Chapter 10: Expenses CASE STUDIES Case study 10.1 Emissions trading: recognising the cost of pollutants 1. What are emission allowances? Do they meet the IASB Framework definition of assets or expenses? Emissions allowances are credits or allowances that a company receives from a regulatory agency that represent the right to emit a specified amount of pollution. Emission allowances are created as part of an emissions trading program. An emission allowance is an asset because it represents a future economic benefit. When the emission allowance is used up, it becomes an expense or consumption of future economic benefits. A company with surplus credits can sell them, giving rise to an inflow of future economic benefits or revenue while a company with insufficient credits will need to purchase them, giving rise to an outflow of future economic benefits and therefore an expense. 2. How do businesses obtain emission allowances? Emission allowances are issued by the regulatory agency responsible for the emission trading program. A number of allowances are given, based on political and economic considerations. Companies can buy, sell or hold their allowances so allowances can also be purchased from other companies which have surplus credits. 3. How are emission allowances accounted for in the USA? Emission allowances are accounted for on an accrual basis. When issued by the regulatory agency, the allowances have a zero cost basis for the receiving entity. Allowances purchased in the market place are recorded as inventory, using lower of cost or market valuation. When allowances are consumed, inventory is reduced and an expense recognised. Sales of allowances give rise to gains and losses, which are recognised in income. 4. Why are the IASB and FASB involved in setting guidelines for accounting for emission trading? The standard setters have proposed that the emission rights be measured at fair value (at balance date) with gains and losses on remeasurement recognised in income in the period in which they accrue. The standard setters are involved in setting guidelines to ensure comparability and consistency in the way in which companies account for emission allowances. The boards aim to ensure that all assets, liabilities, revenues and expenses are recognised in the period to which they relate. Emission trading can gives rise to assets, liabilities, expenses and revenue (as per the IASB Framework) so these transactions should be recognised in the accounts. The standard setters have active projects on their agendas to ensure that suitable guidance for emission trading is issued in the future. Case Study 10.2 Accounting for frequent flyer points: fact or fiction? 1. Describe the accounting process used to account for frequent flyer points prior to the adoption of IFRS. How was the matching principle breached by this practice? Revenue was recorded when points were sold. An expense (the cost of the FF seat) was not recorded at the same time. This was recorded later when travel occurred. The matching principle was breached by early recognition of revenue, without a corresponding increase in expense (‘cost of goods sold’ or cost of ticket given away). 2. How could companies benefit from this accounting practice? Consider both the short and long term. In the short term, the accounting policy of recognising revenue immediately while deferring the FF expense to a later period allows a company to report more revenue and greater profit. However, in the long term there is no benefit as earnings will be reduced by the expense in later years. Presumably companies are concerned about looking good in the short term. Perhaps they are hoping business will improve, so that the deferred expense has relatively lesser impact when it is recognised in the later period. 3. Why was Qantas keen to correct the errors reported in the AFR article? As a major listed company, Qantas would not want to be seen as breaching accounting standards or Corporations Law requirements. Such an action would be viewed badly in the market place. It suggests the company does not employ competent accountants, or does not obey the law. It may imply the company has engaged in earnings management. Such action would raise questions about the corporate governance practices of the company, which could have adverse effects on its reputation. Qantas would seek to protect its reputation as it makes use of public finance and depends on support of investors. It would want to avoid negative publicity arising from inaccurate reporting. 4. Explain the difference between the cost/provision and the deferred revenue approaches. Under the cost/provision approach Qantas recorded an expense at the time of the award, thus effectively reducing the revenue recognised in relation to the associated ticket sale. In addition, liabilities were increased by the value of the seat to be given up in the future. The deferred revenue approach will require Qantas to separate the value of the ticket sold into two parts: revenue relating to the current service (the airline seat) and revenue relating to the future award. Only the current service revenue is recognised and future revenue is allocated to a liability account (deferred revenue) to be settled when the award is exercised. 5. What impact do you expect adopting the deferred revenue approach to have on Qantas’s financial statements? Although the deferred revenue method is different to that previously used by Qantas and different accounts are used, the net effect on Qantas’s accounts is the same. The amount of net revenue is the same and a liability is recognised in relation to the future award. For Qantas IFRIC 13 will not affect net revenue or total liabilities. THEORY IN ACTION Theory in Action 10.1 Options deal dwarfs salary of ANZ chief 1. Since 2005, IFRS 2 (AASB 2) requires companies to record an expense in relation to stock options plans. Explain the requirements of IFRS 2 (AASB 2) and how they differ to previous requirements. (Students will need to consult additional resources. See the list at the end of this chapter). Prior to the application of IFRS 2 Share-based Payment many companies did not include an expense in relation to the cost of providing employee remuneration via stock options. Some managers did not support the recognition of an expense, which would reduce earnings. Under IFRS 2 (AASB 2) companies are required to account for equity-settled and cash-settled share-based payment transactions as well as transactions where an entity receives goods and services and the transaction can be settled with cash, equity instruments or other assets (para 2). For equity-based transactions, the entity measures goods or services received (and the corresponding increase in equity) directly at their fair values. If the entity cannot estimate reliably the fair value of goods or services received, then their value is measured indirectly by reference to the fair value of the equity instruments granted (para 10). Fair value is to be based on market prices at grant date (para 16). If market prices are not available, the fair value is to be estimated using a valuation technique, to reflect measurement based on an arms’ length transaction between knowledgeable and willing parties. The valuation technique used should reflect generally accepted practice for valuing financial instruments and should incorporate factors and assumptions used by knowledgeable and will market participants (para 17). 