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Financial Accounting, 8th Edition [8 ed.]
 9781743763636, 1743763638

Table of contents :
Front Cover
Front Matter
PART 1 THE AUSTRALIAN ACCOUNTING ENVIRONMENT
Chapter 1 An overview of the Australian external reporting environment
Chapter 2 The conceptual framework for financial reporting
PART 2 THEORIES OF ACCOUNTING
Chapter 3 Theories of financial accounting
PART 3 ACCOUNTING FOR ASSETS
Chapter 4 An overview of accounting for assets
Chapter 5 Depreciation of property, plant and equipment
Chapter 6 Revaluations and impairment testing of non-current assets
Chapter 7 Inventory
Chapter 8 Accounting for intangibles
Chapter 9 Accounting for heritage assets and biological assets
PART 4 ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY
Chapter 10 An overview of accounting for liabilities
Chapter 11 Accounting for leases
Chapter 12 Accounting for employee benefits
Chapter 13 Share capital and reserves
Chapter 14 Accounting for financial instruments
Chapter 15 Revenue recognition issues
Chapter 16 The statement of profit or loss and other comprehensive income, and the statement of changes in equity
Chapter 17 Accounting for share-based payments
Chapter 18 Accounting for income taxes
PART 5 ACCOUNTING FOR THE DISCLOSURE OF CASHFLOWS
Chapter 19 The statement of cash flows
PART 6 INDUSTRY-SPECIFIC ACCOUNTING ISSUES
Chapter 20 Accounting for the extractive industries
PART 7 OTHER DISCLOSURE ISSUES
Chapter 21 Events occurring after the end of the reporting period
Chapter 22 Segment reporting
Chapter 23 Related party disclosures
Chapter 24 Earnings per share
PART 8 ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES
Chapter 25 Accounting for group structures
Chapter 26 Further consolidation issues I: accounting for intragroup transactions
Chapter 27 Further consolidation issues II: accounting for non-controlling interests
PART 9 FOREIGN CURRENCY
Chapter 28 Accounting for foreign currency transactions
Chapter 29 Translating the financial statements of foreign operations
PART 10 CORPORATE SOCIAL-RESPONSIBILITY REPORTING
Chapter 30 Accounting for corporate social responsibility
ONLINE CHAPTERS
Chapter 31 Further consolidation issues III: accounting for indirect ownership interests
Chapter 32 Accounting for investments in associates and joint ventures
Appendix A Present value of $1
Appendix B Present value of an annuity of $1
Appendix C Calculating present values
Glossary
Index

Citation preview

Financial Accounting

Craig Deegan’s Financial Accounting 8e continues to be the market-leading and most highly regarded product for the changing needs of today’s instructors and students. New to this edition:

• Redesigned: content is more concise, accessible and easy to use • Currency: comprehensive and up-to-date coverage of areas such as financial statement presentation, the conceptual framework for financial reporting, accounting for leases, revenue recognition, financial instruments and corporate social responsibility reporting

• Digital resources: for the first time, Financial Accounting offers a complete digital package, including LearnSmart and SmartBook, which provide an adaptive and individualised learning experience unique to each student

Connect is proven to deliver better results for you. Proven content integrates seamlessly with enhanced digital tools to create a personalised learning experience that provides you with precisely what you need, when you need it. Ensure maximum learning impact with SmartBook, the first and only adaptive reading experience designed to change the way you read and learn. It creates a personalised reading experience by highlighting the most impactful concepts you need to learn at that moment in time. To learn more about McGraw-Hill SmartBook®, visit http://www.mheducation.com.au/student-smartbook

8th

Edition

  

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Financial Accounting

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To my beautiful daughter Cassie for being the best daughter a dad could ever have

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Craig Deegan

Financial Accounting 8e

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Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd Additional owners of copyright are acknowledged in on-page credits. Every effort has been made to trace and acknowledge copyrighted material. The authors and publishers tender their apologies should any infringement have occurred. Reproduction and communication for educational purposes The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10% of the pages of this work, whichever is the greater, to be reproduced and/or communicated by any educational institution for its educational purposes provided that the institution (or the body that administers it) has sent a Statutory Educational notice to Copyright Agency Limited (CAL) and been granted a licence. For details of statutory educational and other copyright licences contact: Copyright Agency Limited, Level 15, 233 Castlereagh Street, Sydney NSW 2000. Telephone: (02) 9394 7600. Website: www.copyright.com.au Reproduction and communication for other purposes Apart from any fair dealing for the purposes of study, research, criticism or review, as permitted under the Act, no part of this publication may be reproduced, distributed or transmitted in any form or by any means, or stored in a database or retrieval system, without the written permission of McGraw-Hill Education (Australia) Pty Ltd, including, but not limited to, any network or other electronic storage. Enquiries should be made to the publisher via www.mheducation.com.au or marked for the attention of the permissions editor at the address below. National Library of Australia Cataloguing-in-Publication Data Author: Deegan, Craig Michael Title: Financial accounting / Craig Michael Deegan. Edition: 8th edition. ISBN: 9781743764022 (pbk.) Notes: Includes index. Subjects: Accounting—Australia. Accounting—Standards—Australia. Financial statements—Standards—Australia. Dewey Number: 657.021894 Published in Australia by McGraw-Hill Education (Australia) Pty Ltd Level 2, 82 Waterloo Road, North Ryde NSW 2113 Product managers: Lisa Coady and Robert Ashworth Product developer: Cynthia Morali Research coordinator: Carolina Bodin Content producer: Genevieve MacDermott Permissions editor: Haidi Bernhardt Copyeditor: Alison Moore Indexer: Shelley Barons Cover design: Jane Cameron Typeset in Proxima Nova Light 10/13.5pt by SPi Global, India Printed in China on 65gsm matt art by 1010 Printing Int. Ltd

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ABOUT THE AUTHOR

Craig Deegan CRAIG DEEGAN, BCom (University of NSW), MCom (Hons) (University of NSW), PhD (University of Queensland), FCA, is Professor of Accounting in the School of Accounting at RMIT University in Melbourne. Craig has taught at both undergraduate and postgraduate level for about three decades. Prior to working in the university sector Craig worked as a chartered accountant. His research has tended to focus on various social and environmental accountability and financial accounting issues and has been published in a number of leading international accounting journals, including: Accounting, Organizations and Society; Accounting and Business Research; Accounting, Accountability and Auditing Journal; Accounting and Finance; British Accounting Review; Critical Perspectives on Accounting; Journal of Business Ethics; Australian Accounting Review; and The International Journal of Accounting. According to Google Scholar, Craig’s work has attracted approximately 12,000 citations making him one of the most highly cited researchers internationally within the accounting and/or finance literature. Craig has regularly provided consulting services to corporations, government, and industry bodies on issues pertaining to financial accounting and corporate social and environmental accountability, he was former Chairperson of the Triple Bottom Line Issues Group of the Institute of Chartered Accountants in Australia, for a number of years was involved in developing the CPA Program of CPA Australia, and for many years was a judge on the Australian Sustainability Reporting Awards. He is on the editorial board of a number of academic

accounting journals and he has been the recipient of various teaching and research awards, including teaching prizes sponsored by KPMG, and the Institute of Chartered Accountants in Australia. He was the inaugural recipient of the Peter Brownell Manuscript Award, an annual research award presented by the Accounting and Finance Association of Australia and New Zealand. He was also awarded the University of Southern Queensland Individual Award for Research Excellence. Craig is also the author of the leading financial accounting theory textbook, Financial Accounting Theory, now in its fourth edition. Financial Accounting Theory is widely used throughout Australia as well as in many other countries.

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CONTENTS IN BRIEF

PART 1

THE AUSTRALIAN ACCOUNTING ENVIRONMENT

1

Chapter 1 Chapter 2

An overview of the Australian external reporting environment The conceptual framework for financial reporting

2 48

PART 2

THEORIES OF ACCOUNTING

83

Chapter 3

Theories of financial accounting

84

PART 3

ACCOUNTING FOR ASSETS

Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9

An overview of accounting for assets Depreciation of property, plant and equipment Revaluations and impairment testing of non-current assets Inventory Accounting for intangibles Accounting for heritage assets and biological assets

PART 4

ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18

An overview of accounting for liabilities Accounting for leases Accounting for employee benefits Share capital and reserves Accounting for financial instruments Revenue recognition issues The statement of profit or loss and other comprehensive income, and the statement of changes in equity Accounting for share-based payments Accounting for income taxes

PART 5

ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

Chapter 19

The statement of cash flows

PART 6

INDUSTRY-SPECIFIC ACCOUNTING ISSUES

Chapter 20

Accounting for the extractive industries

PART 7

OTHER DISCLOSURE ISSUES

Chapter 21 Chapter 22

Events occurring after the end of the reporting period Segment reporting

139 140 180 202 234 258 300

343 344 376 427 457 481 548 585 625 656

695 696

741 742

779 780 794

vi  Contents in brief vi

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Chapter 23 Chapter 24

Related party disclosures Earnings per share

PART 8

ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

Chapter 25 Chapter 26 Chapter 27

Accounting for group structures Further consolidation issues I: accounting for intragroup transactions Further consolidation issues II: accounting for non-controlling interests

PART 9

FOREIGN CURRENCY

Chapter 28 Chapter 29

Accounting for foreign currency transactions Translating the financial statements of foreign operations

PART 10

CORPORATE SOCIAL-RESPONSIBILITY REPORTING

Chapter 30

Accounting for corporate social responsibility

820 839

869 870 924 966

1007 1008 1028

1049 1050

ONLINE CHAPTERS Chapter 31 Chapter 32

Further consolidation issues III: accounting for indirect ownership interests Accounting for investments in associates and joint ventures

Appendix A Appendix B Appendix C

Present value of $1 Present value of an annuity of $1 Calculating present values

1122 1124 1126

Contents in brief  vii

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CONTENTS IN FULL

About the author v Contents in brief vi Preface xvii Acknowledgments xviii AACSB statement xix How to use this book xx Digital resources xxii Credits xxiv

PART 1

THE AUSTRALIAN ACCOUNTING ENVIRONMENT

1

CHAPTER 1

AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT

2

Accounting, accountability and the role of financial accounting 3 Financial accounting defined 4 Users’ demand for general purpose financial statements 4 Sources of external financial reporting regulations 6 The process of Australia adopting accounting standards issued by the International Accounting Standards Board 25 Structure of the International Accounting Standards Board 34 International cultural differences and the harmonisation of accounting standards 37 Accounting standards change across time 38 The use and role of audit reports 38 All this regulation—is it really necessary? 39

CHAPTER 2

THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

Australia’s use of the IASB conceptual framework What is a conceptual framework? Benefits of a conceptual framework Current initiatives to develop a revised conceptual framework Structure of the conceptual framework Building blocks of a conceptual framework Measurement principles A critical review of conceptual frameworks The conceptual framework as a normative theory of accounting

49 49 50 50 52 54 73 74 77

Learning objectives 2 Summary 43 Key terms 43 End-of-chapter exercises 43 Review questions 44 Challenging questions 44 References 46

48 Learning objectives 48 Summary 78 Key terms 79 End-of-chapter exercises 79 Review questions 79 Challenging questions 80 References 81

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PART 2

THEORIES OF ACCOUNTING

CHAPTER 3

THEORIES OF FINANCIAL ACCOUNTING

Introduction to theories of financial accounting Why discuss theories in a book such as this? Definition of theory Positive Accounting Theory Accounting policy selection and disclosure Accounting policy choice and ‘creative accounting’ Some criticisms of Positive Accounting Theory Normative accounting theories Systems-oriented theories to explain accounting practice Theories that seek to explain why regulation is introduced

PART 3

ACCOUNTING FOR ASSETS

CHAPTER 4

AN OVERVIEW OF ACCOUNTING FOR ASSETS

Introduction to accounting for assets Numbering of Australian Accounting Standards Definition of assets General classification of assets How to present a statement of financial position Determination of future economic benefits Acquisition cost of assets Accounting for property, plant and equipment—an introduction Assets acquired at no cost Possible changes in the requirements pertaining to financial statement presentation

CHAPTER 5

83 84 85 85 86 87 101 102 103 105 109 122

139 140 141 141 142 149 150 153 157 158 169

Learning objectives 140 Summary 173 Key terms 173 End-of-chapter exercises 174 Review questions 174 Challenging questions 176 References 179

170

DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT

Introduction to accounting for depreciation of property, plant and equipment Depreciable amount (base) of an asset Determination of useful life Method of cost apportionment Depreciation of separate components When to start depreciating an asset Revision of depreciation rate and depreciation method Land and buildings Modifying existing non-current assets Disposition of a depreciable asset Depreciation as a process of allocating the cost of an asset over its useful life: further considerations Disclosure requirements

Learning objectives 84 Summary 126 Key terms 127 End-of-chapter exercises 127 Review questions 128 Challenging questions 131 Further reading 134 References 134

180 181 182 183 184 187 188 188 189 191 191

Learning objectives 180 Summary 195 Key terms 196 End-of-chapter exercises 196 Review questions 196 Challenging questions 198

193 194

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CHAPTER 6

REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS

Introduction to revaluations and impairment testing of non-current assets Measuring property, plant and equipment at cost or at fair value—the choice The use of fair values Revaluation increments Treatment of balances of accumulated depreciation upon revaluation Revaluation decrements Reversal of revaluation decrements and increments Accounting for the gain or loss on the disposal or derecognition of a revalued non-current asset Recognition of impairment losses Further consideration of present values Offsetting revaluation increments and decrements Investment properties Economic consequences of asset revaluations Disclosure requirements

CHAPTER 7

212 216 221 223 223 224 226

234 235 235 235 242 250 251

Learning objectives 234 Summary 251 Key terms 252 End-of-chapter exercises 252 Review questions 253 Challenging questions 254 References 257

ACCOUNTING FOR INTANGIBLES

Introduction to accounting for intangible assets Which intangible assets can be recognised and included in the statement of financial position? What is the initial basis of measurement of intangible assets? General amortisation requirements for intangible assets Revaluation of intangible assets Gain or loss on disposal of intangible assets Required disclosures in relation to intangible assets Research and development Accounting for goodwill Is the way we account for intangible assets an improvement over what we did in Australia prior to the introduction of IFRS in 2005?

CHAPTER 9

Learning objectives 202 Summary 227 Key terms 228 End-of-chapter exercises 228 Review questions 229 Challenging questions 231 References 233

INVENTORY

Introduction to inventory Definition of inventory The general basis of inventory measurement Inventory cost-flow assumptions Reversal of previous inventory write-downs Disclosure requirements

CHAPTER 8

203 203 204 205 206 209 210

258 259 261 262 264 267 268 268 269 279

Learning objectives 258 Summary 287 Key terms 287 End-of-chapter exercises 288 Review questions 289 Challenging questions 293 References 298

286

ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS

Introduction to accounting for heritage assets and biological assets Accounting for heritage assets Accounting for biological assets

202

301 301 320

300

Learning objectives 300 Summary 336 Key terms 337 End-of-chapter exercises 337 Review questions 337 Challenging questions 338 References 341

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PART 4

ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

CHAPTER 10

AN OVERVIEW OF ACCOUNTING FOR LIABILITIES

Liabilities defined Contingent liabilities Contingent assets Classification of liabilities as ‘current’ or ‘non-current’ Liability provisions Some implications of reporting liabilities Debt equity debate Accounting for debentures (bonds) Hybrid securities

CHAPTER 11

CHAPTER 12

345 347 350 350 351 356 358 360 365

Learning objectives 344 Summary 366 Key terms 366 End-of-chapter exercises 366 Review questions 367 Challenging questions 371 References 375

376 377 383 383 384 387 388 388 390 401 413

ACCOUNTING FOR EMPLOYEE BENEFITS

Overview of employee benefits Categories of employee benefits Accounting for employee benefits Employees’ accrued employee benefits and corporate collapses

CHAPTER 13

344

ACCOUNTING FOR LEASES

An overview of recent developments in the accounting requirements pertaining to accounting for leases The core principle and scope of the new accounting standard on leasing Exemptions for leases of 12 months or less, and for low-value assets What is a lease? When to recognise a lease Accounting for the service component of a contract that includes a lease The meaning of ‘lease term’ Accounting for leases by lessees Accounting for leases by lessors Implications for accounting-based contracts

343

Learning objectives 376 Summary 416 Key terms 418 End-of-chapter exercises 418 Review questions 419 Challenging questions 421 References 425

427 428 430 431 449

SHARE CAPITAL AND RESERVES

Introduction to accounting for share capital and reserves 458 Different classes of shares 459 Accounting for the issue of share capital 460 Accounting for distributions 467 Redemption of preference shares 468 Forfeited shares 470 Share splits and bonus issues 472 Rights issues and share options 473 Required disclosures for share capital 475 Reserves 475

Learning objectives 427 Summary 450 Key terms 450 End-of-chapter exercises 450 Review questions 452 Challenging questions 453 References 456

457 Learning objectives 457 Summary 476 Key terms 476 End-of-chapter exercises 477 Review questions 478 Challenging questions 480 References 480

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CHAPTER 14

ACCOUNTING FOR FINANCIAL INSTRUMENTS

Introduction to accounting for financial instruments Financial instruments defined Debt versus equity components of financial instruments Set-off of financial assets and financial liabilities Recognition and measurement of financial assets Recognition and measurement of financial liabilities Derivative financial instruments and their use as hedging instruments Compound financial instruments Disclosure requirements pertaining to financial instruments

CHAPTER 15

Learning objectives 481 Summary 539 Key terms 539 End-of-chapter exercises 540 Review questions 541 Challenging questions 544 References 547

548 549 550 551 552 555 559 563 566 566 574

Learning objectives 548 Summary 575 Key terms 576 End-of-chapter exercises 576 Review questions 580 Challenging questions 582 References 584

 HE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME, T AND THE STATEMENT OF CHANGES IN EQUITY

Introduction to the statement of profit or loss and other comprehensive income Profit or loss disclosure Statement of changes in equity Prior period errors Changes in accounting policy Profit as a guide to an organisation’s success Future changes in the requirements pertaining to how we present information about comprehensive income

CHAPTER 17

482 483 488 492 495 509 512 535 537

REVENUE RECOGNITION ISSUES

New accounting standard on revenue recognition Definition of income and revenue Recognition criteria for revenue from contracts with customers Measurement of revenue Income and revenue recognition points Accounting for sales with associated conditions Interest and dividends Unearned revenue Accounting for construction contracts Summary of the steps to be taken when recognising revenue

CHAPTER 16

481

586 589 603 604 607 613

Learning objectives 585 Summary 617 Key terms 618 End-of-chapter exercises 618 Review questions 618 Challenging questions 620 References 624

615

ACCOUNTING FOR SHARE-BASED PAYMENTS

Introduction to accounting for share-based payments Background to the release of AASB 2 Overview of the requirements of AASB 2 Equity-settled share-based payment transactions Cash-settled share-based payment transactions Share-based payment transactions with cash alternatives Possible economic implications of AASB 2 Disclosure requirements

585

625 626 626 628 629 643 647 649 650

Learning objectives 625 Summary 652 Key terms 652 End-of-chapter exercises 652 Review questions 653 Challenging questions 654

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CHAPTER 18

ACCOUNTING FOR INCOME TAXES

Introduction to accounting for income taxes The balance sheet approach to accounting for taxation Tax base of assets and liabilities: further consideration Deferred tax assets and deferred tax liabilities Unused tax losses Revaluation of non-current assets Offsetting deferred tax liabilities and deferred tax assets Change of tax rates Evaluation of the assets and liabilities created by AASB 112

656 657 658 664 667 669 672 679 679 680

Learning objectives 656 Summary 686 Key terms 687 End-of-chapter exercises 687 Review questions 689 Challenging questions 691 References 694

PART 5

ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

CHAPTER 19

THE STATEMENT OF CASH FLOWS

Comparison with other financial statements Defining ‘cash’ and ‘cash equivalents’ Classification of cash flows Format of statement of cash flows Calculating cash inflows and outflows Contractual implications Potential future changes to the statement of cash flows

PART 6

INDUSTRY-SPECIFIC ACCOUNTING ISSUES

CHAPTER 20

ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES

696 697 701 703 704 709 721 722

Learning objectives 696 Summary 727 Key terms 728 End-of-chapter exercises 728 Review questions 731 Challenging questions 735 References 740

741 742

Overview of accounting for exploration and evaluation expenditures under AASB 6 743 Extractive industries defined 744 Alternative methods to account for preproduction costs 745 Abandoning an area of interest 748 Accumulation of costs pertaining to exploration and evaluation activities 748 Basis for measurement of exploration and evaluation expenditures 749 Impairment and amortisation of costs carried forward 750 Restoration costs 752 Sales revenue 754 Inventory 755 Disclosure requirements 755 Does the area-of-interest method provide a realistic value for an entity’s reserves? 764 Research on accounting regulation pertaining to pre-production expenditures 764 Other developments in extractive industry reporting 767 The development of a new accounting standard for extractive activities 769

Learning objectives 742 Summary 772 Key terms 773 End-of-chapter exercises 773 Review questions 773 Challenging questions 775 References 776

PART 7

OTHER DISCLOSURE ISSUES

CHAPTER 21

EVENTS OCCURRING AFTER THE END OF THE REPORTING PERIOD

What is an ‘event after the reporting period’? Types of events after the reporting period Disclosure requirements

695

779

781 782 787

780

Learning objectives 780 Summary 789 Key terms 789 End-of-chapter exercises 789 Review questions 789 Challenging questions 790

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CHAPTER 22

SEGMENT REPORTING

Advantages and disadvantages of segment reporting An introduction to AASB 8 Defining an operating segment Defining a reportable segment Measurement of segment items Required financial disclosures Reconciliation of segment information to financial statements Non-financial disclosures Is there a case for competitive harm?

CHAPTER 23

795 799 801 803 806 807 808 809 811

Learning objectives 794 Summary 811 Key terms 812 End-of-chapter exercises 812 Review questions 815 Challenging questions 817 References 819

RELATED PARTY DISCLOSURES

Introduction to related party disclosures Related party relationship defined AASB 124 Related Party Disclosures Section 300A of the Corporations Act 2001 Examples of related party disclosure notes

CHAPTER 24

794

820 821 821 822 831 835

Learning objectives 820 Summary 836 Key terms 836 End-of-chapter exercises 836 Review questions 836 Challenging questions 837 References 838

EARNINGS PER SHARE

Introduction to earnings per share Computation of basic earnings per share Diluted earnings per share Linking earnings per share to other indicators

839 840 840 851 857

Learning objectives 839 Summary 858 Key terms 859 End-of-chapter exercises 859 Review questions 861 Challenging questions 864 References 867

PART 8

ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

CHAPTER 25

ACCOUNTING FOR GROUP STRUCTURES

Introduction to accounting for group structures Rationale for consolidating the financial statements of different legal entities History of Australian Accounting Standards that govern the preparation of consolidated financial statements ‘Investment entities’: exception to consolidation Alternative consolidation concepts The concept of control Direct and indirect control Accounting for business combinations Gain on bargain purchase Subsidiary’s assets not recorded at fair values Previously unrecognised identifiable intangible assets Consolidation after date of acquisition Disclosure requirements Control, joint control, and significant influence

869 870

871 872 873 877 878 879 885 887 897 898 903 906 908 909

Learning objectives 870 Summary 910 Key terms 911 End-of-chapter exercises 911 Review questions 915 Challenging questions 919 References 923

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CHAPTER 26

FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS

Introduction to accounting for intragroup transactions Dividend payments from pre- and post-acquisition earnings Intragroup sale of inventory Sale of non-current assets within the group

CHAPTER 27

925 925 932 942

Learning objectives 924 Summary 949 Key terms 950 End-of-chapter exercises 950 Review questions 957 Challenging questions 960

FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS

Introduction to accounting for non-controlling interests What is a non-controlling interest? Non-controlling interests to be disclosed in the consolidated financial statements Calculating non-controlling interests

967 967 968 969

PART 9

FOREIGN CURRENCY

CHAPTER 28

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

Introduction to accounting for foreign currency transactions Foreign currency transactions Determination of functional currency and presentation currency Longer-term receivables and payables Translation of other monetary assets such as cash deposits Qualifying assets Hedging transactions Foreign currency swaps

CHAPTER 29

924

Learning objectives 966 Summary 990 Key terms 990 End-of-chapter exercises 991 Review questions 1001 Challenging questions 1003

1007

1009 1009 1013 1014 1015 1016 1018 1019

1008 Learning objectives 1008 Summary 1020 Key terms 1021 End-of-chapter exercises 1021 Review questions 1022 Challenging questions 1025

TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATIONS

Introduction to translating the financial statements of foreign operations Reporting foreign currency transactions in the functional currency Translating the accounts of foreign operations into the presentation currency Consolidation subsequent to translation

966

1029 1029 1036 1041

1028

Learning objectives 1028 Summary 1043 Key terms 1043 End-of-chapter exercises 1043 Review questions 1045 Challenging questions 1045

CONTENTS IN FULL xv

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PART 10

CORPORATE SOCIAL-RESPONSIBILITY REPORTING

CHAPTER 30

ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY

Introduction to social-responsibility reporting 1051 Social and environmental reporting defined 1053 What are the responsibilities of business (to whom and for what)? 1055 Evidence of public social and environmental reporting 1061 Why report? 1063 To whom will the organisation report? 1074 What information shall be reported? 1075 How (and where) will the information be presented? 1077 Other international initiatives to assist corporate social and environmental performance 1101 Social auditing 1104 The critical problem of climate change 1107 Personal social responsibility 1111 Concluding remarks 1112

1049 1050

Learning objectives 1050 Summary 1112 Key terms 1113 End-of-chapter exercises 1113 Review questions 1113 Challenging questions 1116 References 1118

ONLINE CHAPTERS CHAPTER 31

FURTHER CONSOLIDATION ISSUES III: ACCOUNTING FOR INDIRECT OWNERSHIP INTERESTS

CHAPTER 32

ACCOUNTING FOR INVESTMENTS IN ASSOCIATES AND JOINT VENTURES

Appendix A 1122 Appendix B 1124 Appendix C 1126 Glossary1128 Index1137

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PREFACE

This is the eighth edition of a book that was originally published in 1995. Since the first edition of this book was published we have seen extensive changes in relation to the practice and regulation of general purpose financial reporting. These changes continue to occur and this book has always attempted to carefully explain the nature of the changes as well as the potential economic and social consequences which might result from such changes. In the period of time between when the seventh edition of this book was published, and the writing of this eighth edition was completed (writing was completed in March 2016) there have been some rather significant changes in regulation and guidance pertaining to external reporting. These changes have been incorporated within this eighth edition and some of the major changes we cover relate to such areas as financial statement presentation, The Conceptual Framework for Financial Reporting, accounting for leases, revenue recognition, financial instruments, and corporate social-responsibility reporting. Because many of these changes are significant we will provide critical comparisons of the ‘old’ and ‘new’ requirements. Each chapter of this eighth edition contains learning objectives, chapter summaries and a comprehensive endof-chapter exercise. A glossary of key terms is provided towards the back of the book. The book provides material that will enable the reader to gain a thorough grasp of the contents and of the practical application of the majority of financial accounting requirements currently in place in Australia. In the discussion of these requirements, numerous worked examples, with detailed solutions, are provided throughout the text. As well as addressing how to apply the various accounting requirements, this text also encourages readers to critically evaluate the various rules and guidelines. The aim is to develop accountants who are not only able to apply particular accounting requirements, but who will also be able to contribute to the ongoing improvement of accounting requirements. The view taken is that it is not only important for students to understand the rules of financial accounting, but also to understand the limitations inherent in many of the existing accounting requirements. For this reason, reference is made to various

research studies that consider the merit, implications, and costs and benefits of the various accounting requirements. Also, various newspaper articles discussing different aspects of the accounting requirements are reproduced for consideration and discussion. The permission of copyright holders to reproduce this material is gratefully acknowledged. Social-responsibility reporting continues to be an important area of accounting, and one that is rapidly developing. Its importance is further highlighted by the growing evidence of climate change, species extinction, and large scale poverty, hunger and social inequities in many countries. While this book predominantly considers financial accounting and reporting, Chapter 30 focuses on social-responsibility reporting and provides the most up-to-date and comprehensive material available on this important topic with additional material being added on the important topic of Climate Change—both from an accounting and scientific perspective—as well as the inclusion of commentaries on various alternative reporting frameworks. Writing a text like this is an extremely time-consuming exercise and it has been very gratifying that the effort involved has been rewarded by so many institutions across Australia (and also some outside Australia) electing to prescribe previous editions of this book as part of their accounting programs. Given the success of all previous editions, every effort has been made to ensure that this eighth edition is equally valuable to students and teachers, and that it has been substantially and thoroughly revised.

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ACKNOWLEDGMENTS

There are many people who must be thanked for their contribution to the eighth edition of this book. First, our thanks to the following reviewers of the current edition: Bobae Choi, University of Newcastle; Sally Chaplin, Queensland University of Technology; Victoria Clout, University of New South Wales; Sajan Cyril, Australian Catholic University; Colin Dolley, Edith Cowan University; Peter Dryden, Federation University; Hermann Frick, University of Queensland; Syed Haider, Victoria University; Andrew Jackson, University of New South Wales; Arifur Khan, Deakin University; Eric Lee, Monash University; Janet Lee, Australian National University; Jinghui Liu, Southern Cross University; Tracey McDowall, Deakin University; Balachandran Muniandy, La Trobe University; Puspalila Muniandy, Deakin University; Gregory Phillip, University of Newcastle; Pranil Prasad, University of the South Pacific; Maria Prokofieva, Victoria University; Glenn Rechtschaffen, University of Auckland; Natasja Steenkamp, Central Queensland University; Grantley Taylor, Curtin University; Suzanne Mary Taylor, QUT Business School; Maria Tyler, CQUniversity Mackay campus; Effiezal Aswadi Abdul Wahab, Curtin University. This book has also been improved during the course of the first seven editions by the feedback received from many people and I would like to acknowledge the contribution that they have previously made. These people include: Maria Balatbat, University of New South Wales; Peter Baxter, University of the Sunshine Coast; Poonam Bir, Monash University; Phil Cobbin, University of Melbourne; Lome Cummings, Macquarie University; Matt Dyki, Charles Sturt University, Wagga Wagga campus; Natalie Gallery, Queensland University of Technology; John Goodwin, RMIT University; Deborah Janke, University of Southern Queensland; Maurice Jenner, University of Southern Queensland; Graham Jones, Flinders University; Peter Keet, RMIT University; Janet Lee, Australian National University; Steven Lesser, Charles Sturt University, Wagga Wagga campus; Stephen Lim, University of Technology Sydney; Janice Loftus, University of Sydney; Wei Lu, Monash University; Diane Mayorga, University of New South Wales; Kellie McCombie, University of Wollongong; Malcolm Miller, University of New South

Wales; Lee Moermon, University of Wollongong; Gary Monroe, Australian National University; Richard Morris, University of New South Wales; Anja Morton, Southern Cross University, Lismore campus; Karen Ness, James Cook University; Cameron Nichol, RMIT University; Gary Plugarth, University of New South Wales; Lisa Powell, University of South Australia; Jim Psaros, University of Newcastle; Michaela Rankin, Monash University; Andrew Read, University of Canberra; Kathy Rudkin, University of Wollongong; Dan Scheiwe, Queensland University of Technology; Mark Silvester, University of Southern Queensland; Stella Sofocleous, Victoria University of Technology; Jenny Stewart, Griffith University; Seng The, Australian National University; Len Therry, Edith Cowan University; Matthew Tilling, University of Western Australia; Irene Tutticci, University of Queensland; Mark Vallely, University of Southern Queensland; Trevor Wilmshurst, University of Tasmania; Victoria Wise, University of Tasmania; Ann-Marie Wyatt, University of Technology Sydney. Thanks also go to many of my colleagues at RMIT University for their friendship and encouragement. The team at McGraw-Hill Education (Australia) also deserve a great deal of thanks for helping in the preparation of this book. Lastly, but certainly not leastly, thanks again go to my 16-year-old daughter Cassandra for all the love and support she gives me in whatever I seem to be doing and for continually helping me to put everything into perspective. As I have said before, she is indeed my finest work (and my most valuable ‘asset’) and represents that aspect of my life of which I am most proud.

The publisher would also like to thank the following digital contributors: Victoria Clout, Parmod Chand, Maria Prokofieva, Jackie Liu, Maria Balatbat, Eric Lee and Matt Dyki.

xviii Acknowledgments

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AACSB STATEMENT

McGraw-Hill Education is a proud corporate member of AACSB1 International. Understanding the importance and value of AACSB accreditation, Financial Accounting has sought to recognise the curricula guidelines detailed in the AACSB standards for business accreditation by connecting content and exercises to the general knowledge and skill guidelines found in the AACSB standards. The statements contained in Financial Accounting and in its digital resources are provided only as a guide for the users of this text. The AACSB leaves content coverage and assessment within the purview of individual institutions, the mission of the institutions, and the faculty. While Financial Accounting and the teaching package make no claim of any specific AACSB qualification or evaluation, we have, within Financial Accounting identified chapters as containing content and labelled activities according to the general knowledge and skills areas.2

1

The Association to Advance Collegiate Schools of Business [http://www.aacsb.edu/accreditation/standards.asp] AACSB International 2008, ‘Eligibility procedures and accreditation standards for business accreditation’, www.aacsb.edu

2

AACSB statement xix

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CHAPTER 6TO USE THIS BOOK HOW

REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS LEARNING OBJECTIVES (LO)

assets and liabilities identified as arising in a lease contract . . . The new approach would treat all lease contracts as the acquisition of a right to use the leased item for the lease term. Thus, the lessee would recognise the following: (a) an asset representing its right to use the leased item for the lease term (the right-of-use asset) (b) a liability for its obligation to pay rentals.

6.1

Be able to measure the cost of property, plant and equipment.

6.2

Understand the meaning of ‘fair value’.

6.3

Understand how and when to revalue an item of property, plant and equipment in accordance with AASB 116 Property, Plant and Equipment.

6.4

Understand how and when to revalue an intangible asset in accordance with AASB 138 Intangible Assets.

6.5

Understand the meaning of ‘recoverable amount’ and be able to calculate it.

6.6

Understand the difference in accounting treatments for upward revaluations to ‘fair value’, as opposed to write-downs to ‘recoverable amount’.

6.7

Understand what an ‘impairment loss’ is and know when and how to account for one in accordance with AASB 136 Impairment of Assets.

6.8

Understand how to account for revaluations that reverse previous revaluation increments or decrements.

6.9

Understand how to account for accumulated depreciation when a non-current depreciable asset is revalued, and understand that, subsequent to revaluation, new depreciation charges will be based on the revalued amount of the non-current asset.

6.10

Know how the profit on disposal of a revalued non-current asset is determined and understand how asset revaluations can affect an organisation’s profits owing to changes in depreciation expenses and in final gains or losses on the sale of the revalued asset.

The above position was ultimately embraced when IFRS 16 was issued in January 2016 (and AASB 16 was released in Australia in February 2016). Financial Accounting in the Real World 11.1 provides an insight into how the news media was reporting the implications of a new accounting standard on leasing.

11.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Effect on retailers from proposed new rules around lease accounting

6.11 Understand the meaning of a ‘cash-generating unit’ and why it is relevant to calculating depreciation Learning objectives and impairment losses. 6.12 Be able to explain possible motivations an organisation to elect, or not elect, to Each chapter starts with a listthatofmight thedrive chapter’s learning revalue its non-current assets to fair value. objectives. Theserequirements flag what youtoshould know 6.13 Know the disclosure pertaining asset revaluation and when impairmentyou losses.have worked through the chapter. Make these the foundation for your exam revision by using them to test yourself. The end-ofchapter assignments also link back to these learning objectives. 202 PART 3: ACCOUNTING FOR ASSETS We would then debit the machine account by $5 000 and credit the revaluation surplus by $5 000. This would cause Chapter introduction the carrying amount of the asset to be $14 000, which is its fair value. That is, the journal entry would be:

Each chapter begins with an excellent5 000 overview of the material Dr Machine Cr surplus 5 000 to beRevaluation covered, and places it in the broader context of how Subsequent depreciation after a revaluation is based on the revalued amount of the non-current asset. It should be topics in various chapters interrelate. noted that an entity cannot account for a downward revaluation simply by increasing the amount of the accumulated dee64022_ch06_202-233.indd

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depreciation by the amount of the revaluation decrement, even though the net effect would be the same. Worked Example 6.1 illustrates the use of the ‘net method’—which nets off accumulated depreciation against the asset prior to recognition of the fair value increment or decrement.

WORKED EXAMPLE 6.1: Revaluation of a depreciable asset using the net-amount method Assume that, as at 1 July 2018, Farrelly Ltd has an item of machinery that originally cost $40 000 and has accumulated depreciation of $15 000. Its remaining life is assessed to be five years, after which time it will have no residual value. While completing a regular revaluation of all machinery, Farrelly decided on 1 July 2018 that the item should be revalued to its current fair value, which was assessed as $45 000.

In 2008, following spectacular corporate collapses like that of Enron, the International Accounting Standards Board (IASB) outlined a proposal that operating leases should be included on a company’s balance sheets in the interest of transparency for creditors and investors around corporate debt. The IASB was forced into a rethink after a backlash from major retailers including Woolworths and Wesfarmers, denouncing the original proposals as complex and costly. Under the latest changes to lease accounting rules put forward by the IASB, retailers such as Woolworths, Wesfarmers, Myer, David Jones, JB Hi-Fi, Harvey Norman, Specialty Fashion and Premier Investments will have to calculate the net present value of future lease commitments and recognise them as debt on their balance sheets. Instead of recognising rent payments as costs incurred, retailers will have to expense theoretical amortisation and financing costs. This will boost earnings before interest, tax, depreciation and amortisation but will reduce pre-tax and net profits, as the amortisation and financing costs will exceed rental payments, especially for faster growing retailers with relatively new leases. According to a report by Morgan Stanley, the impact on retailers will be ‘considerable’, blowing out gearing levels and reducing return on capital employed, but will vary from retailer to retailer. Reactions to the proposed rules include a report by Morgan Stanley predicting a considerable but varied impact on retailers including reduced capital return and a blow out of gearing levels. The report says Myer, Specialty Fashion and The Reject Shop will be more affected than Kathmandu and Fantastic Furniture as the former have significant and long-term lease liabilities. Also new retailers like Lovisa, who are early into lease terms will probably be impacted more than established leaseholder retailers. Morgan Stanley analyst Tom Kierath says investors aren’t as aware of the change to lease accounting rules as they should be. Examples of the financial impact on Myer, Woolworths and Wesfarmers of the new rules clarify their expected effect. Myer: net debt $340 million but net present value (NPV) of lease liabilities is $2.2 billion. Debt would rise to $2.5 billion. Woolworths: net debt $3 billion but NPV of leases is $15 billion. Debt would rise to $18 billion. Wesfarmers (Coles, Bunnings, Target, Officeworks): net debt $4 billion and NPV of leases is $12 billion. Patricia Stebbens, a KPMG audit partner, believes that some companies will have to renegotiate their debt covenants with their banks because rule changes would increase gearing ratios. However, Angus Thompson, the research director of the Australian Accounting Standards Board, believes that as the new rules are likely to take effect no earlier than January 2018, affected parties have sufficient preparation time. Although there has been a mixed reaction to the new rules, Thompson is confident of the benefits of increased transparency around gearing.

Financial accounting in the real world

Accounting is often a major and controversial part of news items that hit the headlines. Excerpts from the media put various aspects of accounting under the spotlight, emphasising how integral it is to business life. They also help students gain Adapted from ‘Retailers face hit from proposed lease changes’, by Sue Mitchell, The Australian Financial Review, aSOURCE: wider grasp of accounting byaccounting presenting opposing viewpoints 23 April 2015, p. 21 in relation to hot topics. Some show accounting in a historical context; others relate to contemporary issues. 382

PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

REQUIRED Provide the appropriate journal entries to account for the revaluation using the net-amount method.

Figures

SOLUTION The total revaluation increment will represent the difference between the carrying amount and the fair value of the asset at the date of the revaluation. In this case it would be: $45 000 - ($40 000 - $15 000) = $20 000 The appropriate journal entries on 1 July 2018 would be:

dee64022_ch11_376-426.indd

Dr Cr Dr Cr

Accumulated depreciation—machinery Machinery Machinery Revaluation surplus

Figures provide a graphical representation of how events and actions link. 382

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Tables

15 000 15 000

Tables provide useful checklists.

20 000 20 000

According to AASB 116, future depreciation should be based on the revalued amount of the asset. The depreciation charge for the year to 30 June 2019 would be $9 000 (the new carrying amount of $45 000 divided by the remaining

useful life of five years). Where the depreciation charges for any financial period have changed materially owing to a Worked examples revaluation, the financial effect of the change (that is, the increase or decrease in the depreciation charges) should

disclosed in the notes to the financial statements for that financial period. Abewide range of detailed scenarios and solutions, some fairly straightforward and some more complex, are provided While the demonstrated procedure (applying the net-amount method by which the accumulated depreciation for an throughout the text andis are a great aid, helping asset is adjusted to zero upon revaluation) the general approachlearning to be followed for revaluations of property, plant and equipment, AASB 116,how paragraph 35(a), provides an alternative treatment. This treatment and requirestheir that both the gross to reinforce the theory is applied in practice amount of the asset and the accumulated depreciation of the asset be adjusted. This method is sometimes used where reference is made to newer assets than those being revalued. Specifically, paragraph 35(a) of AASB 116 states that relevance to actual situations. when an item of property, plant and equipment is revalued, the accumulated depreciation at the date of the revaluation can be restated proportionately with the change in the gross carrying amount of the asset so that the carrying amount of the asset after revaluation equals its revalued amount. This approach is referred to as the ‘gross method’. The gross method of revaluation is applied in Worked Example 6.2.

xx How to use this book CHAPTER 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS

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assets may be understated but should never be overstated in the financial statements. The recoverable amount of an asset is defined as the higher of an asset’s net selling price and its value in use. Where an upward revaluation of property, plant and equipment is undertaken, the asset is to be revalued to its fair value. Revaluations should be undertaken as part of a process that revalues the entire class of assets to which the revalued non-current asset belongs. Where an asset is revalued upwards, the increase in the recorded value of the asset is not treated as part of profit or loss but is transferred to a revaluation surplus and included as part of ‘other comprehensive income’. The only exception to this rule is where the revaluation increment reverses a previous revaluation decrement, in which case the revaluation increment will be treated as part of the financial period’s profit or loss to the extent that it reverses the previous decrement that was included as an expense within profit or loss. Where an asset is revalued downwards, the decrease in the recorded value of the asset is to be treated as an expense and included within profit or loss. The only exception to this rule is where the revaluation decrement reverses a previous revaluation increment, in which case the revaluation decrement will be debited against (deducted from) the existing revaluation surplus and the related movement included as a reduction to ‘other comprehensive income’. When a revaluation of a depreciable non-current asset is undertaken, the most common approach is to adopt the ‘net method’ whereby we credit any existing accumulated depreciation against the non-current asset to be revalued, and subsequently increase the non-current asset account (debit the account) by the amount of the revaluation. Where a revalued non-current asset is subsequently sold, the gain or loss on disposal is to be measured as the difference between the carrying amount of the revalued asset as at the time of the disposal, and the net proceeds, if any, from disposal. The gain or loss must be recognised in the profit or loss for the financial year in which the disposal of the non-current asset occurs. The chapter has also considered how revaluations can, at times, loosen certain accounting-based debt covenants, such as restrictions written around an organisation’s debt-to-assets ratio.

KEY TERMS Mr Anderson informs you that the directors intend to revalue the property, plant and equipment during the year. The Disclosure requirements

LO 7.8

Where the information is material, paragraph 36 of AASB 102 requires that the financial statements disclose the following information: (a) (b) (c) (d) (e) (f)

the accounting policies adopted for measuring inventories, including the cost formulas used; the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity; the carrying amount of inventories carried at fair value less costs to sell; the amount of inventories recognised as an expense during the period; the amount of any write-down of inventories recognised as an expense in the period; the amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognised as an expense in the period; (g) the circumstances or events that led to the reversal of write-downs of inventories; and (h) the carrying amount of inventories pledged as securities for liabilities.

Inventories Recognition and measurement Inventories are valued at the lower of cost and net realisable value. The net realisable value of inventories is the estimated selling price in the ordinary course of business less estimated costs to sell. Key estimate: net realisable value The key assumptions, which require the use of management judgement, are the variables affecting costs recognised in bringing the inventory to location and condition for sale, estimated costs to sell and the expected selling price. These key assumptions are reviewed at least annually. The total expense relating to inventory write-downs during the year was $46 million (2014: $19 million). Any reasonable possible change in the estimate is unlikely to have a material impact. Costs incurred in bringing each product to its present location and condition are accounted for as follows:

Exhibit 7.1 Accounting policy note from the 2015 Annual Report of Wesfarmers Ltd

Property, plant and equipment Land 100 000 Buildings Land 10070 000 – Cost – Factory (NSW) 000 – Factory (Qld) 150(20 000 – Accumulated depreciation 000) Buildings—net Factory (Qld) – Factory (NSW) 50 000 Land 150 000 80 000 Buildings – Factory (Qld) – Cost 125 000 – Accumulated depreciation (45 000) (b) The relevant journal entries are as follows: 228

PARTDr 3: ACCOUNTING FOR ASSETS Land—factory (NSW)

150 000 150 000 120 000

50000 000 80 (30 000) –

80 000 70 000

30000 000 120 (10 000) 70 000 –

50 000

50 000 30 000 Cr Land—factory (Qld) 30 000 Dr Accumulated depreciation (NSW) 20 000 dee64022_ch06_202-233.indd 228 equipment originally cost Townend $600 000 in 2016, but due to market conditions 05/10/16the 01:26fair PM The plant and Dr Accumulated depreciation (Qld) 45 000 value of the plant and equipment has increased. The directors of Townend Ltd are concerned about the effects Cr Buildings—factory (NSW) 20 000 of the higher carrying value on profits—owing to the higher depreciation it is reducing profits. They ask you, the Cr Buildings—factory (Qld) 45 000 accountant, to reverse the previous revaluation. Being ethical in nature, what would you do? LO 6.3, 6.12 (NSW) that it acquired in 2017 30at 000 18. Bad Dr CompanyBuildings—factory Ltd has some machinery a cost of $4 000 000. In 2018 it is concerned Cr Revaluation surplus 30 000wages, but Bad Company Ltd about high reported profits—the labour union is considering pushing for additional onthem—and revaluationisofconsequently buildings considering ways 10 000 doesDrnot wantLoss to pay to reduce profits. Recently, it has acquired some Cr Buildings—factory (Qld) 10 000 identical machinery to that acquired in 2017. The machinery has been acquired in a liquidation sale of a business that is in the hands of the bank (owing to the business defaulting on a loan) and the cost is $500 000. After this purchase, Bad Company Ltd writes down to $500 000 the machinery acquired in 2017 at a cost of $4 000 000. Is this an appropriate course of action? LO 6.3, 6.4, 6.10, 6.12 19. Petersen Ltd has the following land and building in its financial statements as at 30 June 2018:

A comprehensive exercise and worked solution is provided at the end of each chapter. These are a great revision aid; work through them before tackling the more challenging questions to ensure you are on the right track.

Volume-related supplier rebates, and supplier promotional rebates where they exceed spend on promotional activities, are recognised as a reduction in the cost of inventory. SOURCE: Wesfarmer’s Ltd 2015 Annual Report Exhibits

REVIEW QUESTIONS

These features contain extracts from actual company reports or documents, or provide a commonly used format for accounting. SUMMARY They highlight the relevance of the chapter content to the The chapter addressed the topic of accounting for inventory. Inventory is defined as assets held sale in the ordinary practice of accounting, provide another element tofor the topics course of business, in the process of production for sale, or to be used in the production of goods; and other property or services for sale, including consumable stores and supplies. covered and help to reinforce learning. CHAPTER 7: INVENTORY

251

Chapter summary Key points of the chapter are summarised in this section. Check through it carefully to make sure you have understood topics covered before moving on. 251

(a) In undertaking the revaluations, decisions must be made about what constitutes the relevant classes of Anderson assets. Pty LtdAs is we an Australian diversified its majoris business being to manufacture know, when an item ofindustrial property,company plant andwith equipment revalued,activity AASB 116 requires that flotation devices for babies toddlers. Over past decade, the business been very and Increments the directors, the entire class ofand property, plant andthe equipment to which that assethas belongs mustprofitable be revalued. Simon Anderson and Lisa Anderson, have kept payment of dividends to assets. a minimum to allow the company to diversify and decrements are not permitted to be offset within a class of As shown below, it is considered that into other two activities. The is ainlist ofcase: property, equipment held by the company: classes of following assets exist this landplant usedand in the organisation’s operations; and buildings used in the organisation’s operations. The calculations for determining increments and decrements are as follows: Carrying Current amount ($) fairIncrement/ value ($) Carrying amount Current fair value (decrement) Property, plant and equipment ($) ($) ($) Factory (NSW)

Cr Revaluation surplus End-of-chapter exercise Dr Loss on revaluation of land

• Raw materials: purchase cost on a weighted average basis. • Manufactured finished goods and work in progress: cost of direct materials and labour and a proportion of manufacturing overheads based on normal operating capacity, but excluding borrowing costs. Work in progress also includes run-of-mine coal stocks for resources, consisting of production costs of drilling, blasting and overburden removal. • Retail and wholesale merchandise finished goods: purchase cost on a weighted average basis, after deducting any settlement discount and including logistics expenses incurred in bringing the inventories to their present location and condition.

dee64022_ch07_234-257.indd

recoverable amount 203 revaluation decrement 206 revaluation increment 205

SOLUTION TO END-OF-CHAPTER EXERCISE END-OF-CHAPTER EXERCISES

See Exhibit 7.1 for an example of an accounting policy note, in this case provided by Wesfarmers Ltd in its 2015 Annual Report. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

company has not revalued any assets in the past. accumulated depreciation 206 debt-to-assets ratio 224 REQUIRED asset revaluation 203 independent valuation 225 (a) amount How would you account for theprudence revaluation 209 of the above assets? carrying 203 (b) What would the relevant journal entries be? LO 6.1 6.2 6.3 6.9

05/11/16 09:41 AM

$ profits? Explain your answer. LO 6.10 1. What effect will an asset revaluation have on subsequent periods’ Explain the land, difference in the accounting treatment for 1 revaluation 2. Residential at cost 000 000 increments and revaluation decrements. Do you considerland, that at this difference is ‘conceptually sound’? LO900 6.6000 Factory valuation 2016 3. Buildings, When should a revaluation of000 profit or loss? LO 6.6, 6.8 at valuation 2016increment be included as part 800 4. Accumulated For the purposes of AASB 116 or AASB 136, how is ‘recoverable depreciation (100 000) amount’ determined? LO 6.5 5. When would you determine the recoverable amount for a cash-generating unit rather than for an individual item of property, plant2018, and equipment? At 30 June the balanceLO of6.11 the revaluation surplus is $400 000, of which $300 000 relates to the factory land and $100 000 to the buildings. On this same date, independent valuations of the land and building are CHAPTER 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS 229 obtained. In relation to the above assets, the assessed fair values at 30 June 2018 are:

Review questions

$

Residential land, previously recorded at cost 229 Factory land, previously revalued in 2016 Buildings, previously revalued in 2016

1 100 000 700 000 900 000

These questions ask you to reflect on key topics within the chapter, and help cement your learning. dee64022_ch06_202-233.indd

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REQUIRED

Provide the journal entries to account for the revaluation on 30 June 2018. Petersen Ltd classifies the residential land and the factory land as different classes of assets. LO 6.3, 6.4, 6.6, 6.9

Key terms

CHALLENGING QUESTIONS

Key terms are bolded in the text the first time they are used, defined in the margin at that point, and listed at the end of each chapter. They also appear in the glossary at the end of the book.

20. What, if anything, is the difference between recoverable amount and fair value? Where revaluations are undertaken, can a reporting entity use ‘value in use’ as the basis for the revaluation? LO 6.3, 6.5, 6.6 21. Kanga Cairns Ltd owns two blocks of beachfront land, acquired in 2015 for the purposes of future residential development. Block A cost $250 000 and Block B cost $350 000. Valuations of the blocks are undertaken by an independent valuer on 30 June 2017 and 30 June 2019. The assessed values are: 2017 valuation ($)

2019 valuation ($)

230 000 370 000

290 000 340 000

Block A Block B

REQUIRED Assuming asset revaluations were undertaken for the land in both 2017 and 2019, provide the journal entries for both years. LO 6.3, 6.8

CHAPTER 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS

231

Challenging questions These questions require a detailed problem analysis and help to build problem-solving and critical thinking skills. dee64022_ch06_202-233.indd

231

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How to use this book  xxi

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L E A R N I N G AT T H E S P E E D O F Y O U

A D V A N T A G E

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LearnSmart LearnSmart maximises learning productivity and efficiency by identifying the most important learning objectives for each student to master at a given point in time. It knows when students are likely to forget specific information and revisits that content to advance knowledge from their short-term to long-term memory. LearnSmart is proven to improve academic performance, ensuring higher retention rates and better grades.

To find out more about SmartBook visit

www.mheducation.com.au/student-smartbook

dee64022_Prelims_i-xxiv.indd xxii

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Proven effective With Connect, you can complete your coursework anytime, anywhere. Millions of students have used Connect and the results are in: research shows that studying with McGraw-Hill Connect will increase the likelihood that you’ll pass your course and get a better grade.

Connect support Connect includes animated tutorials, videos and additional embedded hints within specific questions to help you succeed. The Connect Success Academy for Students is where you’ll find tutorials on getting started, your study resources and completing assignments in Connect. Everything you need to know about Connect is here!

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To learn more about McGraw-Hill Connect®, visit

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dee64022_Prelims_i-xxiv.indd xxiii

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CREDITS

International Accounting Standards Board Copyright © IFRS Foundation. All rights reserved.

Australian Accounting Standards Board Copyright © Commonwealth of Australia 2016

Reproduced by McGraw-Hill Education (Australia) Pty Limited with the permission of IFRS Foundation®. Reproduction and use rights are strictly limited. No permission granted to third parties to reproduce or distribute.

All legislation herein is reproduced by permission but does not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In particular, s.182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction or publication beyond that permitted by the Act, permission should be sought in writing from the Australian Accounting Standards Board. Requests in the first instance should be addressed to the Administration Director, Australian Accounting Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria, 8007.

The International Accounting Standards Board, the IFRS Foundation, the authors and the publishers do not accept responsibility for any loss caused by acting or refraining from acting in reliance on the material in this publication, whether such loss is caused by negligence or otherwise.

xxiv Credits

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PART 1

THE AUSTRALIAN ACCOUNTING ENVIRONMENT CHAPTER 1

An overview of the Australian external reporting environment

CHAPTER 2

The conceptual framework for financial reporting

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CHAPTER 1

AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT LEARNING OBJECTIVES (LO) 1.1 1.2 1.3 1.4

1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13

1.14 1.15 1.16

Understand the meaning of ‘financial accounting’ and its relationship to the broader areas of accounting and accountability. Be able to explain who is likely to be a user of general purpose financial statements. Understand the scope of regulation relating to Australian external financial reporting. Understand the sources of accounting regulation within Australia and thus be able to explain the general functions of the Australian Securities and Investments Commission, the Australian Accounting Standards Board, the Financial Reporting Council and the Australian Securities Exchange. Be aware of the requirements within the Corporations Act that require the preparation of a Directors’ Declaration, Directors’ Report and a Declaration by the Chief Executive Officer and Chief Financial Officer. Be able to explain the central requirement that financial statements be ‘true and fair’. Be able to explain the general functions of the International Accounting Standards Board and its direct relevance to Australian accounting standard-setting. Understand the relevance of the IFRS Interpretations Committee to Australian financial reporting. Understand the role of an accounting standard and the process by which it is developed. Understand that accounting standards change across time, meaning that profits calculated in past years are not directly comparable with current profit calculations. Be able to explain the idea of ‘differential reporting’. Understand the role of the auditor and the auditor’s report. Understand the magnitude of changes that occurred in 2003 and 2004 to Australian Accounting Standards as a result of the Financial Reporting Council’s strategic decision that Australia produce financial statements that comply with standards being issued by the International Accounting Standards Board. Be aware of some of the perceived benefits of international standardisation of financial reporting. Be aware of some research which suggests that international standardisation of accounting ignores international differences in culture. Understand that the practice of financial accounting is quite heavily regulated within Australia and be aware of some of the arguments for and against the regulation of financial accounting.

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Accounting, accountability and the role of financial accounting

LO 1.1

In this book we focus on financial accounting, and particularly financial accounting undertaken by larger-sized organisations (which we will generally refer to as reporting entities) that are required to adopt accounting standards. But before we launch into doing some ‘financial accounting’ it is useful to briefly consider how financial accounting relates to the broader area of ‘accounting’, and how accounting relates to the idea of ‘accountability’. Financial accounting represents only a part of the broader area of ‘accounting’. So what is ‘accounting’? Simply stated, accounting can be defined as the provision of information about aspects of the performance of an entity to a particular group of people with an interest, or stake, in the organisation—we can call these parties stakeholders. But what ‘aspects of performance’ should ‘accounting’ address? What ‘accounts’ are stakeholders entitled to? This really depends upon judgements we make about the organisation’s responsibilities and accountabilities. For example, if we were to accept that an entity has a responsibility (and an accountability) for its social and environmental performance, then we, as accountants, should accept a duty to provide ‘an account’ (or a report) of an organisation’s social and environmental performance—perhaps by way of releasing a publicly available corporate social responsibility report. If, by contrast, we considered that the only responsibility an organisation has is to maximise its financial returns (profits) then we might believe that the only account we need to provide is a financial account. We also need to consider the breadth of stakeholders who should be provided with an ‘account’—for example, should it be restricted to shareholders and/or creditors, or do employees, local communities and others also have a right to be provided with particular information about an organisation? Gray, Owen & Adams (1996) developed an accountability model that explains how organisations should deal with stakeholders and proposes that since a firm’s activities affect the wellbeing of a wide range of stakeholders, the firm is morally responsible, and therefore accountable, to these stakeholders. In more practical terms, Gray et al. (1997, p. 334) provide a broader notion of accountability: Accountability is concerned with the relationships between groups, individuals, organisations and the rights to information that such relationships entail. Simply stated, accountability is the duty to provide an account of the actions for which one is held responsible. The nature of the relationships—and the attendant rights to information—are contextually determined by the society in which the relationship occurs. From this definition, we can see that accountability involves two responsibilities or duties, namely: 1. to undertake certain actions (or to refrain from taking actions) in accordance with the expectations of a group of stakeholders; and 2. to provide a reckoning or account of those actions to the stakeholders (Gray, Owen & Adams 1996) Therefore, the broad role of ‘accounting’, and of a corporate report (and corporate reporting) is to inform relevant stakeholders about the extent to which the actions for which an organisation is deemed to be responsible (which in itself is a controversial issue as people can have very different views about the responsibilities of organisations) have actually been fulfilled. Reporting provides a vehicle for an organisation to fulfil its requirement to be accountable. Such accounts do not all have to be prepared in financial terms. For example, if an organisation is considered to be accountable for its water consumption, or its greenhouse gas emissions, then such ‘accounts’ may be presented in physical terms. If a company is considered to be responsible for the people who are making their products in developing countries then it might produce ‘accounts’ about how the organisation is ensuring that factory workplaces in developing countries are safe for the employees. Of course, different people will have different views about the responsibilities of organisations, and therefore will hold different views about what ‘accounts’ should be produced by an organisation. That is, they will have different views about the extent of ‘accounting’ that should be applied. Organisations will have many different responsibilities. These differing responsibilities will lead to many different accountabilities. If we are to accept a very restricted view that organisations are accountable only for their financial performance, then we would believe that organisations need only provide financial accounts. But if we are to accept that organisations are responsible for their social performance and their environmental performance, then we would also expect the organisation to produce social accounts and environmental accounts. The social accounts and the CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  3

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environmental accounts would be of interest to a much broader group of stakeholders than would financial accounts. Financial accounts would primarily be of interest to existing and potential investors, lenders and other creditors. However, we also acknowledge that there will be other stakeholders with an interest in financial accounts. This book focuses on financial accounting, and in particular, on the rules (standards) used to generate general purpose financial statements. However, it needs to be acknowledged that not all ‘accounts’ prepared by an organisation will be, or should be, of a financial nature. Therefore, the purpose of this brief section is merely to emphasise that financial accounting is just one form of ‘accounting’, and it provides information primarily about only one aspect of performance—financial performance—and the information is generally of major interest to those stakeholders with a financial interest in the organisation. If we are also seeking to find out information about an organisation’s social and environmental performance—and such information would be of interest to a broader group of stakeholders—then we will also have to look at other ‘accounts’ released by the entity using broader methods of ‘accounting’. Chapter 30 of this book specifically addresses these other forms of accounts. Specifically, it looks at frameworks used to compile social reports, environmental reports and what have been referred to as sustainability reports. That chapter also explores the idea of accountability in greater depth. At this point you, the reader, should take a little time out to consider what responsibilities you think organisations should embrace and what sort of ‘accounts’ they should produce. Indeed, you can reflect on what the term ‘accounting’ means to you. From the above discussion we can see that ‘accounting’ is actually a very broad activity, or discipline, which is tied to the concept of accountability. We therefore caution against narrow definitions of accounting, as appear in many (other) textbooks, which define accounting in terms of it simply being a process of identifying, measuring and communicating/ reporting economic information to permit informed decisions to be made. Accounting can be a much richer process than just this. (As another example of a narrow definition, Weygandt et al. 2013, p. 4, define accounting as ‘an information system that identifies, records and communicates the economic events of an entity to interested users’.)

LO 1.1

Financial accounting defined

As we have noted above, in this book our focus is on one aspect of accounting known as financial accounting, which can be considered to be a process involving the collection and processing of financial information to meet the decision-making needs of parties external to an organisation and who have an interest in the financial performance of the entity. Financial accounting can be contrasted with management accounting. Management accounting focuses on providing information for decision making—with such information also typically being provided in financial terms—by parties within the organisation (that is, for internal as opposed to external users) and it is largely unregulated. Financial accounting, by contrast, is subject to many regulations. Because management accounting relates to the provision of information for parties within an organisation—such as preparing budgets for managers that focus on the likely future costs and revenues associated with particular products or services—the view is taken that there generally is no need to protect the information needs or rights of these parties as, being insiders, they can relatively easily access the information they require. By contrast, it is generally accepted that the information rights of outsiders, who are not involved in the day-to-day operations of an organisation (such as the shareholders of a listed company), must be protected. Because financial statements prepared for external parties are often used as a source of information for parties contemplating transferring resources to an organisation, it is arguably important that certain rules be put in place to govern how the information should be compiled. That is, the adoption of a ‘pro-regulation’ perspective to protect the interests of parties external to a firm requires some regulation relating to the accounting information that such firms should disclose. (We will consider pro-regulation and ‘free-market’ perspectives in more detail towards the end of this chapter.)

LO 1.2

Users’ demand for general purpose financial statements

General purpose financial statements may be used by an array of user groups for many purposes. However, under the Conceptual Framework for Financial Reporting issued by the Australian Accounting Standards Board (a conceptual framework of accounting seeks to satisfy a number of objectives including identifying the objectives of general purpose financial reporting as well as the qualitative characteristics that financial information should possess), general purpose financial statements are primarily directed towards the information needs of ‘existing and potential 4  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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investors, lenders and other creditors’. Specifically, paragraph OB2 (‘OB’ indicates that the paragraph comes from the chapter of the conceptual framework that deals with the objectives of general purpose financial reporting) states that: The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. In identifying the ‘primary users’ of general purpose financial reports, paragraph OB5 of the conceptual framework 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. The Conceptual Framework for Financial Reporting also acknowledges that there are other potential users of financial reports (for example, management, regulators and other members of the public), but they are not deemed to be the ‘primary’ users of general purpose financial reports and hence these ‘secondary’ users are not the focus of the prescriptions provided within the conceptual framework. As paragraphs OB9 and OB10 state: OB 9 The management of a reporting entity is also interested in financial information about the entity. However, management need not rely on general purpose financial reports because it is able to obtain the financial information it needs internally. OB 10 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. Some parties with an interest in the financial affairs of an entity might be in a position to successfully demand financial statements that satisfy their specific information needs. For example, a bank might demand, as part of a loan agreement, that a borrowing organisation provide information about its projected cash flows. Such a financial statement would be considered a special purpose financial statement—in this case, a financial statement prepared specifically to satisfy the needs of the bank. Other parties with interests in the affairs of an organisation might not have the necessary power to demand financial statements that specifically address their own information requirements, having instead to rely on financial statements of a general nature released by the reporting entity to meet the needs of a broad cross-section of users, such as investors, potential investors, employees, employee groups, creditors, customers, consumer groups, analysts, media, government bodies and lobby groups. These financial statements are referred to as general purpose financial statements, as opposed to special purpose financial statements. As noted above, general purpose financial statements are produced primarily to meet the needs of existing and potential investors, lenders and other creditors; however, the reports will often also satisfy the information needs of a broader crosssection of users, which might include employees, government, news media, researchers, interest groups, and ‘the public’. In this book, we are concerned primarily with general purpose financial reporting. Our explanation of general purpose financial statements is consistent with the definition used in accounting standards. For example, paragraph 7 of AASB 101 Preparation and Presentation of Financial Statements defines general purpose financial statements in the following way: General purpose financial statements (referred to as ‘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. Examples of general purpose financial statements are the financial statements and supporting notes included within an annual report presented to shareholders at a company’s annual general meeting (and thereafter typically made available to shareholders and other interested parties on the

special purpose financial statement A financial statement designed to meet the needs of a specific group or to satisfy a specific purpose. Can be contrasted with a general purpose financial statement, which is intended to meet the information needs common to users who are unable to command the preparation of reports.

general purpose financial statement Financial statements that comply with conceptual framework requirements and accounting standards and meet the information needs common to users who are unable to command the preparation of financial statements tailored specifically to satisfy all their information needs.

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organisation’s website). Our focus in this book will be general purpose financial reporting practices that would typically be used by private sector profit-seeking entities. However, in recent years there have been moves by governments and government departments towards adopting the kind of accounting procedures that are used by business entities in the private sector. Therefore much of our discussion can be applied to government, particularly government trading enterprises that compete directly with private sector firms (for example, government-controlled organisations involved in telecommunications, public transport and shipping). Nevertheless, there continue to be some differences between the reporting practices of some government departments and those of private sector entities, and there are some accounting standards that are dedicated to government bodies (such as AASB 1049 Whole of Government and General Government Sector Financial Reporting).

LO 1.3 LO 1.4 LO 1.5 LO 1.6 LO 1.11

Sources of external financial reporting regulations There are four principal bodies involved in formulating, interpreting and/or enforcing accounting regulations within Australia, these being: 1. 2. 3. 4.

the Australian Securities and Investments Commission the Australian Accounting Standards Board the Financial Reporting Council the Australian Securities Exchange.

The Australian Accounting Standards Board (AASB) is a government body. As we will see in the discussion to follow, the Financial Reporting Council (FRC) oversees the activities of the AASB. The FRC was responsible for the decision (made in 2003) that Australian reporting entities would adopt accounting standards issued by the International Accounting Standards Board (IASB) for accounting periods beginning on or after 1 January 2005. As with the AASB, the functioning of the Auditing and Assurance Standards Board (AUASB) is also overseen by the Financial Reporting Council. Since July 2006, auditing standards released by the AUASB have had legislative backing (as do the accounting standards issued by the AASB). We will now give further consideration to each of the four main bodies involved in formulating and/or enforcing accounting regulations within Australia.

1. Australian Securities and Investments Commission The Australian Securities and Investments Commission (ASIC) evolved from the Australian Securities Commission (ASC). The ASC was established in 1989 by the Australian Securities Commission Act 1989 (Cwlth), and it replaced the National Companies and Securities Commission (NCSC). The name of the ASC was changed to ASIC in July 1998 to reflect the increased responsibility assigned to the ASC in relation to monitoring and regulating various investment products, including superannuation, approved deposit accounts and retirement savings accounts. The website of ASIC (www.asic.gov.au) provides an overview of its role. The information provided on the website about ASIC’s role is reproduced in Exhibit 1.1. As indicated in Exhibit 1.1, ASIC is solely responsible for administering corporations legislation in Australia. It is independent of state ministers or state parliaments, and reports directly to an appointed Minister of the Commonwealth Parliament. Among other things, the Corporations Act,  which is administered by ASIC, outlines the responsibilities of company directors in relation to the nature of their conduct, financial statement preparation, lodgement and distribution. Since the Corporations Act enacts the majority of legislative requirements pertaining to financial accounting, this discussion of ASIC will include a look at a number of the Act’s requirements. For those readers interested in reviewing the content of the Corporations Act (as well as other Acts), free access to electronic versions is available at a site known as ComLaw (www.comlaw.gov.au), which, according to the website, is an integral part of the Australian Law Online initiative to bring the community low-cost or no-cost access to the law and is maintained by the Attorney-General’s department. An important requirement of the Corporations Act is for directors of public companies, large proprietary companies, organisations with securities listed on the Australian Securities Exchange and some small proprietary companies to present shareholders with true and fair financial statements for a given financial year. (This and other requirements of

Australian Securities and Investments Commission (ASIC) Body responsible for administering corporation legislation in Australia. It is independent of state ministers or state parliaments and reports directly to an appointed Minister of the Commonwealth Parliament.

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the Corporations Act do not apply to organisations outside the ambit of the Act, for example, partnerships.) ‘Financial statements for the year’ is defined at s. 295(2) of the Corporations Act. Specifically, s. 295(2) states: The financial statements for the year are: (a) unless paragraph (b) applies—the financial statements in relation to the company, registered scheme or disclosing entity required by the accounting standards; or (b) if the accounting standards require the company, registered scheme or disclosing entity to prepare financial statements in relation to a consolidated entity—the financial statements in relation to the consolidated entity required by the accounting standards. Therefore the above requirements rely directly upon accounting standards, which are released by the AASB (and which are generally developed at an international level by the IASB, which is based in London). To determine which ‘financial statements’ would be included in a financial report we can refer to Accounting Standard AASB 101 Presentation of Financial Statements. Paragraph 10 of the standard states that a complete set of financial statements comprises: (a) a statement of financial position as at the end of the period; (b) a statement of profit or loss and other comprehensive income for the period; (c) a statement of changes in equity for the period; (d) a statement of cash flows for the period; (e) notes, comprising significant accounting policies and other explanatory information; (ea) comparative information in respect of the preceding period as specified in paragraphs 38 and 38A; and (f) a statement of financial position as at the beginning of the preceding period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements in accordance with paragraphs 40A–40D. An entity may use titles for the statements other than those used in this standard. For example, an entity may use the title ‘statement of comprehensive income’ instead of ‘statement of profit or loss and other comprehensive income’. Across time, terminology used in relation to financial statements has changed. For example, within AASB 101 Presentation of Financial Statements, reference is now made to the ‘statement of financial position’. This is equivalent to what many people traditionally called a balance sheet.

WHAT WE DO ASIC is Australia’s corporate, markets and financial services regulator. We contribute to Australia’s economic reputation and wellbeing by ensuring that Australia’s financial markets are fair and transparent, supported by confident and informed investors and consumers. We are an independent Commonwealth Government body. We are set up under and administer the Australian Securities and Investments Commission Act 2001 (ASIC Act), and we carry out most of our work under the Corporations Act. The Australian Securities and Investments Commission Act 2001 requires us to:

• • • • • •

Exhibit 1.1  The role of ASIC

maintain, facilitate and improve the performance of the financial system and entities in it promote confident and informed participation by investors and consumers in the financial system administer the law effectively and with minimal procedural requirements enforce and give effect to the law receive, process and store, efficiently and quickly, information that is given to us make information about companies and other bodies available to the public as soon as practicable.

OUR STRATEGIC PRIORITIES ASIC’s priorities are: . Promoting investor and financial consumer trust and confidence: 1 • education—investor responsibility for investment decisions remains core to our system. We empower investors and financial consumers through our financial literacy work continued CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  7

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2. 3.

• gatekeepers—we will hold gatekeepers to account • consumer behaviour—recognising how investors and consumers make decisions. Ensuring fair, orderly and transparent markets: • achieved through our role in market supervision and competition, and corporate governance. Providing efficient and accessible registration: • with a focus on small business and deregulation.

WHO WE REGULATE We regulate Australian companies, financial markets, financial services organisations and professionals who deal and advise in investments, superannuation, insurance, deposit taking and credit. As the consumer credit regulator, we license and regulate people and businesses engaging in consumer credit activities (including banks, credit unions, finance companies, and mortgage and finance brokers). We ensure that licensees meet the standards—including their responsibilities to consumers—that are set out in the National Consumer Credit Protection Act 2009. As the markets regulator, we assess how effectively authorised financial markets are complying with their legal obligations to operate fair, orderly and transparent markets. We also advise the Minister about authorising new markets. On 1 August 2010, we assumed responsibility for the supervision of trading on Australia’s domestic licensed equity, derivatives and futures markets. As the financial services regulator, we license and monitor financial services businesses to ensure that they operate efficiently, honestly and fairly. These businesses typically deal in superannuation, managed funds, shares and company securities, derivatives and insurance. OUR POWERS The laws we administer give us the facilitative, regulatory and enforcement powers necessary for us to perform our role. These include the power to:

• • • • •

register companies and managed investment schemes grant Australian financial services licences and Australian credit licences register auditors and liquidators grant relief from various provisions of the legislation that we administer maintain publicly accessible registers of information about companies, financial services licensees and credit licensees • make rules aimed at ensuring the integrity of financial markets • stop the issue of financial products under defective disclosure documents • investigate suspected breaches of the law and in so doing require people to produce books or answer questions at an examination • issue infringement notices in relation to alleged breaches of some laws • ban people from engaging in credit activities or providing financial services • seek civil penalties from the courts • commence prosecutions—these are generally conducted by the Commonwealth Director of Public Prosecutions, although there are some categories of matters that we prosecute ourselves. PROTECTING CONSUMERS AND INVESTORS We have powers to protect consumers against misleading or deceptive and unconscionable conduct affecting all financial products and services, including credit. SOURCE: www.asic.gov.au

As we have noted above, the Corporations Act requires financial statements, as defined above, to be ‘true and fair’. The requirement to produce true and fair financial statements is set out in s. 297 of the Corporations Act. Specifically, s. 297 requires that: The financial statements and notes for a financial year must give a true and fair view of: (a) the financial position and performance of the company, registered scheme or disclosing entity; and 8  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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(b) if consolidated financial statements are required, the financial position and performance of the consolidated entity. But why do we need a ‘true and fair’ requirement? The answer to this is that it is generally accepted that it would be unrealistic to assume that specific disclosure rules or accounting standards could be developed to cover every possible transaction or event. For situations not governed by particular rules or standards, the ‘true and fair view’ requirement is the general criterion to assist directors and auditors to determine what disclosures should be made and to consider alternative recognition and measurement approaches. Although there is no definition of ‘true and fair’ in the Corporations Act—which is perhaps somewhat surprising—it would appear that for financial statements to be considered true and fair, all information of a ‘material’ nature should be disclosed so that readers of the financial statements are not misled. However, ‘materiality’ is an assessment calling for a high degree of professional judgement. It is not possible to give a definition of ‘material’ that covers all circumstances. Paragraph 5 of Accounting Standard AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors provides that: omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. The definition of materiality in AASB 108 is consistent with how the concept of materiality is utilised in the Conceptual Framework for Financial Reporting (paragraph QC11) and also consistent with the definition of materiality provided in other accounting standards. The above definition of materiality makes reference to ‘users’. Of particular importance would be the accounting knowledge or expertise of accounting that the users of general purpose financial statements are expected to possess. In this regard, paragraph QC32 of the Conceptual Framework for Financial Reporting states: 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. Moving on to other requirements of the Corporations Act, we note that directors of large and listed companies, as well as some other entities, are required by the Act to attach to the company’s financial statements a Directors’ Declaration and a Directors’ Report. The Corporations Act also requires a declaration to be made by the chief executive officer and the chief financial officer. We will consider each of these requirements, in turn, below.

Directors’ declaration Within the Directors’ Declaration, required pursuant to s. 295(4) of the Corporations Act, directors must state whether, in their opinion, the financial statements comply with accounting standards, and that the financial statements give a true and fair view of the financial position and performance of the entity. Importantly, directors must also state whether or not in their opinion there were, when the declaration was made out, reasonable grounds to believe that the company would be able to pay its debts as and when they fall due. Specifically, s. 295(4) states: The directors’ declaration is a declaration by the directors: (c) whether, in the directors’ opinion, there are reasonable grounds to believe that the company, registered scheme or disclosing entity will be able to pay its debts as and when they become due and payable; and (ca) if the company, registered scheme or disclosing entity has included in the notes to the financial statements, in compliance with the accounting standards, an explicit and unreserved statement of compliance with international financial reporting standards—that this statement has been included in the notes to the financial statements; and (d) whether, in the directors’ opinion, the financial statement and notes are in accordance with this Act, including: (i) section 296 (compliance with accounting standards); and (ii) section 297 (true and fair view); and (e) if the company, disclosing entity or registered scheme is listed—that the directors have been given the declarations required by section 295A. Should directors make such a declaration fraudulently, carelessly or recklessly, it is possible that they might become personally liable for any outstanding debts of the company. Exhibit 1.2 reproduces the Directors’ Declaration in the 2015 Annual Report of BHP Billiton Ltd. CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  9

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Exhibit 1.2 Directors’ Declaration of BHP Billiton Ltd (reproduced from 2015 Annual Report).

In accordance with a resolution of the Directors of the BHP Billiton Group, the Directors declare that: (a) in the Directors’ opinion and to the best of their knowledge the financial statements and notes, set out in sections 7.1 and 7.2, are in accordance with the UK Companies Act 2006 and the Australian Corporations Act 2001, including: (i) Complying with the applicable Accounting Standards; and (ii) Giving a true and fair view of the assets, liabilities, financial position and profit or loss of each of BHP Billiton Ltd, BHP Billiton Plc, the BHP Billiton Group and the undertakings included in the consolidation taken as a whole as at 30 June 2015 and of their performance for the year ended 30 June 2015; (b) the financial report also complies with International Financial Reporting Standards, as disclosed in note 41 ‘Basis of preparation and measurement’; (c) to the best of the Directors’ knowledge, the management report (comprising the Strategic Report and Directors’ Report) includes a fair review of the development and performance of the business and the financial position of the BHP Billiton Group and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that the Group faces; and (d) in the Directors’ opinion there are reasonable grounds to believe that each of the BHP Billiton Group, BHP Billiton Ltd and BHP Billiton Plc will be able to pay its debts as and when they become due and payable. The Directors have been given the declarations required by Section 295A of the Australian Corporations Act 2001 from the Chief Executive Officer and Chief Financial Officer for the financial year ended 30 June 2015. Signed in accordance with a resolution of the Board of Directors. Jac Nasser AO—Chairman Andrew Mackenzie—Chief Executive Officer Dated this 10th day of September 2015 SOURCE: BHP Billiton Annual Report 2015

At this stage you, the reader, should try to obtain some recent corporate annual reports. Find the Directors’ Declaration in each report. You will see that, in most cases, the declaration will be similar in form to the example shown here. As we discuss other accounting requirements throughout this book, please make a point of referring to your collection of recent annual reports to see how the companies in your sample are complying with the various requirements that we are discussing. Referring to corporate annual reports as you progress through this book will serve to give the material you read a more ‘real-world’ feel. Most large, listed, Australian companies provide copies of their annual reports on their websites. Indeed, in recent years companies have provided their annual reports on their websites as an alternative to posting them out to their shareholders. For example, see the websites of: • BHP Billiton (www.bhpbilliton.com) • Westpac Banking Corporation (www.westpac.com.au) • AMP (www.amp.com.au) • Australia and New Zealand Banking Group Limited (www.anz.com.au) • National Australia Bank (www.nab.com.au) • Commonwealth Bank (www.commbank.com.au). The annual reports of corporations will typically be available by clicking on an ‘investors’ or ‘shareholders’ option (or something similar) that is commonly shown on the home page of a company’s website. Financial Accounting in the Real World 1.1  provides an extract from an article that emphasises that company directors can be liable for the debts of a company if the directors sign the directors’ declaration stating that there are reasonable grounds to believe that the organisation will be able to pay its debts as and when they become due and 10  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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payable when perhaps there is evidence that they knew, or should have known, that the organisation was unable to pay the debts as and when they become due.

Directors’ report In the Directors’ Report, required pursuant to ss. 298–300A of the Corporations Act, directors must provide items of information, such as the names of the directors, details of directors’ emoluments, the principal activities of the company, review of operations during the year, significant changes in the state of affairs of the company, likely future developments and results, significant post-reporting-date events and details about compliance with environmental laws. The Directors’ Report often includes a great deal of information that is provided by corporations on a voluntary basis. That is, while the Corporations Act stipulates the minimum level of disclosure that must be made in a Directors’ Report, many organisations voluntarily produce additional information (which raises a number of interesting issues about why they elect to disclose additional information when not required to—we will consider this again in Chapter 3). For example, in recent years it has been common to find companies voluntarily providing information about community-based projects in which they are participating, as well as employee-training schemes and safety initiatives, and company-promoted environmental initiatives. Review the Directors’ Reports of a number of companies to see the variety of topics that are addressed in these reports.

1.1 FINANCIAL ACCOUNTING IN THE REAL WORLD High-stakes case for coal baron Tinkler Gareth Hutchens Liquidators have launched legal action against Nathan Tinkler after the coal baron allegedly allowed one of his companies to trade while insolvent. The action follows a decision by the NSW Supreme Court on Tuesday to approve a funding agreement between Blackwood Corporation and the liquidators of Mulsanne Resources after Mulsanne failed to buy $28.4 million of Blackwood shares last year, despite agreeing to do so. Blackwood said in a statement that if the court finds Mulsanne’s directors liable for insolvent trading, it may make compensation orders against them personally. In a statement, Tinkler Group said: ‘The directors of Mulsanne strongly deny allegations of trading while insolvent and will strongly defend any legal action instigated by the liquidators.’ In documents tendered in the NSW Supreme Court, Ferrier Hodgson said Mulsanne’s directors had no reasonable grounds to believe the company could pay the $28.4 million when the time came to do so. SOURCE: Extract from ‘High-stakes case for coal baron Tinkler’ by Gareth Hutchens, The Australian, 3 May 2013

The Directors’ Report also has to include an operating and financial review. The review should include information that shareholders of the company would reasonably require to make informed assessments of the operations, financial position and future strategies of the organisation. Specifically, s. 299A(1) of the Corporations Act states: The directors’ report for a financial year for a company, registered scheme or disclosing entity that is listed must also contain information that members of the listed entity would reasonably require to make an informed assessment of: (a) the operations of the entity reported on; (b) the financial position of the entity reported on; and (c) the ‘business strategies, and prospects for future financial years, of the entity reported on.

Declaration by the chief executive officer and chief financial officer The chief executive and chief financial officers of entities with securities listed on the Australian Securities Exchange are required to provide a written declaration to the board of directors that the annual financial statements are in accordance with the Corporations Act and accounting standards and that the financial statements present a true and CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  11

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fair view of the entity’s financial position and performance. Specifically, s. 295A(2) of the Corporations Act states that a declaration is to be made that: (a) the financial records of the company, disclosing entity or registered scheme for the financial year have been properly maintained in accordance with section 286; (b) the financial statements, and the notes referred to in paragraph 295(3)(b), for the financial year comply with the accounting standards; (c) the financial statements and notes for the financial year give a true and fair view (see section 297); and (d) any other matters that are prescribed by the regulations for the purposes of this paragraph in relation to the financial statements and the notes for the financial year are satisfied. As we can see from the Directors’ Declaration provided in Exhibit 1.2, towards the end, the Directors’ Declaration of BHP Billiton specifically notes that the directors received the declaration by the chief executive officer and the chief financial officer. Lastly, from time to time ASIC also releases regulatory guides (previously referred to as policy statements) that relate to various issues, including financial reporting. For example, ASIC has released statements in relation to pension accounting, related party transactions and valuing share options. To see current ASIC regulatory guides go to ASIC’s website at www.asic.gov.au.

2. Australian Accounting Standards Board While the Corporations Act, which is administered by ASIC, requires corporations to comply with accounting standards (as per s. 296 of the Corporations Act), ASIC does not actually develop accounting standards. This responsibility is borne by the Australian Accounting Standards Board (AASB). The AASB began operations on 1 January 1991 and replaced the Accounting Standards Australian Accounting Review Board. While its functions, membership and structure were changed in 2000 as a result Standards Board of amendments included in the Corporate Law Economic Reform Program Act 1999 (Cwlth), the Body charged body charged with formulating accounting standards has retained the name ‘Australian Accounting with developing a Standards Board’. The functions of the AASB are listed in s. 227 of the ASIC Act and include to: conceptual framework for accounting practices, making and formulating accounting standards, and participating in and contributing to the development of a single set of accounting standards for worldwide use.



• develop a conceptual framework, not having the force of an accounting standard, for the purpose of evaluating accounting standards and international standards; • make accounting standards under section 334 of the Corporations Act for the purpose of the national scheme laws; • formulate accounting standards for other purposes; and • participate in and contribute to the development of a single set of accounting standards for world-wide use.

The AASB is responsible for ‘making’ accounting standards that have the force of law pursuant to s. 334 of the Corporations Act, and also for ‘formulating’ accounting standards that are to be used in the public and non-profit sectors (that is, by entities that are not governed by the Corporations Act). The difference in terminology between ‘making’ and ‘formulating’ accounting standards can be explained as follows. When the AASB develops accounting standards that have the force of the Corporations Act, it is said to be making standards. When it develops accounting standards that are to be applied by entities other than those governed by the Corporations Act, it is said to be formulating accounting standards. For many years within Australia we had two sets of accounting standards: those that applied to corporations and other entities that are governed by the Corporations Act (which had the prefix AASB); and another set that applied to entities not governed by the Corporations Act (bearing the prefix AAS, which referred to Australian Accounting Standards). Having two sets of accounting standards was a source of confusion for many people. To remove some of this confusion it became the practice of the AASB to issue only one set of accounting standards (with the prefix AASB), which have general applicability to the private, public and not-for-profit sectors. That is, the AASB adopted a ‘sectorneutral’ approach to the development of accounting standards. We will consider the full list of AASB accounting standards later in this chapter. It is worth re-emphasising here that the majority of AASB standards underwent changes in 2003 or 2004 as Australia moved towards adopting accounting

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standards released by the IASB from 2005. We will focus on the AASB standards, which are mostly the same as the standards issued by the IASB, throughout the balance of this book. The AASB reports to the Financial Reporting Council (FRC). The FRC assumes an oversight function in regard to the AASB, and appoints the 12 part-time AASB members. The part-time members of the AASB come from a variety of backgrounds, including the private sector, government, academia, Big 4 accounting firms and independent consultancy. Section 236B of the ASIC Act requires that a person may not be appointed a member of the AASB unless their ‘knowledge of, or experience in, business, accounting, law or government qualifies them for appointment’. The full-time chairperson of the AASB is appointed by the delegated Minister within the Federal Government. (By now it should be becoming clear how much control the government is attempting to exert over accounting standard-setting.) The structure of Australian accounting standard-setting can be summarised diagrammatically, as in Figure 1.1. Referring to the diagram, the Federal Minister appoints the chairman of the Australian Accounting Standards Board (AASB). The Chairman of the AASB is accountable to the Minister in respect of the operations of the AASB and the Office of the AASB. The Office of the AASB provides technical and administrative services, information and advice to the AASB and is responsible to the Minister for financial management of the Office of the AASB. The Chairperson of the AASB is also the chief executive officer of the Office. Figure 1.1 also identifies also identifies ‘focus groups’ as part of the AASB structure. These focus groups are further divided into: • User Focus Group; and • Not-for-Profit (Private Sector) Focus Group. According to the AASB website, the ‘User Focus Group’ was established to increase participation by analysts in the accounting standard-setting process in order to enhance feedback from the perspective of a significant group of users of financial statements. The purpose of the User Focus Group is to assist the AASB in raising awareness of how investors and investment professionals, equity and credit analysts, credit grantors and rating agencies use financial statements and of their information needs. The AASB’s Not-for-Profit (Private Sector) Focus Group is designed to increase participation by those involved with these entities in the accounting standard-setting process and to enhance feedback from the perspective of a significant group of preparers and users of financial statements. The Not-for-Profit Focus Group comprises members who have expertise in, and are involved in, charitable and related organisations; these members are a key source of information in this area and provide feedback to the AASB on selected projects. Figure 1.1 Diagrammatic representation of the structure of Australian accounting standard-setting

Organisational structure The Minister

Financial Reporting Council

Australian Accounting Standards Board

Office of the Australian Accounting Standards Board

Focus groups Project advisory panels Interpretation advisory panels

SOURCE: Adapted from © Australian Accounting Standards Board (AASB) www.aasb.com.au

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As we can see from Figure 1.1, the AASB also has ‘project advisory panels’. Experts in a particular field or topic area are invited to join an advisory panel to provide advice that will assist the AASB in progressing specific standard-setting projects. Panels work with AASB staff to develop agenda materials for consideration by the Board. Interpretations advisory panels are another important component of the AASB structure. Interpretations are required from time to time in respect of how particular accounting requirements are to be interpreted and applied in the Australian context. As stated on the AASB website: ‘Interpretations are issued by the AASB to provide requirements concerning urgent financial reporting issues’. At the international level there is the IFRS Interpretations Committee—which functions under the auspices of the IASB—which was specifically established to provide official Interpretations of the standards being released by the IASB and, therefore, being used within Australia. We discuss the IFRS Interpretations Committee in greater depth later in this chapter. According to the AASB website, one of the features of the ‘Interpretations model’ is that the AASB decides on a topic-by-topic basis whether to appoint an advisory panel, which would be constituted as a committee of the AASB. The role of advisory panels is limited to preparing alternative views on an issue and, where appropriate, presenting recommendations for consideration by the AASB. Each Interpretations Advisory Panel normally includes between four and eight members, including the AASB chairman and at least one other AASB member. Panel members are appointed on the basis of their professional competence and practical experience in the topic area. The AASB seeks to ensure that the perspectives represented include those of preparers, users, auditors and regulators. Where an Interpretations Advisory Panel makes a recommendation, the process would generally be as follows: (a) If an issue proposal relates to an Australian equivalent to IFRS, the Panel will either: • recommend that the AASB take no action and give reasons, or • recommend to the AASB that the issue be referred to the IFRS Interpretations Committee for consideration for inclusion in its work program.

Decisions by the AASB in respect of all rejected issue proposals relating to Australian equivalents to IFRSs will be sent to the IFRS Interpretations Committee for information and be published on the AASB website. Where the AASB refers an issue proposal to the IFRS Interpretations Committee:

(i) if the IFRS Interpretations Committee adds the issue to its work program, the AASB will adopt the IFRS Interpretations Committee decisions, and (ii) if the IFRS Interpretations Committee does not add the issue to its work program, the AASB will assess the reasons for its rejection and, depending on the significance of the issue in Australia and before publishing an agenda rejection statement on the AASB website, decide whether further action, if any, should be taken by the AASB. The AASB may decide to add the issue to its work program and establish an advisory panel. However, the AASB considers that a unique domestic interpretation of an Australian equivalent to IASB requirements will be required only in rare and exceptional circumstances. (b) If the issue proposal relates to domestic requirements that relate only to not-for-profit entities in the public and/or private sectors, the Panel will either: • recommend that the AASB take no action and give reasons, or •  recommend that the issue be added to the work program and, if required, a panel be established to prepare recommendations for consideration by the AASB. The AASB website lists the various Interpretations on issue. Organisations that are required by law to follow AASB Accounting Standards are also required to follow the Interpretations released by the AASB. This is made explicit in AASB 1048 Interpretation of Standards. We will consider AASB 1048 again later in this chapter when we discuss the IFRS Interpretations Committee’s functions more fully. Having discussed the organisational structure of the AASB, we now turn our attention back to accounting standards. Section 231 of the ASIC Act requires the AASB to carry out a cost–benefit analysis of the impact of a proposed accounting standard before making or formulating that standard (to the extent ‘to which it is reasonably practicable to do so in the circumstances’). Of course, working out the costs and benefits of an accounting standard can be a very difficult, and sometimes political, exercise. Section 231 of the ASIC Act states that: (1) The AASB must carry out a cost–benefit analysis of the impact of a proposed accounting standard before making or formulating the standard. This does not apply where the standard is being made or formulated 14  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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by issuing the text of an international standard (whether or not modified to take account of the Australian legal or institutional environment). (2) The AASB must carry out a cost–benefit analysis of the impact of a proposed international accounting standard before: (a) providing comments on a draft of the standard; or (b) proposing the standard for adoption as an international standard. (3) The AASB has to comply with subsections (1) and (2) only to the extent to which it is reasonably practicable to do so in the circumstances. (4) The Minister may direct the AASB to give the Minister details of a cost–benefit analysis carried out under this section. The AASB must comply with the direction. In the context of developing accounting standards, we are left in no doubt that the FRC’s views carry considerable weight in the standard-setting process. Section 232 of the ASIC Act states that: In performing its functions, the AASB must follow the broad strategic direction determined by the FRC under paragraph 225(2)(c). [emphasis added] Once the AASB makes an accounting standard, which as we know is generally the equivalent of a standard issued by the IASB, it is the responsibility of the Commonwealth Parliament to either allow or disallow the standard. Before being approved by parliament, standards released by the AASB are referred to as ‘pending’ accounting standards. The accounting standards themselves will generally provide guidance on how a classification of items (for example, inventory) should be identified, measured, presented and disclosed. Once a pending accounting standard is approved by parliament, directors are required to ensure that a company’s financial statements comply with the standard. This is in terms of s. 296 of the Corporations Act, which requires a company’s directors to ensure that the company’s financial statements for a financial year are made out in accordance with accounting standards. As already noted, from 2004 there is also a requirement within the Corporations Act for the chief executive officer and chief financial officer of listed companies to provide a written declaration to the board of directors to the effect that the financial statements comply with accounting standards. Most ‘small’ proprietary companies, however, are exempted from complying with accounting standards released by the AASB. While the thresholds do change from time to time, at the time of writing, pursuant to the Corporations Act, s. 45A, a proprietary company is considered to be ‘small’ if it satisfies two of the following three tests: 1. Its gross operating revenue is less than $25 million (as determined by applying accounting standards). 2. Its gross assets are less than $12.5 million (as determined by applying accounting standards). 3. It has fewer than 50 equivalent full-time employees. Section 296(IA) of the Corporations Act provides that: the financial report of a small proprietary company does not have to comply with particular accounting standards if: (a) the report is prepared in response to a shareholder direction under section 293; and (b) the direction specifies that the report does not have to comply with those standards. The above requirement therefore needs to be read in conjunction with s. 293. Section 293 states: (1) Shareholders with at least 5% of the votes in a small proprietary company may give the company a direction to: (a) prepare a financial report and directors’ report for a financial year; and (b) send them to all shareholders. (2) The direction must be: (a) signed by the shareholders giving the direction; and (b) made no later than 12 months after the end of the financial year concerned. (3) The direction may specify all or any of the following: (a) that the financial report does not have to comply with some or all of the accounting standards; (b) that a directors’ report or a part of that report need not be prepared; (c) that the financial report is to be audited. CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  15

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Effectively, therefore, a small proprietary company does not have to apply accounting standards or have its financial statements audited unless ASIC requests the company to do so, or if shareholders holding at least 5 per cent of the voting shares request the company to do so. If a proprietary company is not considered small, it is classified as large, and large proprietary companies are subject to more stringent disclosure requirements. Public companies and large proprietary companies will typically have to prepare financial statements that comply with accounting standards, have their financial statements audited and send them to the members (shareholders) of the company (or make them available on the corporation’s website if the shareholder has not made a specific request to receive a hard copy). The existence of this differential reporting requirement for small and large proprietary companies is based on the assumption that the limited number of parties with a material interest in ‘small’ companies would conceivably be able to request information to satisfy their specific needs. However, it is assumed that the majority of shareholders in ‘large’ companies do not have this ability. As organisations become larger there tends to be greater separation between ownership and management (or, as this is often termed, between ownership and control) and owners tend to become more reliant on external reports in order to monitor the progress of their investment. Further, as an entity increases in size, its economic and political importance increases, and in general this increases the demand for financial information about the entity.

Differential reporting In relation to the issue of differential reporting, we know from the above that the Corporations Act does provide some reporting ‘let-outs’ for organisations such as small proprietary companies. However, many other organisations are still required to produce financial statements that comply with accounting standards. Because so many organisations were required to produce financial reports that complied with accounting standards, this arguably created a reporting burden for some organisations in situations where there were questionable benefits to report users. With this is mind the AASB released AASB 1053 Application Tiers of Australian Accounting Standards. AASB 1053 introduced a twotier reporting system for entities producing general purpose financial statements. Tier 1 general purpose financial statements are financial statements that comply with all relevant accounting standards. Tier 2 comprises the recognition, measurement and presentation requirements of Tier 1 but substantially reduced disclosure requirements. Because the Tier 2 requirements do not change the recognition and measurement requirements being applied, the new differential reporting approach is consistent with the position that has been taken by the AASB for a number of years—this being that the same transactions and other events should be subject to the same accounting requirements to the extent feasible (that is, transaction neutrality), and this principle should apply to all entities preparing general purpose financial statements (whether for-profit or not-for-profit). Each Australian Accounting Standard will specify the entities to which it applies and, where necessary, sets out disclosure requirements from which Tier 2 entities are exempt. Complying with Tier 1 requirements will mean compliance with International Financial Reporting Standards as issued by the IASB (IFRSs). Conversely, entities applying Tier 2 reporting requirements would not be able to state that their reports are in compliance with IFRSs (because of the reduced disclosure). In identifying which entities shall apply Tier 1 reporting requirements, paragraph 11 of AASB 1053 states: Tier 1 reporting requirements shall apply to the general purpose financial statements of the following types of entities: (a) for-profit private sector entities that have public accountability; and (b) the Australian Government and State, Territory and Local Governments. In relation to ‘for-profit private sector entities’ (which would include, for example, listed companies) we obviously need to have some definition of ‘public accountability’ given its centrality to the above requirement. Appendix A of AASB 1053 defines it as follows: Public accountability means accountability to those existing and potential resource providers and others external to the entity who make economic decisions but are not in a position to demand reports tailored to meet their particular information needs. The above definition links directly to the definition of ‘general purpose financial statements’, which has been used widely within financial reporting, and which has already been discussed earlier in this chapter. General purpose financial statements are defined in AASB 1053 (and elsewhere, as we have already seen) as statements: 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. 16  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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The definition of ‘public accountability’ reproduced above provides a general principle. Appendix A to AASB 1053 provides practical application guidance. It states: A for-profit private sector entity has public accountability if: (a) its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); or (b) it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. This is typically the case for banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks. Paragraph B2 of Appendix B to AASB 1053 further states: The following for-profit entities are deemed to have public accountability: (a) disclosing entities, even if their debt or equity instruments are not traded in a public market or are not in the process of being issued for trading in a public market; (b) co-operatives that issue debentures; (c) registered managed investment schemes; (d) superannuation plans regulated by the Australian Prudential Regulation Authority (APRA) other than Small APRA Funds as defined by APRA Superannuation Circular No. III.E.1 Regulation of Small APRA Funds, December 2000; and (e) authorised deposit-taking institutions. In relation to which entities are required to apply Tier 2 reporting requirements, paragraph 13 of AASB 1053 states: Tier 2 reporting requirements shall, as a minimum, apply to the general purpose financial statements of the following types of entities: (a) for-profit private sector entities that do not have public accountability; (b) not-for-profit private sector entities; and (c) public sector entities, whether for-profit or not-for-profit, other than the Australian Government and State, Territory and Local Governments. These types of entities may elect to apply Tier 1 reporting requirements in preparing general purpose financial statements. Therefore, for example, if a proprietary company is not deemed to be small (thereby not satisfying the ‘let-out’ provisions included at section 296(1A) of the Corporations Act) then it must, at the least, prepare Tier 2 financial statements. Such financial statements would be referred to as complying with Australian Accounting Standards— Reduced Disclosure Requirements. As paragraph 16 of AASB 1053 states: Disclosures under Tier 2 reporting requirements are the minimum disclosures required to be included in general purpose financial statements. Entities may include additional disclosures using Tier 1 reporting requirements as a guide if, in their judgement, such additional disclosures are consistent with the objective of general purpose financial statements. The above requirements would also need to consider whether the organisation is a reporting entity and therefore required to produce general purpose financial statements. Organisations producing financial statements that comply with Tier 2 requirements are still considered to be producing general purpose financial statements. A reporting entity is defined in AASB 1053 (and elsewhere) as: An entity in respect of which it is reasonable to expect the existence of users who rely on the entity’s general purpose financial statements for information that will be useful to them for making and evaluating decisions about the allocation of resources. A reporting entity can be a single entity or a group comprising a parent and all its subsidiaries. An organisation that is not a ‘reporting entity’ and does not have ‘public accountability’ would not be impacted by the requirements of AASB 1053 to the extent that the organisation does not elect to produce general purpose financial statements. CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  17

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In relation to the disclosures from which Tier 2 entities are exempt, reference must be made to the ‘Application’ section of each Accounting Standard (which typically follows the ‘Objective’ section within the Accounting Standard) and within this section there will be a sub-heading ‘Reduced Disclosure Requirements’. Under this sub-heading will be a statement: The following do not apply to entities preparing general purpose financial statements under Australian Accounting Standards—Reduced Disclosure Requirements: A list of relevant paragraphs would then be provided. Some Australian Accounting Standards are equally applicable to both Tier 1 and Tier 2 entities. Therefore, such Standards do not provide reduced disclosures for Tier 2 entities. Also, some Standards apply only to Tier 1 entities, but Tier 2 entities may elect to use them. Examples are AASB 8 Operating Segments and AASB 133 Earnings per Share, which generally apply only to listed entities. While Australian Accounting Standards are generally equivalent to standards issued by the IASB (IFRS), AASB 1053 represents a departure from what is occurring at the international level. In 2009 the IASB issued its International Financial Reporting Standard for Small and Medium-sized Entities. The IASB standard allows small and medium enterprises (SMEs) to depart from various recognition, measurement and presentation requirements incorporated within IFRS. By contrast, the view adopted by the AASB (as reported in the Basis for Conclusions that supports AASB 1053) was that since Australia has adopted full IFRSs, it would be logical to use the public accountability notion used by the IASB in determining which entities in the for-profit sector should apply Australian Accounting Standards in full (the definition of ‘public accountability’ as used by the AASB is identical to that used by the IASB).The Reduced Disclosure Requirements (RDR) reflected in AASB 1053 are fundamentally different from the approach adopted in the IFRS for SMEs because the RDR involve applying the same recognition and measurement requirements as Tier 1, whereas the IFRS for SMEs modifies the recognition and measurement requirements of full IFRSs. The implications of the IASB approach to SMEs is that there will be disparities in the choice of accounting policies by different entities because precedence will be given to the conceptual framework over full IFRSs as the source of guidance for determining accounting policies in the absence of a specific requirement. Other reasons identified by the AASB for why it elected not to adopt the IASB’s approach to differential reporting included: • the additional initial and ongoing costs of training and education for two sets of standards both for the profession and at the tertiary level • that some subsidiaries of publicly accountable entities would find it burdensome to apply the proposed IFRS for SMEs in preparing their general purpose financial statements. They would need to prepare financial information based on the recognition and measurement requirements of full IFRSs for the purposes of the parent entity consolidation • entities seeking to access international capital markets would generally apply full IFRSs • a loss of comparability across all types of entities’ general purpose financial statements within Australia • adoption of the IFRS for SMEs may be seen as a retrograde step in a country that has already adopted full IFRS recognition and measurement accounting policy options • in the event that an entity moves to, or from, full IFRSs, there would be costs involved in migrating from the recognition and measurement requirements of one Tier of reporting to another. While AASB 1053 does represent a relatively major change to the Australian financial reporting environment, the requirements embodied within AASB 1053 are likely to be amended in the not-too-distant future. As paragraph BC20 from the Basis for Conclusions to AASB 1053 states: The Board regards AASB 1053 as a pragmatic and substantive response to the need to reduce the burden of disclosure requirements on Australian reporting entities. However, the Board does not regard it as a complete or final answer to that need. The Board intends continuing its deliberations on revising the differential reporting framework with a view to ongoing improvements (including having regard to decisions made by the IASB in relation to its IFRS for SMEs). The Board concluded that the reforms in AASB 1053 should not be delayed while consideration of other possible areas of reform continues. Apart from the issue of differential reporting as addressed in AASB 1053, some AASB accounting standards are applicable only to specific classes of companies (for example, companies listed on the Australian Securities Exchange). Further, ASIC may, from time to time and pursuant to the Corporations Act, release a Class Order that grants relief from 18  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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certain Corporations Act provisions, such as the requirement to comply with all accounting standards. As we have indicated in this chapter, from 2000 the AASB has also been responsible for issuing standards applicable to reporting entities that are not governed by the Corporations Act (for example, large partnerships and government departments). As noted above, and pursuant to s. 285(2) of the Corporations Act, AASB standards can apply to some entities that are not of a corporate form—for example, to ‘disclosing entities’. This has had the effect of increasing the ambit of accounting standards so that all disclosing entities need to comply with the majority of AASB accounting standards. According to the Corporations Act, disclosing entities include: (a) entities which have securities that are quoted on a stock market of a securities exchange; (b) entities which have securities (except debentures) that have been issued pursuant to a prospectus; (c) entities which have securities (except debentures) that have been issued as consideration for the acquisition of shares pursuant to a takeover scheme; (d) entities which have securities that have been issued pursuant to a Part 5.1 compromise or arrangement; and (e) borrowing corporations. Disclosing entities are required to comply with AASB accounting standards, with only a limited number of exceptions. Hence, many forms of organisations other than companies are now required by law to follow the majority of AASB accounting standards. This is despite the specific wording of some AASB standards. Before the release of AASB accounting standards, or the release of components of the Conceptual Framework (to be discussed in more detail in Chapter 2), the contents of the proposed releases are subject to critical review. In the past, the typical process involved when the AASB developed an accounting standard was that, once a particular project was initiated, relevant informed individuals were commissioned to develop a discussion paper or theory monograph. This was done within Australia. This paper was then released for public discussion to determine whether key areas had been addressed, particularly as they relate to the Australian context. After further consideration by the regulatory bodies, a draft exposure draft was developed for review by selected parties. Once it was established that the draft document appropriately addressed the issue of concern, an exposure draft was released for public discussion. After considering public comments, a draft standard may have been released or, alternatively, a revised exposure draft may have been developed. There was then a further period for comment, following which an accounting standard or concept statement might finally have been released. Exposure drafts do not have the force of an accounting standard, but they do provide an indication of future reporting requirements. Central to the above process was that the development of the accounting standard was undertaken very much within the Australian context, with due consideration given to international accounting standard developments. However, and as a result of the decision made in 2003 by the FRC that Australia would adopt accounting standards developed by the International Accounting Standards Board (such standards now being referred to as International Financial Reporting Standards or IFRSs), the development of most accounting standards to be used within Australia is now not directly under the control of Australian accounting standard-setters (except to the extent that the accounting standard relates to domestic issues and there is no equivalent IFRS). AASB 1053 discussed earlier is one such example. There are various costs and benefits associated with this delegation of responsibility to the IASB. (Try to think of what some of these costs and benefits might be.)

The true and fair view: further considerations Before the early 1990s, the directors of a company could elect not to comply with an accounting standard on the grounds that applying the particular standard would cause the accounts not to present a true and fair view. The ‘old’ s. 298(2) provided that: where a company’s financial statements for a financial year would not, if made out in accordance with a particular applicable accounting standard, give a true and fair view of the matters with which this division requires the financial statements to deal, the directors need not ensure that the financial statements are made out in accordance with that accounting standard. The above requirement, which allowed directors to elect not to comply with an accounting standard if non-compliance was deemed necessary to create true and fair accounts, was referred to as the ‘true and fair override’. The perspective taken was that in some isolated cases, certain accounting standards might not be appropriate for a particular entity, and application of the standards might actually make the financial statements misleading. However, this view was abandoned some years later, and the corporations law was amended and the override withdrawn such that s. 296 of the Corporations CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  19

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Act requires that ‘[t]he financial report for a financial year must comply with accounting standards’ (although, as we indicated earlier, there is a ‘let-out’ for small proprietary companies). Following the amendment, directors were therefore required to comply with applicable accounting standards. If, in their view, compliance did not generate a true and fair view, additional information had to be presented in the notes to the financial statements. Numerous writers had argued that as the true and fair view requirement is not clearly defined, directors could invoke the ‘true and fair override’ to justify not complying with particular accounting standards. Without a clear definition of ‘true and fair’, it is difficult for ASIC or its predecessors, the ASC and the NCSC, to take action on the basis that the departure did not enhance the truth and fairness of the accounts. As McGregor (1992, p. 70) stated: The tendency of an increasing number of companies to seemingly avoid complying with approved Accounting Standards at will has, in the past, been accompanied by an extreme reluctance on the part of the body responsible for enforcing the law—in the main the National Companies and Securities Commission (NCSC)— to pursue transgressors through the courts because of a perceived difficulty of successfully prosecuting the companies against the ‘true and fair defence’. Henry Bosch, the former chairman of the NCSC, has said: ‘No, there were no prosecutions, for the reason I gave Mr Scholes earlier on—that the true and fair overrides. I told you of a particular case where there was a flagrant breach of an Accounting Standard—the goodwill standard. I was advised that I would not win. It was also put that if we took the case and lost, the dam would burst and everybody would see that what we were saying could not be sustained in court. It seemed too risky to go down that road.’ At present, it appears unlikely that the true and fair override will be reintroduced. Further, if companies were permitted to depart from accounting standards because they believed the departure was necessary to present a true and fair view, then these same companies could not thereafter claim to be presenting financial statements in conformity with IFRS— something that is claimed to be valuable to ‘the marketplace’. So 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 and explaining why. Specifically, paragraph 23 of AASB 101 Presentation of Financial Statements (the reference to ‘the Framework’ below relates to the Conceptual Framework for Financial Reporting) states: In the extremely rare circumstances in which management concludes that compliance with a requirement in an Australian Accounting Standard would be so misleading that it would conflict with the objective of financial statements set out in the Framework, but the relevant regulatory framework prohibits departure from the requirement, the entity shall, to the maximum extent possible, reduce the perceived misleading aspects of compliance by disclosing: (a) the title of the Australian Accounting Standard in question, the nature of the requirement, and the reason why management has concluded that complying with that requirement is so misleading in the circumstances that it conflicts with the objective of financial statements set out in the Framework; and (b) for each period presented, the adjustments to each item in the financial statements that management has concluded would be necessary to achieve a fair presentation. As we can see from the above, AASB 101 includes a rebuttable presumption that if other entities in similar circumstances comply with the requirement, the entity’s compliance with the requirement would not be so misleading that it would conflict with the objective of financial statements set out in the Conceptual Framework. A current problem is that our qualitative requirement (defined below) of true and fair is very unclear. There is no legal definition of ‘true and fair’. Even though the Corporations Act requires directors to make sufficient disclosures to ensure that financial statements present a ‘true and fair’ view, it provides no definition of the concept. Nor has the Australian accounting profession provided definitive guidelines relating to truth and fairness. The Directors’ Declaration of BHP Billiton, reproduced in Exhibit 1.2 above, shows how directors are required to state that the financial statements are true and fair. The auditors of a company are also required to give an opinion on whether, in their opinion, the financial statements are true and fair. Exhibit 1.3 shows the opinion section of the auditor’s report from Commonwealth Bank of Australia 2015 Annual Report. Apart from the audit opinion section, an audit report of a corporation also typically includes sections on the respective responsibilities of directors and auditors.

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Exhibit 1.3 Independent auditor’s report to the members of Commonwealth Bank of Australia

continued

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This opinion has been extracted from the 2015 Annual Report of the Commonwealth Bank of Australia for illustrative purposes only. It should be read in conjunction with the full financial report of the Commonwealth Bank of Australia. SOURCE: Commonwealth Bank of Australia, Marcus Laithwaite, 11 August 2015

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In December 1993, the Legislation Review Board (now disbanded) released a discussion paper entitled ‘A Qualitative Standard for General Purpose Financial Reports: A Review’. In the discussion paper (p. 7), qualitative standards (such as the true and fair view requirement) are defined as: the basis for establishing a benchmark to regulate the overall quality of financial reports prepared under the relevant financial reporting regime . . . the qualitative standard is concerned with prescribing a certain total or overall quality for the information contained in the financial reports that will enhance their usefulness to users of those reports. Within the discussion paper, three alternative qualitative standards were proposed: 1. The first alternative was to retain the true and fair view requirement, but to provide a technical meaning by way of a definition, thus providing a way to remove existing ambiguities relating to the meaning of the concept. 2. The second alternative was to amend the Corporations Act by replacing the true and fair view requirement with a requirement that general purpose financial statements of companies comply with the explicit financial reporting framework comprising statements of accounting concepts and accounting standards. This would allow a qualitative standard to be incorporated within this framework. 3. The third alternative was to require that general purpose financial statements be prepared in accordance with generally accepted accounting procedures (GAAP). The discussion paper did not support one alternative in preference to another and at present the true and fair view requirement is a very important part of Australian corporate reporting. Nevertheless, as there has been such debate on the issue it is possible that the true and fair view requirement will be amended or removed in the future. We will now further consider the organisation that oversees the activities of the AASB, this being the Financial Reporting Council.

3. Financial Reporting Council As noted previously in this chapter, the Financial Reporting Council (FRC) oversees the activities Financial Reporting of the AASB. There are 18 people on the FRC, who are nominated by a number of interest groups Council (FRC) (stakeholders), as well as a chairperson. The website of the FRC at (www.frc.gov.au) provides Body that oversees the the names and occupations of those making up the membership of the FRC. Section 235A(1) of activities of the AASB the Australian Securities and Investments Commission Act 2001 (ASIC Act)—also available on the and the AUASB. ComLaw website referred to earlier—provides that members of the FRC are either appointed directly by the relevant Minister or, alternatively, the Minister may specify an organisation or body to choose someone to represent that organisation. In 2016, members of the FRC were nominated by the Australian Institute of Company Directors, the Investment and Financial Services Association, Heads of Treasurers Accounting and Reporting Advisory Committee, the Association of Superannuation Funds of Australia, Chartered Accountants Australia and New Zealand, the Institute of Public Accountants, the Securities Institute of Australia, ASIC, CPA Australia, the Australian Securities Exchange, the Federal Government, the New Zealand Minister of Finance, the Group of 100, the Australian Prudential Regulation Authority and the Business Council of Australia. (There is a notable absence of representation from groups that are not concerned primarily in the financial performance of reporting entities but might nevertheless be interested in other aspects of the entities’ performance. For example, social, environmental or employee lobby groups are not represented, despite the fact that they would also have a legitimate interest in the financial performance and position of various reporting entities. Do you, the reader, consider that the FRC is appropriately representative of the information needs of the broader community, or is it appropriate that only people with a financial interest in organisations are represented?) While we are concerned primarily here with financial accounting and not the auditing of financial reports, it is worth noting again that in 2003 the federal government decided to extend the responsibilities of the FRC to include overseeing the activities of the Auditing and Assurance Standards Board (AUASB), which is responsible for developing auditing standards within Australia. From July 2006, auditing standards have the force of law. The overall objective of the AUASB is to improve the quality of auditing in Australia. In meeting this objective, the Board develops and promulgates auditing standards and audit guidance releases. In carrying out its functions, the Board seeks to ensure that professional auditing guidance reflects appropriate theory, practice and international developments, and meets reasonable community expectations. The AUASB has full regard to developments occurring within the ambit of the International Auditing and Assurance Standards Board. CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  23

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Section 225 of the ASIC Act details the functions and powers of the FRC. These include: (a) to provide broad oversight of the processes for setting accounting standards in Australia; and (b) to provide broad oversight of the processes for setting auditing standards in Australia; and (c) to monitor the effectiveness of auditor independence requirements in Australia; and (d) to give the Minister reports and advice about the matters referred to in paragraphs (a), (b) and (c); and (e) the functions specified in subsections (2) (specific accounting standards functions), (2A) (specific auditing standards functions) and (2B) (specific auditor quality functions); and (f) to establish appropriate consultative mechanisms; and (g) to advance and promote the main objects of this Part; and (h) any other functions that the Minister confers on the FRC by written notice to the FRC Chair. With regard to what the FRC may not do, s. 225(5), (6), (7) and (8) explicitly state that: • The FRC does not have power to direct the AASB in relation to the development, or making, of a particular standard. • The FRC does not have power to veto a standard formulated and recommended by the AASB (only Parliament can do this). • The FRC does not have power to direct the AUASB in relation to the development, or making, of a particular auditing standard. • The FRC does not have power to veto a standard made, formulated or recommended by the AUASB. The above provisions were introduced in an attempt to ensure the independence of both the AASB and the AUASB.

4. Australian Securities Exchange For those reporting entities that have securities listed on the Australian Securities Exchange (ASX), there are further reporting requirements over and above those provided within accounting standards or in the Corporations Act. As of 1 April 1987 there has been one nationally operated securities exchange in Australia. In November 1998 the ASX became a public company with shares listed on its own exchange. Therefore, while the ASX was previously predominantly self-regulated, it now falls under the control of the Corporations Act, as well as its own listing rules. That is, although the ASX develops and imposes regulations on other companies that are listed on its exchange, it is ASIC that regulates the ASX. Failure to comply with the ASX Listing Rules may lead to removal from the Board. The ASX disclosure requirements help to ensure that information about listed entities is disseminated in an efficient and timely manner. They also reduce the likelihood of individuals prospering through access to privileged information. The ASX Listing Rules are divided into 20 chapters (details of the listing rules are available on the ASX website at www.asx.com.au). Of particular relevance to us are Chapters 3 and 4 of the Listing Rules, which relate to continuous disclosure and periodic disclosure, respectively. You would do well to take the time to review the Listing Rules. Listing Rule 3.1 (relating to continuous disclosure) provides the general principle that:

Australian Securities Exchange (ASX) A company incorporated on 1 April 1987. The ASX sets uniform trading rules, ethical standards and listing requirements.

Once an entity is or becomes aware of any information concerning it that a reasonable person would expect to have a material effect on the price or value of the entity’s securities, the entity must immediately tell ASX that information. The ASX also established the ASX Corporate Governance Council. In 2003 the ASX Corporate Governance Council released its Principles of Good Corporate Governance and Best Practice Recommendations. These Principles, which are now referred to as Corporate Governance Principles and Recommendations, were most recently amended and rereleased in March 2014 and can be accessed on the ASX website. As indicated in the principles document (p. 3): Corporate governance is the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. It encompasses the mechanisms by which companies, and those in control, are held to account. The basis of the ASX corporate governance disclosure recommendations is that to assess the risk of an organisation it is essential to know about the policies and procedures in place that govern how the organisation is run (that is, to know about the organisation’s corporate governance policies). As stated in the recommendations (p. 5), pursuant to 24  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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ASX Listing Rule 4.10, companies are required to provide a statement in their annual report disclosing the extent to which they have followed the Corporate Governance Principles and Recommendations in the reporting period. Where companies have not followed all of the recommendations, they must identify the recommendations that have not been followed, and give reasons for not following them. This is often referred to as an ‘if not, why not?’ approach to disclosure. Therefore, the ASX principles do not compel organisations to change their governance systems, but rather rely upon ‘market forces’ to encourage adoption of best practice. Within the Corporate Governance Principles and Recommendations the Corporate Governance Council has proposed eight essential principles of corporate governance. They are summarised in Exhibit 1.4. Disclosure pertaining to the eight essential principles must be made in the annual report in a dedicated corporate governance section.

CORPORATE GOVERNANCE PRINCIPLES AND RECOMMENDATIONS A company should: . Lay solid foundations for management and oversight 1 A listed entity should establish and disclose the respective roles and responsibilities of its board and management and how their performance is monitored and evaluated. 2. Structure the board to add value A listed entity should have a board of an appropriate size, composition, skills and commitment to enable it to discharge its duties effectively. 3. Act ethically and responsibly A listed entity should act ethically and responsibly. 4. Safeguard integrity in financial reporting A listed entity should have formal and rigorous processes that independently verify and safeguard the integrity of its corporate reporting. 5. Make timely and balanced disclosure A listed entity should make timely and balanced disclosure of all matters concerning it that a reasonable person would expect to have a material effect on the price or value of its securities. 6. Respect the rights of security holders A listed entity should respect the rights of its security holders by providing them with appropriate information and facilities to allow them to exercise those rights effectively. 7. Recognise and manage risk A listed entity should establish a sound risk management framework and periodically review the effectiveness of that framework. 8. Remunerate fairly and responsibly A listed entity should pay director remuneration sufficient to attract and retain high-quality directors and design its executive remuneration to attract, retain and motivate high-quality senior executives and to align their interests with the creation of value for security holders.

Exhibit 1.4 The eight essential corporate governance principles identified by the ASX

SOURCE: ASX Corporate Governance Council, Good Corporate Principles and Recommendations, ASX, Sydney, March 2014.

The process of Australia adopting accounting standards issued by the International Accounting Standards Board

LO 1.7 LO 1.13 LO 1.14

As already indicated, in 2002 the Financial Reporting Council (FRC), which we now know oversees the AASB, decided to commit Australia to adopting accounting standards issued by the International Accounting Standards Board (IASB). Such standards are referred to as International Financial Reporting Standards (IFRSs). When they were previously released by the International Accounting Standards Committee (the IASB’s predecessor), they were referred to as International Accounting Standards (IASs). It would appear that the catalyst for the FRC’s directive was a decision by the European Union that all listed companies within the European Union should adopt IASB standards by 1 January CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  25

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2005 for the purposes of preparing consolidated financial statements. This was to support the ‘single market objective’ that has been embraced within the European Union. The intention was for the European Union to adopt International Financial Reporting Standards directly without modification. This can be contrasted with the Australian situation, where IFRSs are being turned into Australian (AASB) Accounting Standards, each bearing the prefix AASB. In relation to the adoption of IASB standards, former deputy chairperson of the AASB Ruth Picker made the following comments (Picker, 2003): The announcement in July 2002 by the Financial Reporting Council (FRC) that all entities reporting under the Corporations Act would be required to comply with IASs, now referred to as International Financial Reporting Standards (IFRSs), with effect from 1 January 2005, has turned the corporate accounting world on its head. The ambit of the requirement for reporting under IASs is extremely wide as it applies to all reporting entities under the Corporations Act, both listed and unlisted, private and public. This is in contrast to the situation in Europe where compliance with IASs by 1 January 2005 will only be mandatory for listed entities. Furthermore, because the Australian Accounting Standards Board only produces one set of accounting standards for reporting entities, the IASs will effectively apply also to reporting entities that are not Corporations Act entities. Within Australia, our accounting standards are still referred to as Australian Accounting Standards (with the AASB prefix, as previously indicated), and they might have some minor differences from the equivalent International Accounting Standards (for example, they might include more explanatory material and make reference, where necessary, to the Corporations Act 2001)—but essentially they will be the same as the International Accounting Standards (which, as we have already indicated, are referred to as IFRSs). IFRSs are developed for the ‘for-profit’ sector (for example, for profitseeking companies). Within Australia, however, AASB standards have general applicability to the not-for-profit and local government sectors (that is, they are sector-neutral). Hence, material will need to be added by the AASB that describes the scope and applicability of the standards in the Australian context. Table 1.1 shows the accounting standards in place within Australia as at early 2016 with reference to the equivalent IASs/IFRSs. Remember that the standards issued by the IASB (and its predecessor, the IASC) were formerly referred to as International Accounting Standards. It is only recently that IASB-released accounting standards have been referred to as IFRSs. At this stage you should review Table 1.1 to gain an understanding of the many and varied issues addressed by our accounting standards. Appreciate, however, that even all these accounting standards do not cover every conceivable transaction or event, which is why Australia retains the overriding qualitative reporting requirement that corporations must prepare ‘true and fair’ financial statements. Many of the accounting standards listed below will be covered in depth in other chapters of this text. While Table 1.1 provides a list of the standards in place as at early 2016, it should be appreciated that new standards will be added, and particular accounting standards might be withdrawn, over time. This means that such lists of accounting standards do not remain current for long. Further, and as indicated earlier, the wording and requirements incorporated within particular accounting standards will often change, so interested parties (such as practitioners, students and researchers) should always check the websites of standard-setters for the latest versions of accounting standards. Compliance with the AASB standard would still mean compliance with the IASB standard. The AASB standards might also require additional disclosures, particularly if pre-existing AASB standards already have more detailed disclosure requirements. Any difference from the equivalent IFRS will be readily identified within the AASB standard (relevant amended paragraphs will have the prefix Aus). The AASB will issue future standards in Australia at about the same time the standards concerned are issued by the IASB. From time to time the IASB will amend existing IFRSs. This is done by way of what is referred to as ‘omnibus’ standards that explain the changes to particular accounting standards. Following this process the AASB incorporates the changes into what are now referred to as ‘compiled’ standards. That is, ‘compiled standards’ represent the original standard, with the subsequent amendments. A review of the AASB website will reveal numerous ‘compiled standards’. While the AASB will be issuing standards (with slight changes, as noted above) to match those being issued by the IASB, from time to time the AASB might issue standards to cover areas not addressed by the IASB. That is, the AASB will develop additional standards to cater for issues of a domestic nature, and will also issue standards that are specific to the not-for-profit sector and public sector. The AASB will also advise the IASB of issues that it believes should be covered within IASB standards. The decision by the FRC that Australia would adopt IFRSs from 2005 produced a sweep of changes in Australian accounting standards that has been unparalleled in Australian financial reporting history. The decision required reporting 26  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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AASB No.

Title

Equivalent IFRS/IAS

1

First-time Adoption of Australian Equivalents to International Financial Reporting Standards

IFRS 1

2

Share-based Payment

IFRS 2

3

Business Combinations

IFRS 3

4

Insurance Contracts

IFRS 4

5

Non-current Assets Held for Sale and Discontinued Operations

IFRS 5

6

Exploration for and Evaluation of Mineral Resources

IFRS 6

7

Financial Instruments: Disclosures

IFRS 7

8

Operating Segments

IFRS 8

9

Financial Instruments

IFRS 9

10

Consolidated Financial Statements

IFRS 10

11

Joint Arrangements

IFRS 11

12

Disclosure of Interests in Other Entities

IFRS 12

13

Fair Value Measurement

IFRS 13

14

Regulatory Deferral Accounts

IFRS 14

15

Revenue from Contracts with Customers

IFRS 15

16

Leases

IFRS 16

101

Presentation of Financial Statements

IAS 1

102

Inventories

IAS 2

107

Statement of Cash Flows

IAS 7

108

Accounting Policies, Changes in Accounting Estimates and Errors

IAS 8

110

Events after the Reporting Period

IAS 10

111

Construction Contracts

IAS 11

112

Income Taxes

IAS 12

116

Property, Plant and Equipment

IAS 16

117

Leases

IAS 17

118

Revenue

IAS 18

119

Employee Benefits

IAS 19

120

Accounting for Government Grants and Disclosure of Government Assistance

IAS 20

121

The Effects of Changes in Foreign Exchange Rates

IAS 21

123

Borrowing Costs

IAS 23

124

Related Party Disclosures

IAS 24

127

Separate Financial Statements

IAS 27

128

Investments in Associates and Joint Ventures

IAS 28

129

Financial Reporting in Hyperinflationary Economies

IAS 29

Table 1.1 AASB accounting standards, with details of equivalent IASs/IFRSs

continued CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  27

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AASB No.

Title

Equivalent IFRS/IAS

132

Financial Instruments: Presentation

IAS 32

133

Earnings per Share

IAS 33

134

Interim Financial Reporting

IAS 34

136

Impairment of Assets

IAS 36

137

Provisions, Contingent Liabilities and Contingent Assets

IAS 37

138

Intangible Assets

IAS 38

139

Financial Instruments: Recognition and Measurement

IAS 39

140

Investment Property

IAS 40

141

Agriculture

IAS 41

1004

Contributions



1023

General Insurance Contracts



1038

Life Insurance Contracts



1039

Concise Financial Reports



1048

Interpretation of Standards



1049

Whole of Government and General Government Sector Financial Reporting



1050

Administered Items



1051

Land Under Roads



1052

Disaggregated Items



1053

Application of Tiers of Australian Accounting Standards



1054

Australian Additional Disclosures



1055

Budgetary Reporting



1056

Superannuation Entities



1057

Application of Australian Accounting Standards



SOURCE: © Commonwealth of Australia. Reproduced by permission.

entities to prepare financial statements in accordance with IFRSs for accounting periods beginning on or after 1 January 2005. Given the significance of the FRC’s decision, we have reproduced in Exhibit 1.5 the bulletin that was released by the FRC in July 2002 outlining the FRC’s strategic direction. What was apparent at the time was that the FRC’s decision to adopt IFRSs was effectively presented to the AASB as an accomplished fact. We would really have expected more debate on the issue, rather than what amounted to a unilateral decision. Further, we can question whether the FRC went beyond what had been construed as its ‘proper role’ in the standard-setting process. As stated earlier in this chapter, s. 225 of the ASIC Act details the functions and powers of the FRC. These include providing broad oversight of the process for setting accounting standards in Australia; appointing members of the AASB; approving and monitoring the AASB’s priorities, business plan, budget and staffing arrangements; and giving the AASB directions, advice and feedback on matters of general policy. Section 225(5) and (6) explicitly states that the FRC does not have the power to direct the AASB in relation to the development, or making, of a particular standard. These appear to be solid grounds for contending that the FRC went beyond its purview. However, the reality is that the FRC’s decision generated a great deal of work for accountants within Australia as they got familiar with a new set 28  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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BULLETIN OF THE FINANCIAL REPORTING COUNCIL 2002/4—3 July 2002 ADOPTION OF INTERNATIONAL ACCOUNTING STANDARDS BY 2005 The Chairman of the Financial Reporting Council (FRC), Mr Jeffrey Lucy, AM, today announced that the FRC has formalised its support for the adoption by Australia of international accounting standards by 1 January 2005. Subject to the Government’s support at the appropriate time for any necessary amendments of the Corporations Act, this will mean that, from 1 January 2005, the accounting standards applicable to reporting entities under the Act will be the standards issued by the International Accounting Standards Board (IASB). After that date, audit reports will refer to companies’ compliance with IASB standards. The FRC considered the issue at its meeting on 28 June and formally endorsed the 2005 objective, in line with statements made recently by the Parliamentary Secretary to the Treasurer, Senator the Hon Ian Campbell. Mr Lucy paid tribute to the Government’s strong leadership over the last five years in pressing for the international convergence of accounting standards. This objective is reflected in the Government’s 1997 Corporate Law Economic Reform Program initiative (CLERP 1) and amendments made in 1999 to the Australian Securities and Investments Commission Act 2001. The FRC fully supports the Government’s view that a single set of high-quality accounting standards which are accepted in major international capital markets will greatly facilitate cross-border comparisons by investors, reduce the cost of capital, and assist Australian companies wishing to raise capital or list overseas. Mr Lucy said he understood that the 1 January 2005 timing is somewhat later than the Government would have liked. However, it is determined by the decision of the European Union to require EU listed companies to prepare their consolidated accounts in accordance with IASB standards from that date, in support of the EU single market objective. Australia certainly cannot afford to lag [behind] Europe in this regard, Mr Lucy said. He also expressed his support for efforts to encourage the United States to further converge its standards with IASB standards with a view to eventual adoption. Mr Lucy was pleased to note that the Chairman of the IASB, Sir David Tweedie, had issued a statement in London welcoming the FRC’s decision. Sir David said that the FRC’s announcement demonstrates growing support for the development and implementation of a single set of high-quality global accounting standards by 2005. ‘This vote of confidence is a reflection of the leadership role that Australia continues to play in standard-setting, and will increase momentum for convergence towards high-quality international standards. The input and active participation of interested parties in Australia and the Australian Accounting Standards Board (AASB), under the leadership of Keith Alfredson, are and will remain a vital element in ensuring the IASB’s success. It is through national standard-setters, such as the AASB, and the members of our various committees that we are able jointly to develop high-quality solutions to accounting issues, leverage resources to research topics not yet on the international agenda so as to expedite conclusions, reach interested parties throughout the world and better understand differences in operating environments, thus fulfilling our role as a global standard-setter.’ While there will be a need for business and the accounting profession to adapt to significant changes in some standards, and to some complex new standards, the AASB has been harmonising its standards with those of the IASB for some years, resulting in substantial synergies between the two. Nevertheless, Mr Lucy urged the accounting bodies to prepare for the changeover through their programs of professional development and their influence on accounting education. He also urged the business community to participate fully in commenting on exposure drafts of IASB standards issued in Australia in the period ahead. Mr Lucy noted that implementation issues would also need to be considered by the FRC (to the extent they did not involve the content of particular standards) and the AASB between now and 2005. These could relate, for example, to the timing of introduction of particular IASB standards in

Exhibit 1.5 FRC bulletin on the Council’s strategic direction

continued

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Australia before 1 January 2005 (which would be AASB standards until that date), as well as to issues of interpretation. The FRC and AASB will be doing everything they can to keep constituents informed about these issues and to communicate an overall strategy for adoption, Mr Lucy said. Mr Lucy also confirmed that Australia would be making a substantial financial contribution, through the FRC, to the International Accounting Standards Committee (IASC) Foundation in 2002–03. This contribution will be sourced from funds available to the FRC for the standard-setting process contributed by the Commonwealth, State and Development Account (as announced by Senator Campbell on 12 June). Among the FRC’s functions are to further the development of a single set of accounting standards for world-wide use and to promote the adoption of international best practice accounting standards in Australia if doing so would be in the best interests of both the private and public sectors in the Australian economy. The IASB, which is based in London, is committed to developing, in the public interest, a single set of high-quality, global accounting standards that require transparent and comparable information in financial statements. In pursuit of this objective, the IASB cooperates with national standard-setters, including the AASB, to achieve convergence in accounting standards around the world. The AASB has been harmonising its standards with IASB standards for a number of years and is now working in close partnership with the IASB as a liaison standard-setter, aligning its work program with that of the IASB and standing ready to allocate resources to lead or support projects on the IASB agenda. Recently, the AASB issued to its Australian constituents invitations to comment on a number of exposure drafts of IASB standards. Australians are actively involved in the work of the IASB. Mr Ken Spencer is a member of the oversight body for the IASB, the IASC Foundation Trustees (and Chairman of the Foundation’s Nominating Committee). Mr Warren McGregor is a member of the IASB, also designated the Liaison Member for Australia and New Zealand. Mr Kevin Stevenson, a former director of the Australian Accounting Research Foundation, is the IASB’s Director of Technical Activities. Australians are also on the IASB’s Standards Advisory Council (Mr Peter Day and Mr Ian Mackintosh) and its Interpretations Committee (Mr Wayne Lonergan). SOURCE: Bulletin of the Financial Reporting Council 2002/4 - 3 July 2002

of accounting standards. It would be an interesting exercise to try to quantify the costs (and benefits) associated with the FRC’s decision that Australia would adopt IFRSs. Indeed, Keith Alfredson, the chairperson of the AASB at the time of the FRC’s decision, openly questioned whether the FRC had adequately considered the costs and benefits before committing Australia to adopting accounting standards issued by the IASB (as reported in a newspaper article written by Tom Ravlic that appeared in The Age on 5 May 2003 entitled ‘Accountant queries standards move’). Prior to the formalisation of the FRC’s strategic direction supporting adoption of IFRSs, Australia had, since 1995, been involved in a process that would harmonise Australian Accounting Standards with their international equivalents. The ‘harmonisation process’ required Australian Accounting Standards to be as compatible as possible with International Accounting Standards, but still allowed some divergence where the Australian treatment was construed to be more appropriate. The majority of Australian Accounting Standards were changed as a result of the harmonisation process. Once the harmonisation process was almost complete it was decided that harmonisation was not sufficient and that Australia should adopt the standards being issued by the IASB. This meant that many of the standards that went through the harmonisation process were changed yet again to converge them with their international equivalents (that is, to remove any of the minor differences that survived the harmonisation process). This ‘second round’ of changes within such a short time was a source of frustration for both readers and preparers of financial statements (not to mention authors of textbooks!). Australia was one of the first major accounting standard-setters to embark on a program that sought to harmonise its accounting standards with those of the IASB (or, as it was then known, the IASC). The harmonisation of Australian Accounting Standards with their international equivalents was justified on the basis that if Australia elected to retain 30  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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accounting standards that were unique, this would restrict the flow of foreign investment into Australia. (Do you, the reader, think this is a realistic perspective?) This view was promoted within the federal government’s Corporate Law Economic Reform Program. CLERP’s 1997 document Accounting Standards: Building International Opportunities for Australian Business states (p. 15): There is no benefit in Australia having unique domestic Accounting Standards which, because of their unfamiliarity, would not be understood by the rest of the world. Even if these standards were considered to represent best practice, Australia would not necessarily be able to attract capital because foreign corporations and investors would not be able to make sensible assessments, especially on a comparative basis, of the value of Australian enterprises. The need for common accounting language to facilitate investor evaluation of domestic and foreign corporations and to avoid potentially costly accounting conversions by foreign listed companies are powerful arguments against the retention of purely domestic financial reporting regimes. The above view is consistent with that provided in Policy Statement 4, ‘International Convergence and Harmonisation Policy’ (issued in April 2002 by the AASB), which emphasised the need for international comparability of financial statements. As the policy statement notes in paragraph 2: There is considerable divergence between standards issued by national and international standardsetting bodies. The globalisation of economic activity has resulted in an increased demand for high quality, internationally comparable financial information. The AASB believes that it should facilitate the provision of this information by pursuing a policy of international convergence and international harmonisation of Australian accounting standards. In this context, ‘international convergence’ means working with other standard-setting bodies to develop new or revised standards that will contribute to the development of a single set of accounting standards for world-wide use. ‘International harmonisation’ of Australian accounting standards refers to a process which leads to these standards being made compatible with the standards of international standardsetting bodies to the extent that this would result in high quality standards. Both processes are intended to assist in the development of a single set of accounting standards for world-wide use. While the FRC’s 2002 directive was for Australia to adopt IFRSs, because of the requirements of the Corporations Act, the standards had to be released by the AASB (which can be contrasted with the situation within the European Union where IFRSs are generally being used without any changes). Specifically, the Corporations Act requires, pursuant to s. 296, that financial reports must comply with ‘accounting standards’. Section 334 further states that ‘the AASB may make accounting standards for the purposes of this Act. The standards must be in writing and must not be inconsistent with this Act or the regulations.’ Hence, rather than simply embracing IFRSs without change, the standards needed to be issued by the AASB and to be ‘re-badged’ as AASB standards. For some reporting entities, the impact of adopting IFRSs in place of the previous accounting standards was quite significant. Some organisations had their reported profits severely reduced and the assets greatly written down as a result of applying IFRSs. This, in turn, impacted on such things as gearing ratios (which might be utilised within borrowing agreements with banks), and profit-based bonuses that might be paid to employees. Earnings per share and other indicators of performance were also affected. While a number of countries throughout the world are now adopting IFRSs, there are still differences between the United States generally accepted accounting principles (GAAP) and IFRSs, and these differences are expected to continue for some time. For a number of years there was a joint project between the IASB and the US Financial Accounting Standards Board (FASB) aimed at converging IFRSs and FASB standards. There was an expectation for some years that the US would ultimately adopt IFRS, and the aim of the convergence project was to work towards the time when a ‘true’ international standardisation of accounting becomes a reality. In recent years the wisdom of this has been questioned within the US by the Securities Exchange Commission (SEC) and hence it is not at all certain that the US will ultimately adopt IFRS as the basis of its corporate reporting. So, while there appears to be a long-term aim that ultimately there will be one set of standards used internationally, including within the US, the timing as to when the US will adopt IFRSs (and some people still question if it will) is far from certain. Obviously, for the IASB to achieve its aim of developing ‘a single set of high-quality, understandable and international financial reporting standards (IFRSs) for general purpose financial statements’ (as stated on the IASB website), it will need to encourage the US to adopt its standards. 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What benefits can we expect from all this international standardisation? As indicated earlier in this chapter, the Australian government decided that Australia would adopt IFRSs because of perceived benefits. The benefits that have been promoted by the FRC include an increased ability for Australian entities to access capital from international sources and, somewhat relatedly, an increased ability of investors to compare the results of Australian entities with those of overseas entities. There is also the expectation that it will be more efficient for international companies operating in Australia to prepare financial statements internationally on the basis of the same set of accounting standards. In the past, companies that are listed in more than one jurisdiction had to bear the costs of preparing financial statements under more than one accounting system. All convergence and standardisation benefits come at a cost. Such costs include the costs of educating accountants to adopt a new set of accounting standards and the costs associated with changing data-collection and reporting systems. Such costs will be borne by large listed companies, as well as large proprietary companies, not-for-profit entities and local governments. These last three categories of reporting entities are relatively unlikely to benefit from such things as increased capital inflows. Yet they will still incur significant costs. Some of the perceived benefits of harmonisation were discussed in paragraph 7 of Policy Statement 4 ‘International Harmonisation and Convergence Policy’. The main benefits of international harmonisation identified in this document included: (a) increasing the comparability of financial reports prepared in different countries and providing participants in international capital markets with better quality information on which to base investment and credit decisions. It will also reduce financial analysis costs through analysts not having to recast information on a common basis and requiring knowledge of only one set of financial reporting standards rather than several; (b) removing barriers to international capital flows by reducing differences in financial reporting requirements for participants in international capital markets and by increasing the understanding by foreign investors of Australian financial reports; (c) reducing financial reporting costs for Australian multinational companies and foreign companies operating in Australia and reporting elsewhere; (d) facilitating more meaningful comparisons of the financial performance and financial position of Australian and foreign public sector reporting entities; and (e) improving the quality of financial reporting in Australia to best international practice. In relation to the issue of being better able to compare the financial performance of entities from different countries (point (a) above), it is argued that while there are still differences in the accounting standards issued by different countries, the difficulties in comparing the financial performance of reporting entities from different countries will persist. The differences in accounting rules can have significant implications for profit comparisons. In this regard we can consider research undertaken by Nobes and Parker (2004). They undertook a comparison of the results of a small number of European-based multinationals, which reported their results in accordance with both their home nation’s accounting rules and US accounting rules. Their comparative analysis shows, for example, that the underlying economic transactions and events of the Anglo-Swedish drug company AstraZeneca in the year 2000 produced a profit of £9521m when reported in conformity with UK accounting rules, but the same set of transactions produced a reported profit of £29707m when prepared pursuant to US accounting rules—a difference of 212 per cent in reported profits from an identical set of underlying transactions and events! Extending this analysis to a more recent period, the 2006 Annual Report of AstraZeneca (the final year that companies with a dual home country and US listing had been required to provide a reconciliation between their results using IFRS and US accounting rules) shows that net income derived from applying IFRS of $6 043m became a net income of $4 392m when calculated in accordance with US accounting rules—this time a difference of 27 per cent compared to the IFRS rules. In its balance sheet (or as it is also known, its statement of financial position), AstraZeneca’s shareholders’ equity at 31 December 2006 was $15 304m when reported in accordance with IFRS, but this became $32 467m when determined in accordance with US accounting rules, a difference of 112 per cent. Although percentage differences of this size might be unusual, examination of the financial reports of almost any company that reported its results in accordance with more than one nation’s set of accounting regulations will have shown differences between the profits reported under each set of regulations and between the financial position reported under each set of regulations. A further dramatic example of the existence of differences between the accounting rules of different countries is provided by the US corporation, Enron. As Unerman and O’Dwyer (2004) explain, in the aftermath of the collapse of Enron, 32  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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many accounting regulators, practitioners and politicians in European countries claimed that the accounting practices that enabled Enron to ‘hide’ vast liabilities by keeping them off their US balance sheet would not have been effective in Europe. In the United Kingdom this explanation highlighted the differences between the UK and US approaches to accounting regulation. It was argued that under UK accounting regulations these liabilities would not have been treated as off balance sheet, thus potentially producing significant differences between Enron’s balance sheet under UK and US accounting practices. Having considered how different countries’ accounting rules can generate significantly different profits or losses, as well as different assets and liabilities, we should perhaps consider whether such differences are a justification for all the activity that is taking place to standardise accounting standards internationally. What do you think? Certainly, this justification has been used by Australian accounting standard-setters. The view that harmonisation and subsequent adoption of IFRSs would lead to cost reductions in Australia, as well as capital inflows, is not a view that is necessarily supported (or refuted) by any empirical data, but the ASX nevertheless held the view that general compliance with IASB standards would lead to significant additional inflows of foreign investment. In this regard, in May 2000, the International Organisation of Securities Organisations (IOSCO) announced that it would recommend adoption of IASC/IASB standards as a permissible basis for the preparation of financial statements to member exchanges throughout the world. The actions of IOSCO reinforced the position of the IASB as a global accounting standard-setter. Such a move meant that an organisation whose reports already accord with IASB standards and which was seeking listing in another country would not need to adjust its reports to comply with particular national requirements. More details about IOSCO can be found on its website at www.iosco.org. It should also be noted that from late 2007 the Securities Exchange Commission (SEC) in the US adopted rules that permitted foreign private issuers (but not US domestic companies) to lodge, with the SEC, their financial statements prepared in accordance with IFRS without the need to provide a reconciliation to generally accepted accounting principles (GAAP) as used in the United States. That is, foreign companies that are listed across a number of securities exchanges internationally, including within the US, can now lodge their reports in the US even though the reports have not been prepared in accordance with US accounting standards and do not provide a reconciliation to US GAAP. The ruling of the SEC requires that foreign private issuers that take advantage of this option must state explicitly and unreservedly in the notes to their financial statements that such financial statements are in compliance with IFRS as issued by the IASB (without modifications), and they must also provide an auditor’s unqualified report that explicitly provides an opinion that the financial statements have been compiled in accordance with IFRS as issued by the IASB Hence, effectively there are two types of financial statements being lodged within the US (as is the case in many other countries). Foreign companies can lodge their reports within the US in accordance with IFRS, whereas domestic US companies must lodge their reports in accordance with US GAAP.

Numbering system to be used for AASB standards As we can see from Table 1.1 provided earlier in this chapter, there are three different numbering systems being applied by the AASB. The AASB has devised a policy for numbering according to which the numbering system will be: 1. AASB Standards 1–99 Series Where a new IFRS is issued by the IASB its number as determined by the IASB will be used by the AASB. For example, IFRS 1 will become AASB 1. 2. AASB Standards 100–999 Series Where a standard equivalent to an existing or improved IAS is issued, it will be given a number from 100 on. For example, AASB 101 would correspond to IAS 1 (standards issued by the IASB now are referred to as International Financial Reporting Standards and have the prefix IFRS; prior to 2003 they were referred to as International Accounting Standards and bore the prefix IAS). 3. AASB Standards 1000 + Series A further numbering system for standards specifically relates to the public or not-for-profit sectors or for areas of domestic application only. Also to be used for those AASB standards that are to be maintained as part of the post2005 standards. This numbering system is for standards that do not have an international equivalent. Because of the central relevance of the IASB to Australian financial reporting we will now describe the structure of the IASB. CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  33

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LO 1.5 LO 1.7 LO 1.8 LO 1.9

Structure of the International Accounting Standards Board

Because the accounting standards being used within Australia emanate overwhelmingly from the IASB it would be useful to understand the structure of the IASB, and its predecessor, the IASC. The International Accounting Standards Committee (IASC) was established in 1973 with the aim of bringing together parties from throughout the world to develop accounting standards that apply internationally. In April 2001 the IASC was replaced by the IASB. The IASB is now responsible for releasing International Accounting Standards or, as they have now become known, International Financial Reporting Standards (IFRSs). Until the early 2000s, standards issued by the IASC, and subsequently by the IASB, were not of direct importance to countries that had their own standard-setting processes in place. They would, however, typically be referred to for an indication of possible best practice when accounting standards were being developed within these countries. They were also deemed to provide useful guidance when no domestic standard related to a particular accounting issue. Countries that did not have their own accounting standards in place have been known to adopt directly the standards developed by the IASC and later the IASB. This has been the case especially in developing countries. In more recent times, however, some developed countries have established programs either to adopt IFRSs or to harmonise their domestic standards with IFRSs. This was done because of the perceived benefits associated with having globally consistent accounting standards. As noted above, there has been a change in the parties responsible for developing International Accounting Standards. In essence, with the establishment of the IASB, the standard-setting structure of the IASB became very similar to the accounting standard-setting structure established in Australia. There is a group of trustees who comprise the IFRS Foundation (similar to the FRC in Australia) made up of 22 individuals, and these trustees are responsible for the appointment of IASB members as well as the members of the IFRS Interpretations Committee and the Standards Advisory Council (SAC). The trustees also exercise oversight over the IASB and are involved in raising the funds needed by the IASB. The trustees come from a number of different countries, and in 2016 six were from North America, six from Europe, six from the Asia–Oceania region, and four others from any region. Members of the IASB shall be appointed for a term of up to five years, renewable once. The website of the IASB explains how accounting standards are developed and issued within the IASB: • during the early stages of a project, the IASB may establish an Advisory Committee to give advice on the issues arising in the project. Consultation with the Advisory Committee and the Standards Advisory Council (also part of the IASB) occurs throughout the project; • the IASB may then develop and publish Discussion Documents for public comment; • following the receipt and review of comments, the IASB could then develop and publish an Exposure Draft for public comment; and • following the receipt and review of comments, the IASB would issue a final International Financial Reporting Standard. Figure 1.2 provides a diagrammatic representation of how accounting standards are developed by the IASB.

Figure 1.2 How the IASB develops accounting standards

Research programme

Research

Discussion Paper*

Proposal

Standards programme

Exposure Draft*

Published IFRS

Review programme

Post-implementation review*

SOURCE: IFRS Foundation, Who We Are and What We Do, International Accounting Standards Board (IASB), January 2015.

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Each IASB member has one vote on technical and other matters. In relation to how many votes are required for an IFRS or exposure draft to be approved, paragraph 36 of the IFRS Foundation Constitution (as updated January 2013) states: The publication of an exposure draft, or an International Financial Reporting Standard (including an International Accounting Standard or an Interpretation of the Interpretations Committee) shall require approval by nine members of the IASB, if there are fewer than 16 members, or by ten members if there are 16 members. Other decisions of the IASB, including the publication of a discussion paper, shall require a simple majority of the members of the IASB present at a meeting that is attended by at least 60 per cent of the members of the IASB, in person or by telecommunications. When the IASB publishes a standard, it also publishes a Basis for Conclusions to explain publicly how it reached its conclusions and to give background information that might help users of standards to apply them in practice. These Basis for Conclusions documents are publicly available. The IASB would also publish dissenting opinions. The IASB website explains how the Board coordinates its activities with national standard-setters, such as the AASB. The Board believes that close coordination between the IASB’s due process and the due process of national standardsetters is important to the success of the IASB’s mission. Further, according to the IASB website, the IASB is exploring ways to integrate its due process more closely with that of its members. Such integration might grow as the relationship between the IASB and national standard-setters evolves. In particular, the IASB is exploring the following procedure for projects that have international implications: • IASB and national standard-setters (such as the AASB) would coordinate their work plans so that when the IASB starts a project, national standard-setters would also add it to their own work plans so that they can play a full part in developing international consensus. Similarly, where national standard-setters start projects, the IASB would consider whether it needs to develop new standards or revise its existing standards. Over a reasonable period, the IASB and national standard-setters should aim to review all standards where there are currently significant differences, giving priority to areas where the differences are greatest. • National standard-setters would publish their own exposure documents at approximately the same time as IASB exposure drafts are published and would seek specific comments on any significant divergences between the two exposure documents. In some instances, national standard-setters might include in their exposure documents specific comments on issues of particular relevance to their country or include more detailed guidance than is included in the corresponding IASB document. • National standard-setters would follow fully their own due process, which they would, ideally, choose to integrate with the IASB’s due process. Such integration would avoid unnecessary delays in completing standards and would also minimise the likelihood of unnecessary differences between the standards that result. In 2013 the IFRS Foundation established the Accounting Standards Advisory Forum (ASAF), which provides technical advice to the IASB. The ASAF has 12 members who come from standard-setting bodies around the world, one member of which (in 2016) came from Australia. A last point to consider, and remember, is that the IASB is simply a standard-setting body. It does not have any enforcement powers. For example, in Australia we use IFRS developed by the IASB, but the IASB has no power within Australia to enforce its accounting standards. That power in Australia resides with ASIC. Therefore, although many countries throughout the world claim to be using IFRS, whether they are actually being applied properly really is dependent upon the enforcement and compliance policies in place within the respective countries. Because some countries have very weak enforcement strategies, the claim that their organisations are complying with IFRS is often open to challenge. Questioning the logic behind any belief that the efforts of the IASB will realistically lead to international consistencies in accounting practice, Ball (2006, p. 16) states: Does anyone seriously believe that implementation will be of an equal standard in all the nearly 100 countries that have announced adoption of IFRS in one way or another? The list of adopters ranges from countries with developed accounting and auditing professions and developed capital markets (such as Australia) to countries without a similarly developed institutional background (such as Armenia, Costa Rica, Ecuador, Egypt, Kenya, Kuwait, Nepal, Tobago and Ukraine). Even within the EU, will implementation of IFRS be at an equal standard in all countries? The list includes Austria, Belgium, Cyprus, Czech Republic, Denmark, Germany, Estonia, Greece, Spain, France, Ireland,

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Italy, Latvia, Lithuania, Luxembourg, Hungary, Malta, Netherlands, Poland, Portugal, Slovenia, Slovakia, Finland, Sweden and the UK. It is well known that uniform EU economic rules in general are not implemented evenly, with some countries being notorious standouts. What makes financial reporting rules different? Therefore, we should not simply accept claims that international adoption of IFRS automatically leads to the adoption of uniform accounting methods globally and to ‘better’ accounting.

IFRS Interpretations Committee The IASB has a committee known as the IFRS Interpretations Committee, which is the official ‘interpretative arm’ of the IASB. The IASB website states that the IFRS Interpretations Committee reviews, on a timely basis within the context of existing International Accounting Standards and the IASB conceptual framework, accounting issues that are likely to receive divergent or unacceptable treatment in the absence of authoritative guidance, with a view to reaching consensus on the appropriate accounting treatment. While the IFRS Interpretations Committee provides guidance on issues not specifically addressed in IFRS, it also provides Interpretations of requirements existing within IFRS. In developing Interpretations, the IFRS Interpretations Committee works closely with similar national committees and meets about every six to eight weeks. All technical decisions are taken at sessions that are open to public scrutiny. The IFRS Interpretations Committee addresses issues of reasonably widespread importance, and not issues of concern only to a small set of enterprises. The Interpretations cover both: • newly identified financial reporting issues not specifically addressed in IFRSs, and • issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop in the absence of authoritative guidance, with a view to reaching consensus on the appropriate treatment. Given that so many countries have now adopted IFRS, a central objective of the IFRS Interpretations Committee is to achieve consistent Interpretations of IFRS by IFRS-adopters internationally. If IFRSs were interpreted differently within each country, the purpose and benefits of promoting one set of global accounting standards would be diminished. Indeed, the aim of global uniformity in interpreting financial reporting requirements has meant that many national standard-setters have disbanded their own domestic Interpretations committees. For example, within Australia, the AASB disbanded the Urgent Issues Group (which was formerly the Australian equivalent of the IFRS Interpretations Committee) because the AASB considered that disbanding the UIG helped to ensure that IFRSs are being adopted consistently on a worldwide basis. According to its website, the primary responsibility for identifying issues to be considered by the IFRS Interpretations Committee is that of its members and appointed observers. Preparers, auditors and others with an interest in financial reporting are encouraged to refer issues to the IFRS Interpretations Committee when they believe that divergent practices have emerged regarding the accounting for particular transactions or circumstances or when there is doubt about the appropriate accounting treatment and it is important that a standard treatment is established. An issue may be put forward by any individual or organisation. The majority of issues raised with the IFRS Interpretations Committee are not placed on its agenda. Where issues are not accepted for consideration, the IFRS Interpretations Committee issues a rejection notice, which is published on the IASB website. The rejection notice sets out the reasons why the IFRS Interpretations Committee did not place the issue on its agenda, the typical reason provided being that the answer to the issue raised is already available from existing accounting standards and therefore there is no need to issue an Interpretation. The IFRS Interpretations Committee Interpretations are subject to IASB approval and have the same authority as a standard issue by the IASB. Within Australia, Interpretations issued by the IFRS Interpretations Committee and by the AASB are given the same authoritative status as accounting standards by virtue of AASB 1048 Interpretation of Standards, issued by the AASB. AASB 1048 clarifies that all Australian Interpretations have the same authoritative status. Australian Interpretations comprise those issued by the IFRS Interpretations Committee as well as those issued by the AASB, together with those that were issued by the Urgent Issues Group and that have been retained for use. For Interpretations to be mandatory in the Australian context they need to be listed within tables included within AASB 1048. AASB 1048 will be reissued as and when necessary to keep the tables up to date and to give force to newly released Interpretations. The Interpretations can be found on the websites of the IASB and AASB. More information about the IASB and the IFRS Interpretations Committee can be found on the IASB website at www.ifrs.org. As indicated above, the activities of national standard-setters, such as the AASB, can impact on the activities of the IASB. The AASB will from time to time make suggestions for new or revised standards, or make comments on standards 36  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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being developed. The AASB could still also need, from time to time, to issue domestic exposure drafts and standards on topics not covered by the IASB; however, this would only be in isolated circumstances. It would be desirable for the Australian standard-setting body, when seeking to develop a standard not already covered by the IASB, to offer to develop the standard on behalf of the IASB. At this point it should be noted that the IASB is also responsible for developing a conceptual framework—a framework that is used in developing accounting standards. Chapter 2 provides an in-depth review of the IASB Conceptual Framework.

International cultural differences and the harmonisation of accounting standards

LO 1.6 LO 1.15

As we have emphasised in this chapter, globally countries have adopted, or are moving to adopt, International Financial Reporting Standards rather than accounting standards developed domestically. We now consider some factors that might impact negatively on global harmonisation or convergence of accounting standards. There are a number of potential barriers to global standardisation of accounting standards and these would include the influences of different business environments, legal systems, cultures and political environments in different countries. One of these ‘barriers’, which we will consider briefly, is cultural differences. ‘Culture’ itself is described by Gray (1988, p. 4) as a system of societal or collectively held values, where values are defined as a broad tendency to prefer certain states of affairs over others. Perera (1989, p. 43) describes culture as an expression of norms, values and customs, which reflect typical behavioural characteristics. There are many accounting researchers (for example, Gray 1988; Perera 1989; Fechner & Kilgore 1994; Eddie 1996; Chand & White 2007) who argue that the accounting policies and practices adopted within particular countries are to some extent a direct reflection of the cultural and individual values and beliefs in those countries. That is, the values in the accounting subculture are directly influenced by societywide values. Perera (1989, p. 43) argues that culture is a powerful environmental factor affecting the accounting system of a country and, therefore, that accounting cannot be considered to be ‘culture free’. In the same vein, Gray (1988, p. 5) states: the value systems of accountants may be expected to be related to and derived from societal values with special reference to work related values. Accounting ‘values’ will, in turn, impact on accounting systems. For example, if a country is deemed to be basically conservative, the argument is that the accounting policies of that country will tend towards conservatism. Conservative accounting conservative policies would rely on traditional measurement practices (such as historical cost) and would be accounting policies more likely to be used in countries in which the society is generally classified as seeking to minimise Policies that tend uncertainty (Perera 1989). Gray (1988, p. 10) argues that the degree of conservatism varies by to understate the country, ranging from a strongly conservative approach in the Continental European countries, such value of an entity’s net assets. A bias as France and Germany, to a much less conservative approach in the USA and the United Kingdom. towards understating Countries might have cultural attributes that suggest they tend more towards secrecy than the carrying amount of transparency, and their accounting disclosure requirements might reflect this cultural bias. As with assets and overstating degrees of conservatism, Gray (1988, p. 11) argues that the extent of secrecy seems to vary between the carrying amount of countries, with lower levels of disclosure—implying greater secrecy—including instances of secret liabilities. reserves, evident in the Continental European countries, for example, compared with higher levels of disclosure in the USA and the United Kingdom. Eddie (1996) investigated the association of particular national cultural values (identified by Hofstede 1991) with consolidation disclosures made by particular entities within a number of different countries. Consolidation practices are covered in a later chapter of this text; however, at this stage consolidation can be defined simply as the practice of combining the financial statements of various entities within a group to form one set of consolidated financial statements. Eddie found that particular cultural values or attributes—which had been identified and measured in previous research— are significantly associated with the extent of consolidation disclosure and the degree of variation in the extent of consolidation disclosures. If national culture has impacted on the approaches and decisions taken by accounting practitioners and accounting standard-setters within their own particular countries, is it appropriate to expect different countries, with varying cultural values, to adopt internationally uniform accounting practices? Perera (1989, p. 52) considers the potential success of CHAPTER 1: AN OVERVIEW OF THE AUSTRALIAN EXTERNAL REPORTING ENVIRONMENT  37

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transferring accounting skills from Anglo-American countries to developing countries. He notes: ‘The skills so transferred from Anglo-American countries may not work because they are culturally irrelevant or dysfunctional in the receiving countries’ context.’ Following from the above discussion, the issue of ‘culture’ and international cultural differences might have some bearing on whether the harmonisation or adoption of accounting standards on a worldwide basis is a realistic, achievable and sustainable goal. Gray (1988, p. 2) states that ‘fundamentally different accounting patterns exist as a result of environmental differences and that international classification differences may have significant implications for international harmonisation’. Perera (1989) argues that International Accounting Standards themselves are strongly influenced by Anglo-American accounting models and, as such, International Accounting Standards tend to reflect the circumstances and patterns of thinking in a particular group of countries. He argues therefore that International Accounting Standards are likely to encounter problems of relevance in countries with different cultural environments from those found in Anglo-American countries. Perhaps it could be argued that with the increasing globalisation of business, international cultural differences will be reduced. Further consideration of this issue is really beyond the ambit of this book but it is nevertheless an interesting one.

LO 1.7 LO 1.10

Accounting standards change across time

Before concluding our introductory discussion on accounting standards, one last thing we might need to know, or remember, is that accounting standards frequently change across time. Each year various existing accounting standards will be changed, and new ones addressing new topics might be introduced. The accounting standards themselves might retain the same numbers (for example, AASB 101) but undergo changes periodically. Sometimes these changes can be significant. For example, how we account for intangible assets has shown great change across the years and this has had major implications for whether certain expenditures should be treated as assets or expenses. Another major change is how we are to account for leases. Recent changes have meant that many more leased assets, and lease liabilities, are to be recognised in the financial statements and this has also had implications for expense recognition. Many more examples could be given, but what should be appreciated at this point is that it is a fairly silly (or ignorant) exercise to compare the profits or losses of one company for one year with its profits or losses as calculated some years earlier. Effectively the profits or losses calculated in previous years were generated when different accounting rules were in place, which perhaps allowed certain expenditures to be capitalised (that is, treated as assets) when now they must be treated as expenses, or vice versa. Or perhaps certain obligations—such as certain employee benefit-related obligations—were not previously recognised as accounting liabilities (with related expenses), but now they must be. To use a sporting analogy, the ‘rules of the game’ have changed, so old scores (profits) cannot really be meaningfully compared with current ‘scores’ unless a number of adjustments are made. The above discussion should lead us to question some of the analysis that we often see published in newspapers and other media. For example, some people often provide charts that show the trend in profits of a company over an extended period of time, say five to ten years. But what such analysis often ignores is that the accounting rules in place several years ago can be quite different from the rules in place now, so that we are really comparing very different things. The other point that should be made is that because accounting standards do change across time, some of what we learn now (for example, some of what is included in this textbook) might not be terribly relevant in say five or more years. Therefore, to stay up-to-date, financial accountants must continually keep abreast of ongoing changes and this in itself is why professional accounting bodies typically require their members to undergo continuing professional development/ education as part of their membership requirements.

LO 1.8 LO 1.12

The use and role of audit reports

As we have discussed many of the reporting requirements for general purpose financial statements (GPFSs), it would be useful also to consider briefly the use and role of another report that typically appears in corporate annual reports—the audit report. An audit is the independent examination of financial information of any entity—whether profit-oriented or not and irrespective of its size or legal form—where such an examination is conducted with a view to expressing an opinion on that financial information. The audit opinion is the output of the audit process and is provided in the audit report. 38  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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The auditor’s opinion helps to establish the credibility and reliability of the financial information. The user of this information, however, should not assume that the auditor’s opinion is an assurance of the future viability of the entity, or of the efficiency or effectiveness with which management has conducted the affairs of the entity—it is simply an opinion about the financial statements. Also, it cannot be considered with absolute certainty that all transactions have been correctly recorded, even when the auditor provides an unqualified opinion. The auditor does not test/check all transactions; hence there is always the possibility that the financial statements might be materially misstated. It is to be hoped, however, that the probability of material misstatement is kept to a low level. We provided an example of an audit report earlier in this chapter. In the private sector, decisions relating to the internal affairs of an enterprise, as well as lending and investment decisions of creditors and investors, must be made daily. In the public sector, interested parties must decide whether managers are complying with the controls placed upon them and whether the entity is operating efficiently and effectively. Therefore, managers must collect and report financial information about the entity that summarises and communicates the results of their activities to interested groups. To do this, they must identify user needs for the purpose of establishing the nature of the data to be communicated—that is, decisions must be made as to what is ‘material’. It should be remembered that the auditor is not responsible for the preparation of the financial information; that responsibility rests with management. The auditor’s responsibility is to form and express an opinion on the financial information. Arguably, the auditor’s report is the first item a reader should review when looking at an annual report. A review of the audit report might indicate that the financial statements have not been properly prepared and, perhaps, that they should not be relied upon for making resource-allocation decisions. Preparers of financial information include the financial managers of enterprises, each of whom might, at times, place primary importance on maximising their own welfare. This frequently results in the goals of the persons preparing the financial information being different from the goals of those using it. This conflict, which will be further considered in Chapter 3, might cause the preparers of financial information to intentionally or unintentionally introduce misstatements (or bias) into the financial data. Because of the potential bias of management in identifying and presenting such information, there is a need for independent verification of the financial data to assure fairness of presentation. The users of financial statements need their information to be unbiased in order to reduce the information risk they face—that is, the risk of using materially misstated information—when making economic decisions. An independent auditor’s task is to reduce the potential bias and error that the preparers of financial statements might introduce. The reduction (or elimination) of bias makes it a ‘fairer game’ for investors and creditors. When using unbiased financial information, users are given a fairer chance of earning reasonable returns on their investment. With biased information, they might be forced into making inappropriate investment decisions. (Of course, some people will argue that all financial information is ‘biased’ because our current accounting practices ignore many social and environmental externalities being generated, and in a sense, might depict a very successful/profitable organisation when the same organisation might also be contributing to various social and environmental problems, all of which are not reflected in recorded profits—we will return to this issue in the final chapter of this book.) To lessen this risk, users of financial statements are willing to incur an audit fee in return for some assurance that financial statements are fairly presented. The managers of business entities are also generally prepared to subject their financial operations to an audit. Potential investors are thus able to monitor past and future performance in a more confident manner and this might motivate them to invest more funds at a lower required rate of return than would otherwise be required. Of course, the value of the independent audit will be tied to the reputation of the firm performing the audit. Audits are typically required for all public companies, large proprietary companies and a limited number of small proprietary companies, as defined earlier in this chapter. Small proprietary companies will be required to have their financial statements audited if they are controlled by a foreign company or if shareholders holding more than 5 per cent of the voting shares request that the reports be audited. From time to time, ASIC may also request that a small proprietary company has its financial statements audited. Commonwealth and state government departments, statutory authorities, government companies and business undertakings and municipalities also typically have their financial statements audited. From 2006, auditing standards had legal backing.

All this regulation—is it really necessary? As preceding sections of this chapter have discussed, financial accounting is fairly heavily regulated within Australia. There are numerous Corporations Act requirements, and there are many accounting standards and interpretations, with additional standards and interpretations being issued fairly frequently. The ASX also

LO 1.9 LO 1.16

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provides extensive regulation for listed entities. But is all this regulation really necessary? What if we had no accounting standards, and reporting entities could report whatever information they wanted and in whatever format they considered appropriate? Opinions on the need for regulation vary, and range from the ‘free-market’ perspective to the ‘pro-regulation’ perspective. We will now briefly consider some arguments for and against regulation—for a more detailed discussion, refer to a text dedicated to financial accounting theory.

The ‘free-market’ perspective Proponents of a free-market perspective on accounting regulation often believe that accounting information should be treated like other goods, with demand and supply forces being allowed to operate to generate an optimal supply of information about an entity. In support of their claims, a number of arguments are provided. One argument, based on the work of authors such as Jensen and Meckling (1976), Watts and Zimmerman (1978), Smith and Warner (1979) and Smith and Watts (1982), is that even in the absence of regulation, there are private economics-based incentives for the organisation to provide credible information about its operations and performance to certain parties outside the organisation, otherwise the costs of the organisation’s operations would rise. This view is based on a perspective that the provision of credible information allows other parties to monitor the activities of the organisation. Being able to monitor the activities of an entity reduces the risk associated with investing in the entity, and this in turn should lead to a reduction in the cost of attracting capital to the organisation. It has also been argued that there will often be conflicts between various parties with an interest in an organisation, and accounting information will be produced, even in the absence of regulation, to reduce the effects of this conflict. For example, if an owner appoints a manager, the owner might be concerned that the manager will not best serve the interests of the owner. To align the interests of both parties, the manager might be provided with a share of profits, meaning that the manager will work hard to increase profits, with higher profitability also being in the interests of the owners. To determine profits, accounting reports will be produced, and the owners will demand that these reports be produced in an unbiased manner. As will be discussed in Chapter 3, there is also an argument that accounting reports can be used to reduce the conflict that might arise between managers and the providers of loans (debt holders). This is consistent with the usual notion of ‘stewardship’, according to which management is expected to provide an ‘account’ of how it has utilised the funds it has been provided. If an entity that borrows funds also agrees to provide regular financial statements to the providers of the debt capital (the debtholders), this ability to monitor the financial performance and position of the borrower will reduce the risks of the lender. This should translate to lower costs of interest being charged and hence provide an incentive for the borrower (the reporting entity) to provide financial statements even in the absence of regulation. Further, depending on the parties involved and the types of assets in place, it has been argued that managers of the organisation will be best placed to determine what information should be produced to increase the confidence of external stakeholders (thereby decreasing the organisation’s cost of attracting capital). Regulation that restricts the available set of accounting methods (for example, banning a particular method of amortisation that was used previously by some organisations) will decrease the efficiency with which information will be provided. It has also been argued that certain mandated disclosures will be costly to the organisation if they enable competitors to take advantage of certain proprietary information. Hakansson (1977) used this argument to explain costs that would be imposed as a result of mandating segment disclosures. While this discussion is about providing financial statements, a related issue is that of external auditing of such reports. It has been argued that even in the absence of regulation, external parties would demand that financial statement audits be undertaken. If such audits are not undertaken, financial statements would not be deemed to have the same credibility and, consequently, less reliance would be placed on them. If reliable information is not available, the risk associated with investing in an organisation might be perceived to be higher, and this could lead to increases in the cost of attracting funds to the organisation. It has therefore been argued that managers would have their reports audited even in the absence of regulation (Watts 1977; Watts and Zimmerman 1983; Francis and Wilson 1988). That is, financial statement audits can be expected to be undertaken even in the absence of regulation, and evidence indicates that many organisations did have their financial statements audited prior to any legislative requirements to do so (Morris 1984). However, as Cooper and Keim (1983, p. 199) indicate, for auditing to be an effective strategy for reducing the costs of attracting funds, ‘the auditor must be perceived to be truly independent and the accounting methods employed and the statements’ prescribed content must be sufficiently well-defined’.

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There is also a perspective that even in the absence of regulation, organisations would still be motivated to disclose both good and bad news about an entity’s financial position and performance. Such a perspective is often referred to as the ‘market for lemons’ perspective (Akerlof 1970), the view being that in the absence of disclosure the capital market will assume that the organisation is a ‘lemon’. (Something is a lemon if it initially appears or is assumed, perhaps owing to insufficient information, to be of a quality comparable to other products, but later turns out to be inferior. Acquiring the ‘lemon’ will be the result of information asymmetry in favour of the seller.) That is, no information is viewed in the same light as bad information. Hence, even though the firm might be worried about disclosing bad news, it is assumed that the market might make an assessment that silence implies that the organisation has very bad news to disclose (otherwise, it would disclose it). This ‘market for lemons’ perspective provides an incentive for managers to release information in the absence of regulation, as failure to do so will have its own implications for the organisation. That is, ‘non-lemon owners have an incentive to communicate’ (Spence 1974, p. 93). Drawing upon arguments such as the lemons argument above and applying them to preliminary profit announcements, Skinner (1994, p. 39) states: Managers may incur reputational costs if they fail to disclose bad news in a timely manner. Money managers, stockholders, security analysts, and other investors dislike adverse earnings surprises, and may impose costs on firms whose managers are less than candid about potential earnings problems. For example, money managers may choose not to hold the stocks of firms whose managers have a reputation for withholding bad news and analysts may choose not to follow these firms’ stocks . . . Articles in the financial press suggest that professional money managers, security analysts, and other investors impose costs on firms when their managers appear to delay bad news disclosures. These articles claim that firms whose managers acquire a reputation for failing to disclose bad news are less likely to be followed by analysts and money managers, thus reducing the price and/ or liquidity of their firms’ stocks. Reviewing previous studies, Skinner (1994, p. 44) notes that there is evidence that managers disclose both good and bad news forecasts voluntarily. These findings are supported by his own empirical research, which shows that when firms are performing well, managers make ‘good news disclosures’ to distinguish their firms from those doing less well, and when firms are not doing well, managers make pre-emptive bad news disclosures consistent with ‘reputational effects’ arguments (p. 58). Arguments that the market will penalise organisations for failure to disclose information (which might or might not be bad) of course assume that the market knows that the manager has particular information to disclose. This expectation might not always be that realistic, as the market will not always know that there is information available to disclose. That is, in the presence of information asymmetry (which means that information is not equally available to all—for example, a manager might have access to information that is not available to others), a manager might know of some bad news, but the market might not expect any information disclosures at that time. However, if it does subsequently come to light that news was available that was not disclosed, then we could perhaps expect the market to react (and in the presence of regulation, we could expect regulators to react, as failure to disclose information in a timely manner might be in contravention of particular laws). Also, at certain times, withholding information (particularly of a proprietary nature) could be in the interests of the organisation. For example, the organisation might not want to disclose information about certain market opportunities for fear of competitors utilising such information. So, in summary of this point, there are various arguments or mechanisms in favour of reducing accounting regulation, as even in the absence of regulation, firms have incentives to make disclosures. We will now give some consideration to alternative arguments in favour of regulating the practice of financial accounting.

The ‘pro-regulation’ perspective In the above discussion we considered a number of reasons that have been proffered in favour of reducing or eliminating regulation. One of the most simple of arguments is that if somebody really desired information about an organisation, they would be prepared to pay for it (perhaps in the form of reducing their required rate of return) and the forces of supply and demand should operate to ensure an optimal amount of information is produced. Another perspective is that if information is not produced, there will be greater uncertainty about the performance of the entity and this will translate into increased costs for the organisation. With this in mind, organisations would, it is argued, elect to produce information to reduce costs. However, arguments in favour of a ‘free market’ rely on users paying for the goods or services that are being produced and consumed. Such arguments can break down when we consider the consumption of ‘free’ or ‘public’ goods.

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Accounting information is a public good: once it is available, people can use it without paying and can pass it on to others. Parties that use goods or services without incurring some of the associated production costs are referred to as ‘free-riders’. In the presence of free-riders, true demand is understated because people know they can get the goods or services without paying for them. Few will have any incentive to pay for the goods or services, as they can be relatively confident of being able to act as free-riders. This dilemma, it is argued, is a disincentive for producers of the particular good or service, which in turn leads to an underproduction of information. As Cooper and Keim (1983, p. 190) state: Market failure occurs in the case of a public good because, since other individuals (without paying) can receive the good, the price system cannot function. Public goods lack the exclusion attribute, i.e. the price system cannot function properly if it is not possible to exclude non-purchasers (those who will not pay the asked price) from consuming the good in question. To alleviate this underproduction, regulation is argued to be necessary to reduce the impacts of market failure. In relation to the production of information, Demski and Feltham (1976, p. 209) state: Unlike pretzels and automobiles, [information] is not necessarily destroyed or even altered through private consumption by one individual . . . This characteristic may induce market failure. In particular, if those who do not pay for information cannot be excluded from using it and if the information is valuable to these ‘free riders’, then information is a public good. That is, under these circumstances, production of information by any single individual or firm will costlessly make that information available to all . . . Hence, a more collective approach to production may be desirable. While proponents of a free-market approach argue that the market, on average, is efficient, it can also be argued that such ‘on-average’ arguments tend to ignore the rights of individual investors, some of whom might lose their savings as a result of relying upon unregulated disclosures. In addition, whether an individual is able to obtain information about an entity might depend on the individual’s control of scarce resources required by the entity. Although an individual might be affected by the activities of an organisation, without regulation and without control of significant resources, the individual might be unable to obtain the required information. Regulators often use the ‘level playing field’ argument to justify putting legislation in place. From a financial accounting perspective, everybody should (on the grounds of fairness) have access to the same information. This is the basis of laws that prohibit insider trading and that rely upon an acceptance of the view that there will not be, or perhaps should not be, transfers of wealth between parties that have access to information and those that do not. There is also a view (Ronen 1977) that extensive insider trading will erode investor confidence to such an extent that market efficiency will be impaired. Putting in place greater disclosure regulations will make external stakeholders more confident that they are on a ‘level playing field’. If the community has confidence in the capital markets, regulation is often deemed to be in ‘the public interest’. However, we will always be left with the question of what is the socially right level of regulation. Such a question cannot be answered with any degree of certainty. Regulation might also lead to uniform accounting methods being adopted by different entities, and this in itself will enhance comparability of organisational performance. While we have provided only a fairly brief overview of the free-market versus regulation arguments, it should perhaps be stressed that this debate is ongoing with respect to many activities and industries, with various vested interests putting forward many different and often conflicting arguments for or against regulation. The subject often gives rise to heated debate within many economics and accounting departments throughout the world. What do you, the reader, think? Should financial accounting be regulated and, if so, how much regulation should there be? If regulation is introduced, will the regulation favour some parts of the community more than others? Will governments always act in the ‘public interest’ and from whose perspective do we actually evaluate ‘public interest’ arguments. There are many tricky issues when it comes to the issue of regulation. While we can argue about the merits or otherwise of accounting regulation, the current extent of regulation can reasonably be expected to be at least maintained and probably increased in the future.

