Busn 2015 Company Accounting
Chapter 1 – Nature and regulation of
companies
RQ 9.Outline the differences between shares and debentures.
Ordinary shares attract no fixed rate of dividend, carry voting rights and may participate in surplus assets and profits of the company – they represent ownership of x% of the company. Ordinary shares are classified as equity. The company may issue shares either fully paid or partly paid (s. 254A). If partly paid shares are issued, the shareholder is liable to pay calls on the shares (except in the case of no-liability companies). A company also has the right to issue preference shares, but may only do so either if there is a statement in its constitution setting out the rights of these shareholders or if these rights have been approved by a special resolution of the company. Not all preference shares are the same. Classification of preference shares as equity or liabilities depends on the rights and features of the shares – judgment is required re which classification is appropriate. For example, redeemable, cumulative 10% preference shares, which are to be redeemed on a set date, are definitely liabilities. Preference shares redeemable at the option of the company may or may not be liabilities, depending on the probability of the company redeeming them. Debentures are issued by the company raise funds but are borrowings, not equity. Debentures may be secured. A trust deed/trustee must be established to protect the rights of debenture holders.
RQ 11.Does a company have to comply with accounting standards in order to show a ‘true and fair view’ of its financial affairs? Discuss.
Before the early 1990s, the directors of a company could elect not to comply with an accounting standard issued by the AASB if they believed the particular standards would cause the accounts not to present a true and fair view. This 'true and fair override' no longer exists and directors must now comply with applicable accounting standards and add any additional information in the notes to the financial statements if they believe adherence to the standards does not present a true and fair view. Compliance with standards therefore has become the norm, resulting in an increased interest, both positive and negative, in the requirements of accounting standards by different lobby groups, particularly among those required to prepare financial statements.
RQ 14.To which entities do accounting standards apply? Discuss the nature of a reporting entity, and consider reasons for the concept being replaced.
Accounting standards apply to the general-purpose financial statements/reports of entities which are “reporting entities” and also to those entities which decide to prepare general-purpose financial statements even if they are not reporting entities.
The AASB, in SAC 1, provided the following definition of a reporting entity:
Reporting entities are all entities (including economic entities) in respect of which it is reasonable to expect the existence of users who rely on the entity’s general purpose financial report for information that will be useful to them for making and evaluating decisions about the allocation of scarce resources.
All reporting entities are subject to accounting standards when preparing their general-purpose financial statements. Entities such as small proprietary companies, family trusts, partnerships, sole traders and wholly owned subsidiaries of Australian reporting entities will normally not be required to prepare general purpose statements in accordance with accounting standards.
Following the release of the IASB’s Exposure Draft of a Proposed IFRS for Small and Medium-Sized Entities, (SMEs) published in February 2007, the AASB issued, in May of that year, Invitation to Comment ITC 12, proposing to revise the differential reporting regime in Australia by switching the focus away from whether an entity is/is not a reporting entity to whether the entity (subject to a size test) is required to prepare a general-purpose financial statement/report and is publicly accountable. “Public accountability” is defined in the IASB’s ED on SMEs as accountability to those present and potential resource providers and others external to the entity who make economic decisions but who are not in a position to demand reports tailored to meet their particular information needs. An entity has public accountability if: (a) it has issued (or is in the process of issuing) debt or equity instruments in a public market; or (b) it holds assets in a fiduciary capacity for a broad group of outsiders, such as a bank, insurance company, securities broker/dealer, pension (or superannuation) fund, mutual fund or investment bank.
The implications are that if an entity is publicly accountable or satisfies a size test then it will be required to apply Australian equivalents to IFRSs in its general-purpose financial statements. If it is not publicly accountable, and does not meet the size test, then the entity need apply the Australian equivalent of IFRS for SMEs only. See figure 1.3 in section 1.9.2 of the text for a flowchart showing the ITC 12 proposed changes.
However, the AASB received negative comments on the proposals in ITC 12, particularly in relation to the arbitrary nature of the size test, and the fact that the public accountability test appeared to apply to all public sector entities irrespective of size. Therefore, the AASB rejected the thoughts of ITC 12 and issued AASB 1053 Application of Tiers of Australian Accounting Standards in June 2010, requiring the adoption of a Tier 1 and Tier 2 system. Those in Tier 1 must apply Full IFRSs as adopted in Australia, and those in Tier 2 can adopt a Reduced Disclosure Regime (RDR). The RDR involves recognition and measurement requirements of full IFRSs, as already adopted in Australia, with disclosures substantially reduced in comparison with those required under full IFRSs as adopted in Australia. Figure 1.4 in section 1.9.2 illustrates the key elements of AASB 1053.
