Part 1: The Australian accounting environment

Chapter 2

The Conceptual Framework for Financial Reporting

Review questions

What is a conceptual framework of accounting? 2.1

2.1A conceptual framework describes the objectives of, and the concepts for, general purpose financial reporting. A conceptual framework of financial reporting would provide general consensus on issues such as the:

scope and objectives of financial reporting

qualitative characteristics that useful financial information should possess

elements of financial reportinghow they should be defined and when they should be recognisedmeasurement of the elements of financial reporting

disclosure and presentation principles

legal requirement for directors to comply with

2.2There is a general legal requirement that directors must comply with the applicable accounting standards. Nevertheless, if directors believe that particular accounting standards are not appropriate, they have the option of highlighting this fact in the notes to the financial statements and explaining why.

Large listed companies would be considered to be reporting entities and therefore are expected to produce general purpose financial statements which are statements that comply with accounting standards and the Conceptual Framework for Financial Reporting.

2.3The inclusion of two paragraphs in accounting standard AASB 108 Accounting Policies, Changes in Accounting Estimates, and Errors means that preparers of general purpose financial statements are required to follow the Conceptual Framework. Specifically, paragraphs 10 and 11 of AASB 108 state:

10. In the absence of an Australian Accounting Standard that specifically applies to a transaction, other event or condition, management shall use its judgement in developing and applying an accounting policy that results in information that is:

(a) relevant to the economic decision-making needs of users; and

(b) reliable, in that the financial statements:

(i) represent faithfully the financial position, financial performance and cash flows of the entity;

(ii) reflect the economic substance of transactions, other events and conditions, and not merely the legal form;

(iii) are neutral, that is, free from bias;

(iv) are prudent; and

(v) are complete in all material respects.

11. In making the judgement described in paragraph 10, management shall refer to, and consider the applicability of, the following sources in descending order:

(a) the requirements in Australian Accounting Standards dealing with similar and related issues; and

(b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.

Hence, the accounting standard AASB 108, which has the force of law pursuant to the Corporations Act, requires management to refer to the Conceptual Framework for Financial Reporting where a specific issue is not addressed in a particular accounting standard. That is, in the absence of a specific accounting standard to address an issue, reporting entities must be guided by the Conceptual Framework.

2.10Within the IASB Conceptual Framework, the primary users of general purpose financial reports are deemed to be investors, lenders and other creditors. As Paragraph 1.5 states:

Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed.

In the 1989 version Conceptual Framework released by the IASC (which then became the IASB) the public had been identified as a user of general purpose financial statements. However, in the IASB Conceptual Framework released in 2010, and then in 2018, even though a primary group of users are identified, it is proposed that accounting information designed to meet the information needs of investors, creditors and other users will usually also meet the needs of the other user groups identified. As the IASB Conceptual Framework (paragraph 1.10) states:

Other parties, such as regulators and members of the public other than investors, lenders and other creditors, may also find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.

In explaining the reasons why the users of financial statements were identified as primarily being investors, lenders and other creditors, the Basis for Conclusions that accompanied the release of the IASB Conceptual Framework stated:

The reasons why the Board concluded that the primary user group should be the existing and potential investors, lenders and other creditors of a reporting entity are:

(a) Existing and potential investors, lenders and other creditors have the most critical and immediate need for the information in financial reports and many cannot require the entity to provide the information to them directly.

(b) The Boards and the FASBs responsibilities require them to focus on the needs of participants in capital markets, which include not only existing investors but also potential investors and existing and potential lenders and other creditors.

(c) Information that meets the needs of the specified primary users is likely to meet the needs of users both in jurisdictions with a corporate governance model defined in the context of shareholders and those with a corporate governance model defined in the context of all types of stakeholders.

Students should be encouraged to discuss whether they agree with the above depiction of users.

In considering the matter of the level of expertise expected of financial statement readers, it has generally been accepted that readers are expected to have some proficiency in financial accounting. As a result, accounting standards are developed on this basis. The IASB Conceptual Framework, (paragraph 2.36) explains that:

Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.

So financial statements are written for an audience that is educated to some degree in the workings of accountingthis is an interesting observation given the many hundreds of thousands of financial statements being made available to investors annually, most of whom would have no grounding whatsoever in accounting. To usefully consider the required qualitative characteristics financial information should possess (for example, relevance and understandability), some assumptions about the abilities of report users are required. It would appear that those responsible for developing conceptual frameworks have accepted that individuals without any expertise in accounting are not the intended audience of reporting entities financial statements (even though such people may have a considerable amount of their own wealth invested). Again, students should be encouraged to discuss this assumption.

2.12The fundamental qualitative characteristics identified in the IASB Conceptual Framework for Financial Reporting are relevance and faithful representation. In discussing the need for information to be relevant and faithfully represented, paragraph 2.20 of the IASB Conceptual Framework states:

Information must be both relevant and provide a faithful representation of what it purports to represent if it is to be useful. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions.

Relevance is a fundamental qualitative characteristic of financial reporting. Under the IASB Conceptual Framework, information is regarded as relevant if it is considered capable of making a difference to a decision being made by users of the financial statements. Specifically, paragraph 2.6 states:

Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources.

There are two main aspects to relevance. For information to be relevant it should have both predictive value and confirmatory value (or feedback value), the latter referring to informations utility in confirming or correcting earlier expectations.

Closely tied to the notion of relevance is the notion of materiality. General purpose financial statements are to include all financial information that satisfies the concepts of relevance and faithful representation to the extent that such information is material.

The other primary qualitative characteristic (other than relevance) is faithful representation. According to the IASB Conceptual Framework, to be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. According to paragraph 2.13 of the IASB Conceptual Framework:

To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Boards objective is to maximise those qualities to the extent possible.

In terms of the three characteristics of complete, neutral and free from error, that together reflect faithful representation, the IASB Conceptual Framework provides further guidance. Paragraph 1.14 states:

A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. For example, a complete depiction of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical depiction represents (for example, historical cost or fair value).

In relation to neutrality, paragraph 1.15 states:

A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users. Neutral information does not mean information with no purpose or no influence on behaviour. On the contrary, relevant financial information is, by definition, capable of making a difference in users decisions.

When the IASB released the revised Conceptual Framework in 2018 it reintroduced the concept of prudence (it was removed from the 2010 version), which it directly related to the characteristic of neutrality (which as we know is a component of faithful representation). Neutrality is supported by the exercise of prudence, where prudence represents the exercise of caution when making judgements under conditions of uncertainty. Paragraph 2.16 states:

The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets or income or the overstatement of liabilities or expenses. Such misstatements can lead to the overstatement or understatement of income or expenses in future periods.

In relation to the characteristic of freedom from error, paragraph 2.18 states:

Faithful representation does not mean accurate in all respects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. In this context, free from error does not mean perfectly accurate in all respects. For example, an estimate of an unobservable price or value cannot be determined to be accurate or inaccurate. However, a representation of that estimate can be faithful if the amount is described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate.

Hence, from the above we should understand that financial information that faithfully represents a particular transaction or event will depict the economic substance of the underlying transaction or event, which is not necessarily the same as its legal form. Further, faithful representation does not mean total absence of error in the depiction of particular transactions, events or circumstances because the economic phenomena presented in financial statements are often, and necessarily, measured under conditions of uncertainty. Hence, most financial reporting measures involve various estimates and instances of professional judgement. To faithfully represent a transaction or event an estimate must be based on appropriate inputs and each input should reflect the best available information.

2.15According to the IASB Conceptual Framework, to be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. According to paragraph 2.13 of the IASB Conceptual Framework:

In relation to neutrality, paragraph 1.15 states:

When the IASB released the revised Conceptual Framework in 2018 it reintroduced the concept of prudence (it was removed from the 2010 version), which it directly related to the characteristic of neutrality (which in turn is a component of faithful representation). Neutrality is supported by the exercise of prudence, where prudence represents the exercise of caution when making judgements under conditions of uncertainty. Paragraph 2.16 states:

In relation to the characteristic of freedom from error, paragraph 2.18 states:

Hence, from the above paragraphs we should understand that financial information that faithfully represents a particular transaction or event will depict the economic substance of the underlying transaction or event, which is not necessarily the same as its legal form. Further, faithful representation does not mean total absence of error in the depiction of particular transactions, events or circumstances because the economic phenomena presented in financial statements are often, and necessarily, measured under conditions of uncertainty. Hence, most financial reporting measures involve various estimates and instances of professional judgement. To faithfully represent a transaction or event an estimate must be based on appropriate inputs and each input should reflect the best available information.

Challenging questions

For each of the independent situations identified below. Consider and conclude whether the entity is required by the corporations act to prepare financial statement and if so whether it is a reporting entity you should also note the reporting implications of your decision

2.28The general principle is that general purpose financial statements should be prepared by all reporting entities. General purpose financial statements are reports that comply with the Conceptual Framework and accounting standards. AASB 1053 further defines them as follows:

General purpose financial statements are those intended to meet the needs of users who are not in a position to require an entity to prepare reports tailored to their particular information needs.

If an entity is not deemed to be a reporting entity then it will not be required to produce GPFSs; that is, it will not necessarily be required to comply with accounting standards. The determination of whether users are dependent upon GPFSs for the purposes of making and evaluating resource allocation decisions (that is, whether an entity is a reporting entity) requires professional judgement.

(a)ABC Pty Ltd is a small proprietary company with two shareholders. In this case, management is not separated from economic interest as Mr and Mrs ABC are involved in the day-to-day operations. The only user appears to be The Bank, which receives management accounts and budgeted cash flow information. Providing The Bank does not advise that it is dependent upon GPFSs, and ABC Pty Ltd has no economic or political influence, ABC Pty Ltd does not appear to be a reporting entity.

(b)F Pty Ltd exhibits some characteristics of being a non-reporting entity. There are few shareholders and there appears to only be one banker who receives accounts. If the banks borrowing agreement requires GPFSs then while the company may not be a reporting entity, it will have to produce GPFSs.

If the bank does not require GPFSs then consideration needs to be given to the fact that 200 staff are employed and it is one of only two companies involved in widget making in Australia. Does it have economic or political influence?

If widgets are significant to the Australian economy then it may be considered to be a reporting entity. If they are not, it may not be (much judgement!). Are the suppliers also users of the financial statements? Are the 200 employees users of the financial statements?

Providing the business is not significant to the economy, and that the creditors do not rely on the financial statements then, more than likely, the company is not a reporting entity. However, because it appears to meet the criteria within the Corporations Act for being a large proprietary company (it has more than 100 employees and it is likely that one of the other tests are met) then it might be required to prepare financial statements that comply with accounting standards.

(c)In deciding whether E Trust is a reporting entity there would be two factors to consider. The maximum number of members is 30 and quarterly reports are produced disclosing the market value of the trust and each members entitlement.

There is no information given about the trusts borrowing. In the absence of any major borrowings, it would appear that any users are receiving sufficient and timely information without the need to rely on GPFSs.

Although there are 30 members, and hence a separation of management from economic interest, this fact alone does not automatically mean it is a reporting entity. E Trust would probably not be construed to be a reporting entity.

2.31(a)Yes, pursuant to the Conceptual Framework, general purpose financial statements are prepared on the assumption that a reporting entity is a going concern. Some key underlying assumptions within the Conceptual Framework are that for financial statements to meet the objectives of providing information for economic decision making, they should be prepared on the accrual and going concern basis. In relation to the assumption pertaining to the organisation being a going concern, paragraph 3.9 of the Framework states:

The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to enter liquidation or cease trading. If such an intention or need exists, the financial statements may have to be prepared on a different basis. If so, the financial statements describe the basis used.

Hence unless otherwise stated, it is assumed that a general purpose financial statement is prepared on the basis that the entity adopts accrual accounting, and that the entity is a going concern.

AASB 101 Presentation of Financial Statements is also relevant. Paragraphs 25 and 26 of AASB 101 state:

25 When preparing financial statements, management shall make an assessment of an entitys ability to continue as a going concern. An entity shall prepare financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. When management is aware, in making its assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entitys ability to continue as a going concern, the entity shall disclose those uncertainties. When an entity does not prepare financial statements on a going concern basis, it shall disclose that fact, together with the basis on which it prepared the financial statements and the reason why the entity is not regarded as a going concern.

26 In assessing whether the going concern assumption is appropriate, management takes into account all available information about the future, which is at least, but is not limited to, twelve months from the end of the reporting period. The degree of consideration depends on the facts in each case. When an entity has a history of profitable operations and ready access to financial resources, the entity may reach a conclusion that the going concern basis of accounting is appropriate without detailed analysis. In other cases, management may need to consider a wide range of factors relating to current and expected profitability, debt repayment schedules and potential sources of replacement financing before it can satisfy itself that the going concern basis is appropriate.

In relation to the organisation in question, and as reflected in paragraph 26 above, a number of factors need to be assessed in terms of deciding whether it is appropriate to consider that the entity is a going concern. For example, will profits return in the future, can existing debts be paid, what sources of funding are available? Given the information available, there would obviously be some question about whether the organisation is a going concern. It would be anticipated that the auditors would have undertaken extensive investigation before concluding that the going concern assumption was still appropriate in this situation.

(b)If an entity is not considered to be a going concern, then the basis of measuring the assets of the organisation needs to change such that the assets would need to be valued on the basis of what they could generate financially, typically from a sale, in the very near term. It would no longer be appropriate to measure the assets on the basis of their value in use over an extended period. For example, if an item of machinery is very specialised in nature but was formerly expected to be used for the next ten years, then it would have been appropriate to measure that machinery at cost and depreciate it over ten years (to the extent that the recoverable amount of the machine through its value in use is not less than cost). However, if an entity is no longer assumed to be a going concern, then any measurement that is based on a long period of use is inappropriate. Rather, the asset shall be measured on the basis of what it could realise in the short termtypically from a sale. If the machinery, for example, is specialised in nature, then there might be few people who demand the machinery and it might have very minimal sale value, meaning that significant impairment losses might need to be recognised.

explain the importance of sustainability and corporate social responsibility for a firm

Sustainability is a comprehensive approach to management of organizations which is focused on creating and maximizing long - term economic , social and environmental value . It is a response to the challenges of the modern world facing organizations from the public and private sectors .

Step-by-step explanation

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Corporate social responsibility (CSR) refers to a company's commitment to conducting its business in an ethical, socially responsible, and environmentally sustainable manner. This involves considering the interests of various stakeholders, such as employees, customers, suppliers, and the community, in addition to shareholders. Sustainability, on the other hand, is a broader concept that focuses on meeting the needs of the present without compromising the ability of future generations to meet their own needs. It encompasses three main pillars: economic, social, and environmental. In the context of CSR, sustainability means that companies should strive to create long-term value in all three areas. This can be achieved by: 1. Economic sustainability: Ensuring the company's financial stability and growth, while also contributing to the overall economic development of the communities in which it operates. 2. Social sustainability: Promoting fair labor practices, diversity and inclusion, community engagement, and other initiatives that contribute to the well-being of employees and the broader society. 3. Environmental sustainability: Minimizing the company's environmental footprint by reducing waste, conserving resources, and implementing eco-friendly practices. By integrating CSR and sustainability into their business strategies, organizations can not only address the challenges of the modern world but also create a positive impact on society and the environment.

Part 2: Theories of accounting

Chapter 3

Theories of financial accounting

Review questions

3.1A positive theory can be used to explain and predict particular phenomena whereas a normative theory provides a prescription about what should be done.

It should not be said that one is better or more useful than the other as they both fulfil necessary roles in either explaining or predicting current practice, or in informing us what we might do to improve current practice. Arguably you cannot prescribe how to improve an activity unless you understand/are able to explain current activity.

3.2Positive Accounting Theory which is one example of a positive theory of accounting can provide an explanation of creative accounting. It can also predict when some form of creative accounting might be relative more likely to occur.

Positive Accounting Theory relies upon an assumption that all individuals are driven by self-interest and that this self-interest is linked to maximising personal wealth. When a researcher tries to explain why managers might have supported the use of a particular method of financial accounting in preference to another, Positive Accounting Theory could provide insights that, for example, a method was chosen because it increased profits and therefore increased the size of the managers bonus (assuming the manager received a bonus linked to accounting profits). Alternatively perhaps, a method of financial accounting might have been used somewhat creatively because it increased income and/or assets thereby reducing the likelihood that the organisation would breach an accounting-based debt covenant (assuming such covenants had been negotiated between the organisation and is debt providers).

3.4The majority of financial accounting textbooks address the various rules embodied within accounting standards (as this book also does) but fail to consider such issues as:

What motivates management to adopt particular accounting methods when they have a choice between alternative approaches?

Why do some organisations lobby in support of particular accounting methods whereas other organisations oppose the methods?

What costs are likely to follow as a result of new accounting standards being released and are these costs likely to be equal for all stakeholders?

What factors would motivate accounting regulators to favour introducing one method of accounting in preference to another?

How will particular stakeholder groups respond to particular accounting disclosures?