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SUMMARY This chapter commenced with a discussion of accounting and its relationship to accountability. As we discussed, the term ‘accounting’ can be quite broadly interpreted and can relate to providing various types of ‘accounts’, not all of which will necessarily be financial in nature. As we emphasised, perspectives that restrict definitions of accounting to matters that are only financial seem to ignore the relationship between corporate responsibilities and corporate accountabilities. This chapter also provides an overview of the sources of regulation and guidelines relating to financial reporting in Australia. In Australia we have a system under which Australian Accounting Standards are predominantly the standards developed by the International Accounting Standards Board. There are numerous rules relating to external reporting. The body of rules is frequently amended (which also means that care must be taken when comparing profits generated in different years), and therefore accountants in practice (and academia) must continually update their knowledge of the rules. The Australian accounting profession, which is dominated by three bodies—CPA Australia, Chartered Accountants Australia and New Zealand, and the Institute of Public Accountants—requires its members to undertake continuing professional education throughout the period of their professional membership.

KEY TERMS Australian Accounting Standards Board (AASB)  12 Australian Securities and Investments Commission (ASIC)  6 Australian Securities Exchange (ASX)  24

conservative accounting policies  37 Financial Reporting Council (FRC)  23 general purpose financial statement  5

special purpose financial statement  5

END-OF-CHAPTER EXERCISES At the end of each chapter of this book, an exercise will be set that addresses particular issues raised within the chapter. Generally, these exercises will be of a practical nature requiring calculations. However, in some chapters, such as this one, a number of questions of a more theoretical nature will be posed and no answers will be provided. In fact, for some questions there is no single right answer, as any response will be dependent on subjective judgements and personal opinion. The reader is encouraged to contemplate, independently, the various factors that should be considered in answering the questions. As a result of reading this chapter you should be able to provide answers to the following questions. 1. What is a general purpose financial statement, and who are the users of such statements? LO 1.1, 1.2 2. Are some users of general purpose financial statements more important than others? How would you make such an assessment? LO 1.2 3. What are the various sources of financial accounting regulation? Would you consider that financial accounting is over-regulated or under-regulated? Why? LO 1.3, 1.4, 1.5, 1.16 4. From the accountant’s perspective, what does ‘true and fair’ mean? In your opinion, is the true and fair requirement useful, or necessary? LO 1.6 5. How does the conceptual framework for financial reporting contribute to the practice of financial accounting? LO 1.4 6. Australia has adopted IFRSs. As a result, does the Australian Accounting Standards Board still have much relevance, and if so, why? What are some arguments for and against Australia adopting IFRSs? LO 1.7, 1.13, 1.14

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REVIEW QUESTIONS 1. Describe the roles of ASIC, the AASB, the ASX and the FRC and the relationships between these regulatory bodies. LO 1.4 2. What is the IASB and how does it affect financial reporting regulation in Australia? LO 1.7 3. What enforcement powers does the IASB have? LO 1.7 4. What is the role of the independent auditor, and why would the manager or the users of financial statements be prepared to pay for the auditor’s services? LO 1.12 5. With all the regulations that companies must follow, fulfilling the requirement for corporate reporting is an additional expensive activity. What are some possible arguments for and against disclosure regulation? LO 1.4, 1.16 6. Provide a justification as to why large companies should have to produce financial statements that comply with accounting standards but small companies should not have to do this. LO 1.11 7. Provide a brief description of the differential reporting requirements in Australia as addressed by AASB 1053 Application Tiers of Australian Accounting Standards. LO 1.9 8. Define ‘generally accepted accounting procedures’. LO 1.4 9. What is included in a directors’ declaration, and what are the implications if a director signs the declaration and the organisation subsequently fails, owing millions of dollars that it cannot repay? LO 1.5 10. What does it mean to say that some financial statements are ‘true and fair’? How would a director try to ensure that the financial statements are true and fair before he or she signs a directors’ declaration? LO 1.6 11. How are International Financial Reporting Standards developed and revised? Explain the role of the AASB in that process. LO 1.9 12. What is the relevance to Australia of Interpretations issued by the IFRS Interpretations Committee? LO 1.8 13. What authority do Interpretations issued by the IASB and AASB have in the Australian financial reporting context? If they do have authority, from where does this authority emanate? LO 1.8 14. What are the functions of the IASB? LO 1.7 15. Although not permitted, outline some possible theoretical advantages and disadvantages associated with permitting directors to deviate from accounting standards in situations where compliance with particular accounting standards is perceived by the directors as likely to generate financial statements that are not true and fair. LO 1.6, 1.9 16. What are some of the possible cultural impediments to the international standardisation of accounting standards? LO 1.15 17. Why did the FRC decide that Australian Accounting Standards needed to be consistent with those being issued by the International Accounting Standards Board? LO 1.13 18. Explain why the adoption of of International Financial Reporting Standards in Australia might have led to material changes to reported profits. LO 1.13, 1.14

CHALLENGING QUESTIONS 19. If directors believe that the application of a particular accounting standard is inappropriate to the circumstances of their organisation, what options are available to them when compiling their financial statements? LO 1.6 20. If a company adopted a particular accounting policy that the ASIC considered to be questionable, in principle the ASIC might consider taking legal action against the company’s directors for failing to produce true and fair financial statements. However, from a practical perspective, why would it be difficult for the ASIC to prove in court that the company’s financial statements were not true and fair? LO 1.5, 1.6 21. Visit the website of a company listed on the ASX. (Hint: some corporate website addresses are provided in this chapter.) Review the company’s corporate governance disclosures and determine whether the company complies with the ‘Eight Essential Principles of Corporate Governance’ identified by the ASX. If the company discloses noncompliance, evaluate the reasons provided for non-compliance. LO 1.4, 1.5 44  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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22. Considered together, does the set of existing accounting standards provide guidance for all transactions and events that might arise within an organisation? If not, what guidance is available to the organisation?  LO 1.3, 1.4, 1.5 23. The decision that Australia would adopt IFRS was in large part based on the view that Australian reporting entities, and the Australian economy, would benefit from adopting accounting methods that are the same as those adopted internationally. Do you think that all Australian reporting entities have benefitted from international standardisation? LO 1.7, 1.8, 1.9 24. Globally, there are variations in business laws, criminal laws and so forth. Such international variations in laws will be a result of differences in history, cultures, religions and so on. While we are apparently prepared to accept international differences in various laws, groups such as the IASB expect there to be global uniformity in regulations relating to accounting disclosure—that is, uniformity in accounting standards. Does this make sense? LO 1.15 25. It is argued by some researchers that even in the absence of regulation, organisations will have an incentive to provide credible information about their operations and performance to certain parties outside the organisation; otherwise, the costs of the organisation’s operations will rise. What is the basis of this belief? LO 1.16 26. Any efforts towards standardising accounting practices on an international basis imply a belief that a ‘one-size-fitsall’ approach is appropriate at the international level. That is, for example, it is assumed that it is just as relevant for a Chinese steel manufacturer to apply AASB 102 Inventories (IAS 2 Inventories) as it would be for an Australian surfboard manufacturer. Is this a naive perspective? Explain your answer. LO 1.15, 1.16 27. Provide some arguments for, and some arguments against, the international standardisation of financial reporting. Which arguments do you consider to be more compelling? (In other words, are you more inclined to be ‘for’ or ‘against’ the international standardisation of financial reporting?) LO 1.7, 1.9, 1.13, 1.15, 1.16 28. Evaluate the claim that ‘accounting is the language of business’. LO 1.1 29. Review a number of accounting standards and then discuss how accounting standards are structured. LO 1.6 30. You are a junior executive of a large mining company and have been asked to show how the performance (as measured in terms of profitability) of the company has been improving over the past ten years. You subsequently collected financial performance information from the previous ten years and placed it on a graph. A trend of ongoing improvements in profits was apparent and everybody was very happy. The question is, should you have supplied such a graph to your company without some adjustments? LO 1.10 31. Do financial reports provide a good representation of the ‘performance’ of an organisation? LO 1.1 32. Identify some responsibilities that you think organisations have in relation to how they conduct their operations (they could be social, environmental or financial responsibilities). Having done this, think of some ‘accounts’ that could be produced by the organisation to indicate how it has performed in relation to those expected responsibilities. LO 1.1 33. What is the relationship between corporate responsibilities, accountability and accounting? LO 1.1 34. Evaluate and explain the following claim: Unless there is consistency globally in the implementation of accounting standards and subsequent enforcement mechanisms, we cannot expect accounting practices to be uniform throughout the world, despite the initiatives of the IASB, which encourage different nations to adopt IFRSs. LO 1.12, 1.13 35. As we know, there is a requirement within the Corporations Act that financial statements be ‘true and fair’. There is also a requirement that company directors comply with accounting standards. In respect of one such standard, AASB 102 Inventories, there is a requirement that inventory be valued at the lower of cost and net realisable value. There is also another accounting standard, AASB 116 Property, Plant and Equipment, which permits property, plant and equipment to be measured at either cost or fair value. Now assume that Angourie Ltd has assets with the following costs and fair values (fair values can be thought of as the amounts that the company expects the assets could be sold for in the normal course of business, and in a transaction between knowledgeable parties that are not related): Asset type

Cost

Fair value

Inventory Machinery Land Total

$11 000 000 $4 000 000 $16 000 000 $31 000 000

$24 000 000 $6 000 000 $40 000 000 $70 000 000

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In accordance with the options available in the accounting standards, Angourie Ltd decides to measure the assets at cost and therefore discloses the assets in the statement of financial position (balance sheet) at an amount of $31 million despite the fact that it could receive $70 million for them at that point in time if it sold them. Although there is compliance with accounting standards, would such financial statements be ‘true and fair’ if the assets were disclosed at a total of $31 million when they could actually be sold for $70 million? LO 1.6 36. Lehman (1995) provides a definition of accounting, this being that it is ‘both the means for defending actions and the means for identifying which actions one must defend’. He further states that accounting information should ‘form part of a public account given by a firm to justify its behaviour’.

REQUIRED Try to explain what Lehman is arguing in terms of the meaning of accounting, and the role it plays within society. Do you agree with Lehman? LO 1.6

REFERENCES AKERLOF, G.A., 1970, ‘Market for Lemons’, Quarterly Journal of Economics, vol. 84, pp. 488–500. BALL, R., 2006, ‘International Financial Reporting Standards (IFRS): Pros and Cons for Investors’, Accounting and Business Research, International Accounting Policy Forum, pp. 5–27. CHAND, P. & WHITE, M., 2007, ‘A Critique of the Influence of Globalization and Convergence of Accounting Standards in Fiji’, Critical Perspectives on Accounting, vol. 18, pp. 605–22. COMMONWEALTH GOVERNMENT, 1997,  Accounting Standards: Building International Opportunities for Australian Business, Corporate Law Economic Reform Program Proposals for Reform: Paper No. 1, Australian Government Printing Service, Canberra. COOPER, K. & KEIM, G., 1983, ‘The Economic Rationale for the Nature and Extent of Corporate Financial Disclosure Regulation: A Critical Assessment’, Journal of Accounting and Public Policy, vol. 2. DEMSKI, J. & FELTHAM, G., 1976, Cost Determination: A Conceptual Approach, Iowa State University Press. EDDIE, I.A., 1996, ‘The Association between National Cultural Values and Consolidation Disclosures in Annual Reports: An Empirical Study of Asia-Pacific Corporations’, unpublished PhD thesis, University of New England. FECHNER, H.E. & KILGORE, A., 1994, ‘The Influence of Cultural Factors on Accounting Practice’, The International Journal of Accounting, 29, pp. 265–77. FRANCIS, J.R. & WILSON, E.R., 1988, ‘Auditor Changes: A Joint Test of Theories Relating to Agency Costs and Auditor Differentiation’, The Accounting Review, October, pp. 663–82. GRAY, R., DEY, C, OWEN, D., EVANS, R. & ZADEK, S., 1997, ‘Struggling with the Praxis of Social Accounting: Stakeholders, Accountability, Audits and Procedures’, Accounting, Auditing and Accountability Journal, 10, no. 3, pp. 325–64. GRAY, R., OWEN, D. & ADAMS, C., 1996, Accounting and Accountability: Changes and Challenges in Corporate and Social Reporting, Prentice Hall, London. GRAY, S.J., 1988, ‘Towards a Theory of Cultural Influence on the Development of Accounting Systems Internationally’, ABACUS, vol. 24, no. 1, pp. 1–15. HAKANSSON, N.H., 1977, ‘Interim Disclosure and Public Forecasts: An Economic Analysis and Framework for Choice’, The Accounting Review, April, pp. 396–416. HOFSTEDE, G., 1991, Cultures and Organisations, McGraw-Hill International (UK), London. JENSEN, M.C. & MECKLING, W.H., 1976, ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’, Journal of Financial Economics, vol. 3, October, pp. 306–60. LEHMAN, G., 1995, ‘A Legitimate Concern for Environmental Accounting’, Critical Perspectives on Accounting, vol. 6, pp. 393–412. 46  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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MCGREGOR, W., 1992, ‘True and Fair—an Accounting Anachronism’, Australian Accountant, February, pp. 68–71. MORRIS, R., 1984, ‘Corporate Disclosure in a Substantially Unregulated Environment’, Abacus, June, pp. 52–86. NOBES, C. & PARKER, R., 2004, Comparative International Accounting, Harlow: Parson Education Limited. PERERA, M.H.B., 1989, ‘Towards a Framework to Analyze the Impact of Culture in Accounting’, The International Journal of Accounting, 24, pp. 42–56. PICKER, R., 2003, ‘Accounting World on its Head’, Australian CPA, vol. 73, no. 4, pp. 64–6. RONEN, J., 1977, ‘The Effect of Insider Trading Rules on Information Generation and Disclosure by Corporations’, The Accounting Review, vol. 52, pp. 438–49. SKINNER, D.J., 1994, ‘Why Firms Voluntarily Disclose Bad News’, Journal of Accounting Research, vol. 32, no. 1, pp. 38–60. SMITH, C.W. & WARNER, J.B., 1979, ‘On Financial Contracting: An Analysis of Bond Covenants,’ Journal of Financial Economics, June, pp. 117–61. SMITH, C.W. & WATTS, R., 1982, ‘Incentive and Tax Effects of Executive Compensation Plans’, Australian Journal of Management, December, pp. 139–57. SPENCE, A., 1974, Market Signalling: Information Transfer in Hiring and Related Screening Processes, Harvard University Press. UNERMAN, J. & O’DWYER, B., 2004, ‘Basking in Enron’s Reflexive Goriness: Mixed Messages from the UK Profession’s Reaction’, paper presented at Asia Pacific Interdisciplinary Research on Accounting Conference, Singapore. WATTS, R.L., 1977, ‘Corporate Financial Statements: A Product of the Market and Political Processes’, Australian Journal of Management, April, pp. 53–75. WATTS, R.L. & ZIMMERMAN, J.L., 1978, ‘Towards a Positive Theory of the Determinants of Accounting Standards,’ The Accounting Review, January, pp. 112–34. WATTS, R.L. & ZIMMERMAN, J.L., 1983, ‘Agency Problems: Auditing and the Theory of the Firm: Some Evidence’, Journal of Law and Economics, vol. 26, October, pp. 613–34. WEYGANDT, J., MITRIONE, L., RANKIN, M., CHALMERS, K., KEISO, D. & KIMMEL, P., 2013,  Principles of Financial Accounting, 3rd edition, Wiley, Milton, Queensland.

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CHAPTER 2

THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING LEARNING OBJECTIVES (LO) 2.1

Understand the meaning of a ‘conceptual framework’ for financial reporting.

2.2

Understand the need for, and the role of, a conceptual framework.

2.3

Be able to explain the structure, or building blocks, of a well designed conceptual framework.

2.4

Understand the history of the evolution of the conceptual framework in use within Australia.

2.5

Understand the objective of general purpose financial reporting.

2.6

Understand what is meant by the term ‘reporting entity’ and understand the financial reporting implications of being classified as a reporting entity.

2.7

Understand what qualitative characteristics should be possessed by financial accounting information if such information is to be considered useful to users of general purpose financial statements. In particular, understand both the fundamental qualitative characteristics of financial reporting (relevance and faithful representation) as well as the enhancing qualitative characteristics of financial reporting (comparability, verifiability, timeliness and understandability).

2.8

Be able to define the ‘users’ of general purpose financial statements and understand the degree of proficiency in accounting that is expected of users of general purpose financial statements.

2.9

Understand the concept of materiality and how this influences decisions about the disclosure of financial information.

2.10 Be able to define the elements of financial accounting and be able to explain the recognition criteria for the various elements of accounting. 2.11 Understand that measurement forms an important component of a conceptual framework and understand that measurement issues remain as an issue still to be addressed within the IASB conceptual framework project. 2.12 Be aware of initiatives currently being undertaken by the IASB to develop a revised conceptual framework for financial reporting, and understand some of the changes that might arise as a result of this initiative. 2.13 Be able to critically review the existing conceptual framework. 2.14 Understand that a conceptual framework for general purpose financial reporting represents a ‘normative’ theory of accounting. 48  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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Australia’s use of the IASB conceptual framework

LO 2.1

As noted in Chapter 1, in Australia the Australian Accounting Standards Board (AASB) was previously LO 2.2 responsible for the development of a conceptual framework of accounting for use within Australia, the aim of which was to define the nature, subject, purpose and broad content of general purpose conceptual framework financial reporting. However, as a consequence of adopting accounting standards issued by A framework that seeks the International Accounting Standards Board (IASB), there is also a related requirement that we to identify the objective also adopt the conceptual framework developed by the IASB. That is, as International Financial of general purpose Reporting Standards (IFRSs) have been developed in accordance with the IASB Conceptual financial reporting and the qualitative Framework for Financial Reporting, and as we have adopted IFRSs, then we must also adopt the characteristics that IASB conceptual framework. Apart from Australia, conceptual frameworks were also developed financial information in a number of other countries, including the United States, Canada, the United Kingdom and should possess. New Zealand. Those countries that have decided to adopt IFRSs similarly have adopted the IASB framework and abandoned their domestically developed frameworks.

What is a conceptual framework?

LO 2.1 LO 2.2

There is no definitive or ‘absolute’ definition of a conceptual framework. The Financial Accounting Standards Board (FASB) in the USA defined its conceptual framework as a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards. It prescribes the nature, function and limits of financial accounting and reporting (Statement of Financial Accounting Concept No. 1 Objectives of Financial Reporting by Business Enterprises, 1981). The IASB (2015b, p. 6) note that a conceptual framework “describes the objectives of, and the concepts for, general purpose financial reporting”. A central goal in establishing a conceptual framework of accounting will be general consensus on: • the scope and objectives of financial reporting • the qualitative characteristics that financial information should possess (tied to such notions as relevance and representational faithfulness) • what the elements of financial reporting are, including agreement on the characteristics and recognition criteria for assets, liabilities, income, expenses and equity.

It is generally accepted that it is unwise, and perhaps illogical, to develop accounting standards unless there is first some agreement on key, fundamental issues, such as the objectives of general purpose financial reporting; the qualitative characteristics financial information should possess (for example, relevance and representational faithfulness); how and when transactions should be recognised; and who is the audience of general purpose financial statements. Unless we have agreement on such central issues, it is difficult to understand how logically consistent accounting standards can be developed. Conceptual frameworks are developed to provide guidance on key issues, such as objectives, qualitative characteristics, definitions and recognition criteria. While it is reasonable to accept that we need a conceptual framework of accounting before we start developing accounting standards (that is, we need to agree initially on the objectives of general purpose financial reporting, and so forth), this has not always been the view of accounting standard-setters. For example, in Australia the first Statement of Accounting Concept, released as part of the Australian Conceptual Framework Project (SAC 1 Definition of the Reporting Entity), was released in 1990. However, the first recommendations relating to the practice of accounting were released in the 1940s, followed some years later by accounting standards. By the time the first statement of accounting concept was issued (which was an initial building block of the original Australian conceptual framework of accounting), many accounting standards were already in place. Reflecting the lack of agreement in many key areas of financial reporting was the high degree of inconsistency between the various accounting standards, with different standards embracing different recognition and measurement criteria. Accounting standards were also being developed in many other countries in the absence of a conceptual framework. The lack of agreement on central issues prompted a surge of criticism. As Horngren (1981, p. 94) stated: All regulatory bodies have been flayed because they have used piecemeal approaches, solving one accounting issue at a time. Observers have alleged that not enough tidy rationality has been used in the process of accounting policymaking. Again and again, critics have cited a need for a conceptual framework. CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  49

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Reacting to such criticism, the Financial Accounting Standards Board in the United States embarked on its Conceptual Framework Project, with its first Statement of Financial Accounting Concept (SFAC 1 Objectives of Financial Reporting by Business Enterprises) being released in 1978. In Australia, work on the Australian Conceptual Framework commenced in the 1980s, with the first statement of accounting concept (SAC) being released in 1990.

LO 2.2 LO 2.3

Benefits of a conceptual framework

Paragraph 7 of Policy Statement 5, The Nature and Purpose of Statements of Accounting Concepts highlighted some of the benefits that are expected to result from having a conceptual framework of accounting (and such benefits should flow to any jurisdiction that utilises a soundly developed conceptual framework). Utilising the discussion in Policy Statement 5, we can summarise some of the benefits of having a conceptual framework as follows: 1. Accounting standards should be more consistent and logical, because they are developed from an orderly set of concepts. The view is that in the absence of a coherent theory, the development of accounting standards could be somewhat ad hoc. As the FASB and IASB (2005, p. 1) state: To be principles-based, standards cannot be a collection of conventions but rather must be rooted in fundamental concepts. For standards on various issues to result in coherent financial accounting and reporting, the fundamental concepts need to constitute a framework that is sound, comprehensive, and internally consistent. 2. Increased international compatibility of accounting standards should occur, because they are based on a conceptual framework that is similar to that in other jurisdictions (for example, there is much in common between the IASB and FASB frameworks). 3. The AASB and the IASB should be more accountable for their decisions, because the thinking behind specific requirements should be more explicit, as should any departures from the concepts that might be included in particular accounting standards. 4. The process of communication between the IASB and the AASB and their constituents should be enhanced because the conceptual underpinnings of proposed accounting standards should be more apparent when the AASB or the IASB seeks public comment on them. The view is also held that having a conceptual framework should alleviate some of the political pressure that might otherwise be exerted when accounting standards are developed—the Conceptual Framework could, in a sense, provide a defense against political attack. 5. The development of accounting standards and other authoritative pronouncements should be more economical because the concepts developed within the conceptual framework will guide the AASB and the IASB in their decision making. 6. Where accounting concepts developed within a conceptual framework cover a particular issue, there might be less need to develop additional accounting standards.

LO 2.2 LO 2.4 LO 2.12

Current initiatives to develop a revised conceptual framework

As noted earlier, Australia initially developed its own conceptual framework of accounting, as did many other countries. However, when Australia adopted IFRS in 2005, it also adopted the IASB conceptual framework, initially entitled Framework for the Preparation and Presentation of Financial Statements. Following various amendments, it is now known as the IASB Framework for Financial Reporting. In the Australian context, it is known as the AASB Framework for the Preparation and Presentation of Financial Statements. It is generally accepted that there were numerous shortcomings in the IASB framework. Similarly, the conceptual framework developed and used in the US was also considered to have many shortcomings. With this in mind, the IASB and the FASB embarked on a joint project to develop a revised conceptual framework for international use. Any revised framework issued by the IASB would then be applicable within the Australian context. In July 2006 the FASB and the IASB jointly published a discussion paper entitled Preliminary Views on an Improved Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics of Decision-useful Financial Reporting Information. As we have already stressed, determining the objective of general 50  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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purpose financial reporting needs to be the first step when developing a conceptual framework for general purpose financial reporting. That paper was the first in a series of publications jointly developed by the two boards as part of a project to develop a common conceptual framework for financial reporting. The boards released an Exposure Draft in May 2008. The document was entitled Exposure Draft of an Improved Conceptual Framework for Financial Reporting, and this phase of the project specifically addressed the objective of financial reporting and the qualitative characteristics and constraints of decision-useful financial reporting information. According to the Exposure Draft, the conceptual framework is (IASB, 2008a): a coherent system of concepts that flow from an objective. The objective of financial reporting is the foundation of the framework. The other concepts provide guidance on identifying the boundaries of financial reporting; selecting the transactions, other events and circumstances to be represented; how they should be recognised and measured (or disclosed); and how they should be summarised and communicated in financial reports. Again, and as the above definition indicates, the objective of financial reporting is the fundamental building block for the conceptual framework. Hence, if particular individuals or parties disagreed with the objective of financial reporting identified by the IASB and the FASB then they would most likely disagree with the various prescriptions provided within the balance of the revised conceptual framework. The first phase of the joint IASB/FASB initiative was completed in September 2010 and the IASB conceptual framework was amended. It was at this point that it was renamed the Conceptual Framework for Financial Reporting. The October 2010 revised version of the conceptual framework includes the first two chapters that the IASB has published as a result of its first phase of the conceptual framework project, these being: • Chapter 1 The objective of financial reporting, and • Chapter 3 Qualitative characteristics of useful financial information. Chapter 2, which has not yet been updated, will deal with the reporting entity concept. The IASB published an Exposure Draft on the reporting entity concept in March 2010. We will consider this Exposure Draft when discussing the reporting entity concept later in this chapter and we will also consider the Exposure Draft released in May 2015. Chapter 4 contains the remaining text of the original IASB Framework (1989). Therefore, if we were to look at the Conceptual Framework for Financial Reporting, as released by the IASB as at September 2010, we find the following sections (but remember, the framework is still incomplete and there are several projects that will be undertaken to address ‘missing’ chapters of the conceptual framework):

INTRODUCTION • Purpose and status • Scope

CHAPTERS 1. The objective of general purpose financial reporting 2. The reporting entity [to be added at a future date] 3. Qualitative characteristics of useful financial information 4. The Framework (1989): • Underlying assumptions • The elements of financial statements • Recognition of the elements of financial statements • Measurement of the elements of financial statements • Concepts of capital and capital maintenance. Following the 2010 amendments to the IASB framework, the objective of financial reporting is now defined in the following way (paragraph OB2): The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential equity investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  51

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This objective has been retained in the Exposure Draft of the conceptual framework released in May 2015 and therefore represents the latest thinking of the IASB. Hence, pursuant to the IASB (and AASB) framework, information generated through the process of general purpose financial reporting is generated principally to meet the information needs of financial resource providers, as opposed to other stakeholders. It is generally accepted that conceptual frameworks will evolve over time as information demands change, and as financial systems change. Therefore, it is not surprising that the conceptual frameworks of the FASB and the IASB, both of which were initially developed more than two decades ago, were considered to be in need of significant revision. The view that conceptual frameworks will evolve over time is consistent with comments made by the IASB and FASB. They state (IASB 2008b, p. 9): To provide the best foundation for developing principle-based common standards, the boards have undertaken a joint project to develop a common and improved conceptual framework. The goals for the project include updating and refining the existing concepts to reflect changes in markets, business practices and the economic environment that occurred in the two or more decades since the concepts were developed. Although the IASB and the FASB had been jointly developing a revised conceptual framework for a number of years, in 2010 both Boards suspended their work on the joint framework. In 2012, after a short period of inactivity, the IASB restarted the conceptual framework project, but it was no longer being jointly undertaken with the FASB. According to IASB (2013, p.15), for the remainder of the project, it would focus upon: ( a) (b) (c) (d)

elements of the financial statements (including the boundary between liabilities and equity); recognition and derecognition; measurement; presentation and disclosure (including the question of what should be presented in other comprehensive income); and (e) the reporting entity. Details of the progress of the revised conceptual framework can be found on the IASB website (www.ifrs.org) by following the links to the conceptual framework project. In the balance of this chapter we will focus primarily on the IASB Conceptual Framework for Financial Reporting, as revised and released in October 2010, as this is the conceptual framework that must be applied within Australia (and other countries that have adopted IFRS). For the balance of the chapter we will simply refer to it as the conceptual framework. As has already been mentioned, further changes are expected to the conceptual framework, and a full Exposure Draft was released in May 2015 with the intention that a revised conceptual framework will be released in late 2016 or some time shortly thereafter. Where appropriate, we will make reference to ongoing work being undertaken by the IASB, given that this work provides an indication of possible future directions and changes.

LO 2.3 LO 2.4

Structure of the conceptual framework

Prior to 2005, the year in which Australia adopted IFRS and the IASB framework, Australia had its own conceptual framework and this was comprised of four statements of accounting concepts (SACs) that had been developed and issued within Australia. That is, Australia was developing its conceptual framework independently of other countries. Since 2005 we no longer use the entire contents of the conceptual framework that was developed in Australia in the early to mid-1990s. Parts of this conceptual framework (specifically, two statements of accounting concepts— SAC 3 Qualitative Characteristics of Financial Information and SAC 4 Definition and Recognition of the Elements of Financial Statements) were initially replaced by the IASB Framework for the Preparation and Presentation of Financial Statements—a document initially prepared by the International Accounting Standards Committee (IASC) in 1989 and in turn released by the AASB in July 2004. Two of our pre-existing Australian statements of accounting concepts— SAC 1 Definition of the Reporting Entity and SAC 2 Objective of General Purpose Financial Reporting—were retained after 2005 because the related issues were not addressed in the IASB framework. However, with the amendments made to the IASB conceptual framework in 2010, the contents of the previous SAC 2 were no longer applicable within Australia, given that work on defining the objective of general purpose financial reporting—which had been the subject of SAC 2—had been completed by the IASB and incorporated into the framework released in September 2010.

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However, as the work being undertaken by the IASB has not yet been completed in relation to definitional issues associated with the ‘reporting entity’ concept, SAC 1 Definition of the Reporting Entity is still applicable within the Australian context. However, the reporting entity concept has been addressed in the Exposure Draft released by the IASB in May 2015. It needs to be emphasised that the Australian conceptual framework, which currently comprises the IASB conceptual Framework plus SAC 1, is not an accounting standard, and as such does not prescribe recognition, measurement or disclosure requirements in relation to specific transactions or events. Rather, the conceptual framework provides guidance at a general, or conceptual level. Specific transactions and events (such as, for example, how to account for the acquisition of inventory or the acquisition of goodwill) are addressed by particular accounting standards. Previously, it was generally accepted that the conceptual framework was a useful source of guidance, but was not mandatory. However, the inclusion of two paragraphs in Accounting Standard AASB 108 Accounting Policies, Changes in Accounting Estimates, and Errors has changed this position so that preparers of general purpose financial statements are now 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 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. The development of a conceptual framework for accounting is considered to involve the assembly of a number of ‘building blocks’. The framework must be developed in a particular order, with some matters necessarily requiring agreement before work can move on to subsequent ‘building blocks’. Figure 2.1 provides an overview of the framework developed in the late 1980s by the International Accounting Standards Committee (IASC), which was later adopted by the IASC’s successor, the International Accounting Standards Board (IASB). While the earlier framework has been superseded by the IASB Conceptual Framework for Financial Reporting, the building blocks previously identified in the superseded framework are still of relevance. As represented in Figure 2.1, the first matter to be addressed is the definition of financial reporting. Unless there is some agreement on this it would be difficult to construct a framework for financial reporting. Having determined what financial reporting means, we may turn our attention to the subject of financial reporting, specifically which entities are required to produce general purpose financial statements, and the likely characteristics of the users of these statements. Then we look at the objective of general purpose financial reporting, which we have already briefly discussed in this chapter. Once we have an accepted objective for general purpose financial reporting, the next step is to determine the basic underlying assumptions and qualitative characteristics of financial information necessary to allow users to make ‘economic decisions’. We do so later in this chapter. It is to be expected that over time perspectives on the role of general purpose financial reporting will change. Consistent with this view, many, including accounting standard-setters, expect the development of conceptual frameworks to continue—for them to continually evolve over time.

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Figure 2.1 Components of a conceptual framework (based on the IASC/ IASB framework)

1. Definition of financial reporting

2. Definition of the reporting entity

3. Definition of users of accounts and their information needs

4. Objectives of financial statements

5. Underlying assumptions

LO 2.3 LO 2.4 LO 2.5 LO 2.6 LO 2.7 LO 2.8 LO 2.9 LO 2.10

6. Qualitatitive characteristics of financial statements

7. Elements of financial statements

8. Recognition criteria

9. Measurement basis and techniques

Building blocks of a conceptual framework In this section we consider the definition of a reporting entity; perceived users of financial statements; the objectives of general purpose financial reporting; the qualitative characteristics that general purpose financial statements should possess; the elements of financial statements; and possible approaches to the recognition and measurement of the elements of financial statements.

Definition of a reporting entity

A key question in any discussion of financial reporting is: what characteristics of an entity signal the need for it to produce general purpose financial statements? Use of the term general purpose financial statements signifies that such financial statements comply with accounting standards and other generally accepted accounting principles, and are released by reporting entities with the aim of satisfying the general information demands of a varied cross-section of users. Being ‘general purpose’ in nature, general purpose financial statements cannot be expected to meet all the information needs of the various classes of users. As the conceptual framework (paragraph OB6) states (and this has also been retained in the Exposure Draft released in May 2015 by the IASB): General purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need. Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks. General purpose financial statements can be contrasted with special purpose financial statements, which are provided to meet the information demands of a particular user or group of users and which are not required to comply with accounting standards (for example, a special purpose financial statement might be a cash flow projection 54  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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produced for a bank that is providing funds to the entity). As stated earlier, the guidance that we consider in this chapter relates to general purpose financial statements. Clearly, not all entities should be expected to produce general purpose financial statements (with general purpose financial statements being financial statements that are directed towards the common information needs of a wide range of users). For example, there would be limited benefit from requiring an owner—manager to prepare general purpose financial statements (that comply with the whole range of accounting standards) for, say, a small corner shop. There would be few external users with a significant stake or interest in the organisation. The conceptual framework developed within Australia provided more detail on the reporting entity concept than the IASB framework adopted in 2005. The IASB conceptual framework subsequently released in 2010 also did not address the notion of a ‘reporting entity’. That is, the chapter dealing with the reporting entity concept (Chapter 2) was left blank when the 2010 document was released. Nevertheless, the IASB did release an Exposure Draft in 2010 entitled Conceptual Framework for Financial Reporting—The Reporting Entity. However, when the comments on the Exposure Draft were received, this coincided with the time at which work on the conceptual framework was temporarily suspended (November 2010). Hence the Reporting Entity chapter of the conceptual framework was not finalised. Nevertheless, the Exposure Draft released in May 2015 does reflect the current thoughts of the IASB so we will also consider that in the discussion below. Because the conceptual framework, as released in 2010, does not address the reporting entity concept—which is central to general purpose financial reporting—Australia elected to retain, for the time being, the use of SAC 1 Definition of the Reporting Entity—which the AASB developed back in 1990—as a supplement to the IASB Conceptual Framework for Financial Reporting. In the joint work that that was undertaken by the IASB and the FASB, SAC 1 was used as a frame of reference for developing the IASB/FASB perspective of the reporting entity concept. Specifically, FASB and IASB (2005, p.13) stated: The Australian Accounting Standards Boards did issue in 1990 a Concepts Statement, ‘Definition of the Reporting Entity’, that defined an economic entity as a group of entities under common control, with users who depend on general purpose financial reports to make resource allocation decisions regarding the collective operation of the group and examined the implications of that concept. The boards may find that Concept Statement useful in developing a complete, converged concept of reporting entity. Referring to SAC 1, as released by the AASB in 1990, it did provide a definition of a ‘reporting entity’, this being: Reporting entities are all entities (including economic entities) in respect of which it is reasonable to expect the existence of users dependent on general purpose financial reports for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources. The above definition of a reporting entity is consistent with the definition currently provided within AASB 1053: Application of Tiers of Australian Accounting Standards. AASB 1053 defines a reporting entity as: an entity in respect of which it is reasonable to expect the existence of users who rely on the entity’s general purpose financial statements for information that will be useful to them for making and evaluating decisions about the allocation of resources. A reporting entity can be a single entity or a group comprising a parent and all of its subsidiaries. Pursuant to SAC 1, general purpose financial statements (GPFSs) should be prepared by all reporting entities (remember that the full text of SAC 1, and the AASB conceptual framework and the various accounting standards is available on the AASB’s website at www.aasb.gov.au). As previously stated, general purpose financial statements are financial statements that comply with the conceptual framework and relevant accounting standards. They can be contrasted with special purpose financial statements, as defined in Chapter 1. Paragraph 6 of SAC 1 further defines general purpose financial statements as statements ‘intended to meet the information needs common to users who are unable to command the preparation of statements tailored so as to satisfy, specifically, all of their information needs’. This definition is consistent with the definition currently adopted by the AASB in AASB 1053 Application of Tiers of Australian Accounting Standards. In this standard, general purpose financial statements are defined as: those financial statements 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.

reporting entity When users are said to exist who do not have access to information relevant to decision making and who are judged to be dependent on general purpose financial reports, the entity is deemed to be a reporting entity.

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If an entity is not deemed to be a ‘reporting entity’, it will not be required to produce general purpose financial statements—it will not necessarily be required to comply with all accounting standards. Whether an entity is classified as a reporting entity is determined by the extent to which users (of financial information relating to that entity) have the ability to command the preparation of financial statements tailored to their particular information needs. Such a determination depends upon professional judgement. When information relevant to decision making is not otherwise accessible to users who are judged to be dependent upon general purpose financial statements to make and evaluate resource-allocation decisions, the entity is deemed to be a reporting entity. Where dependence is not readily apparent, SAC 1 suggests that factors that might indicate that an organisation is a reporting entity include: • the separation of management from those with an economic interest in the entity—as the spread of ownership and/ or the separation of management and ownership increase, so does the likelihood of an entity being considered to be a reporting entity • the economic or political importance/influence of the entity to/on other parties—as the entity’s dominance in the market and/or its potential influence on the welfare of external parties increase, so does the likelihood of an entity being considered to be a reporting entity, and • the financial characteristics of the entity—as the amount of sales, value of assets, extent of indebtedness, number of customers and number of employees increase, so does the likelihood of an entity being considered to be a reporting entity. Small proprietary companies (as defined in Chapter 1) are frequently not considered to be reporting entities, as it is assumed that most people who require financial information about such an entity will be in a position to specifically demand it. Clearly, the approach adopted in Australia to defining a reporting entity is highly subjective and could produce conflicting opinions on whether or not an entity is a reporting entity. Interestingly, Australian law, as opposed to the conceptual framework, developed more objective criteria for determining when a company is required to provide financial statements that comply with accounting standards. These criteria, which are set out in the Corporations Act, relate to measures such as gross revenue, dollar value of assets and number of employees. Specifically, within the Corporations Act a company is deemed by s. 45A to be a large proprietary company, and therefore subject to greater disclosure requirements than ‘small proprietary companies’, if it meets two or more of the following tests: • Gross operating revenue for the financial year of $25 million or more • Gross assets at the end of the financial year of $12.5 million or more • Full-time-equivalent employees numbering 50 or more. Unless specific conditions exist, as provided in s. 292(2) of the Corporations Act, small proprietary companies do not have to prepare financial statements that comply with all accounting standards. In this chapter we have already made reference to the current definitions of ‘reporting entity’ and ‘general purpose financial statements’ as provided within AASB 1053 Application Tiers of Australian Accounting Standards. As we explained in Chapter 1, AASB 1053 introduced a two-tier reporting system for entities producing general purpose financial statements. That is, within the Australian context, where entities are deemed to be ‘reporting entities’ they will either provide a higher level of disclosures (referred to as Tier 1 general purpose financial statements, which are financial statements that comply with all relevant accounting standards), or lower levels of disclosures (being Tier 2 general purpose financial statements, which will be financial statements that utilise the recognition, measurement and presentation requirements of Tier 1 but have substantially reduced disclosure requirements). In relation to which entities are required to apply Tier 2 (reduced) reporting requirements, paragraph 13 of AASB 1053 states: The following types of entities shall, as a minimum, apply Tier 2 reporting requirements in preparing general purpose financial statements: (a) for-profit private sector entities that do not have public accountability; (b) not-for-profit private sector entities; and (c) public sector entities, whether for-profit or not-for-profit, other than the Australian Government and State, Territory and Local Governments. These types of entities may elect to apply Tier 1 reporting requirements in preparing general purpose financial statements. 56  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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Organisations producing financial statements that comply with Tier 2 requirements are still considered to be producing general purpose financial statements. Hence, although we have provided a definition of a reporting entity, the level of reporting required of the reporting entity will be further governed by the requirements of AASB 1053. An organisation that is not a ‘reporting entity’ and does not have ‘public accountability’ would not be impacted by the requirements of AASB 1053 to the extent that the organisation does not elect to produce general purpose financial statements. In the Exposure Draft of the Conceptual Framework for Financial Reporting released by the IASB in May 2015, the IASB decided not to be prescriptive when defining the reporting entity. This is somewhat in contrast to the current Australian position. The IASB decided not to provide a definition that reflected which entities must, should, or could prepare general purpose financial statements. Rather, they decided to leave such judgements up to various national jurisdictions. The 2015 IASB Exposure Draft simply states that: A reporting entity is an entity that chooses, or is required, to prepare general purpose financial statements. The 2015 Exposure Draft also notes that a reporting entity does not have to be a legal entity, and it can be a portion of an entity. Hence we can see that very little guidance is provided by the IASB in deciding what is a ‘reporting entity’. Having considered the meaning of a reporting entity, and having learned that within Australia reporting entities are required to produce general purpose financial statements, we will now turn our attention to the perceived ‘users’ of general purpose financial statements.

Users of general purpose financial statements If general purpose financial statements are to meet their intended purposes, then to be effective, reporting entities need to identify potential users and their respective information needs. Within the conceptual framework, the primary users of general purpose financial reports are deemed to be ‘investors, lenders and other creditors’. As the conceptual framework (Chapter 1, paragraph OB5) states (and this is also in the 2015 IASB Exposure Draft): 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. Within the conceptual framework there appears to be limited consideration of the ‘public’ being a legitimate user of financial statements. In the previous conceptual framework released by the IASB, the ‘public’ had been identified as a user of general purpose financial statements. However, in the conceptual framework released in 2010, 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 conceptual framework (Chapter 1, paragraph OB10) states (and again, this view is also retained within the IASB 2015 Exposure Draft): 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 Board’s and the FASB’s 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. CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  57

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The issue of which groups should be considered to be legitimate users of financial information about an organisation is one that has attracted a great deal of debate. There are many, such as the authors of The Corporate Report (a discussion paper released in 1975 by the Accounting Standards Steering Committee of the Institute of Chartered Accountants in England and Wales), who hold that all groups affected by an organisation’s operations have rights to information about the reporting entity, including financial information, regardless of whether they are contemplating resource allocation decisions. Indeed, many people would question whether the need for information to facilitate users ‘making decisions about providing resources to the entity’ is the only or dominant issue to consider in determining whether an organisation has a public obligation to provide information about its performance. The activities of organisations, particularly large corporations, impact on society and the environment in many different ways and at many different levels. Such impacts are clearly not restricted to investors or people who are considering investing in the organisation. In large part, the extent to which an organisation impacts on society and the environment, and its ability to minimise harmful impacts, will be tied to the financial resources under its control. As such, a reasonable argument can be made that various groups within society have a legitimate interest in having access to information about the financial position and performance of organisations, and to restrict the definition of users to investors, creditors and other lenders does seem a little too simplistic. In its current work, the IASB appears to maintain a restricted view of the users of general purpose financial statements (more restrictive than the previous Australian position) and tends to disregard information rights and the needs of users who do not have a direct financial interest in the organisation. Do you, the reader, consider that this perspective of ‘users’ of financial reports is too restrictive? Apart from considering the identity of report users, we also need to consider their expected proficiency in interpreting financial accounting information. 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 conceptual framework, (Chapter 3, paragraph QC32) explains that (again, this has been retained in the IASB 2015 Exposure Draft): 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 accounting— this is an interesting observation given the many hundreds of thousands of financial statements being sent 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 the conceptual framework 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). Having established the audience for general purpose financial statements, and their expected proficiency in understanding financial accounting information, we now move on to consider the objectives of general purpose financial reporting.

Objectives of general purpose financial reporting According to Chapter 1, paragraph OB1, of the conceptual framework (which deals with the objective of general purpose financial reporting): The objective of general purpose financial reporting forms the foundation of the Conceptual Framework. Other aspects of the Conceptual Framework—a reporting entity concept, the qualitative characteristics of, and the constraint on, useful financial information, elements of financial statements, recognition, measurement, presentation and disclosure—flow logically from the objective. In terms of the objective of general purpose financial reporting, paragraph OB2 states: The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. 58  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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The above objectives have also been embraced within the 2015 Exposure Draft and therefore represent the latest thinking of the IASB. Hence, the whole structure and contents of the conceptual framework (now and in the likely future) are based around, and follow on from, the identified objective of general purpose financial reporting. Before moving on to consider some of the suggested qualitative characteristics of financial information, for the sake of completeness we will briefly mention the underlying assumptions identified in the conceptual framework. These underlying assumptions are simply 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. Specifically, paragraphs OB17 and 4.1 state: OB17 Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period. 4.1 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 liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed. 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.

Qualitative characteristics of financial information If it is accepted that financial information should be useful for economic decision making in terms of deciding whether to make resources available to a reporting entity, as the conceptual frameworks indicates, a subsequent element (or building block) to consider is the qualitative characteristics (attributes or qualities) that financial information should have if it is to be useful for such decisions (implying that an absence of such qualities would mean that the central objectives of general purpose financial statements would not be met). Conceptual frameworks concentrate quite heavily on identifying the required qualitative characteristics of financial information. The fundamental qualitative characteristics identified in the conceptual framework released in 2010 are ‘relevance’ and ‘faithful representation’. This represents a departure from the previous IASB Framework for the Preparation and Presentation of Financial Statements wherein the primary qualitative characteristics were considered to be ‘relevance’ and ‘reliability’. That is, the ‘new’ framework in place since 2010 has replaced ‘reliability’ with ‘faithful representation’. The use of ‘faithful representation’ has also been used in the 2015 Exposure Draft released by the IASB. In discussing the need for information to be relevant and faithfully represented, paragraph QC17 of the IASB conceptual framework states: Information must be both relevant and faithfully represented 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. Apart from ‘fundamental’ qualitative characteristics, the conceptual framework (and the 2015 Exposure Draft) also identifies a number of ‘enhancing qualitative characteristics’ (which are important, but rank after fundamental qualitative characteristics in order of importance). These ‘enhancing qualitative characteristics’ are comparability, verifiability, timeliness and understandability. As paragraph QC19 of the conceptual framework states: Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. The enhancing qualitative characteristics may also help determine which of two ways should be used to depict a phenomenon if both are considered equally relevant and faithfully represented. We will consider each of these qualitative characteristics (two primary, and four enhancing qualitative characteristics) in turn. CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  59

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Relevance Relevance is a fundamental qualitative characteristic of financial reporting. Under the 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 QC6 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 information’s 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 ‘faithfully represent’ to the extent that such information is material. Paragraph QC11 of the IASB conceptual framework states that an item is material if: omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. Considerations of materiality also provide a basis for restricting the amount of information provided to levels that are comprehensible to financial statement users. It would arguably be poor practice to provide hundreds of pages of potentially relevant and representationally faithful information to financial statement readers—this would result only in an overload of information. Nevertheless, assessing materiality is very much a matter of judgement and at times we might see it being used as a justification for failing to disclose information that could be deemed to be potentially harmful to the reporting entity. The definition of materiality provided in the conceptual framework is consistent with that provided in AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors. Generally speaking, if an item of information is not deemed material (which is, of course, a matter of professional judgement), the mode of disclosure or even whether or not it is disclosed at all should not affect the decisions of financial statement readers. Paragraph 8 of AASB 108 explains that where an item or an aggregate of items is not material, application of the materiality notion does not mean that those items would not be recognised, measured or disclosed. It means, rather, that the entity would not be required to recognise, measure or disclose those items in accordance with the requirements of an accounting standard. In deciding whether an item or an aggregate of items is ‘material’, the nature and amount of the items usually need to be evaluated together. It might be necessary to treat as material an item or an aggregate of items that would not be judged to be material on the basis of the amount involved, because of their nature. An example is where a change in accounting method has taken place that is expected to affect materially the results of subsequent financial years, even though the effect in the current financial year is negligible. Again, if an item is not deemed to be material, the general principle is that you do not have to use a particular accounting standard to account for it. Worked Example 2.1 provides an example of how we might determine the materiality of an item.

Faithful representation The other primary qualitative characteristic (other than relevance) is ‘faithful representation’. According to the 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 QC12 of the 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 IASB’s objective is to maximise those qualities to the extent possible. 60  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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WORKED EXAMPLE 2.1: Determining the materiality of an item Cassandra Ltd has the following assets as at 30 June 2017: $000 Current assets Cash Marketable securities Accounts receivable Inventory Total current assets

1 000 3 000 8 000   1 100 13 100

Non-current assets Investments Property, plant and equipment Intangible assets Total non-current assets Total assets

6 000 12 000   2 000 20 000 33 100

Profits for the year were $6 000 000 and total shareholders’ equity at year end was $12 000 000. Sales for the year were $28 000 000 and related cost of goods sold was $12 000 000. Just before the year-end financial statements were finalised it was discovered that sales invoices of $900 000 had accidentally been excluded from the total transactions of the year. The related cost of goods sold pertaining to these sales was $600 000. REQUIRED Determine whether this omission is likely to be deemed to be material. SOLUTION First, we need to determine the appropriate base amounts. If the sales were properly recorded, sales and accounts receivable would have been $900 000 higher. Inventory would have been $600 000 lower and cost of goods sold would have been $600 000 higher. Profit would have been $300 000 higher.

Shareholders’ equity Profits Sales Cost of goods sold Accounts receivable

Recorded amount

Possible adjustment

Percentage adjustment

12 000 000 6 000 000 28 000 000 12 000 000 8 000 000

300 000 300 000 900 000 600 000 900 000

2.5% 5.0% 3.2% 5.0% 11.3%

On the basis of the above information, we could argue that the impact on accounts receivable would be material if the transaction was omitted from the financial statements. The impacts on the other base amounts would probably not be deemed to be material, but because the impact on accounts receivable is deemed to be material this is sufficient to warrant the financial statements being adjusted to include the omitted sales. But of course, this is all a matter of ‘professional judgement’.

In terms of the three characteristics of ‘complete’, neutral’ and ‘free from error’, that together reflect faithful representation, paragraphs QC13, 14 and 15 of the conceptual framework state: QC13 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, original cost, adjusted cost or fair value). CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  61

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QC14 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. QC15 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 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. In terms of the sequence in which the two fundamental qualitative characteristics of relevance and faithful representation are considered (that is, whether one fundamental qualitative characteristic should be considered before the other), paragraph QC18 of the conceptual framework states: The most efficient and effective process for applying the fundamental qualitative characteristics would usually be as follows (subject to the effects of enhancing characteristics and the cost constraint, which are not considered in this example). First, identify an economic phenomenon that has the potential to be useful to users of the reporting entity’s financial information. Second, identify the type of information about that phenomenon that would be most relevant if it is available and can be faithfully represented. Third, determine whether that information is available and can be faithfully represented. If so, the process of satisfying the fundamental qualitative characteristics ends at that point. If not, the process is repeated with the next most relevant type of information. Of some interest is the fact that when the conceptual framework was released in 2010 it identified representational faithfulness as a fundamental qualitative characteristic, rather than using the qualitative characteristic of ‘reliability’ that was used in the former IASB framework (that is, relevance was replaced by representational faithfulness when the 2010 document was released by the IASB). This has also been embraced within the 2015 Exposure Draft released by the IASB. In explaining the rationale for this replacement, paragraphs BC3.23 and 24 of the Basis for Conclusions that accompanied the release of the conceptual framework in 2010 stated: BC3.23

 nfortunately, neither the IASB or FASB framework clearly conveyed the meaning of reliability. U The comments of respondents to numerous proposed standards indicated a lack of a common understanding of the term reliability. Some focused on verifiability or free from material error to the virtual exclusion of faithful representation. BC3.24 Because attempts to explain what reliability was intended to mean in this context have proved unsuccessful, the Board sought a different term that would more clearly convey the intended meaning. The term faithful representation, the faithful depiction in financial reports of economic phenomena, was the result of that search. That term encompasses the main characteristics that the previous frameworks included as aspects of reliability.

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Balancing relevance and representational faithfulness Ideally, financial information should be both relevant and representationally faithful. However, it is possible for information to be representationally faithful, but not very relevant, or the other way around. Such information would, in this case, not be deemed to be useful. As we have previously indicated, paragraph QC17 of the conceptual framework states: Information must be both relevant and faithfully represented 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. For example, while we might be able to quote the acquisition cost of a building reliably (perhaps we have the details of the original contracts and related payments), how relevant would such information be if the building was acquired in 1970? If available, a current valuation of the building might be more relevant. However, until such time as the building is sold, we might not know the amount that would actually be generated on sale. That is, the valuation might not be very reliable or provide a faithful representation of the underlying value (of course, we could try to make it more representationally faithful by obtaining a number of valuations and possibly taking an average). There is often a trade-off between relevance and representational faithfulness. For example, the earlier we can obtain the financial performance results of an entity, the more relevant the information will be in assessing that entity’s performance. However, to increase the representational faithfulness of the data, we might prefer to use financial information that has been the subject of an independent audit (therefore, for example, reducing the likelihood of error). The resultant increase in representational faithfulness, or reliability, will mean that we will not receive the information for perhaps 10 weeks after the financial year end, at which point the information will not be quite as relevant because of its ‘age’. Therefore, there can, in practice, be a matter of balancing one against the other. However, if the data or information severely lacks one of the characteristics of relevance or faithful representation, then that information should not be provided to financial statement readers. Another consideration that needs to be addressed when deciding whether to disclose particular information is the potential costs of producing relevant and representationally faithful information, relative to the associated benefits. In relation to costs, paragraph QC35 of the conceptual framework states: Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. There are several types of costs and benefits to consider. In considering the associated benefits of financial reporting, paragraphs QC38 and 39 of the conceptual framework state: QC38 In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. When applying the cost constraint in developing a proposed financial reporting standard, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that standard. In most situations, assessments are based on a combination of quantitative and qualitative information. QC39 Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of reporting particular items of financial information will vary. Therefore, the Board seeks to consider costs and benefits in relation to financial reporting generally, and not just in relation to individual reporting entities. That does not mean that assessments of costs and benefits always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different users’ needs or other factors. Hence, while it can be a difficult exercise balancing the costs and benefits associated with particular disclosures, and related regulations, there is a general principle that the benefits derived from information should exceed the cost of providing it. This principle will be considered by the IASB when new accounting standards are being developed.

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Comparability As we indicated previously, apart from the two fundamental qualitative characteristics of relevance and faithful representation, there are also four ‘enhancing qualitative characteristics’. These enhancing qualitative characteristics are comparability, verifiability, timeliness and understandability and each of these qualitative characteristics is assumed to likely enhance the usefulness of information that is both relevant and faithfully represented. As paragraph QC4 of the conceptual framework states: If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable. In relation to the enhancing qualitative characteristic of ‘comparability’, to facilitate the comparison of the financial statements of different entities (and that of the financial statements of a single entity over time), methods of measurement and disclosure must be consistent, but should be changed if no longer relevant to an entity’s circumstances. Drawing on studies by Loftus (2003) and Booth (2003), Wells (2003) argues that a key role of a conceptual framework should be to produce consistent accounting standards that lead to comparable accounting information between different entities, as without such comparability it would be difficult for users to evaluate accounting information. Desirable characteristics such as comparability therefore imply that there are advantages in restricting the number of accounting methods that can be used by reporting entities. However, other academics have argued that steps that result in fewer accounting methods available for use by reporting entities lead potentially to reductions in the efficiency with which organisations operate (Watts & Zimmerman 1986). For example, management might elect to use a particular accounting method because it believes that for its particular and perhaps unique circumstances that method best reflects the entity’s underlying performance (even though no other entity might use the accounting method in question). Restricting the use of such a method might credibly be held to result in a reduction in the efficiency with which external parties can monitor the performance of the entity, and this in itself has been assumed to lead to increased costs for the reporting entity (this ‘efficiency perspective’, which has been applied in Positive Accounting Theory, is explored in Chapter 3). If it is assumed, consistent with the efficiency perspective briefly mentioned here, that firms adopt particular accounting methods because those methods best reflect the underlying economic performance of the entity, it is argued by some theorists that the regulation of financial accounting—particularly calls for uniformity in the use of all accounting methods (which enhances comparability)—imposes unwarranted costs on reporting entities. For example, if a new accounting standard is released that bans the use of an accounting method by particular organisations, this will lead to inefficiencies, as the resulting financial statements will no longer provide the best reflection of the performance of those organisations. Many theorists would argue that management is best able to select the appropriate accounting methods in given circumstances and that government and/or others should not intervene by introducing a ‘one-sizefits-all’ accounting standard. Arguments for and against regulation were provided in Chapter 1. Obviously, the people in charge of developing conceptual frameworks that include comparability as a key qualitative characteristic must believe that the benefits of restricting the number of allowable methods outweigh the potential reductions in efficiency that some organisations may experience as a consequence of their managers not being free to select what they consider to be the most appropriate accounting method.

Verifiability Verifiability refers to the ability, through consensus among measurers, to ensure that information represents what it purports to represent, or that the chosen method of measurement has been used without error or bias. In relation to the enhancing qualitative characteristic of verifiability, paragraph QC26 of the conceptual framework states: Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities can also be verified.

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Timeliness A third ‘enhancing’ qualitative characteristic is ‘timeliness’. The more ‘timely’ (or up-to-date) that financial information is, the more useful it will be. As paragraph QC29 of the conceptual framework states: Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is. However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends.

Understandability The fourth and final ‘enhancing’ qualitative characteristic is ‘understandability’, the view being that for information to be useful it obviously needs to be understandable to the users. In the conceptual framework, information is considered to be understandable if it is likely to be understood by users with some business and accounting knowledge (as discussed earlier). However, this does not mean that complex information that is relevant to economic decision making should be omitted from the financial statements just because it might not be understood by some users. As paragraph QC32 of the conceptual framework states: 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. Given that conceptual frameworks have been developed in large part to guide accounting standard-setters in the setting of accounting rules (rather than as a set of rules to which entities must refer when compiling their financial statements), this qualitative characteristic of understandability is perhaps best seen as a requirement (or challenge) for standard-setters to ensure that the accounting standards they develop for dealing with complex areas produce accounting disclosures that are understandable (irrespective of the complexity of the underlying transactions or events). Based on your knowledge of accounting practice, how successful do you think accounting standard-setters have been at meeting this challenge?

Definition and recognition of the elements of financial statements The previous discussion has addressed the objectives of general purpose financial reporting as well as the qualitative characteristics expected of financial information. The Exposure Draft of the Conceptual Framework for Financial Reporting released by the IASB in May 2015 signalled that no real changes are being made to this area relative to the conceptual framework released in 2010. However, there are some potentially significant changes being proposed in relation to the definitions and elements of financial statements. In this section of the chapter we will consider the existing conceptual framework definitions and recognition criteria after which we will then consider the recommendations included within the 2015 Exposure Draft. The definition and recognition of the elements of accounting are incorporated in Chapter 4 of the Conceptual Framework for Financial Reporting as released in 2010. This material was taken directly from the previous IASB Framework for the Preparation and Presentation of Financial Statements, hence there were no recent changes in how the elements of accounting are defined and are to be recognised. Nevertheless, as we noted above, future changes in definitions and recognition criteria are highly probable. Different approaches can be applied to determining profits (income less expenses). Two such approaches are commonly referred to as the asset/liability approach and the revenue/expense approach. The asset/liability approach links profit to changes that have occurred in the assets and liabilities of the reporting entity, whereas the revenue/ expense approach tends to rely on concepts such as the matching principle, which is very much focused on actual transactions and which gives limited consideration to changes in the values of assets and liabilities. Most conceptual framework projects, including the IASB conceptual framework, adopted the asset/liability approach. Within these frameworks the task of defining the elements of financial statements must start with definitions of assets and liabilities, as the definitions of all the other elements flow from these. This should become apparent as we consider each of the

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elements of accounting in what follows. In relation to the ‘asset and liability view’ of profit determination, the FASB and IASB (2005, pp. 7 and 8) state: In both [FASB and IASB] frameworks, the definitions of the elements are consistent with an ‘asset and liability view’, in which income is a measure of the increase in the net resources of the enterprise during a period, defined primarily in terms of increases in assets and decreases in liabilities. That definition of income is grounded in a theory prevalent in economics: that an entity’s income can be objectively determined from the change in its wealth plus what it consumed during a period (Hicks, pp. 178–9, 1946). That view is carried out in definitions of liabilities, equity, and income that are based on the definition of assets, that is, that give ‘conceptual primacy’ to assets. That view is contrasted with a ‘revenue and expense view’, in which income is the difference between outputs from and inputs to the enterprise’s earning activities during a period, defined primarily in terms of revenues (appropriately recognized) and expenses (either appropriately matched to them or systematically and rationally allocated to reporting periods in a way that avoids distortion of income). . . . Some recent critics advocate a shift back to the revenue and expense view. However, in a recent study about principles-based standards, mandated by the 2002 Sarbanes-Oxley legislation, the U.S. Securities and Exchange Commission said the following: ‘. . . the revenue/expense view is inappropriate for use in standard-setting—particularly in an objectivesoriented regime . . . Historical experience suggests that the asset/liability approach most appropriately anchors the standard-setting process by providing the strongest conceptual mapping to the underlying economic reality (page 30). . . . the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented standard-setting regime (page 42).’ Five elements of financial statements are defined in the conceptual framework: assets, liabilities, expenses, income and equity. We will consider each of these in turn, but notice, once again, as the discussion proceeds, how the definitions of expenses and income depend directly on the definitions given to assets and liabilities.

Definition and recognition of assets asset Defined in the AASB conceptual framework as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

future economic benefits The scarce capacity to provide benefits to the entities that use them— common to all assets irrespective of their physical or other form.

The conceptual framework currently defines an asset as ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. This definition identifies three key characteristics: 1. There must be a future economic benefit. 2. The reporting entity must control the future economic benefits. 3. The transaction or other event giving rise to the reporting entity’s control over the future economic benefits must have occurred. Future economic benefits can be distinguished from the source of the benefit—a particular object or right. The definition refers to the benefit and not the source. Thus whether an object or right is disclosed as an asset will be dependent upon the likely economic benefits flowing from it. In the absence of expected future economic benefits, the object should not be disclosed as an asset. Rather, the expenditure might be construed as an expense. As the conceptual framework states (paragraph 4.14): There is a close association between incurring expenditure and generating assets but the two do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that future economic benefits were sought but is not conclusive proof that an item satisfying the definition of an asset has been obtained.

Therefore, cash is an asset owing to the benefits that can flow as a result of the purchasing power it generates. A machine is an asset to the extent that economic benefits are anticipated to flow from using it. The conceptual frameworks does not require an item to have a value in exchange before it can be recognised as an asset. The economic benefits may result from its ongoing use (often referred to as value-in-use) within the organisation. 66  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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As indicated in the above definition of an asset, a resource must be controlled before it can be considered to be an ‘asset’. Control relates to the capacity of a reporting entity to benefit from an asset and to deny or regulate the access of others to the benefit. The capacity to control would normally stem from legal rights. However, legal enforceability is not a prerequisite for establishing the existence of control. Hence it is important to realise that control, and not legal ownership, is required before an asset can be shown within the body of an entity’s balance sheet (statement of financial position). Frequently, controlled assets are owned, but this is not always the case. Organisations often disclose leased assets as part of their total assets. For example, the 2015 consolidated balance sheet of Qantas includes leasehold improvements (carrying amount of $539 million) and leased aircraft and engines (carrying amount of $1 796 million). In relation to control, the conceptual framework (paragraph 4.12) states:

control (assets) If an asset is to be recognised, control rather than legal ownership must be established. Control is the capacity of an entity to benefit from an asset in the pursuit of the entity’s objectives and to deny or regulate the access of others to that benefit.

Many assets, for example, receivables and property, are associated with legal rights, including the right of ownership. In determining the existence of an asset, the right of ownership is not essential; thus, for example, property held on a lease is an asset if the entity controls the benefits which are expected to flow from the property. Although the capacity of an entity to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. For example, know-how obtained from a development activity may meet the definition of an asset when, by keeping that know-how secret, an entity controls the benefits that are expected to flow from it.

In relation to ‘control’, it follows from the requirement that the relevant transaction must already have occurred that future economic benefits that are not currently controlled are not to be recognised in the statement of financial position. There are many resources that generate benefits for an entity but that should not be recorded owing to the absence of control. For example, the use of the road system generates economic benefits for an entity. However, because the entity does not control the roads, they do not constitute assets of the entity. Similarly, particular waterways will provide economic benefits to entities, but to the extent that such entities do not control the waterways, they are not assets of those entities. In addition to defining an asset, we also need to consider when we should recognise the existence of an asset. According to the conceptual framework, ‘recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition’. In relation to the recognition criteria, the conceptual framework (paragraph 4.38) provides general recognition criteria for all five elements of financial statements (assets, liabilities, income, expenses and equity), these being: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. Hence, for all of the five elements of financial accounting, both probability and measurability are key considerations. Paragraph 4.44 of the conceptual framework specifically addresses the recognition of assets. Consistent with the general recognition criteria provided above, paragraph 4.44 provides that: An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. Again, we can see from the above requirements that the determination of ‘probable’ is central to the recognition criteria applied to the elements of financial statements. Unfortunately, however, the conceptual framework does not define ‘probable’. For guidance we can refer to the superseded SAC 4. Paragraph 40 of SAC 4 defined ‘probable’ as ‘more likely rather than less likely’. If an asset (or another element of financial statements) fails to meet the recognition criteria in one period but satisfies them in another period, the asset can be reinstated (subject to requirements in particular accounting standards). As paragraph 4.42 of the conceptual framework states: An item that, at a particular point in time, fails to meet the recognition criteria in paragraph 4.38, may qualify for recognition at a later date as a result of subsequent circumstances or events. CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  67

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However, it is worth emphasising that while this is a general requirement, the ability to reinstate assets that have been written off will not be available for all assets. Some accounting standards preclude the reinstatement of assets, regardless of whether or not they are subsequently deemed likely to generate future economic benefits. As we have shown, in the hierarchy of rules, accounting standards override the conceptual framework. As an example of a prohibition on reinstating assets we can consider the requirements of AASB 138 Intangible Assets and its requirements in relation to any moves to reinstate previously written-off intangible assets. Specifically, paragraph 71 of AASB 138 states ‘expenditure on an intangible item that was initially recognised as an expense shall not be recognised as part of the cost of an intangible asset at a later date’. While the above definition of an asset is the definition that currently must be used within countries that have adopted IFRS (such as Australia), it should be noted that this definition will most likely change in future years. Given the central importance of the definition of assets to financial reporting, any change to it will conceivably have broad implications for financial reporting. In relation to work being undertaken by the IASB, the IASB released, in March 2015, a document entitled IASB Staff Paper: Effect of Board Redeliberations on Discussion Paper—A Review of the Conceptual Framework for Financial Reporting, which noted that the existing definition of assets has a number of potential shortcomings. The IASB noted the following (IASB 2015a, p.3): The IASB believes that the definitions of assets and liabilities could be clarified. They contain references to expected inflows or outflows of economic benefits. Some have interpreted these references as implying that the asset or the liability is the ultimate inflow or outflow of economic benefits, rather than the underlying resource or obligation. To avoid misunderstandings, the IASB’s preliminary view is that it should amend the definitions to confirm more explicitly that: (a) an asset (or a liability) is the underlying resource (or obligation), rather than the ultimate inflow (or outflow) of economic benefits; and (b) an asset (or a liability) must be capable of generating inflows (or outflows) of economic benefits. Those inflows (or outflows) need not be certain. On 21 May 2014, the IASB tentatively decided that: (a) Assets should be viewed as rights, or bundles of rights, rather than underlying physical or other objects. The IASB noted that in many cases an entity would account for an entire bundle of rights as a single asset, and describe that asset as the underlying object. An entity would account separately for rights within a bundle only when needed to provide a relevant and faithful representation, at a cost that does not exceed the benefits. (b) The reference to future economic benefits should be placed in a supporting definition (of an economic resource), rather than in the definitions of an asset and of a liability. (c) The definition of an economic resource should not include the notion of ‘other source of value’ that was suggested in the Discussion Paper. The guidance supporting the definition of an economic resource should confirm that the notion of a ‘right’ is broad enough to capture any know-how that is controlled by keeping it secret. (d) The term ‘present’ should be retained in the definition of a liability and, as proposed in the Discussion Paper, should be added to the definition of an asset. (e) The phrase ‘as a result of past events’ should be retained in both the definition of an asset and the definition of a liability. On 21 May 2014, the IASB also discussed the role of uncertainty in the definitions of an asset and of a liability and tentatively decided that: (a) The definitions of assets and liabilities should not retain the notion that an inflow or outflow needs to be ‘expected’. (b) The definition of an economic resource should, as proposed in the Discussion Paper, specify that an economic resource must be capable of generating economic benefits. The term ‘capable’ indicates that the economic benefits must arise from some feature that already exists within the economic resource. The term ‘capable’ is not intended to impose a minimum probability threshold, but rather to indicate that, in at least some outcomes, the economic resource will generate economic benefits. (c) The notion ‘is capable of’ should not appear explicitly in the proposed definition of a liability. The supporting guidance should clarify that an obligation must contain an existing feature that is capable of requiring the entity to transfer an economic resource. 68  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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To reflect the decisions above, the draft definitions are now as follows: (a) an asset is a present economic resource controlled by the entity as a result of past events (b) a liability is a present obligation of the entity to transfer an economic resource as a result of past events; and (c) an economic resource is a right that is capable of producing economic benefits. On 21 January 2015, the IASB tentatively decided to replace the term ‘is capable of’ with the term ‘has the potential to’ in the definition of an economic resource. This change is not intended to alter the meaning of the definition of an economic resource. The Exposure Draft will define an economic resource as follows: An economic resource is a right that has the potential to produce economic benefits. When the IASB released its Exposure Draft of the Conceptual Framework for Financial Reporting in May 2015, the above proposals were incorporated therein. Whether the proposals within the Exposure Draft will ultimately form part of a revised conceptual framework is not something about which we can be sure. The IASB sought comments on the Exposure Draft and will take these into account before releasing a revised conceptual framework. However, what we need to appreciate is that given that the definitions of other elements of accounting (equity, income and expenses) rely directly upon the definition of assets, any change to the definition of assets, and the associated recognition criteria, will potentially have very significant impacts on general purpose financial reporting.

Definition and recognition of liabilities The conceptual framework currently presently defines a liability as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. As for the definition of assets, three key characteristics are identified in the definition of liabilities: 1. There must be an expected future disposition of economic benefits to other entities. 2. There must be a present obligation. 3. A past transaction or other event must have created the obligation. As indicated, the present definition of a liability does not restrict ‘liabilities’ to situations where there is a legal obligation. Liabilities should also be recognised in certain situations where equity or usual business practice dictates that obligations to external parties currently exist. As the IASB conceptual framework states:

liability Defined in the conceptual framework as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’.

An essential characteristic of a liability is that the entity has a present obligation. An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. If, for example, an entity decides as a matter of policy to rectify faults in its products even when these become apparent after the warranty period has expired, the amounts that are expected to be expended in respect of goods already sold are liabilities. Hence the liabilities that appear within an entity’s statement of financial position might include obligations that are legally enforceable as well as obligations that are deemed to be equitable or constructive. When determining whether a liability exists, the intentions or actions of management need to be taken into account. That is, the actions or representations of the entity’s management or governing body, or changes in the economic environment, directly influence the reasonable expectations or actions of those outside the entity and, although they have no legal entitlement, they might have other sanctions that leave the entity with no realistic alternative but to make certain future sacrifices of economic benefits. Such present obligations are sometimes called ‘equitable obligations’ or ‘constructive obligations’. An equitable obligation is governed by social or moral sanctions or custom rather than legal sanctions. A constructive obligation is created, inferred or construed from the facts in a particular situation rather than contracted by agreement with another entity or imposed by government. Determining whether an equitable or a constructive obligation exists—and therefore whether a liability should be recognised in the balance sheet (the statement of financial position)—is often more difficult than identifying a legal obligation, and in most cases judgement is required to determine if an equitable or a constructive obligation exists. One consideration is whether the entity has any realistic alternative to making the future sacrifice of economic benefits. If the situation implies that there is no discretion, then a liability would be recognised. In cases where the entity retains discretion CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  69

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to avoid making any future sacrifice of economic benefits, a liability does not exist and is not recognised. It follows that a decision of the entity’s management or governing body, of itself, is not sufficient for the recognition of a liability. Such a decision does not mark the inception of a present obligation since, in the absence of something more, the entity retains the ability to reverse the decision and thereby avoid the future sacrifice of economic benefits. For example, an entity’s management or governing body may resolve that the entity will offer to repair a defect it has recently discovered in one of its products, even though the nature of the defect is such that the purchasers of the product would not expect the entity to do so. Until the entity makes public that offer, or commits itself in some other way to making the repairs, there is no present obligation, constructive or otherwise, beyond that of satisfying the existing statutory and contractual rights of customers. Requiring liability recognition to be dependent upon there being a present obligation to other entities has implications for the disclosure of various provision accounts, for example, ‘Provision for maintenance’. Generally accepted accounting practice in some countries had traditionally required such amounts to be disclosed as a liability, even though it does not involve an obligation to an external party. This issue is partially addressed in paragraph 4.19 of the conceptual framework. It states: . . . when a provision involves a present obligation and satisfies the rest of the definition, it is a liability even if the amount has to be estimated. Examples include provisions for payments to be made under existing warranties and provisions to cover pension obligations. Thus, the conceptual framework requires estimated (and therefore uncertain) present obligations, which have resulted from past events and are likely to result in an outflow of economic resources, to be treated as liabilities. Provisions for maintenance, overhaul and the like would not be considered to be liabilities of a reporting entity because of the absence of an obligation to an external entity. The recognition criteria for liabilities are consistent with those for assets. Paragraph 4.46 of the conceptual framework provides that: A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. As with the other elements of accounting, probability with respect to liabilities means ‘more likely than less likely’. Hence, if Company A is assessed as having a 49 per cent probability of having to pay $100 million, while Company B has a 51 per cent probability of having to pay $1 million, Company A would show no liabilities on the face of the statement of financial position, while Company B would show $1 million. However, given the amount involved and the relatively high probability of payment, Company A would be required to disclose information about the potential obligation in the notes to its financial statements (shown as a contingent liability). Apart from the consideration of probabilities, where a liability cannot be reliably measured but is potentially material the liability should be disclosed within the notes to the financial statements notes to the financial (again, as a contingent liability). statements Requiring liability recognition to be dependent upon there being a present obligation to other entities Further explanation has implications for the disclosure of various provision accounts, such as a provision for maintenance. As or information relating indicated previously, generally accepted accounting practice had typically required such amounts to be to particular items appearing in financial disclosed as a liability, even though they did not involve an obligation to an external party. This practice statements. is now prohibited by virtue of AASB 137 Provisions, Contingent Liabilities and Contingent Assets. We consider this standard in depth in Chapter 10. In Appendix C to AASB 137, the example provided is of a furnace that has a lining that needs to be replaced every five years for technical reasons. At the end of the reporting period, the lining has been in use for three years. According to the Appendix, there is no present obligation and hence no liability would be recognised. It is argued in the Appendix to AASB 137 that: The cost of replacing the lining is not recognised because, at the end of the reporting period, no obligation to replace the lining exists independently of the company’s future actions—even the intention to incur the expenditure depends on the company deciding to continue operating the furnace or to replace the lining. Instead of a provision being recognised, the depreciation of the lining takes account of its consumption, that is, it is depreciated over five years. The re-lining costs then incurred are capitalised with the consumption of each new lining shown by depreciation over the subsequent five years.

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As we have already discussed, the IASB has recently suggested a revised definition of a liability, this being: a liability is a present obligation of the entity to transfer an economic resource as a result of past events. Again, as with the proposed change to the definition of assets, the suggested change to the definition of liability could potentially have significant implications for financial reporting if it was ultimately incorporated within the revised conceptual framework. But whether the above proposed definition ultimately becomes part of the revised conceptual framework is a matter for debate.

Definition and recognition of expenses The definition of expenses is dependent upon the definitions given to assets and liabilities. The conceptual framework provides a definition for expenses. It states: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Therefore, unless we understand what assets and liabilities are, we will not be able to understand what an expense is. Expenses may be considered to be transactions or events that cause reductions in the net assets or equity of the reporting entity, other than those caused by distributions to the owners. The usual tests relating to ‘probability’ and ‘measurability’ apply—as they do to all elements of financial statements. In relation to expense recognition, the conceptual framework states:

expenses Defined in the AASB conceptual framework as ‘decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants’.

Expenses are recognised in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of equipment).

If a resource is used up or damaged by an entity but that entity does not control the resource—that is, it is not an asset of the entity—then to the extent that no liabilities or fines are imposed, no expenses will be recorded by the entity. For example, if an entity pollutes the environment but incurs no related fines, no expense will be acknowledged because ‘the environment’ is not controlled by the entity. This issue will be examined further later in this chapter. It is also addressed in Chapter 32.

Definition and recognition of income As with expenses, the definition of income is dependent upon the definitions given to assets and liabilities. The conceptual framework defines income as: increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Income can therefore be considered to relate to transactions or events that cause an increase in the net assets of the reporting entity, other than increases in net assets that arise as a result of owner contributions. Income can be recognised from normal trading relations, as well as from non-reciprocal transfers such as grants, donations, bequests or where liabilities are forgiven. Consistent with the recognition of all elements of financial statements, income is to be recognised when, and only when: (a) it is probable that the inflow or other enhancement or saving in outflows of future economic benefits has occurred; and (b) the inflow or other enhancement or saving in outflows of future economic benefits can be measured reliably.

income Defined by the AASB conceptual framework as ‘increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants’.

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Elaborating on the recognition of income, paragraph 4.47 of the conceptual framework states: Income is recognised in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities (for example, the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable). It should be noted that the conceptual framework currently draws a distinction between ‘revenues’ and ‘gains’. The category of ‘income’ consists of both revenues and gains. Under the conceptual framework, ‘revenue’ arises in the course of the ordinary activities of an entity and is referred to by a variety of different names, including sales, fees, interest, dividends, royalties and rent. ‘Gains’ represent other items that meet the definition of income and might, or might not, arise in the course of the ordinary activities of an enterprise. Gains include, for example, those arising on the disposal of non-current assets. Some measure of professional judgement will be involved in determining whether a component of income should be classified as ‘revenue’ or as a ‘gain’. Revenue is obviously a crucial number to users of the financial statements in assessing a reporting entity’s performance and prospects. The IASB and the FASB together initiated a joint project to clarify the principles for recognising revenue from ‘contracts with customers’. It applied to all contracts with customers except leases, financial instruments and insurance contracts. As part of the project, an Exposure Draft Revenue from Contracts with Customers was released in November 2011. This ultimately culminated in the release in 2014 of IFRS 15 Revenue from Contracts with Customers, which has the Australian equivalent of AASB 15. While this Accounting Standard is discussed in depth in Chapter 15 of this book, at this point we can summarise that the Accounting Standard incorporates the view that revenue recognition should be consistent with the conceptual framework guidance and should incorporate the notion of ‘control’. That is, 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—something that has been adopted in some accounting standards as the basis for determining whether revenue should be recognised). As paragraph 31 of AASB 15 states: an entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (ie an asset) to a customer. An asset is transferred when (or as) the customer obtains control of the asset. Therefore, an entity satisfies performance obligations, and recognises revenue, when the customer receives the promised goods and services. Revenue reflects the transfer of the goods and services to customers, and not the underlying activities of the entity in producing those goods and services. As with assets and liabilities (as previously discussed), the IASB intends to make changes to the definitions of income and expenses. The Exposure Draft released by the IASB in May 2015 provides the following definitions: Income is increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims. 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. These definitions do seem clearer than the current definitions and in themselves do not represent major changes from the current definitions. The major changes in income and expenses, however, relate to how the IASB has changed the definition of assets and liabilities. The IASB has also proposed that the discussion of income should no longer refer to revenue and gains, and the discussion of expenses should no longer refer equity to expenses and losses. Of course, whether the recommendations will subsequently be incorporated Residual interest in within the conceptual framework cannot be known with certainty. the assets of the entity after deduction of its liabilities. The residual interest is a claim or right to the net assets of the reporting entity.

Definition of equity Paragraph 49(c) of the IASB conceptual framework defines equity as ‘the residual interest in the assets of the entity after deducting all its liabilities’. The residual interest is a claim or right to the net assets of the reporting entity. As a residual interest, equity ranks after liabilities in terms of a claim

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against the assets of a reporting entity. Consistent with the definitions of income and expenses, the definition of equity is directly a function of the definitions of assets and liabilities. Given that equity represents a residual interest in the assets of an entity, the amount disclosed as equity will correspond with the difference between the amounts assigned to assets and liabilities. As such, the criteria for the recognition of assets and liabilities, in turn, directly govern the recognition of equity. Therefore, there is no need for a separate recognition criterion for equity. The definition of equity is not expected to change when a revised conceptual framework is released.

Measurement principles

LO 2.11

Conceptual frameworks have tended to provide very limited prescription in relation to measurement issues. Assets and liabilities are often measured in a variety of ways depending upon the class of assets or liabilities being considered and, given the way income and expenses are defined—which relies upon measures attributed to assets and liabilities—then, this has direct implications for reported profits. For example, liabilities are frequently recorded at present value, face value or on some other basis, depending upon the type of liability in question. Assets are measured in various ways—for example, inventory is to be measured at the lower of cost and net realisable value; some noncurrent assets such as property, plant and equipment can be measured at historical cost less accumulated depreciation or can also be measured at fair value; while other assets such as financial assets are to be measured at fair value. The multiplicity of measurement principles currently in use has resulted in us using what is often referred to as a ‘mixed attribute accounting model’. This is despite the efforts of many accounting standard-setters and accounting researchers who, over the years, have argued that it would be more conceptually sound for a single basis of measurement to be applied—for example, measuring all assets based on fair values. Measurement questions or issues appeared to represent a stumbling block in the development of the FASB conceptual framework. While the FASB framework was initially promoted as being prescriptive, when SFAC 5 was issued in 1984 the FASB appeared to sidestep the difficult measurement issues, with the statement ending up merely describing various approaches to measuring the elements of accounting. SFAC 5 notes that generally five alternative measurement bases are applied in practice: historical cost, current replacement cost, current market value, net realisable value and present value. A descriptive approach such as this was generally considered to represent a ‘cop-out’ on the part of the FASB (Solomons 1986). The IASB conceptual framework explicitly recognises the same variety of acceptable measurement bases as the FASB framework, with the exception of current market value (which could be regarded as comprising elements of current replacement cost and net realisable (sale) value). As we know, the IASB and the FASB were engaged in joint efforts to develop a new, refined conceptual framework. In relation to measurement, the FASB and IASB (2005, p. 12) stated: Measurement is one of the most underdeveloped areas of the two frameworks .  .  . Both frameworks (the IASB and FASB Frameworks) contain lists of measurement attributes used in practice. The lists are broadly consistent, comprising historical cost, current cost, gross or net realizable (settlement) value, current market value, and present value of expected future cash flows. Both frameworks indicate that use of different measurement attributes is expected to continue. However, neither provides guidance on how to choose between the listed measurement attributes or consider other theoretical possibilities. In other words, the frameworks lack fully developed measurement concepts . . . The long-standing unresolved controversy about which measurement attribute to adopt—particularly between historical-price and current-price measures— and the unresolved puzzle of unit of account are likely to make measurement one of the most challenging parts of this project. At present, assets and liabilities are measured in a variety of ways, depending on the class of assets or liabilities being considered. In relation to assets, there are various ways in which these can be measured—on the basis of historical costs, current replacement costs, current selling prices, present value and so forth. When the IASB released its Discussion Paper–A Review of the Conceptual Framework for Financial Reporting in July 2013, it defined ‘measurement’ as (p. 106): the process of determining the amounts to be included in the financial statements. The term ‘measures’ refers to the amounts presented or disclosed. CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  73

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In relation to its current thinking, IASB (2013, p. 112) stated: Consideration of the objective of financial reporting, and of the qualitative characteristics of useful financial information, has led the IASB to the following preliminary views about measurement: (a) the objective of measurement is to contribute to the faithful representation of relevant information about the resources of the entity, claims against the entity and changes in resources and claims, and about how efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s resources (b) a single measurement basis for all assets and liabilities may not provide the most relevant information for users of financial statements (c) when selecting the measurement to use for a particular item, the IASB should consider what information that measurement will produce in both the statement of financial position and the statement(s) of profit or loss and other comprehensive income (d) the selection of a measurement: (i) for a particular asset should depend on how that asset contributes to future cash flows; and (ii) for a particular liability should depend on how the entity will settle or fulfil that liability (e) the number of different measurements used should be the smallest number necessary to provide relevant information. Unnecessary measurement changes should be avoided and necessary measurement changes should be explained (f) the benefits of a particular measurement to users of financial statements need to be sufficient to justify the cost. When the IASB released its Exposure Draft of the Conceptual Framework for Financial Reporting in May 2015 it defined measurement as: the process of quantifying, in monetary terms, information about an entity’s assets, liabilities, equity, income and expenses. A measure is the result of measuring an asset, a liability, equity or an item of income or expense on a specified measurement basis. A measurement basis is an identified feature of an item being measured (for example, historical cost, fair value or fulfilment value). Applying a measurement basis to an asset or a liability creates a measure for that asset or liability and for any related income or expense. The Exposure Draft grouped measurement bases into two broad categories, these being: (a) historical cost; or (b) current value. In terms of the factors to consider when selecting a measurement basis, the Exposure Draft noted: For information provided by a particular measurement basis to be useful to the users of financial statements, it must be relevant and it must faithfully represent what it purports to represent. In addition, the information provided should, as far as possible, be comparable, verifiable, timely and understandable. As with all other areas of financial reporting, cost constrains the selection of a measurement basis. Hence, the benefits of the information provided to the users of financial statements by a particular measurement basis must be sufficient to justify the cost of providing that information. Again, as with the definitions of the elements of accounting, the IASB’s ultimate decisions in relation to measurement has the potential to have major implications for the reported financial performance and financial position of reporting entities.

LO 2.13

A critical review of conceptual frameworks

Having reviewed some of the documents that comprise the conceptual framework together with information about current efforts being undertaken by the IASB to develop an improved conceptual framework, it would be useful to consider criticisms of conceptual frameworks in general. Of course, there will be many parties who disagree with the points that follow. You will need to consider the merits of the respective arguments. Some of the criticisms raised relate to the fundamental objectives of conceptual frameworks. As we know, according to the IASB conceptual framework, the objective of general purpose financial reporting is to ‘provide financial information 74  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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about the reporting entity that is useful to existing and potential equity investors, lenders and other creditors in making decisions about providing resources to the entity’. From this, it can perhaps be concluded that annual reports presented by corporations—and these reports would incorporate general purpose financial statements—should be primarily economic in focus. Does this mean that social and environmental issues—such as an organisation’s safety record, environmental performance, employee training programs and the like—should not be included in the annual report? If this is the position taken by those responsible for formulating the contents of a conceptual framework, it would appear to be inconsistent with the views espoused by many accounting academics (for example, Rubenstein 1992; Gray & Bebbington 2001; Gray, Adams & Owen 2014). The dissenting view is that organisations should be accountable for both their economic and their social and environmental performance. Perhaps those responsible for developing the IASB conceptual framework believe that evidence of social and environmental accountability is either not necessary, or perhaps can best be provided in places other than general purpose financial statements. There are many philosophical positions taken in relation to the general/overall responsibilities of business. The view of famous economist Milton Friedman—perhaps an extreme one—is that: there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud. (1962, reported in Mathews 1993, p. 10) An individual’s view of a business’s responsibilities directly impacts on his or her perceptions of business accountability. Those responsible for developing the conceptual framework do appear to take a restricted view of the accountabilities of business (with the primary audience being identified as existing and potential investors, lenders and other creditors)— which is perhaps not too different from the perspective that might have been adopted by Friedman. The Corporate Report (issued in 1975 by the Accounting Standards Steering Committee of the Institute of Chartered Accountants in England and Wales) provides what appears to be a much broader view of the objectives of general purpose financial reporting and of who should be perceived as a user of financial statements. The report states in paragraph 25: The public’s right to information arises not from a direct financial or human relationship with the reporting entity but from the general role played in our society by economic entities. Such organisations, which exist with the general consent of the community, are afforded special legal and operational privileges, they compete for resources of manpower, materials and energy and they make use of community owned assets such as roads and harbours. Being principally economic in focus, general purpose financial statements typically ignore transactions or events that have not involved market transactions or an exchange of property rights. That is, transactions or events that cannot be linked to a ‘cost’ or a ‘market price’ are not recognised. For example, a great deal of recent literature has been critical of traditional financial accounting for its failure to recognise the damage to the environment caused by business (Gray, Adams & Owen 2014; Deegan 2013). Let us consider a fairly extreme example. Applying generally accepted accounting principles (GAAP), if the environmental consequences of a business’s operations were such that they led to a major reduction in local water quality—thereby killing all local sea creatures and coastal vegetation—reported profits would not be directly affected unless fines or other related cash flows were incurred. That is, no externalities would be recognised, and the reported assets/profits of the organisation would not be conventional financial affected. This is because the waterways are not controlled by the entity (and remember, according reporting practices to the conceptual framework’s definition of assets, control must be established before something is Represented by deemed to be an asset of an entity), and therefore their use (or abuse) is not recorded by financial the set of generally accounting systems. Adopting conventional financial reporting practices, consistent with the accepted accounting principles in place at a conceptual framework, the performance of such a polluting organisation could, depending upon the point in time. They rely financial transactions undertaken, be portrayed as being very successful. In this regard, the view of heavily on historicalGray and Bebbington (1992, p. 6) is that: there is something profoundly wrong about a system of measurement, a system that makes things visible and which guides corporate and national decisions that can signal success in the midst of desecration and destruction.

cost accounting and associated doctrines, such as the doctrine of conservatism.

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What must be borne in mind by the users of general purpose financial statements, however, is that the financial information included within the financial statements reflects only the financial performance of the entity as determined by applying the rules incorporated within relevant accounting standards: they do not provide a means of assessing the social or environmental performance of the entity. This in itself is seen by a number of accounting researchers to be a fundamental limitation of financial accounting as typically used in practice. Following on from the above point, it has been argued that focusing on economic performance in itself further reinforces the importance of economic performance relative to various levels of social and environmental performance. Several writers such as Hines (1988) and Gray and Bebbington (2001) have argued that the accounting profession can play a big part in influencing what forms of social conduct are acceptable to the broader community. Accounting can both reflect and construct social expectations. For example, if profits and associated financial data are promoted as the best measure of organisational success, it could be argued that both the organisation and the community will focus on activities that affect this measure. If accountants embrace other types of performance indicators, including those that relate to the environment and to social factors, this might, conceivably, raise people’s expectations about organisational performance. Nevertheless, at present, profitability as determined by the application of the accounting system is typically used as a guide to an organisation’s success. A review of the financial press indicates that they, too, generally use financial performance indicators as a guide to the success and health of an organisation. For example, the respected daily financial paper The Australian Financial Review each day reports Australian listed companies’ earnings per share, price–earnings ratio and net asset backing per share. It also generally provides some commentary when there are unexpected or major shifts in these indicators. Having said this about financial performance indicators, it must be acknowledged that many organisations do provide voluntary social and environmental disclosures in their annual reports, or in stand-alone corporate social responsibility or sustainability reports. This practice of reporting will be considered in greater depth in Chapter 30. Another criticism of conceptual frameworks for accounting is that they represent simply a codification of existing practice (Hines 1989), putting in place a series of documents that describe existing practice rather than prescribing an ‘ideal’ or logically derived approach to accounting. If the conceptual framework is considered to represent a codification of GAAPs, can such principles logically be used as a rationale for selecting between alternative accounting methods? Perhaps not. In this regard, it would be interesting to see how different from existing practices full-cost method any conceptual framework chapters pertaining to measurement issues might be (we currently do not In relation to the have one), and whether they would prescribe fundamental changes to current generally accepted extractive industries, this method of accounting procedures (GAAPs). History seems to indicate that proposals for major shifts in current accounting requires practices are unlikely to succeed. Hines (1989, p. 79) argues that accounting regulations, as generated all exploration and by the accounting regulators, are no more than the residue of a political process. evaluation costs An interesting case in point is the US experience in relation to accounting for the extractive incurred by an entity industries. In the USA, firms involved in the extractive industries were permitted to use two alternative to be matched against methods to account for their pre-production costs—the full-cost method and the successful-efforts revenue from the total economically method. In July 1977, the Financial Accounting Standards Board (FASB) in the USA released an recoverable reserves Exposure Draft that recommended that only the successful-efforts method be used. Ultimately this discovered by the became the requirement of Accounting Standard SFAS 19, which was issued in December 1977. entity across all sites. However, this requirement represented a major departure from the practice that existed at the time, as many organisations were using the full-cost method. Following much lobbying and debate, a revised standard was issued by the Securities and Exchange Commission that took precedence over SFAS 19. The new standard allowed organisations to use either the full-cost method or the successful-efforts method successful-efforts method—a return to the original and preferred position. Method of accounting As another example of how proposed significant changes to existing accounting practice will used in the extractive ultimately not be accepted, we can consider some of the events leading to the development of the industries under US Conceptual Framework Project. In 1961 and 1962, the Accounting Research Division of the which only costs American Institute of Certified Public Accountants (AICPA) commissioned studies by Moonitz, and resulting directly by Sprouse and Moonitz respectively. These researchers proposed that accounting measurement in the discovery of economically systems be changed from historical cost to a system based on current values. However, before the recoverable reserves release of the Sprouse and Moonitz study, the Accounting Principles Board of the AICPA stated in are carried forward, all relation to this study and another Moonitz study that ‘while these studies are a valuable contribution others being written off to accounting principles, they are too radically different from generally accepted principles for as incurred. acceptance at this time’ (Statement by the Accounting Principles Board, AICPA, April 1962). 76  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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In 1963, the Accounting Principles Board (APB) commissioned Paul Grady to prepare yet another framework of accounting. It was published in 1965 and formed the basis of APB Statement No. 4, Basic Concepts and Accounting Principles Underlying the Financial Statements of Business Enterprises. In effect, APB Statement No. 4 reflected the GAAP of the time. Some years later in the United States, Miller and Reading (1986, p. 64) noted that: The mere discovery of a problem is not sufficient to assure that the FASB will undertake its solution . . . There must be a suitably high likelihood that the Board can resolve the issues in a manner that will be acceptable to the constituency—without some prior sense of the likelihood that the Board members will be able to reach a consensus, it is generally not advisable to undertake a formal project. The above argument suggests that conceptual frameworks and accounting standards are based primarily on the dominant accounting approaches in use at the time and that the development of accounting regulation is a political process, with unpopular accounting approaches failing to be approved. If we accept this, then, following Hines (1991), we may question whether general purpose financial statements can faithfully represent the activities of an organisation, or whether reports that follow the accepted framework can be free from bias—these qualitative characteristics (representational faithfulness and freedom from bias) are included in the IASB conceptual framework. It has been argued that conceptual frameworks have been used as devices to legitimise the ongoing existence of the accounting profession. It is argued that they provide a means of increasing the ability of a profession to self-regulate, thereby counteracting the possibility of government intervention. Hines (1991, p. 328) states: CFs presume, legitimise and reproduce the assumption of an objective world and as such they play a part in constituting the social world . . . CFs provide social legitimacy to the accounting profession. Since the objectivity assumption is the central premise of our society . . . a fundamental form of social power accrues to those who are able to trade on the objectivity assumption. Legitimacy is achieved by tapping into this central proposition because accounts generated around this proposition are perceived as ‘normal’. It is perhaps not surprising or anomalous then that CF projects continue to be undertaken which rely on information qualities such as ‘representational faithfulness’, ‘neutrality’, ‘reliability’, etc., which presume a concrete, objective world, even though past CFs have not succeeded in generating Accounting Standards which achieve these qualities. The very talk, predicated on the assumption of an objective world to which accountants have privileged access via their ‘measurement expertise’, serves to construct a perceived legitimacy for the profession’s power and autonomy. Hines (1989) suggests that conceptual frameworks have been developed when accounting professions have been under threat, and that they are a strategic manoeuvre to provide legitimacy to standard-setting bodies during periods of competition or threatened government intervention. In supporting her case, Hines refers to the work undertaken by the Canadian Institute of Chartered Accountants (CICA). CICA had done very little throughout the 1980s in relation to its Conceptual Framework Project. It had begun to develop a framework in about 1980, a period Hines claims was ‘a time of pressures for reform and criticisms of accounting standard-setting in Canada’ (1989, p. 88). However, interest waned until another Canadian professional accounting body, the Certified General Accountants Association, through its Accounting Standards Authority of Canada, started to develop a conceptual framework in 1986. This was deemed to represent a threat to CICA, ‘who were motivated into action’. Although the criticisms of conceptual frameworks as set out here are varied, the discussion consistently reflects the political dimensions of the accounting standard-setting process.

The conceptual framework as a normative theory of accounting

LO 2.14

As the following chapter explains, theories can be classified in a number of ways. One way of classifying theories is to label them either ‘positive’ or ‘normative’ theories. While the next chapter covers this issue in some depth, we can briefly point out here that a positive theory of accounting is a theory that seeks to explain and predict particular accounting practices. That is, a positive theory of accounting will provide explanations of some of the outcomes that might follow the release of a particular accounting requirement (such as an accounting standard), or perhaps predictions about which entities are likely to favour particular accounting methods or adopt particular accounting methods when there are alternatives. CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  77

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By contrast, a normative theory of accounting provides prescription about what accounting methods an organisation should adopt. Hence, the difference can be summarised by saying that a positive theory of accounting attempts to explain or predict accounting practice, whereas a normative theory of accounting prescribes a particular accounting practice. Conceptual frameworks can be classified as normative theories of accounting as they provide guidance (prescription) to people involved in preparing general purpose financial statements. The next chapter of this text—Chapter 3—provides an overview of various theories of accounting. A number of the theories to be described are positive theories that provide insight into the possible implications of the release of particular accounting regulations. For example, theories are discussed that provide insight into questions such as: • What motivates individuals to support and perhaps lobby regulators for certain accounting methods in preference to others? • What are the implications for particular types of organisations and their stakeholders if one method of accounting is chosen or mandated in preference to other methods? • How will particular stakeholder groups react to particular accounting information? The next chapter also considers factors that motivate organisations to make voluntary accounting disclosures (and all organisations make many voluntary disclosures in their annual report). Further, Chapter 3 reviews various normative theories on how various elements of accounting should be measured and provides insight into the question of whether there is a ‘true measure’ of income. The majority of financial accounting textbooks provide little or no discussion of various theories of accounting. While we acknowledge that the balance of this text could be studied without reading Chapter 3, we believe that a review of Chapter 3 will equip readers to place the impacts of financial accounting in perspective as opposed to merely learning how to apply the respective accounting standards. Accounting plays a very important—pervasive even—role within society and Chapter 3 provides important insight into this role. Ideally, readers should not only understand how to apply the rules embodied in various accounting standards, they should have some understanding of the possible consequences of standard-setters mandating particular requirements. Chapter 3 provides the basis for such an understanding.

SUMMARY In this chapter we considered the history of conceptual frameworks, and we learned that from 2005 Australia has adopted the conceptual framework that has been developed and released by the IASB. Initially, in 2005, we adopted the IASB Framework for the Preparation and Presentation of Financial Statements (which was initially released by the International Accounting Standards Committee in 1989). In 2010 the IASB released a revised framework, referred to as the IASB Conceptual Framework for Financial Reporting (which is effectively a work in progress with various chapters still to be added), and Australia thereafter adopted this framework in place of the previous IASB framework. Australia will also have to adopt further revisions to the conceptual framework that will subsequently be released by the IASB. We learned that the role of a conceptual framework includes identifying the scope and objectives of financial reporting; identifying the qualitative characteristics that financial information should possess; and defining the elements of accounting and their respective recognition criteria. A number of benefits of conceptual frameworks were identified, including accounting standards being more consistent and logical; more efficient development of accounting standards; accounting standard-setters being accountable for the content of accounting standards; and conceptual frameworks providing useful guidance in the absence of an accounting standard that deals with a specific transaction or event. The chapter discussed the concept of the ‘reporting entity’ and noted that if an organisation is deemed to be a reporting entity (which would be determined by whether people exist who rely upon general purpose financial statements for the purposes of decisions relating to the allocation of resources), then it is to release financial statements that comply with accounting standards. A number of qualitative characteristics were identified as being important in terms of financial information. Two fundamental qualitative characteristics were explained as being relevance and representational faithfulness. A further four ‘enhancing’ qualitative characteristics were identified, and these are comparability, verifiability, timeliness and understandability. The concept of materiality was also introduced and we learned that materiality is a threshold concept, which in turn assists a reporting entity to decide whether particular information needs to be separately disclosed. 78  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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The chapter discussed the five elements of accounting: assets, liabilities, income, expenses and equity. We learned that the definitions of income and expenses relied directly upon the definitions given to assets and liabilities. We also learned that the recognition criteria of the respective elements of accounting relied upon judgements about probability and measurability. We concluded the chapter with a critical analysis of conceptual frameworks.

KEY TERMS asset  66 conceptual framework  49 control (assets)  67 conventional financial reporting practices  75

equity  72 expenses  71 full-cost method  76 future economic benefits  66 income  71

liability  69 notes to the financial statements  70 reporting entity  55 successful-efforts method  76

END-OF-CHAPTER EXERCISES Once you have read this chapter you should be able to answer the following: 1. What is the difference in role between the IASB conceptual framework and accounting standards? LO 2.1, 2.2 2. What are the benefits that are generated as a result of having a conceptual framework? LO 2.2 3. What are the definition and recognition criteria of the five elements of accounting? LO 2.10 4. What is the difference between revenues and gains? LO 2.10 5. What ‘fundamental’ and ‘enhancing’ qualitative characteristics should financial information possess? LO 2.7 6. What role does ‘materiality’ have with respect to deciding whether particular financial information should be disclosed? LO 2.7

REVIEW QUESTIONS 1. What is a conceptual framework of accounting? LO 2.1 2. What is a general purpose financial statement? LO 2.5 3. What is a reporting entity, and what factors would you consider in determining whether an entity is a reporting entity? LO 2.6 4. What is the history of conceptual frameworks within Australia? LO 2.4 5. Do we need a conceptual framework in Australia? Why? LO 2.5, 2.6, 2.7, 2.13 6. What is the objective of having a conceptual framework? LO 2.2, 2.13 7. Should the general purpose financial statements of a company be compiled in a manner that is understandable to all investors? LO 2.8 8. What is the difference between revenues and gains and do you think it is useful to subdivide income into revenues and gains? Explain your answer. LO 2.10 9. What are the fundamental qualitative characteristics that financial accounting information should possess? LO 2.7 10. What is an enhancing qualitative characteristic, and what role do enhancing qualitative characteristics have relative to the role of fundamental qualitative characteristics? LO 2.7 11. What does it mean for financial information to be ‘representationally faithful’? LO 2.7 12. Who are the perceived recipients of general purpose financial statements and what knowledge of financial accounting are they presumed to have? LO 2.8 CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  79

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13. If directors of a large listed Australian company consider that the application of a particular accounting standard is not appropriate to their circumstances, what should they do? Do they have to comply with accounting standards? LO 2.9 14. What force of law does the conceptual framework have? LO 2.4 15. The IASB is currently revising the conceptual framework. Explain why any changes it makes in the definition of assets and liabilities will subsequently have implications for the profits of reporting entities. LO 2.12 16. What does a ‘qualitative characteristic’ mean as it relates to financial information? LO 2.7 17. Why don’t we need separate recognition criteria for equity? LO 2.10 18. Why is it preferable to have a well-developed conceptual framework prior to the development of accounting standards? LO 2.2 19. Define the elements and recognition criteria of financial statements as per the conceptual framework. LO 2.10 20. What do ‘probable’ and ‘measured reliability’ mean with respect to the recognition of the elements of financial accounting? LO 2.10 21. Define ‘relevance’ and ‘faithful representation’. Is there a trade-off between the two? LO 2.7 22. Identify and explain some of the perceived shortcomings of the conceptual framework. LO 2.12, 2.13 23. How would you determine whether an item is material? LO 2.7 24. What are the disclosure implications if an item is deemed to be material? LO 2.7

CHALLENGING QUESTIONS 25. Explain what material means, including how you determine whether an item is material. In doing so, you should consider the materiality of an item in terms of the statement of financial position, the statement of profit or loss and other comprehensive income and the statement of cash flows. LO 2.7 26. An organisation has received an interest-free loan from its parent company with no set repayment date. Should the ‘loan’ be disclosed as debt or as equity, and how should it be measured? LO 2.10 27. As at the end of the reporting period, Ripslash Ltd has gross assets of $4 million, total revenue of $11 million and 54 full-time employees who do not own shares in the organisation. Is Ripslash Ltd a reporting entity? LO 2.6 28. Possies Ltd considers that its most valuable asset is its employees—yet it has to leave them off the statement of financial position. Explain this situation. LO 2.10 29. Hines (1991) argues that conceptual frameworks ‘presume, legitimise and reproduce the assumption of an objective world and as such they play a part in constituting the social world . . . conceptual frameworks provide social legitimacy to the accounting profession’. Try to explain what she means. LO 2.1, 2.2, 2.13, 2.14 30. For each of the independent situations identified below, consider and conclude whether the entity is required by the Corporations Act to prepare financial statements and, if so, whether it is a ‘reporting entity’. You should also note the reporting implications of your decision. (a) ABC Pty Ltd is a small proprietary company. The shareholders are Mr and Mrs ABC, who also manage the company’s day-to-day operations. The company’s bankers, The Bank, receive monthly management accounts, budgeted cash-flow information, and the year-end statutory accounts. LO 2.6 (b) F Pty Ltd is a large company—one of only two in Australia—involved in the manufacture of widgets. Although the shares are tightly held—by family members—the company employs more than 200 staff. The company has a small number of major suppliers. The company’s sole banker receives the company’s statutory accounts under its borrowing agreement. LO 2.6 (c) E Trust is a private trust wherein up to a maximum of 30 members may deposit amounts to be invested in blue-chip equities. Members’ funds consist of units of $1 each. Quarterly reports are produced, which disclose the market value of the trust assets and the values of each member’s entitlements. LO 2.6 31. Do you believe that it is appropriate that we have a single, global set of accounting standards as well as one conceptual framework that has global applicability? Explain your answer. LO 2.13, 2.14 32. In a newspaper article that appeared in the Canberra Times on 4 May 2015 entitled ‘Serco unable to detain the red ink as $395 million loss posted’,  it was noted: Although the parent company injected an additional $100 million of equity late last year, Serco Australia reported net assets of only $32 million at year end. Its parent, Serco Group Pty Ltd, reported an even worse 80  PART 1: THE AUSTRALIAN ACCOUNTING ENVIRONMENT

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result, with a net loss of $490 million on revenues of $1.2 billion. Despite the injection of equity, Serco Group reported negative net assets of $43 million at the end of 2014. This means the Serco Group in Australia is technically insolvent as its liabilities exceed its assets by $43 million. Notwithstanding this result and the distress of negative net assets, Deloitte has not qualified the accounts or challenged management's assertion that the company's accounts are appropriately prepared on a going-concern basis.

REQUIRED



(a) Pursuant to the conceptual framework, are general purpose financial statements prepared on the assumption that the reporting entity is a going concern? Does this assumption appear reasonable given the evidence provided above? (b) If an entity is not considered to be a going concern, what implications does this have for how the financial statements should be prepared? LO 2.3, 2.5

33. In an article entitled ‘Unwieldy rules useless for investors’ that appeared in the Australian Financial Review on 6 February 2012 (by Agnes King), the following extract appeared. Read the extract and then answer the question that follows. Millions of dollars have been spent adopting international financial reporting standards to help investors make like-for-like comparisons between companies in global capital markets. But CFOs say they are useless and have driven financial disclosures to unmanageable levels. The criticism comes as the United States, the world’s largest capital market, decides whether to retire its domestic accounting standard (US GAAP) and adopt IFRS. “In seven years I never got one question from fund managers or investment analysts about IFRS adjustments,” former AXA head of finance Geoff Roberts said. “Investors . . . rely on investor reports and management briefings to understand companies’ numbers.” If analysts did delve into IFRS accounts, they would most probably misinterpret them, according to Wesfarmers finance director Terry Bowen. “Once you get into the notes you have to be technically trained. If you’re not, lot of it could be misleading,” Mr Bowen said. Commonwealth Bank chief financial officer David Craig said IFRS numbers were disregarded by investors because they could actually obscure an institution’s true position. You are required to explain which qualitative characteristics of financial reporting, as per the conceptual framework, do not, in the opinion of the above quoted individuals, appear to be satisfied by current reporting practices pursuant to IFRS. Also, you are required to consider whether the views are consistent with the view that corporate financial reports satisfy the central objective of financial reporting as identified in the Conceptual Framework. LO 2.5, 2.7, 2.8, 2.13

REFERENCES ACCOUNTING STANDARDS STEERING COMMITTEE, 1975, The Corporate Report, ICAEW, London. BOOTH, B., 2003, ‘The Conceptual Framework as a Coherent System for the Development of Accounting Standards’, Abacus, 39 (3), pp. 310–24. DEEGAN, C., 2013, ‘The accountant will have a central role in saving the planet . . . . really? A reflection on “green accounting and green eyeshades twenty years later”’, Critical Perspectives on Accounting, 24, pp. 448–58. FINANCIAL ACCOUNTING STANDARDS BOARD, 2006, Preliminary Views—Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information, FASB, Norwalk, CT. FINANCIAL ACCOUNTING STANDARDS BOARD and INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2005, Revisiting the Concepts: A New Conceptual Framework Project, Norwalk, USA: FASB. GRAY, R., ADAMS, C. & OWEN, D., 2014, Accountability, Social Responsibility and Sustainability,  Pearson Education, London. CHAPTER 2: THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING  81

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GRAY, R. & BEBBINGTON, J., 1992, ‘Can the Grey Men Go Green?’, Discussion Paper, Centre for Social and Environmental Accounting Research, The University of Dundee. GRAY, R. & BEBBINGTON, J., 2001, Accounting for the Environment, Sage Publications Ltd, London. HINES, R.D., 1988, ‘Financial Accounting in Communicating Reality: We Construct Reality’, Accounting, Organizations and Society, vol. 13, no. 3, pp. 251–61. HINES, R.D., 1989, ‘Financial Accounting Knowledge, Conceptual Framework Projects and the Social Construction of the Accounting Profession’, Accounting, Auditing and Accountability Journal, vol. 2, no. 2, pp. 72–92. HINES, R.D., 1991, ‘The FASB’s Conceptual Framework: Financial Accounting and the Maintenance of the Social World’, Accounting Organizations and Society, vol. 16, no. 4, pp. 313–31. HORNGREN, C.T., 1981, ‘Uses and Limitations of a Conceptual Framework’, Journal of Accountancy, April, pp. 86–95. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2008a, Exposure Draft of an Improved Conceptual Framework for Financial Reporting, IASB, London. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2008b, Discussion Paper—Preliminary Views on an Improved Conceptual Framework for Financial Reporting, IASB, London. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010, Exposure Draft ED2010/2: Conceptual Framework for Financial Reporting: The Reporting Entity, IASB, London, March. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010, Conceptual Framework for Financial Reporting, IASB, London, September. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2013, Discussion Paper DP/2013/1: A Review of the Conceptual Framework for Financial Reporting, IASB, London, September. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2015, IASB Staff Paper: Effect of Board Redeliberations on DP: A Review of the Conceptual Framework for Financial Reporting, IASB, London, September. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2015, Exposure Draft ED/2-15/3 Conceptual Framework for Financial Reporting, IASB, London, September. LOFTUS, J.A., 2003, ‘The CF and Accounting Standards: The Persistence of Discrepancies’, Abacus, 39 (3), pp. 298–309. MATHEWS, M.R., 1993, Socially Responsible Accounting, Chapman and Hall, London. MCGREGOR, W., 1990, ‘The Conceptual Framework for General-purpose Financial Reporting: Its Nature and Implications’, Charter, vol. 61, no. 11, December, pp. 48–51. MILLER, P.B.W. & READING, R., 1986, The FASB: The People, the Process, and the Politics, Irwin, Illinois. MOONITZ, M., 1961, ‘The Basic Postulates of Accounting’, Accounting Research Study No.1, American Institute of Certified Public Accountants, New York. RUBENSTEIN, D.B., 1992, ‘Bridging the Gap Between Green Accounting and Blank Ink’, Accounting Organizations and Society, vol. 17, no. 5, pp. 501–8. SOLOMONS, D., 1986, ‘The FASB’s Conceptual Framework: An Evaluation’, Journal of Accountancy, 161 (6), pp. 114–24. SPROUSE, R. & MOONITZ, M., 1962, ‘A Tentative Set of Broad Accounting Principles for Business Enterprises’, Accounting Research Study No.3, American Institute of Certified Public Accountants, New York. WATTS, R.L. & ZIMMERMAN, J.L., 1986, Positive Accounting Theory, Prentice Hall, Englewood Cliffs, NJ. WELLS, M., 2003, ‘Forum: The Accounting Conceptual Framework’, Abacus, 39 (3), pp. 273–8.

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PART 2

THEORIES OF ACCOUNTING CHAPTER 3

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CHAPTER 3

THEORIES OF FINANCIAL ACCOUNTING LEARNING OBJECTIVES (LO) 3.1

Understand what constitutes a ‘theory’ and appreciate why students of financial accounting should know about various theories of accounting.

3.2

Be able to describe various normative and positive theories of financial accounting.

3.3

Appreciate that there is no single unified ‘theory of accounting’.

3.4

Understand what constitutes an ‘agency relationship’ and be aware of the major aspects of ‘agency theory’.

3.5

Understand the central tenets of Positive Accounting Theory.

3.6

Understand that from a Positive Accounting Theory perspective, accounting-based measures are often used to resolve conflicts between managers and owners, and managers and debtholders.

3.7

Understand the various pressures and motivations that might have an effect on the accounting methods selected by an organisation.

3.8

Understand that, pursuant to Positive Accounting Theory, the choice of alternative accounting methods can often be explained from either an ‘efficiency perspective’ or an ‘opportunistic perspective’.

3.9

Understand the meaning of ‘political costs’ and how the choice of particular accounting methods might be used as a strategy to reduce political costs.

3.10 Understand what is meant by ‘creative accounting’ and why it might occur. 3.11 Be aware of some normative theories of accounting. 3.12 Know what a ‘systems-based theory’ is and understand the basic tenets of Stakeholder Theory, Legitimacy Theory and Institutional Theory as they can be applied to explaining particular accounting disclosures. 3.13 Understand that there are theories which explain why regulation—such as accounting regulation— is introduced and understand the basic tenets of Public Interest Theory, Capture Theory and the Economic Interest Group Theory of regulation.

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Introduction to theories of financial accounting In the previous two chapters we discussed the bodies responsible for regulating general purpose financial reporting within Australia. We also discussed the IASB conceptual framework and the current activities being undertaken to revise the conceptual framework. As will be demonstrated in this chapter, a conceptual framework can be described as a normative theory of accounting. It prescribes, within a particular framework, the objectives and the qualitative characteristics that financial information should possess if it is to fulfil the objectives (as defined within the framework) of general purpose financial reporting. In this chapter we explore some of the many theories—in addition to conceptual frameworks—that relate to financial accounting. We will see that different accounting theories have different objectives. For example, we will discuss theories that seek to: • explain and predict which accounting methods or approaches management is likely to select when it has alternatives from which to choose (these theories are commonly referred to as positive theories) • prescribe which accounting methods should be used in particular circumstances (these theories are commonly referred to as normative theories, the conceptual framework being an example of a normative theory) • explain how or why accounting regulation is developed (with some theories arguing that accounting regulation is developed in the ‘public interest’ and other economics-based theories promoting the view that accounting regulation is introduced to serve the interests of some parties at the expense of the interests of others). The theory overview in this chapter will provide readers with knowledge of some of the various accounting theories that have been developed. For more detailed coverage, refer to specialised texts devoted entirely to accounting theory, a number of which are listed under ‘Further reading’ at the end of the chapter. In this chapter, we will demonstrate that in the decade or so leading up to the 1970s the notable accounting theories being developed were predominantly normative in nature; that is, they identified what accounting techniques and methods should be applied by reporting entities. Reflecting the higher inflation rates of the time, most of these normative theories were concerned with providing guidelines on how to account for assets and expenses in times of rising prices. The attention of many accounting researchers continues to focus on the development of normative theories of accounting, such as the conceptual framework. However, in the 1970s a number of accounting researchers developed a theory of accounting known as Positive Accounting Theory, which seeks to explain and predict the selection of particular accounting policies and their impact, rather than prescribing what should be done. Positive Accounting Theory therefore has a different emphasis from normative accounting theories. After reading this chapter, you will realise that, among accounting researchers, there is a great deal of disagreement on the role of accounting and of accounting theory; for example, some people argue that theory should explain practice, while others argue it should direct, improve or guide practice (and some people think it should do both). These contrasting types of theories have generated considerable debate within the accounting literature, and this debate is ongoing.

Why discuss theories in a book such as this?

LO 3.1

The study of financial accounting can be approached in a number of different ways. One approach adopted LO 3.3 in many financial accounting textbooks is for the authors to provide an explanation of the rules incorporated within particular financial accounting standards and then illustrate how to apply these rules. That is, a number of texts are predominantly procedural in nature, failing to reflect any deeper thinking about the impact of particular accounting standards and other pronouncements. For example, many financial accounting textbooks elect not to discuss how readers of financial statements might react to the disclosures required by the standards; whether newly mandated disclosures will have positive or negative effects on the organisation; how particular stakeholders affect the disclosure decisions of organisations; and how particular accounting disclosures will influence an organisation’s relationships with other parties within society. In contrast with such texts, the author of this book believes that not only is it useful to discuss the requirements of the various accounting standards—as we do in depth in the following chapters—but that it is important to provide frameworks—as we do in this chapter—within which to consider the implications of organisations making particular accounting disclosures, whether voluntarily or as a result of a particular mandate. We also think it is useful to consider the various pressures, many of which are political in nature, that influence the accounting standardsetting environment. Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  85

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Of course, the balance of the material in this book could be studied without reading this chapter. However, because the impact of financial accounting resonates throughout society, we believe this chapter provides readers with the necessary background to understand the possible implications of an organisation making particular disclosures. The theories in this chapter also provide the basis for understanding the various pressures that drive organisations to make particular disclosures, even in the absence of disclosure requirements pertaining to particular transactions and events. By reading this chapter, together with the material in other chapters of this book, we believe that readers will gain a greater understanding of the broader implications of various accounting standards and other disclosure requirements.

LO 3.1 LO 3.2

Definition of theory

Before we consider some of the theories of accounting, it might be useful to discuss what we mean by a theory. There is no one definitive meaning of the term ‘theory’. The Macquarie Dictionary provides a useful definition: ‘a coherent group of propositions used as principles of explanation for a class of phenomena’. The accounting researcher Hendriksen (1970, p.1) defines a theory as ‘a coherent set of theory Coherent set hypothetical, conceptual and pragmatic principles forming the general framework of reference for of hypothetical, a field of inquiry’. conceptual and Hendriksen’s definition is very similar to the US Financial Accounting Standards Board’s definition pragmatic principles of its Conceptual Framework Project, discussed in Chapter 1: ‘a coherent system of interrelated forming the frame of objectives and fundamentals that is expected to lead to consistent standards’. reference for a field of It is generally accepted that a ‘theory’ is much more than simply an idea, or a ‘hunch’, which inquiry. is how the term is used in some contexts (for instance, we often hear people say that they have a ‘theory’ about why something might have occurred when they mean they have a ‘hunch’). Accounting theories typically either explain and/or predict accounting practice, or they prescribe specific accounting practice. As indicated above, such theories are typically referred to as positive and normative theories respectively. According to Henderson, Peirson & Brown (1992, p. 326): A positive theory begins with some assumption(s) and, through logical deduction, enables some prediction(s) to be made about the way things will be. If the prediction is sufficiently accurate when tested against observations of reality, then the story is regarded as having provided an explanation of why things are as they are. For example, in climatology, a positive theory of rainfall may yield a prediction that, if certain conditions are met, then heavy rainfall will be observed. In economics, a positive theory of prices may yield a prediction that, if certain conditions are met, then rapidly rising prices will be observed. Similarly, a positive theory of accounting may yield a prediction that, if certain conditions are met, then particular accounting practices will be observed. Because positive theories seek to explain and predict particular phenomena, they are often developed and supported on the basis of observations (that is, they are empirically based). The view is that by making numerous observations we will be better placed to predict what will happen in the future (for example, we might study many managers within a particular industry to predict what accounting methods they will select in particular circumstances). By contrast, normative theories are sometimes referred to as prescriptive theories, because they seek to inform others about particular practices that should be followed to achieve particular outcomes. For example, a normative accounting theory might, given certain key assumptions about the nature and objective of accounting, prescribe how assets should be measured for financial statement purposes. The prescriptions about what should be done might represent significant departures from current accounting practice (for example, for many years Raymond Chambers promoted a theory of accounting that prescribed that assets should be measured at market value—at a time when entities were predominantly using historical cost). Therefore, it is not appropriate to assess the validity, or otherwise, of a normative theory on the basis of whether entities are actually using one method or another, although this is a common method of evaluating or testing a positive theory. A normative theory might prescribe a radical departure from current practice. The dichotomy of positive and normative accounting theory provides a useful basis for the following discussion.

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Positive Accounting Theory The name Positive Accounting Theory can in itself cause confusion. A positive theory is a theory that explains and predicts a particular phenomenon. Positive Accounting Theory (PAT) seeks to explain and predict accounting practice. It does not seek to prescribe particular actions. Watts and Zimmerman (1986, p. 7) state: [PAT] is concerned with explaining [accounting] practice. It is designed to explain and predict which firms will and which firms will not use a particular [accounting] method . . . but it says nothing as to which method a firm should use.

LO 3.2 LO 3.3 LO 3.4 LO 3.5 LO 3.6 LO 3.7 LO 3.8 LO 3.9

According to Watts (1995, p. 334), the use of the term ‘positive research’ was popularised in Positive Accounting economics by Friedman (1953) and was used to distinguish research that sought to explain and Theory (PAT) predict from research that aimed to provide prescription. Positive Accounting Theory, the theory Seeks to explain and that was popularised by Watts and Zimmerman, is one of several positive theories of accounting. predict accounting Legitimacy Theory, Institutional Theory and Stakeholder Theory, all discussed in this chapter, are practice. other examples of positive theories. These other positive theories are not grounded in classical economics theory, as is the case with Positive Accounting Theory. We can refer to the general class of theories that attempts to explain and predict accounting practice in lower-case letters (that is, as positive theories of accounting), and we can refer to Watts and Zimmerman’s particular positive theory of accounting as Positive Accounting Theory (that is, with initial letters in upper case). Hence, while it might be confusing, we must remember that Watts and Zimmerman’s Positive Accounting Theory is one specific example of a positive theory of accounting. This confusion might not have arisen had Watts and Zimmerman elected to adopt a different name (or ‘trademark’) for their particular theory. According to Watts and Zimmerman (1990, p. 148): We adopted the label ‘positive’ from economics where it was used to distinguish research aimed at explanation and prediction from research whose objective was prescription. Given the connotation already attached to the term in economics we thought it would be useful in distinguishing accounting research aimed at understanding accounting from research directed at generating prescriptions . . . The phrase ‘positive’ created a trademark and like all trademarks it conveys information. ‘Coke’, ‘Kodak’, ‘Levis’ convey information. Normative accounting theorists have criticised PAT because it does not provide practitioners with guidance, even though it does attempt to explain the possible economic implications of selecting particular accounting policies. PAT focuses on the relationships between the various individuals involved in providing resources to an organisation. This could be the relationship between the owners (as suppliers of equity capital) and the managers (as suppliers of managerial labour), or between the managers and the firm’s debt providers. Many agency relationship relationships involve the delegation of decision making from one party (the principal) to another Involving the party (the agent): this is referred to as an agency relationship. The delegation of decision-making delegation of decision making from the authority can lead to a loss of efficiency and, consequently, increased costs. For example, if the principal to an agent. owner (the principal) delegates decision-making authority to a manager (the agent), it is possible that the manager will not work as hard as the owner would, given that the manager does not share directly in the results of the organisation. Any loss of profits brought about because the manager underperforms is considered to be a cost of decision-making delegation within this agency relationship—an agency cost. The agency costs that arise as a result of delegating decision-making authority from the owner to the manager are referred to in PAT as agency costs of equity. PAT investigates how particular contractual arrangements, many based on accounting numbers, can be put in place to minimise agency costs. One of the most frequently cited expositions of PAT is provided in Watts and Zimmerman (1978). In developing PAT, Watts and Zimmerman relied heavily upon the work of a number of other authors, notably Jensen and Meckling (1976) and Gordon (1964). PAT, developed by Watts and Zimmerman and others, is based significantly on particular assumptions and methods used in the economics literature and, in particular, on the central assumptions of economics that all individual action is driven by self-interest and that individuals will act in an opportunistic manner to increase their wealth. Notions of loyalty and morality are not incorporated within the theory (nor, typically, in many other accounting theories). Organisations are considered collections of self-interested individuals who have agreed to cooperate. Such cooperation does not mean

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that they have abandoned self-interest as an objective; rather it means only that they have entered into contracts that provide sufficient incentives to gain their cooperation. Given the assumption (again, borrowed from economics literature) that self-interest drives individual actions—an assumption that is disdained by many accounting researchers, as will be indicated later in this chapter—PAT predicts that organisations will seek to put in place mechanisms that align the interests of the managers of the firm (the agents) with the interests of the owners of the firm (the principals). As we will see, some of these methods of aligning interests will be based on the output of the accounting system, such as providing the manager with a share of the organisation’s profits. Hence the theory’s direct application to explaining particular accounting practices. Where such accounting-based alignment mechanisms are in place, financial statements will need to be produced. Managers are required to bond themselves to prepare these financial statements. This is costly in itself and under PAT would be referred to as a bonding cost. If we assume that managers (agents) will be responsible for preparing the financial statements, PAT would also predict that there would be a demand for those statements to be audited or monitored. Otherwise, assuming selfinterest, agents would attempt to overstate profits, thereby increasing their absolute share of profits. In PAT, the cost of undertaking an audit is referred to as a monitoring cost. monitoring cost Various bonding and monitoring costs might be incurred to address the agency problems Cost incurred monitoring the that arise within an organisation. If it was assumed, contrary to the assumption of ‘self-interest’ performance of others. employed by PAT, that individuals always worked for the benefit of their employer, there would be less demand for such activities—other than, perhaps, to review the efficiency with which managers operate businesses. As PAT assumes that not all the opportunistic actions of agents can be controlled by contractual arrangements or otherwise, there will always be some residual costs associated with appointing an agent (known as residual loss).

Efficiency and opportunistic perspectives of PAT Research that applies PAT typically adopts either an efficiency perspective or an opportunistic perspective. From the efficiency perspective, researchers explain how various contracting mechanisms can be put in place to minimise the agency costs of the firm—that is the costs associated with assigning decision-making processes to an agent. The efficiency perspective is often referred to as an ex ante perspective—ex ante meaning ‘before the fact’—as it considers what mechanisms are introduced up front with the objective of minimising future agency costs. For example, many organisations in Australia and elsewhere voluntarily prepared publicly available financial statements before regulation compelled them to do so. These financial statements were also frequently subject to audit even though there was no statutory requirement to do so (Morris 1984). Researchers such as Jensen and Meckling (1976) argue that the practice of providing audited financial statements leads to real cost savings as it enables organisations to attract funds at lower costs (in other words, it is an efficient use of resources to prepare financial statements and have them audited). As a result of the audit, external parties have reliable information about the resources of the organisation, which is thus perceived to be able to attract funds at a lower cost than would otherwise be possible. This is because, in the absence of information, it would be difficult to assess the ongoing ‘health’ of an investment in an entity, and this inability to monitor performance would increase the risk associated with an investment. With higher risk, the entity’s cost of attracting capital would increase. Providing ‘credible’ information will arguably lead to a decrease in risk, and a consequent decrease in the costs of attracting capital to the entity. Within the efficiency (ex ante) perspective of PAT, it is also argued that the accounting practices adopted by firms are often explained on the basis that such methods best reflect the underlying financial performance of the entity. Different organisational characteristics are used to explain why different firms adopt different accounting methods. For example, the selection of a particular asset depreciation rule from among many alternative approaches is explained by the fact that it best reflects the underlying use of the asset. Firms that have different patterns of use in relation to an asset are predicted to adopt different amortisation policies. By providing measures of performance that best reflect the underlying performance of the firm, it is argued that investors and other parties will not need to gather additional information from other sources. This will lead to cost savings. As an illustration of research that adopts an efficiency perspective, Whittred (1987) sought to explain why firms voluntarily prepared publicly available consolidated financial statements in a period when there was no regulation requiring them to do so. (Consolidated financial statements are constructed by aggregating the financial statements of numerous organisations within a group of entities where the group comprises a parent entity and its controlled entities.) Whittred found that when companies borrowed funds, security for repayment of the debt often took the form of guarantees provided by entities within the group of organisations. Consolidated financial statements were described as being a more efficient means 88  PART 2: THEORIES OF ACCOUNTING

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of providing information about the group’s ability to borrow and repay debts than providing lenders with separate financial statements for each entity within the group. If it is assumed, consistent with the efficiency perspective, that firms adopt particular accounting methods because they best reflect the underlying performance of the entity, then it is often argued by PAT theorists that the regulation of financial accounting imposes unwarranted costs on reporting entities. For example, if a new accounting standard is released that bans an accounting method being used by a particular organisation, then this could lead to inefficiencies as the resulting financial statements will no longer provide the best reflection of the performance of the organisation. This in itself is believed likely to lead to an increase in the firm’s costs, because if an organisation is no longer able to provide information that best reflects its financial position and performance, this increases the risks of investors and debt providers, who consequently will demand a higher rate of return. Many PAT theorists would argue that management is best able to select which accounting methods are appropriate in given circumstances, and government should not intervene in the process (an anti-regulation argument). Such theorists oppose a ‘one-size-fits-all’ approach to accounting regulation, in which particular accounting standards are required to be used by all reporting entities even though the nature of their operations, financial structure and products might be greatly different. The opportunistic perspective of PAT, on the other hand, takes as given the negotiated contractual arrangements of the firm and seeks to explain and predict certain opportunistic behaviours that will subsequently occur. The opportunistic perspective is often referred to as an ex post perspective—ex post meaning ‘after the fact’—because it considers opportunistic actions that could be taken once various contractual arrangements have been put in place. For example, in an endeavour to minimise agency costs (an efficiency perspective), a contractual arrangement might be negotiated that provides managers with a bonus based on the profits generated by the entity (for example, a manager might be given a bonus that is 5 per cent of reported profits). This will act to align the interests of the managers with the interests of the owners as both parties would likely prosper from increasing profits. Once the contractual arrangement is in place, however, the manager could opportunistically elect to adopt particular accounting methods that increase accounting profits and therefore the size of any bonus (an opportunistic perspective). For example, managers might elect to adopt a particular depreciation method that increases income even though it might not reflect the actual use of the asset. It is assumed within PAT that managers will opportunistically select particular accounting methods whenever they believe this will lead to an increase in their personal wealth (remember, PAT assumes that all individuals are driven by self-interest). PAT assumes that principals (or owners) would predict a manager will be opportunistic. With this in mind principals often stipulate the accounting methods to be used for particular purposes. For example, a bonus plan agreement might stipulate that a particular depreciation method such as straight-line depreciation must be adopted to calculate income for the determination of a bonus. However, it is assumed to be too costly to stipulate in advance all accounting rules to be used in all circumstances. Hence, PAT proposes that there will always be scope for agents to opportunistically select particular accounting methods in preference to others. The following discussion addresses some of the various contractual arrangements that might exist between owners and managers, and between debt holders and managers, particularly contracts that are based on the output of the accounting system. Again, these contractual arrangements are assumed initially to be put in place to reduce the agency costs of the firm (the efficiency perspective). However, it is assumed by Positive Accounting theorists that once the arrangements are in place, parties will adopt manipulative strategies to generate the perquisite greatest economic benefits for themselves (the opportunistic perspective). consumption

Owner–manager contracting A manager who also owns a firm (an owner–manager) bears the costs associated with their own perquisite consumption, which could include consumption of the firm’s resources for private purposes—acquiring an overly expensive company car or luxurious offices or staying in overly expensive hotel accommodation—or the excessive generation and use of idle time. As the percentage of ownership held by the manager decreases, managers begin to bear less of the cost of their own perquisite consumption. The costs begin to be absorbed by the other owners of the firm. As noted previously, PAT adopts as a central assumption that all action taken by an individual is driven by self-interest, and that the major interest of all individuals is to maximise their own wealth. Such an assumption is often referred to as the rational economic person assumption. If all individuals are assumed to act in their own interests, owners would expect managers (their agents) to undertake activities that might not always be in the interests of the owners (the principals).

Consumption by employees of nonsalary benefits.

rational economic person assumption Assumption that all actions by individuals are driven by selfinterest, the prime interest being to maximise personal wealth.

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Further, because of their position within the firm, managers will have access to information that is not available to principals—a problem frequently referred to as information asymmetry—thus increasing the potential for managers to take actions that are beneficial to themselves at the expense of the owners. The costs of divergent behaviour that arises as a result of the agency relationship—that is the relationship between the principal and the agent appointed to perform duties on behalf of the principal—are, as indicated previously, referred to as agency costs (Jensen & Meckling 1976). It is assumed under PAT that principals expect their agents to undertake activities that might be advantageous to the agents but disadvantageous to the value of the firm (the opportunistic perspective). That is, principals assume that agents will be driven by self-interest. As a result, principals will price this into the amounts they are prepared to pay managers. That is, in the absence of controls to reduce the ability of managers to act opportunistically, principals expect such actions and, as a result, will pay their managers a lower salary. This lower salary compensates the principals for, or protects them from, the expected opportunistic behaviour of the agents/managers (often referred to as ‘price protection’). Managers, therefore, bear some of the agency costs of the opportunistic behaviours in which they might or might not engage. If it is expected that managers would derive greater satisfaction from additional salary than from the perquisites that they will be predicted to consume, managers might be better off if they are able to commit or bond themselves contractually to reducing their set of available actions, some of which would not be beneficial to owners. To receive greater remuneration, managers must be able to convince owners that they will work in the interests of owners. Of course, before agreeing to increase the amounts paid to managers, the owners of a firm would need to ensure that any contractual commitments could be monitored for compliance. Managers could potentially be rewarded:

information asymmetry Where some individuals have access to certain information that is not available to others.

• on a fixed basis, that is, given a fixed salary independent of performance; • on the basis of the results achieved; or • by way of a combination of the above two methods. If managers are rewarded purely on a fixed basis, then, assuming self-interest—a central tenet of PAT—they will not want to take great risks because they will not share in any potential gains. There will also be limited incentives for these managers to adopt strategies that increase the value of the firm—unlike equity owners, whose share of the firm might increase in value. Like debtholders, managers with a fixed claim want to protect their fixed income stream. Apart from rejecting risky projects, which might be beneficial to those with equity in the firm, the manager with a fixed income stream is also reluctant to take on optimum levels of debt, as the claims of the debtholders would compete with the manager’s own fixed income claim. Assuming self-interest drives the actions of managers, PAT theorists argue that it can be necessary to put in place remuneration schemes that reward managers in a way that is, at least in part, tied to the performance of the firm. This will be in the interests of managers as they will potentially receive greater rewards and will not have to bear the costs of perceived opportunistic behaviours (which might not have been engaged in anyway). If the performance of the firm improves, the rewards paid to managers increase correspondingly. Bonus schemes tied to the performance of the firm are put in place to align the interests of owners and managers. If the firm performs well, both parties will benefit. bonus scheme Where the manager receives a bonus that is tied to the performance of the organisation.

Bonus schemes generally

It is common for managers to be rewarded in terms of the profits of the firm, sales of the firm or return on assets; that is, their remuneration is based on the output of the accounting system (hence, depending upon the terms of the bonus scheme, a change in profits might directly affect a manager’s personal wealth). Table 3.1 provides a description of some of the accounting-based remuneration plans found to exist in Australia. It is also common for managers to be rewarded in terms of the market price of the firm’s shares. This might be through holding an equity interest in the firm or perhaps by receiving a cash bonus explicitly tied to movements in the market value of the firm’s securities.

Accounting-based bonus plans Given that the amounts paid to managers might be tied directly to accounting numbers—such as profits/sales/assets— any changes in the accounting methods being used by the organisation will affect the bonuses paid. Such changes can occur as a result of a new accounting standard being issued. For example, an article in CFO Magazine (April 2014, p. 8, entitled ‘Revenue Accounting Hits Loans, Bonuses’) notes how a new accounting standard issued by the IASB—IFRS 15 90  PART 2: THEORIES OF ACCOUNTING

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Table 3.1 Accountingbased management bonus plans

Accounting performance measures used in Australia Percentage of after-tax profits for the last year Percentage of after-tax profits after adjustment for dividends paid Percentage of pre-tax profits for the last year Percentage of division’s profit for the last year Percentage of division’s sales for the last year Percentage of the last year’s accounting rate of return on assets Percentage of division’s sales for the last year plus percentage of firm’s after-tax profits Percentage of division’s sales for the last year plus percentage of division’s pre-tax profits Percentage of division’s sales for the last two years plus percentage of the division’s pre-tax profit for the last two years Percentage of firm’s sales for the last year plus a percentage of firm’s after-tax profit Average of pre-tax profit for last two years Average of pre-tax profit for last three years Percentage of the last six months’ profit after tax SOURCE: Craig Deegan, 1997, ‘The Design of Efficient Management Remuneration Contracts: A Consideration of Specific Human Capital Investments’, Accounting and Finance, vol 37, no. 1, May, pp. 1–40. Reprinted by permission of Blackwell Publishing.

Revenue from Contracts with Customers—will affect the timing of when many organisations recognise revenue and this in turn could affect bonuses tied to corporate sales or profits. As another example, consider the consequences if a new rule is issued that requires all Australian research and development expenditure to be written off. (In Australia, subject to certain guidelines, development expenditure can be capitalised and subsequently amortised over future periods.) With such a change, profits would decline and the bonuses paid to managers could also change. If it is accepted, consistent with classical finance theory, that the value of the firm is a function of its future cash flows, the value of the organisation might change as cash flows change. Of course, it is possible for the bonus to be based on the ‘old’ accounting rules in place at the time the remuneration contract was negotiated—perhaps through a clause in the management compensation contract—but this will not always be the case. (As indicated previously, it would be too costly to try to stipulate in advance what accounting methods are to be used subsequently for all transactions.) Contracts that rely on accounting numbers might rely on ‘floating’ generally accepted accounting principles. This means generally accepted that changing an accounting rule that affects an item used within a contract made by the firm might accounting principles consequently change the value of the firm (through changes in related cash flows). Positive Body of conventions, Accounting Theory would argue that if a change in accounting policy had no impact on the cash rules and procedures flows of the firm, the management of the firm would be indifferent to the change. that are generally

Incentives to manipulate accounting numbers

applied by accountants.

There are a number of costs that might arise if incentive schemes are based on accounting output. For example, it is possible that rewarding managers on the basis of accounting profits can induce them to manipulate the related accounting numbers to improve their apparent performance and, importantly, their related rewards—that is, accounting profits might not always provide an unbiased measure of a firm’s performance or value. Healy (1985) provides an illustration of when managers might choose opportunistically to manipulate accounting-based accounting numbers owing to the presence of accounting-based bonus schemes (that is, they bonus scheme Employee adopt an opportunist perspective). He found that when schemes existed that rewarded managers remuneration scheme after a pre-specified level of earnings had been reached, managers would adopt accounting where employees methods consistent with maximising that bonus. In situations where the profits were not expected to receive a bonus tied to reach the minimum level required by the plan, managers appeared to adopt strategies that further accounting numbers. reduced income in that period (frequently referred to as ‘taking a bath’). This leads to higher income Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  91

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in subsequent periods when the profits might be above the required threshold. For example, a manager might write off an asset in one period when a bonus was not going to be earned anyway so that there would be nothing further to depreciate in future periods when profit-related bonuses might be paid. In related research, Holthausen, Larcker and Sloan (1995) utilised private data on a firm’s compensation plans to investigate managers’ behaviour in the presence of management compensation plans. Their results confirmed those of Healy (1985), except that no evidence was found to support the view that management will ‘take a bath’ when earnings are below the lower pre-set bound of the earnings requirement. Investment strategies that maximise the present value of the firm’s resources will not necessarily produce uniform periodic cash flows or accounting profits. It is possible that some strategies might generate minimal accounting returns in early years, yet still represent the best alternatives available to the firm. Rewarding managers on the basis of accounting profits might discourage them from adopting such strategies and might encourage them instead to adopt a short-term, as opposed to a long-term, focus. In Lewellen, Loderer and Martin (1987), it was shown that US managers approaching retirement are less likely to undertake research and development expenditure if their rewards are based on accounting-based performance measures, such as profits. Working within a PAT framework, this is explained on the basis that all research and development has to be written off as incurred in the USA (as has already been mentioned and will be seen in subsequent chapters, this is not the case in Australia). In such circumstances, incurring research and development costs will lead directly to a reduction in profits. Although the research and development expenditure would be expected to lead to benefits in subsequent years, the retiring managers might not be there to share in the gains. The self-interested manager who is rewarded on the basis of accounting profits is predicted not to undertake research and development in the periods close to the point of retirement. This can, of course, be detrimental to the ongoing operations of the business. In such a case, it would be advisable from an efficiency perspective for an organisation that incurs research and development expenditure to take retiring managers off a profit-share bonus scheme or to calculate ‘profits’ for the purpose of the plan after adjusting for research and development expenditures. Alternatively, managers approaching retirement could be rewarded in terms of market-based schemes, as addressed below. What we are emphasising here is that particular accounting rules can create real social consequences. For example, as a result of the accounting requirements that research and development expenditure is required to be treated as an expense, some managers—particularly those on accounting-based bonuses—might decide not to undertake such research and development and this can have subsequent implications for society (perhaps some miracle cure was about to be found).

Market-based bonus schemes Firms involved in some industries might have accounting earnings that fluctuate greatly. Successful strategies might be put in place that will not provide accounting earnings for a number of periods. In such industries, Positive Accounting theorists might argue that it is more appropriate and efficient to reward managers in terms of the market value of the firm’s securities, which are assumed to be influenced by expectations about the net present value The difference net present value of expected future cash flows. This can be done either by basing a cash bonus between the present on any increases in share prices or by providing managers with shares or options to shares in the value of the future cash firm. If the value of the firm’s shares increases, both managers and owners will benefit and, importantly, inflows and the present managers will be given an incentive to increase the value of the firm. value of the future cash As with accounting-based bonus schemes, there are problems associated with managers being outflows relating to a particular project or rewarded in terms of share price movements. First, the share price will not only be affected by factors object. that are controlled by the manager but also by outside, market-wide factors; that is, share prices might provide a ‘noisy’ measure of management performance—‘noisy’ in the sense that they are affected not only by the actions of management but also largely by general market movements over which the manager has no control. Further, only senior managers would be likely to have a significant effect on the cash flows of the firm and, hence, on the value of the firm’s securities. Therefore, market-related incentives might be appropriate for senior management only. Offering shares to lower-level management might be demotivating, as their own individual actions would have little likelihood, relative to the actions of senior management, of affecting share prices and, therefore, their personal wealth. Consistent with this, in Australia it is more common for senior managers to hold shares in their employer than for other employees. Even at the senior level of management, however, firm-specific events might occur that reduce share prices, even though the manager has no ability to influence the events. Consider the extract from the article in Financial Accounting in the Real World 3.1 entitled ‘Oh no, they’ve killed Kerry’, which discusses how the share price of Publishing and Broadcasting Ltd declined as a result of a false report in 2000 that its head, Mr Kerry Packer, had died. 92  PART 2: THEORIES OF ACCOUNTING

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3.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Oh no, they’ve killed Kerry Luke Mcilveen Kerry Packer has died and come back to life before, but Sydney radio station 2UE was sure that yesterday was the end. The 3 p.m. news bulletin had the country’s richest man, who underwent a kidney transplant a fortnight ago, back in Sydney’s Royal Prince Alfred Hospital for minor surgery.  Eight minutes later, presenter Murray Olds was telling listeners Mr Packer might have taken a one-way trip to the other side.  ‘We got a phone call here a short while ago to tell us—and I stress this is a phone call only, but we are trying to get this confirmed—but there are reports whizzing around the city of Sydney that Kerry Packer may have passed away,’ he said. News of the apparent demise sent the fickle finance world into a frenzy. Shares in Mr Packer’s company Publishing and Broadcasting closed 11.3c weaker at $12.907. SOURCE: Extract from ‘Oh no, they’ve killed Kerry’, by Luke Mcilveen, The Australian, 8 December 2000, p. 1

In general, it is argued that the likelihood of accounting-based or market-based performance measures or reward schemes being employed will be driven, in part, by considerations of the relative ‘noise’ of market-based versus accounting-based performance measures. The relative reliance upon accounting-based or market-based measures might potentially be determined on the basis of the relative sensitivity of either measure to general market factors, which are largely uncontrollable. Sloan (1993) indicates that chief executive officer (CEO) salary and bonus compensation appears to be relatively more aligned with accounting earnings in those firms where: • share returns are relatively more sensitive to general market movements (relatively noisy) • earnings have a high association with firm-specific movement in the firm’s share values • earnings have a less positive (or more negative) association with market-wide movements in equity values. Accounting-based rewards have the advantage that the accounting results may be based on subunit or divisional performance. However, it needs to be ensured that individuals do not focus on their division at the expense of the organisation as a whole. Positive Accounting Theory assumes that if a manager is rewarded on the basis of accounting numbers—for example, on the basis of a share of profits—the manager will have an incentive to manipulate the accounting numbers in an effort to increase his or her own personal wealth. Given this assumption, the value of audited financial statements becomes apparent. Rewarding managers in terms of accounting numbers—a strategy aimed at aligning the interests of owners and managers—might not be appropriate if management is solely responsible for compiling those numbers. The auditor will act to arbitrate on the reasonableness of the accounting methods adopted. However, it must be remembered that there will always be scope for opportunism. As emphasised earlier, it would be too expensive and, for practical purposes, impossible to pre-specify a complete set of accounting methods to cover all circumstances. In this regard, it should be remembered that the existing accounting standards do not cover all types of transactions and events, and hence there is much latitude for discretion when compiling financial statements. The above discussion indicates that incentive-based remuneration contracts might act to motivate managers to take actions that are in the best interests of the owners (that is, to align the interests of managers and owners). Another mechanism, which might complement the employment of efficiently designed management remuneration plans and which might motivate managers, is the threat that an underperforming company might be the subject of takeover attempts. The consequence of this is that underperforming managers/agents might lose their jobs when alternative teams of managers target firms with resources that are currently being used inefficiently by the incumbent management team. Given the assumption of an efficient capital market—another central tenet of PAT—managers might be motivated to use their resources efficiently both for the benefit of the owners and because inefficient utilisation might result in the firm being taken over and subsequently in loss of employment for managers. A well-informed labour market will motivate management to work to maximise the value of its firm. Underperformance might lead to dismissal and, if the labour market is efficient in disseminating data, a ‘failed’ manager might have difficulty Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  93

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attracting a position with comparable pay elsewhere. Positive Accounting Theory also assumes that labour markets are efficient. None of the mechanisms mentioned—private contracting, capital markets and labour market forces—is deemed to be perfectly efficient. However, it is assumed within PAT that the concurrent existence of well-designed management compensation contracts, the market for corporate takeovers, and a well-informed labour market should ensure that management, on average, will act in the best interests of owners.

Debt contracting When a party lends funds to another organisation, the recipient of the funds might undertake activities that reduce or even eliminate the probability of the funds being repaid. The costs that relate to the divergent behaviour of the borrower are referred to in PAT as the agency costs of debt. For example, the recipient of the funds might pay excessive dividends, leaving few assets in the organisation to service or repay the debt. Alternatively, the organisation might take on additional and perhaps excessive levels of debt. The new debtholders would then compete with the original debtholders for repayment. Smith and Warner (1979) refer to this practice as ‘claim dilution’. Further, the borrowing firm might also invest in very high-risk projects. This strategy would not be beneficial to its debtholders. They have a fixed claim and therefore if such a project generates high profits they will receive no greater return, unlike the owners who will share in the increased value of the firm. If such a project fails, which is more likely with a risky project, the debtholders might receive nothing. Therefore, while the debtholders do not share in any profits (the ‘upside’) they do suffer the consequences of any significant losses (the ‘downside’). In the absence of safeguards that protect their interests, debtholders will assume that management will take actions that might not always be in the debtholders’ interest. As a result, in the absence of contractual safeguards, it is assumed that they will require the firm to pay higher costs of interest to compensate for the high-risk exposure (Smith & Warner 1979). If a firm contractually agrees—from an efficiency perspective—that it will not pay excessive dividends, not take on high levels of debt and not invest in projects of an excessively risky nature, it is assumed that the firm will be able to attract debt capital at a lower cost than would otherwise be possible. To the extent that the benefits of lower interest costs exceed the costs that might be associated with restricting how management can use available funds, management will elect to sign agreements that restrict its subsequent actions. Early Australian evidence on debt contracts (negotiated between the providers of debt capital and the managers of the organisation) is provided by Whittred and Zimmer (1986, p. 22). They find that: with few exceptions, trust deeds for public debt place restrictions on the amount of both total and secured liabilities that may exist. The constraints were most commonly defined relative to total tangible assets; less often relative to shareholders’ funds. The most frequently observed constraints were those limiting total and secured liabilities to some fraction of total tangible assets. The above quotation makes reference to ‘public’ debt issues. When we note that something is a ‘public issue’, it means that the particular security (such as a debenture, unsecured note or convertible note) was made available for the public to invest in (with the terms of the issue typically provided within a publicly available prospectus document). Investors in a public debt issue would have a trustee who is to act in the interests of all the public investors. By contrast, a private debt issue involves an agreement between a limited number of parties (perhaps just one party, such as a bank) to provide debt capital to an organisation. Cotter (1998a, p. 187) provides more recent (than Whittred and Zimmer) Australian evidence about debt contracts used in private debt issues. She finds that: Leverage covenants are frequently used in bank loan contracts, with leverage most frequently measured as the ratio of total liabilities to total tangible assets. In addition, prior charges covenants that restrict the amount of secured debt owed to other lenders are typically included in the term loan agreements of larger firms, and are defined as a percentage of total tangible assets. Where covenants restrict the total level of debt that may be issued, this is assumed to lead to a reduction in the risk to existing debtholders. This is further assumed to translate to lower interest rates being charged by the ‘protected’ debtholders. It is worth noting that in her unpublished PhD thesis, Cotter found that the commonly used definition of assets allowed for assets to be revalued. However, for the purposes of debt restriction, some banks restricted the frequency of revaluations to once every two or three years, while others tended to exclude revaluations undertaken by 94  PART 2: THEORIES OF ACCOUNTING

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directors of the firm. These restrictions lessen the ability of firms to loosen debt constraints by revaluing assets. Cotter (1998b) found that, apart from debt-to-assets constraints, interest coverage and current ratio clauses are frequently used in debt agreements. Interest coverage clauses typically require that the ratio of net profit—with interest and tax added back—to interest expense be at least a minimum number of times. In the Cotter study, the number of times interest must be covered ranged from one and a half times to four times. The current ratio clauses reviewed by Cotter required that current assets be between one and two times the size of current liabilities, depending on the size and industry of the borrowing firm. In more recent research, Mather and Peirson (2006) undertook an analysis of Australian public and private debt issues between 1991 and 2001. They showed that, relative to the earlier samples used by Whittred and Zimmer, more recent public debt issues show a ‘significant reduction in the use of debt to asset constraints, such as covenants restricting the total liabilities/total tangible assets, or total secured liabilities to total tangible assets, with only 28 per cent of the sample of recent contracts including these covenants’ (p. 292). However, Mather and Peirson provide evidence that, while there is a reduction in the use of covenants that restrict the amount of total liabilities relative to assets, there appears to be a greater variety of covenants being used relative to earlier years. Among the other covenants they found in debt contracts are requirements stipulating required minimum interest coverage, minimum dividend coverage, minimum current ratio, and required minimum net worth. Again, as we know, if these minimum accounting-based requirements are not met, the borrower is considered to be in technical default of the debt agreement and the lenders may take action to retrieve their funds. As we should appreciate, the purpose of the various debt covenants is to provide lenders with regular and timely indicators of the possibility of a borrowing entity defaulting on repaying its debts. A violation of a debt covenant signals an increase in the likelihood of default. However, it needs to be appreciated that the covenant measures are simply indicators of the chances that an organisation will not repay borrowed funds, and that an organisation simply being in technical default of a covenant is not a perfect indicator that the entity would not have repaid the borrowed funds. When debt contracts are written, and where they utilise accounting numbers, the contract can, as we indicated earlier, rely upon either the accounting rules in place when the contracts were signed (often called ‘frozen GAAP’) or the contract might rely upon the accounting rules in place at each year’s reporting date (referred to as ‘rolling GAAP’ or ‘floating GAAP’). Mather and Peirson found that in all but one of the public debt contracts, rolling (or floating) GAAP was to be used to calculate the specific ratios used within the contracts. The use of rolling GAAP increases the risk to borrowers in the sense that if the IASB (and thereafter the AASB) issues a new accounting standard that changes the treatment of particular assets, liabilities, expenses or income, this has the potential to cause an organisation to be in technical default of a loan agreement. For example, a new accounting standard might be released that requires a previously recognised asset to be fully expensed to the income statement (or the statement of profit or loss and other comprehensive income). This could have obvious implications for debt to asset constraints, or interest coverage requirements. As another more specific example, we can consider the release of IFRS 15 Revenue from Contracts with Customers in 2014. For many firms this changed when they recognised revenue, which in turn could have potentially affected accounting-based debt covenants. That is, in the absence of the organisation changing any aspect of its business, a new rule in relation to revenue recognition could create changes in measures used in debt covenants, and create various costs associated with defaulting on debt contracts. This in itself could provide the motivation for organisations to actively lobby accounting standard-setters against a particular draft accounting standard. As Mather and Peirson (2006, p. 294) state: The use of rolling GAAP in Australia means that new (or revisions to) accounting standards might cause breaches of covenants not anticipated at the time of contract negotiation. When comparing the use of covenants in public and private debt issues, Mather and Peirson found that the mean number of accounting-based covenants used in the sample of public debt contracts is smaller (mean of 1.5) than the mean number of covenants found in the sample of private debt contracts (mean of 3.5). That is, more restrictions were placed on privately negotiated debt agreements. Similarly, where debt covenants restricted total liabilities to total tangible assets, Mather and Peirson found that ‘the limits imposed in public debt contracts (a mean total liabilities/total tangible assets of 82.2 per cent) appear to be less restrictive that those in private debt contracts (mean limit of 75.2 per cent)’. The fact that private debt contracts are more restrictive than public debt contracts can be explained from an efficiency perspective. When a covenant is violated, an organisation is in technical default of the debt contract. If an organisation is in technical default, it often has the option of negotiating with the debtholders to try to come up with a compromise that does not involve immediate repayment of the debt. However, it is very difficult, and sometimes nearly impossible, to renegotiate a satisfactory outcome in a public debt issue, as there are so many diverse parties involved—some of which Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  95

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might not even be able to be contacted. Hence we would expect to find the covenant restrictions to be less restrictive in public debt contracts than in private debt contracts. As Mather and Peirson (2006, p. 305) state: In comparison to our sample of recent public debt contracts, private debt contracts contain a greater number, variety and, collectively, more restrictive set of financial covenants. We also document differences in accounting rules associated with financial covenants used in these contracts. Tailoring of the definition of liabilities and earnings in private debt contracts make them more restrictive compared with the definitions in public debt contracts. Our findings support [the] theory that suggests that covenant restrictive and renegotiation–flexible contracts are more suited to borrowers contracting with financial intermediaries in private debt markets than to public debt markets that are characterized by diverse and numerous investors. As with management compensation contracts, PAT assumes that the existence of debt contracts (which are initially put in place as a mechanism to reduce the agency costs of debt and can be explained from an efficiency perspective) provides management with a subsequent (ex post) incentive to manipulate accounting numbers—an incentive that increases as the accounting-based constraint approaches violation. As Watts (1995, p. 323) states: leverage (gearing) Measure of the amount of debt issued by an entity. The greater the use of debt the greater the gearing.

Early studies of debt contract-motivated choice test whether firms with higher leverage (gearing) are more likely to use earnings-increasing accounting methods to avoid default (leverage hypothesis). The underlying assumptions are that the higher the firm’s leverage the less slack in debt covenants and the more likely the firm is to have changed accounting methods to have avoided default. This change is usually interpreted as opportunistic since technical default generates wealth transfers to creditors but it could also be efficient to the extent that it avoids real default and the deadweight loss associated with bankruptcy.

For example, if the firm contractually agreed that the ratio of debt to total tangible assets should be kept below a certain figure (and this is considered to reduce the risk of the debtholders not being repaid), if that figure was likely to be exceeded (constituting a technical default of the loan agreement and thereby potentially requiring the entity to repay the funds immediately) management might have an incentive to either inflate assets (perhaps through an upward asset revaluation) or deflate liabilities. This is consistent with the results reported in Christie (1990) and Watts and Zimmerman (1990). To the extent that such an action was not objective, management would obviously be acting opportunistically and not to the benefit of individuals holding debt claims against the firm. Debt agreements typically require financial statements to be audited. Other research to consider how management might manipulate accounting numbers in the presence of debt agreements includes that undertaken by DeFond and Jiambalvo (1994) and Sweeney (1994). Both of these studies investigated the behaviour of managers of firms that were known to have defaulted on accounting-related debt covenants. DeFond and Jiambalvo (1994) provided evidence that the managers manipulated accounting accruals in the years before and the year after violation of the agreement. Similarly, Sweeney (1994) found that as a firm approaches violation of a debt agreement, managers have a greater propensity to adopt debt covenant Restriction within a trust income-increasing strategies (which also act to increase assets) compared with managers in firms deed on the operations that are not approaching technical default of accounting-based debt covenants. Income-increasing of a borrowing entity. accounting strategies include changing key assumptions when calculating pension liabilities, and adopting LIFO cost-flow assumptions for inventory. Sweeney (1994) also showed that managers with an incentive to manipulate accounting earnings might also strategically determine when they will first adopt a new accounting requirement. When new accounting standards are issued, there is typically a transitional period (which could be a number of years) in which organisations can voluntarily opt to implement a new accounting requirement. After the transitional period, the use of the new requirement becomes mandatory. Sweeney showed that organisations which defaulted on their debt agreements tended to adopt incomeincreasing requirements early, and deferred the adoption of accounting methods that would lead to a reduction in reported earnings. In further related research, Franz, Hassabelnaby and Lobo (2014) report that firms close to violating debt covenants are more likely to manage their earnings in a way that reduces the risk of covenant violation. Debt contracts occasionally restrict the accounting techniques that may be used by the firm, thus requiring adjustments to published accounting numbers. For example, and as stated above, Cotter (1998a) shows that bank loan contracts sometimes do not allow the component related to asset revaluations to be included in the definition of ‘assets’ for the purpose of calculating ratios, such as ‘debt to assets’ restrictions. These revaluations are, however, allowed for

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external reporting purposes. Therefore, loan agreements sometimes require the revaluation component to be removed from the published accounting numbers before the calculation of any restrictive covenants included within the debt contract. Within accounting, management usually has available a number of alternative ways to account debtholder for particular items and, thus, to minimise the effects of existing accounting-based restrictions. External party with Therefore, it might appear optimal for debtholders to stipulate in advance all accounting methods a claim against an that management must use. However, and as noted previously, it would be too costly and impractical organisation for the to write ‘complete’ contracts up front. As a consequence, management will always have some repayment of funds previously advanced. discretionary ability to enable it to loosen the effects of accounting-based restrictions negotiated by debtholders. The role of external auditors, if appointed, would be to arbitrate on the reasonableness of the accounting methods chosen. In relation to auditors, and following on from the discussion so far, there would appear to be a particular demand for financial-statement auditing when: • management is rewarded on the basis of numbers generated by the accounting system • the firm has borrowed funds and accounting-based covenants are in place to protect the investments of debtholders. Consistent with the above, it could also be argued that as the managers’ share of equity in the business decreases and as the proportion of debt to total assets increases, there will be a corresponding increase in the demand for auditing. In this regard, Ettredge et al. (1994) show that organisations that voluntarily elect to have interim financial statements audited tend to have greater leverage and lower management shareholding in the firm. In summing up our discussion on debt contracting we can see that accounting numbers can have significant implications for the ongoing viability of an organisation. Many organisations borrow funds with the terms of the borrowing being stipulated in contracts that incorporate accounting-based debt convents. Failure to comply with these negotiated covenants (often referred to as a ‘technical breach’ of a convent or contract) can, at the extreme, lead to the operations of the organisation being suspended or placed in the hands of a party nominated by the lender, while the lenders seek to gain access to their funds. In this regard we can consider an article that appeared in The Sydney Morning Herald in relation to surfwear company Billabong Ltd entitled ‘Write-down puts Billabong in breach of debt covenant’ (by Collin Kruger, 23 February 2013), which stated: BILLABONG’S path to redemption got tougher on Friday after the surfwear group downgraded earnings guidance and said a $537 million loss for the half-year put it in breach of debt covenants. The breach led its banks to seek a secured charge over most of the business . . . The company said it was in breach of its debt covenants owing to the $567 million worth of write-downs for the half-year. The situation has since been remedied, but at a price. Billabong said it had agreed to move ‘as soon as practicable’ to a secured banking arrangement with its financiers ‘whereby the company will grant security over the majority of its assets’. The new chief financial officer, Peter Myers, said talks with the banks had been ‘extremely constructive’. As another example of how lenders can take control of an organisation in the situation where there is a technical default of a debt covenant we can consider the case of Nufarm Ltd. In an article that appeared in The Australian entitled ‘Nufarm debt in hands of bankers’ (by John Durie, 27 September 2010), it was stated: NUFARM’s banks are working towards a waiver on its debt breaches but no agreement has been reached to clear the company’s immediate future. The company is to unveil its latest profit numbers tomorrow and, having issued five profit downgrades in 18 months, is expected to come within its latest guidance of an operating profit between $55 million and $60m. But the bank clearance is the major news the market is waiting for after Nufarm admitted in July it had breached one of its debt covenants relating to the ratio of earnings to interest payments. The banks have appointed McGrath Nicol to represent their interests and the company has Gresham and Deloittes advising on its future corporate structure. Any move on that front will depend on the banks’ reaction because they effectively control the company at present because of the covenant violation. While this material has discussed how accounting-based debt covenants are often negotiated between borrowers and lenders, we could perhaps expect that the level of reliance that lenders place on accounting-based indicators, as a means of protecting the funds advanced to an organisation, will be influenced by the perceived integrity of the

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accounting systems in place within the borrowing organisation. In this regard Costello and Wittenberg-Moerman (2011) find that if an organisation discloses information about internal control failures within its accounting system, lenders will tend to decrease their reliance on the use of accounting-based covenants. Rather, borrowers who have had instances of poor internal controls tend to encounter higher interest rates and additional security requirements. So, in summarising this discussion, we can understand that many organisations have debt contracts in place that use accounting numbers. The use of particular covenants within debt contracts provides a vehicle for transferring certain rights and decision making from shareholders/managers to creditors/lenders when a company appears to be approaching a situation of financial distress. The covenants thereby provide a mechanism to limit managers’ ability to expropriate the wealth of the creditors/debtholders. Consistent with PAT, this in turn provides incentives to managers (assuming self-interest) to adopt income/asset increasing accounting methods, particularly when they are close to breaching debt covenants. In the discussion that follows, we consider how expectations about the political process can also affect managers’ choice of accounting methods.

Political costs The term ‘political costs’ is used to refer to the costs that particular groups external to the firm may be able to impose on the firm, such as the costs associated with increased taxes, increased wage claims or product boycotts. Organisations are affected by a multitude of stakeholders, including governments, trade unions, environmental lobby groups and consumer groups. Research indicates (Watts & Zimmerman 1978; political costs Wong 1988; Deegan & Hallam 1991) that the demands placed on firms by interest groups might be Costs that groups affected by the accounting results of the firm. For example, if a firm records high profits, this might external to the firm might be able to be used as a justification or an excuse for trade unions to take action to increase their members’ impose on the firm share of the profits in the form of increased wages. Publicity, such as media coverage, is not typically as a result of political given to the accounting methods used to derive particular accounting numbers. Rather, attention actions. seems to be focused on the final numbers themselves, without regard to how those numbers were determined. In this regard, we can consider how representatives of interest groups or political parties might use profits or other accounting numbers as a justification for particular actions. In this respect, a newspaper article appeared in the Hobart Mercury on 9 March 2013 (entitled ‘Tax on big four hits brick wall’) in which the Australian Greens political party used the size of bank assets (measured in accounting terms) as the basis for levying additional taxes on banks. In part, the article stated: The Greens want a levy of 0.2 per cent on all bank assets above $100 billion in return for Federal Government guarantees, which the independent Parliamentary Budget Office has costed as raising $11 billion over the next four years. ‘At a time when there’s pressures on the budget, and the government is looking around for ways of raising revenue, especially in light of the failed mining tax, who can afford to pay it the most?’ Australian Greens’ Mr Bandt said yesterday. ‘If we don’t stand up to the big banks and the big miners, then the Labor Party is going to come after the rest of us, like they have with single parents, and like they are threatening with the forthcoming budget.’ From the above extract we can see how an accounting number—total assets—had been used as the basis of justifying levying the additional tax. While the proposal was rejected by the government, it does show how accounting numbers are used in political debates. In the same article, the banks responded by noting how such a proposed tax would impact many people, including retirees and the ‘working Australian’. Such a response would be aimed at trying to dampen any future calls for additional taxes: The Australian Bankers’ Association warned that if the Greens’ policy was adopted it would effectively amount to a tax on Australians’ retirement savings. The association’s chief executive Steven Munchenberg said the majority of bank profits were paid through dividends to mum and dad shareholders and superannuation funds. ‘Taxing banks’ profits reduces those returns for working Australians saving for their retirement through superannuation accounts and to retirees who are increasingly dependent upon positive business profit growth,’ he said. Government departments can also come under political pressure as a result of reported high profits. That is, government departments can also be subject to political costs. As an example of this, we can consider a story about 98  PART 2: THEORIES OF ACCOUNTING

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New Zealand Post (the government department responsible for mail deliveries and other services). In an article entitled ‘40c stamp follows $72.3 m profit’ (by Craig Howie, The Dominion, 28 June 1995), the New Zealand communications minister states that the increasing profits of NZ Post were reaching a level at which they could be considered by the community as being ‘obscene’. Possibly in expectation of a community backlash, NZ Post reduced the price of its stamps following the announcement of profit results. Perhaps such a price reduction would not have occurred if NZ Post had not recorded such a large accounting profit, which in turn attracted negative media attention. In Australia, banks have often been criticised for charging high rates of interest at the same time as they are reporting high profits. For example, in an article entitled ‘Banks in credit card gouge’ (by Clancy Yeates, Canberra Times, 13 May 2013) it was stated: Big banks have failed to pass on most interest rates cuts to their credit card customers, despite the Reserve Bank cutting them to their lowest level in more than 50 years. Australians charged $6.2 billion in credit card interest bills annually are propping up the record half-year profits of $13.4 billion reported by the big four banks. Again, we can see that accounting profits can draw unwanted attention to an organisation. An industry’s high profits might also be used as a basis for action by groups that lobby politically for increased taxes or decreased subsidies on the grounds of the industry’s ability to pay. For example, Watts and Zimmerman (1986) examine the highly publicised claims about US oil companies made by consumers, unions and government within the US in the late 1970s. It was claimed at the time that oil companies were making excessive reported profits and were in effect exploiting the nation. It is considered that such claims could have led to the imposition of additional taxes in the form of ‘excess profits’ taxes. In a more recent Australian example of how an industry’s profits might be used as a justification for calls for additional taxes, we can consider this article entitled ‘Banks’ rate excuses don’t add up’, which appeared in The Age (8 December 2011). The article stated: Banks are in the business of making money, but at times they seem to forget the costs of angering customers. The big four’s show of silence following Tuesday’s 0.25-point rate cut by the Reserve Bank was one such moment. Yes, the European debt crisis is putting pressure on funding costs and only NAB, which has the lowest standard mortgage rate, failed to pass on last month’s 0.25-point rate cut in full. But Treasurer Wayne Swan is right to insist that the big four banks, whose record profits recently topped $24 billion, have little excuse for not passing on the full rate cut . . . The difficulties of the rate-sensitive retail and construction sectors ought to remind banks of their responsibilities as corporate citizens. They owe a debt to taxpayers who, through government support, stood behind them in the GFC. Despite their desire to protect short-term returns to shareholders, banks should not neglect their role in sustaining the health of the Australian economy, which still provides most of their income. If they don’t play ball, the banks can expect support for a banking super-profits tax to grow. Governments seeking re-election could be motivated to take action against unpopular firms or industries if it were considered that there would be a net increase in electoral support. The following extract from an article by Morgan Mellish and Jason Koutsoukis entitled ‘MPs have banks in their sights’ (The Australian Financial Review, 28 November 2000, p. 3) reports the reaction of one banking executive to this possibility: Commonwealth Bank chief executive Mr David Murray yesterday said he was fearful of politicians increasing the anti-bank rhetoric in an effort to capitalise on community anger towards banks. ‘There are a number of elections in Australia next year and we know the political homework that’s been done in the leadup to those elections includes banking as an issue at every level,’ Mr Murray said. The view that politicians will target unpopular industries to bolster their chances of re-election assumes that the actions of most politicians are motivated by a desire to be re-elected—perhaps not an unrealistic assumption and certainly consistent with the PAT assumption that the actions of all individuals can best be explained in terms of selfinterest. Therefore, it is argued that the reported accounting numbers, such as profits, might result in the imposition of costs on the firm, perhaps through increased taxes, calls for reduced prices or calls for wage increases for workers. Generally speaking, it is argued within PAT that accounting numbers can be used as a means of providing ‘excuses’ for effecting wealth transfers in the political process (Holthausen & Leftwich 1983, p. 83). Politicians can rely on accounting numbers to justify their own particular actions or provide ‘excuses’, given the expectation that it is costly for constituents to ‘unravel’ accounting numbers derived from particular, and perhaps alternative, accounting methods. It would also be costly for constituents to determine the ‘real’ motivations for politicians’ actions, or the economic consequences of those actions. Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  99

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For example, a government might decide to reduce the tariff protection of a particular industry and, in doing so, it could highlight the high profits that have been reported by firms within that industry; that is, it could use the profits as an excuse for the action. Consistent with the work of Downs (1957), individual constituents will not have an incentive to investigate more fully the actual motivations of the government. They have only one vote in the political process and the costs of being fully informed about the government’s actions are assumed to be greater than any subsequent benefits constituents could generate from the knowledge. As already indicated, high profits might also be used by consumer groups to justify a position that prices are too high. For example, consider the difficulties a firm might have justifying a price rise for its goods or services if, at the same time, it is recording high profits. Consistent with Watts and Zimmerman (1978), if a firm believes that it is, or might be, subject to political costs, there might be incentives to adopt income-decreasing accounting methods. In the discussion so far, we examined how representatives of interest groups might use profits as a justification for particular actions. Lower reported profits might reduce the likelihood of demands for increased wages. Hence, if management considers that there might be claims for increased wages in particular years, or the industry might be the target for increased taxes or consumer calls for price decreases, then managers might elect to adopt income-decreasing accounting methods (for example, managers might depreciate assets over fewer years, thereby increasing depreciation expense and reducing profits). In this regard, research in the US by Jones (1991) considered the behaviour of 23 firms from five industries that were the subject of investigations into government import relief from 1980 to 1985. These investigations by the International Trade Commission sought to determine whether the domestic firms were under threat from foreign competition. Where this threat is deemed to be unfair, the government can grant relief in terms of devices such as tariff protection. In making its decision, the government relies upon a number of factors, including economic measures such as profits and sales. The results of the study show that, in the year of the investigations, the sample companies chose accounting strategies that led to a decrease in reported profits. Such behaviour was not exhibited in the year before or the year after the government investigation (perhaps indicating that politicians are fairly ‘shortsighted’ when undertaking investigations). In other US-based research, Cahan (1992) undertook an investigation of the accounting methods used by organisations subject to investigation by the US Department of Justice and Federal Trade Commission and found that firms under investigation tended to adopt income-reducing accounting strategies. In more recent research of a related nature, Hao and Nwaeze (2015, p. 195) reviewed accounting-related behaviour of the US pharmaceutical industry at a period when it became the target of public condemnation for rising drug prices and at the same time faced the prospect of new laws to curtail its revenues. Firms were expected to adopt accounting methods that would lower their profits and thus reduce their unpopularity for being highly profitable, thereby also reducing calls from the public for additional legislation. The authors found a variety of accounting actions were indeed employed that reduced reported profits—consistent with a political cost hypothesis. This study represented yet another example of research that sought to confirm the ‘political cost hypothesis’—a hypothesis that has been subject to repeated investigation for approximately 40 years.

PAT in summary Up to this point, we have shown the following: • PAT proposes that the selection of particular and alternative accounting methods can be explained either from an efficiency perspective or an opportunistic perspective. At times, it is very difficult to distinguish which perspective best explains a particular organisation’s accounting strategies. The selection of particular accounting methods can affect the cash flows associated with debt contracts, the cash flows associated with management-compensation plans, and the political costs of the firm. • PAT indicates that these effects can be used to explain why firms elect to use particular accounting methods in preference to others. This would be of particular relevance to accountants in practice. For example, auditors need to consider the factors that might have motivated a firm to adopt particular accounting methods in preference to others. PAT also provides a basis for explaining why particular organisations might lobby for or against particular proposed accounting requirements. As we know from Chapter 1, when new accounting standards are being developed by the IASB or the AASB, the standard-setters will normally develop a draft accounting standard and then ask for submissions from the public. PAT provides a framework for explaining the lobbying positions taken by the respective respondents and hence provides insights that would be of particular relevance to accounting standard-setters and regulators. • PAT indicates that the use of particular accounting methods might have opposing effects. For example, if a firm adopts a policy that increases income by capitalising an item, rather than expensing it as it is incurred, this might

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reduce the probability of violating a debt covenant and might also increase accounting-related management bonuses. However, it could also increase the political visibility of the firm on account of higher profits. Managers are assumed to select accounting methods that best balance their conflicting effects, while at the same time maximising their own wealth.

Accounting policy selection and disclosure

LO 3.7

As noted earlier in this chapter, a firm might be involved in many agreements that use accounting numbers LO 3.8 relating to profits and assets (for example, an organisation might have instituted a bonus plan where bonuses paid to managers are based on profits, or it might be subject to a debt covenant that restricts its total debt to a certain percentage of its total assets). Hence the decision to expense or capitalise an item might have important financial implications for the organisation and, potentially, for management. It should be noted at this early point in the text that there is much scope in accounting for applying professional judgement in the selection of accounting policies. For example, some companies might use a first-in first-out basis for valuing inventories, while other companies might use a weighted-average approach (both methods are allowed by AASB 102 Inventories). The method selected will have a particular effect on income and assets. This inventory example is only one of numerous choices a firm faces. The old adage that if you put a hundred accountants in a room you might very well get a hundred different figures for the profit or loss of the same business is very true. As we have seen, PAT suggests that the choices that affect profits might in turn have implications for bonus payments to managers, for debt contracts and for political costs. As a result of the choices that confront the accountant, it is imperative that financial statement users are aware of the accounting policies adopted by reporting entities. Comparing the financial results and position of reporting entities that use different accounting methods might be a misleading exercise unless notional adjustments are made to counter the effects of using these different methods and policies. For such adjustments, knowledge of each firm’s accounting policies is necessary. AASB 101 Presentation of Financial Statements requires that a summary of accounting policies be presented in the initial section of the notes to the financial statements. Specifically, paragraph 117 of AASB 101 states: An entity shall disclose its significant accounting policies comprising: (a) the measurement basis (or bases) used in preparing the financial statements; and (b) the other accounting policies used that are relevant to an understanding of the financial statements. In explaining the above requirement, paragraph 118 of AASB 101 states: It is important for an entity to inform users of the measurement basis or bases used in the financial statements (for example, historical cost, current cost, net realisable value, fair value or recoverable amount) because the basis on which an entity prepares the financial statements significantly affects users’ analysis. When an entity uses more than one measurement basis in the financial statements, for example when particular classes of assets are revalued, it is sufficient to provide an indication of the categories of assets and liabilities to which each measurement basis is applied. Paragraph 119 of AASB 101 further states: In deciding whether a particular accounting policy should be disclosed, management considers whether disclosure would assist users in understanding how transactions, other events and conditions are reflected in reported financial performance and financial position. Each entity considers the nature of its operations and the policies that the users of its financial statements would expect to be disclosed for that type of entity. Disclosure of particular accounting policies is especially useful to users when those policies are selected from alternatives allowed in Australian Accounting Standards. When a company has changed its accounting policies from one period to the next, comparing its performance in different periods can become difficult. In this regard, AASB 108 requires that, where there is a change in the accounting policy used in preparing and presenting financial statements or group financial statements for the current financial year, and this change has a material effect on the financial statements or group financial statements, the summary of

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accounting policies is to disclose, or refer to a note disclosing, the nature of the change, the reason for the change and the financial effect of the change. AASB 108, paragraph 14, requires that a change in an accounting policy is to be made only when it: (a) is required by an Australian Accounting Standard; or (b) results in the financial statement providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s position, financial performance or cash flows.

