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Chapter 8: Liabilities and owners’ equity THEORY IN ACTION Theory in Action 8.1 Entity vs Proprietorship Perspective 1. Explain the ways in which Barclays Bank has increased its equity in the past year. Why is raising more equity important in the 2007-2008 economic conditions? The bank conducted a capital raising with investors from the Middle East, that is, it issued new shares in return for cash. The issue of new shares increases equity. In addition, the investment banking business of Barclays acquired the US assets of Lehman Bros. The acquisition generated revenue, which flows through to retained profits and thus increases equity. The bank sought to increase equity as a result of the 2007-2008 global financial crisis. In the crisis, liquidity dried up as banks stopped lending. In the period prior to the crisis banks had extended credit to risky parties and with the financial collapse, some of these loans were written off by banks thus depleting equity. Reduced equity meant that banks could not advance loans until equity was built up again. Banks breached their capital adequacy requirements i.e. the amount of capital to be held compared to loans made, according to banking regulatory requirements. 2. Describe the process by which the sale of its funds subsidiary iShares could ‘boost capital reserves further’? Barclays has a listed subsidiary iShares. If the company sells its interest at a profit the journal entry would be: DR Cash CR Gain on sale CR Investment in iShares The gain on sale flows through the income statement. It increases net profit which then increases retained profit which forms part of share capital and reserves. Thus the sale of iShares can be said to boost ‘capital reserves’ or the owners’ equity interest. 3. Does the writer of the article take an entity view or proprietorship view of Barclays Bank? The writer seems to take an entity perspective in relation to the bank. Several statements refer to the bank as an entity separate from shareholders (e.g. the bank has sufficient capital; the bank is boosting its reserves). The bank’s investment banking business is described as purchasing Lehman Bros, rather than describing the transaction as the existing shareholders making an investment. 4. Could the proprietorship perspective apply to Barclays Bank if the UK government took an ownership (equity) interest in the bank, as occurred at Royal Bank of Scotland? The proprietorship perspective could apply if the government took an ownership interest in the bank. (Background: Following on from the sub-prime crisis in the USA in 2007 and the more general global financial crisis in 2008, many financial institutions were affected by bad debts, leading to large losses, an erosion of equity and consequently reduced lending by banks and a freezing of liquidity in capital markets. In some cases, governments intervened to inject capital into banks and to provide funds for borrowers. In 2008 the UK government acquired an 80% ownership interest in the Royal Bank of Scotland). In Q3 we saw that the writer described the bank from an entity perspective, where the entity is separate from its owners and the accounting is conducted from the point of view of the entity. If the UK government had a majority ownership stake in Barclays, the proprietorship perspective would become relevant. The Government would be interested in the value of its investment, represented by the proprietorship of the company. If the Government influenced operating decisions of the bank through its majority stake, for example by appointing directors, then there is further evidence that the proprietorship perspective applies, because the bank’s assets (less liabilities) belong to the proprietor (in this case the Government) and the income generated by the business also belongs to the Government as the major shareholder. Theory in Action 8.2 New public-private flexibility 1. Describe what is represented by a public-private partnership project (PPP)? A public private partnership represents a contractual arrangement between a government controlled or funded entity (a government department, instrumentality, agency or government business enterprise) and a company (a private or public company, i.e. a company in which individuals, companies, funds or the general public own shares, not the government). The parties enter into a contract for the construction and/or operation of a public-use asset. For example, a prison could be built using a public private partnership. The government and company may jointly obtain the finance for construction, which is undertaken by a private sector agency. The asset may subsequently be operated by the private sector company, on behalf of the government. The project may benefit from government access to lower cost finance (based on the government’s credit rating; the government is likely to be considered lower risk than most private companies). It also benefits from the skills, expertise and efficiencies that the private sector company can bring to the project. However, PPPs may present some specific problems in relation to legal complexity, accounting, governance and management which can affect their success. 2. What is meant by the phrase ‘Off-balance sheet’ liabilities? ‘Off-balance sheet’ liabilities refers to liabilities which exist for the entity but are not shown on the balance sheet. That is, the liabilities meet definition and recognition criteria of the IASB Framework (i.e. a present obligation to an external party for outflow of economic benefits in the future, which is probable and can be measured reliably) but because of current accounting practices and standards, entities are permitted to not recognise the liabilities. Leases are a classic example. Leases may involve lease liabilities which should be recorded on the balance sheet, but IAS 17 allows companies to classify leases as operating and to not recognise a liability on the balance sheet. 3. Why did the government favour public-private partnerships (PPP) which allowed debt to be off-balance sheet? The incentives for a government body to have liabilities ‘off-balance sheet’ are similar to those for a company. If the liability is not shown on the balance sheet, total reported debt is lower. Liquidity ratios are higher and debt (leverage) ratios lower. The entity can access more capital and at a lower price because the entity’s risk appears relatively lower than it actually is. The article states that governments chose the ‘off-balance sheet’ model so as to report lower borrowing State Government borrowing levels and to support credit ratings (i.e. to ensure that credit rating are at the highest possible level). 4. Explain the reasons in favour of recording economic infrastructure PPP projects on government balance sheets. The article states that following adoption of IFRS, some government bodies re-classified PPPs as finance leases and then recorded the lease asset and liability on balance sheet. The benefit of recording assets and liabilities on balance sheet is to improve transparency and improve the information available to assess the position and performance of the government entity. Better information is provided when liabilities are on balance sheet. Stewardship can be better assessed and cash flow predictions may be better. Information available for decision making is of higher quality when liabilities are accurately recognised, potentially leading to better decision making by a range of stakeholders. PPEs are by their nature complex. To determine whether the PPE is successful, reporting should be transparent to allow users to determine the costs and benefit of the contracts. The basis of accounting decisions should be disclosed (i.e. areas of estimation and judgment) to ensure information users are informed. Theory in Action 8.3 Contingent Liabilities 1. Name the parties listed in the note that are taking legal action against the PTA. State the matters or matters under dispute and the amount of the claim if provided. Parties bringing legal action Matter under dispute Amount of claim 1. Leighton Contractors Rise and fall provisions and contaminated material provisions $64 million 2. John Holland Ltd Relates to construction of three stations on the Southern