2. Provide an overview of the advantages and disadvantages of the requirements of IFRS 2 (AASB 2). Standard setters argue that including the cost of share-based payments improves the relevance, reliability and comparability of financial statements. The information helps users of financial reports to better understand the company’s financial expenditure and commitments. Recognising share based payments, and provided associated disclosures, improves the information set with which investors work and thus assists them in analysing and evaluating companies. The information has the potential to enable users to make better resource allocation decisions. Some commentators argue that recognition of share based payments introduces volatility and subjectivity into the accounts. The argument is that since the expense is based on fair value measurement (actual or estimated market prices, which can be volatile) it may introduce volatility into reported earnings. Standard setters argue that volatility is an economic phenomenon and should be captured. However, some managers oppose fair value measurement which they claim introduces volatility because they consider it makes the analysts’ prediction task more difficult and complicates the communication process between managers and analysts. Whether IFRS 2 leads to increased volatility is an empirical question still under investigation. The second argument relates to subjectivity of measurement. Option pricing methods currently in use include the Black-Scholes-Merton model and the binomial valuation model. Obviously these models are based on assumptions, which may vary from reality. Intentional or unintentional error may result. They are also subject to managerial incentives, i.e. managers can influence model inputs and therefore the resulting valuation. There is US evidence of managers controlling valuation inputs to achieve desired option valuations (e.g. Google company in 2007). 3. The article states that certain executives gain much more on options plans than is shown in their company’s accounts. For example, the ANZ CEO gained $19.7m cashing in options, but his pay was shown as $7.2m in the 2006 annual report. Given that IFRS 2 requires the recording of an expense for share based payments, explain how this could occur. As explained in part (1) IFRS 2 requires that options be valued at grant date and that an expense reflecting this value be included in the accounts over the life of the option. Therefore the expense recognised in the accounts is the value at grant date (e.g. at t = 0) not the value when the options are exercised (e.g. t = 3, if options vest in three years). The value at grant date can be less than the value when the option is exercised because the value at grant date is an estimation which can prove to be incorrect. For example, if share prices rise more than predicted the estimated value will be less than actual value and the amount for stock options expense will be less than the amount received by the employees when they exercise the options. 4. In light of your answer to question 3, do you consider that the requirements of IFRS 2 should be changed? Why or why not? It is not necessary to change the requirements of IFRS 2. The difference explained in (3) above arises due to the use of estimation models. Estimation is inevitable in relation to valuing options in many cases so it is not a weakness of the standard which leads to the discrepancy between value at grant date and exercise date. If the difference results from the technique used, it is not a weakness of the standard per se. Of course, the standard could require different techniques, however, it recommends ‘current best practice’ so a change in recommendations is not required. The matter can be resolved by disclosure. Indeed, the information quoted in the article relies on existing disclosures which occur in two places: the value of options at grant date as shown in the financial statements and the value of options at exercise date as shown in the remuneration report included in the annual report. Therefore stakeholders can see the amount of remuneration received via options. Perhaps the writer is concerned about the ability of readers to locate the information and understand the difference between value at grant date and exercise date. Writers of accounting standards assume reasonable ability among people using financial reports. On this basis, standards setters or regulators would claim that in this case the information is transparent and it is therefore up to users to make use of the information provided as they see fit. Theory in Action 10.2 Share option plans worthless 1. Outline the difference between an option plan and a performance rights plan. A share option plan grants employees the right to receive company shares in the future subject to certain conditions being met. Share options may be granted at reduced cost, minimal cost or no cost to employees. When vesting conditions are met, employees have the choice of exercising their options and obtaining company shares. Vesting conditions typically include the share price reaching a particular target and the employee remaining with the company for a particular period (e.g. three years). Instead of increases in share price, performance rights plans use the company’s performance relative to its peers as the benchmark for exercising options. The article states that the performance hurdle usually involves comparing a company’s total shareholder return against a group of similar companies. If the company achieves the performance hurdle (a certain shareholder return compared to its peers) then executives can exercise their options and obtain shares at a favourable price. 