. RMLL is protecting the drug’s formula by keeping it secure in the company vault, rather than by patenting it. RMLL shortly plans to start discussions with vitally interested pharmaceutical companies about producing the drug for commercial sale. Being the first of its kind and, therefore, unique, RMLL has no idea as to the formula’s value. Costs incurred to date in developing the formula are impossible to identify, given that the cure was discovered as a by-product of another research project. Required (a) Outline how RMLL should account for the formula, justifying your answer by reference to relevant definitions and recognition criteria. (LO6 and LO7) (a) The Framework defines an asset as a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity’. The formula satisfies the asset definition as: (1) it represents future economic benefits (via sale of either the drug or licences to produce and sell it); (2) the benefits are controlled (RMLL owns the formula and is keeping it secret, thereby being able to deny or regulate the access of others to it); and (3) there is a past event (the formula was discovered during another research project). Under the Framework, an asset can be recognised only when: (1) it is probable that the future economic benefits embodied in the asset will eventuate; and (2) the asset possesses a cost or other value that provides a faithfully representative (reliable) measure. The probability criterion is clearly met, as pharmaceutical companies are vitally interested in being involved in producing the drug and so future sales are likely. However, at this stage the formula fails the reliable (verifiable, faithfully representative) measurement criterion. As the formula is the first of its kind and, therefore, unique, RMLL has no idea as yet of the formula’s value. Furthermore, the cost to date of developing the formula cannot be traced or identified, as the formula was discovered as a by-product of another project. Accordingly, the formula cannot (as yet) be recognised as an asset. Exercise 10.5 Revenue and revenue recognition Telecommunications company, Toronto Ltd, signed a 15-year deal to sell capacity on its cable net¬work to a rival company for $200 million. The deal was completed on the last day of Toronto Ltd’s financial year, 30 June. The company received an upfront payment of only $20 million from its competitor on that day, but decided to recognise ‘revenue’ of $200 million for the financial year just completed. Required (a) Discuss fully how Toronto Ltd should account for the contract justifying your answer by reference to relevant definitions and recognition criteria and relevant accounting standards. (LO6 and LO7) (a) The Framework defines income as: •increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. A liability is defined in the current Framework as: •a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. A definition of revenue is contained in accounting standard IAS 18/AASB 118 Revenue as follows: •the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants. There is no doubt that Toronto Ltd has an increase in future economic benefits which appear to be income (in the form of revenue) in that the increase is a result of ordinary activities; but there has also been an increase in liabilities in that the entity is presently obliged to provide a service over time for the next 15 years. IFRS 15 / AASB 15 paragraph 35 covers performance obligations satisfied over time. “An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognises revenue over time, if one of the following criteria is met: (a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (see paragraphs B3–B4); (b) the entity’s performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced (see paragraph B5); or (c) the entity’s performance does not create an asset with an alternative use to the entity (see paragraph 36) and the entity has an enforceable right to payment for performance completed to date (see paragraph 37).” Accordingly, as a result of item (a) it is incorrect for Toronto Ltd to recognise the full $200m as revenue as the standard requires revenue from services to be related to a reliable measure of the stage of completion. At 30 June, no completion has occurred and therefore there can be no revenue recognised. Exercise 10.6 Revenue and revenue recognition State the amount of revenue that should be recognised by Whitehall Ltd in the year ended 31 December 2020 for each item below, justifying your answer by reference to the revenue defi¬nition and recognition criteria in IAS 18/AASB 118. Prepare any journal entries where necessary: (a) Whitehall Ltd’s net credit sales for 2020 were $400 000, 75% of which were collected in 2020. Past experience indicates that about 96% of all credit sales are eventually collected. (b) Whitehall Ltd received $100 000 cash from a customer in December 2020 as payment for special-purpose machinery which is to be manufactured and shipped to the customer in February 2021. (c) Whitehall Ltd started renting out its excess warehouse space on 1 October 2020, on which date it received $12 000 cash from the tenant for 6 months rent in advance. Ignore GST. (d) Whitehall Ltd received 10 000 shares in Mitcham Ltd on 20 December 2020, on which date the shares were trading at $4.50 per share, as a gift from a grateful client. (e) Whitehall Ltd received an item of equipment as settlement for goods sold on credit for $3000. On the date of the sale, the equipment had a fair value of $3200 and a carrying amount in the customer’s records of $2200. Prepare also the journal entry to record the receipt of the equip¬ment. Ignore GST. (LO6 and LO7) A definition of revenue is contained in the Conceptual Framework as follows: Revenue 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. (a) Credit sales: For revenue arising from the sale of goods, recognition can occur only when all of the following conditions are satisfied: i. the entity has transferred to the buyer the risks and rewards of ownership of the goods ii. the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control of the goods sold iii. the amount of the revenue can be measured reliably iv. it is probable that the economic benefits associated with the transaction will flow to the entity v. the costs incurred or to be incurred in respect of the transaction can be measured reliably. The entire $400 000 should be recognised as revenue in 2020 under IAS 18/AASB 118, as the goods have passed to the buyer, it is probable (indeed certain) that the economic benefits in the form of an asset (accounts receivable) can be measured reliably, and the costs incurred or to be incurred can be measured reliably (4% doubtful debts). Note that IAS 18/AASB 118 adopt a gross approach to revenue recognition. An expense (bad debts expense) of $16 000 (4%  400 000) should be recognised in 2020 for estimated doubtful debts. The end result of these actions is that revenue of $400 000 is recognised in 2020 and bad debts expense of $16 000 is also recognised in 2020. (b) This will result in revenue from the sale of goods. However, no revenue exists in 2020. The $100 000 received in 2020 is an advance payment from the customer and satisfies the Framework’s liability definition and recognition criteria. The receipt of $100 000 has resulted in an equivalent liability being established. There is a future sacrifice of economic benefits (the required outlay etc. to make the machinery) that the entity is presently obliged to make to the customer as a result of a past event (the contract to make the machinery). It is probable (indeed certain) that the future sacrifice will be required, and the amount of the liability can be measured reliably. This is a liability arising from a contractual arrangement. It is an obligation to provide machinery to a party who has paid in advance for it. Revenue will arise and be recognised in 2021 when the machinery is manufactured and shipped to the customer. Then control of the machinery will pass to the customer, and there will be a savings in outflows of future economic benefits in the form of a liability decrease (obligation to make the machinery). (c) This results in revenue from rent, but rent is not covered specifically in IAS 18/AASB 118. However, it falls under the category as revenue from services. Recognition criteria for revenue from services are as follows. i. The amount of the revenue can be measured reliably. ii. It is probable that the economic benefits associated with the transaction will flow to the entity. iii. The stage of completion of the transaction at the end of the reporting period can be measured reliably. iv. The costs incurred for the transaction and the costs to complete the transaction can be measured reliably. $6000 of the rent, being 3 months’ rent for space supplied for October, November and December, should be recognised in 2020. This meets the definition and recognition criteria for income — it is an inflow of future benefits in the form of an asset increase (cash) that results in an increase in equity (increase in assets, no change in liabilities, thus A – L increases). You control the consideration received (via the rent contract), it is probable (indeed certain) that the inflow in future benefits has occurred, the amount can be measured reliably and the stage of completion of the contract can be measured (3 months). The $6000 received for 3 months’ rent for January, February and March 2021 does not give rise to revenue in 2020. The receipt of $6000 results in an equivalent liability being established. Where an entity provides services in the form of rental property, income will not arise until the entity has a claim against the tenant for rent. This claim arises progressively as the tenant uses the property. If the tenant prepays rent, the increase in future economic benefits does not constitute income. This is because even though the entity has control over the cash received, there has been an equivalent liability established in the form of an obligation to provide rental services over the period of the prepayment. Revenue will arise in relation to this $6000 rent in 2021. (d) This is income from the contribution of assets (AASB 1004) (even though AASB 1004 applies to not-for-profit entities). Receipt of such a gift is a non-reciprocal transfer, which is defined in the appendix to AASB 1004 as a transfer in which the entity receives assets without directly giving approximately equal value in exchange to the other party to the transfer. This meets the Framework’s income definition and AASB 1004 recognition criteria — it is an inflow of future benefits in the form of an asset increase (shares in Mitcham Ltd) that results in an increase in equity (increase in assets, no change in liabilities, thus A – L increases). You control the consideration received (non-reciprocal transfer), it is probable (indeed certain) that the inflow in future economic benefits has occurred, and the amount can be measured reliably. The amount of income to be recognised is $45 000 (10 000  $4.50). AASB 1004 requires income from contributions to be measured at the fair value of the consideration received. The fair value of the shares is the value at which they were trading on the acquisition date. The required journal entry is: Shares in Mitcham Ltd 45 000 Income from Contribution 45 000 (Shares in Mitcham Ltd received as a gift.) (e) This is revenue from the sale of goods (IAS 18/AASB 118). $3000 was recognised as revenue on selling the goods on credit under IAS 18/AASB 118, as control of the goods has passed to the buyer, it was probable (certain) that the inflow of future economic benefits in the form of an asset increase (accounts receivable) has occurred, and the inflow could be measured reliably. The entry on selling the goods on credit was: Accounts Receivable Dr 3 000 Sales Cr 3 000 (Credit sales recorded.) Under IAS 16/AASB 116, assets acquired must be recognised at their cost, which is purchase consideration plus directly attributable costs. The purchase price is the fair value at acquisition date of assets given up/sacrificed by the acquirer. The fair value of what was given up to acquire the equipment is the fair value of the goods sold, i.e. $3000. The fair value of the equipment acquired and the carrying amount of the equipment in the customer’s records are both irrelevant. The journal entry to record the receipt of the equipment is: Equipment Dr 3 000 Accounts Receivable Cr 3 000 (Accounts receivable settled.) Exercise 10.7 Liabilities and liability recognition Outline whether you would recognise each item below as a liability, justifying your answer by reference to the Conceptual Framework’s liability definition and recognition criteria: (a) Your parents have lent you $20 000 to buy a car and have told you to pay it back whenever you like. (b) You are guarantor for your friend’s bank loan: i. You have no reason to believe that