LO 3.10

Accounting policy choice and ‘creative accounting’

Those people responsible for selecting between the different accounting techniques—which, as we have seen, should be explained in the accounting policy notes—might select the alternatives that they believe most effectively and efficiently report the performance of their firm; in other words, they might approach their selection objectively. As paragraph 10 of AASB 108 states: 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 statement (i) represents faithfully the financial position, financial performance and cash flows of the entity; (ii) reflects the economic substance of transactions, other events and conditions, and not merely the legal form; (iii) is neutral, that is, free from bias; (iv) is prudent; and (v) is complete in all material respects.

accounting policy notes Notes showing accounting principles, bases of recognition and measurement rules adopted in preparing and presenting financial statements.

creative accounting Where those responsible for preparing accounts select accounting methods not objectively but according to the result desired by the preparers.

By contrast, it is also possible for such individuals to select the policies that best serve their own interests; in other words, they might approach their selection and application of accounting techniques ‘creatively’. The term creative accounting is frequently used in the media. It refers to instances where those responsible for the preparation of financial statements select accounting methods that provide the result desired by the preparers. As we have already seen, PAT provides an explanation of why firms might be creative—or opportunistic—with their accounting (perhaps to increase the rewards paid to managers, to loosen the effects of accounting-based debt covenants or to reduce potential political costs). Indeed, we saw that there were three general hypotheses, these being referred to as:

• the debt hypothesis; • the management bonus hypothesis; and • the political cost hypothesis. The debt hypothesis predicts that organisations close to breaching accounting-based debt covenants will select accounting methods that lead to an increase in profits and assets. The management bonus hypothesis predicts that managers on accounting-based bonus plans will select accounting methods that lead to an increase in profits. And the political cost hypothesis predicts that firms subject to political scrutiny will adopt accounting methods that lead to a reduction in reported profits. With the range of accounting techniques available—and these techniques will be highlighted throughout this text— account preparers can be creative, yet at the same time follow accounting standards. Although they might not be objective, it might be difficult for parties such as auditors, with an oversight function, to report that the account preparers are doing anything wrong. It is hoped, however, that the vast majority of individuals preparing financial statements place objectivity before self-interest—a hope that is perhaps in conflict with a central assumption of PAT. Griffiths, a British author, devoted an entire book to the issue of creative accounting within the United Kingdom. The book is entitled Creative Accounting: How to Make Your Profits What You Want Them to Be, and in it Griffiths (1987, p. 1) stated: Every company in the country is fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public 102  PART 2: THEORIES OF ACCOUNTING

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have all been changed in order to protect the guilty. It is the biggest con trick since the Trojan horse. Any accountant worth his salt will confirm that this is no wild assertion. There is no argument over the extent and existence of this corporate contortionism, the only dispute might be over the way it is described. Such phrases as ‘cooking the books’, ‘fiddling the accounts’ and ‘corporate con trick’ may raise eyebrows where they cause people to infer that there is something illegal about this pastime. In fact this deception is all in perfectly good taste. It is totally legitimate. It is creative accounting. This is a fairly extreme view of creative accounting, and not one necessarily shared by the author of this book. If the output of the accounting system lacks credibility and assuming that such markets as the capital market are efficient, it would be unlikely that they would use the output of the accounting system in the design of contractual arrangements with such a firm. However, evidence clearly indicates that the market does rely on the output of the accounting system. For example, the bond (debenture) trust deeds of large, Australian listed firms, as well as negotiated lending agreements with banks, without any apparent exception, use the output of the accounting system to control and monitor the behaviour of corporate management. While we need to acknowledge that creative accounting does exist, it is reasonable to argue that, with the increased number of accounting standards being issued, the scope for being creative has decreased. Whatever the actual incidence of creative accounting, to consider that all financial statements are developed on an objective basis would be naive. This chapter has discussed how the wealth of the firm, or particular individuals, might be tied to the output of the accounting system. This can be through the existence of accounting-based debt contracts and accounting-based management compensation schemes, both of which are, according to PAT, initially devised to increase the efficient operations of the entity (the efficiency perspective). The existence of political costs, which might be influenced in part by such accounting numbers as ‘profits’, will also affect the value of an organisation. Adopting the opportunistic perspective of PAT, whenever individuals’ wealth is at stake, there is always the possibility that opportunistic actions might override the dictates of objectivity. Certainly, PAT assumes that considerations of self-interest would drive the selection of accounting policies. Whatever the case, creativity might be employed, but hopefully not too often!

Some criticisms of Positive Accounting Theory

LO 3.3 LO 3.5

Although PAT received fairly widespread acceptance from a large group of accounting academics, there are nevertheless many researchers who opposed its fundamental tenets. Deegan (1997b) provides evidence of the degree of opposition and the intensity of emotion that PAT had generated among its detractors. The following discussion is based on the contents of Deegan (1997b). Some of the rather unflattering descriptions of PAT, made by well-regarded accounting academics, have included: It is a dead philosophical movement. It has provided no accomplishments. It is marred by oversights, inconsistencies and paradoxes. It is imperiously dictatorial. It is empty and commonplace. It is akin to a cottage industry. It is responsible for turning back the clock of research 1 000 years. It provides evidence of doubtful value. It suffers from logical incoherence. It is a wasted effort.

(Christenson 1983, p. 7) (Sterling 1990, p. 97) (Chambers 1993, p. 1) (Sterling 1990, p. 121) (Sterling 1990, p. 130) (Sterling 1990, p. 132) (Chambers 1993, p. 22) (Williams 1989, p. 456) (Williams 1989, p. 459) (Sterling 1990, p. 132)

These quoted criticisms clearly indicate the force of emotion that PAT has stimulated among its critics, particularly the normative theorists, who see the role of accounting theory as providing prescription, rather than description. Some of you might not have expected a theory of accounting (such as PAT) to be capable of eliciting such a reaction. As students of accounting, you might find it interesting to ponder why such a theory has made some people so angry—after all, it is just a theory, isn’t it? Although the descriptions of PAT quoted above are extremely negative, it must be kept in mind that there are many researchers who still favour PAT. That is, they still think that the existence of accounting-based debt covenants, management bonus plans and possible political costs will act to influence the choice of accounting methods being used. What should also be kept in mind is that any theory or model of accounting will be based on certain key underlying assumptions about such things as the purposes of accounting, the purposes of accounting research, what drives Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  103

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individual actions, and so forth. Not all researchers will agree with the assumptions, and hence it is to be expected that there will not be total acceptance of any particular theory of accounting. The discussion below will further highlight some of the perceived shortcomings of PAT. Remember that these ‘shortcomings’ would conceivably be challenged by those who favour PAT and/or conduct research under the banner of PAT. One widespread criticism of PAT is that it does not provide prescription and therefore does not provide a means of improving accounting practice. It is argued that simply explaining and predicting accounting practice is not enough. Using a medical analogy, Sterling (1990, p. 130) states: PAT cannot rise above giving the same answers because it restricts itself to the descriptive questions. If it ever asked how to solve a problem or correct an error (both of which require going beyond a description to an evaluation of the situation), then it might go on to different questions and obtain different answers after the previous problem was solved. If we had restricted the medical question to the description of the smallpox virus, for example, precluding prescriptions to be vaccinated, we would need more and more descriptive studies as the virus population increased and mutations appeared. Luckily Edward Jenner was naughtily normative, which allowed him to discover how cowpox could be used as a vaccine so smallpox was eventually eliminated, which made room for different questions on the medical agenda. Howieson (1996, p. 31) advances the view that, by failing to provide prescription, Positive Accounting theorists might alienate themselves from practising accountants. As he asserts: an unwillingness to tackle policy issues is arguably an abrogation of academics’ duty to serve the community which supports them. Among other activities, practitioners are concerned on a day-to-day basis with the question of which accounting policies they should choose. Traditionally, academics have acted as commentators and reformers on such normative issues. By concentrating on positive questions, they risk neglecting one of their important roles in the community. A second criticism of PAT is that it is not value-free, as it asserts, but rather is very value-laden (Tinker, Merino & Niemark 1982). If we look at research that has been conducted by applying PAT we will see a general absence of prescription. There is no guidance on what people should do. This is normally justified by Positive Accounting theorists on the basis that they do not want to impose their own views on others. They would prefer to provide information about the expected implications of particular actions and thereafter let people decide for themselves what they should do. For example, they might provide evidence to support a prediction that organisations that are close to breaching accountingbased debt covenants will adopt accounting methods that increase the firm’s reported profits and assets. However, as a number of accounting academics have pointed out, the very act of selecting a theory such as PAT for research purposes is based on a value judgement; deciding what to research is based on a value judgement; believing that all individual action is driven by self-interest is a value judgement; and so on. Hence, no research, whether conducted under PAT or otherwise, is value-free and to assert that it is value-free is, arguably, quite wrong. A third criticism of PAT relates to the fundamental assumption that all action is driven by a desire to maximise wealth. To many researchers such an assumption represents a perspective of humankind that is far too negative. In this regard, Gray, Owen and Adams (1996, p. 75) state that PAT promotes ‘a morally bankrupt view of the world’. Certainly, assuming that all action is driven by a desire to maximise one’s own wealth is not an overly kind assumption about human nature, but—and this is not a justification—such an assumption has been the cornerstone of many past and existing theories used within the discipline of economics. Nevertheless, it is arguably a rather simplistic assumption. Given that everybody is deemed to act in their own interests, the perspective of self-interest has also been applied to the research efforts of academics. For example, Watts and Zimmerman (1990, p. 146) argue that: Researchers choose the topics to investigate, the methods to use, and the assumptions to make. Researchers’ preferences and expected payoffs (publications and citations) affect their choice of topic, methods, and assumptions. Many academics would challenge this view and would argue that they undertake their research because of real personal interest in an issue. Another implication of the self-interest issue is that incorporating this self-interest assumption into the teaching of undergraduate students (as has been done in many universities throughout the world in the economics and accounting fields) might result in students thinking that when they subsequently have to make decisions in the workplace, it is both acceptable and predictable for them to place their own interests above others—after 104  PART 2: THEORIES OF ACCOUNTING

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all, that was a key ‘ingredient’ in the theories they were taught. It is perhaps questionable whether such a philosophy is in the interests of the broader community. At the present time, there are many social and ecological problems confronting the planet, not the least of which is climate change. If we are to embrace sustainability in any sort of meaningful way then it is very difficult to understand how efforts to ensure that future generations and the environment will not be disadvantaged by current corporate activities (which would be required for a sustainable future), and quests to maximise current wealth (consistent with ‘self-interest’), can be considered to be mutually compatible. What do you, the reader, think about this issue? Does the teaching of theories that assume self-interest perpetuate the acceptance of self-interest as a guiding motivation? Another criticism of PAT is that, since its beginnings in the 1970s, the theory has not developed greatly. In Watts and Zimmerman (1978) there were three key hypotheses: 1. The debt hypothesis—which typically proposes that organisations that are close to breaching accounting-based debt covenants will select accounting methods that lead to an increase in profits and assets. 2. The bonus-plan hypothesis—which typically proposes that managers on accounting-based bonus schemes will select accounting methods that lead to an increase in profits. 3. The political-cost hypothesis—which typically proposes that firms subject to political scrutiny will adopt accounting methods that reduce reported income. These three hypotheses were considered earlier in this chapter. A review of the recent PAT literature reveals that these hypotheses continue to be tested in different environments and in relation to different accounting policy issues— approximately 40 years after Watts and Zimmerman (1978). In this regard, Sterling (1990, p. 130) asks the following question: What are the potential accomplishments [of PAT]? I forecast more of the same: twenty years from now we will have been inundated with research reports that managers and others tend to manipulate accounting numerals when it is to their advantage to do so. As a last criticism to consider, it has been argued that PAT is scientifically flawed. As the three hypotheses generated by PAT (mentioned above) are frequently not supported by research but, rather, are falsified, PAT should be rejected from a scientific point of view. Christenson (1983, p. 18) states: We are told, for example, that ‘we can only expect a positive theory to hold on average’ (Watts & Zimmerman 1978, p. 127, n. 37). We are also advised ‘to remember that as in all empirical theories we are concerned with general trends’ (Watts & Zimmerman 1978, pp. 288–9), where ‘general’ is used in the weak sense of ‘true or applicable in most instances but not all’ rather than in the strong sense of ‘relating to, concerned with, or applicable to every member of a class’ (American Heritage Dictionary 1969, p. 548) . . . A law that admits exceptions has no significance, and knowledge of it is not of the slightest use. By arguing that their theories admit exceptions, Watts and Zimmerman condemn them as insignificant and useless. However, accounting is a process that is undertaken by people, and the accounting process itself cannot exist in the absence of accountants—it is hard to think of any model or theory that could ever fully explain human action. In fact, to do so would constitute a dehumanising action. Are there any theories of human activity that always hold? What we must appreciate is that theories are simplifications of reality. While the above criticisms do, arguably, have some merit, PAT continues to be used. A number of accounting research journals continue to publish PAT research and many accounting research schools throughout the world continue to teach PAT. What must be remembered is that all theories of accounting will have limitations. They are, of necessity, abstractions of the ‘real world’. Whether we individually prefer one theory of accounting to another will depend on our own assumptions about many of the issues raised in this chapter. In the discussion that follows we turn our attention to normative theories of accounting. As you might expect, such theories are also subject to varied levels of criticism.

Normative accounting theories As the discussion so far in this chapter has indicated, PAT, the theory based on the works of such individuals as Watts and Zimmerman, and Jensen and Meckling, seeks to explain and predict the selection of particular

LO 3.2 LO 3.11

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normative accounting theories Accounting theories that seek to guide individuals in selecting the most appropriate accounting policies.

accounting policies and the implications of that selection. Normative accounting theories, on the other hand, seek to provide guidance to individuals to enable them to select the most appropriate accounting policies for given circumstances. The conceptual framework, discussed in Chapter 2 can be considered a normative theory of accounting. Its purpose is to provide guidance to the individuals responsible for preparing general purpose financial statements. The conceptual framework identifies the objective of general purpose financial reporting and the qualitative characteristics that financial information should possess. The objective of general purpose financial reporting is, according to the IASB conceptual framework (as released in September 2010) deemed to be:

to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. This objective serves as a foundation for the various components or chapters that form the Conceptual Framework Project (this objective was also embraced in the Exposure Draft of the proposed new conceptual framework released by the IASB in 2015 and therefore represents the latest thinking of the IASB). If we were to disagree with this central objective—and many accounting academics do—we would be unlikely to agree with the subsequent prescriptions provided within the framework. Conceptual frameworks seek to provide recognition and measurement rules within a coherent and consistent framework. As also indicated in Chapter 2, one definition of a conceptual framework was provided by the US Financial Accounting Standards Board as: a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards. It prescribes the nature, function and limits of financial accounting and reporting. The use of the term ‘prescribes’ supports the view that the conceptual framework is a normative theory of accounting. The IASB conceptual framework identifies a number of qualitative characteristics that financial information should possess (as discussed in Chapter 2). Two main qualitative characteristics are identified as relevance and faithful representation. In relation to faithful representation, the IASB conceptual framework states: Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. 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 Board’s objective is to maximise those qualities to the extent possible. As you have just read about PAT and how PAT researchers work on the assumption that self-interest drives the actions of all individuals—including those individuals who prepare financial statements—it will now be clear to you that, to be consistent, such researchers consider that managers would not be overly motivated to produce financial statements that are ‘complete’ and ‘neutral’ or that ‘represent faithfully’ the transactions of the business—particularly if there are accounting-based contracts in place with associated cash-flow implications. Objectivity and self-interest are, arguably, mutually exclusive. Apart from the conceptual framework, there have been a number of other normative accounting theories developed by individual scholars. At certain times, particular theories have received support from various sections of the accounting profession. A period in which a number of notable normative accounting theories were developed was the 1950s and 1960s. During this period, a great deal of the theory development related to issues associated with changing prices and their effect on profits and asset valuation. At this time, most Western countries had high rates of inflation, generating a pressing need for guidance on how to account for changing prices. This need was considered to exist because in times of inflation it was felt that historical-cost accounting overstated accounting profits, which in turn could lead to the payment of excessive dividends, eroding the future operating ability of an organisation. The famous works referred to in Chapter 2 (Moonitz, The Basic Postulates of Accounting, 1961; and Sprouse & Moonitz, A Tentative Set of Broad Accounting Principles for Business Enterprises, 1962) acknowledged the limitations of historical-cost accounting in times of rising prices. They proposed a change from historical-cost accounting to a form of current-value accounting. As previously mentioned in this book, although the theory development was sponsored by the US accounting profession, the theories were not embraced, possibly owing to the fact that they represented a radical departure from practices that existed at the time—and to a large extent still exist today. 106  PART 2: THEORIES OF ACCOUNTING

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Dominant normative theories developed in the 1950s and 1960s, all of which addressed issues associated with changing prices, can be broken into the three main classifications (Henderson, Peirson & Brown 1992) of: 1. current-cost accounting 2. exit-price accounting 3. deprival-value accounting. Reflecting the fact that there was no universal agreement on the role of accounting—and there is still none—the alternative normative theories provided conflicting prescriptions. In the discussion that follows we will briefly consider some of the normative theories. We will not consider the actual applications of the various prescriptions in any great detail but, rather, we will consider the main elements of the theories. It should be noted at this point that there is currently little debate on the issues associated with undertaking accounting in periods of changing prices. This might reflect the low rates of inflation we currently experience. Perhaps—and this is sheer conjecture—issues associated with changing prices might again attain prominence if inflation were to reach the heights of past decades.

Current-cost accounting Current-cost accounting was advocated by many accounting researchers, including Edwards and Bell in the USA (The Theory and Measurement of Business Income, 1961) and Mathews and Grant in Australia (Inflation and Company Finance, 1958). Although there are variations within the different models of current-cost accounting, the general aim of the theory is to provide a calculation of income that, after adjusting for changing prices, could be withdrawn from the entity yet still leave the physical capital of the entity intact. Such measures of income are often promoted as true measures of income. As Henderson, Peirson and Brown (1992, p. 40) state:

current-cost accounting A system of accounting that measures the value of goods and services in terms of their current costs.

The essential characteristics of true income theories is that they propose a single measurement basis for assets and a consequent single or unique measure of income (profit). The resulting income measure is regarded as the correct or true measure of income. Almost by definition other measures of income are incorrect or untrue and must, therefore, be misleading. The true measures of income should be suited to the needs of all users of the financial statements. For the purposes of illustration, assume that a company started the period with assets of $50 000. Let us assume also that there are no liabilities, so that the owners’ equity also equals $50 000. During the period, the business sells all of its assets for $70 000. Under historical-cost accounting the profit would be $20 000 and the closing owners’ equity would be $70 000, which would be matched by assets of $70 000 in the form of cash. If the $20 000 was withdrawn in the form of dividends, under historical-cost accounting the owners’ equity of the business would remain as it was at the beginning of the period. However, if we were to adopt current-cost accounting, the profit would not necessarily be the same. If, owing to rising prices, it cost $60 000 to replace the assets that were sold (their ‘current cost’), under current-cost accounting, the profit would be only $10 000, as $60 000 would need to be retained to keep the physical capital of the firm intact. The maintenance of the firm’s physical capital or operating capacity is a central goal of currentcost accounting. Proponents of this normative theory argue that by valuing assets (and this would translate to expense recognition) at their current costs—in some models based on replacement cost—a ‘truer’ measure of profit is provided than is reflected by the historical-cost system. A frequently raised criticism of current-cost accounting is that it introduces an unacceptable amount of subjectivity into the accounting process, as some assets will not have a readily accessible ‘current cost’. However, advocates of the approach argue that the increased relevance of the information more than offsets any disadvantages associated with its reliability, compared with historical-cost data.

Exit-price accounting One of the most famous expositions of a normative accounting theory was developed by the Australian researcher Raymond Chambers. He labelled his theory Continuously Contemporary Accounting (CoCoA). The theory was developed principally between 1955 and 1965. Chambers (1955) advanced the view that accounting research and accounting theory should be developed with an underlying objective of providing a better system of accounting, rather than simply describing or explaining contemporary practices. (Until his death in 1999, Chambers continued to be a strong opponent of positive accounting research.) The most fully developed exposition of Chambers’ theory was provided in his publication Accounting, Evaluation and Economic Behaviour, released

Continuously Contemporary Accounting (CoCoA) A normative theory that proposes an approach to accounting that relies on measuring the exit prices of the entity’s assets and liabilities.

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in 1966. The theory relies on assessments of the exit or selling prices of an entity’s assets and liabilities—hence it is labelled an exit-price theory. The development of CoCoA was based on the key assumptions that: • firms exist to increase the wealth of the owners • successful operations are based on the ability of an organisation to adapt to changing circumstances • the capacity to adapt will be best reflected by the monetary value of the organisation’s assets, liabilities and equities at reporting date, where the monetary value is based on the current exit or selling prices of the organisation’s resources (their current cash equivalent). According to Chambers, a central objective of accounting should be to provide information about an entity’s ability to adapt to changing circumstances or, as he referred to it, an organisation’s capacity to adapt. Capacity to adapt is directly tied to the cash that could be obtained if an entity sold its assets. Chambers’ theory advocated that an entity’s balance sheet (now referred to as a statement of financial position) should base the value of all assets on their respective selling prices. If an asset is not readily saleable (and therefore does not have a sales price), it does not contribute to an entity’s capacity to adapt to changing circumstances. Further, the profit for a period should also be tied to the changes in the current exit prices of the organisation’s assets and, as such, profit as a measure of performance should reflect changes in an organisation’s capacity to adapt. Chambers proposed that his model of accounting would provide information that would be useful to all financial statement users. Chambers’ theory of accounting (CoCoA) is often referred to as a ‘decision usefulness approach’ to accounting theory development, in which he takes a decision-models approach. Proponents of the decision-models approach develop models based capacity to adapt on the researcher’s own perceptions about what is necessary for efficient decision making. A measure, promoted by Chambers, tied to (By contrast, an approach that develops models based on asking other individuals what information the cash that could be they seek, perhaps through using questionnaires, would be referred to as a decision-makers obtained if an entity emphasis.) Chambers’ decision-models approach considers the decision-making requirements of sold its assets. financial statement users to be the primary reason for developing a particular accounting system. This necessarily requires an initial judgement on what kinds of information are necessary for informed decision making. Chambers takes the responsibility for making such judgements on behalf of financial statement users. Under CoCoA, organisations that cannot adapt are considered relatively more likely to fail. The more liquid or saleable an organisation’s assets, the greater the perceived capacity to adapt. If an organisation has very specialised assets, which do not have a secondary market, such an organisation is considered to have a low capacity to adapt. If circumstances/markets change, an organisation with very specialised assets would be more likely to fail. Capacity to adapt should be reflected by the entity’s financial statements, which will highlight adaptive capital. To this end, and as noted above, Chambers prescribed that all assets should be current cash recorded at their current cash equivalents. Current cash equivalents were represented by the equivalents amounts expected to be generated by selling the assets. The net sales or exit prices were to be Represented by the amount that would determined on the basis of an orderly sale. Within the model, the balance sheet should clearly show be expected to be the expected net selling prices of all of the entity’s assets—net selling prices would acknowledge generated by selling any costs that would be incurred in making a sale. Adaptive capital would be represented by the an asset. total net selling prices of the various assets, less the amount of the firm’s liabilities. Profit would reflect the change in the organisation’s capacity to adapt that had occurred since the beginning of the period. Because the valuation of assets is to be based on their current cash equivalents, depreciation expenses would not be recognised within CoCoA. According to the Chambers model, if assets cannot be separately sold, for the purposes of determining the organisation’s financial position they are deemed to have no value. This in itself was considered to be too extreme for many accounting practitioners and researchers, and represented a radical alternative to the existing accounting practices. Assets such as goodwill or some work in progress would be assessed as having no net selling price and therefore would be attributed zero value. Chambers argued that by using current selling prices, accounting reports would be objective and understandable to readers. By using a consistent valuation approach, it was also more valid or even logical to add the values of the various assets together to get an overall total asset value. This can, of course, be compared with the system we have today in which alternative classes of assets are to be valued in a variety of ways but, exit-price theory Normative theory of accounting which prescribes that assets should be valued on the basis of exit prices and that financial statements should function to inform users about an organisation’s capacity to adapt.

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nevertheless, are added together for the purpose of financial statement presentation. Chambers argued that people can easily understand what valuation on the basis of net selling prices means. Under CoCoA, assets are not valued on the basis of arbitrary cost allocations or amortisation nor on the basis of directors’ valuations. As you would expect, there are many criticisms of CoCoA, such as that it does not consider the ‘value in use’ of assets. If an asset is retained, rather than sold, its value in use would likely be greater than its current exit price. This could apply particularly in the case of specialised resources such as a blast furnace that is generating positive returns. It has a positive value in use but if it cannot be sold separately, for the purposes of CoCoA it has no value. As Chambers might argue, however, if something generates a positive return, it should have a market and a corresponding market value. Another criticism of CoCoA is that, in valuing assets at their perceived sales value, it is implied that the firm intends to liquidate the assets. Obviously, this might not be the case. Nevertheless, Chambers’ model does provide useful information for determining an organisation’s capacity to adapt—which he argues is a central objective of accounting. Chambers’ model has also been criticised on the basis that the exit prices are determined by the price that could be achieved in an orderly sale. These sales might be at different times and might not reflect values at reporting date. As values are based on an opinion of perceived selling prices, it has also been argued that such financial statements might not be useful for monitoring the firm’s management.

Deprival-value accounting A further normative (or prescriptive) accounting theory that we will briefly consider is deprival-value accounting. Deprival value itself can be defined as the value to the business of particular assets. It represents the amount of loss that might be incurred by an entity if it were deprived of the use of an asset and the associated economic benefits the asset generates.  In 1975, deprival-value accounting was recommended by the UK Sandilands Committee. net selling price The deprival value of an asset to be reported in the financial statements will be determined by The selling price of considering: the net selling price of the asset; the present value of the future cash flows that the an item less the costs asset will generate; or the asset’s current replacement cost. The deprival value is the lower of that are incidental to current replacement cost and the greater of the net selling price and present value (value in use). making the sale. For example, if an asset could be sold for a net amount of $100 or used to generate a present value of $120, the best use of the asset would be to keep it and use it to generate future cash flows. The deprival value is then the lesser of the present value ($120) and the cost to replace the asset. To present value The value of an item to adopt this form of accounting would require all assets and liabilities to be considered separately in be received or paid for terms of their deprival value to the business. in the future expressed Some criticisms of deprival-value accounting have included the concern that different valuation in terms of its value bases would be used within a single financial statement—such as selling prices, present-value today. calculations and replacement costs. This can be compared with Chambers’ CoCoA, which prescribes one method of valuation—net selling prices. It has also been argued that the valuation procedures would be particularly costly and time-consuming, given that more than one method of valuation current replacement cost might have to be used for particular assets. It might also not be clear which valuation approach A valuation method should be adopted for a particular type of asset. based on the current The aim of the above brief discussion of three different normative theories of accounting (which replacement cost of tell us how we should account) is to show the difference between normative and positive theories an item rather than its of accounting. historical cost. The following discussion focuses on yet another group of theories, classified as systemsoriented theories.

Systems-oriented theories to explain accounting practice

LO 3.1 LO 3.2 LO 3.12

Apart from PAT and the normative accounting theories discussed briefly above, there are numerous other theories applicable to the accounting process. What should be stressed is that, as mentioned previously, theories are abstractions of reality, and no particular theory can be expected to provide a full account or description of a particular phenomenon. Hence it is sometimes useful to consider the perspectives or insights provided by alternative theories. In some cases, different researchers study the same phenomenon but from different theoretical perspectives. For example, some researchers operating within the Positive Accounting Theory paradigm (such as Ness

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& Mirza 1991) argue that the voluntary disclosure of social responsibility information can be explained as a strategy to reduce political costs. Social responsibility reporting has also been explained from a Legitimacy Theory perspective (for example, Patten 1992; Deegan & Islam 2014), and from a Stakeholder Theory perspective (for example, Roberts 1992). The choice of one theoretical perspective in preference to others will, at least in part, be due to value judgements on the part of the authors involved. As O’Leary (1985, p. 88) states: systems-oriented theories Theories that explain the role of information and disclosure in managing the relationships between an organisation and the communities with which it interacts.

Theorists’ own values or ideological predispositions may be among the factors that determine which side of the argument they will adopt in respect of disputable connections of a theory with evidence. One branch of accounting-related theories can be referred to as systems-oriented theories. According to Gray, Owen and Adams (1996, p. 45): a systems-oriented view of the organisation and society .  .  . permits us to focus on the role of information and disclosure in the relationship(s) between organisations, the State, individuals and groups.

From a systems-based perspective, an entity is assumed to be influenced by the society in which it operates and in turn to have an influence on society. This is simplistically represented in Figure 3.1. Three theories with a systems-based perspective are Stakeholder Theory, Legitimacy Theory and Institutional Theory. Within these theories, accounting disclosure policies are considered to constitute a strategy to influence (or, perhaps, manage) the relationships between the organisation and other parties with which it interacts. In recent times, Stakeholder Theory, Legitimacy Theory and Institutional Theory have been applied extensively to explain why organisations might make certain social-responsibility disclosures within their annual reports or sustainability reports, rather than why they might elect to adopt particular financial accounting methods. The theories could, however, also be applied to explain, at least in part, why companies adopt particular financial social-responsibility accounting techniques. disclosures Social-responsibility disclosures themselves can relate, among other things, to information Disclosures of about the interaction of an organisation with its physical and social environment, including the information about community, the natural environment, human resources, energy and product safety. Stakeholder the interaction of an organisation with its Theory, Legitimacy Theory and Institutional Theory will be discussed in greater detail in Chapter 30, physical and social which considers social disclosures. However, as this chapter considers accounting-related theories, environment. some attention here is warranted. We will briefly consider Stakeholder Theory, Legitimacy Theory and Institutional Theory in turn below.

FIGURE  3.1 The organisation viewed as part of a wider social system

Interest groups

The public

Employees

Industry bodies

The Organisation

Consumers

Investors

Suppliers

Media

Government

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Stakeholder Theory Stakeholder Theory can be broadly broken up into two branches—an ethical (normative) branch and a managerial (positive) branch. The ethical branch adopts the view that all stakeholders have certain intrinsic rights (for example, to safe working conditions and fair pay), and these rights should not be violated. As Hasnas (1998, p. 32) states:

Stakeholder Theory Perspective that considers the importance for an organisation’s survival of satisfying the demands of its various stakeholders.

When viewed as a normative (ethical) theory, Stakeholder Theory asserts that, regardless of whether stakeholder management leads to improved financial performance, managers should manage the business for the benefit of all stakeholders. It views the firm not as a mechanism for increasing the stockholders’ financial returns, but as a vehicle for coordinating stakeholder interests and sees management as having a fiduciary relationship not only to the stockholders, but to all stakeholders. According to the normative Stakeholder Theory, management must give equal consideration to the interests of all stakeholders and, when these interests conflict, manage the business so as to attain the optimal balance among them. This of course implies that there will be times when management is obliged to at least partially sacrifice the interests of the stockholders to those of the other stakeholders. Hence, in its normative form, the Stakeholder Theory does imply that business has true social responsibilities.

A stakeholder can be broadly defined as ‘any group or individual who can affect or is affected by the achievement of the firm’s objectives’ (Freeman 1984). Stakeholders would include shareholders, employees, customers, lenders, suppliers, local charities, various interest groups and government. Depending upon how broad we wish to define stakeholders, stakeholders also include future generations and the environment. From this perspective, the organisation is seen as part of a larger social system, as shown in Figure 3.1. Within the ethical branch of Stakeholder Theory, there is also the view that all stakeholders have many rights, including a right to be provided with information about how the organisation is affecting them (perhaps through pollution, community sponsorship, provision of employment, safety initiatives, etc.), even if they choose not to use the information, and even if they cannot directly affect the survival of the organisation. The fact that authors adopting an ethical view espouse normative perspectives of how they believe organisations should act towards their stakeholders does not mean that these perspectives will actually coincide with how organisations behave. Hence the various ethical perspectives cannot be validated by empirical observation—as might be the case if the researchers were adopting descriptive or predictive (positive) theories about organisational behaviour. As Donaldson and Preston (1995, p. 67) state: In normative uses, the correspondence between the theory and the observed facts of corporate life is not a significant issue, nor is the association between stakeholder management and conventional performance measures a critical test. Instead a normative theory attempts to interpret the function of, and offer guidance about, the investor-owned corporation on the basis of some underlying moral or philosophical principles. Turning our attention away from the ethical (normative) branch and to the managerial (or positive) branch of Stakeholder Theory, we see that this branch seeks to explain and predict how an organisation will react to the demands of various stakeholder groups. As the research based on this branch of Stakeholder Theory is used to make predictions, it is reasonable to assess the validity of such research on the basis of its correspondence with actual practice. Within the managerial branch of Stakeholder Theory (see, for example, Roberts 1992), the organisation identifies its group of stakeholders, particularly those that are considered to be important to the ongoing operations and survival of the business. The greater the importance of the stakeholders, the greater will be the expectation that the management of the firm will take actions to ‘manage’ the relationships with those stakeholders (hence why it is called the ‘managerial branch’). As the expectations and power relativities of the various stakeholder groups can change, organisations must continually adapt their operating and disclosure strategies. Roberts (1992, p. 598) states that: A major role of corporate management is to assess the importance of meeting stakeholder demands in order to achieve the strategic objectives of the firm. As the level of stakeholder power increases, the importance of meeting stakeholder demands increases also. The power of stakeholders (for example, owners, creditors or regulators) to influence corporate management is viewed as a function of stakeholders’ degree of control over resources required by the organisation (Ullmann 1985). The more critical the stakeholder-controlled resources are to the continued viability and success of the organisation, the greater the expectation that stakeholder demands will be addressed. A successful organisation is considered to be one Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  111

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that satisfies the demands (sometimes conflicting) of the various powerful stakeholder groups. In this regard Ullmann (1985, p. 2) states: Our position is that organisations survive to the extent that they are effective. Their effectiveness derives from the management of demands, particularly the demands of interest groups upon which the organisation depends. Stakeholders’ power will be stakeholder-organisation specific, and might be tied to such things as command of limited resources (finance, labour), access to influential media, ability to legislate against the company, or ability to influence the consumption of the organisation’s goods and services. The behaviour of various stakeholder groups is considered a constraint on the strategy developed by management to best match corporate resources with the entity’s environment. The strategy of pursuing profits for the benefit of investors is not sufficient in or by itself. Within the variant of Stakeholder Theory that adopts a managerial (or positive) perspective, information, including financial accounting information and information about the organisation’s social performance, is a tool in controlling the sometimes conflicting demands of various stakeholder groups. Gray, Adams and Owen (2014, p. 85) state: Here (under this perspective), the stakeholders are identified by the organisation of concern, by reference to the extent to which the organisation believes the interplay with each group needs to be managed in order to further the interests of the organisation (what Mitchell et al., 1997, call ‘salience’). The more important (salient) the stakeholder to the organisation, the more effort will be exerted in managing the relationship. Information— including financial accounting and social accounting—is a major element that can be employed by the organisation to manage (or manipulate) the stakeholder in order to gain their support and approval (or to distract their opposition and disapproval). As the level of stakeholder power increases, the importance of meeting stakeholder demands increases. Some of this demand might relate to the provision of information about the activities of the organisation. According to Ullmann (1985), the greater the importance to the organisation of the stakeholder’s resources/support, the greater the probability that a particular stakeholder’s expectations will be accommodated within the organisation’s operations. According to this perspective, various activities undertaken by organisations, including public reporting, will relate directly to the expectations of particular stakeholder groups. Furthermore, organisations will have an incentive to disclose information about their various programs and initiatives to the stakeholder groups concerned to clearly indicate that they are conforming with those stakeholders’ expectations. Organisations must necessarily balance the expectations of various stakeholder groups. In relation to corporate social disclosures, Roberts (1992, p. 599) states: social responsibility activities are useful in developing and maintaining satisfactory relationships with stockholders, creditors, and political bodies. Developing a corporate reputation as being socially responsible through performing and disclosing social responsibility activities is part of a strategy for managing stakeholder relationships. Stakeholder Theory (of the positive, or managerial, variety) does not directly provide prescriptions about what information should be disclosed, other than indicating that the provision of information, including information within an annual report, can, if thoughtfully considered, be useful for the continued operations of a business entity. Within the managerial branch of Stakeholder Theory, it is a stakeholder’s control over limited resources that are required by an organisation that influences whether specific information is provided to that stakeholder—not issues associated with rights to information. The insights provided by Stakeholder Theory are of relevance to various people within the accounting profession. For example, accounting regulators will have a better understanding of why some disclosures are being voluntarily made by organisations (perhaps because they are demanded by powerful stakeholders) while other seemingly important or relevant disclosures are not being made (perhaps the related information is sought only by stakeholders who are impacted by the operations of the organisation, but they do not have the necessary power to compel the organisation to make disclosures). This has implications for the need to potentially Legitimacy Theory legislate particular disclosures. Theory which proposes that organisations always seek to ensure that they operate within the bounds and norms of their societies.

Legitimacy Theory Legitimacy Theory is very closely linked to Stakeholder Theory. It posits that organisations continually seek to ensure that they operate within the bounds and norms of their respective societies; that is, they attempt to ensure that their activities are perceived by outside parties to be

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‘legitimate’. These bounds and norms, rather than being fixed, are subject to change, requiring the organisation to be responsive to the environment in which it operates. Lindblom (1993) distinguishes between legitimacy, which is considered to be a status or condition, and legitimation, which she considers to be the process that leads to an organisation being adjudged legitimate. According to Lindblom (p. 2), legitimacy is: . . . a condition or status which exists when an entity’s value system is congruent with the value system of the larger social system of which the entity is a part. When a disparity, actual or potential, exists between the two value systems, there is a threat to the entity’s legitimacy. Legitimacy is a relative concept—it is relative to the social system in which the entity operates and is both timespecific and place-specific. Corporate activities that are ‘legitimate’ in a particular place and time might not be legitimate at a different point in time, or in a different place (for example, what is legitimate behaviour in one country might not be legitimate in another). As Suchman (1995, p. 574) states: Legitimacy is a generalised perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs, and definitions. Within Legitimacy Theory, ‘legitimacy’ is considered to be a resource upon which an organisation depends for its survival (Dowling & Pfeffer 1975; O’Donovan 2002). It is something that is conferred upon the organisation by society, and it is something that is desired or sought by the organisation. However, unlike many other ‘resources’, it is a ‘resource’ that the organisation is considered to be able to impact or manipulate through various disclosure-related strategies (Woodward, Edwards & Birkin 1996). Researchers that use Legitimacy Theory often link ‘legitimacy’ to the idea of a ‘social contract’. social contract That is, they rely on the notion that there is a social contract between an organisation and the society Considered to be in which it operates. An organisation is deemed to be operating with ‘legitimacy’ when its operations an implied contract are perceived by society to be complying with the terms or requirements of the ‘social contract’. The constituted by the expectations that social contract is not easy to define, but the concept is used to represent the multitude of implicit society holds about and explicit expectations that society has about how an organisation should conduct its operations. the conduct of an The law is considered to provide the explicit terms of the social contract, while other, non-legislated organisation. societal expectations embody the implicit terms of the contract. It is assumed that society allows the organisation to continue operations as long as it generally meets society’s expectations. Legitimacy Theory emphasises that the organisation must appear to consider the rights of the public at large, not merely those of its investors. Organisations are not considered to have any inherent right to resources. Legitimacy (from society’s perspective) and the right to operate go hand in hand. As Mathews (1993, p. 26) states: The social contract would exist between corporations (usually limited companies) and individual members of society. Society (as a collection of individuals) provides corporations with their legal standing and attributes and the authority to own and use natural resources and to hire employees. Organisations draw on community resources and output both goods and services and waste products to the general environment. The organisation has no inherent rights to these benefits and in order to allow their existence, society would expect the benefits to exceed the costs to society. The idea of a social contract is not new—it was discussed by philosophers such as Thomas Hobbes (1588–1679), John Locke (1632–1704) and Jean-Jacques Rousseau (1712–1778). Society expects the organisation to comply with the terms of this ‘contract’ and, as noted above, these expressed or implied terms are not static. As Shocker and Sethi (1974, p. 67) state: Any social institution—and business is no exception—operates in society via a social contract, expressed or implied, whereby its survival and growth are based on: (1) the delivery of some socially desirable ends to society in general, and (2) the distribution of economic, social, or political benefits to groups from which it derives its power. In a dynamic society, neither the sources of institutional power nor the needs for its services are permanent. Therefore, an institution must constantly meet the twin tests of legitimacy and relevance by demonstrating that society requires its services and that the groups benefiting from its rewards have society’s approval. Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  113

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As indicated in Deegan and Rankin (1996, p. 54), pursuant to Legitimacy Theory, if an organisation cannot justify its continued operation, the community may, in a sense, revoke the organisation’s ‘contract’ to continue its operations. This might occur through consumers reducing or eliminating the demand for the products of the business, factor suppliers eliminating the supply of labour and financial capital to the business, or constituents lobbying government for increased taxes, fines or laws to prohibit the actions that do not conform to the expectations of the community. The notion of a social contract is something corporate managers have been referring to for a number of years. For example, in an article entitled ‘Westpac chief admits banks failed in the bush’, which appeared in The Australian on 20 May 1999 (by Sid Marris), it was stated: The rush by banks to shut branches in rural areas over the past decade was a ‘mistake’ and broke ‘the social contract’ with the community, Westpac executive Michael Hawker said. Given the potential costs associated with conducting operations that are deemed to be outside the terms of the social contract, Dowling and Pfeffer (1975) state that organisations will take various actions to ensure that their operations are perceived to be legitimate. One such action would be—and this is where we get to the theory’s relevance to accounting— to provide disclosures, perhaps within the annual report. Hurst (1970) suggests that one of the functions of accounting, and subsequently accounting reports, is to legitimate the existence of the corporation. Within such a perspective, the strategic nature of financial statements and other disclosures is emphasised. From the perspective provided by Legitimacy Theory, it is important not only that an organisation operate in a manner consistent with community expectations (that is, consistent with the terms of the social contract), but also that the organisation disclose information to demonstrate that it is complying with community expectations. That is, if an organisation undertakes actions that conform to community expectations, this in itself is not enough to bring legitimacy to the organisation—it must make disclosures to show clearly that it is complying with community perceptions. It is society’s perceptions of an organisation’s actions that are important in establishing legitimacy and not necessarily the actual actions themselves. Because community expectations can change, the organisation must make disclosures to show that it is also changing. In relation to the dynamics associated with changing community expectations, Lindblom (1993, p. 3) states: Legitimacy is dynamic in that the relevant publics continuously evaluate corporate output, methods, and goals against an ever evolving expectation. The legitimacy gap will fluctuate without any changes in action on the part of the corporation. Indeed, as expectations of the relevant publics change, the corporation must make changes or the legitimacy gap will grow as the level of conflict increases and the level of positive and passive support decreases. The ‘legitimacy gap’ (used in the above quote) refers to the difference between the expectations of the ‘relevant publics’ relating to how an organisation should act, and society’s perceptions of how the organisation does act. Legitimacy Theory (and Stakeholder Theory) explicitly considers the organisation in its broader social context. Unlike PAT, Legitimacy Theory does not rely upon the economics-based assumption that all action is driven by individual selfinterest (tied to wealth maximisation), and it emphasises how the organisation is part of the social system in which it operates. A number of studies, four of which are described briefly below (relevant studies will be discussed more fully in Chapter 30), have identified specific types of social-responsibility disclosures that have appeared within annual reports and that have been explained by the respective researchers as being part of the portfolio of strategies undertaken by accountants and their managers to bring legitimacy to, or to maintain the legitimacy of, their respective organisations. Patten (1992) focused on the change in the extent of environmental disclosures made by North American oil companies, other than Exxon Oil Company, both before and after the Exxon Valdez disaster in Alaska in 1989. He argued that if the Alaskan oil spill resulted in a threat to the legitimacy of the petroleum industry, and not just to Exxon, Legitimacy Theory would suggest that companies operating within that industry would respond by increasing the amount of voluntary environmental disclosures in their annual reports. Patten’s results indicate that there were increased environmental disclosures by petroleum companies for the post-1989 period, consistent with a legitimation perspective. This disclosure reaction took place across the industry, even though the incident itself concerned primarily one oil company. Patten (1992, p. 475) argued that ‘it appears that at least for environmental disclosures, threats to a firm’s legitimacy do entice the firm to include more social responsibility information in its annual report’. In an Australian study, Deegan and Rankin (1996) used Legitimacy Theory in an attempt to explain systematic changes in environmental disclosure policies in corporate annual reports around the time of proven environmental prosecutions.

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The authors examined the environmental disclosure practices of a sample of firms that were successfully prosecuted by the New South Wales and Victorian Environmental Protection Authorities (EPAs) for breaches of environmental protection laws during the period 1990 to 1993. (Any prosecutions by these agencies are reported in the EPA’s annual reports, which are publicly available.) The annual reports of a final sample of 20 firms—prosecuted a total of 78 times—were reviewed to ascertain the extent of the environmental disclosures being made. These annual reports were matched by industry and size to the annual reports of a control group of 20 firms that had not been prosecuted. Of the 20 prosecuted firms, 18 provided environmental information in their annual report. However, the disclosures were predominantly self-laudatory and qualitative in nature. Only two organisations made any mention of the prosecutions. Deegan and Rankin found that prosecuted firms disclosed significantly more environmental information in the year of prosecution than any other year in the sample period. Consistent with the view that companies increase disclosures to offset any effects of EPA prosecutions, the EPA-prosecuted firms also disclosed more ‘favourable’ environmental information, relative to non-prosecuted firms. The authors conclude that the public disclosure of proven environmental prosecutions has an impact on the disclosure policies of the firms involved. Changes in disclosure practices are considered to represent a strategy to alter the public’s perception of the legitimacy of the organisation and this might be particularly important when the organisation has received negative publicity about certain aspects of its performance. In a United States study, the choice of an accounting framework was deemed to be related to a desire to increase the legitimacy of an organisation. Carpenter and Feroz (1992) argue that the decision of the government of the State of New York to adopt generally accepted accounting procedures (as opposed to a method of accounting based on cash flows rather than accruals) was ‘an attempt to regain legitimacy for the State’s financial management practices’ (p. 613). According to Carpenter and Feroz, New York State was in a financial crisis in 1975, with the result that many parties began to question the adequacy of the financial reporting practices of all the associated government units. To regain legitimacy, the state elected to implement GAAP (incorporating accrual-based accounting). According to Carpenter and Feroz (pp. 635, 637): The state of New York needed a symbol of legitimacy to demonstrate to the public and the credit markets that the state’s finances were well managed. GAAP, as an institutionalized legitimated practice, serves this purpose .  .  . We argue that New York’s decision to adopt GAAP was an attempt to regain legitimacy for the state’s financial management practices. Challenges to the state’s financial management practices, led by the state comptroller, contributed to confusion and concern in the municipal securities market. The confusion resulted in a lowered credit rating. To restore the credit rating, a symbol of legitimacy in financial management practices was needed. It is debatable whether GAAP was the solution for the state’s financial management problems. Indeed, there is strong evidence that GAAP did not solve the state’s financial management problems. New York needed a symbol of legitimacy that could be easily recognised by the public. In the realm of financial reporting, ‘GAAP’ is the recognised symbol of legitimacy. According to Carpenter and Feroz, few would be likely to oppose a system that is ‘generally accepted’—general acceptance provides an impression of legitimacy. As they state (p. 632): In discussing whether to use the term ‘GAAP’ instead of ‘accrual’ in promoting the accounting conversion efforts, panel members argued that no one could oppose a system that is generally accepted. The name implies that any other accounting principles are not accepted in the accounting profession. GAAP is also seemingly apolitical. Within the context of companies that source their products from developing countries, Islam and Deegan (2010) undertook a review of the social and environmental disclosure practices of two leading multinational sportswear and clothing companies, these being Nike and Hennes & Mauritz. Islam and Deegan found a direct relationship between the extent of global news media coverage of a critical nature being given to particular social issues relating to the industry, and the extent of social disclosure. In particular, they found that once the news media started running a campaign that exposed poor working conditions and the use of child labour in developing countries, it appeared that the multinational companies responded by making various disclosures identifying initiatives that were being undertaken to ensure that the companies did not source their products from factories that had abusive or unsafe working conditions, or used child labour. Islam and Deegan argued that the evidence was consistent with the view that the news media influenced the expectations of Western consumers, thereby causing a legitimacy problem for the companies. The companies

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then responded to the legitimacy crisis by providing disclosures within their annual report that focused particularly on working conditions and the use child labour in developing countries. Islam and Deegan showed that before the news media started running stories about the labour conditions in developing countries (media attention to these issues appeared to start in the early 1990s), the companies were in general not making such disclosures. This was despite the fact that evidence suggests that poor working conditions and the use of child labour existed in developing countries for many years before the newspapers starting covering these issues. Islam and Deegan speculated that had the Western news media not run stories exposing the working conditions in developing countries—which created a legitimacy gap for the multinational companies—then the multinational companies might not have embraced initiatives to improve working conditions, nor provided disclosures about the initiatives being undertaken in relation to working conditions in developing countries. Apart from Stakeholder Theory and Legitimacy Theory, another theory that embraces a systems-oriented perspective and which analyses corporate reporting decisions is Institutional Theory. This theory, which we discuss next, explains that organisations are subject to institutional pressures and as a result of these pressures, organisations within a given environment tend to become similar in their forms and practices.

Institutional Theory Broadly speaking, Institutional Theory considers the forms organisations take and provides explanations for why organisations within particular ‘organisational fields’ tend to take on similar characteristics and forms. DiMaggio and Powell (1983, p. 147) define an ‘organisation field’ as ‘those organizations that, in the aggregate, constitute a recognized area of institutional life: key suppliers, resource and product consumers, regulatory agencies, and other organizations that produce similar services or products’. According to Carpenter and Feroz Institutional Theory (2001, p. 565): Theory that considers the forms organisations assume and explains why organisations within particular ‘organisational fields’ tend to take on similar characteristics and forms.

Institutional theory views organizations as operating within a social framework of norms, values, and taken-for-granted assumptions about what constitutes appropriate or acceptable economic behaviour (Oliver, 1997). According to Scott (1987), ‘organizations, conform [to institutional pressures for change] because they are rewarded for doing so through increased legitimacy, resources, and survival capabilities’ (p. 498). A major paper in the development of Institutional Theory was DiMaggio and Powell (1983). They investigated why there was such a high degree of similarity between organisations. Specifically, in undertaking their research they asked (p. 148):

why there is such startling homogeneity of organizational forms and practices; and [sought] to explain homogeneity, not variation. In the initial stages of their life cycle, organizational fields display considerable diversity in approach and form. Once a field becomes well established, however, there is an inexorable push towards homogenization. According to DiMaggio and Powell, there are various forces operating within society that cause organisational forms to become similar. As they state (1983, p. 148): Once disparate organizations in the same line of businesses are structured into an actual field (as we shall argue, by competition, the state, or the professions), powerful forces emerge that lead them to become more similar to one another. Dillard, Rigsby and Goodman (2004, p. 506) state that: Institutional theory is becoming one of the dominant theoretical perspectives in organization theory and is increasingly being applied in accounting research to study the practice of accounting in organizations. A key reason why Institutional Theory is relevant to researchers who investigate voluntary corporate reporting practices is that it provides a complementary perspective, to both Stakeholder Theory and Legitimacy Theory, for understanding how organisations interpret and respond to changing social and institutional pressures and expectations. Institutional Theory links organisational practices (such as accounting and corporate reporting) to, among other things, the values of the society in which the organisation operates and the need to maintain organisational legitimacy. The view is held that organisational form and practices might tend to some form of homogeneity—that is, the structure of 116  PART 2: THEORIES OF ACCOUNTING

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the organisation and the practices adopted by different organisations tend to become similar to conform with what is considered to be ‘normal’. Organisations that deviate from the form that has become ‘normal’ or expected will potentially have problems gaining or retaining legitimacy. As Dillard, Rigsby and Goodman (2004, p. 509) state: By designing a formal structure that adheres to the norms and behaviour expectations in the extant environment, an organization demonstrates that it is acting on collectively valued purposes in a proper and adequate manner. Institutional Theory provides an explanation for how mechanisms by which organisations might seek to align perceptions of their practices and characteristics with social and cultural values (in order to gain or retain legitimacy) become institutionalised in particular organisations. Such mechanisms might include those proposed by both Stakeholder Theory and Legitimacy Theory, but might conceivably encompass an even broader range of legitimating mechanisms. This is why these three theoretical perspectives (Legitimacy Theory, Stakeholder Theory and Institutional Theory) should be seen as complementary rather than competing. There are two main dimensions to Institutional Theory that are particularly relevant to our discussion of reporting. The first of these is termed isomorphism and the second decoupling. Both can be of central relevance to explaining voluntary corporate reporting practices. The term ‘isomorphism’ is used extensively within Institutional Theory and is defined by DiMaggio and Powell (1983, p. 149) as ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’. That is, organisations that adopt structures or processes (such as reporting processes) at variance with other organisations might find that such differences will attract criticism. As Carpenter and Feroz (2001, p. 566) state: DiMaggio and Powell (1983) label the process by which organizations tend to adopt the same structures and practices isomorphism, which they describe as a homogenization of organizations. Isomorphism is a process that causes one unit in a population to resemble other units in the population that face the same set of environmental conditions. Because of isomorphic processes, organizations will become increasingly homogeneous within given domains and conform to expectations of the wider institutional environment. Dillard, Rigsby and Goodman (2004, p. 509) explain that ‘isomorphism refers to the adaptation of an institutional practice by an organisation’. As voluntary corporate reporting by an organisation is an institutional practice of that reporting organisation, the processes by which voluntary corporate reporting adapts and changes in that organisation are isomorphic processes. DiMaggio and Powell (1983) set out three different isomorphic processes (processes whereby institutional practices such as voluntary corporate reporting adapt and change). These three isomorphic processes are referred to as coercive isomorphism, mimetic isomorphism and normative isomorphism. The first of these isomorphic processes, coercive isomorphism, arises when organisations change their institutional practices in response to pressure from stakeholders upon whom the organisation is dependent (in other words, this form of isomorphism is related to ‘power’ and therefore has similar traits to Stakeholder Theory, as discussed earlier in this chapter). According to DiMaggio and Powell (1983, p. 150): Coercive isomorphism results from both formal and informal pressures exerted on organizations by other organizations upon which they are dependent and by cultural expectations in the society within which organizations function. Such pressures may be felt as force, as persuasive, or as invitations to join in collusion. DiMaggio and Powell go on to advance the following two hypotheses on coercive isomorphism: Hypothesis 1: The greater the dependence of an organization on another organization, the more similar it will become to that organization in structure, climate, and behavioural focus. Hypothesis 2: The greater the centralization of organization A’s resource supply, the greater the extent to which organization A will change isomorphically to resemble the organizations on which it depends for resources. The above form of isomorphism is clearly related to the managerial branch of Stakeholder Theory (discussed earlier) whereby a company will use ‘voluntary’ corporate reporting disclosures to address the economic, social, environmental and ethical values and concerns of stakeholders who have the greatest power over the company. The company is therefore coerced (in this case usually informally) by its influential (or powerful) stakeholders into adopting particular Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  117

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voluntary reporting practices. With regard to applying coercive isomorphism to government’s selection of accounting procedures, Carpenter and Feroz (2001, p. 571) state: Other organizations that can provide resources, such as the credit markets, can exercise power over government entities. This power can be used to dictate the use of certain institutional rules—such as GAAP. Explaining this more directly in terms of the earlier definition of isomorphism, the company is coerced into adapting its existing voluntary corporate reporting practices (including the issues upon which it reports) to bring these into line with the expectations and demands of its powerful stakeholders (while possibly ignoring the expectations of less powerful stakeholders). Because powerful stakeholders might have similar expectations to those of other organisations, there will tend to be conformity in the practices being adopted by different organisations—institutional practices will tend to some form of uniformity. The second isomorphic process specified by DiMaggio and Powell (1983) is mimetic isomorphism. This involves organisations seeking to emulate (perhaps copy) or improve upon the institutional practices of other organisations, often for reasons of competitive advantage in terms of legitimacy. In explaining mimetic isomorphism, DiMaggio and Powell (1983, p. 151) state: Uncertainty is a powerful force that encourages imitation. When organizational technologies are poorly understood, when goals are ambiguous, or when the environment creates symbolic uncertainty, organizations may model themselves on other organizations. According to DiMaggio and Powell, when an organisation encounters uncertainty it might elect to model itself on other organisations. The authors provide the following example of modelling (mimetic isomorphism) (1983, p. 151): One of the most dramatic instances of modelling was the effort of Japan’s modernizers in the late nineteenth century to model new governmental initiatives on apparently successful western prototypes. Thus, the imperial government sent its officers to study the courts, Army, and police in France, the Navy and postal system in Great Britain, and banking and art education in the United States. American corporations are now returning the compliment by implementing (their perceptions of) Japanese models to cope with thorny productivity and personnel problems in their own firms. The rapid proliferation of quality circles and quality-of-work-life issues in American firms is, at least in part, an attempt to model Japanese and European successes. These developments also have a ritual aspect; companies adopt these ‘innovations’ to enhance their legitimacy, to demonstrate that they are at least trying to improve working conditions. DiMaggio and Powell go on to provide the following two hypotheses on mimetic isomorphism: Hypothesis 3: The more uncertain the relationship between means and ends the greater the extent to which an organization will model itself after organizations it perceives to be successful. Hypothesis 4: The more ambiguous the goals of an organization, the greater the extent to which the organization will model itself after organizations that it perceives to be successful. As Unerman and Bennett (2004) explain in the context of a study investigating stakeholder dialogue in corporate social reporting: Some institutional theory studies .  .  . have demonstrated a tendency for a number of organisations within a particular sector to adopt similar new policies and procedures as those adopted by other leading organisations in their sector. This process, referred to as ‘mimetic isomorphism’, is explained as being the result of attempts by managers of each organisation to maintain or enhance external stakeholders’ perceptions of the legitimacy of their organisation, because any organisation which failed (at a minimum) to follow innovative practices and procedures adopted by other organisations in the same sector would risk losing legitimacy in relation to the rest of the sector (Broadbent et al. 2001; Scott 1995). Drawing upon these observations, in the absence of any legislative intervention prescribing detailed mechanisms of debate, a key motivating force for many managers to introduce mechanisms allowing for greater equity in the determination of corporate responsibilities would therefore be their desire to maintain, or enhance, their own competitive advantage. They would strive to achieve this by implementing stakeholder dialogue mechanisms which their economically powerful stakeholders were likely to perceive as more effective than those used by their competitors. It is unlikely that these managers would readily embrace 118  PART 2: THEORIES OF ACCOUNTING

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mechanisms designed to facilitate widespread participation in the determination of corporate responsibilities unless their economically powerful stakeholders expected the interests of economically marginalized stakeholders to be taken into account in this manner, and these managers are only likely to implement the minimum procedures which they feel their economically powerful stakeholders would consider acceptable. This argument links pressures for mimetic isomorphism with pressures underlying coercive isomorphism. As Unerman and Bennett (2004) maintain, without coercive pressure from stakeholders, pressure to mimic or surpass the social reporting practices (institutional practices) of other companies would be unlikely. The final isomorphic process explained by DiMaggio and Powell (1983) is normative isomorphism. This relates to the pressures arising from group norms to adopt particular institutional practices. In the case of corporate reporting, the professional expectation that accountants will comply with accounting standards acts as a form of normative isomorphism for the organisations for whom accountants work to produce accounting reports (an institutional practice) that are shaped by accounting standards. In terms of voluntary reporting practices, normative isomorphic pressures could arise through less formal group influences from a range of both formal and informal groups to which managers belong, for example, the culture and working practices developed within their workplace. These could produce collective managerial views favouring or rejecting certain types of reporting practices, such as collective managerial views on the desirability or necessity of providing a range of stakeholders with social and environmental information through the medium of corporate reports. DiMaggio and Powell provide the following two hypotheses on normative isomorphism: Hypothesis 5: The greater the reliance on academic credentials in choosing managerial and staff personnel, the greater the extent to which an organization will become like other organizations in its field. Hypothesis 6: The greater the participation of organizational managers in trade and professional associations, the more likely the organization will be, or will become, like other organizations in its field. Now that the three forms of isomorphism have been described (coercive, mimetic and normative isomorphism), it is interesting to note that such processes do not necessarily make organisations more efficient. As DiMaggio and Powell (1983, p. 153) put it: It is important to note that each of the institutional isomorphic processes can be expected to proceed in the absence of evidence that they increase internal organizational efficiency. To the extent that organizational effectiveness is enhanced, the reason will often be that organizations are rewarded for being similar to other organizations in their fields. This similarity can make it easier for organizations to transact with other organizations, to attract career-minded staff, to be acknowledged as legitimate and reputable, and to fit into administrative categories that define eligibility for public and private grants and contracts. None of this, however, ensures that conformist organizations do what they do more efficiently than do their more deviant peers. On the same point, Carpenter and Feroz (2001, p. 569) observe: Institutional theory assumes that organizations adopt structures and management practices that are considered legitimate by other organizations in their fields, regardless of their actual usefulness. Legitimated structures or practices can be transmitted to organizations in a field through tradition (organization imprinting at founding), through initiation, by coercion, and through normative pressures . . . Institutional theory is based on the premise that organizations respond to pressure from their institutional environments and adopt structures and/or procedures that are socially accepted as being the appropriate organizational choice . . . Institutional techniques are not based on efficiency but are used to establish an organization as appropriate, rational, and modern . . . By designing a formal structure that adheres to the prescription of myths in the institutional environment, an organization demonstrates that it is acting in a proper and adequate manner. Meyer and Ronan (1977) maintain that myths of generally accepted procedures—such as GAAP—provide a defence against the perception of irrationality and enhanced continued moral and/or financial support from external resource providers. While three distinct types of isomorphism have been described here, in practice it will not necessarily be easy to differentiate between them. As Carpenter and Feroz (2001, p. 573) state: DiMaggio and Powell (1983) point out that it may not always be possible to distinguish between the three forms of isomorphic pressure, and in fact, two or more isomorphic pressures may be operating simultaneously making it nearly impossible to determine which form of institutional pressure was more potent in all cases. Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  119

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In applying the various notions of isomorphism to accounting, the decision to disclose particular items of information may be more about ‘show’ than about ‘substance’. As Carpenter and Feroz (2001, p. 570) state: One manifestation of organizations in need of institutional legitimacy is the collecting and displaying of huge amounts of information that has no immediate relevance for actual decisions. Hence those state governments that have adopted GAAP, yet do not use GAAP information in making financial management decisions (e.g. budgetary decisions), may have adopted GAAP for purposes of institutional legitimacy. Carpenter and Feroz (2001) used Institutional Theory to explain four US state governments’ decisions to switch from a method of accounting based on recording cash flows to methods of accounting based on generally accepted accounting principles (GAAP). In describing the results of their analysis, they state (p. 588): Our evidence shows that an early decision to adopt GAAP can be understood in terms of coercive isomorphic pressures from credit markets, while late adopters seem to be associated with the combined influences of normative and mimetic institutional pressures . . . The evidence presented in the case studies suggests that severe, prolonged financial stress may be an important condition affecting the potency of isomorphic pressures leading to an early decision to adopt GAAP for external financial reporting. They went on to conclude (p. 592): All states were subject to normative isomorphic pressures from the accounting profession, coercive isomorphic pressures from the credit markets, and from the federal government to adopt GAAP from 1975 through 1984. Coercive isomorphic institutional pressures were significantly increased in 1984 with the passage of the Single Audit Act (SAA). And the formation of the Government Accounting Standards Board (GASB). Since it is likely that both normative and coercive isomorphic pressures act in concert to move state governments to GAAP adoption, it may be impossible to empirically distinguish the two forms of isomorphic pressure . . . We note that all state governments were subject to potent institutional pressure to adopt GAAP after 1973. These institutional pressures were created by the federal government, professional accounting associations, and representatives of the credit markets. Thus state governments were subjected to at least two forms of isomorphic pressures: normative and coercive . . . We predict that all state governments in the USA will eventually bow to institutional pressures for change and adopt GAAP for external financial reporting. Our prediction is based on insights from institutional theory, coupled with insight on the potency of the institutional pressures for change identified in our four case studies. Turning to the other dimension of Institutional Theory, decoupling implies that while managers might perceive a need for their organisation to be seen to be adopting certain institutional practices, and might even institute formal processes aimed at implementing these practices, actual organisational practices can be very different from these formally sanctioned and publicly pronounced processes and practices. Thus, the actual practices can be decoupled from the institutionalised (apparent) practices. In terms of voluntary corporate-reporting practices, this decoupling can be linked to some of the insights from Legitimacy Theory whereby social and environmental disclosures can be used to construct an organisational image very different from actual organisational, social and environmental performance. Thus, the organisational image constructed through corporate reports might be one of social and environmental responsibility when the actual managerial imperative is maximisation of profitability or shareholder value. As Dillard, Rigsby and Goodman (2004, p. 510) put it: Decoupling refers to the situation in which the formal organizational structure or practice is separate and distinct from actual organizational practice. In other words, the practice is not integrated into the organization’s managerial and operational processes. Formal structure has much more to do with the presentation of an organizational-self than with the actual operations of the organization (Curruthers, 1996). Ideally, organizations pursue economic efficiency and attempt to develop alignment between organizational hierarchies and activities. However, an organization in a highly institutionalized environment may face conflicts and inconsistencies between the demands for efficiency and the need to conform to ‘ceremonial rules and myths’ of the institutional context (Meyer & Rowan, 1977). In essence, institutionalized, rationalized elements are incorporated into the organization’s formal management systems because they maintain appearances and thus confer legitimacy whether or not they directly facilitate economic efficiency. Insights about ‘decoupling’ are particularly relevant for people who read corporate reports (such as investors, lenders, regulators, researchers and other interested stakeholders) as they provide a warning not to believe that the public 120  PART 2: THEORIES OF ACCOUNTING

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disclosures being made by organisations necessarily always reflect what is actually occurring within an organisation. For example, just because an organisation publicly discloses various missions and values and policies which seem to reflect that the organisation adopts best available environmental or social practices, this does not necessarily mean this is how the organisation actually operates. As such, there is an overlap with insights provided by Legitimacy Theory, Stakeholder Theory and Positive Accounting Theory. From the material provided in this chapter, it can be seen that PAT, Stakeholder Theory, Legitimacy Theory and Institutional Theory all provide different (but sometimes overlapping) theoretical perspectives on why organisations might elect to make particular disclosures. The relevance of such theories would arguably be greater where there is no regulation prescribing how organisations are to account for a particular transaction or event, or how to disclose particular information. In such a case, particular motivations, and not regulation, might drive what disclosures are made and what accounting methods are adopted. The various theories described above are summarised in Table 3.2. Theory

Type

Description

Positive Accounting Theory (PAT)

Positive

Seeks to explain and predict particular phenomena, especially the managers’ choice of accounting methods. Grounded in classical economics, it focuses on relationships between various individuals within and outside an organisation and explains how financial accounting can be used to minimise the cost implications of each contracting party operating in its own self-interest.

Current-cost accounting

Normative

Aims to provide a prescription for a calculation of income that, after adjustments are made for changing prices, could be withdrawn from the entity while leaving its physical capital intact. The maintenance of the firm’s physical capital or operating capacity is central to current-cost accounting.

Exit-price accounting (CoCoA)

Normative

The central objective of CoCoA is to provide information about an entity’s ‘capacity to adapt’ to changing circumstances, with profit being directly related to changes in adaptive capacity. Profit is calculated as the amount that can be distributed while maintaining the entity’s adaptive capital intact.

Deprival-value accounting

Normative

Can be defined as the value to the business of particular assets. Deprival-value accounting provides the basis for how assets should be measured. Deprival value represents the amount of loss that might be incurred by an entity if it were deprived of the use of an asset and the associated economic benefits generated by the asset.

Stakeholder Theory

Managerial (Positive) branch

Seeks to explain and predict how an organisation will react to the demands of various stakeholders. It predicts that organisations will tend to satisfy the information needs of those stakeholders who are important to the organisation’s ongoing survival. Whether a particular stakeholder receives information will depend on how powerful that stakeholder is perceived to be—power often being considered in terms of the scarcity and importance of the resources controlled by the stakeholder concerned.

Ethical (Normative) branch

All stakeholders have intrinsic rights that should not be violated. Stakeholders have rights to information that should be met regardless of the power of the stakeholders involved. Disclosures are considered to be responsibility driven.

Legitimacy Theory

Positive

Often utilizes the notion of a social contract, which is an implied contract representing the norms and expectations of the community in which the organisation operates. An organisation is deemed to be legitimate to the extent that it complies with the terms of the social contract. Legitimacy Theory predicts that the organisation will make information disclosures to gain, maintain or restore its legitimacy (and thereby its ability to continue operating).

Institutional Theory

Managerial/ Positive

Provides a complementary perspective to Stakeholder Theory and Legitimacy Theory. It provides a framework for understanding how organisations interpret and respond to changing social and institutional pressures. There are two frequently applied dimensions to Institutional Theory—namely, isomorphism and decoupling. Isomorphism is related to the managerial branch of Stakeholder Theory, while decoupling tends to be more linked to some of the insights of Legitimacy Theory.

Table 3.2 Theories of accounting summarised

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While there are numerous theories that can be applied to explain managers’ choice of accounting methods or disclosure strategies (particularly where there are no legislative requirements), there are also a number of theories that have been constructed to explain how and why accounting regulation is developed (including theories explaining the introduction of regulation). As with the other theories discussed in this chapter, there is no one generally accepted theory of regulation. In fact, there is much debate about what drives the introduction of regulation. The following discussion will briefly consider some of this debate.

LO 3.13

Theories that seek to explain why regulation is introduced

As indicated in Chapter 1, general purpose financial reporting is subject to a great deal of regulation. For example, listed companies must comply with a multitude of accounting standards, as well as with the corporations legislation and securities exchange listing requirements. In this section, a brief overview is provided of some of the theories developed to explain why regulation is introduced. Arguments in favour of or against regulation (that is, the pro-regulation versus free-market arguments) will not be considered here, as they were briefly considered in Chapter 1. In the material that follows, you will see that different researchers have advanced different arguments about what causes regulation to be introduced. Some theories of regulation suggest that regulation is introduced in the public interest, while other theories suggest that regulation is introduced to benefit some people at the expense of others, that is, in self-interest.

Public Interest Theory According to Posner (1974, p. 335), Public Interest Theory ‘holds that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices’. That is, regulation is initially put in place to benefit society as a whole, rather than to benefit particular vested interests, and the regulatory body is considered to represent the interests of the society in which it operates, rather than the private interests of the regulators. The enactment of legislation is considered to be a balancing act between the social benefits and the social costs of the regulation. The application of this argument to financial accounting, given the existence of a capitalist economy, implies that society needs confidence in the capital markets to help ensure that resources are directed towards productive assets. Regulation is deemed to be an instrument for creating such confidence. There are many people who are critical of this fairly simplistic perspective of why regulation is introduced (for example, Stigler 1971; Posner 1974; and Peltzman 1976). Posner (1974, p. 337) states: [There is] a good deal of evidence that the socially undesirable results of regulation are frequently desired by groups influential in the enactment of the legislation setting up the regulatory scheme . . . Sometimes the regulatory statute itself reveals an unmistakable purpose of altering the operation of markets in directions inexplicable on public interest grounds. Proponents of the economics-based assumption of self-interest would argue against accepting that any legislation was put in place by particular parties because these parties genuinely believe it to be in the public interest. Rather, they consider that legislators will enact legislation only because it might increase their own wealth (perhaps through increasing their likelihood of being re-elected), and people will lobby for particular legislation only if it is in their own interests. Obviously, as with most theoretical assumptions, this (simplistic) self-interest assumption is one that (hopefully!) will not always hold. Nevertheless, and as is shown in this chapter, the belief that ‘self-interest drives all’ is central to many theoretical perspectives.

Capture Theory Researchers who embrace Capture Theory (capture theorists) would typically argue that although regulation might be introduced with the aim of protecting the ‘public interest’ (as argued in Public Interest Theory, as briefly described above), this laudable aim of protecting the public interest will not ultimately be achieved, because in the process of introducing regulation the organisations that are subject to the regulation will ultimately come to control the regulator. The regulated industries will seek to gain control of the regulatory body, because they will know that the decisions made by the regulator will potentially have significant impacts on their industry. The regulated parties or industries will seek to take charge of (capture) the regulator with the intention of ensuring that the regulations subsequently released by the 122  PART 2: THEORIES OF ACCOUNTING

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regulator (post-capture) will be advantageous to their industry. As an example of possible regulatory capture, we might consider the contents of a newspaper article entitled ‘Aviation industry “captured” safety body’ (Canberra Times, 4 July 2008), in which it was stated: A former senior legal counsel to the Civil Aviation Safety Authority for more than a decade has accused the regulator of failing as a safety watchdog because it is too close to the industry. Peter Ilyk, who left the authority in 2006, told a Senate inquiry into CASA’s administration and governance the authority had been ‘captured’ by the industry, making it reluctant to deal decisively with air operators who fell short of safety regulations . . . Another former staff member, Joseph Tully, who was policy manager general aviation before he left last year, agreed CASA was too close to the industry. ‘You have got to keep a professional distance when you’re a regulator . . . we have become more of a partner than a regulator in the last few years,’ Mr Tully said. In another example of potential regulatory capture, this time in relation to how certain large firms have effectively captured the regulations pertaining to who can act in the role of a liquidator, a report in The Australian Financial Review entitled ‘Seeing the wood for the trees and fees’ (by James Eyers, 15 October 2010) stated: Having appeared as a witness before the Senate committee that called last month for a shake-up of the cozy insolvency club, barrister Geoff Slater wasted no time taking the cost of liquidations to task . . . Slater told Federal Court judge Ray Finkelstein on Wednesday the dispute was ‘really a fight over fees’—and the intensity of the issue suggested the potential fees on the matter would be very high. The court should scrutinise ‘the economic dynamic of those fees’, Slater argued, including the profit margins for particular types of work and ‘in particular the tyranny of the hourly fee’ . . . Slater pointed a finger at the Australian Securities and Investments Commission, alleging it had become a victim of regulatory capture. Commissioner Michael Dwyer, who has responsibility for insolvency practitioners, had been a partner at KPMG for most of his career and had been national president of the Insolvency Practitioners Association for two years, Slater told the court. ‘A layperson—rightly or wrongly—might be forgiven for thinking ASIC has a bias towards the status quo,’ Slater said. Furthermore, ASIC’s list of qualifications for insolvency practitioners were nothing more than a device to exclude everyone but the big firms, he said. Mitnick (1980, p. 95, as reproduced in Walker 1987, p. 281) provides a useful description of the Capture Theory perspective: Capture is said to occur if the regulated interest controls the regulation and the regulated agency; or if the regulated parties succeed in coordinating the regulatory body’s activities with their activities so that their private interest is satisfied; or if the regulated party somehow manages to neutralise or ensure non-performance (or mediocre performance) by the regulating body; or if in a subtle process of interaction with the regulators the regulated party succeeds (perhaps not even deliberately) in co-opting the regulators into seeing things from their own perspective and thus giving them the regulation they want; or if, quite independently of the formal or conscious desires of either the regulators or the regulated parties, the basic structure of the reward system leads neither venal nor incompetent regulators inevitably to a community of interests with the regulated party. As with many other industries, at various times and in various jurisdictions it has been argued that large accounting firms have captured the accounting standard-setting process. This was of such concern in the United States that in 1977 the United States Congress investigated whether the Big Eight accounting firms had ‘captured’ the standardsetting process (Metcalf Inquiry). In Australia, Walker (1987) provides an interesting analysis of the early existence of the Accounting Standards Review Board (subsequently replaced by the Australian Accounting Standards Board). Walker’s analysis is consistent with the perspective that the Accounting Standards Review Board (ASRB), a government body, was ‘captured’ by the accounting profession (using the definition of ‘capture’ provided above by Mitnick (1980)). Walker himself was a member of the ASRB from 1984 to 1985. In commenting on his motivation for documenting the case study of the ASRB, Walker states (p. 285) that:  The main concern was to highlight the way that a set of standard-setting arrangements designed to permit widespread consultation and participation were subverted by some likeable, well-meaning individuals who were trying only to promote the interests of their fellow accountants. Chapter 1 discussed some changes that were made several years ago to the processes by which accounting standards are developed in Australia. This involved taking accounting standard-setting out of the hands of the Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  123

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profession and putting it under the control of a government body. As indicated then, the motivation for the changes seemed, at least in part, to be the view that the accounting profession played too great a part in developing standards that would be applied by the accounting profession. The profession appeared to have captured the regulatory process in relation to developing accounting standards. Proponents of Capture Theory typically argue that regulation is usually introduced, or regulatory bodies are established, to protect the public interest. This would seem to be the case in Australia with regard to the establishment of the Accounting Standards Review Board (the predecessor to the AASB). Before the establishment of the ASRB, accounting standards were issued by the accounting profession, and sanctions for non-compliance (which were very rarely imposed) could be imposed only against members of the profession. Walker (1987, p. 270) notes that throughout the 1970s (before the establishment of the ASRB in 1984), monitoring activities by government agencies revealed a high incidence of non-compliance with profession-sponsored accounting rules. It was argued that this non-compliance undermined public confidence in the capital market, and this reduction in public confidence was itself not deemed to be in the public interest. Government-sponsored standards, through the establishment of the ASRB, together with associated legal sanctions, should, it was thought, raise the level of compliance and hence the confidence of the public in company reporting practices. According to Walker (1987, p. 271): The accounting profession strongly opposed the ‘costly and possibly bureaucratic step’ of involving government in the preparation of accounting rules. It publicised counter-proposals that . . . legislative backing be extended to the profession’s own standards. The files of the Commonwealth Attorney-General’s Department relating to the establishment of the ASRB (copies of which were obtained in terms of Commonwealth Freedom of Information legislation) record that National Companies and Securities Commission Chairman Leigh Masel referred to a ‘concerted lobby by the accounting profession’ on these matters. According to Walker (1987), Masel telexed members of the Commonwealth government’s Ministerial Council advising that the NCSC (ultimately replaced by ASIC) had received submissions opposing the profession’s proposals. Part of the message stated: A particular concern expressed in discussions with some respondents was that, if the accounting profession’s proposals are accepted, the status and income of the profession would, effectively, be accorded statutory protection without any corresponding requirement for public reporting and accountability by that profession. For reasons readily apparent, there are many in the profession who would welcome the safe harbour which legislative recognition would provide. By way of concluding remarks on the ASRB’s ‘capture’, Walker (1987, p. 282) states: During 1984–5 the profession had ensured the non-performance of the ASRB and by the beginning of 1986 the profession had managed to influence the procedures, the priorities and the output of the Board. It was controlling both the regulations and the regulatory agency; it had managed to achieve coordination of the ASRB’s activities; and it appears to have influenced new appointments so that virtually all members of the Board might reasonably be expected to have some community of interests with the professional associations. The ASRB had been ‘captured’ by the profession within only 24 months. Chand and White (2007) also consider the issue of regulatory capture. In doing so, they also explain government involvement in the accounting standard-setting process, and why, in the Australian context, the Financial Reporting Council was established to oversee the activities of the Australian Accounting Standards Board. Chand and White (2007, p. 612) state: Some jurisdictions, notably the US and Australia, have taken the regulatory process under the wing of a government agency, to efface or avoid its being captured by the profession. For example, the US has taken steps through the Sarbanes-Oxley legislation to strengthen the regulator’s independence (Herz, 2002; Schipper, 2003). Similarly, in Australia the new standard-setting arrangements were introduced in 1997, including the Financial Reporting Council to oversee the Australian Accounting Standards Board (Haswell and McKinnon, 2003, p. 10). Such remedial measures were seen as necessary in these countries, demonstrating that the regulatory process may have been captured.

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Economic Interest Group Theory of Regulation Another theory of regulation is the Economic Interest Group Theory of Regulation (or, as it is sometimes called, Private Interest Theory of Regulation), which assumes that groups will form to protect particular economic interests. Different groups are viewed as often being in conflict with each other, and the different groups will lobby government to put in place legislation that economically benefits them (at the expense of others). For example, consumers might lobby government for price protection, or producers might lobby for tariff protection. This theoretical perspective adopts no notion of public interest—rather, private interests are considered to dominate the legislative process. As Posner (1974) states, ‘the economic theory of regulation is committed to the strong assumptions of economic theory generally, notably that people seek to advance their self-interest and do so rationally’. In relation to financial accounting, particular industry groups might lobby the regulator to accept or reject a particular accounting standard. For example, in Australia an Accounting Standard relating to the activities of general insurers was released in 1990 (AASB 1023 General Insurance Contracts). One requirement of this standard that was particularly unpopular with some insurance firms was that their investments had to be valued at net market value, with any changes therein to be taken directly to profit or loss. To a number of firms, this introduced unwanted volatility in earnings, which they felt would negatively affect their operations. They lobbied the Australian Accounting Standards Board to amend the requirement. Another example is the fact that many corporations lobbied the AASB to remove the former requirement that purchased goodwill be amortised to the income statement over a maximum period of 20 years (previously required in Australia by AASB 1013), the argument being that this affected their international competitiveness. The accounting standards relating to goodwill and general insurers were not amended to take account of these concerns. However, they were subsequently amended as a result of Australia’s decision to adopt IFRSs by 2005. If we accept the Economic Interest Group Theory of Regulation, the lack of initial success in this instance must have been due to the fact that a more powerful interest group favoured the alternative situation. Watts and Zimmerman (1978) reviewed the lobbying behaviour of United States corporations in relation to a proposal for the introduction of general price level accounting—a method of accounting that, in periods of inflation, would lead to a reduction in reported profits. The authors demonstrated that large, politically sensitive firms favoured the proposed method of accounting, since it led to reduced profits. This was counter to normal expectations that companies would generally prefer to show higher, rather than lower, earnings. It was explained on the (self-interest) basis that the larger firms would be viewed more favourably by various groups in the community if they reported lower profits. Reporting lower profits was less likely to have negative wealth implications for the organisations (perhaps in the form of government intervention, consumer boycotts or claims for higher wages). According to the Economic Interest Group Theory of Regulation, the regulator itself is also an interest group—a group that is motivated to embrace strategies to ensure re-election, or to ensure the maintenance of its position of power or privilege within the community. We should remember that regulatory bodies can be very powerful. The regulatory body, typically government controlled, possesses a resource (potential legislation) that can increase or decrease the wealth of various sectors of the constituency. According to this perspective of regulation, rather than regulation being put in place initially in the public interest (as is initially assumed within Capture Theory and also in Public Interest Theory), it is proposed that regulation is put in place to serve the private interests of particular parties, including politicians who seek re-election. According to Posner (1974, p. 343), economic interest theories of regulation insist that economic regulation serves the private interests of politically effective groups. Further, in relation to the political process, Stigler (1971, p. 12) states: The industry which seeks regulation must be prepared to pay with the two things a party needs: votes and resources. The resources may be provided by campaign contributions, contributed services (the businessman heads a fund-raising committee), and more indirect methods such as the employment of party workers. The votes in support of the measure are rallied, and the votes in opposition are dispersed, by expensive programs to educate (or uneducate) members of the industry and other concerned industries . . . The smallest industries are therefore effectively precluded from the political process unless they have some special advantage such as geographical concentration in a sparsely settled political subdivision. Under the Economic Interest Theory of Regulation, the regulation itself is considered to be a commodity, subject to the economic principles of supply and demand. According to Posner (1974, p. 344):

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Since the coercive power of government can be used to give valuable benefits to particular individuals or groups, economic regulation—the expression of that power in the economic sphere—can be viewed as a product whose allocation is governed by laws of supply and demand . . . There are a fair number of case studies—of trucking, airlines, railroads, and many other industries—that support the view that economic regulation is better explained as a product supplied to interest groups than as an expression of the social interest in efficiency or justice. Reflecting upon the above discussion, do you think that accounting standards are introduced in the public interest, or in the self-interest of particular groups? While our discussion of ‘theories of regulation’ (Public Interest Theory, Capture Theory and Economic Interest Group Theory) is brief and certainly does not include all theories pertaining to why regulation is introduced, the discussion does provide some insights into why particular regulations might have been established. Because accounting is subject to a great deal of regulation, it is often interesting to consider why particular regulations were introduced (and perhaps why some other proposed regulation was not ultimately introduced). The theories briefly described above provide some insights that may be helpful in answering such questions.

SUMMARY This chapter has described various theories that relate to financial accounting. It is stressed that no single accounting theory is universally accepted. A theory itself is defined as a coherent group of propositions used as an explanation for a class of phenomena. The phenomena studied in accounting theory obviously relate to the practice of accounting, but which phenomena are selected for study from the many available will depend on the theoretical approach that is adopted. The chapter has considered the differences between positive and normative theories of accounting. A positive theory of accounting is one that seeks to explain and predict particular accounting-related phenomena, whereas a normative theory of accounting prescribes how accounting should be practised. The conceptual framework of accounting, which was considered in some depth in Chapter 2 (and will be revisited in other chapters throughout this book), is classified as a normative theory of accounting. One positive theory of accounting that we described was Positive Accounting Theory—a theory that was popularised by theorists such as Watts and Zimmerman. Researchers who adopt a Positive Accounting Theory perspective typically study issues such as the capital market’s reaction to particular accounting policies; what motivates managers to select one method of accounting from among competing alternatives; and the reasons for the existence of particular accountingbased contracts. Positive Accounting Theory proponents typically rely upon a fundamental assumption that individual action can be predicted on the basis that all action is driven by a desire to maximise wealth. As we have seen, such an assumption is often criticised by researchers who adopt alternative theoretical perspectives. Normative accounting theorists typically argue that it is a central role of accounting theory to provide prescription, that is, to inform others about the optimal accounting approach to adopt and why this particular approach is considered optimal. In this view, to fail to provide such prescription is to neglect one’s duties as an accounting academic. Normative theories that are considered briefly in this chapter include the conceptual framework, current-cost accounting, exit-price accounting and deprival-value accounting. Each of the normative theories of accounting differs from the others in its prescriptions, depending on the perspective adopted on how information is used by individuals and, linked to this, what information is actually important to inform decision making. This chapter also briefly considers systems-based theories. These theories, which include Stakeholder Theory, Legitimacy Theory and Institutional Theory, see the organisation as being firmly embedded within a broader social system. The organisation is considered to be affected by, and to affect, the society in which it operates. According to these theories, accounting disclosures are a way to manage relations with particular groups outside the organisation. In a sense, organisational activities and accounting disclosures are perceived to be reactive to community pressures. How the firm operates and what it reports will be influenced by a consideration of various stakeholder expectations. Because these ‘systems-based’ theories seek to explain and predict particular corporate actions they can also be considered to be ‘positive theories’ (as opposed to being ‘normative theories’).

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Apart from theories to explain or prescribe the selection of particular accounting methods, we also considered theories that seek to explain how regulation is developed, that is, we considered theories of regulation. We saw that some theories of regulation suggest that regulation is introduced to serve the public interest by regulators who work for the public good, whereas other theories of regulation assume that the development of regulation is driven by considerations of self-interest. This chapter has emphasised that the selection of one theory in preference to another will depend on the views and expectations of the researcher in question. We have seen that there is often heated debate between individuals from the alternative schools of thought. Theories, as abstractions of reality, cannot be expected to perfectly explain and predict all accounting-related phenomena, nor can they be expected to provide optimal solutions in all cases. No one theory of accounting can—or, perhaps, should—ever be definitively described as the best theory. If we accept this, we will see that different theoretical perspectives can, at various times, provide us with valuable insights into accounting issues. In the balance of this book, accounting requirements as stipulated by the different accounting standards will be considered. As appropriate, reference will be made to the theories discussed in this chapter, thus providing insight into the implications of the various accounting requirements and reporting practices that organisations adopt.

KEY TERMS accounting-based bonus scheme  91 accounting policy notes  102 agency relationship  87 bonus scheme  90 capacity to adapt  108 Continuously Contemporary Accounting (CoCoA)  107 creative accounting  102 current cash equivalents  108 current-cost accounting  107 current replacement cost  109 debt covenant  96

debtholder  97 exit-price theory  108 generally accepted accounting principles  91 information asymmetry  90 Institutional Theory  116 Legitimacy Theory  112 leverage (gearing)  96 monitoring cost  88 net present value  92 net selling price  109 normative accounting theories  106

perquisite consumption  89 political costs  98 Positive Accounting Theory (PAT)  87 present value  109 rational economic person assumption  89 social contract  113 social-responsibility disclosures  110 Stakeholder Theory  111 systems-oriented theories  110 theory  86

END-OF-CHAPTER EXERCISES This chapter has raised a number of issues in relation to various theories of financial accounting. To test your comprehension of the various issues, try answering the following questions. If you are unable to answer the questions, consider re-reading some of the material provided in the chapter. 1. What is a theory and how would you evaluate whether a theory is a ‘good’ theory or a ‘bad’ theory? Is there actually such a thing as a good or a bad theory? LO 3.1, 3.3 2. Do you expect that we will ever have a single universally accepted theory of accounting and, if not, why not? LO 3.1, 3.2, 3.3 3. What is the difference between a normative theory and a positive theory? Is one more useful than the other or do they perform different roles? LO 3.2, 3.3, 3.8 4. What is the role of Positive Accounting Theory and what are its central assumptions? Given these assumptions, do you think it is realistic for the conceptual framework to propose that financial statements should be objective and free from bias? LO 3.5, 3.7, 3.8, 3.10 5. Can Positive Accounting Theory explain the existence of creative accounting? LO 3.7, 3.10 6. What is a systems-oriented theory of accounting? LO 3.12

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REVIEW QUESTIONS 1. Why is it useful for students of financial accounting to consider theories such as those discussed in this chapter? LO 3.1 2. Why and how might management not act in the interests of the firm? LO 3.6, 3.7, 3.8 3. How can we use the output of the accounting system to help ensure that management’s actions are in the interests of the owners? LO 3.4, 3.6, 3.7, 3.13 4. How can management expropriate the wealth of debtholders? LO 3.4, 3.6, 3.7, 3.8 5. What is corporate social reporting? LO 3.12 6. Why would firms voluntarily present certain information, such as information about their performance with regard to the environment? LO 3.9, 3.12 7. If firms are voluntarily producing information about the environment, about their initiatives with respect to their employees or about their commitments to the local population, what does this imply about their perceptions of who the ‘users’ of the information are? LO 3.12 8. What are debt covenants and why are they put in place? LO 3.6, 3.7, 3.8 9. What might be a goal of a well-designed management compensation scheme? LO 3.6, 3.8 10. What mechanisms could be put in place to motivate management to consider the interests of: (a) the owners? (b) the debtholders? LO 3.6, 3.7 11. What role does the auditor play in financial reporting? LO 3.6, 3.7, 3.10 12. Why would a change in accounting policy affect a contractual agreement between a firm and a manager or debtholder? LO 3.6 13. According to Positive Accounting Theory, why could a change in the existing set of accounting standards affect the value of a firm? LO 3.6, 3.8 14. Positive Accounting Theory utilises the concept of political costs. Briefly define political costs. What actions might a firm’s management undertake in an attempt to minimise the political costs that might be imposed on the firm? LO 3.9 15. Explain why a firm’s management might be prepared to expend considerable resources to lobby ‘for’ or ‘against’ a proposed accounting standard. LO 3.6, 3.7, 3.8, 3.9 16. If management agrees to restrict its ability to transfer wealth away from debtholders—perhaps through agreeing not to pay excessive dividends; not to take on excessive levels of debt; or not to participate in excessively risky ventures—what effect should this have on the cost of debt capital of the firm? LO 3.6, 3.8 17. Chambers’ theory of accounting, Continuously Contemporary Accounting, relies on the notion of the ‘capacity to adapt’. What is the capacity to adapt and how is it determined? LO 3.2, 3.11 18. Professional accountants are expected to be objective when performing their duties. How would you reconcile this expectation with the central assumptions of Positive Accounting Theory, and are they mutually exclusive? LO 3.5, 3.7, 3.8, 3.9, 3.10 19. Contrast the role of Positive Accounting Theory with the role of normative accounting theories. LO 3.2 20. Under Positive Accounting Theory, what are agency costs of equity and agency costs of debt? Is it possible to put in place mechanisms to reduce all opportunistic action? If not, why not? LO 3.4, 3.6 21. If we accept the assumptions of Positive Accounting Theory, would you expect a manager who is rewarded by way of a profit-sharing bonus scheme to prepare the firm’s financial statements in an unbiased manner? Explain your answer. LO 3.7, 3.8 22. How could accounting regulators use the research conducted by Positive Accounting theorists? LO 3.5, 3.6, 3.7 23. Some researchers who utilise Legitimacy Theory posit that organisations will attempt to operate within the terms of their ‘social contract’. What is a social contract? LO 3.12 24. Using Institutional Theory as your theoretical basis, explain why an organisation might voluntarily elect to make particular financial disclosures. LO 3.12 25. Within Institutional Theory, reference is made to isomorphism and decoupling. What do these terms mean? LO 3.12

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26. If we accept the assumptions of Positive Accounting Theory, would you expect a manager who is employed by a firm that has negotiated lending agreements which include accounting-based debt covenants to have a relatively greater incentive to manipulate the financial statements? Explain your answer. LO 3.7, 3.8, 3.9, 3.10 27. The IASB’s Conceptual Framework for Financial Reporting indicates that financial statements should provide unbiased representations of the underlying transactions. Is this realistic? LO 3.7 28. Provide some arguments to explain what motivates regulators to introduce particular regulations. LO 3.7, 3.13 29. An article entitled ‘A step too far crucifies small business’ appeared in The Australian Financial Review on 4 June 2004 (p. 81) and is adapted below in Financial Accounting in the Real World 3.2. Applying Stakeholder Theory, would the bank care about the concerns of the small business sector and regional business communities? LO 3.12

3.2 FINANCIAL ACCOUNTING IN THE REAL WORLD The NAB and the McMinns: bank policy and its effect on small business Australian banks disseminate reports that small business is now getting a better deal from the banking sector, though the fact that the National Australia Bank (NAB) is losing market share at the sole-proprietor end belies that in the NAB’s case. The journey of a Queensland small business from profitable concern to receivership demonstrates how NAB’s policy changes over a period of years contributed largely to the fate of Alan and Wilma McMinn. On the strength of their relationship with a NAB commercial manager who understood the childcare business and the opportunities opened up in the sector by the population expansion on the Gold Coast, the McMinns bought a childcare centre there in 1995. They decided to build a second centre next to the first and the plan was approved by NAB following the McMinn’s 1996 financial year net profit of $250 000. Success in the new venture rested on the centre being open at the beginning of the 1997 school year. Although all the major banks began cost-cutting on a grand scale around this period, the replacement of the McMinn’s bank manager under the regime of Frank Cicutto, NAB’s general manager of Australian financial services, didn’t cause alarm bells as the subsequent manager reiterated in September 1996 that NAB was committed to the new centre, despite the turmoil at the bank’s head office. The McMinns were told to go ahead while waiting for formal approval paperwork, but in December were ordered to stop work immediately. NAB didn’t give final approval for building for four months so the McMinns missed their 1997 deadline. They attribute the collapse of the business to the bank’s actions from 1995 to 2000, over which period they had to deal with 16 different commercial managers. They have taken NAB to court; the bank has followed its normal practice and made no comment. Although the bank has been hurt by the scandal surrounding its $360 000 million foreign currency option it appears that is what is actually driving SME customer loss is the NAB’s centralisation project where local business bankers (around 110) were redeployed in the capital cities, and customers no longer had a face-to-face banker. Ian MacDonald, now head of NAB’s Financial Services Australia unit, has announced a reversal of the centralisation policy and that NAB will again have a small business banker in its 110 business banking centres Australia-wide and business bankers in branches if needed. There has been criticism of the close relationship of NAB and CBA with their receivers by Evan Jones, University of Sydney Economics Faculty. Jones believes the banks call in the receivers too quickly and without being questioned over their actions. He also blames corporate restructuring for customer loss. SOURCE: Adapted from ‘A step too far crucifies small business’, by Stewart Oldfield, The Australian Financial Review, 4 June 2004, p. 81

30. Read the adapted article by Kate Lahey and Leonie Wood in Financial Accounting in the Real World 3.3. This article is about the collapse of the financial institution Lehman Brothers. After reading the article you are to answer the following questions: (a) What does ‘window dressing’ mean in the context of this article? (b) Using Positive Accounting Theory as the basis of your argument, why would the bank have tried to manipulate the financial statements by understating debt? (c) What qualitative characteristics of the IASB conceptual framework would they have potentially breached? (d) Are firms more likely to engage in ‘window dressing’ their financial statements when they have relatively high levels of debt rather than low levels of debt? Why? LO 3.2, 3.7, 3.8, 3.10 Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  129

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3.3 FINANCIAL ACCOUNTING IN THE REAL WORLD RBA right to doubt Lehman Brothers accounts The Reserve Bank Australia (RBA) questioned Lehman Brothers representatives about transactions it believed were being used to conceal a debt of billions of dollars well before the bank collapsed so spectacularly in September 2008 and severely damaged the world financial markets. It appears the RBA was right to question the bank. A nine-volume, 2 200 page report into Lehmann’s bankruptcy by Anton Valukas, partner in the law firm Jenner & Block and examiner for the bank, was released on 12 March 2010. It contains copies of emails where Lehmann employees discuss whether to reveal to the RBA vague or detailed reasons for Lehman’s accounting practices. The report revealed the causes of the demise of Lehman, including unsecured mortgages and insistence on collateral for loans sought by Lehman from its competitors Citigroup and JPMorgan Chase. The report outlined the ‘materially misleading’ accounting practices used by Lehman to conceal its financial woes and its dependence on borrowed money for survival, Senior Lehman executives and the bank’s accountants at Ernst & Young were aware that $50 billion was ‘removed’ from the accounts in the months before the collapse; Lehman’s CEO at the time, Richard Fuld Jr, certified the accounts were correct. The report said Fuld was ‘at least grossly negligent’; he’d been warned by the treasury secretary, Henry Paulson Jr about the need for Lehman to stabilise its finances or find a buyer to stave off the possibility of collapse. Both Lehman and Ernst & Young had ignored Matthew Lee, a senior vice-president, when he wrote to senior management and auditors about ‘accounting improprieties’. The report found Lehman’s board had not been informed of Lee’s claims and were unaware of the suspect accounting practices. Valukas stated that Lehman executives were involved in ‘actionable balance sheet manipulation,’ and made ‘nonculpable errors of business judgment’ and suggested that there was enough evidence against them, and Ernst & Young, to support civil claims. ‘Our last audit of the company was for the fiscal year ending November 30, 2007. Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.’ This was the official response of Ernst & Young to the report by its representative, Charles Perkins. The accounting practice subject to scrutiny in a large part of the Valukas report is the use of repurchase agreements known on Wall Street as ‘repos’ and as ‘Repo 105’ at Lehman Brothers. Repo 105 transactions, in use since 2001, moved billions off Lehman’s accounts when the bank came under scrutiny. It was use of Repo 105 that the RBA had questioned. They were used extensively before the crash as Fuld Jr ordered his executives to reduce Lehman’s level of debt. Valukas quoted a Lehman executive’s email where it was said about Repo 105 that ‘It’s basically windowdressing’. For example, the amount moved off balance sheets in the final quarter of 2007 was $39 billion, in the first quarter of 2008, $49 billion, and in the second quarter of that year, $50 billion. At the same time the Lehman executives were insisting in public that its finances were in good shape. Fuld denied knowledge of the use of Repo 105 although it has been reported that Herbert McDade, Lehman’s ‘balance sheet czar’ told Fuld about the use of Repo 105. Following the release of the report Lehman’s current CEO, Bryan Marsal, said that they will consider the report and ‘assess how it might help us in our ongoing efforts to advance creditor interests’. Lehman’s creditors in Australia will also be hoping that the report will assist with advancing their interests. Local councils and charities bought up to $1.2 billion of complex derivative instruments from Lehman before its collapse. Lehman’s biggest creditors by a deed of company arrangement sought to protect Lehman and third parties from claims from the councils. The councils are hoping the report strengthens their case to sue but they are waiting for a High Court ruling on the issue. SOURCE: Adapted from ‘Reserve Bank put heat on Lehman over accounting’, by Kate Lahey and Leonie Wood, The Age, 13 March 2010, Web.

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CHALLENGING QUESTIONS 31. In an article that appeared in The Australian on 28 July 2014 entitled ‘Southern Cross CFO quit over writedown’ (by Darren Davidson) it was reported that: Mr Lewis joined Southern Cross after it issued a profit downgrade in May. The owner of the 2DayFM radio network said that it expected full-year net profit to fall 10 per cent below the previous year’s funderlying NPAT of $89 million. Although the company’s gearing remains within its banking covenant of less than 3.5 times earnings before interest, taxes, depreciation and amortisation, there is concern in the market the company is slipping into a danger zone with its debt covenants. Some market analysts believe that if revenues continue to deteriorate, gearing of above three times EBITDA could trigger a breach of banking covenants.

REQUIRED (a) Why might the debt covenants have originally been agreed to by Southern Cross? (b) Why would a reduction in earnings potentially affect the debt covenants? (c) In general, and according to the ‘debt hypothesis’ often utilised within Positive Accounting Theory, if an entity is close to breaching accounting-based debt covenants then what action might the entity take? LO 3.5, 3.6, 3.7, 3.8, 3.10 32. Read the brief extract from Anthony Hughes’ article ‘Credit card profit soars but ANZ feels no guilt’ in Financial Accounting in the Real World 3.4 and answer the following questions (be specific about the theories you are using when providing your answers): (a) Why do you think the bank ‘unveiled a plan to tackle community concerns’? (b) What do you think motivates the government to take action against the banks? (c) The bank’s reported profit seems to be an issue of concern. Do you think that community concern about the actions of the bank would be as great if the bank was not so profitable? (d) Do you think that community concerns about the profits made by banks might motivate the banks to adopt accounting policies that reduce their reported profits? Explain your answer. LO 3.6, 3.7, 3.8, 3.9

3.4 FINANCIAL ACCOUNTING IN THE REAL WORLD Credit card profit soars but ANZ feels no guilt Anthony Hughes ANZ denied yesterday it was overcharging customers after reporting a 71 per cent increase in credit card profits. The bank also reported a 93 per cent profit rise from mortgages.  The overall net profit for the March half was $895 million, a record for the bank.  The result comes just a week after the bank unveiled a plan to tackle community concern about banking standards, including a new customer charter, fee-free over-the-counter banking for people over 65 and the appointment of a senior customer advocate.  ANZ’s chief executive, Mr John McFarlane, defended the credit card profits. ‘. . . These are not unfair businesses and we are not getting unusual levels of returns,’ he said.  Mr McFarlane admitted the banks had been slow to recognise the depth of community concern. ‘Whether we are going to be regulated or not we are going to have to do things differently’. SOURCE: Extract from ‘Credit card profit soars but ANZ feels no guilt’, by Anthony Hughes, The Sydney Morning Herald, 27 April 2001, p. 3

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33. Read the brief extract from an article by Sue Mitchell entitled ‘Rules hit retailers with rolled-up leases’ that appeared in The Canberra Times on 23 April 2015 in Financial Accounting in the Real World 3.5 and answer the following questions: (a) Why would companies have preferred to treat the leases as operating leases (if there is an operating lease then the assets and liabilities associated with leased asset are not shown on the statement of financial position) rather than finance leases (if the lease were a finance lease then the liabilities and assets associated with the lease would be shown on the statement of financial position)? (b) Explain why the change in the accounting standard for leasing might cause organisations to breach covenants included within debt contracts. (c) What is the difference between debt covenants that rely upon ‘floating GAAP’ and those relying on ‘fixed GAAP’, and which provide less risk to the borrower? (d) Which organisations would be more likely to lobby against the accounting standard? LO 3.5, 3.6, 3.7, 3.8, 3.10

3.5 FINANCIAL ACCOUNTING IN THE REAL WORLD Retailers face multibillion-dollar hit from proposed lease accounting changes Sue Mitchell Australia’s fastest growing retailers face a hit to their bottom line profits under proposed accounting rules that will force them to bring more than $40 billion worth of leases onto their balance sheets for the first time.  Under the latest changes to lease accounting rules put forward by the IASB, retailers such as Woolworths, Wesfarmers, Myer, David Jones, JB Hi-Fi, Harvey Norman, Specialty Fashion and Premier Investments will have to calculate the net present value of future lease commitments and recognise them as debt on their balance sheets.  Instead of recognising rent payments as costs incurred, retailers will have to expense theoretical amortisation and financing costs.  According to a report by Morgan Stanley, the impact on retailers will be ‘considerable’, blowing out gearing levels and reducing return on capital employed, but will vary from retailer to retailer.  KPMG audit partner Patricia Stebbens said the proposed changes would boost gearing ratios, forcing some companies to renegotiate debt covenants with bankers. SOURCE: Extract from ‘Retailers face multibillion-dollar hit from proposed lease accounting changes’ by Sue Mitchell, The Canberra Times, 22 April 2015. Web.

34. Read the following extract from an article by Jennifer Borrell entitled ‘Cave in by PM puts us all at risk’ that appeared in the The Age on 23 January 2012 and then answer the questions that follow. Prime Minister Julia Gillard’s capitulation to the powerful poker machine industry is a blow to democracy in this country. Governments are meant to represent the public interest, not be intimidated by industry campaigns against reform in marginal electorates. In this case, the reform was aimed at making the pokie product safer and giving some control back to gamblers. According to the Productivity Commission’s 2010 public inquiry on gambling, 60 per cent of pokie revenue comes from people who have a gambling problem or are at risk, and about a third of regular players have a problem or are at risk. If we were talking about such figures with cars or pharmaceuticals, the product would be immediately withdrawn until the problem was fixed. The inroads made by the pokie industry into democratic process are even more insidious than suggested by recent events. As explained by Dr Peter Adams, the University of Auckland’s Associate Professor of Social and Community Health, civic institutions such as academic and research bodies, media, government agencies and community organisations provide the basis for the social involvement that underpins our democracy. He argues that our very democracy comes under threat when gambling revenue influences day-to-day decisions and processes within such vital institutions. This co-option of civic institutions may be subtle and incremental or it may be blatant, as in the case of mega-pokie businesses in New South Wales using their club credentials and mobilising their membership for commercial advantage. In either case, the cumulative effect is the shaping of public views, which, in turn, affects government policy and regulation. In this way, the influence of gambling revenue infiltrates every level and crevice of civic life, further entrenching the power of gambling industries while weakening us all as 132  PART 2: THEORIES OF ACCOUNTING

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a society. It has been sad to see isolated church and community figures side with the gambling lobby and speak out against reform, but it has not been so surprising. What has been more worrying is the consistency of their public statements with industry ‘talking points’. But industry spin requires dismantling, as it so often amounts to misrepresentations that shamelessly fly in the face of long-established evidence. Based on the information within the extract above, what theory of regulation would appear to explain the apparent lack of controls or regulation to restrict problem gambling? LO 3.13 35. The Accounting Standard AASB 138 Intangible Assets requires Australian companies to expense research expenditure instead of treating it as an asset.

REQUIRED (a) Construct three hypotheses based on each of the three major components of Positive Accounting Theory to predict which companies are more likely to prefer to recognise research expenditure as an asset, rather than being required to treat the related expenditure as an expense. (b) Suggest how a researcher might test these hypotheses. LO 3.5, 3.6, 3.7, 3.8, 3.9 36. In 2006 the Australian Government established an inquiry into corporate social responsibilities with the aim of deciding whether the Corporations Act should be amended so as to specifically include particular social and environmental responsibilities within the Act. At the completion of the inquiry it was decided that no specific regulations would be added to the legislation, and that instead, ‘market forces’ would be relied upon to encourage companies to do the ‘right thing’ (that is, the view was expressed that if companies did not look after the environment, or did not act in a socially responsible manner, then people would not want to consume the organisations’ products, and people would not want to invest in the organisation, work for them, and so forth. Because companies were aware of such market forces they would do the ‘right thing’ even in the absence of legislation). You are required to explain the decision of the government that no specific regulation be introduced from the perspective of: (a) Public Interest Theory (b) Capture Theory (c) Economic Interest Group Theory of regulation. LO 3.13 37. Read the following extract from an article by Greg Barnes entitled ‘Time for Tasmanian tourism industry to allow a free market’ in Financial Accounting in the Real World 3.6, which appeared in the Hobart Mercury on 8 December 2014 and then answer the following questions: (a) Pursuant to Capture Theory, why would the Tasmanian Government respond to the demands of the tourism industry?

3.6 FINANCIAL ACCOUNTING IN THE REAL WORLD Time for a free market in Tasmanian tourism Greg Barnes American economist George Stigler wrote ‘as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit’.  Stigler’s theory of regulatory capture is a sound one and we are witnessing its pernicious impact in Tasmania today. The tourism industry in Tasmania, through its lobby groups the Tourism Council and the Hospitality Association, is embarking on a concerted campaign against . . . ‘rogue’ operators. It wants government to police barriers to entry into the tourism industry.  It is doing so because it wants to curtail competition and it is dressing up its regulatory capture strategy by pretending that it is campaigning on behalf of consumers. The Tourism Council is an opponent of the website Airbnb. . . . The outrage is pure self-interest of course. Regulatory capture is the curse of modern democracy. It erodes competition, innovation and consumer choice. . . .The Tasmanian Government should ignore the media campaign being run by vested interests that are afraid of the chill winds of market forces. SOURCE: Extract from ‘Time for a free market in Tasmanian tourism’, by Greg Barnes, The Mercury, 8 December 2014. Web.

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(b) From a Capture Theory perspective, who benefits from government regulation? (c) Would it be possible to ‘prove’ that the Tasmanian Government has been ‘captured’ by the tourism industry, and if so, what evidence would provide such proof? LO 3.13

FURTHER READING The following texts are dedicated to financial accounting theory and are useful references for readers who want to gain additional insights in the topic: DEEGAN, C., 2014, Financial Accounting Theory, 4th edn, McGraw-Hill, Sydney. GRAY, R., ADAMS, C. & OWEN, D., 2014, Accountability, Social Responsibility and Sustainability, Pearson, London. HENDERSON, S., PEIRSON, G. & HARRIS, K., 2004, Financial Accounting Theory, Pearson Education, Sydney. MATHEWS, M.R., 1993, Socially Responsible Accounting, Chapman and Hall, London. SCOTT, W., 2015, Financial Accounting Theory, 7th edn, Pearson Education, Toronto.

REFERENCES BROADBENT, J., JACOBS, K. & LAUGHLIN, R., 2001, ‘Organisational Resistance Strategies to Unwanted Accounting and Finance Changes: The Case of General Medical Practice in the UK’, Accounting, Auditing & Accountability Journal, 14 (5), pp. 565–86. CAHAN, S.F., 1992, ‘The Effect of Antitrust Investigations on Discretionary Accruals: A Refined Test of the Political Cost Hypothesis’, The Accounting Review, January, pp. 77–95. CARPENTER, V. & FEROZ, E., 1992, ‘GAAP as a Symbol of Legitimacy: New York State’s Decision to Adopt Generally Accepted Accounting Principles’, Accounting, Organizations and Society, vol. 17, no. 7, pp. 613–43. CARPENTER, V. & FEROZ, E., 2001, ‘Institutional Theory and Accounting Rule Choice: An Analysis of Four US State Governments’ Decision to Adopt Generally Accepted Accounting Principles’, Accounting, Organizations and Society, vol. 26, pp. 565–96. CHAMBERS, R.J., 1955, ‘Blueprint for a Theory of Accounting’, Accounting Research, January, pp. 17–55. CHAMBERS, R.J., 1966, Accounting, Evaluation and Economic Behavior, Prentice Hall, Englewood Cliffs, New Jersey. CHAMBERS, R.J., 1993, ‘Positive Accounting Theory and the PA Cult’, Abacus, 29 (1), pp. 1–26. CHAND, P. & WHITE, M., 2007, ‘A Critique of the Influence of Globalization and Convergence of Accounting Standards in Fiji’, Critical Perspectives on Accounting, vol. 18, pp. 605–22. CHRISTENSON, C., 1983, ‘The Methodology of Positive Accounting’, The Accounting Review, vol. 58, January, pp. 1–22. CHRISTIE, A., 1990, ‘Aggregation of Test Statistics: An Evaluation of the Evidence on Contracting and Size Hypotheses’, Journal of Accounting and Economics, January, pp. 15–36. COSTELLO, A. & WITTENBERG-MOERMAN, R., 2011, ‘The Impact of Financial Reporting Quality on Debt Contracting: Evidence from Internal Control Weakness Reports’, Journal of Accounting Research, 49 (1), pp. 97–136. COTTER, J., 1998a, ‘Asset Revaluations and Debt Contracting’, unpublished PhD thesis, University of Queensland. COTTER, J., 1998b, ‘Utilisation and Restrictiveness of Covenants in Australian Private Debt Contracts’, Accounting and Finance, vol. 38, no. 2, pp. 111–38. DEEGAN, C.M., 1997a, ‘The Design of Efficient Management Remuneration Contracts: A Consideration of Specific Human Capital Investments’, Accounting and Finance, vol. 37, no. 1, May, pp. 1–40. 134  PART 2: THEORIES OF ACCOUNTING

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DEEGAN, C.M., 1997b, ‘Varied Perceptions of Positive Accounting Theory: A Useful Tool for Explanation and Prediction, Or a Body of Vacuous, Insidious and Discredited Thoughts?’, Accounting Forum, vol. 20, no. 5, pp. 63–73. DEEGAN, C.M. & HALLAM, A., 1991, ‘The Voluntary Presentation of Value Added Statements in Australia’, Accounting and Finance, May, pp. 1–16. DEEGAN, C. & ISLAM, M., 2014, ‘An Exploration of NGO and Media Efforts to Influence Workplace Practices and Associated Accountability within Global Supply Chains’, The British Accounting Review, vol. 46, no. 4, pp. 397–415. DEEGAN, C.M. & RANKIN, M., 1996, ‘Do Australian Companies Report Environmental News Objectively? An Analysis of Environmental Disclosures by Firms Prosecuted Successfully by the Environmental Protection Authority’, Accounting, Auditing and Accountability Journal, vol. 9, no. 2, pp. 52–69. DEFOND, M. & JIAMBALVO, J., 1994, ‘Debt Covenant Violation and Manipulation of Accruals’, Journal of Accounting and Economics, vol. 17, pp. 145–76. DILLARD, J.F., RIGSBY, J.T., & GOODMAN, C., 2004, ‘The Making and Remaking of Organization Context: Duality and the Institutionalization Process’, Accounting, Auditing & Accountability Journal, 17 (4), pp. 506–42. DIMAGGIO, P.J. & POWELL, W.W., 1983, ‘The Iron Cage Revisited: Institutional Isomorphism and Collective Rationality in Organizational Fields’, American Sociological Review, 48, pp. 146–160. DONALDSON, T. & PRESTON, L., 1995, ‘The Stakeholder Theory of the Corporation—Concepts, Evidence, and Implications’, Academy of Management Review, vol. 20, no. 1, pp. 65–92. DOWLING, J. & PFEFFER, J., 1975, ‘Organisational Legitimacy: Social Values and Organisational Behavior’, Pacific Sociological Review, vol. 18, no. 1, January, pp. 122–36. DOWNS, A., 1957, An Economic Theory of Democracy, Harper and Row, New York. ETTREDGE, M., SIMON, D., SMITH, D. & STONE, M., 1994, ‘Why Do Companies Purchase Timely Quarterly Reviews?’, Journal of Accounting and Economics, September, pp. 131–56. FRANZ, D., HASSABELNABY, H. & LOBO, G., 2014, ‘Impact of Proximity to Debt Covenant Violation on Earnings Management’, Review of Accounting Studies, vol. 19, pp 473–505. FREEMAN, R., 1984, Strategic Management: A Stakeholder Approach, Pitman, Marshall, MA. FRIEDMAN, M., 1953, The Methodology of Positive Economics: Essays in Positive Economics, University of Chicago Press (reprinted in 1966 by Phoenix Books). GORDON, M.J., 1964, ‘Postulates, Principles, and Research in Accounting’, The Accounting Review, April, pp. 251–63. GRAY, R., OWEN, D. & ADAMS, C., 1996, Accounting and Accountability, Prentice Hall, Europe. GRAY, R., ADAMS, C. & OWEN, D., 2014, Accountability, Social Responsibility and Sustainability. Pearson Education, London. GRIFFITHS, I., 1987, Creative Accounting: How to Make Your Profits What You Want Them to Be, Unwin Hyman Limited, London. HAO, M. & NWAEZE, E., 2015, ‘Healthcare Reform Proposal and the Behavior of Pharmaceutical Companies: The Role of Political Costs’, Accounting Horizons, vol. 29, no. 1, pp 171–98. HASNAS, J., 1998, ‘The Normative Theories of Business Ethics: A Guide for the Perplexed’, Business Ethics Quarterly, January, vol. 8, no. 1, pp. 19–42. HEALY, P.M., 1985, ‘The Effect of Bonus Schemes on Accounting Decisions’, Journal of Accounting and Economics, pp. 85–107. HENDERSON, S., PEIRSON, G. & BROWN, R., 1992, Financial Accounting Theory: Its Nature and Development, 2nd edn, Longman Cheshire, Melbourne. HENDRIKSEN, E., 1970, Accounting Theory, Richard D. Irwin, Illinois. HOLTHAUSEN, R.W. & LEFTWICH, R.W., 1983, ‘The Economic Consequences of Accounting Choice: Implications of Costly Contracting and Monitoring’, Journal of Accounting and Economics, August, pp. 77–117. Chapter 3: THEORIES OF FINANCIAL ACCOUNTING  135

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HOLTHAUSEN, R.W., LARCKER, D.F. & SLOAN, R.G., 1995, ‘Annual Bonus Schemes and the Manipulation of Earnings’, Journal of Accounting and Economics, vol. 19, pp. 29–74. HOWIESON, B., 1996, ‘Whither Financial Accounting Research: A Modern-day Bo-Peep?’, Australian Accounting Review, vol. 6, no. 1, pp. 29–36. HURST, J.W., 1970, The Legitimacy of the Business Corporation in the Law of the United States 1780–1970, The University Press of Virginia, Charlottesville. ISLAM, M. & DEEGAN, C., 2010, ‘Media Pressures and Corporate Disclosure of Social Responsibility Performance Information: A Study of Two Global Clothing and Sports Retail Companies’, Accounting and Business Research, vol 40, no. 2, pp. 131–48. JENSEN, M.C. & MECKLING, W.H., 1976, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, Journal of Financial Economics, October, pp. 305–60. JONES, J., 1991, ‘Earnings Management During Import Relief Investigations’, Journal of Accounting Research, vol. 29, no. 2, Autumn, pp. 193–228. KATZ, D., 2014, ‘Revenue Accounting Hits Loans, Bonuses’, CFO Magazine, April, p.8. LEWELLEN, R.A., LODERER, C. & MARTIN, K., 1987, ‘Executive Compensation and Executive Incentives Problems’, Journal of Accounting and Economics, vol. 9, pp. 287–310. LINDBLOM, C.K., 1993, ‘The Implications of Organisational Legitimacy for Corporate Social Performance and Disclosure’, paper presented at the Critical Perspectives in Accounting Conference, New York. MATHER, P. & PEIRSON, G., 2006, ‘Financial Covenants in the Markets for Public and Private Debt’, Accounting and Finance, vol. 46, pp. 285–307. MATHEWS, M.R., 1993, Socially Responsible Accounting, Chapman and Hall, London. MEYER, J.W. & ROWAN, B., 1977, ‘Institutionalised Organizations: Formal Structure as Myth and Ceremony’, American Journal of Sociology, vol. 83, pp. 340–63. MITNICK, B.M., 1980, The Political Economy of Regulation, Columbia University Press. MORRIS, R., 1984, ‘Corporate Disclosure in a Substantially Unregulated Environment’, Abacus, June, pp. 52–86. NESS, K. & MIRZA, A., 1991, ‘Corporate Social Disclosure: A Note on a Test of Agency Theory’, British Accounting Review, 23, pp. 211–17. O’DONOVAN, G., 2002, ‘Environmental Disclosures in the Annual Report: Extending the Applicability and Predictive Power of Legitimacy Theory’, Accounting, Auditing and Accountability Journal, vol. 15, no. 3, pp. 344–71. O’LEARY, T., 1985, ‘Observations on Corporate Financial Reporting in the Name of Politics’, Accounting, Organizations and Society, vol. 10, no. 1, pp. 87–102. PATTEN, D.M., 1992, ‘Intra-industry Environmental Disclosures in Response to the Alaskan Oil Spill: A Note on Legitimacy Theory’, Accounting, Organizations and Society, vol. 15, no. 5, pp. 471–5. PELTZMAN, S., 1976, ‘Towards a More General Theory of Regulation’, Journal of Law and Economics, August. POSNER, R.A., 1974, ‘Theories of Economic Regulation’, Bell Journal of Economics and Management Science, Autumn, pp. 335–58. ROBERTS, R., 1992, ‘Determinants of Corporate Social Responsibility Disclosure: An Application of Stakeholder Theory’, Accounting, Organizations and Society, vol. 17, no. 6, pp. 595–612. SCOTT, W.R., 1995, Institutions and Organisations, Sage Publications Inc, Thousand Oaks, CA. SHOCKER, A.D. & SETHI, S.P., 1974, ‘An Approach to Incorporating Social Preferences in Developing Corporate Action Strategies’, in Sethi, S.P. (ed.), The Unstable Ground: Corporate Social Policy in a Dynamic Society, Melville, pp. 67–80.

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SLOAN, R.G., 1993, ‘Accounting Earnings and Top Executive Compensation’, Journal of Accounting and Economics, vol. 16, pp. 55–100. SMITH, C.W. & WARNER, J.B., 1979, ‘On Financial Contracting: An Analysis of Bond Covenants’, Journal of Financial Economics, June, pp. 117–61. STERLING, R.R., 1990, ‘Positive Accounting: An Assessment’, Abacus, vol. 26, no. 2, pp. 97–135. STIGLER, G.J., 1971, ‘The Theory of Economic Regulation’, Bell Journal of Economics and Management Science, Spring, pp. 2–21. SUCHMAN, M.C., 1995, ‘Managing Legitimacy: Strategic and Institutional Approaches’, Academy of Management Review, vol. 20, no. 3, pp. 571–610. SWEENEY, A.P. 1994, ‘Debt-Covenant Violations and Managers’ Accounting Responses’, Journal of Accounting and Economics, vol. 17, pp. 281–308. TINKER, T., MERINO, B. & NIEMARK, N., 1982, ‘The Normative Origins of Positive Theories: Ideology and Accounting Thought’, Accounting Organizations and Society, vol. 7, pp. 167–200. ULLMANN, A., 1985, ‘Data in Search of a Theory: A Critical Examination of the Relationships among Social Performance, Social Disclosure, and Economic Performance of US Firms’, Academy of Management Review, vol. 10, no. 3, pp. 540–57. UNERMAN, J. & BENNETT, M., 2004, ‘Increased Stakeholder Dialogue and the Internet: Towards Greater Corporate Accountability or Reinforcing Capitalist Hegemony?’, Accounting, Organizations and Society, 29 (7), pp. 685–707. WALKER, R.G., 1987, ‘Australia’s ASRB: A Case Study of Political Activity and Regulatory “Capture”’, Accounting and Business Research, vol. 17, no. 67, pp. 269–86. WATTS, R.L., 1995, ‘Nature and Origins of Positive Research in Accounting’, in Jones, S., Romano, C. & Ratnatunga, J. (eds), Accounting Theory: A Contemporary Review, Harcourt Brace, Sydney, pp. 295–353. WATTS, R.L. & ZIMMERMAN, J.L., 1978, ‘Towards a Positive Theory of the Determination of Accounting Standards’, The Accounting Review, January, pp. 112–34. WATTS, R.L. & ZIMMERMAN, J.L., 1986, Positive Accounting Theory, Prentice Hall Inc., Englewood Cliffs, New Jersey. WATTS, R.L. & ZIMMERMAN, J.L., 1990, ‘Positive Accounting Theory: A Ten Year Perspective’, The Accounting Review, vol. 65, no. 1, pp. 131–56. WHITTRED, G., 1987, ‘The Derived Demand for Consolidated Financial Reporting’, Journal of Accounting and Economics, pp. 259–85. WHITTRED, G. & ZIMMER, I., 1986, ‘Accounting Information in the Market for Debt’, Accounting and Finance, November, pp. 1–12. WILLIAMS, P.F., 1989, ‘The Logic of Positive Accounting Research’, Accounting Organisations and Society, vol. 14, no. 5–6, pp. 455–68. WONG, J., 1988, ‘Economic Incentives for the Voluntary Disclosure of Current Cost Financial Statements’, Journal of Accounting and Economics, April, pp. 151–67. WOODWARD, D.G., EDWARDS, P. & BIRKIN, F., 1996, ‘Organizational Legitimacy and Stakeholder Information Provision’, British Journal of Management, vol. 7, pp. 329–47.

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PART 3

ACCOUNTING FOR ASSETS CHAPTER 4

An overview of accounting for assets

CHAPTER 5

Depreciation of property, plant and equipment

CHAPTER 6

Revaluations and impairment testing of non-current assets

CHAPTER 7

Inventory

CHAPTER 8

Accounting for intangibles

CHAPTER 9

Accounting for heritage assets and biological assets

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CHAPTER 4

AN OVERVIEW OF ACCOUNTING FOR ASSETS LEARNING OBJECTIVES (LO) 4.1

Understand the definition of an asset, the definition of current and non-current assets, and the asset recognition criteria.

4.2

Understand how to determine ‘future economic benefits’.

4.3

Understand the process involved in determining whether particular expenditures should be recognised as assets (that is, capitalised) or expensed.

4.4

Understand how a number of different classes of assets are measured and be aware of the meaning of, and limitations of, the calculation known as total assets.

4.5

Know the meaning of ‘recoverable amount’ and be able to calculate it.

4.6

Be aware of the disclosure requirements embodied within AASB 101 Presentation of Financial Statements as they pertain to a reporting entity’s assets.

4.7

Be able to explain how to calculate the acquisition cost of an asset.

4.8

Understand how to determine the cost of an asset when the payment for the asset is deferred.

4.9

Be able to account for an asset that has been acquired at no cost (e.g. donated asset).

4.10 Be able to discuss various issues surrounding the capitalisation of interest. 4.11 Be aware of possible changes in the requirements pertaining to financial statement presentation.

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Introduction to accounting for assets In this book we will cover a range of issues associated with accounting for assets. To begin with, in this chapter we will consider: • how we define assets • an overview of how we might measure various classes of assets • how assets are classified and disclosed within the statement of financial position (balance sheet) • how we determine the acquisition costs of assets. While the material provided in this chapter has general application to assets, in subsequent chapters we will examine how to account for specific types of assets. For example, in Chapter 7 we will address how to account for inventory; in Chapter 8 we will address how to account for intangible assets; and in Chapter 9 we will address how to account for agricultural assets (for example, how to account for trees and their produce, or livestock). As we will learn, there are different rules to apply when we account for different types of assets. Conceptually, you might have thought that all assets should be measured in the same way, for example, at fair value or at cost, but this is not the case as measurement rules vary depending upon the type of asset in question. Across time, the value of the majority of assets will either increase or decrease. Where the value decreases, we will need to understand how to allocate the cost of an asset across its useful life. To this end, Chapter 5 will address how we depreciate non-current assets for accounting purposes. We will also need to know how to account for valuation changes. Chapter 6 will discuss how we undertake revaluations of non-current assets, and how we account for impairment losses (which are deemed to exist when an asset’s carrying amount exceeds its recoverable amount). After recapping on how Australian Accounting Standards are numbered, we will commence this chapter with a definition of assets.

Numbering of Australian Accounting Standards Because we will be referring to accounting standards in this and subsequent chapters, it might be worthwhile taking another look at the numbering system applied to Australian Accounting Standards (we referred to this in Chapter 1, but in the interests of avoiding potential confusion we return to it here). Accounting standards issued by the International Accounting Standards Board and its predecessor, the International Accounting Standards Committee, were, until 2003, referred to as International Accounting Standards and given the prefix IAS. For example, the accounting standard relating to intangible assets as issued in 1998 is IAS 38 Intangible Assets. Accounting standards issued by the IASB from late 2003 onwards are to be referred to as International Financial Reporting Standards and will have the prefix IFRS. For example, the accounting standard issued in late 2003 that relates to first-time adoption of International Financial Reporting Standards is IFRS 1 First-time Adoption of International Financial Reporting Standards. Where the IASB has issued a standard as an IAS, whether or not it has been the subject of subsequent ‘improvement’, to the extent it was referred to as an IAS it will continue to be referred to as one. Therefore, the IASB will have standards with different prefixes—the ‘older’ standards (which might nevertheless have had recent updates or amendments) will have the prefix IAS and the ‘newer’ standards will have the prefix IFRS. By contrast, when the Australian Accounting Standards Board releases accounting standards they will all have the prefix AASB. However, the number of the AASB standard will depend upon whether the ‘adopted’ standard relates to an ‘old’ or ‘new’ international standard. Where the adopted AASB standard relates to a standard that has the IAS prefix, the Australian standard will be numbered from AASB 101 to AASB 199. For example, our standard on intangible assets will be AASB 138 Intangible Assets (the international standard being IAS 38 Intangible Assets). Where an Australian standard relates to a standard with the IFRS prefix (one of the more recent standards issued by the IASB), the Australian standard will be numbered from AASB 1 to 99. For example, our Australian standard AASB 15 Revenue from Contracts with Customers equates to IFRS 15 Revenue from Contracts with Customers, which was released by the IASB in 2014. In situations where Australia releases an accounting standard that does not have an international equivalent (the AASB might release standards that relate to particular issues of domestic importance that are not covered by the IASB), the numbering system will be from AASB 1001 to AASB 1099. For example, we had an accounting standard issued in 2014 by the AASB that does not have an equivalent, this being AASB 1056 Superannuation Entities. Therefore, we have three different numbering systems for our accounting standards—at least for the foreseeable future. Hopefully, this explanation of the numbering system will prevent confusion in this and following chapters. CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  141

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LO 4.1 LO 4.2 LO 4.3 LO 4.4

Definition of assets

As we learned in Chapter 2, the IASB Conceptual Framework for Financial Reporting (hereafter referred to as the conceptual framework) provides definitions of the elements of accounting, these being assets, liabilities, equity, income and expenses. We also learned in Chapter 2 that the IASB is currently revising the conceptual framework and that this will create changes in how assets are defined and recognised. A review of Chapter 2 will provide information on the nature of these possible changes. The conceptual framework currently defines an asset as: ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. Considering the above asset definition, an asset of an entity should have three fundamental characteristics: 1. An asset is expected to provide future economic benefits to the entity. 2. An asset must be controlled by the entity (but does not have to be legally owned). 3. The transaction or event giving rise to the control must already have occurred. As we can see from the definition of assets provided above, ‘future economic benefits’ is the essence of assets. Future economic benefits represent the scarce capacity of assets to provide benefits to the organisations that control them and they provide the basis for organisations to achieve their objectives. These characteristics are common to all assets regardless of their physical form. In relation to the physical form of an asset, the conceptual framework states: Many assets, for example, property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset; hence patents and copyrights, for example, are assets if future economic benefits are expected to flow from them to the entity and if they are controlled by the entity. Assets can take a variety of forms. For example, cash is an asset because of the command over future economic benefits it provides. It can be easily exchanged for other goods and services, which in turn might provide economic benefits. Accounts receivable are assets because of the cash inflows that are expected to occur when customers pay their accounts. Prepayments—such as prepaid rent or prepaid insurance—are assets because they represent existing rights to receive services. Plant and equipment are assets because they can be used to provide goods or services. The conceptual framework discusses the ways in which assets can generate economic benefits. It states: The future economic benefits embodied in an asset may flow to the entity in a number of ways. For example, an asset may be: (a) used singly or in combination with other assets in the production of goods or services to be sold by the entity; (b) exchanged for other assets; (c) used to settle a liability; or (d) distributed to the owners of the entity.

We can draw a distinction between future economic benefits and the source of those benefits. The definition of an asset refers to the benefits; therefore, in the absence of expected economic benefits, the object or right will not be considered to be an asset. The consequence of this is that any assumption that a particular object or right will always be an asset is incorrect. For example, while a building would normally be control (assets) expected to generate future economic benefits, if it becomes obsolete, unusable or is abandoned If an asset is to be recognised, control then the building would no longer represent an asset (an example here might be a mining town that rather than legal is subsequently abandoned as a result of no economically recoverable reserves remaining within ownership must be the mine site). established. Control As indicated in relation to the definition of an asset provided earlier, a reporting entity does not have is the capacity of to have legal ownership of an asset to record the asset within its statement of financial position. What is an entity to benefit important is that the entity is able to ‘control’ the item’s use. Control represents the capacity of the entity from an asset in the pursuit of the entity’s to benefit from the asset in the pursuit of the entity’s objectives and to deny or regulate the access of objectives and to others to that benefit. Therefore, because ownership is not essential, items such as leased assets are deny or regulate the often included as part of the assets of entities, even though another organisation has legal title to them. access of others to that That is, many leased assets will be shown in an entity’s statement of financial position, even though benefit. legal title to the assets rests with another party. Leased assets will be discussed further in Chapter 11. 142  PART 3: ACCOUNTING FOR ASSETS

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Recognition issues Although the conceptual framework defines assets (see the definition of assets provided earlier), such a definition on its own is not operational. We need further guidance. The conceptual framework provides criteria for the recognition of assets. Specifically: An asset is recognised in the balance sheet when it is: • probable that the future economic benefits will flow to the entity; and • the asset has a cost or value that can be measured reliably. ‘Probable’ is not defined in the conceptual framework; however, it is generally accepted that the term ‘probable’ means that the chance of the future economic benefits arising is more likely rather than less likely. This definition of ‘probable’ would mean that something would be considered to be an asset if the expected probability of future benefits arising is greater than 50 per cent. Conversely, if it is not considered probable that future economic benefits will flow to the entity, an asset should not be recognised. The conceptual framework states: An asset is not recognised in the balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the entity beyond the current accounting period. Instead such a transaction results in the recognition of an expense in the income statement. This treatment does not imply either that the intention of management in incurring expenditure was other than to generate future economic benefits for the entity or that management was misguided. The only implication is that the degree of certainty that economic benefits will flow to the entity beyond the current accounting period is insufficient to warrant the recognition of an asset. A change in company policies could mean that items once considered to be assets might need to be written off in subsequent periods—that is, expensed. For example, and referring to an example provided earlier, a mining company might be involved in mining operations in a remote location around which a town has grown up. As a result of particular circumstances, a decision might be made by the organisation to abandon the mine site. The remote town might then effectively become a ghost town. The buildings owned by the mining company might once have generated economic benefits and were therefore considered assets. However, if they are of no further use to the reporting entity, they should be written off. The write-off of the buildings should be treated as an expense of the company and would typically be referred to as an impairment loss. Given recognition criteria such as ‘probable’, a high degree of professional judgement might be necessary. It is, therefore, possible that an expenditure that is deemed an asset by one financial statement preparer might be considered an expense by another. Such differences of opinion will have obvious consequences for the reported profits of reporting entities. They will also have implications for asset-based ratios such as net asset backing per share (see Worked Example 4.1).

WORKED EXAMPLE 4.1: Asset recognition and consideration of probable economic benefits Assume that Kirra Ltd has assets of $1 million, liabilities of $300 000 and, therefore, shareholders’ funds of $700 000. It has issued a total of 100 000 ordinary shares. Assume that the company then designs and manufactures an item of machinery at a cost of $150 000. The machinery produces a new type of flexible, transparent fin for surfboards. The cost of $150 000 comprises wages of $90 000, raw materials of $35 000 and depreciation of $25 000. The depreciation relates to other plant and machinery used to make the fin-making machine. The wages are to be paid at a future date. REQUIRED (a) Provide the accounting entry for the construction of the machinery, assuming that the machinery satisfies the criteria for recognition of an asset. (b) Provide the accounting entry assuming that the machinery is subsequently revealed not to be an asset because future economic benefits are not considered probable. continued CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  143

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SOLUTION (a) For this expenditure to be recognised as an asset (that is, for it to be capitalised), it must be considered probable that the item will generate net cash flows at least equal to $150 000. In this case, if economic benefits of at least $150 000 are considered probable, the aggregated accounting entry would be: Dr Cr Cr Cr

Machinery—fin-making machine (an asset) Wages payable Raw materials inventory Accumulated depreciation—plant and machinery

150 000 90 000 35 000 25 000

Net assets will not change as a result of treating the expenditure as an asset. That is, before the expenditure, the net assets were $700 000 (which equals assets less liabilities = $1 000 000 − $300 000). After the expenditure on the machine, the net assets will still be $700 000. The manufacture of the machine led to an increase in assets of $90 000 (the increase in machinery of $150 000, less the raw materials consumed, and less the increase in accumulated depreciation). It also led to an increase in liabilities of $90 000 (the wages payable), and hence net assets (assets less liabilities) did not change. Net asset backing per share would be $700 000 ÷ 100 000 = $7 per share. (b) If the probability that the machine will generate any positive net cash flows is subsequently assessed to be below 50 per cent (that is, economic benefits are not probable), the expenditure on the machine would be treated as an expense at the time such an assessment is made. The loss would typically be referred to as an impairment loss. The accounting entry would be: Dr Cr

Impairment loss—machinery Accumulated impairment loss—machinery

150 000 150 000

If the asset is treated as being fully impaired, the net assets will fall to $550 000 and the net asset backing per share of Kirra Ltd would become $5.50 per share. The implications of a reduction in net asset backing per share are not always clear, but it would seem to be a reasonable proposition that a reduction in net asset backing per share from $7.00 to $5.50 would reduce the amount that potential investors would be prepared to pay for securities issued by Kirra Ltd.

Again, it is emphasised that if, at a given time, expenditure is not deemed likely to generate future economic benefits, such expenditure should be expensed in the period in which it becomes apparent that insufficient benefits will be realised. While we will cover the impairment of assets more fully in Chapter 6, it should be appreciated at this point that there is an accounting standard that applies specifically to the impairment of assets, this being AASB 136 Impairment of Assets. AASB 136 requires that when the recoverable amount of an asset (‘recoverable amount’, defined as the higher of an asset’s net selling price and its value in use) is less than its carrying amount (‘carrying amount’ of an asset is defined as the amount at which the asset is recorded in the accounting records as at a particular date—for a depreciable asset, it means the net amount after deducting any accumulated depreciation and accumulated impairment losses), the carrying amount of the asset must be reduced to its recoverable amount. The reduction is referred to as an ‘impairment loss’. Specifically, paragraph 59 of AASB 136 states: If, and only if, the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss. Following the recognition of an impairment loss in an earlier period, it is possible that the recoverable amount of an asset might subsequently increase towards former levels. If, in a subsequent period, additional information becomes available which indicates that benefits are now probable, according to the conceptual framework the asset would be recognised when it so qualifies, even though this might involve amounts that had previously been recognised as expenses of the entity. Therefore the subsequent recognition of an asset will require a credit to the entity’s profit or loss, perhaps labelled something like ‘gain from asset previously derecognised’ or ‘gain from reversal of previous impairment loss’. 144  PART 3: ACCOUNTING FOR ASSETS

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This subsequent reinstatement of the asset is consistent with the requirements of AASB 136 Impairment of Assets, which states at paragraph 114: An impairment loss recognised in prior periods for an asset other than goodwill shall be reversed if, and only if, there has been a change in the estimates used to determine the asset’s recoverable amount since the last impairment loss was recognised. If this is the case, the carrying amount of the asset shall, except as described in paragraph 117, be increased to its recoverable amount. That increase is a reversal of an impairment loss. For an example of a reversal of a prior period impairment loss we can return to Worked Example 4.1. Let us assume that new information became available in a subsequent period that indicated that the machine referred to in Worked Example 4.1 would generate net cash flows equal to at least $150 000 (and assuming it had already been subject to the recognition of an impairment loss), the adjusting accounting entry would be: Dr Cr

Accumulated impairment loss—machinery 150 000 Gain from reversal of previous impairment loss

150 000

While this is a general principle, which is supported by AASB 136, that assets that have been subject to an impairment loss in previous periods can subsequently be recognised again as assets (such as in the illustration given above), it needs to be appreciated that some accounting standards specifically exclude this reversal for specific types of assets. That is, in particular accounting standards relating to specific assets, if expenditure on a particular item was initially expensed then any related asset cannot subsequently be recognised even if it becomes apparent that future economic benefits associated with the previous expenditure are probable. As Chapter 8 will demonstrate, pursuant to AASB 138 Intangible Assets, expenditure on an intangible item that was initially recognised as an expense shall not be recognised as part of the cost of an intangible asset at a later date. In effect, such requirements (which can be deemed to be quite conservative) will cause the balance sheet (statement of financial position) to understate the assets controlled by the entity. As noted in Chapter 3, the firm may be involved in many contractual arrangements that use the accounting numbers relating to profits and assets. For example, there might be interest coverage clauses; clauses that restrict dividend payments to some designated fraction of earnings; management compensation clauses tying managers’ rewards to reported profits; or clauses that specify debt-to-asset constraints. Hence the decision to expense or capitalise an item might be one that has direct implications for the value of the organisation and for the wealth of the managers. As noted in Chapter 2, however, there is an expectation that general purpose financial statements should be prepared in an unbiased manner (see the conceptual framework), regardless of any accounting-based contractual relationships that the organisation and/or its managers might have entered. Chapter 3 referred to research undertaken by Positive Accounting theorists. These researchers, who work on the assumption that individual action is driven by a desire to maximise personal wealth, would argue that the existence of accounting-based contractual arrangements will, at times, motivate individuals within the firm to adopt particular accounting methods in preference to others. Positive Accounting theorists propose that general purpose financial statements will not always represent unbiased accounts of the performance and financial position of the entity. The work performed by the external financial statement auditors should, however, help to increase the objectivity of the financial statements and to minimise any potential bias. For an asset to be recognised, it is required to possess a cost or other value that can be measured reliably. At this stage, it should be appreciated that the asset measurement rules may vary depending on the class of assets being measured. Some individuals consider, from a conceptual perspective, that all assets should be measured on the same basis. In recent times the approach of measuring assets at fair value, rather than at historical cost, seems to have drawn increasing support, with many new accounting standards adopting a ‘fair value’ basis for valuing the respective assets. Nevertheless, while the value of some assets is required to be measured at fair value, many other assets are still measured at historical cost. So while many individuals consider that one approach to measurement should be applied to all classes of assets, such expectations do not match current generally accepted accounting practices. For example, as will be shown in subsequent chapters of this book: • inventory is recorded at the lower of cost and net realisable value • property, plant and equipment may be measured at either cost, or at fair value, which may be well in excess of cost. • certain intangible assets that have been acquired from other parties (as opposed to being internally developed) and which do not have an ‘active market’ (perhaps they are unique) must be carried at cost less accumulated depreciation and any accumulated impairment losses (that is, they cannot be revalued to fair value) CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  145

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• items such as internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets • marketable securities may be valued at fair value. Because different classes of assets are typically measured in different ways (and some intangible assets are not permitted to be recognised as assets in the first place), the sum of the total assets of an entity will not reflect the cost of the assets, or their fair value. Table 4.1 provides a summary of some of the various asset measurement rules currently used in Australia. While conceptually it would seem to make good sense for one method of measurement to be applied to all assets, such as market value or fair value (which would mean that it would be more appropriate to add together the various asset values as they would be measured on the same basis), it does seem unlikely that, in the foreseeable future, there will be any moves to mandate one approach to measurement for all assets. Indeed, recent work undertaken by the IASB on the conceptual framework indicates that there is support for different measurement approaches being used for different classes of assets. In this regard, IASB (2013) noted: • a single measurement basis for all assets and liabilities may not provide the most relevant information for users of financial statements • the number of different measurements used should be the smallest number necessary to provide relevant information. Unnecessary measurement changes should be avoided and necessary measurement changes should be explained • the benefits of a particular measurement to users of financial statements need to be sufficient to justify the cost. When the Exposure Draft of a revised Conceptual Framework for Financial Reporting was released by the IASB in 2015, it also adopted the view that one measurement basis for all assets was not required. Therefore, while there was some speculation that the IASB might propose one uniform approach to measuring assets, this now appears unlikely and a ‘mixed measurement’ approach seems likely to continue for the foreseeable future. Also, the accounting standard-setting process is very political in nature (Watts and Zimmerman 1986). Throughout the process of developing an accounting standard, the public is invited to make submissions—typically at the exposure draft stage. Significant changes to generally accepted accounting practice are likely to be opposed by a significant proportion of financial statement preparers. Research has indicated that managers’ support for particular measurement rules will be influenced by the industry to which they belong. For example, Houghton and Tan (1995) undertook a survey of the chief financial officers of the Group of 100, an association of senior accounting and finance executives representing major companies and government-owned enterprises in Australia. They found that 80 per cent of the respondents were satisfied with historical cost in its modified form. In response to an open-ended question relating to the positive attributes of historical cost, the respondents’ views were that historical cost is objective and verifiable; easily understood and widely known; and allows

Table 4.1 Some classes of assets and their associated measurement rules

Asset

Measurement rule

Cash

Face value

Accounts receivable

Face value less an allowance for doubtful debts

Inventories

Lower of cost and net realisable value

Goodwill

At cost of acquisition—internally generated goodwill is not to be recognised

Property, plant and equipment

At cost, recoverable amount (if recoverable amount is less than cost) or revalued amount. If revaluations are undertaken, the requirement is that the valuations be based on ‘fair value’

Marketable securities

Fair value

Leased assets

At the present value of the expected future lease payments

Biological assets

At fair value less estimated point of sale costs

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for consistency and comparability. Of the 20 per cent of respondents who did not favour historical cost, at least half thought that historical cost was either meaningless or misleading. Given these findings, Houghton and Tan (1995, p. 14) state: The conclusion to be drawn from the results for this group of Australia’s largest enterprises (as represented by the Group of 100) is that there is a strong preference for historical cost over present value or market value as a basis for measurement; the responses favour Historical Cost at the rate of about four to one. Perhaps the above findings are not surprising. If a firm adopts some form of market or fair-valuebased accounting, this will typically introduce some degree of volatility into the financial statements, given that market values tend to fluctuate. This volatility might not be favoured by management, particularly if they have accounting-based debt contracts in place or are themselves rewarded in terms of accounting profits. For example, general insurers in Australia—that is, organisations involved in providing insurance for losses associated with events such as theft, storm, vehicle accidents, fire and flood—are required to value their investments on the basis of the assets’ fair values, with any changes in fair values being treated as part of a financial period’s profit or loss. Many managers of general insurance companies were particularly opposed to the requirement to use market or fair value when it was introduced. In their view it introduces unwanted and unnecessary volatility into the accounts, given that market values of investments can change quite drastically in either direction during an accounting period. When Houghton and Tan performed further analysis of the responses to their survey, they found that the level of support for historical cost or present value and market value seemed to depend on the industry to which the respondent belonged. Individuals working in financial institutions had a statistically significant preference for present-value measures as opposed to historical cost, while non-financial-institution representatives had a significantly stronger preference for historical cost. To explain this difference, the authors note (p. 36): By their nature, a significant part of the activities of financial institutions involves dealing with assets (investments and other financial instruments) for which there are active markets. Accordingly, information based on Present Values might be seen by these users as being more appropriate in evaluating financial performance and position.

historical-cost accounting System of accounting that bases asset values and expenses on the actual prices paid rather than on market valuations.

present-value accounting An approach to accounting that values assets and liabilities on the basis of their net present values.

market-value accounting Where the entity’s assets are recorded at their net market value, with any change in value from the previous period or since the acquisition date being treated as part of the profit or loss for the financial period.

Although the Houghton and Tan study looked only at the perceptions of financial statement preparers and not financial statement users, the results do imply that perhaps it is not appropriate to expect all industries to favour or implement a single uniform basis of measurement such as market value. The views of individuals working within financial institutions differed significantly from those employed elsewhere. Such a consideration might need to be borne in mind by the international accounting standard-setters as they seek to make recommendations on appropriate asset measurement principles as part of any revised conceptual framework. In other related research, Foster and Shastri (2010) report that financial institutions are more likely to support fair value measurements when security markets are stable or increasing − but, of course, this might be because of the ‘favourable’ implications such measurement would create for the financial statements. Navarro-Galera and Rodriguez-Bolivar (2010) reported positive support for fair value measurements of assets by chief financial officers of public sector organisations in Spain. They considered that fair value accounting would improve ‘the accountability of government financial statements in terms of the transparency, understandability, objectivity and reliability of financial reporting’, although this is thought to be possible only if two conditions are met for the assets being valued, these being that there needs to be a liquid market and the fair value estimations need to be practical. As discussed in Chapter 3, another factor shown to influence management support for particular asset measurement approaches is the existence of debt covenants that are linked to accounting numbers. For example, if an organisation is close to breaching an accounting-based debt covenant (such as one that relies on the ratio of debt to assets), then it will be more likely to favour a measurement basis that increases assets. Of course, while managers of organisations might prefer using particular measurement approaches because of the positive effects they might have on balance sheets, ideally management should select a particular measurement approach because it is either required by an accounting standard, or the use of a particular accounting method produces information that is relevant and representationally faithful.

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With all this said, at the present time the statement of financial position (balance sheet) aggregated total, referred to as ‘total assets’, typically represents a summation of numerous asset classes—cash, accounts receivable, inventory, land, buildings and marketable securities. See, for example, Exhibit 4.1, which shows the details of assets held by the BHP Billiton group (in US dollars), taken from BHP Billiton Ltd’s statement of financial position as at 30 June 2015. Each asset class might have been measured on the basis of a different approach from that used for the other asset classes, yet we simply add them all together (perhaps like adding apples to oranges?). The use of different measurement classes within a single financial statement is in marked contrast to suggestions made by accounting researchers such as Chambers (see Chapter 3), but this is nevertheless a generally accepted approach. In relation to the measurement of assets, classes of assets other than those briefly considered above may cause further problems in determining appropriate measurement bases. For example, heritage assets Variously defined. what would be the appropriate basis of asset measurement for a building such as a museum or For example: ‘nonan art gallery? How would we measure the value of a botanical garden or a collection of ancient current assets artefacts? The IASB conceptual framework definitions of assets depend upon the probable that a government generation of future economic benefits. Do museums, art galleries, botanical gardens or artefact intends to preserve collections generate ‘economic benefits’? Certainly, many people accept that they provide social indefinitely because of their unique and cultural benefits. Such items are frequently referred to as heritage assets, which are typically historical, cultural held by government authorities for the use of current and future generations. There is usually no or environmental expectation that they will ever be sold, and any receipts, for example from visitors, are generally less attributes’ (Auditorthan the ongoing expenses of maintaining such resources. They are often considered to generate General of NSW). negative net cash flows. Are such resources assets in accordance with the IASB conceptual framework definitions? Chapter 9 will consider this issue and others associated with accounting for heritage assets, but what do you think? Do you consider that a resource such as a museum collection, which has restrictions on its sale and use, is an asset? Why? It is interesting to note that the Australian National Museum valued future economic benefits The scarce capacity to provide benefits to the entities that use them— common to all assets irrespective of their physical or other form.

Exhibit 4.1 Details of total assets from the BHP Billiton Ltd statement of financial position

ASSETS AS AT 30 JUNE 2015 Assets  Current assets Cash and cash equivalents  Trade and other receivables  Other financial assets  Inventories  Current tax assets Other 

US$m

Total current assets  

16 369

Non-current assets Trade and other receivables Other financial assets  Inventories  Property, plant and equipment  Intangible assets  Investments accounted for using the equity method Deferred tax assets Other assets

1 499 1 159 466 94 072 4 292 3 712 2 861 150

6 753 4 321 83 4 292 658 262

Total non-current assets

108 211

Total assets

124 580

SOURCE: BHB Billiton Ltd.

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the preserved body of Australia’s most famous racehorse, Phar Lap, at $10 million—but what does this $10 million valuation actually represent? There are certainly many restrictions on how Phar Lap’s body can be used and displayed. As a further issue to consider, how should assets such as trees be valued? Many businesses rely upon trees to generate future cash flows, perhaps through the sale of timber or paper. For example, current assets an organisation might plant some pine tree seedlings with the expectation that they will generate An entity shall classify an asset as current commercially saleable timber in 14 years’ time. To assess the financial position of the business, when: (a) it expects there might be an expectation that the trees should be shown as assets in the statement of financial to realise the asset, position, but how would we measure their value? Should they be valued at the cost of the seedlings; or intends to sell or at the cost of the seedlings plus further direct costs such as water, fertilisers and so on; or at present consume it, in its value, which will include assumptions about the timing of the milling, cash receipts, tree survival rate normal operating cycle; (b) it holds the and appropriate discount rates? If the same sort of tree is in a botanical garden, or on the side of a asset primarily for the road maintained by a local council, as opposed to being in a timber forest, would or should it have purpose of trading; the same value? Should it be considered to be an asset? You might be interested to know that the (c) it expects to realise 2014 Annual Report of the City of Melbourne shows a value for trees of $38.46 million. But what the asset within twelve does this value actually represent? Why are trees on the side of the road considered to be assets? months after the The chapter that addresses heritage assets, Chapter 9, will also consider issues associated with reporting period; or (d) the asset is cash accounting for biological assets—a tree would be considered to be a biological asset (which is or a cash equivalent defined in AASB 141 as a living animal or plant).

General classification of assets Definition of current assets

(as defined in AASB 107) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

Most of us would be used to a definition of current assets as assets that, in the ordinary course of business, would be consumed or converted into cash within 12 months after the end of the financial period (the ‘12-month test’). This is what is often taught in introductory courses in financial accounting. However, AASB 101 Presentation of Financial Statements requires us to consider an entity’s normal operating cycle when determining whether assets (and liabilities) should be classified as current or non-current for the purposes of presentation in the statement of financial position (balance sheet). According to paragraph 66 of AASB 101: An entity shall classify an asset as current when: (a) it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle; (b) it holds the asset primarily for the purpose of trading; (c) it expects to realise the asset within twelve months after the reporting period; or (d) the asset is cash or a cash equivalent (as defined in AASB 107) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period. An entity shall classify all other assets as non-current.

According to AASB 101, the operating cycle of an entity is the time between the acquisition of assets for processing and their realisation in cash or cash equivalents. When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be 12 months. As an entity’s ‘operating cycle’ might be greater than 12 months, assets that might not be converted to cash for a period in excess of 12 months can be considered ‘current’ within such entities. The commentary to AASB 101 provides further discussion on defining current assets. AASB 101, paragraph 68, states that: Current assets include assets (such as inventories and trade receivables) that are sold, consumed or realised as part of the normal operating cycle even when they are not expected to be realised within twelve months after the reporting period. Current assets also include assets held primarily for the purpose of trading (examples include some financial assets that meet the definition of held for trading in AASB 9) and the current portion of non-current financial assets. Hence, unlike the traditional approach to classifying assets as current or non-current, which used the 12-month test, some professional judgement is now called for to determine the entity’s ‘normal operating cycle’. The classification CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  149

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current ratio Determined by dividing current assets by current liabilities. A measure of the short-term liquidity or solvency of an organisation.

of assets into current and non-current elements has implications for assessing the liquidity of the reporting entity. For example, analysts typically use such ratios as the current ratio (current assets divided by current liabilities) to assess the ability of the firm to pay its debts as and when they fall due. The decision relating to an entity’s operating cycle will have implications for accounting ratios such as this. Again, it is emphasised that if the ‘normal operating cycle’ is not clearly identifiable, then the normal ‘12-month test’ will apply to the classification of current assets.

Definition of current liabilities

In this chapter our focus is on assets. However, since we are discussing the statement of financial position, we will also briefly consider the definition of current liabilities. While we would probably be familiar with a definition of current liabilities in terms of an obligation being due for payment within 12 months of the end of the financial period (also a 12-month test), AASB 101 requires us to consider the entity’s normal operating cycle. Consistent with the approach taken to define current assets, which considers the ‘normal operating cycle’, paragraph 69 of AASB 101 provides that a liability is to be classified as current when it satisfies any of the following criteria: (a) it expects to settle the liability in its normal operating cycle; (b) it holds the liability primarily for the purpose of trading; (c) the liability is due to be settled within twelve months after the reporting period; or (d) the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. An entity shall classify all other liabilities as non-current. So, in contrast with traditional approaches, something might now be disclosed as a current liability when that liability is not expected to be settled for a period in excess of 12 months. As the commentary within AASB 101 (paragraph 70) states: The same normal operating cycle applies to the classification of an entity’s assets and liabilities. When the entity’s normal operating cycle is not clearly identifiable, it is assumed to be twelve months.

intangible assets Non-monetary assets without physical substance. Common forms of intangible assets include patents, goodwill, brand names and trademarks.

Therefore if there is no single, clearly identifiable operating cycle, or if the cycle is less than 12 months, the 12-month period must be used as the basis for classifying current assets and current liabilities. Apart from the current/non-current dichotomy, there are other ways in which we classify assets. Assets may also be classified as ‘tangible’ and ‘intangible’, both of which could be current or noncurrent. Intangible assets can be defined as non-monetary assets without physical substance, and include brand names, copyrights, franchises, intellectual property, licences, mastheads, patents and trademarks. Chapter 8 describes how to account for intangible assets, including goodwill and research and development.

How to present a statement of financial position As the discussion below will demonstrate, currently there are two basic approaches to presenting a statement of financial position. AASB 101 (paragraph 60) requires that, for the purposes of statement of financial position presentation: An entity shall present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position in accordance with paragraphs 66-76 except when a presentation based on liquidity provides information that is reliable and more relevant. When that exception applies, an entity shall present all assets and liabilities in order of liquidity. As we can see from the above requirement, relevance and reliability are important considerations in determining how the statement of financial position (balance sheet) will be presented. That is, relevance and reliability considerations are important in determining whether the statement of financial position should be presented in a way that separates current assets from non-current assets and current liabilities from non-current liabilities (which could be considered to be the ‘traditional’ approach), or in a way that lists the assets and liabilities in terms of their order of liquidity without any segregation between current and non-current portions. 150  PART 3: ACCOUNTING FOR ASSETS

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Therefore, AASB 101 does not prescribe a single format for the presentation of the statement of financial position. In determining which format to use, the commentary to AASB 101 provides some useful assistance. According to paragraphs 62 and 63 of AASB 101: 62.  When an entity supplies goods or services within a clearly identifiable operating cycle, separate classification of current and non-current assets and liabilities in the statement of financial position provides useful information by distinguishing the net assets that are continuously circulating as working capital (the current portion) from those used in the entity’s long-term operations (the non-current portion). It also highlights assets that are expected to be realised within the current operating cycle, and liabilities that are due for settlement within the same period. 63. For some entities, such as financial institutions, a presentation of assets and liabilities in increasing or decreasing order of liquidity provides information that is reliable and is more relevant than a current/noncurrent presentation because the entity does not supply goods or services within a clearly identifiable operating cycle. AASB 101 also requires specific disclosures in relation to the duration of an entity’s operating cycle. It requires that where the entity presents current assets separately from non-current assets and current liabilities separately from noncurrent liabilities, and the entity has a single clearly identifiable operating cycle greater than 12 months, the length of that operating cycle must be disclosed. Banking institutions such as Westpac, ANZ and the Commonwealth Bank have all elected for some years to adopt the liquidity approach to presentation. Exhibit 4.2 shows how Commonwealth Bank of Australia structured its statement of financial position (which it referred to as a ‘balance sheet’) in its 2015 Annual Report.

Specific disclosures to be made on the face of the statement of financial position Paragraph 54 of AASB 101 requires that the face of the statement of financial position is to include line items that present the following amounts (these line items represent the aggregates of a number of accounts and would typically be supported by additional detail within the notes to the financial statements): (a) property, plant and equipment; (b) investment property; (c) intangible assets; (d) financial assets (excluding amounts shown under (e), (h) and (i)); (e) investments accounted for using the equity method; (f) biological assets; (g) inventories; (h) trade and other receivables; (i) cash and cash equivalents; ( j) the total of assets classified as held for sale and assets included in disposal groups classified as held for sale in accordance with AASB 5 Non-current Assets Held for Sale and Discontinued Operations; (k) trade and other payables; (l) provisions; (m) financial liabilities (excluding amounts shown under (k) and (l)); (n) liabilities and assets for current tax, as defined in AASB 112 Income Taxes; (o) deferred tax liabilities and deferred tax assets, as defined in AASB 112; (p) liabilities included in disposal groups classified as held for sale in accordance with AASB 5; (q) non-controlling interests, presented within equity; and (r) issued capital and reserves attributable to equity holders of the parent. Additional line items can also be disclosed on the face of the statement of financial position. According to paragraph 58 of AASB 101, the judgement of whether additional items are presented separately on the face of the statement of financial position is based on an assessment of: (a) the nature and liquidity of assets; (b) the function of assets within the entity; and (c) the amounts, nature and timing of liabilities. CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  151

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Exhibit 4.2 Illustration of the liquidity approach to statement of financial position disclosure

Balance sheets As at 30 June 2015 Group

Bank

2015 ($m)

2014 ($m)

2015 ($m)

2014 ($m)

Assets Cash and liquid assets Receivables due from other financial institutions Assets at fair value through Income Statement:     Trading     Insurance     Other Derivative assets Available-for-sale investments Loans, bills discounted and other receivables Bank acceptances of customers Shares in and loans to controlled entities Property, plant and equipment Investment in associates and joint ventures Intangible assets Deferred tax assets Other assets

33 116 11 540

26 409 8 065

31 683 9 720

24 108 7 457

26 424 14 088 1 278 46 154 74 684 639 262 1 944 2 833 2 637 9 970 455 9 061

21 459 15 142 760 29 247 66 137 597 781 5 027 2 816 1 844 9 792 586 6 386

25 135 989 45 607 72 304 573 435 1 908 143 756 1 509 1 245 4 700 771 7 405

20 572 561 29 615 131 577 535 247 4 984 64 086 1 467 1 029 4 555 796  4 823

Total assets

873 446

791 451

920 167

830 877

Liabilities Deposits and other public borrowings Payables due to other financial institutions Liabilities at fair value through Income Statement Derivative liabilities Bank acceptances Due to controlled entities Current tax liabilities Deferred tax liabilities Other provisions Insurance policy liabilities Debt issues Managed funds units on issue Bills payable and other liabilities

543 231 36 416 8 493 35 213 1 944 661 351 1 726 12 911 154 429 1 149 11 105

498 352 24 978 7 508 27 259 5 027 688 366 1 363 13 166 142 219 1 214 10 369

497 625 35 516 7 323 39 636 1 908 126 496 578 1 254 130 359  14 361

457 571 24 599 5 152 29 341 4 984 118 920 612 1 084 119 548  10 662

Loan capital

807 629 12 824

732 509 9 594

855 056  13 364

772 473  9 969

Total liabilities

820 453

742 103

868 420

782 442

Net assets

  52 993

   49 348

   51 747

 48 435

27 619 939 2 345

27 036 939 2 009

27 894 1 895 3 195

Shareholders’ Equity Share capital: Ordinary share capital Other equity instruments Reserves

27 323 1 895 3 011

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Retained earnings

21 528

   18 827

 18 763

16 206

Shareholders’ Equity attributable to Equity holders of the Bank

52 431

48 811

51 747

48 435

562

        537

  52 993

49 348

Non-controlling interests Total Shareholders’ Equity



-

 51 747

  

-

 48 435

SOURCE: Commonwealth Bank of Australia 2015 Annual Report

Examples of presentation formats The original version of AASB 101 (released in 2004) included an appendix that provided illustrations of the format of the statement of financial position under both the current/non-current approach, and the liquidity approach. The formats, shown in Exhibits 4.3 and 4.4, relate to consolidated financial statements. The additional guidance provided in the appendix was included in the Australian standard, but not in the international standard (which is IAS 1). In 2006 the AASB made a decision to remove the additional Australian guidance that had been included in a number of accounting standards. As a result, subsequent versions of AASB did not include the appendix. Nevertheless, the appendix to the former version of AASB 101 still provides applicable guidance and hence we still use it here as a basis for describing the current requirements of AASB 101. A review of the liquidity approach shown in Exhibit 4.4 shows that it is very similar to the format used by Commonwealth Bank of Australia, as shown in Exhibit 4.2. Entities may choose to provide other subtotals in addition to those shown in the above exhibits. For example, the statement of financial position could be presented to show: (a) total assets less total liabilities equals net assets/equity; or (b) total assets equals total liabilities plus total equity. While the above approach to presenting a statement of financial position is the approach currently required by AASB 101, it should be noted that in October 2008 the IASB issued a discussion paper entitled ‘Preliminary Views on Financial Statement Presentation’. This discussion paper suggested some significant changes to the way the statement of financial position, statement of profit or loss and other comprehensive income and the statement of cash flows shall be presented. It is anticipated that a revised accounting standard will not be issued for a number of years, and indeed, in more recent years there has been only limited discussion on altering the format of the statement of financial position. Nevertheless, the final section of this chapter provides a brief overview of the proposals that were made within the IASB discussion paper as these proposals give an insight into the types of changes that might occur.

Determination of future economic benefits

LO 4.2 LO 4.3 LO 4.5

As indicated earlier in this chapter, the IASB conceptual framework indicates that the essence of an asset is the ‘future economic benefits’ that the item will generate. Further, it must be ‘probable’ that these economic benefits will be generated and the asset must possess a cost or a value that can be measured reliably. Generally speaking, the economic benefits themselves can be considered to come from two sources. The benefits can be derived from the use of the asset within the reporting entity or through the sale of the asset to an external party. If the expected benefits to be derived from the use of the asset within recoverable amount The net amount the organisation—often referred to as ‘value in use’—exceed the market value, it would be expected expected to be that the entity would retain the asset. Conversely, if the expected sales price exceeds the asset’s recovered through expected value in use, it would be expected that the entity would dispose of the asset. the cash inflows and Typically, assets are recorded initially at cost. Some assets, such as property, plant and equipment, outflows arising from may subsequently be revalued upwards if the net amount that is expected to be recovered through the continued use and the cash inflows and outflows arising from their use and subsequent disposal exceeds their cost. subsequent disposal of an item. Represented (Revaluations are covered in Chapter 6.) Where the recoverable amount of an asset is less than the by the higher of an asset’s cost (‘recoverable amount’ is defined in AASB 136 Impairment of Assets as the ‘higher of an asset’s fair value less asset’s net selling price and its value in use’), according to generally accepted accounting practice, costs of disposal, and the asset should be written down to its recoverable amount. This write-down is referred to as the its value in use. recognition of an ‘impairment loss’. Where the recoverable amount of an asset is to be based on its CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  153

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Exhibit 4.3 Current/ non-current presentation format

XYZ CONSOLIDATED LTD Statement of financial position as at 30 June 2018 Consolidated 2018 ($000)

2017 ($000)

Current assets Cash and cash equivalents Receivables Inventories Property, plant and equipment Other

XX XX XX XX XX

XX XX XX XX XX

Total current assets

XX

XX

Non-current assets Other financial assets Property, plant and equipment Intangible assets Deferred tax assets Other

XX XX XX XX XX

XX XX XX XX XX

Total non-current assets

XX

XX

Total assets

XX

XX

Current liabilities Payables Interest-bearing liabilities Current tax liabilities Provisions Other

XX XX XX XX XX

XX XX XX XX XX

Total current liabilities

XX

XX

Non-current liabilities Interest-bearing liabilities Deferred tax liabilities Provisions Other

XX XX XX XX

XX XX XX XX

Total non-current liabilities

XX

XX

Total liabilities

XX

XX

Equity Share capital Other reserves Retained earnings Parent entity interest Non-controlling interest

XX XX XX XX XX

XX XX XX XX XX

Total equity

XX

XX

fair value less costs to sell—perhaps there is an intention to sell it—to the extent that the asset is not of a specialised nature, it should be relatively easy to determine the value of the future cash flows. If the asset’s value is to be determined by its value in use, determining this value can be highly subjective. This might be the case if the asset is very specialised in nature and there is effectively no market for it. Further, if the ‘value in use’ is calculated by reference to the cash 154  PART 3: ACCOUNTING FOR ASSETS

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Exhibit 4.4 Liquidity presentation format

ABC CONSOLIDATED LMT Statement of financial position as at 30 June 2018 Consolidated

Assets Cash and cash equivalents Receivables Inventories Investment securities Deferred tax assets Other assets Property, plant and equipment Intangible assets Total assets Liabilities Payables Current tax liabilities Provisions Other liabilities Deferred tax liabilities Long-term interest-bearing liabilities Total liabilities Equity Share capital Other reserves Retained earnings Parent entity interest Non-controlling interest Total equity

2018 ($000)

2017 ($000)

XX XX XX XX XX XX XX XX XX

XX XX XX XX XX XX XX XX XX

XX XX XX XX XX XX XX

XX XX XX XX XX XX XX

XX XX XX XX XX XX

XX XX XX XX XX XX

flows in a number of future periods, should those cash flows be discounted to their present value? If so, how should the appropriate discount rate be determined? AASB 136 requires that in determining ‘value in use’ for the purpose of calculating ‘recoverable amount’ (and, therefore, possible impairment losses), the expected cash flows should be discounted to their present value. This is reflected in the definition of ‘value in use’. Value in use is defined in paragraph 6 of AASB 136 Impairment of Assets as: the present value of the future cash flows expected to be derived from an asset or cash-generating unit. The value in use is, according to paragraph 31 of AASB 136, determined by: (a) estimating the future cash inflows and outflows to be derived from continuing use of the asset and from its ultimate disposal; and (b) applying the appropriate discount rate to those future cash flows. We will return to the subject of impairment of assets in Chapter 6. For the purposes of illustration, and ignoring issues associated with calculating the present value of expected future cash flows, let us assume that a reporting entity has acquired an asset at a cost of $25 000. It is expected that the asset will generate an income stream over the next few years that has a present value of only $18 000, after which time the CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  155

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useful life Estimated period over which future economic benefits embodied in a depreciable asset are expected to be consumed by the entity, or the estimated total service to be obtained from the asset by the entity.

amortisation The allocation of the cost of an asset, or its revalued amount, over the periods in which benefits are expected to be derived from this asset. Generally considered to mean the same as ‘depreciation’; however, traditionally, amortisation is often used to refer to the systematic expensing of intangible assets, whereas depreciation is the term often used in relation to tangible assets, such as property, plant and equipment. However, the terms can also be used interchangeably.

asset will be scrapped. In this event it will be necessary for the asset to be written down to its recoverable amount. Its expected future economic benefits from use (that is, its ‘value in use’) are less than the asset’s cost, and the write-down will be treated as an impairment loss of the reporting entity. This write-down would not be considered to be depreciation. Depreciation involves the allocation of the cost (or revalued amount) of an asset over its expected useful life. If an asset is to be held for a number of periods, the service potential of the asset would be expected to decline over time. This should be recognised in the financial statements as an expense. Remember that the definition of an expense relies, in part, on there being a consumption or loss of a future economic benefit. It is generally accepted that the asset should be amortised or depreciated over the period of its useful life. If the expenditure on an item results in a uniform flow of economic benefits to the business over a fixed period, that asset should be expensed on a time basis. This applies, for example, to prepaid property rates and land tax, prepaid insurance premiums and prepaid rent. Where the expenditure results in a benefit to the business for an indefinite period with a specified minimum term, the expenditure should be amortised over the minimum term. If the time over which the future benefits are to be derived is indeterminate or so extended that it is not practicable to determine an apportionment of the expenditure based on assessments of expected related revenue, the amortisation should be done on a time basis over a short period (for example, an arbitrary period of five years might be selected). It will not always be clear whether future revenue will be generated by current expenditures. Consider advertising expenditure—obviously it would be economically irrational to undertake such expenditure except with a view to generating future benefits. Therefore, this would seem to fit the definition of an asset. However, the linkage between expenditure on advertising and future returns is not well defined. Because the returns are uncertain, it is usual for expenditure such as advertising to be written off (expensed) as incurred. The future economic benefits to be derived from advertising cannot generally be ‘measured reliably’, which is one of the criteria for asset recognition in the conceptual framework. AASB 138 Intangible Assets would also act to preclude the recognition of advertising expenditures as an asset—we will consider intangible assets more fully in Chapter 8. If an advertising campaign has been paid for upfront but the advertising services have not been provided by the end of the reporting period, the expenditure would typically be treated as a current asset in the form of a prepayment. The article by Tony Thomas entitled ‘Bond auditor silent: Other queries raised on beer advertising costs’ adapted in Financial Accounting in the Real World 4.1 discusses some of the concerns raised when Bond Corporation capitalised certain beer advertising costs back in 1988. Although this is not a recent event the arguments remain interesting.

4.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Bond Corporation, its auditor and the cost of advertising beer It appears that the National Companies and Securities Commission and the Institute of Chartered Accountants’ Accounting Practices Taskforce may be pushed into a co-operative inquiry into Bond Corporation following media criticism of the company’s accounts, notably by ABC TV’s ‘Four Corners’ program. The Bond Corporation’s auditor, Terry Underwood of Arthur Andersen, Perth, dismissed the ‘Four Corners’ story as vague, and refused to comment further. Other auditors agreed with Underwood that auditors don’t comment on their clients and that they refer any queries back to the client concerned. One auditor said that they investigate a potential client and its business practices before taking them on and then have to stand by the client. The issue of Bond Corporation’s accounts in relation to advertising costs for its beer fascinates some accountants. Warren McGregor, the director of the Accounting Research Foundation, says that very few companies in Australia or overseas defer and amortise advertising costs because they are not in a position to judge the future benefit on sales. ‘There’s nothing special about beer advertising that I know of,’ he says.

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Kevin Stevenson, the director of accounting research at Coopers & Lybrand, says that advertising is normally an ongoing spending item and to capitalise it is ‘fairly hairy’. The advertising of some companies such as CocaCola is valuable and increases the goodwill of the business but the extent can only be known in hindsight, he says. This contradicts the Bond Corporation explanation for its actions that advertising costs ‘are expected to give rise to significant additional revenues in future periods’. The result of Bond’s treatment of its advertising meant its reported profit was higher. SOURCE: Adapted from ‘Bond auditor silent: Other queries raised on beer advertising costs’, by Tony Thomas, Business Review Weekly, 17 March 1989

If a firm capitalises certain expenditures, rather than writing them off as incurred, its assets and profits will obviously be higher in the year of deferral. It should be noted, however, that in the years subsequent to the deferral, the profits of a firm will be higher if it has already expensed items rather than capitalising them. This is because there is nothing to depreciate/amortise in subsequent years. Firms that capitalise such expenditures will report higher depreciation/amortisation charges and therefore lower profits in future periods.

Acquisition cost of assets

capitalise To carry forward (defer) some expenditure as an asset (as opposed to writing it off as an expense) on the basis that it will generate future economic benefits.

There are a number of accounting standards that are relevant when determining the acquisition cost of assets. In LO 4.7 situations where there is a business combination, which is defined as the bringing together of separate entities or operations of entities into one reporting entity, there is a specific accounting standard that deals with related asset acquisitions. We will defer our consideration of assets associated with business combinations until Chapter 25. In relation to intangible assets, which can be defined as non-monetary assets without physical substance, a specific accounting standard, AASB 138 Intangible Assets, deals with how to determine the costs of such assets (see Worked Example 4.2 for an example). Intangible assets are the subject of Chapter 8, so we will limit our remarks on intangibles at this point. However, we can note that intangible assets would include such assets as patents, trademarks, customer lists, development expenditure and goodwill. AASB 138 provides guidance on accounting for intangible assets other than goodwill (with goodwill being covered by the standard on business combinations). According to AASB 138, an intangible asset is initially to be measured at cost.

WORKED EXAMPLE 4.2: Accounting for the cost of an intangible asset Trigger Ltd is developing a new process for producing its major product—surfboards. During 2017, related expenditure amounted to $90 000. This expenditure related to salaries of staff involved in developing the process. It also included the costs of materials consumed in developing the process. In 2018 the related expenditure amounted to $10 000. This related to wages of the staff involved in developing the process. Some general administrative overheads were also allocated to the development process. It was only in 2018 that the entity was able to demonstrate that the new process met the necessary conditions for being considered an asset. The recoverable amount of the asset is estimated as exceeding $10 000. REQUIRED Determine what the carrying amount of the asset should be in 2018. SOLUTION At the end of 2018 the asset pertaining to expenditure incurred on developing the new production process would be recorded at $10 000. The carrying amount of $10 000 does not exceed the recoverable amount of the asset. Because the allocation of administrative overheads does not relate directly to the development of the new continued CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  157

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production process, it would not be included in the cost of the asset. The expenditure incurred in 2017 would have been expensed at that time because the recognition criteria for assets could not be met. Because expenditure on such intangible assets cannot be reinstated after being expensed—a requirement of 138 paragraph 71 of AASB Intangible Assets (which states that ‘expenditure on an intangible item that was initially recognised as an expense shall not be recognised as part of the cost of an intangible asset at a later date’)—the $90 000 expenditure incurred in 2017 will never form part of the cost of the new production process recognised in the statement of financial position.