To consider or explore issues such as those identified above essentially requires us to embrace particular accounting theories, such as those addressed in Chapter 3. Without exploring particular theories it would be difficult to provide considered answers to the above issues. In providing an overview of various theorieswhich is typically not what other financial accounting texts dothe author (as well as lecturers that have prescribed this chapter as part of the students required reading) believes that not only is it useful to discuss the requirements of the various accounting standards, but that it is important to provide frameworks within which to consider the implications of organisations making particular accounting disclosures, whether voluntarily or as a result of particular mandate. We also think it is useful to consider the various pressures, many of which are political in nature, that influence the accounting standard-setting environment.

Of course, financial accounting could be studied without reading about theories of accounting. However, because the impact of financial accounting resonates throughout society (and society also influences the practice of accounting which is why we often argue that accounting is both a technical and a social practice), we believe studying accounting theories provides readers with the necessary background to understand the possible implications of an organisation making particular disclosures. The theories overviewed in Chapter 3 also provide the basis for understanding the various pressures that drive the managers of organisations to make particular disclosures, even in the absence of disclosure requirements pertaining to particular transactions and events. By reading Chapter 3, together with the material in other chapters of this book, we believe that readers will gain a greater understanding of the implications of various accounting standards and other disclosure requirements.

3.5If it is assumed that individuals act in their own self-interest and seek to undertake actions which maximise their own wealth at the expense of others (as is assumed in Positive Accounting Theory (PAT) and various other theories from the economics literature), then it is possible that actions that are in the best interests of the manager may not always be in the best interests of other stakeholders, or the firm as a whole. From a PAT perspective, one way to alleviate this problem is to make the managers wealth dependent upon actions which also would lead to a maximisation of the value of the firm. This is often referred to as an alignment of interests.

The types of management activities that may adversely affect the value of the firm would include perquisite consumption and/or the use of information acquired within the firm for the purposes of private gain. Mechanisms such as an efficiently operating labour market and efficiently devised remuneration plans should, according to PAT theorists, act to eliminate at least some of the actions by management that may not be in the interests of the firm. According to PAT, it is not possible to devise mechanisms that will fully remove the ability of management to undertake actions that are not in the interests of the organisation.

3.14The auditor acts to monitor the compliance of management with particular legislative and professional reporting requirements, and also perhaps with regard to privately negotiated accounting-based contractual arrangements. The value of the external auditor comes from the auditors independence. The auditor should provide an opinion on the financial statements, irrespective of whether it is, or is not, an opinion preferred by management. For many accounting disclosures there is a high degree of professional judgement necessary. Hence, the auditor will frequently have to arbitrate on the reasonableness of the accounting methods employed and the various professional judgements made by managers and their accountants.

Instructors should emphasise the benefits that firms may derive from being audited, and that auditing existed well before regulatory requirements. With greater confidence being attributed to the financial statements (and this in part may be a function of the reputation of the auditor) a firm may be able to attract funds at lower cost, given that greater reliance can be placed on the financial reports.

3.16Political costs may be defined as costs or wealth transfers, which certain parties or groups external to the firm may be able to impose on the firm. Such parties may have no explicit contractual arrangements with the firm. For example, trade unions/employee groups might be able to impose costs on the firm by instigating strikes or claims for wage increases. Particular interest or consumer groups may be able to impose costs on the firm by lobbying government to impose greater regulatory controls on the firm. Environmental groups may be able to impose costs on the firm by recommending product boycotts of those firms that do not comply with the environmental groups own environmental standards or expectations.

Often the actions undertaken by the various groups external to the organisation are justified by high profits that might be reported by the organisation. In a sense the high profits are construed as a sign that the organisation is exploiting other stakeholders for the purpose of generating profits for the purposes of increasing the wealth of owners (shareholders). When we watch or read the news media we often see that different stakeholders directly refer to the profits of the organisation to justify claims for greater financial benefits to stakeholders other than the owners.

Where pushes for wage rises or reductions in prices of the firms goods and services seem to be related to the reported profitability of the firm, then the firm may adopt income decreasing strategies. This would, it is assumed, be successful on the basis that the parties imposing the costs do not adjust the financial statements to offset any changes in profits brought about by the changes in accounting methods employed. That is, the assumption is that if accountants within an organisation creatively reduce reported profits to counter any claims being made by external interest groups, these external groups would not understand that the profits have been opportunistically manipulated.

Where firms are subject to scrutiny by such groups as environmental parties then they may elect to disclose additional qualitative information of a positive or favourable nature in the annual financial statements. This information may act to reduce the effects of the negative publicity being released by the particular interest groups.

3.17As part of the accounting standard setting process, accounting standard setters such as the IASB, FASB and the AASB encourage interested parties to make submission on particular proposals, which are often reflected within Exposure Drafts. This is in itself an interesting process as it implies that the accounting standard-setting process is a political process in which different vested interests voice their support or opposition to proposed accounting requirements such that the final accounting standard could be considered to represent a negotiated outcome.

One argument why a firm might make submissions to the accounting standard setter may be that as the firm might already have in place many contracts tied to accounting numbers, and such contracts rely upon floating GAAP, then any change in accounting requirements may affect these arrangements and the associated cash flowsand hence, value of the firm.

Alternatively, management may believe that the accounting methods it applies are most efficient in disclosing managerial and firm performance (and possibly, for minimising the agency costs of the firm) and that if accounting standard-setters start mandating a different (one-size-fits-all) accounting technique (and thereby reducing the portfolio of possible techniques), inappropriate indicators of performance will be provided to account users. This creates inefficiencies it the ability of the managers to provide signals of the managers, and the firms, performance.

Under PAT there is also the political cost hypothesis, which argues that if an organisation is subject to political scrutiny then the managers might prefer to use accounting methods that reduce reported profits. Therefore, if managers perceive that the organisation is subject to political costs then they might lobby for methods of accounting that are income reducing.

Because the accounting standards being used within Australia now emanate from the IASB, rather than being locally developed, the ability of local organisations to influence accounting standard setters has arguably declined relative to the situation wherein the AASB was responsible for developing Australian accounting standards.

Challenging questions

Does the teaching of positive accounting theory act to install inappropriate values within the minds of students

3.29 This question has been included to stimulate debate. A central assumption of PAT is that all actions by individuals are motivated by self-interest. Some people believe that if you teach students that the best way to predict what somebody will do is to assume that they, like everybody, will act in their own self-interest then the students might start to believe that self-interested behaviour is the expected form of behaviour and that might then influence how they make decisions. Self-interest becomes the norm. In a sense, the view might be that by teaching theories that embrace self-interest as a core behavioural assumption then it might become a self-fulfilling prophecy that the students also start making decisions based on self-interest with little regard for the broader implications of their decisions.

The acceptance of self-interest as an appropriate motivator and efforts to address sever global problems like climate change seem to be mutually exclusive. If we want to address problems like climate change and other sustainability-related issues then we need to think about the implications of our actions on other stakeholders, including future generations. We need to modify or eliminate a fixation on self-interest and private gain. It is not at all clear that espousing PAT is consistent with that ideal, albeit that PAT provides some very useful insights.

read the brief extract from Anthony hughes article credit card profit soars but ANZ feels no quit

3.38(a)We can never be sure why an organisation undertakes a particular strategy. Different theories, such as those discussed in Chapter 3, might provide different insights. Perhaps some managers actually believed that they owed a duty to particular stakeholders to devise such a plan and therefore adopted the strategy because of ethical responsibilities. Alternatively, perhaps they thought that the profitability of the organisation was being influenced by the community concern and to alleviate some of this concern, and perhaps to reinstate some legitimacy, they developed a plan to tackle community concerns.

Again, we cannot really be sure of the motivations and we can refer to different theories of regulation to provide us with some insights. If we adopt a public interest perspective of regulation then we might explain the governments actions on the basis that such actions are in the public interest, rather than in politicians self-interests. However, if we embrace particular economics-based theories of regulation, such as private interest theories of regulation, then politicians would take action to the extent that it serves their own interests; for example, bolsters their chances of re-election. Instructors might quiz the students about which theoretical perspectives they would be inclined to accept. Do we really think politicians would be driven by self-interest or do we accept their position that they serve the public interest (or can it be a mixture of both?)?

We cannot be sure, but the high profits do provide an excuse for people to argue that the banks can do more for the community and perhaps less for the shareholders and managers. The community would probably feel that it is not part of the social contract to have soaring profits while staff numbers are cut, branches are closed, and high fees are charged. There could be a view that the banks have a social responsibility that they simply are not fulfilling, yet they have the resources to be socially responsible. Advocates of PAT would argue that higher profits make the organisation a target of political scrutiny.

Yet again, it depends upon our theoretical perspective. If profits are used as an excuse for governments to take action against an organisation, and if government believes that it can win votes by taking such action, then the banks might be advised to adopt income-reducing strategies. This would decrease the ability of the government to justify its action. However, if the management of the banks do not believe that the community or the government will react favourably to reduced profits then income-reducing strategies might not be adopted. What should be remembered is that reducing profits because of community concerns and the threat of government action is opportunistic conduct and would constitute creative accounting. If management and accountants believe that they should be objective, as our Conceptual Framework recommends, then they would not manipulate accounting profits to get their desired results. Of course, whether we believe that people act objectively will depend upon our own views about what motivates individual behaviour.

Part 10: Corporate social-responsibility reporting

Chapter 32

Accounting for corporate social responsibility

Review questions

32.1There is no precise definition of social-responsibility reporting. It refers to the provision of information to enable others to determine whether an entity has fulfilled its social responsibilities. It is directly tied to notions of accountability. A discussion of social-responsibility reporting requires some consideration of the social responsibilities of business. There are many alternative perspectives on what these are.

The textbook provides one definition of social-responsibility reporting. It defines it as the provision of information about the performance of an organisation in relation to its interaction with its physical and social environment. This would include information about an organisations:

interaction with the local community

level of support for community projects

level of support for developing countries

health and safety record

training, employment and education programs

environmental performance.

32.10 Under a cap-and-trade system, allowances or credits are used to provide incentives for companies to reduce emissions by assigning a monetary value to pollution. In the European Union (EU), each carbon allowance permits the holder to emit one tonne of CO2. The cap phase of the program begins when a government or regulatory body establishes an economy-wide target for the maximum level of aggregate emissions permitted by companies in a specified timeframe. Then, a specific number of emissions allowances equal to the national target are allocated (or auctioned) to participating companies based on a formula that generally includes past emissions levels. Over time, it is expected that the amount of permits (or units) made available will be reduced by the government in line with the quest to reduce carbon emissions.

The trade aspect of the program occurs when a companys actual emissions are greater or less than the number of allowances it holds. Companies that emit less than the number of permits they hold will have excess allowances; those that exceed the number of permits they hold must acquire additional allowances. Additional (or excess) allowances can be purchased (or sold) directly between companies, through a broker, or on an exchange. Excess allowances can be banked and used to satisfy compliance requirements in subsequent years. It is argued that cap-and-trade programs provide companies with added flexibility to choose the most cost-effective way to manage their emissions.

While there is no definitive guidance, it appears from international experience that the following financial accounting approaches would be acceptable within the Australian context to account for the related financial assets and liabilities associated with a cap-and-trade system:

Any emission permits or rights that have been allocated to a reporting entity shall be considered to be intangible assets and can be recognised at their fair value at allocation date.

Permits are subject to periodic impairment tests.

The difference between the price paid for, and the fair value of permits received from the government is initially reported as deferred income and then systematically recognised as revenue over the compliance period regardless of whether the allowances are held or sold.

Increases in fair value of permits are reported in shareholders equity and decreases in fair value are recognised in profit or loss to the extent they exceed the revaluation surplus.

As greenhouse gases are emitted, the reduction in the value of any emission right or permit would be recognised as an expense.

Should organisations emit at levels beyond their permits, the related financial obligation would be of the nature of a liability.

There should be no netting of assets and liabilities related to emissions. (Adapted from Fornaro, Winkelman & Glodstein, 2009.)

32.12Larger organisations do typically disclose information about their social and environmental performance. However, there will be great variation in the types of social and environmental information being disclosed by different organisations.

One organisation that performs a regular survey of CSR reporting is the global accounting firm KPMG. The latest available survey results were released in 2017 (KPMG 2017). KPMG used two broad samples for its research. It surveyed the reporting practices of a global sample of 4900 companies, which was made up of the top 100 companies from 49 different countries (referred to as the N100 companies). It also surveyed the reporting practices of the worlds largest companies by revenue based on the Fortune 500 ranking of companies (referred to as the G250 companies). KPMG reports that 93 per cent of G250 companies and 75 per cent of N100 companies produce CSR reports. The leading countries are the United Kingdom, Japan, India, Malaysia, France, Denmark, South Africa and the United States, with reporting rates for the N100 companies in these countries ranging from 92 per cent to 99 per cent. Australia was ranked 27th, with a reporting rate of 77 per cent.

32.13This is a question that can generate much debate. It has traditionally been accepted that business organisations have a primary responsibility to their owners, and this responsibility has generally been associated with maximising the profits and financial value of the organisation. However, it is increasingly being accepted that organisations must consider the social and environmental impacts created by their operations and that this responsibility extends the range of key stakeholders to include future generations.

Any organisation that claims to be embracing sustainability would need to consider and try to reduce their organisations impacts on future generations, otherwise their claim to be embracing sustainability would be hypocritical.

32.16Yes it does. AASB 116 Property, Plant and Equipment requires the cost of an item of property, plant and equipment to include the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located. Specifically, paragraph 16(c) of AASB 116 states that the cost of an item of property, plant and equipment shall include:

the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.

32.33The arguments embodied within Brown and Deegan (1999) are based upon arguments that emanate from both Legitimacy Theory and Media Agenda Setting Theory. Legitimacy Theory argues that the disclosure practices adopted by companies will be influenced by community expectations and concerns. Media Agenda Setting Theory argues that the media can actually set the public agenda. That is, media coverage of various issues can increase the perceived importance of those issues from the perspective of the media audience. Results of tests of Media Agenda Setting Theory show that the media can be particularly powerful in influencing what people think are important environmental issues. (The environment is deemed to be an unobtrusive issue.)

Hence, if the extent of coverage devoted to specific issues in the media (the media agenda) is considered to impact the publics concern about particular issues (from Media Agenda Setting Theory), and if companies disclosure policies are based on community concerns (from Legitimacy Theory) then we can argue that an increase in the media coverage relating to a particular issue will lead to an increase in corporate disclosures pertaining to that issue.

Challenging questions

32.40(a) Expenses are defined so as to exclude the recognition of any impacts on resources that are not controlled by the entity (such as the environment), unless fines or other cash flows result. Pursuant to the Conceptual Framework, expenses are defined as follows:

Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

An understanding of expenses therefore requires an understanding of assets. An asset is defined in the Conceptual Framework as:

a present economic resource controlled by the entity as a result of past events. (emphasis added)

The recognition of assets therefore relies upon control. Environmental resources such as air and water are shared and not controlled by the organisation and hence cannot be considered to be assets. Therefore, their use and/or abuse are not considered expenses. It should be emphasised that this is a very significant limitation of financial accounting as it pertains to reporting information about social and environmental performance.

(b)As we would know, financial accounting adopts the entity assumption, which requires an organisation to be treated as an entity distinct from its owners, other organisations and other stakeholders. According to this concept, an organisation is treated as an accounting unit that is quite distinct and separate from the owners and other organisations, and the accountant must define the organisations area of interest in such a way as to limit the events and transactions to be included in the financial statements. The organisation and the stakeholders of that organisation are treated as separate accounting entities.

The entity assumption allows the accountant to measure the financial performance and position of each entity, independent of all other entities. According to the entity assumption, if a transaction or event does not directly affect the entity, the transaction or event is to be ignored for accounting purposes. This means that the externalities caused by reporting entities will typically be ignored, and that performance measures (such as profitability) are incomplete from a broader societal (as opposed to a discrete entity) perspective.

Arguably, any moves towards accounting for sustainability would require a modification to, or a move away from, the entity assumption.

(c)The Conceptual Framework provides recognition criteria for the elements of financial reporting. As we know from previous chapters, for a transaction or event to be recognised within the financial statements there is a requirement within the Conceptual Framework that:

the definition of the respective element of accounting be satisfied (the elements being assets, liabilities, income, expenses and equity), and that

the information about the respective element be considered both relevant (which requires consideration of factors such as existence uncertainty and assessments about the probabilities of the related outflow or inflow of economic benefits) and representationally faithful (which requires consideration of factors such as measurement uncertainty).

In relation to considerations relating to the perceived probability of future outflows of economic benefits, the greater the uncertainty in terms of predicting the likelihood of future cash flows occurring, the less relevant would be the disclosure of information about an item of income or expense, or the related asset and liability.