The AASB saw the RDR proposition as eventually replacing the reporting entity concept. Nevertheless, in 2010, the IASB and FASB issued an exposure draft to improve the conceptual framework by adopting a new definition of the reporting entity. The AASB issued the IASB’s exposure draft as ED 193 Conceptual Framework for Financial Reporting: The Reporting Entity, describing a reporting entity as a circumscribed area of economic activities whose financial information has the potential to be useful to existing and potential equity investors, lenders and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity and in assessing whether management and the governing board of that entity have made efficient and effective use of the resources provided.
The focus of this definition is on users, particularly equity investors, lenders and creditors, who are unable to obtain the information necessary to make an economic decision, nor to assess the accountability of the entity’s management. In ED 193, a reporting entity is seen as having three features: a) the conduct of economic activities
b) the economic activities can be objectively distinguished from those of other entities and from the economic environment in which the entity exists; and c) financial information about those economic activities is potentially useful in making economic decisions and in assessing whether the management have made efficient and effective use of the resources provided.
These features are seen as necessary but not always sufficient to identify a reporting entity. Furthermore, a legal entity is not necessarily a reporting entity, although a single legal entity is likely to qualify as being one. Finally, a reporting entity can include more than one entity, or it can be a portion of a single entity e.g. a branch or division of an entity.
Hence, even though there have been attempts in Australia to do away with the reporting entity concept, it is likely to remain because of the IASB and FASB attempts to include such a definition in the conceptual framework, which will be adopted by Australia.
Chapter 2 – Financing company operations
RQ 4.When can a company forfeit its shares? What happens to money already paid by the holder of those shares?
A company can forfeit its shares provided the rules for forfeiture are in the company’s constitution. The rules usually specify that shares would be forfeited for non-payment of calls. Where shares are forfeited, the company can, depending on the constitution, retain the funds already paid on the forfeited shares in which case the Forfeited Shares account will be considered a reserve and part of equity. Alternatively, the forfeited shares can be reissued and the amount received, less the costs of forfeiture and reissue of shares, may then be refunded to the former shareholders. In this case, the Forfeited Shares account is a liability.
RQ 5.How should a company account for the legal costs of formation? Should the accounting treatment be the same as that for underwriting and other share issue costs?
Legal costs of formation were traditionally treated as an asset and then systematically amortised over an arbitrary period. However there are no future economic benefits to be gained from these costs and they should be written off to expense, as per AASB 138 Intangible Assets. Underwriting and other share issue costs are discussed in AASB 132 Financial Instruments: Presentation, paras. 35 and 37, and the appropriate treatment is to regard these costs as a reduction of the share capital being raised. The rationale for the different treatment is that share issue costs and the raising of capital is viewed as a single transaction and as such, the increase in equity is the net amount the company receives from the issue of shares (after considering any tax effect on the share issue costs).
RQ 6.What is a rights issue? Distinguish between a renounceable and a non-renounceable rights issue. How would a company account for such issues?
A rights issue is an issue of new shares to existing shareholders whereby they are given the right to purchase additional shares in proportion to their current shareholdings. Usually the issue price is set below the current market price of the company’s shares.
A renounceable rights issue allows the shareholder to take up the rights issue, let it lapse or sell their rights on the securities market. A non renounceable rights issue only allows the shareholder to either take up the rights by subscribing for more shares, or reject the rights, which mean that they lapse. The shareholders cannot sell the rights.
Accounting for a rights issue is discussed in the chapter at section 2.5.1 and practical aspects are shown in illustrative example 2.6.
RQ 8. What is a share option? How does a company account for share options that lapse?
A share option is an instrument giving the holder the right to buy or sell a set number of shares in the company by a set date at a set price. Options can be issued for a price or at no cost to the recipient. If issued for a price, an options ledger account is used. On expiry of the exercise date, this account balance is transferred to share capital (for the number of options exercised x the options price) and to lapsed options reserve (for the number of options lapsed x the options price). Where options are issued at a cost, then the amount received for options not yet exercised is disclosed in the statement of financial position as an increase in equity and shown below the company’s share capital.