your friend will default on the loan. ii. Your friend has been encountering serious financial problems and you think it is likely that he will default on the loan. (c) The court has ordered you to repair the environmental damage your firm has caused to a park next to your firm’s premises. You have no idea as yet how much this repair work will cost. (d) Your firm has a 20-year history of donating $2000 each year to the Telethon Appeal. As yet, no amount has been paid in the current year and nothing has been recorded in the accounts. (LO6 and LO7) (a) Assuming that you are the accounting entity concerned, this fails the definition as it does not constitute a future sacrifice of economic benefits. Paragraph 61 of the Framework states that an essential liability characteristic is that the present obligation is such that the consequences of failing to honour the obligation leave the entity little, if any, discretion to avoid the future sacrifice. If the entity obliged to make the settlement has a right to decide the settlement date, it has complete discretion as to whether economic benefits are to be sacrificed. Accordingly, a liability cannot exist in respect of this obligation. Recognition criteria are thus irrelevant, as there is no liability under the Framework to recognise. (b) (i) Definition is satisfied — future sacrifice of economic benefit (obligation cannot be avoided if settlement is ultimately required); present legal obligation (under terms of guarantee agreement); past event (agreeing to the guarantee). Reliable measurement recognition criteria is met — amount owing can be measured exactly. However, fails the probability test — Until the borrower defaults, it is not known whether the guarantor will be required to honour the guarantee. The liability will only qualify for recognition if and when it becomes probable that the borrower will default and settlement will be required. At this stage the probability is close to zero. Accordingly, no liability can be recognised. However, disclosure about the liability may be warranted in the notes to financial statements, as information about the guarantee may be considered relevant to the users in making and evaluating their economic decisions. (ii) See (b)(i) for consideration of definition and reliable measurement recognition criterion — both are met. Probability recognition is now met as it is considered likely that default will occur. Accordingly, the liability should be recognised (Dr expense; Cr liability). (c) Definition is satisfied — future sacrifice of economic benefits (obligation cannot be avoided); present legal obligation (Court order); past obligating event (whatever action caused the damage). Probability test is met — settlement must occur and so is certain. However, fails the reliable measurement test — the cost of the required repairs is as yet unknown. Accordingly, no liability can be recognised. However, disclosure about the liability is warranted in the notes to the financial statements, as information about the obligation may assist users in making assessments of the present and expected future financial position of the entity. (d) Definition is satisfied — future sacrifice of economic benefits (the social and/or political consequences of failing to make the donation leave the entity little discretion to avoid the obligation); present constructive obligation (longstanding history of making a $2000 donation per year); past event (its long-standing history of making such donations each year). Probability criterion is met — history shows that making the donation is more than less likely. Reliable measurement test is also met — there is a long-standing (20 year) history of making a $2000 per year donation. Accordingly, a $2000 liability should be recognised (Dr expense; Cr liability). Exercise 10.8 Substance over form Greenvale Ltd sold some property to Thornleigh Ltd for $1 000 000 cash in June 2020, recording a profit of $200 000. A further element of the sale was that Greenvale Ltd gave Thornleigh Ltd an option to sell the property back to Greenvale Ltd at any time after 30 June 2020, the end of Greenvale Ltd’s reporting period, for $1 000 000. If Thornleigh Ltd exercised the option, there would be no cash flow to Thornleigh Ltd from Greenvale until 2 years had passed. The land has a current fair value of $800 000 with no changes expected in this amount in the next 3 years. Required (a) Discuss the appropriate accounting treatment of this transaction in the accounting records of Greenvale Ltd. Ignore GST. (LO6 and LO7) (a) It is a simple matter to record these transactions as given in June 2020, with Greenvale Ltd recognising a profit of $200 000, and Thornleigh Ltd recording a purchase of land at $1 million. However, as the fair value of the land is only $800 000, does this mean that Thornleigh Ltd should write the land down to $800 000? It is more likely that Thornleigh Ltd would exercise the put option and sell the land back to Greenvale Ltd for $1 000 000. The ultimate outcome would be that the land would remain with Greenvale Ltd and Thornleigh Ltd would have lent $1 000 000 to Greenvale Ltd for two years. It can be argued on the grounds of economic substance over legal form, or faithful representation, that no sale should be recorded in the first place, and that Greenvale Ltd should not recognise a profit. On these grounds, it is recommended that the following entry be made by Greenvale Ltd. Cash at Bank Dr 1 000 000 Payable to Thornleigh Ltd Cr 1 000 000 And that Thornleigh Ltd make only the following entry: Receivable from Greenvale Ltd Dr 1 000 000 Cash at Bank Cr 1 000 000 Exercise 10.9 Liabilities The following items occurred in Mitcham Ltd for the year ended 30 June 2020. (a) Some of Mitcham Ltd’s plant and equipment is situated in an area which, on average, is flooded every 15 years. The company has no flood insurance, but provides an amount each year as a liability in the accounts for uninsured flood losses. (b) Mitcham Ltd entered into a contract with Blackburn Ltd to acquire some plant and equip¬ment at a cost of $1 000 000. At the end of the reporting period, Mitcham Ltd had paid a 10% deposit. (c) Mitcham Ltd has a regular program of maintenance for its plant and equipment. In order to provide for this program, the company has been in the habit of establishing a Provision for Plant Maintenance account and disclosing it as part of liabilities. Required (a) Discuss how the items should be treated in the general purpose financial reports of Mitcham Ltd if the company were to comply with the provisions of the Conceptual Framework. Ignore GST. (LO6 and LO7) (a) Note that a liability is defined in the current Framework as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. (a) Provision for uninsured losses. It is argued in a situation such as this that there is no present obligation for Mitcham Ltd at the end of the reporting period; hence no liability and no expense should be recognised. There is no present obligation to any external party merely because the entity makes a ‘book entry’ to recognise insured losses and a provision liability for such losses. There is no liability and no expense until losses from floods (or other such natural disaster) occurs. (b) Mitcham Ltd’s contract with Blackburn Ltd, with a 10% deposit only paid. Does Mitcham Ltd have a liability? Is there a present obligation with a sacrifice requiring settlement in the future that cannot be reasonably be avoided by Mitcham Ltd? Apart from the 10% deposit of $100 000 paid by Mitcham Ltd, which Mitcham Ltd can debit to a plant and equipment asset and credit to Cash at Bank, can Mitcham Ltd record a further asset and liability for plant yet to be delivered? It is possible that if the plant and equipment are being made to the exact specification of Mitcham Ltd, and the contract has been started by Blackburn Ltd, indicating an intention to complete, then a liability and asset could be recognised. (c) Provision for plant maintenance. It is argued in a situation such as this that there is no present obligation for Mitcham Ltd at the end of the reporting period; hence no liability and no expense should be recognised for plant maintenance at the very least until a contract has been signed for the maintenance work to be performed. Exercise 10.10 Assets and asset recognition For several seasons, Megan Gale and Jennifer Hawkins have been employed by David Jones Limited and Myer Limited respectively in order to attract more fashion-conscious customers to their stores. This strategy has met with some success and their continued employment at fashion events in the future for their respective companies appears assured. Required (a) Discuss whether Megan Gale and Jennifer Hawkins should be regarded as assets of David Jones Limited and Myer Limited respectively. Discuss also whether they should have been recognised on the statement of financial position/balance sheet of the respective companies as assets. (LO6 and LO7) (a) An asset is defined in the current Framework 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’. It is proposed to amend the definition of an asset to the following. • An asset of an entity is a present economic resource to which, through an enforceable right or other means, the entity has access or can limit the access of others. Do Megan Gale and Jennifer Hawkins satisfy the definition of an asset? Under their contracts, they are both being paid over $1 million cash, plus share options. Are they both ‘resources’ containing future economic benefits to the respective companies? If you believe so, are those resources ‘controlled’ by the entities concerned, as a result of past events? This is doubtful. After they have performed their modelling duties for each company, do the future economic benefits ‘linger on’? Or do the remunerations paid to them merely represent part of advertising expenses? Under the ‘proposed’ definition of an asset, do the two models represent present economic resources to the two companies, over which they currently have rights that others do not have? Whether the two entities have rights to the exclusion of others is doubtful. If you believe they are assets of the two companies, can they be recognised as such in financial statements? Recognition criteria for an asset are: • it is probable that the future economic benefits will flow to the entity and the asset has a cost or other value that can be measured reliably. Hence, is it ‘probable’ that benefits will flow to the entity? Can the cost or other value be measured reliably. What cost/value do you place on share options given to the two models? Exercise 10.11 Expenses, liabilities and equity Brunswick Ltd is seeking your advice on how to account for the following transactions, in line with the Conceptual Framework and other relevant documents. Discuss and explain your recom¬mended treatment of each of the situations below. 1. Brunswick Ltd spends $10 000 per year to have its head office cleaned and its gardens main¬tained. In order to continue this maintenance, the company established a Provision for Main¬tenance account and classified this provision as a liability on the statement of financial position/ balance sheet. 2. Brunswick Ltd raised $1 000 000 by issuing 100 000 10-year redeemable preference shares. The company classified these shares as equity. 