Hence, for all the five elements of financial accounting, both probability and measurability are key considerations. Evidence suggests that many liabilitiesparticularly those related to the environmentare ignored, often on the basis that they are too difficult to reliably measure and therefore do not satisfy the recognition criteria. In examining how Australian companies disclose information about contaminated sites, Ji and Deegan (2011) undertook an investigation of a number of large Australian companies that were known to have some significantly contaminated land sites under their control. Overwhelmingly, the companies failed to disclose information about liabilities associated with remediating (cleaning up) the contaminated sites, often stating that they were unable to reliably measure the associated liabilitiesusing this as a justification (or an excuse) for non-disclosure. If the liabilities are not recognised on the basis of a supposed inability to measure the liabilities with reasonable accuracy, then the associated expenses will also not be recognised, thereby arguably leading to an overstatement of profits.

(d)As accountants, we do tend to emphasise short-term (annual) performance through our practices of dividing the life of the asset up into somewhat artificial periods of time. Managers are also often rewarded in terms of measures of performance such as annual profits. This can have the effect of discouraging us from making long-term investments in new technologies (including those that will provide longer-term social and environmental benefits). This acts to dissuade us from investment expenditure in more sustainable modes of operation that might not generate positive financial results for many years.

32.46This question should stimulate a great deal of discussion with the students. In terms of the costs and benefits of disclosure we can initially consider the costs. Such costs would include:

the costs of setting up appropriate systems to collect the required information

the costs associated with producing the reports

the costs associated with having the reports verified

some costs in the short run associated with stakeholder reaction to various items of bad news. (However, there is a general expectation that bad news will become known sooner or later and it is probably a good idea for the organisation to tell its stakeholders as early as possible rather than leaving it to someone else to reveal the adverse news.)

In terms of the benefits of reporting, it is a general principle that an organisation with effective reporting mechanisms will be deemed to be of lower risk than other organisations. This should translate to lower costs of capital. Because business risk is very much a function of social and environmental risks, an assessment of business risk requires knowledge of the social and environmental policies of an organisation. Given increased demands for corporate accountability, an organisation with a sound reporting approach will be able to maintain its community licence to operate. Further, collecting information about the social and environmental costs associated with an entitys operations should highlight opportunities for managing and reducing such costs (the adage being that you cannot manage what you do not measure).

Students should be encouraged to consider the sorts of approaches that might be used for reporting. In making decisions about reporting formats, consideration should be given to the needs of stakeholders. Reference might also be made to various authoritative reporting guidance documents (such as the Global Reporting Initiative Sustainability Reporting Standards), as well as to corporate reports deemed to represent current best practice (and the best practice reports might be determined by referring to the winners of some of the various sustainability reporting awards operating throughout the world).

In determining to whom the reports should be disseminated, such a decision will be based on determinations of who the stakeholders are and whether management is focusing on the rights of all stakeholders, or only those stakeholders that are in control of those resources upon which the entity is dependent (that is, the powerful stakeholders). The reporting approach will also depend upon why management is reporting. For example, are they reporting because they believe in properly demonstrating accountability to all affected stakeholders; or because they are seeking direct economic benefits for the organisation, or for themselves (the opportunistic perspective)?

PART 4: Accounting for liabilities and owners equity

Chapter 11

Accounting for leases

Review questions

11.3Lease term is defined within the accounting standard as:

The non-cancellable period for which a lessee has the right to use an underlying asset, together with both:

(a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and

(b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

Considerations of whether something is reasonably certain (as used in the above paragraph) would include a number of factors, including:

whether a purchase option or lease-renewal option exists within the lease contract and whether the nature of the pricing of the options is sufficiently favourable to the lessee to suggest that the lessee is reasonably certain to exercise the option;

whether there has been significant customisation of the lease asset. For example, if the lessee has leased a building and has made significant and costly modifications to the leased building, then this might suggest that if there is an option to renew the lease at typical market rates then the renewal option is reasonably likely to be taken.

11.5Pursuant to IFRS 16/AASB 16, a lessee should capitalise a lease transaction (meaning that the leased asset and lease liability will be included within the statement of financial position) when the lease is for a period in excess of 12 months and the lease is not for a low-value item. A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligations to make lease payments.

For a lessee to be required to capitalise a lease in accordance with IFRS 16/AASB 16, the contractual arrangement needs to satisfy the requirements in terms of being a lease. This requires that the lease obligation be non-cancellable and that the lessee controls the asset for the duration of the lease, meaning that the supplier of the asset (the lessor) does not have a substantive right to substitute the asset throughout the period of use.

11.8The accounting standard requires that the lease component of the contract must be considered separately from the service contract. The customer does not obtain control of a resource as part of a service component. Rather, it commits to purchasing services that it will receive in the future and the supplier retains control of the use of any items needed to deliver the particular service. Therefore:

with a lease, the customer controls the use of the item; and

with a service, the supplier controls the use of the item delivering the service.

The general principle is that service contracts are not to be capitalised on the balance sheet. Because contracts often contain both a lease and a service component, it is necessary for a lessee to separate the amounts for the lease from the amounts to be paid in respect of the service arrangement. A lessee would then recognise on the balance sheet only the amounts that relate to the lease component. The allocation of amounts for the lease and non-lease (service) components would be based on relative stand-alone pricesthat is, on the basis of prices that the lessor, or another similar supplier, would charge on a separate basis for a similar lease, and for a similar service arrangement. If observable prices are unavailable, then the lessee shall estimate stand-alone prices. The accounting standard also allows, in apparent response to requests for simplicity, that the lessee can choose not to separate the services from the lease and treat the whole contract as the lease. Entities would be expected to make this choice only when the service component of the contract is relatively small.

11.9In terms of the initial measurement of the lease liability, paragraph 26 of the accounting standard requires that:

At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessees incremental borrowing rate.

In considering the above requirement, we need further guidance on what to include as part of lease payments and we also need further information about what is meant by interest rate implicit in the lease. In relation to the lease payments that need to be included as part of the lease liability (and it will be their present value that will be calculated), paragraph 27 states:

At the commencement date, the lease payments included in the measurement of the lease liability comprise the following payments for the right to use the underlying asset during the lease term that are not paid at the commencement date:

(a) fixed payments (including in-substance fixed payments as described in paragraph B42), less any lease incentives receivable;

(b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date (as described in paragraph 28);

(d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option (assessed considering the factors described in paragraphs B37B40); and

(e) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

In terms of the leased asset, at the commencement date, a lessee shall measure the right-of-use asset at cost. This requirement obviously necessitates that we need to understand what is to be included within cost. In this regard, paragraph 24 states:

The cost of the right-of-use asset shall comprise:

(a) the amount of the initial measurement of the lease liability, as described in paragraph 26;

(b) any lease payments made at or before the commencement date, less any lease incentives received;

(d) an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period.

As we can see, initial direct costs are referred to in (c) above as forming part of the cost of the right-of-use asset. Initial direct costs are defined in the accounting standard as:

Incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained, except for such costs incurred by a manufacturer or dealer lessor in connection with a finance lease.

11.13The carrying amount of the lease asset will reduce across time through depreciation. This depreciation will often be calculated on a straight-line basis, or on an accelerated basis. In either case, the reduction in the carrying amount will be constant across the lease term, or in the case of accelerated depreciation, will be higher in the earlier periods of the lease.

The carrying amount of the lease liability will reduce each period as a result of the lease payments. These payments will be part interest expense, and part payment of the lease liability. Because the interest expense will be higher in the early periods of the lease, the reduction in the lease liability will be lower in the early periods of the lease. This will have the effect that the reduction in the lease liability will typically be less that the reduction in the carrying amount of the lease asset in the earlier periods of the lease.

11.16To undertake this calculation, students may use trial and error. The implicit rate is 18%, proven as follows:

Present value of initial payment $5000 1.0 = $5000

Present value of yearly payments ($5500 $500) 4.4941 = $22 470

Fair value at lease inception $27 470

Alternatively, and more easily, we can divide the liability on 1 July 2023 (which would exclude the payment of $5000 at lease inception) by the periodic lease payments (after deducting the executory costs) and then search for the appropriate interest rate within the present value tables. This is easy because of the absence of a guaranteed residual or a bargain purchase option.

(27 470 5000) 5000 = 4.494

A review of the present value of an annuity table shows that $4.4941 equals the present value of an annuity in arrears of $1 per year, for 10 years, discounted at 18%.

11.17(a)The implicit rate is defined in the accounting standard as:

The rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor

Bargain purchase options are included as part of the expected lease payments. In this question the implicit rate is 12 per cent, proven as follows:

Periodic lease payments 315 000 3.6048 = 1 135 512

Bargain purchase option 280 000 0.5674 = 158 872

Fair value at lease inception 1 294 384

(b)1 July 2023

Dr Right-of-use asset machinery 1 294 384 Cr Lease liability

(to recognise the leased asset) 1 294 384

30 June 2024

Dr Interest expense 155 326 Dr Lease liability 159 674 Dr Service expenses 35 000 Cr Cash

(to recognise the periodic lease payment) 350 000

[155 326 = 1 294 384 x 0.12]

Dr Depreciation expense 180 731 Cr Accumulated depreciation right-of-use asset machinery

(to recognise depreciation of the leased asset) 180 731

[180 731 = (1 294 384 210 000)/6]

Note that the useful life of the asset is used for depreciation purposes given the existence of the bargain purchase options, which would result in the asset being transferred to the lessee at the end of the 5-year lease.

30 June 2025

Dr Interest expense 136 165 Dr Lease liability 178 835 Dr Service expenses 35 000 Cr Cash

(to recognise the periodic lease payment) 350 000

[136 165 = (1 294 384 159 674) x 0.12]

Dr Depreciation expense 180 731 Cr Accumulated depreciation right-of-use asset machinery

(to recognise depreciation of the leased asset) 180 731

(c)

30 June 2024 30 June 2025

Non-current assets right-of-use asset - machinery $1 294 384 $1 294 384

Less accumulated depreciation $180 731 $361 462

$1 113 653 $932 922

Current liabilities Lease liability $178 835 $200 295

Non-current liabilities Lease liability $955 875 $755 580

The current portion of the lease liability ($178 835 in 2024, and $200 295 in 2025) is the amount by which the lease liability will be reduced by the lease payments in the following 12 months. In 2025 the current liability component would be calculated as:

$315 000 [($1 294 384 $159 674 $178 835) 0.12]

11.18(a)Present value of the lease payments:

(62 500 6250) 3.6048 = 202 770

50 000 0.5674 = 28 370

Present value of minimum lease payments 231 140

Books of Sanders using the net method

1 July 2023

Dr Lease receivable 231 140 Dr Cost of sales 200 000 Cr Inventory 200 000

Cr Sales

(recognition of the lease receivable and the related sale) 231 140

30 June 2024

Dr Cash 62 500 Cr Service expenses recoupment (statement of profit or loss and other comprehensive income) 6 250

Cr Interest revenue 27 737

Cr Lease receivable

(to recognise periodic lease receipt) 28 513

[27 737 = 231 140 0.12]

30 June 2025

Dr Cash 62 500 Cr Service expenses recoupment (statement of profit or loss and other comprehensive income) 6 250

Cr Interest revenue 24 315

Cr Lease receivable

(to recognise periodic lease receipt) 31 935

[24 315 = (231 140 28 513) 0.12]

(b)Books of Gregory Ltd

1 July 2023

Dr Right-of-use asset machinery 231 140 Cr Lease liability

(to recognise the leased asset) 231 140

30 June 2024

Dr Interest expense 27 737 Dr Lease liability 28 513 Dr Service expenses 6 250 Cr Cash

(to recognise the periodic lease payment) 62 500

Dr Depreciation expense 33 020 Cr Accumulated depreciation- right-of-use asset -machinery

(to recognise depreciation of the leased asset) 33 020

[33 020 = 231 140 7]

30 June 2025

Dr Interest expense 24 315 Dr Lease liability 31 935 Dr Service expenses 6 250 Cr Cash

(to recognise the periodic lease payment) 62 500

Dr Depreciation expense 33 020 Cr Accumulated depreciation- right-of-use asset -machinery

(to recognise depreciation of the leased asset) 33 020

[33 020 = 231 140 7]

Chapter 15

Revenue recognition issues

Review questions

15.1Control is central to the recognition of revenue. That is, pursuant to AASB 15, revenue recognition is directly linked to the transfer of the control of the underlying goods and services.

Adopting a view that revenue recognition should be consistent with the Conceptual Framework, the IASB has through AASB 15/IFRS 15 - embraced the view that revenue recognition should be a direct function of whether goods and services have been transferred to the control of the customer (and not be a function of who holds the risks and rewards of ownership of the asset). That is, under the new thinking of the IASB as reflected in AASB 15, revenue recognition from contracts with customers is very much linked to the transfer of control of assets and not to the transfer of the risks and rewards of ownership as has been the accepted position for many years. This is quite a significant shift in thinking.

Therefore, in this case, revenue recognition would not be recognised at the completion of production, but rather, when control of the asset has passed to the customer.

15.7These five steps, which would be addressed sequentially, are:

1. Identify the contract(s) with customers.

2. Identify the performance obligation(s) in the contract.

3. Determine the transaction price of the contract.

4. Allocate the transaction price to each performance obligation.

5. Recognise revenue when each performance obligation is satisfied.

15.8F.o.b. stands for free on board. An item may be sold f.o.b. shipping point, or f.o.b. destination. Destination or shipping point refers to the point at which title and control of the goods passes to the purchaser. If the goods are shipped f.o.b. destination, control does not pass until the buyer receives the goods at the destination. In this case, revenue would not typically be recognised until the goods reach their destination whereby they come under the control of the buyer.

15.13Unearned income is the term used to represent situations in which assets are received by an organisation for services to be performed at a future date.

Common examples of unearned income (also referred to as revenue received in advance) would include rent or interest received in advance, the receipt of consulting fees in advance of the provision of services, or payments made in advance in relation to construction contracts.

Since the services or resources have not been provided to the customer (and hence control of the related good or service has not passed to the customer), the cash or other asset receipts have not been earned and the customer would not be deemed to be in control of the goods or services. In such a scenario, the receipts do not constitute revenue but instead are considered as liabilities. They represent obligations to customers to satisfy particular performance obligations. The entity would be under a present obligation to transfer future economic benefits at a future date (see paragraph 106 of AASB 15).

15.14Dividend revenue would be derived from investments in financial assets, which are financial instruments. Financial instruments are not addressed within AASB 15. Rather, they are addressed in AASB 9 Financial Instruments.

A dividend from pre-acquisition earnings/profits will typically occur when an investor acquires an interest in another company and the shares have been acquired cum divthe term used to refer to shares being bought with an existing dividend entitlement. If an entity pays dividends out of profits earned before the acquisition, it is, in effect, returning part of the net assets originally acquired by the acquirer. Therefore, if dividends are received from pre-acquisition earnings, they shall be treated as a reduction in the cost of the investment rather than being treated as revenue.

15.20To the extent that the benefactor does not have any rights to make a claim to have the donation returned, then the donation would be treated as income, as it would satisfy the definition and recognition criteria of income as provided in the Conceptual Framework. The donation represents an inflow of economic benefits in the form of an increase in assets, which is not a contribution from the owners of the entity. Further, the inflow has occurred and is for a specific amounthence the inflow satisfies the probable test as well as being capable of reliable measurement. Whether it would be treated as revenue or a gain (remember, the conceptual framework divides income into revenues and gains) would be dependent upon the nature of the business. If the entity was the sort of entity that relied upon donations to support its business (for example, if it is a registered charity) then the donation might be treated as revenue. Otherwise it might be treated as a gain.

Challenging questions

15.26 (a) Assuming stage of completion can be reliably determined.

2023 2024 2025

Contract price $10 000 000 $10 000 000 $10 000 000

less Estimated cost Costs to date 2 500 000 6 500 000 8 000 000

Estimated costs to complete 5 500 000 1 500 000 _________

Estimated total cost 8 000 000 8 000 000 8 000 000

Estimated total gross profit $ 2 000 000 $ 2 000 000 $2 000 000

Per cent complete 31.25% 81.25% 100%

Gross profit recognised pursuant to the percentage-of-completion method (assuming that the stage of completion can be reliably estimated).

2023 $2 000 000 31.25% $625 000

2024 $2 000 000 81.25% $ 1 625 000

Less gross profit already recognised 625 000

Gross profit in 2024 $ 1 000 000

2025 $2 000 000 100% $ 2 000 000

Less gross profit already recognised 1 625 000

Gross profit in 2025 $ 375 000

Journal entries

2023 2024 2025

(i) To record costs incurred: Dr Construction in progress (contract asset) 2.5 4.0 1.5

Cr Cash, accounts payable, accum. deprec. 2.5 4.0 1.5

(ii) To record billings to customers: Dr Accounts receivable 2.0 5.0 3.0

Cr Construction in progress (contract asset) 2.0 5.0 3.0

(iii) To record cash collections: Dr Cash 2.0 5.0 3.0

Cr Accounts receivable 2.0 5.0 3.0

(iv) To record periodic income recognised: Dr Construction in progress (contract asset) 0.625 1.0 0.375

Dr Construction expenses 2.500 4.0 1.500

Cr Revenue from long-term contracts 3.125 5.0 1.875

(b)

Stage of completion cannot be reliably determined. In this case, contract costs must be recognised as an expense in the financial year in which they are incurred and, where it is probable that the costs will be recovered, revenue must be recognised only to the extent of costs incurred.