RQ 10.What are share consolidations and share splits? How are they accounted for?
Share consolidations involve packaging the existing capital into a smaller number of shares. This doesn’t affect the balance in the Share Capital account and therefore there is no journal entry required, but only an adjustment to the share register in regard to the number of shares.
Share splits are the opposite to share consolidations. They involve packaging the existing capital into a larger number of shares. For example when BHP merged with Billiton and became BHP Billiton it split its shares on the basis of two shares for every one share. A share split also doesn’t affect the balance in the Share Capital account and therefore there is no journal entry required, but only an adjustment to the share register in regard to the number of shares.
RQ 1.Discuss the definition and essential characteristics of an asset. When should an asset be recognised? How should assets be measured?
Three essential characteristics can be derived from the definition of assets in paragraphs 4.8-4.14 of the Conceptual Framework 2010. i) A resource controlled by the entity,
ii) future economic benefits,
iii) past events.
See section 3.1.1 of the chapter. In section 3.1.2 of the chapter, the proposed asset definition developed jointly by the IASB and the FASB is discussed. A new definition has been developed because of perceived shortcomings of the existing definition. The newly proposed definition is: An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have.
The Conceptual Framework 2010, paragraph 4.38, states that an asset should only be recognised when it is probable that any future economic benefit associated with the item will eventuate and that the asset possesses a cost or other value that can be reliably measured. It is expected that the notion of “a reliable measure” will be replaced by a “faithfully representative and verifiable measure” in the conceptual framework. Initially assets are measured at cost, however subsequent to this initial measurement, different rules may apply depending on the nature of the asset. For example, inventory may be measured at lower of cost and net realisable value; non-current assets may remain measured at cost subject to depreciation or be measured at fair value. See section 3.3.1 of the chapter.
RQ 2.Foxy Ltd was going through some difficult trading times and was barely breaking even. In attempting to improve sales, the company spent $500 000 on an advertising campaign during the current year in the hope that sales would improve in the new year. Management decided that the cost of this campaign should be recorded as an asset in order that the small current profit for the firm would not become a loss. Discuss whether management’s decision is justified.
Advertising costs may be treated as an asset only if they satisfy the definition of an asset. Do they have the essential characteristics of an asset? Do they provide controlled future economic benefits flowing to the entity from a past event or events? Do they satisfy the proposed definition of an asset put forward by the IASB and FASB? See section 3.1.2 of the chapter.
It is not sufficient to treat them as an asset merely to show a better profit figure. If advertising costs are not assets, then management’s decision is not justified. If they are assets, then the decision to treat them as an asset in the records will only be justified if the advertising costs satisfy the recognition criteria, i.e. is it probable that the advertising expenditure will lead to future economic benefits flowing to the entity, and can the costs be measured reliably? Discuss the meaning of “probable”. Note that in this case, there is a cost which can be reliably measured (i.e a faithfully representative and verifiable cost).
RQ 5.As maintenance costs on equipment have been steadily rising every year, Scotch Ltd has been setting aside regularly a provision for plant maintenance at an increasing amount. The provision has been recorded as a liability, and as an expense. Discuss whether Scotch Ltd’s treatment is correct.
The Conceptual Framework 2010 ’s definition of a liability provides that there must be a present obligation. Furthermore, a provision must firstly be a liability for it to exist. See Section 3.1.3 of the chapter. As the recording of future maintenance costs is merely a book entry involving a future self-sacrifice by Scotch Ltd itself, with no present obligation, no liability for maintenance costs exists under the Framework’s definition of liabilities. Nor can there be an expense as there has been no outflow or depletion of assets or incurrence of a liability in Scotch Ltd.
RQ 10.How are income and expenses classified in the preparation of a statement of comprehensive income? Can income and expenses appear directly in the Retained Earnings account, without appearing in the current period’s profit? Explain.
As discussed in question 9, expenses are classified according to their nature or their function. For income items, AASB 118 classifies revenue into different categories by source. See question 8 above.
Paragraph 88 of AASB 101 states that all income and expense items must be included in the current period’s profit and loss, unless an Australian standard requires or permits otherwise. The most common occurrence of this would be when an initial adjustment is made due to a new or revised standard requiring an alternative application, usually an adjustment to retained earnings.
Note therefore that, apart from specified exceptions, income and expenses are to be included in the profit or loss for the reporting period, and not as part of “other comprehensive income”.