3. Brunswick Ltd is in the business of selling house and land packages to its customers. The cur¬rent demand for these packages is extremely low and this is placing Brunswick Ltd in severe financial difficulties. The company has approached Hilands Finance Company Ltd (HFC), to provide special finance for the buyers of their house and land packages. HFC normally charges 13% interest but agrees to lower the interest rate by 3%. Customers of Brunswick Ltd will therefore pay only 10% interest and Brunswick Ltd will then pay HFC a sum equal to 3% interest as soon as each package is sold. Brunswick Ltd wants to know how to treat the 3% pay¬ment to HFC in its accounting records. (LO6 and LO7) Cleaning and garden maintenance costs Briefly, the liability (provision) for maintenance is not justified as there is no liability until work has been carried out by cleaning staff and gardening staff. The liability is then only for any unpaid wages for work performed. Redeemable preference shares Consider the definition of a liability. As equity is a residual (A – L), redeemable preference shares can only be classified as equity if they do not satisfy the definition of a liability. Questions to consider with the preference shares: • Are they redeemable on a specified date for a specified amount? If so they are a liability? • Are they redeemable only at the option of the company? If so, there is no current present obligation and no liability, and they are appropriately treated as equity? • Are they redeemable only at the option of the holder? If so, what is the likelihood of the holder exercising his/her/its option? The 3% interest reduction The 3% interest reduction to be paid by Brunswick Ltd is a cost incurred in an attempt to sell more house and land packages. As such the payment made to HFC to cover the 3% gap is an advertising expense. Apply the definition of expenses to this circumstance. Exercise 10.12 Qualitative characteristics Assume that the IASB (and AASB) is in the process of writing an accounting standard on accounting for water resources, and has received submissions that can be divided roughly into two camps — measurement of the resources at cost, and measurement at fair value. The process has reached the stage of applying the following qualitative characteristics of financial information. Required (a) Place a tick in one of the columns against each characteristic. (b) On the basis of this analysis, discuss which measure should be chosen for water resources. (LO5) We hope that you see that the requirements of this question are ‘nonsense’. After all, if the IASB and AASB are going to use the Conceptual Framework in order to select an appropriate measure (cost or fair value), it should deal only with the characteristics of relevance and faithful representation (fundamental characteristics), understandability, comparability, verifiability and timeliness (enhancing characteristics). These are the only characteristics that are of concern. When you read the Conceptual Framework carefully, consistency is an aspect of comparability; freedom from bias and neutrality are the same; and are both part of the definition of faithful representation; objectivity, prudence and substance over form are not mentioned; and conservatism is regarded as undesirable in that it deliberately introduces bias into the financial reports. You must then understand clearly the nature of each characteristic for this question i.e. the nature of relevance, faithful representation, comparability, understandability, timeliness and verifiability. Once you have examined the nature of these items, are you then able to make a decision on whether to choose cost or fair value? If not, what is the benefit of having a list of qualitative characteristics in the Conceptual Framework? Are they of any use at all? Exercise 10.13 Assets and expenses Wyoming Wines Ltd has suffered a significant reduction in profitability, as a result of the current economic downturn and doubts about the quality of certain boutique wines. The company’s profit for the year ended 30 June 2020 was only $2 150 000. The general purpose financial reports for the year disclosed a note regarding the company’s policy on wine advertising as follows. Advertising costs expecting to generate significant future economic benefits have been treated as an asset and carried forward to future years to be expensed against the future expected revenues. Man¬agement intends to review these deferred costs on a regular basis. The statement of financial position/balance sheet revealed that an amount of $10 million had been treated in this manner up to the end of 30 June 2020 as there was an item called Deferred Expendi¬ture in the statement of financial position/balance sheet. This represented a change to the previous accounting policy of writing off advertising as it was incurred. A finance report in the local newspaper commented that normally advertising is charged as an expense in the period it is incurred. The auditor of the company did not mention the deferred expenditure in the audit report. Required (a) In light of the Conceptual Framework, evaluate Wyoming Wines Ltd’s treatment of the advertising expenditure carried forward. (LO6 and LO7) (a) Advertising expenditure may be treated as an asset only if it satisfies the definition of an asset. An asset should be defined and the essential characteristics of an asset discussed; namely controlled future economic benefits flowing to the entity from a past event or events. The challenge for Wyoming Wines Ltd is to show how the future benefits flowing from the boutique wines are controlled by them. It is not sufficient to treat the costs as an asset merely to show a better profit figure. If advertising costs are not assets, then management’s decision is not justified. The auditor should have discussed this issue with management. If they are assets, then the decision to treat them as such in the records will only be justified if the advertising costs satisfy the recognition criteria, i.e. is it probable that the advertising expenditure will lead to future economic benefits flowing to the entity, and can the costs be measured reliability? Discuss the meaning of ‘probable’. In this case we would need to assess whether Wyoming Wines Ltd’s boutique wines are going to create significant future economic benefits for the company. Note that in this case, there is a cost which can be reliably measured. Exercise 10.14 Costs and income Hampton Housing Ltd (HHL) is a land development company trading in the construction of resi¬dential house and land packages in Sydney’s western suburbs. The company is currently developing a residential subdivision, and the total cost of the development has been estimated at $18 000 000. This is related to future house and land packages, none of which is yet available for sale. HHL treated these costs as an asset. By 30 June 2020, HHL sold 40 house and land packages in a different subdivision for the finan¬cial year. The total value of these packages is $15 000 000. The funds have not been received by HHL because it was arranged that payments would be received from various finance companies by the end of July 2020. HHL recognised the revenue in its income statement for the year ended 30 June 2020. Required (a) Discuss HHL’s treatment of the development costs of $18 000 000 and the packages sold for $15 000 000. Are these treatments consistent with the Conceptual Framework and accounting standards? Explain. (LO6 and LO7) (a) Appropriate definitions are: An asset is defined in the current Conceptual Framework 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’. Expenses are defined in the Conceptual Framework as ‘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’. Note that the definition of an expense is driven by the definitions of assets and liabilities. Development costs For development costs incurred to qualify as an asset, the costs must result in future economic benefits which the entity controls. If this is not the case, then the cost automatically qualifies as an expense, as there is. a reduction in an asset or an increase in a liability which has the effect of decreasing the entity’s equity. However, if future economic benefits are expected, and the entity has control over those benefits to the exclusion of others, then an asset exists. The asset can be recognised if it is probable that these benefits will flow to entity and these is a cost which can be measured reliably. In this case it is expected that the treatment of the $18 000 000 as an asset in the accounting records is legitimate. Packages sold Consider the IAS18/AASB 118 definition of revenue and examine the recognition criteria for the sale of goods. For revenue arising from the sale of goods, recognition can occur only when all of the following conditions are satisfied. (a) The entity has transferred to the buyer the 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 of the goods sold. (c) The amount of the revenue can be measured reliably. (d) It is probable that the economic benefits associated with the transaction will flow to the entity. (e) The costs incurred or to be incurred in respect of the transaction can be measured reliably. Even though funds have not yet been received, and will not be received until the end of July 2020, it is considered that the recognition criteria have all been met and that it is appropriate for the entity (HHL) to recognise all the revenue of $15 000 000 by 30 June 2020. Exercise 10.15 Ordering an asset A well-known Australian airline has placed a non-cancellable order for a new Airbus A380. The price between the airline and the manufacturer is fixed, and delivery is to occur in 24 months with full payment to be made on delivery. Required (a) Should the airline recognise an asset or liability at the time it places the order? Discuss in line with the Conceptual Framework definitions of assets and liabilities. (b) One year later, the price of the Airbus A380 has risen by 6%, but the airline had locked in its contract at a fixed, lower price. Under the Conceptual Framework, should the airline recognise any asset (and income) at the time of the price rise? If the price fell by 6% instead of rising, should the airline recognise a liability (and expense) under the Conceptual Framework? (LO6 and LO7) (a) Firstly define assets and liabilities. i. An asset is 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. ii. A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. The Conceptual Framework states that transactions or events expected to occur in future do not , in themselves, give rise to assets. The Conceptual Framework states: A distinction needs to be drawn between a present obligation and a future commitment. A decision by the management of an entity to acquire assets in the future does not, of itself, give rise to a present obligation. An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable agreement to acquire the asset. In the latter case, the irrevocable nature of the agreement means that the economic consequences of failing to honour the obligation, for example, because of the existence of a substantial penalty, leave the entity with little, if any, discretion to avoid the outflow of resources to another party. Note also, regarding recognition criteria for a liability, the following statement made in the Conceptual Framework: A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. In practice, obligations under contracts that are equally proportionately unperformed (for example, liabilities for inventory ordered but not yet received) are generally not recognised as liabilities in the financial statements. However, such obligations may meet the definition of liabilities and, provided the recognition criteria are met in the particular circumstances, may qualify for recognition. In such circumstances, recognition of liabilities entails recognition of related assets or expenses. As the purchase order for the aeroplane is non-cancellable, it may qualify for recognition as an asset and liability under the Conceptual Framework. What does ‘non-cancellable’ mean? Does this mean that a significant penalty would be paid for cancellation of the contract? Could it be argued that the liability at this stage is the penalty, not the future payment for the aeroplane? The answer lies in management’s intentions. Do they intend to proceed with the purchase? If so the liability would be for the future cost of the aeroplane? Journal entry: Aeroplane to be delivered Dr Liability to manufacturer Cr (b) (i) If the price of the plane rises 6% but contract is locked in. Is there a gain? Note the definition of income here. Has there been an increase/enhancement in the asset without a corresponding increase in the liability? Yes. Does the Conceptual Framework suggest that assets are to be valued at market price (or fair value)? No. There is no clear guidance about appropriate measurement in the Conceptual Framework. But if the entity uses market prices to measure the asset, a gain could be recognised. But has there been an increase in future economic benefits to the airline as a result of this price increase? (ii) If the price falls by 6%, is there a loss? Note the definition of an expense here: An expense is a decrease in economic benefits in the form or outflows or depletions of assets resulting in a decrease in equity. An expense arises when the economic benefits in the asset are consumed, expired or lost. Has this happened? Not necessarily, but market forces which caused the fall in price would need to be investigated. Note the impairment standard AASB 136 would apply here (discussed in a later chapter). Problems Problem 10.16 Conceptual framework Non-GST version After conducting an audit of the accounts of Parramatta Ltd, you discover that the following transactions and events were recorded during the current year. Parramatta Ltd uses the historical cost system. 