2023 2024 2025

(i) To record costs incurred: Dr Construction in progress (contract asset) 2.5 4.0 1.5

Cr Cash, accounts payable, etc. 2.5 4.0 1.5

(ii) To record billings to customers: Dr Accounts receivable 2.0 5.0 3.0

Cr Construction in progress (contract asset) 2.0 5.0 3.0

(iii) To record cash collections: Dr Cash 2.0 5.0 3.0

Cr Accounts receivable 2.0 5.0 3.0

(iv) To record periodic expenses and revenues: Dr Construction expenses 2.5 4.0 1.5

Cr Revenue from long-term contracts 2.5 4.0 1.5

(v) Because the 'contract asset' has a credit balance a contract liability needs to be recognised: Dr

Cr Construction in progress (contract asset)

Contract liability 0.5

0.5 (vi) Reversal of adjusting entry in 2024: Dr Contract liability 0.5

Cr Contract in progress (contract asset) 0.5

(vii) To record the profit on the project: Dr Construction in progress (contract asset) 2.0

Cr Revenue from long-term contracts 2.0

15.28(a)

2024 2025 2026

Contract price $40 000 000 $40 000 000 $40 000 000

less Estimated cost: Costs to date 10 000 000 26 000 000 32 000 000

Estimated costs to complete 22 000 000 6 000 000 __________

Estimated total cost 32 000 000 32 000 000 32 000 000

Estimated total gross profit/(loss) $ 8 000 000 $ 8 000 000 $ 8 000 000

Per cent complete 31.25% 81.25% 100%

Gross profit recognised in:

2024 $8 000 000 31.25% $2 500 000

2025 $8 000 000 81.25% $6 500 000

less Profit already recognised 2 500 000

Profit recognised in year 4 000 000

2026 $8 000 000 100% $8 000 000

less Profit already recognised 6 500 000

Profit recognised in year $1 500 000

(b)Where stage of contract completion cannot be reliably determined.

2024 2025 2026

(i) To record costs incurred: Dr Construction in progress (contract asset) 10.0 16.0 6.0

Cr Cash, accounts payable 10.0 16.0 6.0

(ii) To record billings to customers: Dr Accounts receivable 8.0 20.0 12.0

Cr Construction in progress (contract asset) 8.0 20.0 12.0

(iii) To record cash collections: Dr Cash 8.0 20.0 12.0

Cr Accounts receivable 8.0 20.0 12.0

(iv) To recognise a contract liability as amount invoiced exceeds the construction in progress: Dr Construction in progress (contract asset) 2.0 Cr Contract liability 2.0 (v) To reverse the entry made in previous year: Dr Contract liability 2.0

Cr Construction in progress (contract asset) 2.0

(vi) To record periodic income recognised: Dr Construction in progress (contract asset) 8.0

Dr Construction expenses 10.0 16.0 6.0

Cr Revenue from long-term contracts 10.0 16.0 14.0

(c)Journal entries assuming stage of completion can be reliably determined.

2023 2024 2025

(i) To record costs incurred: Dr Construction in progress (contract asset) 10.0 16.0 6.0

Cr Cash, accounts payable, etc. 10.0 16.0 6.0

(ii) To record billings to customers: Dr Accounts receivable 8.0 20.0 12.0

Cr Construction in progress (contract asset) 8.0 20.0 12.0

(iii) To record cash collections: Dr Cash 8.0 20.0 12.0

Cr Accounts receivable 8.0 20.0 12.0

(iv) To record periodic income recognised: Dr Construction in progress (contract asset) 2.5 4.0 1.5

Dr Construction expenses 10.0 16.0 6.0

Cr Revenue from long-term contracts 12.5 20.0 7.5

15.30 (a) If management was rewarded in terms of accounting profits then it would be reasonable to assume that the management would prefer to have non-volatile profits such that they would receive a more uniform series of cash flows. Also, it would be reasonable to assume that they would prefer that accounting profits not be deferred to future periods, given that the present value of the future receipts would be lower than those received in earlier years.

With this in mind, management rewarded by profit-based schemes would probably prefer to adopt the percentage-of-completion method. In adopting this accounting method they would necessarily need to ensure that the requirements associated with recognising revenue over time, as noted in AASB 15 (such as the requirement that the customer has control of the asset; revenue can be reliably measured; and the contract costs to complete the contract and the stage of completion can be measured reliably), are satisfied.

(b) If a firm is subject to a debt-to-asset constraint, a debt-to-equity constraint or an interest coverage constraint then we may expect that the management would prefer to adopt an approach that recognises revenue over time. If we recognise revenue throughout the term of the contract we take the income to profit or loss and we increase the asset, construction in progress by the amount of profit recognised. This has the effect of loosening the aforementioned accounting ratios.

Part 7: Other disclosure issues

Chapter 22

Segment reporting

Review questions

22.1The advantages of segmental information may include:

(i)It highlights the performance of the management within the different segments and, therefore, helps to identify those segments that are performing above or below expectations.

(ii)Well-performing segments will not be able to mask those segments that perform poorly.

(iii)Different operating segments will be subject to differing levels of risk. Knowledge of entities proportional investment in such segments will be useful to investors and potential investors when assessing their resource allocation decisions.

(iv)Investors should be better able to determine whether the segments are providing a return that is commensurate with the associated risk.

(v)It enables reporting entities to demonstrate greater accountability.

(vi)By providing more refined data, it enables financial statement users to make more informed predictions about future profitability.

(vii)Segment data will enable institutional investors to determine whether an entity is operating within sectors that are outside the ethical investment screens of the various investors.

22.2Some of the potential costs of providing segment data include:

(i)Management may be less inclined to take business risks if results are made more visible (and, therefore, not hidden through a process of aggregation).

(ii)The disclosure of segment data may result in competitors having access to information about the profitability of particular segments.

(iii)The additional segment data might provide encouragement for additional entrants into the industry.

(iv)If segment disclosures are made which indicate that particular segments are making a loss, there is a possibility that these disclosures may lead to takeover bids by other organisations or pressure being exerted upon management to sell the loss-making segments.

(v)The disclosure of operating segment data that indicates different profit rates internationally may attract host-government attention.

(vi)Inter-segment sales may draw attention from fiscal agencies.

(vii)Segment data may attract political attention from various interest groups, such as employee groups or environmental groups, if it is shown that particular segments are making unusually high profits.

22.8A reportable segment is an operating segment, or an aggregation of operating segments, that meet specific criteria provided in AASB 8. Not all operating segments as identified by the entity will be the subject of separate identification and disclosure. A reportable segment is an operating segment for which segment information is disclosed. In relation to reportable segments, paragraph11 of AASB 8/IFRS 8 requires:

An entity shall report separately information about each operating segment that:

(a) has been identified in accordance with paragraphs 510 or results from aggregating two or more of those segments in accordance with paragraph 12; and

(b) exceeds the quantitative thresholds in paragraph 13.

Paragraphs 1419 specify other situations in which separate information about an operating segment shall be reported

22.9Paragraph 11 of AASB 8 states that:

An entity shall report separately information about each operating segment that:

(a) has been identified in accordance with paragraphs 510 or results from aggregating two or more of those segments in accordance with paragraph 12; and

(b) exceeds the quantitative thresholds in paragraph 13.

Paragraphs 1419 specify other situations in which separate information about an operating segment shall be reported.

For the purposes of the above requirements we therefore need to know what an operating segment is. Operating segments are defined in the Appendix to AASB 8 as follows:

An operating segment is a component of an entity:

(a)that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity);

(b)whose operating results are regularly reviewed by the entitys chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance; and

(c)for which discrete financial information is available.

As we can see from the above definition, AASB 8 relies upon how the organisation identifies its operating segments, rather than imposing a particular basis of segment identification upon an entity. That is, AASB 8 requires identification of operating segments on the basis of internal reports that are regularly reviewed by the entitys chief operating decision maker in order to allocate resources to the segment and assess its performance.

22.10AASB 8 requires the amount (for example, profit, assets, liabilities) reported for each operating segment item to be the measure reported to the chief operating decision maker for the purposes of allocating resources to the segment and assessing its performance. This can be the case regardless of the accounting methods being used. In contrast, AASB 114the former Australian accounting standard pertaining to segment disclosurerequired segment information to be prepared in conformity with the accounting policies adopted for preparing and presenting the external financial statements.

The former standard, AASB 114, provided relatively detailed definitions of segment revenue, segment expense, segment result, segment assets and segment liabilities. Again in contrast, AASB 8 does not define these terms, nor require particular measurement approaches to be adopted. But it does require an explanation of how segment profit or loss, segment assets and segment liabilities are measured for each reportable segment. We can see that pursuant to AASB 8 there are far fewer stringent guidelines and much of what used to be a matter of professional judgement is being delegated to the management of the reporting entity.

22.12For the purposes of external reporting, individual operating segments may be aggregated. Indeed, it might be advisable to aggregate similar segments and thus avoid overwhelming readers with information about too many segments. As paragraph 12 of AASB 8 states:

Operating segments often exhibit similar long-term financial performance if they have similar economic characteristics. For example, similar long-term average gross margins for two operating segments would be expected if their economic characteristics were similar. Two or more operating segments may be aggregated into a single operating segment if aggregation is consistent with the core principle of this Standard, the segments have similar economic characteristics, and the segments are similar in each of the following respects:

(a) the nature of the products and services;

(b) the nature of the production processes;

(d) the methods used to distribute their products or provide their services; and

(e) if applicable, the nature of the regulatory environment, for example, banking, insurance or public utilities.

Clearly, whether or not we aggregate two or more operating segments for the purposes of external reporting will be a matter of professional judgement. In relation to the aggregation of similar operating segments, the Basis for Conclusions that accompanied the release of SFAS 131 stated (paragraph 73):

The Board believes that separate reporting of segment information will not add significantly to an investor's understanding of an enterprise if its operating segments have characteristics so similar that they can be expected to have essentially the same future prospects. The Board concluded that although information about each segment may be available, in those circumstances the benefit would be insufficient to justify its disclosure. For example, a retail chain may have 10 stores that individually meet the definition of an operating segment, but each store may be essentially the same as the others.

Similarity of operating segments is not the only criterion for aggregating operating segments for disclosure purposes. Apparently to avoid overwhelming readers with information about a multiplicity of operating segments, AASB 8 sets quantitative thresholds that provide guidance on when an operating segment should be disclosed (or, perhaps, aggregated with other segments instead). According to paragraph 13 of AASB 8:

An entity shall report separately information about an operating segment that meets any of the following quantitative thresholds:

(a) its reported revenue, including both sales to external customers and inter-segment sales or transfers, is 10 per cent or more of the combined revenue, internal and external, of all operating segments;

(b) the absolute amount of its reported profit or loss is 10 per cent or more of the greater, in absolute amount, of (i) the combined reported profit of all operating segments that did not report a loss and (ii) the combined reported loss of all operating segments that reported a loss;

Operating segments that do not meet any of the quantitative thresholds may be considered reportable, and separately disclosed, if management believes that information about the segment would be useful to users of the financial statements.

With regard to the threshold in (b) just quoted, it should be emphasised that this test is based on absolute amounts. Only one of the three testsin (a) to (c) just quotedneeds to be satisfied for the segment to be deemed a reportable segment. It is worth emphasising that segment information is required to be disclosed about any operating segment that meets any of the above tests. In relation to combining operating segments that might not otherwise be deemed to be reportable, paragraph 14 of AASB 8 states:

An entity may combine information about operating segments that do not meet the quantitative thresholds with information about other operating segments that do not meet the quantitative thresholds to produce a reportable segment only if the operating segments have similar economic characteristics and share a majority of the aggregation criteria listed in paragraph 12.

In addition to determining whether or not a specific operating segment should be disclosed, we also need to consider whether, in total, a sufficient number of operating segments have been disclosed. AASB 8 requires a specific proportion of an entitys total revenue to be attributed to operating segments. Specifically, paragraph 15 requires:

If the total external revenue reported by operating segments constitutes less than 75 per cent of the entitys revenue, additional operating segments shall be identified as reportable segments (even if they do not meet the criteria in paragraph 13) until at least 75 per cent of the entitys revenue is included in reportable segments.

The rationale for the above requirement is that in order to provide adequate insight into an entitys operations, reportable segments should represent a substantial proportion of the entitys total operations. In this regard, identification by the entity of sufficient segments so that the total revenues of all reported segments constitute 75 per cent or more of the entitys revenues might help ensure that the reported segments constitute a substantial proportion of the entitys total operations. Because some organisations might have a large number of smaller operating segments that might not warrant separate disclosure (perhaps on the basis of materiality), such segments are required to be combined and disclosed together. As paragraph 16 of AASB 8 states:

Information about other business activities and operating segments that are not reportable shall be combined and disclosed in an all other segments category separately from other reconciling items in the reconciliations required by paragraph 28. The sources of the revenue included in the all other segments category shall be described.

22.14Paragraph 33 of AASB 8 requires the following entity-wide disclosures in relation to geographical areas:

An entity shall report the following geographical information, unless the necessary information is not available and the cost to develop it would be excessive:

(a) revenues from external customers (i) attributed to the entitys country of domicile and (ii) attributed to all foreign countries in total from which the entity derives revenues. If revenues from external customers attributed to an individual foreign country are material, those revenues shall be disclosed separately. An entity shall disclose the basis for attributing revenues from external customers to individual countries;

(b) non-current assets other than financial instruments, deferred tax assets, post-employment benefit assets, and rights arising under insurance contracts (i) located in the entitys country of domicile and (ii) located in all foreign countries in total in which the entity holds assets. If assets in an individual foreign country are material, those assets shall be disclosed separately.

The amounts reported shall be based on the financial information that is used to produce the entitys financial statements. If the necessary information is not available and the cost to develop it would be excessive, that fact shall be disclosed. An entity may provide, in addition to the information required by this paragraph, subtotals of geographical information about groups of countries.

22.16It is a requirement that if the total external revenue reported by operating segments constitutes less than 75 per cent of the entitys revenue, additional operating segments shall be identified as reportable segments (even if they do not meet the criteria in paragraph13) until at least 75 per cent of the entitys revenue is included in reportable segments.

The rationale for this requirement is that in order to provide adequate insight into an entitys operations, reportable segments should represent a substantial proportion of the entitys total operations. In this regard, identification by the entity of sufficient segments so that the total revenues of all reported segments constitute 75 per cent or more of the entitys revenues might help ensure that the reported segments constitute a substantial proportion of the entitys total operations.

22.20As we know, if the chief operating decision maker reviews particular components of an organisation for the purposes of allocating resources and assessing performance, these components will be considered to represent the operating segments of the organisation. Hence, there are four operating segments. However, whether we report information about each individual operating segment will depend on whether the operating segments are considered to be reportable. To determine if they are reportable we apply the quantitative tests provided in paragraph 13 of AASB 8.

Mining and food qualify as reportable segments as their revenue is more than 10 per cent of total segment revenue, thus satisfying test (a).

Mining, food and chemicals qualify as material using test (b), as the absolute-amount total of the profits/losses of the segments that earned a profit is $125 000, whereas the combined reported loss of those that generated a loss totals $35 000. Hence for test (b) we need to compare the absolute amount of the profit/loss with $125 000. Using these criteria, mining, food and chemicals are reportable operating segments.

Using test (c), mining and food are reportable operating segments, as their assets are 10 per cent or more of the total segment assets of all segments.

Therefore, mining, food and chemicals are all reportable segments. Clothing is not a reportable segment as it did not pass any of the three tests. Mining, food and chemicals also generate more than 75 per cent of the entitys total revenues (875/965 100 = 91 per cent), and so meet the test of paragraph 15 of AASB 8.

Note that even though we have considered each segment under all three tests, the passing of only one of the tests would be enough to establish a segment as reportable.

22.21Timber and steel qualify as reportable segments as their revenue is more than 10 per cent of total segment revenue, thus satisfying test (a).

Timber, steel and cardboard qualify as material using test (b), as the absolute-amount total of the profits/losses of the segments that earned a profit is $100 000, whereas the combined reported loss of those that generated a loss totals $15 000. Hence for test (b) we need to compare the absolute amount of the profit/loss with $100 000. Using these criteria, all three segments are reportable operating segments.

Using test (c), all three operating segments are reportable, as their assets are 10 per cent or more of the total segment assets of all segments.

Therefore, timber, steel and cardboard are all reportable segments. Note that even though we have considered each segment under all three tests, the passing of only one of the tests would be enough to establish a segment as reportable.

22.22Clothing, travel and agriculture are reportable segments as their revenue is more than 10 per cent of total segment revenue, thus satisfying test (a).