As we will see in Chapter 8, AASB 138 Intangible Assets specifically excludes the recognition of certain intangible assets for statement of financial position purposes. For example, internally generated goodwill, research expenditure and expenditure on internally generated brands, mastheads, publishing titles, customer lists and items of similar substance are not to be recognised as intangible assets. The accounting standard requires that such assets can be recognised only if they are purchased from another party. For intangible assets that can be recognised for statement of financial position purposes (for example, development expenditure), the cost of an internally generated intangible asset comprises all expenditure that can be directly attributed and is necessary to creating, producing and preparing the asset for it to be capable of operating in the manner intended by management. The cost includes, if applicable: • expenditure on material and services used or consumed in generating the intangible asset • the salaries, wages and other employment-related costs of personnel directly engaged in generating the asset • any expenditure that is directly attributable to generating the asset, such as fees to register a legal right and the amortisation of patents and licences that are used to generate the asset. Apart from determining the cost of intangible assets, we also have standards that specifically address the ‘cost’ of assets such as inventory (AASB 102), property, plant and equipment (AASB 116), and biological assets (AASB 141). The determination of the cost of inventories and the costs of biological assets are covered in Chapters 7 and 9 respectively. We will therefore restrict the following discussion to determining the acquisition cost of property, plant and equipment.

LO 4.1 LO 4.2 LO 4.3 LO 4.4 LO 4.7 LO 4.8 LO 4.10

Accounting for property, plant and equipment—an introduction

AASB 116 Property, Plant and Equipment deals with various issues associated with the recognition, measurement and disclosure of property, plant and equipment. AASB 116 is not applicable to property, plant and equipment that has been classified as being held for sale. There is a separate accounting standard, AASB 5 Non-current Assets Held for Sale and Discontinued Operations, that deals with such assets. Property, plant and equipment are tangible assets and are deemed to be non-current assets because they will be held beyond the next 12 months or beyond the normal operating cycle of the entity. Consistent with the recognition criteria applicable to assets generally, paragraph 7 of AASB 116 requires that the cost of an item of property, plant and equipment be recognised as an asset if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the entity; and (b) the cost of the item can be measured reliably. Paragraph 15 of AASB 116 requires an item of property, plant and equipment that qualifies for recognition as an asset (see above test) to be measured initially at its cost. Specifically, paragraph 15 states: ‘An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its cost’. However, after the initial recognition of the asset at cost, the entity may decide to adopt either the ‘cost model’ or the ‘fair value’ model in measuring the asset. As paragraph 29 of AASB 116 states: An entity shall choose either the cost model in paragraph 30 or the revaluation model in paragraph 31 as its accounting policy and shall apply that policy to an entire class of property, plant and equipment. 158  PART 3: ACCOUNTING FOR ASSETS

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Paragraphs 30 and 31 further stipulate:



Cost Model 30. After recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses. Revaluation Model 31. After recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period.

We will consider the cost model versus the revaluation model in Chapter 6. However, at this stage it should be appreciated that some assets—such as property, plant and equipment—can be measured at cost, or at their fair value. Since property, plant and equipment can be measured at cost, clearly we need to determine what is meant by ‘cost’. According to paragraph 16 of AASB 116, the cost of an item of property, plant and equipment is to comprise: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates; (b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management; and (c) 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. According to paragraph 17 of AASB 116, ‘directly attributable costs’ would include: (a) costs of employee benefits (as defined in AASB 119 Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment; (b) costs of site preparation; (c) initial delivery and handling costs; (d) installation and assembly costs; (e) costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition (such as samples produced when testing equipment); and (f) professional fees. As also indicated above, the cost of an asset should include installation and assembly costs. That is, if amounts are incurred in installing and preparing an asset for use, such expenditure should be included in the cost of the asset. For example, consider a computer network that cost $250 000 to acquire initially, plus $2000 to transport the equipment to its place of use, plus an additional $50 000 paid to computer consultants to make the equipment ready for use. The acquisition cost of the asset would typically be treated as the aggregate amount of the expenditure for the computer—$302 000. This total amount would subsequently be depreciated over the future periods in which the benefits were expected to be derived. Paragraph 19 of AASB 116 provides examples of costs that do not form part of the cost of an item of property, plant or equipment, these being: (a) costs of opening a new facility; (b) costs of introducing a new product or service (including costs of advertising and promotional activities); (c) costs of conducting business in a new location or with a new class of customer (including costs of staff training); and (d) administration and other general overhead costs.

Fair value While we would expect that the majority of the costs associated with acquiring an item of property, plant and equipment would be met with cash, property, plant and equipment can also be acquired by other means, such as by exchanging shares of the company for the assets, or exchanging other types of assets for the property, plant and equipment. This raises questions in relation to determining ‘cost’. CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  159

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AASB 116 requires that if an item of property, plant and equipment is acquired in exchange for equity instruments of the entity (for example, by issuing additional shares), the cost of the item of property, plant and equipment is the fair value of the equity instruments issued. AASB 13 Fair Value Measurement defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Usually, the fair value of the consideration (‘consideration’ being what is given in exchange to acquire a particular asset) is used to measure the acquisition cost of an asset. However, when the consideration is the purchaser’s own equity instruments (such as shares that are not listed on a securities exchange), the fair value of the asset acquired is used to measure the value of the equity issue because it is considered that the fair value of the asset acquired can be measured more reliably. An item of property, plant and equipment may also be acquired through the exchange of another item of property, plant and equipment. The cost of the acquired asset is measured at the fair value of the asset given up, adjusted by the amount of any cash, or cash equivalents, that are transferred. That is, when an asset is exchanged for another asset, the carrying amount (book value) of the asset given in exchange is not generally relevant for determining the ‘cost’ of the acquired asset—it is the fair value of the asset given in exchange that is relevant. This is consistent with paragraphs 6 and 26 of AASB 116, which state, respectively:   6. Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other Australian Accounting Standards, for example, AASB 2 Share-based Payment. 26. If an entity is able to determine reliably the fair value of either the asset received or the asset given up, then the fair value of the asset given up is used to measure the cost of the asset received unless the fair value of the asset received is more clearly evident. Where an entity acquires an item of property, plant and equipment by exchanging another asset, then a gain or loss on disposal will be recognised, with the gain or loss being the difference between the carrying amount of the asset being exchanged, and its fair value. For example, let us assume that we are acquiring some land in exchange for a ship we currently own. If the carrying amount of the ship was $600 000 (and AASB 116 defines carrying amount as ‘the amount at which an asset is recognised after deducting any accumulated depreciation and accumulated impairment losses’), made up by an original cost of $800 000 less accumulated depreciation of $200 000, but its fair value was $750 000, then we would record the land being acquired at a cost of $750 000 and show a net gain of $150 000 on disposal of the ship. Our journal entries would be: Dr Dr Cr Cr

Land Accumulated depreciation—ship Ship Gain on disposal of ship

750 000 200 000 800 000 150 000

The net gain would be the difference between the proceeds from the disposal of the ship (which is equated to the fair value of the land) and the carrying amount of the ship. In situations where the fair value of the asset being given up is difficult to determine, perhaps because the asset is of a type that is not commonly traded, it is permissible to use the fair value of the asset being acquired as its cost. However, there might be cases where neither the fair value of the asset being given up nor that of the asset being acquired can be reliably determined. Perhaps the assets are unique or highly specialised and there is no active market for them. In such cases, the accounting standard permits the cost of the property, plant and equipment acquired in exchange for a similar asset to be measured at the carrying amount of the asset given up in the exchange. While we have been discussing the initial acquisition cost of the asset, it should be appreciated that subsequent accounting periods will require adjustments to the value of the assets by way of depreciation, recognition of impairment losses or, perhaps, through asset revaluations. Subsequent chapters of this book will consider how to account for such changes in value. Again, it is emphasised that for property, plant and equipment there is a requirement that assets initially be recorded at cost. However, following initial recognition, the entity may elect either to continue to measure the asset at cost (less appropriate depreciation and/or impairment losses), or to revalue the asset to its fair value. As a further example of the ‘fair value rule’ provided above, let us assume that a reporting entity exchanged a block of land (carrying amount of $20 000) with another entity for a truck (recorded in the other entity’s books at $30 000). 160  PART 3: ACCOUNTING FOR ASSETS

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Is the reporting entity better off after the transaction? Not necessarily. It is the fair value that is relevant and not the carrying amount. If the block of land had a fair value of $35 000, the truck would initially be recorded at $35 000. If the truck’s carrying amount and fair value were both $30 000, the truck would be recorded at only $30 000, which is less than the fair value of the exchanged land. In real terms the reporting entity might actually be worse off, as it could have sold the block of land for $35 000 (assuming a ready market), acquired the truck for $30 000 and had a balance in cash of $5000. However, from an accounting perspective, if the truck’s carrying amount is based on historical cost, the reporting entity has made a net gain for accounting purposes of $10 000 if the truck is considered to have a fair value of $30 000. Opportunity costs are not recognised. This $10 000 gain would be represented by the difference between the fair value of the truck and the carrying amount of the land. Worked Example 4.3 gives another example of how to determine the acquisition cost of assets.

WORKED EXAMPLE 4.3: Determining the acquisition costs of assets Assume that Joy Ltd is acquiring a portable building from Davies Ltd for the following consideration: Cash Shares Land Liabilities Legal fees

$150 000 100 000 shares with a market value per share of $1.90 Joy is going to transfer title of some rural land to Davies (carrying amount of $120 000; fair value of $95 000) Joy has agreed to take legal responsibility for Davies’ bank loan of $65 000 Pertaining to the acquisition: $9 000, which will be paid one month later

REQUIRED Determine the acquisition cost of the asset. SOLUTION In determining the cost of the acquisition, it is the fair value of the consideration that is relevant, not the historical book values. AASB 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Market participants are expected to be independent of each other and they are assumed to be knowledgeable about the asset or liability. Joy Ltd should account for the cost of the building as follows: Cost Cash Shares Land Legal fees Liabilities

$ 150 000 190 000 95 000 9 000   65 000 509 000

The journal entry to record the acquisition would be: Dr Dr Cr Cr Cr Cr Cr

Building Loss on disposal of land Bank loan Cash Legal fees accrued Land Share capital

509 000 25 000 65 000 150 000 9 000 120 000 190 000

The asset—in this case the building—has a limited life and therefore should subsequently be depreciated over the periods in which the benefits are expected to be derived.

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As indicated in Worked Example 4.3, where the purchase consideration comprises shares or other securities, the acquired asset should be recorded at the fair value of those securities. Where the securities are listed on a securities exchange, the price at which they could be placed on the market will usually be an indication of fair value. However, it would be necessary to make a valuation of the securities of an unlisted company. As indicated above, if the valuation of the assets being given up in the exchange is difficult to determine (say, in the above example, we realise that the valuation of the shares is difficult owing to non-listing or a ‘thin market’), an alternative approach is to value the acquired asset at its fair value if that amount is more clearly determinable than what was given in exchange.

Safety and environmental expenditure Certain items of property, plant and equipment might be acquired for safety or environmental reasons. While these items might not produce any direct economic benefits, the expenditure on them might be necessary for the entity to obtain future economic benefits from its other non-current assets. In this regard, paragraph 11 of AASB 116 states: Such items of property, plant and equipment qualify for recognition as assets because they enable an entity to derive future economic benefits from related assets in excess of what could be derived had it not been acquired. For example, a chemical manufacturer may install new chemical handling processes to comply with environmental requirements for the production and storage of dangerous chemicals; related plant enhancements are recognised as an asset because, without them, the entity is unable to manufacture and sell chemicals. However, the resulting carrying amount of such an asset and related assets is reviewed for impairment in accordance with AASB 136 Impairment of Assets. Where expenditure, such as that referred to above, must be incurred to enable an asset to continue to be used, and future periods in which the asset is used are expected to benefit from the expenditure, the expenditure shall be capitalised. If the expenditure was not incurred, then the service potential of the related asset, or assets, might not be realised. For example, legislation might be promulgated requiring machinery to comply with a minimum level of safety standards, or to fit a device to limit harmful environmental impacts. This safety or environmental expenditure is capitalised because it is necessary (owing to legislative requirements) for the entity to continue its manufacturing process, and failure to comply would mean that the economic benefits embodied in the original asset would not be obtained. Another issue we need to consider in determining the costs of an asset are any estimates of costs that might be required in relation to dismantling or removing the asset, or restoring sites as a result of using the asset. As we saw previously, paragraph 16 of AASB 116 states that the cost of property, plant and equipment is to 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’. As an example of how this requirement applies, an oil company might construct an offshore oil drilling platform. Before establishing the platform, there would be an expectation that the platform would be removed at the completion of the project and any environmental disturbances rehabilitated. These expected future costs would be estimated at the commencement of the project and a liability would be recorded in accordance with AASB 137 Provisions, Contingent Liabilities, and Contingent Assets. The expected costs would be measured at their expected present value and the amount would be included as part of the cost of the asset—the drilling platform. The total amount of the asset, including the estimated costs for dismantling and removal, would be depreciated over the expected useful life of the asset. One rationale for including the costs of dismantling and removal would be that agreeing to undertake such actions might be a necessary precondition for enabling the asset to be available for use. An illustration of this is provided in Worked Example 4.4.

WORKED EXAMPLE 4.4: Capitalisation of expenditure to be incurred subsequent to the acquisition of an asset During the reporting period ending 30 June 2018, Garratt Ltd erected an on-land oil rig just outside Byron Bay. The cost of the exploration rig and associated technology amounted to $6 567 000. Other costs associated with the erection of the oil rig amounted to:

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$ Costs incurred in obtaining access to the site Transportation of rig Erection Resource consent Engineers’ fees

2 324 900 856 300 445 640 1 657 000 900 200 6 184 040

The oil rig was ready to start production on 1 July 2018, with actual production starting on 1 October 2018. At the end of the rig’s useful life, which is expected to be five years, Garratt Ltd is required by its resource consent to dismantle the oil rig, remove it, and return the site to its original condition. After consulting its own engineers and environmentalists, Garratt Ltd estimates these costs to be: $ Dismantling the oil rig Transportation of rig Environmental clean-up costs Replacement of flora and fauna

199 400 355 800 4 854 500 690 300 6 100 000

Garratt Ltd plans to provide for these costs over the expected life of the oil well. It uses a discount rate of 8 per cent. REQUIRED Prepare the journal entries necessary to account for the oil rig for the years ended 30 June 2018, 30 June 2019 and 30 June 2020. Ignore depreciation. SOLUTION 30 June 2018 Dr Oil rig Cr Cash/Accounts payable (6 567 000 + 6 184 040) Cr Provision for restoration costs

16 902 700 12 751 040 4 151 660

As we can see above, at the end of the reporting year of 30 June 2018, a provision for restoration costs must be created. The provision is the best estimate of the expenditure required to settle the obligation. Provisions are to be recorded at present value, pursuant to paragraph 45 of AASB 137 Provisions, Contingent Liabilities, and Contingent Assets. The estimated site restoration costs of $4 151 660 ($6 100 000, payable in 5 years, discounted at 8 per cent, which equals $6 100 000 × 0.6806) are added to the cost of the oil rig. The costs incurred in dismantling the rig, removing it and restoring the site to its original condition are costs that are necessary to realise the future economic benefits embodied in the asset, and the required expenditure has been included in the cost of the asset. Discounting the future obligation creates interest costs for future years. As paragraph 60 of AASB 137 states: Where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognised as borrowing cost. The borrowing (interest) costs are allocated to specific years as follows: Date 1 July 2018 30 June 2019 30 June 2020 30 June 2021 30 June 2022 30 June 2023

Opening balance 4 151 660 4 483 793 4 842 496 5 229 896 5 648 288

Interest at 8% 332 133 358 703 387 400 418 392 451 712

Balance of site restoration costs 4 151 660 4 483 793 4 842 496 5 229 896 5 648 288 6 100 000 continued

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The journal entries to recognise the periodic interest charges are: 30 June 2019 Dr Interest expense Cr Provision for restoration costs

332 133

30 June 2020 Dr Interest expense Cr Provision for restoration costs

358 703

332 133

358 703

As we can see from the above entries, at the end of each period the amount recorded for the provision for restoration costs increases. By the end of the final period of the project, the balance of the provision will be $6 100 000. This amount will then be eliminated when Garratt Ltd undertakes the actual restoration work.

Allocation of cost to individual items of property, plant and equipment From time to time, a group of items of property, plant and equipment might be acquired and paid for in a single payment. For example, a number of computers could be acquired at the same time for the development of a computer laboratory to be used by students. These computers would generally be indistinguishable, so the allocation of the purchase price is straightforward. For example, if 25 computers were acquired at a cost of $145 000, the cost attributable to each computer would be $5800. However, where a number of individual items of property, plant and equipment are acquired and a lump-sum payment is made, the cost of the assets is still determined according to the requirements of AASB 116; that is, pursuant to paragraph 16, the cost would include the fair value of the consideration given, together with any directly attributable costs. How the costs are to be allocated to individual items is not directly addressed by AASB 116. However, generally accepted practice would be for the cost to be allocated to the individual items in proportion to their fair values at the time of acquisition. This is demonstrated in Worked Example 4.5.

WORKED EXAMPLE 4.5: Allocation of cost to individual assets On 15 July 2019, Gilmore Ltd acquired a manufacturing plant for $3 900 500. The purchase price included the land, building, machinery and inventory of raw materials. An external valuer employed by Gilmore Ltd believes the cost can be allocated to the individual items in the following proportions:

Land Building Machinery Inventory

% 55 35 8 2 100

REQUIRED Prepare the journal entry as at 15 July 2019 to record the acquisition of the assets. SOLUTION Allocation of purchase price: Land Building Machinery Inventory

% 55 35 8  2 100

$ 2 145 275 1 365 175 312 040 78 010 3 900 500

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15 July 2015 Dr Land Dr Building Dr Machinery Dr Inventory Cr Bank

2 145 275 1 365 175 312 040 78 010 3 900 500

Components approach Certain classes of property, plant and equipment, for example, aircraft and ships, might comprise a number of individual component parts, each of which has a different useful life. For instance, an aircraft might comprise a number of components, including the airframe, the engines and internal fittings. AASB 116 does not prescribe the unit of measurement for recognition of individual components making up an item of property, plant and equipment. Rather, it is left to the professional judgement of the financial statement preparers. As paragraph 9 of AASB 116 states: This Standard does not prescribe the unit of measure for recognition, that is, what constitutes an item of property, plant and equipment. Thus, judgement is required in applying the recognition criteria to an entity’s specific circumstances. It may be appropriate to aggregate individually insignificant items, such as moulds, tools and dies, and to apply the criteria to the aggregate value. Each of the components might have a different useful life or provide economic benefits to the entity in different patterns. As these individual components have different lives, each might require different depreciation rates and methods. To ensure that the individual components are accounted for separately, paragraph 43 of AASB 116 requires: Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately. In explaining the above requirement, paragraph 44 of AASB 116 states: An entity allocates the amount initially recognised in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part. For example, it may be appropriate to depreciate separately the airframe and engines of an aircraft, whether owned or subject to a finance lease.

Deferred payments It is possible for an entity to acquire an item of property, plant and equipment and arrange with the vendor of the equipment that payment will not be made for some time into the future. In this regard, paragraph 23 of AASB 116 states: The cost of an item of property, plant and equipment is the cash price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and the total payment is recognised as interest over the period of credit unless such interest is recognised in the carrying amount of the asset in accordance with AASB 123. We will consider the requirements of AASB 123 in the next section of this chapter, but essentially what the above paragraph means is that the cost of an item of property, plant and equipment is the cash price equivalent at the acquisition date. This means that the cost of the item must be determined by discounting the amounts payable in the future to their present value at the date of acquisition. The difference between the cash price equivalent and the total payment is recognised as interest expense over the period of credit unless such interest is recognised in the carrying amount of a qualifying asset—and we will consider qualifying assets in the next section of the chapter. The discount rate to be used is the rate at which the acquirer can borrow the amount under similar terms and conditions. An example of how deferred payments are accounted for is provided in Worked Example 4.6. CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  165

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WORKED EXAMPLE 4.6: Accounting for the deferred payment of an asset On 1 July 2018, Double Island Point Ltd acquired a sand-dredging machine. Double Island Point Ltd paid an initial amount of $100 000 on the date of acquisition and agreed to make a further eight annual payments of $150 000, starting on 30 June 2019. Double Island Point Ltd could borrow funds at 9 per cent per annum. REQUIRED Prepare the journal entries as at 1 July 2018, 30 June 2019 and 30 June 2020 to account for the acquisition of the asset. You are not required to give the depreciation entries. SOLUTION Present value of $100 000 initial payment Present value of $150 000 for 8 years discounted at 9% ($150 000 × 5.5348—see Appendix B)

1 July 2018 Dr Sand-dredging machine Cr Bank Cr Loan

$100 000 $830 220 $930 220

930 220 100 000 830 220

30 June 2019 Dr Interest expense—($830 220 × 9%) Dr Loan Cr Bank

74 720 75 280

30 June 2020 Dr Interest expense—([$830 220 - $75 280] × 9%) Dr Loan Cr Bank

67 945 82 056

150 000

150 000

Accounting for borrowing costs incurred when constructing an item of property, plant and equipment An area in which there has been some disparity in accounting treatment is that of interest expenses incurred during the construction of an asset. For example, an organisation might need to borrow funds to finance the ongoing construction of an asset such as a building. At issue would be whether the related interest expenses should be treated as a cost of the asset or whether the interest expenses should be expensed in the period in which they are incurred. How do you think the borrowing costs should be treated? Such a decision could have a significant impact on the organisation’s reported profits and assets. Accounting Standard AASB 111 Construction Contracts relates specifically to accounting for construction contracts. AASB 111 will be considered in greater depth in Chapter 16. The standard stipulates that costs relating directly to a construction contract or costs that can be allocated on a reasonable basis to such a contract should be included in the cost of the contract. Such costs might include borrowing costs. Therefore it would appear that if interest costs can be attributed directly to a construction contract—perhaps the finance is project-specific—they should be treated as part of the cost of that asset. AASB 123 Borrowing Costs provides further guidance. AASB 123 defines borrowing costs as ‘interest and other costs incurred by an entity in connection with the borrowing of funds’. According to paragraph 6 of AASB 123, ‘borrowing costs’ may include: • interest expense calculated using the effective interest method as described in AASB 9;  • finance charges in respect of finance leases recognised in accordance with AASB 117 Leases; and • exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.

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AASB 123 provides a general rule (which it refers to as the ‘core principle’). This core principle is provided at paragraph 1 of AASB 123, which states: Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognised as an expense. Hence, if an asset is deemed to be a ‘qualifying asset’ and borrowing costs have been incurred to acquire, construct or produce the asset, then such costs must be included as part of the cost of the asset. Conversely, if the borrowing costs cannot be attributed to a qualifying asset, then they would be expensed in the period in which the borrowing costs were incurred. Obviously, the above requirement calls for a definition of ‘qualifying asset’. A ‘qualifying asset’ is defined in AASB 123 as ‘an asset that necessarily takes a substantial period of time to get ready for its intended use or sale’. A ‘substantial period of time’ is generally regarded as being more than 12 months. The borrowing costs to be included would be those that would have been avoided if the expenditure on the asset had not been made. The capitalisation of the borrowing costs is to cease when substantially all the activities necessary to prepare the asset for its intended use or sale are complete. Paragraph 7 of AASB 123 provides further guidance in relation to identifying whether a particular asset is a qualifying asset. It states: Depending on the circumstances, any of the following may be qualifying assets: (a) inventories (b) manufacturing plants (c) power generation facilities (d) intangible assets (e) investment properties (f) bearer plants. Financial assets, and inventories that are manufactured, or otherwise produced, over a short period of time, are not qualifying assets. Assets that are ready for their intended use or sale when acquired are not qualifying assets. The consequence of including costs such as interest costs in the cost of an asset is an increase in depreciation expenses in subsequent years (assuming the asset is not being constructed for sale). To the extent that the asset is being produced to sell, the cost of sales will rise as a result of the inclusion of borrowing costs in the cost of the asset. Hence the capitalisation of borrowing costs simply acts to defer the ultimate recognition of those costs. The capitalisation of borrowing costs as part of the cost of a qualifying asset begins on the ‘commencement date’. According to AASB 123, paragraph 17: The commencement date for capitalisation is the date when the entity first meets all of the following conditions: (a) it incurs expenditures for the asset; (b) it incurs borrowing costs; and (c) it undertakes activities that are necessary to prepare the asset for its intended use or sale. As long as the above conditions are met, borrowing costs continue to be capitalised and included as part of the cost of the asset. In relation to when an entity should cease including borrowing costs as part of the cost of an asset, paragraphs 20 and 22 of AASB 123 state:

20. An entity shall suspend capitalisation of borrowing costs during extended periods in which it suspends active development of a qualifying asset. 22. An entity shall cease capitalising borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.

When a qualifying asset is acquired with borrowed funds, either such funds can be borrowed specifically for the purpose of acquiring or constructing the asset, or the borrowed funds might come from funds the organisation has borrowed for general purposes. Where funds are borrowed specifically for the purpose of acquiring an item of property, plant and equipment, and the asset is considered to be a ‘qualifying asset’, the amount to be capitalised is the actual interest paid within the period. For example, assume that on 1 July 2019 Fraser Island Ltd borrowed $500 000 at 12 per cent per annum, for two years,

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for the specific purpose of constructing an item of plant. The amount of interest capitalised as at June 2020 would be $60 000, which is $500 000 × 12%. The journal entry to capitalise the interest borrowed would be: Dr Cr

Plant Interest payable

60 000 60 000

If funds that have been borrowed are temporarily invested, perhaps owing to a delay in the construction or acquisition of the qualifying asset, then any investment income earned is deducted from the borrowing costs incurred. By contrast, where funds are borrowed for general purposes and to fund various activities, and some of these funds are used to acquire or construct a qualifying asset, then related interest is still to be capitalised. In this case, paragraph 14 of AASB 123 requires: To the extent that an entity borrows funds generally and uses them for the purpose of obtaining a qualifying asset, the entity shall determine the amount of borrowing costs eligible for capitalisation by applying a capitalisation rate to the expenditures on that asset. The capitalisation rate shall be the weighted average of the borrowing costs applicable to the borrowings of the entity that are outstanding during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset. The amount of borrowing costs that an entity capitalises during a period shall not exceed the amount of borrowing costs it incurred during that period. For example, assume the same example above where on 1 July 2019 Fraser Island Ltd contracted to construct an item of plant at a cost of $500 000. Let us further assume that the organisation had previously borrowed $1 000 000 at 13 per cent per annum, as well as another $2 000 000 at 10 per cent per annum, and that some of these available funds were used to construct the asset. The weighted average cost of the available funds would be: Loan $

Interest rate %

Interest $

13 10

130 000 200 000 330 000

1 000 000 2 000 000

The average interest rate would be 330 000/$3 000 000 = 11 per cent. Therefore, the amount of interest capitalised would be $55 000, which is $500 000 × 11%. The journal entry to capitalise the interest borrowed would be: Dr Cr

Plant Interest payable

55 000 55 000

Prior research on interest capitalisation While borrowing costs relating to assets that are constructed over a substantial period of time must now be capitalised (to the extent that the capitalisation does not cause the carrying amount of the asset to exceed its recoverable amount), this has not always been the case. Historically, managers had a choice about how to treat such borrowing costs. One study that considered what motivates organisations to voluntarily adopt a particular accounting treatment for dealing with interest expenses incurred during the construction of assets was that of Bowen, Noreen and Lacey (1981). Adopting Positive Accounting Theory (which is explained in Chapter 3), they proposed that the choice to expense or capitalise interest might be affected by the existence of management compensation agreements tied to reported earnings; accounting-based debt covenant constraints; and political costs associated with higher reported earnings. As Bowen, Noreen and Lacey state (p. 153), capitalising interest can have a material effect on increasing the current period’s reported profit, to which management compensation might be tied, and on key financial variables that are constrained by contractual agreements such as debt agreements. In their testing, they assumed that management is free to choose particular accounting methods and that the management compensation contract does not specify the accounting method to be adopted. Such an assumption is frequently made in Positive Accounting research, but obviously it will not always be borne out in practice. The results of Bowen, Noreen and Lacey’s study indicated that firms with management compensation contracts are no more likely to capitalise interest than other firms. This was contrary to the researchers’ expectations, but could in part be due to the potentially naive assumption that the remuneration contracts did not specify whether interest was to be capitalised or expensed. In fact, the remuneration contracts might well have limited the managers’ choice. However, Bowen, Noreen and Lacey did find, as expected, that organisations that capitalised their interest, thereby increasing reported profits and assets, had financial ratios consistent with being closer to the violation of debt covenants. The act of capitalising the interest 168  PART 3: ACCOUNTING FOR ASSETS

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was, therefore, considered a means of loosening the restrictions of the debt agreements and of moving the firm away from a potentially costly default on its debt contracts. Bowen, Noreen and Lacey also found that the largest firms in the oil industry elected to expense interest, rather than capitalise it. The effect of this was to decrease reported income. The explanation for this seems to have been that, in the period under investigation, the petroleum industry was under intense public scrutiny and it was felt that higher profits could attract more adverse attention for the organisations. This potentially adverse attention could have led to wealth transfers away from the firms. By adopting a method of accounting that reduces reported income, the attention focused on the organisation should, according to Positive Accounting Theory, be reduced.

Repairs and additions to property, plant and equipment Following the acquisition of a non-current asset, additional expenditure may be incurred. These costs can range from ordinary repairs to significant additions. The major problem in this area is the decision whether or not to capitalise these expenses and, if the expenditures are capitalised, determining the number of periods over which the expenditure should be amortised. A general approach is to capitalise expenditures that result in increased future benefits (often referred to as ‘improvements’), but expense those expenditures that simply maintain a given level of services. Expenditure on periodic overhauls or repairs would generally be expensed on the basis that such expenditure does not improve the asset from its former state. The capitalised value of an item of property, plant and equipment, together with the costs associated with any subsequent improvements of the asset, will be depreciated over future periods, given that it is usual for non-current assets to have a limited useful life; however, land can be an exception to this general rule.

Assets acquired at no cost

LO 4.9

Resources may also be acquired at no cost, for example, through a donation. In such a case, if nothing is paid for the item, can it be recognised as an asset? To the extent that the item is expected to provide probable and measurable future economic benefits, it should be recognised as an asset. This is consistent with the conceptual framework, which states that: The absence of related expenditure does not preclude an item from satisfying the definition of an asset and thus becoming a candidate for recognition in the balance sheet; for example, items that have been donated to the enterprise may satisfy the definition of an asset. But what would the other side (the credit side) of the accounting journal entry be? As we know, the conceptual framework defines income as ‘increases in economic benefits during the accounting period in the form of inflows or other enhancements of assets or decreases of liabilities that result in increases in equity, other than relating to contributions from equity participants’. Since a donated asset would increase the assets of the entity without increasing its liabilities, the consequent increase in equity would mean that income would be recognised. The conceptual framework further provides that: Income is recognised in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease in a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities. Worked Example 4.7 considers how to account for an asset acquired at no cost.

WORKED EXAMPLE 4.7: Accounting for an asset acquired at no cost Crescent Head Ltd decides as a goodwill gesture to give Point Plummer Ltd, at no cost, a truck with a fair value of $90 000. Point Plummer Ltd is a local not-for-profit organisation that teaches children about water safety. The carrying amount of the truck in the books of Crescent Head Ltd is $80 000 (cost of $100 000; accumulated depreciation of $20 000). REQUIRED Provide the journal entries to record the asset transfer for: (a) Point Plummer Ltd (b) Crescent Head Ltd. continued CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  169

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SOLUTION (a) The entry in the books of Point Plummer Ltd would be: Dr Cr

Truck Donation income (or something similar)

90 000 90 000

(b) Before providing the journal entry in the books of Crescent Head Ltd, we need to determine whether the act of giving up the asset represents an expense. Conceptually, it would appear to represent an expense. It appears to be a ‘loss on disposal’ of an asset. Any associated benefits of donating the asset would be too uncertain to allow them to be recognised as an asset. While the conceptual framework is silent on the issue of gifts or donations, it does state: Expenses are recognised in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets. Hence the accounting entry in the books of Crescent Head Ltd: Dr Dr Cr

Donation expense (or something similar) Accumulated depreciation—truck Asset—truck

80 000 20 000 100 000

Note: Because of the difference between carrying amount and fair value, there is a difference between the expense recognised by Crescent Head Ltd and the revenue recognised by Point Plummer Ltd.

It should be appreciated that while it appears conceptually correct for an organisation to recognise an asset for the purpose of its statement of financial position (as we have discussed above) even when the asset has been donated to the organisation, this treatment is not embraced by AASB 116 Property, Plant and Equipment. The requirements of accounting standards override the requirements within conceptual frameworks. Specifically, paragraph 15 of AASB 116 states that ‘An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its cost.’ It would appear therefore that a strict application of the standard would mean that if the item of property, plant and equipment has been received as a result of a donation, no cost would initially be recognised for the asset (which would mean that no revenue would be recognised either). However, there would be nothing to prevent the organisation from subsequently revaluing the asset to its fair value. Revaluations are considered in Chapter 6. It is interesting to note that AASB 116 provides an alternative treatment for not-for-profit entities. Paragraph Aus15.1 states: ‘In respect of notfor-profit entities, where an asset is acquired at no cost, or for a nominal cost, the cost is its fair value as at the date of acquisition.’ (As a general note, and as indicated in Chapter 1, paragraphs that have been added to an Australian standard and that do not appear in the text of the equivalent IASB standard are identified with the prefix ‘Aus’.) At this point in the chapter we have covered many issues associated with accounting for assets and, in particular, accounting for property, plant and equipment. One issue we have not considered is how to account for a ‘contingent asset’, which is defined in AASB 137 as: A possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain events not wholly within the control of the entity. Chapter 10 addresses AASB 137 Provisions, Contingent Liabilities, and Contingent Assets in some depth and hence we will defer further discussion of contingent assets until then.

LO 4.6 LO 4.11

Possible changes in the requirements pertaining to financial statement presentation

As noted earlier in this chapter, for a number of years there has been some discussion about changing the format for how financial statements are presented. For example, in October 2008 the IASB issued a discussion paper 170  PART 3: ACCOUNTING FOR ASSETS

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entitled ‘Preliminary Views on Financial Statement Presentation’. The discussion paper proposed some significant changes to the way financial statements are to be presented. In July 2010 a ‘staff draft’ of an Exposure Draft of a new Financial Statement Presentation accounting standard was prepared (because it was a ‘staff draft’ it was not open for public comment) and the expectation was that an Exposure Draft for public comment would be issued in 2011 with a final standard to follow some years later. At the present time there is no clear indication of when a new standard will be issued requiring new formats of presentation for the financial statements. The initial project to revise the format of how financial statements are presented was motivated by the IASB’s and FASB’s concerns that financial statements can currently be presented in many alternative ways. This, in turn, makes it difficult for analysts, investors and other users to compare the financial statements of different reporting entities. Further, the formats of the various financial statements do not make it easy for users to see how the information in the respective statements is linked. For example, the statement of cash flows separates operating activities from financing activities, but that distinction is not always apparent in the statement of financial position and the statement of profit or loss and other comprehensive income. This makes it difficult to compare operating income with operating cash flows—a step often taken in assessing the quality of an entity’s earnings. To provide more useful information, the IASB is seeking to make the financial statements more ‘cohesive’; that is, the objective is to format the information in financial statements so that a reader can follow the flow of information through the various financial statements. In this regard, IASB (2008, p. 30) stated: A cohesive financial picture means that the relationship between items across financial statements is clear and that an entity’s financial statements complement each other as much as possible. Financial statements that are consistent with the cohesiveness objective would display data in a way that clearly associates related information across the statements so that the information is understandable. The cohesiveness objective responds to the existing lack of consistency in the way information is presented in an entity’s financial statements. For example, cash flows from operating activities are separated in the statement of cash flows, but there is no similar separation of operating activities in the statements of comprehensive income and financial position. This makes it difficult for a user to compare operating income with operating cash flows—a comparison often made in assessing earnings quality. Similarly, separating operating assets and liabilities in the statement of financial position will provide users with more complete data for calculating some key financial ratios, such as return on net operating assets. Paragraph 60 of IASB (2010) takes this further by stating: Financial statements that are consistent with the cohesiveness principle complement each other as much as possible. To that end, an entity shall display and label line items in a way that clearly associates related information across the statements and helps a user understand those relationships. For example, an entity aligns the line item descriptions of information presented in the statements of financial position, comprehensive income and cash flows to help users find an asset or a liability, and the related effects of a change in that asset or liability, in the same place in each financial statement. For example, an entity with long-term debt presents interest expense and cash paid for interest in the same section and/or category as the long-term debt and labels the line items in such a way that a user of the financial statements can understand that the amounts are related. The IASB also proposed that financial statements should be presented in a more disaggregated manner. In particular, it was proposed that financial statements be prepared in a way that separates an entity’s financing activities from its business and other activities and, further, separates financing activities between transactions with owners in their capacity as owners and all other financing activities. The ‘Business’ section of the financial statements would include all items related to assets and liabilities that management views as part of its continuing business activities. Business activities are those activities conducted with the intent of creating value, such as producing goods or providing services. It is proposed that the ‘Business’ section be further disaggregated into an Operating category and an Investing category. The ‘Financing’ section would include only financial assets and financial liabilities that management views as part of the financing of the entity’s business activities (referred to as ‘financing assets and liabilities’). Amounts relating to financing liabilities would be presented in the Financing liabilities category and amounts relating to financing assets would be presented in the Financing assets category in each of the financial statements. In determining whether a financial asset or liability should be included in the financing section, an entity should consider whether the item is CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  171

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Table 4.2 Proposed format for the presentation of financial statements

Statement of financial position

Statement of comprehensive income

Statement of cash flows

Business • Operating assets and liabilities • Investing assets and liabilities

Business • Operating income and expenses • Investing income and expenses

Business • Operating cash flows • Investing cash flows

Financing • Financing assets • Financing liabilities

Financing • Financing asset income • Financing liability expenses

Financing • Financing asset cash flows • Financing liability cash flows

Income taxes

Income taxes On continuing operations (business and financing)

Income taxes

Discontinued operations

Discontinued operations Net of tax

Discontinued operations

Other comprehensive income Net of tax Equity

Equity

interchangeable with other sources of financing and whether the item can be characterised as independent of specific business activities. Table 4.2 represents the proposed format for presenting information within the financial statements, excluding the notes. (The section names are in bold italics; bullet points indicate required categories within sections.) According to the IASB (2010), each entity would decide the order of the sections and categories but would use the same order in each individual statement. Each entity would decide how to classify its assets and liabilities into the sections and categories on the basis of how an item is used (the ‘management approach’). The entity would disclose why it chose those classifications. In explaining the use of the management approach, IASB (2008 and 2010) notes that, because functional activities vary from entity to entity, an entity would choose the classification that best reflects management’s view of what constitutes its business (operating and investing) and financing activities. Thus, a manufacturing entity may classify the exact same asset (or liability) differently from a financial institution because of differences in the businesses in which those entities engage. In relation to the presentation format proposed for the statement of financial position (see table above), IASB (2008, p. 16) stated: The statement of financial position would be grouped by major activities (operating, investing and financing), not by assets, liabilities and equity as it is today. The presentation of assets and liabilities in the business and financing sections will clearly communicate the net assets that management uses in its business and financing activities. That change in presentation coupled with the separation of business and financing activities in the statements of comprehensive income and cash flows should make it easier for users to calculate some key financial ratios for an entity’s business activities or its financing activities. In relation to the presentation format proposed for the statement of profit or loss and other comprehensive income, IASB (2008, p. 17) stated: The proposed presentation model eliminates the choice an entity currently has of presenting components of income and expense in an income statement and a statement of comprehensive income (two-statement approach). All entities would present a single statement of comprehensive income, with items of other comprehensive income presented in a separate section. This statement would include a subtotal of profit or loss or net income and a total for comprehensive income for the period. Because the statement of comprehensive income would include the same sections and categories used in the other financial statements, it would include

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more subtotals than are currently presented in an income statement or a statement of comprehensive income. Those additional subtotals will allow for the comparison of effects across the financial statements. For example, users will be able to assess how changes in operating assets and liabilities generate operating income and cash flows. While there has been limited work undertaken by the IASB in recent times in relation to changing the format of the financial statements, the above discussion provides an indication of the type of changes that might occur in future years in terms of how we present financial statements. Again, as accountants, we must not assume that the rules we learn now will necessarily be in operation in the future—financial accounting requirements change regularly.

SUMMARY The chapter explored a number of general issues that relate to assets. Assets, we saw, are currently defined as resources controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity (this definition is likely to change). To apply the asset definition, recognition criteria are necessary. The conceptual framework states that for an asset to be recognised, future economic benefits must be both probable and capable of reliable measurement. Given that the recognition criteria are based on assessments of measurability and probability, the recognition of an asset will frequently depend on professional judgement. This means that accountants may differ in their judgements of whether particular expenditure should be accounted for as an expense or as an asset. The chapter emphasised that classes of assets are typically measured using different measurement rules. This, in itself, raises questions about the meaning of the aggregated total (‘Total assets’). The IASB conceptual framework contains no general guidance on measurement rules for assets other than noting that ‘a number of different measurement bases are employed to different degrees and in varying combinations in financial statements (paragraph 4.55)’. Instead, the accounting standards that address individual methods of accounting for particular classes of assets typically provide measurement rules specific to those classes. There is some overlap between the various accounting standards, for example, a number of accounting standards now require particular assets to be measured at fair value. The chapter also considered the accounting standards on the acquisition costs of assets. Specifically considered were AASB 116 Property, Plant and Equipment and AASB 138 Intangible Assets. We noted the general principle that the cost of acquisition of an asset is considered to be the purchase consideration plus any costs incidental to the acquisition. Purchase consideration is typically measured in terms of the fair value of the assets given in exchange. It should be noted that in May 2015 the IASB released an Exposure Draft of a revised Conceptual Framework for Financial Reporting. This Exposure Draft has proposed some changes in the definition and recognition criteria for assets that will in turn have implications for profit or loss. It is anticipated that the new conceptual framework will be in place from 2017. Chapter 2 of this book addresses some of the expected changes that will flow from the Exposure Draft.

KEY TERMS amortisation  156 capitalise  157 control (assets)  142 current assets  149 current ratio  150

future economic benefits  148 heritage assets  148 historical-cost accounting  147 intangible assets  150 market-value accounting  147

present-value accounting  147 recoverable amount  153 useful life  156

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END-OF-CHAPTER EXERCISES Consider the following example. Cabarita Ltd acquired a parcel of land, with a building thereon, in exchange for the following consideration: Cash Shares in Cabarita Ltd Computing machinery

$125 000 200 000 ordinary shares with a fair value of $1.50 per share Cost of $50 000; accumulated depreciation of $15 000; fair value of $20 000

The value of the land is considered to be equivalent to the value of the building.

REQUIRED (a) What are the cost of the land and the cost of the building? (b) Provide the accounting journal entry in the books of Cabarita Ltd. LO 4.2 4.3 4.7

SOLUTION TO END-OF-CHAPTER EXERCISE (a) The cost of the land and the cost of the building are calculated as follows: Fair value of the purchase consideration Cash Shares at fair value—200 000 at $1.50 Computing machinery at fair value Total

$ 125 000 300 000  20 000 445 000

Therefore, as both the land and the building are of equal value, the value of each is $222 500. (b) The accounting entry in the books of Cabarita Ltd is: Dr Dr Dr Dr Cr Cr Cr

Land Building Loss on disposal of computer Accumulated depreciation—computers Cash Share capital Computer machinery

222 500 222 500 15 000 15 000 125 000 300 000 50 000

REVIEW QUESTIONS 1. Differentiate between the ‘definition of assets’ and the ‘criteria for recognition of assets’ provided in the conceptual framework. LO 4.1 2. Should all expenditure carried forward to future periods be amortised/depreciated? Why? LO 4.1, 4.2, 4.3 3. If an asset is expensed in one financial year because future economic benefits were not deemed to be ‘probable’, can the same asset be reinstated in future periods if the benefits are subsequently assessed as probable? In this respect, does the ability to reinstate assets apply to all assets? LO 4.3, 4.4 4. Why would advertising expenditure typically be expensed in the period incurred? What would be an exception to this general rule? LO 4.3 5. Should borrowing costs associated with the construction of a building be treated as part of the cost of the building, or should the borrowing costs be expensed as incurred? LO 4.10 6. In accounting for the acquisition of assets, the assets acquired are to be recorded at the ‘cost of acquisition’. How would you determine the ‘cost of acquisition’? LO 4.7 174  PART 3: ACCOUNTING FOR ASSETS

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7. Explain the essential characteristics of an asset according to the IASB Conceptual Framework for Financial Reporting. LO 4.1, 4.3 8. When should an ‘impairment loss’ be recognised? LO 4.3, 4.5 9. What is the difference between value-in-use and value-in-exchange and of what relevance is either to the determination of the amount at which an asset is to be disclosed within the statement of financial position (balance sheet)? LO 4.2, 4.5 10. Can an entity include an asset in its statement of financial position that it does not legally own? Justify your answer. LO 4.1 11. Assume that, in a particular year, a reporting entity acquires a patent for a solar-powered toothbrush, but the probability of future economic benefits being generated by the patent is considered to be less than 50 per cent. As a result of changed circumstances in a subsequent year, the outlook is that the benefits are more than 50 per cent probable.

REQUIRED Explain whether the patent may be recognised as an asset i) when acquired or ii) when the probability subsequently exceeds 50 per cent. LO 4.1, 4.3, 4.5 12. How are current assets defined for the purpose of presentation in a statement of financial position (balance sheet)? LO 4.1 13. Tea Tree Bay Ltd acquires a Gizmo Machine from Jetsons Ltd for the following consideration: Cash Land

$20 000 In the books of Tea Tree Bay Ltd the land is recorded at its cost of $100 000. It has a fair value of $140 000.

Tea Tree Bay Ltd also agrees to assume the liability of Jetsons Ltd’s bank loan of $30 000 as part of the Gizmo Machine acquisition.

REQUIRED (a) Calculate the acquisition cost of the Gizmo Machine. (b) Provide the journal entries that would appear in Tea Tree Bay Ltd’s books to account for the acquisition of the Gizmo Machine. LO 4.7 14. What are some of the various asset measurement rules currently utilised within accounting standards? LO 4.4 15. If the IASB conceptual framework had a paragraph inserted that addressed measurement and that paragraph suggested that one basis of measurement, such as present value, should be used by all reporting entities, thereby excluding the use of historical cost, do you think that all reporting entities would simply adopt this suggestion? Remember, accounting standards take precedence over the conceptual framework. What would you see as some of the impediments to standard-setters switching to present values as the basis for the measurement of assets? LO 4.4, 4.8 16. AASB 101 stipulates a number of disclosures that many reporting entities are required to make. What specific disclosures are required by AASB 101 in relation to assets? LO 4.6 17. What are intangible assets and how, according to AASB 101 and AASB 138, should they be disclosed in a reporting entity’s statement of financial position? LO 4.4, 4.6 18. AASB 101 provides alternative presentation formats for a reporting entity’s statement of financial position. Explain the alternative presentation formats, and describe the issues to consider as part of the process of selecting from the alternative presentation formats. LO 4.6 19. According to AASB 116, would you expense or capitalise expenditure incurred in repairing an asset? Explain your answer. LO 4.2, 4.3 20. Assume that the Geelong Football Club signs up five promising recruits by offering each of them a five-year player’s contract. As an additional incentive, it also offers each of the players a substantial sign-on fee. Do you think these players, or the associated economic benefits that they will generate, are ‘assets’ of the Geelong Football Club? How would you account for the sign-on fee? LO 4.2, 4.3, 4.4 21. Believing that it will be good for future business prospects, Point Lonsdale Ltd gives Ocean Grove Ltd some computer machinery at no cost. At the time, Ocean Grove Ltd is considering entering into a long-term agreement to acquire raw materials from Point Lonsdale. Just before the asset transfer, the computer machinery has a fair value of $120 000 and a carrying amount of $100 000 (cost of $170 000; accumulated depreciation of $70 000). CHAPTER 4: AN OVERVIEW OF ACCOUNTING FOR ASSETS  175

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REQUIRED (a) Provide the journal entries in the books of Point Lonsdale Ltd to account for the asset transfer. (b) Can the computer machinery be recognised by Ocean Grove Ltd? Do you think that applying the principles and prescriptions of AASB 116 results in a meaningful statement of assets? LO 4.7, 4.9 22. A university spent $4 million on a swimming pool for its staff. The expenditure was made in an endeavour to improve their health and wellbeing. The staff will not be charged any money for using the pool and the expected operating costs of the pool are expected to be $450 000 per year, meaning that the pool will not be directly generating any positive financial returns. Explain whether the university should recognise the $4 million cost of the pool as an asset, or treat it all as an expense. LO 4.3 23. Cactus Ltd acquires some printing machinery. The amount paid to the manufacturer is $85 000, plus an additional $2000 for delivery. Once the machinery is delivered, it needs some modifications before it can be used. The modifications amount to $7000. An additional amount of $2000 is paid for installation.

REQUIRED (a) For accounting purposes, what is the ‘cost’ of the machinery? (b) Could other costs be included in the measurement of the cost of acquiring the printing machinery if its construction and installation took a substantial period of time? LO 4.3, 4.7, 4.8, 4.10

CHALLENGING QUESTIONS 24. What factors would you consider when determining the format to use in disclosing a reporting entity’s statement of financial position? LO 4.6 25. In an article that appeared in The Australian Financial Review on 26 August 2011 (‘Apple could easily flounder without its founder’ by Mark Ritson), it was reported: The news that Steve Jobs has resigned from Apple and will be replaced as CEO by Tim Cook made global headlines yesterday. What has followed since has been a frenzied discussion of what the loss of Jobs will mean for new product development timelines, share price issues and corporate culture. Apple‘s share price fell 5 per cent on the news of the resignation as questions were raised about Apple‘s prospects without its creative guru at the helm. But the real question for Apple as it enters its post-Jobs period is how well the brand will survive without the founder.

REQUIRED The fact that the share prices fell following the departure of Steve Jobs is consistent with the view that Jobs was an ‘asset’ to the company. How do you think this ‘asset’ would have been disclosed in the financial statements of Apple? LO 4.1, 4.2, 4.6, 4.7 26. During the reporting period ending 30 June 2018, Midnight Boil Ltd constructed a nuclear power generator just outside of Melbourne. The cost of the power generator and associated technology amounted to $12 550 000. Other costs associated with the construction amounted to:

Costs incurred in obtaining access to the site Power permits Engineers’ fees

$ 2 500 500 400 500 1 100 500 4 001 500

The plant was ready to start generating power on 1 July 2018, with actual generation starting on 1 October 2018. At the end of the power plant’s useful life, which is expected to be 10 years, Midnight Boil Ltd is required by the

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government to dismantle the plant, remove it, and return the site to its original condition. After consulting its own engineers and environmentalists, Midnight Boil Ltd estimates these costs to be: $ Dismantling the plant Environmental remediation costs Replacement of flora and fauna

750 500 1 249 500 100 000 2 100 000

Midnight Boil Ltd uses a discount rate of 10 per cent.

REQUIRED Prepare the journal entries necessary to account for the power plant for the years ended 30 June 2018, 30 June 2019 and 30 June 2024. Ignore depreciation. LO 4.3, 4.4, 4.5, 4.7 27. For financial accounting purposes, the Australian National Museum placed a $10 million value on the preserved remains of the legendary Australian racehorse Phar Lap.

REQUIRED What do you think this valuation actually represents? LO 4.2, 4.5, 4.7 28. On 1 July 2018, Point Lookout Ltd acquired a boat to use in its surfing holidays business. Point Lookout Ltd paid an initial amount of $250 000 on the date of acquisition and agreed to make a further five annual payments of $300 000, starting on 30 June 2019. Point Lookout Ltd can borrow funds at 8 per cent per annum.

REQUIRED Prepare the journal entries as at 1 July 2018 and 30 June 2023 to account for the acquisition of the asset. LO 4.3, 4.7, 4.8 29. If we look at a reporting entity’s statement of financial position, we will see a total given for all of the entity’s assets (this is a requirement of AASB 101). This aggregate total is derived by adding together the various classes of current and non-current assets. Do you think it is appropriate that the various classes of assets are simply added together, even though they have probably been measured on a number of quite different measurement bases? Justify your answer. LO 4.4 30. Deebar Ltd has constructed an item of machinery at a cost of $220 000. Construction began on 1 January 2018 and was completed on 30 April 2018. The machinery produces a new damage-resistant surfboard. The cost of $220 000 comprises wages of $100 000, raw materials of $75 000 and depreciation of $45 000. The depreciation relates to other plant and machinery used to make the machine. The wages are to be paid at a future date. Deebar borrowed $150 000 at a rate of interest of 7 per cent to finance the construction of the machine. The funds were received on 1 January 2018 and were repaid on 30 June 2018. As part of securing the loan, government taxes of $1500 were paid. Deebar Ltd has a reporting date of 30 June.

REQUIRED (a) Provide the accounting entry for the construction of the machinery, assuming that the machinery satisfies the criteria for recognition of an asset. LO 4.3, 4.4, 4.7, 4.8, 4.10 (b) Provide the accounting entry, assuming that in June 2018 it becomes apparent that the surfboards made by the machine appear to be unpopular with surfers and consequently will not be bought. Further, assume that a surfing historian is prepared to pay $15 000 to acquire the machine, and that this appears to be the option that provides the greatest economic benefits to Deebar Ltd. As part of the sale of the machine, Deebar is required to pay for transporting the machine to the purchaser, and the transport costs amount to $2300. LO 4.2, 4.5 (c) Provide the accounting entry, assuming that on 1 August 2018 the demand for the surfboards suddenly increases because Rick Manning, a surfing champion, won a world title event on a prototype of the

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surfboard. It is now expected that thousands of the board will be sold. The surfing historian had previously indicated that he no longer wished to proceed with the acquisition of the machine. LO 4.2, 4.5 31. Does the statement of financial position item ‘Total assets’ represent the value of a reporting entity’s assets? Explain your answer. LO 4.4 32. Double Island Ltd constructed a Whizbang Machine and incurred the following costs in doing so: Amounts paid to employees to build the machine Raw materials consumed in building the machine Depreciation of manufacturing equipment attributed to the construction of the Whizbang Machine

$120 000 $45 000 $25 000

REQUIRED (a) Provide the journal entries that Double Island Ltd would use to account for the construction of the asset. (b) Assume that immediately after the journal entries in part (a) have been made, new information becomes available that indicates that the recoverable amount of the Whizbang Machine is only $160 000. Provide the adjusting journal entries. LO 4.3, 4.5, 4.7 33. Lighthouse Ltd acquired land for the purpose of building Lighthouse Point, a health and beauty spa. The following costs were incurred: Purchase price of land paid in cash Stamp duty and legal fees Removal of pre-existing buildings Application to local government bodies for development Expenses incurred in evaluating a different site found to be unsuitable Architects’ fees Construction of spa buildings Salary of manager overseeing the Lighthouse Point project for 18 months Borrowing costs (interest) incurred in relation to the project

$1 000 000 $80 000 $20 000 $10 000 $30 000 $100 000 $1 500 000 $120 000 $180 000

The original buildings on the site were removed by Lighthouse Ltd and sold for $50 000.

REQUIRED (a) Determine the cost of the Lighthouse Point health and beauty spa. (b) Allocate costs between land and building so that a depreciable cost can be determined for the buildings. (It is not necessary to calculate depreciation.) Identify those items for which an arbitrary or estimated allocation between land and building was required. LO 4.3, 4.4, 4.7, 4.8 34. On 15 September 2016, Tweed Ltd acquired land on a remote island at a cost of $100 000. The land was held for future development as a resort when transport to the island was made available. At each reporting date, Tweed Ltd made the following assessments of the net selling price of the land and the value of the land to the business if kept for future use: Date

Net selling price

Value in use

$110 000 $90 000 $80 000 $120 000

$130 000 $120 000 $90 000 $110 000

31 December 2016 30 June 2017 31 December 2017 30 June 2018

REQUIRED (a) At what amount should the land be recorded in the statement of financial position (balance sheet) of Tweed Ltd for each reporting date? (b) Assume that on 30 September 2018 the government cancelled all plans to provide transport to the island. There is no prospect of selling the land. The cost to Tweed Ltd of developing transport exceeds the present

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value of expected future benefits of operating the resort. How should Tweed Ltd account for this event? LO 4.2, 4.5

REFERENCES BOWEN, R.M., NOREEN, E.W. & LACEY, J.M., 1981, ‘Determinants of the Corporate Decision to Capitalise Interest’, Journal of Accounting and Economics, August, pp. 151-79. FOSTER, B. & SHASTRI, T., 2010, ‘The Subprime Lending Crisis and Reliable Reporting: Limitations to the Use of Fair Value in Unstable Markets’, CPA Journal, vol. 80, no. 4, pp. 20-25. HOUGHTON, K. & TAN, C., 1995,  Measurement in Accounting: Present Value and Historical Cost—A Report on the Attitudes and Policy Positions of Australia’s Largest Businesses, Group of 100, Melbourne. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2008,  Discussion Paper: Preliminary Views on Financial Statement Presentation, IASB, London, October. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010, Staff Draft of Exposure Draft—IFRS X Financial Statement Presentation, IASB, London, July. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010, Exposure Draft ED2010/2: Conceptual Framework for Financial Reporting: The Reporting Entity, IASB, London, March. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2013, Discussion Paper DP/2013/1: A Review of the Conceptual Framework for Financial Reporting, IASB, London, September. NAVARRO-GALERA, A. & RODRIGUEZ-BOLIVAR, M., 2010, ‘Can Government Accountability Be Enhanced with International Financial Reporting Standards?’ Public Money and Management, November, pp. 379-84. WATTS, R.L. & ZIMMERMAN, J.L., 1986, Positive Accounting Theory, Prentice Hall, Englewood Cliffs, New Jersey.

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CHAPTER 5

DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT LEARNING OBJECTIVES (LO) 5.1

Understand the meaning of ‘depreciation’ and be able to explain the necessity for calculating depreciation expense.

5.2

Understand the role of accounting in allocating the depreciable amount of a non-current asset over the asset’s expected useful life.

5.3

Be aware that the practice of calculating depreciation expense requires a number of decisions to be made including determining the ‘depreciable base’ of the asset, its ‘useful life’ and the appropriate method of cost apportionment.

5.4

Understand the various approaches (straight line, sum of digits, declining balance, production basis) for allocating the depreciable amount of a non-current asset to particular financial periods.

5.5

Understand when to start depreciating a depreciable asset.

5.6

Know how to separately account for land and buildings.

5.7

Know how and when to revise depreciation rates and methods.

5.8

Know how to account for the disposal of a depreciable asset.

5.9

Know the disclosure requirements of AASB 116 Property, Plant and Equipment as they pertain to depreciation.

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Introduction to accounting for depreciation of property, plant and equipment The previous chapter considered how to account for the acquisition cost of assets. Subsequent to their acquisition, non-current assets with limited useful lives will typically need to be depreciated over the period during which economic benefits are expected to be derived. This chapter will consider the accounting requirements pertaining to depreciation. Subsequent to acquisition many non-current assets are also revalued. The next chapter will consider the revaluation of non-current assets, as well as issues associated with impairment testing. Depreciation expense represents a recognition of the decrease in the service potential of depreciation an asset across time. When non-current assets (apart from land perhaps) are acquired, there is a Allocation of the cost general expectation that the economic benefits related to the acquisition will not last indefinitely. of an asset, or its With this in mind, a proportion of the acquisition cost of the asset will be allocated to particular revalued amount, over financial periods throughout the asset’s useful life. As the IASB Conceptual Framework for Financial the periods in which benefits are expected Reporting, paragraph 4.51, states: to be derived.

Where economic benefits are expected to arise over several accounting periods and the association with income can only be broadly or indirectly determined, expenses are recognised in the income statement on the basis of systematical and rational allocation procedures. This is often necessary in recognising the expenses associated with the using up of assets such as property, plant and equipment, goodwill, patents and trademarks; in such cases the expense is referred to as depreciation or amortisation. These allocation procedures are intended to recognise expenses in the accounting periods in which the economic benefits associated with these items are consumed or expire. As the depreciable assets of a business might comprise a significant proportion of the firm’s depreciable asset total assets, the choice of depreciation policies can have a significant impact on the profits of a A non-current asset business. The potential magnitude of depreciation expense is evident from, for example, a review having a limited of BHP Billiton’s consolidated results for the 2015 financial year, which indicated that the total of the useful life. depreciation and amortisation expenses amounted to US$9 158 million, in a year when profit after tax—and therefore after consideration of amortisation and depreciation—was US$2 878 million, and when total assets were US$125 580 million (BHP Billiton reports its results in US dollars). Another example, in the 2015 financial year, is Qantas Ltd’s depreciation and amortisation expenses, which totalled $1 096 million in a year when profit after tax totalled $560 million, and reported assets amounted to $17 530 million. As we can see, depreciation expense can be quite significant. In Australia, the accounting standard relating to the depreciation of property, plant and equipment is AASB 116 Property, Plant and Equipment. The standard provides a set of comprehensive instructions on how to account for tangible non-current assets. AASB 116 addresses issues such as the acquisition costs of property, plant and equipment (which we addressed in Chapter 4) and subsequent measurement, including the revaluation of property, plant and equipment (which we address in Chapter 6), depreciation, and disposal and derecognition. While AASB 116 covers depreciation issues as they relate to property, plant and equipment, AASB 138 Intangible Assets provides rules in relation to the amortisation of intangible assets. We consider intangible assets in more depth in Chapter 8. From an accountant’s perspective, depreciation represents the allocation of the cost of an asset, or its revalued amount, over the periods in which benefits are expected to be derived. Depreciation is defined in AASB 116 as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. Depreciation should not be confused with the decline in the market value, or fair value, of an asset across time. An asset might even increase in value over time, but a depreciation charge might need to be recognised to take into account the wear and tear that the asset might have undergone. As paragraph 52 of AASB 116 states: Depreciation is recognised even if the fair value of the asset exceeds its carrying amount, as long as the asset’s residual value does not exceed its carrying amount. Repair and maintenance of an asset do not negate the need to depreciate it.

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In determining how to allocate the cost of the asset to the period’s profit or loss, three issues must be addressed: 1. What depreciable base should be used for the asset? 2. What is the asset’s useful life? 3. What method of cost apportionment is most appropriate for the asset? While depreciation will frequently be treated as an expense in the period in which it is recognised, at times the depreciation of one asset will contribute to an increase in the value of another asset. For example, an item of machinery might be used to construct a particular item that will subsequently be sold or used by the reporting entity. In such an instance, the depreciation would be recognised by increasing the costs of the asset being constructed, rather than simply treating the depreciation as an expense of the period. As paragraph 48 of AASB 116 states: ‘The depreciation charge for each period shall be recognised in profit or loss unless it is included in the carrying amount of another asset.’ In explaining this requirement, paragraph 49 of AASB 116 states: The depreciation charge for a period is usually recognised in profit or loss. However, sometimes, the future economic benefits embodied in an asset are absorbed in producing other assets. In this case, the depreciation charge constitutes part of the cost of the other asset and is included in its carrying amount. For example, the depreciation of manufacturing plant and equipment is included in the costs of conversion of inventories (see AASB 102). Similarly, depreciation of property, plant and equipment used for development activities may be included in the cost of an intangible asset recognised in accordance with AASB 138 Intangible Assets. As an example of the above requirement, consider Worked Example 5.1.

WORKED EXAMPLE 5.1: Depreciation charge included in the carrying amount of another asset Point Impossible Ltd constructs and sells boats. In making a boat, an electronic sander was used. The cost of the electric sander is $9 000 and it is expected to have a useful life of 500 hours, and no residual value. During the financial year the sander was used for 50 hours on the boat. REQUIRED Provide the journal entry to account for the depreciation of the electric sander. SOLUTION The depreciation expense in this case would be based on the expected life of 500 hours and would equal $9 000 × 50/500 = $900. The journal entry would be: Dr Cr

LO 5.1 LO 5.2 LO 5.3

Boat—inventory Accumulated depreciation—sander

900 900

Depreciable amount (base) of an asset

As we have noted, in order to determine depreciation expense we need to consider the depreciable base, the useful life, and the most appropriate method of cost apportionment. First we will consider the depreciable base. The depreciable amount or, as it is also called, the depreciable base is the cost of a depreciable asset, or other amount substituted for cost in the financial statement, less its residual value. Paragraph depreciable amount 6 of AASB 116 defines residual value as: Historical cost or revalued amount of a depreciable asset less the net amount expected to be recovered on disposal of the asset at the end of its useful life.

the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. For example, if an asset had a cost of $50 000 and it is expected that the asset will be disposed of in five years’ time for $10 000, the ‘depreciable amount’ (or base) is $40 000; that is, $50 000 less the residual of $10 000. Determining the amount to be recovered on disposal—the residual amount—will

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typically be based on professional judgement, unless perhaps a forward exchange arrangement is already in place in which there is an agreement on how much will be received from the sale of the asset at a future point. Therefore, various estimates might be possible. If an asset is relatively unique then it will be more difficult to determine residual value relative to assets that are commonly bought and sold. It should also be appreciated that residual value is determined by reference to what the entity would currently expect to obtain from the asset’s disposal based on its projected age and condition (again refer to the above definition), and not what it expects to actually obtain at a future date. The choice of a particular residual value will have direct implications for future profits and recorded assets. A higher estimate for the residual value will lead to lower depreciation charges and a lower balance of accumulated depreciation and, thus, a larger amount for total assets. For example, in the case of the asset described above, if we depreciate it on a straight-line basis over its expected useful life of five years, given a residual value of $10 000, the yearly depreciation charge would be $8 000. At the end of year 2 the accumulated depreciation of the asset would be $16 000 and the carrying amount of the asset would be $34 000. However, if we estimate that the residual value is $20 000, the yearly depreciation charge would be $6 000. At the end of year 2 the accumulated depreciation would be $12 000 and the carrying amount of the asset would be $38 000. If the residual value of an asset increases so that it is equal to, or greater than, the carrying amount of the asset, no further depreciation is charged. As paragraph 54 of AASB 116 states: The residual value of an asset may increase to an amount equal to or greater than the asset’s carrying amount. If it does, the asset’s depreciation charge is zero unless and until its residual value subsequently decreases to an amount below the asset’s carrying amount.

Determination of useful life Having determined the depreciable amount of an asset, we need to consider its useful life. For the purposes of AASB 116, the useful life of a depreciable asset reflects its useful life for the entity holding the asset, rather than simply its economic life per se. AASB 116 defines useful life as:

LO 5.2 LO 5.3

(a) the period over which an asset is expected to be available for use by an entity; or (b) the number of production or similar units expected to be obtained from the asset by an entity. In Worked Example 5.1 we utilised production hours as the basis of the asset’s useful life. The definition of useful life provided above reflects the view that an asset’s useful life for one entity may be different from its useful life within another entity. In determining useful life, AASB 116 provides some useful guidance. Paragraph 56 states: The future economic benefits embodied in an asset are consumed by an entity principally through its use. However, other factors, such as technical or commercial obsolescence and wear and tear while an asset remains idle, often result in the diminution of the economic benefits that might have been obtained from the asset. Consequently, all the following factors are considered in determining the useful life of an asset: (a) expected usage of the asset. Usage is assessed by reference to the asset’s expected capacity or physical output (b) expected physical wear and tear, which depends on operational factors such as the number of shifts for which the asset is to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle (c) technical or commercial obsolescence arising from changes or improvements in production, or from a change in the market demand for the product or service output of the asset (d) legal or similar limits on the use of the asset, such as the expiry dates of related leases. The possibility of obsolescence, both technical and commercial, is a factor regardless of the physical use of an asset. Worked Example 5.2 helps to make this clearer. Another factor that should be considered in some cases is the legal life of the asset. For intangible assets (nonmonetary assets without physical substance) such as patents, licences, franchises or copyrights, the legal life of the contract period might be the limiting factor in the firm’s use of the asset. Having determined the depreciable amount of the asset and its useful life, it is necessary to determine how the depreciable amount should be allocated or apportioned to future periods. That is, what is the expected pattern of benefits? As with many things in accounting, determining the useful life and the pattern of benefits will depend heavily upon professional judgement. CHAPTER 5: DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT  183

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WORKED EXAMPLE 5.2: Determination of useful life Assume that a business has an item of plant with the following characteristics: • The plant should continue to produce output in its current manner for the next 12 years. • Demand for the output of the plant is expected to be maintained for the next seven years, after which time the demand will fall to such a low level that it will not be viable to produce the goods. • A more technically advanced machine will probably be available in five years and the firm believes that it will need to switch to the new plant in order to remain competitive. REQUIRED Determine the period of time that should be used in the depreciation calculation. SOLUTION Given the above information, the firm would use a period of depreciation of five years, which is the shortest of the following periods: • physical life—12 years • commercial life—7 years • technical life—5 years Five years would represent the period of time the entity expects to hold the asset. Before determining the periodic depreciation expense, consideration should be given to the expected residual value of the plant in five years’ time so that the ‘depreciable amount’ can be determined. Consideration also needs to be given to the expected pattern of the benefits. Evidently, many judgements have to be made about depreciation, and these judgements will have a direct effect on depreciation expenses, and therefore upon reported profits.

sum-of-digits method Method of depreciation that allocates a greater amount of depreciation in the early years of an asset's life.

declining-balance method Method of depreciation to be used when the economic benefits to be derived from a depreciable asset are expected to be greater in the earlier years relative to the later years.

straight-line method Method of amortisation or depreciation where the cost or revalued amount of an asset, less its expected residual value, is uniformly depreciated over its expected useful life.

LO 5.3 LO 5.4

Method of cost apportionment

Having considered the depreciable base and the useful life of a depreciable asset we will now consider the method of cost apportionment to be applied to the depreciable asset. The method of apportionment should best reflect the economic reality of the asset’s use. AASB 116 does not mandate the use of a particular method of depreciation, but rather, AASB 116 indicates that the basis chosen should be that which best reflects the underlying physical, technical, commercial and, where appropriate, legal facts. There are two general approaches to cost apportionment. These are categorised as time-based and activity-based depreciation methods. If the decline in the asset’s value depends on its use, rather than on issues of technical, legal or commercial concern, an activity-based depreciation method should be used. If the decline in value is going to be greatest in early periods, owing to issues such as technical obsolescence, a method that provides for greatest depreciation charges in early years should be used, such as the sum-of-digits method or the declining-balance method (both of which are time-based). If the asset has a defined life, perhaps legally defined by contract, and it is expected that it will be used uniformly, the straight-line method of depreciation should perhaps be used. Again, it is emphasised that the depreciation method chosen should best reflect the underlying economic reality. The choice of depreciation method might have a significant effect on the firm’s profits and total assets. You can see the differences in expense that might result from calculating depreciation expense in various ways by reviewing Worked Example 5.3. The different methods of depreciation just outlined will clearly lead to differences in accounting profits and reported assets. Therefore, and as stressed throughout this book, the choice of an accounting policy might be a choice with cash-flow implications for the organisation, particularly if specific agreements, such as management bonus schemes or debt contracts with restrictive accounting-based covenants, are tied to accounting profits or total assets. It is hoped, however, that management will be objective and select the depreciation method that best reflects the pattern of benefits to be derived from the asset. Again, objectivity and the expectation that accounting information should be free from bias is one of the key qualitative characteristics of

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WORKED EXAMPLE 5.3: A review of alternative depreciation methods Noosa Ltd acquires an asset for $25 000. It is expected to have a residual value of $5 000 in five years’ time—its expected useful life to the entity. REQUIRED Calculate each period’s depreciation, using: (a) the straight-line method (b) the sum-of-digits method (c) the declining-balance method (d) units-of-production method SOLUTION (a) Straight-line depreciation This is a time-based depreciation method and is the most easily understood and widely used depreciation method. With this approach, the depreciable amount is divided by the number of years in the asset’s useful life as follows: (Cost – residual value) ÷ useful life = ($25 000 – $5 000) ÷ 5 = $4 000 per year This method of depreciation would be appropriate when the pattern of benefits derived from the asset are expected to be uniform throughout the asset’s useful life. (b) Sum-of-digits depreciation The sum-of-digits method of depreciation is a time-based depreciation method and like the decliningbalance method considered below, is an accelerated form of depreciation. The use of accelerated methods assumes that the asset will provide greater economic benefits in its earlier years rather than in later years. In these circumstances, higher depreciation charges are allocated in earlier years, with the depreciation expense decreasing in later years. In this example, the asset is expected to be used for five years. The digits from one to the end of the asset’s life, in this case five, are summed. 1 + 2 + 3 + 4 + 5 = 15 Or we could use the formula n(n + 1) ÷ 2, which gives (5 × 6) ÷ 2 = 15 Year

Depreciation

1 2 3 4 5

5 ÷ 15 × ($25 000 − $5 000) 4 ÷ 15 × ($25 000 − $5 000) 3 ÷ 15 × ($25 000 − $5 000) 2 ÷ 15 × ($25 000 − $5 000) 1 ÷ 15 × ($25 000 − $5 000)

=   $6 667 =   $5 333 =   $4 000 =   $2 667 =   $1 333 $20 000

Depreciation based on the sum-of-digits method would be appropriate where the economic benefits expected to be derived from the asset will be greater in the early years than the later years. (c) Declining-balance depreciation (also referred to as the diminishing-balance method) The diminishing-balance method is an accelerated method of depreciation. Rather than multiplying a consistent balance (in this example $20 000) by a reducing fraction, a consistent percentage is applied to a decreasing carrying amount. The percentage to be applied to the opening written-down value (or carrying amount) of the asset is determined by using the following formula: percentage = 1 − the nth root of (salvage value ÷ cost), where n = the life of the asset, which in this case is 5 = 1.0 − 5  0.2 = 1.0 − 0.724 77 = 0.275 23 continued

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Year

Depreciation

1 2 3 4 5

0.27 523 × ($25 000) 0.27 523 × ($25 000 − $6 881) 0.27 523 × ($25 000 − $11 868) 0.27 523 × ($25 000 − $15 482) 0.27 523 × ($25 000 − $18 102)

=   $6 881 =   $4 987 =   $3 614 =   $2 620 =   $1 898 $20 000

As with the sum-of-digits approach, depreciation based on the declining-balance approach would be appropriate where the economic benefits expected to be derived from the asset will be greater in the early years than the later years. (d) Units-of-production method To use this method—which is an activity-based depreciation method—we would need additional information. The units-of-production method results in a depreciation charge based on the expected use or output of the asset. Therefore we need more details about total expected use or output related to the asset, and the use or output for the current accounting period. For this asset we will use expected use denominated in hours and we will assume that the asset is expected to be used for a total of 1000 hours before its useful life is at an end. We will further assume that in the current financial period the asset has been used for 210 hours. Depreciation, therefore, would be calculated as: Actual usage for the year divided by total expected usage multiplied by depreciable amount = (210 ÷ 1 000) × (25 000 – 5 000) = $4 200.

general purpose financial statements (according to the conceptual framework). As an example of the variety of depreciation methods that might be used we can look at the accounting policy note in Exhibit 5.1 from BHP Billiton Ltd’s 2015 annual report.

DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT Exhibit 5.1 The carrying amounts of property, plant and equipment are depreciated to their estimated residual Details of the value over the estimated useful lives of the specific assets concerned, or the estimated life of the accounting policy note for associated mine, field or lease, if shorter. Estimates of residual values and useful lives are reassessed annually and any change in estimate is taken into account in the determination of the remaining depreciation depreciation charges. Depreciation commences on the date of commissioning. The major categories of property, of property, plant and equipment are depreciated on a unit-of-production and/or straight-line basis plant and using estimated lives indicated below. However, where assets are dedicated to a mine, field or lease equipment and are not readily transferable, the below useful lives are subject to the lesser of the asset category’s from BHP useful life and the life of the mine, field or lease: Billiton Ltd’s 2015 Annual • Buildings 25 to 50 years Report • Land • Plant and equipment • Mineral rights and  petroleum interests • Capitalised exploration

Not depreciated 3 to 30 years straight-line Based on reserves on a unit-of-production basis

Based on reserves on a unit evaluation and development of production basis expenditure

SOURCE: BHP Billiton Ltd 2015 Annual Report

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Depreciation of separate components

LO 5.2

As was indicated in Chapter 4, AASB 116 requires the ‘components approach’ to be used when accounting for items of property, plant and equipment. This requires the cost of an item of property, plant and equipment to be allocated to its various components and where these individual components have different lives or where the consumption of economic benefits embodied in the components differs, each component must be accounted for separately. An example of this would be an aircraft, where the engines, internal fittings and airframe would be accounted for separately as they all have different useful lives. As paragraph 44 of AASB 116 states: An entity allocates the amount initially recognised in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part. For example, it may be appropriate to depreciate separately the airframe and engines of an aircraft, whether owned or subject to a finance lease. An example of the components approach to depreciation is provided in Worked Example 5.4.

WORKED EXAMPLE 5.4: A components approach to depreciation At the beginning of the financial period, De Lange Ltd acquired an aircraft for use in its travel business. The aircraft cost $3 569 000. De Lange Limited’s maintenance and engineering department have provided the accounting department with the following list of component parts and useful lives. Useful life (years)

Component cost ($)

15 10  5

  1 830 000   1 324 000    415 000 3 569 000

Airframe Engines Interior fixtures and fittings

These components and lives are consistent with those previously used, and with what is currently used within the industry. REQUIRED Assuming that the individual components of the aircraft are depreciated on a straight-line basis over their useful lives, and they will have no residual value, prepare the journal entries necessary to account for the depreciation expense at the end of the 12-month reporting period. SOLUTION Calculating the depreciation expense

Airframe Engines Interior fixtures and fittings

Component cost $

Useful life (years)

Depreciation expense ($)

1 830 000 1 324 000 415 000 3 569 000

15 10  5

122 000 132 400 83 000 337 400

Journal entry Dr Cr Cr Cr

Depreciation expense Accumulated depreciation—airframe Accumulated depreciation—engines Accumulated depreciation—interior fixtures and fittings

337 400 122 000 132 400 83 000

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LO 5.5

When to start depreciating an asset

Having considered the depreciable base, useful life and method of cost apportionment, the next step is to consider when we should start depreciating the asset. The rule provided in AASB 116 is that depreciation charges are to be made from the date when a depreciable asset is first put into use, or held ready for use. Therefore, an asset being constructed would not be depreciated until it is ready for use. If an item is able to be used but will not actually be used for a number of periods, the asset would nonetheless be required to be depreciated once it is completed, even though it is not being used. Such depreciation would account for the possibility of decreases in service potential not caused by use but perhaps by technical or commercial obsolescence. As paragraph 55 of AASB 116 states: Depreciation of an asset begins when it is available for use, that is, when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. Depreciation of an asset ceases at the earlier of the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with AASB 5 and the date that the asset is derecognised. Therefore, depreciation does not cease when the asset becomes idle or is retired from active use unless the asset is fully depreciated. However, under usage methods of depreciation the depreciation charge can be zero while there is no production.

LO 5.7

Revision of depreciation rate and depreciation method

The depreciation expense charged to each accounting period is an estimate that involves the exercise of judgement. As it takes into account technical, commercial and other considerations, the basis for calculating the depreciation expense should be reviewed annually to take changing circumstances into account. For this to be achieved, two issues must be considered: the useful life of the asset, and the depreciation method used. How these two factors affect the assessment of the annual depreciation charge is considered below. If it becomes apparent that the expected useful life of a non-current asset has changed, the entity concerned is required to revise its depreciation rate. It might be decided that the useful life of a non-current asset is different from that originally expected because of a number of factors. For example, the useful life might be extended because of certain expenditures that improve the asset and lengthen its life. Alternatively, technological changes or changes in the market for the products of the asset might reduce the useful life of the asset. Changes in the repair and maintenance policy of the entity might also impact on the expected useful life of the asset. In relation to expectations about the useful life (and the residual value) of a non-current asset, paragraph 51 of AASB 116 requires that: The residual value and the useful life of an asset shall be reviewed at least at each financial year-end and, if expectations differ from previous estimates, the change(s) shall be accounted for as a change in an accounting estimate in accordance with AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors. Apart from revisions of expectations about the useful life of an asset, there might also be changes in expectations about the pattern of benefits expected to be derived from the asset. In this regard, paragraph 61 of AASB 116 requires the following: The depreciation method applied to an asset shall be reviewed at least at each financial year-end and, if there has been a significant change in the expected pattern of consumption of the future economic benefits embodied in the asset, the method shall be changed to reflect the changed pattern. Such a change shall be accounted for as a change in an accounting estimate in accordance with AASB 108. Revisions of depreciation rates can have very significant impacts on profits. AASB 116 requires that, if a revision of useful life or of the amounts expected on disposal causes a material change in the depreciation charges of a firm, the financial effect of that material change should be disclosed. According to Paragraph 5 of AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors, an item is deemed to be material if the omission or misstatement of the item: could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. As emphasised earlier in this text, decisions pertaining to materiality are based upon professional judgement: what is considered material by one party might not be considered to be material by another. 188  PART 3: ACCOUNTING FOR ASSETS

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Land and buildings

LO 5.6

Where land and buildings are acquired together, AASB 116 requires that the cost be apportioned between the land and the buildings, and that the buildings be systematically depreciated over time. Land itself would not usually be depreciated, given its usually indefinite life. As paragraph 58 of AASB 116 states: Land and buildings are separable assets and are accounted for separately, even when they are acquired together. With some exceptions, such as quarries and sites used for landfill, land has an unlimited useful life and therefore is not depreciated. Buildings have a limited useful life and therefore are depreciable assets. An increase in the value of the land on which a building stands does not affect the determination of the depreciable amount of the building. Paragraph 59 of AASB 116 further states: If the cost of land includes the costs of site dismantlement, removal and restoration, that portion of the land asset is depreciated over the period of benefits obtained by incurring those costs. In some cases, the land itself may have a limited useful life, in which case it is depreciated in a manner that reflects the benefits to be derived from it. For example, if a land and building package is acquired at a cost of $400 000 and it is considered that the land has a value of $150 000, $250 000 would be attributed to the building and this amount of $250 000 would need to be depreciated over the useful life of the building (after consideration of its ultimate residual value). Company directors have been known to complain about having to depreciate buildings on the grounds that buildings’ value typically increases over time. This argument, however, is invalid. Generally, it is the land that increases in value, not the buildings. Buildings generally have a limited useful life and this must be recognised through depreciation charges. Again, it should be emphasised that directors must depreciate their buildings under existing accounting standards. Electing not to depreciate buildings (and therefore failing to act in compliance with AASB 116) will have the effect of increasing the profits and total assets of the firm. However, these effects may be reversed on the ultimate sale of the depreciable asset. Although the above discussion has related to property, plant and equipment, which are tangible assets, intangible assets should also be systematically amortised over their useful lives. As we know, ‘intangible assets’ are non-monetary assets without physical substance and would include brand names, copyrights, franchises, intellectual property, licences, mastheads, patents and trademarks. The term ‘depreciation’ is often used interchangeably with the term ‘amortisation’. The terms have the same meaning; however, ‘depreciation’ is generally used in relation to non-current assets that have physical substance (such as property, plant and equipment) whilst the term ‘amortisation’ is generally used in relation to intangible non-current assets. We will consider intangible assets in more depth in Chapter 8. However, at this stage we note that AASB 138 Intangible Assets applies to intangible assets. AASB 138 requires that entities determine whether an intangible asset has an indefinite or a finite useful life. For the purposes of AASB 138, an intangible asset is regarded as having an indefinite useful life when, based on an analysis of the relevant factors, there is no foreseeable limit on the period over which the asset is expected to generate net cash inflows for the entity. Where an intangible asset is considered to have a finite life, paragraph 97 of AASB 138 requires that: The depreciable amount of an intangible asset with a finite useful life shall be allocated on a systematic basis over its useful life. Amortisation shall begin when the asset is available for use, that is, when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. Amortisation shall cease at the earlier of the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with AASB 5 and the date that the asset is derecognised. The amortisation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably, the straight-line method shall be used. The amortisation charge for each period shall be recognised in profit or loss unless this or another Standard permits or requires it to be included in the carrying amount of another asset. Conversely, if an intangible asset is considered to have an indefinite useful life, AASB 136, paragraph 107, states ‘an intangible asset with an indefinite useful life shall not be amortised’. Rather, the asset would be subject to annual impairment testing. Impairment testing is addressed in Chapter 6 and involves testing whether the recoverable amount of an asset—which is the higher of its fair value less costs of disposal and its value in use—is greater or less than the CHAPTER 5: DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT  189

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carrying amount of the asset. If as a result of the testing it is found that the recoverable amount is less than the carrying amount of the asset, then an impairment loss shall be recognised. Worked Example 5.5 further illustrates some of the issues that we need to consider when determining how to depreciate assets.

WORKED EXAMPLE 5.5: A further consideration of depreciable life (a) Ochillupo Ltd purchases a canning machine from a major supplier holding a clearance sale. The machine will start to be used in two years’ time, when Ochillupo Ltd plans to expand the current business to include a fruitcanning operation. The machine costs $150 000 at the sale, a saving of $50 000 on its recommended retail price. The machine will be kept in storage until it is needed. It is reported to have a useful life of 10 years if operating at full capacity. (b) Ochillupo Ltd recently purchased some new commercial vehicles at a cost of $220 000. The documentation that came with the vehicles boasts that the useful economic life of these vehicles when they are worked hard is approximately 150 000 km. Given the size of the orchard in which the vehicles are to be used, management estimates that it will take approximately 15 years to reach this level of usage. A new model vehicle with exceptional advantages over the current model is expected on the market within five years. The company will probably update its vehicles when this new model is released. (c) An asset purchased six years ago for $100 000 had an estimated useful life of seven years and accordingly will be fully written off at the end of the next financial year. The asset is being carried in the accounts as follows: Cost less Accumulated depreciation

$ 100 000 (85 716) 14 284

A review by Ochillupo Ltd indicates that the machine can be used effectively within the business for a further five years. It has been established that the carrying amount of the asset is a good approximation of the recoverable amount of that asset. REQUIRED Determine the appropriate depreciation treatment for the three cases described. SOLUTION (a) Canning machine The ‘depreciable amount’ will be the cost of the asset. The recommended retail price is not relevant. The asset is not earning revenue at present and is not expected to be used for two years. Depreciation should be charged from the time a depreciable asset is first put into use or is held ready for use. Since the canning machine is being held ready for use, it would seem that depreciation should be charged immediately and allocated over a period of 12 years. (b) Commercial vehicles These vehicles have a physical life of 15 years. However, they are expected to be used by the present owner for only five years—their technical life. Therefore the company should depreciate the assets over five years. The depreciable amount is the difference between the carrying amount and the expected residual value. An estimate of the residual value in five years is necessary. (c) Other assets AASB 116 requires that an asset’s useful life should be reviewed regularly. The company believes that the asset has a useful life of five years and that the current carrying amount is a good approximation of the recoverable amount of that asset. Thus the carrying value of $14 284 should be depreciated over a revised estimated useful life of five years, providing a revised depreciation charge of $2 857 per year.

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Modifying existing non-current assets

LO 5.2

As indicated in Chapter 4, when modifications or improvements are made to existing non-current assets and the expenditure is material and considered to enhance the service potential of the asset, such expenditure should be capitalised to the extent that particular accounting standards do not preclude such capitalisation (for example, AASB 138 prohibits the capitalisation of expenditures on certain types of intangible assets). Where expenditure is capitalised, the expenditure would subsequently be depreciated to the entity’s statement of profit or loss and other comprehensive income. How we depreciate the modification or improvement will depend upon whether the improvement or modification retains a separate identity (perhaps an asset’s life is enhanced by adding a component to the asset and that component can be removed and used elsewhere if desired), or whether the expenditure relates to something that becomes an integral part of the asset and is not feasibly removable. The depreciable amount of any addition or extension to an existing depreciable asset that becomes an integral part of that asset must be allocated over the remaining useful life of that asset. The depreciable amount of any addition or extension to an existing depreciable asset that retains a separate identity and will be capable of being used after that asset is disposed of must be allocated independently of the existing asset, and on the basis of its own useful life.

Disposition of a depreciable asset

LO 5.8

Items of property, plant and equipment can cease to be used for a number of reasons. These include sale, exchange, permanent withdrawal or destruction. Irrespective of the method of disposal, the accounting treatments follow three basic steps, these being: • eliminate the cost or revalued amount and the accumulated depreciation • record the consideration received (if any) • record the gain or loss on disposal.

Sale When an asset is sold, there will generally be either a profit or a loss on the sale. In relation to calculating the gain or loss on disposal of a depreciable asset, paragraph 71 of AASB 116 states: The gain or loss arising from the derecognition of an item of property, plant and equipment shall be determined as the difference between the net disposal proceeds, if any, and the carrying amount of the item. The standard also states that ‘The gain or loss arising from the derecognition of an item of property, plant and equipment shall be included in profit or loss when the item is derecognised’. As can be seen from the above material extracted from AASB 116, the standard adopts the term ‘derecognition’. The term incorporates the retirement and disposal of an asset. According to AASB 116, the carrying amount of an item of property, plant and equipment is to be derecognised: (a) on disposal; or (b) when no future economic benefits are expected from its use or disposal. From the above requirements we can see that knowledge of the ‘carrying amount’ of an item is necessary to determine the gain or loss on ‘derecognition’ of an asset. As previously indicated, the carrying amount of an asset is defined by AASB 116 as the amount at which an asset is recognised after deducting any accumulated depreciation and accumulated impairment losses (impairment losses, which arise when the recoverable amount of an asset is less than its carrying amount, are addressed in detail within Chapter 6). Therefore, if a firm has decided not to depreciate an asset (meaning the carrying amount will be higher), its profit on sale would be lower than for a firm that had been depreciating the asset. For example, assume that a firm buys an item of plant for $25 000. It is expected to have a useful life of five years and no salvage value. The firm sells the asset at the end of the third year for $12 000. If the item has been depreciated according to the straight-line method for three years, total depreciation would amount to $15 000 and the carrying amount would be $10 000. The profit on sale would be $2 000. Hence the net effect on profits over the three years would be negative $13 000 (profit on sale of $2 000 less the accumulated depreciation of $15 000). CHAPTER 5: DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT  191

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If the item is not depreciated, its carrying amount would still be $25 000, and the loss on sale would be $13 000. The difference in expense recognition would be a matter of timing. Worked Example 5.6 looks at the disposal of a depreciable asset.

WORKED EXAMPLE 5.6: Disposal of a depreciable asset Sandon Point Ltd acquires an item of machinery on 1 July 2016 for a cost of $100 000. When the asset is acquired, it is considered to have a useful life for the entity of five years. After this time, the machine will have no residual value. It is believed that the pattern of economic benefits would best be reflected by applying the sum-of-digits method of depreciation. However, contrary to expectations, on 1 July 2018 the asset is sold for $70 000. REQUIRED Calculate the gain or loss on disposal of the asset and provide the appropriate journal entries in the books of Sandon Point Ltd to record the disposal. SOLUTION For an asset with a useful life of five years the sum-of-digits depreciation is: n(n + 1) ÷ 2 = 5 × 6 ÷ 2 = 15 First year depreciation = 5 ÷ 15 × $100 000 = Second year depreciation = 4 ÷ 15 × $100 000 = Total accumulated depreciation at 1 July 2018 =

$33 333 $26 667 $60 000

Therefore the carrying amount of the asset is $40 000 as at 30 June 2018, made up of the historical cost of $100 000 less the accumulated depreciation of $60 000. The gain on the sale of the asset would therefore be represented by the difference between the proceeds of the sale, and the carrying amount of the machinery, which would give a gain of $30 000. Pursuant to AASB 116, the gain or loss on disposal is recognised on a ‘net basis’. Using a ‘net basis’ means that the proceeds from the disposal should not be separately treated as revenue. The accounting entry would be: Dr Dr Cr

Cash at bank Accumulated depreciation—machinery Gain on sale of machinery

Cr

Machinery

70 000 60 000 30 000 100 000

Sale proceeds deferred When the receipt of the sale proceeds on the disposal of an item of property, plant and equipment is deferred for a period of time, the fair value of the consideration is to be recognised initially at its ‘cash price equivalent’.  The requirement to record the sale proceeds at their current cash equivalent is required by AASB 15 Revenue from Contracts with Customers. The difference between the nominal amount of the consideration and the current cash equivalent is recognised as interest revenue. The discount rate to be used is the rate at which the vendor could invest the amount under similar terms and conditions. An example of deferred sales proceeds is provided in Worked Example 5.7.

WORKED EXAMPLE 5.7: Sale proceeds deferred Assume the same information provided for Sandon Point Limited in Worked Example 5.6 but this time the sale proceeds of $70 000 will be received in two years’ time, on 30 June 2020. The applicable interest rate is 8 per cent. REQUIRED Provide the journal entries necessary to account for the sale of the asset.

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SOLUTION Calculation of the present value of the consideration receivable: $70 000 in 2 years at 8 % = $70 000 × 0.85 734 × $60 013 The journal entry at the date of the disposal is: 1 July 2018 Dr Loan receivable Dr Accumulated depreciation—machinery Cr Machinery Cr Gain on sale of machinery

60 013 60 000 100 000 20 013

At the end of the financial year, the increase in the value of the loan receivable must be recognised. It will be calculated as $60 013 × 8% = $4 801. 30 June 2019 Dr Loan receivable Cr Interest revenue

4 801 4 801

Again, at the end of the second year, the increase in the value of the receivable must be recognised, and then the receipt of cash must be accounted for. The interest revenue to be recognised equals ($60 013 + $4 801) × 8% = $5 186. 30 June 2020 Dr Loan receivable Cr Interest revenue Dr Cash at bank Cr Loan receivable

5 186 5 186 70 000 70 000

Depreciation as a process of allocating the cost of an asset over its useful life: further considerations

LO 5.1 LO 5.2

As we have seen in this chapter, when we depreciate an asset we are effectively allocating the cost (or revalued amount) of an asset over its expected useful life. For example, if we acquire a useful life machine for $1 000 000 that has an expected useful life of 10 years with no expected residual value Estimated period over we would recognise $100 000 in depreciation each year (assuming that the pattern of benefits is which future economic expected to be uniform across the useful life of the asset and assuming we have not revalued the benefits embodied in asset). The effect of this is that across the useful life of the asset we have reduced profits by the a depreciable asset are expected to be cost of the machine, which was $1 000 000. What must be appreciated, however, is that the cost consumed by the of replacing the machine might have increased across time so that it is greater than the aggregate entity, or the estimated amount that we have recognised as a depreciation expense. For example, if the cost of replacing the total service to be machine after 10 years has doubled to $2 000 000, it could be argued that we have not recognised obtained from the sufficient expenses and might have distributed to shareholders too much in dividends (dividends asset by the entity. being distributed out of profits). Indeed, this is one of the main criticisms of historical-cost accounting (Chapter 3 briefly considered some alternative approaches to historical-cost accounting, which take into account current valuations of assets). We will address asset revaluations in the next chapter; however, at this stage we should note that if assets are revalued to fair value at regular intervals this has the effect of increasing the total amount of depreciation being recognised, thereby reducing profits and hence the amount available to distribute in the form of dividends. It is not our intention to pursue the above issue about depreciation any further at this point. Nevertheless, you should consider whether you think that allocating the historical cost of an asset over its useful life (and therefore recognising CHAPTER 5: DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT  193

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this cost as an expense) is appropriate when the cost of that asset might be significantly increasing across time due to factors such as inflation. The article adapted in Financial Accounting in the Real World 5.1 by Roger Montgomery called ‘Airline losses masked as profits’, which appeared in The Australian Financial Review of 19 December 2003, outlines some interesting arguments in relation to the use of depreciation in the airline industry. Consider whether you agree with the arguments being presented in the newspaper article.

5.1 FINANCIAL ACCOUNTING IN THE REAL WORLD A stark warning to investors in airlines Roger Montgomery, director of Clime Asset Management, issued a stark warning to small investors against choosing to invest in airlines. He said that because airlines are ‘capital-intensive, fiercely competitive and ultimately selling a commodity’ they are not a secure long-term investment. Capital-intensive businesses are allowed by present accounting standards and practices to post a profit by depreciating big items like equipment, plant and property based on historical costs. As the business deducts inadequate expenses, not reflecting the reality of the present day, the published profit doesn’t accurately reflect the viability of the business. For example, in the airline business, the replacement cost of an aircraft today, and the costs of servicing and maintaining it, are far higher than the cost of a plane bought 20 years ago and maintained and serviced for that period. Montgomery believes that ‘depreciation’ should be substituted as an accounting entry by something that reflects replacement cost. He gave the following illustration of his thesis: Take a business that purchased $1 million of machinery 25 years ago. Over the ensuing 2.5 decades, profits have been reduced by $1 million in depreciation, leaving an assumed total profit over the period of $2.5 million. If we assume that machinery with the same capacity has risen in price by the rate of inflation, say 4 per cent, then the replacement cost of the machinery would be $2.7 million. If the machinery is to be replaced so that the business is in the same position, the cost to and the cost of running the business is 2.5 times more than that which has been accounted for.  For the business to continue it will have to outlay $2.7 million, thus the accounting profits have been exaggerated by $1.7 million. The company has made an economic profit over the 25 years of $800 000, not the $2.5 million it declared.  Even worse, the company would have paid taxes on a higher declared profit and may have paid dividends it could not afford. Move from millions to tens of billions and you get some idea of the magnitude of the problem. When creditors refuse to extend further credit to businesses out on a limb with debt and leasing arrangements, as happened with United Airlines, shareholders suffer. The business collapses as shareholders are asked to keep it afloat by continuing injections of funds. Montgomery gives the example of an Australian airline where although capital raising by shareholders rose 18 per cent each year over five years and retained earnings averaged three per cent annually, shareholders’ equity only increased by 5.56 per cent over the period. Not a good result. SOURCE: Adapted from ‘Airline losses masked as profits’, by Roger Montgomery, The Australian Financial Review, 19 December 2003, p. 23

LO 5.9

Disclosure requirements

AASB 116 provides a number of disclosure requirements in relation to depreciation. As we will see below, the disclosures will be required for each ‘class of property, plant and equipment’. AASB 116 states that a class of property, plant and equipment is a grouping of assets of a similar nature and use in an entity’s operations. Examples of separate classes would be: land; land and buildings; machinery; ships; aircraft; motor vehicles; furniture and fixtures; 194  PART 3: ACCOUNTING FOR ASSETS

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and office equipment. Paragraph 73 of AASB 116 requires (and these disclosures would be made in the notes to the financial statements) the following: The financial statements shall disclose, for each class of property, plant and equipment: (a) the measurement bases used for determining the gross carrying amount; (b) the depreciation methods used; (c) the useful lives or the depreciation rates used; (d) the gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period; and (e) a reconciliation of the carrying amount at the beginning and end of the period showing: (i) additions; (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) acquisitions through business combinations; (iv) increases or decreases resulting from revaluations and from impairment losses recognised or reversed in other comprehensive income in accordance with AASB 136; (v) impairment losses recognised in profit or loss in accordance with AASB 136; (vi) impairment losses reversed in profit or loss in accordance with AASB 136; (vii) depreciation; (viii) the net exchange differences arising on the translation of the financial statements from the functional currency into a different presentation currency, including the translation of a foreign operation into the presentation currency of the reporting entity; and (ix) other changes.

SUMMARY The chapter considered a number of issues relating to the depreciation of non-current assets. It made specific reference to the applicable Accounting Standard AASB 116 Property, Plant and Equipment for depreciation requirements as they pertain to property, plant and equipment. The chapter also referred to AASB 138 Intangible Assets for details of how intangible assets should be amortised. The focus in this chapter was predominantly on property, plant and equipment. From an accounting perspective, depreciation represents the allocation of the cost of an asset, or its revalued amount, over the accounting periods expected to benefit from its use. That is, depreciation is an allocation process rather than a valuation process. Three general issues arise when accounting for depreciation: determination of the depreciable base of the asset; the useful life of the asset; and the method to be used in allocating the cost of the asset over the various accounting periods. There is also a decision to be made about when to start depreciating an asset. The depreciable base of the asset will be its historical cost, or its revalued amount, less any anticipated residual to be received from the ultimate disposal of the asset at the end of its useful life, less any impairment losses that have been recognised. The determination of useful life will depend on judgements relating to the physical, technical and commercial life of the asset. The method used to allocate the cost of the asset should reflect the pattern of benefits being derived from its use, taking into account issues associated with the physical wear and tear on the asset and technical and commercial obsolescence. There are various methods of depreciation, including the straight-line method; sum-of-digits method; declining-balance method; and depreciation calculated on a production basis. The method used should reflect the pattern of benefits being generated by the asset. Depreciation itself should start from the time when a depreciable asset is first put into use or is held ready for use. When a depreciable asset is ultimately sold, the difference between the net amount received on disposal and its historical cost, or other revalued amount substituted for historical cost, less accumulated depreciation and less any accumulated impairment losses must be recognised in the profit or loss of the period. CHAPTER 5: DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT  195

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KEY TERMS declining-balance method  184 depreciable amount  182 depreciable asset  181

depreciation  181 straight-line method  184

sum-of-digits method  184 useful life  193

END-OF-CHAPTER EXERCISES Fistral Ltd acquires a blank-making machine—blanks are the inner foam core of a surfboard—for the following amounts: • Initial price paid to the supplier on 1 July 2017: • Cost to deliver the machine to the site: • Amount paid to an engineer to make the machine work:

$70 000 $ 5 000 $35 000

The engineer completes her work on 31 December 2017. It is expected that the benefits from the blank-making machine will be derived uniformly over 10 years and that the machine will have no residual value. On 1 July 2018, an additional component is acquired at a cost of $60 000 and is attached to the blank-making machine acquired on 1 July 2017. Although this does not extend the life of the blank-making machine, it makes the machine more efficient. The additional component is expected to have a useful life of 20 years, and to be able to be used on other machines when the useful life of the existing blank-making machine is over. At the end of 20 years the component will have no residual value.

REQUIRED Determine the total depreciation expense for the blank-making machine and attachment for the year ended 30 June 2019.

LO 5.1 5.2 5.3 5.4 SOLUTION TO END-OF-CHAPTER EXERCISE As the additional component can continue to be used beyond the life of the blank-making machine, the two items should be depreciated independently. As the benefits are expected to be derived uniformly, it is appropriate to use the straightline method of depreciation. The depreciable amount of the blank-making machine should include the initial cost, delivery cost and the amount paid to the engineer—that is, the costs necessary to get the machine into a usable state. This gives a total cost of $110 000. One year’s depreciation of this, assuming no residual and a life of 10 years, is $11 000. The depreciation expense of the additional component will be its cost allocated over 20 years. This gives an amount of $3 000. Hence the total depreciation expense for the year to 30 June 2019 is $14 000.

REVIEW QUESTIONS 1. Does depreciation reflect a change in the fair value of an asset? LO 5.1 2. Define ‘useful life’ in terms of the decision to depreciate an asset. LO 5.2, 5.3 3. What effect does depreciation have on the statement of profit or loss and other comprehensive income, and on the statement of financial position? LO 5.2 4. An item of plant is acquired at a direct cost of $110 000. It requires installation and modifications amounting to $20 000 and $10 000, respectively, before it is efficiently operational. It is expected to have a useful life of six years, at which point it will have a residual value of $15 000. 196  PART 3: ACCOUNTING FOR ASSETS

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REQUIRED Provide the depreciation entries for the first two years using: (a) the sum-of-digits method (b) the declining-balance method (c) the straight-line method. LO 5.3, 5.4 5. What is the difference between amortisation and depreciation? LO 5.1 6. You have been appointed the accountant of a new organisation that is preparing its first set of financial statements. In determining the depreciation for the first year, what sorts of information would you need? LO 5.3, 5.4, 5.5 7. You are the accountant for a manufacturing company and have decided to review the depreciation expenses being recognised. Your review has caused the depreciation charges for a number of factory machines to increase significantly. In response to this change a number of the factory managers are angry at you as they believe that they have put in place maintenance schedules that will extend the workable lives of the assets for a number of years and hence should have led to a reduction in the depreciation expenses being recognised. How would you justify your proposed increases in depreciation expenses? LO 5.1, 5.2, 5.7 8. The financial statements of ABC Ltd indicate that the directors did not depreciate their buildings on the basis that the increase in the value of the associated land more than offset the decline in the value of the buildings, and the increase in the value of the land was not treated as income. Is this a valid argument? LO 5.1, 5.2 9. Staunton Ltd acquires a new tractor for its pineapple farm. The tractor is expected to be operational for a period of 18 years, although a more economical version, which Staunton Ltd’s competitors will probably acquire, will be available in six years. It is envisaged that Staunton Ltd will close down in 15 years, as its existing lease will expire.

REQUIRED Determine the number of periods over which the tractor should be depreciated. LO 5.1, 5.3 10. What could motivate management to use one method of depreciation in preference to another? LO 5.3, 5.4 11. How is the gain or loss on the disposal of a non-current asset determined? LO 5.8 12. Winkipop Ltd acquires an item of machinery on 1 July 2015 for a total acquisition cost of $90 000. The life of the asset is assessed as being six years, after which time Winkipop Ltd expects to be able to dispose of the asset for $10 000. It is expected that the benefits will be generated in a pattern that is best reflected by the sum-of-digits depreciation approach. On 1 July 2018, owing to unforeseen circumstances, the machinery is exchanged for a motor vehicle. The motor vehicle is two years old, originally cost $30 000 and has a fair value of $20 000.

REQUIRED Provide the journal entry to record the disposal of the machinery on 1 July 2018. LO 5.4, 5.8 13. What considerations would you take into account when deciding to use one depreciation method, for example, the straight-line method, in preference to another? LO 5.3, 5.4 14. If a company depreciates its property, plant and equipment, what are the associated disclosure requirements? LO 5.9 15. Can an organisation switch depreciation methods from one financial period to the next? LO 5.7 16. On 1 July 2017, Bells Beach Tourist Operations acquired an aircraft that can be used for taking wealthy surfers to remote surfing destinations with lovely waves and limited crowds. The aircraft cost $12 000 000. An engineer’s analysis commissioned by the company determined that the aircraft could be broken down into the following components: airframe, engines and fittings. The airframe comprised 55 per cent of the cost, while the engines were 40 per cent of the cost, with the fittings comprising 5 per cent of the cost. The airframe is estimated to have a useful life of 15 years. At the end of its useful life it will have an estimated scrap value of $150 000. The engines have an estimated useful life of 20 000 hours, while the fittings are expected to have a useful life of five years. Both the engines and the fittings are expected to have no residual value at the end of their useful lives. During the first year the aircraft was operating for 2920 hours.

REQUIRED Prepare all journal entries necessary to account for the acquisition of the aircraft, and its depreciation, for the year ending 30 June 2018. LO 5.4, 5.5 CHAPTER 5: DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT  197

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17. Assume you are the accountant for an organisation and that the managing director queries you about an item of machinery that is shown in the financial statements at a cost of $200 000 less accumulated depreciation of $60 000. He tells you that you need to recognise more depreciation for the asset as he is convinced that the fair value of the machinery at reporting date is only $110 000. How would you respond to his query? LO 5.1, 5.7

CHALLENGING QUESTIONS 18. Is depreciation an allocation process or a valuation process? Provide reasons for your answer. LO 5.1, 5.2 19. At the beginning of 2015, Lorne Ltd acquired an item of machinery at a cost of $100 000. At the time it was expected that the machinery would have a useful life of 10 years and a residual value of $10 000. Until the end of the 2017 financial year the depreciation expense was recognised on a straight-line basis. At the beginning of the 2018 financial year the remaining useful life was reassessed as being 11 years and the residual value was reassessed at $14 000.

REQUIRED Calculate the depreciation expense for the 2016, 2017 and 2018 financial years. LO 5.3, 5.4, 5.7 20. Anglesea Ltd constructed a building in 2014 for a cost of $960 000. The building was expected to have a useful life of 25 years after which time it would be demolished at an expected demolition cost of $100 000. Being on the coast, the building was subject to wild winds at times. At the end of the 2018 financial year the roof of the building was blown away and a replacement was constructed at a cost of $200 000. It was predicted that by replacing the building’s roof its expected useful life would be extended a further 25 years after the end of the 2018 financial year.

REQUIRED Calculate the depreciation cost for the 2017, 2018 and 2019 financial years. LO 5.7 21. Lonsdale Ltd has a machine that makes one type of fin for surfboards. The machine was acquired in 2016 at a cost of $20 000 and it is expected that the machine will be able to produce approximately 2000 fins before it would need to be replaced. It is not expected to have any residual value. At the beginning of the 2019 financial year an attachment for the machine is acquired at a cost of $5 000, which feeds the sheets of fibreglass into the fin-making machine. The attachment is expected to have a life of five years and can be utilised on other machines if required. The attachment will act to extend the useful life of the fin-making machine so that after 2019 the finmaking machine is expected to be able to produce a further 1000 fins in total. The numbers of fins produced in 2016, 2017, 2018 and 2019 were 400, 600, 500 and 800, respectively.

REQUIRED Calculate the depreciation expense for the fin-making machine and attachment for each of the years from 2016 to 2019 and discuss whether the expense would be included as part of the cost of inventory. LO 5.3, 5.4 22. Wastewater Ltd acquired an item of plant on 1 July 2016 for $3 660 000. When the item of plant was acquired, it was initially assessed as having a life of 10000 hours. During the reporting period ending 30 June 2017 the plant was operated for 3000 hours. At 1 July 2017 the plant had a remaining useful life of 7000 hours. On 1 July 2017 the plant underwent a major upgrade costing $234 600. Management believes that this upgrade will add a further 2000 hours of operating time to the plant’s life. During the reporting period ended 30 June 2018 the plant was operated for 4000 hours. On 1 July 2018 the plant underwent a further major upgrade, the cost of which amounted to $344 900, and this added a further 3100 hours’ operating time to its life. During the reporting period ending 30 June 2019 the plant was operated for 3800 hours.

REQUIRED Prepare all the journal entries that Wastewater Ltd would prepare for the years ending 30 June 2017, 30 June 2018 and 30 June 2019 to account for the acquisition, subsequent expenditure and depreciation on the asset. LO 5.2, 5.3, 5.4, 5.7

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23. On 1 July 2015 Sprintfast Couriers Ltd, which has a year-end of 30 June, purchased a delivery truck for use in its courier operations at a cost of $65 000. At the end of the truck’s useful life it is expected to have a residual value of $5 000. During its six-year useful life, Sprintfast Couriers Ltd expected the truck to be driven 246 000 kilometres.

REQUIRED Calculate the annual depreciation charge for each of the six years of the truck’s life using the following methods: LO 5.4 (a) the straight-line method (b) the sum-of-digits method (c) the declining-balance method (d) the units-of-production method using kilometres as the basis of use and assuming the following usage: Year 2016 2017 2018 2019 2020 2021

Kilometres 28 000 34 000 42 000 55 000 68 000 19 000 246 000

24. On 1 July 2015, Bear Island Ltd acquires a computer for an initial cost of $50 000. To make the computer more efficient in the workplace, a number of hardware modifications are necessary before installation. These modifications cost $40 000. The computer is ready for use on 1 January 2016. The computer is expected to be used by the entity for a period of five years, after which time it will be scrapped. On 1 July 2017, a high-speed disk drive is acquired at a cost of $20 000. This disk drive will work only on the existing computer.

REQUIRED Determine the total depreciation expense for the computer and disk drive for the year ended 30 June 2018, using the straight-line method, and provide the required journal entries. LO 5.2, 5.3, 5.4 25. Gazza Ltd acquires a machine for a cost of $29 000. It is expected that the machine will continue to be operational for seven years, during which time it is expected to run for 35 000 hours. The estimated residual value of the machine is $7 000 at the end of its useful life.

REQUIRED Calculate the depreciation charge for each of the first three years, using the following methods: (a) the straight-line method (b) the sum-of-digits method (c) the declining-balance method, using a 33 per cent rate (d) the units-of-production method, based on hours of operation, given that operating times are as follows: year 1 year 2 year 3

6 000 hours 7 000 hours 5 500 hours

LO 5.4

26. First Point Ltd acquires an item of machinery on 1 July 2015 for a cost of $250 000. When the asset is acquired, it is considered to have a useful life for the entity of six years. After this time, the machine will have no residual value. It is believed that the pattern of economic benefits would best be reflected by applying the sum-of-digits method of depreciation. However, contrary to expectations, on 1 July 2018 the asset is sold for $110 000. The amount is to be received as follows: $60 000 on 30 June 2019 and $50 000 on 30 June 2020. The applicable interest rate is 6 per cent.

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REQUIRED Calculate the profit on disposal of the asset and provide the appropriate journal entries in the books of First Point Ltd to record the disposal and the subsequent receipts of cash. LO 5.8 27. Brisbane Ltd purchased a property 10 years ago for $3 000 000. Included in this amount is $350 000 that relates to buildings constructed on the land. A recent valuation has shown that the property is now valued at $5 400 000. The valuer has suggested that the location of the property and the quality of the soil are such that it is unlikely that the value will ever drop below the initial cost of acquisition. The buildings on the property are of a general nature.

REQUIRED Describe the appropriate depreciation treatment. LO 5.1, 5.2, 5.6 28. On 1 July 2016 Long Boards Ltd acquired a printing machine at a cost of $120 000. At acquisition the machine had an expected useful life of 12 000 machine hours and was expected to be in operation for four years, after which it would have no residual value. Actual machine hours were 3000 in the year ended 30 June 2017 and 3 400 in the year ended 30 June 2018. On 1 July 2018 the machine was sold for $50 000.

REQUIRED (a) Prepare journal entries to record depreciation of the printing machine for each of the years ended 30 June 2017 and 30 June 2018 using the straight-line method. State the carrying amount of the machine at the end of each period. Prepare the journal entry to record the sale of the machine on 1 July 2018. (b) Prepare journal entries to record depreciation of the printing machine for each of the years ended 30 June 2017 and 30 June 2018 using the declining-balance method with a depreciation rate of 40 per cent. State the carrying amount of the machine at the end of each period. Prepare the journal entry to record the sale of the machine on 1 July 2018. (c) Prepare journal entries to record depreciation of the printing machine for each of the years ended 30 June 2017 and 30 June 2018 using the sum-of-digits method. State the carrying amount of the machine at the end of each period. Prepare the journal entry to record the sale of the machine on 1 July 2018. (d) Prepare journal entries to record depreciation of the printing machine for each of the years ended 30 June 2017 and 30 June 2018 using the production basis. State the carrying amount of the machine at the end of each period. Prepare the journal entry to record the sale of the machine on 1 July 2018. LO 5.3, 5.4, 5.8 29. Malibu Ltd acquired a building on 1 July 2011 at a cost of $800 000. The useful life of the building was estimated as 20 years with no residual value. Malibu Ltd used the straight-line method of depreciation. On 30 June 2017 the estimate of the remaining useful life of the building was revised to 15 years.

REQUIRED Prepare journal entries for depreciation of the building for the years ended 30 June 2016, 2017 and 2018, and state the carrying amount of the building at the end of each of the three reporting periods. LO 5.6 30. Read the adapted article below in Financial Accounting in the Real World 5.2 originally entitled ‘Doing it tough? Let them watch pay TV’ by Lisa Murray, which appeared in The Sydney Morning Herald on 4 August 2006, and provide a reason to justify Austar’s change in depreciation policy. LO 5.7

5.2 FINANCIAL ACCOUNTING IN THE REAL WORLD Austar results unaffected by tough times in the regions Austar, controlled by John Malone’s Liberty Group, a US media company, reported a half-year net profit of $26.5 million (a 48 per cent increase). After a debt refinancing which decreased its interest payments its plan is to pay a special dividend of $202 million to shareholders (at 16 cents per share).

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The strong result was assisted by both increasing subscriber numbers (there are now more than 570 000 in the regions) and a change in accounting practice where installation costs are depreciated over a longer period (five years not three), cutting $6.3 million from depreciation expense in the current period. The CEO, John Porter, believes petrol prices in regional Australia have more impact on people than interest rate rises so expects the latest interest rate rise will have no impact on Austar. People who are staying at home because they are minimising car use rely on their pay TV subscription for entertainment. Porter predicts that in three to five years, without acquisitions, Austar will double its business. The company has also moved into provision of broadband, launching in Wagga in June, but would not confirm take-up numbers. Its plans include providing broadband via its network in 25 other markets (a total of 750 000 subscribers) and, in a joint exercise with Unwired Group and SP Telemedia (Soul), attempting to gain government funding to extend the network to another 750 000 subscribers. After WIN Corporation’s takeover bid for the pay TV company SelecTV Austar shares fell to $1.30 (down 1.5 cents) but Porter denied concern. SOURCE: Adapted from ‘Doing it tough? Let them watch pay TV’, by Lisa Murray, The Sydney Morning Herald, 4 August 2006, p. 21 

31. Many organisations measure their property, plant and equipment at cost, less accumulated depreciation and accumulated impairment losses (while other organisations might measure their property, plant and equipment at fair value). You are required to discuss some of the problems associated with basing depreciation expense on historical cost (rather than some other value, such as replacement cost). You are also required to explain why managers might prefer to measure property, plant and equipment using the cost model rather than measuring the assets on the basis of fair value. LO 5.2, 5.3 32. Possoes Ltd acquired an aeroplane in 2016 for $75 million. Possoes does not revalue its assets, but instead measures its aeroplanes at cost less accumulated depreciation. If the cost of the same type of aeroplane increases to $110 million over the next three years, and assuming that the organisation distributes all of its profits to shareholders (in the form of dividends), then does the practice of basing depreciation on historical cost create any possible problems for the organisation? If, by contrast, the organisation periodically revalues its assets to fair value, would this have acted to alleviate such problems? LO 5.1, 5.2

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CHAPTER 6

REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS LEARNING OBJECTIVES (LO) 6.1

Be able to measure the cost of property, plant and equipment.

6.2

Understand the meaning of ‘fair value’.

6.3

Understand how and when to revalue an item of property, plant and equipment in accordance with AASB 116 Property, Plant and Equipment.

6.4

Understand how and when to revalue an intangible asset in accordance with AASB 138 Intangible Assets.

6.5

Understand the meaning of ‘recoverable amount’ and be able to calculate it.

6.6

Understand the difference in accounting treatments for upward revaluations to ‘fair value’, as opposed to write-downs to ‘recoverable amount’.

6.7

Understand what an ‘impairment loss’ is and know when and how to account for one in accordance with AASB 136 Impairment of Assets.

6.8

Understand how to account for revaluations that reverse previous revaluation increments or decrements.

6.9

Understand how to account for accumulated depreciation when a non-current depreciable asset is revalued, and understand that, subsequent to revaluation, new depreciation charges will be based on the revalued amount of the non-current asset.

6.10 Know how the profit on disposal of a revalued non-current asset is determined and understand how asset revaluations can affect an organisation’s profits owing to changes in depreciation expenses and in final gains or losses on the sale of the revalued asset. 6.11 Understand the meaning of a ‘cash-generating unit’ and why it is relevant to calculating depreciation and impairment losses. 6.12 Be able to explain possible motivations that might drive an organisation to elect, or not elect, to revalue its non-current assets to fair value. 6.13 Know the disclosure requirements pertaining to asset revaluation and impairment losses.

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Introduction to revaluations and impairment testing of non-current assets Financial statements prepared under the historical-cost accounting convention are frequently criticised on the ground that recorded historical cost might bear no relation to the current value of the assets concerned. Within Australia, entities are permitted to revalue many of their non-current assets, either upwards or downwards, to reflect their current value. However, while many non-current assets may be revalued, the revaluing of certain types of assets is specifically excluded by virtue of some accounting standards. For example, AASB 138 Intangible Assets will permit some intangible assets to be revalued upwards only when there is an ‘active market’ for the asset. An active market is deemed to exist when the items being traded within the market are homogeneous, willing buyers and sellers can normally be found at any time, and prices are available to the public. AASB 138 also specifically excludes the revaluation of many types of internally generated intangibles, such as brand names, publishing titles and so forth. We concentrate on intangible assets in Chapter 8. The requirements for undertaking revaluations of property, plant and equipment (covered by AASB 116) are not as strict as those imposed for intangibles, and an item of property, plant and equipment may be revalued to the extent that a ‘fair value’ can be determined. In this chapter our discussion will relate chiefly to the revaluation of property, plant and equipment. So, within Australia, we have a system that allows many non-current assets to be revalued from cost to fair value. Interestingly, while upward asset revaluations are not permitted in some countries, such as the USA, they are permitted in others, in particular, those countries that have adopted accounting standards released by the IASB (such as Australia, the United Kingdom and the European Union). Revaluations have been permitted in Australia for many years. In those situations where the carrying value of an asset exceeds the recoverable amount, AASB 136 Impairment of Assets requires that the non-current asset be written down to its recoverable amount. Impairment losses, which we also address in some depth in this chapter, should not be confused with depreciation (which was covered in the previous chapter). Depreciation is recognised even if the recoverable amount of an asset exceeds its carrying amount.

Measuring property, plant and equipment at cost or at fair value—the choice

asset revaluation Recognising a reassessment of the carrying amount of a non-current asset to its fair value as at a particular date, excluding recoverable amount write-downs.

recoverable amount The net amount expected to be recovered through the cash inflows and outflows arising from the continued use and subsequent disposal of an item. Represented by the higher of an asset’s fair value less costs of disposal, and its value in use.

carrying amount Net amount shown in the accounts for any asset, liability or equity item. For an asset it is the cost of the asset, or its revalued amount, less any accumulated depreciation and accumulated impairment losses.

The relevant accounting standard is AASB 116 Property, Plant and Equipment. AASB 116 covers a number of issues, including determining the cost of property, plant and equipment and the depreciation, LO 6.1 derecognition and revaluation of property, plant and equipment. In this chapter we will concentrate on LO 6.2 revaluations and impairment of property, plant and equipment. LO 6.4 Once an item of property, plant and equipment has been recognised by an entity, AASB 116 requires each class of property, plant and equipment to be measured either at cost (referred to in the standard as the ‘cost model’), or at fair value (referred to as applying the ‘revaluation model’). It is permissible for some classes of property, plant and equipment to be valued at cost and other classes to be valued at fair value, but an entire class must be measured on the same basis. Specifically, the requirements of paragraphs 30, 31 and 36 of AASB 116 are as follows: 30. Cost model After recognition as an asset, an item of property, plant and equipment shall be carried at its cost less any accumulated depreciation and any accumulated impairment losses. 31. Revaluation model After recognition as an asset, an item of property, plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period.

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36. If an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued. Again, it is emphasised that a class of property, plant and equipment can be measured by using either the cost model or the revaluation model (which adopts fair values as the basis of measurement) as described above, but all assets within a given class must be measured on the same basis. AASB 116 defines a class of property, plant and equipment as a grouping of assets with a similar nature and use within an entity’s operations. The following are examples of separate classes: • land • buildings • machinery • ships • aircraft • motor vehicles • furniture and fittings. Once an entity elects to value a class of assets on the basis of fair value—that is, it adopts the revaluation model—it is expected to maintain this basis of valuation for this class of assets. However, AASB 116 allows an entity to switch from the fair-value basis of valuation back to the cost basis as long as the change generates financial information that is more relevant and reliable and as long as adequate disclosures of the change in accounting policy are made. Clearly, by permitting some classes of non-current assets to be valued on the cost basis and others to be valued at fair value, we have not eliminated the confusion associated with understanding what the total balance of non-current assets actually represents. It is neither cost nor fair value, but a combination of the two. How meaningful do you think this aggregated number is?

LO 6.2

The use of fair values

Where a revaluation of an item of property, plant and equipment is undertaken (which under AASB 116 is the ‘allowed alternative treatment’ to the cost model), the revaluation must be to fair value rather than to any other value. A revaluation can be defined as the act of recognising a reassessment of the carrying amount of a non-current asset to its fair value as at a particular date, but excluding impairment losses. Fair value is defined in the accounting standard and in accordance with AASB 13 Fair Value Measurement as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. This definition of fair value is the same as that of fair value used in other accounting standards. Hence, under AASB 116 a specific valuation method has been stipulated, this being fair value.

How does an entity determine fair value? The commentary in AASB 116 as well as the contents of AASB 13 provide some guidance on determining fair values. It is emphasised that fair values are determined on the basis that the entity is a going concern and there is no need or intention to liquidate its assets. If there is an active and liquid market for an asset, the market price represents evidence of the asset’s fair value. Otherwise, reference should be made to the price (based on the best evidence available) at which the asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. AASB 116 requires certain disclosures to be made in the notes to the financial statements in respect of how fair values were determined for the purposes of a revaluation. Specifically, paragraph 77 requires, in addition to the disclosures required by AASB 13 Fair Value Measurement, that: If items of property, plant and equipment are stated at revalued amounts, the following shall be disclosed: (a) the effective date of the revaluation; (b) whether an independent valuer was involved; (c)–(d) [deleted]; (e) for each revalued class of property, plant and equipment, the carrying amount that would have been recognised had the assets been carried under the cost model; and (f) the revaluation surplus, indicating the change for the period and any restrictions on the distribution of the balance to shareholders. 204  PART 3: ACCOUNTING FOR ASSETS

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Valuations to be kept up to date Once it has been decided to revalue a class of non-current assets, the valuations (and, hence, fair values) must be kept up to date. Paragraph 31 of AASB 116 requires that, if the fair-value basis of measurement is adopted: revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period. The determination of ‘sufficient regularity’, as just referred to, will depend upon the nature of the class of assets. The standard suggests that where the value of revalued property, plant and equipment changes frequently and the changes are material, a revaluation could be necessary each reporting period. Where such changes are not material, the commentary suggests that revaluations every three to five years will be sufficient. Assets within a given class of non-current assets are expected to be revalued at substantially the same time to avoid the selective revaluation of assets. Specifically, paragraph 38 of AASB 116 states: The items within a class of property, plant and equipment are revalued simultaneously to avoid selective revaluation of assets and the reporting of amounts in the financial statements that are a mixture of costs and values as at different dates. However, a class of assets may be revalued on a rolling basis provided revaluation of the class of assets is completed within a short period and provided the revaluations are kept up to date.

Revaluation increments

LO 6.3

AASB 116 requires that a revaluation increment be credited directly to a revaluation surplus account that is part of shareholders’ funds (equity). The increase in revaluation surplus is not included as part of profit or loss, but rather, it is included as part of ‘other comprehensive income’ within the statement of profit or loss and other comprehensive income. The format of the statement of profit or loss and other comprehensive income is explored and discussed in Chapter 16. However, at this stage you need to remember that while some gains and losses are required to be included in profit or loss, some other gains or losses are explicitly excluded by virtue of particular accounting standards. Rather, the excluded gains or losses are to be included in ‘other comprehensive income’. Exhibit 6.1 provides an example of a statement of profit or loss and other comprehensive income and shows where a revaluation increment would be shown. In relation to the increase in the revaluation surplus, paragraph 39 of AASB 116 states:

revaluation increment When an asset is revalued upwards, the revaluation increment represents the difference between the carrying amount of the asset and the amount based on its current valuation.

If an asset’s carrying amount is increased as a result of a revaluation, the increase shall be recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus. However, the increase shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss.

XYZ LIMITED Statement of comprehensive income for the year ended 31 December 2018 2018 ($000)

2017 ($000)

Revenue Cost of sales

390 000 (245 000)

355 000 (230 000)

Gross profit Distribution costs Administrative expenses Other expenses Finance costs

145 000 (9 000) (20 000) (2 100)  (8 000)

125 000 (8 700) (21 000) (1 200)   (7 500)

Exhibit 6.1 Example of a statement of comprehensive income

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2018 ($000)

2017 ($000)

105 900 (31 770)

86 600  (25 980)

74 130

60 620

5 000 20 000

10 667 4 000

 (6 000)

 (1 200)

Other comprehensive income for the year, net of tax

19 000

13 467

Total comprehensive income for the year

93 130

74 087

Profit before tax Income tax expense Profit for the year Other comprehensive income: Exchange differences on translating foreign operations Gains on property revaluation Income tax relating to components of other comprehensive  income

accumulated depreciation Total amount of depreciation recorded for an asset, or a class of assets. For statement of financial position purposes, shown as a deduction from the relevant class of assets.

LO 6.9

As we can see from the above paragraph, there is an exception to the general rule that revaluation increments shall go to ‘other comprehensive income’ rather than profit or loss, this being where an increment reverses a previous decrement of the same asset. We will discuss this exception later. At this point, however, the general form of the entry for a revaluation increment would be: Dr Cr

Asset Revaluation surplus

X X

In this chapter we will not consider the income-tax effects of recognising revaluations as this relies upon material that is introduced in Chapter 18. Chapter 18 will provide further illustrations of the revaluation of non-current assets, with consideration then being given to related tax effects.

Treatment of balances of accumulated depreciation upon revaluation

There are two general approaches to dealing with accumulated depreciation at the date of a revaluation. The most commonly used approach, which is referred to as the net method, requires that, if the revalued assets are depreciable assets, any balances of accumulated depreciation existing for those assets at the revaluation date be credited in full to the asset accounts to which they relate. The asset accounts are then to be increased or decreased by the amount of the revaluation increments or revaluation decrements. Specifically, paragraph 35(b) of AASB 116 directs that when an item of property, plant and equipment is revalued, the accumulated depreciation at the date of the revaluation is to be eliminated against the carrying amount of the asset and the net amount restated to the revalued amount of the asset. The amount of the adjustment arising on the elimination of accumulated depreciation forms part of the increase or decrease in the carrying amount. For example, assume we have a machine with a cost of $10 000 and accumulated depreciation of $1 000 (giving a carrying amount of $9 000). Let us further assume that it is decided to revalue the machine to its fair value of $14 000. To take account of the accumulated depreciation we would initially debit accumulated depreciation by $1 000—thus causing the balance of accumulated depreciation as it relates to this asset to be zero—and credit the asset account by $1 000. That is, the journal entry would be:

revaluation decrement When an asset is revalued downwards, the revaluation decrement represents the difference between the carrying amount of the asset and the amount based on its current valuation.

Dr

Accumulated depreciation

Cr

Machine

1 000 1 000

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We would then debit the machine account by $5 000 and credit the revaluation surplus by $5 000. This would cause the carrying amount of the asset to be $14 000, which is its fair value. That is, the journal entry would be: Dr Cr

Machine Revaluation surplus

5 000 5 000

Subsequent depreciation after a revaluation is based on the revalued amount of the non-current asset. It should be noted that an entity cannot account for a downward revaluation simply by increasing the amount of the accumulated depreciation by the amount of the revaluation decrement, even though the net effect would be the same. Worked Example 6.1 illustrates the use of the ‘net method’—which nets off accumulated depreciation against the asset prior to recognition of the fair value increment or decrement.

WORKED EXAMPLE 6.1: Revaluation of a depreciable asset using the net-amount method Assume that, as at 1 July 2018, Farrelly Ltd has an item of machinery that originally cost $40 000 and has accumulated depreciation of $15 000. Its remaining life is assessed to be five years, after which time it will have no residual value. While completing a regular revaluation of all machinery, Farrelly decided on 1 July 2018 that the item should be revalued to its current fair value, which was assessed as $45 000. REQUIRED Provide the appropriate journal entries to account for the revaluation using the net-amount method. SOLUTION The total revaluation increment will represent the difference between the carrying amount and the fair value of the asset at the date of the revaluation. In this case it would be: $45 000 - ($40 000 - $15 000) = $20 000 The appropriate journal entries on 1 July 2018 would be: Dr Cr Dr Cr

Accumulated depreciation—machinery Machinery Machinery Revaluation surplus

15 000 15 000 20 000 20 000

According to AASB 116, future depreciation should be based on the revalued amount of the asset. The depreciation charge for the year to 30 June 2019 would be $9 000 (the new carrying amount of $45 000 divided by the remaining useful life of five years). Where the depreciation charges for any financial period have changed materially owing to a revaluation, the financial effect of the change (that is, the increase or decrease in the depreciation charges) should be disclosed in the notes to the financial statements for that financial period.

While the demonstrated procedure (applying the net-amount method by which the accumulated depreciation for an asset is adjusted to zero upon revaluation) is the general approach to be followed for revaluations of property, plant and equipment, AASB 116, paragraph 35(a), provides an alternative treatment. This treatment requires that both the gross amount of the asset and the accumulated depreciation of the asset be adjusted. This method is sometimes used where reference is made to newer assets than those being revalued. Specifically, paragraph 35(a) of AASB 116 states that when an item of property, plant and equipment is revalued, the accumulated depreciation at the date of the revaluation can be restated proportionately with the change in the gross carrying amount of the asset so that the carrying amount of the asset after revaluation equals its revalued amount. This approach is referred to as the ‘gross method’. The gross method of revaluation is applied in Worked Example 6.2.

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WORKED EXAMPLE 6.2: Revaluation of a depreciable asset—the use of the gross method Assume as in Worked Example 6.1 that on 1 July 2018 Farrelly Ltd has an item of machinery that originally cost $40 000 and has accumulated depreciation of $15 000. Its remaining life is assessed to be five years. It is decided on 1 July 2018 that the item should be revalued to its current fair value assessed as $45 000. A review of a newer but comparable item of machinery indicates that the newer machine has a market value of $72 000. REQUIRED Adopting the gross method, provide the appropriate journal entries to account for the revaluation. SOLUTION The gross carrying amount of the asset and the accumulated depreciation account are to be restated proportionately, which is the requirement of paragraph 35(a) of AASB 116. The following steps show how this asset can be revalued using the gross method. STEP 1: Calculate the ratio of accumulated depreciation (AD) over gross amount of the asset (GA) immediately prior to the revaluation. The calculation is: 15 000/40 000 = 0.375 The ratio is 0.375, which means 37.5% of the gross amount has been reduced by depreciation charges just before revaluation. In other words, the accumulated depreciation balance is 0.375 of the gross amount of the asset balance. This ratio must be the same just after the revaluation. STEP 2: Solve the equation: We know from STEP 1 that: therefore:

GA - AD = $45 000 AD = 0.375 × GA GA - (0.375GA) = $45 000 0.625GA = $45 000 GA = $72 000

We just worked out what the balance of the GA should be. It is simple to work out the AD balance because GA - AD = $45 000, so AD = $27 000. Now we know what the balance of the AD account should be. Notes: • $45 000 is the amount the asset is being revalued to = GA - AD = the carrying amount • $27 000/$72 000 = 0.375 = the ratio calculated at STEP 1 so we know we are correct STEP 3: Do the journal entries to make the balances of GA and AD equal to the balances that we calculated at STEP 2. Dr Cr Cr

Machinery Accumulated depreciation Revaluation surplus

32 000 12 000 20 000

It should be noted that whether the net-amount method or the gross method is used, the carrying amount of the noncurrent assets will be the same. For example, the balances under both methods after revaluation would be: Net-amount method $

Gross method $

Machinery Accumulated depreciation

45 000          0

72 000 27 000

Carrying amount

45 000

45 000

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Revaluation decrements

LO 6.3

The concept of prudence was traditionally applied within financial accounting. According to the former (pre2010) IASB conceptual framework, the exercise of prudence meant the inclusion of a degree of caution in the exercise of the judgements needed to make the estimates required under conditions of uncertainty, prudence such that income and/or assets are not to be overstated, and expenses and/or liabilities are not to be Traditional approach understated. The requirements of AASB 116 are consistent with the notion of prudence. Consistent requiring asset values with the concept of prudence (and conservatism), the requirements of AASB 116 are that if a class never to be overstated of non-current assets is revalued, the revaluation decrement should be treated as an expense of and liabilities never the period and referred to as a loss on revaluation (remember, the revaluation increment went to to be understated. the revaluation surplus, which is part of equity but which is not recognised in profit or loss but rather Involves the exercise of caution when is treated as an item of ‘other comprehensive income’). The first part of paragraph 40 of AASB 116 making judgements requires that: ‘If an asset’s carrying amount is decreased as a result of a revaluation, the decrease under conditions of shall be recognised in profit or loss’. While prudence seems to be embraced within AASB 116, when uncertainty. the most recent edition of the conceptual framework was released, reference to prudence was removed (although when the Exposure Draft for a revised conceptual framework was released by the IASB in 2015, it reintroduced an explicit reference to the notion of prudence). The requirement now is that financial statements should ‘faithfully represent’ the underlying transactions and events. According to paragraph QC12 of the conceptual framework, financial information faithfully represents particular phenomena when it is complete, neutral and free from error. Therefore, the asymmetric treatment of revaluation increments and decrements does not appear to be totally consistent with the revised conceptual framework (but, as we know, accounting standards have precedence over the conceptual framework). The accounting treatment for a revaluation decrement is examined in Worked Example 6.3. An exception to this general rule, to be considered after Worked Example 6.3, is the case where the decrement reverses a previous increment relating to the same asset.

WORKED EXAMPLE 6.3: A revaluation decrement Young Ltd acquires some machinery at a cost of $150 000 on 1 July 2017. On 30 June 2018, the machinery, which has an accumulated depreciation balance of $20 000, is assessed as having a fair value equal to $100 000. Young Ltd measures machinery at fair value. REQUIRED Provide the journal entries to reflect the revaluation decrement. SOLUTION As noted previously, upon revaluation we would need to offset the accumulated depreciation against the asset account (unless reference is being made to a newer asset and the gross method is used) before recognising the revaluation decrement. The accounting entry would be: Dr Cr Dr Cr

Accumulated depreciation Machinery Loss on revaluation of machinery Machinery

20 000 20 000 30 000 30 000

The loss of $30 000 represents the difference between the carrying amount of the revalued non-current asset (in this case, $130 000) and the fair value. This loss would be recognised as an expense and would cause a reduction in profits. Again, notice that the loss associated with the reduction in fair value is treated as an expense and therefore reduces profits, whereas if it had been a gain related to an increase in fair value then it would not be treated as income and would not increase profits (rather, the gain is included as part of other comprehensive income and therefore does increase total comprehensive income).

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LO 6.8

Reversal of revaluation decrements and increments

With respect to a class of assets, reversals of previous revaluations should, as far as possible, be accounted for by entries that are the reverse of those bringing the previous revaluations to account. For example, where a revaluation decrement reverses a previous increment (or cumulative increment) for an individual asset, it would be debited to the revaluation surplus previously credited for that asset, rather than being debited to the period’s profit or loss. The reduction in the revaluation surplus would be shown as a negative item in ‘other comprehensive income’ within the statement of profit or loss and other comprehensive income. Any excess over the previous revaluation increment would then be debited to the profit or loss. That is, if there had previously been no downward revaluation, the revaluation decrement would be treated as an expense and therefore as a part of profit or loss (as indicated in Worked Example 6.3). However, if there has previously been a revaluation increment for the same asset, the subsequent decrement for that asset is to be adjusted against the balance in the revaluation surplus as it pertains to that asset. As paragraph 40 of AASB 116 states: If an asset’s carrying amount is decreased as a result of a revaluation, the decrease shall be recognised in profit or loss. However, the decrease shall be recognised in other comprehensive income to the extent of any credit balance existing in the revaluation surplus in respect of that asset. The decrease recognised in other comprehensive income reduces the amount accumulated in equity under the heading of revaluation surplus. Similarly, where a revaluation increment reverses a previous decrement (or cumulative decrement), it would be credited to the profit or loss (that is, treated as income). Any excess over and above the previous revaluation decrement would then be credited to the revaluation surplus. As paragraph 39 of AASB 116 states: If an asset’s carrying amount is increased as a result of a revaluation, the increase shall be recognised in other comprehensive income and accumulated in equity under the heading of a revaluation surplus. However, the increase shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss. Consider Worked Example 6.4, which gives an example of reversals of previous revaluation increments and decrements.

WORKED EXAMPLE 6.4: Reversals of previous revaluation increments and decrements PK Ltd acquires a block of land on 1 January 2017 for $200 000 in cash. Due to increased housing demand in the area, the land has a fair value of $290 000 on 30 June 2018. However, it becomes known in the next year that the land and its surrounding area was previously the site of a toxic dump. As a result, the fair value falls to $140 000 on 30 June 2019. REQUIRED Assuming the firm makes revaluations on both 30 June 2018 and 30 June 2019, provide the appropriate journal entries, and show how and where the revaluation increases and decreases would be shown in the statement of profit or loss and other comprehensive income. SOLUTION 1 January 2017 Dr Land Cr Cash (to record the initial acquisition of land)

200 000 200 000

30 June 2018 Dr Land 90 000 Cr Revaluation surplus 90 000 (to represent the increment in the fair value of land. This increase would be treated as part of ‘other comprehensive income’ but not as part of profit or loss)

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30 June 2019 Dr Revaluation surplus 90 000 Dr Loss on revaluation of land 60 000 Cr Land 150 000 (fair value of land falls from $290 000 to $140 000; the loss of $60 000 represents the reduction over and above the previous revaluation increment. The amount of $90 000 would be a reduction in ‘other comprehensive income’ while the amount of $60 000 would be a reduction to profit or loss) While all the necessary amounts for various income and expenses are unknown in this example, the following statement shows where the amounts associated with the above journal entries will be presented.

PK LTD Statement of comprehensive income for the year ended 30 June 2019

Revenue Cost of sales Gross profit Distribution costs Administrative expenses Loss on revaluation of land Profit before tax Income tax expense Profit for the year

2019 ($000)

2018 ($000)

xx xxx   (xx xxx)

xx xxx (xx xxx)

xx xxx (xx xxx) (xx xxx) (60 000)

xx xxx (xx xxx) (xx xxx) –

xx xxx   (xx xxx)

xx xxx (xx xxx)

xx xxx

   xx xxx

(90 000)  (xx xxx)

90 000 (xx xxx)

 (xx xxx)

xx xxx

xx xxx

xx xxx

Other comprehensive income: Gains/(losses) on property revaluation Income tax relating to components of other comprehensive income Other comprehensive income for the year, net of tax Total comprehensive income for the year

It should be noted that if the above land had not been revalued in June 2018—that is, if it had been recorded at cost—impairment testing would be required pursuant to AASB 136 Impairment of Assets. An impairment loss would be recognised if the recoverable amount of the asset declines below its carrying amount. That is, regardless of whether the cost model or the revaluation model is used, an item of property, plant and equipment shall not have a carrying amount in excess of its recoverable amount. The recoverable amount is determined as the greater of the value in use and the net selling price of the asset. In this example, if the recoverable amount of the asset is assumed to be the same as the net selling price—in this case $140 000—and to the extent that this is below the carrying amount of the asset (which would be $200 000 if no revaluation was undertaken in 2018), an impairment loss of $60 000 must be recognised. We will consider impairment losses in more depth later in this chapter.

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LO 6.10

Accounting for the gain or loss on the disposal or derecognition of a revalued non-current asset

AASB 116, paragraph 71, provides that: The gain or loss arising from the derecognition of an item of property, plant and equipment shall be determined as the difference between the net disposal proceeds, if any, and the carrying amount of the item. In relation to the timing of the gain or loss, AASB 116, paragraph 68, states that: ‘The gain or loss arising from derecognition of an item of property, plant and equipment shall be included in profit or loss when the item is derecognised’. Paragraph 68 therefore does not require the separate disclosure of the proceeds of the sale as revenue and the presentation of the carrying amount of the asset as an expense—only the net amount, the gain or the loss, is to be presented. The term ‘derecognition’ as used in paragraph 68 refers to the point in time at which an item is removed from the statement of financial position—that is, when it is no longer recognised. According to paragraph 67 of AASB 116, the carrying amount of an item of property, plant and equipment is to be derecognised on disposal or when no future economic benefits are expected from its use or disposal. Worked Example 6.5 sets out how to account for the gain or loss on disposal of a revalued item of property, plant and equipment. The accounting entries for the sale of revalued land, as shown in Worked Example 6.5, do not remove the balance of the asset revaluation that is in the revaluation surplus as a result of the revaluation undertaken on 1 July 2018. That is, there is still a balance of $15 000 in the revaluation surplus, even though the asset to which the revaluation relates has been sold. What should be done with the remaining balance in the revaluation surplus? AASB 116, paragraph 41, provides some guidance in this regard: The revaluation surplus included in equity in respect of an item of property, plant and equipment may be transferred directly to retained earnings when the asset is derecognised. This may involve transferring the whole of the surplus when the asset is retired or disposed of.

WORKED EXAMPLE 6.5: Accounting for a gain or loss on disposal of a revalued non-current asset On 1 July 2017, Bombo Ltd acquires a block of land at a cost of $60 000. On 1 July 2018 it is revalued to $75 000. On 30 June 2019 the land is sold for $90 000. REQUIRED Determine the gain or loss on the sale of the land according to AASB 116 and prepare the journal entry to record the sale. SOLUTION As the carrying amount of the land at the date of disposal is $75 000 (owing to the earlier revaluation increment), the gain on the sale of the land is $15 000. If the land had not previously been revalued, the gain on sale would have been $30 000. The gain on the sale of the land—which would be included as part of profit or loss—would be represented by the difference between the proceeds of the sale and the carrying amount of the land. The gain on the sale would also need to be disclosed. The accounting entry would be: Dr Cash at bank Cr Gain on sale of land Cr Land

90 000 15 000 75 000

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So, to eliminate the balance of the revaluation surplus that relates to the land disposed of, the following entry may be made (it is emphasised that, in the terminology of the accounting standard, the entry may be made, which implies an option to leave amounts in the revaluation surplus for assets that have been derecognised): Dr Cr

Revaluation surplus Retained earnings

15 000 15 000

AASB 116 specifically prohibits transfers from the revaluation surplus to profit or loss. That is, when a revalued asset is subsequently sold, any existing revaluation is not to be eliminated by treating it as part of profits. The revaluation increment would previously have been included in ‘other comprehensive income’. Specifically, paragraph 41 of AASB 116 states ‘Transfers from revaluation surplus to retained earnings are not made through profit or loss’. Worked Example 6.6 provides another example of how to account for the revaluation surplus on the sale of an item of property, plant and equipment. In determining the gain on sale in Worked Example 6.6, we need to calculate the difference between the net sales proceeds and the carrying amount of the machine. At 1 July 2021 there would have been two years of accumulated depreciation since the revaluation was undertaken in 2019. At that point the asset was valued at $96 000 and it was expected to have a remaining useful life of eight years. With no residual value, this means that the annual depreciation charge would be $12 000 per year. It should also be noted that had the revaluation not been undertaken in 2019, the written-down value of the asset (that is, the carrying amount) would have been $60 000 in 2021 and the gain on sale would have been $29 000 rather than $17 000—the difference being the amount of the revaluation less the additional depreciation in the following two years, or $16 000 - 2 × ($12 000 - $10 000). It should be stressed at this point that companies do not have to revalue their property, plant and equipment upwards for the purpose of their financial statements, but once they elect to measure property, plant and equipment at fair value, that value must be kept up to date for that class of assets. Therefore, a reporting entity may have a class of non-current assets accounted for by way of the cost model with a carrying amount (cost less accumulated depreciation and less accumulated impairment losses, if any) that is significantly below its current fair value, without its financial statements failing to comply with Australian (and international) accounting requirements. This raises a number of issues. Why would a company not revalue its assets to their fair value? Conversely, what would motivate a company to perform an upward revaluation?

WORKED EXAMPLE 6.6: Sale of a revalued item of property, plant and equipment Gunnamatta Ltd acquired a printing machine on 1 July 2017 for $100 000. It is expected to have a useful life of 10 years, with the benefits being derived on a straight-line basis. The residual is expected to be $nil. On 1 July 2019 the machine is deemed to have a fair value of $96 000 and a revaluation is undertaken in accordance with Gunnamatta Ltd’s policy of measuring property, plant and equipment at fair value. The asset is sold for $89 000 on 1 July 2021. REQUIRED Provide the journal entries necessary to account for the above transactions and events. SOLUTION 1 July 2017 Dr Printing machine Cr

100 000

Cash/payables

100 000

(to recognise the acquisition of the machine) 30 June 2018 Dr Depreciation expense Cr Accumulated depreciation—printing machine (to recognise depreciation expense for the year)

10 000 100 000

continued Chapter 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS  213

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30 June 2019 Dr Depreciation expense Cr Accumulated depreciation—printing machine (to recognise depreciation expense for the year)

10 000 100 000

1 July 2019 Dr Accumulated depreciation 20 000 Cr Printing machine (to offset two years’ depreciation against the cost of the asset) Dr Printing machine 16 000 Cr Revaluation surplus (to revalue the asset to its fair value of $96 000) 30 June 2020 Dr Depreciation expense Cr Accumulated depreciation—printing machine (to recognise depreciation expense for the year) 30 June 2021 Dr Depreciation expense Cr Accumulated depreciation—printing machine (to recognise depreciation expense for the year) 1 July 2021 Dr Cash at bank Dr Accumulated depreciation Cr Printing machine Cr Gain on sale of printing machine (to account for the sale of the asset)

20 000

16 000

12 000 12 000

12 000 12 000

89 000 24 000 96 000 17 000

1 July 2021 Dr Revaluation surplus 16 000 Cr Retained earnings 16 000 (to transfer the balance of the revaluation surplus to retained earnings following the disposal of the asset)

If a company revalues a non-current asset, any subsequent gain on sale (the gain being determined as the difference between the carrying amount of the asset at the date of sale and the consideration received and which would be included in profit or loss for the period) will be reduced, compared with the gain obtained if the asset had not been revalued. This was demonstrated in Worked Example 6.5. Further, if the asset is depreciable, subsequent depreciation charges will be increased. Depreciation charges are based on cost or, if the depreciable non-current asset has been revalued, on the revalued amount. So increasing the value of the asset will increase subsequent depreciation charges. Again, it must be remembered that the revaluation increment goes to the revaluation surplus account and the increment is included as part of ‘other comprehensive income’ and not as part of profits (unless it reverses a previous decrement). A further example of how a revaluation will affect subsequent profits is given in Worked Example 6.7. A review of the entries in Worked Example 6.7 shows that, for the period from 2017, the accumulated effects on profits are that, if a revaluation had not been undertaken, profits would be $20 000 higher ($5714 less in depreciation and an additional $14 286 gain on sale). This amount is equivalent to the amount credited to the revaluation surplus. That is, from the revaluing company’s perspective, the sum of the lower profit (or greater loss) arising from the higher depreciation charges and the lower gain on sale will be equal to the amount of the revaluation. In some cases, firms might prefer to show lower profits; perhaps because they are being accused of being monopolistic and of earning

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excessively high profits. In such cases an asset revaluation might be a preferred option, even though a decision to revalue made on this basis would constitute ‘creative accounting’ and would therefore not be consistent with the basic tenets espoused in the conceptual framework.

WORKED EXAMPLE 6.7: Profit comparison with and without a revaluation Drouyn Ltd acquires an asset for a consideration of $100 000 on 1 July 2017. The asset has an expected life of 10 years and no expected residual value. As at 1 July 2020, the asset has a fair value of $90 000. The asset is depreciated using the straight-line method. The asset is sold for $80 000 on 30 June 2022. REQUIRED Provide the journal entries, both without and with a revaluation, for:

(a) years 1 to 3 (b) year 4 (c) year 5

SOLUTION Without a revaluation (a) Years 1 to 3 30 June 2018/2019/2020 Dr Depreciation expense Cr Accumulated depreciation (b) Year 4 30 June 2021 Dr Depreciation expense Cr

With a revaluation

10 000 10 000

1 July 2021 Dr Accumulated depreciation

10 000

Accumulated depreciation

30 June 2018/2019/2020 Dr Depreciation expense Cr Accumulated depreciation

10 000

10 000 10 000

30 000

Cr Truck 30 000 (to eliminate accumulated depreciation for previous three years) 1 July 2021 Dr Truck Cr Revaluation surplus

20 000 20 000

30 June 2021 Dr Depreciation expense 12 857 Cr Accumulated depreciation (depreciation is based on revalued amount, $90 000 ÷ 7) (c) Year 5 30 June 2022 Dr Depreciation expense Cr Accumulated depreciation Dr Dr Cr Cr

Accumulated depreciation Cash Truck Gain on sale

10 000 10 000 50 000 80 000 100 000 30 000

30 June 2022 Dr Depreciation expense Cr Accumulated depreciation ($90  000 ÷ 7) Dr Accumulated depreciation Dr Cash Cr Truck Cr Gain on sale Dr Revaluation surplus Cr Retained earnings

12 857

12 857 12 857 25 714 80 000 90 000 15 714 20 000 20 000

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Managers might also elect to measure their property, plant and equipment at fair value (and therefore undertake periodic revaluations) because the valuations better reflect the value of the organisation’s assets. It might also make the organisation less likely to be taken over owing to undervalued assets. Directors might consider that undertaking periodic revaluations provides more relevant information for financial statement readers’ decision making.

LO 6.5 LO 6.6 LO 6.7 LO 6.11

Recognition of impairment losses

Where an entity elects to change from the cost basis to a fair-value basis for measuring a class of non-current assets, and that class has previously been the subject of an impairment loss —to be explained below—any increase in the carrying amount of the asset must first be recognised as income (thereby reversing the previous expense) to the extent that the increase in value does not exceed the amount that would have been recorded for the asset had no write-down previously occurred. Any increase in the fair value of the asset above the amount that would have been recorded for the asset had no impairment loss been recognised is to be transferred to an account known as the revaluation surplus. As we already know, the revaluation surplus is part of owners’ equity. For example, let us assume that we have an item of land acquired in 2015 for $1 million. If the recoverable value of the land in 2017 is considered to be $800 000, an expense of $200 000 would be recognised in 2017 (an impairment loss). If the value of the land has then increased to $1.3 million in 2019 and a revaluation is undertaken, $200 000 would be recognised as income (effectively reversing the previous $200 000 impairment loss) and $300 000 would be transferred to the revaluation surplus. Worked Example 6.8 provides an illustration of an asset revaluation where there has been a previous impairment loss.

WORKED EXAMPLE 6.8: Reversal of a previous impairment loss Point Impossible Ltd acquired some land in 2017 at a cost of $2.5 million. In 2018 it was determined that the recoverable amount of the land was $2 million. In 2019 it was decided to switch to the ‘revaluation model’ and to revalue the land to its fair value, which was then assessed as having increased to $2.8 million. REQUIRED Provide the journal entries to record the above movements in value. SOLUTION First, where the ‘cost model’ is used there is nevertheless the requirement to recognise an impairment loss when the recoverable amount of an asset is less than the carrying amount. 2018 Dr Impairment loss—land (to be included in profit or loss) Cr Accumulated impairment loss—land 2019 In 2019 the organisation has switched to the ‘revaluation model’ Dr Land Dr Accumulated impairment loss—land Cr Reversal of previous impairment loss—land (to be included in profit or loss) Cr Revaluation surplus (gain to be included in other comprehensive income)

500 000 500 000

300 000 500 000 500 000 300 000

As indicated, the above impairment reversal would be treated as part of income in 2019. The revaluation surplus is part of equity. The accumulated impairment loss is a ‘contra asset’ account, which is shown as an offset against the asset—in this case, against land. AASB 136 Impairment of Assets imposes the general requirement that a non-current asset should be written down to its recoverable amount when its carrying amount is greater than its recoverable amount. AASB 136 defines an impairment loss as ‘the amount by which the carrying amount of an asset or a cash-generating unit exceeds its recoverable amount’. 216  PART 3: ACCOUNTING FOR ASSETS

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Pursuant to AASB 136, different approaches to accounting for an impairment loss of property, plant and equipment will be required, depending upon whether the cost model or revaluation model has been adopted. As paragraph 60 of AASB 136 states: An impairment loss shall be recognised immediately in profit or loss, unless the asset is carried at revalued amount in accordance with another Standard (e.g. in accordance with the revaluation model in AASB 116). Any impairment loss of a revalued asset shall be treated as a revaluation decrease in accordance with that other Standard. Therefore, if an asset has been revalued, the impairment loss will be recognised by reducing (debiting) the balance of the revaluation surplus as it pertains to the previous revaluation. Otherwise, the impairment loss is recognised by recognising an expense directly. Worked Example 6.9 provides an example of this difference.

WORKED EXAMPLE 6.9: Recognition of an impairment loss where either the cost model or fair-value model is used Coogee Ltd has a parcel of land that has a carrying value of $500 000. As at the end of the reporting period, the recoverable amount of the asset has been determined as being equal to $350 000. If we assume use of the cost model to account for this class of asset, the entry would be: Dr Cr

Impairment loss Accumulated impairment losses—land

150 000 150 000

However, if the land was measured at fair value by way of an asset revaluation (that is, the revaluation model was previously adopted) and if we assume that the previous revaluation increment was $60 000 (which would have meant a debit of $60 000 to Land, and an equivalent credit to Revaluation surplus), we would first eliminate the respective balance in the revaluation surplus and then recognise an impairment loss as follows: Dr Dr Cr Cr

Impairment loss Revaluation surplus Accumulated impairment losses—land Land

90 000 60 000 90 000 60 000

Where a non-current asset is measured on the cost basis, any write-downs to recoverable amounts are not considered to be revaluations. They are ‘impairment losses’. Hence the recognition of an impairment loss in respect of a non-current asset does not oblige the entity to revalue the whole class of non-current assets to which that asset belongs. Paragraph 12 of AASB 136 identifies a number of factors which might signal that the value of an asset has been impaired. It states: In assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications: External sources of information (a) there are observable indications that the asset’s value has declined during the period significantly more than would be expected as a result of the passage of time or normal use; (b) significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated; (c) market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset’s value in use and decrease the asset’s recoverable amount materially; (d) the carrying amount of the net assets of the entity is more than its market capitalisation; Internal sources of information (e) evidence is available of obsolescence or physical damage of an asset; Chapter 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS  217

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(f) significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset belongs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite; and (g) evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.

Determining the recoverable amount of an asset As indicated in the definition of an impairment loss (that being, the amount by which the carrying amount of an asset or a cash-generating unit exceeds its recoverable amount), a consideration of both the ‘carrying amount’ and the ‘recoverable amount’ is necessary in determining the impairment loss. Within AASB 136 Impairment of Assets, ‘carrying amount’ and ‘recoverable amount’ are defined at paragraph 6 as follows: Carrying amount is the amount at which an asset is recognised after deducting any accumulated depreciation (amortisation) and accumulated impairment losses thereon. The recoverable amount of an asset or a cash-generating unit is the higher of its fair value less costs of disposal and its value in use. The above definition of recoverable amount further requires definitions of ‘fair value less costs of disposal’ and ‘value in use’. We will consider these definitions in more depth soon; however, at this stage we can note that ‘fair value’ is defined in paragraph 6 as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. ‘Costs of disposal’ is defined as the ‘incremental costs directly attributable to the disposal of an asset or cash-generating unit, excluding finance costs and income tax expense’. ‘Value in use’ is defined as ‘the present value of the future cash flows expected to be derived from an asset or cash-generating unit’. These definitions further require us to consider the meanings of ‘cash-generating unit’ as well as considering how present value should be determined for the purpose of determining value in use. First, in relation to present values, we can see that from the above definition of ‘recoverable amount’ and its reference to ‘present values’, it is apparent that AASB 136 requires the cash flows assessed in determining recoverable amount to be discounted where the recoverable amount is determined by reference to expectations relating to the asset’s value in use. Any discussion of present values raises the obvious issue of what discount rate should be used to discount the expected future cash flows when determining ‘value in use’. Paragraph 55 of AASB 136 Impairment of Assets requires: The discount rate (rates) shall be a pre-tax rate (rates) that reflect(s) current market assessments of: (a) the time value of money; and (b) the risks specific to the asset for which the future cash flow estimates have not been adjusted. Paragraph 56 of AASB 136 further explains the use of discount rates. It states: A rate that reflects current market assessments of the time value of money and the risks specific to the asset is the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the asset. This rate is estimated from the rate implicit in current market transactions for similar assets or from the weighted average cost of capital of a listed entity that has a single asset (or a portfolio of assets) similar in terms of service potential and risks to the asset under review. However, the discount rate(s) used to measure an asset’s value in use shall not reflect risks for which the future cash flow estimates have been adjusted. Otherwise, the effect of some assumptions will be double-counted. Current practice therefore requires a two-step process in determining ‘value in use’. First, we estimate the future cash inflows and outflows to be derived from the expected continued use of the asset and its subsequent disposal. Second, we apply the appropriate discount rate to the cash flows. Worked Example 6.10 provides an illustration of the use of the cost model with an associated impairment loss. 218  PART 3: ACCOUNTING FOR ASSETS

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WORKED EXAMPLE 6.10: Use of the cost model and determination of an impairment loss Point Lookout acquired some machinery at a cost of $1 million. As at 30 June 2018 the machinery had accumulated depreciation of $200 000. On 30 June 2018 it was determined that the machinery could be sold for a price of $650 000 and the costs associated with making the sale would be $20 000. Alternatively, the machinery is expected to be useful for another five years and the net cash flows expected to be generated from the machine would be $180 000 over each of the next five years. As at 30 June 2018 it is assessed that the market would require a rate of return of 7 per cent on this type of machinery. REQUIRED Determine whether an impairment loss needs to be recognised in relation to the machinery and, if so, provide the appropriate journal entry. SOLUTION In accordance with AASB 136, an impairment loss is to be recognised when the recoverable amount of an asset is less than its carrying amount. The carrying amount of the machinery is its cost less accumulated depreciation and any accumulated impairment losses. In this example, this equates to $800 000. The recoverable amount is determined as the higher of the asset’s net selling price and its value in use. The net selling price is $650 000 less $20 000, which is $630 000. The ‘value in use’ is determined by discounting the expected future net cash flows to be generated by the asset using a discount rate relevant to the asset. Utilising the tables provided in Appendix B, we find that the present value of an annuity of $1 for five years discounted at 7 per cent is $4.1002. Hence, the value in use is determined as $180 000 multiplied by 4.1002, which gives us $738 036. According to AASB 136, the recoverable amount is the higher of the value in use and the net sales price, which in this case is $738 036. Therefore the impairment loss is $800 000 less $738 036, which equals $61 964. The journal entry would be: Dr Cr

Impairment loss—machinery Accumulated impairment losses—machinery

61 964 61 964

In the above entry we used an account entitled accumulated impairment losses. This is similar to how we depreciate assets by crediting the adjustment to an accumulated depreciation account, rather than crediting the amount directly against the asset.

Following an impairment loss, future depreciation charges will also need to be adjusted. Specifically, paragraph 63 of AASB 136 states: After the recognition of an impairment loss, the depreciation (amortisation) charge for the asset shall be adjusted in future periods to allocate the asset’s revised carrying amount, less its residual value (if any), on a systematic basis over its remaining useful life. As we noted above, ‘fair value less costs of disposal’ and ‘value in use’ are determined by reference to either a specific asset or to a cash-generating unit. AASB 136 defines a cash-generating unit as ‘the smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets’. The reason we are sometimes required to consider values for a cash-generating unit instead of an individual asset is that in some circumstances it might not be possible to separately determine the recoverable amount of an individual asset because of the way it is combined in a larger unit, or collection of assets. That is, the cash flows being generated might be dependent upon a combination of assets and it might not be possible to determine the expected cash flows Chapter 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS  219

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specific to a particular asset. Worked Example 6.11 provides an illustration of how we might account for an impairment loss by reference to a cash-generating asset. Determination of recoverable amount and value in use can be rather subjective as it relies on various judgements. Exhibit 6.2 provides details of the impairment policy note from the 2015 annual report of BHP Billiton Ltd

WORKED EXAMPLE 6.11: Accounting for an impairment loss by reference to a cash-generating unit Ulladulla Ltd has a printing process comprising four separate but highly interdependent assets. The printing machinery has a combined carrying amount of $1 000 000, made up as follows: Asset 1 Asset 2 Asset 3 Asset 4

$100 000 $200 000 $300 000 $400 000 $1 000 000

After considering various issues it was determined that the value in use of the cash-generating unit, which is calculated at its present value, amounted to $800 000. Alternatively, the current fair value less costs of disposal of the entire unit is $750 000. The total impairment loss will therefore be equal to $1 000 000 less the greater of the value in use and fair value less costs of disposal. This gives us a total impairment loss of $200 000. The impairment loss would be apportioned across the four assets by using their respective carrying amounts as the basis for the allocation. For example, the allocation of the impairment loss to Asset 4 would be 400 000 divided by 1 000 000 multiplied by 200 000. This would equal $80 000. Hence the accounting entry to record the impairment loss on the cash-generating unit would be: Dr Cr Cr Cr Cr

Impairment loss Accumulated impairment losses—Asset 1 Accumulated impairment losses—Asset 2 Accumulated impairment losses—Asset 3 Accumulated impairment losses—Asset 4

Exhibit 6.2  Accounting policy note from BHP Billiton Ltd 2015 Annual Report

200 000 20 000 40 000 60 000 80 000

(G) IMPAIRMENT AND REVERSAL OF IMPAIRMENT OF NON-CURRENT ASSETS Formal impairment tests are carried out annually for goodwill. In addition, formal impairment tests for all assets are performed when there is an indication of impairment. The Group conducts an internal review of asset values annually, which is used as a source of information to assess for any indications of impairment or reversal of previously recognised impairment losses. External factors, such as changes in expected future prices, costs and other market factors, are also monitored to assess for indications of impairment or reversal of previously recognised impairment losses. If any such indication exists, an estimate of the asset’s recoverable amount is calculated, being the higher of fair value less direct costs of disposal and the asset’s value in use. If the carrying amount of the asset exceeds its recoverable amount, the asset is impaired and an impairment loss is charged to the income statement so as to reduce the carrying amount in the balance sheet to its recoverable amount. A reversal of a previously recognised impairment loss is limited to the lesser of the amount that would not cause the carrying amount to exceed (a) its recoverable amount; or (b) the carrying amount that would have been determined (net of depreciation) had no impairment loss been recognised for the asset or cash-generating unit. Fair value is determined as the amount that would be obtained from the sale of the asset in an orderly transaction between market participants. Fair value for mineral assets is generally determined as the present value of the estimated future cash flows expected to arise from the continued use of the asset, including any expansion prospects,

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and its eventual disposal, using assumptions that an independent market participant may take into account. These cash flows are discounted at an appropriate rate to arrive at a net present value of the asset. Value in use is determined as the present value of the estimated future cash flows expected to arise from the continued use of the asset in its present form and its eventual disposal. Value in use is determined by applying assumptions specific to the Group’s continued use and cannot take into account future development. These assumptions are different to those used in calculating fair value and consequently the value in use calculation is likely to give a different result (usually lower) to a fair value calculation. In testing for indications of impairment and performing impairment calculations, assets are considered as collective groups and referred to as cash-generating units. Cash-generating units are the smallest identifiable group of assets, liabilities and associated goodwill that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets. The impairment assessments are based on a range of estimates and assumptions, including: Estimates/assumptions • Future production • Commodity prices • Exchange rates • Discount rates

Basis Proved and probable reserves, resource estimates and, in certain cases, expansion projects Forward market and contract prices, and longer-term price protocol estimates Current (forward) market exchange rates Cost of capital risk-adjusted appropriate to the resource

SOURCE: BHP Billiton Ltd 2015 Annual Report

Further consideration of present values

LO 6.5 LO 6.7

As noted previously, ‘recoverable amount’ is defined in AASB 136 Impairment of Assets as the higher of an asset’s net selling price and its value in use. AASB 136 defines ‘value in use’ as: ‘The present value of the future cash flows expected to be derived from an asset or a cash-generating unit’. The general principle espoused in AASB 136 is that if an asset’s carrying amount is in excess of its recoverable amount an impairment loss shall be recognised and the asset consequently written down to its recoverable amount. Recoverable amount is to be determined after considering appropriate discount rates. Discounting the future cash flows will have direct implications for the calculated value of recoverable amount and perhaps the need to change the value of an asset in a downward direction. The process of discounting the expected future cash flows will reduce the calculated recoverable amount. For example, assume that an entity has land with a carrying value of $5 million, but a current market value of only $4 million. Further, assume that the organisation is not using the land, so that there are no cash flows being generated from its use. Management considers that the land will be able to be sold in five years’ time for $6 million. Perhaps there is already a forward agreement to sell the asset. Pursuant to AASB 136 we need to determine the present value of expected future cash flows. Assuming a discount rate of 8 per cent for the purposes of illustration, the present value of the future sales price is only $4.084 million ($6 million × 0.6806, where $0.6806 would represent the present value of $1 received in five years, discounted at a rate of 8 per cent per annum). As the recoverable amount of $4.084 million is less than the carrying amount of the asset, AASB 136 requires the recognition of an impairment loss. The current requirement to determine present values requires making many assumptions or judgements, for example, about the pattern of cash flows and appropriate discount rates. AASB 136 notes that estimating the value in use of an asset involves the following steps: (a) estimating the future cash inflows and outflows to be derived from continuing use of the asset and from its ultimate disposal; and (b) applying the appropriate discount rate to those future cash flows. Chapter 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS  221

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AASB 136 provides quite extensive guidance on measuring future cash flows associated with ‘value in use’. In relation to the ‘basis for estimates of future cash flows’, paragraph 33 of AASB 136 states that in measuring ‘value in use’ an entity shall: (a) base cash flow projections on reasonable and supportable assumptions that represent management’s best estimate of the range of economic conditions that will exist over the remaining useful life of the asset. Greater weight shall be given to external evidence; (b) base cash flow projections on the most recent financial budgets/forecasts approved by management, but shall exclude any estimated future cash inflows or outflows expected to arise from future restructurings or from improving or enhancing the asset’s performance. Projections based on these budgets/forecasts shall cover a maximum period of five years, unless a longer period can be justified; and (c) estimate cash flow projections beyond the period covered by the most recent budgets/forecasts by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years, unless an increasing rate can be justified. This growth rate shall not exceed the longterm average growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used, unless a higher rate can be justified. The expected cash flows themselves should include projections of cash inflows from the continued use of the asset, together with projections of the cash outflows necessary to generate the cash inflows as a result of continuing to use the asset. The net cash flows, if any, to be received (or paid) for the disposal of the asset at the end of its useful life also need to be considered. In relation to the discount rate to be used to determine the present value of the cash flows associated with the asset, AASB 136 requires that the discount rate should take into account the time value of money and the risks specific to the asset. Therefore, the greater the current demand for money within the economy, and the greater the volatility of the cash flows associated with the asset, the higher the discount rate. Worked Example 6.12 provides an illustration of where present values must be used to determine the amount of a potential impairment loss.

WORKED EXAMPLE 6.12: Calculating the impairment in value of an item of property, plant and equipment On 1 July 2017, Torquay Ltd acquired and installed an item of plant for use in its manufacturing business. When acquired, the item cost $850 000, had an estimated useful life of 10 years, and had an expected residual value of $10 000. Torquay Ltd depreciates manufacturing plant on a straight-line basis over its useful life. At 30 June 2019 the machinery had a carrying amount of $682 000. At the end of the 2019 reporting period, the annual review of manufacturing plant found that as the item of plant had incurred significant damage, its carrying amount was likely to exceed its recoverable amount. As a result of the damage, the engineering department estimated the fair value less costs of disposal of the plant at the end of the reporting period was $420 500. As the plant can operate in a limited capacity, and apart from the residual value of $10 000, it could be expected to provide annual net cash flows of $85 000 for the next 8 years. The expected residual value will remain unchanged. The management of Torquay Ltd uses a discount rate of 12 per cent for calculations of this kind. REQUIRED Determine the amount of, and provide the journal entry for, any impairment in the manufacturing machine. SOLUTION To establish whether the manufacturing machine is impaired, the carrying amount must be found to be greater than the recoverable amount. According to AASB 136, an asset’s recoverable amount is the greater of the fair value less costs of disposal and its value in use. As the fair value less costs of disposal amount of $420 500 is given, the value in use must be established.

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Calculation of value in use: Value in use is calculated by discounting the net cash flows at 12 per cent. = $422 246 $85 000 at 12% for 8 years ($85 000 × 4.9676) = $4 039 $10 000 in 8 years at 12% ($10 000 × 0.4039) $426 285 As the value in use is greater than the fair value less costs of disposal, this is the recoverable amount. Measuring the impairment: Carrying amount Recoverable amount Amount of impairment to be recognised Journal entry: 30 June 2019 Dr Impairment loss Cr Accumulated impairment losses— manufacturing plant

$682 000 ($426 285) $255 715

255 715 255 715

Offsetting revaluation increments and decrements

LO 6.3 LO 6.6

Prior to the release of AASB 116 Property, Plant and Equipment, which became operative in 2005, our former Australian Accounting Standard AASB 1041 ‘Revaluation of Non-current Assets’ required that revaluation increments and decrements be offset against one another within a class of non-current assets, but that they were not to be offset in respect of different classes of non-current assets. For example, if one block of land had a fair value that increased by $1 million and another decreased in fair value by $800 000, the net amount of $200 000 would be credited to the revaluation surplus. This requirement was changed. Revaluation increments and decrements may be offset only to the extent that they pertain to a specific, individual asset. Hence, in relation to the example just described, the requirement now is to take $1 million dollars to the revaluation surplus in respect of one of the items of land, and recognise a loss on revaluation of $800 000 in respect of the other block of land. In relation to revaluation increments, as already indicated in this chapter, AASB 116, paragraph 39 requires: If an asset’s carrying amount is increased as a result of a revaluation, the increase shall be recognised in other comprehensive income and accumulated in equity under the heading of a revaluation surplus. However, the increase shall be recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognised in profit or loss.

While we focus in this text on for-profit entities, it is interesting to note that paragraphs Aus40.1 and 40.2 of AASB 116 allow not-for-profit entities to offset increments and decrements within a class of assets—the treatment that was available to for-profit entities prior to 2005.

Investment properties

LO 6.1 LO 6.2 LO 6.3

While our focus in this chapter has been on property, plant and equipment in general, it is worth noting the existence of an accounting standard that relates specifically to investment properties: AASB 140 Investment Properties. An investment property is defined in AASB 140 as property (land, buildings—or part of a building, or both) that is held by the owner or by the lessees to earn rentals, or for a capital appreciation, or both. An investment property is considered to generate cash flows that are largely independent of the other assets of the entity. This can be contrasted with owner-occupied property, where the related cash flows would not only be attributable

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to the property, but would also be attributable to the other assets used in the operations of the entity. Property being developed for sale in the ordinary course of business would be deemed to be ‘inventory’ and not an investment property. Also, property that is held for the purpose of long-term rentals would not be considered to be investment property. For example, a building that is leased to another entity under a lease contract which stipulates that the lease period is for the major part of the building’s life would not be construed to be an investment property. Once an item is deemed to be an investment property it is initially to be recorded at the cost of acquisition—as is the case for other property, plant and equipment. Subsequent to initial measurement, AASB 140 requires that investment properties are measured either at fair value (the fair-value model) or at cost (the cost model). If the fair-value model is adopted, then changes in the fair value of investment properties are recognised directly in profit or loss, and not in the revaluation surplus as would be the case under AASB 116. This represents an interesting requirement and one that is probably justifiable on the ground that any gains or losses on an investment property are more likely to be realised in the near future compared to any changes in the fair value of other property, plant and equipment.