Suburbs Railway $6.89 million 3. RailLink Joint Venture Relates to civil, rail and structures portion of the Southern Suburbs Railway $2.62 million 4. Leighton Contractors Misleading and deceptive conduct in relation to contracts work insurance Not stated 2. To what extent has the PTA incurred losses of economic benefits in relation to these matters? All the matters are under dispute. The PTA states in the note that it denies all liability (items 1 and 4) and that it is defending the claims (items 1 - 4). At the time of the annual report, losses of future economic benefits have not occurred but there is a possibility that they may occur in the future. For this reason, the PTA provides information about the legal claims in progress. The claims are contingent liabilities because they meet the definition provided in IAS 37 (preface) which defines a contingent liability as: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability. The items disclosed in PTA’s note fit this definition. They relate to past events, but a liability will only come into existence if an event occurs, namely judgment against PTA. 3. “Contingent liabilities are not liabilities of an entity; in fact, they may never eventuate so their disclosure is misleading.” Explain whether you agree or disagree with this statement and provide reasons for your view. The statement is correct when it states that contingent liabilities are not liabilities. They are not liabilities because they do not meet the Framework definition and recognition criteria. In relation to these pending legal cases, there is no present obligation to an external party because the decision about the case has not been reached. When the case is decided, a liability may come into existence, if the decision is against PTA. The disclosure of contingent liabilities should not be misleading. The Framework assumes that users have “a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence” (para 25). Therefore, users should be able to interpret the word contingent and the associated disclosures. It is true that contingent liabilities may never eventuate. Nevertheless, they may do so. The fact that they may eventuate means that they are of interest to users of financial reports. Without information about contingent liabilities, users may be misled about the future position and performance of the entity. 4. The PTA is a government business enterprise, with one shareholder, the Western Australian State Government. Discuss whether disclosure of contingent liabilities is less relevant for the PTA than for a publicly listed company with widely held shares. The PTA may have only one shareholder but it has many stakeholders. These include employees, lenders, creditors and members of the public, which includes taxpayers who provide finance to the entity. All these parties have interests in the future position and performance of the entity and therefore need to be informed about contingent liabilities. These parties cannot obtain information directly from the entity and are therefore dependent on public information. The Framework explicitly states (para 9) that there are many users of financial information other than shareholders. Therefore, one cannot claim that disclosure is less important for a government business enterprise than a listed company with widely held shares. Theory in Action 8.4: Hybrid Securities 1. Outline the debt and equity situation of Orica at the time of the purchase of Dyno Nobel in 2005. Orica had already used debt to fund acquisitions and investments. It required funding for the Dyno Nobel acquisition but it also wanted to protect its BBB+ credit rating, which could have been put at risk through more borrowing. Orica had raised $500 million in equity through a rights issue. Issuing more equity would have been costly and reduced its earnings per share, a key performance metric used by analysts. In addition, equity finance is considered the most expensive form of finance and therefore the least attractive. 2. Describe the features of Step-Up Preference Securities (SPS) created by the company. Step-Up Preference Securities (SPS) are hybrid securities with specific features. Payments to investors are discretionary but can only be suspended if all dividend payments are suspended. The securities are perpetual, but they can be redeemed by Orica at the end of 5 years. If the securities are not redeemed, the interest rate will increase by an additional 2.5 per cent. 3. Explain how the securities can be considered as equity for accounting purposes but as debt by investors? The article states that SPS were treated as equity for accounting purposes but were treated as subordinated debt by investors. The article states that the securities can be considered ‘intermediate equity’, that is, in some middle ground between equity and debt. The Framework definition of equity is “the residual interest in the assets of the entity after deducting all its liabilities” (paragraph 49(c)). Therefore to classify the SPS as equity, the company had to demonstrate that the securities did not meet the definition and recognition criteria of a liability. A key feature of the SPS is that payments to holders are discretionary, meaning that the company does not have a present obligation to sacrifice future economic benefits. In addition, the company is not obligated to repay the holders. Therefore the company could classify the securities as equity. Their issue does not increase debt and therefore has no impact on credit ratings. Because of the features of the issue, the interest rate was 6.98% only marginally more than 6.25% that BBB+ rated corporates were paying at the time, hence the company described the securities as ‘cheap equity rather than expensive debt’. However, the securities had restrictive features which made them attractive to lenders. First, lenders will receive payments unless dividends are suspended, which the lenders may view as unlikely. So while payments are not guaranteed, lenders are confident they will receive them. Second, lenders are not guaranteed that repayment of principal will be made in five years, but if it is not, they will receive additional repayments (the interest rate payable increases by 2.25%). CASE STUDIES Case Study 8.1 Disclosure of Environmental Liability 1. The article states that the US standard setter FASB requires companies to record provision in relation to environmental costs of retiring an asset (‘to reserve environmental liabilities’) if its fair value could be reasonably estimated. How do you think companies would go about estimating such a provision? To estimate a provision for the cost of retiring an asset the company would engage suitably qualified personnel (e.g. environmental engineers, builders) to estimate the cost of removing and disposing the materials of which the asset was constructed. Next they would estimate the costs involved in restoring the land on which the asset was based. The date that the costs are expected to be incurred would be determined. Cost accountants would work with these predicted future expenses to estimate the present value of the outflows and to arrive at the amount of the provision to be recognised in the accounts. 2. What aspects of the requirements were used by US companies to defer recognition of a liability? Why would companies want to do this? The US requirement stated that a provision was to be recorded in the accounts if its amount could be reliably estimated. Some companies responded by stating that they could not reliably estimate costs and therefore they avoided recognition of the provision. A reduction in profit and an increase in liabilities which result from recognising a provision may not be viewed favourably by managers because of the impact on share price, financial ratios and remuneration. Students should consider the incentives at play behind decisions to record (recognise) an item in the accounts or to disclose information. 