2. The article states that almost three quarters of employee share option plans issued by the top 50 ASX firms are now worthless. Explain how options can be worthless when companies have billions of dollars of assets. Share option plans are ‘in the money’ when the value of the share is greater than the cost of the option. In this situation, a wealth maximising individual will exercise the option and obtain the shares. If options are granted at a discount to share price, then as long as the share price rises they are ‘in the money’ and have value for the employee. By January 2009, share prices had declined dramatically as part of the global financial crises which took hold of markets from October 2008. The value of option plans is linked to share price (not to the value of the company’s assets) so the fall in share prices rendered options worthless because the cost of exercising the option was greater than the value of the share obtained when the option was exercised. Options became ‘out of the money’ and had no value to the holder. 3. What does an environment of falling share prices reveal about the effectiveness of incentive plans as motivational tools? Share option plans were introduced as a way of incentivising employees and aligning their interests with those of shareholders. If employees are able to increase their company’s share price to meet the conditions of the option plan, then shareholder wealth increases but so too does the value of employee options and consequently the employees’ wealth. Share option plans were popular prior to the tech stock crash in April 2001. Options permitted firms to compensate employees without an outflow of cash and without a remuneration expense being recorded (because of accounting standards in force at the time) which would have reduced earnings. However, when stock prices crashed after April 2001, in some cases options became worthless. Consequently, companies adopted performance rights plans. They were set up with different performance hurdles which were not as sensitive to overall movements in the share price. As we can see by observing markets, share prices move in response to many factors and in many circumstances these factors are outside the control of individual managers (e.g. share prices move in response to the weather and terrorist acts). Therefore it is in the managers’ interests to link their remuneration to factors over which they have relatively more control. Instead of requiring a certain level of increase in share price (difficult to achieve when the market falls) the test for exercising the options is based on comparing the performance of the company to that of other similar companies. Thus employees benefit when their firm outperforms others but the award of options is not affected by overall market movements (which affect all firms). This situation shows that option plans can still be used to motivate employees in times of falling prices if they are set up in an appropriate way. It also shows that the principles of incentive plans do not change, but the way plans are set up evolve as market conditions change. Theory in Action 10.3 Loophole lets bank rewrite the calendar 1. Outline the events which led to Société Générale recording a 2008 loss in the company’s 2007 accounts. How did the bank justify its action? In 2008 the French bank suffered an enormous loss due to the unauthorised trading activity of employee Jérôme Kerviel. The loss occurred in January 2008 but since the 2007 accounts had not been finalised the bank decided to include the loss in 2007. The bank offset the 2008 loss against the 2007 profit to give a result of a net loss of Euro 4.9 billion. In the annual report the bank stated that applying IAS 39 Financial Instruments: Recognition and Disclosure and IAS 10 Events after Balance Sheet date would have been inconsistent with a ‘fair presentation’ of its results. The article states that the bank does not elaborate on why this would be so. Therefore, readers are left to draw their own conclusions. One view is that the event was not a positive one for the bank (either in terms of financial performance or corporate image) or for the banking sector in general or the French securities market. Therefore management included the loss in 2007 (despite it having occurred in the 2008 financial year) possibly because the managers (or major investors or the French banking/company regulator) wanted to ‘get it out of the way’ i.e. it wanted to take the loss, make the disclosure, and move on. 2. On what grounds has the bank’s approach been criticised? The bank’s action has been criticised for several reasons. First, the loss had not occurred at the end of 2007. If Kerveil’s actions had been discovered in 2007, the loss would not have been incurred as his positions were profitable in that year. Second, the bank made use of the ‘carve out’ related to IAS 39,which was itself controversial. For many parties, the use of the ‘carve out’ is not best practice. In addition, the company did not disclose what results would have been if the carve out had not been used, thus their reporting was not transparent for investors. 3. Evaluate the role of the auditors in this situation. The role of the auditors is to attest that the financial statements provide a fair presentation of the company’s position and performance in compliance with accounting standards. On the face of the situation, it seems difficult to understand how accounts can be in accordance with accounting standards if IAS 39 and IAS 10 have not been followed. IAS 1 Presentation of Financial Statements requires that a company’s financial report fairly present the financial position, financial performance and cash flows of an entity. The application of International Financial Reporting Standards, with additional disclosure when necessary, is presumed to result in a financial report that achieves a fair presentation (paragraph 13). Further, IAS 1 para 21 allows that a company can depart from the rules in the extremely rare circumstance that management concludes that compliance with the rules would be so misleading that it would conflict with the objective of financial statements. The bank has taken advantage of para 21in IAS 1 to depart from accounting standards. But whether this action results in a fair presentation is debatable. The bank has taken the position that departure from IAS 39 and IAS 10 is necessary to provide a fair presentation. The auditors have concurred with the company’s view. Observers have questioned the independence of the auditors and the French regulator because they have concurred with the managers’ treatment. We are told that the IAS 1 fair presentation override is rarely invoked in Europe. The article quotes one auditor who said he had not seen it used in 40 years. The issue is politically sensitive, with possible implications for investment in the banking sector and/or French market, so it is possible that the independence of the auditors and the regulator was compromised in this case. 4. Comment on the implications of this case for the consistent application of IFRS in the European Union and