RQ 11.When do dividends become a legal debt of the company? When are they to be recognised as liabilities?
Where a company has a constitution that provides for directors to declare a dividend, then a dividend becomes a debt of the company once the dividend is declared. Where no such statement exists in a company’s constitution, then the debt will only arise when the time for payment of the dividend arrives.
However, a dividend determined or publicly recommended by the time of completion of the financial report but not on or before the reporting date must not be recognised as a liability as at the reporting date. Instead such a dividend must be disclosed in notes as an event after reporting date. See sections 3.4.1 and 3.4.2 of the chapter.
Case Study 1:
LIVERCHESTER
Assets are defined in the Conceptual Framework 2010, para. 4.4 as ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. According to paras 4.8-4.14 of the Framework, an asset has three essential characteristics: 1. An asset contains future economic benefits in the form of a potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. 2. The future benefits must be controlled by the entity. This means that an asset does not have to be legally owned. Control is not defined in the Framework; nevertheless, in para. 4.12, an ability of the entity to deny or regulate access to those benefits is implied. 3. Assets must have come into existence as a result of past events. Future economic benefits which are not currently controlled by the entity are not assets. A past event must have occurred. Hence, inventories expected to be acquired by the company next month are not assets to the entity at present. Once these three essential characteristics are satisfied, an asset exists. Under the Conceptual Framework 2010, the existence of an asset is not dependent on factors such as whether it has been purchased at a cost, is ‘tangible’ or has a physical existence, has a legally enforceable claim over it, or is exchangeable in the marketplace for cash or other assets
Does the Liverchester club have future economic benefits? Yes. In the form of ticket sales, promotional and sponsorship benefits
Does Liverchester control the future economic benefits? As control means the capacity to deny or regulate the access of others to those benefits, Liverchester would appear to have control. Substantial transfer fees are required if a player wants to go to another club.
Has there been a past event? Yes, there is a contract signed with each player.
Can the players be recognised as assets? Recognition criteria could be discussed if it is agreed that the players are assets. But how do you obtain a reliable measure of your asset?
And what about other officials e.g. coaching staff, management? Are they not assets as well? Does the IASB and FASB proposed definition of an asset change your opinion? The proposed definition is as follows: An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have.
RQ 9.Outline the differences between shares and debentures.
Ordinary shares attract no fixed rate of dividend, carry voting rights and may participate in surplus assets and profits of the company – they represent ownership of x% of the company. Ordinary shares are classified as equity. The company may issue shares either fully paid or partly paid (s. 254A). If partly paid shares are issued, the shareholder is liable to pay calls on the shares (except in the case of no-liability companies). A company also has the right to issue preference shares, but may only do so either if there is a statement in its constitution setting out the rights of these shareholders or if these rights have been approved by a special resolution of the company. Not all preference shares are the same. Classification of preference shares as equity or liabilities depends on the rights and features of the shares – judgment is required re which classification is appropriate. For example, redeemable, cumulative 10% preference shares, which are to be redeemed on a set date, are definitely liabilities. Preference shares redeemable at the option of the company may or may not be liabilities, depending on the probability of the company redeeming them. Debentures are issued by the company raise funds but are borrowings, not equity. Debentures may be secured. A trust deed/trustee must be established to protect the rights of debenture holders.
RQ 11.Does a company have to comply with accounting standards in order to show a ‘true and fair view’ of its financial affairs? Discuss.
Before the early 1990s, the directors of a company could elect not to comply with an accounting standard issued by the AASB if they believed the particular standards would cause the accounts not to present a true and fair view. This 'true and fair override' no longer exists and directors must now comply with applicable accounting standards and add any additional information in the notes to the financial statements if they believe adherence to the standards does not present a true and fair view. Compliance with standards therefore has become the norm, resulting in an increased interest, both positive and negative, in the requirements of accounting standards by different lobby groups, particularly among those required to prepare financial statements.
RQ 14.To which entities do accounting standards apply? Discuss the nature of a reporting entity, and consider reasons for the concept being replaced.
Accounting standards apply to the general-purpose financial statements/reports of entities which are “reporting entities” and also to those entities which decide to prepare general-purpose financial statements even if they are not reporting entities.
The AASB, in SAC 1, provided the following definition of a reporting entity:
Reporting entities are all entities (including economic entities) in respect of which it is reasonable to expect the existence of users who rely on the entity’s general purpose financial report for information that will be useful to them for making and evaluating decisions about the allocation of scarce resources.