LO 6.10 LO 6.12

Economic consequences of asset revaluations

Some academic research suggests that fair value is superior to historical cost as a means of valuing assets (Herrmann, Saudagaran & Thomas 2005) as they argue it has predictive value, feedback value, timeliness, neutrality, representational faithfulness, comparability and consistency. Other academics have tested the value relevance of revaluing assets and found that in some countries the existence of revaluation reserves contribute significantly to explaining the market value of equity (Piak 2009). Another focus of researchers has been on the behavioural implications of asset revaluations. If a business has contracts in place that are tied to reported profits, such as profit-based management bonuses and interest-coverage clauses, management might have incentives not to revalue its assets because to do so would reduce future reported profits. A revaluation would also reduce measures such as return on assets, given that asset bases will increase. Remember, of course, that if management is selecting a revaluation policy on an opportunistic rather than an objective basis, such a strategy might, if it materially affects the financial statements, be noted and reported on by the auditors. However, if assets are increased, an asset revaluation might loosen constraints such as debt-to-asset restrictions, possibly imposed by the debtholders of the firm. For example, a firm’s unadjusted statement of financial position might show total assets of $100 million and total liabilities of $55 million. If that firm had an agreement with lenders that its debt-to-assets ratio was not to exceed 50 per cent, it would be in technical debt-to-assets ratio default of the agreement and could, at the extreme, be subject to closure. Now assume that, before Derived by dividing finalising the financial statements, the firm revalues its non-current assets by $15 million. The effect the total debt of an of this would be to increase assets to $115 million. Liabilities would remain at $55 million (the credit organisation by its total side of the journal entry would be to the revaluation surplus, which is part of shareholders’ funds) and assets. the revised debt-to-assets ratio would be 47.8 per cent. The firm would no longer be in technical default of its debt agreement. Debtholders are aware that asset revaluations act to loosen debt-to-asset constraints. As such, it is not surprising that there are restrictions placed on revaluations. In their review of public trust deeds, Whittred and Zimmer (1986) found: The trust deeds permitted asset revaluations. However, most were specific as to which assets may be revalued and who may conduct the revaluation. Typically, the trust deeds excluded any amount [by] which the book value of any tangible asset is written up subsequent to the annual balance date immediately preceding the date of the Deed, except where such writing up is made in accordance with, and so that the book value does not exceed a valuation by, an independent valuer approved by the trustee. Brown, Izan and Loh (1992) investigated management incentives associated with choosing to revalue non-current assets upwards. They argue that, as the process of undertaking a revaluation is costly, there must be some real expected benefits associated with the revaluation. (Revaluation costs are considered to include fees charged by a valuer; opportunity and out-of-pocket costs of time spent by directors in reviewing the figures being reported and discussing them with auditors; the record-keeping costs; and the costs charged by auditors for the additional review.) Some of the benefits to the organisation are deemed to relate to the ability to loosen restrictive debt covenants as a result of an upward revaluation. Brown, Izan and Loh contend that the higher the ratio of debt to total tangible assets (a ratio frequently used in debt contracts), the more likely it is that a firm will revalue its assets. They further propose that a firm with a debt covenant in place is more likely to revalue than a firm without a debt covenant. 224  PART 3: ACCOUNTING FOR ASSETS

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Brown, Izan and Loh (1992) also maintain that, as upward revaluations will lead to a reduction in profits (through increased depreciation and reduced gain on sale of the revalued non-current asset), firms subject to political scrutiny, either from government or other interest groups, will be relatively more likely to revalue assets upwards. As they state (p. 39): When larger firms report ‘high’ profits, their profit reports are more likely to be noticed by regulators and others who may have incentives and the capacity to reallocate resources away from them. Under such circumstances, larger firms have greater incentives to adopt income reducing procedures and cut the expected loss from regulation. In relation to asset revaluations and their implications for reducing political costs (through reducing reported income), Whittred and Chan (1992) raise an interesting point. They pose the question (p. 63) of whether it is rate of return or size that makes a firm politically visible. The effects of a revaluation can work in opposite directions in this regard. A revaluation acts to increase the reported asset size of the organisation, which could make the organisation more visible. However, a revaluation of non-current assets also acts to reduce income, which, in a sense, can make the organisation less visible. Leaving aside this possible impasse (about whether political visibility is related to reported profits or assets) and returning to Brown, Izan and Loh (1992), we find that these researchers assume that a reduction in profits resulting from the discretionary adoption of an upward asset revaluation will lead to a reduction in the propensity for outside parties to transfer wealth away from the organisation. This assumption necessarily relies upon another key assumption, that regulators, and other parties in the political process, focus on the reported profit figures rather than the accounting methods used to derive those profits. As the authors (p. 39) state: ‘Underlying the political process theory is the crucial assumption that regulators and other interested parties do not incorporate into their decisions the substantive effect of an accounting change’. Assumptions such as this are frequently made in the Positive Accounting Theory literature—particularly in studies that consider ‘political costs’ (see Chapter 3). It is typically assumed (often without this assumption being made clear) that regulators either do not understand the implications of adopting different accounting methods or that they do not consider it justifiable to unravel the effects of alternative accounting methods. Remember, the revaluation of non-current assets is undertaken simply via a book entry, which in turn causes the increase in reported assets and the subsequent reduction in reported profits (through increased depreciation charges and reduced profit on disposal). Whether these assumptions about regulators are realistic is clearly a matter of personal opinion. With this said, Brown, Izan and Loh (1992) further propose that firms operating in strike-prone industries are more likely to revalue their non-current assets upwards than firms operating in other industries. It is argued that if an organisation reduces reported income, unions will feel that they have less justification for demanding increased salaries. The results of the Brown, Izan and Loh study generally supported their predictions. From the sample of companies reviewed, they found that those companies that revalued their assets upwards tended to have greater levels of debt relative to their assets, were close to violating debt covenant constraints, and were larger. Revaluers were also found to be more likely to be operating in strike-prone industries. Chapter 3 considered the issue of ‘political costs’ and how the selection of particular accounting methods can act to reduce political costs. Within Australia, revaluations of non-current assets can be made on the basis of valuations made independent by directors or by independent valuers. Logically, there might be expected to be a perception that valuation independent valuations would, on average, be more reliable than valuations made by directors. Further, For non-current assets, there would conceivably be differences in the competence, and reputation, of different independent a valuation made by valuers and therefore in the perceived reliability of their valuations. AASB 116 requires that where an expert in valuations a class of non-current assets has been revalued to fair value in accordance with an independent of that class of assets whose pecuniary or valuation, this must be disclosed within the notes to the financial statements. Conceivably, this would be other interests could useful information to the readers of financial statements as an independent valuation would arguably not be capable of be deemed to be more impartial or objective than a valuation undertaken by employees of the entity. affecting that person’s Considering issues such as the competence of the valuer, Goodwin and Trotman (1996) undertook ability to give an a study of external auditors’ judgements in relation to non-current asset revaluations undertaken by unbiased opinion on that valuation. their clients. The results indicated that the amount of time spent on the audit of the revalued noncurrent assets related directly to the perceived competence of the independent valuer. As perceived competence increased, the time spent on auditing the balance of the revalued assets decreased. Goodwin and Trotman (1996) also considered the implications of whether the organisation being audited was proposing to make a public share issue. The authors argue that a proposal to make a public share issue might provide Chapter 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS  225

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management with an incentive to revalue non-current assets to ‘strengthen the balance sheet prior to issue’, thereby increasing the inherent risk of the non-current assets being misstated. The results of the study indicated that auditors spend more time on the audit of revalued non-current assets when management proposes to issue shares to the public.

LO 6.13

Disclosure requirements

AASB 116 includes a number of disclosure requirements pertaining to the revaluation of non-current assets. We discussed these requirements earlier in this chapter under the section entitled ‘How does an entity determine fair value?’. As we showed in that section, information such as dates of revaluation, whether an independent valuer was involved in determining valuations, and the approach used to determining fair value, must be disclosed in the notes to the financial statements. AASB 116 also has disclosure requirements relating to the depreciation methods used, and assumptions made about the useful lives of property, plant and equipment. AASB 116 also requires a reconciliation of the opening and closing carrying amounts of property, plant and equipment, as shown in the statement of financial position. Specifically, paragraph 73 of AASB 116 states: An entity shall disclose its significant accounting policies comprising: (a) the measurement bases used for determining the gross carrying amount; (b) the depreciation methods used; (c) the useful lives or the depreciation rates used; (d) the gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period; and (e) a reconciliation of the carrying amount at the beginning and end of the period showing: (i) additions; (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) acquisitions through business combinations; (iv) increases or decreases resulting from revaluations under paragraphs 31, 39, Aus39.1, 40, Aus40.1 and Aus40.2 and from impairment losses recognised or reversed directly in equity in accordance with AASB 136; (v) impairment losses recognised in profit or loss in accordance with AASB 136; (vi) impairment losses reversed in profit or loss in accordance with AASB 136; (vii) depreciation; (viii) the net exchange differences arising on the translation of the financial statements from the functional currency into a different presentation currency, including the translation of a foreign operation into the presentation currency of the reporting entity; and (ix) other changes. There are also a number of disclosures that a reporting entity is required to make if impairment losses have been recognised. The extensive disclosure requirements are stipulated in paragraphs 126 to 137 of AASB 136 Impairment of Assets. These disclosure requirements include the following: 126. An entity shall disclose the following for each class of assets: (a) the amount of impairment losses recognised in profit or loss during the period and the line item(s) of the statement of comprehensive income in which those impairment losses are included; (b) the amount of reversals of impairment losses recognised in profit or loss during the period and the line item(s) of the statement of comprehensive income in which those impairment losses are reversed; (c) the amount of impairment losses on revalued assets recognised directly in equity during the period; and (d) the amount of reversals of impairment losses on revalued assets recognised directly in equity during the period. 130. An entity shall disclose the following for an individual asset (including goodwill) or a cash-generating unit, for which an impairment loss has been recognised or reversed during the period: (a) the events and circumstances that led to the recognition or reversal of the impairment loss; 226  PART 3: ACCOUNTING FOR ASSETS

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(b) the amount of the impairment loss recognised or reversed; and (c) for an individual asset: (i) the nature of the asset; and (ii) if the entity reports segment information in accordance with AASB 8, the reportable segment to which the asset belongs. (d) for a cash-generating unit: (i) a description of the cash-generating unit (such as whether it is a product line, a plant, a business operation, a geographical area, or a reportable segment as defined in AASB 8); (ii) the amount of the impairment loss recognised or reversed by class of assets and, if the entity reports segment information in accordance with AASB 8, by reportable segment; and (iii) if the aggregation of assets for identifying the cash-generating unit has changed since the previous estimate of the cash-generating unit’s recoverable amount (if any), a description of the current and former way of aggregating assets and the reasons for changing the way the cash-generating unit is identified; and (e) whether the recoverable amount of the asset (cash-generating unit) is its fair value less costs of disposal or its value in use; (f) if the recoverable amount is fair value less costs of disposal, the entity shall disclose the following information: (i) the level of the fair value hierarchy (see AASB 13) within which the fair value measurement of the asset (cash-generating unit) is categorised in its entirety (without taking into account whether the ‘costs of disposal’ are observable); (ii) for fair value measurements categorised within Level 2 and Level 3 of the fair value hierarchy, a description of the valuation technique(s) used to measure fair value less costs of disposal. If there has been a change in valuation technique, the entity shall disclose that change and the reason(s) for making it; and (iii) for fair value measurements categorised within Level 2 and Level 3 of the fair value hierarchy, each key assumption on which management has based its determination of fair value less costs of disposal. Key assumptions are those to which the asset’s (cash-generating unit’s) recoverable amount is most sensitive. The entity shall also disclose the discount rate(s) used in the current measurement and previous measurement if fair value less costs of disposal is measured using a present value technique; and (g) if recoverable amount is value in use, the discount rate(s) used in the current estimate and previous estimate (if any) of value in use. 131. An entity shall disclose the following information for the aggregate impairment losses and the aggregate reversals of impairment losses recognised during the period for which no information is disclosed in accordance with paragraph 130: (a) the main classes of assets affected by impairment losses and the main classes of assets affected by reversals of impairment losses; and (b) the main events and circumstances that led to the recognition of these impairment losses and reversals of impairment losses.

SUMMARY The chapter considered the revaluation of non-current assets with the emphasis on property, plant and equipment. A revaluation can be defined as the act of recognising a reassessment of the carrying amount of a non-current asset to its fair value as at a particular date. Within Australia, to the extent that a non-current asset has a recoverable amount in excess of its carrying amount, there is no requirement to perform an upward revaluation. On the other hand, if the recoverable amount is below the carrying amount, a non-current asset shall be the subject of an impairment loss. This is consistent with the traditionally conservative approach adopted in accounting to the valuation of assets, that is, that Chapter 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS  227

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assets may be understated but should never be overstated in the financial statements. The recoverable amount of an asset is defined as the higher of an asset’s net selling price and its value in use. Where an upward revaluation of property, plant and equipment is undertaken, the asset is to be revalued to its fair value. Revaluations should be undertaken as part of a process that revalues the entire class of assets to which the revalued non-current asset belongs. Where an asset is revalued upwards, the increase in the recorded value of the asset is not treated as part of profit or loss but is transferred to a revaluation surplus and included as part of ‘other comprehensive income’. The only exception to this rule is where the revaluation increment reverses a previous revaluation decrement, in which case the revaluation increment will be treated as part of the financial period’s profit or loss to the extent that it reverses the previous decrement that was included as an expense within profit or loss. Where an asset is revalued downwards, the decrease in the recorded value of the asset is to be treated as an expense and included within profit or loss. The only exception to this rule is where the revaluation decrement reverses a previous revaluation increment, in which case the revaluation decrement will be debited against (deducted from) the existing revaluation surplus and the related movement included as a reduction to ‘other comprehensive income’. When a revaluation of a depreciable non-current asset is undertaken, the most common approach is to adopt the ‘net method’ whereby we credit any existing accumulated depreciation against the non-current asset to be revalued, and subsequently increase the non-current asset account (debit the account) by the amount of the revaluation. Where a revalued non-current asset is subsequently sold, the gain or loss on disposal is to be measured as the difference between the carrying amount of the revalued asset as at the time of the disposal, and the net proceeds, if any, from disposal. The gain or loss must be recognised in the profit or loss for the financial year in which the disposal of the non-current asset occurs. The chapter has also considered how revaluations can, at times, loosen certain accounting-based debt covenants, such as restrictions written around an organisation’s debt-to-assets ratio.

KEY TERMS accumulated depreciation  206 asset revaluation  203 carrying amount  203

debt-to-assets ratio  224 independent valuation  225 prudence  209

recoverable amount  203 revaluation decrement  206 revaluation increment  205

END-OF-CHAPTER EXERCISES Anderson Pty Ltd is an Australian diversified industrial company with its major business activity being to manufacture flotation devices for babies and toddlers. Over the past decade, the business has been very profitable and the directors, Simon Anderson and Lisa Anderson, have kept payment of dividends to a minimum to allow the company to diversify into other activities. The following is a list of property, plant and equipment held by the company:

Property, plant and equipment Factory (NSW) Land Buildings – Cost – Accumulated depreciation Factory (Qld) Land Buildings – Cost – Accumulated depreciation

Carrying amount ($)

Current fair value ($)

100 000

150 000

70 000 (20 000)

80 000 –

150 000

120 000

125 000 (45 000)

70 000 –

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Mr Anderson informs you that the directors intend to revalue the property, plant and equipment during the year. The company has not revalued any assets in the past.

REQUIRED (a) How would you account for the revaluation of the above assets? (b) What would the relevant journal entries be? LO 6.1 6.2 6.3 6.9

SOLUTION TO END-OF-CHAPTER EXERCISE (a) In undertaking the revaluations, decisions must be made about what constitutes the relevant classes of assets. As we know, when an item of property, plant and equipment is revalued, AASB 116 requires that the entire class of property, plant and equipment to which that asset belongs must be revalued. Increments and decrements are not permitted to be offset within a class of assets. As shown below, it is considered that two classes of assets exist in this case: land used in the organisation’s operations; and buildings used in the organisation’s operations. The calculations for determining increments and decrements are as follows: Carrying amount ($)

Current fair value ($)

Increment/ (decrement) ($)

100 000 150 000

150 000 120 000

50 000 (30 000)

50 000 80 000

80 000 70 000

30 000 (10 000)

Property, plant and equipment Land – Factory (NSW) – Factory (Qld) Buildings—net – Factory (NSW) – Factory (Qld) (b) The relevant journal entries are as follows: Dr Cr Dr Cr Dr Dr Cr Cr Dr Cr Dr Cr

Land—factory (NSW) Revaluation surplus Loss on revaluation of land Land—factory (Qld) Accumulated depreciation (NSW) Accumulated depreciation (Qld) Buildings—factory (NSW) Buildings—factory (Qld) Buildings—factory (NSW) Revaluation surplus Loss on revaluation of buildings Buildings—factory (Qld)

50 000 50 000 30 000 30 000 20 000 45 000 20 000 45 000 30 000 30 000 10 000 10 000

REVIEW QUESTIONS 1. What effect will an asset revaluation have on subsequent periods’ profits? Explain your answer. LO 6.10 2. Explain the difference in the accounting treatment for revaluation increments and revaluation decrements. Do you consider that this difference is ‘conceptually sound’? LO 6.6 3. When should a revaluation increment be included as part of profit or loss? LO 6.6, 6.8 4. For the purposes of AASB 116 or AASB 136, how is ‘recoverable amount’ determined? LO 6.5 5. When would you determine the recoverable amount for a cash-generating unit rather than for an individual item of property, plant and equipment? LO 6.11 Chapter 6: REVALUATIONS AND IMPAIRMENT TESTING OF NON-CURRENT ASSETS  229

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6. Prior to 2005, reporting entities within Australia could offset increments and decrements within a class of assets so that only the net amount would go to profit or loss, or the revaluation surplus. This practice is no longer permitted for for-profit entities (not-for-profit entities are still permitted to offset increments and decrements within a class of assets). You are required to identify whether you prefer the pre- or post-2005 requirements, and justify your preference. LO 6.3, 6.6 7. If an item of property, plant and equipment is measured at cost, but the recoverable amount of the asset is determined to be less than cost, what action must be taken? LO 6.2, 6.5, 6.6, 6.7 8. If a reporting entity decides to revalue its property, plant and equipment, what basis of valuation must be adopted? LO 6.3 9. If a reporting entity elects to use either cost or fair value as the basis for measuring its property, plant and equipment, can it elect to switch to the other method at a later time? LO 6.3 10. For the purposes of AASB 116, how is a ‘class of assets’ defined? Would residential land and farming land be included in the same class of assets? LO 6.3 11. How could a revaluation of a non-current asset minimise or loosen the effects of a restrictive debt covenant? LO 6.10, 6.12 12. Ignoring reversals of previous revaluations, do you think that requiring revaluation decrements to be part of the period’s profit or loss but letting revaluation increments go to the revaluation surplus is consistent with the requirements of the conceptual framework? Explain your answer. LO 6.3, 6.6, 6.10 13. An item of depreciable machinery is acquired on 1 July 2015 for $120 000. It is expected to have a useful life of 10 years and a zero residual value. On 1 July 2019, it is decided to revalue the asset to its fair value of $110 000.

REQUIRED Provide journal entries to account for the revaluation. LO 6.1, 6.2, 6.3 14. What does the ‘impairment of an asset’ mean? How should an impairment of an item of property, plant and equipment be accounted for? LO 6.7 15. How should the reversal of an impairment loss be accounted for? LO 6.7 16. An asset having a cost of $100 000 and accumulated depreciation of $20 000 is revalued to $120 000 at the beginning of the year. Depreciation for the year is based on the revalued amount and the remaining useful life of eight years. Shareholders’ equity, before adjusting for the above revaluation and subsequent depreciation, is as follows: $ Share capital Revaluation surplus Capital profits reserve Retained earnings

300 000 45 000 85 000 70 000 500 000

REQUIRED Prepare journal entries to reflect the revaluation of the asset and the subsequent depreciation of the revalued asset. Which of the equity accounts would be affected directly or indirectly by the revaluation? LO 6.3, 6.9, 6.10, 6.12 17. Townend Ltd has the following assets in its statement of financial position as at 30 June 2018. $ Plant and equipment, at independent valuation less Accumulated depreciation

2 000 000 400 000

Carrying amount

1 600 000

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The plant and equipment originally cost Townend $600 000 in 2016, but due to market conditions the fair value of the plant and equipment has increased. The directors of Townend Ltd are concerned about the effects of the higher carrying value on profits—owing to the higher depreciation it is reducing profits. They ask you, the accountant, to reverse the previous revaluation. Being ethical in nature, what would you do? LO 6.3, 6.12 18. Bad Company Ltd has some machinery that it acquired in 2017 at a cost of $4 000 000. In 2018 it is concerned about high reported profits—the labour union is considering pushing for additional wages, but Bad Company Ltd does not want to pay them—and is consequently considering ways to reduce profits. Recently, it has acquired some identical machinery to that acquired in 2017. The machinery has been acquired in a liquidation sale of a business that is in the hands of the bank (owing to the business defaulting on a loan) and the cost is $500 000. After this purchase, Bad Company Ltd writes down to $500 000 the machinery acquired in 2017 at a cost of $4 000 000. Is this an appropriate course of action? LO 6.3, 6.4, 6.10, 6.12 19. Petersen Ltd has the following land and building in its financial statements as at 30 June 2018: $ Residential land, at cost Factory land, at valuation 2016 Buildings, at valuation 2016 Accumulated depreciation

1 000 000 900 000 800 000 (100 000)

At 30 June 2018, the balance of the revaluation surplus is $400 000, of which $300 000 relates to the factory land and $100 000 to the buildings. On this same date, independent valuations of the land and building are obtained. In relation to the above assets, the assessed fair values at 30 June 2018 are: $ Residential land, previously recorded at cost Factory land, previously revalued in 2016 Buildings, previously revalued in 2016

1 100 000 700 000 900 000

REQUIRED Provide the journal entries to account for the revaluation on 30 June 2018. Petersen Ltd classifies the residential land and the factory land as different classes of assets. LO 6.3, 6.4, 6.6, 6.9

CHALLENGING QUESTIONS 20. What, if anything, is the difference between recoverable amount and fair value? Where revaluations are undertaken, can a reporting entity use ‘value in use’ as the basis for the revaluation? LO 6.3, 6.5, 6.6 21. Kanga Cairns Ltd owns two blocks of beachfront land, acquired in 2015 for the purposes of future residential development. Block A cost $250 000 and Block B cost $350 000. Valuations of the blocks are undertaken by an independent valuer on 30 June 2017 and 30 June 2019. The assessed values are: 2017 valuation ($)

2019 valuation ($)

230 000 370 000

290 000 340 000

Block A Block B

REQUIRED Assuming asset revaluations were undertaken for the land in both 2017 and 2019, provide the journal entries for both years. LO 6.3, 6.8

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22. Warren Ltd acquires a four-wheel-drive bus on 1 July 2015 for $300 000. The bus is expected to have a useful life to Warren Ltd of seven years, after which time it will be towed out to sea and sunk to make an artificial reef for marine life (after all oils and solvents have been removed). The straight-line method of depreciation is used. On 1 July 2017 the bus is revalued to $250 000 and its useful life is reassessed: it is expected, at that date, to have a remaining useful life of six years. On 1 July 2018 it is unexpectedly sold for $220 000.

REQUIRED Provide the journal entries to record the revaluation on 1 July 2017 and the subsequent sale on 1 July 2018.  LO 6.2, 6.5, 6.6, 6.7 23. Many organisations elect not to measure their property, plant and equipment at fair value, but rather, prefer to use the ‘cost model’. This will provide lower total assets and lower measures, such as net asset backing per share. You are required to answer the following questions: (a) What might motivate directors not to revalue the property, plant and equipment? (b) What are some of the effects the decision not to revalue might have on the firm’s financial statements? (c) Would the decision not to revalue adversely affect the wealth of the shareholders? LO 6.12 24. On 1 July 2017, Ocean Grove Ltd acquired and installed an item of machinery for use in its manufacturing business. When acquired the machinery cost $1 200 000, had an estimated useful life of 10 years, and had an expected residual value of $200 000. Ocean Grove Ltd depreciates machinery on a straight-line basis over its useful life. At 30 June 2019 the machinery had a carrying amount of $1 000 000. At the end of the 2019 reporting period the annual review of all machinery found that this particular item of machinery had incurred significant damage as a result of being rolled down a sand dune. As a result of the damage, the engineering department estimated the fair value less costs of disposal of the machinery at the end of the reporting period was $710 000. As the machinery can operate in a limited capacity, it could be expected to provide annual net cash flows of $105 000 for the next 8 years. The expected residual value will remain unchanged. The management of Ocean Grove Ltd uses a discount rate of 8 per cent for calculations of this kind.

REQUIRED Determine whether Ocean Grove Ltd has incurred an impairment loss in relation to the asset. If so, determine the amount of the impairment loss, and provide the journal entry necessary to recognise any impairment in the machine. LO 6.5, 6.6, 6.7 25. On 1 July 2016 Big Wednesday Ltd acquired land at a cost of $1 000 000. Big Wednesday Ltd makes the following estimates of the value of the land:

30 June 2017 30 June 2018 30 June 2019

Net selling price

Value in use

Fair value

$900 000 $900 000 $920 000

$1 050 000 $960 000 $900 000

$950 000 $950 000 $970 000

REQUIRED (a) Determine the recoverable amount of the land for each reporting date. (b) Assume that Big Wednesday Ltd uses the cost method. For each year, calculate the carrying amount of the land. Prepare the journal entries necessary to effect any adjustments required by accounting standards. (c) Assume that Big Wednesday Ltd revalues its land at the end of each year. For each year, calculate the carrying amount of the land. Prepare the journal entries necessary to effect any adjustments required by accounting standards. LO 6.2, 6.3, 6.5, 6.6, 6.8

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26. Endless Summer Ltd purchased two parcels of land (Bruce and Brown) for $2 000 000 each on 1 July 2016. Subsequent to initial measurement, Endless Summer revalued the land. Fair values are as follows:

Parcel of land Bruce Brown

Fair value 30 June 2017

Fair value 30 June 2018

$1 800 000 $2 500 000

$1 600 000 $2 200 000

REQUIRED (a) Prepare journal entries to record the revaluations on 30 June 2017 and 30 June 2018. (b) The manager claims, ‘There should be no adjustment for the decline in fair value because the recoverable amount of each parcel of land exceeds $2 000 000 at 30 June 2018’. Explain whether this is consistent with accounting standards. LO 6.2, 6.3, 6.5, 6.6, 6.7 27. The US Financial Accounting Standards Board does not allow revaluation of non-current assets to fair value, but it does make it compulsory to account for the impairment costs associated with non-current assets as per FASB Statement No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets. What implications do you think these rules have for the relevance and representational faithfulness of US corporate financial statements? LO 6.6, 6.7 28. Superbank Ltd acquired some machinery at a cost of $2 000 000. As at 30 June 2018 the machinery had accumulated depreciation of $400 000 and an expected remaining useful life of four years. On 30 June 2018 it was determined that the machinery could be sold at a price of $1 200 000 and that the costs associated with making the sale would be $50 000. Alternatively, the machinery is expected to be useful for another four years and it is expected that the net cash flows to be generated from the machine would be $390 000 over each of the next four years. It is assessed that at 30 June 2018 the market would require a rate of return of 6 per cent on this type of machinery.

REQUIRED Determine whether any impairment loss needs to be recognised in relation to the machinery and, if so, provide the appropriate journal entry at 30 June 2018. Also, provide the journal entry to account for depreciation in 2019. LO 6.5, 6.6, 6.7, 6.9

REFERENCES BROWN, P., IZAN, H.Y. & LOH, A., 1992, ‘Fixed Asset Revaluations and Managerial Incentives’, Abacus, vol. 28, no. 1, pp. 36–57. GOODWIN, J. & TROTMAN, K., 1996, ‘Factors Affecting the Audit of Revalued Non-current Assets: Initial Public Offerings and Source Reliability’, Accounting and Finance, vol. 36, no. 2, pp. 151–70. HERRMANN, D., SAUDAGARAN, S. & THOMAS, W., 2005, ‘The Quality of Fair Value Measures for Property, Plant and Equipment’, Accounting Forum, vol. 30, pp. 43–59. PIAK, G.,  2009, ‘The Value Relevance of Fixed Asset Revaluation Reserves in International Accounting’, International Management Review, vol. 5, no. 2, pp. 73–80. WHITTRED, G. & CHAN, Y.K., 1992, ‘Asset Revaluations and the Mitigation of Underinvestment’, Abacus, vol. 28, no. 1, pp. 58–74. WHITTRED, G. & ZIMMER, I., 1986, ‘Accounting in the Market for Debt’, Accounting and Finance, November, pp. 1–12.

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CHAPTER 7

INVENTORY

LEARNING OBJECTIVES (LO) 7.1

Understand the meaning of ‘inventory’.

7.2

Be able to calculate the cost of inventory pursuant to AASB 102 Inventories.

7.3

Understand how to apply the lower of cost and net-realisable value rule for measuring inventory.

7.4

Understand how and when to reverse a previous inventory write-down.

7.5

Understand why there is typically a necessity to make inventory cost-flow assumptions.

7.6

Be able to apply the inventory cost-flow assumptions permitted by AASB 102.

7.7

Understand the difference between a perpetual and a periodic inventory system and how this influences inventory valuation.

7.8

Know the disclosure requirements of AASB 102.

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Introduction to inventory For a large proportion of businesses, the asset known as inventory—which is also sometimes known as stock—accounts for a significant proportion of total assets. The related expense, cost of goods sold, accounts for a significant amount of the total expenses of many firms. For example, the 2015 consolidated financial statements of Wesfarmers Ltd (see www.wesfarmers.com.au) indicate that inventories totalled $5497 million. Wesfarmers’ cost of goods sold in 2011 was $43 405 million when profits after tax amounted to $2440 million. Therefore, for companies such as Wesfarmers (which controls a variety of stores including Bunnings, Coles and Officeworks), the accounting methods relating to inventories will be of great importance in terms of their impact on reported assets and profits. The relevant accounting standard in Australia is AASB 102 Inventories. As stated at paragraph 2 of AASB 102: This Standard applies to all inventories, except: (a) [deleted]; (b) financial instruments (see AASB 132 Financial Instruments: Presentation and AASB 9 Financial Instruments); and (c) biological assets related to agricultural activity and agricultural produce at the point of harvest (see AASB 141 Agriculture). As further indicated at paragraph 3, nor does AASB 102 apply to the measurement of inventories held by: (a) producers of agricultural and forest products, agricultural produce after harvest, and mineral and mineral products, to the extent that they are measured at net realisable value in accordance with well-established practices in those industries. When such inventories are measured at net realisable value, changes in that value are recognised in profit or loss in the period of the change; and (b) commodity broker–traders who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognised in profit or loss in the period of the change.

inventory Goods, other property and services held for sale in the ordinary course of business; or in the process of production, preparation or conversion for such sale; or in the form of materials or supplies to be consumed in the production of goods or services available for sale.

cost of goods sold Cost of inventory sold during the financial period. Can be determined either on a periodic basis or on a perpetual (continuous) basis.

Definition of inventory

LO 7.1

Inventories are defined in paragraph 6 of AASB 102 as assets: • held for sale in the ordinary course of business; • in the process of production for such sale; or • in the form of materials or supplies to be consumed in the production process or in the rendering of services. Therefore, inventories include finished goods, raw materials and stores, and work in progress. The above definition specifically requires that assets held for sale be held for sale ‘in the ordinary course of business’. Therefore, if an item is being held for sale, but not in the ordinary course of business, that asset is not deemed to be inventory, and AASB 102 does not apply. Rather, if the asset is a non-current asset, AASB 5 Non-Current Assets Held for Sale and Discontinued Operations applies. There are two main purposes of accounting for inventory. The first is to provide a measure of ‘inventory’ for statement of financial position (balance sheet) purposes, while the second main purpose is to determine the cost of goods sold for inclusion in the reporting entity’s statement of profit or loss and other comprehensive income.

lower of cost and net realisable value Cost is the aggregate of costs such as purchase and conversion; net realisable value is the estimated proceeds of sale less costs to completion and costs to sell.

The general basis of inventory measurement AASB 102, paragraph 9, requires that inventories are to be measured at the lower of cost and net realisable value and such measurement would usually be undertaken on an item-by-item basis. However, paragraph 29 of

LO 7.2 LO 7.3

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AASB 102 provides that in some circumstances it might be appropriate to group similar or related items together when determining the lower of cost and net realisable value. Specifically, paragraph 29 states: Inventories are usually written down to net realisable value item by item. In some circumstances, however, it may be appropriate to group similar or related items. This may be the case with items of inventory relating to the same product line that have similar purposes or end uses, are produced and marketed in the same geographical area, and cannot be practicably evaluated separately from other items in that product line. It is not appropriate to write inventories down on the basis of a classification of inventory, for example, finished goods, or all the inventories in a particular operating segment.  AASB 102 provides that not-for-profit entities may also adopt a different treatment for measuring inventory. In respect of not-for-profit entities, inventories held for distribution are to be measured at the lower of cost and current replacement cost. Returning to the rule that applies to most reporting entities—that inventories be measured at the lower of cost and net realisable value—it would obviously be useful to define what we mean by ‘cost’ and what we mean by ‘net realisable value’. First we will consider ‘cost’. Paragraph 10 of AASB 102 states: The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. So in applying the requirements of paragraph 10 of AASB 102, we need to understand what is meant by: (a) costs of purchase; (b) costs of conversion; and (c) other costs incurred in bringing the inventories to their present location and condition. According to AASB 102: • The ‘cost of purchase’ comprises the purchase price, import duties and other taxes, as well as transport, handling and other costs directly attributable to the acquisition of finished goods, material and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase. • The ‘costs of conversion’ of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. • ‘Other costs’ are included to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories.

Items excluded from the cost of inventory In relation to what should not be included in the cost of inventory, paragraph 16 of AASB 102 requires that costs of inventory exclude costs that relate to: • abnormal amounts of wasted materials, labour or other production costs • storage costs, unless those costs are necessary in the production process prior to a further production stage • administrative overheads that do not contribute to bringing inventories to their present location and condition • selling costs. When acquiring inventory it is quite common for the purchaser to be offered a discount for early payment. For example, the purchaser might be sold assets on terms that state ‘3/7, n/30’. This is an abbreviation signifying that if the purchaser of the asset pays within seven days of receipt they will be given a 3 per cent discount on the purchase price, otherwise they are expected to pay the full amount within 30 days. The discount would be considered to relate to the management of accounts receivable and would be treated as an income item, perhaps labelled something like ‘discount revenue’. The discount for early payment would not be accounted for by reducing the cost of the inventory being acquired. Similarly, if a penalty for late payment is imposed, this would similarly not be included as part of the cost of inventory. Instead, it would be treated as a ‘late payment expense’. 236  PART 3: ACCOUNTING FOR ASSETS

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Allocating costs to inventory In allocating costs to inventories, a decision must be made on how to treat fixed production costs. Fixed production costs are costs of production that remain relatively constant from financial period to financial period irrespective of variations, within normal operating limits, in the volume of production. They would include costs such as those relating to the depreciation of factory buildings and costs of factory management and administration. Where more than one product is being produced, it might be necessary to allocate fixed manufacturing costs between different products. As paragraph 14 of AASB 102 states: A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or when there is a main product and a by-product. When the costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis. The allocation may be based, for example, on the relative sales value of each product either at the stage in the production process when the products become separately identifiable, or at the completion of production. Most by-products, by their nature, are immaterial. When this is the case, they are often measured at net realisable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost. The two main methods for dealing with manufacturing fixed costs are direct costing and absorption costing. AASB 102 requires the adoption of absorption costing. Under absorption costing, fixed manufacturing costs are included in the cost of inventories because they are considered to be as much a part of the cost of conversion as are direct labour and other variable costs. Under direct costing, fixed production costs are treated as period costs (that is, they are recognised as expenses in the financial period in which they are incurred) and are excluded from the cost of inventories. Although direct costing is frequently used for internal management purposes, it is not permitted for external reporting purposes. Again, absorption costing is required by AASB 102. Pursuant to AASB 102, the cost of inventory is to include both variable and fixed production overheads. Production overheads are indirect costs of production, preparation or conversion that cannot be identified specifically or traced to the individual goods or services being produced in an economically feasible manner. Paragraph 13 of AASB 102 requires that: The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognised as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed overhead allocated to each unit is decreased so that inventories are not measured above cost. Variable production overheads are allocated to each unit of production on the basis of the actual use of production facilities. Many organisations also use standard costs to allocate costs to inventory. Pursuant to AASB 102, standard costs may be used to arrive at the cost of inventory only where the standards are realistically attainable, reviewed regularly and, where necessary, revised in the light of current conditions. Standard costs are predetermined product costs established on the basis of, among other things, planned products and/or operations, planned cost and efficiency levels and expected capacity utilisation. Under a standard-cost accounting system, inventories are costed at a standard cost and the computation of cost variances becomes part of the accounting cycle. If standards have been properly set and maintained, they are a sound basis for the purpose of inventory valuation and all variances from standard can be charged or credited to profit or loss in the period in which they arise. Costs arising from exceptional wastage should be excluded from the cost of inventories.

fixed production costs Costs of production that are not expected to fluctuate as levels of production change.

fixed costs Costs that do not fluctuate (at least in the shorter term) as levels of production/activity change.

direct costing Where fixed production costs are treated as period costs (brought to account as expenses in the financial period in which they are incurred) and thus excluded from the cost of inventories.

absorption costing Where the cost of inventory includes variable production costs and fixed production costs. Often referred to as ‘full costing’.

period costs Costs that are written off in the period in which they are incurred since they are not expected to provide economic benefits beyond the end of the current financial period. standard costs Used to assign costs to inventory, they are predetermined product costs established on the basis of planned products and/or operations, planned cost and efficiency levels and expected capacity utilisation.

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As an example of determining the cost of inventory, consider Worked Example 7.1.

WORKED EXAMPLE 7.1: Determination of the cost of inventory The following list relates to expenditure incurred by Burridge Ltd for the latest financial year. Burridge Ltd makes a standard, one-design surfboard referred to as a ‘pop-out’. Standard costing is not applied. Rather, fixed manufacturing costs are allocated to inventory, on the basis of normal operating capacity. Item of expenditure

$000

Advertising Bad debts Depreciation—administrative equipment Depreciation—factory equipment Directors’ salary Electricity—administration building Electricity—factory Freight in of raw material Freight out of inventory Insurance—administration building Insurance—factory Interest expense Purchase of materials used to make pop-outs Purchase of office stationery and supplies Rates—administration building Rates—factory Rent—administration building Rent—factory Repairs and maintenance—administration building Repairs and maintenance—factory Salaries—administrative personnel Sales commissions Wages—factory personnel

10 15 20 30 90 10 30 30 20 10 15 30 400 70 20 20 100 200 10 30 150 180   300 1 790

Other information

(i) 10 000 pop-outs are made during the year. (ii) There is no opening inventory at the beginning of the year. (iii) Normal operating capacity is 10 000 pop-outs. (iv) Burridge received a discount of 2 per cent for paying early for the $400 of raw materials used to make the pop-outs.

REQUIRED Pursuant to AASB 102, what is the unit ‘cost’ of a pop-out? SOLUTION Costs need to be divided into those that relate to inventory, and those that do not. Any costs of an administrative nature or related to the sale of the products are not to be included in the ‘cost’ of inventory. Item of expenditure Advertising Bad debts Depreciation—administrative equipment

Costs that relate to inventory ($000)

Other costs ($000) 10 15 20

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Depreciation—factory equipment Directors’ salary Electricity—administration building Electricity—factory Freight in of raw material Freight out of inventory Insurance—administration building Insurance—factory Interest expense Purchase of materials used to make pop-outs Purchase of office stationery and supplies Rates—administration building Rates—factory Rent—administration building Rent—factory Repairs and maintenance—administration building Repairs and maintenance—factory Salaries—administrative personnel Sales commissions Wages—factory personnel Total

30 90 10 30 30 20 10 15 30 400 70 20 20 100 200 10 30 150 180 300 1 055

735

Pursuant to AASB 102, fixed factory overheads must be allocated to inventory on the basis of normal capacity. As the current period’s output is considered to be ‘normal’, we can simply add all the production costs together, including the fixed manufacturing overheads (such as the factory rent, rates and insurance) and divide the total cost by the level of output. Because only one product is being produced there is no need to allocate various costs to different products. The cost per pop-out, therefore, is: $1 055 000 ÷ 10 000 = $105.50

In Worked Example 7.1 note that we have not deducted the 2 per cent early payment discount received by Burridge from the cost of the inventory. Rather, this would be shown separately as an income item, perhaps labelled something like ‘discounts for early payment’. Nor have we included the interest expense as part of inventory. As we will discuss later in this chapter, costs associated with borrowing can sometimes be included in the cost of inventory. Such treatment is governed by AASB 123 Borrowing Costs. AASB 123 does allow interest costs to be included in the cost of inventory, but only when the inventory is considered to be a ‘qualifying asset’. AASB 123 defines a ‘qualifying asset’ as ‘an asset that necessarily takes a substantial period of time to get ready for its intended use or sale’. A ‘substantial period of time’ is generally regarded as being more than 12 months. The borrowing costs to be included would be those that would have been avoided if the expenditure on the asset had not been made. If it is assumed that the inventory of Burridge Ltd did not take Burridge more than 12 months to complete–as would often be the case–the cost of inventory would exclude the interest expenses. As we have noted, inventory is to be valued at the lower of cost and net realisable value. We have just considered one illustration of the determination of ‘cost’. We consider net realisable value in Worked Example 7.2. ‘Net realisable value’ is defined in AASB 102 as the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Worked Example 7.3 provides another example of inventory cost determination. CHAPTER 7: INVENTORY  239

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WORKED EXAMPLE 7.2: Lower of cost and net realisable value Rayday Ltd holds four lines of inventory. The total production costs of each item of inventory on hand at the end of the financial period are shown below. Apart from the production costs, estimates of future packaging costs and transportation costs are also provided. It is considered that the items are not saleable unless they are packaged in crates and transported to market. Product line Gidgets Widgets Didgets Sidgets

Production costs ($000)

Transport costs ($000)

Packaging costs ($000)

Expected sales proceeds ($000)

20 30 15 25

2 4 1 2.5

3 4 1.5 2.5

35 30 22 35

REQUIRED Determine the closing value of inventory for Rayday Ltd. SOLUTION As indicated earlier, where practical to do so, the lower of cost and net realisable value rule must be applied on an item-by-item basis. It is not permissible to net the differences off between the items. The net realisable value of the items is determined by subtracting the additional future transportation costs and packaging costs from the expected sales proceeds. Product line Gidgets Widgets Didgets Sidgets TOTAL

Net realisable value ($)

Cost ($)

Lower of cost and net realisable value ($)

30 000 22 000 19 500  30 000 101 500

20 000 30 000 15 000 25 000 90 000

20 000 22 000 15 000 25 000 82 000

The value of closing inventory would therefore be disclosed as $82 000. A review of the data above shows that $82 000 is well below the net realisable value of the total inventory. Lower of cost and net realisable value can provide a very conservative reflection of the value of inventory, with the result that the amount reported in the entity’s financial statements may be a great deal less than its market value. This treatment, as espoused in AASB 102, is generally consistent with the accountant’s somewhat dated ‘Doctrine of Conservatism’. This doctrine—which is also consistent with the notion of ‘prudence’—holds that gains should not generally be recognised until they are realised, while losses should be recognised in the period in which they first become foreseeable—that is, losses do not have to be realised to be recognised for accounting purposes. This asymmetric approach to the recognition of expenses and income is not consistent with the AASB conceptual framework. The conceptual framework requires that the recognition of income and expenses should be made on the same basis, with due recognition given to issues such as the probability that the inflow or outflow of economic benefits has occurred and whether the inflow or outflow can be reliably measured. However, as we have noted before, accounting standards such as AASB 102 have precedence over the conceptual framework. As a further point, it should also be remembered that, although expenditures associated with such activities as marketing, selling and distribution are not to be included in the ‘cost’ of inventory for statement of financial position purposes, they must necessarily be considered when calculating ‘net realisable value’.

WORKED EXAMPLE 7.3: Inventory cost determination Scottie Thomson Ltd commenced business at the beginning of the current financial year. The company manufactures life-size dolls. Relevant data are:

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Normal operating capacity (units) Goods produced (units) Opening finished goods inventory (units) Closing finished goods inventory (units) Opening value of raw materials inventory Closing value of raw materials inventory Factory salaries Administration salaries Factory rent Depreciation of factory equipment Rental of office equipment Raw materials purchased Sales price per unit Delivery costs of finished goods

100 000 100 000 Nil 20 000 Nil $100 000 $250 000 $90 000 $120 000 $80 000 $60 000 $300 000 $9.00 per unit $1.00 per unit

At the end of the year there are no partly finished goods. REQUIRED Determine the value at which inventory should be disclosed in the year-end statement of financial position. SOLUTION Under AASB 102, absorption costing is required. Under absorption costing, any fixed production costs are assigned to inventory on the basis of normal capacity, that is, they are treated as product costs. Pursuant to paragraph 16 of AASB 102, other fixed costs, such as those relating to administration, are expensed in the period incurred, and are thus treated as period costs, not product costs. The company in this illustration is operating at normal capacity of 100 000 units. Costs of inventory Variable costs Factory salaries Raw material purchased less Closing inventory divided by Units produced Per unit variable costs Fixed costs Factory rent Factory depreciation divided by Normal operating capacity Per unit fixed costs Total cost per unit Net realisable value Sales price per unit less Delivery costs per unit

$250 000 $300 000 $100 000

$200 000 $450 000 100 000 $4.50

$120 000 $80 000 $200 000 100 000 $2.00 $6.50 $9.00 $1.00 $8.00

Closing value of inventory As inventory is to be valued at the lower of cost and net realisable, and as cost is lower than net realisable value, the value of inventory on hand at the end of the reporting period would be: 20 000 × $6.50 = $130 000

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It should be noted that, for inventory covered by AASB 102, upward revaluations are not permitted. Therefore, if an item is worth more than cost, it should be left at cost. If it is worth less, it should be written down and the write-down treated as an expense in the period of writedown, perhaps called something like ‘inventory write-down expense’. That is, the rule about the lower of cost and net realisable value must be adhered to and cannot be circumvented by asset revaluations. As indicated in Chapter 6, the accounting standards pertaining to revaluations specifically exclude inventories. However, if in a subsequent period the circumstances that caused the inventory to be written down below cost no longer exist, then paragraph 33 of AASB 102 requires the inventories to be reinstated to the extent that the new carrying amount does not exceed the lower of the original cost or the net realisable value in the current period. Inventory held in the form of marketable securities, explicitly not covered by the inventory standard AASB 102, may be deemed to be a ‘trading security’, which is a security held for sale in the normal course of business. It is becoming usual practice within Australia for firms to value trading securities at market value (often referred to as ‘marking to market’) with the valuation increments and decrements both being included in the period’s profit or loss. A trading security would include such things as shares listed on a securities exchange. The requirement to recognise the gain or loss arising from a change in the fair value of a ‘financial asset’ is stipulated with AASB 9 Financial Instruments. A more thorough investigation of accounting for financial instruments is provided in Chapter 14. Returning to inventories covered by AASB 102, as stipulated by paragraph 15 of AASB 102, other costs will also often be incurred in bringing inventories to their present location and condition. These costs might include additional costs necessary to meet the needs of specific customers—for example, some customers might require that inventory be packaged in a particular way, or be slightly modified relative to the inventory being sold to other purchasers. Such ‘other costs’ would be included in the cost of inventory. As we indicated earlier in this chapter, it is also possible for borrowing costs to be incurred by an entity in the process of producing inventory. For example, an entity might need to borrow funds to acquire particular raw materials used to produce its inventory. At issue here is whether we should include the borrowing costs—such as the interest expenses—in the costs of the inventory. We can look to AASB 123 Borrowing Costs for guidance. Paragraph 11 of AASB 123 requires that interest be included in the cost of inventory to the extent that the inventories are qualifying assets. Paragraph 8 states:

write-down Reducing the carrying value of an asset.

An entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity shall recognise other borrowing costs as an expense in the period in which it incurs them. Given that a qualifying asset is one that ‘takes a substantial period of time’ to be completed, we would expect that most inventory items would not satisfy the requirements of AASB 123, and hence borrowing costs would not be included in the cost of inventory. However, for an item such as a ship under construction, borrowing costs might be included in the cost of the inventory—the inventory being the ship. AASB 123 provides a number of examples of assets that could be considered as ‘qualifying’—and that therefore could include interest expenses as part of their ‘cost’. Specifically, paragraph 7 of AASB 123 states: Depending on the circumstances, any of the following may be qualifying assets: (a) inventories (b) manufacturing plants (c) power generation facilities (d) intangible assets (e) investment properties (f) bearer plants. Financial assets, and inventories that are manufactured, or otherwise produced, over a short period of time, are not qualifying assets. Assets that are ready for their intended use or sale when acquired are not qualifying assets. Further discussion relating to accounting for borrowing costs is provided in Chapter 4.

LO 7.5 LO 7.6 LO 7.7

Inventory cost-flow assumptions In Worked Example 7.3 we assumed that all units cost the same amount and we performed the calculation at year end. However, if the costs of the individual inventory items fluctuate throughout the year, which would

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be likely in most organisations where items are manufactured or acquired at various times throughout the year, and we cannot or do not wish to identify the specific ‘cost’ of each individual item, certain cost-flow assumptions must be made. During the year, inventory is likely to be purchased or manufactured at several different prices/costs. If inventories are to be measured at cost and numerous purchases have been made at different unit costs, the question arises of which of the various cost prices should be assigned to each transaction. Conceptually, a specific identification of the items sold and the items on hand at reporting date seems optimal, but this approach might be impractical to apply. Also, if items are identical and costs are fluctuating, it is possible that attempting to identify specifically which items were sold might lead to profit manipulation by, for example, identifying lower-cost items as those sold—thereby reducing costs of goods sold—so as to report more profit in the current period. Instead of attempting to identify items specifically, a cost-flow assumption is frequently made and consistently applied in determining cost of goods sold and closing inventory. Thus, the actual physical flow of goods, and the flow of goods according to the cost-flow assumption, might be quite different. In selecting a cost-flow method, management must exercise judgement to ensure that the method chosen provides the most practical accounting reflection of the real situation. For example, it might be inappropriate to apply averages based on costs incurred over a whole financial period in circumstances where there was a complete turnover of inventories several times during that financial period. According to AASB 102, costs of inventories should be assigned to particular items of inventory by one or more of the following methods: • specific identification—this method assigns specific costs to identified units of inventory; • weighted average cost—this method assigns weighted average costs, arrived at by means of either a continuous calculation, a periodic calculation or a moving periodic calculation; and • first-in, first-out (FIFO)—this method assigns costs on the assumption that the inventory quantities on hand represent those last purchased or produced. If the production costs or purchase prices of inventory items did not change, the above three specific-identification methods would generate the same costs, but steady prices would rarely be expected across time. The method method adopted should be appropriate to the circumstances (that is, there is some correspondence Method of accounting between the cost-flow assumption and the physical flow of inventory) and be applied consistently for the cost flow of inventory. Significant from financial period to financial period. An entity is to use the same method for all inventories dollar value items are having a similar nature or use. For inventories with a different nature or use, different methods may often accounted for be applied (so long as the method chosen is one of the three options just listed). this way, particularly Under the specific-identification method of inventory valuation, and assuming items being sold where they have a are similar or identical, the seller determines which item is sold and the cost of that specific item is unique characteristic such as a unique expensed to cost of sales. This could lend itself to profit manipulation. The ending inventory is costed product number. at the cost of the specific individual items on hand at the end of the year. For example, a seller has for sale three identical inventory items with costs of $100, $150 and $200. Since the inventory items are identical, purchasers will have no preference for a particular item. The seller can manipulate the value of ending inventory (assets) and income (profit) by selecting different items for sale. If the seller chooses to sell the $100 item, profits and closing inventory will be $100 greater than if the $200 item had been sold. With this ability to manipulate accounting numbers in mind, paragraph 24 of AASB 102 prohibits the use of the specific-identification method for interchangeable inventory items. Items with a significant dollar value, such as motor vehicles, are frequently accounted for by the specific-identification method, particularly when the items have a unique characteristic, such as a unique product or identification number. When items have different characteristics, and the buyers are not indifferent about which item they select, the ability to manipulate profits is reduced. Paragraph 23 of AASB 102 requires that specific identification be used to assign costs to inventory items that are: (a) not ordinarily interchangeable; or (b) goods or services produced and segregated for specific projects. As noted above, paragraph 24 of AASB 102 states that specific identification is not appropriate when there are large numbers of inventory items that are ordinarily interchangeable, as the selection of items remaining in inventory could be made to obtain predetermined effects on the result for the reporting period. CHAPTER 7: INVENTORY  243

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For goods that are ordinarily interchangeable, or are not produced and segregated for specific projects, AASB 102 requires that the costs be assigned using the weighted-average cost or the firstin, first-out (FIFO) formulas. Under the weighted-average approach, an average cost is determined based on the cost of beginning inventory and the costs of items purchased or manufactured during the period. The various costs of the individual units are weighted by the number of units at a particular purchase price. The units in ending inventory and units sold are costed at this average cost. The weighted-average cost method is appropriate where the goods are homogeneous in nature and the turnover of items is high. Under the first-in, first-out cost-flow method (FIFO) of inventory valuation, the goods from beginning inventory and the earliest purchases are assumed to be the goods sold first. This would seem to be the pattern of selling behaviour in most entities. Ending inventory is assumed to be made up of the more recent purchases, or the more recently manufactured items, and thus represents a more current value of the inventory for the statement of financial position. It should be noted that this cost-flow assumption may be used even when it does not match the physical flow of goods. While FIFO is commonly used within Australia, it is often criticised because it tends to match old or outdated inventory costs with current sales prices and by doing so tends to result in inflated profits relative to what would be recorded if current up-to-date costs were used to determine cost of goods sold. The last-in, first-out cost-flow method (LIFO) of inventory valuation is not acceptable under AASB 102; however, it is discussed here for the sake of completeness. Under the LIFO cost-flow first-in, first-out costmethod, the most recent items purchased or manufactured are assumed to be the first goods sold. flow method (FIFO) Method of assigning Therefore, ending inventory is assumed to be composed of the oldest goods. This could result in costs to inventory inventory being valued at costs that were paid or incurred some years before. The cost of sales where it is assumed contains relatively current costs, thus achieving a potentially better matching of current costs to that the first inventory revenues. In a period of rising prices, LIFO adopters would show lower profits and lower closing that enters an inventory than FIFO adopters. Allowing the adoption of LIFO would potentially open the door to organisation’s stock is the first inventory that profit manipulation, as acquiring inventory at year end might alter the period’s profit, even if those is sold. items acquired are still on hand at year end. Interestingly, LIFO may be used in the USA for external reporting purposes. If it is used for these purposes—an option available to the reporting entity in the USA—it may also be used for last-in, first-out costthe purposes of calculating the entity’s taxation liability. In a period of rising prices, adopting LIFO flow method (LIFO) effectively results in higher cost of goods sold, lower profits and, consequently, lower taxes. Further, Method of assigning the choice of an inventory cost-flow assumption does not have to reflect the underlying physical flow costs to inventory of inventory. LIFO is prohibited in countries that adopt the standards produced by the IASB (as we where it is assumed know, in Australia the contents of IAS 2 are subsumed in AASB 102). that the last inventory The benefits of lower taxes that are available to US firms that adopt LIFO have to be traded off item that enters an organisation’s stock is against other implications of reporting lower profits. Conceivably, reporting lower profits and lower the first inventory that closing inventory might have implications for certain accounting-based contractual arrangements, is sold. such as accounting-based management bonus schemes, and debt-to-asset constraints or interestcoverage clauses contained in negotiated debt agreements. As discussed in previous chapters of this book, management can often choose between particular accounting procedures, for example: weighted-average approach An average cost is determined for inventory based on beginning inventory and items purchased during the period. The costs of the individual units are weighted by the number of units acquired or manufactured at a particular price. The units in ending inventory and units sold are costed at this average cost.

• revaluing or not revaluing non-current assets • capitalising or expensing a particular expenditure • using the straight-line or sum-of-digits method of depreciation. Accounting researchers often seek to explain why management chooses one method of accounting in preference to another. Many researchers working within the Positive Accounting Theory paradigm have attempted to explain accounting policy choices in terms of the debt hypothesis, the management-bonus hypothesis and the political-cost hypothesis (see Chapter 3 for an overview of these hypotheses and of Positive Accounting Theory). Hunt (1985) reports that organisations within the USA that elect not to adopt LIFO—and therefore report higher profits and assets in periods of increasing prices—typically have higher leverage and lower interest-coverage ratios. His results were consistent with the frequently used ‘debt hypothesis’, which holds that organisations potentially close to breaching debt covenants (such as maximum debt-to-asset ratios and minimum interest-coverage ratios) will adopt income-increasing (which is also

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equity increasing) and, hence, asset-increasing accounting methods. Some support for the debt hypothesis explaining the selection of particular inventory cost-flow assumptions was provided by Cushing and LeCleare (1992). In relation to research that attempts to explain the adoption of a particular accounting method (and this point could have been raised numerous times in this book), it should be remembered that organisations typically have available to them numerous choices between alternative accounting methods. Some methods might increase income (for example, adopting FIFO in preference to LIFO), while others might lead to a reduction periodic inventory in income (for example, an organisation might elect to upwardly revalue its non-current assets, system Also known as the thereby increasing future depreciation charges and reducing any profits on sale). Therefore it can physical inventory be misleading to try to explain a particular accounting choice in isolation rather than as part of an method, this is a organisation’s entire portfolio of accounting policy choices. Although one choice of accounting method of accounting method might, on its own, increase reported income, other methods voluntarily chosen by the firm for inventory where might act to reduce income. When various ‘positive’ research studies are considered throughout this inventory is counted periodically and then book, this potential research limitation should be borne in mind. priced. Returning to the Australian treatment of inventory (which prohibits the use of the LIFO method discussed above), the determination of cost of sales and closing inventory under each of the costflow assumptions further depends on the method used to record movements in the inventory, that perpetual inventory is, whether the periodic or perpetual inventory system is used. We use either the perpetual or system periodic inventory method to work out the number of units of inventory on hand. So in determining Also known as the cost of goods sold (for the statement of profit or loss and other comprehensive income) and the cost continuous method, of closing inventory (for the statement of financial position), we not only need to consider what costthis is a method flow assumptions have been made (for example, FIFO, specific-identification or weighted-average of accounting for inventory where a approach), we also need to determine whether the perpetual or periodic system is being employed running total is kept of to determine the actual number of units of inventory on hand. Under the periodic inventory system, the units on hand by inventory is counted periodically (for example, at year end) and then costed. In contrast, under the recording all increases perpetual inventory system, a running total is kept of the units on hand (and possibly their value) and decreases as they by recording all increases and decreases as they occur. Some inventory cost-flow examples and occur. methods are reviewed in Worked Examples 7.4 and 7.5.

WORKED EXAMPLE 7.4: Inventory cost-flow example Bernie Ltd has the following inventory transactions for the year ending 30 June 2018: Opening inventory at 1 July 2017 Purchases on 1 October 2017 Purchases on 1 February 2018 Purchases on 1 June 2018 Total

2 000 units @ $5 6 000 units @ $6 8 000 units @ $8 4 000 units @ $10 20 000 units

$10 000 $36 000 $64 000   $40 000 $150 000

During the year Bernie Ltd sells 15 000 units, and has 5000 units on hand at year end. Bernie Ltd uses the periodic system to record inventory. REQUIRED Compute the cost of sales and ending inventory amounts under the following cost-flow methods:

(a) First-in, first-out (FIFO) (b) Weighted average (c) Last-in, first-out (LIFO)

SOLUTION (a) FIFO The cost of sales comprises the beginning inventory of 2 000 units and the next 13 000 units purchased. That is, the first items of inventory that came in were assumed to be the first ones that went out—first in, first out. The ending inventory comprises the last 5 000 units purchased. continued CHAPTER 7: INVENTORY  245

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Cost of sales = (2000 @ $5) + (6000 @ $6) + (7000 @ $8) = $102 000 Ending inventory = (1000 @ $8) + (4000 @ $10) = $48 000

(b) Weighted average The cost of sales and ending inventory are costed at the weighted-average price of beginning inventory and purchases. Weighted-average cost = $150 000 ÷ 20 000 units = $7.50 per unit Cost of sales = (15 000 @ $7.50) = $112 500 Ending inventory = (5000 @ $7.50) = $37 500

(c) LIFO The cost of sales comprises the last 15 000 units purchased. The ending inventory comprises the beginning inventory of 2000 units and 3000 units purchased on 1 October 2017. Cost of sales = (4000 @ $10) + (8000 @ $8) + (3000 @ $6) = $122 000 Ending inventory = (2000 @ $5) + (3000 @ $6) = $28 000

WORKED EXAMPLE 7.5: Inventory cost-flow methods Bakehouse Ltd begins selling rolling pins in 2017. Each rolling pin looks the same; however, the unit costs of manufacturing rolling pins (which is done in batches) have fluctuated due to rising material costs. Bakehouse Ltd adopts a FIFO cost-flow assumption and employs a perpetual inventory system. Details of costs are as follows. Date completed

Number completed

Unit costs ($)

100 300 250 300    200 1 150

2.50 2.70 2.80 3.00 3.10

Number sold

Unit price ($)

90 210 300 200 150 950

5.00 5.00 5.10 5.00 5.20

10 July 2017 10 Aug. 2017 5 Dec. 2017 1 Mar. 2018 1 June 2018 Details of sales are as follows: Date of sale 12 July 2017 15 Aug. 2017 10 Dec. 2017 25 Mar. 2018 15 June 2018

REQUIRED What is the cost of sales for the year ended 30 June 2018 and what is the value of inventory for statement of financial position purposes as at 30 June 2018? SOLUTION Because the inventory items, which are rolling pins, are identical we cannot precisely determine the cost of each specific item sold. For example, is the firm selling items in December that were in fact produced in July, August or December? Typically we would not know. We need to make cost-flow assumptions. For example, we may assume that the first rolling pins produced are the first ones sold, that is, we could adopt the FIFO costflow assumption. With this assumption, cost of goods sold would be $2 660, reconciled as follows (assuming a perpetual inventory system is employed in which inventory records are updated each time an item is sold or manufactured):

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Date

Manufactured

Sold

100 @ 2.50 = $250

10 July 12 July 10 Aug.

90 @ $2.50 = $225 300 @ 2.70 = $810 10 @ $2.50 = $ 25 200 @ $2.70 = $540

15 Aug. 250 @ 2.80 = $700

5 Dec.

100 @ $2.70 = $270 200 @ $2.80 = $560

10 Dec. 300 @ 3.00 = $900

1 Mar.

50 @ $2.80 = $140 150 @ $3.00 = $450

25 Mar. 1 June

200 @ 3.10 = $620

15 June

                                 1 150            $3 280

150 @ $3.00 = $450 950           $2 660

Balance 100 @ $2.50    10 @ $2.50 10 @ $2.50 300 @ $2.70 100 @ $2.70                    100 @ $2.70 250 @ $2.80 50 @ $2.80                    50 @ $2.80 300 @ $3.00 150 @ $3.00                    150 @ $3.00 200 @ $3.10 200 @ $3.10

Closing inventory would therefore be valued at $620 (200 × $3.10). From the above example we can see how the selection of a particular inventory cost-flow assumption creates a different cost of goods sold, and different balances of closing inventory for use within the statement of financial position. In times of rising prices, LIFO will generate the highest cost of goods sold and the lowest closing inventory whereas FIFO will generate the lowest cost of goods sold and the highest closing inventory. Weighted-average cost will generate results in between those generated by LIFO and FIFO. The periodic system was used for the calculations in Worked Example 7.4. The implication of this is that calculations of cost of goods sold are done periodically, for example, at the end of the financial period, rather than each time a sale is made. Contrast these calculations with those shown in Worked Example 7.5, where the perpetual inventory system is used, and cost of goods sold and inventory balances are updated each time a sale occurs. As we can see from this example, if the perpetual system is used, the balance of inventory on hand is kept up to date. In Worked Example 7.6 we consider, for comparative purposes, the journal entries that are needed under both a periodic and a perpetual inventory system. As we will see, when the periodic system is used we use a ‘purchases’ account, and cost of goods sold will be determined at the end of the period using the following formula: COST OF GOODS SOLD = OPENING INVENTORY + PURCHASES – PURCHASE RETURNS (if any) − CLOSING INVENTORY

WORKED EXAMPLE 7.6: Journal entries to be used in accounting for inventory: a comparison of the periodic and perpetual systems of accounting for inventory Trigger Ltd sells Malibu surfboards acquired from Byron Bay Ltd. At the beginning of July 2017 Trigger Ltd had 60 Malibu surfboards that cost $600 each. During the year the following transactions took place:

(a) (b) (c) (d) (e)

On 10 July 2017 Trigger Ltd sold 50 Malibus for cash at $800 each. On 5 August 2017 Trigger Ltd purchased 70 Malibus at $700 each and this cost included freight costs. On 10 August 2017 Trigger Ltd paid for the purchases and received a 2 per cent discount for early payment. On 5 September 2017 Trigger Ltd sold 60 Malibus at $900 each. On 15 September 2017 Trigger Ltd returned 10 defective Malibus purchased on 5 August to the supplier and received a cash refund for the entire amount; the fibreglass on the boards was lifting. continued

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(f) On 1 December 2017 Trigger purchased 40 Malibus at $720 each and this cost included freight costs. (g) On 10 December 2017 Trigger Ltd paid for the purchases and received a 2 per cent discount for early payment. (h) On 10 June 2018 Trigger Ltd sold 40 Malibus at $1 000 each.

Following the above transactions and events, we can see that Trigger had 10 Malibus on hand at the end of the reporting period (30 June 2018) that cost $700 each. REQUIRED (a) Provide the journal entries to account for the above transactions using first the periodic system and then the perpetual system. Trigger Ltd uses the FIFO cost-flow assumption. (b) Determine cost of goods sold and the balance of closing inventory. (c) Provide a calculation of gross profit—that is, sales less COGS sold. SOLUTION As a first step to answering this question it is useful to provide a reconciliation of inventory coming in and out of the organisation, and the respective costs of the movements adopting the FIFO cost-flow assumption. Date Op. bal. 10 July 5 Aug.

Purchased/(returned)

50 @ $600 70 @ $700

5 Sept. 15 Sept. 1 Dec.

10 @ $600 50 @ $700 (10) @ $700 40 @ $720

10 June

10 @ $700 30 @ $720  

(a) Perpetual inventory system 10 July 2017 Dr Cash Cr Sales revenue Dr Cost of goods sold (50 @ $600) Cr Inventory 5 Aug. 2017 Dr Inventory (70 @ $700) Cr Accounts payable 10 Aug. 2017 Dr Accounts payable Cr Cash Cr Discount revenue 5 Sept. 2017 Dr Cash Cr Sales revenue

Sold

$70 800

Balance 60 @ $600 10 @ $600 10 @ $600 70 @ $700 20 @ $700 10 @ $700 10 @ $700 40 @ $720 10 @ $720

$99 600

Periodic inventory system 40 000

Dr Dr

Cash Sales revenue

40 000

Dr Cr

Purchases Accounts payable

49 000

49 000

Accounts payable Cash Discount revenue

49 000

48 020 980

Dr Cr Cr

Cash Sales revenue

54 000

54 000

Dr Cr

40 000

40 000

30 000 30 000 49 000

49 000

54 000

49 000

48 020 980

54 000

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Dr

Cost of goods sold (10 @ $600,50 @ $700) Inventory

Cr

15 Sept. 2017 Dr Cash Cr Inventory

10 Dec. 2017 Dr Accounts payable Cr Cash Cr Discount revenue 10 June 2018 Dr Cash Cr Sales revenue Dr Cost of goods sold (10 @ $700, 30 @ $720 Cr Inventory

Cash Purchase returns

7 000

7 000

Dr Cr Dr Cr

Purchases Accounts payable

28 800

28 800

Accounts payable Cash Discount revenue

28 800

28 224 576

Dr Cr Cr

Cash Sales revenue

40 000

40 000

Dr Cr

28 800

28 800

40 000

7 000

28 800

28 224 576

40 000

28 600 28 600

Here we can see that different accounts are used. Under the perpetual system, when purchases are made, the asset account of inventory is updated immediately. By contrast, under the periodic system, when purchases are made the purchases go to an expense account called ‘purchases’. Under the perpetual system, each time a sale is made the inventory account is updated and a related cost of goods sold is recorded. Under the periodic system, cost of goods sold is determined at the end of the accounting period rather than throughout the period (and we show the required entry below). The cost of goods sold under a periodic system can be calculated as: Opening inventory plus Purchases less Purchase returns less Closing inventory Cost of goods sold



41 000 7 000

1 Dec. 2017 Dr Inventory (40 @ $720) Cr Accounts payable



41 000

36 000  77 800 113 800   (7 000) 106 800 7 200   99 600

(b) To record cost of goods sold under the periodic system, we would also need to provide the following journal entry at the end of the period (no such entries are required for the perpetual systems because—as we see above—with the perpetual system the cost of goods sold is updated each time a sales transaction occurs): Dr Dr Dr Cr Cr

Inventory (that is, closing inventory, which would be 10 units at $720 each using FIFO) Cost of goods sold (this is the balancing item) Purchase returns (we close off purchase return account) Inventory (we remove the balance of the opening inventory from the inventory account) Purchases (we close off the purchases account so as to include it in COGS)

7 200 99 600 7 000 36 000 77 800

continued CHAPTER 7: INVENTORY  249

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(Following the above entry, closing inventory would be $7200, which is the 10 Malibus still on hand at the end of the year multiplied by their price of $720 each; cost of goods sold would now be recognised for the purposes of determining profit or loss; and the purchases and purchases return accounts would have a zero balance ready to start the new financial period. It should also be noted that the closing inventory of $7200 therefore becomes the opening inventory for the next period in terms of determining the next period’s cost of goods sold.) (c) Calculation of gross profit Sales Cost of goods sold Gross Profit

$134 000 99 600 34 400

Before concluding our discussion of the differences between the periodic and perpetual inventory system we should perhaps briefly consider the role of an end-of-period stocktake using the perpetual and periodic methods of accounting for inventory. Under the perpetual system we constantly update our records of inventory as sales, purchases and returns are made. The role of the stocktake in this case would be to determine whether what is on hand actually corresponds with what our accounting records indicate. A difference might indicate, for example, that a theft has occurred. The stocktake might also reveal obsolete or damaged inventory. Where a periodic system is utilised, the stocktake is needed to tell us how much inventory is on hand as under this system we do not update inventory each time an inventory movement occurs.

LO 7.4

Reversal of previous inventory write-downs

As previously indicated in this chapter, if in a subsequent period information becomes available which indicates that inventory previously written down to net realisable value has subsequently increased in value, it is permissible to reverse the previous write-down. However, in keeping with the rule that inventory is to be valued at the lower of cost and net realisable value, any subsequent increase in value is to be restricted to the amount that was previously written down, that is, the value of the inventory must not be increased above its original cost. Where there is a reversal of a previous inventory write-down, the entry would involve a debit to the inventory account and a credit to an income account labelled ‘Reversal of previous inventory write-down’ or its equivalent. For the purposes of illustration, we may consider Worked Example 7.7.

WORKED EXAMPLE 7.7: Reversal of a previous inventory write-down Mungo Ltd has 500 000 blocks of surf wax in inventory. The blocks of wax cost Mungo $2 each. At 30 June 2017, and because of a pollution scare that has worried surfers, the net realisable value of the blocks of wax was reassessed at $1.40 each. As a result, at 30 June 2017 the following entry would be required: Dr Cr

Inventory write-down expense Inventory

300 000 300 000

REQUIRED If in August of the next financial year the pollution problems have been resolved and it is determined that the net realisable value has risen to $2.90, what accounting entry would be required (remember, the write-back would be restricted to the amount of the original write-down as inventory is not permitted to be valued in excess of cost)? SOLUTION Dr Cr

Inventory Reversal of previous inventory write-down (income)

300 000 300 000

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Disclosure requirements

LO 7.8

Where the information is material, paragraph 36 of AASB 102 requires that the financial statements disclose the following information: (a) the accounting policies adopted for measuring inventories, including the cost formulas used; (b) the total carrying amount of inventories and the carrying amount in classifications appropriate to the entity; (c) the carrying amount of inventories carried at fair value less costs to sell; (d) the amount of inventories recognised as an expense during the period; (e) the amount of any write-down of inventories recognised as an expense in the period; (f) the amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognised as an expense in the period; (g) the circumstances or events that led to the reversal of write-downs of inventories; and (h) the carrying amount of inventories pledged as securities for liabilities. See Exhibit 7.1 for an example of an accounting policy note, in this case provided by Wesfarmers Ltd in its 2015 Annual Report. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Inventories Recognition and measurement Inventories are valued at the lower of cost and net realisable value. The net realisable value of inventories is the estimated selling price in the ordinary course of business less estimated costs to sell. Key estimate: net realisable value The key assumptions, which require the use of management judgement, are the variables affecting costs recognised in bringing the inventory to location and condition for sale, estimated costs to sell and the expected selling price. These key assumptions are reviewed at least annually. The total expense relating to inventory write-downs during the year was $46 million (2014: $19 million). Any reasonable possible change in the estimate is unlikely to have a material impact. Costs incurred in bringing each product to its present location and condition are accounted for as follows:

Exhibit 7.1 Accounting policy note from the 2015 Annual Report of Wesfarmers Ltd

• Raw materials: purchase cost on a weighted average basis. • Manufactured finished goods and work in progress: cost of direct materials and labour and a proportion of manufacturing overheads based on normal operating capacity, but excluding borrowing costs. Work in progress also includes run-of-mine coal stocks for resources, consisting of production costs of drilling, blasting and overburden removal. • Retail and wholesale merchandise finished goods: purchase cost on a weighted average basis, after deducting any settlement discount and including logistics expenses incurred in bringing the inventories to their present location and condition. Volume-related supplier rebates, and supplier promotional rebates where they exceed spend on promotional activities, are recognised as a reduction in the cost of inventory. SOURCE: Wesfarmer’s Ltd 2015 Annual Report

SUMMARY The chapter addressed the topic of accounting for inventory. Inventory is defined as assets held for sale in the ordinary course of business, in the process of production for sale, or to be used in the production of goods; and other property or services for sale, including consumable stores and supplies. CHAPTER 7: INVENTORY  251

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Within Australia, pursuant to AASB 102, inventory is to be measured at the lower of cost and net realisable value on an item-by-item basis. Cost itself is defined as the aggregate of the cost of purchase; the cost of conversion; and other costs incurred in the normal course of operations in bringing the inventories to their present location and condition. Net realisable value is the estimated proceeds of sale less, where applicable, all further costs to the stage of completion and less all costs to be incurred in marketing, selling and distribution to customers. For the purposes of financial statement presentation it is a requirement of the accounting standard that inventory should include an allocation of fixed manufacturing costs—that is, absorption costing and not direct costing should be applied. In accounting for the flow of inventory (which is necessary to determine the value of inventory and the cost of goods sold for the period), it is typically necessary to make some cost-flow assumptions, as it is not possible or practical to trace the flow of particular items of inventory through the system. The cost-flow method adopted by management must be the most practical accounting reflection of the reality of the inventory flow. Within Australia, costs may be assigned to inventory using the specific-identification method, the weighted-average method or the first-in, first-out method. Use of the last-in, first-out method is specifically prohibited in Australia. Organisations also need to choose between using the perpetual or periodic system to determine the number of units of inventory on hand.

KEY TERMS absorption costing  237 cost of goods sold  235 direct costing  237 first-in, first-out cost-flow method (FIFO)  244 fixed costs  237 fixed production costs  237

inventory  235 last-in, first-out cost-flow method (LIFO)  244 lower of cost and net realisable value  235 period costs  237 periodic inventory system  245

perpetual inventory system  245 specific-identification method  243 standard costs  237 weighted-average approach  244 write-down  242

END-OF-CHAPTER EXERCISES Capetown Ltd started business at the commencement of the current financial year. The company manufactures rugby balls. The following information is available in relation to its production activities: Normal operating capacity (units) Goods produced (units) Opening finished goods inventory (units) Closing finished goods inventory (units) Opening value of raw materials inventory Closing value of raw materials inventory Factory wages Administration salaries Salespersons’ salaries ($1 per unit sold) Factory rent Depreciation of factory equipment Factory supervisor’s salary Rental of office equipment Raw materials purchased Sales price per unit Delivery and advertising costs per unit sold

200 000 200 000 Nil 50 000 Nil $200 000 $1 550 000 $100 000 $150 000 $150 000 $100 000 $50 000 $50 000 $600 000 $13.00 per unit $2.00

At the end of the year there are no partly finished goods.

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REQUIRED Determine the value at which inventory should be disclosed in the year-end statement of financial position. LO 7.1 7.2 7.3

SOLUTION TO END-OF-CHAPTER EXERCISE As indicated earlier in this chapter, pursuant to AASB 102, absorption costing is required when valuing inventory for the purposes of general-purpose financial reporting. Under absorption costing, any fixed production costs, such as the supervisor’s salary and factory rent, are assigned to inventory on the basis of normal operating capacity—that is, they are treated as product costs. Other fixed costs, such as those relating to administration, are treated as period costs, not product costs, and are expensed in the period incurred. Costs of inventory Variable costs Factory wages Raw material purchased less Closing inventory divided by Units produced Per unit variable costs Fixed costs Factory rent Factory supervisor’s salary Factory depreciation

$1 550 000 $600 000 $200 000

$9.75 $150 000 $50 000 $100 000 $300 000 200 000

divided by Normal operating capacity Per unit fixed costs Net realisable value per unit Sales price per unit less Delivery and selling costs less Salespersons’ salary per unit

$400 000 $1 950 000 200 000

$1.50 $11.25 $13.00 $2.00 $1.00

$3.00 $10.00

CLOSING VALUE OF INVENTORY As inventory is to be valued at the lower of cost and net realisable value, the value of inventory on hand at the end of the reporting period would be: 50 000 × $10.00 = $500 000

REVIEW QUESTIONS 1. Outline arguments for and against the use of the lower of cost and net realisable value rule. LO 7.3 2. Is it permissible to revalue inventory to its fair value? Do you think the requirements in relation to inventory valuation are overly conservative? LO 7.2, 7.3 3. What should be included in the ‘cost’ of inventories? LO 7.2 4. What does net realisable value mean as it pertains to inventory? LO 7.3 5. What is an inventory cost-flow assumption and why is one necessary? LO 7.5 6. What inventory cost-flow assumptions are permitted in Australia? LO 7.6 7. Distinguish between the periodic and perpetual inventory methods. LO 7.7 8. Explain the difference between absorption and direct costing. LO 7.2, 7.3

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9. Assuming that costs of inventory are rising across time, you are required to determine which of either the first-in, first-out (FIFO) or the weighted average cost approach will generate the highest cost of goods sold. LO 7.5 10. What is a ‘standard cost’? According to AASB 102, when may standard costs be used to assign costs to inventory? LO 7.2, 7.5 11. Explain how it is possible for profits to be manipulated through the use of the specific-identification and LIFO inventory cost flow assumptions. LO 7.2, 7.5, 7.6 12. AASB 102 prohibits the use of the LIFO method. What is the argument against the use of LIFO? LO 7.2, 7.6 13. Moondoggie Ltd holds four lines of inventory. The total production costs of each item are shown below. Apart from the production costs, estimates of future packaging costs and transportation costs are provided. It is considered that the items are not saleable unless they are packaged and transported to market. Production costs ($)

Transport costs ($)

Packaging costs ($)

5 000 3 000 10 000 20 000

1 000 1 000 2 000 2 000

1 000 2 000 1 500 2 500

Wet-suits Blocks of wax Flippers Board shorts

Sales proceeds ($) 9 000 5 000 13 000 25 000

REQUIRED Determine the closing value of inventory for Moondoggie Ltd. LO 7.2, 7.3 14. Shelley Ltd starts selling bowling balls in 2017. Although each ball looks the same, the unit cost of manufacture (which is done in batches) has fluctuated during the period. Shelley Ltd adopts a FIFO cost-flow assumption and employs a perpetual inventory system. Details of costs are as follows: Date completed

Number completed

Unit costs ($)

200 300 150 200   200 1 050

75 80 88 90 88

Number sold

Unit price ($)

100 230 100 300 100 830

100 110 105 120 130

2 July 2017 1 Aug. 2017 24 Dec. 2017 15 Mar. 2018 15 June 2018

Details of sales are as follows: Date of sale 5 July 2017 10 Aug. 2017 30 Dec. 2017 16 Mar. 2018 25 June 2018

REQUIRED What is the cost of sales for the year ended 30 June 2018 and what is the value of inventory as at 30 June 2018? LO 7.1, 7.2, 7.5

CHALLENGING QUESTIONS 15. Explain in which circumstances it would be appropriate to use the following cost-flow assumptions: (a) specific-identification assumption (b) weighted-average cost assumption (c) first-in, first-out assumption. LO 7.5, 7.6 254  PART 3: ACCOUNTING FOR ASSETS

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16. Lynch Ltd has some inventory of wet-suits on hand at 30 June 2018. Costs for making the wet-suits comprise material worth $10 000, labour of $8000 and factory overheads applied on the basis of normal operating capacity amounting to $4000. Lynch Ltd considers that only one customer, Wayne Ltd, will buy the wet-suits, which are all bright pink with fluorescent green inserts. Wayne Ltd is prepared to buy them all in July 2018 for a total amount of $20 000, provided Lynch Ltd sews a smiley face on the right arm of each suit at a total cost to Lynch Ltd of $2000. Lynch Ltd will also be required to pay for the freight charges to get the inventory to Wayne Ltd. This freight cost will be $1000.

REQUIRED As at 30 June 2018, at what amount should inventory be recorded in the books of Lynch Ltd? LO 7.2, 7.3 17. Horan Ltd has the following inventory transactions for the year ending 30 June 2018. All inventory items are identical. Opening inventory at 1 July 2017 Purchases on 1 Sept. 2017 Purchases on 12 Feb. 2018 Purchases on 21 June 2018

1 000 units @ $10 3 000 units @ $12 4 000 units @ $14 2 000 units @ $15

Horan Ltd sells 8000 units during the year, and has 2000 units on hand at year end. The company uses the periodic system to record inventory. At year end, the net realisable value of each inventory item is $20 per unit.

REQUIRED Compute the cost of sales and ending inventory amounts under the following cost-flow methods: (a) first-in, first-out (FIFO) method (b) weighted-average cost method (c) last-in, first-out (LIFO) method. LO 7.2, 7.3, 7.5, 7.7 18. The following list relates to expenditure incurred by Warm Buttered Ltd for the year ended 30 June 2018. Warm Buttered Ltd makes a standard, one-size-fits-all hat. Item of expenditure Advertising Amortisation of franchise licence Depreciation—administrative equipment Depreciation—factory equipment Directors’ salaries Electricity—administration building Electricity—factory Factory supervisor’s salary Freight in of raw material Freight out of inventory Income tax expense Insurance—administration building Insurance—factory Purchase of materials used to make hats Purchase of office stationery and supplies Rates—administration building Rates—factory Rent—administration building Rent—factory Repairs and maintenance—administration building Repairs and maintenance—factory Salaries—administrative personnel Sales commissions Wages—factory personnel

$000 20 15 30 50 100 20 50 60 10 30 100 20 30 200 50 10 20 100 300 20 40 100 120 200 CHAPTER 7: INVENTORY  255

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OTHER INFORMATION • A total of 10 000 hats are made during the year. • There was no opening inventory at the beginning of the year. • Normal operating capacity is 10 000 hats.

REQUIRED Pursuant to AASB 102, what is the unit ‘cost’ of a hat? LO 7.2, 7.3, 7.6 19. Coolum Pty Ltd manufactures sunglasses that are sold to department stores, pharmacies, optical dispensers and optometrists. During the current year, Coolum Pty Ltd produced 60 000 pairs of sunglasses. Owing to increased competition and unseasonally wet weather affecting sales of sunglasses the company operated at only 60 per cent of its normal capacity. Other than costs associated with raw materials, variable costs are indicated by (V) and fixed costs are indicated by (F). Opening finished goods inventory (units) Opening finished goods inventory Closing finished goods inventory (units) Opening value of raw materials inventory Closing value of raw materials inventory Raw materials purchased Factory wages (V) Factory supervisor’s salary (F) Administration salaries (F) Cleaning of factory (V) Maintenance of factory equipment (V) Selling expenses (F) Depreciation of factory equipment (F) Rental of office equipment (F) Factory insurance (F) Freight outward (V) ($0.16 per unit sold) Sales price per unit

5 000 $40 000 15 000 $20 000 $10 000 $290 000 $90 000 $35 000 $80 000 $5 000 $25 000 $30 000 $65 000 $15 000 $50 000 $8 000 $12

Coolum Pty Ltd uses the first-in, first-out cost-flow method.

REQUIRED (a) Prepare a statement showing the cost of goods manufactured. (b) Prepare a statement of profit or loss and other comprehensive income extract showing the cost of goods sold and identifying those costs that are recognised as expenses in the current period. LO 7.2, 7.3 20. As at 30 June 2018, which is the end of the financial year, Rincon Ltd has 100 000 hats in inventory, all of the same type and size. The hats cost Rincon Ltd $4 each. At 30 June 2018, and because of a decrease in demand for hats, the sales price of the hats was assessed as being $2.50 each. There would be an average selling price of $0.30 per hat. Subsequently, in August 2018, and because of the drastic onset of global warming, there was an unexpected surge in the demand for hats such that each hat can be sold for $30. In August 2018 there were still 100 000 hats in inventory; however, it was expected that these would be sold within the following months.

REQUIRED You are required to provide the accounting entry that would be made in August 2018 to measure inventory at the lower of cost and net realisable value and which takes into account the information about the surge in demand for hats. LO 7.2, 7.3, 7.4 21. Billybang Pty Ltd imports surf shorts and sells them to department stores throughout Australia. At 1 July 2017 opening inventory comprised 10 units @ $22.00 each. Throughout the quarter ended 30 September 2017 the sales price of surf shorts was $30.00 and distribution costs were $0.50 per unit. Extracts from Billybang’s inventory record reveal the following transactions: 256  PART 3: ACCOUNTING FOR ASSETS

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Date

Purchases

31 July 2 Aug. 4 Aug. 31 Aug. 3 Sept. 10 Sept. 29 Sept.

20 units @ $20.00

Sales 5 units 16 units

15 units @ $18.00 12 units 10 units @ $21.00 11 units

REQUIRED (a) Calculate the cost of goods sold and ending inventory assuming that Billybang Pty Ltd uses the: • periodic inventory system with the weighted-average cost-flow method • periodic inventory system with the FIFO cost-flow method • periodic inventory system with the LIFO cost-flow method • perpetual inventory system with the weighted-average cost-flow method • perpetual inventory system with the FIFO cost-flow method • perpetual inventory system with the LIFO cost-flow method. (b) Explain why some entities might prefer a perpetual inventory system to a periodic inventory system. (c) In the US the LIFO cost-flow method has been permitted for a long time and some companies carry inventory at purchase costs that existed decades ago. Why do you think that such companies are typically reluctant to allow inventory to fall to levels that would mean using the longstanding LIFO layers? LO 7.2, 7.3, 7.5, 7.7 22. Strapper Ltd sells one type of surfboard. Its financial year ends on 30 June and it commenced the financial year with 50 surfboards that cost $450 each. Strapper Ltd uses the FIFO method and it had the following transactions throughout the financial year: (i) On 30 July it acquired 60 surfboards at $400 each. (ii) On 4 August it paid for the purchase on 30 July and received a discount of 2 per cent for early payment. (iii) On 28 August it sold 40 surfboards for $700 each; the sales were made for cash. (iv) On 23 September it acquired 30 surfboards for $420 each, less a trade discount of 4 per cent. (v) On 1 November it paid for the purchases made on 23 September. Because of the late payment Strapper Ltd was charged a penalty of 1 per cent. (vi) On 24 December Strapper Ltd sold 15 surfboards for $900 each. (vii) On 1 March Strapper Ltd purchased another 40 surfboards for $500 each. No trade discount was received. (viii) On 5 March the amount due for the 1 March purchase was paid and a 2 per cent discount was received for early payment. (ix) On 30 June it was assessed that there was a downturn in the demand for surfboards and as a result the net realisable value of the surfboards was assessed as being $350 each.

REQUIRED (a) Using the periodic system of accounting, provide the journal entries for the above transactions and determine the balance of cost of goods sold for the year and the value of closing inventory. (b) Using the perpetual system of accounting, provide the journal entries for the above transactions and determine the balance of cost of goods sold for the year and the value of closing inventory. LO 7.2, 7.5, 7.7

REFERENCES CUSHING, B.J. & LECLEARE, M.J., 1992, ‘Evidence on the Determinants of Inventory Accounting Policy Choice’, Accounting Review, April, pp. 355–67. HUNT, H.G., 1985, ‘Potential Determinants of Corporate Inventory Accounting Decisions’, Journal of Accounting Research, Autumn, pp. 448–67.

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CHAPTER 8

ACCOUNTING FOR INTANGIBLES LEARNING OBJECTIVES (LO) 8.1

Understand what types of assets can be considered intangible assets and understand the differences between intangible and tangible assets.

8.2

Understand when expenditure on intangible assets should be recognised as an asset.

8.3

Understand when expenditure on intangible assets must be expensed.

8.4

Understand how to measure an intangible asset and be aware of the required disclosures in relation to intangible assets.

8.5

Understand that intangible assets will need to either be systematically amortised or be the subject of impairment testing and that this choice will depend upon whether the asset is expected to have a limited useful life or an indefinite life.

8.6

Know when and how to revalue an intangible asset.

8.7

Understand how to account for research and development expenditure.

8.8

Be able to describe some empirical research that has been undertaken on corporate accounting practices relating to research and development.

8.9

Be able to define goodwill and explain how it is calculated for accounting purposes.

8.10 Be aware that the adoption of International Financial Reporting Standards (IFRSs) in Australia greatly reduced the amount of intangible assets that Australian entities are permitted to recognise on their statements of financial position. 8.11 Be able to evaluate whether the accounting standards pertaining to intangibles provide useful information for financial statement users.

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Introduction to accounting for intangible assets

LO 8.1 LO 8.2 LO 8.3

Intangible assets are generally defined as non-monetary assets without physical substance. Common forms of intangible assets include patents, goodwill, mastheads, brand names, copyrights, research and development and trademarks. From this definition we can see that the lack of physical substance does not preclude an item from being considered an asset. According to paragraph 54 of AASB 101 Presentation of Financial Statements, intangible assets, as a category, must be separately disclosed in a corporation’s statement of financial position. For example, the 2015 statement of financial position of Orica Ltd shows that within the Orica Group there was $1 633.2 million in intangible assets in 2015 (classified under non-current assets). Exhibit 8.1 provides the details about intangibles as shown at Note 8 to Orica Ltd’s 2015 consolidated financial statements. Have a look at the exhibit and see the types of assets that are disclosed in the financial statements as ‘intangible assets’. But as we will see in this chapter, many intangible assets will not be shown within the financial statements because of the restrictions placed on recognition within our accounting standards. Therefore, total intangible assets as reported by organisations will typically be considered to be understated relative to what the ‘true’ value of intangible assets might be.

NOTE 8. INTANGIBLE ASSETS Consolidated 2015

2014

Goodwill Less accumulated impairment losses

$m 2 471.4 (1 312.2)

$m 2 378.5     (477.3)

Total net carrying amount of goodwill

1 159.2

1 901.2

Patents, trademarks and rights Less accumulated amortisation

305.5       (68.1)

273.9       (66.2)

Total net carrying amount of patents, trademarks and rights

  237.4

  207.7

Software Less accumulated amortisation

281.7      (77.4)

223.8       (66.8)

Total net carrying amount of software

   204.3

       157.0

Customer contracts and relationships Less accumulated amortisation

95.6     (93.4)

279.2      (175.7)

Total net carrying amount of customer contracts and relationships

     2.2

  103.5

Other Less accumulated amortisation

41.1    (11.0)

35.9    (16.8)

Total net carrying amount of other

   30.1

   19.1

Total net carrying amount of intangibles

1 633.2

2 388.5

Exhibit 8.1 Intangible asset note provided in the 2015 Annual Report of Orica Ltd

SOURCE: Orica Ltd 2015 Annual Report

Intangible assets can have significant value. An organisation known as Interbrand (www.interbrand.com) provides details of the value of the world’s top 100 brand names. The top ten values attributed to various global brand names in 2014 were the following: Apple, US$118.86 billion; Google, US$107.44 billion; Coca-Cola, US$81.56 billion; IBM, US$72.24 billion; Microsoft, US$61.15 billion; General Electric, US$45.48 billion; Samsung, US$45.66 billion; Toyota, US$42.39 billion; McDonald’s, US$42.25 billion; and Mercedes Benz, US$34.34 billion. What we will also learn in this chapter is that while these brand names are obviously considered to have very high values, in situations where these names have been developed by the organisation itself (and not acquired), they cannot be recognised within the organisation’s financial statements. AASB 138 specifically excludes such recognition. Chapter 8: ACCOUNTING FOR INTANGIBLES  259

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identifiable intangible assets Include patents, trademarks, brand names and copyrights. Can be considered identifiable as a specific value can be placed on each asset, and they can be separately identified and sold.

unidentifiable intangible assets Intangible assets that cannot be separately sold, such as loyal customers and established reputation. Cannot be individually measured with acceptable levels of reliability.

goodwill Unidentifiable intangible assets representing the future economic benefits associated with an existing customer base, efficient management, reliable suppliers and the like.

Intangible assets are frequently classified either as identifiable or unidentifiable. Identifiable intangible assets include patents, trademarks, licences, research and development, brand names (as discussed above), mastheads and copyrights. In a sense, such intangibles can be considered identifiable because a specific value can be placed on each individual asset, and they can be separately identified and sold. Previously, within Australia identifiable intangible assets could be recognised for financial accounting purposes regardless of whether they had been acquired from an external party or developed internally. However, under the accounting standard on intangibles in place from 2005—AASB 138 Intangible Assets—amounts expended on internally generated intangibles must be expensed as incurred. Specifically, AASB 138 requires research expenditures and expenditures on internally generated brands, mastheads, publishing titles, customer lists and items similar in substance to be expensed as incurred regardless of whether they are likely to generate future economic benefits. Something is ‘internally generated’ if it has been developed within an organisation rather than being acquired at cost from an external party. Pre-2005 accounting practice within Australia saw many companies capitalising such expenditure even when the related asset had been internally developed. This is no longer permitted. Unidentifiable intangible assets, on the other hand, would be those intangible assets that cannot be separately sold. For example, an organisation might be particularly successful because of factors such as loyal customers, established reputation and good employees. Although they are valuable to the business, they cannot be individually measured with acceptable levels of reliability. Rather, we may treat them as a composite asset entitled goodwill. As we will see later in this chapter, the unidentifiable intangible asset known as ‘goodwill’ is permitted to be recognised for accounting purposes only when it has been externally acquired, not when it has been internally generated. As we will also see, this prohibition on recognising internally generated goodwill has proved very unpopular from the perspective of many reporting entities. The major accounting standard dealing with intangible assets is AASB 138 Intangible Assets. It defines an intangible asset as ‘an identifiable non-monetary asset without physical substance’. Hence, for the purposes of AASB 138, three conditions need to be established before we can contemplate recognising an item as an intangible asset. The item must be: • non-monetary • identifiable and • lack physical substance.

AASB 138 defines monetary assets as ‘money held and assets to be received in fixed or determinable amounts of money’. In requiring that an item be ‘identifiable’, AASB 138 distinguishes other intangible assets from goodwill. Goodwill is an unidentifiable asset that AASB 138 does not permit to be recognised (bear in mind, however, that AASB 3 Business Combinations does allow goodwill to be recognised subject to certain conditions). In relation to the requirement that an item be identifiable before it is recognised as an intangible asset, paragraph 12 of AASB 138 states: An asset is identifiable if it either: (a) is separable, i.e. is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so; or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. The ‘Basis for Conclusions’ to IAS 38 Intangible Assets, paragraph 8, states: In revising IAS 38 and developing IFRS 3, the Board affirmed the view in the previous version of IAS 38 that identifiability is the characteristic that conceptually distinguishes other intangible assets from goodwill. The Board concluded that to provide a definitive basis for identifying and recognising intangible assets separately from goodwill, the concept of identifiability needed to be articulated more clearly. 260  PART 3: ACCOUNTING FOR ASSETS

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As a ‘side issue’, Basis for Conclusions—such as that relating to IAS 38—are available on the AASB’s website and summarise the International Accounting Standards Board’s considerations in reaching the conclusions in various standards—in this case, IAS 38 Intangible Assets. In recent decades the total recorded amount of assets shown by companies is being based increasingly on their intangible assets, rather than on their tangible assets. Hence issues associated with the valuation of intangible assets are tending to become more important across time. As Moodie (2000, p. 42) states: What makes the current market so radically different is that in the old mining boom days, investors were at least placing bets on a tangible asset—an unexplored ore body. But the new breed of cyber-investors are placing their bets fairly and squarely on an intangible asset—a company’s intellectual capital. With greater value being attributed to intangible assets, there is a consequent need for sound financial information about such assets. As we have indicated, accounting standards require expenditure on many intangible assets to be expensed, with the result that many valuable intangible assets will not appear in statements of financial position (balance sheets). This can be contrasted with the previous Australian accounting requirements that permitted many internally generated intangibles to be shown in the statement of financial position. This reduction in information means that financial statement readers will not be able to know about certain intangible assets—for example, about the value of copyrights or brand names—because the related expenditure to develop the ‘assets’ internally has to be expensed (written off) as incurred. This is despite the fact that such ‘assets’ will in many cases be expected to generate future economic benefits. It is questionable whether an accounting rule that requires all internally generated intangibles (with the exception of development expenditure) to be written off, even when there is an expectation that future economic benefits will be derived, will provide information that is useful to financial statement users. Certainly this approach is much more restrictive (or ‘conservative’) than the pre-2005 situation in Australia, which allowed many internally generated intangible assets to be shown in statements of financial position. As with the majority of other assets, intangible assets, whether identifiable or unidentifiable, typically have a limited life. Those that are not considered to have a limited life are deemed to have an indefinite life. Pursuant to AASB 138, the assessment of whether an intangible asset has a limited life or an indefinite life affects in turn how we amortise the asset in subsequent years (as we explain in what follows).

Which intangible assets can be recognised and included in the statement of financial position?

LO 8.1 LO 8.2

As indicated above, and pursuant to AASB 138 Intangible Assets, many internally generated intangible assets are specifically precluded from being carried forward as assets, regardless of the future economic benefits that might be expected to be generated. For example, paragraph 54 of AASB 138 states 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. Further, paragraph 63 states: Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets. Other intangible assets may be recognised only where there is an associated ‘cost’. This cost is to include the purchase price (including taxes, legal fees and deducting discounts provided) and the costs associated with getting the asset ready for its use (which could include employee costs associated with work undertaken to get the asset ready for use). Initial recognition of an intangible asset at an amount other than cost is not permitted. As we will see, there is also a general prohibition on revaluing intangible assets that were not initially recognised at cost. That is, unrecognised intangibles cannot subsequently be recognised through revaluation. However, such recognition was possible in Australia prior to the adoption of IFRSs in 2005. Pursuant to AASB 138, intangible assets (other than goodwill, which is also addressed in AASB 3) are required to be separable (which, as we saw earlier, is one of the attributes associated with an item being deemed to be ‘identifiable’) if they are to be recognised as assets for statement of financial position purposes. ‘Separable’ means that the organisation could rent, sell, exchange or distribute the specific future economic benefits attributable to the asset without also disposing of future economic benefits that flow from other assets used in the same revenue-earning activity. The implication of this is that intangible assets such as the formation or start-up costs of an organisation can no longer be shown as an asset. Chapter 8: ACCOUNTING FOR INTANGIBLES  261

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Consistent with the recognition of assets generally, an intangible asset must be recognised when it is probable that the future economic benefits that are attributable to the asset will flow to the entity and the cost of the asset can be measured reliably. There is also an imperative that the entity has control over the future economic benefits that are expected to flow from the asset.

LO 8.4

What is the initial basis of measurement of intangible assets?

Expenditure on many internally generated intangibles does not qualify for deferral (that is, for inclusion as an asset) and therefore must be treated as an expense. In this regard, and as noted above, paragraph 63 of AASB 138 specifically excludes the recognition of a number of internally generated intangible assets. If 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. Once an intangible asset has been acquired and made ready for use, any subsequent expenditure is to be recognised as an expense unless both of the following conditions are met: 1. It is probable that the expenditure will increase the future economic benefits embodied in the asset in excess of the standard of performance assessed immediately before the expenditure was made. 2. The expenditure can be measured and attributed reliably to the asset. As indicated above, intangible assets can also be acquired as part of a business combination. AASB 3 Business Combinations defines a business combination as follows: A transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as ‘true mergers’ or ‘mergers of equals’ are also business combinations as that term is used in this Standard. For example, one company may acquire all the shares of another company and then consolidate all the assets and liabilities of the acquired company with those assets and liabilities that it held prior to the acquisition. 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 various assets—including identifiable intangible 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 at the acquisition date about the probability that the 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. 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 combinations’. This seems to be a simplistic assumption and not in accord with the asset recognition criteria in the Conceptual Framework for Financial Reporting, which require consideration to be given to the probability of future economic benefits being generated. In the Basis for Conclusions that was released with IAS 38, the IASB acknowledged the conflict. It stated at paragraph 18 of ‘Basis for Conclusions to IAS 38’ that: The Board observed that this highlights a general inconsistency between the recognition criteria for assets and liabilities in the Framework (which states that an item meeting the definition of an element should be recognised 262  PART 3: ACCOUNTING FOR ASSETS

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only if it is probable that any future economic benefits associated with the item will flow to or from the entity, and the item can be measured reliably) and the fair value measurements required in, for example, a business combination. However, the Board concluded that the role of probability as a criterion for recognition in the Framework should be considered more generally as part of a forthcoming Concepts project. So this apparent inconsistency will be addressed in future work. For our purposes, however, 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. Again, 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 are not to recognise the list as an asset, but if their organisation is acquired, the list of titles may in fact be recognised by the acquiring party. 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 (unrecognised) assets may be recognised by the acquirer. On why internally developed intangible assets cannot be recognised within 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. AASB 138 also requires that when some expenditure related to an intangible asset has been recognised as an expense in a previous financial period, the subsequent recognition of this expenditure as part of the cost of an intangible asset is prohibited. As paragraph 71 of AASB 138 states: Expenditure on an intangible item that was initially recognised as an expense shall not be recognised as part of the cost of an intangible asset at a later date. Here again, we can question the logic that if expenditure incurred on an intangible asset is initially expensed, then it cannot be recognised at a subsequent date. This requirement is not consistent with the conceptual framework, which prescribes that if information subsequently comes to light to suggest that future economic benefits that were previously in doubt are deemed to be probable, an asset should be reinstated. Worked Example 8.1 provides an example of when to carry forward expenditure on intangible assets and Worked Example 8.2 provides an example of a situation where some intangible assets are measured at cost and others at fair value.

WORKED EXAMPLE 8.1: Capitalising expenditure on intangible assets During the financial year Point Leo Ltd made the following expenditures:

(a) Point Leo Ltd spent $250 000 promoting the recognition of its brand name (b) Point Leo Ltd acquired a patent (a right to produce a certain product) for a cost of $400 000 and (c) Point Leo Ltd spent $90 000 acquiring a customer database but after further consideration is not sure that the list will provide very many new customers.

REQUIRED In relation to the above expenditures, which items will be carried forward to future periods as intangible assets? continued Chapter 8: ACCOUNTING FOR INTANGIBLES  263

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SOLUTION Point Leo Ltd is permitted to carry forward expenditure on intangible assets (that is, capitalise expenditure on intangible assets) only where such expenditure represents the acquisition of intangible assets, and where associated economic benefits are deemed to be ‘probable’. Many internally generated intangibles (such as expenditures relating to research, internally generated brands, mastheads, publishing titles, customer lists and items similar in substance) are not to be recognised as intangible assets. Therefore, the only expenditure that would be carried forward as an intangible asset would relate to the patent—and only to the extent that the amount is considered to be recoverable from future operations. The expenditure on the brand name would be expensed as it related to an expenditure that is specifically precluded from asset recognition by virtue of paragraph 63 of AASB 138. The expenditure on the customer list would be expensed because the associated economic benefits would not be considered to be ‘probable’.

WORKED EXAMPLE 8.2: The recognition of some intangible assets at cost and others at fair value During the financial year Pines Ltd made the following expenditures:

(a) It acquired a patent at a cost of $300 000. Shortly after the acquisition, Pines was offered $800 000 for the patent. (b) It acquired another business called Dromana Ltd for a cost of $1 000 000 and will combine that business with its own. At the date of acquisition, Dromana Ltd had $100 000 in liabilities and assets with a fair value of $1 100 000. The assets acquired as part of the acquisition were recorded in Dromana’s accounts at cost, but had the following fair values:

Land (cost) Customer lists (internally generated) Publishing titles (acquired)

Carrying amount in Dromana Ltd’s financial statements $400 000 Nil $50 000

Fair value

$800 000 $100 000 $200 000

REQUIRED You are required to determine the amount at which the assets acquired by Pines Ltd will be shown within Pines Ltd’s financial statements. SOLUTION (a) The patent acquired at a cost of $300 000 will be shown at cost. The fact that it might have a fair value of $800 000, or more, is not relevant. The general principal is that acquired intangible assets shall be recorded at cost. As we will see shortly, there is major restriction on the revaluation of intangible assets. Some intangible assets are permitted to be revalued, but only where there is an ‘active market’ for such assets (b) However, if intangible assets are acquired as part of a business combination then the intangible assets, as well as the tangible assets, shall be recorded at fair value. Therefore, Pines Ltd shall recognise land at $800 000, customer lists at $100 000 and publishing titles at $200 000.

LO 8.5 LO 8.10

General amortisation requirements for intangible assets

Intangible assets (other than goodwill) that are considered to have a limited useful life are required to be amortised over their useful lives (we will consider goodwill in more depth in due course). The useful life of an intangible asset is defined at paragraph 8 of AASB 138 as: the period of time over which the asset is expected to be used by the entity, or the number of production or similar units expected to be obtained from the asset by the entity. 264  PART 3: ACCOUNTING FOR ASSETS

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Amortisation methods based on time would be applied to intangible assets whose lives are limited by time. For example, if an intangible asset is acquired that has a life of 10 years (perhaps stipulated by a contract), the asset could be amortised over 10 years on a straight-line basis. Alternatively, if an intangible asset’s life is limited to the production of a certain number of units of product, amortisation on a production basis would be appropriate. For example, if an intangible asset is acquired that allows an expected production of 10 000 units and if 2200 units are produced in the first year, 22 per cent of the asset would be amortised. Where the pattern of benefits is uncertain, the straight-line method is required to be used. As paragraph 97 of AASB 138 states: The depreciable amount of an intangible asset with a finite useful life shall be allocated on a systematic basis over its useful life. Amortisation shall begin when the asset is available for use, that is, when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. Amortisation shall cease at the earlier of the date that the asset is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with AASB 5 and the date that the asset is derecognised. The amortisation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. If that pattern cannot be determined reliably, the straight-line method shall be used. The amortisation charge for each period shall be recognised in profit or loss unless this or another Standard permits or requires it to be included in the carrying amount of another asset. In determining the amortisation charge of an asset we generally need to consider what the residual value of the asset is expected to be. The total sum of amortisation charges pertaining to an asset will equal the cost (or revalued amount where a revaluation is permitted) less the expected residual. Pursuant to AASB 138, the residual value of intangible assets with finite lives is generally considered to be zero. Under the accounting standard, the residual value of an intangible asset with a finite useful life is to be assumed to be zero unless: • there is a commitment by a third party to purchase the asset at the end of its useful life; or • there is an active market for the asset, and the residual amount can be determined by reference to that market, and it is probable that the market will still exist at the end of the useful life of the asset. In many cases these conditions will not be met, with the result that no residual value will be recognised. AASB 138 requires the useful life, residual value and the amortisation method and period to be reviewed annually. In some circumstances an intangible asset may be considered to have an indefinite useful life. The accounting standard defines an indefinite useful life as occurring where: ‘There is no foreseeable limit on the period over which the asset is expected to generate cash flows’. Where an asset is considered to have an indefinite life there is no requirement to amortise the asset. Specifically, paragraph 107 states: ‘an intangible asset with an indefinite useful life shall not be amortised’. An indefinite life does not mean the same thing as an infinite life—an infinite life would imply that the asset was expected to last forever. As paragraph 91 states: The term ‘indefinite’ does not mean ‘infinite’. The useful life of an intangible asset reflects only that level of future maintenance expenditure required to maintain the asset at its standard of performance assessed at the time of estimating the asset’s useful life, and the entity’s ability and intention to reach such a level. A conclusion that the useful life of an intangible asset is indefinite should not depend on planned future expenditure in excess of that required to maintain the asset at that standard of performance. Although there is no requirement to amortise intangible assets that are considered to have an indefinite life, such assets are required to be subject to impairment testing at the end of each reporting period. If there is deemed to be an impairment in the value of the asset (its recoverable amount is less than its carrying amount), this amount of impairment is shown as an expense. AASB 138 requires the assumption that the asset has an indefinite life to be reviewed annually. Further, the entity has to disclose the reasons supporting its view that the asset has an indefinite life. Amortisation charges must be expensed unless another standard requires the amount to be included in the carrying amount of another asset. For example, and as paragraph 99 of AASB 138 explains, the cost of amortisation of an intangible asset might be included in the cost of inventory and therefore not be recognised as an expense until the item is ultimately sold (in which case the expense would be included within the cost of goods sold). Chapter 8: ACCOUNTING FOR INTANGIBLES  265

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Amortisation is to start when the intangible asset is ready for use. Worked Example 8.3 illustrates how to arrive at the amortisation expense for intangible assets.

WORKED EXAMPLE 8.3: Determining amortisation expense During the year ending 30 June 2018, Shoreham Ltd acquired the following intangible assets:

(a) A patent at a cost of $500 000. This patent allows the production of 200 000 units. During the year ended 30 June 2018, Shoreham Ltd produced 40 000 units. (b) The right to use the trade name ‘Coca Cooler’ in the local district for a cost of $700 000. Coca Cooler is a highly recognised brand of soft drink that has been popular for more than 50 years and is expected to be popular indefinitely. As at 30 June 2018, it is considered that Shoreham Ltd would easily be able to obtain $700 000 if it wanted to dispose of the trade name.

REQUIRED Determine the amortisation expense for Shoreham Ltd for the year ended 30 June 2018. SOLUTION The patent would be amortised on the basis of the amount of production as it appears that production units rather than time is the factor that determines the useful life of the asset. Therefore, amortisation for the year for the patent would be 20 per cent (that is, 40 divided by 200) multiplied by $500 000, which equals $100 000. The trade name is considered to have an indefinite useful life and would therefore be subject to annual impairment testing. As the value of the trade name has not been impaired, no impairment expense would be recognised.

Prior to Australia’s 2005 adoption of IFRSs, the Australian Securities and Investments Commission (ASIC) had been particularly critical of organisations that failed to amortise their identifiable intangible assets. It had, on a number of occasions, rejected the view that intangibles can have indefinite lives. Corporate executives in Australia had in turn been critical of ASIC’s stance and to some extent the concerns of many corporate managers have been addressed as a result of the adoption of IFRSs. That is, we now have a specific accounting standard for intangibles, and an acceptance (contrary to ASIC’s previous view) that intangible assets can have an indefinite life and therefore might not be required to be amortised (although there would still need to be an assessment of whether their value has been impaired during the financial period). While corporate managers were pleased with these developments, it is far from certain that they were pleased with the general requirement that many internally developed intangibles not be allowed to be recognised for statement of financial position purposes (meaning that the related expenditure would be expensed). The adapted article in Financial Accounting in the Real World 8.1 provides an insight into the concern this requirement caused among some Australian corporate managers back when the accounting standard was initially being introduced to Australia.

8.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Companies object to proposed new accounting standards The prospect of the Australian Accounting Standards Board adopting the International Accounting Standards Board rules around intangible assets and business combinations is causing corporate angst. Objectors include a range of companies, from Epic Energy to Wesfarmers and Ernst & Young. The proposals are expected to affect loan agreements, tax liability and the payment of dividends. Companies will have to expense the costs of restructuring, including post-merger restructuring costs like redundancies. They will have to reverse revaluations of intangible assets like customer lists, brands and mastheads, which will cause write down of assets. Brian Long, chairman of Ernst & Young, says implementation of the new rules will cause corporate hardship.

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Even the positive step of removing the systematic amortisation of goodwill and its replacement by an impairment standard with annual assessment, has not pleased the critics. Epic Energy believes the new rules mean Australian companies won’t be able to compete internationally and make foreign takeovers more likely. Wesfarmers expressed disquiet about rules relating to disclosure. SOURCE: Adapted from ‘‘Big flaws’ in accounting changes’, by Fiona Buffini, The Australian Financial Review, 9 April 2003, p. 4

Revaluation of intangible assets

LO 8.6

We addressed the general principles associated with revaluations in Chapter 6. The requirements of AASB 138 state that intangibles may be revalued only if there is an ‘active market’. Therefore, most intangible assets will not be able to be revalued as there is no active market for them given that most intangible assets are unique in nature. An active market can be considered to be a market exhibiting all of the following: the items traded are homogeneous; willing buyers and sellers can normally be found; and prices are publicly available. Further, the fact that only assets that have been acquired at a cost can subsequently be revalued places a prohibition on the revaluation of many internally generated intangible assets. The requirement that an ‘active market’ must exist before intangibles can be revalued is something that was, and continues to be, opposed by Australian industry. Where a revaluation occurs, it is to be to the fair value of the asset. Consistent with other standards, fair value is defined within the accounting standard consistent with the definition provided in AASB 13 Fair Value Measurement. AASB 13 defines fair value as: ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly sale between market participants at the measurement date’. Because of the unique nature of many intangible assets, in most cases an ‘active market’ will not exist. As paragraph 78 of AASB 138 states: It is uncommon for an active market to exist for an intangible asset, although this may happen. For example, in some jurisdictions, an active market may exist for freely transferable taxi licences, fishing licences or production quotas. However, an active market cannot exist for brands, newspaper mastheads, music and film publishing rights, patents or trademarks, because each such asset is unique. Also, although intangible assets are bought and sold, contracts are negotiated between individual buyers and sellers, and transactions are relatively infrequent. For these reasons, the price paid for one asset may not provide sufficient evidence of the fair value of another. Moreover, prices are often not available to the public. The accounting standard requires revaluations to be done regularly so that the recorded value does not differ materially from fair value at the end of the reporting period. Subsequent to revaluation, any amortisation charges are to be based on the revalued amount of the intangible asset after taking into account the remaining useful life. Where revaluations are undertaken, they are to be done the same way as for property plant and equipment, as explained in Chapter 6. That is, where there is a revaluation increment, the increase is credited to a revaluation surplus account (and the amount is shown as part of ‘other comprehensive income’), except where it reverses a previous revaluation decrement, in which case the revaluation increment would be recognised as income and be included in profit or loss. Where there is a revaluation decrement, the decrement will be recognised as an expense (and included in profit or loss) unless there has been a previous revaluation increment, in which case the decrement would be debited to the revaluation surplus (with this also representing a deduction to ‘other comprehensive income’). Where there has been a revaluation increment to an asset, and that asset is subsequently sold, the relevant balance in the revaluation surplus may be transferred to retained earnings. Alternatively, the balance in the revaluation surplus may be transferred to retained earnings throughout the life of the asset in proportion to the amortisation of the asset. As paragraph 87 of AASB 138 states: The cumulative revaluation surplus included in equity may be transferred directly to retained earnings when the surplus is realised. The whole surplus may be realised on the retirement or disposal of the asset. However, some of the surplus may be realised as the asset is used by the entity; in such a case, the amount of the surplus realised is the difference between amortisation based on the revalued carrying amount of the asset and amortisation that would have been recognised based on the asset’s historical cost. The transfer from revaluation surplus to retained earnings is not made through profit or loss. Chapter 8: ACCOUNTING FOR INTANGIBLES  267

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Revaluations of goodwill are not permitted in Australia, whether internally generated or externally acquired. Worked Example 8.4 provides some insight into how to approach revaluing intangible assets.

WORKED EXAMPLE 8.4: Revaluation of intangible assets Ocean Grove Ltd wants your advice on which of the following intangible assets may be revalued and, if a revaluation can be done, what the accounting entry would be.



(a) The company has developed its brand name to the point where it is a very valuable asset. It would appear that if it were to sell the brand name it would receive at least $2 million for it. (b) The company acquired a patent two years previously for $1 million. The associated production process is quite specialised; however, there is one other manufacturer who has the necessary knowledge to utilise the patent. That other manufacturer would probably be prepared to pay at least $1.5 million for the patent. (c) The company acquired a franchise—McDingbat Hamburgers—for $500 000. There is great demand for this franchise as evidenced by the ‘wanted’ advertisements placed in a number of franchise journals. The current market price for such a franchise is $670 000.

SOLUTION AASB 138 requires that intangible assets may be revalued, but only where there is an active market. As the expenditure on the brand name would be expensed by virtue of paragraph 63 of AASB 138, and is not permitted to be recognised as an asset because it was internally generated, then no revaluation is permitted. In relation to the patent, as there is an absence of an active market, a revaluation is prohibited. In relation to the franchise, the intangible asset was acquired from an external party and there is an active market. Hence the only intangible asset that is permitted to be revalued would be the franchise. The accounting entry—ignoring taxation effects—would be: Dr Cr

LO 8.3

McDingbat franchise Revaluation surplus

170 000 170 000

Gain or loss on disposal of intangible assets

According to paragraph 113 of AASB 138, the gain or loss on the disposal of intangible assets will be determined as the difference between the net proceeds from the disposal, if any, and the carrying amount of the asset. The carrying amount of the asset is defined in the accounting standard as: ‘The amount at which an asset is recognised in the statement of financial position after deducting any accumulated amortisation and accumulated impairment losses therefrom’. This determination of the gain or loss is consistent with how the gain or loss on the sale of tangible assets, such as property, plant and equipment, would be determined (as explained in Chapter 6).

LO 8.4

Required disclosures in relation to intangible assets

AASB 138 contains numerous disclosure requirements. Among them is a requirement for the financial statements to disclose the following for each class of intangible assets, distinguishing between internally generated intangible assets and other intangible assets (paragraph 118): (a) whether the useful lives are indefinite or finite and, if finite, the useful lives or the amortisation rates used; (b) the amortisation methods used for intangible assets with finite useful lives; (c) the gross carrying amount and any accumulated amortisation (aggregated with accumulated impairment losses) at the beginning and end of the period; (d) the line item(s) of the statement of comprehensive income in which any amortisation of intangible assets is included; (e) 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; 268  PART 3: ACCOUNTING FOR ASSETS

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(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. As noted above, the above disclosure requirements are to be made for each class of intangible asset. Examples of different classes of intangible assets include: • brand names • mastheads and publishing titles • computer software • licences and franchises • copyrights, patents and other industrial property rights, service and operating rights • recipes, formulas, models, designs and prototypes • intangible assets under development. Paragraph 122 of AASB 138 also requires the financial statements to disclose: (a) if an intangible asset is assessed as having an indefinite useful life, the carrying amount of that asset and the reasons supporting the assessment of an indefinite useful life. In giving these reasons, the entity shall describe the factor(s) that played a significant role in determining that it has an indefinite useful life; (b) a description, the carrying amount and remaining amortisation period of any individual intangible asset that is material to the financial statements; (c) for intangible assets acquired by way of a government grant and initially recognised at fair value: (i) the fair value initially recognised for these assets; (ii) their carrying amount; and (iii) whether they are measured after recognition under the cost model or the revaluation model; (d) the existence and carrying amounts of intangible assets whose title is restricted and the research and carrying amounts of intangible assets pledged as security for liabilities; and development (e) the amount of contractual commitments for the acquisition of intangible assets. The standard also requires a number of disclosures in relation to research and development expenditure. Although we will consider research and development more fully in the next section of this chapter, it should be appreciated at this stage that the accounting standard contains disclosure requirements that are specific to research and development. For example, the financial statements are required to disclose the aggregate amount of research and development expenditure recognised as an expense during the period. Having discussed intangible assets generally, we will now specifically examine two types of intangible assets. First we will discuss research and development, and then accounting for goodwill.

Research and development

Research is original investigation, while development is defined as activities undertaken with specific commercial objectives, and involves the translation of research knowledge into designs for new products.

LO 8.4 LO 8.7 LO 8.8 LO 8.10

AASB 138 Intangible Assets applies to intangible assets generally (as discussed in this chapter), although there are a number of paragraphs that relate specifically to research and development. Research and development expenditures might account for a large proportion of the total expenditures of many entities. The accounting problem is one of determining whether the expenditure will, with reasonable probability, provide future economic benefits. At times there would be a high degree of uncertainty about whether expenditure incurred on research and development would ultimately generate future economic benefits.

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Accounting Standard AASB 138 makes a simplifying assumption—it requires the immediate expensing of all expenditure undertaken on the research component of research and development. Research is required to be considered separately from development. Research generally precedes development and is defined in AASB 138 as: original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development, which generally follows research, is defined in paragraph 8 of AASB 138 as: the 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 prior to the commencement of commercial production or use. Hence, development typically involves the commercial application of ‘knowledge’ generated in earlier research phases. The accounting standard provides a number of examples of development activities. These include: (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 or systems. The tests for deferral of research and development changed considerably in Australia when we adopted IFRSs. Since 2005, AASB 138 has required that research expenditure must be written off as incurred, whereas development expenditure may be capitalised to the extent that certain conditions are satisfied (these are described below). In relation to research expenditures, paragraph 54 of AASB 138 states: 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. The expensing of research is justified by the fact that it is undertaken in the early stages of developing a new product or process and that the likelihood of it being possible to link the expenditure with future economic benefits is deemed to be uncertain. Specifically, paragraph 55 of AASB 138 states: In the research phase of an internal project, an entity cannot demonstrate that an intangible asset exists that will generate probable future economic benefits. Therefore, this expenditure is recognised as an expense when it is incurred. As we progress towards the subsequent stage (development), this uncertainty is deemed to reduce to levels that are acceptable for the purpose of asset recognition (at least in the minds of those responsible for developing the accounting standard). Paragraph 57 of AASB 138 requires that expenditure on development may be deferred (capitalised) and recognised as an asset only if the entity can demonstrate all of the following: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale; (b) its intention to complete the intangible asset, and use or sell it; (c) its ability to use or sell the intangible asset; (d) how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset, or the intangible asset itself, or if it is to be used internally, the usefulness of the intangible asset; and (e) the availability of adequate technical, financial and other resources to complete the development and use or sell the intangible asset; and (f) its ability to measure reliably the expenditure attributable to the intangible asset during its development. 270  PART 3: ACCOUNTING FOR ASSETS

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The test for deferral is the same that applies to other intangible assets. Specifically, paragraph 21 of AASB 138 requires that: An intangible asset should be recognised if, and only if: (a) it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and (b) the cost of the asset can be measured reliably. This is consistent with the asset recognition criteria provided within the Conceptual Framework for Financial Reporting (although, as mentioned elsewhere in this book, changes have been proposed to the definition and recognition criteria for assets and liabilities—see in particular Chapter 2). Hence, the test for deferral of development costs relies upon assessing that the benefits are ‘probable’ (which means the generation of benefits is more likely than less likely). Where the total of the deferred development costs carried forward exceeds the expected recoverable amount, the deferred costs must be written down to the recoverable amount. This would be referred to as an impairment loss. An example of accounting for research and development expenditure is given in Worked Example 8.5.

WORKED EXAMPLE 8.5: Accounting for research and development Portsea Ltd is developing a new product called a burble. The company spent $300 000 researching the demand for the burble. It then spent $250 000 working out whether the compounds out of which the burble is made will biodegrade in less than 50 years. As a result of the knowledge gained in the preceding steps, the company designed machinery to produce the burbles. This design phase cost $600 000. It is expected that millions of burbles will be sold for at least $10 each. All the expenditure was incurred within the one reporting period. REQUIRED How much of the above expenditure would qualify to be shown as an intangible asset? SOLUTION The accounting standard requires the expensing of all research expenditure. The first two expenditures above would be considered to constitute research and therefore $550 000 would be expensed as incurred. The funds spent designing the machinery would be considered to constitute development. Hence to the extent that the future economic benefits are measurable with reasonable accuracy and are probable, $600 000 would be recognised in the statement of financial position. This amount would be subject to future amortisation charges unless it could be justified that the life of the asset was indefinite.

The requirement that all research must be written off as incurred does mean that much research activity that does in fact lead to subsequent economic benefits will nevertheless be required to be expensed. This has major implications for the reported profits of organisations that are heavily involved in research and development. While the requirement to write off all research as incurred does appear relatively ‘harsh’ (or conservative), this treatment is not as harsh as the treatment required in the USA (IFRSs are not used in the USA), where all research and development expenditure must be expensed as incurred regardless of whether or not it generates, or is expected to generate, economic benefits. This US position is extremely conservative. At least in Australia, and other countries that have adopted IFRSs, we can capitalise development expenditure. However, even though we are permitted to capitalise development expenditure, some organisations nevertheless choose to expense their development expenditure as well as their research expenditure. For example, Cochlear Ltd—an Australian organisation that has developed a number of significant medical-related devices including the cochlear hearing implant—appears to expense all of its research and development as it occurs. For example, in 2015 Cochlear Ltd expensed all of its $127 985 000 investment in research and development. This has obvious implications for lowering reported profits, but it does tend to mean that subsequent measures, such as return on assets, will tend to be higher (subsequent profits will, in part, be generated by assets that have been written off). Chapter 8: ACCOUNTING FOR INTANGIBLES  271

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Costs included as part of research and development In relation to the costs that would be included in research and development, AASB 138 provides general guidance. It notes at paragraph 66 that the costs of internally generated intangible assets (a great deal of research and development would be internally generated) would comprise all directly attributable costs necessary to create, produce and prepare the asset to be capable of operating in the manner intended by management. Examples of directly attributable costs are: (a) costs of materials and services used or consumed in generating the intangible asset; (b) costs of employee benefits (as defined in AASB 119 Employee Benefits) arising from generation of the intangible asset; (c) fees to register a legal right; and (d) amortisation of patents and rights that are used to generate the intangible asset.

Amortisation of deferred development costs AASB 138 provides a number of requirements for the amortisation of intangibles. These requirements therefore also apply to any development expenditure that has been capitalised and deferred to future periods. Paragraph 97 applies to intangible assets that are deemed to have a finite useful life. We discussed paragraph 97 earlier in this chapter. Amortisation, which is to commence when the asset is available for use, might be based on output levels, or upon the expiration of time—whichever is the more appropriate. In relation to assessing the useful life of an intangible asset, paragraph 90 of AASB 138 provides some useful guidance: Many factors need to be considered in determining the useful life of an intangible asset, including: (a) the expected usage of the asset by the entity and whether the asset could be managed efficiently by another management team; (b) typical product life cycles for the asset and public information on estimates of useful lives of similar types of assets that are used in a similar way; (c) technical, technological, commercial, or other types of obsolescence; (d) the stability of the industry in which the asset operates and changes in the market demand for the products or services output from the asset; (e) expected actions by competitors or potential competitors; (f) the level of maintenance expenditure required to obtain the expected future economic benefits from the asset and the entity’s ability and intent to reach such a level; (g) the period of control over the asset and legal or similar limits on the use of the asset, such as the expiry dates of related leases; and (h) whether the useful life of the asset is dependent on the useful life of other assets of the entity. The amortisation period and the amortisation method are also required to be reviewed regularly. Paragraph 104 of AASB 138 states: The amortisation period and the amortisation method for an intangible asset with a finite useful life shall be reviewed at least at the end of each annual reporting period. If the expected useful life of the asset is different from previous estimates, the amortisation period shall be changed accordingly. If there has been a change in the expected pattern of consumption of the future economic benefits embodied in the asset, the amortisation method shall be changed to reflect the changed pattern. Such changes shall be accounted for as changes in accounting estimates in accordance with AASB 108. As with all intangible assets, and as noted above, amortisation is to start when the intangible asset is ready for use. Where an intangible asset is considered to have an indefinite life, the accounting standard requires that the asset not be amortised. However, the entity is required to compare the recoverable amount of the asset with its carrying amount and, if the value has been impaired below its carrying amount, recognise an expense. The accounting standard further requires that the assumption that an asset has an indefinite life be reviewed regularly. An example of the amortisation of deferred development costs is given in Worked Example 8.6. 272  PART 3: ACCOUNTING FOR ASSETS

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WORKED EXAMPLE 8.6: Amortisation of deferred development costs Streaky Bay Ltd is involved in research and development. For the year ended 30 June 2018, research and development on Project X is incurred as follows: Research Development

$185 000 $300 000

Project X is expected to return profits of $250 000 over the next four years (with about $62 500 expected to be recognised each year), starting from 1 July 2018. Streaky Bay Limited uses a discount rate of 8 per cent. REQUIRED (a) How much research and development should be expensed in the year to 30 June 2018? (b) How much research and development should be amortised in the year to 30 June 2019? SOLUTION (a) As noted above, AASB 138 requires that research be written off as incurred. The balance of the development expenditure should be carried forward only to the extent that it is expected to be recouped from future operations. $ Research Development Amount expected to be recouped Research and development expensed in 2018

$ 185 000

300 000 (207 006)

92 994 277 994

The aggregated accounting entry for the 2018 therefore would effectively be: Dr Dr Dr Cr

Research expenditure expense Development expenditure expense Development asset Cash, payables, accumulated depreciation, etc.

185 000 92 994 207 006 485 000

Of relevance to this worked example is paragraph 60 of AASB 138. It states: To demonstrate how an intangible asset will generate probable future economic benefits, an entity assesses the future economic benefits to be received from the asset using the principles in AASB 136 Impairment of Assets.



Therefore, to answer this question we need to consider the contents of AASB 136. As was detailed in Chapter 6, the recoverable amount of an asset is defined in paragraph 6 of AASB 136 as the ‘higher of its fair value less costs of disposal and its value in use’. Fair value less costs of disposal is the amount that can be obtained from the sale of an asset in an arm’s length transaction between knowledgeable, willing parties, less the costs of disposal. The ‘value in use’ is the present value of the future cash flows that the entity expects to derive from the asset. The present value of future cash flows needs to be determined using an appropriate discount rate. In this example, the amount expected to be recouped from future operations— which is the recoverable amount—is the present value of future cash flows expected to be derived from the asset. Relying upon the present value table provided in Appendix B, the amount expected to be recouped is $62 500 × 3.3121 = $207 006. (b) As development has a limited life when considered as an asset, it should be amortised over its useful life, with the amortisation commencing from when it is ready to use. Where the present value of the expected cash flows (value in use used to determine recoverable amount) is expected to exceed the carrying amount (cost) of the development expenditure, then it is usual to amortise the development asset on a straight-line continued Chapter 8: ACCOUNTING FOR INTANGIBLES  273

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basis over the life of the asset. However, in this case, the amount capitalised for the development asset is the recoverable amount (present value of the expected future cash flows, which was lower than the cost) and therefore the recoverable amount will be reassessed at the end of the reporting period. The present value of the remaining three-year stream of returns is: $62  500 × 2.57114 = $160 694

The amount of amortisation therefore is:

$207  006 - $160 694 = $46 312

The accounting entry is:

Dr Cr

Development amortisation expense Accumulated amortisation—development asset

46 312 46 312

Empirical research on accounting for research and development As stated previously, in the United States research and development expenditure typically must be expensed as incurred. The position adopted by the FASB is a most conservative position and one that does not enable differentiation between entities that have valuable research and development projects and those that do not. However, in comparison with the Australian treatment, which allows the carrying forward of development expenditure (to the extent that certain tests based on ‘probability’ are met), the immediate write-off rule removes any latitude for judegment that might, at different times, be used opportunistically to manipulate profits. Requiring firms to expense research and development expenditure as incurred reduces both profits and assets in the period of the research and development activity. It is conceivable that, when SFAS 2 initially became operative within the USA, firms faced difficulties associated with contractual arrangements they had previously entered into, such as interest-coverage clauses and debt-to-asset constraints (although the definition of ‘assets’ within particular debt contracts may exclude intangibles). This might have been the case particularly for smaller research and development firms that were involved in a limited number of projects. Horwitz and Kolodny (1980) tested this proposition and found support for the view that smaller research and development firms reduced their research and development expenditure around the time SFAS 2 was introduced. The results, however, were not replicated in a similar study undertaken by Dukes, Dyckman and Elliot (1980). Requiring all research and development to be written off, as has traditionally been the case within the USA, might potentially affect managers’ decisions if they are rewarded on the basis of accounting earnings. Research and development expenditures might take a number of periods to translate into higher earnings. The motivation to manipulate such expenditures and, in the process, related profits might be particularly strong if a manager who is rewarded principally on the basis of ‘profits’ is also approaching retirement (this is frequently referred to as a ‘horizon problem’). It has been assumed by some researchers that the incentive for a manager approaching retirement to manipulate discretionary expenditures, such as deciding to undertake new research and development activities, will be tempered if the manager holds shares in the firm or is rewarded on the basis of the market’s valuation of the firm. As Lewellen, Loderer and Martin (1987, p. 290) state: The time horizon relevant to shareholders is in principle unlimited since all future cash flows should be impounded in share prices. Managers may therefore need to be given an explicit claim to those future cash flows in order to encourage proper attention to decisions that will favourably affect them. Lewellen, Loderer and Martin (p. 292) go on to state: Stock [share] based compensation therefore can assist in aligning managerial and shareholder interests, by increasing the cost to managers of investments that decrease share prices and raising the pay-off to them from variance-increasing investments (if the firm is levered). This view is consistent with the findings of Dechow and Sloan (1991), who reviewed expenditures on research and development by US firms. They found that, in a sample of firms with managers responsible for determining expenditure on research and development who were also approaching retirement, managers with stronger share-price-based 274  PART 3: ACCOUNTING FOR ASSETS

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incentives were less likely to cut research and development expenditures. Assuming that managers are motivated primarily by a desire to maximise their own wealth (although we know from Chapter 3 that there are a number of notable accounting researchers who strongly disagree with this simplistic assumption), there will be a trade-off between any expected increase in wealth brought about by manipulating earnings and related bonuses and any expected decreases in wealth brought about by changes in the market value of the firm. Among the managers reviewed by Dechow and Sloan (1991), those who elected not to manipulate accounting earnings are assumed to have considered that any expected gains from accounting-based rewards would have been more than offset by the reduction in wealth caused by reductions in the market value of the firm’s securities. Baber, Fairfield and Haggard (1991) also looked at research and development strategies in the USA. Studying the period from 1977 to 1987, they found evidence to support the view that managers might reduce their research and development expenditure in periods where such a strategy is necessary to report positive or increasing profits. They conclude (p. 829) that: The evidence is consistent with assertions that US manufacturing firms are not competitive internationally in part because managers are concerned about how their R & D investment decisions affect current-period earnings . . . Our results are consistent with conclusions that compliance with SFAS No. 2 discouraged investment in R & D (Elliot et al. 1984; Horwitz & Kolodny 1980). That is, the evidence suggests that managers are more likely to consider current period income effects when making R & D decisions than when making capital-budgeting decisions, whose costs are amortised over a number of accounting periods. Considering the above findings, it would be interesting to investigate whether Australia has become less competitive in terms of research and development now that all research must be expensed as incurred. What do you think? What we are emphasising here is how particular accounting rules—as stipulated in accounting standards— can actually influence the behaviours and strategies of corporate management. Further, when new accounting rules are developed by accounting standard-setters, this can often cause real changes in managerial behaviour—and such changes are not always necessarily positive. This emphasises the point that accounting is both a technical and social practice. In another US study, Feroz and Hagerman (1990) examined the lobbying choices and insider trading behaviour adopted by managers before and after the issue of the 1974 FASB exposure draft on research and development. This exposure draft proposed that research and development costs be written off as incurred. As Feroz and Hagerman state (p. 299): If a firm bases its compensation awards on reported accounting earnings, the management has incentives to lobby for and/or choose accounting alternatives that increase the reported accounting earnings. Similarly, if a proposed regulation is likely to affect management compensation adversely, the management will have incentives to lobby against the proposed regulation. Feroz and Hagerman argued that if the mandatory expensing of research and development will reduce the value of the firm, apart from lobbying against it, management will also sell their own private investments in the firm. (This assumes that their inside knowledge is superior to that of the market, thereby enabling them to outperform the market.) The results of Feroz and Hagerman confirmed the view that managers who believed that mandatory expensing of research and development costs would reduce the value of their firm lobbied against the standard. They also sold their private investments in the firm. Further, managers compensated under an accounting-based compensation scheme were found to lobby against the 1974 exposure draft in anticipation of the negative effects the proposed standard was to have had on reported profits. In a further study, in a different national setting, Goodacre and McGrath (1997) investigated whether UK investment analysts exhibit mechanistic tendencies with respect to the accounting treatment of research and development expenditures. According to Goodacre and McGrath, the ‘mechanistic hypothesis’ is concerned with the relationship between accounting method changes and market prices. Specifically, the mechanistic hypothesis argues that individual users of accounting information will react (as if mechanistically) to earnings numbers in a given way, regardless of the accounting methods actually used to generate the particular profit or loss. Such a view assumes that individual investors and others who use accounting reports would have an unsophisticated grasp of accounting and, as a result, would not properly adjust the information in the financial statements to reflect the alternative accounting methods that might be applied. According to such a view, an organisation that generates Chapter 8: ACCOUNTING FOR INTANGIBLES  275

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a larger profit by adopting a particular accounting method would be considered more favourably by the market than a similar or identical organisation that reports lower profits as a result of adopting an alternative accounting method. To some extent, the predictions of the mechanistic hypothesis might be similar to predictions of Positive Accounting Theory (see Chapter 3). Positive Accounting theorists might argue that accounting methods that lead to an increase in income and assets will reduce the likelihood of firms breaching accounting-based debt covenants and this in itself might lead to a reduction in cash outflows and, consequently, to an increase in the value of the firm’s securities. To test how investment analysts reacted to different treatments of research and development (either capitalising or expensing the research and development expenditure), Goodacre and McGrath constructed a set of financial statements, complete with supporting notes, for a hypothetical electronics company. Different versions of the financial statements were prepared. One scenario involved a company that spends an industry-average amount each year on research and development, and immediately expenses all research and development expenditure. The second scenario involves a company that also spends an industry-average amount on research and development but capitalises all research and development expenditure and writes off the resulting asset over the anticipated life of the asset, which is assumed to be four years. In all other respects, the ‘expensing’ and ‘capitalising’ companies were identical. On the basis of the financial statements and supporting notes that were supplied, investment analysts (drawn from UK stockbrokers, banks and other investment intermediaries) were asked to forecast a share price for the company as at the date of the current year end. The results of the study showed that the mean market value for both the capitalising and the expensing companies was not significantly different. The authors state (p. 171) that: On balance, it can be concluded that the analysts’ valuation of the companies’ shares, on average, does not appear to be significantly affected by the accounting treatment of R & D expenditure. This result supports previous market-based research (Dukes 1976 and others) which suggests that investors see through R & D accounting differences and value companies appropriately. It also confirms similar experimental studies which have focused on different, but related, accounting issues such as capitalisation of leases (Wilkins and Zimmer 1983; Abdel-Khalik, Thomson and Taylor 1978 and 1981) in which analysts and bankers have not been ‘fooled’ by different accounting treatments. Goodacre and McGrath (1997) comment further (p. 174) that: It is interesting to speculate on the implications of the results. In terms of policy making they suggest that the accounting treatment of R & D does not appear to prejudice the valuation of companies by analysts, although comments received from the analysts suggest that disclosure of amounts spent or capitalised is important. There is no evidence in this research to support the contention that encouraging, or even requiring, companies to capitalise more R & D would influence analysts to look more favourably on R & D spenders. Arguments such as that provided by Goodacre and McGrath (1997) claiming that the choice of a particular accounting method in preference to another will not affect the value of the firm—because people can ‘see through’ the effects of the accounting method choice—are dependent upon full disclosure of information about the accounting methods employed. (Perhaps this should be in the accounting policy section, which typically is included as an initial note in the notes to the financial statements.) However, such arguments ignore the contractual issues discussed in Chapter 3. We considered in Chapter 3 how organisations are frequently involved in accounting-based contractual arrangements, such as debt-to-assets constraints and interest-coverage requirements. Such restrictions are frequently part of agreements between organisations and providers of debt capital. The choice of the accounting method to be used to account for research and development can affect these agreements, although it should be noted that intangible assets such as research and development are often not included in the definition of ‘assets’ for the purposes of such agreements. Some accounting researchers argue that if the agreements are affected and there are associated cash-flow consequences, the accounting-based agreements might have to be renegotiated—in itself often a costly exercise—and the choice of accounting method might well affect the value of the organisation and hence that of its shares. Such a view necessarily assumes that the value of the firm in itself will be a function of expected future cash flows and that a change in accounting method is anticipated to affect such cash flows. In Worked Example 8.7 we take a closer look at calculating deferred development balances. 276  PART 3: ACCOUNTING FOR ASSETS

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WORKED EXAMPLE 8.7: Calculating deferred development balances As at the end of the 2019 financial period, Slater Ltd is working on four research and development projects. Summarised data relating to each project’s expenditure and recoverable amount is provided below. Actual ($000) Project

Budgeted ($000)

2018

2019

2020

2021

2022

A. R & D expenditure

15

15

20

20

0



10

10

10

0

0

40

40

70

0

0

0

0

100

250

100

300

100

50

0

0

0

0

350

350

150

D. R & D expenditure

0

300

0

0

0



0

0

100

50

50

Expected revenue inflows

B. R & D expenditure

Expected revenue inflows

C. R & D expenditure

Expected revenue inflows

Expected revenue inflows

All revenue and expenditure predictions are deemed to be ‘probable’. A discount rate of 9 per cent is used. In relation to the specific projects, the following information is also available: Project A This project involves documenting existing knowledge about the migratory behaviour of deep-sea tuna. The revenue inflows of $10 000 per year represent a three-year government grant. Project B This project relates to the ultimate development of surfboard wax that will be easy to apply on the coldest winter day, but will not melt off even if left in the sun on the hottest summer day. The expenditure in 2018 was considered to represent research and the expenditure in 2019 was deemed to represent development. Project C This project involves the development of medication to stop ear infections. A significant breakthrough at the beginning of 2019 caused the researchers to believe that all costs would be recouped through future production and sales. Before 2019, the viability of the project had appeared doubtful. Only $50 000 of the expenditure in 2018 was deemed to represent research and the balance of all other expenditure was deemed to be development. Project D This project involves the development of a new fluorescent long-sleeved ‘rashie’ for wearing while surfing. $50 000 has been spent on research and the balance on development relating to this garment. It is expected that only $200 000 will be recoverable. REQUIRED Determine how much research and development expenditure should be deferred as at the end of 2019. SOLUTION We can consider each of the projects separately, as follows: Project A As the work being undertaken relates only to the documentation of existing knowledge, the associated expenditure would probably not be considered to constitute development. The expenditure would consequently be written off as incurred. As such, there is no need to determine the recoverable amount. continued Chapter 8: ACCOUNTING FOR INTANGIBLES  277

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Project B This project would meet the definition of research and development. The recoverable amount is determined by discounting the future cash flows at the discount rate of 9 per cent as follows: $100 000 $250 000 $100 000

× × ×

0.9174 0.8417 0.7722

= = =

$ 91 740 $210 425  $ 77 220 $379 385

Given that the recoverable amount of $379 385 is expected to exceed the sum of the actual and budgeted costs, all expenditure incurred to date on development ($40 000) can be carried forward and amortised over the expected useful life. The amount spent on research will be expensed as incurred in accordance with the accounting standard. Project C This project would meet the definition of research and development. However, since it is not until the beginning of 2019 that the future economic benefits are deemed to be probable, none of the expenditure incurred before 2019 can be carried forward. Further, the accounting standard specifically states that expenditure on intangible assets that failed previously to meet the criterion for deferral (based on the assessment of probability) and were charged to profit or loss are not to be written back in the light of subsequent events. The recoverable amount of Project C is determined by discounting the future cash flows at the discount rate of 9 per cent as follows: $350 000 $350 000 $150 000

× × ×

0.9174 0.8417 0.7722

= = =

$321 090 $294 595 $115 830 $731 515

As the recoverable amount of $731 515 exceeds the development expenditure, $100 000 may be capitalised and carried forward. The period of amortisation would need to be determined. Project D The recoverable amount of Project D is determined by discounting the future cash flows at the discount rate of 9 per cent as follows: $100 000 $50 000 $50 000

× × ×

0.9174 0.8417 0.7722

= = =

$ 91 740 $42 085   $38 610 $172 435

As the development expenditure incurred of $250 000 is more than the recoverable amount of $172 435, the full amount of the development expenditure should not be carried forward. The research expenditure would be expensed as incurred. As at the end of 2019, the remaining recoverable amount is $172 435. Therefore, for Projects A, B, C and D, as at the end of 2019, the amount of $312 435 can be deferred to future periods, summarised as follows: Project

Amount carried forward ($)

A B C D

0 40 000 100 000 172 435 312 435

Having considered how to account for research and development, we will now focus our attention on another intangible asset, this being goodwill.

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Accounting for goodwill

LO 8.4 LO 8.5 LO 8.9 LO 8.10

What is goodwill?

Goodwill arises when one entity acquires another entity, or part thereof. For example, if one company acquires a controlling interest in another entity (the acquired entity becoming a subsidiary), goodwill might arise. In this section we consider the main issues associated with accounting for goodwill. However, we will defer consideration of issues that arise on the consolidation of a group of entities until Chapter 25. Goodwill itself is an unidentifiable intangible asset. It cannot be individually identified and is an intrinsic part of a business. It cannot be purchased or sold separately, but only as part of an entity in its entirety. Because goodwill is not separable it fails to meet the criteria provided in AASB 138, which requires that an intangible asset be identifiable as well as non-monetary and non-physical in nature (but it can be recognised by virtue of other accounting standards). Goodwill represents the future economic benefits associated with an existing customer base, efficient management, reliable suppliers and the like. However, each of these individual factors is not usually separately valued or identified within an entity’s statement of financial position. Rather, they are typically combined into the composite asset of goodwill. Miller (1995, p. 7) provides a useful definition of goodwill: Goodwill is a different type of asset: it is not a discrete resource but a plug representing the excess of an entity’s value as a totality over the aggregate of the individual values of its net assets. It often arises from the way the physical assets and human resources of the acquired business have been arranged and coordinated in relation to environmental conditions and may be attributed to such factors as market penetration, an excellent distribution network, good industrial relations and superior management. This definition would appear to be consistent with the definition provided in Appendix A of AASB 3 Business Combinations, which 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.

Goodwill might be built up over a number of periods or obtained by acquiring an existing business. Many individuals or organisations buy businesses with the intention of making them successful and then selling them at a higher price, taking into account the goodwill that they will have built up within the business. Therefore, goodwill may be internally generated or acquired by purchasing an existing business. Under IFRS, and therefore pursuant to Australian accounting standards, internally generated goodwill is not to be recognised as an asset for the purpose of disclosure within the statement of financial position. The reason for this is that according to the accounting standard-setters, purchased goodwill can be measured more objectively on the basis purchased goodwill of the amount paid for it than internally generated goodwill, which is not capable of being reliably Goodwill that has been measured. Consequently, the accounting treatment for purchased goodwill differs from that for acquired through a internally generated goodwill. transaction with an Within AASB 138, paragraph 48 states ‘internally generated goodwill shall not be recognised as external party, as an asset’. In explaining this requirement, paragraph 49 states: opposed to goodwill In some cases, expenditure is incurred to generate future economic benefits, but it does not result in the creation of an intangible asset that meets the recognition criteria in this Standard. Such expenditure is often described as contributing to internally generated goodwill. Internally generated goodwill is not recognised as an asset because it is not an identifiable resource (i.e. it is not separable nor does it arise from contractual or other legal rights) controlled by the entity that can be measured reliably at cost.

that is generated by the reporting entity itself. In Australia purchased goodwill must be shown as an asset of the reporting entity.

Therefore, goodwill can be recognised only where it is acquired as part of a business acquisition. This means that a company may have extremely valuable goodwill, but be unable to show any value for the asset. Yet, as soon as another party buys the business, that acquiring party can disclose that same goodwill as an asset. Again, we can question the logic of this requirement. If an asset exists, should not it exist regardless of its source, that is, regardless of whether it is acquired or internally generated? However, the argument of the standard-setters is that it is simply too difficult to reliably measure the value of goodwill unless it has been acquired in a market transaction. Of course, there would be ways to measure the value of internally generated goodwill. For example, we might obtain a valuation of the business as a Chapter 8: ACCOUNTING FOR INTANGIBLES  279

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whole (perhaps its market capitalisation if it is a listed company) from which we would deduct the fair value of the entity’s identifiable net assets to thereafter give the balance of goodwill. However, while this is possible in principle, we are still left with the rather harsh requirement that no internally generated goodwill may be recognised for accounting purposes.

How is goodwill measured? Pursuant to AASB 3 Business Combinations, purchased goodwill is measured as the excess of the cost of acquisition incurred by the acquirer over the fair value of the identifiable net assets and contingent liabilities acquired. Fair value is defined as: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Market participants, as used in this definition of fair value, are assumed to be independent of each other and be knowledgeable about the asset or liability being traded. Purchase consideration should be measured at the fair value of what is given up in exchange. As an example of calculating goodwill, consider Worked Example 8.8.

WORKED EXAMPLE 8.8: Calculation of goodwill Horan Ltd purchases the Coolum Store for the consideration of: Cash Land

$150 000 Horan Ltd is going to transfer title of some land to the owners of the Coolum Store (the carrying amount of the land is $120 000; fair value is $195 000).

The statement of financial position of the Coolum Store as at the date of acquisition shows assets of $290 000 and liabilities of $95 000. All assets are fairly valued except the Coolum Store’s building, which is in the financial statements at $60 000, but has a fair value of $85 000. There are no contingent liabilities. REQUIRED What is the value of goodwill? SOLUTION Fair value of purchase consideration Cash Land (at fair value) Fair value of net assets acquired Carrying amount of assets Excess of fair value over carrying amount less Liabilities Goodwill

$

$

150 000 195 000

345 000

290 000 25 000 315 000 95 000

220 000 125 000

Therefore, following the above acquisition, Horan Ltd will show goodwill in its financial statements totalling $125 000. Yet, pursuant to the accounting standard, before the acquisition no amount could be shown for goodwill in the financial statements of the Coolum Store. Therefore, if we are to accept that goodwill is an asset, the assets of the Coolum Store, at the date of acquisition, are understated owing to the non-recognition of the internally generated goodwill. However, as noted above, the accounting standard justifies this non-recognition of goodwill on the basis of the difficulties encountered, or expected to be encountered, in reliably measuring goodwill that in itself has not been the subject of a market transaction. It is sometimes questioned whether or not goodwill is actually an asset. Unlike other assets, it cannot be sold separately from the business to which it belongs. Hence those individuals in favour of some form of current-cost or market-based accounting argue that because goodwill is not individually saleable, it should not be shown as an asset. 280  PART 3: ACCOUNTING FOR ASSETS

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For example, in Chapter 3 we considered Chambers’ model of accounting, Continuously Contemporary Accounting (CoCoA). According to CoCoA, assets should be valued on the basis of their individual exit prices. The total of the exit values of the individual assets are then, in turn, used as a guide to determining the entity’s ‘capacity to adapt’ to changing circumstances. If the net assets of the organisation have a low aggregated exit value, the organisation may be considered to have a low capacity to adapt. That is, in the short term, the organisation would be relatively unable to switch its activities into alternative pursuits, as it does not have sufficient liquid assets to enable such a change. As goodwill cannot be sold separately, in such a model of accounting it would be given zero value. Having said this, however, if we accept that goodwill is an asset, as indicated in our Australian Accounting Standard, the next issue to consider is how (or if) to amortise it.

Goodwill amortisation versus impairment Arguably, it was the requirement to amortise purchased goodwill that made the superseded goodwill accounting standard (in Australia, this was AASB 1013) one of the most controversial of all accounting standards. Most of the opposition related to the standard’s mandatory requirement that purchased goodwill be amortised over a period of no more than 20 years. Most businesses felt that they would actually be building up the value of goodwill across time through activities including advertising, which would typically be written off as incurred. They thought it inappropriate to ignore the internally generated goodwill, while at the same time being required to amortise the purchased goodwill. When Australia adopted Accounting Standard AASB 3 Business Combinations as part of the process of adopting IFRSs, the requirement to systematically amortise goodwill was abandoned. This pleased many corporate managers as the previous requirement for the periodic amortisation of goodwill in some organisations meant the recognition of many millions of dollars of expenses. The requirement to amortise goodwill was replaced with the requirement to undertake annual impairment testing. Regarding the impairment losses relating to goodwill, paragraph 124 of AASB 136 Impairment of Assets states: ‘An impairment loss recognised for goodwill shall not be reversed in a subsequent period’. An impairment loss is defined in AASB 136 as the amount by which the carrying amount of an asset or a cashgenerating unit exceeds its recoverable amount. The recoverable amount of an asset is defined in AASB 136 as the higher of its fair value less costs of disposal and its value in use. As we explained in our discussion of impairment losses in Chapter 6, value in use is the present value of the future cash flows expected to be derived from an asset or cashgenerating unit. If the recoverable amount of an asset is lower than its carrying amount (the amount at which the asset is recognised in the statement of financial position), this difference is deemed by AASB 136 to be an impairment loss, which should be recognised by debiting an expense (impairment loss) and crediting a contra-asset (in this case, ‘accumulated impairment losses-goodwill’, which would be offset against goodwill). There is a prohibition on revaluing goodwill, so if the recoverable amount of goodwill is assessed as being greater than its carrying value, no revaluation may be made. Worked Example 8.9 provides an example of how to account for the impairment of goodwill.

WORKED EXAMPLE 8.9: Impairment of goodwill Rip Ltd acquires Curl Ltd on 1 July 2018 for $5 000 000 being the fair value of the consideration transferred. At that date, Curl Ltd’s net identifiable assets have a fair value of $4 400 000. Goodwill of $600 000 is therefore the difference between the aggregate of the consideration transferred and the net identifiable assets acquired. The fair value of the net identifiable assets of Curl Limited are determined as follows: ($000) Patent rights Machinery Buildings Land Less: Bank loan Net assets

200 1 000 1 500 2 300 5 000 600 4 400 continued Chapter 8: ACCOUNTING FOR INTANGIBLES  281

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At the end of the reporting period of 30 June 2019, the management of Rip Ltd determines that the recoverable amount of the cash-generating unit, which is considered to be Curl Ltd, totals $4 500 000. The carrying amount of the net identifiable assets of Curl Ltd, excluding goodwill, is unchanged and remains at $4 400 000. REQUIRED (a) Prepare the journal entry to account for any impairment of goodwill. (b) Assume instead that at the end of the reporting period the management of Rip Ltd determines that the recoverable amount of the cash-generating unit, which is considered to be Curl Ltd, totals $4 100 000. Prepare the journal entry to account for the impairment. SOLUTION We will consider a number of issues before ultimately providing the solution. First, we need to consider the level of aggregation we use when considering the asset that is subject to possible impairment. That is, should we consider it separately, or as part of a larger ‘cash-generating unit’? As we have indicated in this chapter, a cash-generating unit is defined in AASB 136 as: The smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. In terms of whether an asset should be considered separately, or in combination with other assets, for the purposes of recognising an impairment, paragraph 66 of AASB 136 states: If there is any indication that an asset may be impaired, recoverable amount shall be estimated for the individual asset. If it is not possible to estimate the recoverable amount of the individual asset, an entity shall determine the recoverable amount of the cash-generating unit to which the asset belongs (the asset’s cash-generating unit). In providing further explanation for the above requirement, paragraphs 67 and 68 of AASB 136 state: 67. The recoverable amount of an individual asset cannot be determined if: (a) the asset‘s value in use cannot be estimated to be close to its fair value less costs of disposal (e.g. when the future cash flows from continuing use of the asset cannot be estimated to be negligible); and (b) the asset does not generate cash inflows that are largely independent of those from other assets. In such cases, value in use and, therefore, recoverable amount, can be determined only for the asset’s cash-generating unit. 68. As defined in paragraph 6, an asset’s cash-generating unit is the smallest group of assets that includes the asset and generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Identification of an asset’s cash-generating unit involves judgement. If recoverable amount cannot be determined for an individual asset, an entity identifies the lowest aggregation of assets that generate largely independent cash inflows. The recoverable amount of goodwill cannot be considered independently of other assets that it supports. While the above requirements relate to the impairment of assets in general, there are some requirements within AASB 136 that specifically relate to goodwill. Of particular relevance is paragraph 80, which states: For the purpose of impairment testing, goodwill acquired in a business combination shall, from the acquisition date, be allocated to each of the acquirer’s cash-generating units, or groups of cash-generating units, that is expected to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of the acquiree are assigned to those units or groups of units. Each unit or group of units to which the goodwill is so allocated shall: (a) represent the lowest level within the entity at which the goodwill is monitored for internal management purposes; and (b) not be larger than an operating segment as defined by paragraph 5 of AASB 8 Operating Segments before aggregation.

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Hence, there is a requirement that rather than treating goodwill as an asset of the overall organisation, goodwill should be allocated to the relevant sub-component of the organisation. Sometimes, however, the goodwill may relate to a number of cash-generating units within the organisation. As paragraph 81 of AASB 136 explains: Goodwill recognised in a business combination is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised. Goodwill does not generate cash flows independently of other assets or groups of assets, and often contributes to the cash flows of multiple cash-generating units. Goodwill sometimes cannot be allocated on a non-arbitrary basis to individual cash-generating units, but only to groups of cash-generating units. As a result, the lowest level within the entity at which the goodwill is monitored for internal management purposes sometimes comprises a number of cash-generating units to which the goodwill relates, but to which it cannot be allocated. References in paragraphs 83–99 and Appendix C to a cash-generating unit to which goodwill is allocated should be read as references also to a group of cash-generating units to which goodwill is allocated. In this worked example, the assets of Curl Ltd are deemed to be the smallest group of assets that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets. Therefore, Curl Ltd is a cash-generating unit. The cash-generating unit comprising Curl Ltd includes goodwill within its carrying amount. As such, it must be tested annually for impairment (or more frequently if there is an indication that it may be impaired). As paragraph 90 of AASB 136 states: A cash-generating unit to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the unit may be impaired, by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit. If the recoverable amount of the unit exceeds the carrying amount of the unit, the unit and the goodwill allocated to that unit shall be regarded as not impaired. If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity shall recognise the impairment loss in accordance with paragraph 104. (a) Carrying amount Recoverable amount Impairment loss

Goodwill of Curl Ltd ($000)

Net identifiable assets ($000)

Total ($000)

600

4 400

5 000 4 500 500

Journal entry Dr Impairment loss—goodwill Cr Accumulated impairment loss—goodwill

500 500

(b)

Carrying amount Recoverable amount Impairment loss

Goodwill of Curl Ltd ($000)

Net identifiable assets ($000)

Total ($000)

600

4 400

5 000 4 100 900

AASB 136, paragraph 104, requires the impairment loss of $900 000 to be allocated to the assets in the cashgenerating unit (Curl Ltd) 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 continued Chapter 8: ACCOUNTING FOR INTANGIBLES  283

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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, $600 000 of the total impairment loss (see above) of $900 000 can be offset against the goodwill, leaving a balance of the impairment loss of $300 000. The remaining impairment loss of $300 000 is recognised by reducing the carrying amounts of Curl Ltd’s identifiable assets as follows: Goodwill of Curl Ltd ($000)

Net identifiable assets ($000)

Total ($000)

600 (600)    

4 400 (300) 4 100

5 000 900 4 100

Carrying amount Impairment loss

Allocating the $300 000 balance of the impairment loss pro-rata against the identifiable assets on the cashgenerating unit on the basis of carrying values provides the following calculations: ($000) Patent rights Machinery Buildings Land

200 1 000 1 500 2 300 5 000

Allocation of impairment loss × × × ×

300/5000 300/5000 300/5000 300/5000

12 60 90 138 300

Journal entry: Dr Dr Cr Cr Cr Cr Cr

Impairment loss—goodwill Impairment loss—identifiable assets Accumulated impairment losses—goodwill Accumulated impairment losses—patent rights Accumulated impairment losses—machinery Accumulated impairment losses—buildings Accumulated impairment losses—land

600 300 600 12 60 90 138

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

Economic implications associated with the choice to recognise goodwill impairment losses There is a growing body of research that explores the economic implications associated with managers’ choice of whether, and when, to recognise impairment losses in relation to goodwill. As we know, corporate management needs to determine whether the value of purchased goodwill has fallen. This requires a great deal of professional judgement. As we also know, the existence of a potential impairment loss within a particular cash-generating unit is determined by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit. Determining 284  PART 3: ACCOUNTING FOR ASSETS

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the carrying amount of the respective part of the business obviously requires many judgements, including judgements about various fair values and the appropriate discount rates to use in calculating the value in use of particular assets. Because people that are external to corporations (for example, many of the users of general purpose financial statements) will not know about various fair values, and because there is a general lack of transparency in the various pieces of information available to corporate managers, this provides corporate managers with the ability to manage the timing of when, or if, they recognise goodwill impairment losses (Ramanna & Watts 2008). Of course, we would hope that managers will recognise various expenses—including goodwill impairment losses—objectively when evidence suggests that particular fair values have been eroded. But there is nevertheless a great deal of research to suggest that corporate managers will not always be objective and that, in particular circumstances, managers will manipulate accounting numbers to generate desired results (often referred to as the practice of ‘creative accounting’). Hence, as we have emphasised many times in this book, it would be naive to assume that all financial accounting numbers have been objectively determined. Therefore, it will not always be clear whether management is correctly accounting for possible goodwill impairments, or whether they are using management discretion to manage reported profits. There is extensive literature which suggests that corporate combination (takeover) activities are inherently risky and that the value of any business acquisition is ultimately determined by whether synergies between the acquiring organisation, and the acquired organisation, ultimately eventuate. Research suggests (for example, see Sirower 1997; Ji 2013) that as many as half of all acquisitions fail to create valuable synergies, thereby bringing into question the value of goodwill acquired in many acquisitions. Yet, authors such as Carlin and Finch (2009) suggest that the actual incidence of goodwill impairments being recognised is comparatively scarce, and much lower than might be expected. It would appear that managers often delay recognising impairment losses until periods in which recognition would create fewer problems for the organisation (particularly, perhaps, fewer problems for the managers and the owners) and that firms with lower reported returns on assets are likely to defer the recognition of goodwill impairment losses (Jahmani, Dowling and Torres 2010). Evidence also indicates that a firm‘s debt covenants and accounting-based management bonus plans (see Chapter 3), as well as the identity of the Chief Executive Officer (CEO), affect decisions about when to recognise goodwill impairment losses. For example, Beatty and Weber (2006) indicate that the existing debt contracts within a corporation (and as we explained in Chapter 3, when organisations borrow funds they are often required to sign debt contracts that utilise covenants which are linked to accounting numbers), the accounting-based management bonus schemes in place and the CEO identity affect decisions about whether goodwill impairment losses will be recognised. Specifically, Beatty and Weber (2006) find that if an organisation is close to breaching an accounting-based debt covenant; if it has management bonus schemes that are linked to accounting profits; and, if the incumbent CEO was in the organisation at the time a particular business combination occurred, then there will be less likelihood that an impairment loss would be recognised. Consistent with the above results, Ramanna and Watts (2008) also explore whether the recognition of impairment losses is undertaken either to provide useful information to readers of financial statements (that is, the financial statements are prepared objectively), or whether they are undertaken to opportunistically manage financial reports. Ramanna and Watts (2008) find that the recognition of impairment losses is more likely to be linked to opportunistic motivations. Impairment losses are found to be less likely to be recognised if a firm is close to breaching an accounting-based debt contract. In an Australian study, Ji (2013) identified a group of organisations that had acquired business units which subsequently were underperforming, thereby consistent with a perspective that the goodwill acquired had been eroded and an impairment loss should be recognised. The results in Ji (2013) provided evidence that management tended to either delay or avoid the recognition of goodwill impairment losses despite evidence to suggest that goodwill was overstated for financial statement purposes. Hence, the available evidence questions the relevance and/or the objectivity associated with the amounts often being attributed to purchased goodwill. While we are probably right in assuming that the vast majority of corporate managers will be objective when preparing their general purpose financial statements, if we are to believe available research, then some caution should nevertheless be taken when considering the underlying economic benefits associated with the goodwill currently being presented in corporate statements of financial position. We might also question whether the shift in accounting treatment for dealing with goodwill (that is, the movement away from systematic amortisation to a requirement for impairment testing) has actually improved the quality of corporate reporting as the accounting standardsetters assert. Chapter 8: ACCOUNTING FOR INTANGIBLES  285

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LO 8.10 LO 8.11

Is the way we account for intangible assets an improvement over what we did in Australia prior to the introduction of IFRS in 2005?

In a paper written for CPA Australia (August 2003), Colin Parker (former staff member of the Australian Accounting Research Foundation and former member of the Urgent Issues Group) made the following comment in relation to AASB 138: While the intangible asset standard will promote a new level of international consistency in financial reporting, it is seriously flawed and an archly conservative standard. It fails to require recognition of many intangible assets; and places a number of severe restrictions on the recognition of internally generated intangible assets and on revaluation on those assets. Users will find a loss of information on intangibles as many will now go unreported. To capture the importance of knowledge assets, the standard-setters need to do much better than this proposed standard. The AASB has not covered itself in glory by blindly following the international reporting standard. If there is ever a case to modify an international accounting standard in the Australian context this is it. Perhaps Parliament will veto the standard on the basis that it is not in the national interest! Obviously, the above view is extremely critical (and the government did not ‘veto’ the accounting standard). At issue is whether the perceived benefits of international convergence, which are discussed in Chapter 1, outweigh the costs that arose in relation to adopting IFRSs. As Parker indicates, the accounting standard for intangibles (AASB 138) resulted in many valuable internally generated intangibles not being permitted to be recognised for statement of financial position purposes. Arguably, this reduced the value or relevance of statements of financial position in relation to providing information about the resources under the control of the reporting entity. Given the conservative nature of the accounting standard that requires expenditure on many internally generated intangibles to be expensed, it will not be possible to differentiate an entity that has valuable internally generated intangibles from one that has expended resources on intangible assets that are not expected to generate future economic benefits. In relation to the requirement relating to impairment testing of goodwill, it is likely that a deal of subjectivity will be introduced into accounting. Rather than amortising goodwill over a set period of time (which could in itself be deemed to be somewhat arbitrary), assessments will now have to be made about whether the value of goodwill has been ‘impaired’. Given the nature of goodwill, determining whether its value has been impaired will not always be straightforward. As we have seen, this means that there could be a propensity for corporate managers to opportunistically decide if, and when, goodwill impairment losses will be recognised. In relation to research and development, the requirement that all research be written off as incurred is very conservative and, again, means that financial statement users will not be able to differentiate between entities that have expended resources on research that is expected to culminate in economic benefits and those that have incurred expenditure that is not expected to generate economic benefits. Further, there is the possibility that requiring organisations involved in research and development to expense all research as incurred might discourage them from undertaking certain research given the impacts such activities will have on corporate profits. Such an eventuality is obviously not in the interests of the nation given the benefits that successful research might bring. Further, within Australia there was previously no prohibition on revaluing identifiable intangible assets (other than goodwill). However, as a result of adopting IFRSs we are now allowed to revalue identifiable intangible assets only if there is an ‘active market’ for such assets. As we know, an active market is defined as a market where the items traded are homogeneous, there are willing buyers and sellers at any time, and prices are known to the public. Such stringent requirements will now preclude the revaluation of most identifiable intangible assets within Australia. So as a result of adopting IFRSs, in most cases where intangible assets are recognised they will be recorded at cost, less accumulated amortisation and less accumulated impairment losses, rather than being shown at their fair value. Information about fair values would tend to be more relevant to the users of financial statements, so we can question the

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value of the information being produced under the accounting standards. The qualitative characteristic of ‘relevance’ seems to have been abandoned by the standard-setters. In concluding this section of the chapter, to many observers it does appear that for the sake of enhancing international comparability, Australia has embraced a less than ideal accounting standard. It is acknowledged that we are being particularly critical of the accounting standard relating to intangible assets (as we are also critical of some of the other accounting standards discussed in other chapters of this book). We do this on the basis that in the ‘real world’ we do not need to know only how to apply certain rules—sometimes it is also useful to reflect upon whether the rules actually make any sense, or what the limitations inherent in the rules might be.

SUMMARY The chapter addressed issues relating to intangible assets. It considered how to account for intangible assets generally, as well as how to account specifically for research and development, and goodwill. Intangible assets themselves are considered to be non-monetary assets without physical substance and include patents, goodwill, mastheads, brand names, copyrights, research and development, and trademarks. There is a specific requirement that expenditure associated with many internally generated intangible assets (including research expenditure and expenditure on internally generated brands, mastheads, publishing titles, customer lists and items similar in substance) be expensed as incurred. Such internally generated intangibles are also not permitted to be revalued. Where intangible assets are revalued, such revaluations can be undertaken only where there is an ‘active market’ for such assets and fair values can be ascertained. Intangible assets can be classified as either identifiable intangible assets or unidentifiable intangible assets. Goodwill is an example of an unidentifiable intangible asset. Intangible assets can be considered to have either a limited useful life or an indefinite life. Where intangible assets are considered to have a limited (finite) life, there is a need to allocate their cost, or revalued amount, over their useful lives by way of periodic amortisation (other than for goodwill). Where an intangible asset is considered to have an indefinite life, amortisation charges do not apply. Rather, the asset is subject to annual impairment testing. In relation to research and development expenditure, this chapter explained that research and development comprise various expenditures, including the costs of material and services consumed in research and development activities; salaries and wages; and depreciation of research-related equipment. Research must be considered separately from development. Research expenditure is required to be expensed as incurred. Development expenditure may be carried forward as an asset to the extent that future economic benefits are deemed probable, and such benefits are measurable with reasonable accuracy. Development expenditure would need to be amortised in subsequent periods. The other specific intangible asset addressed in this chapter is goodwill. Goodwill is defined as the future benefits from unidentifiable assets, where unidentifiable assets are assets that are not capable of being both individually identified and specifically recognised. Only purchased goodwill can be recognised for external reporting purposes. Purchased goodwill is measured as the excess of the cost of acquisition incurred by an entity over the fair value of the identifiable net assets and contingent liabilities acquired. Goodwill carried forward to future periods is subject to annual impairment testing rather than requiring periodic amortisation.

KEY TERMS goodwill  260 identifiable intangible assets  260

purchased goodwill  279 research and development  269

unidentifiable intangible assets  260

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END-OF-CHAPTER EXERCISES Midget Ltd operates a surfboard manufacturing plant. It has decided to purchase a 100 per cent interest in Dion Ltd, a fibreglass manufacturing business. The cost of the acquisition is $1 000 000 plus associated legal costs of $50 000. As at the date of acquisition, the statement of financial position of Dion Ltd shows: $ Assets Current assets Cash Accounts receivable Provision for doubtful debts Inventory Total current assets Non-current assets Land and buildings, at cost Accumulated depreciation—land and buildings Plant and equipment Acc. depreciation—plant and equipment Total non-current assets Total assets Liabilities Current liabilities Accounts payable Bank overdraft Total current liabilities Non-current liabilities Bank loan Total liabilities Net assets

$

$

10 000 60 000 (10 000)

700 000 (150 000) 400 000 (100 000)

50 000 140 000 200 000

550 000 300 000 850 000 1 050 000

70 000 30 000 100 000 200 000 300 000 750 000

Additional information The assets and liabilities of Dion Ltd are fairly stated, except for the following: • Land and buildings have a fair value of $700 000. • Some of the fibreglass has been water-damaged, so that total inventory has a fair value of $110 000. • Dion Ltd has a patent over a particular manufacturing process. This is not recorded in the statement of financial position, but has a fair value of $80 000. • There are no contingent liabilities.

REQUIRED Determine, for accounting purposes, the amount of goodwill that has been acquired by Midget Ltd. LO 8.4 8.9

SOLUTION TO END-OF-CHAPTER EXERCISE $ Acquisition cost Net assets shown in the statement of financial position as at the date of acquisition Adjustments Excess of fair value of land and buildings over the carrying amount

1 000 000 750 000 150 000

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Excess of carrying value of inventory over the fair value Patent at fair value, unrecorded in the statement of financial position Fair value of the identifiable net assets being acquired Goodwill acquired in transaction

(30 000)   80 000    950 000     50 000

Notes 1. Although the acquisition cost of assets would normally include 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. 2. The identifiable assets must be measured at their fair values, with goodwill being measured as the excess of the cost of the acquisition over the fair value of the identifiable net assets acquired. So valuation adjustments are required for the land and buildings, and the inventory. The patent must be recognised even though it is not recognised in the statement of financial position of Dion Ltd.

REVIEW QUESTIONS 1. We have a separate accounting standard, AASB 138, that specifically deals with intangible assets and it provides different requirements from those for property, plant and equipment (the rules for which appear in AASB 116). What is it about intangible assets that requires them to have a separate accounting standard? Do you think the differences in requirements are logical? LO 8.1, 8.2 2. Provide an argument in support of the accounting requirement that research is to be expensed as incurred. Do you think this requirement is overly ‘conservative’? LO 8.2, 8.3, 8.7 3. Explain the difference in how you measure intangible assets that are individually acquired compared with those that are acquired as part of a business combination. LO 8.4 4. What activities should be included in the cost of research and development? In your answer differentiate between research activities and development activities. LO 8.2, 8.7, 8.8 5. Explain the difference between tangible assets and intangible assets. Is it necessary to have different accounting rules for tangible and intangible assets? LO 8.1 6. Explain the change in requirements for accounting for research and development costs resulting from adopting International Financial Reporting Standards. Do the current requirements provide a better representation of the financial performance and financial position of the entity? LO 8.7, 8.8, 8.10, 8.11 7. What is the difference between an unidentifiable intangible asset and an identifiable intangible asset? LO 8.1, 8.2, 8.3, 8.9 8. How is the value of goodwill determined for accounting purposes? LO 8.9 9. Would goodwill be considered an ‘asset’ according to the Conceptual Framework for Financial Reporting? LO 8.9 10. Why did many Australian reporting entities oppose the mandatory amortisation of goodwill that was prescribed under Australian Accounting Standards prior to international convergence in 2005? LO 8.9, 8.10, 8.11 11. Which of the following costs would be included as part of (i) research costs or (ii) development costs for a project to improve the production process of a confectionery plant? (a) depreciation of administrative equipment during the research phase of the project (b) salaries of administrative staff during the development phase of the project (c) salaries of staff working half-time on the research project and half-time on other work (d) depreciation of laboratory equipment used to undertake development of the new production process (e) consulting fees paid to outside consultants used in the research phase and development phase of the project (f) raw materials used in the research phase and development phase of the project. LO 8.7 12. What are possible arguments for and against the prohibition of recognition of internally generated goodwill? LO 8.1, 8.9 Chapter 8: ACCOUNTING FOR INTANGIBLES  289

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13. What is an ‘active market’, and is an active market likely to exist for intangible assets such as brand names or development-related expenditures? Explain your answer. LO 8.2, 8.3, 8.4, 8.7 14. Evidence in Whittred and Zimmer (1986) indicates that intangibles are typically excluded from the definitions of ‘assets’ employed in debenture trust deeds. Why do you think this is the case? LO 8.2, 8.4 15. (a) If an accounting standard is introduced that requires certain types of expenditures to be expensed rather than capitalised, and that type of expenditure is discretionary, would you expect management to change their expenditure patterns from what they would have been in the absence of the standard? Use the results of empirical research described in this chapter to support your argument. (b) Would your expectation in the above situation be different if the manager is rewarded primarily on the basis of accounting earnings? (c) What effect would the further knowledge that the manager is approaching retirement have on your views? LO 8.1, 8.8 16. Energy Ltd is involved in the research and development of a new type of three-finned surfboard. For this R & D it has incurred the following expenditure: • $50 000 obtaining a general understanding of water-flow dynamics • $30 000 on understanding what local surfers expect from a surfboard • $90 000 on testing and refining a certain type of fin • $190 000 on developing and testing a full prototype of the three-finned board, to be called the ‘thruster’.  There is expected to be a very large market for the product, which will generate many millions of dollars in revenue.

REQUIRED Determine how the above expenditure would be treated for accounting purposes. LO 8.7 17. Tamarama Ltd acquires 100 per cent of Bronte Ltd on 1 July 2017. Tamarama Ltd pays the shareholders of Bronte Ltd the following consideration: Cash Plant and equipment Land

$70 000 fair value $250 000; carrying amount in the books of Tamarama Ltd $170 000 fair value $300 000; carrying amount in the books of Tamarama Ltd $200 000

There are also legal fees of $35 000 involved in acquiring Bronte Ltd. On 1 July 2017 Bronte Ltd’s statement of financial position shows total assets of $700 000 and liabilities of $300 000. The fair value of the assets is $800 000.

REQUIRED Has any goodwill been acquired and, if so, how much? LO 8.9 18. Nat Ltd purchases a 100 per cent interest in Angourie Ltd. The cost of the acquisition is $1 400 000 plus associated legal costs of $70 000. As at the date of acquisition, the statement of financial position of Angourie Ltd shows: $

$

$

Assets Current assets Cash

20 000

Accounts receivable

80 000

Allowance for doubtful debts

(10 000)

70 000

Inventory

100 000

Total current assets

190 000

Non-current assets Land and buildings, at cost

850 000

Accumulated depreciation—land and buildings

(150 000)

700 000

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Plant and equipment

510 000

Accumulated depreciation—plant and equipment

(100 000)

Total non-current assets

410 000 1 110 000

Total assets

1 300 000

Liabilities Current liabilities Accounts payable

90 000

Bank overdraft

20 000

Total current liabilities

110 000

Non-current liabilities Bank loan

190 000

Total liabilities Net assets

300 000 1 000 000

Additional information • The assets and liabilities of Angourie Ltd are fairly stated except for land and buildings, which have a fair value of $800 000. • Angourie Ltd has a brand name that is not recognised on the statement of financial position and that has a fair value of $50 000. • There are no contingent liabilities.

REQUIRED (a) Determine, for accounting purposes, the amount of goodwill that has been acquired by Nat Ltd. (b) Why do you think that Nat Ltd would have been prepared to pay for goodwill? (c) Can Nat Ltd revalue the goodwill upwards in a subsequent period? LO 8.2, 8.6, 8.9 19. In 2017 McGoy Ltd decided to develop a surfboard out of a new type of material that was resistant to damage. The material to be used was more like plastic than the fibreglass that was traditionally used on surfboards. In 2017 McGoy Ltd spent $510 000 on research aimed at understanding the properties of different types of plastics. This knowledge provided what the company considered to be a significant breakthrough, which if utilised should lead to significant future economic benefits. In 2018 McGoy Ltd developed a prototype of its surfboard. It asked several leading surfers to ride its surfboard at the annual Rip and Curl Pro Event at Bells Beach. Costs involved in developing the prototype in 2018 were $780 000. The reaction to the new surfboard was positive and many major retailers put in orders for the board. Anticipating the demand, McGoy Ltd had spent $25 000 on legal costs to register a patent for the board. The patent has a life of five years after which time other producers may copy the surfboard design. Because of the positive reaction, in 2019 McGoy Ltd undertook worldwide marketing of the surfboard at a cost of $2 200 000. It became apparent that demand for this new surfboard was huge, and within four months, orders for over $40 million dollars’ worth of the boards were received. McGoy Ltd employed a firm of accountants to work out the present value of the new surfboard and they believed that the product had a present value of at least $200 million. The managing director of McGoy Ltd then decided that he would like to have the present value of the surfboard reflected in the company’s financial statements; that is, he wanted it to be valued at its fair value. While his accountants considered that the present value was $200 million, a major competitor made a legally binding offer to buy the patent for the product for a price of $150 million.

REQUIRED Describe how to account for the above transactions and events and provide appropriate journal entries. LO 8.7, 8.8 20. Describe the amortisation requirements for certain identifiable intangible assets and the changes to accounting for goodwill introduced as part of the convergence with international accounting standards. How have these changes affected reported profit? LO 8.5, 8.9, 8.10, 8.11 Chapter 8: ACCOUNTING FOR INTANGIBLES  291

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21. Mam Ltd acquired Bo Ltd on 1 July 2018 for cash of $7 000 000. At that date, Bo Ltd’s net identifiable assets had a fair value of $5 800 000. The fair value of the net identifiable assets of Bo Ltd are determined as follows: ($000) Customer list Machinery Buildings Land

50 1 450 1 500 3 000 6 000 200 5 800

Less: Bank loan Net assets

At the end of the reporting period of 30 June 2019, the management of Mam Ltd determines that the recoverable amount of the cash-generating unit, which is considered to be Bo Ltd, totals $6 200 000. The carrying amount of the net identifiable assets of Bo Ltd, which excludes goodwill, has not changed since acquisition and is $5 800 000.