3. In what ways does the recognition of the liability in relation to future restoration activity affect (a) net profit and cash flow in the current year and future years; and (b) liabilities in the current and future years? A provision for restoration involves the following journal entry to initially raise the provision: Year 1 DR Restoration expense Year 1 CR Provision for restoration. It reduces profit (by creating a restoration expense) but not cash flow in the year it is recorded. It increases liabilities in the year it is recorded. In the future when the liability is settled, the following journal entry is recorded Year x DR Provision for restoration Year x CR Cash There is no effect on profit but there is an outflow of cash for the amount of the restoration expense. At this time the liability is reduced. The entries are basic accrual accounting. Students should refer to discussion in the chapter about IAS 37 and the limitations on the use of provisions. 4. The article refers to changes in disclosure requirements relating to environmental liabilities in many countries around the world. How important is it that companies recognise the liability? To what extent is disclosure about the liability sufficient? Ideally, accounting measures transactions and reports information which is useful for decision making. One argument is that as long as information is disclosed, users can factor it into their decision making. That is, disclosure is sufficient for competent users. As long as they are aware of the amount and timing of the expected outflow of future economic benefits they can include it in their models predicting cash flows and profit and make informed decisions. Recognition of the amount in the accounts is not necessary. However, the counter argument is that less attention is given to note disclosure by users and auditors compared to when items are recognised. Potentially, users could miss the information if it is not recognised in the accounts and they focus on amount recognised in the accounts. One view is that companies may give lower importance to amounts which are disclosed (not recognised). When an amount must be recognised, it has economic consequences which will ensure that managers give close attention to the management of the underlying item. That is, if amounts are included in the accounts, managers will endeavour to make accurate assessments of these amounts. Remember that accounting is a means of holding managers accountable and recognition of liabilities is a more effective way of doing this than simply disclosing an item. In addition, research shows that auditors apply stricter tests and closer scrutiny to amounts which are recognised compared to those which are disclosed. Case Study 8.2 Post-retirement employee benefits PART A 1. Compare BT’s pension liabilities and market capitalisation at December 2007. What are the implications of what you observe? BT has pension liabilities of ₤39 billion, which exceed the market value of the company (at December 2007 ₤18 billion). The implication of these numbers is that the company would be unable to meet the pension commitment if it was required to do so at December 2007. Even if liquidated, the company could not meet its pension commitment, which exceeds the value of the company. Hence, BT has been described as UK’s biggest pension fund which happens to run a telecom business. The point of this comment is that the pension liability could overwhelm the business, which is not a favourable position for a company. The members of the fund are also at risk of not receiving their entitlements. 2. Should changes in pension assets and liabilities be included in net finance income? Giver reasons for your answer. The question is whether finance income and finance expense relating to the pension plans are expenses of the business. If we consult the IASB Framework, we can see that these items do represent revenues and expenses of the business because they represent future inflows and outflows of economic benefits which relate to past transactions or events. It is probable that they will occur and we can estimate their amount. While it could be argued that the pension plan is not part of core business operations for the telecom company, the plan is part of daily business operations in the sense that it is part of the employees’ remuneration. Employees would want the net assets of the plan to be recognised by the company to ensure that employees’ interests are protected. Investors would also want to see recognition of assets and liabilities relating to the plan so that future commitments are fully disclosed. If assets and liabilities are recognised in the accounts, then it follows that net income derived from the change in the assets and liabilities should also be recognised. Poor performance in equity markets since March 2007 means that returns on the pension assets are low. If the loss on plan assets is included in finance income in the 2008 accounts, it is predicted that BT’s pre-tax profit will be ‘wiped out’. These statements show the severity of the problem, which needs to be clearly disclosed to protect the interests of employees and investors. Revealing the problem means that action must be taken to address it. Omitting an amount from the accounts so that they will ‘look better’ does not suggest sound economic management of the business. 3. The company has a pension asset/liability mismatch because it holds mainly equities not long-dated bonds in its pension plans (pension asset portfolio). Explain the risk of this approach. The company needs long-dated bonds to provide the cash flow to meet its current and ongoing pension commitments, which are a long term commitment. In fact, it needs ₤28 billion of 5% yield bonds just to meet is current pension commitments but it has only ₤8 billion on hand. The collapse of asset prices in equity markets from 2007 means that the company is limited in the extent to which it can sell equity securities to purchase the amount of long-dated bonds needed. These numbers reveal the riskiness of the company’s position: it must use operating cash flow to meet annual pension commitments as the pension assets do not generate sufficient cash flows to meet obligations. If the company uses operating cash flows to pay pensions then such cash flows are not available to finance the business. 4. Companies must make assumptions when measuring the value of pension assets and liabilities. Assume you are an investor in BT. What information do you require about the assumptions made by the company? Measuring the pension assets and liabilities is a complicated process involving market data, price estimations and actuarial assumptions (assumptions made by actuaries about life expectancy of fund members). The company employs suitably qualified experts to provide actuarial assumptions and it also collects other data about actual and estimated market prices for equities and bonds. The superannuation liability relates to an amount to be paid in the future, so estimations of future interest rates and market returns must be made. An investor would be interested in disclosure of the assumptions made in estimating the liability (e.g. assumptions about future interest rates) because a small change in assumptions can have a large impact on the amount of the liabilities. Investors may be interested in disclosure of a range of estimates (a sensitivity analysis) and information about the likelihood of factors occurring which will cause interest rates to change. PART B 1. What has caused the large increase in unfunded superannuation (pension) liabilities during the period July – December 2008? During the period July – December 2008 capital markets throughout the world experienced falling share prices as part of the ‘global financial crisis’. Many Australian superannuation funds hold investments in the Australian share market. As the market crashed, the value of these investments declined creating the ‘unfunded’ liability, i.e. the superannuation fund liability was greater than the amount of the superannuation assets held by the fund. In addition to the value of assets falling, the value of liabilities also increased. During the period July – December 2008 funds were also affected by the decline in interest rates. The 10 year government bond yield fell from 6.5 per cent to 4 per cent. Therefore present value of the future liability of the superannuation funds increased. In present value terms, more money is required to settle a future liability when the interest rate is lower because the amount which can be earned over time on investments and used to settle the liability is less. 2. Should the unfunded superannuation liability be shown on the balance sheets of companies such as Qantas, Telstra, Rio Tinto, Westpac, BlueScope Steel, Amcor and ANZ? The ‘unfunded liability’ meets the definition and recognition criteria in the IASB Framework. The liability represents a present obligation to an external party i.e. a currently in force legal, moral and equitable obligation of the company to ensure that the superannuation fund has sufficient resources to pay benefits to members. There will be a future outflow of economic benefits (resources used to top up the shortfall in fund assets) which can be measured reliably. Measurements techniques include calculating the fair value of plan assets based on observed market values or estimations of market value and estimating the present value of plan liabilities using present value techniques. 