All reporting entities are subject to accounting standards when preparing their general-purpose financial statements. Entities such as small proprietary companies, family trusts, partnerships, sole traders and wholly owned subsidiaries of Australian reporting entities will normally not be required to prepare general purpose statements in accordance with accounting standards.
Following the release of the IASB’s Exposure Draft of a Proposed IFRS for Small and Medium-Sized Entities, (SMEs) published in February 2007, the AASB issued, in May of that year, Invitation to Comment ITC 12, proposing to revise the differential reporting regime in Australia by switching the focus away from whether an entity is/is not a reporting entity to whether the entity (subject to a size test) is required to prepare a general-purpose financial statement/report and is publicly accountable. “Public accountability” is defined in the IASB’s ED on SMEs as accountability to those present and potential resource providers and others external to the entity who make economic decisions but who are not in a position to demand reports tailored to meet their particular information needs. An entity has public accountability if: (a) it has issued (or is in the process of issuing) debt or equity instruments in a public market; or (b) it holds assets in a fiduciary capacity for a broad group of outsiders, such as a bank, insurance company, securities broker/dealer, pension (or superannuation) fund, mutual fund or investment bank.
The implications are that if an entity is publicly accountable or satisfies a size test then it will be required to apply Australian equivalents to IFRSs in its general-purpose financial statements. If it is not publicly accountable, and does not meet the size test, then the entity need apply the Australian equivalent of IFRS for SMEs only. See figure 1.3 in section 1.9.2 of the text for a flowchart showing the ITC 12 proposed changes.
However, the AASB received negative comments on the proposals in ITC 12, particularly in relation to the arbitrary nature of the size test, and the fact that the public accountability test appeared to apply to all public sector entities irrespective of size. Therefore, the AASB rejected the thoughts of ITC 12 and issued AASB 1053 Application of Tiers of Australian Accounting Standards in June 2010, requiring the adoption of a Tier 1 and Tier 2 system. Those in Tier 1 must apply Full IFRSs as adopted in Australia, and those in Tier 2 can adopt a Reduced Disclosure Regime (RDR). The RDR involves recognition and measurement requirements of full IFRSs, as already adopted in Australia, with disclosures substantially reduced in comparison with those required under full IFRSs as adopted in Australia. Figure 1.4 in section 1.9.2 illustrates the key elements of AASB 1053.
The AASB saw the RDR proposition as eventually replacing the reporting entity concept. Nevertheless, in 2010, the IASB and FASB issued an exposure draft to improve the conceptual framework by adopting a new definition of the reporting entity. The AASB issued the IASB’s exposure draft as ED 193 Conceptual Framework for Financial Reporting: The Reporting Entity, describing a reporting entity as a circumscribed area of economic activities whose financial information has the potential to be useful to existing and potential equity investors, lenders and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity and in assessing whether management and the governing board of that entity have made efficient and effective use of the resources provided.
The focus of this definition is on users, particularly equity investors, lenders and creditors, who are unable to obtain the information necessary to make an economic decision, nor to assess the accountability of the entity’s management. In ED 193, a reporting entity is seen as having three features: a) the conduct of economic activities
b) the economic activities can be objectively distinguished from those of other entities and from the economic environment in which the entity exists; and c) financial information about those economic activities is potentially useful in making economic decisions and in assessing whether the management have made efficient and effective use of the resources provided.
These features are seen as necessary but not always sufficient to identify a reporting entity. Furthermore, a legal entity is not necessarily a reporting entity, although a single legal entity is likely to qualify as being one. Finally, a reporting entity can include more than one entity, or it can be a portion of a single entity e.g. a branch or division of an entity.
Hence, even though there have been attempts in Australia to do away with the reporting entity concept, it is likely to remain because of the IASB and FASB attempts to include such a definition in the conceptual framework, which will be adopted by Australia.
Chapter 2 – Financing company operations
RQ 4.When can a company forfeit its shares? What happens to money already paid by the holder of those shares?
A company can forfeit its shares provided the rules for forfeiture are in the company’s constitution. The rules usually specify that shares would be forfeited for non-payment of calls. Where shares are forfeited, the company can, depending on the constitution, retain the funds already paid on the forfeited shares in which case the Forfeited Shares account will be considered a reserve and part of equity. Alternatively, the forfeited shares can be reissued and the amount received, less the costs of forfeiture and reissue of shares, may then be refunded to the former shareholders. In this case, the Forfeited Shares account is a liability.