REQUIRED (a) Prepare the journal entry to account for any impairment of goodwill. (b) Assume instead that at the end of the reporting period the management of Mam Ltd determines that the recoverable amount of the cash-generating unit, which is considered to be Mam Ltd, totals $4 800 000. Prepare the journal entry to account for the impairment. LO 8.9 22. Kelly Ltd is currently working on four research and development projects. Summarised data relating to each project’s expenditure and recoverable amount is provided below. Actual ($000) Project Alpha Beta Gamma Delta

R & D expenditure Expected revenue inflows R & D expenditure Expected revenue inflows R & D expenditure Expected revenue inflows R & D expenditure Expected revenue inflows

Budgeted ($000)

2018

2019

2020

2021

2022

75 50 200 0 1 500 0 0 0

75 50 200 0 500 0 1 500 0

100 50 350 500 250 1 750 0 500

100 0 0 1 250 0 1 750 0 250

0 0 0 500 0 750 0 250

All revenue and expenditure predictions are deemed to be ‘probable’. A discount rate of 6 per cent is used. In relation to the specific projects, the following information is also available: Project Alpha This project involves the compilation of all known information about the abrasive natures of different types of seaweed. The revenue inflows of $50 000 per year are being provided by a major shipping company. Project Beta This project relates to the ultimate development of a surfboard that will allow surfers to do more radical manoeuvres. Fifty per cent of the expenditure in 2018 was considered to represent research, while the balance of the related expenditures represents development. Project Gamma This project involves the development of a wetsuit with a rechargeable heat-pack. Initially, surfers rejected the concept because they believed it would create pain because of small electric shocks, and sales prospects looked poor. However, in 2019, surfers changed their minds and large-scale demand for the product was created. Only $250 000 of the expenditure in 2018 was deemed to represent research and the balance of all other expenditure was deemed to be development. 292  PART 3: ACCOUNTING FOR ASSETS

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Project Delta This project involves the development of a new wristwatch that predicts the height of waves. $250 000 has been spent on research and the balance on development. It is expected that only $1 000 000 will be recoverable.

REQUIRED Determine how much research and development expenditure should be deferred as at the end of 2019. LO 8.7 23. Paragraph 23 of an earlier version of IAS 38 Intangible Assets stated that: The Board’s view, consistently reflected in previous proposals for intangible assets, is that there should be no difference between the requirements for: (a) intangible assets that are acquired externally; and (b) internally generated intangible assets, whether they arise from development activities or other types of activities.

REQUIRED Evaluate the above view. Identify and explain inconsistencies between this view and the current requirements of AASB 138. LO 8.1, 8.2, 8.3, 8.4, 8.5

CHALLENGING QUESTIONS 24. Should computer software be classified as an intangible asset or as part of property, plant and equipment? LO 8.1, 8.2, 8.3 25. Inglis Ltd has a number of taxi licences that are shown in the financial statements at cost. Can these licences be revalued to fair value and, if so, do they also need to be subject to periodic amortisation? LO 8.1, 8.6, 8.9 26. An article that appeared in The Australian on 23 November 2005 (p. 45) by Blair Speedy, entitled ‘Aussie firms quick to adopt new regime’, included the following extract. Read the extract and evaluate the comments made by Sir David Tweedie, Chairperson of the IASB. LO 8.1, 8.2, 8.3, 8.4, 8.10, 8.11 Under the International Financial Reporting Standards, many intangibles can no longer be booked as an asset on a company’s balance sheet. The change saw News Corp, parent company of The Australian, this month book a first quarter loss of $US433 million ($588 million), due to a one-off accounting charge of $US1 billion relating to a change in rules governing the valuation of licences. Sir David said intangible assets such as newspaper mastheads might one day be allowed to be booked as assets. ‘As we get smarter, perhaps we’ll allow some of them back on, but the rest of the world doesn’t believe in them at the moment because of their unreliability and arguments over how they should be measured, so we’ve said that until that’s settled, they should be off balance sheets,’ he said. 27. As goodwill is not to be amortised, does this mean that the balance of goodwill can be carried forward indefinitely? LO 8.9 28. IP Ltd reports the following intangible assets: $m Patents at directors’ valuation less Accumulated amortisation Trademarks, at cost Goodwill, at cost less Accumulated amortisation Brand name Licence at cost less Accumulated amortisation

160   (40) 120 15 50  (10) 40 100 10 (1) 9 Chapter 8: ACCOUNTING FOR INTANGIBLES  293

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Patents were acquired at a cost of $80 million and were revalued soon afterwards. They have an estimated life of 16 years, of which 12 years remain. The trademark can be renewed indefinitely, subject to continued use. The cost represents registration fees, which were initially expensed but recognised five years later after the trademark had started to become recognised by consumers. Goodwill has been purchased and amortised on the straight-line basis. The brand name is stated at fair value and is internally generated. The licence has a 10-year life of which nine years remain. The licence can be traded in an active market and has a fair value of $17 million.

REQUIRED (a) State how each asset, or class of assets, should be reported in accordance with AASB 138. (b) Apply AASB 138 and state the carrying amount and whether each asset/asset class should be amortised. Specify any choice of methods permitted for IP Ltd. LO 8.1, 8.2, 8.3, 8.6, 8.9 29. Paragraph 107 of AASB 138 Intangible Assets states: An intangible asset with an indefinite useful life shall not be amortised.

REQUIRED Evaluate the above requirement. LO 8.4, 8.5 30. In 1999 the Group of 100, an Australian group representing senior executives from large Australian companies, made a submission to the Australian Accounting Standards Board. They were worried about the ‘strict’ rules incorporated in IAS 38 and were concerned that similar rules might be embraced in Australia, particularly in regard to the amortisation of intangibles. In its submission, the G100 stated: Were Australian companies to amortise all their identifiable assets, they would have considerably lower, if any, distributable profits out of which to pay dividends to shareholders. The shareholders of Australian companies would clearly be disadvantaged economically by mandatory amortisation. The economic impact cannot be understated.

REQUIRED Evaluate the above statement. LO 8.4, 8.5 31. At its September 2000 meeting, the AASB decided to provide interested parties with access to the document Strategy Paper—Intangible Assets through its website. In a section entitled ‘Key issues’ the document states: Some argue that if accounting standards were to not require/allow the recognition of some or all intangible assets as assets, the usefulness of financial reports would be undermined, particularly in the current environment when a substantial value of many entities is purported to be attributable to intangible assets. However, the dilemma for standard setters is that the integrity and therefore usefulness of financial reports will be undermined if intangible assets that do not meet the asset recognition criteria are allowed to be recognised.

REQUIRED Evaluate the above statement and discuss the relationship between ‘integrity’ and ‘usefulness’. Is the prohibition on recognising certain internally generated intangible assets too arbitrary to achieve a balance between usefulness and integrity? LO 8.1, 8.2, 8.3, 8.4 32. State whether the following assets may be revalued. Prepare journal entries for any revaluations permitted by accounting standards. Assume that each item listed below represents a separate class of assets. (a) A company has developed a masthead for its newspaper to the point where it is a very valuable asset. Although the masthead is not currently recognised, management believes it could be sold for at least $3 million. (b) A company purchased a publishing title two years ago for $1.2 million when another publisher went into liquidation. The book has been very successful and management believes that it could probably sell for $1.5 million if ever they put it on the market.

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(c) A company acquired a franchise for an ice-cream stand at a beach at a cost of $100 000. There is great demand for this type of franchise as evidenced by recent sales of equivalent franchises at other beaches. The current market price for such a franchise is $200 000. (d) A company has deferred development costs of $520 000 and the estimated recoverable amount for the development project is $860 000. LO 8.2, 8.3, 8.4, 8.5, 8.6 33. Innovator Ltd incurred expenditure researching and developing a cure for a common disease found in turnips. At the end of 2017 management determined that the research and development project was unlikely to succeed because trials of the prototype had been unsuccessful. During 2018 a breakthrough in agricultural science improved chances of the product succeeding and development resumed. The project was completed in 2018. At the end of 2018 costs incurred on the project were expected to be recoverable. Innovator expects that 10 per cent of the project revenue will be received in 2019, 20 per cent in 2020, 30 per cent in 2021, 30 per cent in 2022 and 10 per cent in 2023. After five years the product will be at the end of its useful life because the disease found in turnips will have been eradicated. Costs incurred were as follows:

2017 2018

Research ($000)

Development ($000)

40 12

10 60

REQUIRED (a) How much research expenditure and development expenditure should be recognised as an expense in 2017? (b) How much research and development expenditure should be recognised as an expense in 2018? (c) State how much expenditure should be carried forward (deferred) and reported in the statement of financial position at the end of 2017 and 2018. (d) Prepare journal entries for the amortisation of deferred costs in 2019 and 2020, assuming that actual revenues are as expected. State the amount of deferred expenditure carried forward in the statement of financial position in relation to the deferred costs. (e) Assume that after charging amortisation based on sales revenue at the end of 2018 the discounted net cash flows expected to be generated from the deferred expenditure were estimated as $15 000. Prepare any journal entries required to account for this information. LO 8.7 34. Read the adapted newspaper article in Financial Accounting in the Real World 8.2 and decide if you believe that the rules within AASB 138 actually led to more efficient flows of capital. LO 8.10, 8.11

8.2 FINANCIAL ACCOUNTING IN THE REAL WORLD Australia needs to take a leading role in global standard setting Roger Cotton’s article considers the implications of the decision to adopt International Financial Reporting Standards (IFRS) by the Australian government and Financial Reporting Council (FRC). Cotton is the Chief Executive of Australia’s National Institute of Accountants. The presumption is that investors will be more likely to invest in Australian business when they can readily compare investment opportunities across countries. The one sticking point for Australia was the adoption of International Accounting Point 38 (IAS 38) which the Australian Accounting Standards Board (AASB) tried unsuccessfully to persuade a meeting of the International Accounting Standards Board (IASB) to amend. The AASB wanted Australian companies to be able to follow their present practice of including intangible assets like brands in their accounts. continued

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If intangible assets are not recognised globally they will be ‘de-recognised’ and struck off a company’s bottom line. Interested parties in Australia are expected to lobby against adoption of IAS 38 but the benefits of Australia’s adherence to the IFRS in gaining access to markets and investment opportunities outweighs the new compliance regime. Cotton believes that AASB’s influence on IASB must be increased by giving it the resources to make direct representations and participate actively in the making of accounting standards. Only then can Australia’s particular circumstances be taken into account by the global body. SOURCE: Adapted from ‘Locals need more influence on standards’, by Roger Cotton, The Australian Financial Review, 5 March 2004, p. 54

35. As explained within the chapter, Australian accounting standards now prohibit goodwill from being subject to amortisation. Rather, there is a requirement that goodwill be subject to impairment testing. In relation to impairment testing of goodwill, Petersen and Plenborg (2010, p.420) state: Many argue that an impairment test only approach seems a logical step in the development of accounting for goodwill. First, the underlying logic for removing the traditional amortization methodology is that the amortization on a straight-line basis over a number of years contains no information value for those using financial statements (Jennings et al., 2001). Moreover, IFRS 3 (IASB, 2004b) no longer requires that companies perform the almost impossible task of estimating the useful life of goodwill (Jansson et al. 2004). Second, the impairment approach should provide users of financial statements with better information, as goodwill is not automatically amortized (Colquitt and Wilson, 2002; Bens and Heltzer, 2005). Finally, goodwill impairment tests would be operational and capture a decline in the value of goodwill (Donnelly and Keys, 2002).

REQUIRED You are to provide a clear argument as to why you agree or disagree with the perspectives provided in the paragraph above. LO 8.5, 8.9, 8.10, 8.11 36. Bloom (2009, p.381) notes how a great deal of the market value of a listed company relates to the value of its goodwill—much of which has been internally generated and which is prohibited from being recognised. In this regard he states: Paragraph 48 of AASB 138 states that ‘internally generated goodwill shall not be brought to account’. I reiterate that this dismisses some 45 per cent of the market capitalisation of all companies listed in the ASX, and 52.5 per cent of that of the top fifty companies. How can this be compatible with the objectives of general purpose financial reporting, let alone common sense?

REQUIRED Critically evaluate the above paragraph. LO 8.9, 8.11 37. In an article by Sue Mitchell entitled ‘Undies, sheets key to Pacific recovery’ that appeared in The Australian Financial Review on 27 August 2014 (p. 15), it was reported that: Pacific Brands’ fourth chief executive in seven years is counting on higher sales of Bonds underwear and Sheridan sheets to underpin earnings growth, as the clothing and textiles distributor sells assets and faces new head winds from the weaker Australian dollar . . . David Bortolussi confirmed on Tuesday earnings in 2015 could fall to the lowest level since 2004—despite six years of restructuring and cost cutting under his predecessors Paul Moore, Sue Morphet and John Pollaers—as gross margins came under pressure and costs continued to rise . . . ‘We’ve said it will be materially down but not catastrophic,’ Mr Bortolussi told The Australian Financial Review on Tuesday after reporting a 28.2 per cent fall in underlying net profit to $53.0 million in 2014 and a bottom line loss of $224.5 million, the fourth annual loss in six years . . . While sales rose 3.8 per cent to $1.322 billion in 2014, earnings before interest tax and one-off items fell 25.3 per cent 296  PART 3: ACCOUNTING FOR ASSETS

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to $91.2 million, in line with guidance. Pacific Brands also booked one-off costs of $312 million, including goodwill impairment charges of $242.3 million and restructuring costs of $32.9 million. These one-off costs took total impairment charges and restructuring costs over the last six years to more than $1.2 billion and led to a bottom-line loss of $224.5 million in 2014 compared with a $73.8 million profit in 2013. The company withheld its final dividend.

REQUIRED (a) At what point in time should goodwill impairment losses be recognised? (b) How would management determine whether a goodwill impairment loss should be recognised? LO 8.9 38. In an article by Peter Williams entitled ‘Bus ALS’ that appeared in The West Australian on 29 May 2015 (p. 75) it was reported that: The oil price slump has led to global testing provider ALS writing off about $290 million from a business it bought just two years ago. ALS in 2013 paid $US533 million for Reservoir Group, an international services and equipment provider for the oil and gas industry . . . ALS said yesterday that despite winning some significant contracts, the business’ annual earnings fell well below management’s expectations because of a sharp deterioration in market conditions . . . The goodwill impairment saw ALS hand in a $174 million net loss for the year to March 31. Underlying net profit was down 21 per cent to $135 million.

REQUIRED (a) How would ALS have originally calculated the carrying amount of goodwill? (b) How do you think investors might react to the large goodwill impairment loss? LO 8.9 39. In an article by Jeff Whalley entitled ‘QBE Superstorm’ that appeared in The Herald Sun on 10 December 2013 (p. 29) it was reported that: INSURANCE INVESTORS have stripped more than $4 billion from QBE’s market value after the insurance group cut its profit-margin forecasts for the fourth time in as many years. In a torrid day for the company, its shares plunged 22.3 per cent—the worst single-day market rout for the group in 12 years. It all but eroded all the group’s gains on the market this year. At $12, QBE shares are barely a third of the highs they hit above $35 in 2007. The dramatic plunge came as chairwoman Belinda Hutchinson, who has led the board since 2010, announced she would step down in March. QBE warned it expected to report a net loss of about $US250 million ($275 million) for the group’s current financial year, which ends this month . . . It is paying the price for its exposure to the US market, where the Hurricane Sandy ‘superstorm’ and the worst drought in 50 years have hit its profitability. Mr Neal said QBE expected to deliver a net profit after tax on a cash basis—effectively an underlying profit—of about $US850 million, down from $US1.04 billion last year. The group is expecting to report a profit margin in its insurance business of about 6 per cent, compared with a previous forecast of 11 per cent. QBE took a goodwill impairment charge of about $US600 million and a one-time impairment charge of $US150 million following a review of its North America business.

REQUIRED (a) How would the goodwill impairment charge reported above be disclosed in QBE’s financial statements? (b) If it was shown that some of the drop in share price was attributable to the departure of QBE’s chairperson, Belinda Hutchinson, then this would indicate that she was an ‘asset’ of the organisation while she was there (an intangible asset perhaps?). If she was of economic benefit to QBE then how would she have been measured and disclosed for financial statement purposes? LO 8.9 40. In an article by Carrie La Frenz entitled ‘Hastie auditor rejects PPB concerns’ that appeared in The Australian Financial Review on 22 January 2013 (p. 16) and is adapted here, it was reported that: In 2012 Hastie Group collapsed and there were wide-ranging job losses (2,100). PPB Advisory was appointed as Hastie’s administrator. PPB’s second report to Hastie’s creditors criticised the company’s auditors, Deloitte Australia, and said there were issues with Deloitte’s diligence in checking Hastie’s accounts. Deloitte’s adherence to Chapter 8: ACCOUNTING FOR INTANGIBLES  297

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accounting standards was in question and it appeared that undervaluing of impairment charges by Hastie had occurred or that they were not expensed when they should have been. This had given a false impression of Hastie’s earning forecasts. Craig Crosbie from PPB said that Deloitte knew that Hastie was carrying excessive goodwill in the June 2011 statements despite Hastie’s ongoing poor financial performance but didn’t insist on further impairment. At the time the company collapsed the impairment charges were $254M and goodwill was $291M. The PPB report said the goodwill should have been written down at the time of the June 2011 statements especially as it was followed by a capital raising of $160M in July 2011 and a further write down in December 2011. In its defence, Deloitte said that it had implemented proper auditing standards in its audits of Hastie Group and refused to comment further.

REQUIRED (a) On the basis of the facts provided, what do you believe was the correct accounting treatment in relation to goodwill? If you need additional information to make your judgement then what information would that be? (b) What are some possible reasons for why the management of the Hastie Group might not have wanted to reduce the value of the assets being reported in its financial statements? LO 8.9

REFERENCES BABER, W., FAIRFIELD, P. & HAGGARD, J., 1991, ‘The Effect of Concern about Reported Income on Discretionary Spending Decisions: The Case of Research and Development’, The Accounting Review, October, pp. 818–29. BEATTY, A. & WEBER, J., 2006, ‘Accounting Discretion in Fair Value Estimates: An Examination of SFAS 142 Goodwill Impairments’, Journal of Accounting Research, 44 (2): 257–88. BLOOM, M., 2009, ‘Accounting for Goodwill’, ABACUS, vol. 45, no. 3, pp. 379–89. CARLIN, T.M. & FINCH, N., 2009, ‘Discount Rates in Disarray: Evidence on Flawed Goodwill Impairment Testing’, Australian Accounting Review, 19 (4): 326–36. DECHOW, P. & SLOAN, R., 1991, ‘Executive Incentives and the Horizon Problem’, Journal of Accounting and Economics, 14, pp. 51–89. DUKES, T., DYCKMAN, T. & ELLIOT, J., 1980 Supplement, ‘Accounting for Research and Development Expenditures’, Journal of Accounting Research, pp. 1–26. FEROZ, E.H. & HAGERMAN, R.L., 1990, ‘Management Compensation, Insider Trading and Lobbying Choice: The Case of R & D’, Australian Journal of Management, December, pp. 297–314. GOODACRE, A. & MCGRATH, J., 1997, ‘An Experimental Study of Analysts’ Reactions to Corporate R & D Expenditure’, British Accounting Review, vol. 29, pp. 159–79. HORWITZ, B. & KOLODNY, R., 1980 Supplement, ‘The Economic Effects of Involuntary Uniformity in the Financial Reporting of Research and Development Expenditures’, Journal of Accounting Research, pp. 38–74. JAHMANI, Y., DOWLING, W. & TORRES, P.D., 2010, ‘Goodwill Impairment: A New Window for Earnings Management?’, Journal of Business and Economics Research, 8 (2): 19–24. JI, K., 2013, ‘Better Late than Never: The Timing of Goodwill Impairment Testing in Australia’, Australian Accounting Review, 23 (4): 369–79. LEWELLEN, W., LODERER, C. & MARTIN, K., 1987, ‘Executive Compensation and Executive Incentive Problems’, Journal of Accounting and Economics, 9, pp. 287–310.

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MILLER, M.C., 1995, ‘Goodwill Discontent: The Meshing of Australian and International Accounting Policy’, Australian Accounting Review, issue 9, vol. 5, no. 1, pp. 3–16. MOODIE, D., 2000, ‘Banking on Thin Air’, Charter, vol. 71, May, pp. 42–5. PARKER, C., 2003, ‘Intangible Assets: New Rules for 2005’, CPA Australia Food for Thought Seminar, 6 August. PETERSEN, C., & PLENBORG, T., 2010, ‘How Do Firms Implement Impairment Tests of Goodwill?’, ABACUS, vol. 46, no. 4, pp. 419–46. RAMANNA, K. & WATTS, R.L., 2008, ‘Evidence from Goodwill Non-impairments on the Effects of Unverifiable FairValue Accounting’, unpublished working paper, accessed November 2015 at http://www.hbs.edu/faculty/ Publication%20Files/08-014.pdf. SIROWER, M., 1997, The Synergy Trap – How Companies Lose the Acquisitions Game, Free Press, New York. WHITTRED, G. & ZIMMER, I., 1986, ‘Accounting in the Market for Debt’, Accounting and Finance, November, pp. 1–12.

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CHAPTER 9

ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS LEARNING OBJECTIVES (LO) 9.1

Understand what items constitute heritage assets and be familiar with the attributes of heritage assets that differentiate them from other assets.

9.2

Understand what types of assets can be classified as biological assets and know the unique attributes of such assets.

9.3

Be able to explain whether heritage assets appear to conform with accepted asset definition and recognition criteria.

9.4

Explain the arguments for and against measuring heritage assets in financial terms.

9.5

Be aware of the alternative approaches to measuring heritage assets.

9.6

Be able to explain how the nature of biological assets differs from many other assets.

9.7

Be able to explain why net market value or fair value has been suggested by some researchers as the appropriate basis for valuation of biological assets pertaining to agricultural activity.

9.8

Understand the various issues associated with changes in the market value of biological assets and be able to explain when such changes in value should be recognised in profit or loss.

9.9

Be aware of some ongoing accounting debates in relation to heritage assets and biological assets and be able to evaluate the logic of the various arguments supporting or criticising particular valuation and disclosure approaches.

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Introduction to accounting for heritage assets and biological assets In previous chapters we have considered a number of accounting standards relating to specific types of assets, such as inventory (AASB 102) and intangible assets (AASB 138). We have also considered other accounting standards that cover issues associated with determining the acquisition cost of property, plant and equipment, how to depreciate and revalue property, plant and equipment (AASB 116) and how to account for the impairment of assets (AASB 136). In this chapter, we will consider how to account for two general classes of assets that pose a number of very interesting accounting questions. These classes of assets are defined as heritage assets and biological assets. Various views will be provided on how to measure and disclose such assets. This chapter will introduce you to various arguments in favour of one method of accounting, as opposed to some others. The chapter will also discuss the sorts of debate that are ongoing within the financial accounting domain.

Accounting for heritage assets Definition of heritage assets There is no single accepted definition of a heritage asset. In a paper released in 2006 by the Accounting Standards Board (UK) entitled Heritage Assets: Can Accounting Do Better?, a heritage asset was defined as: An asset with historic, artistic, scientific, technological, geophysical or environmental qualities that is held and maintained principally for its contribution to knowledge and culture and this purpose is central to the objectives of the entity holding it. The release of the 2006 discussion paper in the UK ultimately led to the June 2009 release of an accounting standard by the Accounting Standards Board (UK) entitled FRS 30 Heritage Assets. There is no comparable accounting standard within Australia, nor has the IASB issued a related standard. Within FRS 30 there was a slight change in the definition of a heritage asset, the definition being: A tangible asset with historical, artistic, scientific, technological, geophysical or environmental qualities that is held and maintained principally for its contribution to knowledge and culture.

LO 9.1 LO 9.3 LO 9.4 LO 9.5 LO 9.9

heritage asset An asset with historic, artistic, scientific, technological, geophysical or environmental qualities that is held and maintained principally for its contribution to knowledge and culture and this purpose is central to the objectives of the entity holding it.

The above definition is interesting, particularly perhaps because the entity’s ‘purpose’ in holding the asset is central to qualifying the item for classification as a heritage asset. This is similar to assessments that need to be made when classifying other assets such as inventory (for example, a motor vehicle may be part of inventory in the hands of a car dealer, but for most organisations it would be part of property, plant and equipment). As the Accounting Standards Board (UK) (2006, p. 21) states: Entities may hold assets that might be regarded as heritage assets but the assets do not meet the definition proposed above. For example, a university may use an historic building to house teaching facilities—this rather than heritage is the building’s principal purpose. A profit-oriented company may own works of art which it holds for decorative purposes but contribution to knowledge and culture is not central to its primary objective which is to make a profit. The auditor-general of NSW has defined heritage assets as: those non-current assets that a government intends to preserve indefinitely because of their unique historical, cultural or environmental attributes. A common feature of heritage assets is that they cannot be replaced (e.g. monuments, historic museum collections, wilderness preserves and historic buildings). (NSW, Report of the Auditor-General, 1993)

As indicated above, the classification ‘heritage assets’ (also often referred to as ‘heritage, cultural and community assets’) can encompass many different types of items, such as national parks, national monuments, museum and library collections, historical buildings and sailing vessels. Typically, heritage assets are unique and have no alternative use.

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They are commonly under the control of government (as reflected in two of the definitions provided above), although they can be controlled by private-sector entities. They are typically controlled and maintained by the government because they are commonly not considered to be positive net present value investments (their cash outflows exceed their cash inflows)—a consideration that would be of primary importance to most private-sector entities and individuals. Heritage assets can consume large amounts of resources in terms of their initial acquisition, storage and ongoing maintenance. More often than not, heritage assets will cost more to maintain than the cash inflows they generate (that is, they generate negative net cash flows). In relation to the broad scope of items covered by the label ‘heritage assets’, the UK Accounting Standards Board (2006, p. 18) identifies the following as being heritage assets: • Works of art, antiquities or other exhibits such as biological and mineral specimens or technological artefacts, typically held in collections by museums and galleries. Their heritage value might arise from their provenance or their particular association with historical or cultural events. Some of these objects might be displayed to the public, while access to others might be restricted to those who need it for research purposes. • Collections of rare books, manuscripts and other reference material held by libraries and preserved for their historical and cultural value as a reference source. • Historical monuments such as standing stones and burial mounds. • Historical buildings that feature unique architectural characteristics or have significant historical associations. They need not necessarily be old; some modern buildings are regarded as worthy of preservation. • Elements of the natural landscape and coastline. Typically, these might include distinct geological and physiographical formations and discrete geographical areas encompassing the habitats of threatened species of animals or plants. These are preserved for scientific, cultural or environmental reasons. The above examples of heritage assets are quite broad ranging. As we explained earlier, we must also consider ‘purpose’ when determining whether an item is to be classified as a heritage asset. For example, in relation to ‘corporate art’, the UK Accounting Standards Board (2006, p. 51) states: Entities may hold assets that might be regarded as heritage assets but the entities are not primarily heritage organisations. An example encountered in the UK context is a government department which happens to hold antiques and other works of art for decorative purposes. Similarly, a profit-oriented company may possess antiques or works of art, not for investment purposes, but which reflect the company’s history or are used to create ambience in the company’s headquarters. Some commentators have referred to these as ‘ambience’ heritage assets or ‘corporate art’, they are ‘nice to have’ but not strictly necessary since contribution to knowledge and culture is not a purpose central to the objectives of these entities. For example, a company’s primary objective is usually to make a profit. For financial reporting purposes, such assets should not be regarded as heritage assets since they do not meet the proposed definition even if the assets are, occasionally, on display to the public. In these circumstances the assets should be accounted for under existing financial reporting requirements for tangible fixed assets i.e. recognised at cost or valuation. The Government’s Financial Reporting Manual requires government entities to report corporate art at a current (open market) value.

What is different about heritage assets? There have been many articles written about accounting for heritage assets. Often examined in such articles are questions such as: • Should heritage assets, which are typically controlled by government, be treated from an accounting perspective in the same manner as other assets? • Would heritage assets be considered to be ‘assets’ if assessed against accepted definitions and recognition criteria of ‘assets’ (such as the criteria included within the Conceptual Framework for Financial Reporting)? • Are the definition and recognition criteria of assets provided in the Conceptual Framework for Financial Reporting appropriate for public-sector assets? • How do we financially measure heritage assets? • Should we financially measure heritage assets? You, the reader, should take a minute to consider how you would respond to the above questions. There is anything but universal consensus on these issues. Some authors, such as Carnegie and Wolnizer (1995), believe that to measure 302  PART 3: ACCOUNTING FOR ASSETS

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heritage assets such as museum collections in financial terms for the purposes of inclusion in a statement of financial position (balance sheet) constitutes ‘intellectual vulgarism’. They suggest that any such financial quantification would also be an ‘accounting fiction’ (p. 32). Certainly, one could identify with such a view. For example, is it appropriate to put a financial value on ancient, unique and irreplaceable artefacts? Can such things usefully be represented in monetary terms? What is the purpose of quantifying such objects in monetary terms? Is there a demand for financial valuations of heritage assets? Will financial quantification assist in monitoring the accountability of those individuals charged with looking after heritage assets? The answers to such questions will, at least in part, be a function of your own personal values. One view, according to Carnegie and Wolnizer (1996, p. 84), is that: Apart from the logical impropriety and empirical impossibility of quantifying non-financial (non-monetary) properties of collections—such as their cultural, heritage, scientific and educative values—in monetary terms, the bringing of collections to account for financial reporting purposes may have counter-productive or destructive impacts on the organisational and social functions of museums. For example, such a practice may facilitate the implementation of government-imposed charges or levies on museums that could result in deaccessioning choices of a genre not previously contemplated, and which could irrevocably destroy the integrity of collections— and hence diminish their cultural, heritage, scientific, educative and other values to the community. The views of Carnegie and Wolnizer are not shared by all people within the accounting profession and are not consistent with accounting requirements within Australia, as well as within many other countries, where government departments are being instructed to put a financial value on their heritage assets for the purpose of disclosure in general-purpose financial statements. AASB 116 Property, Plant and Equipment also specifically addresses heritage assets. According to paragraph Aus6.2: Examples of property, plant and equipment held by not-for-profit public sector entities and for-profit government departments include, but are not limited to, infrastructure, cultural, community and heritage assets. Therefore, it is accepted by accounting standard-setters that ‘property, plant and equipment’ held by not-forprofit public-sector entities and for-profit government departments can include ‘heritage assets’. AASB 116 provides guidance in relation to heritage and cultural assets. The ‘Australian Implementation Guidance’ (found at the end of AASB 116) states: This guidance accompanies, but is not part of, AASB 116. This guidance is pertinent to not-for-profit public sector entities and for-profit government departments that hold heritage or cultural assets. G1. In accordance with paragraphs 7(b), 15 and Aus15.1 of AASB 116, only those heritage and cultural assets that can be reliably measured are recognised. It depends on the circumstances as to whether the reliable measurement recognition criterion can be satisfied in relation to a particular heritage or cultural asset. Heritage and cultural assets acquired at no cost, or for a nominal cost, are required to be initially recognised at fair value as at the date of acquisition. Depending on circumstances, it may not be possible to reliably measure the fair value as at the date of acquisition of a heritage or cultural asset. G2. Of those heritage and cultural assets that satisfy the reliable measurement criterion for initial recognition purposes, paragraph 29 of AASB 116 permits, but does not require, revaluation. However, under AASB 1049 Whole of Government and General Government Sector Financial Reporting, GGSs and whole of governments are required to adopt those optional treatments in Australian Accounting Standards that are aligned with the principles or rules in the Australian Bureau of Statistics Government Finance Statistics (GFS) Manual. Consequently, those entities would be required to adopt a revaluation model for heritage and cultural assets recognised under AASB 116 where the reliable measurement recognition criterion is satisfied. G3. Furthermore, given the nature of many heritage and cultural assets that meet the recognition criteria, those assets may not have limited useful lives (for example, when the entity adopts appropriate curatorial and preservation policies), and therefore may not be subject to depreciation. However, they would be subject to impairment testing when there is an indication of impairment. So, again, we can see that heritage assets are expected to be recognised for financial statement purposes to the extent that they can be reliably measured. But from a broader societal perspective we might still question whether they should be measured in financial terms. CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  303

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In the accounting standard released in the UK (June 2009)—this being FRS 30 Heritage Assets—the UK Accounting Standards Board also took the view that heritage assets should be recognised for balance sheet purposes. Paragraph 11 of SFR 30 states: Where heritage assets are reported in the balance sheet, the following should be disclosed: (i) the carrying amount of heritage assets at the beginning of the financial period and at the balance sheet date, including an analysis between those classes or groups of heritage assets that are reported at cost and those that are reported at valuation; and (ii) where assets are reported at valuation, sufficient information to assist in an understanding of the valuations being reported and their significance. This should include: (a) the date of the valuation; (b) the methods used to produce the valuation; (c) whether the valuation was carried out by external valuers and, where this is the case, the valuer’s name and professional qualification, if any; and (d) any significant limitations on the valuation. In explaining the rationale for recognising heritage assets, paragraphs 14 and 15 of the Appendix to FRS 30 state: 14. If heritage assets are not capitalised, the balance sheet will provide an incomplete picture of an entity’s financial position. For this reason, it is better to report heritage assets in the balance sheet where information is available on cost or value rather than leave these assets out of the balance sheet. 15. The Board considers the best financial reporting is achieved when heritage assets are reported as tangible fixed assets at values that provide useful and relevant information at the balance sheet date. It is therefore likely that a current valuation will be more useful than historical cost, although it is acknowledged there can be difficulties in obtaining valuations for heritage assets. Hence, we can see from the above that the AASB, the ASB (UK) and the IASB all believe that heritage assets can, and should, be measured and disclosed in financial terms. Consistent with the views of the accounting standard-setters, there are many accounting writers who consider that heritage assets should be measured and disclosed in financial terms. For example, Micallef and Peirson (1997, p. 34) state: Information about cultural, heritage, scientific and community collections (CHSCCs) held by museums, art galleries and libraries and controlled by public sector entities is necessary to make informed assessments about the allocation of (scarce) public funds, and any changes in the allocation of funds from period to period. For example, such information would be important to allow parliament, government and taxpayers to assess whether the resources devoted to particular activities warrant ongoing financial support or whether resources should be diverted to other public activities. It is also part of the information necessary to assess whether the value of the assets controlled by the entity has been eroded, improved or retained, and for assessments of previous decisions to acquire CHSCCs. In addition, including information about CHSCCs in general-purpose financial reports enables the managers of museums, art galleries and libraries to discharge their accountability by providing some of the information necessary to enable assessments of their performance. Micallef and Peirson (1997, p. 34) further state that: A large part of the collections controlled by many [institutions] is in storage rather than on public display. [Whether] the level of items in storage is excessive and should be reduced cannot be [determined] without information about both the quantity and financial value of those items. Let us consider various arguments for and against the financial recognition of heritage assets. This will provide some insight into one of a number of ongoing accounting debates. It is to be hoped that the discussion will encourage you to consider how you believe such assets should be accounted for. Again, you should consider whether we actually need to put a financial value on all valuable resources. In considering arguments for and against the recognition of heritage assets we can begin with the Conceptual Framework for Financial Reporting as a frame of reference (but we need to keep in mind that this is a framework developed for profit-seeking entities rather than entities in not-for-profit sectors). As we know, the conceptual framework

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currently defines assets as ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. The conceptual framework states: An entity usually employs its assets to produce goods or services capable of satisfying the wants or needs of customers; because these goods or services can satisfy these wants or needs, customers are prepared to pay for them and hence contribute to the cash flow of the entity. Cash itself renders a service to the entity because of its command over other resources. Paragraphs Aus54.1 and Aus54.2 of the AASB conceptual framework provide further guidance of relevance to heritage assets. These paragraphs state: Aus54.1 In respect of not-for-profit entities, whether in the public or private sector, the future economic benefits are also used to provide goods and services in accordance with the entities’ objectives. However, since the entities do not have the generation of profit as a principal objective, the provision of goods and services may not result in net cash inflows to the entities as the recipients of the goods and services may not transfer cash or other benefits to the entities in exchange. Aus54.2 In respect of not-for-profit entities, the fact that they do not charge, or do not charge fully, their beneficiaries or customers for the goods and services they provide does not deprive those outputs of utility or value; nor does it preclude the entities from benefiting from the assets used to provide the goods and services. For example, assets such as monuments, museums, cathedrals and historical treasures provide needed or desired services to beneficiaries, typically at little or no direct cost to the beneficiaries. These assets benefit the entities by enabling them to meet their objectives of providing needed services to beneficiaries. Returning to the current definition of an asset, there are three fundamental characteristics that should be present before something can be considered to be an asset: 1. The item must be expected to provide future economic benefits. 2. The item must be controlled (as opposed to legally owned). 3. The transaction or event giving rise to the control must already have occurred. As we know from previous chapters, the conceptual framework provides criteria for the recognition of assets. An asset is to be recognised in the statement of financial position when and only when: (a) it is probable that the future economic benefits embodied in the asset will eventuate; and (b) the asset possesses a cost or other value that can be measured reliably. Having considered the definition and recognition criteria of assets, we can determine if heritage assets meet these criteria. In particular, we can consider the following questions: • Do heritage assets provide future economic benefits? • Who controls heritage assets? • Are the economic benefits measurable with reasonable accuracy? Some answers to these questions are considered in turn below.

Do heritage assets provide future economic benefits? As we know, if an object is not likely to generate future economic benefits, it is not an asset. One of the major arguments against the recognition of heritage assets in financial terms is that they typically lead to net cash outflows, rather than positive net cash inflows. This has actually led some authors to consider that perhaps heritage assets would more correctly be considered to be liabilities than assets (see, for example, Mautz 1988). However, the fact that an object might generate net cash outflows (meaning the cash outflows exceed the cash inflows) throughout its life is not sufficient for that item to be considered a liability. According to the conceptual framework, a liability requires a current obligation to transfer resources to an external party—this might not be the case for heritage assets, even when future negative net cash flows are anticipated. Heritage assets do provide ‘needed or desired services to beneficiaries’, but asset recognition under the conceptual framework relies upon probable economic benefits being generated for the benefit of the entity that controls the source

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of the benefits—not benefits to the recipients of the asset’s output or services. As Carnegie and Wolnizer (1999a, p. 18) state in relation to items such as public collections held in places like museums or public art galleries: In the case of public arts institutions, the objectives are non-commercial—they are concerned with enhancing the intellectual capital of communities rather than (necessarily) increasing the financial wealth of organisations. Further, the community is clearly better off with the existence of monuments, parks, historical museum collections and the like. However, can these benefits be considered economic? Also, if the benefits are considered to be of a social nature, can or should they be quantified in monetary terms? In this regard, Carnegie and Wolnizer (1996, p. 87) note: It has recently been argued by accounting policy makers that items such as collections held by not-for-profit entities benefit the entities by enabling them to meet their objective of providing needed service to beneficiaries and, hence, qualify them for recognition as assets. We agree that the public museums are judged to be meeting their organisational objectives but we are unable to find any commercial reality in this contrived interpretation. The financial valuation of collections on the grounds that museums provide social and other non-financial benefits to communities does not, in any meaningful sense, transform collections into financial assets. Such transformation would take place if a museum’s organisational objectives were changed to embrace profit seeking or wealth maximisation, providing the legal and ethical prohibitions on collection trading were removed to enable museum management to achieve the new (commercial) organisational objectives. Generally, entities responsible for maintaining and safeguarding a particular heritage asset, for example a museum in charge of a collection of historical artefacts, do not have any discretion to decide to dispose of collection items. Although it is possible that buyers would be available for the objects within a collection, if the entity is forbidden to dispose of the ‘asset’, does it really make sense to calculate a notional market value—one that will probably never be realised? Nevertheless, there are existing requirements for public-sector entities to value their assets, inclusive of their heritage assets, for the purpose of statement of financial position presentation. AASB 1049 Whole of Government and General Government Sector Financial Reporting requires government departments that are reporting entities to adopt asset, liability, expense and income definitions and recognition criteria consistent with those provided in the conceptual framework—that is, to adopt accrual accounting. This represents a departure from accounting approaches that were adopted a number of years ago when government departments typically accounted for their activities by means of cashbased accounting systems. As government departments are required to prepare financial statements using Australian equivalents of IFRSs, all assets that satisfy the recognition criteria contained in the conceptual framework should be recognised in the reporting entity’s statement of financial position. This would include artefacts of cultural or historical significance or heritage and community assets. The longevity of heritage or infrastructure assets means that their historical cost or initial carrying value is unlikely to remain relevant for economic decision making, including an assessment of accountability over the life of the asset. AASB 116 states that for those heritage assets which satisfy the reliable measurement criterion for initial recognition purposes, the standard permits, but does not require, revaluation. If it is accepted that heritage assets, if held by government, do enable government to achieve its particular objectives (many of which are social), yet nevertheless frequently generate negative net cash flows, some writers have argued that the definition and recognition criteria for assets held by government and not-for-profit organisations might need to be different from those for assets held by for-profit organisations—in other words, we would need a different version of the conceptual framework that is specifically developed for not-for-profit entities. Mautz (1988, p. 123) states The implication is that we need to give some serious and perhaps innovative consideration to the nature of accounting for not-for-profit organisations. If they have substantive differences from for-profit enterprises—and I believe they do—we may need some modification of our for-profit building block concepts before we apply them where they do not fit. Otherwise we accountants will continue to confuse ourselves as well as those who read our financial reports. At this point we leave it to you to ponder whether the conceptual framework, in its current form, is appropriate for application to government not-for-profit entities and, in particular, to issues associated with the financial recognition of heritage assets. At present, views on the subject diverge widely. 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benefits. The UK Accounting Standards Board expressed the following views on the economic benefits generated by heritage assets in its accounting standard FRS 30 (2009). Paragraph 11 of the Appendix to the standard states: Heritage assets are central to the purpose of an entity such as a museum or gallery: without them the entity could not function. An artefact held by a museum might be realisable for cash, it might generate income indirectly through admission charges or the exploitation of reproduction rights. However, and in most cases much more importantly, the museum needs the artefact to function as a museum. The artefact has utility: it can be displayed to provide an educational or cultural experience to the public or it can be preserved for future display or for academic or scientific research. The future economic benefits associated with the artefact are primarily in the form of its service potential rather than cash flows. In the Board’s view, by virtue of the service potential they provide, heritage assets meet the definition of an asset; that is, they provide ‘rights or other access to future economic benefits controlled by an entity as a result of past transactions or events’. In 2014 the International Public Sector Accounting Standards Board, which is an international body that makes pronouncements on public-sector accounting, released its public-sector-specific conceptual framework entitled The Conceptual Framework for General Purpose Financial Reporting by Public Sector Entities. While it has no direct authority within countries such as Australia, it is interesting to note how it has defined assets. According to paragraph 5.6 of the IPSASB conceptual framework, an asset is: A resource presently controlled by the entity as a result of a past event. What is interesting is that the above definition is effectively the same as the definition of assets that the IASB has recently proposed as part of the work to develop a revised Conceptual Framework for Financial Reporting (see Chapter 2)—which is being developed by the IASB for ‘for-profit’ organisations. Hence, calls for a ‘different’ definition of assets for not-for-profit sectors seem to have gone unanswered. In terms of the above definition of an ‘asset’, further clarification is provided in respect of what a ‘resource’ means. Paragraph 5.7 of the IPSASB conceptual framework states: A resource is an item with service potential or the ability to generate economic benefits. Of specific interest is the definition of ‘service potential’ that is provided at paragraph 5.8. It emphasises that something can be considered to have service potential, and therefore be a ‘resource’ and an ‘asset’, even if it does not generate positive cash flows. As paragraph 5.8 states: Service potential is the capacity to provide services that contribute to achieving the entity’s objectives. Service potential enables an entity to achieve its objectives without necessarily generating net cash inflows. Apart from projects, such as the development of a conceptual framework for the public sector just discussed, the IPSASB undertook a review of the accounting issues specifically relating to heritage assets. The review led to the development of a Consultation Paper in 2006; however, due to other priorities the project was suspended in 2008 with the intention of reactivating the work at a subsequent date. However, as of 2016, the project had not been reactivated. The Australian Accounting Standards Board noted the following in the minutes of a meeting held on 3 May 2006 (as accessed on the AASB’s website) in respect of the Consultation Paper: The Boards agreed that the submissions to the IPSASB should: (a) in relation to the specific matters for comment, reflect the view that heritage assets are a subset of property, plant and equipment. The Boards noted that, depending on circumstances, the life cycle of an item of property, plant and equipment may mean that it takes on or loses heritage attributes. Accordingly, heritage assets should be treated in the same way as other items of property, plant and equipment, including being recognised on an asset-by-asset basis rather than on an all-or-nothing basis, and measured at cost (or deemed cost) or fair value; (b) acknowledge that accounting for heritage assets is a difficult issue, especially for certain jurisdictions, such as in Europe, that hold large numbers of heritage assets that have not previously been recognised; (c) note that a significant issue the IPSASB will need to address is how to assist entities making the transition from non-recognition of heritage assets that meet the asset recognition criteria to recognition of those heritage assets. The Boards noted that, given the transitional nature of the issues and depending on a cost/ benefit assessment, they could accept a mixed model so that at least the accounting for future acquisitions of heritage assets is consistent with the accounting for other types of property, plant and equipment; CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  307

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(d) acknowledge the difficulties in obtaining reliable measurements for many types of heritage assets, and suggest that practical valuation guidance for heritage assets would assist entities to transition to recognition; and (e) emphasise that heritage assets are not an homogenous class of assets and that different accounting treatments (including disclosure of non-financial information about heritage assets) or guidance may be appropriate for different types of heritage assets. From a fair value measurement perspective, the different types of heritage assets may fall into the following categories: (i) heritage assets for which fair value can be reliably estimated and it incorporates entirely the heritage attribute of the assets (for example, a heritage asset for which there is a market in the same or similar assets); (ii) heritage assets for which fair value can be reliably estimated but it does not fully incorporate the heritage attribute of the assets (for example, a heritage asset for which there is no market but for which there are attributable cash flows, although those cash flows do not reflect the full heritage attribute of the asset); and (iii) heritage assets for which fair value cannot be reliably estimated (for example, a heritage asset for which there is no market, no attributable cash flows and no other basis for reliably determining fair value). Hence, we can see that the Australian accounting profession appears to embrace the view that heritage assets should be recognised in financial terms. Another important factor when it comes to recognising future economic benefits is that of who controls those benefits. This issue is considered next.

Who controls heritage assets? From earlier chapters, we know that an entity must be able to demonstrate ‘control’ over an asset before it is recognised for financial reporting purposes. In the Exposure Draft of the Conceptual Framework of Financial Reporting released by the IASB in May 2015 as part of the process of releasing a revised conceptual framework, the IASB defined control in the following terms (paragraph 3.23): An entity controls an economic resource if it has the present ability to direct the use of the economic resource so as to obtain the economic benefits that flow from it. In relation to heritage assets, there are some specific issues that pertain to ‘control’ and that might lead to some questions about whether the objects in question should be recognised as assets. One issue to consider is the identity of the department that ultimately controls an asset. As Burritt and Gibson (1993, p. 20) state: In considering heritage assets, there is considerable uncertainty as to whether control rests at the Federal, State or Local Government level. Many of these assets, particularly those of an environmental nature, are owned by the states, but are subject to varying degrees of control by the government. Within the private sector, it is generally possible to deny others’ access to assets that are in a private entity’s control. For heritage assets, however, it is typically difficult to exclude access. For example, national parks, monuments, museums or botanical gardens are typically accessible to everybody. However, the departments that are charged with maintaining the heritage assets will typically also have other assets to which they can clearly regulate access—for example, their motor vehicles. At issue is whether heritage assets should be included within the statement of financial position along with other assets such as motor vehicles where determination of control is less problematic. There are also restrictions (some of them statutory) on what can be done with an asset. For example, it might be that an asset may not be disposed of. Whether such a restriction constitutes lack of ‘control’ cannot be clearly determined. In relation to the ‘control’ of museum collections, Carnegie and Wolnizer (1995, p. 42) sum up as follows: Repositories of collections are not freely able to dispose of their holdings, and are not able to deny or regulate the access of others to enjoying the services they provide, leading us to conclude that the second essential characteristic of an ‘asset’ (control) is not met in the case of collections. Such views would also be relevant to other types of heritage assets. The Accounting Standards Board in the UK also addressed the matter of holders of heritage assets typically not being able to sell them. However, the Board 308  PART 3: ACCOUNTING FOR ASSETS

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adopted a position contrary to that of Carnegie and Wolnizer when it stated in the appendix to FRS 30 (paragraphs 12 and 13): 12. Heritage assets are often described as ‘inalienable’ i.e. the entity cannot dispose of them without external consent. Such a restriction may, for example, be imposed by trust law, arise from the charity’s governing documents or in some cases by statute. The key feature of inalienability is that it prevents an asset being readily realisable. Some argue that assets held in trust are not assets of the entity, equating the inability to sell such items with forgoing the economic benefit inherent in them. But assets that are inalienable may well have utility to the entity and therefore meet the definition of an asset. 13. Inalienability is not a robust concept—it is possible that a donor’s wishes may be revoked and even statutory restrictions are not immutable from amendment or revocation by Parliament. Some assets are so central to the purpose of an entity that it is inconceivable they would ever be sold; so, in substance, they are inalienable. Because it is imprecise, the concept of ‘inalienability’ does not therefore provide a suitable criterion for framing accounting requirements. The opposing views just quoted serve well to highlight the controversy and debate that can be generated by the varying accounting treatments of heritage assets.

Are the benefits measurable with reasonable accuracy? For an asset to be recognised for the purposes of disclosure in a general-purpose financial statement, it must possess a cost or other value that can be reliably measured. Heritage assets by their very nature are unique, making measurement problematic. Values for similar assets are typically not available. Those charged with valuing an asset will therefore lack experience in valuing such assets at either market price or replacement cost. It is a difficult proposition to come up with a reliable valuation. In this regard we can consider an extract from a newspaper article entitled ‘WA Museum insurance was too high’ (by Stephen Bevis in The West Australian, 6 November 2014) in which it was reported that the Western Australian Museum paid higher insurance premiums than it should have to insure its collection because an accounting mistake overstated its value by almost $200 million. In the article it was stated that: The 2009 valuation was by Victorian cultural heritage specialist Simon Storey, who has valued collections for the National Gallery, the National Museum and the Australian War Memorial. Mr Storey said the error was not picked up by himself or the museum despite draft reports that the directorate and chief financial officer would presumably check. For five years, the collection had an inflated value of $638.31 million but was revalued this year at $347.06 million, $291.25 million or 46 per cent less than in 2009, with new accounting methods factored in. Mr Coles [Museum Director, WA Museum] said the decrease did not affect the integrity or intrinsic value of collections or reflect or imply fewer items in collections, which had increased. It would appear from the extract provided above that the apparently inflated value for the museum’s assets went undetected for several years—that is, it was not obvious to the valuer, the museum staff or the auditors that the financial amount attributed to the assets was almost twice what it should have been. This possibly emphasises the uncertainty associated with such valuations. Conceivably, different valuations made by ‘expert’ valuers could provide widely disparate results. Such an outcome would be grounds against asset recognition. Where market prices are not available, alternative valuation techniques can be employed, although these could be cause for concern from a reliability point of view, raising questions in turn about how an external auditor might assess the reasonableness of asset valuations appearing in a statement of financial position (again, keep the above newspaper article extract in mind). We will consider various valuation techniques later in this chapter. At this point, however, we examine some interesting cases. For example, the National Museum of Australia valued the preserved remains of legendary racehorse Phar Lap at $10 million. Clearly, different individuals would value Phar Lap’s remains at different amounts. How would an external auditor verify that $10 million is appropriate? Further, Carnegie and West (2005, p. 913) note that these preserved remains of Phar Lap do not actually include the skeleton. Indeed, they noted that the skeleton of Phar Lap is held by the Museum of New Zealand, which has placed a value of $1 million on it. Another interesting valuation is one made by the City of Ballarat, which valued the original Eureka Flag—the symbol of an 1850s uprising by gold-miners that has acquired iconic status within Australia—at $10 million (Carnegie and West, 2005, p. 913). So, with such valuations in mind, what value should be placed on the remains of Charles Darwin’s finch, which was crucial to his development of the theory of CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  309

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evolution? Would it be valued at the same amount as the preserved remains of other finches that appear similar? Does putting a financial value on such items make sense in the first place? Does it become more important if it has a higher valuation? What do you, the reader, think? (See, the study of accounting does raise some interesting issues! Accounting can indeed be exciting . . .)

Demand for financial information on heritage assets Determining whether there is a demand for financial information on heritage assets is a very important issue. If there is limited demand for certain information, resources are being wasted on providing such information. This applies to any item within a financial statement, or indeed, within any report. Requiring that heritage assets be disclosed in financial terms must be predicated on the perception that such information is valuable to the users of the reports. In relation to cost-versus-benefit considerations associated with the recognition of assets, the IASB Exposure Draft of the revised Conceptual Framework for Financial Reporting (released May 2015) notes (paragraph 5.24): As with all other areas of financial reporting, cost constrains recognition decisions. There is a cost to recognizing an asset or a liability. Preparers of financial statements incur costs in obtaining a relevant measure. Users of financial statements also incur costs in analyzing and interpreting information. In some cases, the cost of recognition may outweigh the benefits. Standard-setters and regulators of financial information need to employ processes for gathering information about the merits of requirements that they are proposing. So, before making particular accounting requirements mandatory, it is essential for accounting standard-setters to ensure that the benefits to be derived from the increased disclosures exceed the costs incurred in making such disclosures. Jaenicke and Glazer (1992) report the results of a survey, undertaken by the US Financial Accounting Standards Board, of museum users and their views on a requirement to disclose museum collections in financial terms. Jaenicke and Glazer noted (p. 46) that many members of the museum community expressed concern that a requirement to capitalise museum collections could be extremely costly to implement, especially for collection items acquired in previous periods, and would not provide any significant benefits. In relation to interviews they personally conducted, Jaenicke and Glazer (1992, p. 46) state: The interviews we conducted in the course of our research indicated that users of financial statements are not concerned about the value of a museum’s collection or about comparing the value of one museum’s collection with those of others. Rather than being relevant, information provided by capitalising collection items could mislead users of financial statements into believing that collection items could be readily sold and the proceeds used to meet a museum’s operating or other financial needs. Carnegie and Wolnizer (1995) report the results of two surveys of arts institutions. One of their surveys relied upon questionnaires sent to 67 arts institutions outside Australia to ascertain their accounting policies for collections. Carnegie and Wolnizer report (p. 35) that they received 32 responses to their questionnaire. These responses came from the United States, the United Kingdom, New Zealand, France and Spain. The results indicated that most institutions did not recognise their collections as assets and only two of the entities recorded collections in their balance sheet at valuation. When asked why they did not value their collections for financial purposes, the respondents indicated that the collections were not available to meet financial obligations, that their value could not be calculated, and that valuation was not cost-beneficial. The other survey reported on by Carnegie and Wolnizer (1995) was of 26 major Australian arts institutions, all of them government bodies. The authors report (p. 35) that: With the exception of the Art Gallery of New South Wales, Art Gallery of Western Australia, Northern Territory of Australia Museums and Galleries Board and the South Australian Film Corporation, major Australian arts institutions do not value their collections for financial reporting purposes. The above results are reflected in steps taken in the United States and Canada. As Carnegie and Wolnizer (1999a, p. 18) report: Recent proposals to mandate the financial valuation of collections in the US and Canada were withdrawn, in part, because of the lack of significant user demand for such information. The ‘International Accord’ adopted at the International Conference on the Value and Valuation of Natural Science Collections held at the University of 310  PART 3: ACCOUNTING FOR ASSETS

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Manchester in April 1995 contained a principle which confirmed this view: ‘Governments should . . . recognise that the value of natural science collections lies in their scientific and cultural importance, and that, although in certain circumstances it may be possible to place a verifiable financial valuation on such material for accounting purposes, there appears to be no demonstrable benefit in doing so’ (International Accord on the Value of Natural Science Collections 1995). If we accept that what is actually reported typically reflects what is demanded, it is questionable whether financial information about various forms of heritage assets is really necessary. If we accept such a position, we must, nevertheless, acknowledge that information of some form must be produced for parties interested in the ongoing performance of those charged with looking after heritage assets. However, such information does not have to be restricted to being purely financial. In this regard, Jaenicke and Glazer (1992) provide some suggested disclosures for museums in a US context. They state (p. 47): The major goal of the [US] FASB proposal presumably is to provide relevant, reliable information about collection items to users of financial statements. We believe, however, that museums will have significant problems implementing a capitalisation requirement. One workable alternative is to require museums to present a schedule of changes in the number of items in the collection that would reconcile the beginning and ending figures, including the number of collection items purchased, contributed and sold during a period. Those disclosures, together with dollar figures for total current-period purchases, contributions and sales of collection items, would provide the financial statement user with relevant and reliable information about the nature and sources of changes in the collection. Notice that they do not rely upon financial valuations of the collections.

Measuring heritage assets in financial terms One of the major purposes of financial reporting is to enable the management personnel of a reporting entity to demonstrate their accountability for the resources entrusted to them in financial terms. Management, however, should be accountable only for things under their control. Further, the purpose or central roles of the organisation (perhaps reflected in the organisation’s or department’s mission statement) must be carefully considered when determining appropriate criteria for assessing the performance or accountability of managers. In relation to the mission statements of 16 major Australian museums, Carnegie and Wolnizer (1996, p. 86) report that: the statements exclude reference to income generation, financial wealth creation or wealth maximisation, profitability and surplus distribution. Rather, the statements emphasise the cultural, heritage, scientific and educative values which museum managers aspire to impart thereby enhancing the intellectual capital of society. Museum managers are neither charged with the responsibility of maximising the financial value of the collections or return on investment, nor do they have authority and fiscal freedom under the statutes which govern their operation to freely buy and sell collection items that would be required to discharge such responsibilities. If we look at the Vision and Mission Statement of the National Museum of Australia (as provided on its website in 2016), we find the following: Vision A recognised world-class museum exploring Australia’s past, illuminating the present, imagining the future. Mission To promote an understanding of Australia’s history and an awareness of future possibilities by: • developing, preserving and exhibiting a significant collection • taking a leadership role in research and scholarship • engaging and providing access for audiences nationally and internationally • delivering innovative programs. We can see that no mention is made of issues associated with financial performance or position. At issue, therefore, is whether those in charge of looking after heritage assets should be assessed on financial criteria. In this regard, Pallot (1990, p. 84) states: Managers should not be held accountable for what they do not control. If managers are prohibited from disposing of, or making replacement decisions about, certain assets and such power is a necessary condition CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  311

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for performance, it is unfair to assess management in terms of the efficiency with which the assets are used, especially given use is by the public rather than the governmental unit itself. With respect to such assets it may be preferable to measure management performance by such criteria as the availability and accessibility of the assets to the public. Alternative points of view have been provided by Burritt and Gibson (1993) and Hone (1997). Burritt and Gibson (1993, p. 21) propose that one of the aims of the public sector in reporting heritage assets is to ensure that the basis of performance measurement for the entity or department responsible for those assets will be more accurate, as rate of return, for example, will be calculated on a total asset base. The question here, however, is whether financial performance indicators, such as rate of return, are relevant for those charged with looking after heritage assets—particularly given the details of their mission statements. Hone (1997, p. 39) advances the view that the valuation of public collections is a potentially valuable tool in making collection managers accountable for the efficient use of public resources. He states: To be able to allocate funds in a meaningful way between competing uses and to evaluate the performance of collection managers, collections need to be valued in terms of the value of the flow of services the collections provide to the community. On the other hand, to be able to monitor the legitimacy of the acquisition programs, the collections need to be valued in terms of their current market values. An alternative perspective is that the financial quantification of heritage assets can lead to negative impacts on the way assets are utilised and, indeed, on whether they are retained to serve the purposes for which they were acquired. In this regard, and in relation to heritage assets of an archaeological nature, Carnegie and Wolnizer (1999b, p. 145) state: If we allow a monetary value to be placed on archaeological material for financial reporting purposes, we normalize the concept of archaeological remains as a resource and thereby invite its comparison with other— possibly more highly prized—resources. Such systems of valuation and comparison may ultimately require the disposal of ‘archaeological assets’ in order to meet financial charges laid upon supposedly ‘asset-rich’ archaeological organizations. Hence there is considerable power and possibly misrepresentation in ‘numbers’. Anyone who proposes to wield them in new ways or contexts ought to explain how organizations and society generally might be changed for the better through their generation. What we are left with is something of an impasse between those who consider that it is appropriate for managers of heritage assets to be accountable for their performance on bases tied to the financial value of the resources under their control and those who hold the contrary view. In relation to ‘accountability’, it is commonly accepted that accountability itself does not have to be assessed in terms of financial indicators alone. As Gray (1983, p. 4) states: Accountability is a concept which is generally underdeveloped in the accounting literature. As a result it is frequently misused, and commonly taken as synonymous with external financial reporting or financial accounting. Accountability is, however, a very ‘rich’ concept and its relationship with ‘accounting’ is rather more complex than is generally recognised in the literature. Gray, Adams and Owen (2014, p. 50) provide a fairly simple, but useful, definition of accountability, which is: The duty to provide an account or reckoning of those actions for which one is held responsible. Gray, Adams and Owen further note (p. 51) that accountability: Involves two broad responsibilities or duties: the responsibility to undertake certain actions, or forbear from taking actions, and the responsibility to provide an account of those actions. Hence, we can see that judgements about the required accountability of an organisation can be very subjective. Assessments need to be made about such issues as: • Why report? • To whom to report (who are the stakeholders)? • What aspects of performance to report? • How to report? 312  PART 3: ACCOUNTING FOR ASSETS

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Carnegie and Wolnizer (1996) emphasise the importance of the service provided by those who maintain heritage assets (for example, the managers of a museum) for the benefit of society. As they state (p. 91): In assessing the services of museums, it is crucial to recognise the importance of the ‘quality of the experience’ provided to visitors. Information about the uses made of collections, the number of persons who visit them, and other data gained through visitor surveys is of relevance in the evaluation of the performance of museum management. In summary, up to this point we have considered why it might not be appropriate to recognise heritage assets in a financial sense. The arguments against such recognition have been based on a number of key points: • Heritage assets often do not provide economic benefits. • Determination of ‘control’ is problematic. • The benefits are difficult to quantify in monetary terms. • Demand for financial information on heritage assets has not been clearly established. • The accountability of those charged with managing heritage assets is not well assessed by reliance on financial valuation. Nevertheless, as we know, government departments are in fact subject to a requirement to disclose heritage assets within general-purpose financial statements. If we accept that heritage assets must be valued to comply with existing accounting standards, such valuation can be undertaken in a variety of interesting ways. The following section briefly considers some of the valuation approaches that have been adopted. However, before we move on we will touch on some of the alternative approaches to reporting heritage assets as discussed by the UK Accounting Standards Board (2006). It outlines three possible accounting approaches for heritage assets: 1. a ‘mixed’ capitalisation approach 2. a ‘full’ capitalisation approach 3. a non-capitalisation approach. Under the mixed capitalisation approach, some assets will be capitalised and others merely discussed in the notes to the financial statements. The ASB was not generally in favour of this approach. The ASB was concerned about the apparent inconsistency in reporting practice. In relation to the ‘full capitalisation approach’ the ASB states (2006, p. 27): Under a capitalisation approach, heritage assets, including those acquired in previous accounting periods, should be recognised and capitalised in the balance sheet. This would ensure that the accounting policy is applied consistently to all heritage assets held. Such an approach is consistent with the Statement of Principles which requires the recognition of an asset if there is sufficient evidence it exists and it can be measured at a monetary amount with sufficient certainty. Heritage assets might be reported at historical (transaction) cost or a current value; some jurisdictions permit the use of notional values. These bases of measurement have their relative merits and disadvantages. In considering these it is clear that notional values will not provide useful and relevant information. The nature of heritage assets means that historical cost is not generally an appropriate measurement basis for them and so the basis of measurement under a capitalisation approach should be a current value based on market values. The ASB recognised that there are practical difficulties with determining a current value for heritage assets and summarised these difficulties as follows (ASB 2006, p 34): Incomparable nature: Some heritage assets (such as the Rosetta Stone) simply cannot be valued as there are no comparable assets from which to determine a value. The provenance of a heritage asset (for example, the spear that killed Captain Cook) may determine its cultural (as well as monetary) value which cannot be ascertained properly from like-forlike comparisons or from its reproduction cost as the heritage provenance cannot be recreated. Lack of active market: Heritage assets tend to be held indefinitely and may be rarely sold. Consequently there may be no market reference from which to identify a current value. And where markets do exist they may be specialised and the volumes of transactions small, so that prices fluctuate making it impossible to determine meaningful trends. CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  313

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Insurance values may not be available or relevant: The incomparable nature of heritage assets which, being unique, cannot be replaced also brings into question the appropriateness of insurance values. For this reason many entities do not generally insure heritage assets, although they may insure against accidental damage where items are loaned to another institution. Large collections to be valued: Museums and galleries may hold thousands of heritage assets. The sheer volume of objects precludes their valuation on cost–benefit grounds alone. Sampling techniques may have some application where large collections of similar objects are held. However, a museum collection may well not be homogeneous in nature and the incomparable nature of heritage assets might preclude wider application of sample-based valuations. In relation to the ‘non-capitalisation approach’ alternative (the third alternative), the Board states (2006, p. 28): Under a non-capitalisation approach entities would not be permitted to capitalise heritage assets acquired in the past or during the current reporting period. This would ensure that an accounting policy is applied consistently to all heritage assets. This approach would clearly be straightforward to implement as it avoids practical problems in determining values. However, in applying a non-capitalisation approach, the treatment of acquisitions and disposals in the current reporting period will need to be determined. One treatment might be to record the acquisition of a heritage asset as an expense in the income and expenditure account. This approach is permitted in a number of jurisdictions (see Appendix 2). However, this could be seen to misrepresent the substance of the transaction in that an asset has been acquired and has not been consumed. This distorts the level of reported expenses and does not properly reflect financial performance. Reporting the full proceeds from the disposal of heritage assets as income in the performance statement is also distorting. An alternative treatment would be to present the acquisition and disposal of heritage assets separately, outside of the income and expenditure account, to distinguish clearly these transactions from other activities of the entity. It is proposed that under a non-capitalisation approach acquisitions and disposals of heritage assets should be presented separately from income and expenditure. This will aid transparency of reporting and, linked to enhanced disclosures, should provide a clearer picture of heritage asset transactions for the reporting period. Regarding which of the three approaches was favoured, the ASB (2006, p. 31) states: The objective of the proposals is to improve the quality of financial reporting of heritage assets by requiring an entity to adopt a consistent and transparent accounting treatment. Heritage assets should be reported as assets at values that provide useful and relevant information at the balance sheet date. A capitalisation approach is therefore proposed where it is practicable to obtain valuations which, when supplemented with appropriate disclosures, provide useful and relevant information sufficient to assist in an assessment of the value of heritage assets held by an entity. Where this cannot be achieved, an entity should instead adopt a non-capitalisation approach. Paragraphs 16 to 18 of the appendix to FRS 30 (issued by the ASB in 2009) emphasised the point that the reporting entity must consider the difficulties and the costs and benefits associated with capitalising heritage assets: 16. The Board considered a number of alternative approaches during the course of its work, ranging from capitalising no heritage assets through to a requirement to capitalise all heritage assets. The noncapitalisation approach, although straightforward to apply, has little conceptual merit and will result in heritage assets not being capitalised where information is available on their cost or value. It also raises issues regarding the reporting of acquisitions and disposals of heritage assets. In particular, it would be wrong to report the purchase of a heritage asset as an expense. 17. On the other hand, a full capitalisation approach is unlikely to be applied consistently, given the unique nature of many heritage assets and the many practical difficulties associated with identifying cost or determining a current value. 18. Neither of these approaches provides an appropriate basis for a standard; hence the Board developed an approach that it considered conceptually sound as well as being pragmatic. This approach was 314  PART 3: ACCOUNTING FOR ASSETS

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exposed in the Discussion Paper and required the valuation of heritage assets where it is practicable to obtain valuations, which, when supplemented with appropriate disclosures, provide useful and relevant information sufficient to assist in an assessment of the value of heritage assets held by the entity at the balance sheet date. Although the ASB has expressed a preference for the capitalisation approach, it has noted that whatever approach is adopted, additional disclosures would be necessary. Such additional disclosures include the following (paragraphs 6 to 15 of FRS 30): • the nature and scale of heritage assets held • the entity’s policy for acquisition, preservation, management and disposal of heritage assets • accounting policies adopted • for heritage assets that are not reported in the balance sheet, the reasons why • information that is helpful in assessing the value of those heritage assets that are not reported in the entity’s balance sheet • preservation and management policy for respective assets • acquisitions and disposals. We can see that there are various approaches to valuing assets. That is, if we embrace a view that we should capitalise heritage assets wherever possible and/or practicable (the view favoured by the ASB), the next issue to present itself is determining how to attribute value to the asset. Perhaps if the asset is not unique we can readily determine a market value. However, many heritage assets are unique, making it impossible to refer to a ‘market price’. In such circumstances alternative measurement approaches have been suggested and some of these are discussed in the following section. It is interesting to note that FRS 30 (paragraph 21) made no specific recommendations in relation to valuation, other than noting that: Valuations may be made by any method that is appropriate and relevant.

Approaches to valuation of heritage assets With the absence generally of a ‘market’ for heritage assets, a number of alternative approaches have been developed to attribute a value to them. As we have seen up to now, there are some accounting researchers who consider it inappropriate to put a value on heritage assets of a unique nature. With this said, however, we will now examine some of the approaches adopted in practice by individuals who do need to attribute a financial value to heritage assets.

Contingent-valuation method (CVM) One approach to valuing heritage assets, particularly those that generate recreational enjoyment for users such as national parks, is the contingent-valuation method (CVM). CVM typically relies on a survey administered to a sample of individuals who are deemed to represent society. These respondents are asked how much they would be willing to pay to retain a particular resource such as a national park or a museum collection. The results from the sample can then be scaled up to determine what society as a whole—or perhaps a subset of society that constitutes the users of the resource—would be prepared to pay for the item. Hone (1997) notes that this approach assumes respondents are rational and able to make informed decisions about the value to themselves of the particular items being examined. According to Hone (p. 41):

contingent-valuation method (CVM) An approach often used in valuing heritage assets, typically relying upon a survey administered to a sample of individuals who are asked how much they would be willing to pay to retain a particular resource.

In Australia the most celebrated use of CVM was in the federal government’s inquiry into the management of the Kakadu conservation zone in the Northern Territory which was carried out by the Resource Assessment Commission (Imber, Stevenson and Wilks). The approach was used to determine how much Australians were willing to pay over the long term to protect the Kakadu area from mining activity. The results of the study suggested that, on average, people were willing to pay $120 a year for ten years to protect the region from substantial mining activities.

In applying CVM, a number of key decisions must be made. It is essential, first, to define the population of individuals from which a sample of views is to be taken. Decisions must also be made about how to describe the item to be valued. For example, if the item is a national park, should details of all the flora and fauna be provided within the questionnaire? CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  315

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CVM is subject to a number of potential criticisms. A common criticism relates to the realism of the questions. If we are asked how much we would pay, would we provide an ‘accurate’ response when we know that we do not really have to pay? Also, if we think the valuations provided will affect the supply of the particular resource, would we perhaps inflate our valuation in an endeavour to increase the supply of the resource? Another issue relates to the ‘observability’ of the item(s). For example, a collection of items might be extremely important for research purposes but, for whatever reason, not be on public display. This inability to observe the collection could have a negative impact on the value attributed to the item(s) by the public. Exhibit 9.1 provides an illustration of the use of CVM as reported in a report entitled Making economic valuation work for biodiversity conservation as released by Land and Water Australia in 2005. As we can see, the illustration relates to valuing a species of possum. Again we are left to wonder—‘Should we place a financial value on a possum?’ As human beings, what rights do we actually have to place economic valuations on other species? Indeed, do issues of economics and nature belong together? What do you, the reader, think? If the economic value of the timber is calculated to be greater than the ‘conservation value’ attributed to the possums is this really a rationale for destroying their habitat and thereby potentially killing off the possums? Is there a moral justification for such a trade-off?

travel-cost method (TCM) Method that relies on collecting data about the costs incurred by individuals who visit a particular location. These costs are used to determine what individuals are paying to use that resource.

Exhibit 9.1 An illustration of the application of CVM

CASE STUDY: THE WORTH OF A POSSUM The contingent-valuation method was used to explore people’s willingness to pay for two aspects of biodiversity: all endangered species of flora and fauna in Victoria (about 700 species); and one threatened species, Leadbeater’s possum. The study was motivated by a legislative requirement to include social and economic valuation in species and biodiversity conservation policy decision making in Victoria. Method

Two questionnaires were circulated among a random sample of 3900 Victorians drawn from the electoral roll. One questionnaire asked how much people were prepared to pay for the conservation of 700 species and the other for the conservation of Leadbeater’s possum. People were asked how much they would be willing to pay a year to conserve these two aspects. The payment vehicle was an increase in state taxes and/or a donation to a private conservation organisation. Findings

The conservation value of Leadbeater’s possum alone was estimated to be between $40 million ($29 per household) and $84 million (around $60 per household) a year. The range of values for conserving all 700 endangered species was estimated to be $160 ($118 per household) to $340 million (around $250 per household) a year. Policy relevance

The estimated economic value for conserving Leadbeater’s possum is two to three times the value of timber cut from its habitat and equivalent in value to both water conservation and recreation values. Therefore, conservation of the Leadbeater’s possum habitat would be given priority as it provided a positive benefit to the community when compared to alternate uses. The estimated value for conserving all 700 endangered species was at least an order of magnitude larger than government expenditure on flora and fauna conservation at the time of the study (about $10 million a year). These figures could be interpreted as strong support for increasing spending on conservation. SOURCE: Australian Government, Dept of the Environment and Heritage, and Land and Water Australia, 2005

Travel-cost method (TCM) Another widely used approach to valuing heritage assets is the travel-cost method (TCM). This method relies on collecting data about individuals who visit a particular location. Information is collected about the costs incurred by individuals in travelling to a particular location plus the opportunity costs of any wages forgone as a result of making the visit. These costs are then used as a basis for determining what individuals are ‘paying’ to use a particular resource 316  PART 3: ACCOUNTING FOR ASSETS

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(even if there is no entrance fee). The results are then extrapolated to determine what the total number of users would be prepared to pay. Using TCM involves many choices. How can we value the cost of time? Do we use average wage rates or do we assume that the users of a particular resource (such as a public art collection) have higher-than-average wage rates? Should leisure time actually be charged at the individual’s wage rate as is often done—that is, are leisure time and work time substitutable? Another perceived problem of TCM is that it relies upon the costs incurred by users of the resource (‘use benefits’). It is conceivable, however, that individuals who do not use the resource would nevertheless be prepared to pay for or subsidise its existence. Methods of valuation such as CVM and TCM have, from time to time, generated much controversy, particularly when such valuations are subsequently compared with the economic benefits that might follow if a heritage asset is to be sold to private interests. For example, government might be considering allowing private interests to take over a national park, perhaps for the purposes of logging or mining. The expected economic benefits to be derived from the mining or logging activity, by the community as a whole or perhaps initially by the particular private entity, might exceed the valuation attributed to the heritage asset. If this is so, this may provide government with the necessary rationale for stripping the resource of its heritage status. Of course, care should be taken with such an approach, since it necessarily assumes that social benefits can be reduced to economic numbers. We also need to remember that methods such as TCM and CVM rely on many subjective assumptions. Exhibit 9.2 provides an illustration of the use of TCM as reported in a report entitled Making economic valuation work for biodiversity conservation as released by Land and Water Australia in 2005.

CASE STUDY: ASSESSING THE RECREATIONAL VALUES OF NATIONAL PARKS AND STATE FORESTS IN VICTORIA Parks outside urban areas are usually natural areas containing biodiversity that produces a wide range of direct, indirect and non-use values. This study was carried out to guide policies and strategic directions for park management, monitor changes in economic output over time through repeat studies, justify funding allocation and aid infrastructure and government investment decision making.

Exhibit 9.2 An illustration of the application of TCM

Method

The travel-cost method was chosen and the analysis used existing survey data. Data were collated on point of origin postcode for each visitor, frequency of visits, group size, length of stay, means of travel, type of accommodation etc. Findings were extrapolated to parks for which no survey data existed, using ‘benefit transfer’ (see below). Findings

The sample of 23 non-metropolitan parks (national parks, state parks etc.) revealed that the average visitor enjoyed a net benefit of over $19 a day when visiting a park. The total recreational value for all 23 parks for the years 1997/98 was over $173 million. Policy relevance

The estimate for recreation value is part of the total economic benefit provided by the parks. This estimate alone exceeded the public expenditure on managing parks. Therefore these findings could be used to justify or increase existing expenditure on park management. SOURCE: Australian Government, Dept of the Environment and Heritage, and Land and Water Australia, 2005

Alternative valuation practices Other valuation methods have been adopted when there is no actual market for an asset. Some Australian government departments have made valuations on land, such as parkland, based on the market values of nearby privately held properties. For example, in relation to valuations made by the City of Sydney Council, its 2014 City of Sydney Financial Statements (Note 23) stated that: Community land is valued on the deprival method using Valuer-General valuations of immediately adjacent properties. CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  317

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Valuing land on such a basis is consistent with the requirements embodied within AASB 1049 Whole of Government and General Government Sector Financial Reporting. However, doing so represents a departure from previous treatments, where such resources were frequently valued at a notional value of $1. For example, the Report of the Auditor General, NSW (1993) states that: Generally, all land pertaining to museums, Art Gallery and Library is to be valued at $1 on the basis that such land would not become available for sale or alternative development. If such was not the case, an appropriate valuation would seem to be alternative use based on surrounding land usage ... there is a significant range of assets in the public sector which are often not valued in the department’s statement of financial position other than at the nominal value of $1. When the practice was to disclose assets at a notional value of $1, departments were nevertheless required to disclose a summary of significant assets employed or held to which no, or only nominal, values had been attributed. Specific disclosures were required of the names and functions of the assets, including reference to their size, quantity and quality and the amount of expense incurred in the current financial period in respect of such assets. Recently there has been a general shift by all government departments away from using nominal valuations (such as the $1 approach just described) for their heritage assets. Consequently, use of alternative methods such as those outlined above has increased. Interested readers are encouraged to obtain copies of government departments’ annual reports to review the valuations of the departments’ heritage assets, as well as the basis for those valuations. In the process of changing valuation methods, some interesting values have been attributed to particular assets, including trees on council land. As Boreham (1995) notes: The City of Melbourne cannot be accused of taking a half-hearted approach to valuing its assets. Its accountants have ascribed a value of $210 to each of its 50 000 trees, including its famous and rather long-lived oak trees, and will recognise these wooden assets in the 1994–1995 accounts. Another valuation issue that has attracted much attention is that of valuing land under roads, although this land is not classified as a heritage asset. Councils are required to provide a value for this land, but, again, we can perhaps challenge the sense of this requirement. While the roads obviously provide many benefits of a social and economic nature, do we really need to value the land upon which they sit? In concluding this section on heritage assets, let us consider the article ‘Heritage hangs in the balance’ by Garry Carnegie and Peter Wolnizer in Financial Accounting in the Real World 9.1. As already indicated in this chapter, these writers are strongly opposed to requirements for the financial recognition of heritage assets. Obviously, we should keep in mind that their views do not reflect the views of all parties involved in researching or regulating the disclosure of heritage assets. When deciding whether or not to agree with particular views, it is always necessary to consider the logic of the various parties’ arguments. The article by Carnegie and Wolnizer not only summarises their views, but also effectively much of the material in this chapter so far. The extract from Alex May’s article ‘True values’ in Financial Accounting in the Real World 9.2 describes how particular heritage assets might be valued.

9.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Heritage hangs in the balance Garry Carnegie and Peter Wolnizer Putting a monetary value on museum collections is a futile exercise and may endanger priceless cultural records, write Garry Carnegie and Peter Wolnizer. The following scene should be recorded for posterity as an example of late 20th century accounting nonsense. Right now, scores of accountants and valuers are combing through the back vaults of Australia’s not-for-profit museums, libraries and public record offices trying to put dollar signs on collections of stuffed animals, indigenous relics, fossils, specimens, artistic and literary works.

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Accountants and valuers may be buoyed by the opportunity to ‘value’ public collections, but most Australian museum managers do not welcome this intrusion into their job of preserving and enhancing the cultural, heritage, scientific, educative and other non-financial values of these public assets. Rightly, most museum managers are not convinced that the accounting information will be useful. Instead, they are concerned that advocates of financial valuation have little understanding of the primary function of their collections, which is ‘to be’ and ‘to hold’. The objectives or mission statements of many Australian and overseas public museums exclude references to income generation, wealth creation, profitability and surplus distribution. Indeed, museum managers are not allowed, under the statutes which govern their organisations, to do so. Collections of public museums are held in trust for the national and the international community. John Carman writes, in Valuing Ancient Things: Archaeology and Law, that heritage laws are important morally and culturally, elevating museum objects out of the everyday world into the higher realm of the ‘public domain’. The financial valuation of collections effectively miscategorises them. It places collections in an economic realm where they have no place. This miscategorisation has important implications, particularly for ‘reserve’ (or not on display) collections which may be seen as ‘excessive’ by some accountants and government policy makers, even though they are an integral part of the museum’s complete collection. Collections can only be regarded as excessive if they are regarded as ‘stock’. Thus, the financial valuation of collections may have unexpected counter-productive or even destructive consequences. For instance, it may lead to government-imposed charges on museums, such as an annual capital charge based on the financial valuation of assets which could destroy the integrity of publicly owned collections. Saleable items may have to be liquidated just to pay the charges. Collections, of themselves, do not generate net cash inflows either through normal museum operations or by commercial exchanges. Financial valuation is appropriate only where items have been de-accessioned (that is, removed from the public domain), and a resale market exists for them. It is an empirical impossibility to reliably quantify in monetary terms the values of collections, such as their cultural, heritage, scientific and educative values. How can the ‘value’ of Phar Lap to the community be quantified in money terms—or the value of indigenous artefacts to the people whose ancestors made them? The Australian proposal for valuing museum collections comes from a ‘limited-scope’ financial accountability focus adopted by the accounting standard-setters as part of a shift to ‘commercial accounting’ for public sector management. But, for public museums, a more functional notion of accountability is needed. We suggest that a wider range of factual ‘indicators’ be developed to strengthen accountability while maintaining the integrity of their organisational missions. SOURCE: ‘Heritage hangs in the balance’, by Garry Carnegie and Peter Wolnizer, The Australian Financial Review, 10 July 1997, p. 16

9.2 FINANCIAL ACCOUNTING IN THE REAL WORLD True values Alex May Sydney-based cultural and heritage valuer Simon Storey says everything has a value. Even the rarest item that will never be sold has a dollar-price. It has to, according to Australian accounting standards that require all of our nation’s cultural goods and chattels to be valued. Phar Lap’s heart? $1 million. The splinter of propeller from Kingsford-Smith’s Southern Cross plane? $15 000. And the value of that same piece of propeller after astronaut continued CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  319

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Andy Thomas took it into space in 1996? ‘Anything between $AUS30 000 and $AUS40 000,’ says Storey. Storey makes his living valuing the collections of Australia’s museums and art galleries and ‘trying to keep the auditors happy’ with those Australian accounting standards that require him to value the priceless. Sometimes there is a formula to create the value—Storey is currently assessing how much it would cost to re-collect 350 body parts on loan from a museum to a university’s medical faculty. Other items are so rare that only ‘gut feeling’ creates the value. ‘With Phar Lap’s heart I had to create fair value by asking taxi drivers and men in the street what they thought it would be worth,’ says Storey, who was a fine art auctioneer before he began valuing collections when accounting standards changed in the 1990s. ‘The valuation came from what I thought it would cost this country to wipe away the tears if the thing ever got pinched.’ SOURCE: ‘True Values’, by Alex May, Sunday Life, February 2006

LO 9.2 LO 9.6 LO 9.7 LO 9.8 LO 9.9

Accounting for biological assets

In the first section of this chapter we considered how to account for heritage assets. Now we turn our attention to another interesting type of asset—biological assets and the produce generated by, or relating to, agricultural activity. The relevant standard is AASB 141 Agriculture, which at paragraph 5 defines agricultural activity as ‘the management by an entity of the biological transformation and harvest of biological assets for sale or for conversion into agricultural produce or into additional biological assets’. A biological asset is defined as a living animal or plant. biological asset AASB 141 Agriculture, which was initially released in July 2004 (and subsequently amended A living animal or plant. and re-released), replaced AASB 1037 Self-generating and Regenerating Assets. AASB 1037 was initially released within Australia by the Australian Accounting Standards Board in 1998. This was before the IASB developed its own standard on ‘biological assets’. The Australian standard formed the basis for IAS 41 Agriculture. Because the development of the standard within Australia informed much of the work undertaken by the IASB we will spend some time considering the initial work that was done in Australia. This work addressed a number of very interesting issues. As in the field of heritage assets, there had traditionally been a general lack of guidance on how to account for selfgenerating and regenerating assets (SGARAs), as they were referred to within Australia. In fact, accounting standards that dealt with such issues as inventories, depreciation of non-current assets, and the revaluation of non-current assets traditionally excluded from their ambit forests, livestock or similar regenerative natural resources. However, in 1995 the Australian Accounting Research Foundation (which no longer exists) released Discussion Paper No. 23 entitled ‘Accounting for Self-Generating and Regenerating Assets’. This discussion paper, written by Roberts, Staunton and Hagen (hereafter referred to as RSH), provides the basis for the discussion that follows. As a discussion paper, it does not have any mandatory status but it does provide some very interesting insights into particular presentation and measurement issues. The discussion paper relied heavily on the definitions and recognition criteria embodied within the Australian Conceptual Framework Project (replaced, as we know, by the AASB conceptual framework, which is based in turn on the IASB conceptual framework). The Discussion Paper concentrates on assets held for the generation of economic benefits, particularly forests held as part of a forestry operation and animals held as part of a livestock operation by for-profit operations. Its recommendations can therefore be contrasted with the recommendations outlined earlier under heritage assets, which are generally held by not-for-profit operations. Following the release of the discussion paper, Exposure Draft ED 83 Self-generating and Regenerating Assets was released for comment in August 1997. This Exposure Draft ultimately led to the release of AASB 1037 Self-generating and Regenerating Assets in August 1998. The requirements of AASB 1037 became applicable for financial years ending on or after 30 June 2001. As we have indicated, from 2005, AASB 141 Agriculture replaced AASB 1037. RSH, and the discussion within this section of the chapter, places considerable emphasis on the SGARAs of forests and livestock because of their economic significance to the Australian economy and because of the large number of reporting entities that hold such assets. RSH nevertheless considers that the fundamental self-generative and regenerative characteristics of all SGARAs (and biological assets) mean that the principles developed and discussed for the forestry and livestock industries can be applied generally to all SGARAs (and biological assets). 320  PART 3: ACCOUNTING FOR ASSETS

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Definition of self-generating and regenerating assets (SGARAs) and biological assets RSH (p. 3) defines SGARAs as ‘non-human-related living assets’. This definition was adopted in AASB 1037. It is similar to the definition of ‘biological asset’ now used within AASB 141, which is ‘a living animal or plant’. In considering the scope of our current accounting standard, AASB 141, paragraph 1 states: This Standard shall be applied to account for the following when they relate to agricultural activity: (a) biological assets, except for bearer plants; (b) agricultural produce at the point of harvest; and (c) government grants covered by paragraphs 34 and 35.

SGARAs Self-generating and regenerating assets; that is, non-humanrelated living assets, including trees and animals.

Hence, to be within the ambit of AASB 141 the living animal or plant, and the related produce, must be related to, or generated by, agricultural activity. Effective from 2016, ‘bearer plants’ are excluded from AASB 141 and now must be accounted for pursuant to AASB 116 Property, Plant and Equipment. A bearer plant is defined at paragraph 5 of AASB 141:

A bearer plant is a living plant that: (a) is used in the production or supply of agricultural produce; (b) is expected to bear produce for more than one period; and (c) has a remote likelihood of being sold as agricultural produce, except for incidental scrap sales.

In terms of the accounting treatment of bearer plants, as now contained in AASB 116, the bearer plants would initially be recorded at cost. In this regard, paragraph 22A of AASB 116 requires: Bearer plants are accounted for in the same way as self-constructed items of property, plant and equipment before they are in the location and condition necessary to be capable of operating in the manner intended by management. Consequently, references to ‘construction’ in this standard should be read as covering activities that are necessary to cultivate the bearer plants before they are in the location and condition necessary to be capable of operating in the manner intended by management. Therefore, the general rule is that all costs associated with getting a bearer plant to the point of being productive would be included in the cost of the asset. Pursuant to AASB 116, bearer plants shall subsequently be accounted for using either the ‘cost model’ or the ‘revaluation model’. As we will see shortly, for those biological assets within the ambit of AASB 141—and we now know that bearer plants are outside the ambit of AASB 141—there is a general requirement that biological assets be measured at fair value less costs to sell. AASB 141 has adopted the definition of assets currently provided by the AASB conceptual framework. Paragraph 10 of AASB 141 states: An entity shall recognise a biological asset or agricultural produce when, and only when: (a) the entity controls the asset as a result of past events; (b) it is probable that future economic benefits associated with the asset will flow to the entity; and (c) the fair value or cost of the asset can be measured reliably. We have already defined biological assets. As we know from the above discussion, the accounting standard also applies to agricultural produce. Agricultural produce is defined at paragraph 5 of AASB 141 as ‘the harvested produce of the entity’s biological assets’. AASB 141 does not apply to produce that is the result of processing after harvest. For example, wine, which is a product that results from processing after harvest, would be covered by AASB 102 Inventories. Paragraph 4 of AASB 141 provides some examples of biological assets, agricultural produce, and products that result from processing after harvest. The examples are reproduced in Table 9.1. Again, the items in the third column would not be covered by AASB 141, but would be covered by AASB 102 Inventories. We explored how to account for inventories in Chapter 7. Some plants, for example, tea bushes, grape vines, oil palms and rubber trees, usually meet the definition of a bearer plant and are within the scope of AASB 116. However, the produce growing on bearer plants, for instance, tea leaves, grapes, oil palm fruit and latex, is within the scope of AASB 141. CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  321

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Table 9.1 Examples of biological assets, agricultural produce and products resulting from processing

Biological assets

Agricultural produce

Products that are the result of processing

Sheep

Wool

Yarn, Carpet

Trees in a timber plantation

Felled trees

Logs, lumber

Dairy cattle

Milk

Cheese 

Pigs

Carcass

Sausages, Cured ham

Cotton plants

Harvested cotton

Thread, clothing

Sugarcane

Harvested cane

Sugar

Tobacco plants

Picked leaves

Cured tobacco

Tea bushes

Picked leaves

Tea

Grape vines

Picked grapes

Wine

Oil palms

Picked fruit

Palm oil

Rubber trees

Harvested latex 

Rubber products

Fruit trees

Picked fruit 

Processed fruit

There are some accounting issues that are peculiar to biological assets. These arise as a result of the unique attributes of such assets. It is physical change (both in quality and quantity) that is economically important in relation to biological assets. For example, biological assets such as forests or livestock can grow or multiply without any direct human intervention or transactions. As RSH states (p. 89—but do remember that in their work the authors referred to selfgenerating and regenerating assets rather than biological assets. Their arguments also apply to biological assets, which are simply a subset of SGARAs and so, for the sake of clarity, we have changed any reference to SGARAs to biological assets, including references made within quoted material): Particular financial reporting issues are encountered in relation to biological assets because changes are automatically produced in such assets without originating transactions, or at least between human originating transactions, and the changes arising from biological assets are fundamentally remote. To complicate matters further, what is present at the end of a period may be significantly different in quantity, quality and type from what (if anything) was present at the beginning. Traditionally, accounting is accustomed to a record process beginning with a definable acquisition. Without transactions indicating acquisition, production or development, the traditional accounting treatment is inadequate. Prior to the issue of accounting standards on SGARAs (and, subsequently, biological assets), evidence shows that there was a great deal of variation in the accounting treatments adopted by different reporting entities. In 1995, RSH argued that the development of an accounting standard would create: comparability of information about biological assets in different reporting entities’ financial reports and hence the usefulness of information for making decisions in relation to such economically significant assets would be enhanced by the development of specific financial reporting requirements for biological assets. Such a notion relies upon the view embraced within the Conceptual Framework for Financial Reporting that comparability is an important attribute of general-purpose financial information. According to RSH a number of key issues needed to be considered before an accounting standard on SGARAs/ biological assets was released. These issues, considered in turn next, are the following: • Since SGARAs/biological assets are unique, do they warrant a dedicated accounting standard? • How should SGARAs/biological assets be classified and presented in financial statements? • How should SGARAs/biological assets be measured? • When and how should revenue associated with SGARAs/biological assets be recognised? 322  PART 3: ACCOUNTING FOR ASSETS

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The unique nature of biological assets Biological assets have many unique characteristics that have implications for the development of valuation and disclosure guidelines. These unique characteristics include the following: • Unlike most other assets, biological assets have a natural capacity to grow and/or procreate that directly affects the value of the asset. • A great deal of the increase in value of the resource might be due to the input of ‘free goods’, such as sun, air and water. • Frequently, a large proportion of the costs are incurred early in the life of the asset, for example, in the establishment of a forest, yet the economic benefits are not derived until many years later. • The production (growing cycle) of the assets can be particularly long—for example, some forests may take in excess of 30 years to generate millable timber—resulting in questions about when the revenue should be recognised. In relation to a forest, should we wait until the ultimate harvest before we recognise revenue? • There is not necessarily any relationship between expenditure on the asset and the ultimate returns, perhaps owing to unforeseen circumstances such as droughts, flooding and variations in the quality of soils.

How should biological assets be classified and presented in financial statements? Prior to the issue of the accounting standard on SGARAs/biological assets, there were a variety of possible approaches to classifying and disclosing such assets, as emerges from any review of Australian companies’ annual reports of the time. Prior to the adoption of the standard, for assets such as forests, a number of Australian organisations such as Amcor Ltd and CSR Ltd classified forestry assets as property, plant and equipment. Other organisations, such as North Broken Hill Peko Ltd, disclosed them as a separate class of assets, namely regenerative assets. In relation to livestock assets, Foster’s Brewing Ltd treated these as inventory and valued them on the basis of the lower of cost and net realisable value. Other entities, such as CSR Ltd, disclosed livestock as both current and non-current inventory. This approach was also adopted by Goodman Fielder Wattie Ltd. The classification of biological assets such as forests or livestock will very much depend on management’s intentions. For example, livestock may be classed as ‘current’ if it is to be used for meat but ‘non-current’ if it is to be used for breeding over a number of years. Further, a particular asset such as livestock might change from breeding stock to meat stock, thereby requiring a change in classification. Decisions are sometimes made during the period that can render previous classifications misleading. As RSH (p. 21) states: The classification of biological assets into short-term/long-term, and therefore current/non-current, is not without its difficulties. For example, the life of certain biological assets such as poultry, pigs, fish, cattle and lambs will depend upon management intent. For example, the life of pigs intended for meat may be four months compared with the life of pigs (sows) intended for breeding, which may be two to four years. Such assets therefore have alternative economic uses during their lives and their classification will depend upon management decisions. In some instances, particularly in relation to livestock, it may not be possible for management to make a classification decision, for example where reporting date is prior to mustering. A further example of the difficulty in classification is given in the case of forestry. Although one possible form of output is a ‘final product’ (millable timber after 25 years) the trees could instead be harvested for pulp at any time after eight to ten years. Therefore, for these assets, although they are consumable they can continue to grow ‘in storage’, and their classification is dependent upon management intent. Given the difficulties in classifying biological assets and given the unique economic attributes of biological assets, it is perhaps justifiable for them to be subject to a classification scheme different from that used for other assets, thereby reducing reliance on management’s intent as a determinant of classification. RSH (p. 25) suggests: In view of the inability to reliably classify biological assets as either current or non-current, or as either inventory or plant and equipment, this Paper concludes that they should be shown in a separate category ‘biological assets’ and identified by sub-categories or types of biological assets (such as plants and animals). Although ED 83 proposed that SGARAs/biological assets should not be classified into current and non-current groups (consistent with the arguments of RSH provided above), this proposal was not ultimately included within AASB CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  323

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1037. AASB 1037 required that SGARAs/biological assets ‘be presented separately in the balance sheet’, but did not prohibit their classification into current and non-current elements. This is consistent with the current requirements in AASB 101 Presentation of Financial Statements, which requires that the statement of financial position include a line item that relates to biological assets within the scope of AASB 141 Agriculture. Nevertheless, the classification of assets into their current and non-current components should be consistent with the requirements of AASB 101. Paragraph 41 of AASB 141 does, however, require that ‘an entity shall provide a description of each group of biological assets’. Paragraphs 43 to 45 also requires additional disclosures in relation to the nature of the biological assets: 43. An entity is encouraged to provide a quantified description of each group of biological assets, distinguishing between consumable and bearer biological assets or between mature and immature biological assets, as appropriate. For example, an entity may disclose the carrying amounts of consumable biological assets and bearer biological assets by group. An entity may further divide those carrying amounts between mature and immature assets. These distinctions provide information that may be helpful in assessing the timing of future cash flows. An entity discloses the basis for making any such distinctions. 44. Consumable biological assets are those that are to be harvested as agricultural produce or sold as biological assets. Examples of consumable biological assets are livestock intended for the production of meat, livestock held for sale, fish in farms, crops such as maize and wheat, produce on a bearer plant and trees being grown for lumber. Bearer biological assets are those other than consumable biological assets; for example, livestock from which milk is produced, and fruit trees from which fruit is harvested. Bearer biological assets are not agricultural produce but, rather, are held to bear produce. 45. Biological assets may be classified either as mature biological assets or immature biological assets. Mature biological assets are those that have attained harvestable specifications (for consumable biological assets) or are able to sustain regular harvests (for bearer biological assets).

How should biological assets be measured? Exhibit 9.3 provides the valuation bases used by four Australian companies in relation to their forestry assets as disclosed in the accounting policy sections of their 1999 annual reports (that is, before AASB 1037 became operational). Prior to the implementation date of AASB 1037, it is evident there was considerable variation in the valuation approaches adopted by these entities. RSH (p. 30) believes that, as with disclosure practices, this lack of measurement consistency was in itself good grounds for the development of an accounting standard on biological assets. As this is a common argument for regulation, you should consider its logic, giving due consideration to the associated costs and benefits of mandating one method of valuation for all reporting entities. Valuations of forestry assets in Australia were undertaken on a historical-cost basis, a replacement-cost basis and/or a market-value basis. This kind of variation in measurement practices is not surprising in the absence of an accounting standard. There has been limited investigation into what might motivate a particular entity to use one method instead of another to account for its biological assets. Whatever measurement technique is used, there are direct implications for total assets, income and expenses, and equity. Perhaps reporting entities select a particular measurement basis because they feel that it best reflects the underlying economic performance of their entity (an efficiency argument) or perhaps they select particular accounting methods on the basis of self-interested opportunism. For example, they might choose a method that increases management bonuses, loosens debt constraints or reduces political costs. (These three hypotheses and the assumption of self-interest are typically adopted by researchers working within the opportunistic perspective of Positive Accounting Theory, described in Chapter 3.) Future research, whether from a Positive Accounting Theory perspective or not, might shed some light on the motivation for selecting a particular method of accounting and on the attributes of a firm that might drive such a selection—ownership structure, size, leverage, composition of bonus plans, types of assets, ages of assets and so on. At this stage, little is known about these factors. A review of Exhibit 9.3 reveals that some entities departed from a historical-cost basis when valuing forests. This might be a direct result of the perceived limitations of historical cost in valuing assets with unique attributes such as biological assets. According to RSH (p. 34), historical cost has the following limitations in its application to biological assets such as forestry assets: • it ignores accretion in value through natural events; • it ignores price changes; 324  PART 3: ACCOUNTING FOR ASSETS

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• • • • •

it provides irrelevant information; it does not reflect the relative values of comparable forests; it does not satisfy management’s accountability obligations and provides irrelevant information on performance; it results in unreliable information; and it ignores the value of native forests.

CSR LTD Growing timber is a non-current asset. Each year the net increase or decrease in volume of growing timber is calculated at commercial rates. This amount is recognised as profit or loss for the period and added to, or deducted from, the value of growing timber. Expenses related to growing timber are charged against profit as incurred. AUSPINE LTD Prior to site quality assessment, usually carried out at 10 years of age, standing timber is recorded at net historical cost, which comprises establishment and subsequent development costs, and includes interest incurred in financing the growing forest. After assessment of site quality, standing timber is valued based on net market values. CARTER HOLT HARVEY LTD Forest assets are recorded at cost. Cost includes direct costs of forest establishment, silviculture and maintenance, plus interest at average corporate rates. AMCOR LTD Afforestation expenditure gives rise to book/tax accounting differences as plantation establishment expenditure including capitalised interest is claimed for income tax purposes when incurred and capitalised in the accounts, until such time as trees are felled, when the appropriate book values are charged to profit. The consolidated entity’s policy is to continue to invest funds to establish and maintain its plantations in perpetuity.

Exhibit 9.3 Some valuation policies adopted in relation to forestry assets (extracted from the accounting policy notes of the respective 1999 annual reports)

SOURCE: CSR, Auspine, Carter Holt Harvey, Amcor 1999 Annual Reports

A review of these limitations reveals that many of the points could equally be raised in relation to non-biological assets. Such views depend on an individual’s own perspective on the role of accounting. As stressed in earlier chapters, it is likely that there will be other accounting researchers/regulators who believe that historical cost is the appropriate model of accounting for biological assets. The views held by RSH are consistent with those of earlier accounting researchers, such as Chambers (see Chapter 3). As an alternative to valuing forestry assets at historical cost, RSH considers both net present value and current market value. As RSH indicates, the net-present-value method (NPV) estimates the present value of future cash flows through a discounting process. NPV is an economic concept based on the notion that an asset’s value can be determined from its future net cash flows. NPV models vary depending on the perceptions of those responsible for determining the input criteria, which might include discount rates and growth projections, and also the use to which the model is put. NPV techniques have frequently been criticised by advocates of historical-cost accounting on the basis that the need for numerous assumptions in NPV calculations reduces the reliability of the calculated data. If NPV is used in relation to assets such as forests, numerous decisions or estimates must be made, for example: • Should the forestry operation be considered to be a continuing activity, including tending, harvesting and replanting, or should the NPV be calculated on the basis of the individual trees? • What is the time taken for trees to mature? • What is the volume yield and processing utility—for example, what is the expected diameter, length and quality of the timber? • What is the future market price, adjusted for logging and transportation costs? • What is the cost of maintenance in bringing the tree to the stage of harvest? • What is the appropriate discount rate? CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  325

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With all the assumptions that are necessary, RSH (p. 43) concludes that the NPV method of accounting is not appropriate for forests or many other biological assets. As the authors state: The fact that the estimates identified are required to be made is regarded as a major shortcoming of the NPV method. This shortcoming is of particular concern due to NPV’s sensitivity to the estimates, including the discount rate. Because the value is predominantly based on subjective expectations, it may not satisfy the qualitative characteristics of ‘reliability’ as specified in SAC 3. This is particularly the case for estimates of volume, but it extends to most of the factors which must be taken into account where future prices and costs are used. The lack of reliability of the estimates is exacerbated the further into the future the estimates are required to be made. Hence, it is argued by some, the NPV method is particularly unsuitable for young trees. RSH suggests that a measurement basis tied to current market values be adopted for forestry assets. Implementing a current-market-value basis of measurement might entail difficulties, particularly where there is a long period before existing trees are ready for sale. If this is the case, RSH (p. 49) considers that, though not ideal, NPV might be used as a surrogate for current market value. Alternatively, reference may be had to other forests that have been established and are about to achieve the objectives for which the reporting entity acquired its biological assets. RSH encourages scientists to develop growth models of trees so that accountants can determine the point at which forests enter their production cycle. As they state (p. 49): For example, a direct approach to deriving such a surrogate for current market value for immature trees is to apply biological modelling techniques to determine the biological growth in a tree, and therefore a forest, which has occurred up to any point in time. If a tree is 50 per cent grown from a biological point of view (relative to its intended use), then 50 per cent of the current market value of a mature tree of the same grade could be recognised as the value of the half-grown tree. In relation to grading, if biological predictions are that the tree will be, for example, second grade due to its knots and other features, the relevant market value is the value of a mature second-grade tree. Modelling, such as that described above, would conceivably be costly and this cost should be compared with any perceived benefits that might be generated from providing information that is potentially more reliable. Turning our attention to livestock, there is also some degree of variation in how reporting entities had previously valued this biological asset. Organisations such as Foster’s Brewing Ltd and CSR Ltd had traditionally valued livestock on the basis of the lower of cost and net realisable value. This is consistent with the requirements of AASB 102 Inventories, even though AASB 102 explicitly excludes livestock from its application. Other entities, such as Pioneer Sugar Mills Ltd, were known to value their livestock at net market value. Consistent with their recommendations in relation to forestry assets, RSH argues against the use of historical cost (or variants such as the lower of cost and net realisable value) and opts instead for a method of valuation based on current market values. This is consistent with Roberts (1988, p. 75), who states: The unique characteristics of livestock, its duality, its changing nature and the virtual impossibility of ascertaining the cost of many components of flocks and herds of animals, means that in most circumstances historical cost for livestock inventories is an unsuitable and impractical basis of valuation. Many illustrations can be found to demonstrate difficulties and shortcomings of historical cost for livestock. Assume that a farmer purchases a heifer for $250. A year later it is a mature cow. What is its cost at this stage? Six months later it is in calf. What is its cost then? What costs should be absorbed in the ongoing costs—fodder? pasture improvement? tractor expenses? drench? dose? veterinary expenses? wages? repairs to fences? part of the cost of the bull? If the farm also runs sheep and goats, how are the costs to be apportioned? In recommending market value for livestock, RSH acknowledges that the market can be volatile, but as market value reflects the actual economic value of the assets at a particular time, it is considered appropriate. The authors further argue that, unlike the situation for forestry assets, there is generally an active market for livestock at all stages of development, and so determination of ‘current market value’ is easier and more reliable. AASB 1037 effectively adopted the proposals of RSH, with paragraph 5.2 stating that a SGARA/biological asset must be measured at its net market value as at the reporting date. Paragraph 5.2.1 further stated: SGARAs (and biological assets) are different from non-living assets because they change biological form over their lives through growth and other means, resulting in changes in future economic benefits. The future 326  PART 3: ACCOUNTING FOR ASSETS

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economic benefits embodied in SGARAs (and biological assets) may also change in the absence of changes in biological form, because their prices change. Measuring a SGARA (or a biological asset) at its current value ensures that the effects of both biological changes and price changes are recognised in financial reports. In considering the ‘new’ requirements of AASB 141 Agriculture, it is interesting to note that the IASB also effectively adopted the Australian arguments. AASB 141, paragraph 12, states: ‘A biological asset shall be measured on initial recognition and at the end of each reporting period at its fair value less costs to sell, except for the case where the fair value cannot be measured reliably’. ‘Fair value less costs to sell’ is essentially the same as ‘net market value’—the terminology used by RSH. Consistent with other accounting standards, ‘fair value’ is defined in AASB 141 as: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ‘Costs to sell’ are defined in AASB 141 as: The incremental costs directly attributable to the disposal of an asset, excluding finance costs and income taxes. In relation to gains and losses associated with holding biological assets, AASB 141, paragraph 26, states: A gain or loss arising on initial recognition of a biological asset at fair value less costs to sell and from a change in fair value less costs to sell of a biological asset shall be included in profit or loss for the period in which it arises. In some circumstances, market-determined prices or values might not be available for a biological asset in its present condition. In these circumstances, AASB 141 suggests that an entity measure the biological asset at cost less any accumulated depreciation and any accumulated impairment losses. Specifically, paragraph 30 of AASB 141 states: There is a presumption that fair value can be measured reliably for a biological asset. However, that presumption can be rebutted only on initial recognition for a biological asset for which quoted market prices are not available and for which alternative fair value measurements are determined to be clearly unreliable. In such a case, that biological asset shall be measured at its cost less any accumulated depreciation and any accumulated impairment losses. Once the fair value of such a biological asset becomes reliably measurable, an entity shall measure it at its fair value less costs to sell. Interestingly, it is only on initial recognition that an entity can use cost. As paragraph 31 states: The presumption in paragraph 30 can be rebutted only on initial recognition. An entity that has previously measured a biological asset at its fair value less costs to sell continues to measure the biological asset at its fair value less costs to sell until disposal. In relation to measuring agricultural produce, paragraph 32 of AASB 141 requires: In all cases, an entity measures agricultural produce at the point of harvest at its fair value less costs to sell. This Standard reflects the view that the fair value of agricultural produce at the point of harvest can always be measured reliably. AASB 141 also provides guidance for situations where the value of the biological asset is not separate from other assets. Paragraph 25 of AASB 141 states: Biological assets are often physically attached to land (for example, trees in a plantation forest). There may be no separate market for biological assets that are attached to the land but an active market may exist for the combined assets, that is, for the biological assets, raw land, and land improvements, as a package. An entity may use information regarding the combined assets to determine fair value for biological assets. For example, the fair value of raw land and land improvements may be deleted from the fair value of the combined assets to arrive at a fair value of biological assets. While IAS 41/AASB 141 requires that biological assets be measured at fair value—as we now know—there were nevertheless a number of dissenting opinions from the members of the IASB. That is, although the majority of the CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  327

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members of the IASB supported the use of fair value, which lead to it being incorporated within the accounting standard, some members of the Board opposed it. The Basis for Conclusions that accompanied the release of IAS 41 states (paragraph B17): Those who oppose measuring biological assets at fair value believe there is superior reliability in cost measurement because historical cost is the result of arm’s length transactions, and therefore provides evidence of an open-market value at that point in time, and is independently verifiable. More importantly, they believe fair value is sometimes not reliably measurable and that users of financial statements may be misled by presentation of numbers that are indicated as being fair value but are based on subjective and unverifiable assumptions. Information regarding fair value can be provided other than in a single number in the financial statements. They believe the scope of the Standard is too broad. They also argue that: (a) market prices are often volatile and cyclical and not appropriate as a basis of measurement; (b) it may be onerous to require fair valuation at each balance sheet date, especially if interim reports are required; (c) the historical cost convention is well established and commonly used. The use of any other basis should be accompanied by a change in the IASC Framework for the Preparation and Presentation of Financial Statements  (the ‘Framework’). For consistency with other International Accounting Standards and other activities, biological assets should be measured at their cost; (d) cost measurement provides more objective and consistent measurement; (e) active markets may not exist for some biological assets in some countries. In such cases, fair value cannot be measured reliably, especially during the period of growth in the case of a biological asset that has a long growth period (for example, trees in a plantation forest); (f) fair value measurement results in recognition of unrealised gains and losses and contradicts principles in International Accounting Standards on recognition of revenue; and (g) market prices at a balance sheet date may not bear a close relationship to the prices at which assets will be sold, and many biological assets are not held for sale. Hence, even among accounting regulators there is not universal acceptance that fair value is appropriate for measuring biological assets. It is also interesting to note that the International Accounting Standards Committee (IASC—replaced by the IASB) Steering Committee on Agriculture issued a draft statement of principles (DSOP) in December 1996, which included proposals different from the current requirements of AASB 141 (and the requirements of the previous Accounting Standard AASB 1037). The DSOP proposed that the changes in the fair value of biological assets be broken into two components, namely those related to price changes and those related to biological changes. It was recommended in the DSOP that the price changes be recognised as part of equity—through a reserve such as a revaluation surplus—and the biological change be recognised as part of the period’s profit or loss. No such division was adopted within AASB 1037 or in the subsequent standard AASB 141, owing in part, perhaps, to the difficulties involved in making such calculations. We will look further into this distinction between price changes and biological (or volume) changes in the next section, which addresses income recognition associated with biological assets.

When and how should revenue associated with biological assets be recognised? We have examined how we value biological assets such as forestry assets and livestock. RSH recommended that a method based on current market value be used. As we know, if we increase (debit) or decrease (credit) the asset, we will need to match this movement/adjustment with a change to equity. However, should this change in equity (if upward) be treated as income or, perhaps, as a change to the revaluation surplus? Here we consider this issue in more detail. As Exhibit 9.3 demonstrates, various approaches have been adopted historically to the recognition of the change in value of biological assets. In considering how the change in current market value is to be treated for income purposes, RSH (p. 66) identifies two possible components of this change: (a) changes in current market value as a result of biological factors, for example, growth, quality, ageing and changes in composition (such factors are unique to biological assets and are termed ‘volume changes’); and (b) changes in market value as a result of price changes. 328  PART 3: ACCOUNTING FOR ASSETS

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A review of Exhibit 9.3 shows that, in relation to forestry assets, CSR Ltd recognised only the change in volume—see (a) above—for income purposes. This is similar to the recommendation of the IASC’s DSOP just mentioned. In earlier years, organisations such as Carter Holt Harvey Ltd moved valuation changes to an asset revaluation reserve (now to be referred to as a revaluation surplus). Organisations such as Auspine Ltd had not, prior to the accounting standard, recognised any upward movement in the value of the asset until the asset was sold. In relation to livestock, there has also been considerable variation in accounting treatment. For example, Pioneer Sugar Mills used a net-market-value approach to valuing its livestock, and treated any unrealised gains or losses as part of the reporting period’s profit or loss (treated as ‘other income’). Other organisations, such as Stanbroke Pastoral Company Pty Ltd, recognised increases in volume only—see (a) above—as part of the financial period’s profit or loss. Although RSH suggest that current market value should be used to value biological assets for statement of financial position (balance sheet) purposes, they suggest that only those changes in value due to volume changes be treated as income. Changes in value owing to changes in market prices should, they argue, be transferred directly to a reserve and not be treated as part of the period’s profit or loss. They adopt this perspective because they believe this will enable the reporting entity to distribute the gains relating to volume increases (perhaps as cash dividends), while maintaining their operating capacity intact, as at the beginning of the year. This view, which is consistent with the IASC’s DSOP, is based on arguments contained in Roberts (1988, p. 76). Roberts states: Within the spirit of the principles of current-cost accounting it is reasonable, true and fair to have the livestock inventory shown in the balance sheet at net-realisable value provided that the basis is stated and that it is verifiable. Such a value is also meaningful and acceptable for extrapolations of ratios such as returns on capital employed. It is, however, in the area of accounting for profit that dissensions occur. This is particularly so where breeding, and thus the problems associated with animated plant and the retention of productive capacity, arises. The inherent disadvantages of accepting as profit or loss all market-value changes in livestock inventories are illustrated in the following example. Assume that after all animals ready for sale have been sold during the year, a cattle grazier has a similar herd composition, condition and quality at the end of the year as he had at the beginning of the year, but that the total current net selling value of the livestock has increased by $50 000. If the $50 000 is treated as profit: (i) the farmer/manager cannot convert the gain to cash without reducing the productive basic capacity of the farm; (ii) it is not meaningful when assessing managerial performance; (iii) it is of little value in internal or external comparative result analysis; and (iv) if considered as profit for dividend purposes (involving a change in entity ownership of funds), it would be tantamount to a distribution of capital. The farmer is unlikely to count the $50 000 as profit in a trading sense any more than would be the case had there been an increase in the value of land and machinery. In most cases, the farmer considers that livestock profit should be represented tangibly by extra cash and/or increased numbers of livestock. RSH’s view that gains related to price changes should not be treated as part of distributable profits is an interesting one and one that has proved to be useful in sparking subsequent debate—and debate is essential if ‘sensible’ accounting standards are to be developed. As one might expect, there are many researchers/regulators who challenge such a view (as there would also be those who believe that the herd should be accounted for using historical cost and that any profits should not be recognised until the animals are sold). As indicated in subsequent chapters of this book, some accounting standards specifically require that changes in the fair value of certain assets (due to price changes) are to be treated as part of the period’s profit or loss. Many individuals have taken issue with these requirements. AASB 141 does not (and nor did AASB 1037) incorporate the recommendations of RSH and gains do not have to be broken down into volume changes and price changes. The combined gain is treated as part of income. As we have already indicated, AASB 141, paragraph 26, states: A gain or loss arising on initial recognition of a biological asset at fair value less costs to sell and from a change in fair value less costs to sell of a biological asset shall be included in profit or loss for the period in which it arises. CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  329

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Nevertheless, although not mandated by AASB 141, the standard ‘encourages’ disclosures that differentiate between changes in fair values that are based upon price changes, and those that are based upon physical changes. As paragraph 51 of AASB 141 states: The fair value less costs to sell of a biological asset can change due to both physical changes and price changes in the market. Separate disclosure of physical and price changes is useful in appraising current period performance and future prospects, particularly when there is a production cycle of more than one year. In such cases, an entity is encouraged to disclose, by group or otherwise, the amount of the change in fair value less costs to sell included in profit or loss due to physical changes and due to price changes. This information is generally less useful when the production cycle is less than one year (for example, when raising chickens or growing cereal crops).

Accounting for agricultural produce As we indicated earlier, AASB 141 addresses both biological assets (which has been the predominant focus of the discussion above) and agricultural produce. As we have already noted, the agricultural produce of a biological asset is defined in AASB 141 as ‘the harvested produce of the entity’s biological assets’ and would include fruit picked from a fruit tree, wool shorn from a sheep, a felled log and a slaughtered cow. Following the point of harvest, agricultural produce is no longer a biological asset and as a result it falls within the scope of AASB 102 Inventories. As paragraph 3 of AASB 141 states: This Standard is applied to agricultural produce, which is the harvested produce of the entity’s biological assets, only at the point of harvest. Thereafter, AASB 102 Inventories or another applicable Standard is applied. Accordingly, this Standard does not deal with the processing of agricultural produce after harvest; for example, the processing of grapes into wine by a vintner who has grown the grapes. While such processing may be a logical and natural extension of agricultural activity, and the events taking place may bear similarity to biological transformations, such processing is not included within the definition of agricultural activity in this Standard. As we know from Chapter 7, AASB 102 Inventories requires inventory to be valued at the lower of cost and net realisable value . . . but what is the cost of agricultural produce? AASB 141, paragraph 13, states that: Agricultural produce harvested from an entity’s biological assets shall be measured at its fair value less costs to sell at the point of harvest. Such measurement is the cost at that date when applying AASB 102 or another similar Standard.

Non-financial disclosures Although RSH deals predominantly with measurement issues associated with biological assets, they suggest that it would be useful for readers of general-purpose financial statements to be provided with supplementary information of a non-financial nature about the biological assets in the entity’s control. They state (p. 93): It is recommended that biological assets be disclosed in general-purpose financial reports with sufficient description in non-financial terms for the user to identify the types of biological assets controlled by the entity and their relative quantities and qualities, and the nature of externally imposed restrictions thereon. It is also recommended that disclosure be made of the extent to which losses arising from natural events are insured, and that some specific form of geographical segment information be disclosed to allow users to assess the risks attached to biological asset holdings. Further, the accounting profession is encouraged to seek to play a role in assisting the development of the increasingly important area of accountability relating to environmental accounting. Further to RSH’s final recommendation on disclosures pertaining to an entity’s environmental accountability, Chapter 32 of this book is dedicated to issues associated with social-responsibility reporting, particularly regarding the organisation’s impact on its physical environment.

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In relation to non-financial disclosures, it is interesting to note that AASB 141 does in fact require a number of disclosures that meet the expectations of RSH. AASB 141, paragraph 41, requires that an entity provide a description of each group of biological assets. Paragraph 46 further requires that: If not disclosed elsewhere in information published with the financial statements, an entity shall describe: (a) the nature of its activities involving each group of biological assets; and (b) non-financial measures or estimates of the physical quantities of: (i) each group of the entity’s biological assets at the end of the period; and (ii) output of agricultural produce during the period. Worked Example 9.1 provides an example of how to account for biological assets and agricultural produce. Exhibit 9.4 provides some of the disclosures made in the 2014 annual report of Elders Ltd in relation to its biological assets.

WORKED EXAMPLE 9.1: Accounting for biological assets and agricultural produce In 2014, Tassie Orchard Ltd established and commenced operation of an apple orchard in New Norfolk. The trees were planted in 2014, and began producing saleable apples in 2018. In 2019, 80 per cent of the apples are sold, immediately after they are picked, for a sales price of $96 000. Selling costs are assumed to be immaterial. The remaining 20 per cent of the picked apples are recognised as inventories at the end of the reporting period. The fair value of the apple trees at 30 June 2018 (the end of the previous reporting period) was $95 000, and at 30 June 2019, $109 000. During the reporting period ending 30 June 2019, employee expenses, fertilisers, lease expenses and other expenses amounted to $40 000. The fair value less costs to sell of the apples immediately after picking and packing amounted to $120 000. Picking and packing costs amounted to $30 000. REQUIRED Prepare the journal entries to record: (a) the costs incurred to maintain the biological assets (b) the harvesting of the agricultural produce from the biological asset (c) the sale of the agricultural produce (d) the changes in the fair value of the bearer plants between the ends of the two reporting periods assuming that the ‘revaluation model’ is being applied. SOLUTION Prior to amendments made in 2014 (to AASB 141 and AASB 116), all biological assets were to be recorded at fair value less costs to sell with all changes therein being reflected in profit or loss. However, the amendments require ‘bearer plants’—which in this illustration would be the apple trees—to now be excluded from AASB 141 and for AASB 116 to be applicable, meaning that either a ‘cost model’ or ‘revaluation model’ can be applied to the apple trees. Before bearer plants reach maturity the plants shall be measured at accumulated costs. (a) Costs incurred in maintaining biological assets 30 June 2019 Dr Expenses (salaries, fertiliser, etc.) Cr

Cash/Accounts payable

40 000 40 000

The organisation has an option to use either the cost model or the fair-value model to value the apple trees. It has selected the fair-value model. The expenses incurred in maintaining the biological assets are expensed as incurred and are not capitalised. Paragraph 20 of AASB 116 states that: when an item is in the location and condition necessary for it to be capable of operating in the manner intended by management, subsequent costs are not recognised in the carrying amount of the property, plant and equipment. continued

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(b) Harvesting of agricultural produce 30 June 2019 Dr Inventory

120 000

Cr

Gain arising on recognition of harvested 120 000 apples The above entries are consistent with paragraphs 13 and 28 of AASB 141, which state:



13. Agricultural produce harvested from an entity’s biological assets shall be measured at its fair value less costs to sell at the point of harvest. 28. A gain or loss arising on initial recognition of agricultural produce at fair value less costs to sell shall be included in profit or loss for the period in which it arises.

30 June 2019 Dr Picking and packing costs 30 000 Cr Cash 30 000 The picking and packaging costs would be treated as a cost of the period, and not treated as ‘costs to sell’, which would be offset against inventory. This is consistent with paragraph 5 of AASB 141, which states: Costs to sell are the incremental costs directly attributable to the disposal of an asset, excluding finance costs and income taxes. (c) Sale of agricultural produce 30 June 2019 Dr Cash 96 000 Cr Sales revenue—apples 96 000 30 June 2019 Dr Cost of good sold 96 000 Cr Inventory 96 000 Because the inventory is sold at its fair value less costs to sell (80% × $120 000 = $96 000) no further gain or loss arises on sale. The fair value less costs to sell is deemed to be ‘cost’ for the purposes of inventory and, therefore, also for determining cost of good sold. As paragraph 13 of AASB 141 states: Agricultural produce harvested from an entity’s biological assets shall be measured at its fair value less costs to sell at the point of harvest. Such measurement is the cost at that date when applying AASB 102 or another applicable Standard. (d) Changes in fair value of the bearer plants between the ends of the reporting periods 30 June 2019 Dr Bearer plants—apple trees 14 000 Cr Revaluation surplus 14 000 The above entry recognises the change in fair value of the bearer plants ($109 000 – $95 000). This change in value is accounted for pursuant to the ‘revaluation model’ identified in AASB 116 Property, Plant and Equipment.

Exhibit 9.4 Note disclosure for biological assets as reported in the 2014 Annual Report of Elders Ltd

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ( j) Biological assets

Elders holds biological assets in the form of livestock and plantations. Livestock is measured at fair value, which has been determined based upon various assumptions, including livestock prices, less costs to sell. These assumptions reflect the different categories of livestock held. The market value increments or decrements are recorded in profit and loss. Plantations are measured at anticipated fair value less point-of-sale costs. These assumptions forecast plantation growth and yields at the current average annual growth rates, with prices based on the current price plus indexation and forecast of the net present value of future net cash flows from harvest and costs of maintaining plantations to maturity.

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NOTE 7. BIOLOGICAL ASSETS (a) Livestock

Current Fair value at the end of the period

2014 $000 41 123

2013 $000 36 671

The table below discloses the fair value of livestock assets in their fair-value hierarchy: 2014 Fair value input Level 1 Level 2 Level 3

Cattle type None None All

$000 – – 41 123 41 123

Head – – 34 507 34 507

2013 $000 – – 36 671 36 671

Head – – 44 440 44 440

All of Elders’ cattle are valued at fair value, using Level 3 price inputs. Cattle are held for live export and feedlotting purposes, which means that quoted prices in active markets for identical cattle are not available, nor are there other input prices other than quoted prices, which are available. Fair-value inputs are summarised as follows: • Level 1 price inputs—are quoted prices (unadjusted) in active markets for identical assets or liabilities that can be accessed at the measurement date. • Level 2 price inputs—are input prices other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. • Level 3 price inputs—are unobservable inputs for the asset or liability. At balance date, 34 507 head of cattle (2013: 44 440) are included in livestock. This includes: • 16 321 cattle held in Australia and New Zealand destined for the Chinese and Indonesian live export markets; • 18 186 cattle held in Australia and Indonesia for feedlotting purposes.  attle are held for short-term trading and feeding purposes, and at period end an unrealised C $1.7 million (2013: $1.5 million) fair-value increment was recognised. In regard to live export cattle, as Elders has access to different active markets, Elders has used the most relevant one, being the market that is going to be used, in determining fair value. Fair value has been determined internally by Elders based on the estimated selling price of cattle (allowing for breed and specifications of the cattle), less costs to sell, including associated shipping and transportation costs. Feedlot cattle are valued internally by Elders as there is no observable market for them. The value is based on the estimated exit price per kilogram and the value changes for the weight of each animal as it progresses through the feedlot program. The key factors affecting the value of each animal are price/kg, days on feed and the feed conversion ratio. The average daily gain of weight is in the range of 1.5kg to 2.0kg. The value is determined by applying the average weight gain per day by the number of days on feed from induction to exit at which point the cattle are delivered to market. The value per animal is based on the breed and specifications of the animal and the market it is destined for. Significant increases/(decreases) in any of the significant unobservable valuation inputs for feedlot cattle in isolation would result in significantly lower/(higher) fair-value measurement. The group is exposed to a number of risks related to its livestock: Regulatory and environmental risks

Elders is subject to laws and regulations and has established environmental policies and procedures aimed at compliance with local environmental and other laws. Management performs regular reviews to identify environmental risks and ensure systems in place are adequate to manage those risks. continued CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  333

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Supply and demand risk

Elders is exposed to financial risk in respect of livestock activity. The primary financial risk associated with this activity occurs due to the length of time between expending cash on the purchase and ultimately receiving cash from the sale to third parties. Elders’ strategy to manage this financial risk is to actively review and manage its working capital requirements. Elders is exposed to risks arising from fluctuations in price and sales volumes. Where possible, Elders manages these risks by aligning volumes with market supply and demand. Other risks

Elders’ livestock is exposed to the risk of damage from disease and other natural forces. Elders has extensive processes in place aimed at monitoring and mitigating those risks, including regular health inspections and industry pest and disease surveys. (b) Plantations

As at 1 April 2014, the remaining forestry assets were reclassified as held for use after it became apparent that efforts to exit certain associated leases were unsuccessful.

Non-current Fair value at classification as held for use Costs incurred in respect of forestry  plantations Unrealised fair-value increment in period Fair value at the end of the period

2014 $000 4 588 4 101 217

2013 $000 –  –  –

270 4 588

– –

The table below discloses the fair value of plantation assets in their fair-value hierarchy: Fair-value input Level 1 Level 2 Level 3

– – 4 588 4 588

 –  – – –

Plantations are valued at fair value, using Level 3 price inputs. Fair-value inputs are summarised as follows: • Level 1 price inputs—are quoted prices (unadjusted) in active markets for identical assets or liabilities that can be accessed at the measurement date. • Level 2 price inputs—are input prices other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. • Level 3 price inputs—are unobservable inputs for the asset or liability. Physical quantity of forestry plantation timber at the end of the 2014 year was 2 699ha. Residual lease obligations are estimated to be $1.6 million a year and these costs have been fully provided for. The fair-value methodology for forestry assets is detailed in note 2( j). The assumptions used in the valuation model to determine fair value less costs to sell are as follows: CPI: Discount rate: Period to harvest:

Current woodchip FOB price:

2.5% to 4% 14.5% Between 5 and 7 years, depending upon year of   establishment and current harvest schedule for   the individual property. $170 per BDMT (bone dry metric tonne)

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Elders is exposed to a number of risks related to its plantations: Regulatory and environmental risks

Elders is subject to laws and regulations and has established environmental policies and procedures aimed at compliance with local environmental and other laws. Management performs regular reviews to identify environmental risks and ensure systems in place are adequate to manage those risks. Supply and demand risk

Elders is exposed to financial risk in respect of forestry activity. The primary financial risk associated with this activity occurs due to the length of time between expending cash on the purchase or planting and maintenance of the plantations and ultimately receiving cash from the sale of timber to third parties. Elders’ strategy to manage this financial risk is to actively review and manage its working capital requirements. Elders is exposed to risks arising from fluctuations in price and sales volumes. Where possible, Elders manages these risks by aligning harvest volumes with market supply and demand. Climate and other risks

Elders’ plantations are exposed to the risk of damage from climatic changes, diseases, forest fires and other natural forces. Elders conducts regular plantation health inspections and is involved in industry pest and disease surveys. SOURCE: Elders Ltd 2014 Annual Report

Opposition to AASB 1037 and AASB 141 When AASB 1037 and AASB 141 (the ‘old’ and the ‘new’ standards on biological assets) were released, they were the subject of sustained criticism by many working within industries that are affected by the standards. Members of the wine industry were particularly vocal in their criticism. For example, in an article by Ian Porter entitled ‘Wine chief slams accounting move’ (The Australian Financial Review, 26 March 1999, p. 9),  the chairperson of Australia’s biggest wine producer, Southcorp Ltd, was critical of the standard because it would lead to the recognition of income in advance of when the company believed it should be reported, which could in turn cause some investors to question dividends being paid on the basis that they were perceived to be too low. Another article published at the time the first accounting standard on biological assets was issued is reproduced in Financial Accounting in the Real World 9.3, ‘Seeing wood beyond money trees’. This article identifies a number of criticisms of AASB 1037, including the costs associated with complying with the standard. As we are aware, by issuing AASB 1037, the Australian Accounting Standards Board directly influenced the development of IAS 41, on which AASB 141 was then based.

9.3 FINANCIAL ACCOUNTING IN THE REAL WORLD The new accounting standard for self-generating and re-generating assets (SGARAs) The Australian accounting standards authorities, after a delay of a year because of an overwhelmingly negative reaction from affected industries, has implemented a new accounting standard for ‘Self-generating and regenerating assets’ (SGARA). The new standard requires that all SGARAs (including fish, agricultural livestock, crops, orchards and forests) be accounted for on a company’s balance sheet. The intention was to create an environment where investors could more easily make comparisons between potential investments based on valuations of the SGARA assets. Although there is no equivalent international standard the Australian authorities thought that as much of Australia’s wealth was based on the agricultural sector, they would become world leaders in accounting standards by creating one for living assets. continued

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The practical result of the new standard is that in each reporting period SGARAs must be given a net market value based on most recent market price, value of related assets, costs of feeding and pest control and the like. Industry has not welcomed the new standard. Southcorp claimed that it will damage the wine industry. Glen Cunningham, the company’s executive general manager of corporate affairs said ‘you’re reporting something that’s further away from actual cashflow’, bemoaned the costs of compliance and slammed the desire of the authorities to lead the standard setting. On the other hand, Colin Parker, director of accounting and auditing at CPA Australia, endorsed the new standard’s asset comparison rationale. SOURCE: Adapted from ‘Seeing wood beyond money trees’, by Leon Gettler, The Age, 3 July 2000, p. C3

It is not uncommon for corporate executives to be critical of accounting standards that limit the methods of accounting that they can use. There could be a number of reasons for this. The individuals might genuinely believe that the approach that they currently use best reflects their underlying performance and that to prohibit them from using it will only introduce inefficiencies. This would be an ‘efficiency-based’ argument. A counterargument, however, might be that managers favour using methods that allow them to provide the results they want to disclose—that is, the methods that allow them to be creative. In this regard, Colin Parker, former audit director of CPA Australia, remarks: It was possible (in the absence of the standard) for companies within the same industry to use different accounting policies to report their profits. Some companies are bagging the standard, saying it is too hard, but the pick-and-choose approach to valuing assets is on the way out. (The Australian Financial Review, 20 May 1999, p. 20) Although AASB 1037 was to be implemented for financial years ending on or after 30 June 2000, this deadline was extended to June 2001. According to a report in The Australian Financial Review on 14 May 1999 (p. 15), the standard was deferred after many of the 100 largest companies in Australia argued (through the Group of 100, which is a body that represents the 100 largest Australian companies) that they were having trouble devising systems and valuations to meet the earlier deadline. Corporate managers were questioning whether the increased detail provided information that was really useful (and the issue of cost versus benefit is something standard-setters consider when developing accounting standards). However, despite the opposition to the standard, the chairperson of the AASB at the time, Mr Ken Spencer, was quoted as saying: ‘Nonetheless, we feel you’ll come up with a more meaningful number than just trying to deal with live assets on a historical cost basis’. The development and introduction of AASB 1037 (which led to AASB 141) indeed provided some very interesting and lively debate!

SUMMARY The chapter considered two areas of accounting that had for many years not been subject to any accounting standards— that is, accounting for heritage assets and accounting for biological assets pertaining to agricultural activities. Various views have been provided on how these assets should be measured and disclosed. We have considered arguments for and against the accounting valuation of heritage assets and we have seen how some members of the accounting profession hold very different views on whether and how heritage assets should be recognised for accounting purposes. Try to weigh the merits of the alternative arguments and consider whether you think that all valuable resources need to have a financial value attributed to them. The unique accounting attributes of biological assets, defined as living animals and plants, have been emphasised in this chapter. The relative merits of historical-cost and market-based valuations have been considered, relying upon the work of Roberts, Staunton and Hagen (1995). The view was expressed that, in valuing biological assets, market-based valuations provide more relevant information than does historical-cost accounting. As shown in this chapter, accounting regulators have opted to adopt market-based/fair-value valuations for the purposes of the accounting standard pertaining to ‘agriculture’ (although they subsequently excluded bearer plants from this standard and, through AASB 116, allowed the use of either cost or fair value for measuring bearer plants). 336  PART 3: ACCOUNTING FOR ASSETS

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KEY TERMS biological asset  320 contingent-valuation method (CVM)  315

heritage asset  301 SGARAs  321

travel-cost method (TCM)  316

END-OF-CHAPTER EXERCISES This chapter has raised a number of issues about accounting for heritage assets and biological assets relating to agricultural activity. To test your comprehension of these issues, see if you can answer the following questions. If you find that you cannot, you might need to re-read some of the material provided in the chapter. 1. What is a heritage asset and what attributes of heritage assets would support the notion that they need to be accounted for differently from other assets? LO 9.1 2. Why would particular authors argue that valuing certain heritage assets in financial terms is ‘intellectual vulgarism’ and no more than an ‘accounting fiction’? Do you agree with such claims? LO 9.1, 9.3, 9.4, 9.5, 9.9 3. Would heritage assets be considered assets under the Conceptual Framework for Financial Reporting? LO 9.3 4. What is a biological asset and what attributes of such assets would support the notion that they need to be accounted for differently from other assets? LO 9.2, 9.6 5. How would you value a biological asset used within, or generated by, agricultural activities, and how are changes in valuation to be treated for the purposes of an entity’s profit or loss? LO 9.6, 9.7, 9.8, 9.9

REVIEW QUESTIONS 1. What are some of the characteristics of a heritage asset? LO 9.1 2. What are some of the differences between heritage assets and assets that are typically held by private-sector entities? LO 9.1, 9.3 3. Do you think that heritage assets should be classified as assets pursuant to the Conceptual Framework for Financial Reporting? Explain your answer with particular reference to the definition and recognition criteria embodied within the conceptual framework. LO 9.1, 9.3, 9.4, 9.5 4. Carnegie and West (2005, p. 908) state that ‘full accrual accounting systems are now being applied to a range of public sector institutions that have no profit making nor financial wealth maximisation objective’. You are required to explain whether you believe this application of financial accounting is appropriate? LO 9.4, 9.9 5. Because heritage assets typically generate negative net cash flows, some authors have argued that they should be treated as liabilities and not as assets. Do you agree with such a view? Why? LO 9.1, 9.3 6. AASB 116 permits ‘heritage and cultural assets’ to be revalued. What would be some potential problems in revaluing heritage assets? LO 9.1, 9.3, 9.4, 9.5 7. Do you think that we should have different asset definitions for not-for-profit organisations and for-profit organisations? Explain your answer. LO 9.3, 9.9 8. The Exposure Draft for a revised Conceptual Framework for Financial Reporting released by the IASB in May 2015 suggests that regulators should consider the costs and benefits of particular disclosure requirements before such requirements are mandated. What could be some of the costs and benefits? LO 9.9 9. Would you consider that the accountability of managers of heritage assets is best determined by requiring them to provide up-to-date valuations of the ‘assets’ under their control? Explain your answer. LO 9.4, 9.5, 9.9 10. What is a biological asset? LO 9.2 11. What particular attributes of biological assets differentiate them from other assets? LO 9.2, 9.6 CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  337

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12. Explain and contrast the valuation suggestions made by Carnegie and Wolnizer in relation to national parks that are considered to be heritage assets and the valuation suggestions of Roberts, Staunton and Hagen (1995) for forest reserves held for the purposes of milling. LO 9.4, 9.5, 9.9 13. Roberts, Staunton and Hagen (1995) suggest that increases in the valuation of livestock can be broken down into two components: (i) changes in current market value as a result of biological factors, for example, growth, quality, ageing and changes in composition (volume changes) (ii) changes in market value as a result of price changes. They suggest that only the ‘volume changes’ should be treated as part of the period’s profit or loss. What is the basis of their argument and do you think it is valid? LO 9.7, 9.8 14. Do you consider that lack of consistency across entities in the accounting treatments of particular items (for example, the measurement of biological assets) is sufficient justification for the development of an accounting standard? Explain your answer. LO 9.9

CHALLENGING QUESTIONS 15. Evaluate the following comment: Some cultural or heritage assets are so important that their ‘worth’ should not be reflected by any form of monetary valuation. That is, they are beyond pricing and it would be inappropriate to try to value them in monetary terms. LO 9.1, 9.5 16. What types of information do you believe a government-funded museum should provide to reflect its performance, and what could be the purpose of providing the information you suggest? LO 9.1, 9.5 17. Carnegie and Wolnizer (1995) argue that quantifying heritage assets in financial terms is an ‘accounting fiction’. Explain what they mean. Do you agree with them? Why, or why not? LO 9.4, 9.5, 9.9 18. How would you value a museum collection of ancient Aboriginal artefacts? LO 9.4, 9.5 19. Carnegie and West (2005, p. 910) state: The consequences of the weak definitional basis for the monetary valuation of collections are often compounded by difficulties, sometimes of a particularly perplexing nature, in assigning money values to collection items and determining appropriate depreciation policies. There are frequently no markets for these items as their unique character often means that they do not belong to any generic category of commodities necessary for a market to be constituted: ‘like all museum artefacts, each one has an immensely personal story’ (Heinrich, 2002, p. 1; see also Carman et al., 1999). Such ‘stories’ contribute substantially to the uniqueness of particular artefacts and their non-financial values, and may also precipitate legal measures designed to protect such items in a special domain beyond the economics of the marketplace. In other instances, only thin and sporadic markets for collection items exist. Money values assigned to collections and other non-financial resources are therefore typically arbitrary and unreliable (Carnegie and Wolnizer, 1995, pp. 43–44; Jaenicke and Glazer, 1991, p. 9).

REQUIRED Explain and evaluate the above statements. LO 9.4, 9.5 20. In the April 1998 edition of Charter (p. 71), an article appeared on self-generating and regenerating (biological) assets. In the article it is noted that: The main criticism against net market value accounting is that it does not reflect actual events. It’s accounting for what’s going to happen in the future, not what’s already happened. A common sentiment of many blueblood accountants is that if it’s not realised, it’s not real. An unrealised gain on lambs might not be worth a penny if they all fall over and die before sale time. 338  PART 3: ACCOUNTING FOR ASSETS

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REQUIRED Evaluate the above comment. LO 9.6, 9.7, 9.8 21. Corbett (1996, p. 138) provides a view that the self-interest of the accounting profession was an important influence on the standard-setting agenda that led to the requirement that heritage assets be accounted for in the same manner as assets held by profit-seeking entities. He states: There is a large measure of self-serving self-interest in what the accounting profession’s senior bodies are trying to do. If they can impose a common set of standards on the public sector, their members, whose experience is mainly in the private sector, will suddenly become experts in what public sector accounts should contain and will thus become eligible to serve as consultant experts and contract auditors.

REQUIRED Are you inclined to agree or disagree with the above claim? In explaining your answer you might find it useful to consider various theories of regulation as discussed in Chapter 3 of this text. LO 9.4, 9.5, 9.9 22. A recent annual report of the City of Sydney Council did not include library books on the statement of financial position, notwithstanding the existence of a substantial library collection. The City of Sydney Council’s accounting policy for library books is to expense them at the time of acquisition. A note in the annual report reveals that in applying this policy the council considered the following factors: • As soon as the book is purchased its fair value is minimal compared with its cost. • The acquisition costs of individual books are below the council’s capitalisation policy. • The useful life of a book is variable and indeterminable, making depreciation difficult.

REQUIRED Critically evaluate the council’s accounting policy for its library collection. Suggest an alternative accounting policy or supplemental information that could be reported, if appropriate. LO 9.4, 9.5 23. Shoreham Vineyard Ltd grows grapes, which are sold to local wine producers. At 1 January 2018 Shoreham Vineyard Ltd’s grape vines had a fair value of $150 000. During the year ended 31 December 2018, $10 000 was spent on fertilisers. Grapes with a market value of $80 000 were harvested at a cost of $12 000. The grapes would have to be packaged and delivered at a cost of $4 000 before they could be sold. At 31 December 2018, the fair value of Shoreham Vineyard’s Ltd’s grape vines was $155 000.

REQUIRED Prepare journal entries to account for the agricultural assets of Shoreham Vineyard Ltd for the year ended 31 December 2018. LO 9.7, 9.8 24. In 2012, Nambour Ltd established and commenced operation of a mango farm. The trees were planted in 2012 and began producing saleable mangoes in 2018. On 30 June 2019, 90 per cent of the mangoes are sold, one week after they were picked, for a sales price of $210 000. Selling prices were $3 000. The remaining 10 per cent of the picked mangoes are recognised as inventories at the end of the reporting period, this being 30 June 2019. The fair value of the mango trees at 30 June 2018 (the end of the previous reporting period) was $480 000 and, at 30 June 2019, $550 000. During the reporting period ending 30 June 2019, employee expenses, fertilisers, lease expenses and other expenses amounted to $50 000. The fair value less costs to sell of the mangoes immediately after picking and packing amounted to $220 000. Picking and packing costs amounted to $15 000.

REQUIRED Prepare the journal entries to record: (a) the costs incurred to maintain the biological assets (b) the harvesting of the agricultural produce from the biological asset (c) the sale of the agricultural produce (d) the changes in the fair value of the biological assets between the ends of the two reporting periods. LO 9.7, 9.8 CHAPTER 9: ACCOUNTING FOR HERITAGE ASSETS AND BIOLOGICAL ASSETS  339

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25. Paragraph 9 to the appendix to FRS 30 Heritage Assets, issued in the UK by the Accounting Standards Board, states: The new FRS will result in the continued reporting of at least some of an entity’s heritage assets in the balance sheet. In the Board’s view, this is preferable to not reporting any assets in the balance sheet, even where, as under the current approach, it results in the reporting of recently acquired assets at cost. The improved disclosures prescribed by the new FRS will make clear the extent to which heritage assets are reported in the balance sheet and mitigate the disadvantages of an entity reporting only part of their total holding of heritage assets in the balance sheet. While the ASB thinks it is preferable to recognise heritage assets for balance sheet purposes, what are some of the negative aspects or impacts of such a practice? LO 9.4, 9.5, 9.9 26. In a newspaper article entitled ‘WA Museum insurance was too high’ (by Stephen Bevis in The West Australian, 6 November 2014), it was reported that the Western Australian Museum paid higher premiums than it should have to insure its collection because an accounting mistake overstated its value by almost $200 million. In the article it was stated that: The 2009 valuation was by Victorian cultural heritage specialist Simon Storey, who has valued collections for the National Gallery, the National Museum and the Australian War Memorial. Mr Storey said the error was not picked up by himself or the museum despite draft reports that the directorate and chief financial officer would presumably check. For five years, the collection had an inflated value of $638.31 million but was revalued this year at $347.06 million, $291.25 million or 46 per cent less than in 2009, with new accounting methods factored in. Mr Coles said the decrease did not affect the integrity or intrinsic value of collections or reflect or imply fewer items in collections, which had increased. What does the failure to detect the accounting error potentially tell us about the usefulness of the accounting valuation? Also, critically evaluate the statement by Mr Coles. LO 9.1, 9.4, 9.5 27. In a newspaper article by Rosemary Neill entitled ‘Museum’s assets take a $400m hit as insects lose their worth’ as reported in The Australian on 6 April 2014, it was reported that: The value of the Australian Museum’s collection—the country’s biggest natural history and cultural collection—has been slashed by almost $400 million, following a radical revaluation. The official value of the museum’s collection, particularly its biological specimens, has almost halved, from $860m in 2011 to $485m last year. A little-noticed paragraph in the Sydney museum’s 2012–13 annual report says a ‘revised valuation methodology resulted in the value of assets reducing by $375.5m’. In response to controversies relating to the falling valuation, the following comment was reported: The museum’s incoming director, Kim McKay—the first woman and first non-scientist to lead the institution— played down the revaluation’s significance. ‘We’ve got 18 million items in the collection,’ she said. ‘There are still 18 million items-plus in the collection. There is a valuation methodology that was changed . . . the collection hasn’t changed.’ Evaluate the comment by Kim McKay and in doing so consider the possible implications the information in the newspaper extract has for the apparent relevance of the financial valuation of the collection. LO 9.1, 9.4, 9.5 28. Paragraph 11 to the appendix to FRS 30 Heritage Assets, issued in the UK by the Accounting Standards Board, states: Throughout the project, the Board has retained the view that, conceptually, heritage assets are assets. They are central to the purpose of an entity such as a museum or gallery: without them the entity could not function. An artefact held by a museum might be realisable for cash, it might generate income indirectly through admission charges or the exploitation of reproduction rights. However, and in most cases much more importantly, the museum needs the artefact to function as a museum. The artefact has utility: it can be displayed to provide an educational or cultural experience to the public or it can be preserved for future display or for academic or scientific research. The future economic benefits associated with the artefact 340  PART 3: ACCOUNTING FOR ASSETS

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are primarily in the form of its service potential rather than cash flows. In the Board’s view, by virtue of the service potential they provide, heritage assets meet the definition of an asset; that is, they provide ‘rights or other access to future economic benefits controlled by an entity as a result of past transactions or events’. Do you agree that heritage assets provide economic benefits and therefore satisfy the definition of assets as provided in the Conceptual Framework for Financial Reporting? LO 9.4, 9.5 29. Paragraph 12 to the appendix to FRS 30 Heritage Assets, issued in the UK by the Accounting Standards Board, states: Heritage assets are often described as ‘inalienable’, i.e. the entity cannot dispose of them without external consent. Such a restriction may, for example, be imposed by trust law, arise from a charity’s governing documents or, in some cases, by statute. The key feature of inalienability is that it prevents an asset being readily realisable. Some argue that assets held in trust are not assets of the entity, equating the inability to sell such items with foregoing the economic benefit inherent in them. But assets that are inalienable may well have utility to the entity and therefore, as noted in paragraph 11 above, meet the definition of an asset. A key component of the definition of assets is ‘control’. Can an organisation be considered to be in control of an item if it does not have the freedom to make decisions about its disposal? Would a strict application of the definition of assets as provided by the conceptual framework preclude an organisation from recognising heritage assets for balance sheet purposes? LO 9.1, 9.3, 9.4, 9.5 30. Exhibit 9.1 provided earlier in this chapter gives an illustration of the use of CVM as stated in a report entitled Making Economic Valuation Work for Biodiversity as released by Land and Water Australia in 2005. The illustration relates to valuing a species of possum. At that point we posed some questions which we shall now attempt to answer. These questions are: (a) Should we place a financial value on a possum? (b) As human beings, what rights do we actually have to place economic valuations on other species? Indeed, do issues of economics and nature belong together? LO 9.4 31. Having read this chapter, do you think that heritage assets should be measured in financial terms and that they should be disclosed within financial statements? Justify your opinion. LO 9.3, 9.4

REFERENCES ACCOUNTING STANDARDS BOARD, 2006, Heritage Assets: Can Accounting do Better?, Accounting Standards Board, London. BOREHAM, T., 1995, ‘Council Asset Valuation Opens Up a Can of Worms’, Business Review Weekly, 4 September, pp. 80–1. BURRITT, R. & GIBSON, K., 1993, ‘Who Controls Heritage Listed Assets?’, unpublished working paper, Australian National University. CARNEGIE, G.D. & WEST, B.P., 2005, ‘Making Accounting Accountable in the Public Sector’, Critical Perspectives on Accounting, vol. 16, pp. 905–28. CARNEGIE, G.D. & WOLNIZER, P.W., 1995, ‘The Financial Value of Cultural, Heritage and Scientific Collections: An Accounting Fiction’, Australian Accounting Review, vol. 5, no. 1, pp. 31–47. CARNEGIE, G.D. & WOLNIZER, P.W., 1996, ‘Enabling Accountability in Museums’, Accounting, Auditing and Accountability Journal, vol. 9, no. 5, pp. 84–99. CARNEGIE, G.D. & WOLNIZER, P.W., 1999a, ‘Unravelling the Rhetoric About the Financial Reporting of Public Collections as Assets: A Response to Micallef and Peirson’, Australian Accounting Review, vol. 9, no. 1, pp. 16–21. CARNEGIE, G.D. & WOLNIZER, P.W., 1999b, ‘Is Archaeological Valuation an Accounting Matter?’, Antiquity, vol. 73, no. 279, March, pp. 143–8.

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CORBETT, D., 1996, Australian Public Sector Management, 2nd edn, Allen and Unwin, Sydney. GRAY, R., 1983, ‘Accounting, Financial Reporting and Not-for-profit Organisations’, AUTA Review, vol. 15, no. 1, pp. 3–23. GRAY, R., ADAMS, C., & OWEN, D., 2014,  Accountability, Social Responsibility and Sustainability, Pearson Education Limited, London. HONE, P., 1997, ‘The Financial Value of Cultural, Heritage and Scientific Collections: A Public Management Necessity’, Australian Accounting Review, vol. 7, no. 1, pp. 38–43. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2015, Exposure Draft ED/2015/3 Conceptual Framework for Financial Reporting, IASB, London. JAENICKE, H.R. & GLAZER, A.S., 1992, ‘Art and Historical Treasures: A Solution to the Museum Controversy’, CPA Journal, March, pp. 46–50. MAUTZ, R.K., 1988, ‘Monuments, Mistakes, and Opportunities’, Accounting Horizons, June, pp. 123–8. MICALLEF, F. & PEIRSON, G., 1997, ‘Financial Reporting of Cultural, Heritage, Scientific and Community Collections’, Australian Accounting Review, vol. 7, no. 1, pp. 31–7. PALLOT, J., 1990, ‘The Nature of Public Assets: A Response to Mautz’, Accounting Horizons, June, pp. 79–85. ROBERTS, D.L., 1988, ‘Agribusiness Livestock Trading and the Livestock Inventory Puzzle’, Charter, April, pp. 74–7. ROBERTS, D.L., STAUNTON, J.J. & HAGAN, L.L., 1995, ‘Accounting for Self-generating and Regenerating Assets’, Discussion Paper No. 23, Australian Accounting Research Foundation, Caulfield. (Extracts reproduced with the permission of the Australian Society of CPAs and The Institute of Chartered Accountants in Australia.)

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PART 4

ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY CHAPTER 10 An overview of accounting for liabilities CHAPTER 11 Accounting for leases CHAPTER 12 Accounting for employee benefits CHAPTER 13 Share capital and reserves CHAPTER 14 Accounting for financial instruments CHAPTER 15 Revenue recognition issues CHAPTER 16 The statement of profit or loss and other comprehensive income, and the statement of changes in equity CHAPTER 17 Accounting for share-based payments CHAPTER 18 Accounting for income taxes

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CHAPTER 10

AN OVERVIEW OF ACCOUNTING FOR LIABILITIES LEARNING OBJECTIVES (LO) 10.1 Know the definition of a liability and understand how to apply the recognition criteria provided in the Conceptual Framework for Financial Reporting. 10.2 Understand what a contingent liability represents and understand how it should be disclosed within the notes to a reporting entity’s financial statements. 10.3 Understand that liabilities can be disclosed on a current/non-current basis or in order of liquidity. 10.4 Understand which ‘provisions’ should be treated as liabilities. 10.5 Understand why, with certain transactions, professional judgement is required to determine whether the transaction gives rise to a liability, or should be recognised as part of equity. 10.6 Understand some of the reasons why firms would typically prefer to disclose a transaction as part of equity, rather than as a liability. 10.7 Understand how to calculate the issue price of securities such as bonds (debentures). 10.8 Know how to apply the effective-interest method when accounting for liabilities. 10.9 Know how to account for any premium or discount that arises on the issue of debentures. 10.10 Understand what a ‘hybrid’ security is and understand how they shall be disclosed. 10.11 Understand what a ‘contingent asset’ is and understand how they shall be disclosed.

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Liabilities defined

LO 10.1 LO 10.5

AASB 137 Provisions, Contingent Liabilities and Contingent Assets defines a liability as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. liability The above definition is the same as the definition of liabilities currently provided in the Defined in the Conceptual Framework for Financial Reporting. However, as we know from previous chapters, the conceptual framework IASB is currently revising the conceptual framework and in 2015 it issued an Exposure Draft of a as ‘a present obligation of the entity arising revised conceptual framework that provided a changed definition of liabilities, this being: ‘a present from past events, the obligation of the entity to transfer an economic resource as a result of past events’. For the rest of settlement of which the chapter we will refer to the existing definition and recognition criteria for liabilities, but where is expected to result relevant, we will also make reference to the recommendations within the 2015 Exposure Draft. in an outflow from the In previous chapters, and in particular, within Chapter 2, we learned that there are three key entity of resources embodying economic components in the existing definition of ‘liability’, these being: 1. There must be an expected future disposition of economic benefits to other entities. 2. There must be a present obligation. 3. A past transaction or other event must have created the obligation.

benefits’.

In addition to defining liabilities, the conceptual framework provides recognition criteria for liabilities. For a liability to be recognised and disclosed in a reporting entity’s statement of financial position, the current requirements are that it must be probable that the sacrifice of economic benefits will be required, and the amount of the liability must be able to be reliably measured. Specifically, the conceptual framework currently states that: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. The above recognition criteria refer to an ‘element’. In relation to the five elements of financial statements, the conceptual framework states: Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These broad classes are termed the elements of financial statements. The elements directly related to the measurement of financial position in the balance sheet are assets, liabilities and equity. The elements directly related to the measurement of performance in the income statement are income and expenses. The cash flow statement usually reflects income statement elements and changes in balance sheet elements; accordingly, this Conceptual Framework identifies no elements that are unique to this statement. The element we focus on in this chapter is liabilities. The recognition of liabilities is not to be restricted to situations where there is a legal obligation. Liabilities should also be recognised in certain cases where equity or usual business practice dictates that obligations to external parties currently exist. As the conceptual framework states: An essential characteristic of a liability is that the entity has a present obligation. An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. If, for example, an entity decides as a matter of policy to rectify faults in its products even when these become apparent after the warranty period has expired, the amounts that are expected to be expended in respect of goods already sold are liabilities. So the liabilities that appear within an entity’s statement of financial position might include obligations that are legally enforceable as well as obligations that are deemed to be equitable or constructive. When determining whether a liability exists, the intentions or actions of management need to be taken into account. That is, the actions or representations of the entity’s management or governing body or changes in the economic environment directly influence the reasonable expectations or actions of those outside the entity and, although they have no legal entitlement, they might have other sanctions that leave the entity with no realistic alternative but to make certain future sacrifices of economic benefits. CHAPTER 10: AN OVERVIEW OF ACCOUNTING FOR LIABILITIES  345

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Such present obligations are sometimes called ‘equitable obligations’ or ‘constructive obligations’. An equitable obligation is governed by social or moral sanctions or custom rather than legal sanctions. A constructive obligation is created, inferred or construed from the facts in a particular situation rather than contracted by agreement with another entity or imposed by government. Some examples of entities with equitable or constructive obligations include the following: • A retail store that habitually refunds purchases by dissatisfied customers even though it is under no legal obligation to do so. The store could not change its policy without incurring unacceptable damage to its reputation. • An entity that has identified contamination in land surrounding one of its production sites. The entity might not be legally obliged to clean up the surrounding land but, because of concern for its long-term reputation and relationship with the local community and because of its published policies or past actions, is presently obliged to do so. • A government that makes a public commitment to provide financial assistance to victims of a natural disaster and, because of custom and moral considerations, has no realistic alternative but to provide the assistance. Determining whether an equitable or a constructive obligation exists is often more difficult than identifying a legal obligation, and in most situations calls for professional judgement. As noted above, one consideration is that the entity should have no realistic alternative to making the future sacrifice of economic benefits and this implies that there is no discretion. In cases where the entity retains discretion to avoid making any future sacrifice of economic benefits, no liability exists. It follows that a decision of the entity’s management or governing body is not in itself sufficient for the recognition of a provision. Such a decision does not mark the inception of a present obligation since, in the absence of something more, the entity retains the ability to reverse the decision and thereby avoid the future sacrifice of economic benefits. For example, an entity’s management or governing body might resolve that the entity will offer to repair a defect it has recently discovered in one of its products, even though the nature of the defect is such that the purchasers of the product would not expect the entity to do so. Until the entity makes public that offer, or commits itself in some other way to making the repairs, there is no present obligation, constructive or otherwise, beyond that of satisfying the existing statutory and contractual rights of customers. What is being emphasised here is that in some cases (for example, where there is a possible constructive or equitable obligation), some degree of professional judgement might be required in determining whether a liability should be recognised. Where a liability is based on a legal obligation there is less reliance on professional judgement. While the above discussion has referred to the existing recognition criteria that appear within the Conceptual Framework for Financial Reporting (based upon assessments of probability and measurability), the IASB has also recommended changes to the recognition criteria of liabilities (as well as for the other elements of financial reporting). In the Exposure Draft of the revised Conceptual Framework for Financial Reporting released in 2015 it was stated at paragraph 5.9: An entity recognises an asset or a liability (and any related income, expenses or changes in equity) if such recognition provides users of financial statements with: (a) relevant information about the asset or the liability and about any income, expenses or changes in equity; (b) a faithful representation of the asset or the liability and of any income, expenses or changes in equity; and (c) information that results in benefits exceeding the cost of providing that information. Hence, we can see that under the proposed recognition criteria there is no direct reference to considerations of probability and measurability as there is with the current recognition criteria. Nevertheless, paragraph 5.13 of the Exposure Draft does state in relation to the broad issue of ‘relevant information’: . . . if one or more of the following factors applies, recognition may not provide relevant information: (a) if it is uncertain whether an asset exists, or is separable from goodwill, or whether a liability exists; (b) if an asset or a liability exists, but there is only a low probability that an inflow or outflow of economic benefits will result; or (c) if a measurement of an asset or a liability is available (or can be obtained), but the level of measurement uncertainty is so high that the resulting information has little relevance and no other relevant measure is available or can be obtained. There is a general belief that the proposed recognition criteria—as proposed within the Exposure Draft—will not create significant differences to the amounts of assets and liabilities being recognised for financial statement purposes.

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Contingent liabilities

LO 10.2 LO 10.5

Where the recognition criteria for a liability are not satisfied (that is, the future outflow is perhaps not probable and/ or reliably measurable), the item should not be included within the statement of financial position (that is, a liability should not be recognised). However, if it is possible that the firm will be obliged (although not presently obliged) to transfer resources in the future as a result of an agreement that has already been entered into—and the possibility is not deemed to be ‘remote’—and the amount is potentially material, disclosure in the notes to the financial statements is appropriate. Further, if there is an existing obligation, but the obligation cannot be measured with reasonable accuracy, then while the item cannot be disclosed in the statement of financial position it would be appropriate to contingent liability Obligations that are disclose it in the notes to the financial statements to the extent it is potentially material. payable contingent In the circumstances just described, where an obligation is dependent upon a future event (for upon a future event example, a future court ruling pertaining to a claim already made against the reporting entity), or where or obligations that are the amount of the obligation cannot be measured reliably at a given point in time, the associated not probable (in terms obligation is referred to as a contingent liability. As there is either no probable obligation at reporting of resource outflows) or are not measurable date, or no obligation that can be measured reliably, it would be inappropriate to include contingent with sufficient reliability. liabilities within the statement of financial position itself. That is why disclosure of contingent liabilities is relegated to the notes to the financial statements. AASB 137, paragraph 10, defines a contingent liability as arising when there is: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability. Worked Example 10.1 provides an illustration relating to when a contingent liability should be recognised.

WORKED EXAMPLE 10.1: Recognition of a contingent liability During 2017, Mark Richards Ltd, whose reporting period ends on 30 June each year, guarantees the bank overdraft of Shawn Thomson Ltd. At the time of providing the guarantee, Shawn Thomson Ltd was in a sound financial position. During 2019, international trading conditions deteriorated to such an extent that Shawn Thomson Ltd incurred substantial losses. Finally, on 28 June 2019, Shawn Thomson Ltd was forced to file for protection from its creditors. REQUIRED How would Mark Richards Ltd report the guarantee provided to Shawn Thomson Ltd in its financial statements ending 30 June 2018 and 30 June 2019? SOLUTION In this illustration, the obligating event is the provision of the guarantee, which gives rise to a legal obligation. At 30 June 2018, it is unlikely that an outflow of resources embodying economic benefits will occur. No provision is recognised. However, the guarantee is disclosed within the notes to the financial statements as a contingent liability. At 30 June 2019, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation. A provision—which is a liability which must be recognised within the financial statements—for the best estimate of the obligation must be recognised. Some authors have speculated that companies sometimes seek to project a view that particular obligations cannot be measured reliably as justification for keeping particular liabilities off the statement of financial position (as we know from the above discussion, a liability is not to be recognised if it cannot be measured reliably). For example, Ji and Deegan (2011) reviewed the disclosure practices of a number of large Australian companies to document how the companies disclosed information about their obligations to clean up contaminated sites. The authors found that it was very common for companies to argue that they were unable to reliably estimate the magnitude of the costs necessary

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to clean up particular contaminated sites and, as a result, the companies did not recognise the associated liabilities for the purposes of the statement of financial position. The authors speculated about whether it was reasonable to believe that organisations were unable in so many instances to provide some form of reliable estimate of the costs that might be incurred to clean up or remediate contaminated sites. Rather, the companies tended to provide some information about the obligation to clean up the contaminated sites within the notes to the financial statements; typically, in a note entitled ‘Contingent Liabilities’. As an example of some disclosures made in relation to an organisation’s accounting policy relating to contingent liabilities, the 2015 Annual Report of Orica Ltd stated in the notes to the financial statements (note 22, p. 101): In the normal course of business, contingent liabilities may arise from product-specific and general legal proceedings, from guarantees or from environmental liabilities connected with current or former sites. Where management are of the view that potential liabilities have a low probability of crystallising or it is not possible to quantify them reliably, they are disclosed as contingent liabilities. Contingent liabilities would include potential liabilities associated with guarantees that have been given to cover the debts of other organisations or potential obligations associated with legal actions taken, or to be taken, against the firm. Appendix B to AASB 137 provides a useful decision tree for determining whether a transaction or event should be recognised as a provision and therefore included within the statement of financial position, or disclosed as a contingent liability within the notes to the financial statements. The decision tree is reproduced in Figure 10.1. Figure 10.1 Decision tree for use in determining whether to recognise a provision or make a contingent liability disclosure in the notes to the financial statements

Start

Present obligation as a result of an obligating event?

No

Yes

Probable outflow?

No

Yes

No

Yes

Reliable estimate?

Possible obligation?

Remote?

Yes

No

No (rare)

Yes

Provide

Disclose contingent liability

Do nothing

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The disclosure requirements for contingent liabilities are detailed in AASB 137. These disclosures should be made in the notes to the financial statements unless the possibility of any outflow of economic benefits in settlement is considered to be ‘remote’. At the end of the reporting period, an entity should disclose each class of contingent liability, together with a brief description of the nature of the contingent liability. Specifically, paragraph 86 of AASB 137 states: Unless the possibility of any outflow in settlement is remote, an entity shall disclose for each class of contingent liability at the end of the reporting period a brief description of the nature of the contingent liability and, where practicable: (a) an estimate of its financial effect, measured under paragraphs 36–52; (b) an indication of the uncertainties relating to the amount or timing of any outflow; and (c) the possibility of any reimbursement. In rare circumstances it is possible that disclosure of the information required by AASB 137 might seriously prejudice an entity engaged in a dispute with another party on the subject matter of the provision, contingent liability or contingent asset. In these circumstances, paragraph 92 of AASB 137 states that the information need not be disclosed but the entity is required to disclose the nature of the dispute, together with the fact that and reasons why the information has not been disclosed. Exhibit 10.1 reproduces the contingent liability note from the 2015 financial statements of Qantas Airways Ltd. NOTE 30. CONTINGENT LIABILITIES Details of contingent liabilities are set out below. The Directors are of the opinion that provisions are not required with respect to these matters, as it is not probable that a future sacrifice of economic benefits will be required or the amount is not capable of reliable measurement. Guarantees

Qantas has entered into guarantees in the normal course of business to secure a self-insurance licence under the Safety, Rehabilitation and Compensation Act 1988, New South Wales Workers Compensation Act, the Victorian Accident Compensation Act and the Queensland Workers’ Compensation Act and Rehabilitation Act, to support non-aircraft operating lease commitments and other arrangements entered into with third parties. Due to specific self-insurance provisions raised, the Directors are of the opinion that the probability of having to make a payment under these guarantees is remote.

Exhibit 10.1 Contingent liability note from the 2015 Annual Report of Qantas Airways Ltd

Aircraft Financing

As part of the financing arrangements for the acquisition of aircraft, the Qantas Group has provided certain guarantees and indemnities to various lenders and equity participants in leveraged lease transactions. In certain circumstances, including the insolvency of major international banks and other counterparties that have a minimum credit rating of A-/A3, the Qantas Group may be required to make payment under these guarantees. Litigation

Freight and Passenger Third Party Class Actions: Qantas is a party to a number of third party class actions relating to its freight and passenger divisions. Qantas continues to have a number of defences to these class actions. Qantas expects the outcome of these class actions will be known over the course of the next few years. Other Claims and Litigation: From time to time, Qantas is subject to claims and litigation during the normal course of business. The Directors have given consideration to such matters, which are or may be subject to litigation at year end and, subject to specific provisions raised, are of the opinion that no material contingent liability exists. SOURCE: Qantas Airways Ltd Annual Report 2015

Contingent liabilities can potentially be very material. Failure to be aware of the potential and material liabilities to which a firm might be subject—for example, the firm might have guaranteed the debts of a related entity—can make the financial statements misleading. Again, it is emphasised that if an obligation is contingent on a future event, there is no ‘present obligation’ and therefore no liability would need to be disclosed in a reporting entity’s statement of financial position. This explains why CHAPTER 10: AN OVERVIEW OF ACCOUNTING FOR LIABILITIES  349

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organisations such as Qantas Airways Ltd (see Exhibit 10.1) do not treat items such as guarantees as liabilities but rather treat them as contingent liabilities, which are disclosed in the notes to the financial statements (and not included within the statement of financial position).

LO 10.11

Contingent assets Apart from contingent liabilities, we also have something called contingent assets. A contingent asset is defined in AASB 137 as:

a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. An example of a contingent asset would be the possible receipt of damages that is associated with a legal claim being made against another entity. Paragraph 31 of AASB 137 requires that ‘an entity shall not recognise a contingent asset’. According to paragraph 34 of AASB 137, a contingent asset should be disclosed within the notes to the financial statements when an associated inflow of economic benefits is deemed to be probable. Pursuant to paragraph 89 of AASB 137, the disclosure requirements are as follows: where an inflow of economic benefits is probable, an entity shall disclose a brief description of the nature of the contingent assets at the end of the reporting period, and, where practicable, an estimate of their financial effect. According to paragraph 33 of AASB 137, contingent assets are not recognised in financial statements since this may result in the recognition of income that may never be realised. However, when the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition as an asset is appropriate, along with the related revenue. As we hopefully should see, the use of ‘virtually certain’ as part of the recognition criteria associated with contingent assets—as identified above—is much stronger than the test of ‘probable’, which is used for assets generally. This will effectively lead to an understatement of assets relative to the assets that would be recognised by simply applying the requirements of the conceptual framework (based on ‘probable’ rather than the more difficult test of ‘virtually certain’). This is also not consistent with contingent liabilities. If the outflow of economic benefits associated with a contingent liability subsequently become ‘probable’ then a liability would be recognised within the financial statements. As an example of a contingent asset note, consider the following note that appeared at Note 31 in the 2014 Annual Report of Rio Tinto: Contingent assets The Group has various insurance claims outstanding with reinsurers including claims relating to the Manefay slide at Kennecott Utah Copper in April 2013. An interim progress payment was received on this claim in 2013. Further receipts are considered probable but the amount cannot currently be reliably estimated.

LO 10.3

Classification of liabilities as ‘current’ or ‘non-current’

current liability Liabilities that satisfy any of the four criteria provided by AASB 101.

non-current liability Any liability that does not pass the test provided within AASB 101 for a current liability.

In disclosing liabilities within the financial statements (and not contingent liabilities, which, as we know, are not disclosed in the statement of financial position), a reporting entity has a choice, based on notions of relevance and reliability, to disclose liabilities either on the basis of a current/noncurrent liability dichotomy or on the basis of order of liquidity. Specifically, paragraph 60 of AASB 101 Presentation of Financial Statements states: An entity shall present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position in accordance with paragraphs 66–76 except when a presentation based on liquidity provides information that is reliable and more relevant. When that exception applies, an entity shall present all assets and liabilities in order of liquidity. Hence, reporting entities have a choice of how to disclose their liabilities—but the choice must be governed by which presentation format provides more relevant and reliable information.

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In explaining the benefits of using the respective approaches to disclosing liabilities, paragraphs 62 and 63 of AASB 101 state: 62. When an entity supplies goods or services within a clearly identifiable operating cycle, separate classification of current and non-current assets and liabilities in the statement of financial position provides useful information by distinguishing the net assets that are continuously circulating as working capital from those used in the entity’s long-term operations. It also highlights assets that are expected to be realised within the current operating cycle, and liabilities that are due for settlement within the same period. 63. For some entities, such as financial institutions, a presentation of assets and liabilities in increasing or decreasing order of liquidity provides information that is reliable and is more relevant than a current/noncurrent presentation because the entity does not supply goods or services within a clearly identifiable operating cycle. In relation to disclosure it is also possible that some organisations might disclose some of their liabilities separately as current and non-current while the same organisation might disclose other liabilities on the basis of order of liquidity. In this regard, paragraph 64 of AASB 101 states: In applying paragraph 60, an entity is permitted to present some of its assets and liabilities using a current/ non-current classification and others in order of liquidity when this provides information that is reliable and is more relevant. The need for a mixed basis of presentation might arise when an entity has diverse operations. In considering the current/non-current liability dichotomy, we would probably be familiar with a definition of current liabilities in terms of an obligation being due for payment within 12 months of the end of the financial period (referred to as the 12-month test). This was the traditional approach to defining current liabilities. However, consistent with the approach taken in defining current assets within AASB 101, which considers the ‘operating cycle’, paragraph 69 of AASB 101 states: An entity shall classify a liability as current when: (a) it expects to settle the liability in its normal operating cycle; (b) it holds the liability primarily for the purpose of trading; (c) the liability is due to be settled within twelve months after the end of the reporting period; or (d) it does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. An entity shall classify all other liabilities as non-current. We see that, in contrast with traditional approaches, a liability may now be disclosed as a current liability when it is not expected to be settled for more than 12 months. If liabilities are disclosed as current on the basis of the entity’s operating cycle, and this cycle is greater than 12 months, the reporting entity should disclose the length of its operating cycle. In explaining the use of the entity’s ‘operating cycle’, paragraphs 70 and 71 of AASB 101 state the following: 70. Some current liabilities, such as trade payables and some accruals for employee and other operating costs, are part of the working capital used in the entity’s normal operating cycle. An entity classifies such operating items as current liabilities even if they are due to be settled more than twelve months after the reporting period. The same normal operating cycle applies to the classification of an entity’s assets and liabilities. When the entity’s normal operating cycle is not clearly identifiable, it is assumed to be twelve months. 71. Other current liabilities are not settled as part of the normal operating cycle, but are due for settlement within twelve months after the reporting period or held primarily for the purpose of trading. Examples are financial liabilities that meet the definition of held for trading in AASB 9, bank overdrafts, and the current portion of non-current financial liabilities, dividends payable, income taxes and other non-trade payables. Financial liabilities that provide financing on a long-term basis (i.e. are not part of the working capital used in the entity’s normal operating cycle) and are not due for settlement within twelve months after the reporting period are non-current liabilities, subject to paragraphs 74 and 75.

Liability provisions It is accepted that liabilities will include such items as accounts payable, bank overdrafts, loans and leases. Traditionally, various types of ‘provisions’ have also been included among an entity’s liabilities and disclosed as such in its statement of financial position. These include provisions for annual leave, provisions for

LO 10.4 LO 10.5

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long-service leave and provisions for warranty repairs. While ‘provisions’ for such items as future repairs and maintenance had traditionally been created and recognised, and while such provisions had traditionally been considered liabilities in the statement of financial position, this practice is no longer permitted. Amounts that are ‘provided’ for future expenditure, but that do not constitute an obligation to an external party—such as provisions for repairs and maintenance—are not liabilities. For an item to be disclosed as a ‘provision’ it must be a liability. Therefore, one consideration in assessing whether a ‘provision’ exists is whether the entity has a present obligation to an external party to make a future sacrifice of economic benefits. Because the entity cannot be both the recipient of the economic benefits and the party under the duty to perform, a present obligation implies the involvement of two separate parties: the entity and another party. However, it is not necessary to know the identity of the party to whom the present obligation is owed in order for a present obligation to exist. In describing ‘provisions’, paragraph 19 of AASB 137 Provisions, Contingent Liabilities and Contingent Assets states: It is only those obligations arising from past events existing independently of an entity’s future actions (that is, the future conduct of its business) that are recognised as provisions. Examples of such obligations are penalties or clean-up costs for unlawful environmental damage, both of which would lead to an outflow of resources embodying economic benefits in settlement regardless of the future actions of the entity. Similarly, an entity recognises a provision for the decommissioning costs of an oil installation or a nuclear power station to the extent that the entity is obliged to rectify damage already caused. In contrast, because of commercial pressures or legal requirements, an entity may intend or need to carry out expenditure to operate in a particular way in the future (for example, by fitting smoke filters in a certain type of factory). Because the entity can avoid the future expenditure by its future actions, for example by changing its method of operation, it has no present obligation for that future expenditure and no provision is recognised. The defining characteristic of a ‘provision’ as opposed to other ‘liabilities’ is that the timing of the ultimate payment, and perhaps the amount of the ultimate payment, are uncertain. That is, something is labelled a provision if it is a liability of uncertain timing and/or amount. Therefore if something is disclosed as a provision, this should alert the reader of the financial statements to the uncertainties inherent in its ultimate payment. Indeed, paragraph 10 of AASB 137 defines a provision as ‘a liability of uncertain timing or amount’. In describing provisions, paragraph 11 of AASB 137 states: Provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement. By contrast: (a) trade payables are liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the supplier; and (b) accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued vacation pay). Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions. Accruals are often reported as part of trade and other payables, whereas provisions are reported separately. In relation to when provisions are to be recognised, paragraph 14 of AASB 137 states: A provision shall be recognised when: (a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognised. Worked Example 10.2 explores how to determine whether an obligation shall be considered to create a provision.

WORKED EXAMPLE 10.2: Determining whether an obligation should be recognised as a provision First Point Ltd has the following obligations: • It has agreed to repair faulty surfboards that it has sold. Evidence indicates that of the 2 000 surfboards that were produced in overseas factories, about 20 percent used defective fibreglass that will need to be replaced at an expected cost of about $250 per surfboard.

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• It has a policy of providing long service leave to its employees. Under the arrangement, if employees stay for a period of 10 years then they are entitled to an additional 15 weeks of holidays. First Point believes it can reliably estimate how much the current year’s operations have contributed to this obligation. • First Point has an amount owing to its overseas supplier of $70 000, which it expects to pay within the next month. • First point has a bank loan of $500 000. REQUIRED For the above transactions and events you are required to determine whether a provision should be recognised. SOLUTION For a provision to be considered to exist, the amount and/or timing of the ultimate payment must be uncertain. Nevertheless, for the provision to be recognised within the statement of financial position, the obligation must be able to be reliably (although not ‘precisely’) estimated, and must relate to an obligation to an external party for a transaction or event that has already occurred. With this said, provisions would be recognised for the future surfboard repairs and for the long service leave commitments. The amounts payable to the overseas suppliers, and for the bank loan, would not be uncertain and hence would be recognised as liabilities, but not as ‘provisions’.