3. What are the implications for employees of belonging to defined benefit schemes? What are the implications for employers of providing defined benefit schemes? In a defined benefit fund, employees expect a certain amount for retirement e.g. a specified percentage of final average salary. The amount is not affected by share market movements or earnings on investments, so members do not benefit when share prices or interest rates increase and, equally, they are not adversely affected when they decline. When they offer a defined benefit fund, employers are committed to providing a specified amount of employment benefits. If the value of investments held in share markets has declined or interest earned on investments is lower, the companies must fund the superannuation fund liability from other sources besides the fund assets. 4. Why are defined benefit funds being phased out and replaced by defined contribution schemes? In defined contribution schemes employees are entitled to receive the amount of contributions (from employee and employer) and the earnings on the contributions. When markets perform well and assets increase the employees receive the increase in value, but when markets decline and/or the superannuation fund investments lose money, the loss is borne by the fund members (employees) not the employer. Australian companies favour defined contribution schemes because investment risk is borne by the employees. QUESTIONS With respect to the proprietary theory: (a) What is the objective of the firm? (b) How important is the concept of ‘stewardship’? (c) What is the relationship between assets/liabilities and the owner? (d) How would you define revenues, expenses, profit? (e) What are three effects on current practice? (f) What are the theory’s limitations? (a) The firm essentially is the proprietor. The firm is simply the proprietor’s instrument to achieve his or her purpose, which is to increase his or her wealth. Income represents the increase in the wealth of the proprietor in a given period. (b) Stewardship is relatively unimportant, because accountability to outside parties is not critical. The proprietor is, in effect, the firm, and therefore is in a privileged position to know what is happening. Liabilities are usually short term, and therefore there is no need to give a continual accounting to creditors. (c) The assets are ‘owned’ by the owner, and the liabilities are ‘owed’ by the owner. This shows that there is no separation between the firm and the owner. In the accounting equation, P stands for the net worth of the owner. A – L = P (d) Revenue is the increase in proprietorship; expense is the decrease in proprietorship; and profit is the net effect of proprietorship, excluding additional investments and withdrawals by the owner. Revenue and expense accounts are truly subsidiary accounts of P. They have the same algebraic characteristic as ‘net worth’ — increases in net worth are credits and decreases in net worth are debits. The proprietary theory focuses on P in viewing income. Revenues and expenses are caused by the decisions and actions of the proprietor. The profit of the firm belongs to the proprietor and that is why P is affected in the accounting equation. (e) The following are examples of the effect of the proprietary theory on accounting practice: Dividends paid are a distribution of earnings, not an expense; and interest charges are an expense. In a sole proprietorship or partnership, salaries to owners who work in the firm are not considered an expense of the business. The reason is that the firm and the owner are not separate entities; they are the same. The equity method for long-term investments focuses on the proprietary interest of the investor company in the invested company. The parent company theory for consolidating financial statements views the parent as ‘owning’ the subsidiary. Minority interest is considered an ‘outside’ claim, and logically should therefore be a liability on the consolidated statement of financial position. The pooling of interests method for business combinations emphasises the uniting (pooling) of the owners’ interests of the two combining companies. Common terms used reveal the proprietary interests of owners are: book value per share, earnings per share and income to shareholders. The use of the consumer price index for general price level adjustments shows that the ‘consumer desires’ of owners are considered. The financial capital view is pertinent to owners. (f) The proprietary theory does not accord with the realities of the large corporation. The law recognises the corporation as a separate entity, distinct from the owners. The corporation — not the shareholders — owns (controls) the assets, and is liable for the debts. For the large corporation, withdrawals of cash or other assets by shareholders cannot be made without running afoul of the law. This shows that the ownership rights of shareholders are limited. Accountability to shareholders is significant; otherwise, shareholders have no knowledge of the status and operations of the business. The assumptions of the proprietary theory are not relevant to the shareholders of large firms. With respect to the entity theory: (a) What are the reasons for concentrating on the entity as a unit of accountability rather than the proprietor? (b) What is the objective of accounting? (c) How important is the concept of ‘net worth’? (d) What is the reason for modifying the accounting equation to Assets = Equities? (e) On what side of the equation in (d) would retained profits appear? (f) Why is there a stress on profit determination? (g) How do the concepts of revenues, expenses and profits differ from the proprietary theory? What about interest charges, dividends and income tax? (h) What are three effects on current practice? (a) Emphasis is on the entity, because in the 20th century the separation of owners from management in the corporate form of business is common. Shareholders of large corporations have little power to make decisions for the company. The corporation, the entity, has a life of its own. It is therefore more realistic to view the entity as the unit of accountability — that is, to see the accounting process from the point of view of the entity. It is the entity (through its management) that has the power to make decisions that affect the financial status and operations of the business. (b) Stewardship or accountability to equityholders is of primary significance. The entity needs to account to those who have supplied funds (shareholders and creditors). There are two views of entity theory, but both stress accountability to equityholders. The conventional view emphasises stewardship because equityholders are seen as ‘associates’ in business. The newer view focuses on stewardship because of legal, contractual requirements, and also to maintain good relations with equityholders in the event of the company needing more funds. (c) The net worth of the owner is not a meaningful concept, because the owner is not recognised as such but as an equityholder, a provider of funds. So-called owners are not seen as having the power to make decisions for the firm. The net assets belong to the entity. However, net worth can be a meaningful concept. An argument can be made that the entity needs to know the worth of its net assets for its own purposes. (d) The reason is that the entity is the focus of attention, and