1. The company borrowed $600 000 from a bank at an interest rate of 10% to construct a new warehouse. At the completion of construction, the loan was repaid and the following entry was made: 2. A patent with a cost of $160 000 was being amortised over its useful life of 8 years. The amortisation entry made at the end of the current year was: 3. A speed-control device was installed on each of the company’s 8 delivery trucks at a cost of $300 each plus GST. The transaction was recorded as follows: 4. At the beginning of the current year, a new vehicle was purchased for $36 000. The vehicle had an estimated useful life of 4 years. Depreciation expense for the year was recorded as follows in order to avoid reporting a loss: 5. Inventory was acquired at $30 per unit throughout the current year until the last purchase was made in the last month of the year. At that time the company was able to negotiate a special deal and acquired 10 000 units at $25 per unit. Ignore GST. The purchase was recorded as follows: Required (a) For each item, determine which accounting concept(s) (if any) is violated, and explain why. (b) For each violation, indicate the correct treatment. (LO5, LO6 and LO7) (a) and (b) 1. A violation of the expense recognition criteria has occurred. Interest is considered to be an expense of borrowing money and should be treated as an expense in the year in which the money is borrowed. However, if the warehouse is seen to satisfy the definition of a ‘qualifying asset’ in IAS 23/AASB 123 Borrowing Costs (see later chapters in the text), then the interest cost has been correctly recorded as part of the cost of the warehouse, and no violation has occurred. 2. A violation of the expense recognition criteria since the amortisation of the patent is an expense and should be charged against income in the income statement (statement of profit or loss). The debit should have been to amortisation expense. 3. Probably no violation has occurred. Although the devices may have a useful life equal to that of the trucks, the items are probably not material and should be expensed in the current period. However, if considered material, they devices should be treated as assets and depreciated accordingly. 4. A violation of the expense recognition criteria since an improper amount of expense has been recorded against income. Also a violation of the qualitative characteristic of faithful representation because the depreciation expense recorded is not based on a faithful representation of the economic events in the entity. The entry should have included a debit to depreciation expense for $9000. 5. A violation of the income definition since no inflow of future economic benefits has yet occurred, and violation of the requirement to record the acquisition of inventory at lower cost and net realisable value, as per IAS 2/AASB 102 (see later chapters). The inventory should have been debited for its cost of $250 000. Further, a violation has occurred of the definition of revenue and the recognition criteria for sale of goods under IAS 18/AASB 118. Problem 10.16 Conceptual framework GST version After conducting an audit of the accounts of Parramatta Ltd, you discover that the following transactions and events were recorded during the current year. Parramatta Ltd uses the historical cost system. 1. The company borrowed $600 000 from a bank at an interest rate of 10% to construct a new warehouse. At the completion of construction, the loan was repaid and the following entry was made: 2. A patent with a cost of $160 000 was being amortised over its useful life of 8 years. The amortisation entry made at the end of the current year was: 3. A speed-control device was installed on each of the company’s 8 delivery trucks at a cost of $300 each plus GST. The transaction was recorded as follows: Maintenance Expense GST Receivable Cash at Bank 2 400 240 2 640 4. At the beginning of the current year, a new vehicle was purchased for $36 000. The vehicle had an estimated useful life of 4 years. Depreciation expense for the year was recorded as follows in order to avoid reporting a loss: 5. Inventory was acquired at $30 per unit throughout the current year until the last purchase was made in the last month of the year. At that time the company was able to negotiate a special deal and acquired 10 000 units at $25 per unit. Ignore GST. The purchase was recorded as follows: Required (a) For each item, determine which accounting concept(s) (if any) is violated, and explain why. For each violation, indicate the correct treatment. (LO5, LO6 and LO7) (a) 1. A violation of the expense recognition criteria has occurred. Interest is considered to be an expense of borrowing money and should be treated as an expense in the year in which the money is borrowed. However, if the warehouse is seen to satisfy the definition of a ‘qualifying asset’ in IAS 23/AASB 123 Borrowing Costs (see later chapters in the text), then the interest cost has been correctly recorded as part of the cost of the warehouse, and no violation has occurred. 2. A violation of the expense recognition criteria since the amortisation of the patent is an expense and should be charged against income in the income statement (statement of profit or loss). The debit should have been to amortisation expense. 3. Probably no violation has occurred. Although the devices may have a useful life equal to that of the trucks, the items are probably not material and should be expensed in the current period. However, if considered material, they devices should be treated as assets and depreciated accordingly. 4. A violation of the expense recognition criteria since an improper amount of expense has been recorded against income. Also a violation of the qualitative characteristic of faithful representation because the depreciation expense recorded is not based on a faithful representation of the economic events in the entity. The entry should have included a debit to depreciation expense for $9000. 5. A violation of the income definition since no inflow of future economic benefits has yet occurred, and violation of the requirement to record the acquisition of inventory at lower cost and net realisable value, as per IAS 2/AASB 102 (see later chapters). The inventory should have been debited for its cost of $250 000. Further, a violation has occurred of the definition of revenue and the recognition criteria for sale of goods under IAS 18/AASB 118. Problem 10.17 Conceptual framework Martindale Ltd uses the historical cost system. While reviewing the business activities of the company, you discover that the following transactions and events were recorded. Ignore GST. 1. Ending inventory for the current year had a cost of $115 200 and a selling price of $102 000. The inventory was valued at cost because the company’s accountant believed that ‘the selling price will probably increase again during the next year’. 2. On 28 December of the current year, Martindale Ltd signed a contract with a customer under which Martindale Ltd agreed to manufacture equipment for the customer during January of the following year at a price of $39 000. Martindale Ltd received a cheque for $7500 from the customer on 28 December and made the following entry. 3. A new vehicle was purchased at an auction for cash of $32 000. If purchased from the company’s normal supplier, the cash price of the machine would have been $38 000. The Vehicles account was debited for $38 000 and the following entry was made: 4. Ignition security locks were installed in each of Martindale Ltd’s six delivery trucks at a cost of $180 each. The trucks had an average remaining useful life of 5 years. The transaction was recorded as: 5. Building improvements with an estimated useful life of 20 years were completed early in the current year at a cost of $120 000. Martindale Ltd believed that the building to which the improvements were made could be used for only 15 years. To record depreciation for the current year, the accountant made the following entry: Required (a) For each of items (1) to (5), determine which accounting concept(s) (if any) is violated, and explain why. For each violation, indicate the correct treatment. (LO5, LO6 and LO7) (a) 1. The qualitative characteristic of representation and the requirements of IAS 2/AASB 102 Inventories have been violated. The value of the inventory should be measured by its net realisable value if lower than cost. The financial report must provide a faithful representation of the transactions and events which have occurred; hence, if the price of the inventory has fallen, the best representation of the fair value of the inventory is net realisable value at the end of the reporting period. (But consider what to do if the fair value is above cost.) 2.Martindale Ltd has not yet performed under the contract. At this point, Martindale Ltd has and should record a liability for $7500. There is no revenue, and revenue recognition should be deferred until performance is carried out in the following year. The cash receipts should be recorded by a debit to Cash at Bank for $7500 and a credit to Unearned Revenue (a liability) for $7500. Is the accounting treatment different if the order placed with Martindale Ltd was for specialised equipment, which only Martindale Ltd is licensed to make? Under IAS 18/AASB 118’s revenue recognition criteria, it could be argued that no violation has occurred in the recognition of the increase in the asset via accounts receivable, as the inflow may pass the probability test and can be reliably measured. The credit entry, however, would be to a liability rather than to revenue, as the contract is executory in nature. 3. The principle of valuing assets at cost as per IAS 16/AASB 116, and the definition of income, have been violated. Under the accounting standard, the machinery must be recorded (debit) at its actual cost of $32 000 as measured by the amount of cash paid (credit) to acquire it. 4. No violation has occurred as the cost of the ignition security locks is probably immaterial. The costs should be charged to expense during the current year. 5. The definition of an expense and the expense recognition criteria have been violated. Since the building improvements are attached to the property, the future benefits of the improvements are consumed over the life of the building, and should be depreciated over 15 years, which is shorter than the overall useful life of the improvements. Thus, the depreciation expense on the building improvements should be recorded at $8000 per annum rather than $6000. Problem 10.18 Assets and income A legal wrangle developed between the Australian Taxation Office (ATO) and Box Hill Ltd con¬cerning the treatment of certain disputed income tax payments. This prompted ASIC to seek a formal ruling on the dispute and call for full disclosure of the effects of tax disputes in the com¬pany’s financial statements. Box Hill Ltd and several other leading companies operated an in-house, tax-minimisation scheme which was unacceptable to the ATO. As a result, the ATO assessed Box Hill Ltd as owing $15 million in tax stemming from the use of the scheme. The company paid the tax to the ATO but then challenged the ATO in court and won its challenge to the assessment in the state Supreme Court. Since then, the ATO has appealed against the decision to the Federal Court, but no decision has yet been made. In its financial statements at the end of the financial year, Box Hill Ltd included the amount of $15 million as an asset, refundable from the ATO. On reviewing the financial statements, ASIC expressed concern about the treatment of the money expected to be recovered from the ATO as an ‘asset’, as the amount appeared to affect materially the reported profits of the company. ASIC sug¬gested that disputed taxation assessments do not qualify as items resulting from past transactions or to which a company has a definite legal right. Required (a) Discuss whether the disputed amount should be recognised as an asset and as income in the financial statements of Box Hill Ltd. (LO6 and LO7) (a) It would appear from the case that Box Hill Ltd has made the following entry: Receivable from Australian Taxation Office Dr 15 000 000 Income from Recovery of Tax Cr 15 000 000 The question to be asked here is whether the entry made by Box Hill Ltd is legitimate under the Conceptual Framework’s definitions of assets and income. Does Box Hill Ltd have an asset? Are there future economic benefits? Yes, it has been decided so by the court. Does the entity control those benefits? According to the definition of control, there is a legal debt owed exclusively to Box Hill Ltd, so control follows. Is there a past event? Yes, there is a legal decision by the court, in spite of the ASIC’s protestations. So there is an asset, and it can be recognised as the recognition criteria, if you accept that the probability of receipt from the Australian Taxation Office is greater than 50%, and that the amount is reliably measured at $15 000 000, are also satisfied. Does Box Hill Ltd have income? Has there been an increase in future economic benefits in the form of an asset, and an increase in equity? Yes. Income exists and can be recognised. Some may object to the above reasoning and argue that the decision is yet to come before the Federal court of appeal for a final verdict. Hence, there may be an asset and income, but if the probability of receipt is assessed as being less than 50%, no asset