Clothing, travel and agriculture qualify as material using test (b), as the absolute-amount total of the profits/losses of the segments that earned a profit is $180 000, whereas the combined reported loss of those that generated a loss totals $15 000. Hence for test (b) we need to compare the absolute amount of the profit/loss with $180 000. Using these criteria, clothing, travel and agriculture are reportable operating segments.

Using test (c), clothing and travel are reportable operating segments, as their assets are 10 per cent or more of the total segment assets of all segments.

Therefore, clothing, travel and agriculture are all reportable segments. Motor vehicle manufacture is not a reportable segment as it did not pass any of the three tests. Clothing, travel and agriculture also generate more than 75 per cent of the entitys total revenues (510/555 100 = 92 per cent), and so meet the test of paragraph 15 of AASB 8.

Note that even though we have considered each segment under all three tests, the passing of only one of the tests would be enough to establish a segment as reportable.

Challenging questions

22.26In the absence of other factors, a segment would be considered material if one or more of the following conditions applied:

(a)its revenue is 10 per cent or more of total revenue of all segments (including inter-segment sales and transfers)

(b)the absolute amount of its profit or loss is 10 per cent or more of the greater, in absolute amount, of:

the combined reported profit of all segments that earned a profit

the combined segment loss of all segments that earned a loss

(c)its segment assets are 10 per cent or more of total assets of all segments.

Entertainment (passes tests (a), (b) and (c)), clothing (passes tests (b) and (c)), food (passes test (a)), and agriculture (passes test (b)) would all be considered to be material industry segments.The following disclosure is appropriate:

Segment information

Entertainment Clothing Food Agriculture Eliminations Consolidated

$ $ $ $ $ $

Revenue External sales 600 80 200 40 920

Inter-segment sales 50 10 (60)

Total segment revenue 650 80 200 50 (60) 920

Result Segment profit 100 20 (10) 20 (15)* 105

Unallocated corporate expenses (10)

Profit before income tax expense 95

Income tax expense 40

Net profit 55

Segment assets 800 300 100 110 1 310

Unallocated corporate assets 50

Consolidated total assets 1 360

Segment liabilities 200 100 150 100 550

Unallocated corporate liabilities 250

Consolidated total liabilities 800

Acquisition of property, plant and equipment and intangible assets 50 10 20 10 90

Depreciation 20 10 15 25 70

Unallocated depreciation 20

Non-cash expenses other than depreciation 10 5 10 15 60

Unallocated expenses 20

* This number for profit on inter-segment sales has been assumed, as the information was not provided in the question.

Geographical information

Petersen Ltd operates solely within Queensland, Australia.

Information about major customers

Revenues from one customer of Petersen Ltds entertainment segment represents approximately $100 000 of Petersen Ltds total revenues. No other single customer is responsible for 10 per cent or more of the entitys total revenues.

Part 7: Other disclosure issues

Chapter 23

Related party disclosures

Review questions

23.1AASB 124 Related Party Disclosures defines related parties as follows:

A related party is a person or entity that is related to the entity that is preparing its financial statements.

(a) A person or a close member of that persons family is related to a reporting entity if that person:

(i) has control or joint control over the reporting entity;

(ii) has significant influence of the reporting entity; or

(iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.

(b) An entity is related to a reporting entity if any of the following conditions applies:

(i) The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others).

(ii) One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member).

(iii) Both entities are joint ventures of the same third party.

(iv) One entity is a joint venture of a third entity and the other entity is an associate of the third entity.

(v) The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.

(vi) The entity is controlled or jointly controlled by a person identified in (a).

(vii) A person identified in (a)(i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).

(viii)The entity, or any member of a group of which it is a part, provides key management personnel services to the reporting entity or to the parent of the reporting entity.

The above definitions of related parties in turn rely upon a number terms; these being control, significant influence, joint venture, close member of the family and key management personnel.

23.2A related party transaction is defined in AASB 124 as: a transfer of resources, service services or obligations between a reporting entity and a related party, regardless of whether a price is charged.

23.3Some of the negative consequences of related party transactions are that they might be undertaken in a manner that advantages some of the organisations stakeholders, while disadvantaging others. For example, key management personnel might be able to arrange payments to themselves that are excessive and which therefore reduce the financial resources available for other stakeholders (such as shareholders and creditors). Managers might also structure transactions in a way that profits are earned by related entities operating overseas in low tax rate countries. This disadvantages communities in the local country because lower taxes are paid there and hence less money is available to provide services in that local country. The use of related parties might also create waste and inefficiency if contracts are negotiated with related organisations that are not as efficient as other independent organisations.

Because of the possible adverse consequences or related party transactions, details of such transactions have the potential to be relevant to the readers of financial statements.

23.5Related party information could be valuable to financial statement users. Transactions involving related parties cannot be presumed to be carried out on an arms length basis, as the requisite conditions of competitive, free-market dealings may not exist. This may lead to a situation in which transactions may occur at a price not in accord with fair values. That is, the existence of a related party relationship may expose a reporting entity to risks, or provide opportunities that would not have existed in the absence of the relationship. A related party relationship may therefore have a material effect on the performance, financial position and financing and investing activities of a reporting entity. To properly assess the performance of an entity, and the impact of related party transactions, knowledge of such relationships would be necessary.

23.6This is an interesting question that could be used to stimulate debate among the students. On average, it could be argued that users of financial statements would be aware of the potential implications of related party transactions. If a reporting entity was not required to make any disclosures, and the reporting entity elected not to voluntarily make any disclosures, then the readers of the financial statements may feel that due to a lack of information the relative risk of the reporting entity is higher, relative to a situation where fuller disclosures were provided. They would be unsure whether the results and financial position of the reporting entity had been impacted by related party transactions that were not undertaken on an arms length basis. That is, the existence of a related-party relationship may expose a reporting entity to risks, or provide opportunities which would not have existed in the absence of the relationship. To properly assess the performance of an entity, and the impact of related party transactions, knowledge of such relationships would be necessary. Without such knowledge and with such uncertainty, the reporting entity may find that it is more expensive to attract capital.

The above argument would relate to all reporting entities. That is, there would be some adverse effects if a reporting entity elected not to make disclosures pertaining to related party transactions, even if it had no such transactions that were of material consequence. However, specific reporting entities may feel that the disclosure of particular related party transactions may be of such consequence that the negative implications that would flow from making no disclosures at all may be less than the negative consequence of making specific disclosures. For example, if an entity was to report information which indicated that its directors were being grossly overpaid and that numerous large unsecured loans had been provided to directors on interest-free terms, this could have significant consequences for the ongoing operations of the entity. If this was the perspective held by the management of the entity, then the directors may prefer that no disclosures are made. However, this would obviously not be deemed to be an objective approach to financial reporting (and would also be in contravention of the accounting standards).

23.10To determine what disclosures are required we need to refer to AASB 124, and section 300A of the Corporations Act. Students should review the disclosure requirements included within the accounting standards and the Corporations Act.

There are a number of disclosure requirements in relation to key management personnel within AASB 124. Indeed, this is an area that is heavily regulated in terms of required disclosures. Paragraph 17 of AASB 124 requires the following disclosures at an aggregated level:

An entity shall disclose key management personnel compensation in total and for each of the following categories:

(a) short-term employee benefits;

(b) post-employment benefits;

(d) termination benefits; and

(e) share-based payment.

Paragraph 17 just quoted refers to compensation. This word is often used interchangeably with remuneration. Remuneration is the term used in the Corporations Act. In this regard, paragraph Aus9.1.1 states:

Although the defined term compensation is used in this Standard rather than the term remuneration, both words refer to the same concept and all references in the Corporations Act to the remuneration of directors and executives is taken as referring to compensation as defined and explained in this Standard.

There are also general disclosure requirements that relate to all related parties, inclusive of key management personnel. In relation to the disclosure of information about transactions between related parties, paragraph 18 of AASB 124 requires the following:

If an entity has had related party transactions during the periods covered by the financial statements, it shall disclose the nature of the related party relationship as well as information about those transactions and outstanding balances, including commitments, necessary for users to understand the potential effect of the relationship on the financial statements. These disclosure requirements are in addition to those in paragraph 17. At a minimum disclosures shall include:

(a) the amount of the transactions;

(b) the amount of outstanding balances, including commitments, and:

(i) their terms and conditions, including whether they are secured, and the nature of the consideration to be provided in settlement; and

(ii) details of any guarantees given or received;

(d) the expense recognised during the period in respect of bad or doubtful debts due from related parties.

The disclosures required by paragraph 18 of AASB 124 must be classified by related party. Paragraph 19 of AASB 124 stipulates:

The disclosures required by paragraph 18 shall be made separately for each of the following categories:

(a) the parent;

(b) entities with joint control of, or significant influence over, the entity;

(d) associates;

(e) joint ventures in which the entity is a joint venturer;

(f) key management personnel of the entity or its parent; and

(g) other related parties.

23.12This question has been assigned to encourage students to review the disclosures for themselves for the purpose of determining which specific disclosures have the greatest implications in terms of exposing the entity to various risks associated with related party transactions. Students should justify the selection of particular transactions.

Challenging questions

23.13This is a matter of opinion given that views about accountability necessarily require a consideration of organisational responsibilities, and in particular about such factors as to whom is an organisation responsible, and for what aspects of performance it is responsible.

Because managers would be considered to have a responsibility to the owners of the organisation, and because related party transactions have the potential to negatively impact the wealth of owners, then owners arguably have a right to information about related party transactions, and managers have an accountability to provide such information.

Related party transactions also have the potential if structured in certain ways - to reduce tax payments within particular countries. That is, various approaches to transfer pricing might be used to minimise taxable profits in the higher tax rate countries. As such, government and the community within particular countries also arguably have a right to be provided with information about the related party transactions entered into by organisations.

PART 3: Accounting for assets

Chapter 8

Accounting for intangibles

Review questions

8.1This question has been asked to stimulate debate. Certainly, in recent times it would appear that a greater proportion of corporate assets are often found to be in assets that are classified as intangible, and hence there might be a case for having an accounting standard dedicated to intangible assets. But it is perhaps questionable why the rules applying to intangible assets are so differentand so much stricterthan the rules that apply to tangible assets.

For example, is there adequate justification for disallowing the recognition of intangible assets on the basis that they have been internally generated, particularly when such assets can subsequently be recognised by another party if there is a business acquisition. Internally developed intangibles, such as brand names, publishing titles, distribution rights, goodwill and so forth can have significant value and prohibiting their recognition from corporate statements of financial position obviously has implications for the relevance of information being provided in statements of financial position. Also, why do we restrict the revaluation of intangible assets to situations where there is an active market when such restrictions are not explicitly in place for tangible assets such as property, plant and equipment?

There is also the conservative requirement that stipulates that if an intangible asset is initially expensed then it cannot be reinstated even if information comes to light to suggest that future economic benefits are deemed to be probable. This is not consistent with the requirements for tangible assets wherein tangible assets can be reinstated and it is also not consistent with the recommendations of the Conceptual Framework. It would appear that the regulators have provided limited justification for these differences.

8.3If an intangible asset is acquired separately, and not as part of a business acquisition (and in a business combination, many assets would be acquired), the costs of the intangible asset are to include the costs associated with acquiring the asset and preparing the asset for its intended use. As paragraph 27 of AASB 138 states:

The cost of a separately acquired intangible asset comprises:

(a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates; and

(b) any directly attributable cost of preparing the asset for its intended use.

AASB 3 Business Combinations defines a business combination as the bringing together of separate entities or businesses into one reporting entity. Paragraph 33 of AASB 138 states that where intangible assets are acquired as part of a business combination, rather than as a separate acquisition of an asset, the assets will initially be recognised at their fair value. This can be contrasted with individual acquisitions of intangible assets, where they are recognised at cost. Paragraph 33 of AASB 138 states:

In accordance with AASB 3 Business Combinations, if an intangible asset is acquired in a business combination, the cost of that intangible asset is its fair value at the acquisition date. The fair value of an intangible asset will reflect market participants expectations about the probability that the expected future economic benefits embodied in the asset will flow to the entity. In other words, the entity expects there to be an inflow of economic benefits, even if there is uncertainty about the timing or the amount of the inflow. Therefore, the probability recognition criterion in paragraph 21(a) is always considered to be satisfied for intangible assets acquired in business combinations. If an asset acquired in a business combination is separable or arises from contractual or other legal rights, sufficient information exists to measure reliably the fair value of the asset. Thus, the reliable measurement criterion in paragraph 21(b) is always considered to be satisfied for intangible assets acquired in business combinations.

The above requirement is interesting, particularly the statement that the probability criterion is always considered to be satisfied for intangible assets acquired in a business combination. This seems to be a simplistic assumption and not in accord with the asset recognition criteria in the Conceptual Framework, which require consideration to be given to the probability of future economic benefits being generated.

Therefore, we need to appreciate that different recognition criteria apply to intangible assets, depending upon whether an intangible asset is acquired individually, or as part of a business combination. If an intangible asset is acquired as part of a business combination it is to be recognised at its fair value. However, if it is acquired separately it is to be recognised at cost.

What is also interesting is that if intangible assets are acquired as part of a business combination they can be recognised by the acquirer even though they might originally have been internally generated. For example, if a publisher has developed a successful list of publishing titles internally they may not recognise the list as an asset (because the list was internally developed and not acquired from an external party), but if their organisation is acquired, the list of titles may in fact be recognised by the acquiring party. As paragraph 34 of AASB 138 states:

In accordance with this Standard and AASB 3, an acquirer recognises at the acquisition date, separately from goodwill, an intangible asset of the acquiree, irrespective of whether the asset had been recognised by the acquiree before the business combination. This means that the acquirer recognises as an asset separately from goodwill an in-process research and development project of the acquiree if the project meets the definition of an intangible asset. An acquirees in-process research and development project meets the definition of an intangible asset when it:

(a) meets the definition of an asset; and

(b) is identifiable, i.e. is separable or arises from contractual or other legal rights.

So, although paragraph 63 of AASB 138 stipulates that certain intangible assets may not be recognised if they have been internally developed, if an entity is acquired by another entity its assets may be recognised. On why internally developed intangible assets cannot be recognised by the original entity, paragraph 64 of AASB 138 states:

Expenditure on internally generated brands, mastheads, publishing titles, customer lists and items similar in substance cannot be distinguished from the cost of developing the business as a whole. Therefore, such items are not recognised as intangible assets.

We are left to wonder how the case is conceptually different in a business combination. How are we able to distinguish various intangible assets from goodwill when we acquire a business when we are assumed to be unable to do so when developing such assets internally? Certainly AASB 138 does appear to be vulnerable in a number of respects to criticism on logical grounds. Moreover, some of its requirements seem to be inconsistent with others within the standard.

8.8AASB 3 Business Combinations defines goodwill as an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised. Purchased goodwill is measured as the excess of the cost of acquisition (purchase consideration measured at fair value) incurred by the acquirer over the fair value of the identifiable net assets and contingent liabilities acquired. Purchase consideration should be measured at the fair value of what is given up in exchange. More specifically (and also taking into consideration the existence of non-controlling interests and multiple acquisitions in an investee), paragraph 32 of AASB 3 states:

The acquirer shall recognise goodwill as of the acquisition date measured as the excess of

(a) over (b) below:

(a) the aggregate of:

(i) the consideration transferred measured in accordance with this Standard, which generally requires acquisition-date fair value (see paragraph 37);

(ii) the amount of any non-controlling interest in the acquiree measured in accordance with this Standard; and

(iii) in a business combination achieved in stages (see paragraphs 41 and 42), the acquisition-date fair value of the acquirers previously held equity interest in the acquiree.

(b) the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with this Standard.

8.10Paragraph 118 of AASB 138 requires a reconciliation of the carrying amount at the beginning and end of the period showing:

(i) additions, indicating separately those from internal development, those acquired separately, and those acquired through business combinations;

(ii) assets classified as held for sale or included in a disposal group classified as held for sale in accordance with AASB 5 and other disposals;

(iii) increases or decreases during the period resulting from revaluations and from impairment losses recognised or reversed in other comprehensive income;

(iv) impairment losses recognised in profit or loss during the period;

(v) impairment losses reversed in profit or loss during the period;

(vi) any amortisation recognised during the period;

(vii) net exchange differences arising on the translation of the financial statements into the presentation currency, and on the translation of a foreign operation into the presentation currency of the entity; and

(viii) other changes in the carrying amount during the period.

8.12According to AASB 138, research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Paragraph 54 requires that no intangible asset arising from research (or from the research phase of an internal project) shall be recognised. Expenditure on research (or on the research phase of an internal project) shall be recognised as an expense when it is incurred. Paragraph 56 of AASB 138 provides examples of research activities, and these include:

(a)activities aimed at obtaining new knowledge;

(b)the search for, evaluation and final selection of, applications of research findings or other knowledge;

(c)the search for alternatives for materials, devices, products, processes, systems or services; and

(d)the formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, processes, systems or services.