therefore creditors and owners are seen simply as those who supplied the funds to the entity. Their financial interest in the company is ‘equities’ — claims on the assets. Thus, they are seen as equityholders. Their relationship with the company is a contractual one. (e) Paton and Littleton argue that the shareholders have a contractual residual claim on the assets, and it is for this reason that income is placed in the retained earnings account. Shareholders get the leftovers after the creditors have been paid, in the event of liquidation of the company. The newer view of entity theory sees retained earnings as the firm’s equity or investment in itself. (f) Profit is stressed for two reasons: Profit is what equityholders are interested in, because it represents the results of their investment in the company The firm is in business to make a profit — profit is essential to the firm’s survival. (g) Revenue is the inflow of assets (increase in total assets) due to the events undertaken by the firm with regard to its output. Under the proprietary theory, revenue is the increase in proprietorship. Expense is the decrease in assets or increase of liabilities due to the consumption of assets and services by the firm to generate current revenue. Under proprietary theory, expense is the decrease in proprietorship. For both the entity and proprietary theories, profit is the difference between revenues and expenses. Entity theory, however, emphasises the left side of the accounting equation (assets), whereas the proprietary theory concentrates on the right side (proprietorship). Entity theory focuses on what the entity does, its performance; whereas proprietary theory focuses on the effect on proprietorship. For traditional entity theory, interest charges, dividends and income taxes should be distributions of earnings. The theory considers these as payments to the equityholders for the use of their funds. Of course, the government does not provide funds as the others, but provides intangible services (funds?) such as protection from foreign powers. The newer version of entity theory sees interest charges, dividends and income taxes as payments to ‘outsiders’, and therefore they are expenses. (h) Although conventional accounting theory subscribes to entity theory, the theory has had little effect on actual practice. The reason is that the theory was formulated in the 20th century, and many current practices were devised since the time of the Italian city–states and are based on the proprietary theory. The following show the effect of the entity theory on practice: The physical capital view is in consonance with the entity theory. Salaries to corporate employees who are also shareholders are expenses, because the company is a separate, distinct entity from the holders. In consolidating financial statements, an entity theoretical approach can be taken. Instead of concentrating on the proprietary interest of the parent (parent company theory), entity theory sees the consolidation from the point of view of the consolidated entity. The use of profit and cost centres for internal purposes is based on entity theory. The centre is seen as an individual entity. Liabilities are all ‘obligations’ under the Framework definition of liabilities. What is an obligation, and why does the Framework rely heavily on it in the definition? A liability is a present obligation to act or perform in a certain way. An obligation is a duty; a responsibility or requirement. It may be legally enforceable in the courts or simply ‘equitable’ or ‘constructive’. The Framework definition emphasises the future sacrifice, but it should be remembered that a liability exists now — it is also a presently existing requirement. If a liability is a present obligation, does that mean that a legally enforceable claim must exist before a liability exists? Explain. Conversely, if a legally enforceable claim exists, does that mean that a liability must exist? Explain. A liability need not be legally enforceable. According to the Framework for the Preparation and Presentation of Financial Statements, it may be equitable or constructive. Most liabilities are legal liabilities, but company policy of a ‘moral obligation’ may give rise to a recordable liability as long as the intent is to transfer assets or render a service to settle the obligation. Examples are Christmas bonuses that may be accrued if not paid in December, or vacation pay. The past transaction or event is not as clear for non-legal liabilities as for legal liabilities, and thus may be more difficult to recognise. For such liabilities, the future sacrifices cannot be avoided without significant penalty, such as a decrease in employee morale. Interpreting the meaning of significant penalty is a matter of opinion. A legally enforceable claim need not exist for an asset to exist according to the Framework. Control is the main criterion, not ownership. On the other hand, if a legally enforceable claim against the entity exists, it is clear that there is a present obligation, and presumably a liability. Under some countries’ accounting regulations, unrealised foreign exchange gains and losses are not immediately recognised in a firm’s statement of financial performance. Instead, unrealised gains are put into a deferred credit account. Is this a liability? Why or why not? It is not truly a liability because it does not meet the definition of a liability. There is no present obligation to sacrifice future economic benefits. To the contrary, there is a potential inflow of future economic benefits (foreign currency asset) or a potential reduction in outflows of future economic benefits. Hunter Ltd is attempting to bring its accounts in line with Australian accounting standards and statements of accounting concepts. Advise the accountant of Hunter Ltd whether a liability exists in each of the following cases and, if so, what the liability is: (a) The company is being sued for injuries sustained by an employee who claimed that the workplace steps he fell down were unsafe. The outcome of the lawsuit is highly uncertain. (b) An order for raw materials has been placed with the firm’s regular supplier. (c) There is a signed contract for the construction by Suzanna Ltd of a major item of plant for Hunter Ltd. (d) The firm has unsecured notes of $1 000 000 outstanding. Interest is payable 6-monthly in June and December. It is now August. (e) At the end of the year, half of the firm’s employees have non-vested sick leave owing. (a) Contingent liabilities are not recorded, but are disclosed. A decision must be made on whether these items are ‘straight’ liabilities or contingent liabilities. This decision is based on two criteria: (1) it is probable that a liability has been incurred; and (2) the amount can be estimated reliably. In this case, there is no liability. According to the Framework for the Preparation and Presentation of Financial Statements,, the event must make it ‘probable’ that a liability has been incurred and the amount must be ‘estimable’. These two conditions are not met. (b) No liability. The pertinent event is not placing an order but receiving title to the goods. When title passes, then a purchase has been made, and accounts payable is recorded. (c) Unclear. Until there is performance, there is nothing to record as no party has an obligation under the contract until there is some performance under that contract. On the other hand, if signing the contract has created that legal obligation, then a liability and an equal asset should be recorded — the event is the signing of the contract and the passing of some form of consideration that creates rights and obligations under the contract. (d) Interest payable for two months. Accrued interest is to be recorded. The event is the passing of time; the company is using the money that was borrowed each day. (e) No liability exists for the non-vested rights. The following four conditions can be considered for the recording of an accrued liability for sick pay: the sick pay is based on services already rendered rights to sick pay are vested or ‘accumulated’ (earned but unused) payment is probable the amount can be reasonably estimated. If sick pay benefits vest, an accrual should be made. If they ‘accumulate’ but do not vest, accrual is not required. Does the IASB/AASB Framework adopt the principle of conservatism? Why or why not? Do you think that conservatism is desirable in the definitions of assets, liabilities and equity, or in their recognition criteria? Why or why not? Conservatism calls for the recognition of liabilities on less stringent grounds than assets. According to the Framework for the Preparation and Presentation of Financial Statements, if it is ‘probable’ that a liability has been incurred and the amount can be reasonably estimated, then it is to be recorded. The Framework is conservative in its approach since it incorporates the concept of ‘prudence’. Paragraph 37 of the Framework, for example, includes the following: ‘Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.’ As such, liabilities (like assets) are to be recognised when they are more likely than not to require a flow of service potential or economic benefit, and when they can be measured. Since conservatism is a virtue according to general practice, it is likely that the Framework will lead to less conservative recognition of liabilities than general practice. How does owners’ equity differ from liabilities? Give examples where they are closely aligned, and examples of where they are not. Owners’ equity represents the owners’ claim on the assets of the company. The owners have a residual interest in the firm. They share in what is left over after liabilities are paid out of assets. The accounting equation (Assets – Liabilities = Owners’ equity) expresses in mathematical terms the relationships involved. The amount of net assets equals the amount of owners’ equity. We should remember that the valuation of owners’ equity is not necessarily the same as the concept of owners’ equity. Owners’ equity can be described without reference to a sum of money. Owners’ equity differs from liabilities in that liabilities are claims that the entity is presently obliged to settle with an outflow of economic resources. Owners’ equity is a residual attributable to the owners after liabilities are discharged. Preference shares and convertible notes possess characteristics of both liabilities and owners’ equity. Accounts payable and general reserves are examples where liabilities and owners’ equity clearly differ. In your opinion, when should the following be recognised as assets or liabilities? Explain whether, how and why, your answer deviates from Australian accounting standards. (a) Accounts payable (b) Put options (c) Call options (d) Raw materials inventory (e) Finance lease obligations (f) Operating lease obligations (g) Warranty commitments (a) Accounts payable. A purchase has occurred on account; payment is probable. Record a liability at the time of the transaction. Consistent with IAS 39. Put options (the holder has option but not the obligation to sell the underlying item). A derivative financial instrument under IAS 139. The standard requires recognition at fair value at date of transaction and remeasurement at subsequent balance date, with increases and decreases in value to be recorded in the income statement. Derivates are in the ‘fair value through profit and loss’ category of IAS 39. Call options (the holder has the right to buy the underlying item). As for (b). Raw materials inventory. If a perpetual system is used, a purchase (expense) has occurred and the amount of asset remaining at the end of the period is recorded in a stocktake. If a periodic system is used, the amount of inventory that the firm has title to is recorded as an asset at the date of purchase of the raw materials. (e) Finance lease obligations. According to AASB 117, a finance lease obligation occurs when the lease transfers substantially all the risks and rewards incidental to ownership of an asset. The standard mandates that at the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their balance sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. Lessors shall recognise assets held under a finance lease in their balance sheets and present them as a receivable at an amount equal to the net investment in the lease. (f) Operating lease obligations. AASB 117 specifies that in the books of the lessee, lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit. For lessors, lease income from operating leases shall be recognised in income on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which use benefit derived from the leased asset is diminished. (g) Warranty commitments. A liability arises with the sale of the product and the existence of warranty contract. At this stage, the amount can be reasonably estimated. The contract means there is a present obligation to an external party. The amount to be claimed can be reasonably estimated based on the company’s past experience. When, if ever, should a firm recognise a superannuation liability, and why? Superannuation commitments meet the definition of a liability. The important elements of a liability are: present obligation asset or service to be transferred at a future date to another entity past event. Superannuation is based on services already rendered by employees, but compensation will be paid to them in the future in the form of pension benefits. Therefore, a present obligation exists as the employee renders service. The obligation is settled by payment of cash in the future. The liability is created by a past event, the rendering of services by the employees. Under the terms of most superannuation agreements, not only is the superannuation payment probable, but also its measurement is reasonably reliable; so recognition should occur as the obligation accrues by virtue of the employee’s provision of service. Explain the concept of capital maintenance, and how it can apply to different concepts of capital. The main source of income for an entity is an increase in the wealth of a firm resulting from operations for the period. This can be described as the maximum amount that can be distributed to owners and still leave the firm as well off at the end of the period as at the beginning. This maximum amount that can be distributed is income; the amount that needs to be retained to leave the firm as well off at the end of the period as at the beginning of the period is capital. Under the concept of capital maintenance, then, income is only that amount that can be distributed without impairing the capital of the firm. So, capital cannot be distributed to owners as dividends, only income. Current cost accounting aims to ensure the firm’s physical/operating capital base is not eroded during periods of inflation, as the otherwise inflated profits reported can result in increased dividends that actually result in reducing the ‘real’ capital of the firm. Under a general price level accounting system (GPLA or CPP), income is recognised only after the purchasing power of the start-of-period owners’ equity has been maintained. Under CoCoA, the concept of capital is ‘adaptive capacity’ so income is not recognised until the firm earns enough to maintain its operating adaptive capacity, as reflected in the net realisable value of its assets, less liabilities. A benefactor pays off a loan for a university. How should the university record the transaction, and why? The university should record the transactions as a donation. The entry is: DR Loan CR Revenue According to the Framework, donations should be classified as revenue because they are inflows of probable future economic benefits other than contributions by owners. How should a mining company account for (a) a contract which stipulates that on maturity of a cash loan to the company, it must pay the principal in cash or provide a given quantity and grade of extracted minerals, whichever is the higher? And (b) a contract which stipulates that $1 000 000 is to be spent on mine restoration at the end of the project in 10 years’ time? Part (a) The recording of a liability is justified, because: a present obligation exists. The company is using borrowed money. the company will pay cash (an asset) or minerals (an asset) at a future date to settle the obligation. the obligation arose out of a past event — the use of the borrowed money. The liability meets recognition criteria in that a future outflow of economic benefits is probable. Also, there is a reliable