elsewhere. This case generated much discussion because it raised the question of whether IFRS could be applied consistently in different jurisdictions. In this case, the bank, its two auditors and the French regulator all agreed with the treatment. However, the treatment was questioned by other parties, such as European auditors and ex-IASB and FASB Board members, who stated that the treatment was a manipulation of earnings. The implication is that the treatment was incorrect and should not have been accepted by the auditors and regulator. Accounting standards are enforced at a national level. Although there are European bodies involved with the co-ordination of enforcement (e.g. CESR), national bodies retain sovereignty. This case is an example of national sovereignty being exercised in the national interest, ahead of the goal of consistent application of accounting standards. Thus, it highlights that consistent application of IFRS and comparable financial reporting is subject to political will and thus is vulnerable to circumstances and personalities. Questions 1. How is the cash outflow of an entity related to expenses? In the ideal case, liabilities are payables whose value is the present value of the future cash outflow of the firm, and expenses are the increase in value of the liabilities. This shows that expenses relate to cash payments. In other words, eventually all expenses are paid in cash. In the real world of uncertainty, expenses are related to the using up of assets and services in the operations of the business. The assets and services are paid for at some time. Under accrual accounting, the payment may be made before the use of the asset or service or at the same time or after. In this sense, we can say that expenses are paid in cash at some point(s) in the life of the firm. 2. What is the ‘monetary event’ associated with the notion of expense? How is the ‘using up of goods or services’ related to expense? The monetary event is the increase in the value of liabilities (or shareholders’ equity) or the decrease in the value of the assets. The monetary event relates to the abstract portion of the definition of an expense — that is, that part which relates to the accounting equation. The reason why the monetary event occurs is that the firm does something to make it happen. In particular, the firm uses up goods (assets) and services. The using up of goods and services refers to the real-world part of the definition of expense. 3. What is the difference between expense and loss? How does the AASB Framework apply to expenses and losses? In the AASB Framework paragraph 70, expenses are defined as follows: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Expenses arise in the course of the ordinary activities include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment (Framework, paragraph 78). Expenses encompass losses as well as expenses which arise in the course of ordinary activities of the entity. Losses may or may not arise in the course of ordinary activities of the entity. However, the Framework states that losses represent decreases in economic benefits and are therefore not different in nature from other expenses. Therefore they are not regarded as a separate element (paragraph 79). 4. Explain the connection between accruals and deferrals on the one hand and the process of matching on the other. Give two examples. Matching is an attempt to deduct the cost of using up assets and services (expenses) with the revenues that were generated (supported) by that ‘using up’ activity. That is to say, matching attempts to associate the real world operations that give rise to expenses and revenues. Abstract Real-world operations Revenue: Inflow (increase) in assets or decrease in liabilities Production or sale of product in current period Expense: Decrease in assets or increase in liabilities Using up of assets and services in support of the production or sale activity Given a certain amount of revenue that is determined by the revenue recognition principle, the matching process focuses on the ‘using up’ operations that helped to generate the amount of revenue recognised in the current period. In the matching process, accruals refer to ‘using up activities’ that occurred in the current period, but which have not been recorded, mainly because they have not been paid. Deferrals refer to ‘using up activities’ that occurred in the current period, but which have not been recorded — mainly because they have not yet been paid. Deferrals refer to ‘using up activities’ that will occur in the future, but which have been recorded (usually as assets) — mainly because they were paid in the current or past period. Accruals and deferrals also refer to revenue, but this question pertains to matching and therefore the focus is on expenses. Accrual accounting and the matching process concentrate on certain operations that, by theory, will generate income. If not for theory, these particular operations would not have such significance. Accruals and deferrals are done because of accounting theory — they are imposed on the actual cash flow to ascertain periodic income according to theory. Examples of accrued expense: Interest, rent, salaries and wages, taxes. Examples of deferred (prepaid) expense: Interest, insurance, rent, wages, taxes. 5. Name the three basic methods of matching. Give an example of each. How do they align with the expense recognition criteria outlined in AASB Framework? The three basic principles of matching are: (1) Cause and effect: cost of goods sold, sales commissions, salaries and wages, certain selling costs (2) Systematic and relational allocation: depreciation, amortisation, depletion, insurance (3) Immediate recognition: R&D, advertising, utilities. Some expense can be said to be due to cause and effect and are immediately recognised — for example, utilities, salaries and wages. The AASB Framework focuses on the recognition criteria more than on matching. The two criteria for the recognition of expenses are stated in paragraph 83: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. For an expense to be recognised in the financial statements, it must meet both of the recognition criteria. These criteria imply that any matching of expenses and revenue is limited by the extent to which the recognition criteria are met. Therefore, under the Framework expenses should be matched to the period in which the asset expiry or liability increase occurs rather than being matched against the revenues that they have contributed to earning. The recognition criteria relate to the outflow of service potential or future benefits having occurred, and the need for the amount to be reliably measurable. The application of the matching concept under the Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets and liabilities. However, the matching concept underpins accrual accounting. Therefore, the Framework recognises the matching concept in paragraph 95 which states ‘Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income’. The matching process involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events. For example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods (paragraph 95). 