or income can be recognised. Alternatively, for those who are prepared to recognise the asset and income, if the decision is reversed, then Box Hill Ltd can pass the following entry: Expense from Loss of Court Case Dr 15 000 000 Receivable from Australian Taxation Office Cr 15 000 000 Problem 10.19 Assets, expenses and liabilities Land and Water Waste Disposal Ltd (LAWWD) is a public company providing waste disposal services to private homeowners and to customers in the commercial, industrial and public sectors. Because of its active research program, the company has built a fine reputation as the leading han¬dler of waste products in Adelaide. During the year ended 30 June 2020, LAWWD undertook an investigation on the feasibility of establishing a waste processing plant in one of Melbourne’s eastern suburbs. Financial advisers, engineers, architects and lawyers were consulted to determine the economic and legal feasibility of establishing such a plant. As at 30 June 2020, the company had incurred costs of $800 000 but was still unable to determine clearly the feasibility of the project; these costs were deferred as assets in the company’s financial statements. LAWWD has several long-term contracts which specify that predetermined quantities of waste must be delivered to certain locations each year. The contracts specify that, if LAWWD is unable to deliver the predetermined quantities, shortfalls must be made up in equivalent cash payments. Unfortunately, LAWWD has not developed a system to keep track of exact quantities delivered to each location. It has become an acceptable practice for delivery requirements to be renegotiated during the life of any contract. Shortly after the end of the financial year ending 30 June 2020, LAWWD was advised by one of its clients, Dorset Ltd, that there was a shortfall in the tonnage of land waste delivered. The cash penalty for this deficiency was approximately $300 000. Because of the long-standing business relationship between the two parties, the management of Dorset Ltd agreed to a future meeting with LAWWD to be held on 30 September 2020 to discuss waiving the penalty and reducing next year’s delivery requirements. In the finalisation of its general purpose financial reports at the end of August 2020, LAWWD has not recognised any liability for penalties under this contract. Required (a) In the light of the Conceptual Framework, discuss LAWWD’s treatment in the general purpose financial reports of the costs incurred for the feasibility study, and the penalty under the contract with Dorset Ltd. (LO6 and LO7) (a) Issues to be considered: • Costs of feasibility study. • Penalty under contract with Dorset Ltd. i. Cost of feasibility study: • $800 000 incurred during year ended 30 June 2020. • Feasibility of project uncertain. • Costs deferred in statement of financial position, i.e. capitalised as asset. • issue is one of assessment of the existence and probability of future economic benefits • From the feasibility study, i.e. the definition and recognition of an asset. Definition Future economic benefits (= means by which entities achieve objectives) — yes, if plant goes ahead, company will generate future cash flows. Control — yes, no one else can benefit from results of study (unless the company decides to sell its results) and the company can deny/regulate access. Past event — yes, study has been at least partly completed, i.e. past event could be commencement of study. Recognition Reliable (faithfully representative) measurement — yes — costs known. Only has to be ‘a cost or other value’. Probability of future economic benefits eventuating — This is a problem. — What is the likelihood? if > 50% — can be recognised as asset. if < 50% — cannot be recognised as asset; hence the costs must be recorded as an expense. The question states that the company is ‘unable to determine clearly the feasibility of project’ — need to evaluate this uncertainty in terms of probability. If probability 50%, the Conceptual Framework would require reinstatement as asset. ii. Penalty: • Shortfall in waste delivered (predetermined quantities required). • Cash penalty = $300 000. • Possibility of waiver of penalty and reducing future delivery receipts under the contract. • No liability recognised by LAWWD. • History — delivery receipts renegotiated despite penalty provisions. • Should evaluate penalty in terms of liability definition and recognition criteria. Definition Present obligation — yes, legal (under contract). Default on the terms has occurred, therefore a penalty incurred. Future settlement/sacrifice of future economic benefits Involves notion of discretion to avoid settlement — adverse financial concepts. Penalty is legally enforceable, so condition satisfied. Past event — default on terms of delivery receipts — yes. Recognition Reliable (faithfully representative) measurement — yes. Probability — problem. History shows penalty provisions not enforced in past; instead delivery receipts renegotiated — this is accepted practice. Meeting to be held soon re possibility of waiver of this penalty. Unlikely that future sacrifice will be required, i.e. probably the recognition criteria are not met. So, should not recognise as liability — company’s treatment thus correct. You should also address other ‘side’ of potential entry, i.e. expense. Again, no expense recognised as no liability recognised. Probability < 50% that consumption of economic benefits has occurred. Problem 10.20 Reporting entity, revenues and expenses Dowden Machinery Ltd (DML), a reporting entity which distributes heavy-duty equipment to industrial entities, has had a significant increase in sales over the last few years to government departments. By 30 June 2020, the percentage of sales to the government sector had risen to 40% of total sales. The shareholders of DML are considering an offer to sell the company to Rawson Roads Ltd and have agreed to an audit of the company by Rawson Roads Ltd’s auditors, Carson. During their investigations, Carson questioned DML’s accounting policies in relation to heavy equipment sales to the government. Sales to government departments were carried out under the following terms. 1. Sales are made at normal retail prices, and the sales price is payable at the date of delivery of the equipment. Ownership title transfers at the date of delivery. 2. DML guarantees to repurchase the equipment for a predetermined sum, either at the completion of a specified period of time (normally 2 years), or based on a specified equipment usage factor 3. The purchaser is responsible for normal recurring maintenance on the equipment; however, DML is responsible for providing, at no cost to the purchaser, any maintenance above normal levels. 4. The purchaser bears the full risk of any loss on the sold equipment once title has passed and up to the date on which the equipment is repurchased by DML or sold to an independent third party. DML has followed the policy of recognising revenue on government sales on the date of delivery. The auditors assess that DML’s guaranteed price for repurchase of the equipment, as per (2) above, is quite high, and is likely to lead to 70% of all equipment subject to government sales being repurchased by DML. The auditors further assess that DML is likely to incur losses on resale of some of this repurchased equipment. DML has also followed a policy of not accruing any future costs that may be incurred from its maintenance obligations above the normal level. Required (a) Briefly discuss how a company such as DML determines whether it is a reporting entity. (b) In the light of the Conceptual Framework, discuss DML’s treatment in the accounting records of: i. the revenue from government sales of heavy equipment, given the guaranteed repurchase option ii. the treatment of future costs for abnormal maintenance. (LO3, LO6 and LO7) (a) Definition of reporting entity must be mentioned (as per SAC 1) — especially reasonable expectation of the existence of users without power, i.e. those reliant on general purpose financial reports for information — can mention also the 3 categories of users. Will this changes under the IASB’s proposed definition of a reporting entity? Guidelines to assess whether an entity is a reporting entity (as per SAC 1). (b) From the chapter, you will need to define carefully: •revenue •assets •liabilities. As well as mention their recognition criteria in answering this question. i. Using the facts of the case, discuss DML’s recognition of revenue from government sales. Is there any revenue at all? Consider the economic substance of these transactions rather than the legal form. It could be argued that no revenue has occurred for 70% of the sales as it is likely that 70% will most likely have to be repurchased. Is it probable that equipment would be returned? Is there a liability arising from the repurchase guarantee? If so, should it be recognised? ii. The treatment of future costs for abnormal maintenance. Is there a liability under a warranty for abnormal maintenance here? There is certainly a present legal obligation requiring a sacrifice on the happening of a specified event. Under the Conceptual Framework, a warranty is clearly regarded as a liability. Can we recognise it? Is there an expense? Could it be recognised as a contingent liability? What is ‘abnormal’ maintenance? If you were on the board of Rawson Roads Ltd, would you buy the DML company, given the investigation by Carson? Problem 10.21 Revenues and expenses Celebrity Monthly is a glossy monthly magazine that has been on the market for nearly 2 years. It currently has a circulation across several countries of 1.6 million copies per month. Currently, negotiations are under way for the company that produces the magazine, among other publications, to obtain a loan from a bank in order to upgrade production facilities. The company is currently producing close to capacity and expects to grow at an average of 15% over the next 3 years. After reviewing the financial statements of the company, the bank loan officer, Joe Teller, has indicated that a loan could be made if the company is able to improve its debt–equity ratio (non-current liabilities divided by equity) and current ratio (current assets divided by current liabilities) to a specified level. The company’s marketing manager, Jess Smith, has devised a plan to meet these requirements. Smith indicates that an advertising campaign can be initiated immediately to increase the com¬pany’s circulation. The campaign would include: an offer to subscribe to Celebrity Monthly at 75% of the normal price for 1 year a special offer to all new subscribers to receive another of the company’s publications, Age of Discovery, at a guaranteed price of $8; Age of Discovery usually sells for $15.95 and costs $11 to produce an unconditional guarantee that any subscriber will receive a full refund if dissatisfied with the magazine. Although the offer for a full refund is risky, Smith claims that very few people ask for a refund after receiving half of their subscription issues. Smith also claims that other magazine companies have tried this sales campaign and have had great success, with an average cancellation rate of only 25%. Overall, these other companies increased their initial circulation threefold, and in the long run increased circulation to twice that which existed before the promotion. Furthermore, 80% of the new subscribers are expected to take up the Age of Discovery offer. Smith feels confident that the increased subscriptions from the campaign will increase the current ratio and reduce the debt–equity ratio to the required levels. The managing director agrees. You are the accountant for the company, and must give your opinion of the accounting treat¬ment for the proposed campaign. Required (a) In light of the Conceptual Framework, explain: i. how you would treat the costs of the advertising campaign ii. when revenue should be recognised from the new subscriptions iii. how you would treat sales returns stemming from the unconditional guarantee iv. how the extra $8 received per Age of Discovery should be recorded. (LO6 and LO7) (a) (i) You must define an asset and determine whether advertising costs meet definition. You must discuss whether there are future economic benefits, control (2 aspects) and past transactions or events. If it is an asset, what should we call it? [Is it an ‘intangible’ asset? If so, can it be recognised under IAS 38/AASB 138? No.] If it is an asset, you must then state the recognition criteria and determine whether the asset meets these: (a) Probability — on basis of other companies’ experience, not a problem. (b) Reliable (faithfully representative) measurement — advertising campaign would have a cost or other value capable of measurement, e.g. estimated/invoiced amount incurred for the campaign, predicted gross sales from campaign, and so on. (ii) State the