measure, even if it is not exactly the amount that will be required to be repaid if the minerals extracted have a high value. DR Cash CR Loan (PV of expected cash outflows) Part (b) The recording of a liability is justified, because: a present obligation exists. The company has a contractual commitment (a legal obligation) to complete the restoration. There will be an outflow of future economic benefits in ten years’ time in relation to activities over the prior ten years. the obligation arose out of a past event — the mining activity. The liability meets recognition criteria in that a future outflow of economic benefits is probable. Also, there is a reliable measure as the restoration cost is stated at $1 000 000. The company should capitalise the expected restoration cost as part of Mine Development asset and amortise it over the ten year life of the mine (thus allocating the restoration expenses over the prior ten years and offsetting it against production revenue). When production commences: DR Mine Development Asset 1 000 000 CR Provision for restoration 1 000 000 Each year a proportion of the total mine development asset (which includes other capitalised costs relating to the development of the mine) is expensed as a cost of production. When mining is complete and restoration expense is paid: DR Provision for restoration 1 000 000 CR Cash 1 000 000 How should Shannondoah Ltd account for a cash loan to the company where the contract requires that the principal will be redeemed in ordinary shares at maturity? Ten shares will be given for each $1 000 bond. The current market value of the shares is $120. Because shares are to be given on the date of maturity, two questions arise: Is the issuance of the bonds that convert to company shares a liability? What amount should be recorded now? According to the definition of a liability, a liability must be settled by transferring assets or services at a future date. The ordinary shares of the company are not assets or services. Therefore, the bonds do not appear at first to qualify as a liability. However, the classification is not that straightforward, as explained below, and in AASB 132 ‘Disclosure and Presentation’. If the converting notes convert to a variable number of shares, depending on the market value of the shares at the time of the conversion, then the issue of the converting notes is equivalent to an issue of debt that is then repaid in cash, which the lender then invests in the shares of the borrowing entity. The lender is not exposed to residual risk at all during the period of holding the converting notes. As such, during the period prior to conversion, it is appropriate to classify such converting bonds as liabilities. On the other hand, if the converting notes convert to a fixed number of shares, then the issue of the converting notes exposes the holder of the notes to residual risk from the outset. As such, the converting notes are equivalent to an issue of equity, with a fixed dividend stream. The lender is exposed to residual risk during the period of holding the converting notes. As such, during the period prior to conversion, it is appropriate to classify such converting bonds as equity. In this case, the loan converts to a fixed number of shares, so it should be treated as equity. The holder is subject to residual risk: if the value of the firm changes, they receive the same number of shares on conversion (10 per $1000 bond), so they bear the risk of changes in the value of the shares, and in the value of the equity. What amount should be recorded? If we knew what the market value of the shares should be on the date of maturity, we could find the present value of the amount of the total market value of all the shares involved. But we do not know that. Although the bondholders must have taken into account the current market price of the shares when they purchased the bonds, and probably expected the market price to increase, the recording of the sale of the bonds should be based on the value of the shares. The reason is that it is too difficult to estimate market values of shares. The method used when a large share dividend is declared provides a guideline. On a per-bond basis, the following appears to be an appropriate record: 10 shares  $120 par = $1200 Cash $1000 Deferred discount on converting note issue $ 200 Share capital $1200 Interest will be paid each year based on the principal of $1 000 000. Should this be considered interest expense or dividends? The interest is a periodic payment on an equity instrument Therefore, it should be treated as a direct debit to equity, and as dividends. Perhaps this bond issue is attractive to investors, because a specific amount of ‘interest’ each year will be received by contract as opposed to actual dividends that may or may not be paid, and the expectation of receiving more than the stated principal amount because of the likelihood of the market value of the shares increasing in value. Skipper Ltd financed the construction of its new office block by issuing securities for $50 000 000 in 2000. Buyers of the securities received a 30% ownership interest in the office block, and receive 30% of the rent revenue related to letting the offices. The securities mature on 30 April 2015, when Skipper Ltd must redeem the securities at 30% of the value of the office block or $50 000 000, whichever is higher. What should Skipper Ltd have recorded in its accounts on 30 April 2000, and what other journal entries should be recorded throughout the term of the securities? The $50 000 000 issue constitutes a loan. It has the features of a loan because of the following: It has a definite maturity date — 30 April 2015. It has a specified amount to be paid on the maturity date — either $50 000 000 or 30% of the appraised value of the shopping centre, whichever is higher. It does not confer a residual claim to the value of the firm. The variable component of the value of the loan is in relation to one specific asset, buildings. Although an interest rate is not stated, there is something similar, which is 30% of the income per year. The amount each year would not be the same, but this is true also for variable rate bonds. The 30% ownership of the shopping centre by the holders of the securities is, in effect, the collateral on the loan. The ownership of the holders is temporary, only until the maturity date, unless the company defaults. Entries: 30 April 2000 Cash $50 000 000 Loan payable $50 000 000 When payment of the 30% of income is made each year: Interest Expense x Cash x If the value of the probable payment on maturity exceeds $50 000 000, the loan should be restated: DR Buildings CR Loan Payable Upon maturity: DR Loan Payable CR Cash PROBLEMS Problem 8.1 1. When accounting for various transactions related to assets, how should Jessica’s Revals Ltd record the following scenarios: a) Purchase of land with associated loss on land development b) Investment in available-for-sale securities with subsequent loss recognition c) Changes in the values of current and fixed assets under a mixed measurement system d) Sale of land with a note receivable recorded at present value e) Exchange of dissimilar non-monetary assets with an objective value f) Purchase of land with payment made in company shares, considering the share price's potential impact on the transaction's valuation. The purpose of this problem is to show that determining cost or value in practice is not always simple. (a) The question indicates that the two blocks of land have identical values. As such, the appropriate entries would be: Gibson Land $1 000 000 Cash/other consideration $1 000 000 To record purchase of land at cost Loss on land development $50 000 Old Land $50 000 To record loss on land development Since the Revals is in the business of property development, the loss will be taken to the income statement. Conservatism (or prudence, para 37 in Framework) suggests that the loss will be recognised as soon as it is foreseeable. Refer to Framework definitions: an expense arises in the ordinary course of business. It takes the form of an outflow or depletion of assets (para 78). The expense is recognised because decrease in future economic benefits has occurred, and can be measured reliably (para 94). Note that this is not a land revaluation under AASB 116, which allows firms to revalue property to fair value (para 31). Under AASB 116, an asset revaluation creates an asset revaluation reserve and a devaluation of the asset (previously revalued) goes against the reserve (para 39). (b) This is an investment in a financial asset, so AASB 139 applies. The question states that the ‘shares are held for investment purposes’. Assuming Jessica’s Revals classifies the investment as available for sale the investment should be recorded at fair value. 