6. What are some of the problems connected with the cause-and-effect method? On the surface, the cause and effect rule looks reasonable. As certain costs are incurred, these result in revenue. But these associations are difficult to substantiate, although they seem to be very sensible. Critics say that the basis of this rule is costs attach. Since the costs attach theory cannot be verified, then it is not surprising that cause and effect relationships cannot be confirmed. The implication of the rule is that a particular amount of expense can be associated with a particular amount of revenue; but in almost all cases, this cannot be proven. 7. What are some of the problems related to the immediate recognition method? The immediate recognition rule is applicable when future benefits of a given expenditure cannot be measured, except in an arbitrary manner. Trying to decide if future benefits exist or not and estimating the amount is a difficult task. Because of the difficulty involved, expenses can be manipulated. For example, capitalising or expensing the cost of rearrangement of machinery could go either way. In relation to R&D expenditure, AASB 138 requires that research be expensed, but development costs are to be capitalised when certain circumstances are met. Another example is advertising, which is normally expensed as incurred (required by AASB 138). 8. What is the ‘allocation problem’ as argued by Thomas? What is your opinion of this problem? How is it dealt with under the AASB Framework? Thomas argues that allocations are theoretically unjustified, because they do not meet the three criteria he poses: additivity, unambiguity and defensibility. A variety of methods of allocation exist, each of which can be defended, but there is no conclusive way to select one over another. Accountants defend allocations in two ways. First, they say, the allocation patterns reflect the cost of the services received in given periods. Thomas argues that accountants must demonstrate that the service received contributed to a given amount of cash inflows or revenue or cost savings. They can’t, Thomas says, because allocations do not reflect anything real. Also, input patterns cannot be associated with output patterns because of interaction. There is an ‘extra’ amount of output due to interaction that cannot be related to particular inputs. The second way accountants defend allocations is to argue that allocated data are useful. Thomas says people are conditioned to believe such data are useful. The fact that accountants continue to allocate shows that they still believe allocations are meaningful. Whether Thomas is correct or not is debatable. Even if his argument is not accepted, Thomas has made accountants more conscious of the need for evidence to support accounting practices. Under the Framework, the allocation problem is dealt with indirectly. Expenses are determined by reference to assets and liabilities, not costs. As such, and because the Framework encompasses a variety of accounting measurement systems, the allocation problem is not a major concern in the Framework. 9. How has allocation been defended by some researchers? Eckel believes that allocations could be considered rational if the objective of allocations is redefined. Presently, the objective is to determine income by matching (mainly, cause and effect). Eckel suggests that the objective of allocations can be changed to simply the determination of income by the difference between revenue and allocated costs. Callen used ‘Shapley’ values in game theory to show that the interactive element can be dealt with so that allocations of individual input costs can be made rationally. Zimmerman demonstrated that allocations of costs for internal purposes are useful for controlling and motivating managers, and therefore are justified. He showed that cost allocations represent certain hard-to-observe ‘costs’ when managers are given decision-making responsibilities. That is, cost allocations help to lessen some of the problems of control and coordination that arise when managers within the firm are given the right to make certain decisions. Miller and Buckman showed that there is a logical reason for the allocation of fixed costs by a service department in setting a price to charge a user department. 10. Determine whether an asset or expense should be charged for the following, and state your reasons: (a) cost of removing two small machines to make way for a larger new machine (b) cost of repairing a floor damaged when a new machine was dropped while being unloaded (c) cost of a new calculator, $48 (d) cost of major repairs to equipment. The need for repair was discovered immediately after acquisition. There is no warranty on the equipment. (a) It depends. If the estimated salvage value of the two small machines had taken into consideration expected costs of removal so that a net salvage value was used in the calculation of depreciation, then the present cost of removal is an expense. If not, then the cost would be capitalised to the new machinery. (b) Expense. The cost of repairing the floor is not a ‘necessary’ expenditure to acquire the machine or to put the machine in operating condition. The cost is due to carelessness. (c) Expense. The amount is not material. (d) Expense. The company should have inspected the equipment more carefully before purchase. If the need had been discovered, presumably the purchase price would have been reduced to account for the necessary repair. 11. What guidance is provided by the AASB Framework in relation to the convention of conservatism ? The recognition criteria of the Framework are part of a Framework which includes both neutrality and prudence as qualitative characteristics of financial information. The two criteria for the recognition of expenses (paragraph 83) are: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. These criteria should be applied following the principles of neutrality and prudence. The principle of neutrality suggests that to be reliable information should be free from bias (paragraph 36). Further, information is not neutral if by its selection or presentation decision making or judgement is influenced to achieve a predetermined result or outcome. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making estimates under conditions of uncertainty such that assets or income are not overstated and liabilities and expenses understated (paragraph 37). The doctrine of conservatism describes the view that it is better for accountants to err on the conservative side when preparing statements that present a reporting entity’s financial position and performance. By applying this doctrine it reduces the risk of overstatement of net assets and profits of an entity. Australia’s pre-2005 conceptual framework included SACs 3 and 4. These concept statements did not consider prudence to be a qualitative characteristic of financial information. They recommended that financial information should be neutral and free from bias (the neutrality principle stated above). Conservatism was considered a bias and therefore to be avoided. The IASB/AASB Framework is not as strong in its stand against conservatism. Although a more conservative interpretation is permitted under the Framework than under SAC 3 and 4, the Framework does explicitly state that the principle of prudence does not allow the creation of hidden reserves or excessive provisions or the deliberate understatement of assets or income or the deliberate overstatement of liabilities and expenses because this would mean the financial report was not neutral and therefore not reliable (paragraph 37). 12. Standard setters have been criticised for being ‘balance sheet biased’. What does this mean? What evidence is available to support this criticism? Standard setters have been criticised as ‘balance sheet biased’, that is, there is a bias toward the statement of financial position (or balance sheet) rather than the operating statement. The evidence for this view includes the following: (1) revenues and expenses were defined in terms of changes in assets and liabilities (2) the requirement that an item needed to satisfy the definition of assets, liability or equity. Standard setters took the view that the balance sheet should contain only items which met the recognition criteria for assets and liabilities. Some deferred assets and liabilities could no longer be recognised. (Previously deferrals had been used so that the effect of certain events in the operating statement could be recorded over a number of reporting periods.) It was argued by the AASB that defining revenues and expenses in terms of changes in assets and liabilities provides a framework for reporting those elements according to their economic substance, and limits the scope for bias in the reporting of revenues and expenses. The Board also maintained that the recognition criteria for revenues and expenses cannot be applied independently of the recognition criteria for assets and liabilities if the operating statement and the statement of financial position are to appropriately link with each other. Hence the criteria for recognition of assets and liabilities ‘drive’ the application for the criteria for recognition of revenue and expenses. 13. Explain the arguments for and against expensing share (stock) options. The arguments commonly proposed for the recognition of assigning share options to employees as an expense, include: 1) They are basically another component of salary expense and should be recognised as such. 2) There is a legal obligation created at the point that the options are assigned and this requires recognition. 3) It would provide a clear indication to all stakeholders as to the full remuneration costs of management and the incentives such options create. Arguments against include: 1) There is no expense until the option is actually exercised and the option may never be exercised. 2) Options are difficult to value. How do we decide what value to ascribe to the option? 14. Leonard Ltd is a small firm. For the 6-month period ending 30 June of the current year, it made sales totalling $40 000. These sales were on credit and were all made in the last 4 months. To determine its bad debts expense, it uses an ageing schedule of accounts receivable that has proven to be relatively accurate. For the 6-month period, the following calculation was made of accounts receivable multiplied by the uncollectable percentage: There was no remaining balance in Provision for Doubtful Debts at the end of the 6-month period. Leonard Ltd recorded $1560 as a bad debts expense, which was one of the expenses deducted from sales revenue of $40 000 on the income statement. Is the $1560 the proper amount of expense to match against the $40 000 sales revenue? Explain. Where the Provision for Doubtful Debts is inadequate, leading to a significant expense affecting current year profits but relating to revenue from a previous period, is it consistent with the matching concept to write off the debt in the current period? The bad debts estimate is based on accounts receivable, a statement of financial position account. This is an acceptable procedure. Since the estimate is based on accounts receivable rather than on sales, the bad debts expense does not match well with the sales revenue for the current period. Receivables in this problem include those that were from sales made in the previous 6-month period. The sales for the current period were all made in the last four months, and therefore proper matching would call for bad debts expense related to sales made in the last four months. Bad debts expense is considered a cost of generating credit sales. Two ways of ascertaining the amount exist: the statement of financial position approach (% of accounts receivable) and the income statement approach (% of sales). Logically, only the latter method would give a proper matching. 15. Decide whether the following expenditures should be put into an asset or expense account: (a) The cost of an insurance policy, which had been purchased by Y Ltd to cover goods in transit to the company from suppliers for the current year. (b) The salary for the general manager in charge of plant operations for Z Manufacturing Ltd. The cash component of the salary is $100 000; employer-contributed superannuation is $20 000, and the general manager is offered 40 000 share options in the company to be exercised after 2 years at 50% of the market value of the shares at the date the options are exercised. Cover each component of the general manager’s remuneration in your answer. (c) The legal fees incurred in the unsuccessful prosecution of a patent infringement suit. (d) The fees paid to a consultant who designed a more efficient layout for plant operations. (e) The fees paid to an underwriter for handling the share issue when T Ltd was first established. (a) Capitalise to purchases or inventory. The cost of the insurance is a ‘necessary’ business expenditure to acquire merchandise. (b) The salary of the general manager is considered a general administrative expense. It does not qualify as direct labour for product costing nor overhead, because the general manager is not involved in the actual manufacturing process. (c) This is an expense because the case was unsuccessful. (d) It depends. Theoretically, since the layout is more efficient (greater productivity), the cost should be placed in an intangible asset account. But the materiality of the amount should be considered — if small, expensing would be justified. (e) This would be part of establishment costs, which are an intangible asset. 