According to AASB 138, development is the subsequent application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use. Paragraph 57 of AASB 138 provides that an intangible asset arising from development (or from the development phase of an internal project) shall be recognised if, and only if, an entity can demonstrate all of the requirements within the paragraph.

In considering the expenditure undertaken within the question it would generally be accepted that the administrative costs (parts (a) and (b) of the question) would not be considered to directly relate to the research and development activities and hence the costs would be expensed as incurred. The costs that would be included as research activities, and hence also treated as expenses, would be:

(i)that proportion of staff salaries that relates to the research activities (that is, half of their salaries)

half of the consulting fees

the raw material used in the research phase of operations.

Subject to the deferral requirements of paragraph 57 of AASB 138, the following costs would be considered to relate to the development phases and hence be shown as an asset:

(i)the depreciation of the laboratory equipment

(ii)half of the consulting fees

the raw material used in the development phase of operations.

8.15Subject to certain tests for deferral, expenditure on development activity can be deferred to future periods and disclosed as an asset. Expenditure on research activities is to be written off as an expense as incurred. Paragraph 59 of AASB 138 provides examples of development activities. These are:

(a)the design, construction and testing of pre-production or pre-use prototypes and models;

(b)the design of tools, jigs, moulds and dies involving new technology;

(c)the design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production; and

(d)the design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.

The $50 000 spent on developing a general understanding of water flow dynamics would be considered as research and would be expensed as incurred.

The $30 000 spent on understanding what local surfers expect from a surfboard would be research and would be expensed as incurred.

The $90 000 spent on testing and refining a certain type of fin and the $190 000 spent on the prototype would be construed as development expenditure and to the extent that the expenditure satisfies the tests for deferral then the expenditures will be capitalised.

8.16

Fair value of consideration Cash $70 000 Plant and equipment $250 000 Land $300 000 $620 000

Fair value of net assets acquired Asset $800 000 less Liabilities $300 000 $500 000

Goodwill $120 000

In relation to the legal fees of $35 000, these have been excluded when calculating goodwill. Although the acquisition cost of assets would normally include associated legal fees, AASB3, paragraph 53, specifically notes that in a business combination, acquisition-related costs, such as legal fees, are to be treated as expenses. Specifically, paragraph 53 states:

Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finders fees; advisory, legal, accounting, valuation and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities shall be recognised in accordance with AASB 132 and AASB 9.

8.17(a)

Fair value of consideration Direct cost of acquisition $1 400 000

Fair value of net assets acquired Carrying amount of net assets $1 000 000 Fair value of brand name $50 000 Fair value adjustment for land and buildings $100 000 $1 150 000

Goodwill $250 000

As can be seen from the above calculation, an adjustment was made for the fair value of the brand name. The brand name was not shown on the statement of financial position of the acquired company (perhaps because it was internally developed). Paragraph 63 of AASB 138 states that internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets. This is explained by paragraph 64 which states that expenditure on internally generated brands, mastheads, publishing titles, customer lists and items similar in substance cannot be distinguished from the cost of developing the business as a whole. Therefore, such items are not recognised as intangible assets.

If the acquiring entity has clearly included a payment of $50 000 for the brand name (as part of the total payment) and this is quite explicit in the purchase agreement, then the amount of goodwill can be reduced to $250 000 and a $50 000 brand name could also be disclosed within the statement of financial position.

(b)Nat Ltd would have been prepared to pay for the goodwill because of the economic benefits that the goodwill is expected to generate. Further, Nat Ltd must believe that it is more efficient to acquire existing goodwill rather than trying to create the goodwill itself.

(c)Because only purchased goodwill is allowed to be disclosed in the financial statements, there is a general prohibition on the subsequent revaluation of goodwill.

Challenging questions

8.23(a)

Goodwill of Bo Ltd Net identifiable assets Total

($000) ($000) ($000)

Carrying amount 1 200 5 800 7 000

Recoverable amount 6 200

Impairment loss 800

Journal entry

Dr Impairment lossgoodwill 800

Cr Accumulated impairment lossgoodwill 800

(to recognise impairment of goodwill)

(b)

Goodwill of Bo Ltd Net identifiable assets Total

($000) ($000) ($000)

Carrying amount 1 200 5 800 7 000

Recoverable amount 4 800

Impairment loss 2 200

AASB 136, paragraph 104, requires the impairment loss of $2 200 000 to be allocated to the assets in the cash-generating unit (Bo Limited) by first reducing the carrying amount of goodwill. Once the balance of goodwill is fully eliminated, the balance of the impairment loss must be allocated on a pro-rata basis against the identifiable assets within the respective cash-generating unit. Specifically, paragraph 104 states:

An impairment loss shall be recognised for a cash-generating unit (the smallest group of cash-generating units to which goodwill or a corporate asset has been allocated) if, and only if, the recoverable amount of the unit (group of units) is less than the carrying amount of the unit (group of units). The impairment loss shall be allocated to reduce the carrying amount of the assets of the unit (group of units) in the following order:

(a) first, to reduce the carrying amount of any goodwill allocated to the cash-generating unit (group of units); and

(b) then, to the other assets of the unit (group of units) pro rata on the basis of the carrying amount of each asset in the unit (group of units).

These reductions in carrying amounts shall be treated as impairment losses on individual assets and recognised in accordance with paragraph 60.

Hence, $1 200 000 of the total impairment loss (see above) of $2 200 000 can be offset against the goodwill, leaving a balance of the impairment loss of $1 000 000. The remaining impairment loss of $1 000 000 is recognised by reducing the carrying amounts of Bo Limiteds identifiable assets as follows:

Goodwill of Bo Ltd Net identifiable assets Total

($000) ($000) ($000)

Carrying amount 1 200 5 800 7 000

Impairment loss (1 200) (1 000) 2 200

4 800 4 800

Allocating the $1 000 000 balance of the impairment loss pro-rata against the identifiable assets on the cash-generating unit on the basis of carrying amounts provides the following calculations:

Allocation of impairment loss

($000)($000)

Customer list 50 1000/6000 8.33

Machinery 1 450 1000/6000 241.67

Buildings 1 500 1000/6000 250

Land 3 000 1000/6000 500

6 000 1 000

Journal entry:

DrImpairment lossgoodwill 1 200

Dr Impairment lossidentifiable assets 1 000

Cr Accumulated impairment lossgoodwill 1 200

Cr Accumulated impairment losscustomer list 8.33

Cr Accumulated impairment lossmachinery 241.67

Cr Accumulated impairment lossbuildings 250

Cr Accumulated impairment lossland 500

(to recognise total impairment losses)

As already noted, an impairment loss recognised in relation to goodwill is not permitted to be reversed in subsequent periods.

PART 4: Accounting for liabilities and owners equity

Chapter 14

Accounting for financial instruments

Review questions

14.1AASB 132 Financial Instruments: Presentation defines a financial instrument as any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Such a definition, in turn, generates a need to define a financial asset, a financial liability and an equity instrument.

According to paragraph 11 of AASB 132, financial asset means any asset that is:

(a) cash;

(b) an equity instrument of another entity;

(i) to receive cash or another financial asset from another entity; or

(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or

(d) a contract that will or may be settled in the entitys own equity instruments and is:

(i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entitys own equity instruments; or

(ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entitys own equity instruments. For this purpose the entitys own equity instruments do not include puttable financial instruments that are a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entitys own equity instruments. For this purpose the entitys own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entitys own equity instruments.

A financial liability, on the other hand, means any liability that is

(a)a contractual obligation:

(i)to deliver cash or another financial asset to another entity; or

to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or

(b)a contract that will or may be settled in the entitys own equity instruments and is:

(i)a non-derivative for which the entity is or may be obliged to deliver a variable number of the entitys own equity instruments; or

(ii)a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entitys own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entitys own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Also, for these purposes the entitys own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entitys own equity instruments.

If a financial instrument does not give rise to a contractual obligation on the part of the issuer to deliver cash or another financial asset, or to exchange another financial instrument under conditions that are potentially unfavourable, then it is considered to be an equity interest where equity is defined as the residual interest in the assets of the entity after deduction of its liabilities.

14.2According to paragraph 11 of AASB 132, financial asset means any asset that is:

(a) cash;

(b) an equity instrument of another entity;

(i) to receive cash or another financial asset from another entity; or

(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or

(d) a contract that will or may be settled in the entitys own equity instruments and is:

(i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entitys own equity instruments; or

A financial liability, on the other hand, means any liability that is

(a)a contractual obligation:

(i)to deliver cash or another financial asset to another entity; or

to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or

(b)a contract that will or may be settled in the entitys own equity instruments and is:

(i)a non-derivative for which the entity is or may be obliged to deliver a variable number of the entitys own equity instruments; or

(ii)a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entitys own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entitys own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Also, for these purposes the entitys own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entitys own equity instruments.

An equity instrument is defined in AASB 132 as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

14.4Examples of primary financial instruments would include receivables, payables and equity securities, such as shares. Primary financial instruments generate rights and obligations between the parties directly involved in the underlying transaction. For example, acquiring shares in a company gives the investor a financial asset in the company and the shares are considered an equity instrument of the company. Acquiring inventory on credit from a company gives the selling company a financial asset (a right to cash), and the purchaser a financial liability (an obligation to deliver cash to the company).

14.5Derivative financial instruments have been defined as instruments which create rights and obligations that have the effect of transferring one or more of the financial risks inherent in an underlying primary financial instrument, and the value of the contract normally reflects changes in the value of the underlying financial instrument (International Accounting Standards Committee, Exposure Draft 40: Financial Instruments). This is consistent with the description provided at paragraph AG 16 of AASB 132 which states:

Derivative financial instruments create rights and obligations that have the effect of transferring between the parties to the instrument one or more of the financial risks inherent in an underlying primary financial instrument. On inception, derivative financial instruments give one party a contractual right to exchange financial assets or financial liabilities with another party under conditions that are potentially favourable, or a contractual obligation to exchange financial assets or financial liabilities with another party under conditions that are potentially unfavourable. However, they generally do not result in a transfer of the underlying primary financial instrument on inception of the contract, nor does such a transfer necessarily take place on maturity of the contract. Some instruments embody both a right and an obligation to make an exchange. Because the terms of the exchange are determined on inception of the derivative instrument, as prices in financial markets change, those terms may become either favourable or unfavourable.

Derivative financial instruments would include financial options, futures, forward contracts, and interest rate or currency swaps.

14.6The value of a derivative is directly related to another underlying item. For example, a share optionwhich is a derivativederives its value from the market value of the underlying shares. Derivative financial instruments create rights and obligations that have the effect of transferring one or more of the financial risks inherent in the underlying primary financial instrument. According to AASB 9, the value of a derivative:

... changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the underlying).

In relation to the measurement of derivative financial instruments there is a general requirement, as provided in AASB 9, that financial instruments are to be measured at fair value. As with financial instruments generally, all derivatives are required to be initially recognised and measured at fair value. Gains and losses on the financial instruments would generally go directly to profit or loss. However, this will be influenced by whether there is an associated hedge that has been designated as a hedge and that has been deemed to be effective.

Where there is a designated cash flow hedge the gain or loss on the hedging instrument (for example, a futures contract) is initially recorded in equity. It can subsequently be transferred to profit or loss so as to offset the impact on profit or loss of any change in value of the hedged item (for example, an amount owing to an overseas supplier).

Where an item is designated a fair value hedge the change in value of the hedged item and the change in value of the hedging instrument are both immediately recognised in profit or loss.

14.7A call option gives the holder of the option a right to buy a specific item (for example, shares in a particular company) at a future time for a pre-specified price. This price is usually described as either the exercise price or the strike price. Once the exercise price is determined it will remain fixed regardless of variations in the market price of the underlying item. To the extent that the option can be traded, the sale price of the option would fluctuate as the value of the underlying item changes, with an increase in the price of the underlying item leading to an increase in the price of the option (and vice versa).

A put option on shares entitles the holder of the option to require another party to buy a given quantity of a specific item (for example, shares) at a future date for a pre-specified price. The value of the put option will also be dependent upon the market price of the underlying asset.

14.11Compound financial instruments include both equity instruments and financial liabilities. The debt and equity components of a compound security should be accounted for and disclosed separately on the basis of the economic substance of the security at the time of its initial recognition. As paragraph AG31 of AASB 132 states:

A common form of compound financial instrument is a debt instrument with an embedded conversion option, such as a bond convertible into ordinary shares of the issuer, and without any other embedded derivative features. Paragraph 28 requires the issuer of such a financial instrument to present the liability.

We must determine the fair value of the liability componentwhich is recognised within the financial statementsand allocate the difference between the fair value of the liability component and the fair value of the entire instrument to the equity component. That is, the amount attributed to the equity component is the residual.

14.25 (a)1 July 2022

The financial asset would initially be recorded at fair value. If the financial asset is measured at fair value through profit or loss, then transaction costs associated with the acquisition of the asset shall be treated as an expense within profit or loss. This is consistent with paragraph 5.1.1 of AASB 9.

DrInvestment in McTavish Ltd1 000 000

DrBrokerage fee expense1 500

CrCash1 001 500

(to recognise the acquisition of shares in McTavish Ltd)

30 June 2023

DrInvestment in McTavish Ltd200 000

CrGain in fair value of equity investments200 000

(to recognise increase in fair value of investment)

Where a financial asset is measured at fair value through profit or loss then there are no impairment adjustments as any change in fair value has already been recognised in profit or loss.

(b)1 July 2022

The financial asset would initially be recorded at fair value. If the financial asset is measured at fair value through other comprehensive income then transaction costs associated with the acquisition of the asset shall be included as part of the cost of the asset (and not treated as an expense within profit or loss).

DrInvestment in McTavish Ltd1 001 500

CrCash1 001 500

(to recognise the acquisition of shares in McTavish Ltd)

30 June 2023

DrInvestment in McTavish Ltd200 000

CrGain in fair value included within OCI200 000

(to recognise increase in fair value of investment)

There would be a reserve that is part of equity, which would accumulate the gains that are included within OCI. This could be labelled something like Fair value gains on equity instruments not recorded within profit or loss. For equity instruments, this reserve cannot subsequently be transferred to profit or loss.

14.26It should recognise a financial liability. Wedding Cake Ltd will receive $10 million for its shares regardless of whether the price of the shares goes up or down. This means that there is a contractual obligation to deliver a variable number of its own equity instruments. As paragraph 21 of AASB 132 explains, such a contract is a financial liability of the entity even though the entity must or can settle it by delivering its own equity instruments. It is not an equity instrument because the entity uses a variable number of its own equity instruments as a means to settle the contract. Accordingly, the contract does not evidence a residual interest in the entitys assets after deducting all of its liabilities.

14.28 The rate of return required by the market might fluctuate daily; hence it is usual for bonds (also known as debentures) not to be issued at par (face value). Bonds would only be issued at the par value if the rate demanded by investors (the market rate) happened to coincide with the rate shown on the bond certificate (called the coupon rate). It should also be remembered that, regardless of what investors pay for the bond, they will receive the face value (or par value) on redemption; and the interest received will equal the rate written on the bond certificate, referred to as the coupon rate, multiplied by the par value of the security (regardless of the actual price paid for the bonds). That is, the amount received on redemption and the periodic interest receipts will not change, regardless of what is paid for the security.

When the markets required rate of return is less than the coupon rate being offered on a bond, the price the bond will be sold for (its fair value) will be above its face value. The reason for this is that if the market was requiring a lower rate (for example, 8 per cent), but the coupon rate was higher (for example, 10 per cent) then there would be high demand for the bond. This would push its price up to the point at which the interest payments on the higher price, plus the repayment of the principal, provides an effective rate of return equal to the rate required by the market. That is, the effective rate of return will equate to the markets required rate of return on the bond. Therefore, when the markets required rate of return is less than the rate being offered on a bond the price of that bond will be above its face value. That is, it will be issued at a premium and at an amount that then causes the effective interest rate provided by the investment to become equal to the rate of return required by the market.

14.31 In terms of AASB 9, leverage is a contractual cash flow characteristic of some financial assets. Leverage increases the variability of the contractual cash flows with the result that the cash flows do not have the economic characteristics of interest. Options, forward contracts and swap contracts are examples of financial assets that include leverage. For example, a forward exchange contract (also often referred to as a futures contract) on interest rates or foreign currency rates can increase or decrease dramatically in value as a result of a relatively small increase or decrease in relevant interest or exchange rates. Therefore, if the contractual terms of the financial asset includes leverage (for example, a stand-alone option or a forward or swap contract), this will result in returns that could show high volatility and therefore would not be of the same nature as interest revenue, which would tend to be relatively fixed in nature.