essential characteristics of income: (a) an inflow or enhancement; (b) an increase in assets or reduction in liabilities; (c) an increase in equity apart from a contribution by owners In addition, revenue under IAS 18/AASB 118 must be from (d) part of ordinary activities. Discuss when revenue exists using the facts of the case. State the recognition criteria — probability of inflow having occurred and reliable measurement plus the criteria in IAS 18/AASB 118 See text p. 744). Discuss when to recognise the revenue, including a discussion of the probability of the revenue being received and of a reliable (faithfully representative) measure of the amount, given the average return rate of 25% and the anticipated doubling of circulation. Furthermore, is there a liability from an unconditional guarantee? Discussion of this aspect either here or in the next section. (iii) Discuss whether sales returns are to be treated as an expense, or as a reduction of revenue. Outline the definition of an expense. (iv) What about the cost of $11 to produce Age of Discovery? If the cost of advertising is treated as an asset, should this include the $11 cost of producing Age of Discovery? Then, how should we treat the $8 recoupment? If $11 cost is capitalised as part of the costs of the advertising campaign, the $8 recoupment should be credited to the asset as a reduction in advertising costs. If advertising costs are expensed, and the $11 cost of producing Age of Discovery is an asset, then we treat the $8 recoupment as revenue, making a loss of $3. Problem 10.22 Conceptual framework — income, liabilities and equity Landsdale Leasing Ltd (LLL) is the owner–lessor of some high-quality apartment blocks, which have pleasant surroundings of parks and gardens and are only a short walk to a busy shopping centre and to public transport. In order to achieve tax benefits, the company leased all units in the blocks to its customers for a period of 20 years, requiring all customers to pay for the lease with a lump sum in advance. All units have been leased and LLL has received approximately $30 million in cash. Since the customers (lessees) were to receive the benefits of their lease over a 20-year period, LLL decided to account for the cash received in advance as deferred lease income, and to use a straight-line basis over 20 years in order to recognise revenue. In LLL’s accounts at the end of the year, the deferred lease income was disclosed as a non-current liability. ASIC objected to this treatment and argued that the item in question should be disclosed in the company’s statement of financial position/balance sheet not as a liability but as a separate amount after total equity. Required (a) Using the Conceptual Framework as a guide, discuss whether ASIC’s proposed treatment of the $30 million in the financial reports of LLL is correct, stating your reasons. Consider also whether LLL’s program for recognising revenue is appropriate. (LO4, LO6 and LO7) (a) Appropriate definitions from the Conceptual Framework to use in this problem are the definitions of: • income (including Revenue from IAS 18/AASB 118) • liabilities • equity. As LLL has required lessees to pay rent in advance for up to 20 years, and has collected approximately $30 million in cash, the company cannot regard this as income/revenue as it now has a present obligation to supply rental services to the lessees for the next 20 years. In accordance with the definition of a liability, there is a present obligation to supply such services. Hence, LLL was correct in treating the rent received in advance as a non-current liability; however, the title of ‘deferred lease income’ is misleading, as this implies no obligation exists. (Note also the musings of the IASB/AASB to issue a standard on revenue recognition from contracts with customers, as discussed under learning objective 7 in the chapter). It appears that ASIC was confused in that it wanted the entity to regard the rent in advance as a separate category below equity, i.e. not a liability, not equity but an ‘extra’. This in itself is contrary to the Conceptual Framework, which argues that there is no such thing as an ‘extra’. Equity is regarded as a Residual, namely Equity = Assets – Liabilities. Based on the definition of revenue, and the recognition criteria for revenue from services, as shown in IAS 18/AASB 118, service revenue is to be recognised based on the notion of ‘stage of completion’. LLL is doing this by transferring from the liability account on a straight line basis the revenue earned as the services have been provided. Perhaps LLL would provide more relevant information if the revenue recognition per period were to be based on the decline in the discounted present value of the liability. Apart from this, their treatment of revenue appears to be appropriate. Problem 10.23 Museum and art gallery collections — assets? Read the extract Invisible assets. Required (a) Discuss whether museum and art collections should be recognised as assets on the statement of financial position/balance sheet of a public museum. Do you agree with Tyzack? Why or why not? (LO6 and LO7) (a) The extract from the article by Helen Tyzack covers only the essential characteristics of the asset definition, namely the existence of future economic benefits, and control over those benefits by an entity, such as a museum in this case. The extract does not discuss recognition, which can only be considered if museum and art collections are assets in the first place. If they are not assets, then recognition is not an issue. Defining an asset – resources containing future economic benefits Tyzack argues that public heritage collections possess a number of future benefits, but questions whether those benefits are ‘economic’. She argues that admission fees, grants and sponsorship money certainly come into the museum, but that it is too difficult to associate these cash flows exclusively with the heritage and art collections. Rather the cash flows come from ‘the overall operation of the museum’. She also questions whether current or past data can be used to provide evidence of future benefits. Control Certainly, it appears that the museum does control the art collections and heritage pieces, in that it has a capacity to receive the benefits in the pursuit of its objectives and it can deny access to those benefits by others. Legal ownership or enforceability is not relevant in the definition of an asset. Recognising an asset If you consider that heritage and art collections are assets of a museum, can they be recognised? This requires assessment of the probability of the future economic benefits being received, and a cost of other value is a faithfully representative (or reliable) measure. Tyzack argues (outside of the piece in the textbook) that obtaining a reliable measure of these items is far too difficult to determine and far too costly to be assessed by valuers, and that they should not be recognised as assets of a museum. In summary, the main question in determining whether heritage and art collections are assets seems to be whether they lead to future ECONOMIC benefits. The other side of the argument Others disagree with Tyzack, e.g. Frank Micallef who wrote a reply to Tyzack, in ‘Art and Accountability’ Charter, September 1998, pp. 73–4. Micallef argued that ‘economic’ benefits are not simply ‘cash flows’, but can also represent ‘utility and value’ to the beneficiaries of not-for-profit entities such as museums. Micallef also argues that obtaining a valuation for heritage and art collections can be done by assessing their replacement cost. (Perhaps in today’s worlds which focuses more on fair value, the fair value is a better measure. Fair value for an asset is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date, as per the requirements of IFRS 13. Fair value is basically a measure of an item’s selling market value on a particular date in the normal course of business). He also believes that the expense of obtaining such valuations ‘has been greatly exaggerated by those who oppose valuing collection items’ (see p. 74). He further points out that the cost of valuing and recognising museum collection items is only justified if it satisfies the objectives of general purpose financial reports, namely whether it provides information useful to users of financial reports. Micallef claims that it does and that heritage and art collections should be treated as assets in the financial statements of museums. What do you think? Problem 10.24 Existence of assets and liabilities — contracts Read the following extract from an article Is prudence still a virtue?, which is about Bob Jane’s latest business venture. Required (a) By referring to definitions and recognition criteria of the elements of financial statements, as contained in the Conceptual Framework, discuss when and how Bob Jane’s business should account for the deal signed with the Chinese government officials. (LO6 and LO7) (a) Firstly define assets and liabilities. (i) An asset is 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. The essential characteristics are: • a resource containing future economic benefits • control • past transactions or events. (ii) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. The essential characteristics arising from this definition are: • A legal debt constitutes a liability, but a liability is not restricted to being a legal debt. Its essential characteristic is the existence of a present obligation, being a duty or responsibility of the entity to act or perform in a certain way. A present obligation may also be a ‘constructive’ obligation as well as those resulting from legally enforceable contracts. It is not sufficient for an entity merely to have an intention of sacrificing economic benefits in the future. A present obligation needs to be distinguished from a future commitment • A liability must result in the giving up of resources embodying economic benefits which requires settlement in the future. The entity has little, if any, discretion in avoiding this sacrifice. • A liability must result from a past event. Consider also the recognition criteria for assets and liabilities as discussed in the Conceptual Framework. Consider the probability test and faithfully representative (reliable) measurement test. The Conceptual Framework states that transactions or events expected to occur in future do not , in themselves, give rise to assets. The Conceptual Framework states: A distinction needs to be drawn between a present obligation and a future commitment. A decision by the management of an entity to acquire assets in the future does not, of itself, give rise to a present obligation. An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable agreement to acquire the asset. In the latter case, the irrevocable nature of the agreement means that the economic consequences of failing to honour the obligation, for example, because of the existence of a substantial penalty, leave the entity with little, if any, discretion to avoid the outflow of resources to another party. Note also, regarding recognition criteria for a liability, the following statement made in the Conceptual Framework: A liability is recognised … when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. In practice, obligations under contracts that are equally proportionately unperformed (for example, liabilities for inventory ordered but not yet received) are generally not recognised as liabilities in the financial statements. However, such obligations may meet the definition of liabilities and, provided the recognition criteria are met in the particular circumstances, may qualify for recognition. In such circumstances, recognition of liabilities entails recognition of related assets or expenses. Regarding the contract for building a car-racing track, and so on , is it non-cancellable? If so, it may qualify for recognition as an asset and liability under the Conceptual Framework. What does ‘non-cancellable’ mean? Does this mean that a significant penalty would be paid for cancellation of the contract? If there is a liability, is there also an asset? Note here the intention of the IASB/AASB to issue a standard on revenue recognition from contracts with customers. Refer to the discussion under learning objective 7 in the chapter. This proposed standard will provide the key as to when Bob Jane should recognise assets and liabilities under the project. Any assets and liabilities which are not recognised in the accounting records because they do not satisfy the recognition criteria may be disclosed in the notes included in general purpose financial reports, if considered relevant. In this case relevance is assured as Bob Jane himself sees this project as ‘the most exciting venture’ he’s been involved with in 50 years of business. Problem 10.25 Conceptual framework Marshall Manufacturing Ltd is a manufacturer of fuel