RQ 5.How should a company account for the legal costs of formation? Should the accounting treatment be the same as that for underwriting and other share issue costs?
Legal costs of formation were traditionally treated as an asset and then systematically amortised over an arbitrary period. However there are no future economic benefits to be gained from these costs and they should be written off to expense, as per AASB 138 Intangible Assets. Underwriting and other share issue costs are discussed in AASB 132 Financial Instruments: Presentation, paras. 35 and 37, and the appropriate treatment is to regard these costs as a reduction of the share capital being raised. The rationale for the different treatment is that share issue costs and the raising of capital is viewed as a single transaction and as such, the increase in equity is the net amount the company receives from the issue of shares (after considering any tax effect on the share issue costs).
RQ 6.What is a rights issue? Distinguish between a renounceable and a non-renounceable rights issue. How would a company account for such issues?
A rights issue is an issue of new shares to existing shareholders whereby they are given the right to purchase additional shares in proportion to their current shareholdings. Usually the issue price is set below the current market price of the company’s shares.
A renounceable rights issue allows the shareholder to take up the rights issue, let it lapse or sell their rights on the securities market. A non renounceable rights issue only allows the shareholder to either take up the rights by subscribing for more shares, or reject the rights, which mean that they lapse. The shareholders cannot sell the rights.
Accounting for a rights issue is discussed in the chapter at section 2.5.1 and practical aspects are shown in illustrative example 2.6.
RQ 8. What is a share option? How does a company account for share options that lapse?
A share option is an instrument giving the holder the right to buy or sell a set number of shares in the company by a set date at a set price. Options can be issued for a price or at no cost to the recipient. If issued for a price, an options ledger account is used. On expiry of the exercise date, this account balance is transferred to share capital (for the number of options exercised x the options price) and to lapsed options reserve (for the number of options lapsed x the options price). Where options are issued at a cost, then the amount received for options not yet exercised is disclosed in the statement of financial position as an increase in equity and shown below the company’s share capital.
RQ 10.What are share consolidations and share splits? How are they accounted for?
Share consolidations involve packaging the existing capital into a smaller number of shares. This doesn’t affect the balance in the Share Capital account and therefore there is no journal entry required, but only an adjustment to the share register in regard to the number of shares.
Share splits are the opposite to share consolidations. They involve packaging the existing capital into a larger number of shares. For example when BHP merged with Billiton and became BHP Billiton it split its shares on the basis of two shares for every one share. A share split also doesn’t affect the balance in the Share Capital account and therefore there is no journal entry required, but only an adjustment to the share register in regard to the number of shares.
RQ 1.Discuss the definition and essential characteristics of an asset. When should an asset be recognised? How should assets be measured?
Three essential characteristics can be derived from the definition of assets in paragraphs 4.8-4.14 of the Conceptual Framework 2010. i) A resource controlled by the entity,
ii) future economic benefits,
iii) past events.
See section 3.1.1 of the chapter. In section 3.1.2 of the chapter, the proposed asset definition developed jointly by the IASB and the FASB is discussed. A new definition has been developed because of perceived shortcomings of the existing definition. The newly proposed definition is: An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have.
The Conceptual Framework 2010, paragraph 4.38, states that an asset should only be recognised when it is probable that any future economic benefit associated with the item will eventuate and that the asset possesses a cost or other value that can be reliably measured. It is expected that the notion of “a reliable measure” will be replaced by a “faithfully representative and verifiable measure” in the conceptual framework. Initially assets are measured at cost, however subsequent to this initial measurement, different rules may apply depending on the nature of the asset. For example, inventory may be measured at lower of cost and net realisable value; non-current assets may remain measured at cost subject to depreciation or be measured at fair value. See section 3.3.1 of the chapter.
RQ 2.Foxy Ltd was going through some difficult trading times and was barely breaking even. In attempting to improve sales, the company spent $500 000 on an advertising campaign during the current year in the hope that sales would improve in the new year. Management decided that the cost of this campaign should be recorded as an asset in order that the small current profit for the firm would not become a loss. Discuss whether management’s decision is justified.