A futures contract is a contract to buy or sell an agreed quantity of a particular item, at an agreed price, on a specific date. Substantial gains or losses can be made given that typically only a small deposit is made on the contract. For example, a deposit of 5 per cent may be made on a futures contract that requires the delivery of a commodity for a fixed price of $1million. If the price of the commodity rises to $1.05 million (a modest increase of 5 per cent) the futures trader has lost $50 000 on the contract (the trader is locked in to receiving only $1 million for an asset that can be acquired on the market for $1.05 million)that is, the trader has lost the entire amount of the deposit as a result of a 5 per cent rise in the price of the commodity.

14.35Long Ltd, as a result of entering the forward rate contract, has locked-in the amount it will pay for the inventory. That is, it will pay $1,428,571 for the inventory, regardless of what happens to the exchange rate. Board Bank has agreed to provide Long Ltd with US$1,000,000 at a price of $A1,428,571 regardless of what happens to exchange rates. Effectively, the foreign currency risks associated with the inventory have been shifted to Board Bank.

14.36To calculate the issue price of the bonds we need to determine the present value of the future cash flows. We will use the markets required rate of return as the interest rate necessary to determine the present value.

Present value of annual payments:$100 000 3.4331$343 310

Present value of principal repayment: $1 000 000 0.5194$519 400

$862 710

Determining amortised cost using the effective-interest method

1. Year ended 2. Opening bond payable

$ 3. Payment

$ 4. Interest at 14% (column 2 14%)

$ 5. Increase in bond payable (column 4 column 3)

$ 6. Amortised cost of bond payable (column 2 + column 5)

30 June 2023 862 710 100 000 120 779 20 779 883 489

30 June 2024 883 489 100 000 123 689 23 689 907 178

30 June 2025 907 178 100 000 127 005 27 005 934 183

30 June 2026

39 June 2027

934 183

964 969

100 000

1 000 000 130 786

135 096 30 786

35 095 964 969

1 000 064

64*

*rounding error of $64 due to using present values to only 4 decimal places.

The annual interest cost is measured by multiplying the effective interest rate by the amount of the liability at the beginning of each period. Any excess of interest cost over the amount of interest paid is accounted for as an increase in the carrying amount of the liability (which is its present value). By the maturity date, the liability will be increased to an amount equal to the principal, as the discount reduces to zero.

Journal entries

1 July 2022

Dr Cash 862 710 Cr Bond payable 862 710

(Issuing bonds for $862 710)

30 June 2023

Dr Interest expense 120 779 Cr Bond payable 20 779

Cr Bank 100 000

(Interest payment and amortisation of bond payable using effective-interest rate of 14%)

PART 4: Accounting for liabilities and owners equity

Chapter 12

Accounting for employee benefits

Review questions

12.1According to AASB 119 Employee Benefits, employee benefits means all forms of consideration given by an entity in exchange for services rendered by employees, or for the termination of their employment. Employee benefits would include, but would not be limited to, wages and salaries (including fringe benefits and non-monetary benefits), annual leave, sick leave, long-service leave, superannuation and other post-employment benefits.

12.2This is false. When we recognise an amount due for annual leave or long service leave we debit the expense and we credit a provision (a liability). There is no direct cash flow. Rather, in accordance with the accrual method of accounting, we recognise the expenses when it is incurred, and to the extent that a related payment has not been made, we recognise (accrue) a liability. So, as we should appreciate, the act of making an accrual does nothing to ensure that any cash will actually be available to pay employees their accrued entitlements should the employer organisation become insolvent (that is, the act of creating or increasing the size of an employee benefit provision does not involve any actual movements in cash). Companies can have a vast amount sitting in provisions and reserves accounts, but in fact have no cash.

12.3This is false. If an organisation wishes to shift the risks associated with superannuation to their employees, then it would establish a defined contribution plan. Superannuation plans can be classified as either:

defined contribution plans, or

defined benefit plans.

A defined contribution plan is a superannuation benefit scheme under which amounts to be paid as retirement benefits are determined by contributions made to the fund together with investment earnings on those contributions. A defined benefit plan, on the other hand, is a plan to which amounts to be paid as retirement benefits are paid from an aggregated fund by reference to a members annual salary or are paid as a specified amount regardless of the contributions already paid by the employee.

If it is a defined contribution superannuation plan, we need to understand that the employers obligation is limited to ensuring that the agreed percentage of salary has been transferred to the superannuation fund (which is typically administered and operated by an independent third party). There is no further obligation on the employer, and the employee will receive the aggregate of these contributions made on their behalf, plus the earnings thereon, less the related fees. Effectively, the employee is subject to the risks in relation to what financial amount is ultimately received on retirement.

If, by contrast, it is a defined benefit superannuation plan, we need to understand that the employers obligation is to ensure that the payment to the employee on retirement (based on years of service and final salary) as agreed by way of a formula is actually paid. If there are insufficient funds within the superannuation fund to pay the agreed benefit, the employer will need to make further contributions. Effectively, the employer is subject to risks in relation to what is ultimately paid to the employees on retirement.

12.4This is false. Payments made to employees will not always be treated as an expense. For example, if employees are directly involved in making inventory that will subsequently be sold, then the employee benefits will initially be treated as part of the cost of the inventory. Ultimately, the employee benefits would then form part of cost of goods sold as the inventory is sold.

Similarly, if employees are involved in the construction of, for example, plant and equipment then the employee benefits would be treated as part of the cost of the plant and equipment. Ultimately the employee benefits would form part of the depreciable base of the plant and equipment, and this depreciable base would be depreciated over the useful life of the asset.

12.5This is false. The annual leave expense should be recognised as the employee accumulates the annual leave entitlement. This is in accordance with the accrual method of accounting wherein an expense and a related provision (Provision for annual leave) are recognised as the employee performs their services. As the leave is taken, the provision would be reduced.

12.6AASB 119 requires that short-term employee benefit obligations be measured on an undiscounted basis. Short-term employee benefits could include wages, salaries, social security contributions, short-term compensated absences, profits sharing and bonuses payable within 12 months.

Obligations for employee benefits, inclusive of salary and wages, that are payable beyond 12 months after the end of the reporting period are to be recorded at their present value. For the purpose of determining present values, the discount rate is to be based on market yields at the end of the reporting period of high quality corporate bonds. The currency and terms of the bonds are to be consistent with the current and estimated term of the obligations.

While paragraph 83 of AASB 119 states that reference should be made to high quality corporate bonds, it also states that where there is no deep market in such bonds the market yields on government bonds shall be used. Paragraph 83 states:

The rate used to discount post-employment benefit obligations (both funded and unfunded) shall be determined by reference to market yields at the end of the reporting period on high quality corporate bonds. For currencies for which there is no deep market in such high quality corporate bonds, the market yields (at the end of the reporting period) on government bonds denominated in that currency shall be used. The currency and term of the corporate bonds or government bonds shall be consistent with the currency and estimated term of the post-employment benefit obligations.

12.7The rates on high-quality corporate bonds shall be used to discount employee benefit obligations payable beyond 12 months after the end of the reporting period when there is an active and liquid market in high quality corporate bonds.

12.18(a)The accounting entry at the end of the reporting period to recognise eight days salary and wages expense would be (this assumes a ten-day working week, of which 8 days remain unpaid at the end of the reporting period):

30 June

Dr Wages and salaries expense 24 000 Cr PAYG tax payable 8 000

Cr Wages and salaries payable

(to recognise salary expenses to 30 June) 16 000

($24 000 = $30 000 8/10)

(b)When the amount is ultimately paid to employees on 2 July, the entry would be:

2 July

Dr Wages and salaries expense 6 000 Dr Wages and salaries payable 16 000 Cr PAYG tax payable 2 000

Cr Cash at bank

(to recognise payment made to employees) 20 000

$6000 represents two days salary, which would be included as an expense of the new financial period. The employees would receive the net amount after deduction of the PAYE tax, that is, $30 000 less $10 000. This entry assumes that no reversing entries were made on 1 July.

(c)When the amounts are paid to the ATO on Monday, the entry would be:

6 July

Dr PAYG tax payable 10 000 Cr Cash

(to recognise amount paid to ATO) 10 000

12.19(a)Jerry Lopezs annual leave will cost his employer $100000 4/52 1.175. This equals $9038 or $174 per week. Therefore, the total amount paid to Lopez each year would be:

For 48 weeks at normal pay-rate: $100 000 48/52 = $92 308

For 4 weeks inclusive of loading: $100 000 4/52 1.175 $9 038

Total salary and annual leave $101 346

If Lightning Bolt Ltd recognises the annual leave obligation throughout the year, there would be the following entry each week:

Dr Annual leave expense 174 Cr Provision for annual leave

(to recognise annual leave earned by the employee) 174

(b)If Lopez was to take two weeks annual leave, and assuming the related tax is $1200, the entry would be:

Dr Provision for annual leave 4 519 Cr PAYG tax payable 1 200

Cr Cash at bank 3 319

( to recognise the payment made for annual leave, where $4519 = $9038/2)

Lightning Bolt Ltd would also need to provide the usual weekly annual leave journal entry, even when Lopez is on holidays. That is:

Dr Annual leave expense 174 Cr Provision for annual leave

(to recognise the increased employee entitlement to annual leave) 174

Challenging questions

12.20

Years of service Current salary No. Salary number of employees Inflation N to maturity Proj. sal. Entitlement PV Prob. LSL provn6 yrs50 000 2 100 000 1.025 4 110 381.30* 16 557.19** 11 729.53*** 0.45 5278****

7 yrs65 000 2 130 000 1.025 3 139 995.80 24 499.26 19 998.70 0.7 13 999

8 yrs70 000 2 140 000 1.025 2 147 087.50 29 417.50 26 181.47 1 26 181

$45 459

*(1.025)4 $100 000 = $110 381.3

** 6/10 13 $110 381.3/52 = $16 557.19

*** $16 557 1/(1.09)4 = $11 729.53

**** $11 729.53 0.45 = $5278

Note: the interest rate at the beginning of the year of 8 per cent was not relevant. What is relevant are the rates in place at the end of the reporting period that match the period until maturity.

DrLSL Expense$12 959

CrLSL Provision$12 959

(To recognise the increase in the provision = closing balance of provision opening balance of provision = $45 459 - $32 500 = $12 959)

12.21(a)The expected annual sick leave expense for Bear Island Ltd (on the basis of average salaries) would be:

$300 000 2 0.6 = $360 000

$300 000 1 0.2 = $60 000

$300 000 1/5 0.1 = $6000

$426 000

(b)This would equate to $8192 per week. On this basis, Bear Island Ltd could post the following journal entry each week:

Dr Sick leave expense 8192 Cr Sick leave payable 8192

( to recognise weekly cost for sick leave where $8192 = $426 000/52)

12.22(a)Calculations (see notes below for explanation of calculations under each column):

Employee name Projected salary Accumulated LSL benefit Present value of LSL obligation Probability that LSL will be paid LSL liability

Black 48 760 1 563 724 15% 109

White 46 866 3 004 17 481 20% 350

Brown 56 308 5 414 3710 50% 1855

Green 64 946 8 326 6595 70% 4617

Purple 72 828 11 671 10 426 90% 9383

16 314

Notes

1. The projected salary is determined by the following calculation:

Current salary (1 + inflation rate)n, where n = number of years until the long service leave entitlement vests. In this question it is assumed that the inflation rate will continue to be 2 per cent. For the first listed employee, the calculation would be $40000 (1.02)10 = $48 760.

2. Accumulated LSL benefit is determined by the following calculation:

Accumulated LSL entitlement = (years of employment)/(number of periods until entitlement can be taken in leave) weeks of LSL entitlement/52 projected salary.

For the first listed employee, the calculation would be 2/12 10/52 $48 760 = $1563.

3. The present value of the long-service leave calculation is determined by the following calculation:

Accumulated long service leave benefit

(1 + appropriate government bond rate)n

where n is the number of years until long-service leave entitlements can be taken. For the first listed employee the calculation would be $1563/(1.08)10 = $724.

4. Probability that long-service leave will be taken:

The probability that long-service leave will be taken would be determined by reference to prior experience within the organisation and industry. For example, it has been assessed that an employee with 2 years service has a probability of 15 per cent of staying in the firm until long-service leave must be taken. Once an employee reaches the pre-conditional period (in this question, 12 years) the probability is 100 per cent that a payment will be made. For the first listed employee, the calculation would be $724 0.15 = $109.

Following on from the above calculations, after considering all five employees, the long service leave provision at the end of the period should total $16 314.

(b)If the balance in the provision account at the beginning of the year had been $12 500, then the expense for the year would be $3814. This would represent the increase in the obligation that has occurred throughout the year. The accounting entry to recognise the long-service leave expense would be:

Dr Long-service leave expense 3814 Cr Provision for long-service leave

(to recognise long service leave expense for the year) 3814

Part 9: Foreign currency

Chapter 30

Accounting for foreign currency transactions

Review questions

30.1The foreign exchange rate is the ratio of exchange between two currencies. That is, it is the rate at which one currency can be exchanged for another

30.2A foreign currency transaction is a transaction that is undertaken with another entity in a currency that is different from the organisations functional currency.

30.3The functional currency is the currency used in the primary, or main, economic environment in which the organisation operates. Determining the functional currency is important as this identifies the currency into which the transactions will initially be converted/translated.

The presentation currency is defined in AASB 121 as the currency in which the financial statements are presented. In relation to the determination of the presentation currency, paragraph 38 of AASB 121 states:

An entity may present its financial statements in any currency (or currencies). If the presentation currency differs from the entitys functional currency, it translates its results and financial position into the presentation currency. For example, when a group contains individual entities with different functional currencies, the results and financial position of each entity are expressed in a common currency so that the consolidated financial statements may be presented.

30.5At the end of the reporting period all foreign currency monetary assets and foreign currency monetary liabilities must be translated to Australian dollar equivalents (assumed to be the functional currency) using the exchange rate in place at the end of the reporting period. As paragraph 23 of AASB 121 states:

At each end of the reporting period foreign currency monetary items shall be translated using the closing rate.

Apart from a limited number of cases (for example, transactions relating to qualifying assets and gains and losses pertaining to certain hedges), gains or losses on translating the foreign currency monetary items must be treated as either expenses or income of the reporting period and included within profit or loss. This is consistent with paragraph 28 of AASB 121 which states:

Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements, shall be recognised in profit or loss in the period in which they arise, except as described in paragraph 32.

30.6When a transaction occurs that is denominated in a foreign currency, that transaction should initially be translated to the functional currency at the exchange rate in place at the date of the transaction (also referred to as the spot rate). This is consistent with paragraph 21 of AASB 121 which states:

A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.

30.181 May 2022

Dr Accounts receivable 5 952 381

Cr Sales 5 952 381

(to record sale: US$5 000 000 0.84 = $5 952 381)

30 June 2022

Dr Foreign exchange loss 70 028

Cr Accounts receivable 70 028

(to record loss on accounts receivable due to movements in foreign exchange rates: (US$5000 000 0.85) (US$5 000 000 0.84) = $70 028)

1 Sept 2022

Dr Foreign exchange loss 68 400

Cr Accounts receivable 68 400

(to record loss on accounts receivable due to movements in foreign exchange rates: (US$5000 000 0.86) (US$5 000 000 0.85) = $68 400)

1 Sept 2022

Dr Cash 5 813 953

Cr Accounts receivable 5 813 953

(the amount is received from the customer)

Challenging questions

30.20(a)15 March 2022

No entry as order only

11 May 2022

Dr Inventory 731 707 Cr Accounts payable 731 707

[to recognise the purchase of inventory (300 000/0.41)]

30 June 2022

Dr Accounts payable 34 033 Cr Foreign exchange gain 34 033

300 000 0.41 = 731 707

300 000 0.43 = 697 674

Gain 34 033

14 August 2022

Dr Foreign exchange loss 71 556 Cr Accounts payable 71 556

300 000 0.43 = 697 674

300 000 0.39 = 769 230

71 556

Dr Accounts payable 769 230 Cr Cash 769 230

(300 000 0.39)

(b)15 March 2022

No entry as order only

11 May 2022

Dr Plant and equipment 731 707 Cr Accounts payable 731 707

[to recognise the purchase. (300 000 0.41 = 731 707)]

30 June 2022

Dr Accounts payable 34 033 Cr Foreign exchange gain 34 033

(300 000 0.41) (300 000 0.43) = 34 033

This is not a qualifying asset as the asset was not acquired under a contract which necessarily took a substantial period of time to get the asset ready for its intended use. As such, any gain or loss to the date of delivery is transferred to profit or loss.

14 August 2022

Dr Foreign exchange loss 71 557 Cr Accounts payable 71 557

(300 000 0.43 300 000 0.39)

Dr Accounts payable 769 231 Cr Cash 769 231

(to recognise settlement: 300 000 0.39 = 769 231)

(c)Swaps occur when borrowers exchange aspects of their respective loan obligations. Foreign currency swaps occur when the obligation related to a loan denominated in one currency is swapped for a loan denominated in another currency

If an entity has receivables and payables that are both denominated in a particular foreign currency, changes in the spot rates will create gains on one and losses on the other. To the extent that the receivables and payables are for the same amount and denominated in the same currency, the losses on one monetary item (perhaps the foreign currency payable) will be offset by gains on the other monetary item (perhaps the foreign currency receivable).