16. The following items are typical expenses. Identify the asset or service that is used up: (a) income tax expense (b) interest expense (c) cost of goods sold (d) warranty expense (e) goodwill amortisation expense (f) research and development expense (g) life insurance expense (on life of chief executive) (h) superannuation expense (i) rates expense. (a) Government services, such as protection from foreign powers, etc (b) Cash borrowed (c) Inventory (d) Service to make good the deficiency of the product sold (includes labour, parts) (e) Goodwill (intangible factors that create superior earning power) (f) Services expended doing research and development (includes labour and assets such as equipment) (g) Service of insuring against any loss to company during the past period, because of death of chief executive (h) Services of employees rendered during the past period, but this portion is payable to them after they retire (i) State government services, such as fire and police protection. 17. An entity receives 100 emission trading allowances from the government. It purchases an additional 50 allowances for $3,000 each. (a) What is the average cost of the allowances? What journal entries are required to record these transactions? The total cost of the 150 allowances is $150,000. The average cost is $1,000 each. DR Inventory – emission allowances 150,000 CR Cash at bank 150,000 (b) How should the entity record sale of one allowance for $4,000? What entry is required if the entity uses all 150 allowances? The entity should reduce inventory by $1,000 and record a profit of $3,000. DR Cash at bank 4,000 CR Profit on sale of emission allowance 3,000 CR Inventory 1,000 If all 150 allowances are consumed: DR emission trading expense 150,000 CR inventory – emission allowances 150,000 PROBLEMS Problem 10.1 Discuss the accounting treatment for expenses related to share options, patents, development expenses, goodwill impairment, depreciation of trucks and equipment, maintenance expenses, storm damage, changes in estimates for depreciation, advertising expenses, warranty expenses, loss on purchase commitments, long-term contracts, exchange of non-monetary assets, provision for doubtful debts, and the donation of a building. Include explanations for determining economic life, estimating service costs, and capitalization decisions. 1. An expense representing the fair value of the options issued must be recognised in the financial statements. An expense is recorded at grant date and over the life of the options. Estimated fair value of options at exercise date is 10 000 shares at $250 = 2 500 000 less cash payment on exercise $1 800 000 = 700 000. Spread over three years = $233 333 per annum. Therefore expense to be recorded in each of the three years: Employee benefit expense $233 333 Share options $233 333 2. Patent $64 000 Cash $64 000 Amortisation Expense 4 000 Patent 4 000 The journal entries are simple enough to record, but how does one determine the economic life of eight years? How do we know that a good estimate of the cost of the services provided by the patent is $8000 a year? How do companies arrive at their estimates? 3. Development Expense $140 000 Cash, etc. $140 000 Development expenses written off, assuming criteria of AASB 138 paragraph 57 are not met. Some students may capitalise the development expense on the assumption that the criteria are met. Patent 13 600 Cash 13 600 The economic life of 20 years implies future economic benefits which are expected to exceed the cost of the patent. An asset is recognised and amortised over its legal life (paragraph 94). Amortisation Expense (3/12 $800 a year) 200 Patent 200 If development expenses been capitalised, the amortisation expense would be $1920 rather than $200. 4. According to AASB 3, goodwill is not amortised but tested annually for impairment. Ryder must review goodwill for impairment as per AASB 136 (paragraph 12). If an entry is required, it would be: Dr Goodwill impairment xxx Cr Goodwill xxx to write down goodwill to cost less any impairment losses. 5. Depreciation Expense of Trucks $18 000 Accumulated Depreciation $18 000 $35 000 5 trucks = $175 000 $175 000 less $25 000 salvage value = $150 000 $150 000/1 000 000 miles = $0.15 a mile $0.15 120 000 actual miles = $18 000 Depreciation Expense — Equipment $500 000 Accumulated Depreciation $500 000 The amount of depreciation of the trucks was affected by the strike, since the trucks were not used for three months. The amount of depreciation of the equipment was not affected by the strike, because the straight-line method is based on time rather than use. Both methods are acceptable. The depreciation for the trucks could have been on a straight-line basis, and the equipment could have been on the service basis. If so, the depreciation recorded for the trucks and equipment would have been different from that actually recorded. For example, for the trucks, depreciation under straight-line, based on five years, would have been $30 000 instead of $18 000. Both figures are correct, in the sense that both are based on accepted methods of calculation. But the effect on income is quite different. 6. Is this to be capitalised or not? Two factors should be considered. First, when the company estimated the economic life of the building, say, at 20 years, did it expect that the building would be painted in order that it last for 20 years? The answer should be yes; and therefore, the expenditure should be maintenance expense. The second factor has to do with the materiality of the amount. If it is not material, not expensing it confirms the previous conclusion. If material, then capitalising would be acceptable. Maintenance Expense $20 000 Cash or Accounts Payable $20 000 The entry shows the amount to be expensed, but if someone or the company insisted that it be capitalised, it would be difficult to say that capitalisation is incorrect. 7. Write down due to storm damage $50 000 Building $50 000 The amount must be recorded as an expense in the income statement. AASB 101 does not permit items to be as extraordinary (para 85). If an item is material its nature and amount should be separately disclosed (para 86). 8. 