Now that we have considered the rules pertaining to the recognition of a provision, we also need to look at the rules relating to measurement. In relation to the measurement of a provision, paragraph 36 of AASB 137 requires that 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. The above requirement makes reference to the ‘best estimate’. The best estimate is the amount the entity would pay to settle this obligation at the end of the reporting period or to transfer it to a third party at that time. Estimates of outcomes and financial effects are determined by the judgement of management of the entity, supplemented by experience of similar transactions and possibly by reports of independent experts. Events after the end of the reporting period provide further supplementary evidence as to the existence of provisions. Uncertainties surrounding the amount to be recognised as a provision are dealt with by various means according to the circumstances. Where a single obligation is measured, the individual most likely outcome might be the best estimate of the liability. Other possible outcomes should also be considered. For example, an entity might be required to rectify a fault in an item of plant it constructed for a customer. The single most likely outcome might be for the fault to be repaired at the first attempt at a cost of $10 000. However, a provision would need to be made for a greater amount if there is a significant chance that further attempts at repair are likely. Where a large population of items is involved, the provision is measured by weighting all possible outcomes by their associated possibilities. This is known as the expected-value method of estimation. Using this basis, the amount of the provision will depend on the possibility of a loss. An example of this is provided in Worked Example 10.3.

WORKED EXAMPLE 10.3: Calculating a provision using the expected-value method Quicksliver Ltd sells ‘four-slice’ pop-up toasters. The toasters are sold with a six-month warranty that covers the costs of repairing any manufacturing defects that become apparent within six months of purchase. If minor defects are detected in all products sold, repair costs of $1 050 000 would result. If major defects are detected in all products sold, repair costs of $6 500 000 would result. Based on past experience and future expectations, Quicksliver Ltd is able to estimate that 80 per cent of all toasters sold will have no defects, 12 per cent of goods sold will have minor defects, and 8 per cent will have major defects. REQUIRED Establish the expected costs of repairs and prepare the journal entry to record them. continued CHAPTER 10: AN OVERVIEW OF ACCOUNTING FOR LIABILITIES  353

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SOLUTION In this situation, AASB 137 requires Quicksliver Ltd to assess the probability of outflow for the warranty obligation as a whole. The expected cost of repairs is ([80% of nil] + [12% of $1 050 000] + [8% of $6 500 000]) = $646 000. Dr Cr

Warranty expense Provision for warranty expense Provision for warranty expense on toasters

646 000 646 000

AASB 137, paragraph 42, requires the risks and uncertainties that inevitably attend many events and circumstances to be taken into account in reaching the best estimate of a provision. Two matters need to be considered: the risks and uncertainties surrounding the provision; and the time value of money. Risk describes the variability of outcome. An increase in risk might increase the amount at which a liability is measured. The existence of uncertainty, however, does not justify the creation of excess provisions or a deliberate overstatement of liabilities. In relation to measuring the amount of a provision, if materially different to its undiscounted amount, a provision shall be recognised at its present value. Specifically, paragraph 45 of AASB 137 states: 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. As paragraph 46 of AASB 137 explains, provisions are discounted to reflect the fact that provisions relating to cash flows that arise soon after the end of the reporting period are more onerous than when the same cash flows arise later, because of the time value of money. If cash flows are not discounted, two provisions giving rise to the same cash flows but with different timing would be recorded at the same value, although rational economic appraisal would regard them as different. Paragraph 47 of AASB 137 identifies what rate should be used to discount expected future cash flows. It states: 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. Provisions are required to be reviewed regularly. As paragraph 59 of AASB 137 states: Provisions shall be reviewed at the end of each reporting period and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation, the provisions shall be reversed. If an entity is discounting its provisions to present value, even if the absolute amount of a provision does not change, the present value of the provision can be expected to change across time. Where the change in the carrying amount of a provision is due to the impacts of using present values, AASB 137 requires that the change be recognised as a borrowing cost. Specifically, paragraph 60 of AASB 137 stipulates that ‘Where discounting is used, the carrying amount of a provision increases in each period to reflect the passing of time. This increase is recognised as a borrowing cost’. Worked Example 10.4 explores how to account for changes in the present value of provision.

WORKED EXAMPLE 10.4: Accounting for a change in the present value of a provision In 2019, Big Australian Power Ltd (BAP) commenced operating a power-generating facility in outback Australia. The organisation has a legal obligation to remediate the site (return it to a state that is useful for other purposes) when it closes the operation, which is expected to be in 20 years’ time. As at 30 June 2019, the best estimate to remediate the site (in 2039) is $20 000 000. One year later, on 30 June 2020, the best estimate of remediating the site (in 19 years’ time) is still considered to be $20 000 000. The pre-tax rates that reflect current market assessments of the time value of money and the risks specific to the liability were 8 per cent as at 30 June 2019 and 7 per cent as at 30 June 2020.

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REQUIRED Provide the journal entries in relation to the above obligation for the years ending 30 June 2019 and 30 June 2020. SOLUTION Provisions are to be recorded at present value, pursuant to paragraph 45 of AASB 137 Provisions, Contingent Liabilities and Contingent Assets. Therefore, we first need to determine the present value of the liability as at 30 June 2019. It is: $20 000 000 × 0.2145 = $4 290 000 The next issue to determine is what account shall be debited. That is, is it an expense, or is an asset? As noted in Chapter 5, paragraph 16 of AASB 116 states that the cost of property, plant and equipment is to 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. Before establishing the power-generating plant there would be an expectation that the plant would be removed at the completion of the project and any environmental disturbances rehabilitated. These expected future costs would be estimated at the commencement of the project and a liability would be recorded in accordance with AASB 137 Provisions, Contingent Liabilities and Contingent Assets. The expected costs would be measured at their expected present value and the amount would be included as part of the cost of the asset. The total amount of the asset, including the estimated costs for dismantling and removal, would be depreciated over the expected useful life of the asset. The journal entry on 30 June 2019 therefore would be: Dr Cr

Power-generating plant Provision for restoration costs

4 290 000 4 290 000

On 30 June 2020 we have to again calculate the present value of the obligation. In this case there has been a change in discount rate to 7 per cent (and the discounting period is now 19 years rather than 20 years). The obligation is now: $20 000 000 × 0.2765 = $5 530 000. This represents an increase in the provision by $1 240 000. The increase in the amount of the provision is treated as a borrowing cost. The entry on 30 June 2020 would be: Dr Cr

Interest expense Provision for restoration costs

1 240 000 1 240 000

To this point, we have examined liabilities, provisions and contingent liabilities. In Worked Example 10.5 we put this knowledge into use by determining whether a transaction or event creates a liability, a provision or a contingent liability.

WORKED EXAMPLE 10.5: Determining whether a transaction or event creates a liability, a provision or a contingent liability The draft financial statements for the year ending 30 June 2018 for Whites Beach Ltd are being completed. During the conduct of the audit you, as audit manager, have been informed that a senior executive who was dismissed in January 2018 has subsequently taken legal action against the company alleging wrongful dismissal and claiming damages of $1 000 000. Whites Beach Ltd’s solicitors estimate that the former executive has a 25 per cent chance of success in her claim. The outcome of the action is expected to be settled by December 2018. Legal costs, which will not be recoverable, of approximately $200 000 will be incurred by Whites Beach Ltd regardless of the outcome of the action. Of this amount, $30 000 has already been incurred in the months to 30 June 2018. This $30 000 is unpaid as at 30 June 2018. REQUIRED Explain how the above matter should be treated within the financial statements and accompanying notes of Whites Beach Ltd for the year ending 30 June 2018, and where appropriate, determine the required journal entries. continued CHAPTER 10: AN OVERVIEW OF ACCOUNTING FOR LIABILITIES  355

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SOLUTION This scenario falls within the scope of AASB 137 Provisions, Contingent Assets and Contingent Liabilities. Remember, a provision is a liability of uncertain timing or amount. Also, pursuant to the conceptual framework, a liability exists when there is a present obligation as a result of a past (obligating) event, which will result in a probable outflow of economic benefits that can be reliably estimated. As the action has commenced before the end of the year, the ‘past event’ criterion is met. The solicitors estimate that the former executive has a 25 per cent likelihood of success—therefore, it is not ‘probable’, but rather, is a ‘possible obligation’. Hence, it is not a liability, but is a contingent liability, which should be disclosed within the notes to the financial statements (assuming it is material). The disclosure should identify the nature and timing of the possible outflows of economic benefits. For example, the contingent liability note should disclose that there is a legal case against the company with a 25 per cent chance of being successful and which might result in the company having to pay $1 000 000. Also, the timing of the possible outflows should be disclosed if possible, together with details of any likely reimbursements (which in this case appear to be zero). The $200 000 in legal costs are irrecoverable and will be incurred by Whites Beach Ltd regardless of the success of the former executive’s action. This is a liability. The ‘past event’ is the legal action. The obligating nature of it is the contract to hire the solicitor. The liability is ‘probable’. Because the ultimate amount of the legal expenses is somewhat uncertain, it would be considered to represent liability in the form of a provision. The amount of legal fees already incurred in relation to the case ($30 000) would be recognised as a payable at year end. The balance of the legal fees ($200 000 – $30 000) would be considered to represent a provision. As it is expected to be settled within a year of the end of the financial period, the amount does not need to be recorded at present value. The required journal entries would be: Dr Cr Dr Cr

LO 10.1 LO 10.3 LO 10.5 LO 10.6

Legal fees Legal fees payable Legal fees Provision for future legal fees

30 000 30 000  170 000 170 000

Some implications of reporting liabilities

As we saw in Chapter 3, organisations commonly enter into contractual arrangements that are tied in part to the liabilities of the firm—for example, debt-to-assets constraints. So how liabilities are measured and disclosed can be of great importance to the ongoing survival of the organisation. For example, organisations might borrow funds from external sources, and the ongoing availability of these funds might depend on the organisation maintaining, at a minimum, certain pre-specified levels of performance—for example, ensuring by way of an interestcoverage clause that the organisation’s profits, perhaps after some adjustments, exceed interest expense by a certain minimum number of times. The ongoing availability of the funds might also depend on the firm ensuring that it does not exceed an agreed maximum level of debt—for example, through a pre-specified debt-to-assets constraint. As we know, such contractual requirements are based on numbers generated through an organisation’s financial accounting system. So whether something is disclosed as an asset, a liability, an expense or income can be very important for an organisation. For example, if a firm has determined that a transaction will not generate probable future economic benefits—a decision that, as we know, depends on professional judgement—the transaction will be treated as an expense. Compared with treating the expenditure as an asset, this will have a detrimental effect on a firm’s debt-to-assets ratio and interestcoverage ratio. These clauses may be included within the contractual arrangements of the organisation, which might influence whether the organisation will comply with, or breach, specific contractual arrangements. Researchers working within the Positive Accounting Theory paradigm (see Chapter 3) typically hypothesise that managers in organisations close to breaching particular accounting-based debt covenants will choose, where there is a choice, accounting methods that increase income, and thereby assets and equity, or decrease debt, thereby reducing the probability of debt covenant violation (Watts & Zimmerman 1986; 1990). To the extent that potential violation of debt covenants drives the selection of one accounting method in preference to another, such practices could be considered to represent ‘creative accounting’. They would also represent a departure from the principles espoused in the Conceptual Framework for Financial Reporting, where it is argued that financial

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information included within a general-purpose financial statement should be relevant and should faithfully represent the underlying transactions. The view that managers will adopt particular accounting methods to circumvent the coming into effect of debt restrictions necessarily assumes that there are costs associated with breaching debt-covenant restrictions and that lenders or their trustees will take action to impose costs on covenant-defaulting firms. Frequently, where a firm does breach a debt-related contractual requirement, it is given a period of time (a grace period) within which to remedy the breach before any action is taken (Chen & Wei 1993). Alternatively, when a breach occurs, lenders can insist upon early repayment; restrictions on the firm borrowing further funds; the firm selling some of its assets; and so on. It should also be acknowledged that the debt-related contractual restrictions are typically written around accounting numbers that are prepared for the purpose of inclusion in half-yearly or yearly financial statements. Hence, it is possible for a firm to default on a particular accounts-based debt clause but be able to remedy the breach prior to the reporting date (DeFond & Jiambalvo 1994). As we know, generally accepted accounting principles change frequently. Such changes can result from the release of accounting standards prohibiting the use of accounting methods that were previously permitted. Certainly there was an immense number of changes in 2005 within Australia as a result of Australia adopting IFRSs. The release of a new accounting standard can, in itself, have an adverse effect on a firm’s leverage, and therefore on whether the firm complies with particular debt covenants. For example, an accounting standard might be released that precludes a certain transaction from being capitalised, instead requiring it to be expensed as incurred. Alternatively, an accounting standard might be released that mandates a maximum period of amortisation. Both of these potential changes could have adverse cash-flow effects on an organisation, particularly if the organisation is subject to accounting-based debt covenants, and the debt contract in question does not pre-specify the accounting rules to be used for a particular class of transactions. When an accounting-based debt covenant is breached, perhaps as a result of the issue of a new accounting standard, it is possible that management might be able to negotiate with the lenders to relax the restriction. Such negotiation can in itself be costly, but might be particularly appropriate when a change in financial accounting requirements was not anticipated by any of the parties to a contractual arrangement. However, renegotiation of a debt contract might not always be possible. It is generally argued (for example, see Smith 1993) that the greater the number of lenders within a loan syndicate, the harder and more costly it is to renegotiate a clause when a technical default has occurred. Consistent with this, it is also argued that it is easier to renegotiate private debt agreements than those entered into for public debt issues (which might include thousands of debtholders). However, if a firm is in financial distress, debtholders might not want to renegotiate their debt contracts. Instead, they might wish to extract assets from the defaulting organisation before it becomes even more debt-laden. Interestingly, there are some researchers who write at length about the benefits that should flow if a firm finds itself in financial distress. They argue that being highly debt-laden, having difficulty servicing interest and principal payment schedules and being close to breaching debt agreements need not necessarily be considered all bad news. For example, Gilson (1989; 1990) argues that financial stress can cause an organisation to rethink its strategies, which might result in a shift in the activities of the organisation. These refocused activities might, in turn, lead to an increase in cash flows and, hence, in the value of the organisation. Gilson (1989) and others also argue that financial stress can be good because it provides the necessary stimulus to remove existing managers and replace them with a new and more efficient management team. Certainly such a change will potentially lead to improvements in profitability so that, in strict financial terms, such a management change will appear successful. However, as we noted in Chapter 3 and will consider further in Chapter 32, financial accounting does not consider social costs. For example, some researchers would argue that the social costs of creating unemployed managers must be considered before espousing the (economic) virtues of replacing a management team. They would argue, perhaps rightly, that organisations have many social obligations that are not reflected in financial performance and that some consideration should be given to these responsibilities when agreeing to future corporate strategies. However, further discussion of social issues of this nature is deferred until Chapter 32. While the above discussion relates to the use of debt covenants in lending agreements, it does not directly consider the securities market reaction to disclosures of debt covenant violation. It would be reasonable to expect that if debt covenants are violated then this could be viewed quite negatively by the market. As Griffin, Lont and McClune (2011, p. 1) state: A debt covenant violation can be a significant and costly event for a company’s shareholders with uncertain consequences, primarily because a violation shifts control rights to creditors who, through the threat of

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bankruptcy, can exert substantial influence on loan terms, corporate governance, and management decision making. Creditors’ options depend on the severity of the violation and may range at one extreme from calling the loan and demanding repayment to less onerous actions such as changing the loan terms, modifying the covenant, and/or waiving the violation for a period during which they can exercise their control rights to improve the situation. In the study of how insiders might gain from trading as a result of having information about covenant violations, Griffin, Lont and McClune predict that insiders who have special access to information will sell their shares in the company before the debt covenant violation is disclosed (because disclosure of the violation provides information about a significant adverse event therefore leading to a price decline) and will buy back shortly after the violation (at a time when actions are being taken to address the violation). In relation to the results of their study, Griffin, Lont and McClune (2011, p. 15) state that the market’s reaction to disclosure of debt covenant violation is ‘prompt, negative, and arguably efficient’. In discussing their results, they state (p. 38): Our results suggest that insiders benefit by selling shares before a covenant disclosure (to avoid the loss from a price decline) and benefit further by purchasing shares after such disclosure, although the losses avoided from the earlier selling exceed the gains from the later buying. Our results also suggest that insiders base their trades on an information advantage derived from access to debt and/or covenant renegotiations, in that a regression analysis suggests that insiders may gain by selling at least one month prior to a pre-disclosure drop in market-adjusted stock price and by buying at least one month prior to a post-disclosure stock price increase.

LO 10.5 LO 10.6

Debt equity debate

All things being equal, firms would typically prefer to disclose low levels of debt. Where firms are close to breaching existing debt restrictions—perhaps they have a debt-to-assets constraint that they have negotiated with lenders that they are approaching—but, nonetheless, need an injection of funds, additional debt might lead to a technical breach of their contractual agreements and therefore possibly the winding up of the company. Deegan (1986) documented how firms might, when faced with a need for additional funds, issue debt-like securities, labelling them equity. Examples are provided of firms issuing securities, labelled redeemable preference shares (preference shares are also discussed in Chapter 14), which:

dividend A distribution of the profits of an entity to the owners of that entity, typically in the form of cash.

preference shares Shares that receive preferential treatment relative to ordinary shares, with the preferential treatment relating to various things, such as dividend entitlements or order of entitlement to any distribution of capital on the dissolution of the company.

• are redeemable (exchangeable for cash) at a specified date • provide a fixed rate of dividend payment • do not provide voting rights • are guaranteed by related organisations. Such securities are obviously very debt-like—consider the three key components of a liability provided at the beginning of the chapter. Nevertheless, such securities were found to be typically disclosed as equity. In support of such a practice, clause 15 of Schedule 5 to The Corporations Law—this schedule no longer exists—required preference shares to be disclosed as part of the share capital of the firm. That is, Schedule 5 took a form-over-substance approach. Another point that should be noted is that if a security is labelled ‘equity’, the associated distributions would be termed dividends, which are not an expense but a distribution of profits. If the securities are defined as ‘debt’, the associated payments would be treated as interest, which would lead to a reduction in reported profits. In contrast with the former Schedule 5 treatment of preference shares, AASB 132 Financial Instruments: Presentation adopts a more logical substance-over-form approach. Paragraph 18 of AASB 132 states: The substance of a financial instrument, rather than its legal form, governs its classification on the entity’s statement of financial position. Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity but are liabilities in substance and others may combine features associated with equity instruments and features associated with financial liabilities. 

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In further considering preference shares, paragraphs AG 25 and 26 of AASB 132 state the following: AG25.  Preference shares may be issued with various rights. In determining whether a preference share is a financial liability or an equity instrument, an issuer assesses the particular rights attaching to the share to determine whether it exhibits the fundamental characteristic of a financial liability. For example, a preference share that provides for redemption on a specific date or at the option of the holder contains a financial liability because the issuer has an obligation to transfer financial assets to the holder of the share. The potential inability of an issuer to satisfy an obligation to redeem a preference share when contractually required to do so, whether because of a lack of funds, a statutory restriction or insufficient profits or reserves, does not negate the obligation. An option of the issuer to redeem the shares for cash does not satisfy the definition of a financial liability because the issuer does not have a present obligation to transfer financial assets to the shareholders. In this case, redemption of the shares is solely at the discretion of the issuer. An obligation may arise, however, when the issuer of the shares exercises its option, usually by formally notifying the shareholders of an intention to redeem the shares. AG26.  When preference shares are non-redeemable, the appropriate classification is determined by the other rights that attach to them. Classification is based on an assessment of the substance of the contractual arrangements and the definitions of a financial liability and an equity instrument. When distributions to holders of the preference shares, whether cumulative or non-cumulative, are at the discretion of the issuer, the shares are equity instruments. The classification of a preference share as an equity instrument or a financial liability is not affected by, for example: (a) a history of making distributions; (b) an intention to make distributions in the future; (c)  a possible negative impact on the price of ordinary shares of the issuer if distributions are not made (because of restrictions on paying dividends on the ordinary shares if dividends are not paid on the preference shares); (d) the amount of the issuer’s reserves; (e) an issuer’s expectation of a profit or loss for a period; or (f) an ability or inability of the issuer to influence the amount of its profit or loss for the period. Preference shares that are redeemable at a scheduled redemption date, and so exhibit characteristics of liabilities, should be differentiated from preference shares that are redeemable at the option of the issuer (and so exhibit characteristics of share capital). As can be seen from Worked Example 10.6, the requirement to treat preference shares as debt can have significant implications for a firm’s debt-to-assets ratios. Although the issue of preference shares has been a limited phenomenon in recent years, one would expect that the recently introduced requirements within Australian Accounting Standards will further reduce the issuing of such shares.

share capital The balance of owners’ equity within a company, which constitutes the capital contributions made by the owners.

WORKED EXAMPLE 10.6: Impact of classifying preference shares as debt, rather than equity As at 30 June 2019 Burridge Ltd has total assets of $2.5 million and total liabilities of $1.6 million. On the same date, Burridge issues $800 000 in preference shares. These shares are redeemable in two years’ time at the option of the shareholder and offer a dividend rate of 10 per cent. They do not include voting rights. REQUIRED Calculate the debt-to-assets ratio for Burridge Ltd as at 30 June 2019, assuming that:

(a) the preference shares are treated as equity (b) the preference shares are treated as debt continued

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SOLUTION If the preference shares are issued, assets will increase by $800 000 to $3.3 million to reflect the additional $800 000 in cash.

(a) If the preference shares are treated as equity, the debt-to-assets ratio is calculated as: 1.6 ÷ 3.3 = 48.48 per cent. (b) If the preference shares are treated as debt, the debt-to-assets ratio is calculated as: 2.4 ÷ 3.3 = 72.73 per cent.

While the above calculations show how the alternative classification as debt or equity will impact on the debtto-assets ratio, because the redemption is at the option of the shareholder the correct treatment would see the preference shares being treated as debt.

LO 10.7 LO 10.8 LO 10.9

Accounting for debentures (bonds)

A debenture is a written promise to pay a principal amount at a specified time in the future, as well as interest calculated at a specified rate. Debenture liabilities are typically secured over the assets of the entity issuing the debentures. That is, if the entity issuing the debentures (the borrower) defaults on the agreement and does not make the agreed payments, the entity acquiring the debentures (the lender) can have the right debenture to seize assets that were provided as security. Debentures may be issued at par, at a premium or at A written promise to a discount. Debentures are also referred to as ‘bonds’. pay a principal amount Within Australia, corporations are responsible for issuing significant amounts of debt in the form at a specified time, of debentures/bonds. With the large amounts being issued, valuation is an important issue, since as well as interest how debentures/bonds are valued will have direct implications for reported liabilities and expenses. calculated at a specific An article entitled ‘Australian companies to tap European debt markets in 2015’ that appeared in rate. the Australian Financial Review on 7 January 2015 (by Sally Rose) provides some insight into the magnitude of the Australian bond market. In the article, which refers to Australian corporate bonds (non-government bonds) being issues within both Australia and overseas, it is stated that: The amount of money raised by Australian issuers in the local market lifted for the sixth year in a row to a record high of $US138.2 billion ($170 billion) in 2014, surpassing the previous record of $US136.3 billion raised in 2013, according to a new report from Dealogic. There was a big dip in the amount of debt raised by Australian issuers in foreign markets, down 16 per cent year on year to $US126.3 billion, the lowest volume since 2011. But while foreign issues were down as fewer Australian companies raised money in the United States in 2014, more local finance and treasury teams took the opportunity to tap European debt markets. In the same article, reference is also made to the amount of government bonds being issued. It is stated: It was a bumper year for syndicated Australian government bond issues, as Federal Treasurer Joe Hockey struggles to balance the budget as the value of Australia’s iron ore, coal and oil exports tumble. The volume of new ‘Kangaroo’ bond issues jumped 34 per cent in 2014 to $US35.4 billion—the biggest year on record.

par (or face) value The amount debenture holders receive on maturity of debentures.

coupon rate The rate of interest specified on the face of a security.

In terms of the total amount of Australian government bonds on issue, it is believed to have been approximately $340 billion in 2014 according to information from the Australian Office of Financial Management (as accessed in May 2015).

Debentures issued at par The par (or face) value of a debenture/bond represents the amount that the debenture holders will receive on maturity of the debentures. Investors will be prepared to pay the par value if they believe that the rate of interest offered by the issuing company on the debentures—this would be written on the debenture certificate and is often referred to as the ‘coupon rate’—matches what they believe the rate of interest should be. The fair value of the debentures would, in this instance, be the same as the face value of the debentures. As will be indicated below, if the market believes that the firm is

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not offering a high enough rate of interest they will not be prepared to pay the full par value—they will demand a discount. That is, the fair value will be less than its face value. Fair value is defined in AASB 13 Fair Value Measurement as: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Conversely, if the market believes that the firm is offering a relatively high rate of interest, they will be prepared to pay more than the full par value, offering to pay a premium (the fair value will be greater than its ‘face value’). Worked Example 10.7 provides an example of debentures being issued at par value.

WORKED EXAMPLE 10.7: Issue of debentures at par value Company C issues $10 million of five-year, 10 per cent, semi-annual coupon debentures to the public (which pay interest each six months). The market also requires a rate of return of 10 per cent. Assume that the moneys come in and the debentures are allotted on the same day: 30 June 2019. REQUIRED Provide the accounting entries at 30 June 2019, 31 December 2019 and 30 June 2024 to record:

(a) the receipt of funds (b) the first payment of interest (c) the redemption of the debentures

SOLUTION Because Company C is issuing bonds that provide a rate of return matching the rate of return expected by the market, there is no need to issue the securities at a discount or a premium—they can be issued at their face value. (a) Legally, on receipt of funds, the firm must place the cash from a public issue in trust until such time as it allots the debentures. 30 June 2019 Dr Cash trust 10 000 000 Cr Application—debentures 10 000 000 (to record the receipt of funds from the investors) Dr Cash at bank 10 000 000 Cr Cash trust 10 000 000 (to transfer funds to the entity’s operating account following the allocation of the debentures) Dr Application—debentures 10 000 000 Cr Debentures 10 000 000 (to record the allocation of the debentures, and to eliminate the ‘application’ account)



The application account is considered to be a liability, as are the debentures. When the debentures have been issued, the issuing organisation has fulfilled its obligation and thereafter the application account can be closed. (b) The entry to record the first payment of interest would be: 31 December 2019 Dr Interest expense Cr Cash at bank (interest expense for six months = $10m × 10% ÷ 2)



500 000 500 000

(c) When the debentures are redeemed on 30 June 2024, the entry to record the redemption would be: 30 June 2024 Dr Debentures 10 000 000 Cr Cash at bank (to recognise the repayment of the face value of the debentures)

10 000 000

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Debentures issued at a discount It is worth noting that the following discussion relies upon the reader having some knowledge of how to calculate present values. For those readers with limited knowledge in this area, Appendix C provides a brief explanation of how to calculate present values. In financial accounting, a number of different categories of liabilities must be discounted to their present value, so accountants must know how to calculate present values. The rate of return required by the market might fluctuate daily; hence it is usual for debentures not to be issued at par (face value). Remember, debentures would be issued at the par value only if the rate demanded by investors (the market rate) happened to coincide with the rate shown on the debenture certificate (called the coupon rate). It should also be remembered that, regardless of what investors pay for the debenture, they will receive the face value (or par value) on redemption; and the interest received will equal the rate written on the debenture certificate, referred to as the coupon rate, multiplied by the par value of the security (regardless of the actual price paid for the debentures). That is, the amount received on redemption and the periodic interest receipts will not change, regardless of what is paid for the security. If the market requires a rate of return in excess of the coupon rate of the debentures, the issue price of the debentures must be reduced to the price at which the cash flows to the investor—in the form of the periodic interest receipts and the final repayment of principal—represent a rate of return equivalent to that required by the market. That is, the debentures will be issued at a discount. As a ‘real life’ example of corporate bonds being issued at a discount, an extract from an article entitled ‘BHP whips up $1bn in bonds’ that appeared in The Australian Financial Review on 20 March 2015 (by Jonathon Shapiro) stated: The world’s largest miner BHP Billiton has raised a quick-fire $1 billion of debt at its cheapest ever rate in the Australian bond market . . . In only its second Australian corporate bond issue since 2001, the global miner sold five-year bonds at a rate of 3.15 per cent, taking advantage of an all-time low in local interest rates used to set the price of corporate bonds. Strong demand for the bond issue allowed it to refine pricing guidance slightly from 0.90 percentage points over the bank rate to 0.87 percentage points to pay a yield of 3.15 per cent, which is likely to be the lowest ever funding rate achieved by an Australian company for a five-year bond. BHP announced to the stock exchange that the bond will pay an interest of 3 per cent but it was sold at a discount to par value resulting in a slightly higher yield. As we can see in the above extract, by reducing the issue price of the bonds, this led to an increase in the yield (or, in the ‘effective rate of interest’) to a rate that was required by the market, in this case being 3.15 per cent. Worked Example 10.8 provides an illustration of debentures being issued at a discount.

WORKED EXAMPLE 10.8: Debentures issued at a discount Assume that the market requires 12 per cent for the debentures considered in Worked Example 10.7. REQUIRED Calculate the issue price of the debentures and include the relevant accounting entries. SOLUTION We need to work out the present value of the future receipts, discounted at the market’s required rate of return—in this example it is 12 per cent. As the market rate exceeds the coupon rate, we should realise that the securities will be issued at a discount. That is, they will be issued for an amount less than their face value. To determine the issue price of the securities, and for the sake of simplicity, we will divide the market’s required annual rate of return (12 per cent) by two to provide the rate of return required for each six-month period (given that the securities are semi-annual). The present value of the annuity, and the present value of the principal, can be calculated by referring to the present value tables provided in the appendices to this book (although for this example we have used present value calculations that go to 7 decimal places).

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Present value of interest payments $500 000 for 10 periods @ 6 per cent $500 000 × 7.3600866 Present value of principal repayment $10 000 000 in 10 periods @ 6 per cent $10 000 000 × 0.5583948 Present value of future cash flows

= $3 680 043

= $5 583 948 $9 263 991

The price of $9 263 991 represents the fair value of the securities (that is, the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction), and it is the fair value of the securities that must be disclosed as a liability in the statement of financial position. The journal entry on the issue of debentures would be: 30 June 2019 Dr Cash Cr Debentures

9 263 991 9 263 991

The present value of the liability shall be disclosed within the statement of financial position. It is a requirement of AASB 9 Financial Instruments that the effective-interest method be used to account for a financial liability such as a debenture. AASB 9 provides the following definition of effective-interest method: The method that is used in the calculation of the amortised cost of a financial asset or a financial liability and in the allocation and recognition of the interest revenue or interest expense in profit or loss over the relevant period. Pursuant to the effective-interest method, the interest expense for a period is calculated by multiplying the present value of the outstanding liability at the beginning of the period by the market’s required rate of return (interest rate). In the example being used here, the rate is 6 per cent. Using the effective-interest method, the carrying amount of the debenture at the end of the debenture’s life will equal the face value of the debenture, as Table 10.1 demonstrates.

Effective-interest method We can use a table to determine the interest expense calculated using the effective-interest method.

Period

Opening liability

Effective interest @ 6 per cent

Coupon rate

  0

Net liability   9 263 991

  1

9 263 991

555 839.5

500 000

  9 319 830.5

  2

9 319 830.5

559 189.8

500 000

  9 379 020.3

  3

9 379 020.3

562 741.2

500 000

  9 441 761.5

  4

9 441 761.5

566 505.7

500 000

  9 508 267.2

  5

9 568 267.2

570 496.0

500 000

  9 578 763.2

  6

9 578 763.2

574 725.8

500 000

  9 653 489

  7

9 653 489

579 209.3

500 000

  9 732 698.3

  8

9 732 698.3

583 961.9

500 000

  9 816 660.2

  9

9 816 660.2

588 999.6

500 000

  9 905 659.8

10

9 905 659.8

594 339.6

500 000

10 000 000

Table 10.1 Determining the periodic interest expense under the effective-interest method

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effective-interest method Calculating interest expense for a period by multiplying the opening present value of a liability by the appropriate market rate of interest.

As shown in Table 10.1, the amount of the liability reduced each period using this method equals the difference between the present value of the opening liability, multiplied by the market rate of interest (which gives the interest expense), and the actual payment being made (based on the coupon rate). Adopting the effective-interest method  means that the balance of the debenture liability represents the present value of the liability throughout the debenture term (adopting the market’s required rate of return at the date the debentures were issued as the discount rate). Using the effective-interest method, the accounting entries would be: 31 December 2019 Dr Interest expense Cr Debentures Cr Cash 30 June 2020 Dr Interest expense Cr Debentures Cr Cash 31 December 2020 Dr Interest expense Cr Debentures Cr Cash

premium The amount paid per debenture in excess of the par or face value.

market rate of return The rate of return that the market, typically the capital market, requires from a particular investment.

555 839 55 839 500 000 559 190 59 190 500 000 562 741 62 741 500 000

As we can see above, the interest expense increases across time as the present value of the liability increases.

Debentures issued at a premium If debentures are issued that provide a coupon rate in excess of that demanded by the market, then investors will be prepared to pay a premium (that is, more than the face value of the bonds). In this case, when the returns are compared with the higher price paid for the debentures, the effective rate of return on the debentures equates with the return required by the market. That is, whatever coupon rate is offered, it is assumed that the actual issue price of the securities will be adjusted by the market so that the actual cash flows generated from the investment will provide a rate of return equivalent to that required by the market (the market rate of return). This is examined more closely in Worked Example 10.9.

WORKED EXAMPLE 10.9: Debentures issued at a premium The debenture issue is the same as that in Worked Example 10.6, except the market demands 8 per cent per annum (or 4 per cent each six months) on such debentures. REQUIRED Calculate the issue price (fair value) of the debentures and provide the accounting journal entries for 30 June 2019, 31 December 2019 and 30 June 2020. SOLUTION Present value of interest payments $500 000 for 10 periods @ 4 per cent $500 000 × 8.1108925

= $ 4 055 446

Present value of principal repayment $10 000 000 in 10 periods @ 4 per cent $10 000 000 × 0.675 564 3 Issue price

=  $6 755 643 = $10 811 089

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Hence the premium is $811 089. We will also assume that this is a direct private placement and therefore we will not use a trust or application account. As we know, the debentures (bonds) are to be disclosed at their fair value. 30 June 2019 Dr Cash Cr Debentures Using the effective-interest-rate method 31 December 2019 Dr Interest expense Dr Debentures Cr Cash (interest expense = 10 811 089 × 0.04 = 432 444) 30 June 2020 Dr Interest expense Dr Debentures Cr Cash [interest expense = (10 811 089 - 67 556) × 0.04 = 429 741]

Hybrid securities

10 811 089 10 811 089

432 444 67 556 500 000

429 741 70 259 500 000

LO 10.10

Although a more detailed description of financial instruments will be provided in Chapter 15, it should be noted at this point that reporting entities will sometimes issue hybrid securities, which have both debt and equity characteristics. We have already discussed how preference shares can hybrid securities have both debt and equity characteristics. Some companies also issue debt that allows conversion, at Securities exhibiting both debt and equity the debtholder’s option, into shares of the issuing company. That is, the securities may be converted characteristics. or redeemed for cash. These are commonly referred to as convertible notes. An issue that arises in the case of convertible notes (loans that can be converted to shares) is whether they should be treated as debt or equity—or perhaps part debt and part equity. If conversion of the securities to shares is probable, they would have an equity component. They would also have a liability component relating to the payment obligations that exist prior to conversion. If redemption of the securities for cash is the probable outcome they would need to be partly classified as liabilities. While we will be covering hybrid securities in more depth in Chapter 15, we can note here that AASB 132 stresses that financial instruments such as convertible notes should be disclosed partially as debt and partially as equity. As paragraph 29 of AASB 132 states: An entity recognises separately the components of a financial instrument that (a) creates a financial liability of the entity and (b) grants an option to the holder of the instrument to convert it into an equity instrument of the entity. For example, a bond or similar instrument convertible by the holder into a fixed number of ordinary shares of the entity is a compound financial instrument. From the perspective of the entity, such an instrument comprises two components: a financial liability (a contractual arrangement to deliver cash or another financial asset) and an equity instrument (a call option granting the holder the right, for a specified period of time, to convert it into a fixed number of ordinary shares of the entity). The economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants. Accordingly, in all cases, the entity presents the liability and equity components separately on its statement of financial position. With regard to determining the amount to be assigned to the equity component and the amount to be assigned to the debt component, paragraph 32 of AASB 132 states: The issuer of a bond convertible into ordinary shares first determines the carrying amount of the liability component by measuring the fair value of a similar liability (including any embedded non-equity derivative features) that does not have an associated equity component. The carrying amount of the equity instrument CHAPTER 10: AN OVERVIEW OF ACCOUNTING FOR LIABILITIES  365

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represented by the option to convert the instrument into ordinary shares is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole. As mentioned previously, however, we will consider issues associated with convertible notes in more depth in Chapter 15.

SUMMARY The chapter addressed the general issues pertaining to liabilities. A liability is currently defined in the Conceptual Framework for Financial Reporting as a present obligation of an entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities are to be recognised when the future transfer of economic benefits is considered to be probable and the amount of the obligation can be measured reliably. For statement of financial position (balance sheet) purposes, liabilities can be classified as current or non-current or presented in order of liquidity. Current liabilities are those that are repayable within 12 months of the reporting date or within the entity’s ‘normal operating cycle’. This chapter considers the accounting treatment of preference shares and convertible notes, and indicates that the way such securities are disclosed should be dependent upon whether they are of the substance of debt or of equity. ‘Provisions’ are also considered, and it is stressed that, for a provision to be considered a liability, there must be a present obligation (legal, moral or constructive) to other entities, with the result that provisions for such things as future repairs do not constitute liabilities. Accounting for the issue of debentures (bonds) is also discussed. Where the coupon rate of the debentures is the same as the required market rate, debentures will be issued at their par or face value; where the required market rate of the debentures is less than the coupon rate, debentures will be issued at a premium; and where the required market rate of the debentures is greater than the coupon rate, debentures will be issued at a discount.

KEY TERMS contingent liability  347 coupon rate  360 current liability  350 debenture  360 dividend  358

effective-interest method  364 hybrid security  365 liability  345 market rate of return  364 non-current liability  350

par (or face) value  360 preference shares  358 premium  364 share capital  359

END-OF-CHAPTER EXERCISES On 1 July 2019, Kruger Ltd privately issues $1 million in six-year debentures, which pay interest each six months at a coupon rate of 6 per cent per annum (3 per cent each 6 months). At the time of issuing the securities, the market requires a rate of return of 4 per cent. Consistent with the requirements of AASB 9, the debentures are accounted for using the effective-interest method.

REQUIRED (a) Determine the fair value of the debentures at the time of issue (which will also be their issue price). (b) Provide the journal entries at: (i) 1 July 2019 (ii) 31 December 2019 (iii) 30 June 2020. LO 10.7, 10.8, 10.9 366  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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SOLUTION TO END-OF-CHAPTER EXERCISE In this question, the interest payments of 6 per cent per annum are made each six months for six years. Therefore we will treat the debentures as offering a coupon rate of 3 per cent over 12 periods. Similarly, the market rate will be calculated as 2 per cent for 12 periods. (a) The issue price is equal to the present value of the interest annuity and the principal repayment. The discount rate is the market’s required rate of return, in this case, 2 per cent per six-month period. Present value of principal = $1 000 000 × 0.7885 Present value of annuity = $30 000 × 10.5753 Issue price

= $788 500 = $317 259 = $1 105 759

Because the market rate of the debentures is less than their coupon rate, the debentures’ fair value is assessed as being greater than their face value; that is, they are issued at a premium, as shown above. (b) Journal entries 1 July 2019 Dr Cash Cr Debentures

1 105 759 1 105 759

The interest expense in each period will be the present value of the liability at the commencement of the period, multiplied by the market’s required rate of return. In this case it will be $1 105 759 × 0.02 = $22 115. 31 December 2019 Dr Interest expense Dr Debentures Cr Cash 30 June 2020 Dr Interest expense Dr Debentures Cr Cash Interest = ($1 105 759 − $7 885) × 0.02 = $21 957

22 115 7 885 30 000 21 957 8 043 30 000

REVIEW QUESTIONS 1. What attributes should an item or transaction exhibit in order to be classified a liability? LO 10.1 2. What is a contingent liability and how should it be disclosed for financial reporting purposes? LO 10.2 3. If a reporting entity has an obligation to clean up a contaminated site, but does not believe it can measure the liability with any reliability, then should the obligation be disclosed at all within the financial statements and accompanying notes? If so, how would it be disclosed? LO 10.1, 10.2 4. An entity has determined that it will cost approximately $15 million to clean up a site that it previously contaminated as a result of its operations. Pursuant to AASB 137, what attributes should this proposed clean-up have if it is to satisfy the requirements necessary for labelling it a provision? LO 10.4 5. Determine whether the following items would be classified and recorded as liabilities: (a) provision for repairs (b) provision for long-service leave (c) dividends payable (d) a guarantee for the debts of a subsidiary. LO 10.1, 10.2, 10.4 6. What factors may cause the price of a debenture (also referred to as a ‘bond’) at issue date to be different from its face value? LO 10.7

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7. It is often argued that managers would prefer to show lower levels of debt than higher levels of debt. Why do you think this might be so? LO 10.6 8. Some researchers argue that it would be harder to renegotiate a public debt agreement than a private debt agreement. Why do you think this might be the case? LO 10.6 9. If a company is in financial distress, some accounting researchers argue that this is not necessarily all bad news. The fact that the company is in distress might signal that the incumbent management team is inefficient, thereby providing the mechanism or impetus to remove it and replace it with a new, more efficient team. This is a good outcome. Evaluate this view. LO 10.5, 10.6 10. How would you determine the discount or premium on a debenture issue? LO 10.7, 10.8 11. Company X recognises the following instruments within the ‘Shareholders’ equity’ section of its statement of financial position: • redeemable preference shares • perpetual convertible notes • preference shares • subordinated loans

REQUIRED How would these instruments be disclosed pursuant to AASB 101, AASB 137 and the Conceptual Framework for Financial Reporting? LO 10.1, 10.10 12. Brighton Ltd is a manufacturer of boats and gives warranties at the time of sale to purchasers of its boats. Pursuant to the warranty terms, Brighton Ltd undertakes to make good, by repair or replacement, manufacturing defects that become apparent within a period of three years from the date of sale.

REQUIRED Should a liability in the form of a provision be recorded? How would it be measured and how should it be presented to financial statement users? LO 10.1, 10.2, 10.4 13. Hampton Ltd has a number of non-current assets, some of which require, in addition to normal ongoing maintenance, substantial expenditure on major refits/refurbishment at certain intervals or on major components that require replacement at regular intervals.

REQUIRED Should a liability in the form of a provision be recorded? How would it be measured and how should it be presented to financial statement users? LO 10.1, 10.4 14. Sandringham Mining Ltd has been mining in a particular coastal area. A requirement of the local Environmental Protection Authority is that the area be restored to a state that is beneficial to the local fauna.

REQUIRED Does a liability exist and, if so, when should a provision for restoration be recognised? LO 10.1, 10.2, 10.4 15. Elwood Chemicals Ltd has, as a result of its ongoing operations, contaminated the land on which it operates. There is no legal requirement to clean up the land.

REQUIRED Should Elwood Chemicals Ltd recognise a liability? LO 10.1, 10.2 16. Explain how the release of a new accounting standard could potentially cause a reporting entity to violate an existing debt covenant. LO 10.1, 10.5, 10.6 17. Midnight Boil Ltd sells electricity generated from its nuclear power plant. Its managing director, Peter Polly, is not overly concerned about the environment but nevertheless knows that the company has a legal obligation to clean up the site in 20 years’ time when the plant is shut on 30 June 2039. As at 30 June 2019, the best estimate to clean up the site (in 2039) is $10 500 000. One year later, on 30 June 2020, the best estimate at cleaning up the site (in 19 years’ time) is still considered to be $10 500 000. The pre-tax rates that reflect current market assessments of the time value of money and the risks specific to the liability were 7 per cent as at 30 June 2019 and 6 per cent as at 30 June 2020.

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REQUIRED Provide the journal entries in relation to the above obligation for the years ending 30 June 2019 and 30 June 2020. LO 10.4, 10.8 18. Cactus Ltd issues some convertible notes in 2019. These notes are issued for $20 each and allow note holders the option to convert each note to one ordinary share in Cactus Ltd. The date for conversion is 31 July 2020. If the conversion option is not exercised, cash of $20 per note will be paid to the note holders. At 30 June 2020 the price of Cactus Ltd’s shares is $18.00. Would you disclose the notes as debt or as equity as at 30 June 2020? LO 10.5, 10.10 19. On 1 July 2018 Michaela Ltd issues $1 million in five-year debentures that pay interest each six months at a coupon rate of 10 per cent. At the time of issuing the securities, the market requires a rate of return of 8 per cent. Interest expense is determined using the effective-interest method.

REQUIRED (a) Determine the issue price. (b) Provide the journal entries at: (i) 1 July 2018 (ii) 30 June 2019 (iii) 30 June 2020. LO 10.7, 10.8, 10.9 20. On 1 July 2018 Bombo Ltd issues $2 million in six-year debentures that pay interest each six months at a coupon rate of 8 per cent. At the time of issuing the securities, the market requires a rate of return of 6 per cent. Interest expense is determined using the effective-interest method.

REQUIRED (a) Determine the issue price. (b) Provide the journal entries at: (i)   1 July 2018 (ii) 30 June 2019 (iii) 30 June 2020. LO 10.7, 10.8, 10.9 21. On 1 July 2018 Rankin Ltd issues $1 million in 10-year debentures that pay interest each six months at a coupon rate of 10 per cent. At the time of issuing the securities, the market requires a rate of return of 12 per cent. Interest expense is determined using the effective-interest method.

REQUIRED (a) Determine the issue price. (b) Provide the journal entries at: (i) 1 July 2018 (ii) 30 June 2019 (iii) 30 June 2020. LO 10.7, 10.8, 10.9 22. On 1 July 2018 Kiama Ltd issues $5 million in five-year debentures that pay interest each six months at a coupon rate of 8 per cent. At the time of issuing the securities, the market requires a rate of return of 10 per cent. The interest expense is calculated using the effective-interest method.

REQUIRED (a) Determine the issue price. (b) Provide the journal entries at: (i) 1 July 2018 (ii)  30 June 2019 (iii) 30 June 2020. LO 10.7, 10.8, 10.9 23. The following parts of this question relate to contingent assets. (a) What is a contingent asset?

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(b) When should a contingent asset be disclosed within the notes to the financial statements? (c) If something is initially disclosed as a contingent asset, when can it subsequently be recognised as an ‘asset’ within the financial statements? LO 10.11 24. The adapted article in Financial Accounting in the Real World 10.1 relates to potential legal action to be taken against the construction group Leighton Holdings. Read the article and identify if and how Leighton should disclose information about the possible action within either its financial statements or the notes thereto. LO 10.1, 10.2, 10.5

10.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Leighton Holdings shareholders may join class action against the company Shareholders in Leighton Holdings, whose parent company is the German company Hochtief, are considering a class action against the financially under-performing construction company. Disclosure is the central issue for any class action. Leighton’s net profit forecast for the year was $480 million on 24 February but had turned into a forecast of a loss of $427 million – and a plan to raise $757 million – by 11 April after trading temporarily ceased on 4 April. Hugh McLernon, Managing Director of IMF, a Perth litigation funder firm, confirmed that IMF is looking into the possibility of shareholder class action against Leighton. Other plaintiff law firms are believed to be undertaking similar assessments. The scrutiny also covers what Hochtief, which has some company directors in common with Leighton and has a significant 54 per cent interest in the Australian company, knew about the updated returns forecast and writedowns. On 7 April, before informing the market in Australia Hochtief announced the profit downgrade in Germany. As well as facing disgruntled shareholders Leighton has to answer questions from the Australian Securities Exchange around the question of just when it became aware that the forecast profit would become a loss. The company’s woes are in major part caused by payment problems with the Al Habtoor joint venture in the Middle East and cost blowouts at home in important construction projects (e.g. Airport Link; desalination plant in Victoria). The company stated that the 7 April trading halt had resulted from an internal review which concluded on 11 April, the day the company announced its plan to offer a one-for-nine entitlement in an attempt to raise $757 million. Before trading was halted the share price was $28.94; the shares were discounted to $22.50 for the funds raiser but had not traded below the discount price by 19 April. Whether the class action will go ahead will be in part determined by Leighton’s share performance and how material is the loss by its shareholders. SOURCE: Adapted from ‘Leighton investors consider lawsuit’, by Tracy Lee, The Australian, 20 April 2011, p. 31

25. Read the adapted article in Financial Accounting in the Real World 10.2, and, assuming that KPMG was a reporting entity and required to produce general purpose financial reports, explain when KPMG would have first disclosed information about the lawsuit and how it would disclose it. Once KPMG agreed to settle the claim, how would the settlement be disclosed in the financial statements? LO 10.1, 10.2, 10.3, 10.4

10.2 FINANCIAL ACCOUNTING IN THE REAL WORLD The Westpoint collapse: the aftermath Investors were hardly ecstatic over the 1 February announcement in the High Court by the Australian Securities and Investments Commission wherein it said that the settlement with KPMG and some Westpoint directors, including controversial founder Norm Carey, brought to an end its recovery actions. Investors are expected to

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see a return of about $170 million of the $388 million that was lost when the Perth-based Westpoint collapsed in 2006. ASIC had alleged that KMPG negligently carried out audits of Westpoint by failing to identify issues related to the solvency of the companies. ASIC also claimed that KPMG should have notified it of suspected breaches of the Corporations Law. The settlement announcement pre-empted KPMG’s action in the High Court to challenge ASIC’s power to act for investors in suing on their behalf. The settlement terms were confidential but it was believed that KPMG, who said agreeing to the settlement didn’t constitute admitting liability, would pay small investors $67 million. Three hundred and eighty-eight million dollars was lost when Westpoint failed. Norm Carey asserted that the company was still solvent in 2006 and blamed ASIC for Westpoint’s collapse. He said that ASIC should have let Westpoint’s projects finish instead of closing it down, as the investors could then have retrieved their investments. He was still planning to continue a malfeasance suit against the regulator. The effect on the Westpoint investors since 2006 has been devastating, leading to the suicide of some, and general financial hardship. David Ramsay, an investor from Perth, said the only winners were liquidators and lawyers and that the Westpoint directors seemed to feel no pain. He believed he would lose $150 000 out of his $250 000 investment. The head of the Westpoint Investors Group, Graham Macaulay from Sydney, reinforced how devastating the crash had been to him personally (he’d invested $300 000 and had only recovered $5 000) and as confidant of investors who had lost everything. SOURCE: Adapted from ‘KPMG settled Westpoint claims’, by Andrew Burrell, The Australian, 2 February 2011, p. 35

CHALLENGING QUESTIONS 26. In an article entitled ‘Berry nasty’ that appeared in the Courier Mail on 15 February 2015 (by Greg Stolz), it was reported that: Queenslanders who have eaten a popular brand of frozen berries are being warned to watch for symptoms of hepatitis A after a major health scare in southern states. At least five people from Victoria and NSW have contracted the potentially deadly illness after reportedly eating Nanna’s frozen mixed berries. Victorian health authorities issued a public warning yesterday as manufacturer Patties Foods ordered an urgent product recall. Queensland Health echoed the warning as thousands of consumers took to social media to vent their concerns about the berries, sourced from China and Chile  .  .  .  Queensland Chief Health Officer Dr Jeannette Young said the berries had not been conclusively linked to any cases of hepatitis A in Queensland ‘but we are continuing to monitor the situation’. Victoria-based Patties issued a recall for the 1kg packets of Nanna’s ‘amazingly juicy’ frozen mixed berries, which are available in the Coles, Woolworths and IGA supermarkets. Victoria’s Chief Health Officer, Dr Rosemary Lester, said the berries had been implicated in recent outbreaks of hepatitis A. In relation to the same issue, another article that appeared in The Australian on 21 February 2015 by Tim Boreham entitled ‘Patties Foods braces for berry scandal fallout’ stated: But what about the trashed stock itself? Patties chairman Mark Smith says it’s too early to tell whether the product recall will have a financial impact—and to what degree. It’s hard to see Patties escaping the fallout, given the likelihood of a class action and the inevitable reputational hit . . . Patties shares have been marked down by about 12 per cent. CHAPTER 10: AN OVERVIEW OF ACCOUNTING FOR LIABILITIES  371

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REQUIRED (a) In the light of the information in the article, do you believe that it is appropriate for Patties Foods to utilise a contingent liability note as the vehicle to provide information about the organisation’s potential liability in relation to the berry claims? (b) Alternatively, are there any grounds to suggest that Patties Foods should recognise a provision in relation to the berry claims? (c) If possible, review the annual reports of Patties Foods from 2015 and then determine the actual disclosures that have been made by Patties in relation to the berries. You are to discuss whether you agree with the disclosure policy adopted by Patties as it relates to the berries. LO 10.1, 10.2, 10.4 27. The following is an extract from an article entitled ‘Tax office pursues BHP Billiton and Rio Tinto over Singapore tax shelter’ by Neil Chenoweth that appeared in The Australian Financial Review on 7 April 2015. It details information about taxation concerns related to offshore operations. Mining giants BHP Billiton and Rio Tinto are being pursued by the Australian Taxation Office for channelling billions of dollars in profits from iron ore sales through companies that pay almost no tax in Singapore.  The Australian Financial Review has obtained documents that show the two mining companies report $2.6 billion a year in profits in their Singapore marketing hubs, whose tax rates there are as low as 2.5 per cent.  The arrangements save the two companies more than $750 million a year in Australian tax and the ATO regards it as tax avoidance under the transfer pricing rules. The Tax Office is pursuing multibilliondollar claims against each company, says a source with direct knowledge of the disputes.  . . . both companies have fought the Tax Office for years and argue that their Singapore operations were not set up to reduce tax. .  .  .  They say their marketing arms perform a vital function and are in Singapore to be close to customers, not for tax reasons. Exhibit 10.2 reproduces the contingent liability note from BHP Billiton Ltd’s 2015 Annual Report.

REQUIRED In the light of the brief information provided in the article, evaluate the disclosures provided by BHP in its 2015 Annual Report, as shown in Exhibit 10.2. LO 10.1, 10.2

Exhibit 10.2 Contingent liability note from BHP Billiton Ltd’s 2015 Annual Report

35 CONTINGENT LIABILITIES Contingent liabilities at balance date, not otherwise provided for in the financial statements, are categorised as arising from:

Associates and joint ventures Tax and other matters (a) Total associates and joint ventures Subsidiaries and joint operations Bank guarantees (b) Tax and other matters (a) Total subsidiaries and joint operations Total contingent liabilities

2015 US$M

2014 US$M

1 313 1 313

1 662 1 662

3 1 947 1 950 3 263

23 1 691 1 714 3 376

(a) Tax and other matters include actual or potential litigation and tax-related amounts, predominantly relating to a number of actions against the Group, none of which are individually significant and where the liability is not probable and therefore the Group has not provided for such amounts in these financial statements. Additionally, there are a number of legal claims or potential claims against the Group, the outcome of which cannot be foreseen at present, and for which no amounts have been included in the table above.

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(b) The Group has entered into various counter-indemnities of bank and performance guarantees related to its own future performance in the normal course of business. The Separation Deed between BHP Billiton Ltd and BHP Billiton Plc and South32 Ltd (South32) deals with certain commercial, transitional and legal issues arising from the separation of South32 from the Group. A key part of the Separation Deed is the agreement between the parties in relation to the ‘Demerger Principle’. The fundamental underlying principle of the demerger is that:





(i) South32 has the entire economic benefit, commercial risk and liabilities of the South32 Businesses (and former South32 Businesses) as if South32 and not the Group had owned those Businesses at all times; and (ii) the Group has the entire economic benefit, commercial risk and liabilities of the BHP Billiton Businesses (including the entire risk in former BHP Billiton Businesses), as if the Group and not South32 had owned those Businesses at all times. To give effect to the principle, subject to certain exceptions, BHP Billiton Ltd indemnifies South32 against all claims and liabilities relating to the BHP Billiton Businesses and former BHP Billiton Businesses and South32 indemnifies the Group against all claims and liabilities relating to the South32 Businesses and former South32 Businesses. The Separation Deed also contains specific indemnities with respect to certain matters. No amounts have been claimed or provided for as at 30 June 2015 pursuant to the Separation Deed. In May 2015, the Group announced the resolution of the previously disclosed investigation by the US Securities and Exchange Commission (SEC) into potential breaches of the US Foreign Corrupt Practices Act (FCPA). The US Department of Justice has also completed its investigation into BHP Billiton without taking any action. The investigations related primarily to previously terminated minerals exploration and development efforts, as well as hospitality provided by BHP Billiton at the 2008 Beijing Olympic Games. The US investigations have now been concluded on all matters. The matter was resolved with the SEC pursuant to an administrative order, which imposed a US$25 million civil penalty. The SEC order made no findings of corrupt intent or bribery by BHP Billiton. As previously disclosed, an investigation by the Australian Federal Police (AFP) is ongoing and the Group continues to cooperate. In light of the continuing nature of the AFP investigation, it is not appropriate at this stage for BHP Billiton to predict outcomes.

SOURCE: BHP Billiton Ltd Annual Report 2015

28. Read the extract below from an article entitled ‘Suits overshadow the Ts at American Apparel’ by Joann Lublin that appeared in The Australian on 28 May 2015: American Apparel was supposed to be focused by now on fixing its battered business. Instead, it is caught up in a firing that won’t go away. Nearly a year after moving to oust chief executive Dov Charney, the maker of T-shirts, tank tops and hoodies continues to fight with its controversial founder on multiple fronts. The wrangling is proving a distraction as the company simultaneously struggles to overcome a tide of red ink and maintain its relevance with fickle young shoppers .  .  . Mr Charney has filed an arbitration claim accusing the company of breach of contract and wrongful termination, and has sued American Apparel and its lead director, alleging they defamed him. Two shareholder lawsuits accuse the company of proxy fraud in connection with Mr Charney’s termination. Another lawsuit filed by Mr Charney’s lawyer on behalf of former employees that seeks class action status accuses the company of failing to give about 200 workers proper notice before firing them . . . American Apparel has denied the claims and shot back in mid-May with a lawsuit of its own alleging that Mr Charney co-ordinated the various complaints as part of an attempt to ‘wrest control of the company away from the board and management and reinstate himself as CEO and a director’ in violation of the standstill agreement. CHAPTER 10: AN OVERVIEW OF ACCOUNTING FOR LIABILITIES  373

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REQUIRED On the basis of the brief information provided in the extract above, you are to suggest how American Apparel should account for the action being taken by the former executive. LO 10.1, 10.2, 10.3, 10.4 29. In an article entitled ‘Nailed. Father’s discovery sparks punching bag recall’ by Angus Thompson that appeared in The Advertiser on 11 March 2015 it was reported that: A father’s claims that he found nails, broken glass and medical waste in a punching bag bought for his sons has led to a full product recall. Iulian Bucur, of Narre Warren in Melbourne, said he discovered the bag’s revolting contents after unzipping it last Thursday to repair its strap. ‘I was sold a bag full of garbage instead of the punching bag I paid for,’ Mr Bucur said . . . He said that on opening the bag in his back yard last Thursday ‘I started pulling out rags, and then I got a sewing machine needle stuck in my finger.’ He said he found more needles, nails, food scraps, and even a sanitary pad. Sportswear manufacturer Spalding and its Australian licensee, Spartan Sporting Goods, are preparing a recall of all punching bags branded with its logo from retailers immediately. Spalding told The Advertiser it was treating the allegations as a priority, given their extremely serious nature, and had begun an investigation.

REQUIRED How do you think the organisations mentioned in the abstract above should account for this incident? LO 10.1, 10.2, 10.3, 10.4 30. Read the following extract from an article entitled ‘Tanks to go at old refinery’ by Cameron England that appeared in The Advertiser on 17 September 2012. The demolition of the Port Stanvac oil refinery has begun, nine years after the site was abandoned. Site owner Exxon Mobil says it will take until the end of next year to remove the refinery and storage tanks, but full remediation of the site will take another few years . . . The Port Stanvac refinery was mothballed in 2003 with the loss of 1090 jobs after supplying the state’s transport fuels for 40 years. Most of Australia’s petroleum production has now moved offshore. Mobil decided in 2009 it would never reopen the site and has since been working on a plan to remediate it. Demolition of the site started last month. [Mobil Spokesman] Mr Bailey said Mobil did not believe the site was heavily contaminated, but because of the four decades of heavy industrial use, it would still need to be remediated. ‘Over that length of time, there are impacts on the site,’ he said. ‘It’s a very big site and much of the site has not had any oil processing or tanks on it, so a lot of the site is lightly impacted, if any.’ Mobil discontinued its refining operations in Port Stanvac, South Australia, over a decade ago. Due to years of operations, the land is thought to be highly contaminated, yet the contamination has not been resolved. Assuming that Mobil is required to produce general purpose financial reports that comply with Australian reporting requirements, how do you believe that Mobil should currently account for the costs that could be necessary to remediate the site? When should Mobil have started recognising the costs and liabilities associated with the contamination? LO 10.1, 10.2, 10.4, 10.5 31. Read the following adaptation of an article entitled ‘CBA in payout on “toxic” products’ by Leo Shanahan that appeared in The Australian on 4 April 2015. In 2012 a claim was lodged in the Federal Court against the Commonwealth Bank by Gloucester Council and an investment company, Clurname, alleging that CBA had breached its duty of care and engaged in misleading and deceptive conduct in selling them ‘toxic’ investments, ignoring their request for conservative investments. Eventually around 35 investors, who had been sold $140 million worth of AAA-rated collateralised debt obligations (CDOs), participated in the class action.  CBA settled with the investors for $50 million, including legal fees, and agreed to pay $1.5 million to International Litigation Partners, funder of the class action. The bank refused to comment on the settlement, saying the court still had to approve it, although CBA had previously said the investor’s claim had no merit. In the course of the case it had been revealed that CBA had settled with at least 14 other CDO investors.  CBA had earlier been faced with the fallout from the frauds perpetrated by some of its financial planners, which led to public apologies and expensive settlements. 374  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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REQUIRED On the basis of the brief information provided, consider how, if you were the chief accountant at the Commonwealth Bank, the case would be disclosed within the annual report of CBA. What factors would you consider in determining the form the disclosures should take, and in which years the disclosures would be made? LO 10.1, 10.2, 10.4

REFERENCES CHEN, K.C.W. & WEI, K.C.J., 1993, ‘Creditors’ Decisions to Waive Violations of Accounting-based Debt Covenants’, Accounting Review, April, pp. 218–32. DEEGAN, C.M., 1986, ‘Preference Shares—Issues Relating to their Use and Disclosure’, Chartered Accountant in Australia, October, pp. 48–53. DEFOND, M.L. & JIAMBALVO, J., 1994, ‘Debt Covenant Violation and Manipulation of Accruals’, Journal of Accounting and Economics, vol. 17, pp. 145–76. GILSON, S.C., 1989, ‘Management Turnover and Financial Distress’, Journal of Financial Economics, vol. 25, pp. 241–62. GILSON, S.C., 1990, ‘Bankruptcy, Boards, Banks, and Block Holders’, Journal of Financial Economics, vol. 27, pp. 355–87. GRIFFIN, P.A., LONT, D. & MCCLUNE, K., 2011, ‘Insightful Insiders? Insider Trading and Stock Return Around Debt Covenant Violation Disclosures’, Accounting and Finance Association of Australia and New Zealand Annual Conference, Darwin, July. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2015, Exposure Draft ED/2015/3 Conceptual Framework for Financial Reporting, IASB, London. JI, S. & DEEGAN, C., 2011, ‘Accounting for Contaminated Sites: How Transparent Are Australian Companies?’, Australian Accounting Review, vol. 21, no. 2, June, pp. 131–53. SMITH, C.W., 1993, ‘A Perspective on Accounting-based Debt Covenant Violations’, Accounting Review, April, pp. 289–303. WATTS, R.L. & ZIMMERMAN, J.L., 1986, Positive Accounting Theory, Englewood Cliffs, NJ, Prentice Hall. WATTS, R.L. & ZIMMERMAN, J.L., 1990, ‘Positive Accounting Theory: A Ten-year Perspective’, Accounting Review, January, pp. 131–56.

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CHAPTER 11

ACCOUNTING FOR LEASES LEARNING OBJECTIVES (LO) 11.1 Be aware of some recent significant changes in the rules that apply when accounting for leases, and be aware of the implications these changes have for financial statements. 11.2 Understand what a ‘lease’ represents. 11.3 Understand the core principle and the scope of the accounting standard pertaining to leases. 11.4 Understand when to recognise a lease. 11.5 Know how to determine the ‘lease term’. 11.6 Understand that a customer (lessee) leasing assets shall recognise assets and liabilities arising from a lease. 11.7 Understand how, from the lessee’s perspective, to measure lease assets (which are ‘rights-of-use’ assets) and lease liabilities, be able to measure lease-related expenses (which would typically include interest expense and amortisation expense), and be able to prepare the related accounting journal entries. 11.8 Understand what interest rate shall be used to calculate the present value of lease-related assets and liabilities. 11.9 Know how to account for the service component of a contract that includes both a lease and a service component. 11.10 Understand that for lessors, leases can be classified as either finance leases or operating leases, and that finance leases can be further subclassified as direct financing leases or dealer- or manufacturer-type leases, and understand how to account for such leases. 11.11 Understand how, from the lessor’s (supplier’s) perspective, to measure a lease receivable, be able to measure lease-related revenues, and be able to prepare the related accounting journal entries. 11.12 Understand that for lessors, a lease receivable will often be substituted for the underlying asset that is the subject of the lease. 11.13 Understand the implications the accounting standard pertaining to leases has for various accountingbased contractual arrangements that a reporting entity might have negotiated.

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An overview of recent developments in the accounting requirements pertaining to accounting for leases

LO 11.1 LO 11.2 LO 11.4 LO 11.6 LO 11.13

There have been recent and major changes in how we account for leases, with a new accounting standard on leasing having been released by the IASB in January 2016, this being IFRS 16 Leases. This was subsequently followed by the release in Australia of AASB 16 Leases in February 2016. For many years within Australia, and internationally, we have had an accounting standard (and in Australia the accounting standard pertaining to leases was AASB 117 Leases, which was the local equivalent of the former international lease accounting standard IAS 17 Leases), which excluded many lease assets, and associated liabilities, An agreement from being recorded on the balance sheets (statements of financial position) of lessees. Basically, conveying the right under the former system, which was in place for about 30 years, if a lease contract was considered from a lessor to a to transfer substantially all the ‘risks and rewards incidental to ownership of an asset’ to the lessee to use property for a stated period in lessee, then—and only then—was it classified as a ‘finance lease’, and a related lease asset and return for a series of a lease liability were required to be recognised within the financial statements of the lessee— payments. otherwise no asset or liability was generally recognised by the lessee for balance sheet purposes. In determining whether the ‘risks and rewards incidental to ownership of an asset’ passed to the lessee from the lessor, the former accounting standards (IAS 17 and its Australian equivalent AASB finance lease 117) had required that the lease contract must have been non-cancellable and also had included A lease in which the one of the following elements: terms of the lease



agreement transfer

(a) the lease ultimately transferred ownership of the asset to the lessee at the end of the the risks and benefits lease term; of ownership from the lessor to the lessee. (b) as part of the lease contract, the lessee had the option to purchase the lease asset at a price that was expected to be sufficiently lower than the fair value at the date the option became exercisable, such that it was reasonably certain, at the inception of the lease, that the option would be exercised; (c) the lease term was for the major part of the economic life of the asset (generally construed as being 75 per cent or more of the economic life of the asset), even if title did not transfer; and (d) at the inception of the lease the present value of the lease payments amounted to at least substantially all of the fair value of the leased asset (generally construed as being at least 90 per cent of the fair value).

Again, if any one of the above requirements was satisfied, and the lease was non-cancellable, then the lease was considered to have transferred substantially all of the risks and rewards incidental to ownership to the lessee and the lease would have been deemed to be a ‘finance lease’ with the consequence that a lease asset, and a corresponding lease liability (equal to the present value of the lease payments), would have been required to be recognised by the lessee. Otherwise, the lease was considered to be an ‘operating lease’ and no operating lease lease liability, or lease asset, was recognised by the lessee, regardless of the fact that the Lease in which the organisation might have had a non-cancellable obligation to make lease payments for a number risks and rewards of of years. ownership stay with the So if, for example, an organisation leased a building for five years and the lease contract did not lessor. transfer ownership of the leased asset at the end of the lease, it had no bargain purchase option, and the expected economic life of the building was considered to be 50 years, then under the former accounting standard this lease would not satisfy the requirements for lease capitalisation as identified above (it would not be considered to be a ‘finance lease’ as the ‘risks and rewards incidental to ownership of the asset’ had not effectively been transferred from the lessor to the lessee as the lessee was not leasing the asset for the major part of the economic life of the asset, so the lease would be considered to be an ‘operating lease’) and no lease asset or lease liability would have been recognised by the lessee. This was the case even though the lessee would have had a non-cancellable obligation to make five years of lease payments (which would constitute a liability in accordance with the conceptual framework, but, as we know, accounting standards override the conceptual framework), and also had a right-to-use the lease asset to generate future economic benefits for the next five years (which would also constitute an asset pursuant to the conceptual framework). Therefore, the requirements within the former accounting standard (IAS 17/AASB 117)—which had been in place for many years—meant that many leased assets and associated liabilities were not being recorded on balance sheets. In some larger organisations this meant that hundreds of millions of dollars of liabilities and assets were unrecognised. CHAPTER 11: ACCOUNTING FOR LEASES  377

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That is, under the former accounting standard, a lessee’s balance sheet typically did not provide a complete representation of: • the assets it controlled and used in its operations; and • the lease payments that, economically, it could not avoid. This was generally accepted as being highly inappropriate and obviously brought into question the reliability of the liabilities, and assets, being disclosed on corporate balance sheets. To assist our understanding of the above discussion we can consider Worked Example 11.1 that follows.

WORKED EXAMPLE 11.1: Illustration of how a lease would be accounted for under the ‘old’ and ‘new’ requirements for accounting for leases Let us assume that on 1 July 2019 Farmco Ltd enters a contract to lease some farming land from Supplier Ltd for a period of five years. The contract, which is binding and can be cancelled only at significant penalty to Farmco, requires an upfront payment of $500 000 and four annual payments of $500 000 to be made at the beginning of each of the next four years. We will assume that Farmco Ltd’s incremental borrowing rate on such transactions is 6 per cent. TREATMENT OF THE LEASE UNDER THE ‘OLD’ REQUIREMENTS OF IAS 17/AASB 117 This lease is for land. As land is generally expected to have an infinite life, this means that leases of land would not normally be considered to constitute a lease term that would represent a major part of the economic life of the asset. Therefore, leases of land that did not ultimately transfer ownership to the lessee were generally considered to be ‘operating leases’ and were not capitalised. Therefore, with the information provided in this illustration, the upfront payment would generally be considered to be a prepayment, which would then be expensed as the land is used across the 12 months. Hence, under the ‘old’ accounting standard the accounting entry in the accounts of the lessee at the inception of the lease would have been: Dr Cr

Prepaid lease rentals—land Cash at bank

500 000 500 000

No liabilities would be recognised by the lessee despite the fact that the organisation had a non-cancellable obligation to make four more annual payments of $500 000. The organisation also had a right-to-use the land for another four years beyond the current year, which also was not recognised as an asset. At the end of the first year, the lease expenses would be recognised as follows: Dr Cr

Lease expense Prepaid lease rentals—land

500 000 500 000

TREATMENT OF THE LEASE UNDER THE ‘NEW’ REQUIREMENTS OF IFRS 16/AASB 16 Under the new accounting standard released in January 2016—IFRS 16 Leases—a lease asset and a lease liability would be recognised (that is, the new accounting standard brings what were formerly designated as ‘operating leases’ onto the balance sheet of lessees). The lease asset and the lease liability would be recognised based upon the present value of the lease payments. The present value of all of the lease payments in this illustration using the lessee’s incremental borrowing rate of 6 per cent would be: $500 000 + ($500 000 × 3.4651) = $2 232 550. A lease asset and a lease liability would initially be recognised as follows: Dr Cr Cr

Leased land Lease liability Cash at bank

2 232 550 1 732 550 500 000

Subsequent journal entries would then allocate the future lease payments to interest expense and to reduce the lease liability, and the leased land would also be subject to periodic amortisation charges as follows (we will explain these entries in more depth later in the chapter, but at this stage we are trying to demonstrate the change in the

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accounting treatment of leases as a result of the release of IFRS 16 and, subsequently, AASB 116). The accounting entry at the end of the first year would be: Dr Cr

Interest expense Lease liability

103 953 103 953

(interest expense equals the opening liability multiplied by the interest rate, which equals $1 732 550 × 6%) Dr Cr

Amortisation expense Accumulated amortisation—leased land

446 510 446 510

(the amortisation of the asset is undertaken on a straight-line basis unless another approach provides a better reflection of the use of the asset) As we can see, there is quite a difference in the results generated under the ‘old’ accounting standard (IAS 17/ AASB 117) and the ‘new’ accounting standard (IFRS 16/AASB 16) in terms of assets, and liabilities, being recognised by lessees, as well as in the expenses being recognised. Under the former accounting standard, no assets or liabilities would have been recognised and the pattern of expense recognition would have been different.

While Worked Example 11.1 reflects one simple illustration of how many assets and liabilities were not recognised under the former accounting standard (thereby necessitating the need for a change), compared with the recently released accounting standard, the IASB provided some ‘real-life’ examples of how the former accounting standard created a situation in which many assets and liabilities were being left off balance sheets. The IASB (August 2014) provided information about the operating lease commitments of a number of well-known retail chains in the UK and the US that subsequently went into some form of reorganisation or liquidation (Circuit City, Borders, Woolworths, HMV, Clinton Cards). The unrecorded lease liabilities (the liabilities relating to unrecognised operating leases) were between 7 and 90 times the debt they actually reported. Perhaps financial problems would have been predicted earlier if the full extent of such debt had been disclosed on their balance sheets. For example, the organisation Circuit City (US) had reported debts of $50 million on its balance sheet but had uncapitalised operating lease commitments of $4537 million, which failed to appear on the balance sheet despite the fact that there was an obligation to make these future lease payments. The former accounting standard allowed this significant amount of debt to be left off the balance sheet. Because of the problems inherent in IAS 17 (and also therefore in AASB 117 in Australia), as well as perceived problems with the leasing accounting standard used within the US (remember that US organisations used accounting standards issued in the US), the IASB and the US Financial Accounting Standards Board (FASB) had—for many years— been working together on the development of the new accounting standard. This was initially signalled by way of a joint media release in December 2006 from both the IASB and FASB. The Chairperson of the IASB at the time, David Tweedie, was a particular ‘champion of the cause’ of changing the rules associated with accounting for leases. One industry he often mentioned was the airline industry, and the fact that most airline companies lease their planes by way of operating leases—with the result that the aircraft, and the associated lease liabilities, which could be extremely significant, nevertheless did not appear on the balance sheets. He was often quoted as saying he dreamed of the day he would fly on an aircraft that actually appeared on the airline’s balance sheet (interesting to hear what subjects some accountants dream about . . .). As a first step towards releasing a revised accounting standard, the IASB and FASB initially issued a discussion paper in 2009. An Exposure Draft Leases was then released in August 2010 and another revised Exposure Draft was released in 2013. After numerous delays and further amendments by the IASB, the final accounting standard, IFRS 16, was released in January 2016—almost a decade after the project commenced. The standard is effective from 1 January 2019, although early adoption is permitted. A reporting entity can elect to apply IFRS 16 before 1 January 2019 only if also applies IFRS 15 Revenue from Contracts with Customers. IFRS 15 effectively requires that revenue from contracts with customers be recognised when ‘control’ of the good or service passes from the seller to the customer, and has relevance in relation to what are known as sale and leaseback arrangements. A sale and leaseback arrangement occurs where an owner of an asset sells it and immediately leases it back. IFRS 15 (and therefore AASB 15) would preclude any revenue from being recognised by the lessee in such an arrangement if the owner/lessee does not surrender control of the asset to the buyer/lessor. CHAPTER 11: ACCOUNTING FOR LEASES  379

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The project to develop a new accounting standard attracted a great deal of interest and many submissions from various vested parties. Because the project would potentially culminate in new rules that would require organisations to recognise more liabilities (and in some cases, significantly more liabilities), many organisations opposed the project. The IASB (August 2014, p.4) provides a quote from the US Securities Exchange Commission that was made back in 2005, and which predicted back then that the leasing project would create controversy. The statement made by the SEC back in 2005 was: The fact that lease structuring based on the accounting guidance has become so prevalent will likely mean that there will be strong resistance to significant changes to the leasing guidance, both from preparers who have become accustomed to designing leases that achieve various reporting goals, and from other parties that assist those preparers . . . [I]t is likely that a project on lease accounting would generate significant controversy; many issuers see leasing as an attractive form of financing asset acquisition in part because leases can be structured so as to avoid recording debt . . . a project on lease accounting is likely to take a significant amount of time as well as . . . resources. Nonetheless . . . the potential benefits in terms of increased transparency of financial reporting would be substantial enough to justify the time and effort required. As we have already noted, the project on lease accounting did indeed ‘take a significant amount of time’ to culminate in the release of the new accounting standard. In explaining the need to develop a new accounting standard, the IASB and FASB noted a number of criticisms of the accounting requirements within the superseded accounting standard IAS 17, and its US equivalent, including the following (as noted in IASB and FASB, 2009, paragraphs 1.12 to 1.15): • the accounting model for leases in IAS 17 failed to meet the needs of users of financial statements; • many users believed that assets and liabilities associated with operating leases should be recognised on the balance sheet; • IAS 17 motivated organisations to opportunistically structure a lease in a way that allowed the related assets and liabilities to be left off the balance sheet; • IAS 17 was conceptually flawed and departed from the conceptual framework given its failure to recognise leaserelated assets and liabilities. The IASB and FASB embraced the view that, when accounting for leases from the perspective of the lessee, the differentiation between finance leases and operating leases should be abandoned such that assets and liabilities associated with many leases that were traditionally considered to be operating leases (remember, operating leases were leases that had a lease term that was typically not for the major part of the economic life of the underlying asset) should, in the future, also be included in the statement of financial position. As the IASB and FASB (2009, p. 23) stated in relation to the former requirements: The accounting model for lessees fails to meet the needs of users. In particular, it fails to represent faithfully the economics of many lease contracts. For example, on entering into a 15-year non-cancellable lease of real estate, a lessee obtains a valuable right (the right to use the property). In addition, the lessee assumes a significant obligation (the obligation to pay rentals). However, if the lease is classified as an ‘operating lease’ [because it does not satisfy one of the tests necessary to be classified as a finance lease], the lessee recognises no assets or liabilities (other than the accrual of rentals due or prepaid). To identify the rights and obligations arising in a simple lease contract, the IASB and FASB utilised the following example (2009, p. 24): A machine is leased for a fixed term of five years; the expected life of the machine is 10 years. The lease is noncancellable, and there are no rights to extend the lease term or to purchase the machine at the end of the term and no guarantees of its value at that point. Lease payments are due at regular intervals over the lease term after the machine has been delivered; these are fixed amounts that are specified in the original agreement. The above lease would be deemed to be an operating lease pursuant to the former accounting standard IAS 17 (and AASB 117 in Australia) as the lease term is only for 50 per cent of the life of the asset and therefore would not satisfy the requirements to be a ‘finance lease’, which would require that the lease term was for the ‘major part’ of the economic 380  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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life of the asset. Consequently, no asset or liability would have been recognised for the purposes of the statement of financial position. However, this ignores the fact that the entity does have a non-cancellable financial obligation for the next five years, as well as a contractually enforceable right to use the asset. The conceptual framework, which as we know provides, among other things, the definition and recognition criteria for assets and liabilities, suggests that such rights and obligations would meet the test for recognition as an asset and liability respectively. The discussion paper released by the IASB and FASB suggested that a lease, such as that described above, should be included within the statement of financial position. The IASB and FASB stated (2009, paragraphs 3.16 and 3.17): 3.16 The boards identified the right to use the leased item as an economic resource of the lessee because the lessee can use it to generate cash inflows or reduce cash outflows. The boards concluded that: (a) the lessee controls the right to use the leased item during the lease term because the lessor is unable to recover or have access to the resource without the consent of the lessee (or breach of contract). (b) the control results from past events—the signing of the lease contract and the delivery of the item by the lessor to the lessee. Some think that the lessee’s right to use the machine described in the example is conditional on the lessee making payments during the lease term. In other words, if the lessee does not make payments, it may forfeit its right to use the machine (this is similar to the situation that would arise if an entity failed to make payments on an instalment purchase). However, unless the lessee breaches the contract, the lessee has an unconditional right to use the leased item. (c) future economic benefits will flow to the lessee from the use of the leased item during the lease term. 3.17 Accordingly, the boards concluded that the lessee’s right to use a leased item for the lease term meets the definitions of an asset in the Conceptual Framework. In summarising the IASB’s and FASB’s view that a lease, such as the simple five-year lease example described above, will create assets and liabilities that should be recognised in the statement of financial position, the Boards provided the following tables identifying the respective assets and liabilities (2009, p. 28). As we know, according to the Conceptual Framework for Financial Reporting: • An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. • A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. As we can see from Tables 11.1 and 11.2 the asset to be recognised would relate to the ‘right-of-use’ of the leased asset, and the liability would relate to the obligation to pay rentals. Specifically, IASB and FASB (2009, p. 29) stated: On the basis of the preceding analysis, the boards concluded that the existing lease accounting model [as reflected in IAS 17] is inconsistent with the asset and liability definitions in theConceptual Framework. The boards decided to develop a new approach to accounting for leases that would result in the recognition of the

Description of right

Control

Past event

Right to use machinery during the lease term

Legally enforceable right established by the lease contract

Delivery following signing of the lease contract

Description of obligation Obligation to pay rentals

Present obligation

Past event

Legally enforceable obligation established by the lease contract

Delivery following signing of the lease contract

Future economic benefit

Asset?

Yes

Yes

Outflow of economic benefits Yes (cash payments)

Liability? Yes

Table 11.1 Explanation of why a ‘right-of-use’ asset is an asset consistent with the conceptual framework Table 11.2 Explanation of why an obligation to make lease payments is a liability consistent with the conceptual framework

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assets and liabilities identified as arising in a lease contract . . . The new approach would treat all lease contracts as the acquisition of a right to use the leased item for the lease term. Thus, the lessee would recognise the following: (a) an asset representing its right to use the leased item for the lease term (the right-of-use asset) (b) a liability for its obligation to pay rentals. The above position was ultimately embraced when IFRS 16 was issued in January 2016 (and AASB 16 was released in Australia in February 2016). Financial Accounting in the Real World 11.1 provides an insight into how the news media was reporting the implications of a new accounting standard on leasing.

11.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Effect on retailers from proposed new rules around lease accounting In 2008, following spectacular corporate collapses like that of Enron, the International Accounting Standards Board (IASB) outlined a proposal that operating leases should be included on a company’s balance sheets in the interest of transparency for creditors and investors around corporate debt. The IASB was forced into a rethink after a backlash from major retailers including Woolworths and Wesfarmers, denouncing the original proposals as complex and costly. Under the latest changes to lease accounting rules put forward by the IASB, retailers such as Woolworths, Wesfarmers, Myer, David Jones, JB Hi-Fi, Harvey Norman, Specialty Fashion and Premier Investments will have to calculate the net present value of future lease commitments and recognise them as debt on their balance sheets. Instead of recognising rent payments as costs incurred, retailers will have to expense theoretical amortisation and financing costs. This will boost earnings before interest, tax, depreciation and amortisation but will reduce pre-tax and net profits, as the amortisation and financing costs will exceed rental payments, especially for faster growing retailers with relatively new leases. According to a report by Morgan Stanley, the impact on retailers will be ‘considerable’, blowing out gearing levels and reducing return on capital employed, but will vary from retailer to retailer. Reactions to the proposed rules include a report by Morgan Stanley predicting a considerable but varied impact on retailers including reduced capital return and a blow out of gearing levels. The report says Myer, Specialty Fashion and The Reject Shop will be more affected than Kathmandu and Fantastic Furniture as the former have significant and long-term lease liabilities. Also new retailers like Lovisa, who are early into lease terms will probably be impacted more than established leaseholder retailers. Morgan Stanley analyst Tom Kierath says investors aren’t as aware of the change to lease accounting rules as they should be. Examples of the financial impact on Myer, Woolworths and Wesfarmers of the new rules clarify their expected effect. Myer: net debt $340 million but net present value (NPV) of lease liabilities is $2.2 billion. Debt would rise to $2.5 billion. Woolworths: net debt $3 billion but NPV of leases is $15 billion. Debt would rise to $18 billion. Wesfarmers (Coles, Bunnings, Target, Officeworks): net debt $4 billion and NPV of leases is $12 billion. Patricia Stebbens, a KPMG audit partner, believes that some companies will have to renegotiate their debt covenants with their banks because rule changes would increase gearing ratios. However, Angus Thompson, the research director of the Australian Accounting Standards Board, believes that as the new rules are likely to take effect no earlier than January 2018, affected parties have sufficient preparation time. Although there has been a mixed reaction to the new rules, Thompson is confident of the benefits of increased transparency around gearing. SOURCE: Adapted from ‘Retailers face hit from proposed lease accounting changes’, by Sue Mitchell, The Australian Financial Review, 23 April 2015, p. 21

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The core principle and scope of the new accounting standard on leasing

LO 11.3 LO 11.6

As we now know, IFRS 16 was released in January 2016 (and AASB 116 was released in Australia the following month). The core principle of the new accounting standard is that an entity shall recognise assets and liabilities arising from a lease. According to paragraph 1 of the accounting standard, the objective of the standard is: to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions. This information gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of an entity. From the perspective of many people, this represents an improvement over the requirements in the former accounting standard, which did not require lease assets and lease liabilities to be recognised in relation to many leases. To achieve the above objective, the accounting standard requires assets and liabilities to be recognised by lessees for all leases of more than 12 months—with the asset being of the nature of a ‘right-of-use asset’ that provides a right to use the lease asset for the term of the lease, and the liability being for lease payments that are economically unavoidable over the lease term. In terms of scope, the accounting standard does not apply to all leases. Specifically, paragraphs 3 and 4 state: 3. An entity shall apply this Standard to all leases, including leases of right-of-use assets in a sublease, except for: (a) leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources; (b) leases of biological assets within the scope of AASB 141 Agriculture held by a lessee; (c) service concession arrangements within the scope of Interpretation 12 Service Concession Arrangements; (d) licences of intellectual property granted by a lessor within the scope of AASB 15 Revenue from Contracts with Customers; and (e) rights held by a lessee under licensing agreements within the scope of AASB 138 Intangible Assets for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights. 4. A lessee may, but is not required to, apply this Standard to leases of intangible assets other than those described in paragraph 3(e).

Exemptions for leases of 12 months or less, and for low-value assets

LO 11.4

Due to concerns from various parties about the potential costs and complexities involved in complying with the accounting standard on leases, the IASB made a decision that for leases with a duration of 12 months or less, and for leases of low-value assets (for example, tablet and personal computers, small items of office furniture and telephones), lessees do not have to recognise lease-related assets and liabilities (see paragraph 5 of the standard). In terms of the value that items would have for them to be deemed to be of ‘low value’, IASB (2016b) suggests they would be in the order of magnitude of US$5000 or less. So, lessees have a choice. If the reporting entity elects to exercise the option not to recognise the lease asset and lease liability for leases of 12 months or less, or for leases of low-value assets, then the entity shall simply recognise the lease payments as an expense. In this situation, liabilities would be recognised only if the required lease payments have not been paid at the end of the reporting period, and assets would be recognised if the payments constitute prepayments for the future use of the asset. Worked Example 11.2 provides an example of accounting for a short-term lease.

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WORKED EXAMPLE 11.2: Example of accounting for a short-term lease On 1 July 2019 Margaret Ltd enters a lease agreement with River Ltd for the lease of an item of machinery for eight months. The lease cost is $20 000 per month. Margaret Ltd has decided that for such leases, the exemption available within the accounting standard will be taken, such that no lease liability or lease asset shall be recognised. REQUIRED Provide the journal entries that would be made in the books of Margaret Ltd to account for the lease. SOLUTION As the lease term is less than 12 months, the lessee has the option to elect not to recognise the right-of-use asset and the lease liability. In this case, they have selected that option. As such, each payment will be treated as a rental payment, there will be no interest expense, and the lessee will not recognise any depreciation expenses. The accounting entry each month in the books of Margaret Ltd would therefore simply be: Dr Cr

Rental expense—machinery Cash

20 000 20 000

If Margaret Ltd had not paid the lease payment by the end of the reporting period, an amount would need to be accrued as a lease expense payable (a liability), rather than there being a credit to cash.

LO 11.2 LO 11.4

What is a lease?

At this point of the chapter we would probably be feeling that we understand the meaning of ‘lease’, ‘lessee’ and ‘lessor’. Nevertheless, we need to consider the actual definitions provided within the accounting standard. The definition of a lease is important because if a contract contains a ‘lease’ then the customer (lessee) will be required to recognise assets and liabilities arising from the lease (subject to the exemption described earlier for shortterm leases, and leases of low-value assets). The accounting standard defines a lease—and this definition applies to both parties to a contract, that is, to the customer (lessee), and to the supplier (lessor)—as: A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. The ‘underlying asset’ referred to above is defined as: An asset that is the subject of a lease, for which a right to use that asset has been conveyed to a lessee. According to the accounting standard, a lease exists when the customer controls the use of the underlying asset throughout the period of use. This requires the customer to be able to: • obtain substantially all of the economic benefits from the use of the identified asset throughout the contracted period of use; and • direct the use of the identified asset throughout that period of use, which means the customer has the ability to change how, and for what purpose, the asset is used during the contractual term. So, with the above requirements in mind, if the supplier of the asset (the lessor) has a ‘substantive right’ to substitute the asset throughout the period of use, then an ‘identified asset’ would not be deemed to exist and the requirements of the accounting standard would not apply, with the result that a lease asset and lease liability would not be recognised and the periodic lease payments would simply be treated as an expense. As paragraph B14 states: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist: (a) the supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting the asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and (b) the supplier would benefit economically from the exercise of its right to substitute the asset (ie the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset). 384  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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If the above conditions exist, then this would support the view that the supplier has a ‘substantive right’ to substitute the asset and no ‘identified asset’ would be deemed to exist. The contract would not be covered by IFRS 16/AASB 16. IASB (October, 2015) provides some illustrative examples that provide insights into: • whether there is an identified asset; and • whether the customer controls the use of the identified asset throughout the period of use. A sample of these illustrative examples is reproduced within Exhibit 11.1. Again, for the purposes of the accounting standard, a lease requires an ‘identified asset’ and there is no ‘identified asset’ if the supplier has a ‘substantive right’ to substitute the asset. A substantive right to substitute the asset would be deemed to exist if both of the following conditions are satisfied: • the supplier has the practical ability to substitute the asset; and • the supplier can benefit from substituting the asset. If the supplier is simply allowed or required to substitute other assets when the underlying asset is not operating properly, or if a technical upgrade becomes available, then such conditions would not in themselves create a ‘substantive substitution right’, and a lease could still be recognised. EXAMPLE 1A: RAIL CARS FACTS: A contract between Customer and a freight carrier (Supplier) provides Customer with the use of 10 rail cars of a particular type for five years. The contract specifies the rail cars; the cars are owned by Supplier. Customer determines when, where and which goods are to be transported using the cars. When the cars are not in use, they are kept at Customer’s premises. Customer can use the cars for another purpose (for example, storage) if it so chooses. However, the contract specifies that Customer cannot transport particular types of cargo (for example, explosives). If a particular car needs to be serviced or repaired, Supplier is required to substitute a car of the same type. Otherwise, and other than on default by Customer, Supplier cannot retrieve the cars during the five-year period. The contract also requires Supplier to provide an engine and a driver when requested by Customer. Supplier keeps the engines at its premises and provides instructions to the driver detailing Customer’s requests to transport goods. Supplier can choose to use any one of a number of engines to fulfil each of Customer’s requests, and one engine could be used to transport not only Customer’s goods, but also the goods of other customers (i.e. if other customers require the transportation of goods to destinations close to the destination requested by Customer and within a similar timeframe, Supplier can choose to attach up to 100 rail cars to the engine).

EXHIBIT 11.1: Determination of whether a ‘lease’ exists

IS THERE AN IDENTIFIED ASSET? There are 10 identified cars. The cars are explicitly specified in the contract. Once delivered to Customer, the cars can be substituted only when they need to be serviced or repaired. The engine used to transport the rail cars is not an identified asset because it is neither explicitly specified nor implicitly specified in the contract. DOES THE CUSTOMER CONTROL THE USE OF THE IDENTIFIED ASSET THROUGHOUT THE PERIOD OF USE? Customer has the right to control the use of the 10 rail cars throughout the five-year period of use because:



(a) Customer has the right to obtain substantially all of the economic benefits from the use of the cars over the five-year period of use. Customer has exclusive use of the cars throughout the period of use, including when they are not being used to transport Customer’s goods. (b) Customer has the right to direct the use of the cars. The contractual restrictions on the cargo that can be transported by the cars are protective rights of Supplier and define the scope of Customer’s right to use the cars. Within the scope of its right of use defined in the contract, continued CHAPTER 11: ACCOUNTING FOR LEASES  385

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Customer makes the relevant decisions about how and for what purpose the cars are used by being able to decide when and where the rail cars will be used and which goods are transported using the cars. Customer also determines whether and how the cars will be used when not being used to transport its goods (for example, whether and when they will be used for storage). Customer has the right to change these decisions during the five-year period of use. Although having an engine and driver (controlled by Supplier) to transport the rail cars is essential to the efficient use of the cars, Supplier’s decisions in this regard do not give it the right to direct how and for what purpose the rail cars are used. Consequently, Supplier does not control the use of the cars during the period of use. CONCLUSION The contract contains leases of rail cars. Customer has the right to use 10 rail cars for five years. A right-of-use asset and a lease liability shall be recognised. EXAMPLE 1B: RAIL CARS FACTS: The contract between Customer and Supplier requires Supplier to transport a specified quantity of goods by using a specified type of rail car in accordance with a stated timetable for a period of five years. The timetable and quantity of goods specified is equivalent to Customer having the use of 10 rail cars for five years. Supplier provides the rail cars, driver and engine as part of the contract. The contract states the nature and quantity of the goods to be transported (and the type of rail car to be used to transport the goods). Supplier has a large pool of similar cars that can be used to fulfil the requirements of the contract. Similarly, Supplier can choose to use any one of a number of engines to fulfil each of Customer’s requests, and one engine could be used to transport not only Customer’s goods, but also the goods of other customers. The cars and engines are stored at Supplier’s premises when not being used to transport goods. IS THERE AN IDENTIFIED ASSET? The rail cars and the engines used to transport Customer’s goods are not identified assets. Supplier has the substantive right to substitute the rail cars and engine because:



(a) Supplier has the practical ability to substitute the cars and engine throughout the period of use; alternative cars and engines are readily available to Supplier and Supplier can substitute the cars and engine without Customer’s approval. (b) Supplier would benefit economically from substituting the cars and engine. There would be minimal, if any, cost associated with substituting the cars or engine because the cars and engines are stored at Supplier’s premises and Supplier has a large pool of similar cars and engines. Supplier benefits from substituting the cars or the engine in contracts of this nature because substitution allows Supplier to, for example, (i) use cars or an engine to fulfil a task for which the cars or engine are already positioned to perform (for example, a task at a rail yard close to the point of origin) or (ii) use cars or an engine that would otherwise be sitting idle because they are not being used by a customer.

DOES THE CUSTOMER CONTROL THE USE OF THE IDENTIFIED ASSET THROUGHOUT THE PERIOD OF USE? Accordingly, Customer does not direct the use, nor have the right to obtain substantially all of the economic benefits from the use, of identified cars or an engine. Supplier directs the use of the rail cars and engine by selecting which cars and engine are used for each particular delivery and obtains substantially all of the economic benefits from use of the rail cars and engine. Supplier is only providing freight capacity. CONCLUSION The contract does not contain a lease of rail cars or an engine. Therefore, no right-of-use asset or lease liability shall be recognised.

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EXAMPLE 2—CONCESSION SPACE FACTS A coffee company (Customer) enters into a contract with an airport operator (Supplier) to use a space in the airport to sell its goods for a three-year period. The contract states the amount of space and that the space may be located at any one of several boarding areas within the airport. Supplier has the right to change the location of the space allocated to Customer at any time during the contract term. There are minimal costs to Supplier associated with changing the space for the Customer; Customer uses a kiosk (which Customer owns) to sell its goods that can be moved easily. There are many areas in the airport that are available and which would meet the specifications for the space in the contract. IS THERE AN IDENTIFIED ASSET? Although the amount of space Customer uses is specified in the contract, there is no identified asset. Customer controls its owned kiosk. However, the contract is for space in the airport, and this space can change at the discretion of Supplier. Supplier has the substantive right to substitute the space Customer uses because:



(a) Supplier has the practical ability to change the space used by Customer throughout the period of use. There are many areas in the airport that meet the specifications for the space in the contract, and Supplier has the right to change the location of the space to other space that meets the specifications at any time without Customer’s approval. (b) Supplier would benefit economically from substituting the space. There would be minimal cost associated with changing the space used by Customer because the kiosk can be moved easily. Supplier benefits from substituting the space in the airport because substitution allows Supplier to make the most effective use of the space at boarding areas in the airport to meet changing circumstances.

DOES THE CUSTOMER CONTROL THE USE OF THE IDENTIFIED ASSET THROUGHOUT THE PERIOD OF USE? In this example, because there is no ‘identified asset’, this assessment is not needed to conclude upon whether the contract is, or contains, a lease. The contract does not constitute a lease. Therefore, no right-of-use asset or lease liability shall be recognised.

While we have now addressed the issue of what a ‘lease’ is, and appreciate that a lease represents an agreement between a lessee and a lessor, we have not actually referred to the definition of lessee and lessor as they appear within the accounting standard. These terms are defined as follows: Lessee: An entity that enters into a contract to obtain the right to use an underlying asset for a period of time in exchange for consideration. Lessor: An entity that enters into a contract to provide the right to use an underlying asset for a period of time in exchange for consideration.

When to recognise a lease

LO 11.4

Once we understand what a lease is and have determined that a lease exists (there is an identified asset that is controlled by the customer for a period of time), then the next issue to consider is when do we recognise a lease? In this regard, paragraph 22 of the accounting standard states: At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability. The commencement date is defined in Appendix A of the accounting standard as: The date on which a lessor makes an underlying asset available for use by a lessee. CHAPTER 11: ACCOUNTING FOR LEASES  387

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LO 11.9

Accounting for the service component of a contract that includes a lease

At this point we should hopefully understand when a ‘lease’ exists, and when to recognise a lease. We will now consider whether a ‘service arrangement’ should be included as part of a lease. Contracts for the use of an asset often also include associated services (a service agreement). For example, a customer might sign a contract to lease a car and the contract could include a requirement that the lessee pay a specific ongoing amount to have the car maintained and serviced by a particular service provider. The 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 principal 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 prices—that 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. Because the accounting standard specifically allows for the service component of an agreement not be treated as a lease this might provide incentives for some organisations to ask suppliers to inflate the amounts that are allocated to the service component and thereby reduce the amount that is allocated to the lease (while maintaining the combined total payment).

WORKED EXAMPLE 11.3: A contract that includes both a lease and service component A retailer enters into a contract with a property owner to lease a shop for 10 years. The property owner charges the retailer $190 000 per year. For this total amount of $190 000 the property owner also provides cleaning and security services that have an independent value of $40 000 per year. REQUIRED Determine which payments would constitute the ‘lease’ of the property. SOLUTION In this case, a lease asset and a lease liability would be recognised for the present value of the 10 years of lease payments of $150 000 per year. No asset or liability for the service component would be recognised as the retailer is not in control of the assets that generate the service. Therefore, the payment of $40 000 each year for the service component would be treated as an expense in each year.

LO 11.5

The meaning of ‘lease term’

When recognising a lease liability we are required to calculate the present value of the unavoidable lease payments to be made over the ‘lease term’. This necessitates a definition of lease term. ‘Lease 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. 388  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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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. In considering the above definition of ‘lease term’, we can consider the following worked example.

WORKED EXAMPLE 11.4: Determination of the lease term Customer Ltd has entered into a number of agreements as identified below: AGREEMENT 1 Customer Ltd has signed a contract to lease an item of machinery with an initial non-cancellable period of two years and with an available lease extension for an additional year if both Customer Ltd and the lessor agree. AGREEMENT 2 Customer Ltd has signed a contract to lease a shop for a non-cancellable period of 10 months. There is an option to extend the lease for another six months, with the monthly payments in this additional six-month period being significantly below market rates. No significant leasehold improvements have been undertaken to the property. AGREEMENT 3 Customer Ltd has signed a contract to lease a motor vehicle for a non-cancellable term of 10 months. There is an option to extend the lease for another six months. The lease payments in this additional period are to be at usual market rates. AGREEMENT 4 Customer Ltd has signed a contract to lease a building for a non-cancellable period of five years. The arrangement also provides an option for Customer Ltd to renew the lease for a further two years at market rates. Customer Ltd has undertaken expensive modifications to the building and these modifications are expected to have a useful economic life of 10 years. REQUIRED What is the ‘lease term’ in each of the above agreements? SOLUTION AGREEMENT 1 The initial two years would satisfy the condition for being the lease term. The one-year extension would not, however, as either party could unilaterally decide not to extend the arrangement without incurring any significant financial penalty. AGREEMENT 2 The lease term in this case is 16 months as at the lease commencement date Customer Ltd would be reasonably certain to exercise the option to extend the lease given that the subsequent rates are significantly below market rates. AGREEMENT 3 The lease term in this case is 10 months, as at the date of lease commencement, Customer Ltd would not be reasonably certain to exercise the option as there is no obvious financial benefit in doing so given that the rates being offered are normal market rates. Because the lease term is less than 12 months, Customer Ltd can elect not to recognise the lease liability and lease asset and simply treat the monthly lease payments as an expense, as incurred. AGREEMENT 4 The lease term in this case would be seven years. At lease commencement date Customer Ltd would be reasonably certain to renew the lease term as the leasehold improvements would still have significant value at the end of five years.

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LO 11.4 LO 11.5 LO 11.6 LO 11.7 LO 11.8 LO 11.9

Accounting for leases by lessees In this section we will discuss how to measure the assets and liabilities associated with a lease contract, including determining the relevant interest rate. We will also provide the required accounting journal entries. There are particular rules to be applied in respect of the initial measurement, and the subsequent measurement, of the right-of-use asset, and the associated lease liability. We will consider these in turn below.

Initial measurement Paragraph 22 of the accounting standard requires: At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability.

In 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 lessee’s 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); (c) amounts expected to be payable by the lessee under residual value guarantees; (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 B37–B40); 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 presentation of the lease liabilities, they would be disclosed separately in the balance sheet, with the total liability being split into current and non-current portions. As we can see in the above paragraph, residual value guarantees are to be included as part of residual value the lease payments. The accounting standard defines a ‘residual value guarantee’ as: The actual or estimated net realisable value of a depreciable asset at the end of its useful life.

A guarantee made to a lessor by a party unrelated to the lessor that the value (or part of the value) of an underlying asset at the end of a lease will be at least a specified amount.

A residual value guarantee is often provided by the lessee to the lessor. It provides an assurance to the lessor that the assets being returned to the lessor will have a certain value at the end of the lease term. A related amount will be included in the capitalised lease payments. This is demonstrated in Worked Example 11.5.

WORKED EXAMPLE 11.5: Residual value guarantee to be included within lease payments Customer Ltd has entered a lease contract. As part of the contract, Customer Ltd has guaranteed Lessor Ltd that Lessor Ltd will be able to realise at least $50 000 from the sale of the leased asset at the end of the lease term, which is 10 years. Customer believes that when it returns the underlying asset to Lessor at the end of the lease term, the asset will have a fair value of $35 000. The interest rate implicit in the lease is 5 per cent.

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REQUIRED In terms of the residual value guarantee, how much would Customer Ltd include as part of the lease payments and what would be the present value of this amount at the commencement date of the lease? SOLUTION An amount of $15 000 to be paid in 10 years would be included as part of total lease payments. It is the difference between what has been guaranteed ($50 000) and what Customer Ltd believes the lease asset will be able to be sold for at the end of the lease ($35 000). The present value of this lease payment would be: $15 000 × 0.6139 = $9209 As we saw above, paragraph 27 of the accounting standard requires that the lease liability shall also include the exercise price of a purchase option if the lessee is reasonably certain to exercise that option. What this is referring to is what is often referred to as a bargain purchase option. If there is an option within the lease contract that provides the lessee the right, usually at the end of the lease term, to acquire the underlying asset at an amount well below its expected fair value then the expectation would be, at the inception of the lease, that the lessee would exercise that option and acquire the underlying asset. As such, the liability for lease payments shall also include the present value of the bargain purchase option. Worked Example 11.6 provides an example of how to account for a lease in the presence of a bargain purchase option.

WORKED EXAMPLE 11.6: Example of accounting for a lease that includes a bargain purchase option On 1 July Maroubra Ltd entered a contract to lease an item of machinery in which it agreed to make payments to the lessor of $15 000 at the end of each of the next four years. Maroubra Ltd was also required to make a payment of $20 000 at the beginning of the lease. The lease contract does not include a service component. Also included within the lease contract is an option that is available to Maroubra Ltd that gives it the right to acquire the machine at the end of the lease term for an amount of $30 000. Maroubra Ltd expects the machine to have a fair value of $55 000 at the end of the lease term. Maroubra Ltd’s incremental borrowing rate is 5 per cent. REQUIRED Determine the lease liability that would be recognised by Maroubra Ltd at the inception of the lease. SOLUTION Because Maroubra Ltd would be expected to exercise the option to acquire the machinery at the end of the lease term—it is a ‘bargain purchase option’—then the present value of this option would be included within the lease payments. Therefore the amount of the lease liability to be recognised at the inception of the lease, and which is measured at present value, is: Up-front payment Periodic lease payments Bargain purchase option Lease liability to be recognised at the inception of the lease

$15 000 × 3.5460 $30 000 × 0.8227

$20 000 $53 190 $24 681 $97 871

Now, turning our attention to the lease-related asset, in terms of the amount to be initially recognised in relation to the asset—which is referred to in the accounting standard as a ‘right-of-use asset’—paragraph 23 requires: At the commencement date, a lessee shall measure the right-of-use asset at cost. The above 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; CHAPTER 11: ACCOUNTING FOR LEASES  391

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(c) any initial direct costs incurred by the lessee; and (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. Such costs would include commissions, legal fees and costs of preparing and processing documentation for new leases. Again, the accounting standard requires that a lessee capitalise their initial direct costs that relate to a lease as part of the cost of the lease asset. Therefore, where such costs are incurred, the lease asset comprises the present value of the lease payments plus the amount of initial direct costs incurred. The total amount would then be subject to regular depreciation (amortisation). As we can see, too, the cost of the right-of-use asset is also to include an estimate of the future costs of dismantling the asset and any necessary restoration costs (all at present value). This is consistent with the requirements included within AASB 116 Property, Plant and Equipment.

Interest rate to be applied As we have seen, at the commencement date of the lease, lessees shall recognise assets and liabilities in their statements of financial position (balance sheets). The amounts to be recognised will be based on present value calculations. Obviously when determining present values, we need to use a discount rate. For a lessee, the interest rate implicit in the lease (which we will show below) is to be used to discount the lease payments if this is practicable to determine; if not, the lessee’s incremental borrowing rate is to be used. The rate implicit in the lease is the rate of interest being charged by the lessor and 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. The above requirement makes reference to the ‘unguaranteed residual’. This is defined in the accounting standard as: That portion of the residual value of the underlying asset, the realisation of which by a lessor is not assured or is guaranteed solely by a party related to the lessor. So, the unguaranteed residual is the amount that the underlying asset is expected to be valued at when the lease is over, but this amount is not guaranteed by the lessee, meaning that the risks related to asset value at the end of the lease are borne by the lessor. The accounting standard requires the lessor to disclose, within the notes to the financial statements, how it manages this risk.

WORKED EXAMPLE 11.7: Example of computing discount rate McTavish Ltd decides to lease some machinery from Cornish Ltd on the following terms: Date of entering lease Duration of lease Life of leased asset Unguaranteed residual value Lease payments Fair value of leased asset at date of lease inception

1 July 2019 10 years 11 years $2000 $4000 at lease inception, $3500 on 30 June each year (that is, 10 yearly payments in arrears of $3500 each) $26 277

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REQUIRED Determine the interest rate implicit in the lease. SOLUTION From the appendices to this book, we know that the present value of an annuity of $1 in arrears (‘in arrears’ means the amount is received, or paid, at the end of each year) for 10 years discounted at 10 per cent is $6.1446 (see the present value tables in the appendices). The present value of $1 in 10 years, discounted at 10 per cent, is $0.3855. Hence, the present value of the 10 payments of $3500 is $3500 multiplied by 6.1446, which equals $21 506, and the present value of the unguaranteed residual is $771, which is $2000 multiplied by 0.3855. The present value of the up-front payment of $4000 is not discounted. Therefore, using a rate of 10 per cent for discounting purposes, the present value of the lease payments and the unguaranteed residual is: Present value of payment on 1 July 2019 Present value of 10 yearly payments Present value of unguaranteed residual

$4 000 $21 506      $771 $26 277

The discounted value of $26 277 is the same as the fair value of the asset at lease inception. Thus, 10 per cent is the implicit rate in this example. Note that some degree of trial and error might be involved in determining the discount rate. The rate of interest is then used to determine the interest expense incurred each period. The present value of the liability at the beginning of the period is multiplied by the rate of interest to determine the interest expense for the period. The balance of the lease payment is then treated as a reduction of the lease liability. In some circumstances the lessee might be unable to determine the fair value of the asset at the inception of the lease (perhaps because the asset has unique attributes), or the lessee might not be able to reliably estimate the residual value. In such circumstances it might not be possible to determine the implicit interest rate. In these circumstances the lessee is to discount the lease payments by using the lessee’s incremental borrowing rate. The lessee’s incremental borrowing rate is defined in the accounting standard as: The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment. For a lessor (rather than the lessee), the interest rate to be used would be the rate that causes the sum of the present value of the lease payments to be made by the lessee, plus the present value of the amount the lessor expects to derive from the underlying asset at the end of the lease, excluding any amount in lease payments (for example, a guaranteed residual payment that is included in lease payments) to equal the fair value of the asset at the inception of the lease asset plus, in the case of a direct financing lease (to be explained later in the chapter), any initial direct costs. With the above background discussion we will now consider Worked Example 11.8, which explores how to account for a lease from the perspective of the lessee.

WORKED EXAMPLE 11.8: Initial measurement by a lessee of the lease liability and right-of-use asset On 1 July 2018 the lessee—Lessee Ltd—enters into a five-year lease of a machine with an option to extend the lease for another five years at usual market rates, which are expected to rise relative to current lease payments. The lessee incurs initial direct costs associated with the lease of $10 000 (these costs represent the costs that are directly attributable to negotiating and arranging the lease and would not have been incurred without entering the lease). According to the contract, contracted payments will be $115 000 in the first five years, with the first payment being made at the commencement of the lease, and $135 000 per year if the option for the further five years is taken. Lease payments are made on 30 June each year (meaning there are four more lease payments following the initial payment). Included within all these payments is a $15 000 per year service arrangement, which requires the supplier to maintain the machine in good working order. continued CHAPTER 11: ACCOUNTING FOR LEASES  393

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At the commencement of the lease, the lessee makes a judgement that it does not intend to exercise the option to lease the asset beyond the first five years. The rate of interest charged by the lessor is not readily determinable, but the lessee’s incremental borrowing rate is 6 per cent for similar transactions. The machine is expected to have an economic life of 10 years and the financial year end is 30 June. TAX EFFECTS In this and other examples used in this chapter we will ignore related tax effects. Because there will be timing differences between the lease-related expenses that are recognised for accounting purposes (for example, for accounting purposes we would recognise interest expense and depreciation expense) and those that would be deductible for tax purposes (the total lease payments would typically be deductible for tax purposes), we would expect to generate temporary differences in accordance with AASB 112 Income Taxes (as explained in Chapter 18). Because the interest expenses in the early part of the lease will be higher, this will mean that the expenses recognised for accounting purposes would typically be higher than the expenses that would be deductible for tax purposes (the lease payment made each period), thereby creating a deferred tax asset in the earlier years of the lease that would then be reversed in the later part of the lease. However, as just noted, to keep our examples focused on issues associated with leasing, we will ignore potential tax implications associated with leases throughout this chapter and hence we will not consider such temporary tax differences—but in practice we would need to take this implication into account. REQUIRED Provide the accounting journal entries to initially recognise the lease liability and right-of-use asset. SOLUTION First, is there a lease? From the facts, there does seem to be an identifiable asset that is under the control of the lessee, and the lessor does not appear to have a substantive right to substitute the underlying asset for another asset. Therefore, there is a ‘lease’ that is covered by the accounting standard on leases. The lease term is assessed as being five years. To calculate the liability, we need to determine which payments to include. We shall include those contracted payments that have yet to be made and which are unavoidable. In this case we will calculate the present value of the remaining four lease payments. We will not include the service agreement as part of the capitalised lease payments. Therefore, the lease liability is calculated by determining the present value of four future payments of $100 000 discounted at 6 per cent, which equals: $100 000 × 3.4651 = $346 510 For the right-of-use asset, we calculate the initial cost of the asset as equal to the initial measurement of the liability, plus the lease payment made at the commencement of the lease, plus any initial direct costs, which in this case equals: $346 510 + $100 000 + $10 000 = $456 510 There is no guaranteed residual payment in this example. Had there been one, then an amount would have had to be included within the lease payments. The accounting journal entry to recognise the lease at the commencement date of the lease arrangement therefore is: Dr Cr Cr

Leased machinery Lease liability Cash at bank

456 510 346 510 110 000

Subsequent measurement We have just explored how to measure initially the lease liability and the right-of-use asset. We will now consider how to account for the lease contract in the periods that follow the initial recognition and measurement. In relation to the lease liability, the accounting standard requires the lease liability to be accounted for in a manner that is consistent with how other financial liabilities are accounted for. That is, the liability shall be accounted for on an 394  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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amortised cost basis (see Chapter 14 for an overview of this method). This means that the liability will be reduced each period, with each lease payment constituting part interest expense and part repayment of the lease liability, with the interest component being determined by applying a constant interest rate to the opening balance of the lease liability of each period. A leased asset should be amortised using the amortisation (depreciation) policies normally followed by the lessee in relation to the assets that are owned. Failure to amortise the leased asset could mean that the leased asset remains in the accounts indefinitely. The period of amortisation/depreciation should be the number of accounting periods that are expected to benefit from the asset’s use. Where there is reasonable assurance at the inception of the lease that the lessee will obtain ownership of the asset at the end of the lease term (for example, the lease might provide for transfer of the asset to the lessee, or it might contain a ‘bargain purchase option’), the asset should be depreciated over its expected useful life; otherwise, the asset should be depreciated over the lease term (see paragraph 32 of the accounting standard). For the right-of-use asset in Worked Example 11.8, we can now provide the accounting journal entries that would be made at the end of the first year of the lease. In terms of the interest expense, we can construct the following table to determine the interest expense and the repayment of principal for each year. Interest expense is determined by multiplying the opening present value of the liability by the relevant interest rate, which in this case is 6 per cent. The reduction in the principal is the balance of the lease payment after deducting the interest expense component. Lease payment

Date

Interest expense

Principal reduction

1 July 2018

Present value of lease liability 346 510

30 June 2019

100 000

20 791

79 209

267 301

30 June 2020

100 000

16 038

83 962

183 339

30 June 2021

100 000

11 000

89 000

94 339

30 June 2022

100 000

5 661

94 339

0

The amortisation of the right-of-use asset will be calculated by dividing the cost of the right-of-use asset by the term of the lease (please note that we are using the terms ‘depreciation’ and ‘amortisation’ interchangeably, which is consistent with what happens in practice). Again, we use the lease term for the period of amortisation as Lessee Ltd will return the machine to the lessor at the end of the lease term. We are using a straight-line method of amortisation on the assumption that the economic benefits from the underlying asset are derived uniformly throughout the lease. This gives an amortisation expense of: $456 510 ÷ 5 = $91 302 The accounting journal entry at 30 June 2019 to record the lease payment therefore is: Dr Dr Dr Cr

Interest expense Lease liability Service expenses Cash at bank

20 791 79 209 15 000 115 000

In the above journal entry, the amount allocated to interest expense would typically be shown in the statement of cash flows as part of operating activities (unless the organisation has elected to classify interest expenses as part of financing activities), while the amount allocated to the lease liability (principal repayment) would be treated as part of financing activities. As explained in Chapter 19, in a statement of cash flows, cash flows are currently classified into three categories, these being operating activities, investing activities and financing activities (as noted in Chapter 19, changes are expected to be made by the IASB with respect to how a statement of cash flows is presented such that it is possible in the future that these categories of cash flows might change). The accounting journal entry to record the period’s amortisation expense is: Dr Cr

Amortisation expense Accumulated amortisation—leased machinery

91 302 91 302 CHAPTER 11: ACCOUNTING FOR LEASES  395

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We will now consider examples of accounting for a lease. In doing so we will introduce a few additional elements, including: an analysis of the pattern of expense recognition across the lease term; how to account for a guaranteed residual payment; and how to account for a lease that ultimately transfers ownership of the underlying asset to the lessee.

WORKED EXAMPLE 11.9: Further example of accounting for a lease by a lessee On 1 July 2018 Lessee Ltd leased a truck for a period of five years with an up-front payment of $50 000 and payments of $150 000 being made at the end of each of the next five years. Included within these payments of $150 000 is an amount of $20 000, which the lessor is charging as part of a service contract. The economic life of the asset is also assumed to be five years and the truck is assumed to have no residual value at the end of the lease term. The fair value of the truck at the commencement of the lease was $583 026. REQUIRED

(a) Determine the interest rate implicit in the lease. (b) Provide the accounting journal entries to account for the lease for the year ending 30 June 2019. (c) Determine the total expenses recognised by the lessee and compare these expenses to those that would be recognised if we were simply to treat the lease payments as expenses and we did not recognise the lease asset and lease liability (in much the same way that ‘operating leases’ were treated in the former accounting standard).

SOLUTION

(a) In this example we are not told what the incremental borrowing rate of Lessor Ltd is. However, we do not need it as we should be able to determine the rate implicit in the lease. As we already know, the accounting standard defines the ‘rate implicit in the lease’ 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.   In this case the lease payments, which do not include the service contract component, amount to $130 000 per year for the next five years, plus the upfront payment of $50 000. We also know the fair value of the truck is $583 026. There is no unguaranteed residual.   The present value of the future lease payments, after deducting the upfront lease payment, is $533 026. Therefore, if we divide $533 026 by $130 000 we get 4.1002 (remember, in this illustration all of the lease payments are made at the end of the year). If we now go to the present value table at Appendix B to this book and go to the column with number of payments, go down to 5, and then scroll across the columns we will see that the factor 4.1002 equates to an interest rate of 7 per cent, which in this case is therefore the rate implicit in the lease. Therefore, using 7 per cent, the present value of the total lease payments is: $50 000 + ($130 000 × 4.1002) = $583 026.



  Because this equals the fair value of the truck at the start of the lease, then the rate implicit in the lease must be 7 per cent. (b) To determine interest expense and the reduction of principal in each year we can use the following table: Date

Lease payment

Interest expense

Principal reduction

1 July 2018

Present value of lease liability 533 026

30 June 2019

130 000

37 312

92 688

440 338

30 June 2020

130 000

30 824

99 176

341 162

30 June 2021

130 000

23 881

106 119

235 043

30 June 2022

130 000

16 453

113 547

121 496

30 June 2023

130 000

8 504

121 496

0

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  The amortisation will be calculated by dividing the cost of the right-of-use asset by the term of the lease. In this case the lease term and the economic life of the asset are both five years. This gives an amortisation expense of: $583 026 ÷ 5 = $116 605   The accounting journal entries for the year ending 30 June 2019 therefore are: 1 July 2018 Dr Lease truck Cr Cash at bank Cr Lease liability

583 026 50 000 533 026

30 June 2019 Dr Interest expense Dr Lease liability Dr Service expenses Cr Cash at bank Dr Cr

37 312 92 688 20 000 150 000

Amortisation expense Accumulated amortisation—leased machinery

116 605 116 605

(c) The following table summarises the total expenses associated with this lease.

Amortisation

Interest expense

Service expense

Total expenses

30 June 2019

116 605

37 312

20 000

173 917

50 000 + 150 000

30 June 2020

116 605

30 824

20 000

167 429

150 000

30 June 2021

116 605

23 881

20 000

160 486

150 000

30 June 2022

116 605

16 453

20 000

153 058

150 000

30 June 2023

116 605

8 505

20 000

145 110

150 000

800 000

800 000

Year ended



Lease payment

  The above table provides some interesting insights. First, we can see that when we recognise a lease, the expenses tend to be ‘front-loaded’ in earlier years. That is, capitalising a lease—and therefore complying with the accounting standard—creates higher expenses in earlier years (in the first year of the lease the total expenses are $173 917, but in the final year of the lease the total expenses have decreased to $145 110). This is because the interest expense is higher in earlier years as the lease liability is higher. In this illustration we have used straight-line amortisation for the lease assets (which would be common). If some form of accelerated depreciation was used (which recognises more amortisation in the earlier years), then expense recognition would have been even greater in the earlier years.   Secondly, we can see that had we not recognised the lease asset and lease liability but simply treated the full lease payments as expenses, (which would be a contravention of the accounting standard, but would be consistent with treating the lease as an ‘operating lease’—and kept off the balance sheet—as was sometimes permitted by the former accounting standard), then the total expenses would have been the same—in this case, $800 000. What is different is the timing of the expenses. Of course, if an organisation had a portfolio of leases with leases starting and ending at a variety of times then the difference in expense recognition between capitalising and not capitalising the lease would be minimal. What would also be different is how the expenses are presented. If the lease was treated as an operating lease, a single expense would be shown each period. However, when the lease is capitalised there would be depreciation expenses and interest expenses shown separately. continued CHAPTER 11: ACCOUNTING FOR LEASES  397

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  In terms of cash flows, as would be reported in a statement of cash flows, there would be no difference in the cash flows directly related to the lease if an organisation capitalised, or did not capitalise, the lease asset and lease liability. What would be different would be where the cash flows are reported in the statement of cash flows. If the lease was not capitalised—which was allowed for many leases under the former accounting standard—then the entire lease payment would be shown as part of operating cash flows. If the lease is now capitalised, the interest component would usually be shown as part of operating cash flows, but the component of the payment that represents payment of part of the liability would be shown as a financing cash flow. Therefore, the introduction of IFRS 16 (and, subsequently, AASB 16) has an affect on the presentation of cash flows—operating cash flows will reduce but there will be a corresponding increase in financing cash outflows.

WORKED EXAMPLE 11.10: A further leasing example, with this example including a guaranteed residual payment On 1 July 2018 Lessee Ltd leased a large item of machinery for four years with an up-front payment of $100 000 and payments of $250 000 being made at the end of each of the next four years. The rate of interest implicit in the lease is quoted as being 4 per cent. There is no intention to seek an extension of the lease. Included within annual lease payments is an amount of $30 000, which the lessor is charging as part of a service contract to maintain the machinery. The economic life of the asset is assumed to be eight years. The lessee has agreed to commit to a residual value guarantee as part of the lease contract. The lessee has agreed to guarantee the lessor that the machinery will have a value of $500 000 when it is returned to the lessor. The lessee and the lessor believe that given the nature of the use of the machine, the lessor will be able to sell the machine for $380 000 at the end of the lease term (meaning that at the commencement of the lease, the lessee believes it will be required to make a payment of $120 000 at the end of the lease term in respect of the residual value guarantee; this payment would therefore be considered to be part of the lease payments). The fair value of the machinery at the start of the lease was $1 325 978. REQUIRED

(a) Prove that the rate of interest implicit in the lease is 4 per cent. (b) Provide the accounting journal entries to account for the lease for the year ending 30 June 2019.

SOLUTION

(a) Using the present value tables provided in Appendices A and B, and a rate of interest of 4 per cent, provides us with the following: Present value of the lease payments: $100 000 + ($220 000 × 3.6299) + ($120 000 × 0.8548) = Present value of the amount that the asset is expected to be worth at the end of the lease term: $380 000 × 0.8548 =





$1 001 154

$324 824 $1 325 978

  Because the above amount equals the fair value of the asset at the commencement of the lease, then 4 per cent must be the rate of interest implicit in the lease. The liability for lease payments would not include the present value of the $380 000 as this represents the expected value of the asset that will be returned to the lessor. (b) To determine interest expense and the reduction of principal in each year we can use the following table: Date

Lease payment

Interest expense

Principal reduction

Present value of lease liability

1 July 2018 30 June 2019 30 June 2020 30 June 2021 30 June 2022

220 000 220 000 220 000 340 000*

36 046 28 688 21 036 13 076

183 954 191 312 198 964 326 924

901 154 717 200 525 888 326 924 0

*Includes payment of $120 000 in relation to the residual value guarantee

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  The amortisation will be calculated by dividing the cost of the right-of-use asset by the term of the lease. In this case the lease term is four years, and the lessee is expected to return the lease asset at the end of the lease term. This gives an amortisation expense of: $1 001 154 ÷ 4 = $250 288   The accounting journal entries for the year ending 30 June 2019 therefore are: 1 July 2018 Dr Lease machine Cr Cash at bank Cr Lease liability 30 June 2019 Dr Interest expense Dr Lease liability Dr Service expenses Cr Cash at bank Dr Cr

Amortisation expense Accumulated amortisation—leased machinery

1 001 154 100 000 901 154

36 046 183 954 30 000 250 000 250 288 250 288

WORKED EXAMPLE 11.11: Further example of a lease that ultimately transfers ownership of the lease asset Trigger Ltd enters into a non-cancellable five-year lease agreement with Brothers Ltd on 1 July 2019. The lease is for an item of machinery that, at the inception of the lease, has a fair value of $369 824. The machinery is expected to have an economic life of six years, after which time it will have an expected salvage value of $60 000. There is a bargain purchase option that Trigger Ltd will be able to exercise at the end of the fifth year for $80 000. There are to be five annual payments of $100 000, the first being made on 30 June 2020. Included within the $100 000 lease payments is an amount of $10 000 representing payment to the lessor for the insurance and maintenance of the equipment. The equipment is to be depreciated on a straight-line basis. A review of the appendices to this book shows that the present value of an annuity in arrears of $1 for five years at 12 per cent is $3.6048, while the present value of an annuity of $1 for five years at 14 per cent is $3.4331. Further, the present value of $1 in five years discounted at 12 per cent is $0.5674, while the present value of $1 in five years discounted at 14 per cent is $0.5194. REQUIRED

(a) Determine the rate of interest rate implicit in the lease and calculate the present value of the minimum lease payments. (b) Prepare the journal entries for the years ending 30 June 2020 and 30 June 2021. (c) Prepare the portion of the statement of financial position (balance sheet) relating to the leased asset and lease liability for the years ending 30 June 2020 and 30 June 2021. (d) Prepare the journal entries for the year ending 30 June 2024 (the final year of the lease).

SOLUTION

(a) The interest rate implicit in the lease agreement is the interest rate that results in the present value of the minimum lease payments, and any unguaranteed residual value, being equal to the fair value of the leased property at the inception of the lease. The lease payments include any bargain purchase option. As already noted, the accounting standard requires that lease payments are to include ‘the exercise price of a purchase continued CHAPTER 11: ACCOUNTING FOR LEASES  399

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option if the lessee is reasonably certain to exercise that option’. If we use a rate of interest of 12 per cent, the discounted value of the payments is $369 824, determined as: Present value of five lease payments of $90 000 discounted at 12 per cent (we eliminate the service costs) Present value of the bargain purchase option

= $90 000 × 3.6048 = $80 000 × 0.5674

= $324 432 =   $45 392 $369 824

  As the amount of the lease payments discounted at 12 per cent equates to the fair value of the asset at lease inception, the interest rate implicit in the lease is 12 per cent. We do not therefore need to do the calculation using the rate of 14 per cent. (b) Lease payment (exclusive of executory costs)

Date 01 July 2019 30 June 2020 30 June 2021 30 June 2022 30 June 2023 30 June 2024

90 000 90 000 90 000 90 000 170 000*

Interest expense 44 379 38 904 32 773 25 906 18 214

Principal reduction

Outstanding balance

45 621 51 096 57 227 64 094 151 786

369 824 324 203 273 107 215 880 151 786 0

*Includes bargain purchase option

1 July 2019 Dr Lease machinery Cr Lease liability

369 824 369 824

(to record the leased asset and liability at the inception of the finance lease) 30 June 2020 Dr Service expenses Dr Interest expense Dr Lease liability Cr Cash

10 000 44 379 45 621 100 000

(to record the lease payment of $100 000) Dr Cr

Lease depreciation expense Accumulated lease depreciation

51 637 51 637

(to record depreciation expense [($369 824 – $60 000) ÷ 6])   As the lessee will most probably retain the asset after the lease period as a result of the bargain purchase option, the economic life of the asset, and not the lease term, is used for depreciation purposes. 30 June 2021 Dr Service expenses Dr Interest expense Dr Lease liability Cr Cash

10 000 38 904 51 096 100 000

(to record the lease payment of $100 000) Dr Cr

Lease depreciation expense Accumulated lease depreciation

51 637 51 637

($369 824 less $60 000 divided by six years)

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(c) Portion of the statement of financial position for years ending 30 June 2020 and 30 June 2021

Assets Leased asset less Accumulated depreciation Current liabilities Lease liability Non-current liabilities Lease liability



2020 ($)

2021 ($)

369 824   51 637 318 187

369 824 103 274 266 550

51 096

57 227

273 107

215 880

  As at 30 June 2020, the present value of the outstanding lease liability is $324 203. The current portion of the liability ($51 096) is the amount by which the lease liability will be reduced by the lease payments in the next 12 months (from the lease payments schedule). (d) Journal entries for the final year of the lease 30 June 2024 Dr Service expenses Dr Interest expense Dr Lease liability Cr Cash

10 000 18 214 151 786 180 000

(to record the final payment of $180 000) Dr Lease depreciation expense Cr Accumulated lease depreciation (to record depreciation expense [($369 824 – $60 000) ÷ 6])

51 637 51 637

  At this point the lease liability will have a zero balance, and the lease machinery will have a carrying amount of $111 637, which is original amount recognised on 1 July 2019 of $369 824 less accumulated amortisation of $258 187. Because the asset is no longer leased, we would perform the following accounting journal entries, which will close off the accumulated lease depreciation account and transfer the remaining balance of the lease machinery account to the new account ‘Machinery’: 30 June 2024 Dr Dr Cr

Machinery Accumulated lease depreciation Lease machinery

111 637 258 187 369 824

Accounting for leases by lessors While the 2013 IASB Exposure Draft on leases suggested changes to how lessors shall account for leases (relative to the requirements in IAS 17, and therefore also relative to the former requirements in AASB 117), it was ultimately decided by the IASB, on the basis of feedback about the related benefits, that they would not at this stage alter how lessors are to account for leases. Therefore, lessor accounting remained largely unchanged as a result of the release in January 2016 of IFRS 16. Nevertheless, additional disclosure requirements have been introduced for lessors because of concerns about the lack of information about a lessor’s risk exposure to leases. In particular, lessors are now required to provide information about exposure to residual value risk. Specifically, the accounting standard now requires a lessor to disclose information about:

LO 11.4 LO 11.5 LO 11.8 LO 11.9 LO 11.10 LO 11.11 LO 11.12

a. assets subject to operating leases separately from owned assets held and used for other purposes by the lessor; and b. how it manages exposure to residual value risk. CHAPTER 11: ACCOUNTING FOR LEASES  401

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While the act of classifying leases into either finance leases or operating leases has now been removed as a requirement for lessees when accounting for leases, the requirement to classify leases into finance and operating leases has been retained for lessors when accounting for leases. Specifically, paragraph 61 of the accounting standard requires: A lessor shall classify each of its leases as either an operating lease or a finance lease. That is, from the lessor’s perspective, how we account for the lease will be dependent upon whether or not the lease is considered to be a finance lease or an operating lease. A finance lease is defined in the accounting standard as: A lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset. By contrast, an operating lease is defined as: A lease that does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset. Therefore, we can see that transfer—from the lessor to the lessee—of substantially all of the risks and rewards incidental to ownership of the underlying asset is a key issue in determining how a lessor shall classify and therefore account for a lease. If, as a result of entering the lease, the lessee thereafter holds the risks and rewards of ownership, risks and rewards the lessee’s risk exposure is basically what it would be if the lessee acquired the asset by way of a of ownership purchase transaction. Therefore, if the risks and rewards of ownership are transferred in substance to Risks include those the lessee, the lessee’s risk exposure in relation to holding the asset is basically equivalent to what it associated with would have been if the lessee had acquired the asset for cash or by way of a loan. idle capacity and It is not always a straightforward exercise to determine whether the risks and rewards incidental obsolescence and benefits include gains to ownership have passed substantially to the lessee. Professional judgement might be required. As in realisable value. a result, the accounting standard dedicates paragraphs 63 to 65 to assisting the determination of whether a lease is a finance lease or an operating lease. These paragraphs have been taken from the former accounting standard with only very slight modification. These paragraphs explain: 63. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are: (a)  the lease transfers ownership of the asset to the lessee by the end of the lease term; (b)  the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised; (c)  the lease term is for the major part of the economic life of the asset even if title is not transferred; (d)  at the inception of the lease the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset; and (e)  the underlying asset is of such a specialised nature that only the lessee can use it without major modifications. 64. Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are: (a)  if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee; (b)  gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and (c)  the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. 65. The examples and indicators in paragraphs 63–64 are not always conclusive. If it is clear from other features of the lease that the lease does not transfer substantially all risks and rewards incidental to ownership of an underlying asset, the lease is classified as an operating lease. For example, this may be the case if ownership of the asset transfers at the end of the lease for a variable payment equal to its then fair value, or if there are variable lease payments, as a result of which the lessee does not transfer substantially all such risks and rewards. We will now further reflect upon some of the key considerations included in the above paragraphs. 402  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Non-cancellability If a lease is cancellable at limited cost to the lessee, the lessee has limited risks and the lease is considered to be an operating lease. For the lessee to be considered to bear the risks associated with asset ownership it is logical that there should be costs for the lessee should the lessee choose to cancel the lease. This is why paragraph 64(a) is considered to be an important consideration in determining whether a lease should be classified as a finance lease. How a lease is classified will depend on the economic substance of the lease agreement and, as already indicated, the exercise of professional judgement is required. Leases that do not appear to satisfy any of the above criteria (in paragraphs 63 to 65) will typically be classified and accounted for by the lessor as operating leases (which means that the lessor will not recognise a lease receivable and will not recognise interest revenue).

Major part of the economic life of the underlying asset As we can see above, two conditions [see 63(a) and 63(c) above] within a lease that would cause a lease to be classified as a finance lease would be where the lease term is for the ‘major part’ of the economic life of the asset, or where it is expected that the lease will transfer ownership of the lease asset at the end of the lease term. ‘Major part’ is not defined within the accounting standard and determining whether the lease term is for the major part of the economic life of the asset is based on professional judgement. This condition would generally be considered to be satisfied when the lease term is greater than, or equal to, 75 per cent of the expected economic life of the leased asset.

Present value of lease payments amounts to substantially all of the fair value of the underlying asset Another condition within a lease that would cause a lease to be classified as a finance lease [see 63(d) above] is where, at the inception of the lease, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset. It is not clear from the standard what ‘substantially all of the fair value of the underlying asset’ means. It would seem to be a higher amount than ‘major part’. Again, accountants are required to exercise professional judgement. ‘Substantially all’ would appear to mean an amount very close to 100 per cent of fair value. But the standard does not provide any precise guidelines or percentages. However, it is generally considered that if the present value of the lease payments amounts to at least 90 per cent of the fair value of the leased asset (which in itself means that any unguaranteed residual value is relatively small), the lease is a finance lease. Nevertheless, it needs to be appreciated that given the ambiguity of the requirements stipulated in the accounting standard, it could be argued that 85 per cent is close enough, or that 90 per cent is not enough, and it should be at least 95 per cent. It is not clear where to draw the line, but it is clear that it must be a very high percentage.

Bargain purchase option Another condition within the accounting standard [see 63(b)] which would indicate that the lease is a finance lease is where the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised. Such a condition is often referred to as a ‘bargain purchase option’. While it is not a term that is used explicitly within the accounting standard, a bargain purchase option is a provision that allows the lessee to purchase the leased asset for a price that is expected to be significantly lower than the expected fair value of the asset at the date the purchase option becomes exercisable. This is effectively what paragraph 63(b) of the accounting standard (reproduced above) is referring to. The difference between the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured. This evaluation is made at the inception of the lease. If the exercise of the option is likely (by definition, a rational party would not forgo a ‘bargain’), it is also likely that transfer of ownership will occur, and the risks and rewards of ownership are therefore assumed to be transferred.

The lease asset is of a highly specialised nature If the underlying asset is of a very specialised nature such that only the lessee can, or will, use it, then the lessor might have no other economic opportunities other than to lease the asset to the lessee and as such we would expect the lease conditions to reflect this. The lessee would be unlikely to be able to find another party to take responsibility for the lease payments. CHAPTER 11: ACCOUNTING FOR LEASES  403

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We can summarise some of the main factors that need to be considered when classifying a lease in Figure 11.1 below. As the figure shows, the first factor to consider is whether the lease can easily be cancelled by the lessee without the lessee incurring significant costs. If it can be easily cancelled then this means that the lessee would not be subjected to the usual risks and rewards incidental to ownership, and the lease would therefore be an operating lease. For example, if a newer, more efficient or less costly alternative became available and the lessee could easily enter an alternative transaction for the substitute asset, then the risks and rewards associated with ownership would not have been transferred to the lessee. Once it is established that the lease is not cancellable, then the lease arrangement would potentially need to satisfy only one of the other conditions shown in Figure 11.1 (and identified in paragraph 63 of the accounting standard) for it to be deemed to be a finance lease. We have now considered various factors that would indicate whether the risks and rewards of ownership have been shifted to the lessee, and therefore would indicate whether the lease is a finance lease. If the evidence suggests that a lease is a finance lease, then the supplier/lessor shall on initial measurement: • derecognise the carrying amount of the underlying asset; • recognise a lease receivable;

Figure 11.1 Factors to consider by a lessor when classifying lease as an operating lease or a financial lease

Yes

Can the lease be cancelled by the lessee at limited cost to the lessee?

Does the lease transfer ownership of the asset to the lessee by the end of the lease term?

No

Yes No

Does the lessee include a bargain option? Yes No

Is the lease term for the major part of the economic life of the asset? Yes

No

At the inception of the lease does the present value of the lease payments amount to at least substantially all of the fair value of the underlying asset?

Operating lease

Finance lease

Yes

No

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• recognise a residual asset (if applicable); and • recognise any resulting profit or loss on the lease (if applicable). In terms of providing an initial measurement for the lease receivable, paragraph 70 of the accounting standard states: At the commencement date, the lease payments included in the measurement of the net investment in the lease comprise the following payments for the right to use the underlying asset during the lease term that are not received at the commencement date: (a) fixed payments (including in-substance fixed payments as described in paragraph B42), less any lease incentives payable; (b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date; (c) any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee; (d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option (assessed considering the factors described in paragraph B37); and (e) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease. If the lease conditions are such that the lease does not transfer the risks and rewards of ownership (for example, the term of the lease is not for the major part of the life of the asset or the lease is not expected to transfer ownership to the lessee at the end of the lease term)—in which case it would be an operating lease—then the lessor direct-financing lease shall recognise the lease payments as lease income in profit or loss over the lease term, and no A lease that is not lease receivable would be recognised (that is, the underlying asset would not be substituted for a a lease involving a lease receivable). manufacturer or dealer While, from the perspective of the lessor, leases shall be classified as either finance or operating in which the lessor leases, finance leases can—as reflected in Figure 11.2 below—be further classified into either: acquires legal title to • direct-financing leases; or • leases involving manufacturers or dealers (which have a profit or sale component). These classifications are discussed further below.

Lessor accounting for direct-financing leases A direct-financing lease is the term we will use to describe a lease in which the lessor provides the financial resources to acquire the asset. The lessor typically acquires the asset, giving the lessor legal title, and then enters a lease agreement to lease the asset to the lessee, who may subsequently

an asset then leases the asset to the lessee by way of a lease that is for the major part of the underlying asset’s life, or by way of a lease that transfers ownership at the end of the lease term.

Figure 11.2 Classification of leases by lessors

From the lessor’s perspective leases can be subdivided into

Operating leases

Finance leases

(which do not transfer substantially all the risks and rewards of ownership)

(which do transfer substantially all the risks and rewards of ownership) Finance leases can be further subdivided into

Direct financing leases

Dealer’s or manufacturer’s leases

CHAPTER 11: ACCOUNTING FOR LEASES  405

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control the asset. No sale is recorded. Rather, the lessor derives income through periodic interest revenue. The lessor substitutes a lease receivable for the underlying asset. The total interest to be earned by the lessor over the lease term will be represented by the difference between the fair value of the leased asset, and the sum of the undiscounted lease payments plus any residual value. Consistent with the interest expense for the lessee, the total interest revenue for the lessor is determined by multiplying the opening present value of the lease receivable (and the residual value of the asset, if any) by the interest rate implicit in the lease. At the commencement date of the lease, the lessor might incur initial direct costs. These are initial direct costs incremental costs that are directly attributable to negotiating and arranging a lease. Such costs would Costs that are include commissions, legal fees and costs of preparing and processing documentation associated directly attributable with new leases. Under a direct-financing lease, the initial direct costs are, if material, to be included to negotiating and as part of the lessor’s investment in the lease. arranging a lease and would not have Amounts received by the lessor that represent a recovery of service costs, being those costs been incurred without that are related specifically to the operation and maintenance of the leased property, including entering into the lease. insurance, maintenance and repairs, should be treated as revenue by the lessor in the financial years in which the related costs are incurred. This provides a proper matching of expenses to revenues because the revenues associated with providing the services are matched to the period in which the costs for providing those services are incurred. It should be noted that, as the underlying asset itself (for example, a building or an item of machinery) is not recorded in the accounts of the lessor (rather, a lease receivable is substituted and disclosed), no depreciation for accounting purposes will be recorded in the accounts of the lessor. If the lease, for example, is for the majority of the economic life of the asset, or is expected to transfer ownership of the asset to the lessee at the end of the lease term, then control has effectively passed to the lessee. Hence, consistent with the conceptual framework’s definition of assets, the lessor will not show the leased asset within its statement of financial position. Rather, it will show a lease receivable. lease receivable A lessor’s right to receive lease payments arising from a lease, measured on a present value basis.

WORKED EXAMPLE 11.12: Example of accounting for a direct financing lease by a lessor To show how the entries for a lessor compare with the entries made by the lessee, we will use the same data as that used in Worked Example 11.11, except this time we will be doing the exercise from the perspective of Brothers Ltd. REQUIRED

(a) Determine the interest rate implicit in the lease, and calculate the present value of the lease payments. (b) Prepare the journal entries for the years ending 30 June 2020 and 30 June 2021.

SOLUTION



(a) As for the lessee, the lessor will capitalise the present value of the lease payments, but as a lease receivable rather than as a leased asset. We have already determined that the present value of the lease payments is $369 824, and that the implicit rate is 12 per cent. In this example there is no residual value expected to accrue to the benefit of the lessor at the end of the lease term. Had there been a residual, the present value of the residual would also be recognised. (b) As when preparing the entries for the lessee, we typically use a table to determine the allocation between interest revenue and principal reduction. This table is reproduced below from the perspective of the lessor— the figures are of course the same as in Worked Example 11.11. Note that, from the lessor’s perspective, no depreciation entries are made for accounting purposes as the lessor does not control the underlying asset.

Date 01 July 2019 30 June 2020 30 June 2021 30 June 2022 30 June 2023 30 June 2024

Lease payment (exclusive of executory costs)

Interest revenue

Principal reduction

90 000 90 000 90 000 90 000 170 000 530 000

44 379 38 904 32 773 25 906 18 214 160 176

45 621 51 096 57 227 64 094 151 786 369 824

Outstanding balance 369 824 324 203 273 107 215 880 151 786 0

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1 July 2019 Dr Machinery Cr Cash (to recognise the initial acquisition of the machinery by the lessor)

369 824 369 824

Dr Lease receivable 369 824 Cr Machinery 369 824 (to substitute the lease receivable for the asset; it would be inappropriate to continue to disclose the machinery in the statement of financial position because the lessor no longer ‘controls’ it) 30 June 2020 Dr Cash Cr Service expense recoupment (part of profit or loss) Cr Interest revenue Cr Lease receivable (to record the lease receipt of $100 000) 30 June 2021 Dr Cash Cr Service expense recoupment (part of profit or loss) Cr Interest revenue Cr Lease receivable (to record the lease receipt of $100 000)

100 000 10 000 44 379 45 621

100 000 10 000 38 904 51 096

We shall now consider a worked example—Worked Example 11.13—that has a lease which includes an unguaranteed residual.

WORKED EXAMPLE 11.13: Lessor accounting for a direct financing lease that has an unguaranteed residual On 1 July 2019 Clovelly Ltd—the lessor—acquires a machine and immediately leases the machine to Bombi Ltd (the lessee). The fair value of the machine at the commencement of the lease is $528 210 (and this was the price paid for the machine by Clovelly Ltd), and the rate of interest being charged for the lease is 8 per cent. There is assumed to be no initial direct costs that are incurred as a result of entering the lease arrangement. The lease term is for four years and requires Bombi Ltd to make an up-front payment of $50 000, and four payments of $110 000 on 30 June each year. Included in these payments of $110 000 is a service cost of $10 000 to maintain the machine in good working order. At the end of the lease (30 June 2023), Clovelly Ltd expects the machine to have a value of $200 000, although this amount is not guaranteed by Bombi Ltd, meaning that Clovelly Ltd is bearing the risk related to any decline in the fair value of the machine. REQUIRED

(a) Show that the implicit rate of interest is 8 per cent. (b) Provide the required journal entries for the year ended 30 June 2020.

SOLUTION

(a) Using the present value tables provided in the appendices to this book and using the rate of interest of 8 per cent: Up-front payment at the commencement date of the lease Present value of the lease component of the payments: $100 000 × 3.3121 = Present value of the unguaranteed residual: $200 000 × 0.7350 = Fair value of the machine at the commencement date of the lease

$50 000 $331 210 $147 000 $528 210 continued

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  Because the present value of the lease payments plus the unguaranteed residual, discounted at 8 per cent, equal the fair value of the asset at the commencement date of the lease, 8 per cent must be the implicit rate of interest. The lease receivable and the residual asset will be accounted for separately. (b) 1 July 2019 Dr Machinery 528 210 Cr Cash 528 210 (to recognise the initial acquisition of the machinery by the lessor) Dr Cash 50 000 Dr Lease receivable 331 210 Dr Residual asset 147 000 Cr Machinery 528 210 (to substitute the lease receivable and the residual asset for the underlying asset; it would be inappropriate to continue to show the machinery in the statement of financial position because the lessor no longer ‘controls’ it. Rather, it is replaced by two other assets—the lease receivable, and the residual asset) 30 June 2020 Dr Cash Cr Service expense recoupment (part of profit or loss) Cr Interest revenue ($331 210 × 8 per cent) Cr Lease receivable Dr Residual asset Cr Interest revenue ($147 000 × 8 percent) (to adjust the present value of the residual asset)

110 000 10 000 26 497 73 503 11 760 11 760

  At the end of the lease term, and after the required present value adjustments have been performed each year, the carrying amount of the residual asset would be $200 000. At the end of the lease term this asset would then be reclassified to machinery and to do so there would be a debit to ‘Machinery’ of $200 000 and a credit to ‘Residual asset’ of $200 000.

Lessor accounting for lessors that are manufacturers or dealers of the leased asset As we saw previously, from the lessors’ perspective, finance leases can be further subclassified into direct financing leases, and manufacturers- or dealers-type leases. Manufacturers or dealers of assets can often choose between selling an asset to a purchaser, or leasing it to them. For example, motor vehicle dealers often lease motor vehicles to customers rather than becoming involved in an outright sale. A lease involving a manufacturer or dealer is one in which the fair value of the property at the inception of the lease differs from its cost to the lessor (with the lessor being the dealer or manufacturer). In effect, where this type of lease is involved, there are two parts to the transaction. First, there is a sale with a resulting gain (being the difference between the fair value of the asset and the cost to the dealer or manufacturer). There is also a lease transaction, which will provide interest revenue over the period of the lease. In a lease involving a dealer or manufacturer, the lessor’s investment in the lease would be accounted for in the same manner as for a direct-financing lease. The value of the sale would be recorded as the fair value of the asset at the date of sale, which would also equal the present value of the lease payments. Initial direct costs (commissions, legal fees and the costs of preparing and processing documentation for the new leases) may be incurred by the lessor. The initial direct costs relating to a lease involving a dealer or manufacturer are to be accounted for by the lessor as a cost of sales of the financial year in which the lease transaction occurs. That is, such costs are not treated as part of the investment in the lease receivable (see paragraph 74 of the accounting standard— but as we know, this was not the case for a direct financing lease for which the initial direct costs were included as part of the lease receivable). 408  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Lease rentals representing a recovery of service costs are, if material, to be treated by the lessor as revenue of the financial years in which the related costs are incurred. Further explanation of leases involving dealer or manufacturer lessors is provided in Worked Example 11.14.

WORKED EXAMPLE 11.14: Example of lease involving a dealer or manufacturer Sullivan Ltd enters into a non-cancellable five-year lease agreement with Bubbles Ltd on 1 July 2019. The lease is for a number of spa baths that, at the inception of the lease, have a fair value of $924 560. The spas are being used as part of the amenities at Sullivan’s exclusive executive club, a club whose main clients are politicians. The baths are expected to have an economic life of seven years, after which time they will have no residual value. There is a bargain purchase option that Sullivan Ltd will be able to exercise at the end of the fifth year, for $200 000. Bubbles Ltd manufactures the spa baths. The cost of the spa baths to Bubbles Ltd is $800 000, with the result that Bubbles Ltd is making a profit on sale of $124 560. There are to be five annual payments of $250 000, the first being made on 30 June 2020. Included within the $250 000 lease payments is an amount of $25 000 representing payment to the lessor for the insurance, sanitation and maintenance of the equipment. The equipment is to be depreciated on a straight-line basis. The rate of interest implicit in the lease is 12 per cent. REQUIRED

(a) Calculate the present value of the lease payments. (b) Prepare the journal entries for the financial years ending 30 June 2020 and 30 June 2021 in the books of Bubbles Ltd.

SOLUTION

(a) First, as the lease is for the major part of the economic life of the assets, we will substitute a lease receivable for the underlying assets. Present value of five lease payments of $225 000 discounted at 12 per cent (we eliminate the service costs) The present value of the bargain purchase option



= $225 000 × 3.6048 = $200 000 × 0.5674

= $811 080 = $113 480 $924 560

  As the present value of the lease payments is equivalent to the fair value of the asset at the inception of the lease, we have proved that the rate of interest implicit in the lease is 12 per cent. (b) Journal entries in Bubbles Ltd’s books

Date 01 July 2019 30 June 2020 30 June 2021 30 June 2022 30 June 2023 30 June 2024

Lease payment (excluding executory costs)

Interest revenue

Principal reduction

225 000 225 000 225 000 225 000    425 000 1 325 000

110 948 97 261 81 932 64 764   45 535 400 440

114 052 127 739 143 068 160 236 379 465 924 560

Outstanding balance 924 560 810 508 682 769 539 701 379 465 0

1 July 2019 Dr Lease receivable 924 560 Dr Cost of sales 800 000 Cr Inventory 800 000 Cr Sales 924 560 (the lease receivable represents the present value of the minimum lease payments, and the cost of goods sold represents the cost of the asset to the lessor) continued CHAPTER 11: ACCOUNTING FOR LEASES  409

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30 June 2020 Dr Cash Cr Service expense recoupment (part of profit or loss) Cr Interest revenue Cr Lease receivable (to represent receipt of lease payment) 30 June 2021 Dr Cash Cr Service expense recoupment (part of profit or loss) Cr Interest revenue Cr Lease receivable (to represent receipt of lease payment)

250 000 25 000 110 948 114 052

250 000 25 000 97 261 127 739

  Again we notice that the lessor does not depreciate the underlying asset. The lessee will depreciate the ‘right-of-use’ asset.

Lessor accounting for an operating lease Where a lease is classified by the lessor as an operating lease, the leased property subject to the lease is to be accounted for as a non-current asset to the extent that such an asset satisfies the usual requirements to be considered a non-current asset. As paragraph 88 of the accounting standard states: A lessor shall present underlying assets subject to operating leases in its statement of financial position according to the nature of the underlying asset. That is, the lessor effectively retains control of the asset in the presence of an operating lease and, therefore, should disclose the asset that has been leased to another party. There shall be no substitution of a lease receivable for the underlying asset. Further, if the asset is depreciable, the lessor involved in an operating lease is required to depreciate the asset. As paragraph 84 of the accounting standard states: The depreciation policy for depreciable underlying assets subject to operating leases shall be consistent with the lessor’s normal depreciation policy for similar assets. A lessor shall calculate depreciation in accordance with AASB 116 and AASB 138. If a lease is not for the major part of the asset’s expected economic life or does not look likely to transfer ownership of the underlying asset to the lessee at the end of the lease term, then the leased property subject to the lease is to be accounted for as a non-current asset to the extent that such an asset satisfies the usual requirements to be considered a non-current asset. The lessor effectively retains control of the asset in the presence of such a lease and, therefore, should disclose the asset that has been leased to another party. That is, for example, if the lessor has leased a machine to a lessee then the machine would still be shown in the accounts of the lessor. Further, if the asset is depreciable, the lessor involved in such a lease is required to depreciate the asset. The lease receipts are treated as rental revenue.

WORKED EXAMPLE 11.15: Lessor accounting for a lease that is only for a minor part of the asset’s life On 1 July 2019 Tamarama Ltd—the lessor—leases a building to Bronte Ltd (the lessee) for a period of three years. The lease requires an up-front payment (prepayment) of $100 000 and then payments (prepayments for the following 12 months) on 30 June 2020 and 30 June 2021 of $100 000 each. The building is expected to have an economic life of 60 years. REQUIRED Provide the required journal entries for Tamarama Ltd for the year ending 30 June 2020.

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SOLUTION The journal entries for the year ending 30 June 2020 would be: 1 July 2019 Dr Cash 100 000 Cr Rent received in advance 100 000 (the initial payment would be treated as a liability labelled ‘Rent received in advance’) 30 June 2020 Dr Rent received in advance Cr Rental income (as the rent has now been earned, we recognise revenue)

100 000 100 000

Dr Cash 100 000 Cr Rent received in advance 100 000 (the payment made on 30 June 2020 represents rent received in advance for the next 12 months) In this worked example, because the lease is for only a very small fraction of the life of the asset, we do not substitute a lease receivable for the underlying asset in the accounts of the lessor. As such, the lessor would also need to recognise periodic depreciation expense associated with the underlying asset. The lessee would, however, recognise a lease liability and right-of-use asset in relation to the lease as the only time a lessee shall not recognise a lease liability is if the lessee elects to exercise the option available for short-term leases (12 months or less), or leases of low-value assets—two options that would not be available for a situation such as that in the worked example.

Lessor’s leases of land and building As land is an asset that normally has an indefinite life, the accounting standard asserts that the risks and rewards of the ownership of land cannot be transferred to the lessee unless the lease will, at its completion, transfer ownership, or the lease contains a bargain purchase option. Hence, unless the lease is reasonably assured of transferring ownership to the lessee, a lease of land would be treated as an operating lease by the lessor. If, for example, there was a 100-year non-cancellable lease arrangement for some land, then despite the length of the lease, and the fact that the lease might be non-cancellable, the lessor would not be required to recognise a lease receivable. Hence, if the lease is not assured of transferring ownership of the land and buildings to the lessee at the completion of the lease, the lease payments allocated to the land component are to be treated as if the lease were an operating lease. Whether the payments allocated to the building(s) on the land are classified as pertaining to an operating lease or a financial lease from the perspective of the lessor will depend on whether the lease transfers the risks and rewards of ownership of the building(s) to the lessee applying the rules we have already considered. That is, the usual tests for determining whether a lease is a finance or operating lease would be applied. Because it is very possible that the lease of land and buildings will need to be separated into two components, these being the land component (which from the lessor’s perspective would typically be deemed to be an operating lease) and the building component (which from the lessor’s perspective may be a finance lease or an operating lease), some means of allocation of the lease payment is necessary. In this regard, paragraph B56 of the accounting standard states: Whenever necessary in order to classify and account for a lease of land and buildings, a lessor shall allocate lease payments (including any lump-sum upfront payments) between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception date. If the lease payments cannot be allocated reliably between these two elements, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases, in which case the entire lease is classified as an operating lease. An exception to the above general rule would be where the fair value of the land at the inception of the lease is immaterial to the fair value of the total property. In such a case, the property may be treated as a unit for the purposes of the lease classification and the land component may effectively be ignored. If the lease of the buildings then appears to CHAPTER 11: ACCOUNTING FOR LEASES  411

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transfer the risks and rewards of ownership, the total lease for the land and buildings may be treated as a finance lease by the lessor; otherwise it would be treated as an operating lease. As paragraph B57 of the accounting standard states: For a lease of land and buildings in which the amount for the land element is immaterial to the lease, a lessor may treat the land and buildings as a single unit for the purpose of lease classification and classify it as a finance lease or an operating lease applying paragraphs 62–66 and B53–B54. In such a case, a lessor shall regard the economic life of the buildings as the economic life of the entire underlying asset. Accounting for a lease involving land and buildings is examined more closely in Worked Example 11.16.

WORKED EXAMPLE 11.16: Accounting by the lessor for a lease involving land and buildings On 1 July 2019, Thom Ltd signs a non-cancellable agreement to lease a land and building package to Musgrave Ltd. The lease agreement requires seven annual payments of $75 000, with the first payment being made on 30 June 2020. $5000 of each of these payments represents a payment to Thom Ltd for rates and maintenance of the property. Owing to harsh climatic conditions, the buildings are expected to have a life of only nine years, after which time they will have no residual value. At 1 July 2019 the land and buildings have a fair value of $133 028 and $310 400 respectively, providing a total for land and buildings of $443 428. The land and buildings are expected to have a value (unguaranteed by the lessee) of $200 000 at the end of year seven, with the land component expected to be worth $60 000 and the building component expected to be worth $140 000. The rate of interest implicit in the lease is 10 per cent. REQUIRED

(a) Prove that the rate of interest implicit in the lease is 10 per cent. (b) Allocate the lease payments between the land and buildings. (c) Provide the journal entries for the years ending 30 June 2020 and 30 June 2021 as shown in the books of Thom Ltd.

SOLUTION

(a) The interest rate implicit in the lease agreement is the interest rate that causes the present value of the lease payments and any unguaranteed residual value to be equal to the fair value of the leased property at the inception of the lease. Present value of seven lease payments of $70 000 discounted at 10 percent (we eliminate the executory costs) Present value of the unguaranteed residual



=   $70 000 × 4.8684 = $200 000 × 0.5132

= $340 788 = $102 640    $443 428

  As the minimum lease payments plus the unguaranteed residual discounted at 10 per cent equates to the fair value of the asset at lease inception, the interest rate implicit in the lease is 10 per cent. (b) The lease payments should be allocated on the basis of the fair values of the assets at the inception of the lease. Therefore the allocation of lease payments is: Land Buildings

= 70 000 × (133 028 ÷ 443 428) = 70 000 × (310 400 ÷ 443 428)

= $21 000 = $49 000

  In this illustration, as the fair value of the land is greater than 25 per cent of the fair value of the total land and building, and as the lease does not transfer the land to the lessee at completion of the lease period, the portion of the lease attributable to the land will be treated as an operating lease.   The present value of the lease payments relating to the buildings is: $49 000 × 4.8684 = $238 551   As the terms of the lease agreement transfer substantially all the risks and rewards of ownership of the buildings to Musgrave Ltd, Thom Ltd will treat the payments allocated to the buildings as a finance lease.

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(c) Journal entries for the years ending 30 June 2020 and 30 June 2021 Date

Lease payment for building

Interest revenue

Receivable reduction

01 July 2019

Outstanding balance 238 551

30 June 2020

49 000

23 855

25 145

213 406

30 June 2021

49 000

21 341

27 659

185 747

30 June 2022

49 000

18 575

30 425

155 322

30 June 2023

49 000

15 532

33 468

121 854

30 June 2024

49 000

12 185

36 815

85 039

30 June 2025

49 000

8 504

40 496

44 543

30 June 2026

  49 000 343 000

    4 455 104 447

  44 545 238 553

0*

*Note: There is a $2 rounding error due to the use of only 4 decimal places in the calculations.

1 July 2019 Dr Lease receivable 238 551 Dr Residual asset (140 000 × 0.51321) 71 849 Cr Building 310 400 (to record the leased receivable and the residual asset which replace the building in the accounts of Thom Ltd) 30 June 2020 Dr Cash Cr Service expense recoupment (part of profit or loss) Cr Interest revenue (see table above) Cr Lease receivable Cr Rental income—land

75 000 5 000 23 855 25 145 21 000

Dr Residual asset 7 185 Cr Interest revenue 7 185 (to record the increase in the present value of the residual asset, which is $71 849 × 10%) 30 June 2021 Dr Cash Cr Service expense recoupment Cr Interest revenue (see table above) Cr Lease receivable Cr Rental income—land (to record the lease receipt of $75 000)

75 000 5 000 21 341 27 659 21 000

Dr Residual asset 7 903 Cr Interest revenue 7 903 [to record the increase in the present value of the residual asset, which is (71 849 + 7185) × 10%]

Implications for accounting-based contracts

LO 11.1

As we should now understand, there was a significant recent change in how lessees shall account for LO 11.13 leases, with the implication that many more lease assets, and lease liabilities, shall now be recognised by lessees for financial reporting purposes. But what we also need to appreciate is that this was an accounting change only—whether we recognise lease assets or lease liabilities in our financial statements does not of itself directly CHAPTER 11: ACCOUNTING FOR LEASES  413

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affect the lease-related cash flows, which must be made regardless of the financial reporting requirements. Further, the legal obligations to the lessor will exist regardless of whether the obligation/liability appears within the lessee’s balance sheet. Indirectly, however, how we account for the lease assets and lease liabilities can impact future cash flows because of the effects the changes in reported assets, and liabilities, might have for other agreements, which in themselves might rely upon accounting numbers. For example, because there are typically many contractual arrangements that rely upon the numbers appearing within the financial statements, any changes in accounting numbers might impact future cash flows (therefore, there are indirect cash-flow implications associated with a lessee being required to capitalise lease assets and lease liabilities). For example, and as demonstrated earlier in this chapter, the pattern of expense recognition will change for organisations that must now recognise lease assets and liabilities (greater expenses will be recognised in the earlier years of a lease), and this will impact reported profit or loss. If managers are paid a percentage of profits (a performance-based bonus) then the cash flows associated with this bonus plan might change if profits change (if the accounting-based performance indicator that is used to calculate the manager’s bonus changes, then the payment to the manager will change). Because the value of a firm is considered to be a function of its expected future cash flows, changing cash flows will also conceivably impact the firm’s value. As we have indicated earlier in this chapter, and as discussed extensively in Chapter 3, organisations often agree to restrictive accounting-based debt covenants when negotiating to borrow funds (and in agreeing to the restrictions contained in the debt covenants the organisation should then be able to attract debt funds at a lower cost than might otherwise be possible). For example, to restrict the amount of debt that the firm can borrow and to therefore protect the lenders’ own financial interests, those parties that provide the debt funds to the organisation (the lenders) might require the borrowing organisation to agree to (contract to) restrict the total debt the borrower is allowed to have. This can be done by, for example, stipulating maximum debt-to-asset ratios that the organisation must then not exceed (or else be in technical default of the borrowing agreement, which could then trigger certain technical default penalties, such as the lenders having the immediate right to demand repayment of their funds or to When a borrowing seize certain assets over which the lenders have security). So, if more liabilities are to be recognised— entity has failed to perhaps as a result of capitalising more leases—then this can potentially trigger a default on lending comply with certain agreements, which in turn would impact current operations, cash flows and, therefore, potentially the restrictive covenants that have been value of the firm. negotiated with For example, assume that a company has assets of $10 million and liabilities of $5.5 million. Also lenders. assume that the debt-to-asset constraint imposed on the firm as a result of agreements signed with lenders requires that the debt-to-asset ratio is to be kept below 0.6. Now assume that the firm wishes to lease some assets and the present value of the lease payments is $1.5 million. If the lease debt-to-asset assets and lease liabilities are not recognised (which, in certain circumstances, was permitted under constraint the former accounting standard), debt and assets will not be affected, so the debt-to-asset ratio will A restriction included not be affected. However, if the lease is recognised in accordance with the accounting standard, in a debt agreement then the debt-to-asset ratio would become 0.609 (7 000 000 ÷ 11 500 000) and the company would limiting the amount be in technical default of the loan agreement—potentially a costly situation for the company. Of of debt an entity may have relative to its total course, it might be possible that the borrowing agreement (contract) requires the use of the assets. accounting rules that were in place back when the debt contract was negotiated (often referred to as ‘frozen generally accepted accounting principles’), in which case a change in accounting rules will not have an impact, but this will not always be the case. Many debt contracts are written to use ‘floating accounting rules’—which means they use the accounting rules as currently released by the IASB and hence the basis of calculations will change as new accounting standards are released—a situation that can make corporate managers quite concerned when new accounting rules are being developed. In part, the long transition period available under IFRS 16/AASB 16 (which is about three years from the time when the accounting standard was released to the time when it must be applied) was to allow time for renegotiation of various agreements that rely upon accounting-based numbers—many of which would be impacted by the new accounting standard on leases. Reflective of concerns about how the new leasing standard would potentially affect various contracts that use accounting-based numbers, IASB (March 2015) provides an example of how certain indicators used in debt contracts would be impacted by the latest requirements to capitalise leases that were previously kept off the balance sheet. In doing so, the IASB compared examples of typical organisations in the retail, airline and distribution industries. 414  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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The accounting-based indicators that they reviewed and which are commonly used in debt contracts negotiated between borrowers and lenders, and which would be impacted by the requirement to capitalise leases, were:

Leverage indicators • Debt ÷ Earnings Before Interest, Income Taxes, Depreciation and Amortisation (EBITDA) • Interest coverage = EBITDA ÷ INTEREST COSTS

Performance indicators • Return on capital employed = Profit ÷ (Equity plus Liabilities, including recognised lease liabilities) In all cases, and consistent with many concerns held by various organisations, the indicators deteriorated as a result of capitalising the lease assets and lease liabilities. While many concerns were raised about the implications for debt contracts (and many other accounting-based contracts) as a result of IFRS 16 being released by the IASB in January 2016, this debate is not new. Approximately three decades ago similar concerns were raised when the first version of the former accounting standard was released, which for the first time required some leases (finance leases) to be capitalised for balance sheet purposes. Prior to the former accounting standard, it was common for no lease liabilities or lease assets at all to be recognised for balance sheet purposes. In this regard, El Gazaar (1993) considered the effects that US Accounting Standard SFAS 13 (released in 1976) had on US firms. SFAS 13 required US firms to capitalise ‘finance leases’ (as was also the requirement pursuant to the former accounting standard IAS 17/AASB 117). Where restrictive debt covenants were in place (for example, debtto-asset constraints and/or interest-coverage requirements), the effect of SFAS 13 was to make those covenants more binding. As we know, capitalising off-balance-sheet leases increases assets and liabilities, which raises the likelihood of violating debt covenant restrictions if the debt agreements use floating (rolling) generally accepted accounting principles. El Gazaar argued that the introduction of the accounting standard requiring the capitalisation of finance leases had negative cash-flow implications for firms. As he explained (p. 260): Lessees with significant increases in the tightness of covenant constraints might incur additional costs as a result of operating under tighter contractual conditions or actual technical default. If lenders do not waive the violations, management could take actions to alleviate these effects. These actions could include issuance of additional equity capital, redemption of outstanding debt or renegotiation of debt contracts. All of these actions are costly in that they alter the mix of investing and financing policies that is based on economic analysis. El Gazaar’s results were consistent with the view that capitalising leases that were previously left off the statement of financial position (balance sheet) increases the probability of ending up in technical default of debt contracts. This increase in the tightness of debt covenants is considered to have negative cash-flow effects and, consistent with this, it was found that tighter debt covenant restrictions correlated with negative changes in security prices around the time of the release of SFAS 13. Just as the introduction of the previous leasing standards (which utilised the concept of ‘financial’ versus ‘operating’ leases) created concerns for reporting entities and led to various strategies being undertaken to devise leases that were construed as operating leases, it will be interesting to see how reporting entities will react to the recently released accounting standard (IFRS 16/AASB 16) that abandons the concept of ‘finance leases’ versus ‘operating leases’ for lessees and now requires all leases to be shown within the statement of financial position (other than short-term leases and leases of low-value assets). This will be an interesting research topic for financial accounting researchers. As we know, with the release of the new accounting standard, lessees’ statements of financial position will incorporate rightof-use assets as well as the obligations to make lease payments (lease liability), which previously were not recognised. In terms of profit or loss, the recognition of leases will require lessees to recognise interest expense (which is typically higher in the early years of a lease) and to also recognise amortisation expenses related to the right-of-use asset. Amortising the right-to-use asset and recognising the interest expenses on the liability will lead to a pattern of lease expense recognition that is ‘front loaded’—that is, the new standard will reduce profits in earlier years, which will also have potential impacts on key ratios such as interest coverage ratios. Because leases can no longer be left off the balance sheet of lessees (other than for leases of 12 months or less, or leases of low-value items), it can perhaps be predicted that the use of leases will decline in the future and organisations might tend to increase the amount of assets they buy with borrowed funds (or from cash reserves). Only time will tell. This discussion again highlights the role of accounting within society and how a change in an accounting standard can impact many stakeholders and many decisions being made within an organisation. CHAPTER 11: ACCOUNTING FOR LEASES  415

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SUMMARY The following table provides a summary of the main points to consider in accounting for leases. Table 11.3 A summary of some of the key requirements for lease accounting

Issue

Required treatment

When should the lease be recognised?

A lessee and a lessor shall measure lease assets and lease liabilities at the date of commencement of the lease. The date of commencement of the lease is the date on which the lessor makes the underlying asset available for use by the lessee.

How should the lease be measured?

The lessee shall initially recognise a liability to make lease payments and a rightof-use asset, both measurements being based upon the present value of lease payments. The right-of-use asset is defined as an asset that represents a lessee’s right to use an underlying asset for the lease term. The liability shall subsequently be measured at amortised cost, whereby lease payments are allocated between interest expense and a reduction of the lease obligation. The lessee shall amortise (depreciate) the right-of-use asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits.

What are included in the capitalised lease payments?

The lease liability recognised by the lessee comprises payments made by a lessee to a lessor relating to the right of use of an underlying asset during the lease term, and consisting of the following:

(a) fixed payments, less any lease incentives received or receivable from the lessor; (b) variable lease payments that depend on an index or a rate, or are insubstance fixed payments; (c) the exercise price of a purchase option if the lessee has a significant economic incentive to exercise that option; and (d) payments for penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

For the lessee, the lease liability also includes amounts expected to be payable by the lessee under residual value guarantees. Lease payments do not include payments allocated to non-lease components of a contract except when the lessee is required to combine non-lease and lease components and account for them as a single lease component. For the lessor, the lease payments included in the initial measurement of the lease receivable include:

(a) fixed payments less any lease incentives payable; (b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date; (c) any residual value guarantees provided to the lessor by the lessee; (d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and (e) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

The lease receivable does not include payments allocated to non-lease components (for example, service components). What is the lease term?

The lease term is to be defined as: The non-cancellable period for which a lessee has the right to use an underlying asset, together with both of the following: (a) periods covered by an option to extend the lease if the lessee has a significant economic incentive to exercise that option; and (b) periods covered by an option to terminate the lease if the lessee has a significant economic incentive not to exercise that option. This means that the lease term will include optional renewal periods that are more likely than not to be exercised.

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What is the required discount rate?

The lessee would use the rate the lessor charges the lessee when that rate is available—known as the rate implicit in the lease—otherwise the lessee is to use its incremental borrowing rate. The lessee’s incremental borrowing rate is the rate of interest that, at the date of inception of the lease, the lessee would have to pay to borrow over a similar term and with a similar security, the funds necessary to purchase a similar underlying asset.

How are initial direct costs to be accounted for?

Initial direct costs are defined as: Costs that are directly attributable to negotiating and arranging a lease and would not have been incurred without entering into the lease. Lessees, and lessors using a direct financing lease, should capitalise initial direct costs by adding them to the carrying amount of the right-of-use asset and the lease receivable, respectively. For lessors with a manfacturers- or sales-type lease, the initial direct cost are treated as part of the cost of sales.

Residual value guarantees

Capitalised lease payments should include residual value guarantees in the measurement of the lessee’s liability to make lease payments. They would also be included in the lessor’s right to receive lease payments (lease receivable).

Purchase option

Lease payments should include the exercise price of a purchase option (bargain purchase options) in the measurement of the lessee’s liability to make lease payments and the lessor’s lease receivable, if the lessee has a significant economic incentive to exercise the purchase option.

Amortisation of rightof-use asset

If it is determined that the lessee has a significant economic incentive to exercise a purchase option, or if the lease transfers ownership of the lease asset to the lessee at the completion of the lease, the right-of-use asset recognised by the lessee should be amortised over the economic life of the underlying asset, otherwise the right-of-use asset should be amortised over the lease term.

Lessor recognition of a residual asset

At the end of the lease term, the lessor might have rights to a residual asset if the lease term is not for the life of the underlying asset. Where a residual asset will exist: 1. The lessor would recognise both a right to receive lease payments and a residual asset at the date of the commencement of the lease. 2. The lessor would initially measure the right to receive lease payments as the sum of the present value of the lease payments, discounted using the rate that the lessor charges the lessee. 3. The lessor would initially measure the residual asset as an allocation of the carrying amount of the underlying asset and would subsequently measure the residual asset by increasing it over the lease term using the rate that the lessor charges the lessee. The increase in the value of the residual asset across time (which in part would be due to the effects of discounting) would be included in profit or loss as interest income.

Are there exclusions for short-term leases?

A short-term lease is defined as: A lease that, at the commencement date, has a maximum possible term under the contract, including any options to extend, of 12 months or less. Any lease that contains a purchase option is not a short-term lease. A lessee need not recognise lease assets or lease liabilities subject to a shortterm lease. For those leases, the lessee can recognise lease payments in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which use is derived from the underlying asset. For those excluded leases, a lessor should continue to recognise and depreciate the underlying asset and recognise lease income over the lease term on a systematic basis. Lessees also have exemptions allowed for lowvalue items.

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KEY TERMS debt-to-asset constraint  414 direct-financing lease  405 finance lease  377

initial direct costs  406 lease  377 lease receivable  406 operating lease  377

residual value  390 risks and rewards of ownership  402 technical default  414

END-OF-CHAPTER EXERCISES Because of his continued inability to keep up with other riders when cycling, Scott Thomson from Melbourne decides to take action to reduce the popularity of cycling. To this end, he decides to pursue the development of motorised roller blades, a product some might see as offering an alternative to cycling. To do so, he forms Thomson Ltd. To make the roller blades, Thomson Ltd needs to acquire some machinery from Fernster Ltd, which designs and manufactures the machinery. To manufacture the equipment, which has an estimated economic life of eight years, costs Fernster Ltd $200 000. Fernster Ltd sells the equipment to parties such as Thomson Ltd for $263 948. Thomson Ltd decides to lease the equipment from Fernster Ltd for a period of seven years, by way of a noncancellable lease. The lease commences on 1 July 2019. The lease payments are made at the end of each year and amount to $55 000. The lease payments include reimbursement of Fernster Ltd’s costs for servicing the machinery at an amount of $5000 per annum. There is an unguaranteed residual at the end of the lease term of $40 000, which represents expectations of what the lessee and lessor expect the machinery to be worth at the end of the lease term.