Advertising costs may be treated as an asset only if they satisfy the definition of an asset. Do they have the essential characteristics of an asset? Do they provide controlled future economic benefits flowing to the entity from a past event or events? Do they satisfy the proposed definition of an asset put forward by the IASB and FASB? See section 3.1.2 of the chapter.
It is not sufficient to treat them as an asset merely to show a better profit figure. If advertising costs are not assets, then management’s decision is not justified. If they are assets, then the decision to treat them as an asset in the records will only be justified if the advertising costs satisfy the recognition criteria, i.e. is it probable that the advertising expenditure will lead to future economic benefits flowing to the entity, and can the costs be measured reliably? Discuss the meaning of “probable”. Note that in this case, there is a cost which can be reliably measured (i.e a faithfully representative and verifiable cost).
RQ 5.As maintenance costs on equipment have been steadily rising every year, Scotch Ltd has been setting aside regularly a provision for plant maintenance at an increasing amount. The provision has been recorded as a liability, and as an expense. Discuss whether Scotch Ltd’s treatment is correct.
The Conceptual Framework 2010 ’s definition of a liability provides that there must be a present obligation. Furthermore, a provision must firstly be a liability for it to exist. See Section 3.1.3 of the chapter. As the recording of future maintenance costs is merely a book entry involving a future self-sacrifice by Scotch Ltd itself, with no present obligation, no liability for maintenance costs exists under the Framework’s definition of liabilities. Nor can there be an expense as there has been no outflow or depletion of assets or incurrence of a liability in Scotch Ltd.
RQ 10.How are income and expenses classified in the preparation of a statement of comprehensive income? Can income and expenses appear directly in the Retained Earnings account, without appearing in the current period’s profit? Explain.
As discussed in question 9, expenses are classified according to their nature or their function. For income items, AASB 118 classifies revenue into different categories by source. See question 8 above.
Paragraph 88 of AASB 101 states that all income and expense items must be included in the current period’s profit and loss, unless an Australian standard requires or permits otherwise. The most common occurrence of this would be when an initial adjustment is made due to a new or revised standard requiring an alternative application, usually an adjustment to retained earnings.
Note therefore that, apart from specified exceptions, income and expenses are to be included in the profit or loss for the reporting period, and not as part of “other comprehensive income”.
RQ 11.When do dividends become a legal debt of the company? When are they to be recognised as liabilities?
Where a company has a constitution that provides for directors to declare a dividend, then a dividend becomes a debt of the company once the dividend is declared. Where no such statement exists in a company’s constitution, then the debt will only arise when the time for payment of the dividend arrives.
However, a dividend determined or publicly recommended by the time of completion of the financial report but not on or before the reporting date must not be recognised as a liability as at the reporting date. Instead such a dividend must be disclosed in notes as an event after reporting date. See sections 3.4.1 and 3.4.2 of the chapter.
Case Study 1:
LIVERCHESTER
Assets are defined in the Conceptual Framework 2010, para. 4.4 as ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. According to paras 4.8-4.14 of the Framework, an asset has three essential characteristics: 1. An asset contains future economic benefits in the form of a potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. 2. The future benefits must be controlled by the entity. This means that an asset does not have to be legally owned. Control is not defined in the Framework; nevertheless, in para. 4.12, an ability of the entity to deny or regulate access to those benefits is implied. 3. Assets must have come into existence as a result of past events. Future economic benefits which are not currently controlled by the entity are not assets. A past event must have occurred. Hence, inventories expected to be acquired by the company next month are not assets to the entity at present. Once these three essential characteristics are satisfied, an asset exists. Under the Conceptual Framework 2010, the existence of an asset is not dependent on factors such as whether it has been purchased at a cost, is ‘tangible’ or has a physical existence, has a legally enforceable claim over it, or is exchangeable in the marketplace for cash or other assets
Does the Liverchester club have future economic benefits? Yes. In the form of ticket sales, promotional and sponsorship benefits
Does Liverchester control the future economic benefits? As control means the capacity to deny or regulate the access of others to those benefits, Liverchester would appear to have control. Substantial transfer fees are required if a player wants to go to another club.
Has there been a past event? Yes, there is a contract signed with each player.
Can the players be recognised as assets? Recognition criteria could be discussed if it is agreed that the players are assets. But how do you obtain a reliable measure of your asset?
And what about other officials e.g. coaching staff, management? Are they not assets as well? Does the IASB and FASB proposed definition of an asset change your opinion? The proposed definition is as follows: An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have.
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