2005 2004 2003 Depreciation — new method $19 200 $24 000 $30 000 Depreciation — old method 15 000 15 000 15 000 Decrease in Income $4 200 $9 000 $15 000 Depreciation Expense 4 200 Cumulative Effect Due to Change 24 000 Accumulated Depreciation $28 200 Discuss whether the 2005 income be decreased by $24 000 for the effect of the change pertaining to 2004 and 2003. Does it reflect the matching principle or expected future useful life or the warehouse? 9. Legal settlement $125 000 Cash $125 000 The legal settlement is recorded as an expense of the current year. Although the case was initiated in 2004, adjustments to prior period’s retained earnings are not permitted except in limited circumstances (AASB 101 paragraphs 98–100). 10. This is a change in estimate. $300 000/20 years = $15 000 a year $15 000 10 years = $150 000 accumulated depreciation $150 000 book value on 1 Jan. 2010/20 remaining years = $7500 depreciation a year. Depreciation Expense $7 500 Accumulated Depreciation $7 500 Is the amount of $7500 proper matching of depreciation? If the company had correctly determined its estimated life at the very start, depreciation would have been $10 000 a year (= $300 000/30 years). 11. It is conventional to expense advertising expenditures, because of the difficulty of measuring the future benefits. Despite the fact that the benefits are acknowledged, the uncertainty of the length of time would only make allocation arbitrary. Advertising Expense $200 000 Cash of Accounts Payable $200 000 AASB 138 does not permit capitalisation of advertising expenditure. 12. For the sake of matching, we are willing to estimate and guess at the future amount of the repair cost. There should be past experience to give us a basis for this estimate. Warranty Expense $68 000 Estimated Liability on Product Warranty $68 000 13. On 31 December 2009, the following entry is to be made: Loss on Purchase Commitment $90 000 Liability from Purchase Commitment $90 000 This is a promise in exchange for a promise. The transaction of purchasing the material will occur in 2010, but because of conservatism we anticipate and record the loss now (7500 tonnes $12 = $90 000). Since the transaction has not occurred yet, the matching principle is violated by recording the loss now. This entry shows that conservatism is more important than matching. 14. (a) Construction in Progress $424 000 Cash, Materials, etc. $424 000 (b) Accounts Receivable 350 000 Partial Billings 350 000 (c) Cash 310 000 Accounts Receivable 310 000 (d) Loss on Long-term Contracts 10 000 Construction in Progress (or a liability) 10 000 $424 000 actual costs incurred 106 000 expected costs to complete $530 000 total costs 520 000 contract price $ 10 000 loss Again, because of conservatism the loss is recorded now. According to the completed contract method, there is no revenue until the project is completed; yet, a loss is recorded now when the project is not completed. 15. The new asset has a more objectively determinable fair value; therefore, the loss is calculated as follows: Value received: fair value of new asset $50 000 cash 5 000 $55 000 Value given: book value of old asset 70 000 Loss $15 000 Cash $ 5 000 Machine (new) 50 000 Loss on Exchange 15 000 Accumulated Depreciation 20 000 Machine (old) $90 000 A loss is always recorded in an exchange of non-monetary assets. 16. First debit the provision for doubtful debts. Since the amount is large, it will be greater than the provision so the excess must be charged to bad debts expense. The amount may be separately disclosed because it is material. Bad Debts Expense/ Provision for Doubtful Debts $60 000 Accounts Receivable $60 000 17. The building must be recorded, and accumulated depreciation against it should be recorded over the life of the building. But depreciation should be offset in some way, because really there is no ‘cost’ to the company. 2 Jan. 2009 Land $300 000 Building $100 000 General Reserve $400 000 31 Dec. 2009 General Reserve 10 000 Accumulated Depreciation 10 000 or Depreciation Expense 10 000 Accumulated Depreciation 10 000 General Reserve 10 000 Revenue (donation) 10 000 Problem 10.2 Mangold Ltd received several donations. Record the journal entries for the following events: 1. Cash of $10 000 is received from a shareholder as a donation. 2. The cash donation is used to pay salaries and wages expenses. 3. Equipment is received at the beginning of the year from Lin Pty Ltd as a donation. The fair value is $20 000. The carrying amount for Lin Pty Ltd is $15 000. Estimated useful life at the time of receipt of the equipment is 10 years. 4. The equipment received from Lin Pty Ltd is used in operations for the year. 5. Land is received from a shareholder as a donation. The fair value is $50 000. 6. The land is sold for $55 000. Solution 1. It is conventional that when cash is received as a donation, to consider this to be other income, because it can be used immediately in the business. Cash $10 000 Other income $10 000 2. Salaries and wages expense 10 000 Cash 10 000 Notice that although other income is offset by the expense the net income is affected by the donation. If not for other income, the net income for the period would have been less. 3. Although there is no cost, the company does have an asset that should be recorded. Equipment 20 000 Revenue 20 000 4. Journal Entry Depreciation Expense 2 000 Accumulated Depreciation 2 000 5. Land 50 000 General Reserve 50 000 6. Most accountants would record the following entry: Cash 55 000 Land 50 000 Gain 5 000 Problem 10.3 The Flying Fox Group of companies owns the tollway from the centre of a major city to the airport. Under the agreement with the state government, Flying Fox must upgrade the road every 10 years. Flying Fox has established a provision account to allocate the future cost of upgrading the road over the next 10 years. Outline the accounting entries to provide for such a provision. Is this approach consistent with the matching principle? How does this approach relate to IAS 16/AASB 116 Property, Plant and Equipment and IAS 37/AASB 137 Provisions, Contingent Liabilities and Contingent Assets? Solution Accounting entries: Dr Maintenance Expense Cr Provision for Maintenance When the maintenance expenditure is incurred then: Dr Provision for Maintenance Cr Cash This approach is inconsistent with the depreciation approach adopted under historical cost in that there is a systematic write-down of value; however, the maintenance provision indicates that there will be an extension or at least maintenance of value. Perhaps the provision for maintenance is sufficient; however, the HC system requires the systematic allocation of depreciation. Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152
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