7 Sept 2009 Available for sale securities $18 000 Cash $18 000 31 July 2010 Loss on securities $2 000 Available for sale securities $2 000 Note: Loss on securities is shown in Statement of Changes in Equity for available for sale securities. AASB 139 allows items to be written off directly against asset or via use of an allowance account. (c) If Jessica’s Revals Ltd applied a strict historical cost measurement system, it would do nothing about these increases in value, because to do so would violate the historical cost principle. Under the mixed measurement system in use by the vast majority of firms, an entry would not be made in relation to the current assets, however the fixed assets can be revalued under AASB 116. We recommend the following entry if the firm adopts a mixed measurement system: 31 July Fixed assets $600 000 Asset revaluation reserve $600 000 If the current assets include trading or available for sale financial assets then market value should be recorded as per AASB 139 31 July Trading/available for sale securities $20 000 Gain on securities $20 000 Note: Gain on securities is shown in the Income Statement for trading securities and in the Statement of Changes in Equity for available for sale securities. (d) Initial acquisition: July 31 Land $81 000 Cash/other consideration $81 000 The receivable arising on sale of land must be recorded at fair value (AASB 139, para 43). Therefore, the present value of the note must be recorded. Using the present value of an ordinary annuity for 10 periods at 10%, the present value is: $13 000 × 6.144567 = $79 879 Notes receivable $79 879 Loss on Sale of Land 1 121 Land $81 000 Jessica’s Revals Ltd will receive principal repayments in relation to the loan each year. No interest revenue is recorded each year as the note was non-interest bearing. In subsequent years, the receivable is to shown at amortised cost, using the effective interest method. (e) In this instance there is an exchange of dissimilar non-monetary assets, for which we are able to estimate market values. If an objective value is available, it can be used as the basis for determining the value of the asset received. Assuming Jessica’s Revals Ltd works for others at an established sales price, the contract price of $17 000 can be considered objectively determinable. A case could be made for recording the bricks at $16 500. This is a lower figure, and on the basis of conservatism it can be argued that it should be recorded. However, following the cost principle, the asset received should be valued based on a measure of the benefit sacrificed, which in this case is a service worth $17 000. By working for the brick manufacturer, Jessica’s Revals Ltd is forgoing $17 000 in revenue from another contract. Hence, this is the cost. Materials (Bricks) $17 000 Sales revenue $17 000 Cost of goods sold $12 000 Inventory, labour, etc. $12 000 (f) There are two choices here: to record the land at $83 000 or $82 000. Following the cost principle, the land should be stated at $83 000 because that is what was sacrificed: 1,000 shares at $83 per share. There is a question as to whether 1000 shares constitute such a large number that the share price would be affected. Assuming that 1,000 shares would not materially affect the share price, and given that the market quotation can be relied upon because it is from the Australian Securities Exchange, the $83 000 represents the cost of the land. Land $83 000 Paid-up capital (1000 × $50) $83 000 To be consistent assumptions used in (a), land would be written down to fair value Loss on land development $1 000 Land $1 000 To record loss on land development Problem 8.2 How should a firm consider different valuation methods, such as present value, fair value, carrying amount, and current cost, when evaluating the sale of an apartment building, and what is the relevance of each method in the decision-making process? 1. Present value. For the decision at hand, this figure is highly relevant. Its reliability depends on how good the estimates are. The use of 15% as the discount rate of return is acceptable. The calculation is based on past experience. Future circumstances may change, perhaps drastically over the next 20 years. However, anyone making a decision to buy or sell an apartment building should make projections about expected cash flows in order to have a rough price to work with. Any offer that is substantially lower than the present value would be rejected. When compared with the fair value, the present value seems to be conservative, which should give the seller confidence that it represents a minimum value. 2. Fair value. This value is the most relevant of the four. It represents the market’s assessment of what the property is worth, and is therefore a more objective value than present value. Present value represents the seller’s expectations of the value in use of the assets over 20 years; fair value represents the market’s expectations if the asset were to be sold now. In this case, you have the opinion of two appraisers as to the market value of the property. Their estimates are presumably based on their expert knowledge of the market. The average taken by the accountant of the two figures is a reasonable approach. 3. Carrying amount. The carrying amount is only relevant for computing the accounting gain when the property is sold. It should not be used to determine whether the property should be sold. Exchange value is determined in the marketplace. One of the assumptions of accounting theory is the ‘going concern’. Based on this, the notion is that allocated cost on the income statement is more pertinent than current value because it shows the cost to the business for using the asset in a given period. Thus, the purpose of the carrying amount is not for making decisions about the sale of the asset in question. It represents unallocated cost — that is, cost that is still waiting to be allocated to the income statement. Because land is assumed to have an indefinite life, the original cost remains the unallocated cost. If it were not possible to determine current value, at least the carrying amount can be seen as a very conservative estimate of current value. It is conservative, because of the use of historical cost in accounting and the existence of inflation. 4. Current cost. The current cost calculated on the basis of price indices involves a great deal of estimation. Are price indices market prices? Although the price indices are market based, they are very general and do not necessarily reflect the current costs in the particular area where the property is located. Construction costs in Sydney could be quite different from those in Hobart, Melbourne, Darwin or Oodnadatta. The deduction of five years of depreciation is an accounting procedure, and is not market-based. The current cost of constructing a building is not necessarily what it will sell for. A contractor would wish to sell to make a gain. Also several buyers may want a particular building and bid the price up. The relevance of this figure depends on the reliability of the computation. If the computed current cost is reflective of the market prices of the component factors in the area, then it is very relevant. If for some reason, fair value cannot be determined then the computed current cost is an alternative. In summary, the relevance of the four figures in priority order is: Fair value Current cost (computed) Present value Book value. Note, however, that present value is highly relevant as a comparison with fair value or current cost to determine the merits of sale or replacement, based on the value in use of the block of units. Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152

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