injection systems for the automotive industry. At the beginning of the current financial year, Marshall Manufacturing Ltd entered an agreement with Auto Essentials Ltd to manufacture and to supply to Auto Essentials Ltd 10 000 fuel injection systems at a stipulated price before the end of the financial year. The systems were to be made to the exact specifications required by Auto Essentials Ltd. If Marshall Manufac¬turing Ltd failed to perform as per the agreement, severe financial penalties were included as part of the contractual arrangements. The agreement also provided that Auto Essentials Ltd would make royalty payments to Marshall Manufacturing Ltd after each batch of 2000 systems was delivered. Each royalty payment was to be $100 000, and was to be paid by Auto Essentials Ltd for the use of Marshall Manufacturing Ltd’s patent rights attached to the fuel injection systems, and to help in supplying working capital to Marshall Manufacturing Ltd during the manufacturing process. The royalty payments were con¬sidered to be a part payment of the ultimate selling price, which was receivable in full immediately on delivery of the final batch. On delivery of the first batch of 2000 systems to Auto Essentials Ltd, the batch was found not to comply with the exact specifications required, and the batch was returned to Marshall Manufac¬turing Ltd. Auto Essentials Ltd refused to pay the royalty payment attached to that batch until the appropriate modifications had been carried out. Furthermore, Auto Essentials Ltd indicated that, unless the modifications were completed promptly, financial penalties under the contract would be instigated. Marshall Manufacturing Ltd assessed that the modifications would delay completion of all batches by 6 months. Auto Essentials Ltd was prepared to accept this delay without imposing penalties, but indicated that no further delays would be tolerated. If further delays occur, the con¬tract would be cancelled. Required (a) Discuss, with reference to the Conceptual Framework, the appropriate accounting treatment in the accounting records of Marshall Manufacturing Ltd for its contract with Auto Essentials Ltd. Pay particular attention to the timing of recognition of the appropriate financial statement elements. (LO6 and LO7) (a) Introduce the answer with a discussion of the Conceptual Framework’s definitions and recognition criteria for the relevant elements — assets, income (revenues) and liabilities. Issues to outline The ‘sureness’ of the ‘sale’ of 2000 injection systems, and the ‘sales return’ of the systems due to Marshall Manufacturing Ltd’s non-compliance with specifications. Does income/revenue exist at the end of the current financial year? Would you recognise revenue and a sales return to show net revenue of nil? The sureness of the ‘potential’ liability i.e. the financial penalties and the delay in production — does this make the possible financial penalties a recognisable liability now, at the end of the financial year? There is a legal obligation under the contract, but is the obligation recognisable — assess probability levels. Hence, should a liability for penalties be recognised in the financial statements? Or disclosed in the notes? Not included at all? The treatment of the royalty payments due to Marshall Manufacturing Ltd, i.e. are they income to Marshall Manufacturing Ltd in the current period even though Auto Essentials Ltd has refused to pay until modifications are complete? Also, note that the royalty payments are said to be part of the selling price; hence they may be included in the sales and sales return above? Due to the modifications taking an additional 6 months, the next reporting period may be relevant, i.e. should some revenue and corresponding expense (cost of sales) be carried over into the next reporting period? Or should all revenue and expenses be delayed until the fuel injection systems are complete and have been accepted by Auto Essentials Ltd? This may only arise in the new reporting period. Problem 10.26 Liabilities, equity and expenses Cambridge Ltd is a public company supplying different types of packaging for the food and bev¬erage industry. Among its products are labels for beer bottles, soft-drink bottles and jam jars and tins, and packages for frozen foods, cheese, yoghurt, confectionery and snack foods. Cambridge Ltd has reported sales of approximately $25 million for the year ended 30 June 2019. The directors of the company have been considering a public share offer and have contacted a merchant banker to investigate the possibility. On 15 November 2019, the company made a private placement of 100 000 8% cumulative, redeemable, non-participating preference shares at an issue price of $2.50 per share. The share issue was made for the purpose of financing expansion of needed plant and equipment. Each pref¬erence share is convertible into two ordinary shares at the option of the holder, and is subject to mandatory conversion in the event of a public share issue or mandatory redemption in cash on 15 November 2021 for $4.00 per share, whichever occurrence is the earlier. It is expected that no cumulative preference dividends will be due when the preference shares are converted. In preparing its draft general purpose financial reports for the year ended 30 June 2020, the chief accountant of Cambridge Ltd, Adam Brown, disclosed the preference shares in the equity section. Brown did not adjust periodically the carrying amount of the preference shares for the dif¬ference between the issue price and the redemption price. On examining the draft financial reports, Cambridge Ltd’s auditor argued that the preference shares should be regarded as long-term debt financing and reported as non-current liabilities, and that the periodic adjustment, representing the difference between the issue price and the redemp¬tion price, should be reported over time as interest expense in the income statement. Required (a) Discuss, with reference to the Conceptual Framework, the appropriate accounting treatment for these preference shares and for the potential increase in the redemption price. (LO6 and LO7) (a) There are two issues here, which are as follows. 1. Are the preference shares a liability or equity? We must: i. define a liability and equity under the Conceptual Framework; ii. discuss whether the preference shares are a liability as per the definition, and essential characteristics; and iii. consider recognition criteria especially probability criterion in this case — the probability of options being exercised. Probability of future events will depend on predictions of the future share price. Will the price go above $8? If so, convert; if not, redeem. 2. How to treat the increase in the redemption price (from $5 to $8). Should this increase be treated as an expense? Need to: i. define an expense, and to consider whether the increased redemption price qualifies as an increase in a liability? ii. if so, when do we recognise the expense? Immediately or gradually, as in smoothing across time? If gradually, based on straight-line, diminishing balance or present value calculations? Problem 10.27 Income and liabilities Carl Caldersmith owns 80% of the issued shares of Caldersmith Commercial Cleaning Ltd (CCC), a distributor of cleaning equipment for industrial purposes. During the annual audit of CCC, the firm’s auditors, Standing and Sampson, noticed two irregularities in the accounts and asked Caldersmith to provide reasons for these irregularities. First, CCC had, in error, been charging GST for the last year on certain equipment sales that were exempt from GST, under the government’s roll-back scheme, as they had been sold to various not-for-profit institutions. Caldersmith, as managing director, claimed that it was impractical and costly to refund the GST collected (approximately $150 000) to these customers. These amounts had been transferred to current year’s profits. Second, Standing and Sampson noticed that at the beginning of the current year Caldersmith had advanced $400 000 to CCC, at an interest rate of 8% per year. Because of the concerns of bank creditors as to the weak capital position of CCC at year’s end, Caldersmith decided to regard these advances as further capital contributions to CCC, and the $400 000 was recorded as contributed equity. Interest for the current year, totalling $32 000, had been recorded as an expense. Third, a number of years ago, Caldersmith had purchased and donated to CCC a collection of artworks, which had cost Caldersmith $400 000. CCC had recorded these works in its own records at that price. Caldersmith had these artworks valued by a licensed valuer on 30 June at $1 000 000. CCC passed a journal entry to revalue the artworks and recognise income of $600 000. Required (a) In the light of the Conceptual Framework, discuss CCC’s treatment in the accounts of the GST overcharge, the treatment of Caldersmith’s advance plus the interest on the advance, and the artworks. (LO6 and LO7) (a) You are expected to discuss the Conceptual Framework’s definitions, essential characteristics and recognition criteria for liabilities, equity and income. Discuss the GST potential refund along the lines of the essential characteristics of a liability. If not a liability that can be recognised, then it is automatically to be recorded as income under the definition. What about GST on cash sales? Can the outside party be identified? Under the Conceptual Framework, identification of the party does not matter. Discuss the advance by Caldersmith in the case as to whether it is a liability or equity. The ultimate treatment will impact on the debt-equity ratio. Is it likely that the $400 000 advance will need to be sacrificed back to Caldersmith at a future date? Discuss of the treatment of the interest on the advance — distribution to equity holders, or an expense? The artworks? Is it legitimate to revalue non-current assets from a price of $400 000 to the current fair value? See the requirements of IAS 16/AASB 116 here. Is the increase in the fair value of $600 000 income? IAS 16/AASB 116 argues that the increase is a ‘revaluation surplus’, which is to be treated as part of other comprehensive income (not profit) and as a direct adjustment to equity. Problem 10.28 Assets and liabilities Dampier Dirtworks Company Ltd (DDC) was floated by public subscription on 1 July 2020. The entity so formed engaged in a number of revenue-earning activities which had been previously administered by the government’s Maritime Department. However, the government, in order to generate much-needed cash flows, decided to sell these activities to private enterprise. The two major revenue-earning activities acquired by DDC were as follows. 1. Operation and maintenance of all shipping channels within the port of Eden. After the company was formed, it acquired a number of dredges from the Maritime Department, these being used to prevent silting of shipping channels. Constant dredging of the channels and creation of new channels has occurred since the city began, because only limited natural channels exist within the port. In return for undertaking these activities, DDC has the authority to charge shipping fees on all visiting cargo ships using the channels. Many other forms of shipping traffic such as pleasure craft, tourist boats, fishing trawlers, ferries, power boats and jet skis also use these shipping channels because of the shallowness of the port, but are not required to pay any formal shipping fees. No organ¬isation other than DDC is permitted to dredge channels. 