As ABC Ltd has a number of payables that are denominated in a foreign currency, changes in spot rates can potentially create sizeable foreign currency gains or losses. If the organisation is able to convert some of its domestic receivables into foreign currency receivables of the same denomination as its payables, it will effectively insulate, or hedge itself, against the effects of changes in spot rates. Such an organisation might try to find another entity that is prepared to swap its foreign currency receivables for the organisations domestic receivables.

30.21Journal entries for purchase of machinery

This would not represent a qualifying asset as the asset has not taken a substantial period of time to get ready for its intended use.

(i)30 April 2022

Dr Machinery 328 947 Cr Accounts payable 328 947

Being the purchase of the asset on 30 April at a rate of US$0.76

328 947 = 250 000 0.76

(ii)30 June 2022

Dr Foreign exchange loss 8 891 Cr Accounts payable 8 891

Being the movement in the exchange rate to 30 June 2022 brought to account

250 000 0.76 = 328 947

250 000 0.74 = 337 838

8 891

(iii)31 July 2022

Dr Foreign exchange loss 9384 Cr Accounts payable 9384

Dr Accounts payable 173 611 Cr Bank 173 611

Being adjustment of accounts payable to 31 July 2022 at US$0.72 and payment of the first instalment.

250 000 0.74 = 337 838

250 000 0.72 = 347 222

9 384

347 222 0.5 = 173 611

(iv)31 August 2022

Dr Accounts payable 4 692 Cr Foreign exchange gain 4 692

Dr Accounts payable 168 919 Cr Bank 168 919

Being final adjustment and payment of the second instalment. The asset was delivered on 31 August 2022, and so remains a qualifying asset until that date.

125 000 0.72 = 173 611

125 000 0.74 = 168 919

4 692

(v)30 June 2023

Dr Depreciation expense 27 412 Cr Accumulated depreciationmachinery 27 412

Being 10 months depreciation of asset at 10 per cent p.a.: $328 947 @ 10% 10/12

Spare parts purchase

The required journal entries would be as follows:

30 May 2022

DrInventory357 143

CrAccounts payable357 143

(500 000 1.40)

30 June 2022

DrForeign currency loss42 857

CrAccounts payable42 857

(500 000 1.25) (500 000 1.40)

31 August 2022

Dr Foreign exchange loss 34 783

Cr Accounts payable 34 783

[(500 000 1 .15) 500 000 1.25]

Dr Accounts payable 434 783

Cr Cash at bank 434 783

Part 6: Industry-specific accounting issues

Chapter 20

Accounting for the extractive industries

Review questions

20.1Pursuant to paragraph Aus7.3 of AASB 6:

An area of interest refers to an individual geological area whereby the presence of a mineral deposit or an oil or natural gas field is considered favourable or has been proved to exist. It is common for an area of interest to contract in size progressively, as exploration and evaluation lead towards the identification of a mineral deposit or an oil or natural gas field, which may prove to contain economically recoverable reserves. When this happens during the exploration for and evaluation of mineral resources, exploration and evaluation expenditures are still included in the cost of the exploration and evaluation asset notwithstanding that the size of the area of interest may contract as the exploration and evaluation operations progress. In most cases, an area of interest will comprise a single mine or deposit or a separate oil or gas field.

20.2First, there may have been an efficiency argument (Chapter 3 discusses the efficiency perspective) in which it was argued that those firms that used the full-cost method did so because they believed that it most reliably reflected their performance, relative to other accounting choices. Eliminating the full-cost method from their portfolio of accounting methods may have then necessitated them using a method which did not efficiently reflect their performance.

The elimination of the full-cost method would have required the full-costers to reduce their assets and their owners equity, as a result of the requirement to write off expenses associated with expenditures carried forward in relation to unsuccessful areas. This would have adverse effects on gearing ratios and interest coverage ratios. To the extent that such ratios were included within accounting-based contracts that were already in place, then such adverse movements may have motivated the management of the full-cost firms to lobby against the standard. Further, the full-cost method minimises the volatility of earnings relative to other methods. Low volatility of earnings would typically be preferred by management.

To the extent that management bonuses were tied to reported earnings, then this may also have motivated management to lobby for the full-cost method. This would assume, of course, that the measure of profit used in the compensation plan does not adjust for the method used to account for pre-production expenditures.

20.3We can refer to AASB 15 Revenue from Contracts with Customers for the requirements relating to the recognition of revenue in the extractive industries (see Chapter 15). Generally, sales revenue should not be brought to account until such time as control of the resource has passed to the customer.

20.4An entity in the extractive industry should recognise restoration costs throughout the various phases of its operations. That is, if a particular activity generates the need for subsequent restoration work, then restoration expenses should be recognised at that time rather than waiting until such time as the restoration work will ultimately be undertaken. AASB 6 does not provide guidance in relation to restoration work. Rather, reference needs to be had to AASB 137 Provisions, Contingent Liabilities, and Contingent Assets. Paragraph 11 of AASB 6 states:

In accordance with AASB 137 Provisions, Contingent Liabilities and Contingent Assets an entity recognises any obligations for removal and restoration that are incurred during a particular period as a consequence of having undertaken the exploration for and evaluation of mineral resources.

Provisions, including provisions for restoration, are to be measured at present values. Specifically, paragraphs 36, 45 and 47 of AASB 137 require:

36. The amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.

45. Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation.

47. The discount rate (or rates) shall be a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the liability. The discount rate(s) shall not reflect risks for which future cash flow estimates have been adjusted.

Appendix C to AASB 137 provides an illustration of a provision that has a bearing on this question. This Appendix is reproduced in Chapter 20. As the Appendix indicates, if the construction of particular facilities, such as drilling platforms and so forth necessitates future remediation or restoration works when such facilities are removed, then a provision for restoration should be recognised at the time the facilities are constructed and the expected cost of restoration should be included as part of the cost of the assets, with the total cost being amortised over the useful life of the site. Other restoration costs necessitated by the ongoing operations of the site should be provided for throughout the operations and treated as part of the cost of the respective phases of operations. These costs will ultimately form part of the cost of the inventory of the organisation.

The reporting entity would be required periodically to reassess the amount provided for the restoration provision in the light of changes in expected future costs, changes in expectations relating to the amount of disturbance being caused, changes in relevant laws and changes in technologies utilised to perform the restoration and rehabilitation works.

Entities involved in the extractive industries might also be held responsible for environmental damage caused by spills and leakages to land or water. Cost related to required clean-ups would typically be treated as expenses in the periods in which the spills or leakages occur.

20.6AASB 6 does not specifically require the disclosure of information about balances of provisions for restoration expenditure, or information about how the provisions were determined. However, reference can be made to AASB 137, which includes requirements that are of relevance in relation to disclosing provisions for restoration. Specifically, paragraphs 26 and 27 require:

26. For each class of provision, an entity shall disclose:

(a) the carrying amount at the beginning and end of the period;

(b) additional provisions made in the period, including increases to existing provisions;

(d) unused amounts reversed during the period; and

(e) the increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate.

Comparative information is not required.

27. An entity shall disclose the following for each class of provision:

(a) a brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits;

(b) an indication of the uncertainties about the amount or timing of those outflows. Where necessary to provide adequate information, an entity shall disclose the major assumptions made concerning future events, as addressed in paragraph 48; and

(c) the amount of any expected reimbursement, stating the amount of any asset that has been recognised for that expected reimbursement.

20.19If circumstances suggest that carried forward exploration and evaluation expenditure exceeds their recoverable amount, then an impairment loss shall be recognised. This is consistent with the general principle that an impairment loss needs to be recognised for any asset where the recoverable amount is less than the carrying amount. As paragraph 18 of AASB 6 states:

Exploration and evaluation assets shall be assessed for impairment when facts and circumstances suggest that the carrying amount of an exploration and evaluation asset may exceed its recoverable amount. When facts and circumstances suggest that the carrying amount exceeds the recoverable amount, an entity shall measure, present and disclose any resulting impairment loss in accordance with AASB 136

20.22Accounting standard AASB 6 states that assets associated with exploration and evaluation activities may be carried forward, as long as a reasonable probability of success exists in that area of interest. Therefore, the expenditure can be expensed as incurred if an entity chooses. Specifically, paragraphs Aus 7.1 and 7.2 of AASB 6 state:

Aus7.1An entitys accounting policy for the treatment of its exploration and evaluation expenditures shall be in accordance with the following requirements. For each area of interest, expenditures incurred in the exploration for and evaluation of mineral resources shall be:

(a)expensed as incurred; or

(b)partially or fully capitalised, and recognised as an exploration and evaluation asset if the requirements of paragraph Aus7.2 are satisfied.

An entity shall make this decision separately for each area of interest.

Aus7.2An exploration and evaluation asset shall only be recognised in relation to an area of interest if the following conditions are satisfied:

(a)the rights to tenure of the area of interest are current; and

(b)at least one of the following conditions is also met:

(i)the exploration and evaluation expenditures are expected to be recouped through successful development and exploitation of the area of interest, or alternatively, by its sale; and

(ii)exploration and evaluation activities in the area of interest have not at the reporting date reached a stage which permits a reasonable assessment of the existence or otherwise of economically recoverable reserves, and active and significant operations in, or in relation to, the area of interest are continuing.

Hence, pursuant to AASB 6, a reporting entity can elect to write-off all exploration and evaluation expenditure as incurred, regardless of their expectations regarding the likelihood that the expenditure will lead to the discovery of economically recoverable reserves. Students should be encouraged to consider why a reporting entity might elect to write-off all exploration and evaluation expenditure.

Challenging questions

20.24(a) Area-of-interest method

2021

Dr Exploration and evaluation assetsGood Site 23 Dr Exploration and evaluation assetsBad Site 16 Dr Exploration and evaluation assetsIndifferent Site 25 Cr Cash, payables, accumulated depreciation, etc. 64

(To account for the initial exploration and evaluation costs incurred in each site; the expenditure is initially measured at cost and, subject to the requirements of AASB 116 and AASB 138, can be revalued. It is assumed, however, that the entity adopts the cost model and does not perform revaluations.)

2022

Dr Impairment lossexploration and evaluation assets 16 Cr Exploration and evaluation assetsBad Site 16

Dr Assets under constructionproperty, plant and equipment (Good Site) 18.4 Dr Assets under constructionintangible mineral assets (Good Site) 4.6 Cr Exploration and evaluation assetsGood Site 23

(To reclassify the balance of the exploration and evaluation expenditure at Good Site to assets under construction (or similar account) consistent with paragraph 17 of AASB 6 and to recognise an impairment loss in relation to Bad Site since the site has been abandoned. Because Indifferent Site has not reached a stage where a reasonable assessment can be made of the existence of recoverable reserves, then there is no reclassification of the related expenditure.)

Dr Assets under constructionproperty, plant and equipment (Good Site) 20 Dr Assets under constructionintangible mineral assets (Good Site) 7 Cr Cash/payables/accumulated depreciation, etc. 27

(To recognise the development costs incurred in relation to Good Site. Such capitalised costs will be reclassified when the development phase concludes. Because the assets are not ready for use they will not be depreciated; however, they will be subject to impairment testing. The capitalised costs will ultimately form part of the cost of inventories as a result of applying the entitys amortisation/depreciation policies.)

Dr Property, plant and equipment (Good Site) 38.4 Dr Intangible mineral assets (Good Site) 11.6 Cr Assets under constructionproperty, plant and equipment (Good Site) 38.4

Cr Assets under constructionintangible mineral assets (Good Site) 11.6

(to reclassify the assets as a result of the movement from the preproduction phase to the production phase)

Dr Inventory of crude oil 10 Cr Accumulated depreciationproperty, plant and equipment (Good Site) 7.68

Cr Accumulated depreciationintangible mineral assets (Good Site) 2.32

(3 m $3.3333 where $50 m/15 m = $3.3333 per tonne)

Dr Inventory of crude oil 4 Cr Cash, payables, accumulated depreciation, etc. 4

Dr Cash/receivables 57 Cr Sales revenue 57

(1.9 m $30)

Dr Cost of goods sold 8.87 Cr Inventory of crude oil 8.87

[(10 + 4)/3] 1.9 = 8.87

(b)Full-cost method

2021

Dr Exploration and evaluation assets 64 Cr Cash, payables, accumulated depreciation, etc. 64

2022

Cr Assets under constructionproperty, plant and equipment

Assets under constructionintangible mineral assets

Exploration and evaluation assets

51.2

12.8 64

Dr Assets under constructionproperty, plant and equipment

Assets under constructionintangible mineral assets 20

7 Cr Cash/payables

Dr Property, plant and equipment

Intangible mineral assets

Assets under constructionproperty, plant and equipment

Assets under constructionintangible mineral assets

Inventory of crude oil 71.2

19.8

18.2 71.2

19.8

Cr Accumulated depreciationproperty, plant and equipment

Accumulated depreciationintangible mineral assets 14.24

3.96

(91 3/15)

Dr Inventory of crude oil 4 Cr Cash, payables, accumulated depreciation, etc. 4

Dr Cash/receivables 57 Cr Sales revenue 57

Dr Cost of goods sold 14.06 Cr Inventory of crude oil 14.06

(22.2 1.9/3)

20.25(a) Area-of-interest method

2021

Dr Exploration and evaluation assetsIan site 1 500 Dr Exploration and evaluation assetsEddie site 2 000 Cr Cash, payables, accumulated depreciation, etc. 3 500

2022

Dr Exploration and evaluation assetsIan site 2 000 Dr Exploration and evaluation assetsEddie site 3 000 Cr Cash, payables, accumulated depreciation, etc. 5 000

2023

Dr Exploration and evaluation assetsIan site 3 000 Dr Exploration and evaluation assetsEddie site 4 000 Cr Cash/payables 7 000

Dr Assets under constructionproperty, plant and equipment

Assets under constructionintangible mineral assets 5 200

1 300 Cr Exploration and evaluation assetsIan site 6 500

Dr Impairment lossexploration and evaluation assets 9 000 Cr Exploration and evaluation assetsEddie site 9 000

2024

Dr Property plant and equipment 2 000 Cr Cash, payables, accumulated depreciation, etc. 2 000

Dr Buildings 500 Cr Cash/payables 500

Dr Property, plant and equipment

Intangible mineral assets

Assets under constructionproperty, plant and equipment

Inventory of crude oil 5 200

1 300

2 268 5 200

1 300

Cr Accumulated depreciationproperty, plant and equipment

Accumulated depreciationintangible mineral assets 1 920

348

(400 $5.67, where ($5200 + $1300 + $2000)/1500 = $5.67 per tonne)

Dr Inventory of crude oil 50 Cr Accumulated depreciation: portable buildings 50

(It is assumed buildings were acquired at the commencement of the year. 50 = 500/10)

Dr Inventory of crude oil 2 000 Cr Cash, payables, accumulated depreciation, etc. 2 000

(400 5.00)

Dr Cash/receivables 6 250 Cr Sales revenue 6 250

(250 25.00)

Dr Cost of goods sold 2 699 Cr Inventory of crude oil 2 699

[(2268 + 50 + 2000)/400] 250 = 2699

(b)Full-cost method

2021

Dr Exploration and evaluation assets 3 500 Cr Cash, payables, accumulated depreciation, etc. 3 500

2022

Dr Exploration and evaluation assets 5 000 Cr Cash, payables, accumulated depreciation, etc. 5 000

2023

Dr Exploration and evaluation assets 7 000 Cr Cash, payables, accumulated depreciation, etc. 7 000

Dr Assets under constructionintangible mineral assets

Assets under constructionproperty, plant and equipment 3 100

12 400 Cr Exploration and evaluation assets 15 500

(It is assessed that future production will enable the recoupment of all of this expenditure.)

2024

Dr Property, plant and equipment 2 000 Cr Cash, payables, accumulated depreciation, etc. 2 000

Dr Buildings 500 Cr Cash/payables 500

Dr Property, plant and equipment

Assets under constructionproperty, plant and equipment

Intangible mineral assets

Assets under constructionintangible mineral assets

Inventory of crude oil 12 400

3 100

4 668 12 400

3 100

Cr Accumulated depreciationproperty, plant and equipment

Accumulated depreciationintangible mineral assets 3 840

828

(400 $11.67, where ($12 400 + $3100 + $2000)/1500 = $11.67 per tonne)

Dr Inventory of crude oil 50 Cr Accumulated depreciationportable buildings 50

(It is assumed buildings were acquired at the commencement of the year. 50 = 500/10)

Dr Inventory of crude oil 2 000 Cr Cash/payables 2 000

(400 5.00)

Dr Cash/receivables 6 250 Cr Sales revenue 6 250

(250 25.00)

Dr Cost of goods sold 4 199 Cr Inventory of crude oil 4 199

[(4668 + 50 + 2000)/400] 250 = 4199

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