2. The basin of the Torrent River on which the port of Eden is situated is very rich in gravel. Hence, as a result of the dredging operations, a very large tonnage of high-quality gravel is dredged by DDC. All gravel is sold under a fixed contract to Croydon Concrete Ltd. Gravel is also quarried by a number of other companies around the port of Eden. The general manager of DDC is having difficulty in clarifying a number of conceptual and practical issues about the entity he now controls. He is seeking answers to the following questions: • What assets does DDC have? • Are the river channels assets or are they a public good? • Tons of gravel are lying on the river bed, just waiting to be dredged. Is it an asset now, or when it is ‘floating gravel’, or when it is delivered, or at some other time? • As DDC is required by the government to keep the channels clean or face penalties, is there a liability here? Over how many years? • Pleasure craft use DDC’s channels. Does this affect the classification of the channels? Required (a) As consultant to DDC, provide a report to the general manager to help him determine what items should be included in DDC’s financial statements and how to account for the activities of the business. (LO6 and LO7) (a) What assets does DDC have? Are the river channels assets? Dredges: There is no doubt that one of the assets held by DDC is ‘dredges’, which would have been purchased from the Maritime Department. These will be depreciated across time as the future benefits are used up in the dredges. Channel: However, the more interesting question is whether DDC can recognise ‘shipping channels’ as an asset. There are certainly future economic benefits in the form of shipping fees from cargo ships’ use of the channel. Does DDC control the channels? It could be argued that it does, as only DDC can obtain economic benefits from the channel, and it can deny or regulate access to the channel. The fact that pleasure craft tourist boats, trawlers, ferries and other boats can use the river does not mean that they use the channel. If the channel is an asset, at what amount should it be recognised? The present value of expected shipping fees? Should it be depreciated? If so, how do you determine its useful life? Is its useful life infinity? Gravel: There is no doubt that gravel in the channel is the asset of DDC, but the gravel not in the channel can be extracted by others and is not the asset of DDC. However, can it be recognised? Probably not, because of reliable measurement problems, as often exists with mineral reserves in extractive industries. It is probable that the gravel can be recognised once it has been dredged out of the channel and placed on the barge (dredge). If the gravel were to be recognised as an asset once placed on the barge, the reliable measure would be the direct and indirect costs of dredging. Given that the gravel is sold under a fixed contract to Croydon Concrete Ltd, could revenue be recognised prior to its sale? Most likely, in practice, the revenue from gravel will be recorded on sale of the gravel to Croydon Concrete Ltd. Are there any other assets? For example, is the contract providing dredging rights in the channel an asset? Or are these rights subsumed by recognising the channel as an asset? Does DDC have any liabilities? It could be argued that under the contract with the Maritime Department, there is a present obligation for DDC to keep the channels clean. Does this obligation result in future sacrifices requiring settlement? Yes. Hence, a liability under the Conceptual Framework. A sacrifice would exist if DDC does not keep the channels clean and there is a penalty imposed by the Maritime Department, possibly in the event that a cargo ship becomes stuck in the river. Case studies Decision analysis Recognition of revenue Brian Kelly has spent many years of his life panning for gold, with little success. On several occasions, he has found small traces of gold along the usual river banks that he is licensed to pan. However, on his last trip to the Ballarat River, almost by accident he managed to find a very prom¬ising piece of rock which he placed in his satchel. He took the rock into town to be examined and valued by experts, who assured him that the rock was a valuable gold nugget and that it was worth at least $60 000. Brian was elated and opened a bottle of champagne to celebrate with his friends. About 2 weeks later, he sold the nugget to a jeweller for $75 000 in cash. Required (a) Based on the Conceptual Framework and IAS 18/AASB 118 Revenue, decide whether and when revenue exists, and decide on the appropriate time for this revenue to be recognised in the accounts of Brian Kelly, Gold Prospector. (a) The students must discuss the definition and recognition criteria for income/revenue under the Conceptual Framework and IAS 18/AASB 118, as per the text. The first step is to ask when income/revenue exists. Does it exist when Brian Kelly: (a) places the ‘rock’ into his satchel? (b) has the nugget valued by experts at a conservative value of $60 000? (c) sells the nugget for $75 000 cash? (d) all three points above? Many students may argue that income/revenue exists only at point (c); but why would Brian Kelly break open the champagne at point (b)? Does he not believe that income/revenue exists at that point, i.e. an enhancement of future economic benefits? A good case can be argued that income/revenue exists, as per the definition of income in the Conceptual Framework, at point (b), and perhaps even at point (a)! But can we recognise it? The second step, after deciding when income/revenue exists, is to determine when to recognise it. A good case can be provided for recognition after seeking the opinion of ‘experts’. Is $60 000 a reliable measure? Is it probable that the benefits would be received at point (b)? Note that IAS 18/AASB 1118 does not help us very much in this case as there is no discussion of revenue achieved by ‘discovery’ in the standard? Note as well that the standard that requires revenue to be measured at fair value. If the nugget is to be measured by reference to its market value, and the changes in market value are included in the profit or loss, the standard does not apply to this situation. There is no standard here. Maybe valuable metals could be accounted for in a similar manner to agricultural assets? The final question to be raised in this case is whether the gold nugget represents ‘inventory’ in Brian Kelly’s business? If so, then IAS 2/AASB 102 must apply if Brian Kelly is a reporting entity, and the nugget will have to be valued at the lower of cost and net realisable value? But what is the cost? How is it assessed? Is cost a more reliable measure than current market value in this situation? Critical thinking Accounting and politics Visit the websites of the IASB (www.ifrs.org), the FASB (www.fasb.org) and the AASB (www.aasb.com.au). Required (a) Discuss what influence politics has on the establishment of accounting standards? (b) Examine whether political factors have played a role in the development of accounting standards in Australia, and comment on whether you agree or disagree with the Australian Government’s involvement in the standard-setting process. (a) The influence of politics on the standard-setting process, from the article, appears to be significant. The FASB is criticised whether it bends the rules or not. From the article, the FASB’s bending-of-the-rules was criticised by those who do not want to see political interference into the independence of the Board. The Board was criticised for its lack of strength to uphold its judgments in the face of pressure. Even the SEC chairman was disappointed to see the that the ‘independent agency buckled to the strong-armed tactics of Congress’. Will the FASB survive if it does not bow to political pressure? If not, the members would be out of a job. Who has the power to ensure that the Board survives if it does not bow to the wishes of the US Congress? In years gone by, Professor David Solomons, a keen advocate of developing a conceptual framework, argued that the development of a conceptual framework was essential to act as a deterrent against the influence of politics in standard setting. The FASB and other Boards could use the conceptual framework to provide a reasoned approach to the objectives, concepts and policies upon which standards could be based. However, the FASB is not required to follow the conclusions of the conceptual framework. (b) Political factors have played a significant influence over the standard-setting process in Australia. See Learning objective 1 in the chapter. The Australian government stepped into the standard-setting arena as early as 1984, mainly because of non-compliance with existing standards, and political lobbying for or against the Board’s decisions has been constant. Note the influence of the ASX and the Group of 100 in the mid-1990s in terms of influencing future directions of the AASB. Currently the AASB is a government board under the influence of the Financial Reporting Council which forced the AASB to adopt the international financial reporting standards of the IASB in 2005. Furthermore, each accounting standard issued in Australia has to be approved by the Australian Parliament in Canberra. Have any standards been modified or amended by Parliament? The answer is Yes. One notable standard was the standard on business combinations, which has since been replaced by AASB 3. Will standard setting be political in the future? Sadly, yes. Even the conceptual framework is influenced by politics, in that its requirements can be amended by serious political lobbying, e.g. if a company doesn’t like the definition of an asset, it can lobby to have the definition changed. International issues in accounting Future considerations Visit the websites of the IASB (www.ifrs.org) and the AASB (www.aasb.com.au). Required (a) Find out the major issues currently on the agenda for consideration in future accounting standards, and present a report to the class on the basic requirements of those standards. (b) Determine and report to the class on the latest issues being discussed by the IASB and the FASB in their joint project of revising the conceptual framework. There is no answer provided here as this is a student investigation of items currently on the AASB, FASB and IASB websites. Financial analysis Refer to the latest financial report of JB Hi-Fi Limited on its website, www.jbhifi.com.au, and answer the following questions. 1. From the nature of the report, JB Hi-Fi Limited is a reporting entity. Why is this so? 2. Who would you consider to be the main users of the JB Hi-Fi Limited financial report? What types of decisions would they make based on the information contained in the report? 3. Does JB Hi-Fi Limited use the historical cost system or some other method of valuing assets? Is there any evidence that the company has revalued any of its assets in the past 12 months? Explain. 4. In the report, a summary statistical analysis is often presented. What is the importance of the statement of accounting policies in interpreting these figures? Do you consider that the figures would be of benefit to users of the report? 1. Because of its size and economic/political importance, the company is a reporting entity. Based on SAC 1 (until it is replaced), it is reasonable to expect the existence of users who are dependent on general purpose financial reports for information about the entity in order to assist in making economic decisions. Furthermore, the company clearly satisfies the size criterion under the Corporations Act 2001. 2. Main user groups would be shareholders and prospective shareholders and their representatives (financial analysts), creditors and prospective creditors and suppliers, customers, employees, and groups performing an oversight function, such as government, taxation authorities, unions, environmental groups. Shareholders and prospective shareholders will be interested in profitability (financial performance), financial position, dividends, and capital gains in the share price; and will therefore make decisions concerning the purchase and sale of their shares. Furthermore, they are interested in corporate governance issues and in transactions between related parties. Creditors and suppliers will be interested in the entity’s profitability, liquidity and solvency, and will decide whether to lend more cash to the entity or to sell merchandise to the entity on credit. Employees and unions are interested in work conditions, rates of pay, fringe benefits, and the profitability of the entity in order to decide whether to continue in employment, and to press for better working conditions and remuneration. The government, including taxation authorities is interested in the ability of the company to act responsibly in the community, in its ability to affect the economic structure of the nation, in its ability to pay various taxes, in its size and financial structure in order to carry out its legislative role. Environmental groups are interested in the entity’s policies concerning environmental issues, such as its use of environmentally sensitive resources in the products sold and of the packaging used in sales to customers. 3. See Note 1(a). The company generally uses the historical cost system, except in the case of available-for-sale financial assets and derivative financial assets and liabilities which are measured at fair value [note 1(o)], inventories valued at lower of cost and net realisable value [note 1(q)], goodwill at cost less any accumulated impairment losses [note 1(p)], and plant and equipment at cost less accumulated depreciation and impairment losses [note 1(t). 4. A formal statistical analysis or financial summary is presented in the early pages of the current report. Consider with the students whether the statistical analysis and summary of accounting policies help in interpreting the results and financial position of the group, and whether the financial statements are useful for making and evaluating economic decisions if based on historical cost data. Solution Manual for Accounting John Hoggett, John Medlin, Claire Beattie, Keryn Chalmers, Andreas Hellmann, Jodie Maxfield 9780730344568