REQUIRED (a) Determine the interest rate implicit in the lease. LO 11.8 (b) Provide the journal entries in the books of Thomson Ltd as at 1 July 2019 and 30 June 2020. LO 11.3, 11.5, 11.6, 11.7 (c) Provide the journal entries in the books of Fernster Ltd as at 1 July 2019 and 30 June 2020. LO 11.3, 11.5, 11.6, 11.7, 11.10

SOLUTION TO END-OF-CHAPTER EXERCISE (a) The interest rate implicit in the lease is that which, when used to discount the lease payments and any unguaranteed residual, causes the combined present value to be equal to the fair value of the asset at lease inception. If we use a discount rate of 10 per cent, the present value of the lease payments over seven years, and the unguaranteed residual, are as follows: Lease payments Unguaranteed residual

$50 000 × 4.8684 = $243 420 $40 000 × 0.5132 =   $20 528 $263 948

  As the discounted value equals the fair value of the asset at lease inception, 10 per cent must be the rate of interest implicit in the lease. (b) Journal entries in the books of Thomson Ltd 1 July 2019 Dr Lease machinery 243 420 Cr Lease liability 243 420 (to recognise the lease asset and lease liability at the commencement date of the lease; the lessee does not include the unguaranteed residual as part of the lease liability because it is ‘unguaranteed’ and therefore there is no obligation for the lessee to make a payment) 418  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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30 June 2020 Dr Service costs Dr Interest expense Dr Lease liability Cr Cash (to recognise the first lease payment)

5 000 24 342 25 658 55 000

Dr Depreciation expense 34 774 Cr Accumulated lease depreciation 34 774 (to recognise the period depreciation expense = $243 420 ÷ 7. We use the lease term and not the economic life of the asset as the lessee will not take ownership of the underlying asset at the end of the lease term) (c) Journal entries in the books of Fernster Ltd 1 July 2019 Dr Lease receivable 243 420 Dr Residual asset 20 528 Dr Cost of goods sold 179 472 Cr Inventory 200 000 Cr Sales revenue 243 420 (to recognise the sale of inventory to Thomson Ltd and the related lease receivable and residual asset. The cost of goods sold represents the cost of the equipment to Fernster Ltd less the present value of the unguaranteed residual at the end of the lease. The sales revenue represents the present value of the lease payments—which by definition excludes unguaranteed residuals) 30 June 2020 Dr Cash Cr Lease receivable Cr Interest revenue Cr Recoupment of service costs (to recognise the receipt of the periodic lease payment)

55 000 25 658 24 342 5 000

Dr Residual asset 2 053 Cr Interest revenue 2 053 (by increasing the residual asset by the amount of interest, the residual asset will have a carrying amount of $40 000 at the end of the lease term. At the end of the lease term the lessor would reclassify the residual asset to an account such as the ‘Machinery’ account. It would do this at the end of the lease term by debiting ‘Machinery’ by $40 000 and crediting ‘Residual asset’ by $40 000.)

REVIEW QUESTIONS 1. Provide an overview of how accounting for leases was changed as a result of the release of IFRS 16 Leases. LO 11.1, 11.3 2. What is a ‘lease’? LO 11.2 3. What is a ‘lease term’ and how is it determined? LO 11.5 4. What factors would influence whether an agreement with a supplier is considered to be a ‘lease’ and therefore would require lease assets and lease liabilities to be recognised. LO 11.3, 11.4 5. When should a lessee capitalise a lease transaction? LO 11.4 6. What exemptions are available that would allow a lessee not to capitalise lease assets and lease liabilities? LO 11.4 7. What is the difference between a ‘direct financing lease’ and a ‘manufacturers’ (‘dealers’)-type lease’? LO 11.12 8. How do we account for service costs that are included within a contract to lease an asset? LO 11.11 CHAPTER 11: ACCOUNTING FOR LEASES  419

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9. When a lease transaction is to be capitalised, how do we determine the value of the leased asset, and the lease liability? LO 11.6, 11.7 10. When a lessee recognises a lease, why are the expenses associated with the lease generally higher in the earlier years of the lease? LO 11.7 11. How shall the lessee and lessor account for a residual value guarantee if it exists? LO 11.7, 11.8 12. Leoni Ltd has entered into a number of agreements as identified below: Agreement 1 Leoni Ltd has signed a contract to lease a truck for a non-cancellable term of 12 months. There is an option to extend the lease for another 12 months. The lease payments in this additional period are to be at usual market rates. Agreement 2 Leoni Ltd has signed a contract to lease machinery for a non-cancellable period of 11 months. There is an option to extend the lease for another 13 months, with the monthly payments in this additional 13-month period being 80 per cent of normal market rates. Agreement 3 Leoni Ltd has signed a contract to lease a shop with an initial non-cancellable period of three years and with an available lease extension for an additional two years should both Leoni Ltd and the lessor agree. Agreement 4 Leoni Ltd has signed a contract to lease a machine for a non-cancellable period of four years. The arrangement also provides an option for Leoni Ltd to renew the lease for a further two years at market rates. Leoni Ltd has modified the machine and these modifications are expected to still be valuable in the two-year period of the lease renewal, if the decision to renew the lease is made.

REQUIRED What is the ‘lease term’ in each of the above agreements? LO 11.5 13. Why would the carrying amount of a lease asset typically reduce more quickly than the carrying amount of a lease liability? LO 11.7 14. What are initial direct costs and how are lessees and lessors required to account for them? LO 11.7, 11.11 15. When a lessor leases an asset to a lessee, will the underlying asset appear in the balance sheet of the lessor and will the lessor depreciate the underlying asset? LO 11.10, 11.12 16. Rankin Ltd has entered into an agreement to lease an item of equipment that produces teddy bears. The terms of the lease are as follows: • Date of entering lease: 1 July 2019. • Duration of lease: 10 years. • Life of leased asset: 10 years. • There is no residual value. • Lease payments: $5000 at lease inception, $5500 on 30 June each year (that is, 10 payments). • Included within the lease payments are executory costs of $500. • Fair value of the machine at lease inception: $27 470.

REQUIRED Determine the interest rate implicit in the lease. LO 11.8 17. Burt Ltd enters into a non-cancellable five-year lease agreement with Earnie Ltd on 1 July 2019. The lease is for an item of machinery that, at the inception of the lease, has a fair value of $1 294 384. The machinery is expected to have an economic life of six years, after which time it will have an expected residual value of $210 000. There is a bargain purchase option that Burt Ltd will be able to exercise at the end of the fifth year for $280 000. There are to be five annual payments of $350 000, the first being made on 30 June 2020. Included within the $350 000 lease payments is an amount of $35 000 representing payment to the lessor for the insurance and maintenance of the equipment. The equipment is to be depreciated on a straight-line basis. 420  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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REQUIRED (a) Determine the rate of interest implicit in the lease and calculate the present value of the lease payments. LO 11.8 (b) Prepare the journal entries in the books of Burt Ltd for the years ending 30 June 2020 and 30 June 2021. LO 11.2, 11.3, 11.4, 11.5, 11.6, 11.7 (c) Prepare the portion of the statement of financial position for the year ending 30 June 2021 relating to the lease asset and lease liability. LO 11.6, 11.7 18. Gregory Ltd enters into a non-cancellable five-year lease agreement with Sanders Ltd on 1 July 2019. The lease is for an item of machinery that, at the inception of the lease, has a fair value of $231 140. The machinery is expected to have an economic life of seven years, after which time it will have no residual value. There is a bargain purchase option, which Gregory Ltd will be able to exercise at the end of the fifth year, for $50 000. Sanders Ltd manufactures the machinery. The cost of the machinery to Sanders Ltd is $200 000. There are to be five annual payments of $62 500, the first being made on 30 June 2020. Included within the $62 500 lease payments is an amount of $6250 representing payment to the lessor for the insurance and maintenance of the machinery. The machinery is to be depreciated on a straight-line basis. The rate of interest implicit in the lease is 12 per cent.

REQUIRED Prepare the journal entries for the years ending 30 June 2020 and 30 June 2021 in the books of: (a) Sanders Ltd (b) Gregory Ltd. LO 11.2, 11.3, 11.4, 11.5, 11.6, 11.7, 11.11, 11.12

CHALLENGING QUESTIONS 19. In an address entitled ‘Introductory comments to the European Parliament’ (made in Brussels, Belgium) on 11 January 2016, the Chairperson of the IASB, Hans Hoogervorst, made the following comments in relation to the new accounting standard on accounting for leases (as reported 11 January 2016 on the IASB webside at www.ifrs.org): I would like to make some comments about our upcoming Leases Standard, which we will publish the day after tomorrow. Currently, listed companies around the world have around 3 trillion euros’ worth of leases, especially in sectors such as the airline industry, retail and shipping. Under current accounting requirements, over 85 per cent of these leases are labelled as operating leases and are not recorded on the balance sheet. Clearly, the accounting today does not reflect economic reality. Despite operating leases being off balance sheet, there can be no doubt that they create real liabilities. During the financial crisis, some major retail chains went bankrupt because they were unable to adjust quickly to the new economic reality. They had significant long-term operating lease commitments on their stores, and yet had deceptively lean balance sheets. In fact, their off balance sheet lease liabilities were up to 66 times greater than the debt reported on their balance sheet. Moreover, the current accounting for leases leads to a lack of comparability. An airline that leases most of its aircraft fleet looks very different from its competitor that bought most of its fleet, even when in reality their financing obligations may be very similar. There is no level playing field between these companies. These problems will be resolved in the upcoming Leases Standard. All leases will be recognised as assets and liabilities by lessees. The accounting will better reflect the underlying economics. This change is expected to affect roughly half of all listed companies and will not be popular with everyone. Accounting changes are often controversial and can be met with warnings of adverse economic effects and costs of system changes. The IASB has looked at all these possible risks very carefully and we will publish a detailed effect analysis on the Standard. Our conclusion is that the risks and costs of the new Leases Standard are manageable. First of all, IFRS 16 will not put the leasing industry out of business. Leases will remain attractive as a flexible source of finance. It will remain appealing to companies to lease assets so that they do not bear the risks of owning them. While CHAPTER 11: ACCOUNTING FOR LEASES  421

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the cosmetic accounting benefits of leasing will disappear, the real business benefits of leasing will not change as a result of the new Standard. We do not deny there will be costs involved in updating systems to implement the new Leases Standard, but we have done our best to keep these costs to a minimum. For example, we are not requiring companies to recognise assets and liabilities for short term and small ticket leases. This should be especially beneficial for smaller companies. In sum, we expect the benefits of the new Leases Standard to greatly outweigh its costs. The new visibility of all leases will lead to better informed investment decisions by investors, and to more balanced lease-versus-buy decisions by management. IFRS 16 will lead to improved capital allocation, which should be beneficial for economic growth.

REQUIRED (a) Explain why the Chairperson of the IASB believes that the former accounting standard for leases did ‘not reflect economic reality’. LO 11.1 (b) What is the reason why, under the former accounting standard, reporting entities’ ‘off balance sheet lease liabilities were up to 66 times greater than the debt reported on their balance sheet’? LO 11.1 (c) Why does the Chairperson of the IASB argue that under the former accounting standard for leases there was ‘no level playing field’ between some airline companies? LO 11.1 (d) Why do you think the Chairperson of the IASB said that the new accounting standard for leases ‘will not be popular with everyone’? What would cause this unpopularity? LO 11.13 (e) What are some of the possible reasons why the Chairperson of the IASB would say: ‘The new visibility of all leases will lead to better informed investment decisions by investors, and to more balanced lease-versus-buy decisions by management’? LO 11.1, 11.4, 11.7 20. There were extensive consultation and deliberation processes involved in the development of IFRS 16. Specifically, there was, according to IASB (2016a): • a 2009 Discussion Paper; • a 2010 Exposure Draft; • a 2013 Revised Exposure Draft; • more than 1700 comment letters received and analysed; • meetings with IASB’s advisory bodies; • hundreds of outreach meetings with investors, analysts, preparers, regulators; standard-setters, accounting firms, and others; and • 15 public round table meetings.

REQUIRED Provide some explanations to why this process took so long and why so many comment letters were received by the IASB. LO 11.1, 11.13 21. According to IASB (2016a), the implementation of IFRS 16 is expected to: (a) improve comparability between companies that lease assets and companies that borrow to buy assets; and (b) create a more level playing field in providing transparent information about leases to all market participants.

REQUIRED Provide an explanation for the above views. LO 11.1 22. In IASB (2016b, p.5) it is stated: The IASB acknowledges that the change in lessee accounting (brought about by the release of IFRS 16) might have an effect on the leasing market if companies decide to buy more assets and, as a consequence, lease fewer assets.

REQUIRED Provide a possible explanation as to why, when now required to capitalise leases, reporting entities might be more likely to buy more assets, and lease fewer assets. LO 11.1, 11.13

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23. On 1 July 2019, Iselin Ltd signs a non-cancellable agreement to lease a building from Weber Ltd. The lease agreement requires seven annual payments of $375 000, with the first payment being made on 30 June 2020. Within each  of these payment, $25 000 represents a payment to Weber Ltd for rates and maintenance of the property. The building is expected to have a life of only nine years, after which time it will have no salvage value. At 1 July 2019 the land and building have a fair value of $588 160 and $1 372 370 respectively. The land and building are expected to have a value (unguaranteed by the lessee) of $500 000 at the end of year 7, with the land component expected to be worth $150 000 and the building component expected to be worth $350 000. The rate of interest implicit in the lease is 10 per cent.

REQUIRED (a) Prove that the rate of interest implicit in the lease is 10 per cent. LO 11.8 (b) Provide the journal entries for the years ending 30 June 2020 and 30 June 2021 for Iselin Ltd. LO 11.2, 11.3, 11.4, 11.5, 11.6, 11.7 (c) Provide the journal entries for the years ending 30 June 2020 and 30 June 2021 for Weber Ltd. LO 11.2, 11.3, 11.4, 11.5, 11.11, 11.12 24. Consider the following two illustrative examples, which involve a fibre optic cable (and which were discussed within IASB, October 2015) and determine for each example whether: • there is an identifiable asset; • the customer controls the use of the identified asset throughout the period of use; • the contract contains a lease. LO 11.2, 11.4 Example A Customer enters into a 15-year contract with a utilities company (Supplier) for the right to use three specified, physically distinct dark fibres within a larger cable connecting Hong Kong to Tokyo. Customer makes the decisions about the use of the fibres by connecting each end of the fibres to its electronic equipment (i.e. Customer ‘lights’ the fibres and decides what data, and how much data, those fibres will transport). If the fibres are damaged, Supplier is responsible for the repairs and maintenance. Supplier owns extra fibres, but can substitute those for Customer’s fibres only for reasons of repairs, maintenance or malfunction (and is obliged to substitute the fibres in these cases). Example B Customer enters into a 15-year contract with Supplier for the right to use a specified amount of capacity within a cable connecting Hong Kong to Tokyo. The specified amount is equivalent to Customer having the use of the full capacity of three fibre strands within the cable (the cable contains 15 fibres with similar capacities). Supplier makes decisions about the transmission of data (i.e. Supplier lights the fibres and makes decisions about which fibres are used to transmit Customer’s traffic and the electronic equipment connected to the fibres). 25. Explain why the release of IFRS 16, and subsequently AASB 16, might have been expected to influence a number of agreements organisations may have negotiated with lenders, or with their senior managers. LO 11.1, 11.13 26. Determine for each of the following arrangements the manner in which the relevant lease should be classified by the lessor pursuant to IFRS 16/AASB 16. Give reasons for your answers. (a) Company A enters into a non-cancellable lease with a five-year term for an item of plant, which has an expected useful life of eight years. The lease is renewable for a further two-year period at commercial rates prevailing at the time of renewal. The present value of the minimum lease payments is equal to 80 per cent of the fair value of the leased property at the inception of the lease. The remaining 20 per cent of the fair value is represented by the guaranteed residual value. The residual value has been guaranteed by an independent third party, an insurance company, which is unrelated to either the lessor or the lessee. LO 11.10 (b) Company B enters into a non-cancellable lease with a seven-year term for an item of plant, which has an expected useful life of 10 years. The present value of minimum lease payments is equal to 75 per cent of the fair value of the asset at the date of inception of the lease. The residual value accounts for the remaining 25 per cent. So confident is the lessor that the plant will retain its value that it is guaranteeing 50 per cent of the residual value, with the lessee being responsible for guaranteeing the remaining 50 per cent of the residual value. LO 11.10

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(c) Company C enters into a non-cancellable lease with a five-year term for a large commercial vehicle, which has an expected useful life of eight years. The lease is renewable for a further two years at commercial rates prevailing at the time of renewal. The present value of minimum lease payments is equal to 65 per cent of the fair value of the asset at the date of inception of the lease. The residual value is not guaranteed by the lessee and the vehicle will revert to the lessor. In a separate agreement, the lessee has written a put option, which entitles the lessor to put the leased property to the lessee in five years’ time on payment of an amount equal to the residual value of the leased asset. LO 11.10 (d) Company D enters into a non-cancellable lease for plant with a term of eight years. The plant has a useful economic life of 12 years. Company D has an option to renew the lease with the same rental for a further four years, even though market rentals are expected to increase with inflation over the next decade. The present value of the minimum lease payments is 70 per cent of the sum of the fair value of the plant. LO 11.10 27. Classic Malibu Ltd decides to lease some machinery from Noosaville Ltd on the following terms:

• • • • • •

Date of entering lease: 1 July 2019. Duration of lease: 10 years. Life of leased asset: 10 years. Unguaranteed residual value: $15 000. Lease payments: $10 000 at lease inception, $12 000 on 30 June each year for the next 10 years. Fair value of leased asset at date of lease inception: $97 469.

REQUIRED Determine the interest rate implicit in the lease. LO 11.8 28. Mark Richards Ltd enters an agreement to lease an asset from Michael Petersen Ltd. The lease term is for seven years and the leased asset is initially recorded in Mark Richards Ltd’s accounts as $250 000 at the date of lease inception. The asset is expected to have a useful life of eight years. The lease terms include a guaranteed residual of $20 000 and Mark Richards expects that the asset will have a residual value of $10 000 at the end of its useful life.

REQUIRED Determine the lease depreciation expense assuming that: (a) Mark Richards Ltd is expected to get ownership of the asset at the end of the lease term. LO 11.5, 11.7 (b) Mark Richards Ltd is not expected to get ownership of the asset at the end of the lease term. LO 11.5, 11.7 29. On 1 July 2019, Flyer Ltd decides to lease an aeroplane from Finance Ltd. The term of the lease is 20 years. The implicit interest rate in the lease is 10 per cent. It is expected that the aeroplane will be scrapped at the end of the lease term. The fair value of the aeroplane at the commencement of the lease is $2 428 400. The lease is non-cancellable, returns the aeroplane to Finance Ltd at the end of the lease, and requires a lease payment of $300 000 on inception of the lease (on 1 July 2019) and lease payments of $250 000 on 30 June each year (starting 30 June 2020). There is no residual payment required.

REQUIRED (a) Provide the entries for the lease in the books of Flyer Ltd as at 1 July 2019. LO 11.3, 11.4, 11.5, 11.6, 11.7 (b) Provide the entries for the lease in the books of Finance Ltd as at 1 July 2019. LO 11.3, 11.4, 11.5, 11.10, 11.11, 11.12 (c) Provide the journal entries in the books of Flyer Ltd for the final year of the lease (that is, the entry in 20 years’ time). LO 11.3, 11.4, 11.5, 11.6, 11.7 (d) Provide the journal entries in the books of Finance Ltd for the final year of the lease (that is, the entry in 20 years’ time). LO 11.3, 11.4, 11.5, 11.10, 11.11, 11.12 30. Deliveries Ltd leased a truck from a truck dealer, City Vans Ltd. City Vans Ltd acquired the truck at a cost of $180 000. The truck will be painted with Deliveries Ltd’s logo and advertising and the cost of repainting the truck to make it suitable for another owner four years later is estimated to be $40 000. Deliveries Ltd plans to keep the 424  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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truck after the lease but has not made any commitment to the lessor to purchase it. The terms of the lease are as follows: • Date of entering lease: 1 July 2019. • Duration of lease: four years. • Life of leased asset: five years, after which it will have no residual value. • Lease payments: $100 000 at the end of each year. • Interest rate implicit in the lease: 10 per cent. • Unguaranteed residual: $50 000. • Fair value of truck at inception of the lease: $351 140.

REQUIRED (a) Demonstrate that the interest rate implicit in the lease is 10 per cent. LO 11.8 (b) Prepare the journal entries to account for the lease transaction in the books of the lessor, City Vans Ltd, at 1 July 2019 and 30 June 2020. LO 11.3, 11.4, 11.5, 11.10, 11.11, 11.12 (c) Prepare the journal entries to account for the lease transaction in the books of the lessee, Deliveries Ltd, at 1 July 2019 and 30 June 2020. LO 11.3, 11.4, 11.5, 11.6, 11.7 (d) On 30 June 2023 Deliveries Ltd pays the residual of $50 000 and purchases the truck. Prepare all journal entries in the books of Deliveries Ltd for 30 June 2023 in relation to the termination of the lease and the purchase of the truck. LO 11.3, 11.4, 11.5, 11.6, 11.7 31. Hopeful Ltd leased a portable sound recording studio from Lessor Ltd. Lessor has no material initial direct costs. Hopeful Ltd does not plan to acquire the portable studio at the end of the lease because it expects that, by then, it will need a larger studio. The terms of the lease are as follows: • Date of entering lease: 1 July 2019. • Duration of lease: four years. • Life of leased asset: five years. • Lease payments: $50 000 at the beginning of each year. • First lease payment: 1 July 2019. • Lease expires: 1 July 2023. • Interest rate implicit in the lease: 8 per cent. • Guaranteed residual: $40 000.

REQUIRED (a) Determine the fair value of the portable sound recording studio at 1 July 2019. LO 11.7, 11.10 (b) Prepare a schedule for the lease payments incorporating accrued interest expense. LO 11.5, 11.6, 11.7, 11.8 (c) Prepare the journal entries to account for the lease in the books of Hopeful Ltd at 1 July 2019, 30 June 2020 and 1 July 2020. LO 11.3, 11.4, 11.5, 11.6, 11.7 (d) At the termination of the lease, Hopeful Ltd returns the portable sound recording studio to Lessor Ltd, but its fair value at that time is $25 000. What must Hopeful Ltd do to comply with the terms of the lease? Prepare the journal entries in the books of Hopeful Ltd for return of the asset to Lessor Ltd and the settlement of all obligations under the lease on 1 July 2023. LO 11.3, 11.4, 11.5, 11.6, 11.7

REFERENCES EL GAZAAR, S.M., 1993, ‘Stock Market Effects of the Closeness to Debt Covenant Restrictions Resulting from Capitalisation of Leases’, Accounting Review, April, pp. 258–72. INTERNATIONAL ACCOUNTING STANDARDS BOARD & FINANCIAL ACCOUNTING STANDARDS BOARD, 2009, Discussion Paper DP/2009/01, Leases: Preliminary Views, IASB, March, London. CHAPTER 11: ACCOUNTING FOR LEASES  425

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INTERNATIONAL ACCOUNTING STANDARDS BOARD & FINANCIAL ACCOUNTING STANDARDS BOARD, 2013, Exposure Draft ED/2013/6 Leases, IASB, May, London. INTERNATIONAL ACCOUNTING STANDARDS BOARD & FINANCIAL ACCOUNTING STANDARDS BOARD, 2014, Project Update: Leases, IASB, August, London. INTERNATIONAL ACCOUNTING STANDARDS BOARD & FINANCIAL ACCOUNTING STANDARDS BOARD, 2015, Project Update: Leases: Practical Implications of the New Leases Standard, IASB, March, London. INTERNATIONAL ACCOUNTING STANDARDS BOARD & FINANCIAL ACCOUNTING STANDARDS BOARD, 2015, Leases Project Update: Definition of a Lease, IASB, October, London. INTERNATIONAL ACCOUNTING STANDARDS BOARD & FINANCIAL ACCOUNTING STANDARDS BOARD, 2016a, Project Summary and Feedback Statement IFRS 16 Leases, IASB, October, London. INTERNATIONAL ACCOUNTING STANDARDS BOARD & FINANCIAL ACCOUNTING STANDARDS BOARD, 2016b, Effects Analysis IFRS 16 Leases, IASB, October, London.

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CHAPTER 12

ACCOUNTING FOR EMPLOYEE BENEFITS LEARNING OBJECTIVES (LO) 12.1 Understand the various forms of benefits that employees can receive from their employers. 12.2 Be able to account for various forms of employee benefits, including salaries and wages, annual leave, sick leave, long-service leave and superannuation. 12.3 Understand whether particular employee entitlement obligations should be recorded at their nominal value or at their discounted present value. 12.4 Know the accounting implications associated with sick leave that vests, relative to sick leave that does not vest. 12.5 Be able to explain the difference between a ‘defined benefit’ and a ‘defined contribution’ superannuation plan and be aware of the different accounting treatments of each. 12.6 Be able to provide the necessary disclosures in conformity with AASB 119 Employee Benefits. 12.7 Understand that even if an employee-related liability (provision) has been recognised, this does not ensure that employees will ultimately receive payment for their entitlements should the employer subsequently encounter financial difficulties.

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LO 12.1 LO 12.2

Overview of employee benefits

Under their employment agreement with an employer, employees can receive various forms of benefits in return for their services. Such benefits will usually lead to the recognition of expenses by the employer, and any benefits (also referred to as entitlements) that have been earned by employees, but not paid as at the end of the reporting period, become liabilities from the perspective of the employer. If the services of employees are used to generate items that are expected to provide future economic benefits—for example, employees generate inventories in the form of work in progress—then amounts paid or payable may be considered to be part of the cost of the respective assets. The relevant accounting standard for accounting for employee benefits is AASB 119 Employee Benefits. ‘Employee’ is not actually defined in AASB 119, but it does define ‘employee benefits’. Paragraph 8 of AASB 119 defines ‘employee benefits’ as ‘all forms of consideration given by an entity in exchange for service rendered by employees, or for the termination of employment’. We will now consider some of the possible components of employee benefits.

Wages and salaries The terms ‘wages’ and ‘salaries’ are often used interchangeably. Traditionally, wages were paid for manual labour, while salaries were paid to other employees. This distinction has blurred in recent times. Now, the word ‘salaries’ typically refers to a regular payment made to an employee on a periodic basis, typically fortnightly. annual leave Number of weeks of paid leave to which full-time employees are entitled in a year.

Annual leave

Generally speaking, most full-time employees are entitled to a specified number of weeks of paid annual leave each year. A common entitlement within Australia is four weeks per year. This amount is usually provided over and above any entitlements to public holidays. Normally, annual leave entitlements accrue from the commencement of duties. Some organisations have restrictions on the maximum amount of annual leave entitlements that can be carried forward. When employees finish their time with a particular employer, they are normally paid on departure for any annual leave earned but not taken.

sick leave Paid leave entitlement per year for when an employee is not fit for duties.

Sick leave

Employees are generally entitled to a specified amount of paid sick leave each year. The entitlements are usually dependent upon the amount of time the employee has been in the employment of the employer concerned. In some organisations there is an upper limit to the amount of sick leave that can accrue. Sick leave can be classified as cumulative or non-cumulative. Cumulative sick leave continues to accrue until employment ceases. For example, if an employee is entitled to two weeks of paid sick leave each year and that employee has been with an employer for two years and has not taken any sick leave, the employee would be entitled to up to four weeks’ paid paid sick leave if the need arises. Non-cumulative sick-leave entitlements, on the other hand, lapse if not taken. Hence, the maximum entitlement would be two weeks per year for the same employee. Unused sick leave might or might not be paid out when an employee resigns or retires, depending on the terms of the employment contract. Sick leave that can be paid out is typically referred to as ‘vesting’ sick leave. If the entitlement to sick leave lapses when employment ceases, such entitlements would be referred to as ‘non-vesting’. Whether or not unused sick leave is paid out on resignation or retirement will have direct implications for how the employer accounts for employee sick leave entitlements. Most sick leave entitlements in Australia are ‘non-vesting’—that is, when the employee leaves the organisation, the employee is not paid for any unused sick leave.

Long-service leave long-service leave Leave in addition to annual leave granted if an employee stays with an employer for a minimum number of periods.

In Australia, unlike many other countries, employees are generally entitled to additional leave, known as long-service leave, over and above their annual leave if they stay with a particular firm for a minimum number of periods. A common entitlement in Australia is that employees who remain with a particular employer for 15 years will receive an entitlement of 13 weeks’ paid leave. Within a limited number of industries or occupations it is possible to transfer long-service leave entitlements from one employer to another. For example, Australian university academics are generally able to negotiate an arrangement whereby service performed in one Australian university may be transferred for the

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purposes of long-service leave calculations to a subsequent university if they elect to move. Within Australian universities, employees are typically entitled to 13 weeks’ long-service leave after 10 years of service, and after 10 years of service the entitlements grow on a pro-rata basis.

Superannuation

superannuation Payments made to employees after their retirement, in a stream of periodic payments or a lump sum on termination.

Employees generally receive superannuation entitlements as part of their employment agreement. This usually involves the employer transferring funds to an independent superannuation fund that is administered by an independent trustee. Within Australia we have a compulsory superannuation contribution referred to as the ‘Superannuation Guarantee’, and it is currently equivalent to 9.5 per cent of an employee’s wage (this is a minimum and some employers pay more than 9.5 per cent). Pursuant to the Superannuation Guarantee, an employee is entitled to superannuation contributions from an employer if they are: 1. at least 18 years of age and 2. paid $450 or more (before tax) in a month. This applies to full-time, part-time or casual employees and the payment does not come out of the employees’ wages. Rather, it is an extra payment made by the employer. Payment to a superannuation fund can be contributory (both employee and employer make periodic contributions to the fund) or non-contributory (only the employer makes contributions to the fund). Typically, employees may receive payments from the fund only after retirement and upon attaining a specified age, commonly between 55 and 60 years of age. The fund might allow for the payment of a lump sum, a pension, or a combination of the two. Superannuation funds might pay benefits that are based on an employee’s final salary or their average salary over a number of years. Such funds would be classified as defined benefit funds. Alternatively, funds might pay benefits that are based on the contributions made to the funds and the earnings on those specific funds. In this case, the fund would be classified a defined contribution fund (also often referred to as an ‘accumulation fund’).

Share entitlements

defined benefit fund A fund where the amounts to be paid to members at normal retirement age are specified or determined, at least partly, by years of membership and/or salary level.

defined contribution fund A fund where the amounts to be paid to members at normal retirement age are determined by accumulated contributions and the earnings of the fund.

Some employers provide their employees with shares in the organisation as part of their total salary package. These shares can be issued by way of an interest-free loan to the employee or they can be issued at a discount on the prevailing market price. Generally speaking, the philosophy behind offering shares to employees is that it is hoped that, by doing so, employers will make employees feel more a part of the organisation. Further, since they are being made owners of the organisation, employees are assumed to be likely to work harder towards increasing the value of the organisation and, consequently, the value of their own shareholding. In some organisations, employees have also been offered the right to acquire shares in the share option future for a pre-specified price. These are known as share options. For example, an organisation Entitlement that gives might provide some of its employees with options to buy a specified number of shares in five years’ the holder the right time for a price equal to the current market price of the organisation’s shares. If employees stay with to buy shares at or the organisation and the share price increases—which might in part be a result of the efforts of the before a future date at a specified price. employees—they can make significant gains. Sometimes there are restrictions on the timing of when such options may be exercised. In Australia, for example, generally an option’s life may not legally be more than five years. This can act as a means of encouraging employees to stay within the organisation if there is a related requirement that they must still be an employee of the organisation to exercise their options and buy the shares—departure before the date when the options may be exercised might result in a significant financial loss being imposed upon the employee. For such reasons, share options are often offered to ‘key’—or important—employees. Because of their employee-retention characteristics, share options are often referred to as a type of ‘golden hand-cuff’. Accounting for share options is considered further in Chapter 17, which addresses share-based payments.

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Bonuses As indicated in Chapter 3, employees can also be offered various forms of performance-based rewards. For example, an employee might receive a cash bonus based on the profits of the employer. Other accounting-based performance measures are also often used as a basis for assessing and rewarding employees’ work. For example, cash bonuses might be paid on the basis of sales, or return on assets. Cash bonuses might also be tied to increases in the organisation’s share prices. Shares, or options to buy shares, might also be provided to employees if certain performance requirements are met.

Other entitlements There are a variety of other ways in which employees can be paid that are not discussed here. Some payments are made after the employee has left the organisation. These are referred to as ‘post-employment benefits’ and can include, apart from cash payments, the employer making payments for the employee’s medical costs, insurance costs and so forth. What should be apparent from the above discussion, however, is that because there are so many ways in which employees can be paid or rewarded by employers for their services, many issues arise about how to account for employee benefits. Many of these issues relate to considerations of measurement, particularly in relation to employee benefit expenses, and related liabilities. Other issues relate to ‘recognition’—that is, when should the employee benefits be recognised within the financial statements. We will now consider, in more depth, some of the categories of employee benefits.

LO 12.1 LO 12.2 LO 12.3

Categories of employee benefits AASB 119 divides employee benefits into a number of categories. These include: • • • •

short-term employee benefits post-employment benefits (which would include pensions payable through a superannuation fund) termination benefits other long-term employee benefits (which would include long-service leave).

In relation to the above categories, AASB 119 defines ‘short-term employee benefits’ as ‘employee benefits (other than termination benefits) that are expected to be settled wholly before twelve months after the end of the annual reporting period in which the employees render the related service’. Short-term employee benefits include wages, salaries and social security contributions. They also include annual leave and sick leave to the extent they are paid within 12 months of the period in which the employee renders the employee services. Short-term employee benefits must be measured on an undiscounted basis (also referred to as their ‘nominal amount’)—that is, present values are not to be used. In this regard, paragraph 11 of AASB 119 requires: When an employee has rendered service to an entity during an accounting period, the entity shall recognise the undiscounted amount of short-term employee benefits expected to be paid in exchange for that service: (a) as a liability (accrued expense), after deducting any amount already paid. If the amount already paid exceeds the undiscounted amount of the benefits, an entity shall recognise that excess as an asset (prepaid expense) to the extent that the prepayment will lead to, for example, a reduction in future payments or a cash refund; and (b) as an expense, unless another Australian Accounting Standard requires or permits the inclusion of the benefits in the cost of an asset (see, for example, AASB 102 Inventories, and AASB 116 Property, Plant and Equipment). For salaries and wages, social security contributions and other employee benefits (for example, termination benefits, post-employment benefits and other long-term employment benefits) that do not fall due wholly within 12 months of the end of the period in which the employee renders the related service, AASB 119 requires that the related obligations be discounted to their present value. The discount rate to be used is to be determined by reference to market yields at the end of the reporting period on ‘high-quality corporate bonds’. Hence, it is not a requirement of AASB 119 that the reporting entity’s own earnings rate be used to discount the related obligations.

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We will now consider the accounting treatment for some of the various forms of employee benefits. It should be appreciated that the following discussion does not cover all of the forms of employee benefits contemplated by AASB 119. Nevertheless, it includes the most commonly used components of employee benefit packages.

Accounting for employee benefits

LO 12.2 LO 12.3 LO 12.4 LO 12.5 LO 12.6

Salaries and wages

As we have noted, for short-term employee benefits such as salaries and wages payable within 12 months of the end of the reporting period, there is no requirement to discount any outstanding obligations to their present value. In relation to obligations for salaries and wages, liabilities for salaries and wages (and annual leave) entitlements will arise only where the services have been rendered by the employee but the associated entitlements have not been paid as at the end of the reporting period. Worked Example 12.1 gives an example of accounting for salaries and wages. In Worked Example 12.1, salaries and wages are treated as an expense in the same period in which the obligation to make the payment is recorded. At times, however, the amount might instead be treated as an asset. For example, consider amounts due to employees working on the production of particular items of inventory that will subsequently be

WORKED EXAMPLE 12.1: Accounting for salaries and wages Thruster Ltd employs its staff on a five-day work week, with employees being paid on Fridays. The weekly salaries expense is $10 000 and employees are paid in arrears. That is, when the employees are paid, the salaries paid are for work performed in the preceding week. Thruster Ltd retains $3 000 per week to pay the Australian Taxation Office for pay-as-you-go (PAYG) tax on behalf of the employees. This is paid on the following Monday of each week. It also retains $500 per week to pay staff premiums to the Oceanic Medical Benefits Fund. If we assume that the end of the reporting period falls on a Thursday, the accounting entry at the end of the reporting period to recognise four days’ salary and wages expense would be: Dr Wages and salaries expense Cr PAYG tax payable Cr Oceanic MBF payable Cr Wages and salaries payable (8 000 = 10 000 × 4/5)

8 000 2 400 400 5 200

When the wages are ultimately paid to employees on Friday, the entry (assuming no reversing entry is made at the beginning of the new period) would be: Dr Wages and salaries expense 2 000 Dr Wages and salaries payable 5 200 Cr PAYG tax payable 600 Cr Oceanic MBF payable 100 Cr Cash at bank 6 500 ($2 000 represents one day’s salary, which would be included as an expense of the new financial period; the employees would receive the net amount after deduction of the PAYG tax and the medical fund contribution, that is $10 000 less $3 000, less $500) When the amounts are paid to the Australian Taxation Office (ATO) and the medical fund on Monday, the entry would be: Dr Dr Cr

PAYG tax payable Oceanic MBF payable Cash

3 000 500 3 500

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sold, thereby providing future economic benefits for the employer. The salaries and wages in such cases would initially be recorded as part of work in progress (that is, treated as part of the cost of an asset). They would then be transferred to finished goods and would ultimately become an expense in the form of cost of goods sold. The cost of employee benefits can also be included in the cost of property, plant and equipment to the extent that employees are involved in establishing an item of property, plant and equipment for use. As paragraph 17 of AASB 116 Property, Plant and Equipment stipulates, costs of employee benefits directly attributable to the construction or acquisition of an item of property, plant and equipment are to be included within the cost of the asset. Other than through possible impairment losses, such costs would typically be recognised through periodic depreciation. Employees frequently receive bonuses related to performance in a preceding period. For example, an employee might receive a bonus of 5 per cent of net profits for the year. Such bonuses form part of salaries and wages and are to be treated in the same manner.

Annual leave As noted earlier, in Australia it is typical for employees to be given four weeks’ annual leave entitlement for each year in which they are employed. Many employees within Australia also receive an additional annual leave loading of 17.5 per cent. This is not the case in many other countries. To the extent that the obligation is payable within 12 months of the end of the reporting period, there is no need to discount the obligation to its present value. In Worked Example 12.2, we consider how to account for annual leave.

WORKED EXAMPLE 12.2: Accounting for annual leave Terry Fitzgerald works for Hot Buttered Ltd. He receives an annual salary of $70 000 and is entitled to four weeks’ annual leave and to a leave loading of 17.5 per cent. Terry Fitzgerald’s annual leave will, therefore, cost his employer: $70 000 × 4 ÷ 52 × 1.175 = $6 327 (or $122 per week) Therefore, the total amount paid to Fitzgerald each year would be: For 48 weeks at normal pay rate For four weeks inclusive of loading Total salary and annual leave

70 000 × 48 ÷ 52 70 000 × 4 ÷ 52 × 1.175

= $64 615 = $6 327 = $70 942

If Hot Buttered Ltd recognises the annual leave obligation throughout the year, there would be, apart from the types of entries shown in Worked Example 12.1, the following entry each week: Dr Annual leave expense Cr Provision for annual leave [122 = (70 000 × 4 ÷ 52 × 1.175) ÷ 52]

122 122

If Fitzgerald then takes two weeks’ annual leave, the entry would be (assuming the tax per week is $500 and there are no deductions for medical benefits): Dr Provision for annual leave Cr PAYG tax payable Cr Cash at bank (3163.5 = 6327 ÷ 2)

3163.50 1000.00 2163.50

Hot Buttered Ltd would also need to provide the usual weekly annual leave journal entry, even when Fitzgerald is on holidays: Dr Cr

Annual leave expense Provision for annual leave

122 122

It should be noted that in Worked Example 12.2 we did not consider some of the other costs that are also incurred as a result of employing an individual. For example, the employer incurs not only the actual direct wage cost of an employee but also a number of other costs, such as payroll tax, workers’ compensation insurance and superannuation 432 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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contribution. These additional costs of employing someone, which are not received directly by the employee, are usually called ‘on-costs’. When calculating the employer’s obligations for employee benefits (such as for annual leave, sick leave, long-service leave and superannuation) such costs should be explicitly considered.

Sick leave

on-costs Costs other than salaries and wages incurred by an employer as a result of employing individuals.

Sick-leave entitlements are divided into two types, these being vesting sick-leave entitlements and non-vesting sick-leave entitlements. Vesting sick leave can accumulate and vest in a similar manner to annual leave, and any unused accrued entitlements can be paid out to employees when they resign from the employer. The accounting entries for vesting cumulative sick leave would therefore be similar to those used for annual leave, as shown in Worked Example 12.2. Non-vesting sick-leave entitlements will be paid only upon a valid claim for sick leave by the employee. For accounting purposes, when it comes to non-vesting sick leave, only that part of the entitlement which has accumulated through past service and which is expected to be taken should be recognised as a liability within the financial statements. As with all expenses, liabilities, assets and income, the sick-leave entitlement should be recognised only when it is capable of being reliably measured (see Worked Example 12.3).

WORKED EXAMPLE 12.3: Accounting for non-vesting sick leave Dion Ltd has a weekly payroll of $100 000. In accordance with common practice, the employees are entitled to two weeks’ sick leave per year. However, the entitlements to unused sick leave do not accrue. Further, any unused sick leave for the year will not be paid out should the employee resign or retire (i.e. it is not ‘vesting’). The management of Dion Ltd believe that past experience within the organisation and within the industry suggests that 50 per cent of employees will take their full entitlement each year and 20 per cent of employees will take one week’s sick leave each year. The balance of the employees are assumed to take no sick leave. The expected annual sick-leave expense for Dion Ltd (on the basis of average salaries) would therefore be: $100 000 × 2 × 0.5 $100 000 × 1 × 0.2

= $100 000 =   $20 000 $120 000

This would equate to $2 308 per week. On this basis, Dion Ltd could pass the following journal entry each week: Dr Sick-leave expense 2 308 Cr Provision for sick leave 2 308 (2308 = 120 000 ÷ 52) Subsequently, if employees are sick, their entitlements are charged to provision for sick leave rather than to salaries and wages. For example, if Farrelly, who has a weekly salary of $400—which is $80 per work day—is ill for three days and works two days, the accounting entry for the week, assuming a 20 per cent tax rate, would be: Dr Dr Cr Cr

Provision for sick leave Salaries and wages PAYG tax payable Cash at bank

240 160  80 320

Long-service leave Long-service leave liabilities must be accrued, and the liability is to be measured at its present value to the extent that the obligation is payable beyond 12 months after the end of the reporting period. The initial version of AASB 119 that was operative in 2005 included some additional guidance on how to account for long-service leave. This guidance was found in a section of the standard entitled ‘Australian Guidance’. At a meeting of the AASB in April 2006 it was decided Chapter 12: ACCOUNTING FOR EMPLOYEE BENEFITS  433

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to delete all of the Australian guidance to AASB 119. This was a (perhaps unfortunate) policy decision made by the AASB that entailed the AASB removing additional Australian guidance from a number of accounting standards. Nevertheless, the insight provided by the former guidance continues to be a useful point of reference. Paragraphs G4 to G8 of the former ‘Australian Guidance’ section of AASB 119 addressed long-service leave. Paragraph G4 identified three common categories of long-service leave entitlement: 1. Preconditional period—in the early years of employment no legal entitlement to any cash payment or leave will exist until such time as the individual has been employed for the minimum period of service necessary to qualify for the entitlement. If the employee leaves in this early period, no long-service leave entitlement is required to be paid by the employer. 2. Conditional period—in certain circumstances a legal entitlement to pro rata payment in lieu of long-service leave arises after a conditional period of service has been completed. For example, the employment agreement might provide that employees are entitled to take 13 weeks’ leave after 15 years of service. The agreement might provide further that, once a conditional period of employment has been served—for example 10 years—the employee is entitled to a pro rata cash payment in relation to long-service leave. Under such an arrangement, an employee who has served nine years before resignation would not be entitled to any cash payment. An employee who serves 11 years might not be entitled to take leave but would be entitled to 9.53 weeks’ salary on resignation. This equals 11/15 × 13 weeks. 3. Unconditional period—an unconditional legal entitlement to payment arises after a qualifying period of service (usually 10 or 15 years). After this qualifying period, long-service leave can be taken. Accumulation of long-service leave entitlement continues after this point until the leave is taken. For example, if an employee was to serve 20 years without taking any long-service leave and assuming an entitlement of 13 weeks for every 15 years of service, that employee could be entitled to take 17.33 weeks’ leave (which equals 20/15 × 13 weeks). It should be noted that the long-service leave entitlement is additional to any entitlements to annual leave, which, as stated previously, are typically four weeks per year within Australia. In relation to the above categories and to the extent that they are expected to result in future cash outflows for an employer, long-service leave entitlements accumulated by employees in the unconditional, conditional and preconditional entitlement categories during the financial year will satisfy the definition of expenses. This is because the employer will have consumed employees’ services during the period and the entitlement accumulates with the provision of employees’ services. Also, the component of the expense not settled as at the end of the reporting period will usually satisfy the definition of liabilities since the employer has a present obligation to make future cash outflows as a result of consuming employees’ services. To calculate the obligation for long-service leave, a number of judgements have to be made. This can be quite a time-consuming and difficult exercise, as demonstrated in Worked Example 12.4. Organisations typically employ individuals that specialise in performing such calculations, usually actuaries. Not all employees will stay with an employer until the nominated preconditional period and therefore some probabilities must be calculated as to the likelihood of employees staying until long-service leave benefits vest. The ultimate payment of long-service leave entitlements will be based on the salary being earned at the time the leave is taken or paid out, and not on the salary level at the time the entitlement was earned. Hence, projections must be made about future pay levels, which must themselves be based on projections of inflation rates, promotion prospects and the like. As the expected future payments are to be measured at their present value, decisions must be made about the appropriate discount rate. To some extent the IASB, and hence the AASB, has made this an easier task by requiring that the discount rate for such entitlements be based on the rates generated by high-quality corporate bonds. However, the bond rates selected must generally match the expected timing of the long-service leave entitlements. In relation to the practice of discounting, as we have indicated, AASB 119 requires estimated future cash outflows to be discounted to present value when measuring benefits to be paid beyond 12 months from the end of the reporting period. Let us now consider, in Worked Example 12.4, how to calculate an organisation’s long-service leave obligation. For purposes of illustration, we will restrict the number of employees to six.

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WORKED EXAMPLE 12.4: Accounting for long-service leave Let us assume that Tea-Tree Bay Ltd has six employees. According to their particular employment award, long-service leave (LSL) can be taken after 15 years, at which time the employee is entitled to 13 weeks’ leave (4.333 days per year entitlement). Further, we will assume that, after 10 years, pro rata payment is allowed so that if employees leave after serving 10 years they will be entitled to a cash payment in relation to their pro rata entitlement to long-service leave (that is, the period between 10 and 15 years is considered to be the ‘conditional period’). The number of employees of Tea-Tree Bay Ltd, their current salaries and their years of service are provided in the table below: Number of employees

Current salaries

Years of service

Years until LSL vests

Probability that LSL will vest

1 1 1 1 1 1 6

$50 000 $40 000 $60 000 $40 000 $50 000 $80 000

3 4 6 7 10 12

7 6 4 3 0 0

20% 25% 35% 60% 100% 100%

To determine the obligation for long-service leave we will need estimates of: • projected salaries • probabilities that entitlements to long-service leave will ultimately vest. We will also need to determine the market yields on high-quality corporate bonds, as these will be the rates used to discount the expected future payments back to their present value. We will assume that such bonds exist with periods to maturity exactly matching the various periods that must still be served by the employees before longservice leave entitlements vest with them. High-quality corporate bonds periods to maturity

Bond rate (%)

7 6 4 3

8.0 7.5 6.5 6.0

We will also assume that the projected inflation rate for the foreseeable future is 3 per cent and that wage increases will merely keep pace with inflation. REQUIRED (a) Calculate the long-service leave liabilities for Tea-Tree Bay Ltd. (b) Provide the accounting entry for long-service leave from your calculations. SOLUTION (a) The table below presents the results of calculations based on the assumptions made about Tea-Tree Bay Ltd. Below the table are notes that explain the calculations in each column.

Current salary

Years of service

Projected salary (1)

Accumulated LSL benefit (2)

Present value of LSL obligation (3)

Probability  that LSL will be paid (4)

LSL liability

$50 000 $40 000

3 4

$61 494 $47 762

$3 074 $3 184

$1 794 $2 063

20 25

$359 516 continued

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Current salary

Years of service

Projected salary (1)

Accumulated LSL benefit (2)

Present value of LSL obligation (3)

Probability  that LSL will be paid (4)

$60 000 $40 000 $50 000 $80 000

6 7 10 12

$67 530 $43 709 $50 000 $80 000

$6 753 $5 099 $8 333 $16 000

$5 249 $4 281 $8 333 $16 000

35 60 100 100

LSL liability 1 837 2 569 8 333 16 000 29 614

Notes 1 Projected salary Projected salary = current salary × (1 + inflation rate)n where n = number of years until the long-service leave entitlement vests. In this example it is assumed that the inflation rate will continue to be 3 per cent. For the first employee listed, the calculation would be:   $50  000 × (1.03)7 = $61 494 2 Accumulated LSL benefit Accumulated LSL benefit = years of employment ÷ number of periods required to be served before leave can be taken × weeks of LSL entitlement that are available after conditional period has been served ÷ 52 weeks × projected salary. For the first-listed employee, the calculation would be:   3 ÷ 15 × 13 ÷ 52 × $61 494 = $3 074 3 Present value of long-service leave obligation Present value of long-service leave obligation = accumulated long-service benefit ÷ (1 + appropriate corporate bond rate)n where n = number of years until long-service leave entitlements can be taken. For the first-listed employee, the calculation would be: $3 074 ÷ (1.08)7 = $1 794  4 Probability that long-service leave will be taken The probability that long-service leave will be taken would be based on previous experience within the organisation and industry. For example, it has been assessed that an employee with three years’ service has a 20 per cent probability of staying in the firm until the preconditional period has been reached. Once an employee reaches the preconditional period (in this example, 10 years) the probability is 100 per cent that a payment will be made. For the first-listed employee, the calculation would be:   $1  794 × 0.20 = $359 Following on from the above calculations, and after considering all six employees, the long-service leave provision at the end of the period should total $29 614. If the balance in the provision at the beginning of the year had been, for example, $22 300, the expense for the year would be $7 314. This would represent the increase in the obligation that has occurred throughout the year. (b) The accounting entry to recognise the long-service leave expense would be: Dr Cr

Long-service leave expense Provision for long-service leave

7 314 7 314

It will be necessary to break the provision up into both a current and a non-current portion. The amount represented as a current liability would generally represent the amount of long-service leave that is expected to be taken in the 12 months following the end of the reporting period. When long-service leave is subsequently taken, the amount is recognised by reducing the provision, and reducing cash at bank, as follows: Dr Cr

Provision for long-service leave Cash at bank

X X

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In this chapter we are not considering the tax affects relating to employee benefits. Accounting for income taxes is addressed in Chapter 18. As we will learn in Chapter 18, the recognition of long-service leave expenses through the creation of a provision for long-service leave does not actually create a tax deduction for the organisation as the tax office will generally give the deduction only when the amounts are actually paid. Nevertheless, for accounting purposes, an expense is still recognised, which therefore reduces reported profits. The implication of this is that the recognition of long-service leave expenses will generally give rise to deferred tax assets. Again, we will not consider the issue of taxes further in this chapter, but these tax-related issues as they relate to employee entitlements (and other income and expenses) will be addressed in Chapter 18.

Superannuation At this point it should perhaps be noted that there are separate requirements for how a superannuation plan, or a ‘superannuation entity’, itself should account for the plan’s assets, liabilities, expenses and income. The relevant accounting standard for such entities is AASB 1056 Superannuation Entities, which was released in June 2014 (and which replaced the former accounting standard AAS 25 Financial Reporting by Superannuation Funds). Australia did not adopt the International Accounting Standard pertaining to superannuation entities (which is IAS 26 Accounting and Reporting by Retirement Benefit Plans) because of perceived shortcomings with the standard. This is one of the few instances where an accounting standard issued by the IASB has not been adopted for use within Australia. Because within this chapter we are not considering how the separate, independent superannuation fund shall account for its own activities we will therefore not be referring to AASB 1056. That is, we are restricting our discussion to how to account for the employee entitlements paid/payable by the employer and hence AASB 119 remains the relevant accounting standard within this chapter. Returning to the accounting requirements of the employer, AASB 119 contains a considerable amount of material on how the reporting entity is to account for the superannuation entitlements of its employees, as well as other postemployment benefits such as post-employment life insurance and post-employment health care. AASB 119 states that arrangements whereby an entity provides post-employment benefits are considered to be ‘post-employment benefit plans’. Superannuation is therefore deemed to emanate from a ‘post-employment benefit plan’ established by the employer. Figure 12.1 provides a simple diagrammatic illustration of how superannuation works in terms of the flow of contributions and payments. While the employer makes payments to the employee for services rendered by the employee, the employer will also contribute funds irrevocably to the superannuation fund. The employee might also make contributions to the superannuation fund thereby increasing the total funds available when they retire. On retirement the employee will then typically receive a flow of payments from the superfund (a pension), although in some funds there is an option to take a lump sum on retirement.

Employee $$ superannuation payments on retirement

$$ contributions Services

$$ salary

Figure 12.1 Simple diagrammatic representation of fund flows to and from a superannuation fund

Superannuation fund

$$ contributions Employer

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According to AASB 119, post-employment benefit plans are 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 member’s annual salary or are paid as a specified amount regardless of the contributions already paid by the employee. Across time, less use is being made of defined benefit plans and although many still exist, most new funds are defined contribution plans. As we will see, the accounting treatment for defined contribution plans is relatively simple compared with that for defined benefit plans. Although we concentrate on superannuation in the discussion that follows, post-employment benefit plans can be established for benefits other than superannuation. For example, and as already indicated, they can be established for post-employment life insurance and post-employment medical care benefits. We will consider defined contribution plans and defined benefit plans in their turn below.

Defined contribution plans For a defined contribution plan, the employer’s contribution to a plan is set at a specified amount—for example, a certain percentage of salary—and the employee’s final payout will depend upon such factors as the earnings generated by the contributions. That is, the employer does not stipulate what the final payment on retirement to be made to the employee will be. In describing defined contribution plans, paragraph 28 of AASB 119 states: Under defined contribution plans the entity’s legal or constructive obligation is limited to the amount that it agrees to contribute to the fund. Thus, the amount of the post-employment benefits received by the employee is determined by the amount of contributions paid by an entity (and perhaps also the employee) to a postemployment benefit plan or to an insurance company, together with investment returns arising from the contributions. In consequence, actuarial risk (that benefits will be less than expected) and investment risk (that assets invested will be insufficient to meet expected benefits) fall on the employee. The accounting issues associated with defined contribution plans are relatively straightforward given that the commitment of the employer is restricted to the amount of the agreed contributions. For example, the employer might be committed to contribute 10 per cent of current salary to an externally managed superannuation fund. The actual contribution would be recognised as an expense (unless, for example, it is to be included as part of the cost of inventory, or the cost of an item of property, plant and equipment) and the associated liability would be limited to the amount of the 10 per cent obligation that is unpaid as at the end of the financial year. As paragraph 50 of AASB 119 states: Accounting for defined contribution plans is straightforward because the entity’s obligation for each period is determined by the amounts to be contributed for that period. Consequently, no actuarial assumptions are required to measure the obligation or the expense and there is no possibility of any actuarial gain or loss. Moreover, the obligations are measured on an undiscounted basis, except where they are not expected to be settled wholly before twelve months after the end of the annual reporting period in which the employees render the related service. In relation to the accounting treatment for defined contribution plans, paragraphs 51 and 52 of AASB 119 state:

51. When an employee has rendered service to an entity during a period, the entity shall recognise the contribution payable to a defined contribution plan in exchange for that service: (a) as a liability (accrued expense), after deducting any contribution already paid. If the contribution already paid exceeds the contribution due for service before the end of the reporting period, an entity shall recognise that excess as an asset (prepaid expense) to the extent that the prepayment will lead to, for example, a reduction in future payments or a cash refund; and (b) as an expense, unless another Australian Accounting Standard requires or permits the inclusion of the contribution in the cost of an asset (see, for example, AASB 102 and AASB 116).

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52. When contributions to a defined contribution plan are not expected to be settled wholly before twelve months after the end of the annual reporting period in which the employees render the related service, they shall be discounted using the discount rate specified in paragraph 83.

Worked Example 12.5 requires accounting entries to be determined to recognise an employer’s obligation in relation to contributions to a defined contribution superannuation plan.

WORKED EXAMPLE 12.5: Accounting for contributions to a defined contribution plan Point Leo Ltd has a defined contribution superannuation plan set up to cover two employees. This is the first year the plan has been operating. Point Leo Ltd contributes 10 per cent of the employees’ salaries to a superannuation plan, which is managed by an external trustee. The salaries, and related contributions, are as follows: Name Damien Harding Barton Lynch

Annual salary

Contribution

$125 000 $175 000

$12 500 $17 500 $30 000

REQUIRED Provide the accounting entry necessary to recognise the superannuation obligation of Point Leo Ltd. SOLUTION The accounting entry would be as follows: Dr Cr

Employee benefits cost—superannuation Employee benefits payable

30 000 30 000

When the amount is ultimately paid there will be a reduction in the amount shown against employee benefits payable. That is: Dr Cr

Employee benefits payable Cash

30 000 30 000

The amount would not be subject to discounting to the extent the obligation to the fund is paid within 12 months of the end of the reporting period. In relation to required disclosures, paragraph 46 of AASB 119 requires an entity to disclose the amount recognised as an expense for defined contribution plans.

Defined benefit plans The accounting issues associated with defined benefit plans are rather more complex than those associated with defined contribution plans. For example, an employer might have established a defined benefit superannuation plan that is to provide employees with a pension of 40 per cent of their final salary after they reach the age of 60. In determining the amount to contribute to the fund so as to ensure the obligation is met, estimates need to be made of such things as projected final salary, earnings rates of the fund, the costs associated with managing the fund, the probability that the employee will stay with the organisation until retirement, and so forth. The employer effectively bears the risks associated with the earnings of the fund as the employer has committed to paying a set amount—a defined benefit—to the employee at the point of retirement (perhaps either as a lump sum paid to the employee or as a pension). This can be contrasted with the defined contribution plan, where the employer pays a set amount into a fund and what the employee ultimately receives depends upon how much the plan has earned in the interim period. In describing defined benefit plans, paragraph 30 of AASB 119 states:

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Under defined benefit plans: (a) the entity’s obligation is to provide the agreed benefits to current and former employees; and (b) actuarial risk (that benefits will cost more than expected) and investment risk fall, in substance, on the entity. If actuarial or investment experience are worse than expected, the entity’s obligation may be increased. Illustrative of the complexity of defined benefit plans is the fact that a large proportion of AASB 119 is dedicated to the accounting treatment of defined benefit plans. This material in the accounting standard is rather complex and, in parts, can be quite difficult to understand. In determining the obligation of employers under defined benefit plans we would need to know whether the fund, which might be externally managed, accepts the risks for unexpected changes in earnings or whether the employer retains the associated risks—and at this stage we need to remember, again, that in this chapter we are considering the accounting treatment required by the employer only. As paragraph 56 of AASB 119 states: Defined benefit plans may be unfunded, or they may be wholly or partly funded by contributions by an entity, and sometimes its employees, into an entity, or fund, that is legally separate from the entity and from which the employee benefits are paid. The payment of funded benefits when they fall due depends not only on the financial position and the investment performance of the fund but also on an entity’s ability (and willingness) to make good any shortfall in the fund’s assets. Therefore, the entity is, in substance, underwriting the actuarial and investment risks associated with the plan. Consequently, the expense recognised for a defined benefit plan is not necessarily the amount of the contribution due for the period.

Steps involved in accounting for defined benefit plans As paragraph 57 of AASB 119 indicates, there are a number of steps involved in accounting for contributions to a defined benefit plan. Accounting by an entity for defined benefit plans involves the following steps: (a) determining the deficit or surplus. This involves: (i) using an actuarial technique, the projected unit credit method, to make a reliable estimate of the ultimate cost to the entity of the benefit that employees have earned in return for their service in the current and prior periods (see paragraphs 67–69). This requires an entity to determine how much benefit is attributable to the current and prior periods (see paragraphs 70–74) and to make estimates (actuarial assumptions) about demographic variables (such as employee turnover and mortality) and financial variables (such as future increases in salaries and medical costs) that will affect the cost of the benefit (see paragraphs 75–98); (ii) discounting that benefit in order to determine the present value of the defined benefit obligation and the current service cost (see paragraphs 67–69 and 83–86); (iii) deducting the fair value of any plan assets (see paragraphs 113–115) from the present value of the defined benefit obligation. (b) determining the amount of the net defined benefit liability (asset) as the amount of the deficit or surplus determined in (a), adjusted for any effect of limiting a net defined benefit asset to the asset ceiling (see paragraph 64); (c) determining amounts to be recognised in profit or loss: (i) current service cost (see paragraphs 70–74); (ii) any past service cost and gain or loss on settlement (see paragraphs 99–112); (iii) net interest on the net defined benefit liability (asset) (see paragraphs 123–126). (d) determining the remeasurements of the net defined benefit liability (asset), to be recognised in other comprehensive income, comprising: (i) actuarial gains and losses (see paragraphs 128 and 129); (ii) return on plan assets, excluding amounts included in net interest on the net defined benefit liability (asset) (see paragraph 130); and (iii) any change in the effect of the asset ceiling (see paragraph 64), excluding amounts included in net interest on the net defined benefit liability (asset). Where an entity has more than one defined benefit plan, the entity applies these procedures for each material plan separately. 440 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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These steps can be summarised as follows: Step 1: Use an actuarial technique to reliably estimate the ultimate cost to the entity that employees have earned in return for their services in the current and prior period. Step 2: Discount the benefits determined in Step 1 to determine the present value of the defined benefit obligation and the current service cost. Step 3: Determine the fair value of the plan assets used to service the obligation to employees. Step 4: Determine the amounts to be recognised in profit or loss. These include: • current service cost • any past service cost and gains or losses on settlement • net interest on the net defined benefit liability (asset). Step 5: Determine the remeasurements on the net defined benefit liability (asset) to be recognised in other comprehensive income. These include: • actuarial gains or losses • returns on plan assets, excluding amounts already included in net interest on the net defined benefit liability (asset) • any change in the effect of the asset ceiling, excluding amounts already included in net interest on the net defined benefit liability (asset). We will consider each of the above steps in turn and then combine the steps in a comprehensive example. It is emphasised that this is a fairly complicated calculation to make.

Step 1: Use an actuarial technique to reliably estimate the ultimate cost to the entity that employees have earned in return for their services in the current and prior period The first step requires entities to make use of actuarial assumptions to determine the amounts of benefits attributable to current and prior periods when determining the expected benefits they will ultimately be liable for. These include demographic assumptions that consider: • mortality both during and after employment • rates of employee turnover, disability and early retirement • the proportion of plan members with dependents who will be eligible for benefits • the proportion of plan members who will select each form of payment option available under the plan terms • claim rates under medical plans. Apart from demographic assumptions, firms must also consider financial assumptions that include items such as: • the discount rate • benefit levels, excluding any cost of the benefits to be met by employees, and future salary • in the case of medical benefits, future medical costs, including claim-handling costs (i.e. the costs that will be incurred in processing and resolving claims, including legal and adjuster’s fees) • taxes payable by the plan on contributions relating to service before the reporting date or on benefits resulting from that service. Actuarial assumptions should be unbiased and mutually compatible, which means that they should reflect the economic relationships between factors such as inflation, rates of salary increase and discount rates. Financial assumptions should be based on market assumptions at the end of the reporting period, for the period over which the obligations are to be settled. Knowledge of the formula used to determine benefits to be provided to the employer is needed to determine what benefits the employees have earned for their service. As paragraph 70 of AASB 119 states: In determining the present value of its defined benefit obligations and the related current service cost and, where applicable, past service cost, an entity shall attribute benefit to periods of service under the plan’s benefit formula. For example, let us assume that Super Ltd has two employees in its defined benefit plan. As part of the plan’s ‘formula’, the employees are entitled to a lump-sum payment of 10 per cent of final salary for each year of service when they retire at age 55. Both of the employees are expected to retire in another four years’ time and have been working for the organisation for one year. The employees started on a salary of $50 000 each, which is expected to rise by Chapter 12: ACCOUNTING FOR EMPLOYEE BENEFITS  441

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10 per cent each year. That is, the combined salaries were $100 000. The combined salaries at the end of year 1 were $110 000 (as expected). An actuarial assumption is required about final salaries—hence the 10 per cent. At an expected growth rate of 10 per cent per year the expected total final salaries in year 5 of employment, the expected time of retirement, will be $161 051. This equals: $100 000 × (1.1)5 Ten per cent of this amount is $16 105. We can use the following table to determine the benefits the employees would have earned at the end of each year: Year

1    

2    

3    

4    

5    

Benefit attributed to: • Prior years

0

16 105

32 210

48 315

64 420

• Current year (10% of final salary)

16 105

16 105

16 105

16 105

16 105

• Current and prior years

16 105

32 210

48 315

64 420

80 525

For the sake of simplicity, in the above illustration we have not considered the probability of the employees not staying until retirement age. It has been assumed that the employees will definitely stay until age 55. In reality such an assumption could not be made and hence obligations for payment would be determined after considering the probability that the employee might leave before the date payment is due. It is also assumed that all payments to the defined benefit plan are made at year end. In considering the obligations of the entity under a defined benefit plan we need to consider whether the benefits have vested in the employee (meaning the ultimate payment of the benefit earned in the current period is not conditional on satisfying any further service requirements). If the benefit has vested in the employee (the payment is unconditional), then the probability of the amount earned being paid will be 100 per cent. However, if the payment has not yet vested (perhaps because the employee has not yet worked the minimum time required for a payment to be made), the use of probabilities of satisfying the service requirement will be necessary. This will act to reduce the expense recognised by the entity in the current period. As paragraph 72 of AASB 119 states: Employee service gives rise to an obligation under a defined benefit plan even if the benefits are conditional on future employment (in other words they are not vested). Employee service before the vesting date gives rise to a constructive obligation because, at the end of each successive reporting period, the amount of future service that an employee will have to render before becoming entitled to the benefit is reduced. In measuring its defined benefit obligation, an entity considers the probability that some employees may not satisfy any vesting requirements. Similarly, although certain post-employment benefits, for example, post-employment medical benefits, become payable only if a specified event occurs when an employee is no longer employed, an obligation is created when the employee renders service that will provide entitlement to the benefit if the specified event occurs. The probability that the specified event will occur affects the measurement of the obligation, but does not determine whether the obligation exists. For the purposes of this illustration, let us assume that the benefits do vest in the hands of the employees. The above obligations have not yet been discounted to their present value. As they fall due beyond 12 months after the end of the reporting period they are required to be discounted to their present value.

Step 2: Discount the benefits determined in Step 1 to determine the present value of the defined benefit obligation and the current service cost As we would appreciate, if we are required to make a payment in a future period, the present value of that payment is less than the absolute (undiscounted) amount required to be paid. This difference takes into account to some extent the fact that it is possible to invest funds in the current period that will generate a return sufficient to provide necessary funds to make the ultimate payment. The discount rate required to be used by AASB 119 is stipulated at paragraph 83, as follows: 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 442 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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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 shall be used. The currency and term of the corporate bonds or government bonds denominated in that currency shall be consistent with the currency and estimated term of the post-employment benefit obligations. AASB 119 also provides specific guidance to not-for-profit public sector entities. Paragraph Aus 83.1 states: Notwithstanding paragraph 83, in respect of not-for-profit public sector entities, post-employment benefit obligations denominated in Australian currency shall be discounted using market yields on government bonds. In explaining the use of discount rates, paragraph 84 of AASB 119 states: One actuarial assumption which has a material effect is the discount rate. The discount rate reflects the time value of money but not the actuarial or investment risk. Furthermore, the discount rate does not reflect the entity-specific credit risk borne by the entity’s creditors, nor does it reflect the risk that future experience may differ from actuarial assumptions. For the purposes of illustration and coming back to the example of Super Ltd, let us assume that the market yields at the end of the reporting period on high-quality corporate bonds with four years to maturity are 7 per cent. (Remember, we are doing these calculations after the end of one year and hence at a time when the related superannuation obligations have four years to maturity.) Discounting the required payments in successive years at a discount rate of 7 per cent gives the following: Year

1   

2   

3   

4   

5   

Benefit (undiscounted) • Prior years

0

16 105

32 210

48 315

64 420

• Current year (10% of final salary)

16 105

16 105

16 105

16 105

16 105

• Current and prior years—as calculated at Step 1

16 105

32 210

48 315

64 420

80 525

Opening obligation

0

12 286

26 292

42 199

60 205

Interest at 7%

0

860

1 840

2 955

4 215

Current service cost

12 286

13 146

14 067

15 051

16 105

Closing obligation

12 286

26 292

42 199

60 205

80 525

Present values

The interest expense calculated above is determined by multiplying the opening obligation by the respective rate of interest. This rate of interest will fluctuate from year to year. The above calculations are based on rates of interest in place at the end of year 1. There is no interest expense in year 1 because the plan was established in that year and there was a nil balance for the opening obligation. Because interest rates will change, present values will need to be recalculated at the end of each year based on the current market yields on high-quality corporate bonds. The interest cost reflects the change in the present value from one period to the next. That is, interest cost is the increase during a period in the present value of a defined benefit obligation, which arises because the benefits are one period closer to settlement. In relation to the closing obligation shown at the end of year 1, $12 286 × (1.07)4 = $16 105. To determine whether the employer has any outstanding obligation for superannuation at year end, the closing obligation for superannuation entitlements (calculated above) needs to be compared with the fair value of the plan’s assets.

Step 3: Determine the fair value of the plan assets used to service the obligation to employees In the above calculation, we determined the present value of the closing obligation to the employee for each period in relation to the defined benefit plan. Whether an obligation to the plan exists will be determined by reference to the fair value of the plan’s assets. If the fair value of the plan’s assets actually matched the expected payout to employees, no Chapter 12: ACCOUNTING FOR EMPLOYEE BENEFITS  443

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further liabilities would exist. If the fair value exceeded the obligation an asset would exist. As paragraph 65 of AASB 119 states: A net defined benefit asset may arise where a defined benefit plan has been overfunded or where actuarial gains have arisen. An entity recognises a net defined benefit asset in such cases because: (a) the entity controls a resource, which is the ability to use the surplus to generate future benefits; (b) that control is a result of past events (contributions paid by the entity and service rendered by the employee); and (c) future economic benefits are available to the entity in the form of a reduction in future contributions or a cash refund, either directly to the entity or indirectly to another plan in deficit. The asset ceiling is the present value of those future benefits. In relation to the above requirement that any surplus of the fair value of the superannuation plan’s net assets over the present value of the accrued benefits should be disclosed as an asset, it should be appreciated that, at least conceptually, it could conceivably be argued that such an excess does not represent an ‘asset’. The surplus would not usually be available to the employer and the employer would have little or no ‘control’ over the excess. Hence, it is questionable whether considering the excess as an asset would be consistent with the definition of an asset in the Conceptual Framework for Financial Reporting. Nevertheless, AASB 119 requires the surplus to be treated as an asset and accounting standards take precedence over the conceptual framework. In relation to the fair value of the plan’s assets, paragraph 113 of AASB 119 states: The fair value of any plan assets is deducted from the present value of the defined benefit obligation in determining the deficit or surplus. Fair value is defined in AASB 119 as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. For the purposes of our illustration we will assume that the fair value of the plan assets at the end of each financial year are as follows. We will also assume that the following contributions have been paid into the fund: Year

1     

2     

3     

4     

5     

Fair value of plan assets

11 500

25 500

42 000

61 000

81 000

Contributions for the year

11 500

11 500

11 500

12 000

12 000

Step 4: Determine the amounts to be recognised in profit or loss The costs relating to the net defined benefit liability (asset) that must be recognised in profit or loss include the current service cost, past service cost and gain or loss on settlement, and net interest on the net defined benefit liability (asset). Current service cost The current service cost is defined at paragraph 8 of AASB 119 as ‘the increase in the present value of the defined benefit obligation resulting from employee service in the current period’. This has been detailed in Step 2 above. Past service cost Past service cost is defined at paragraph 8 of AASB 119 as ‘the change in the present value of the defined benefit obligation for employee service in prior periods, resulting from a plan amendment (the introduction or withdrawal of, or changes to, a defined benefit plan) or a curtailment (a significant reduction by the entity in the number of employees covered by a plan)’. Past service costs must be recognised as an expense at the earlier of the date the plan amendment or curtailment occurs, and the date the entity recognises related restructuring costs or termination benefits. Plan amendment includes the introduction or withdrawal of a defined benefit plan or changes to the benefits payable under an existing defined benefit plan. A curtailment involves a significant reduction in the number of employees covered by a plan. It may result from an isolated event, such as the closing of a plant, discontinuance of an operation or termination or suspension of a plan. Past service costs can be either positive or negative. Positive past service costs will result in an increase in the present value of the defined benefit obligation, or negative, which results in a decrease in the present value of the defined benefit obligation. 444 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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According to paragraph 108 of AASB 119, the following are excluded from past service costs: (a) the effect of differences between actual and previously assumed salary increases on the obligation to pay benefits for service in prior years (there is no past service cost because actuarial assumptions allow for projected salaries); (b) underestimates and overestimates of discretionary pension increases when an entity has a constructive obligation to grant such increases (there is no past service cost because actuarial assumptions allow for such increases); (c) estimates of benefit improvements that result from actuarial gains or from the return on plan assets that have been recognised in the financial statements if the entity is obliged, by either the formal terms of a plan (or a constructive obligation that goes beyond those terms) or legislation, to use any surplus in the plan for the benefit of plan participants, even if the benefit increase has not yet been formally awarded (there is no past service cost because the resulting increase in the obligation is an actuarial loss, see paragraph 88); and (d) the increase in vested benefits (i.e. benefits that are not conditional on future employment, see paragraph 72) when, in the absence of new or improved benefits, employees complete vesting requirements (there is no past service cost because the entity recognised the estimated cost of benefits as current service cost as the service was rendered). Gains or losses on settlement Paragraph 8 of AASB 119 defines a settlement as ‘a transaction that eliminates all further legal or constructive obligations for part or all of the benefits provided under a defined benefit plan, other than a payment of benefits to, or on behalf of, employees that is set out in the terms of the plan and included in the actuarial assumptions’. The gain or loss on settlement is calculated as the difference between the present value of the defined benefit obligation being settled, determined on the date of settlement and at the settlement price. The settlement price includes any plan assets transferred and any payments made directly by the entity in connection with the settlement. A gain or loss on settlement of a defined benefit plan is recognised in profit or loss when the settlement occurs. Net interest on net defined benefit liability (asset) Net interest on the net defined benefit liability (asset) is defined in paragraph 8 of AASB 119 as the ‘the change during the period in the net defined benefit liability (asset) that arises from the passage of time’. It is calculated by multiplying the net defined benefit liability (asset) determined at the beginning of the reporting period by the discount rate determined by reference to market yields at the end of the reporting period on high-quality corporate bonds (or in countries where there is no deep market in such bonds, the market yields on government bonds) taking account of any changes in the net defined benefit liability (asset) during the period as a result of contribution and benefit payments. Net interest on the net defined benefit liability (asset) then comprises interest income on plan assets, interest cost on the defined benefit obligation and interest on the effect of the asset ceiling (paragraph 124 of AASB 119).

Step 5: Determine the remeasurements on the net defined benefit liability (asset) to be recognised in other comprehensive income According to paragraph 127 of AASB 119, remeasurements of the net defined benefit liability (asset) comprise: • actuarial gains and losses • the return on plan assets, excluding amounts included in the net interest on the net defined benefit liability (asset) • any change in the effect of the asset ceiling, excluding amounts included in net interest on the net defined benefit liability (asset). Actuarial gains and losses Actuarial gains and losses result from differences between the calculated and actuarially determined present value of the defined benefit obligation due to changes in actuarial assumptions and experience adjustments. According to paragraph 128 of AASB 119: Causes of actuarial gains and losses include, for example: (a) unexpectedly high or low rates of employee turnover, early retirement or mortality or of increases in salaries, benefits (if the formal or constructive terms of a plan provide for inflationary benefit increases) or medical costs; Chapter 12: ACCOUNTING FOR EMPLOYEE BENEFITS  445

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(b) the effect of changes to assumptions concerning benefit payment options; (c) the effect of changes in estimates of future employee turnover, early retirement or mortality or of increases in salaries, benefits (if the formal or constructive terms of a plan provide for inflationary benefit increases) or medical costs; and (d) the effect of changes in the discount rate. Changes in the present value of the defined benefit obligation due to the introduction, amendment, curtailment or settlement of the defined benefit plan, or changes to the benefit payable under the defined benefit plan, are not included in actuarial gains or losses. Instead, these changes result in past service cost or gains or losses on settlement (see Step 4). Return on plan assets Paragraph 8 of AASB 119 defines return on plan assets as: interest, dividends and other income derived from the plan assets, together with realised and unrealised gains or losses on the plan assets, less: (a) any costs of managing plan assets; and (b) any tax payable by the plan itself, other than tax included in the actuarial assumptions used to measure the present value of the defined benefit obligation. To calculate the return on plan assets, paragraph 130 of AASB 119 requires the entity to deduct the cost of managing the plan assets and any tax payable by the plan itself (other than tax included in the actuarial assumptions used to measure the defined benefit obligation). This means that the costs of managing the plan assets included in the return on plan assets are recognised in other comprehensive income as part of remeasurements. Other administration costs are not deducted from the return on plan assets (paragraph 130 of AASB 119). Change in the effect of the asset ceiling Paragraph 126 of AASB 119 describes remeasurements of the net defined benefit liability (asset) arising from changes in the effect of the asset as follows: Interest on the effect of the asset ceiling is part of the total change in the effect of the asset ceiling, and is determined by multiplying the effect of the asset ceiling by the discount rate specified in paragraph 83, both as determined at the start of the annual reporting period. The difference between that amount and the total change in the effect of the asset ceiling is included in the remeasurement of the net defined benefit liability (asset). To continue with the example we have been using, we have assumed an earnings rate of 7 per cent on high-quality corporate bonds. Obviously, this will change across time. We also need to consider what the expected return on the plan’s assets will be. This will not necessarily be the same as the discount rate used, which is based on high-quality corporate bonds. Those in charge of the fund’s assets would need to estimate the earnings of the plan’s assets when calculating the ability of the fund to meet its obligations. For the purposes of our illustration it is assumed that there is no unrecognised past service cost and that no benefits have been paid to the employees during the period. The market rate of high-quality corporate bonds as at the end of each year and the expected rate of return on the plan’s assets are as follows:

Year

1

2

3

4

5

Discount rate for the year (being the rate of return on high-quality corporate bonds)

7%

8%

9%

8%

9%

Expected rate of return on plan assets at the start of the year



10%

10%

9%

10%

446 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Using revised rates, the revised present value of the obligation at each year end is as follows: Year

1

2

3

4

5

0

16 105

32 210

48 315

64 420

• Current year (10% of final salary)

16 105

16 105

16 105

 16 105

16 105

• Current and prior years—from Step 1

16 105

32 210

48 315

64 420

80 525

Opening present value of obligation—from Step 2

0

12 286

25 569

40 666

59 648

Interest cost*

0

983

2 301

3 253

5 368

12 286

12 785

13 555

14 912

16 105

 0

 (485)

 (759)

817

(596)

12 286

25 569

40 666

59 648

80 525

Opening fair value of plan assets

0

11 500

25 500

42 000

61 000

Expected return on plan assets—included within OCI

0

1 150

2 550

3 780

6 100

11 500

11 500

11 500

12 000

12 000

 0

1 350

2 450

3 220

1 000

11 500

25 500

42 000

61 000

80 100

Benefit (undiscounted) • Prior years

Present values

Current service cost** Actuarial (gain) loss on obligation (balancing figure)—included within OCI Closing present value of obligation***

Contributions Actuarial gain (loss) on plan assets (balancing figure)—included within OCI Closing fair value of plan assets

* Interest cost is calculated by multiplying the opening present value of the obligation by the discount rate in place for the year. The rates change each year and hence do not remain at 7 per cent as originally expected. This amount will be included within profit or loss. ** The present value of the current service cost of $16 105 discounted at the respective year-end expected rate of return. It is assumed that all payments are made at year end. For example, year 2 equals 16 105 ÷ (1.08)3, given that the payment is made at the end of year 2, and therefore there are three years to go. This amount will be included within profit or loss. *** This number will differ from the numbers shown earlier as those calculations used a discount rate of 7 per cent across all years. However, the actual rates changed each year. At the end of year 2, for example, the closing present value of the obligation is $32 210 × (1.08)−3 given that there are three years to go, and this equals $25 569.

To determine the closing liability for each period we need to determine the difference between the present value of the obligation to the employees and the fair value of the plan’s assets that are available to meet the obligation to the employees. These figures are derived from the above table. Year

1     

2     

3     

4     

5     

Present value of the obligation (see above)

12 286

25 569

40 666

59 648

80 525

Fair value of plan assets (see above)

11 500

25 500

42 000

61 000

80 100

   786

69

(1 334)

(1 352)

 425

786

 (717)

(1 403)

 (18)

1 777

Liability (asset) to be recognised in statement of financial position* Change in the balance of the liability (asset)

* It is a liability if the present value of the obligation exceeds the fair value of the plan assets. This disclosure was not always required but was introduced by the IASB because of concern that many superannuation (pension) funds were greatly underfunded (the obligations to employees greatly exceeded the assets available to pay them), yet the level of underfunding was largely unknown.

Chapter 12: ACCOUNTING FOR EMPLOYEE BENEFITS  447

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For this illustration, to determine the total expenses to be recognised in relation to the defined benefit plan we need to consider: • current service costs • interest costs • expected return on assets • net actuarial gain or loss, which will be the sum of the two actuarial gains calculated above. This information is available from the previous calculations. It is summarised as follows: Year

1

2

3

4

5

12 286

12 785

13 555

14 912

16 105

0

983

2 301

3 253

5 368

12 286

13 768

15 856

18 165

21 473

Expected return on plan assets

0

(1 150)

(2 550)

(3 780)

(6 100)

Net actuarial (gain) loss recognised in year*

0

(1 835)

 (3 209)

 (2 403)

 (1 596)

Total OCI

0

(2 985)

 (5 759)

 (6 183)

 (7 696)

12 286

10 783

10 097

11 982

13 777

Current service cost Interest cost Total expenses—included within profit or loss Other comprehensive income (OCI) Items that will not be reclassified to profit or loss Remeasurements of defined benefit liability:

Total to the statement of profit or loss and other comprehensive income

* This amount equals the sum of the actuarial gain on the plan assets plus the actuarial gain on the obligation as previously calculated. Note: It is assumed that all contributions were made at year end, hence there is no interest cost or expected return on plan assets as at the end of year 1.

The aggregated accounting journal entries for the first three years would be: Year 1 Dr Cr Cr

Superannuation expense (profit or loss) Cash Liability on defined benefit plan

12 286

Year 2 Dr Dr Cr Cr

Superannuation expense (profit or loss) Liability on defined benefit plan Superannuation gain (OCI) Cash

13 768  717

Year 3 Dr Dr Dr Cr Cr

Superannuation expense (profit or loss) Liability on defined benefit plan Asset on defined benefit plan Superannuation gain (OCI) Cash

15 856    69   1 334

11 500 786

2 985 11 500

5 759 11 500

Remember that movement in the fair value of the plan assets are not directly recorded by the employer as those assets are held by the superannuation fund (entity). But knowledge of the fair value of the assets is required so as to determine if there is a shortfall that needs to be recognised. 448 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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AASB 119 requires numerous disclosures in relation to defined benefit plans. In what follows we relate some of these disclosure requirements to our example: Year

1

2

3

4

5

Movements in the net liability recognised in the statement of financial position Opening net liability



786

69

(1 334)

(1 352)

12 286

13 768

15 856

18 165

21 473

0

(2 985)

(5 759)

(6 183)

(7 696)

(11 500)

(11 500)

(11 500)

(12 000)

(12 000)

 786

 69

 (1 334)

 (1 352)

 425

Expected return on plan assets

0

1 150

2 550

3 780

6 100

Actuarial gain (loss) on plan assets

0

1 350

2 450

3 220

1 000

Actual return on plan assets

0

2 500

5 000

7 000

7 100

Amounts recognised in: Profit or loss Other comprehensive income Contributions paid Closing net liability (asset) Actual return on plan assets:

Employees’ accrued employee benefits and corporate collapses

LO 12.7

In this chapter we have discussed how employers recognise accruals (provisions) for unpaid employee benefits. As we should appreciate, however, the act of making an accrual does nothing to ensure that cash reserves 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 accounts, but in fact have no cash reserves. Employees often find that when a firm encounters financial difficulties, payment for their services becomes doubtful. Lopez (1999, p. 30) makes the following comments: Employees are particularly vulnerable when insolvency is an issue. Unlike suppliers or other external creditors, it is difficult for them to withdraw their services from an insolvent company, particularly when unemployment is high. Protecting the rights of employees in insolvent companies has long been high on the legislative agenda. Australian law has approached the problem by granting of priorities in times of insolvency. Under the law, employees do have some preferential access to payment when a company experiences difficulties; however, the existence of secured creditors (creditors with claims to assets as a result of particular contractual arrangements) can affect what is available to employees. Whatever the case, and regardless of where employees rank on the list of claimants, they will receive payment only to the extent that the organisation actually has assets available to meet the claims—and assets might not always be available. Recent notorious collapses in which employees have lost accumulated entitlements (for example, the Oakdale Collieries and National Textiles Ltd corporate collapses) have led to calls for the establishment of central funds that protect the claims of employees. Such schemes are in existence in other countries. For example, funds of this nature were established in Holland as far back as 1968. The funding schemes could take various forms, such as government-backed compulsory insurance or a compulsory trust to which all employers contribute. In reflecting on the current state of safeguards in relation to accumulated employee benefits, Lopez (1999, p. 31) makes the following pertinent comment: While there is a widespread social and economic cost of any company failure, nowhere is this cost felt more acutely than by the employees and their families. In most cases, employees have no other sources of income Chapter 12: ACCOUNTING FOR EMPLOYEE BENEFITS  449

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and the loss of employee entitlements has horrendous consequences. Try as they might, current laws do not protect employees when insolvent companies have no assets with which to meet employee entitlements. Significant changes are necessary to address this issue.

SUMMARY The chapter discussed accounting for employee benefits (entitlements). These benefits can include wages and salaries; annual leave; sick leave; long-service leave; superannuation; share entitlements; and bonuses. The relevant accounting standard is AASB 119. This standard provides guidance on recognition and measurement issues that relate to various employee benefits, for example: • Salaries and wages payable within 12 months of the end of the reporting period are to be recorded at their nominal amount, and liabilities are to be recognised where salaries have been incurred but employees have not been fully paid at the end of the reporting period. • Annual leave liabilities payable within 12 months of the end of the reporting period are to be recognised at the nominal amount of the entitlement. At year end there will generally be a provision for vesting, but unpaid, annual leave. • Obligations for employee benefits, including salary and wages, that are payable beyond 12 months after the end of the reporting period are to be recorded at their present value. • The discount rate to be used to determine present values is determined by reference to market yields at the end of the reporting period on high-quality corporate bonds. The currency and term of the bonds are to be consistent with the currency and estimated term of the post-employment benefit obligations. • Sick leave is to be divided into vesting and non-vesting entitlements. For accounting purposes, vesting sick leave can be treated in the same manner as annual leave. For non-vesting sick-leave entitlements, only the part of the entitlement that is accumulated through past service and that is expected to be taken should be recognised as a liability within the financial statements. • Long-service leave (LSL) entitlements are to be accrued and the liability is to be measured at its present value. The determination of the obligation (and the expense) for LSL will require various assumptions, including assumptions about future pay levels, promotion prospects, inflation rates and the likelihood of LSL entitlements ultimately vesting. Failure to recognise LSL obligations can lead to a significant overstatement of profits and a significant understatement of recorded liabilities. • Post-employment benefit plans are classified as either defined contribution plans or defined benefit plans. The accounting requirements for defined benefit plans are a great deal more complex than those pertaining to defined contribution plans.

KEY TERMS annual leave  428 defined benefit fund  429 defined contribution fund  429

long-service leave  428 on-costs  433 share option  429

sick leave  428 superannuation  429

END-OF-CHAPTER EXERCISES Sunshine Beach Ltd has five employees. According to their particular employment award, long-service leave can be taken after 15 years, at which time the employee is entitled to 13 weeks’ leave. If the employee leaves before they 450 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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have completed 15 years’ service, there will be no entitlement to leave or to a cash payment in lieu of leave. The names of the employees, their current salaries and their years of service as at the end of the reporting period are as follows: Name of employee

Current salary ($)

Years of service

Years until LSL vests

Smith Jones Johnson Gunston Billabong

30 000 40 000 40 000 50 000 40 000

5 8 10 15 18

10 7 5 0 0

The provision for long-service leave as at the beginning of the reporting period is $20 900. High-quality corporate bonds exist with periods to maturity that exactly match the various periods that must still be served by the employees before LSL entitlements vest with them. These bond rates are as follows: Corporate bond period to maturity

Bond rate (%)

10    7    5

7.0 6.2 6.0

The projected inflation rate for the foreseeable future is 2 per cent. The projected probabilities that the employees will stay until such time as the LSL vests are provided in the following table: Name

Probability (%) that employee will stay until LSL vests

Smith Jones Johnson Gunston Billabong

20 30 60 100 100

REQUIRED (a) Calculate the long-service leave obligation for Sunshine Beach Ltd as at the end of the reporting period. (b) Provide the necessary accounting entry to recognise the long-service leave expense for the year. LO 12.2, 12.3

SOLUTION TO END-OF-CHAPTER EXERCISE (a) The calculations for long-service leave are presented in the table below, followed by explanatory notes on how the figures in each column have been calculated. Projected salary 36 570 45 947 44 163 50 000 40 000

Accumulated LSL benefit

Present value of LSL obligation

Probability that LSL will be paid

3 048 6 126 7 361 12 500 12 000

1 549 4 021 5 501 12 500 12 000

20% 30% 60% 100% 100%

LSL liability 310 1 206 3 301 12 500 12 000 29 317

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Notes 1 Projected salary for each employee Projected salary in the year in which the right to LSL vests with the employee = current salary × (1 + inflation rate)n. For Smith, the calculation would be: $30 000 (1.02)10 = $36 570 2 Accumulated LSL benefit Accumulated LSL entitlement = (years of employment) ÷ (number of years required to be served before leave can be taken) × weeks of LSL entitlement that are available after the conditional period has been served ÷ 52 × projected salary. For Smith, the calculation would be: 5 ÷ 15 × 13 ÷ 52 × $36 570 = $3 048 3 Present value of the long-service leave calculation Present value = accumulated LSL benefit ÷ (1 + appropriate government bond rate)n. For Smith, the calculation would be: $3 048 ÷ (1.07)10 = $ 1549 4 Probability that LSL will be taken The probability that long-service leave will be taken would be based on experience within the organisation and industry. For Smith, the calculation would be: $1 549 × 0.20 = $310 The LSL provision at the end of the period should total $29 317. As the balance in the provision account at the beginning of the year is $20 900, the expense for the year is $8 417.

(b) The accounting entry to recognise the LSL expense for the current year would be: Dr Cr

Long-service leave expense Provision for long-service leave

8 417 8 417

REVIEW QUESTIONS 1. What is an employee benefit and what are the various forms that these benefits can take? LO 12.1 2. According to AASB 119, how should an employer’s obligation for employee benefits be measured? LO 12.2, 12.3 3. According to AASB 119, when should the rates on high-quality corporate bonds be used to discount expected future payments back to their present value? LO 12.3, 12.5 4. According to AASB 119, when should the rates on government bonds be used to discount expected future payments back to their present value? LO 12.3, 12.5 5. Critically evaluate AASB 119’s requirement that present values be determined by reference to high-quality bond rates rather than organisation-specific, market-determined, risk-adjusted discount rates. LO 12.3, 12.5 6. Which employee benefits are required to be discounted in accordance with AASB 119? LO 12.3, 12.5 7. When would payments made to employees be considered to be an asset? LO 12.2, 12.3 8. When would it be considered that income has arisen in relation to employee benefits? LO 12.2, 12.3 9. Explain the difference between a defined benefit plan and a defined contribution plan. Which plan poses more of a challenge to the accountant, and why? LO 12.5 10. Some employers will pay out employees for any unused sick-leave entitlements if they leave the organisation, whereas in other organisations employees forfeit this entitlement when they leave. Explain how these different types of sick-leave entitlements are treated for accounting purposes. LO 12.4 11. In relation to superannuation entitlements from a defined benefit plan, how do we determine the related expense to be recorded by the reporting entity? LO 12.5

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12. Why do some employers provide their employees with shares or options to buy shares in the organisation? LO 12.1 13. What is long-service leave and what is meant by: a preconditional period; a conditional period; and an unconditional period? LO 12.1, 12.2 14. Shelley Ltd pays its salaries fortnightly in arrears. The next pay day is Thursday 2 July. The fortnightly salary expense is $30 000, of which $10 000 is retained to pay the Australian Taxation Office on behalf of the employees. Payments to the ATO are made every second Monday, with the next payment being made on Monday 6 July. Shelley Ltd’s reporting period ends on 30 June.

REQUIRED Provide the journal entries in the books of Shelley Ltd for: (a) 30 June (b) 2 July (c) 6 July. LO 12.2, 12.3 15. Jerry Lopez works for Lightning Bolt Ltd. His annual salary is $100 000 and he is paid weekly. As part of his employment agreement, he is entitled to four weeks’ annual leave each year. He receives a leave loading of 17.5 per cent.

REQUIRED (a) Provide the weekly journal entries to record the recognition of Jerry Lopez’s annual leave entitlements. (b) Provide the appropriate journal entries, assuming that Jerry Lopez takes two weeks’ annual leave after being employed for one year and assuming that the tax deducted from the payment for the two weeks is $1 200. LO 12.2, 12.3 16. Surf School Ltd has six employees who are entitled to long-service leave (LSL). The LSL can be taken after 10 years of service, at which time the employee is entitled to 13 weeks’ leave. Entitlements to payment on departure arise after eight years of service. The following information about the employees is available:

No. of employees 2 2 2

Current salary per employee

Years of service

Probability % that LSL will be paid

Periods to maturity

High-quality corporate bond rate (%)

50 000 65 000 70 000

6 7 8

45 70 100

4 3 2

9 7 6

Employees’ salaries are expected to increase by 2.5 per cent per annum. The opening balance of the LSL provision was $32 500, and the interest rate for corporate bonds for all relevant periods to maturity was 8 per cent at the beginning of the year.

REQUIRED What is the accounting journal entry to record LSL expense for the current period (round amounts to the nearest dollar)? LO 12.2, 12.3

CHALLENGING QUESTIONS 17. Bear Island Ltd has a weekly payroll of $300 000. The employees receive entitlements to two weeks’ sick leave per year. The sick-leave entitlements are classified as non-vesting. Past experience, and experience within the industry, suggest that 60 per cent of employees will use their full two weeks’ entitlement each year; 20 per cent of employees will take one week’s sick leave each year; and 10 per cent of employees will take one day’s sick leave each year.

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REQUIRED (a) Calculate the expected annual sick-leave expense for Bear Island Ltd (on the basis of average salaries). (b) Provide the journal entries necessary to recognise the sick-leave entitlement expense as it accrues. LO 12.2, 12.3, 12.4 18. Alexandra Bay Ltd has five employees. According to their particular employment award, long-service leave can be taken after 12 years, at which time the employee is entitled to 10 weeks’ leave. If an employee were to leave before the completion of 12 years’ service, no entitlement would be paid. Name of employee

Current salary ($)

Years of service

Years until LSL vests

Mike Black Jan White

40 000 40 000

2 4

10 8

Noel Brown Peter Green Alvin Purple

50 000 60 000 70 000

6 8 10

6 4 2

High-quality corporate bond rates exist with periods to maturity that exactly match the various periods that must still be served by the employees before LSL entitlements vest with them. Corporate bond period to maturity 10  8  6  4  2

Bond rate (%) 8.0 7.0 6.5 6.0 5.8

The projected inflation rate for the foreseeable future is 2 per cent. The projected probabilities that the employees will stay long enough for the LSL to vest—that is, for a total of 12 years—are as follows:

Name Mike Black Jan White Noel Brown Peter Green Alvin Purple

Probability (%) that LSL will vest 15 20 50 70 90

REQUIRED (a) Calculate Alexandra Bay’s current obligation for long-service leave. (b) If the opening provision for long-service leave is $12 500, provide the journal entry to record Alexandra Bay’s long-service leave expense. LO 12.2, 12.3 19. Australasia Ltd started operating on 1 July 2017 with 12 employees. Three years later all of those employees were still with the company. On 1 July 2019 the company hired 15 more people but by 30 June 2020 only 10 of those employed at the beginning of that year were still employed by Australasia Ltd. All employees are entitled to 13 weeks’ long-service leave after a conditional period of 10 years of employment with Australasia Ltd.

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At 30 June 2020 Australasia Ltd estimates the following: • the aggregate annual salaries of all employees hired on 1 July 2017 is now $600 000 • the aggregate annual salaries of all current employees hired on 1 July 2019 is now $400 000 • the probability that employees hired on 1 July 2017 will continue to be employed for the duration of the conditional period is 40 per cent • the probability that employees hired on 1 July 2019 will continue to be employed for the duration of the conditional period is 20 per cent. Salaries are expected to increase indefinitely at 1 per cent per annum. The interest rates on high-quality corporate bonds are as follows:

Corporate bonds maturing in seven years Corporate bonds maturing in eight years Corporate bonds maturing in nine years Corporate bonds maturing in ten years

1 July 2019

30 June 2020

4% 5% 5% 6%

6% 8% 8% 10%

At 30 June 2019 the provision for long-service leave was $6 000.

REQUIRED (a) Calculate the total accumulated long-service leave benefit as at 30 June 2020. (b) What amount should be reported for the long-service leave provision as at 30 June 2020 in accordance with AASB 119? (c) Prepare the journal entry for the provision for long-service leave for 30 June 2020 in accordance with AASB 119. LO 12.2, 12.3 20. For many years Switches Ltd provided a defined benefit superannuation plan for its employees, but owing to concerns about its exposure to risk it has been phasing out the defined benefit superannuation plan and replacing it with a defined contribution superannuation plan. Most employees belong to the defined contribution plan. Switches Ltd has paid contributions of $160 000 to the trustee of the defined contribution plan for the year ended 30 June 2019, but the contribution payable for services rendered by employees in the fund was $180 000 for the year. There are only four employees in the defined benefit plan at 30 June 2019 and they are due to retire on 30 June 2022. The employees’ entitlement increases with the length of their employment. At 30 June 2018 they were entitled to receive three times their annual salary on retirement. By 30 June 2019 they were entitled to receive 3.2 times their annual salary on retirement. The aggregate salaries of the four members of the defined benefit fund are $200 000 for the year ended 30 June 2019 and are expected to increase by 5 per cent per annum over the next three years. All members of the defined benefit fund are expected to continue employment until retirement. The estimated benefits earned by employees who were members of the defined benefit fund were $694 574 and the present value of the defined benefit obligation was $529 887 at 30 June 2018. The interest rate used to discount the defined benefit obligation was 7 per cent at 30 June 2018 and 30 June 2019. The defined benefit plan assets had a fair value of $529 887 at 30 June 2018. For the year ended 30 June the contributions were $20 000 and the fair value of plan assets at 30 June 2019 was $585 000. The expected return on the plan assets was 8 per cent for the year ended 30 June 2019.

REQUIRED (a) Prepare the journal entry to record Switches Ltd’s current superannuation obligation for the defined contribution plan as at 30 June 2019. (b) Calculate the estimated benefits earned by employees in the defined benefit plan as at 30 June 2019. (c) Determine the present value of the defined benefit obligation as at 30 June 2019.

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(d) Calculate the interest cost of the defined benefit obligation for the year ended 30 June 2019 and the current year service cost. (e) Determine the amount of the actuarial gains and losses on the defined benefit obligation and the defined benefit plan assets for the year ended 30 June 2019. LO 12.2, 12.3, 12.5

REFERENCES LOPEZ, G., 1999, ‘Company Collapses and Employee Entitlements’, Australian CPA, August, pp. 30–1.

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CHAPTER 13

SHARE CAPITAL AND RESERVES LEARNING OBJECTIVES (LO) 13.1 Understand that the equity of an organisation can consist of several different accounts. 13.2 Understand that within equity there can be various classes of shares, each affording different rights to holders. 13.3 Be able to provide the journal entries to recognise the issue of both fully paid and partly paid shares by a company and know how to account for both a public and a private issue of shares. 13.4 Be able to provide the journal entries to account for cash and non-cash distributions (dividends). 13.5 Know what a preference share is and be able to identify factors that would determine whether particular preference shares should be disclosed as debt or equity. 13.6 Be able to provide the journal entries necessary when preference shares are to be redeemed. 13.7 Be able to provide the journal entries necessary when shares are forfeited by their owners. 13.8 Be able to provide the journal entries necessary to account for rights issues and option issues. 13.9 Understand what constitutes a share split and a bonus issue of shares and know the accounting implications of both. 13.10 Know the disclosure requirements of AASB 101 Presentation of Financial Statements in relation to share capital and reserves.

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Introduction to accounting for share capital and reserves As we know, under conventional double-entry accounting, the equity (often referred to as owners’ equity) of an organisation—for a company, this would be its shareholders’ funds—equals the total assets of the organisation, less its total liabilities (that is, Equity = Assets minus Liabilities). Alternatively, we can say that the total assets of an organisation will be matched by the total of the claims held by external parties (liabilities) plus claims held by the owners (that is, Assets = Liabilities plus Equity). The Conceptual Framework for Financial Reporting defines equity as the ‘residual interest in the assets of the entity after deducting all its liabilities’. The residual interest is a claim or right to the net assets (assets minus liabilities) of the reporting entity. As a residual interest, equity ranks after liabilities in terms of a claim against the assets of a reporting entity. As noted in Chapter 2, the shareholders’ funds definition of equity is directly a function of the definitions of assets and liabilities. Given that equity In a company, shareholders’ is the residual interest in the assets of the entity and given that the amount assigned to equity will funds represent the always correspond to the excess of the amounts assigned to its assets over the amounts assigned difference between to its liabilities, the criteria for the recognition of assets and liabilities effectively provide the criteria total assets and total for the recognition of equity. liabilities. In previous chapters we have considered how to account for different assets and liabilities. As noted above, how we do this will have a direct impact on the balance of equity. For example, a decision to revalue non-current assets upwards above their historical cost—a process that we discussed in Chapter 6— will increase equity by increasing the revaluation surplus account (which is part of equity). Similarly, valuing all marketable securities at their fair value (as described in Chapter 14) will change the value of those assets and hence the value of equity. New requirements to recognise particular liabilities that were traditionally not recognised will also lead to a negative change in equity. Changes in the measurement of particular liabilities will also affect the balance of equity (for example, changes from face value to present value in the measurement of liabilities). Hence the adoption of particular measurement techniques for assets and liabilities, perhaps as a result of a change in accounting standards, will directly affect the balance of equity given that equity equals assets minus liabilities. The total of equity is typically made up of a number of different accounts. Within a company, equity—or shareholders’ funds—can comprise: equity The owners’ share of the business calculated by subtracting the liabilities of the entity from its assets.

• share capital relating to one class or several classes of shares—for example, ordinary shares plus various classes of preference shares • reserves such as a revaluation surplus, foreign currency translation reserve, capital redemption reserve, general reserve, forfeited shares reserve • retained earnings (or accumulated losses). As an illustration of the various accounts that can make up shareholders’ funds, consider Exhibit 13.1. It shows an extract from the consolidated statement of financial position (balance sheet) for BHP Billiton Ltd as at 30 June 2015. Only

Exhibit 13.1 Components of BHP Billiton Ltd’s equity as at 30 June 2015

2015 US$m

2014 US$m

17 17 17 18 18

1 186 1 057 (76) 2 557 60 044 64 768

1 186 1 069 (587) 2 927 74 548 79 143

18

  5 777 70 545

   6 239 85 382

Notes EQUITY Share capital—BHP Billiton Ltd (a) Share capital—BHP Billiton plc (a) Treasury shares Reserves Retained earnings Total equity attributable to members of BHP Billiton Group Non-controlling interests Total equity SOURCE: BHP Billiton Ltd

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the part of the statement of financial position that relates to equity is shown. Supporting the numbers that appear in the statement of financial position will be notes to the financial statements. For example, there will be notes to the financial statements that provide further details on issued shares, as well as on the composition of ‘Reserves’. Referring to Note 18, for example, we find that the total Reserves balance of US$2 557 million is comprised of: Share premium account ($518m); Foreign currency translation reserve ($52m); Employee share awards reserve ($372m); Hedging reserve— cash flow hedges ($141m); Financial asset reserve ($9m); Share buy-back reserve ($177m); and Non-controlling interest contribution reserve ($1 288). As is the case for BHP Ltd above, retained earnings often makes up a significant proportion of total shareholders’ funds. Retained earnings, which we will consider in more depth in Chapter 16, represent the accumulation of prior periods’ profits or losses, less any dividends declared and paid and less any transfers that might be made out of retained earnings to other reserves. Retained earnings might also be used (reduced) for the purpose of a bonus issue of shares, as we will see in this chapter. The total reserves of a company will often include a revaluation surplus. We discussed the revaluation surplus in Chapter 6. As we learned, when certain classes of non-current assets are revalued upwards, this increase is not treated as part of profit or loss (but is included as part of ‘other comprehensive income’), but rather, any increase in the fair value of the asset is transferred directly to revaluation surplus. However, while the amount of an upward revaluation of a non-current asset is not treated as part of the period’s profit or loss (as explained in Chapter 6, when a non-current asset is revalued to fair value there is a debit to the relevant asset account and a credit to revaluation surplus), the amount of the asset revaluation is included within ‘other comprehensive income’, and is included within ‘total comprehensive income for the year’ and disclosed within the statement of profit or loss and other comprehensive income. The statement of profit or loss and other comprehensive income is examined in detail in Chapter 16.

Different classes of shares Companies can have on issue various classes of shares. For example, many companies issue both ordinary shares and preference shares.

Ordinary shares Ordinary shares might be composed of issues of shares made at different times so that some shares may be fully paid, while others are partly paid to various amounts. Further, even though all ordinary shares might have the same rights, ordinary shares might be issued at different prices, depending on the market’s demand for the shares at the time of the share issue. Ordinary shares confer voting rights—except in certain circumstances, such as when the company is in financial distress—and owners are entitled to a distribution of profits in the form of dividends. However, they are not assured of dividends, and in particular years they might receive no cash payments. Failure to receive dividends in one year does not mean that a right to dividends will accrue until dividends are ultimately paid. Holders of ordinary shares typically rank last in any distribution of assets when a company is wound up.

Preference shares Preference shares are so called because of preferential treatment their holders might receive over and above ordinary shareholders. The preferential treatment may be in relation to the receipt of dividends or the order of ranking in relation to asset distributions on the winding up of a company. Some preference shares confer voting rights, some confer voting rights only if dividend entitlements have not been paid, while others do not confer voting rights at any time. There is such a plethora of different forms of preference shares that it is not possible to describe them all, but some forms of preference shares include: • non-redeemable, participating preference shares • convertible, redeemable, participating preference shares • convertible, redeemable preference shares • redeemable preference shares secured by a letter of credit or other security • short-term redeemable preference shares secured by a put option backed by a letter of credit.

LO 13.1 LO 13.2 LO 13.5

ordinary shares A class of shares that typically ranks last in terms of any distribution of capital.

preference shares Shares that receive preferential treatment relative to ordinary shares, with the preferential treatment relating to various things, such as dividend entitlements or order of entitlement to any distribution of capital on the dissolution of the company.

dividend A distribution of the profits of an entity to the owners of that entity, typically in the form of cash.

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From the first to the last type in the above list, the preference shares become progressively more debt-like. If preference shares are described as ‘participating’, this indicates that after they have received the preference dividend at a fixed rate, the preference shareholders may then participate with the ordinary shareholders in any further profits that are to be distributed. Preference shares also sometimes come with the right of conversion to ordinary shares according to some pre-specified terms (that is, convertible preference shares); they might also enable the holder to redeem the shares for cash at the option either of the company or of the shareholder (that is, redeemable preference shares). As noted above and within previous chapters, some preference shares can take on the characteristics of equity, while others can take on the characteristics of debt. As will be shown in Chapter 14, on financial instruments, where preference shares have the characteristics of debt, they must, according to AASB 132 Financial Instruments: Presentation, be disclosed as debt, and the related payments are to be considered expenses rather than a distribution of profits (that is, as interest expense rather than dividends). Normally, preference shares that are redeemable on a fixed date, or at the option of the shareholder, and provide a fixed rate of return and no voting rights will be considered to be of the same substance as debt, and therefore should be disclosed as debt. As paragraph 18 of AASB 132 states: The substance of a financial instrument, rather than its legal form, governs its classification on the entity’s statement of financial position. Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity but are liabilities in substance and others may combine features associated with equity instruments and features associated with financial liabilities. For example: (a) a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a financial liability. Paragraphs 31 and 36 of AASB 132 address the issue of how we might measure the equity component and the debt component of instruments such as preference shares (again, we return to this issue in more depth in Chapter 14). Paragraph 36 discusses how the classification of an instrument as either debt or equity will in turn affect whether the related payments are classified as interest or dividend payments. Paragraph 36 states: 36.  The classification of a financial instrument as a financial liability or an equity instrument determines whether interest, dividends, losses and gains relating to that instrument are recognised as income or expense in profit or loss. Thus, dividend payments on shares wholly recognised as liabilities are recognised as expenses in the same way as interest on a bond. Similarly, gains and losses associated with redemptions or refinancings of financial liabilities are recognised in profit or loss, whereas redemptions or refinancings of equity instruments are recognised as changes in equity. Changes in the fair value of an equity instrument are not recognised in the financial statements.

share capital The balance of owners’ equity within a company, which constitutes the capital contributions made by the owners.

par value While no longer permitted, within Australia shares were once attributed a notional, fixed value and this was referred to as ‘par value’. Shares would typically be issued above (a premium) or below (a discount) this par value.

share premium The difference between the issue price of a share and the par value of that share.

LO 13.3

Accounting for the issue of share capital

The share capital (also referred to as contributed equity) of a company represents the amounts that owners have contributed to the organisation. Traditionally, when shares were issued in Australia, we needed to consider the par value (or notional value) of the shares. Shares were normally not issued below par value but they could be, and usually were, issued in excess of par. If shares were issued at a price in excess of par, this excess amount was referred to as a share premium. For example, if a company issued its shares at $1.80 each and they had a par value of $1.00, the share premium on the issue would have been $0.80 per share. In July 1998 The Corporations Law (which subsequently became the Corporations Act 2001) was amended so that companies are no longer permitted to issue shares that have a par value. Section 254C of the Corporations Act 2001 states that ‘shares of a company have no par value’. Given this amendment, shares of a company cannot be considered to be issued at a premium or a discount, as the determination of a premium or a discount is calculated relative to the par value of a share. The use of a share premium reserve, also, is therefore no longer necessary. A company may now elect to issue its shares at any price. However, the issue price of a company’s shares will depend on market demand.

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Worked Example 13.1 considers the determination of share capital.

WORKED EXAMPLE 13.1: Determination of share capital Coolum Ltd commences its life by issuing 1 million ordinary shares at an issue price of $1.40 per share. Hence, Coolum Ltd receives $1.4 million in total. REQUIRED Prepare the equity section of the statement of financial position immediately after the issue of the shares. SOLUTION Following the issue, the shareholders’ equity section of the statement of financial position would be represented as: Shareholders’ equity Share capital Total shareholders’ equity

$1 400 000 $1 400 000

Shares issued for cash When a company makes an issue of shares to the public, it is a requirement of the Corporations Act that the contributed capital be held in a trust account until such time as the shares are allotted. Consider Worked Example 13.2, which relates to a public issue of shares.

WORKED EXAMPLE 13.2: Public issue of shares As a result of an offer to the public, Peregian Ltd receives applications for 5 million shares during July 2019. Peregian Ltd subsequently issues 5 million shares on 1 August 2019. The shares are issued at a price of $2.10 each. REQUIRED Provide the accounting entries to recognise the receipt of the application monies and the subsequent allotment of shares. SOLUTION The accounting entries to recognise the receipt of the application monies and the subsequent allotment of shares would be: 1–31 July 2019 Dr Bank trust Cr Application

10 500 000 10 500 000

(to recognise the aggregated receipt of application monies during July 2019) Until such time as the company allots the shares, it does not have a right to use the monies paid on application by the prospective shareholders. Therefore it places the funds in trust. Section 722 of the Corporations Act states that:



If a person offers securities for issue or sale under a disclosure document (for example, a prospectus), the person must hold: (a) all application money received from people applying for securities under the disclosure document; and (b) all other money paid by them on account of the securities before they are issued or transferred; in trust under this section for the applicants until: (c) the securities are issued or transferred; or (d) the money is returned to the applicants.

When companies make an initial offer of shares to the public (which will require the compilation of a prospectus), this is typically referred to as an initial public offering (IPO). IPOs are often managed by another party, such as a financial continued

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institution or a stockbroker because such organisations have expertise in managing the public issue of shares. The financial institution or stockbroker might also employ the services of an underwriter. The underwriter gives advice on various matters, such as how to market the securities and what prices to ask for the securities. The underwriter also typically agrees to acquire all of the available shares that were made available to the public but for which the public did not subscribe. Therefore, in the presence of an underwriter any risks associated with undersubscription are shifted from the company to the underwriter. If, unlike the case in this example, the shares are being directly offered to a particular institutional investor (meaning a prospectus would not be used), then typically a trust account would not be used. The bank trust account would be considered an asset of the reporting entity and the application account would be considered a liability. 1 August 2019 Dr Application Cr Share capital

10 500 000 10 500 000

(to recognise the issue of shares and to close off the application account) The amount in share capital is determined by multiplying the issue price of the shares by the number of shares issued. In this example we have assumed that there has been no oversubscription. 1 August 2019 Dr Cash at bank Cr Bank trust

10 500 000 10 500 000

Once the shares have been allotted, the organisation can then use the funds in the operation of the business; hence the cash is transferred from the trust account to the general operating bank account. A cash trust account will be used whenever there is a minimum number of subscriptions that must be received before proceeding with a share issue. If the required minimum number of applications—as indicated in the prospectus—are not received the monies received will be repaid to the applicants from the trust account. Quite frequently, there will be an oversubscription for shares when there is an IPO. That is, more shares will be applied for than the number that are to be issued. Where there has been an oversubscription, the company needs to consider what to do with the excess applications. We will consider how to account for oversubscriptions later in this chapter.

Partly paid shares A company may issue shares on an instalment basis. This will require an amount to be paid on issue and a further amount at some specified future date. In such cases, where shares are partly paid, the paid portion of the shares is accounted for in the same manner as fully paid shares, while the balance, the deferred consideration, is of the nature of a receivable. This deferred consideration meets the Conceptual Framework for Financial Reporting definition of an asset because the company has a future economic benefit, the benefit is controlled by the directors, as they have determined when it is to be receivable, and the benefit arose as a result of a past event, the issue of the shares. Furthermore, it is probable that the future economic benefit can be measured with reliability. Where no future date has been specified for calling up the unpaid portion, an asset is not recognised until the company has specified a future date or dates for calling up the unpaid portion and informs shareholders of these dates. However, where shares have been issued on an instalment basis, with an amount to be paid on issue and with further amounts payable at specified future dates, a receivable must be recognised. This is shown in Worked Example 13.3.

WORKED EXAMPLE 13.3: Issue of partly paid shares Yeates Ltd commenced operations on 1 July 2019 by issuing 15 million ordinary shares by way of a direct private placement and at an issue price of $1.50 per share (because it is a private placement there is no need to use a trust account). Shareholders were required to pay $1.00 on application, with a further $0.35 payable on 1 September 2019 and a further $0.15 payable on 1 December 2019.

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REQUIRED Prepare the journal entries in the books of Yeates Ltd to account for the issue of the shares. SOLUTION 1 July 2019 Dr Cash Cr Share capital (Issuing of shares for cash)

15 000 000 15 000 000

1 July 2019 Dr First call 5 250 000 Dr Second call 2 250 000 Cr Share capital 7 500 000 (Recognising equity receivable—the call accounts are considered to be receivables) 1 September 2019 Dr Cash Cr First call (Receipt of cash for first call of $0.35 per share) 1 December 2019 Dr Cash Cr Second call (Receipt of cash for second call of $0.15 per share)

5 250 000 5 250 000

2 250 000 2 250 000

The call accounts, which are amounts receivable in the future by Yeates Ltd for the shares, meet the Conceptual Framework for Financial Reporting definition of an asset. Clearly, Yeates Ltd has a future economic benefit that is controlled—the directors have already determined when it is receivable, and the benefit arose from a past event, the issue of the shares. Because the amounts receivable on the future calls will be received in less than a year there would not be a need to discount the receivables to their present value. In Worked Example 13.3, the receivable is measured at its estimated realisable value. Where the collection of the receivable becomes doubtful, an allowance for doubtful debts should be raised.

Issue of shares other than for cash Shares in a company may be issued for a consideration other than cash. This consideration may take the form of: • promissory notes • contracts for future services • real or personal property, or • other securities of the company (for example, convertible debentures). Where shares are to be issued for a consideration other than cash, the directors of the company must determine the fair value of the consideration for the issue. Fair value is defined in the accounting standards as: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The issue of shares other than for cash is shown in Worked Example 13.4.

WORKED EXAMPLE 13.4: Issue of shares other than for cash On 1 December 2018, Joel Ltd invited Parkinson Ltd to purchase 700 000 shares at $2.50 per share. At the time of accepting the offer, Parkinson Ltd only had cash resources available of $900 000. The balance of the purchase price would be made up of future consulting services that Parkinson Ltd would supply to Joel Ltd. continued CHAPTER 13: SHARE CAPITAL AND RESERVES   463

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By 30 June 2019, Parkinson Ltd had supplied $400 000 worth of services to Joel Ltd. The balance of the consulting services are expected to be utilised by 31 November 2019. REQUIRED Provide the accounting entries to record the issue of the Joel Ltd shares. SOLUTION The entries to reflect the sale of the shares by Joel Ltd would be: 1 December 2018 Dr Cash Dr Future consulting services receivable Cr Share capital (Issuing of shares for cash and for future services)

900 000 850 000 1 750 000

30 June 2019 Dr Consulting fees expense (statement of profit or loss and other comprehensive income) Cr Future consulting services receivable (Recording portion of services received)

400 000 400 000

The above entry assumed that the services consumed by Joel Ltd were not used in the manufacture of inventory or in the construction of particular non-current assets. Had they been used for such purposes then the cost of the services would have been included within the cost of the respective assets rather than being expensed within profit or loss.

Shares oversubscribed Quite frequently, there will be an oversubscription for shares. That is, more shares will be applied for than the number to be issued. Where there has been an oversubscription, the company needs to consider what to do with the excess applications. Worked Example 13.5 provides an illustration of accounting for an oversubscription of shares.

WORKED EXAMPLE 13.5: Oversubscription for shares issued as partly paid In July 2019, Mooloolaba Ltd calls for public subscriptions for 10 million shares. The issue price per share is $1.20, to be paid in three parts, these being $0.50 on application, $0.40 within one month of the shares being allotted and $0.30 within two months of the first and final call, with the call for final payment being payable on 1 September 2019. By the end of July, when applications close, applications have been received for 12 million shares; that is, 2 million in excess of the amount to be allotted. The shares are allotted on 1 August 2019. REQUIRED Provide the accounting entries to record the issue of Mooloolaba Ltd’s shares. SOLUTION The accounting entries to record the receipts of the monies and the subsequent issue would be as follows. 1–31 July 2019 Dr Bank trust Cr Application

6 000 000 6 000 000

(to recognise the aggregated applications for shares made in July at the rate of $0.50 per share on application, the funds must stay in the trust account until such time as the shares are allotted) There has been an oversubscription for shares, and a number of approaches can be adopted to manage this oversubscription. The approach to be adopted would normally be prescribed in the prospectus related to the

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share issue (for a public issue of shares). Two approaches that could be adopted in the case of an oversubscription are: 1. satisfying the full demand of a certain number of subscribers and refunding the funds advanced by the other subscribers. This approach can be adopted where the shares are issued through an underwriter and the underwriter seeks to look after some favoured clients. Typically, where a publicly listed issue is oversubscribed, gains will be made by the initial investors on the first day of share trading (demand exceeds supply, leading to a price increase); 2. issuing shares to all subscribers on a pro rata basis. If shares are issued on a pro rata basis, the excess monies on application can either be refunded to all subscribers or they can be used to reduce any further amounts that might be owing on allotment (if shares are issued as partly paid). In this example, we will assume that the excess funds are used to offset the amount due on allotment ($0.40 per share), and that all subscribers will receive an allotment of shares on a pro rata basis. This means that if somebody has subscribed for 10 000 shares, they will receive 8333 shares: that is, 10 000 × 10 ÷ 12 shares. Allotment of shares is made on 1 August. 1 August 2019 Dr Application 5 000 000 Cr Share capital 5 000 000 (to allot the shares as partly paid to $0.50) Dr Allotment 4 000 000 Dr Call 3 000 000 Cr Share capital 7 000 000 (to recognise the amount due on allotment at $0.40 per share and the amount due on the first and final call of $0.30 per share; the allotment account and the call account are receivables, but are typically disclosed in the statement of financial position as a reduction against share capital) Dr Application 1 000 000 Cr Allotment 1 000 000 The excess amounts paid on application are offset against the amount due on allotment, rather than providing a refund to the subscribers. Following this entry, each subscriber is considered to owe the company a further $0.30 per share as a result of the share allotment. Dr Cash at bank 6 000 000 Cr Bank trust 6 000 000 Once the shares have been allotted to the investors, the company can transfer the funds out of its trust account for use in the day-to-day running of the business. 30 August 2019 Dr Cash at bank Cr Allotment (to recognise the receipt of amounts due on allotment)

3 000 000 3 000 000

It is assumed that all amounts due on allotment are paid. In practice, however, it is common for some investors to fail to pay the amounts due on allotment. Such a failure can result in the shares being forfeited. (We will consider the accounting treatment of forfeited shares later in this chapter.) Forfeiture would be very common where the market price of the share has fallen to the extent that what remains to be paid on the partly paid shares exceeds their current market value. 1 September 2019 Dr Cash at bank Cr Call

3 000 000 3 000 000

It is assumed that all holders of the partly paid shares pay the final instalment on their shares and that no shares are subsequently forfeited.

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Share issue costs When a company sells shares, various costs are incurred that are directly associated with the issue of the equity instruments. These include legal, promotional, accounting, underwriting and brokerage fees directly related to the issue of the shares. These costs are necessary to ensure the legal requirements associated with the sale are complied with and would not have been incurred had the shares not been issued. Share issue costs directly incurred as a result of the issue of shares are deducted from the proceeds of the share issue. This is consistent with AASB 132, paragraph 37. A company can also incur various indirect costs during a share issue. These costs include the costs of management time, costs associated with researching and negotiating sources of finance and costs of feasibility studies as well as the allocation of various internal costs. These indirect costs are not deducted from the proceeds of the share issue. An example of the allocation of costs associated with a share issue is detailed in Worked Example 13.6.

WORKED EXAMPLE 13.6: Accounting for share issue costs On 1 July 2019, Swellnet Ltd publicly issued 1 000 000 shares at $2.50 each. All of the shares were subscribed for. Swellnet Ltd incurred the following costs that were associated with the share issue: $ Advertising of share issue and prospectus

8 500

Accounting fees associated with drafting of prospectus

2 800

Legal expenses associated with share issue

3 600

Brokerage fees

1 080

Administration costs of existing staff members and other overheads

2 300

Costs associated with negotiating sources of finance

  3 020 2 1300

REQUIRED Prepare the journal entries necessary to account for the issue of the shares. SOLUTION Journal entries 1 July 2019 Dr Bank trust 2 500 000 Cr Application 2 500 000 (to recognise the aggregated applications for shares; the funds must stay in the trust account until such time as the shares are allotted) Dr Application 2 500 000 Cr Share capital 2 500 000 (to allot the shares) Dr Cash at bank 2 500 000 Cr Bank trust 2 500 000 (to transfer cash to the organisation’s working account) Dr Share capital 15 980 Dr Administration overheads (statement of 5 320 comprehensive income) Cr Cash 21 300 (allocating costs associated with share issue) The administration costs and costs associated with negotiating sources of finance are not deducted from the proceeds of the share issue.

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Accounting for distributions

LO 13.4

Distributions made by a company to its shareholders may take a number of forms. Although the usual form of distribution is a cash dividend, distributions can also be made in the form of a redemption of shares or the repurchase and cancellation of shares. Distributions can also be made in the form of cash, other assets or the conversion of equity to a liability. Where distributions are not made in the form of cash, they must be recorded at the fair value of the consideration at the date of distribution.

Accounting for cash dividends Dividends are a distribution of profits to shareholders. They are authorised by the directors of the company subject to any conditions that might be contained in the constitution of the company. Usually, a dividend is paid during the course of the year. An interim dividend is paid in anticipation of the current year’s profit and can be paid at any time during the year. A final dividend is authorised and typically paid after the end of the reporting period, once the financial statements have been completed. Whether or not a shareholder receives a dividend depends largely on the type of shares held. For example, holding ordinary shares does not automatically entitle a shareholder to a dividend. Dividends are paid at the discretion of the directors, and subject to the broad requirement that dividends can be paid only if the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; that the payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and that the payment of the dividend does not materially prejudice the company’s ability to pay its creditors (as required by s. 254T of the Corporations Act). The journal entries associated with the payment of dividends depend on whether the company draws a distinction between the various components of equity for financial reporting purposes. Where no distinction is held between the various components of equity, the entry to record the distribution of dividends is: Dr Cr

Dividends paid Cash

XXX XXX

At the end of the reporting period, the dividends paid will be closed off to equity. Dr Cr

Retained earnings Dividends paid

XXX XXX

It should be noted that some entities might simply debit retained earnings and credit cash, rather than performing the two separate sets of entries above. The net effect is the same.

Interim dividends When the directors pay an interim dividend, an appropriation is recorded in the records of the company. Dr Cr

Interim dividends Cash

XXX XXX

At the financial year end, the appropriation of interim dividends is closed to retained earnings. Dr Cr

Retained earnings Interim dividends

XXX XXX

Final dividends Once the final profit for the year has been calculated, which is after the end of the financial year, the directors are in a position to decide on the amount of final dividends to allocate to shareholders. Australian Accounting Standards prohibit the recognition of a dividend at the end of the reporting period unless the dividend has been declared prior to year end and the payment of the dividend does not require further ratification by other parties, such as by the shareholders at the annual general meeting (which is typically held after the year end). AASB 110 Events After the Reporting Period specifically prohibits the recognition of dividends as a liability at the end of the reporting period if the dividends have been declared after the end of the reporting period. As paragraphs 12 and 13 state: 12. If an entity declares dividends to holders of equity instruments (as defined in AASB 132 Financial Instruments: Presentation) after the reporting period, the entity shall not recognise those dividends as a liability at the end of the reporting period. 13. If dividends are declared (i.e. the dividends are appropriately authorised and no longer at the discretion of the entity) after the reporting period but before the financial statements are authorised for issue, the CHAPTER 13: SHARE CAPITAL AND RESERVES   467

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dividends are not recognised as a liability at the end of the reporting period because no obligation exists at that time. Such dividends are disclosed in the notes in accordance with AASB 101 Presentation of Financial Statements. The rationale behind this is that dividends declared after the reporting period do not meet the definition of a present obligation at the end of the reporting period because the entity has the discretion rather than an unavoidable commitment at the end of the reporting period to pay the dividends. However, it is again stressed that if a final dividend is declared at or before the end of the reporting period and requires no further ratification (the payment is binding), then it should be recorded as a liability. The entries would be of the form: Dr Cr Dr Cr

Final dividend declared Dividend payable Retained earnings Final dividend declared

XXX XXX XXX XXX

When the dividends are ultimately paid, the entries would be of the form: Dr Cr

Dividend payable Cash

XXX XXX

Accounting for the distribution of assets other than cash When a distribution made by a company does not take the form of cash, the value that the distribution is recorded at is the fair value of the consideration at the date of the distribution. If the fair value of the asset being distributed is different from its carrying amount, the difference is recognised as an income or expense item. For example, assume that because of cash-flow considerations the directors of a company decided to pay a dividend in the form of a truck. At the date of distribution the fair value of the asset was $100 000. It had originally cost $150 000 and had a carrying amount of $80 000. The journal entry to record the distribution would be: Dr Dr Cr Cr

Dividends paid Accumulated depreciation Truck Gain on disposal of asset

100 000 70 000 150 000 20 000

In this example the $20 000 gain on the disposal of the asset is the fair value adjustment recognised as a component of profit or loss.

LO 13.6

Redemption of preference shares

The Corporations Act imposes a number of requirements (in s. 254 (J) and (K)) in relation to the redemption of preference shares. As shown in Worked Example 13.7, where a company redeems its preference shares, s. 254K requires that the shares are to be redeemed out of profits that would otherwise be available for dividends, or out of the proceeds of a fresh issue of shares made for the purposes of the redemption. Section 254K also requires that only fully paid preference shares are to be redeemed.

WORKED EXAMPLE 13.7: Redemption of preference shares On 1 July 2019 Granite Bay Ltd makes a private placement of redeemable preference shares to Noosa National Park Ltd. Ten million preference shares are issued at a price of $3.00 per share, and they are redeemable at a fixed date, this being 30 June 2022. On 30 June 2022 the shares are redeemed as expected. REQUIRED Provide the accounting entries to reflect the issue and subsequent redemption of Granite Bay Ltd’s redeemable preference shares. SOLUTION The accounting entries to reflect the issue and the subsequent redemption would be:

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1 July 2019 Dr Cash at bank 30 000 000 Cr Share capital—preference shares 30 000 000 (to recognise the issue of 10 million preference shares at a price of $3.00 per share) Given the substance of the issue, the shares would be considered debt. The share capital account would be listed under the liabilities of Granite Bay Ltd, with a suitable note explanation as to why they have been classified as debt and not as equity. The returns paid to the holders would be recognised as interest expense rather than dividends. 30 June 2022 Dr Share capital—preference shares Cr Capital redemption reserve

30 000 000 30 000 000

This entry has the effect of eliminating the preference shares and creating a capital redemption account. The Corporations Act requires that a redemption of preference shares should not reduce total share capital. The balance in the capital redemption account can be transferred to share capital (see below). Dr Cr

Retained earnings Cash

30 000 000 30 000 000

To redeem the shares out of profits in accordance with s. 254K of the Corporations Act, the preference shares must be redeemed only out of profits or out of the proceeds of a new issue made for the purposes of the redemption. Hence, following the above entry, shareholders’ equity has been reduced by the carrying amount of the preference shares. While the above entries are consistent with the traditional approach to redeeming preference shares, Practice Note 6 ‘New financial reporting and procedural requirements’ (issued in 1998 by ASIC) indicates—as we have already seen—that any balance in the capital redemption reserve becomes part of the company’s share capital. The effect of this requirement would be that the first entry provided in this solution for 30 June is effectively reversed by an entry that debits the capital redemption account (therefore closing it off) and credits share capital. The entry would be: Dr Cr

Capital redemption reserve Share capital

30 000 000 30 000 000

Further, the requirement would also mean that, although we have redeemed preference shares (meaning there are fewer shares on issue), total share capital will not change. Practice Note 68 ‘New financial reporting and procedural requirements’ (released in 1998 by the Australian Securities and Investments Commission (ASIC) and updated in 2005) provides various guidelines on the redemption of preference shares. It notes that in redeeming preference shares we would typically create a capital redemption reserve that forms part of total shareholders’ equity. According to paragraph 99 of Practice Note 68: Paragraph 99: Redeemable preference shares would normally be classified as a liability in accordance with accounting standard AASB 132 Financial Instruments: Presentation. Where s. 254K(b) applies and the redemption is out of the proceeds of a fresh issue of shares, the entries would be as follows (assuming the fresh issue of shares and redemption are satisfied by cash): Dr Cash Cr Share capital (equity/liability) (the issue of shares)

X

Dr Share capital—redeemable preference shares (liability) Cr Cash (the redemption of the preference shares)

X

X

X

While the above entries relate to a redemption of preference shares by means of a ‘fresh’ issue of shares, preference shares can also be redeemed out of accumulated profits (retained earnings). Paragraphs 100 and 101 of Practice Note 68 provide guidance in this regard. They state: Paragraph 100: Where s. 254K(b) applies and the redemption is ‘out of profits’, the amount of the redemption should be recorded in the appropriations section of the profit and loss account rather than as an expense. CHAPTER 13: SHARE CAPITAL AND RESERVES   469

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The redemption is met ‘out of profits’ rather than being a component of profits. The requirement of s. 254K(b) would take precedence over the requirements of accounting standards or any Statement of Accounting Concepts. Paragraph 101: Redeemable preference shares are normally a liability in substance and the repayment of a liability would not normally give rise to an expense. Where all or part of the redemption is met out of profits, s. 254K(b) requires an additional entry in the nature of a transfer from retained profits in order to preserve the capital of the company and protect creditors. The entries required would be as follows (assuming the redemption is satisfied by cash): DR Retained earning CR Share capital (equity) (to transfer retained earnings to share capital)

X

DR Share capital—redeemable preference shares (liability) CR Cash (to redeem the preference shares)

X

LO 13.7

X

X

Forfeited shares

As noted previously in this chapter, if shares are issued as partly paid and some shareholders subsequently fail to pay the amounts due on allotment or on subsequent calls, their shares can be forfeited. If the forfeiture of shares results from non-payment of amounts owing, the shareholder will thereafter cease to be forfeited shares a member of the company. The shareholder may be entitled to a full or partial refund of the monies account paid before the forfeiture of the shares. There are various possible outcomes: An account reflecting the amounts paid by investors for partly paid shares and where those shares have been cancelled owing to failure of investors to pay all amounts due.

forfeited shares reserve A reserve for nonrefundable amounts paid by defaulting shareholders, shown as part of shareholders’ funds of the company.

•  If the company is listed on the Australian Securities Exchange or if the company’s operating rules (within its constitution) state that refunds are to be made, a refund is made to the investor. The amount refunded, however, might not represent the full amount paid by the investor, as the company will typically deduct the costs incurred in reissuing the shares. If the company is listed on the Australian Securities Exchange or its constitution provides for a refund to the defaulting shareholder, amounts paid by defaulting investors are recorded within a forfeited shares account. This account is a liability and will exist until such time as the monies are refunded to the former shareholders. •  If the company is not listed on the Australian Securities Exchange and its constitution makes no mention of refunding amounts previously paid by defaulting investors, the company is entitled to retain the amounts paid by the former shareholders, less any amounts incurred to reissue the shares. In this case, the amounts paid by the defaulting investors are recorded within a forfeited shares reserve, which would be shown as part of the shareholders’ funds of the company.

To illustrate the use of a forfeited shares account, assume, for example, that Coogee Ltd is listed on the Australian Securities Exchange. It has issued 10 million shares at a price of $2.00 per share. The investors are required to pay $1.00 on application and a further $1.00 when a call is made some months later. Following the call for $1.00 per share, it becomes apparent that the holder(s) of 100 000 shares have failed to pay the amount due on the call. As a result, the directors of the company elect to forfeit the shares. The accounting entry to record the forfeiture would be:

Dr Cr Cr

Share capital Call (a receivable) Forfeited shares account

200 000 100 000 100 000

As the company is listed on the Australian Securities Exchange, a refund will need to be made to the defaulting investors. But this refund will be made only after the costs of the reissue have been deducted. Let us also assume that Coogee Ltd reissues the shares as fully paid for an amount of $1.60; that is, $0.40 below the original issue price. We will suppose that the costs involved in generating the sale of the shares amount to $2 500. The accounting entries would be: Dr Dr Cr Dr Cr

Cash at bank Forfeited shares account Share capital Forfeited shares account Cash at bank

160 000 40 000 200 000 2 500 2 500

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The forfeited shares account is used to make up any shortfall on the issue of the shares and to fund the costs of the share reissue. Following the above journal entries, there would be a balance of $57 500 in the forfeited shares account. This represents a liability that must be paid to the former shareholders. The accounting entry relating to the refund would be: Dr Cr

Forfeited shares account Cash at bank

57 500 57 500

Note, once again, that if the company is not listed on the Australian Securities Exchange and its constitution is silent on the refunding of monies associated with forfeited shares, the net amount of $57 500 in the above illustration could be retained by the company. The amount would be transferred from the forfeited shares account to the forfeited shares reserve and would form part of shareholders’ funds. Another illustration of share forfeiture is considered in Worked Example 13.8.

WORKED EXAMPLE 13.8: Forfeiture of shares Torquay Ltd is listed on the Australian Securities Exchange. On 1 July 2019 the company allots 1 million shares for a price of $1.00 as partly paid to $0.50 per share. The call for the balance of the share price—$0.50—is made on the same date. By 1 December 2019, the holders of 900 000 shares have made the payment that is due on the call. The directors decide to forfeit the remaining 100 000 shares. The shares are reissued on 14 December 2019 as fully paid. The company receives $0.70 per share when the shares are reissued. The costs of conducting the sale amount to $500. The surplus amounts are returned to the original shareholders after payment of all the expenses associated with reissuing the shares. REQUIRED Provide the journal entries necessary to account for the call, forfeiture and subsequent reissue of Torquay Ltd’s shares. SOLUTION Journal entries to account for the call, forfeiture and subsequent reissue of Torquay Ltd’s shares are as follows: 1 July 2019 500 000 Dr Cash Dr Call 500 000 Cr Share capital 1 000 000 (to record the receipt of cash and the issue of a call of $0.50 per share on 1 million shares) 1 December 2019 Dr Cash at bank 450 000 Cr Call 450 000 (to record the aggregated receipt of call monies received from the holders of 900 000 shares) Dr Share capital Cr Call Cr Forfeited shares account (to record the forfeiture of 100 000 shares)

100 000 50 000 50 000

14 December 2019 70 000 Dr Cash at bank Dr Forfeited shares account 30 000 Cr Share capital 100 000 (to recognise the amount received on the subsequent sale of the forfeited shares) Dr Forfeited shares account 500 Cr Cash at bank 500 (to recognise the payment of costs incurred in relation to the sale of the shares) Dr Forfeited shares account 19 500 Cr Cash at bank 19 500 (to recognise the return of remaining monies to the original shareholders)

CHAPTER 13: SHARE CAPITAL AND RESERVES   471

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LO 13.9

Share splits and bonus issues

From time to time, particular companies might elect, pursuant to a resolution passed at a general meeting, to undertake a share split. A share split involves the subdivision of the company’s shares into shares of a smaller value. For example, a company that has issued 100 million shares might elect to subdivide these shares to create 200 million shares. Companies might undertake a share split because they feel that share split The subdivision of the the lower-priced shares will make the securities more marketable—but there is limited empirical company’s shares into research to support such a view. shares of a smaller When a share split occurs, there is no change to owners’ equity. The balance of the share face value, resulting in capital remains the same. A share split does not require any accounting journal entries, but it does no change to owners’ require the company to amend its share registers, which in itself will create some costs. Therefore, equity. management must believe that there are some benefits associated with share splits. If a company performs a share split, and the shares to be split are partly paid, the share split must be done in such a way as to divide the uncalled portion equally among the shares issued. For example, if a company has issued 1 million shares on which there was an amount of 50 cents uncalled per share, and the company splits its shares in two, the company would have 2 million shares on which 25 cents can be called per share. This treatment is consistent with s. 254H(3) of the Corporations Act, which stipulates that: ‘any amount unpaid on shares being converted is to be divided equally among the replacement shares’. bonus shares Shares received from a Companies can also issue bonus shares. When a bonus issue is made, existing shareholders bonus issue. receive additional shares, at no cost, in proportion to their shareholding at the date of the bonus issue. For example, a company might have issued 10 million ordinary shares. On a given date it decides to issue 1 million bonus shares out of retained earnings (a ‘one-for-ten’ bonus issue). If the market price per share is $1.00, the accounting journal entry to record the bonus issue may be summarised as: Dr Cr

Retained earnings Share capital—ordinary shares

1 000 000 1 000 000

The effect of the above entry is that one equity account—share capital—increases, while another equity account— retained earnings—decreases. There is no net effect on owners’ equity; however, the procedure does effectively ‘lock in’ the retained earnings, making them unavailable for future cash dividends. When bonus issues are made out of retained earnings, they are commonly referred to as a bonus share dividend bonus share dividend. Although shareholders typically feel as though they have gained from a A distribution to bonus issue, what must be remembered is that their proportional share in the net assets of the existing shareholders business does not change. For example, if the company referred to above has total assets of $100 in the form of additional million, and liabilities of $23 million, the net asset backing per share would be $7.70 per share shares in the entity, before the bonus issue. This is calculated by dividing the net assets of the company by the number normally on a pro rata of shares on issue ($77 000 000 ÷ 10 000 000). Therefore an individual holding of 10 000 shares basis. would have a total claim against the net assets of the business of $77 000. Following the bonus issue, the net asset backing per share would be $7.00 per share ($77 000 000 ÷ 11 000 000— the assets of the business do not change, but the issued shares increase by 1 million). The individual initially holding 10 000 shares would hold 11 000 shares following the bonus issue, and the investor’s share of the net assets of the business would still be $77 000 (11 000 × $7.00). So although the shareholders might be happy with a bonus issue, are they really any better off after such an issue compared with before the issue? Interestingly, total market there is some evidence to suggest that the total market capitalisation of a company after a bonus capitalisation issue tends, on average, to be greater than it was before the bonus issue. (Market capitalisation Calculated by of a company is calculated by multiplying the number of shares on issue by their market price.) In multiplying the number part, this might be due to a signalling effect. Evidence, such as that provided in Ball, Brown and Finn of issued shares in a (1977), suggests that the majority of share splits and bonus issues are accompanied by increases company by their latest market price. in the total dividends paid by the companies. This might indicate to investors that the company is going to be in a position to pay greater dividends, which, in itself, might warrant a reappraisal of the value of the organisation. Of course, undertaking a bonus issue or share split is a very indirect way for a company to signal increased dividends—it could more easily simply announce that total dividend payments will increase in the future. Another approach to issuing shares is by way of either rights issues or by releasing share options. We will briefly consider these in the following section. However, options are covered in more detail in Chapter 17 on share-based payments. 472  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Rights issues and share options

LO 13.8

A rights issue generally involves providing existing shareholders with the right to acquire additional shares in the entity for a specified—and often quite attractive—price. For example, a company might offer existing shareholders the right to acquire one additional share in the company for each 10 shares currently held. The acquisition price would be specified. If all current shareholders acquired the shares available under the rights issue the proportional ownership interest of each shareholder would not change. Some rights issues may be tradeable, and others not. If the rights are tradeable (often referred to as ‘renounceable’) the recipients of the rights (shareholders) will have the ability to sell the rights to others. Rights that cannot be transferred or traded are referred to as non-renounceable rights. The accounting entries for a rights issue are similar to those for a share issue. Worked Example 13.9 considers a rights issue.

WORKED EXAMPLE 13.9: A rights issue Coolum Ltd required additional equity funding and decided to issue a renounceable rights offer. To reduce the risks associated with the rights issue, Coolum Ltd appointed an underwriter. Coolum sent out details of the rights issue to existing shareholders on 1 July 2019, offering existing shareholders the right to acquire an additional share in Coolum Ltd for $2.20 per share. The shares were to be fully paid on application and all applications had to be received by 1 September 2019. The total shares on offer through the rights issue were 10 million (meaning total subscriptions of $22 million). By 1 September 2019 applications had been received for 9 million shares, meaning that the underwriter was responsible for acquiring the remaining 1 million shares. The shares were issued on 7 September 2019, with this also being the date on which amounts due from the underwriter were received. REQUIRED Provide the journal entries to account for the Coolum Ltd rights issue. SOLUTION As with the public issue of shares, the monies received from the rights issue must initially be placed in the trust account. 1 September 2019 Dr Bank trust Cr Application

19 800 000 19 800 000

Because of the undersubscription, the underwriter is required to acquire the additional 1 million shares. The amount due from the underwriter is a receivable. Dr Receivable—underwriter 2 200 000 Cr Application 2 200 000 7 September 2019 Dr Cash at bank Cr Receivable—underwriter Cr Bank trust Dr Application Cr Share capital

22 000 000 2 200 000 19 800 000 22 000 000 22 000 000

Issuing additional shares, whether through a rights issue or otherwise, can lead to individual shareholders having a diluted interest in a company in situations where new investors are offered the opportunity to buy new shares in the company. Turning our attention to the accounting treatment of share options, a share option will give the holder the right to acquire shares at a particular price in the future. In this respect, they are similar to rights issues. However, options are often sold by the entity or are provided as part of a salary package provided to employees. Some options also have a life of a number of years before they are either exercised or expire. Rights issues, by contrast, typically have quite short lives. CHAPTER 13: SHARE CAPITAL AND RESERVES   473

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Once share options are issued, the actual options may or may not be exercised in the future. They will be exercised to the extent they are ‘in the money’. An option is deemed to be ‘in the money’ to the extent that the exercise price (the price to acquire the share) is less than the current market price of the share. Accounting for option issues—particularly putting a cost on them—can be a difficult exercise. AASB 2 Share-Based Payments provides the rules for accounting for share options and we will consider how to account for share options in more depth in Chapter 17 on share-based payments. As Chapter 17 will reveal, accounting for share options was a particularly controversial topic—especially the issue of placing a cost on the share options that were issued to employees. Many companies argued that such options cost the company nothing and therefore they recognised no expenses in relation to the issue. Pursuant to AASB 2, a cost must now be attributed to the options, as we will see in Chapter 17. Worked Example 13.10 provides a relatively straightforward example of accounting for share options provided to employees. In this example we nominate a cost for each option, thereby avoiding the tricky valuation issue.

WORKED EXAMPLE 13.10: Share options provided to employees On 1 July 2019 Caloundra Ltd provided a total of 5 million options to three of its key managers. The options have a fair value of 50 cents each and allowed the executives to acquire shares in Caloundra Ltd for $5 each. The executives are not permitted to exercise the options before 30 June 2021, but may then exercise them any time between 1 July 2021 and 30 June 2022. The market price of the Caloundra Ltd shares on 1 July 2019 was $4.40. Therefore, if the executives are unable to formulate strategies to increase the value of the firm’s shares the options will be ‘out of the money’ and therefore of limited value. It is assumed that on 31 December 2021 the share price reaches $6.00 and all of the executives exercise their options and acquire the shares in Caloundra Ltd. REQUIRED Account for the issue and exercise of the options in Caloundra Ltd. SOLUTION The initial provision of options to the executives is to be treated as part of total salaries cost. Therefore the entry is: 1 July 2019 Dr Salaries expense Cr Share options (part of share capital)

2 500 000 2 500 000

The share option account would be considered to be part of total equity and would be disclosed separately from share capital. Should the options ultimately not be exercised—because the market price of the shares does not exceed $5 throughout the period in which the right to exercise has vested—AASB 2 Share-Based Payments allows the entity to transfer the balance in the share option account to another equity account. Specifically, paragraph 23 of AASB 2 states: Having recognised the goods or services received in accordance with paragraphs 10–22, and a corresponding increase in equity, the entity shall make no subsequent adjustment to total equity after vesting date. For example, the entity shall not subsequently reverse the amount recognised for services received from an employee if the vested equity instruments are later forfeited or, in the case of share options, the options are not exercised. However, this requirement does not preclude the entity from recognising a transfer within equity, that is, a transfer from one component of equity to another. However, in this example the options are in fact exercised by the managers, which leads to the following entries: 31 December 2021 Dr Cash at bank Cr Share capital Dr Share options Cr Share capital

25 000 000 25 000 000 2 500 000 2 500 000

As we can see from the above entry, the cost attributed to the options at the date of their issue will be transferred to share capital when the options are exercised. Had some of the options been allowed to expire then, consistent with the paragraph provided above, we could have transferred an amount from the ‘share option’ account to another equity account, such as to a ‘general reserve’.

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Required disclosures for share capital

LO 13.10

AASB 101 Presentation of Financial Statements, requires a number of disclosures to be made in relation to share capital. For example, paragraph 78(e) requires an entity to disclose, either on the face of the statement of financial position (balance sheet) or in the notes, further subclassifications of equity capital and reserves so that the information is disaggregated into various classes, such as paid-in capital and reserves. According to paragraph 79 of AASB 101: An entity shall disclose the following, either in the statement of financial position or the statement of changes in equity, or in the notes: (a) for each class of share capital: (i) the number of shares authorised; (ii) the number of shares issued and fully paid, and issued but not fully paid; (iii) par value per share, or that the shares have no par value; (iv) a reconciliation of the number of shares outstanding at the beginning and at the end of the period; (v) the rights, preferences and restrictions attaching to that class including restrictions on the distribution of dividends and the repayment of capital; (vi) shares in the entity held by the entity or by its subsidiaries or associates; and (vii) shares reserved for issue under options and contracts for the sale of shares, including the terms and amounts; and (b) a description of the nature and purpose of each reserve within equity.

Reserves

LO 13.1 LO 13.10

As we know, companies can have numerous types of reserves forming part of their shareholders’ funds. In Chapter 6, as well as previously within this chapter, we considered the revaluation surplus, which forms part of the shareholders’ funds of a company. The revaluation surplus is created through the upward revaluation of noncurrent assets. For example, if an organisation revalues its land from $700 000 to $850 000, ignoring tax implications, the accounting entry to record the revaluation would be: Dr Cr

Land Revaluation surplus

150 000 150 000

Apart from the revaluation surplus, companies often create reserves that they label ‘general reserves’. Such titles are not overly informative, as the reserves could have been created for any number of reasons. Some companies establish general reserves as a means of transferring profits out of retained earnings for future expansion plans. For example, a company might consider that it needs to put aside $750 000 per year for three years to fund the restructuring of the organisation in three years’ time. The entry each year would be: Dr Cr

Retained earnings General reserve

750 000 750 000

general reserve Reserve that is part of shareholders’ funds and is created for various reasons— sometimes as a means of transferring profits for future expansion plans.

The net effect of the above entry on shareholders’ funds is nil. The purpose of this entry might be that directors want to signal, by reducing retained earnings, that they do not intend to pay, as dividends, the amount transferred to the general reserve. There are many other reserves that companies can have in addition to those discussed above. For example, particular accounting standards require the creation of reserves. For instance, as is explained in Chapter 14, there is a requirement within AASB 9 Financial Instruments that a ‘hedging instrument’ used to hedge future cash flows shall be measured at fair value, with any gains or losses on the instrument initially going to equity in the form of a transfer to a ‘cash flow hedge reserve’. As another example, and as is explained in Chapter 31, pursuant to AASB 121 The Effects of Changes in Foreign Exchange Rates, when the financial statements of a foreign subsidiary are translated to a different presentation currency, this will lead to the creation of a foreign currency translation reserve. In relation to equity, AASB 101 Presentation of Financial Statements requires the entity to present a statement that shows all changes in equity that have occurred throughout the reporting period. This ‘statement of changes in equity’ CHAPTER 13: SHARE CAPITAL AND RESERVES   475

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(which is further considered in Chapter 16) is to be produced along with the statement of financial position, statement of profit or loss and other comprehensive income, statement of cash flows and notes to the financial statements. In relation to the required content of a statement of changes in equity, paragraph 106 of AASB 101 states: The statement of changes in equity includes the following information: (a) total comprehensive income for the period, showing separately the total amounts attributable to owners of the parent and to non-controlling interest; (b) for each component of equity, the effects of retrospective application or retrospective restatement recognised in accordance with AASB 108; and (c) [deleted by the IASB] (d) for each component of equity, a reconciliation between the carrying amount at the beginning and the end of the period, separately disclosing changes resulting from: (i) profit or loss; (ii) other comprehensive income; and (iii) transactions with owners in their capacity as owners, showing separately contributions by and distributions to owners and changes in ownership interests in subsidiaries that do not result in a loss of control. Paragraph 107 of AASB 101 further requires: An entity shall present, either in the statement of changes in equity or in the notes, the amount of dividends recognised as distributions to owners during the period, and the related amount per share. Again, the statement of changes in equity is considered in more detail in Chapter 17.

SUMMARY The chapter addressed a number of accounting issues associated with share capital and reserves, which are themselves components of equity (or shareholders’ funds, as companies commonly refer to equity). Equity is defined as the residual interest in the assets of an entity after deduction of its liabilities. The balance of equity will be directly affected by the various rules for asset and liability recognition and measurement adopted by the reporting entity. For a company, shareholders’ funds (equity) can comprise many accounts, including revaluation surplus, general reserves, retained earnings and share capital. Where shares are issued to the public, there is a legislative requirement that the funds be placed in trust until such time as the shares are allotted to investors. Any additional amounts due from subscribers following the share allotment are considered assets of the share-issuing company. The chapter also noted that, as well as ordinary shares, companies can issue preference shares. Preference shares should be disclosed as debt or equity (or perhaps as part debt and part equity), depending upon the conditions associated with their issue. Forfeiture of shares, share splits and bonus issues were also discussed. As indicated, share splits and bonus issues have no effect on the total of shareholders’ funds in a company.

KEY TERMS bonus share dividend  472 bonus shares  472 dividend  459 equity  458 forfeited shares account  470

forfeited shares reserve  470 general reserve  475 ordinary shares  459 par value  460 preference shares  459

share capital  460 share premium  460 share split  472 shareholders’ funds  458 total market capitalisation  472

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END-OF-CHAPTER EXERCISES Noosa Ltd makes an offer of shares to the public. In its prospectus it notes that the shares are to be issued at $1.00 per share. The shares are to be paid in three instalments. The first payment, to be made on application, is $0.40. A second amount of $0.40 will be due within one month of allotment, and the third amount of $0.20 will be due within one month of the first and final call. Noosa Ltd will seek to issue 10 million shares. The closing date for applications is 31 August 2019. By the closing date, applications have been received for 14 million shares. To deal with the oversubscription, Noosa Ltd has decided to issue shares to all subscribers on a pro rata basis. All amounts due on allotment are paid by the due date. The first and final call for $0.20 is made on 30 November 2019, with the amounts being due by 31 December 2019. Holders of two million shares fail to pay the amount due on the call by the due date, and on 15 January 2020 these holders have their shares forfeited. The forfeited shares are auctioned on 15 February 2020. An amount of $0.70 per share is received. The cost of holding the auction is $5 000. The shares are sold as ‘fully paid’.

REQUIRED Provide the accounting journal entries necessary to account for the above transactions and events. LO 13.3, 13.7

SOLUTION TO END-OF-CHAPTER EXERCISE The accounting entries to record the above transactions and events are as follows: 31 August 2019 Dr Cash trust 5 600 000 Cr Application (to recognise the total amounts received on application for shares)

5 600 000

An amount of $0.40 per share was received on 14 million shares. The application account is considered to be a liability. Dr Application 4 000 000 Cr Share capital 4 000 000 (to recognise the issue of the shares at $0.40 per share) Dr Allotment 4 000 000 Dr Call 2 000 000 Cr Share capital 6 000 000 (to recognise the amount of $0.40, which is due within one month of the allotment and the call which will be due for an amount of $0.20 per share payable on 30 November 2019) Dr Application 1 600 000 Cr Allotment 1 600 000 (excess amounts paid on application are offset against amounts due on allotment) It is assumed that the company has decided to issue the shares on a pro rata basis and that it is permitted to offset the additional amounts paid on application against the amounts due on allotment. Dr Cash at bank 5 600 000 Cr Cash trust (to transfer the funds into the company’s operating account)

5 600 000

30 September 2019 Dr Cash at bank 2 400 000 Cr Allotment 2 400 000 (the aggregated entry to record the receipt of the amounts due on allotment)

CHAPTER 13: SHARE CAPITAL AND RESERVES   477

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31 December 2019 Dr Cash at bank 1 600 000 Cr Call 1 600 000 (the aggregated entry to recognise the receipt of monies due from the holders of 8 million of the shares) 15 January 2020 Dr Share capital 2 000 000 Cr Call 400 000 Cr Forfeited shares account 1 600 000 (to record the forfeiture of those 2 million shares on which the call of $0.20 was not paid; the amount of $1.6 million represents the amount that has already been paid by the defaulting shareholders) 15 February 2020 Dr Cash at bank 1 400 000 Dr Forfeited shares account 600 000 Cr Share capital 2 000 000 (to recognise the receipt of $0.70 per share on those shares sold as fully paid to $1.00) Dr Forfeited shares account Cr Cash at bank (to recognise the cost of the auction)

5 000 5 000

Dr Forfeited shares account 995 000 Cr Cash at bank 995 000 (to refund the balance remaining in the forfeited shares account to the former shareholders)

REVIEW QUESTIONS 1. What are share splits and what accounting entries are necessary when a share split is undertaken? LO 13.9 2. Would you expect the total market capitalisation of an entity to increase following a share split? LO 13.9 3. When shares are issued, accounts such as the application, allotment and call accounts are used.

REQUIRED Describe, respectively, whether these accounts are assets or liabilities (or neither). LO 13.3 4. Bronte Ltd has 50 million $1 shares on issue. It decides to do a ‘one-for-five’ bonus issue from retained earnings.

REQUIRED Provide the necessary journal entries. LO 13.9 5. Assuming that there is an oversubscription for shares in a company, how can the directors of the company deal with the funds that have been oversubscribed? LO 13.3 6. Explain why equity is affected by the choice of particular asset and liability measurement practices. LO 13.1 7. How do Australian Accounting Standards require preference shares to be disclosed? LO 13.5, 13.10 8. Clovelly Ltd issues some preference shares. They provide a rate of return of 6 per cent and are redeemable at the option of the company. Would you disclose these preference shares as debt or equity? Explain your decision. LO 13.1, 13.5 9. What forms of preferential treatment can the holders of preference shares receive over and above the rights of holders of ordinary shares? LO 13.5 10. Are preference shares debt or equity? LO 13.5 11. What disclosures are required in relation to the reserves of a company? LO 13.10 12. What is the role of the statement of changes in equity? LO 13.10 13. First Point Ltd commences operations by issuing 1 million shares at a price of $1.40 per share, payable in full on application. Application monies are received on 31 July 2019 and the shares are allotted on 4 August 2019. The share issue is made as a result of an offer being made to the public. 478  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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REQUIRED Provide the journal entries to account for the receipt of the application monies and the subsequent allotment of the shares. LO 13.3 14. On 1 July 2018, Mick Ltd invited Fanning Ltd to purchase 1 million shares at $3.00 per share. At the time of accepting the offer, Fanning Ltd—which is an insurance company—had cash resources available of only $2 600 000. The balance of the purchase price would be made up of insurance to be provided by Fanning Ltd to Mick Ltd. By 30 June 2019, Fanning Ltd had supplied $280 000 worth of insurance to Mick Ltd.

REQUIRED Provide the accounting entries to record the issue of the Mick Ltd shares. LO 13.3 15. On 1 July 2019, Coastalwatch Ltd issued 5 million shares at $5.00 each. All the shares were subscribed for. Coastalwatch Ltd incurred the following costs that were associated with the share issue: Advertising of share issue and prospectus Accounting fees associated with drafting of prospectus Legal expenses associated with share issue

$ 10 000 4000 5000

REQUIRED Prepare the journal entries necessary to account for the issue of the shares. LO 13.3 16. Tewantin Ltd makes an offer to the public for investors to subscribe for 10 million shares. The shares are issued at $2.00 per share. Applications for shares close on 15 July 2019, with $1.00 being paid on application and a further $1.00 being payable within one month of allotment. By 15 July 2019 applications have been received for 11 million shares, and it is decided that all subscribers will receive shares on a pro rata basis, with any excess paid on application to be offset against the amount due on allotment. The shares are allotted on 20 July 2019. Subsequently, holders of 1 million shares fail to make their payments due on allotment by 20 August 2019. On 31 August the 1 million shares are forfeited and auctioned as fully paid. An amount of $1.50 is received for each share sold.

REQUIRED Provide the journal entries to account for the above events. LO 13.3, 13.7 17. Byron Ltd required additional equity funding and decided to issue a renounceable rights offer. To reduce risks associated with the rights issue, Byron Ltd appointed an underwriter. Byron Ltd sent out details of the rights issue to existing shareholders on 1 July 2019 and offered existing shareholders the right to acquire an additional share in Byron Ltd for $3.00 per share. The shares were to be fully paid on application and all applications had to be received by 10 September 2019. The total shares on offer through the rights issue were 15 million. By 10 September 2019 applications had been received for 13 million shares, meaning that the underwriter was responsible for acquiring the remaining 2 million shares. The shares were issued on 17 September 2019 with this also being the date on which amounts due from the underwriter were received.

REQUIRED Provide the journal entries to account for the Byron Ltd rights issue. LO 13.3, 13.8 18. On 1 July 2019 Cooloola Ltd provided 1 million options to its chief executive officer. The options were valued at $1.00 each and allowed the chief executive officer to acquire shares in Cooloola Ltd for $7 each. The chief executive officer is not permitted to exercise the options before 30 June 2021 but may then exercise them any time between 1 July 2021 and 30 June 2022. The market price of the Cooloola Ltd shares on 1 July 2019 was $6.50. On 31 December 2021 the share price reaches $7.70 and the chief executive officer decides to exercise her options and acquire the shares in Cooloola Ltd.

REQUIRED Account for the issue and exercise of the options in Cooloola Ltd. LO 13.8 CHAPTER 13: SHARE CAPITAL AND RESERVES   479

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CHALLENGING QUESTIONS 19. If a company declares a final dividend to shareholders, under what conditions would such a dividend declaration create a liability that would be required to be disclosed in the statement of financial position? LO 13.4 20. Tamarama Ltd issues 1 million redeemable preference shares of $2.00 each on 1 July 2019. The shares offer a rate of return of 7 per cent per annum. The shares are later redeemed at the option of the shareholders on 30 June 2021.

REQUIRED (a) Would you classify these preference shares as debt or equity? Why? LO 13.5 (b) Provide the journal entries necessary to record the issue and subsequent redemption of the shares. LO 13.3, 13.6 21. Brighton Ltd issues a prospectus inviting the public to subscribe for 10 million ordinary shares of $2.00 each. The terms of the issue are that $1.00 is to be paid on application and the remaining $1.00 within one month of allotment. Applications are received for 12 million shares during July 2019. The directors allot 10 million shares on 5 August 2019. All applicants receive shares on a pro rata basis. The amounts payable on allotment are due by 5 September 2019. By 5 September 2019 the holders of 2 million shares have failed to pay the amounts due on allotment. The directors forfeit the shares on 10 September 2019. The shares are resold on 15 September 2019 as fully paid. An amount of $1.80 per share is received.

REQUIRED Provide the journal entries necessary to account for the above transactions and events. LO 13.3, 13.7

REFERENCES BALL, R., BROWN, P. & FINN, F., 1977, ‘Share Capitalisation Changes, Information and the Australian Equity Market’, Australian Journal of Management, October, pp. 105–25.

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CHAPTER 14

ACCOUNTING FOR FINANCIAL INSTRUMENTS LEARNING OBJECTIVES (LO) 14.1 Understand what a financial instrument is and when a financial instrument shall be recognised. 14.2 Know what constitutes a financial asset, a financial liability, and an equity instrument. 14.3 Understand the factors that determine whether a financial instrument shall be presented as debt, or equity, in the financial statements of the issuing entity. 14.4 Understand the difference between a primary financial instrument and a derivative financial instrument. 14.5 Understand what a compound financial instrument is and how the debt and equity components of a compound equity instrument are to be determined. 14.6 Understand what a ‘set-off’ represents, when it is permitted and what benefits it generates. 14.7 Understand how to measure financial instruments and know that financial instruments are initially to be recorded at fair value. 14.8 Understand the measurement rules for financial instruments subsequent to initial recognition and understand that the basis of measurement depends upon both the entity’s business model for managing financial assets and the contractual cash flow characteristics of the financial instrument. 14.9 Know how to account for gains and losses on financial instruments measured at fair value. 14.10 Understand how to account for derivatives and the assets and liabilities that are part of a hedging arrangement. 14.11 Understand what a futures contract represents and understand that futures contracts can be used as hedging instruments. 14.12 Understand the difference between a fair value hedge and a cash flow hedge, and know how to account for the respective ‘hedged items’ and ‘hedging instruments’. 14.13 Understand what options are, and how to account for them. 14.14 Understand the meaning of a ‘foreign currency swap’, and an ‘interest rate swap’, and know how to account for them. 14.15 Understand that some derivative financial instruments can significantly increase the risk exposure of an organisation—and so appreciate the necessity for full disclosure in relation to such instruments. 14.16 Have a general understanding of the disclosure requirements embodied in AASB 7 Financial Instruments: Disclosure. CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  481

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Introduction to accounting for financial instruments Accounting for financial instruments can be a rather complicated activity given the myriad of forms that financial instruments can take (for example, ‘financial instruments’ would include shares, bonds, share options, interest rate futures, share price index futures, currency futures and compound financial instruments). Until 2009 the major accounting standard dealing with financial instruments was AASB 139 Financial Instruments: Recognition and Measurement. However, the IASB embarked on a project to simplify the classification and measurement requirements for financial instruments. The project, which ultimately culminated in major changes being made to IFRS 9 Financial Instruments (which was initially released in 2009), comprised of three phases. These phases as applied to financial instruments were: • Phase 1: Classification and measurement; • Phase 2: Impairment methodology; and • Phase 3: Hedge accounting. The IASB completed the final element of the project with the publication of IFRS 9 Financial Instruments in July 2014. At this time, the IASB issued a press release, which is reproduced below: PRESS RELEASE OF THE IASB: IASB completes reform of financial instruments accounting 24 July 2014 The International Accounting Standards Board (IASB) today completed the final element of its comprehensive response to the financial crisis by issuing IFRS 9 Financial Instruments. The package of improvements introduced by IFRS 9 includes a logical model for classification and measurement, a single, forward-looking ‘expected loss’ impairment model and a substantially-reformed approach to hedge accounting. The new Standard will come into effect on 1 January 2018 with early application permitted. Classification and Measurement Classification determines how financial assets and financial liabilities are accounted for in financial statements and, in particular, how they are measured on an ongoing basis. IFRS 9 introduces a logical approach for the classification of financial assets, which is driven by cash flow characteristics and the business model in which an asset is held. This single, principle-based approach replaces existing rule-based requirements that are generally considered to be overly complex and difficult to apply. The new model also results in a single impairment model being applied to all financial instruments, thereby removing a source of complexity associated with previous accounting requirements. Impairment During the financial crisis, the delayed recognition of credit losses on loans (and other financial instruments) was identified as a weakness in existing accounting standards. As part of IFRS 9, the IASB has introduced a new, expectedloss impairment model that will require more timely recognition of expected credit losses. Specifically, the new Standard requires entities to account for expected credit losses from when financial instruments are first recognised and to recognise full lifetime expected losses on a more timely basis. The IASB has already announced its intention to create a transition resource group to support stakeholders in the transition to the new impairment requirements. Hedge accounting IFRS 9 introduces a substantially-reformed model for hedge accounting, with enhanced disclosures about risk management activity. The new model represents a significant overhaul of hedge accounting that aligns the accounting treatment with risk management activities, enabling entities to better reflect these activities in their financial statements. In addition, as a result of these changes, users of the financial statements will be provided with better information about risk management and the effect of hedge accounting on the financial statements. Own credit IFRS 9 also removes the volatility in profit or loss that was caused by changes in the credit risk of liabilities elected to be measured at fair value. This change in accounting means that gains caused by the deterioration of an entity’s own credit risk on such liabilities are no longer recognised in profit or loss. Early application of this improvement to financial reporting, prior to any other changes in the accounting for financial instruments, is permitted by IFRS 9. 482  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Hans Hoogervorst, Chairman of the IASB commented: The reforms introduced by IFRS 9 are much needed improvements to the reporting of financial instruments and are consistent with requests from the G20, the Financial Stability Board and others for a forward-looking approach to loan-loss provisioning. The new Standard will enhance investor confidence in banks’ balance sheets and the financial system as a whole. Apart from AASB 9 Financial Instruments, another relevant accounting standard when discussing financial instruments is AASB 132 Financial Instruments: Presentation (equivalent to IAS 32). AASB 132 acts as a companion to AASB 9 (IFRS 9). As paragraphs 2 and 3 of AASB 132 state: 2. The objective of this Standard is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. It applies to the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments; the classification of related interest, dividends, losses and gains; and the circumstances in which financial assets and financial liabilities should be offset. 3. The principles in this Standard complement the principles for recognising and measuring financial assets and financial liabilities in AASB 9 Financial Instruments, and for disclosing information about them in AASB 7 Financial Instruments: Disclosures. Apart from determining whether particular financial instruments should be presented as liabilities or as equity from the perspective of the issuer (this issue is addressed in AASB 132—and the classification as debt or equity will in turn have implications for whether the related payments are classified as dividends or interest expense), there will also be various disclosure requirements. For example, the entity might be expected to disclose information about the nature and extent of risks arising from financial instruments to which the entity is exposed, or the total interest income derived from financial instruments. Various required disclosures for financial instruments are identified in another accounting standard, this being AASB 7 Financial Instruments: Disclosures. Paragraphs 1 and 2 of AASB 7 identify the objectives of AASB 7. These are: 1. The objective of this Standard is to require entities to provide disclosures in their financial statements that enable users to evaluate: (a) the significance of financial instruments for the entity’s financial position and performance; and (b) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks. 2. The principles in this Standard complement the principles for recognising, measuring and presenting financial assets and financial liabilities in AASB 132 Financial Instruments: Presentation and AASB 9 Financial Instruments. Hence, while it is perhaps somewhat confusing, when we account for financial instruments we need to consider three accounting standards: • AASB 9 Financial Instruments, which specifies the requirements for recognising and measuring financial instruments; • AASB 132 Financial Instruments: Presentation, which specifies presentation requirements for financial instruments; and, • AASB 7 Financial Instruments: Disclosures, which specifies disclosure requirements for financial instruments.

financial instrument Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial instruments defined Given that this chapter addresses issues associated with ‘financial instruments’, we need to first be confident that we know what this term means. For the purposes of this discussion, we adopt the definition of financial instruments provided in paragraph 11 of AASB 132 Financial Instruments: Presentation, this being:

LO 14.1 LO 14.2 LO 14.3 LO 14.4

any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. If these components do not exist, the item is not deemed to be a financial instrument. It is stressed that a ‘financial instrument’ has two sides—one party to the contract must have a financial asset (such as equity investment in a company, CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  483

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financial asset An asset that is cash or a contractual right to receive cash from or exchange financial instruments with another entity.

financial liability A contractual obligation 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.

equity instrument Financial instrument that provides the holder with a residual interest in an entity after deduction of its liabilities.

or hold a debt instrument that provides evidence of a claim against a company as a result of lending funds to it), whereas the other party to the contract has responsibilities in relation to the issued financial liability, or equity instrument. As the definition of ‘financial instrument’ indicates, there must be a contractual right or obligation in existence for something to be deemed to be a financial instrument. If there is no contractual right or obligation then there is no financial instrument. The above definition of a financial instrument calls for us to define, in turn, a financial asset, a financial liability and an equity instrument (given that these terms are used in the definition of ‘financial instrument’). Financial assets are defined from the perspective of the holder of the financial instrument (such as the investor or the lender), whereas financial liabilities and equity instruments are defined from the perspective of the issuing organisation. According to paragraph 11 of AASB 132, ‘financial asset’ means any asset that is: (a) cash; (b) an equity instrument of another entity; (c) a contractual right: (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 entity’s 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 entity’s 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 entity’s own equity instruments. For this purpose the entity’s 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 entity’s own equity instruments.

‘Financial liability’, on the other hand (and remember, financial liabilities and equity instruments are defined from the perspective of the issuing entity), means any liability that is: (a) a contractual obligation: (i) to deliver cash or another financial asset to another entity; or (ii) 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 entity’s 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 entity’s 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 entity’s own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s 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 entity’s 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 entity’s own equity instruments. ‘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’. The most commonly issued equity instrument would be an ordinary share in a company. An attribute of an equity instrument is that the holder (investor) is not entitled to a fixed-rate of return. 484  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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The above definitions also make reference to derivatives (also termed derivative financial instruments). Derivatives, such as share options, futures and currency swaps, derive their value from other underlying items, such as receivables or ordinary shares. For example, the value of BHP share options (options to buy shares in BHP Ltd)—which are derivatives—will be dependent upon the value of BHP shares. Derivatives are discussed at paragraph AG16 of AASB 132. This paragraph 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. In determining the classification of a financial instrument as either a financial liability or an equity instrument, a central issue is the existence, or not, of a ‘contractual obligation’. 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, it is considered to be an equity instrument (see paragraph 17 of AASB 132). Given the above definitions of ‘financial asset’ and ‘financial liability’ we can see that in some circumstances the recognition of a financial asset or a financial liability will be tied to a determination of whether one party to the contractual arrangement will be required to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity (meaning it would be a financial asset), or whether the party will be required to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity (in which case it would be a financial liability). But what is meant by ‘favourable’ and ‘unfavourable’ in this context? The distinction is illustrated in Worked Example 14.1 in which a contractual arrangement is entered into, with one party to a contract buying an option contract from another entity.

WORKED EXAMPLE 14.1: Share options and determining whether a financial asset or a financial liability exists On 1 July 2019 Buyer Ltd purchases an option contract from Seller Ltd for $1000 that gives Buyer Ltd the right (or ‘option’) to acquire 10 000 shares in Bells Ltd for a price (exercise price) of $5.00 per share. When the contract was exchanged the price of Bells Ltd’s shares was $4.50 each. The option entitles Buyer Ltd to exercise the options to buy the shares at any time within the next six months. If the options are not exercised within the six-month period, they will expire on 31 December 2019. REQUIRED Determine whether a financial liability or financial asset exists. SOLUTION This options contract establishes a financial instrument that gives Buyer Ltd the right to acquire 10 000 shares in Bells Ltd for $5.00 a share, and creates an obligation for Seller Ltd to sell 10 000 shares in Bells Ltd to Buyer Ltd for $5.00 a share. From Buyer Ltd’s perspective it has a financial asset. The contract gives Buyer Ltd the right to exchange financial assets (cash for shares) under conditions that are potentially favourable. That is, should the price of Bells Ltd’s shares increase beyond $5.00, the outcome would be favourable to Buyer Ltd and it would exercise the options and make a profit. The worst case scenario for Buyer Ltd would be that the shares in Bells Ltd do not increase beyond $5.00 (they would be ‘out of the money’). Then Buyer Ltd would let the options lapse, and simply lose the original payment of $1000. From Seller Ltd’s perspective, it has a financial liability. Seller Ltd has entered a contract to exchange financial assets (shares for cash) under conditions that are potentially unfavourable to the entity. For example, if the shares in Bells Ltd increase to $7.00, Seller Ltd will be required to acquire 10 000 shares from the market for $7.00 each, and sell them to Buyer Ltd for $5.00 each. This scenario would create a net loss to Seller Ltd of $19 000 on these options. CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  485

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Paragraph AG17 of AASB 132 notes that the likelihood of an option—such as that referred to in Worked Example 14.1—being exercised does not impact on its classification as a financial liability. As paragraph AG17 states: A put or call option to exchange financial assets or financial liabilities (i.e. financial instruments other than an entity’s own equity instruments) gives the holder a right to obtain potential future economic benefits associated with changes in the fair value of the financial instrument underlying the contract. Conversely, the writer of an option assumes an obligation to forgo potential future economic benefits or bear potential losses of economic benefits associated with changes in the fair value of the underlying financial instrument. The contractual right of the holder and obligation of the writer meet the definition of a financial asset and a financial liability, respectively. The financial instrument underlying an option contract may be any financial asset, including shares in other entities and interest bearing instruments. An option may require the writer to issue a debt instrument, rather than transfer a financial asset, but the instrument underlying the option would constitute a financial asset of the holder if the option were exercised. The option-holder’s right to exchange the financial asset under potentially favourable conditions, and the writer’s obligation to exchange the financial asset under potentially unfavourable conditions, are distinct from the underlying financial asset to be exchanged upon exercise of the option. The nature of the holder’s right and of the writer’s obligation are not affected by the likelihood that the option will be exercised. The Application Guidance paragraphs in AASB 132 provide further examples of what kinds of items represent financial assets and financial liabilities. Some of these examples are reproduced below. AG3.  Currency (cash) is a financial asset because it represents the medium of exchange and is therefore the basis on which all transactions are measured and recognised in financial statements. A deposit of cash with a bank or similar financial institution is a financial asset because it represents the contractual right of the depositor to obtain cash from the institution or to draw a cheque or similar instrument against the balance in favour of a creditor in payment of a financial liability. AG4.  Common examples of financial assets representing a contractual right to receive cash in the future and corresponding financial liabilities representing a contractual obligation to deliver cash in the future are: (a) trade accounts receivable and payable; (b) notes receivable and payable; (c) loans receivable and payable; and (d) bonds receivable and payable.  In each case, one party’s contractual right to receive (or obligation to pay) cash is matched by the other party’s corresponding obligation to pay (or right to receive). AG5.  Another type of financial instrument is one for which the economic benefit to be received or given up is a financial asset other than cash. For example, a note payable in government bonds gives the holder the contractual right to receive and the issuer the contractual obligation to deliver government bonds, not cash. The bonds are financial assets because they represent obligations of the issuing government to pay cash. The note is, therefore, a financial asset of the note holder, and a financial liability of the note issuer. AG10.  Physical assets (such as inventories, property, plant and equipment), leased assets, and intangible assets (such as patents and trademarks) are not financial assets. Control of such physical and intangible assets creates an opportunity to generate an inflow of cash or another financial asset, but it does not give rise to a present right to receive cash or another financial asset. As the name ‘financial instrument’ suggests, the ultimate transfer of a financial asset is required: if an arrangement does not involve the ultimate transfer of a financial asset, it is not considered to be a financial instrument. For example, if a contractual commitment is to be satisfied through the delivery of a non-financial asset, such as inventory, or through the provision of services, it is not a financial instrument. Similarly, prepayments are not financial instruments because they typically provide a right to future goods or services and not to cash or another financial instrument. Financial instruments can be further classified as either primary financial instruments or derivative (sometimes called ‘secondary’) financial instruments. Examples of primary financial instruments include receivables, payables and equity securities such as ordinary shares. The accounting treatment of primary financial instruments is fairly 486  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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straightforward. Therefore, a great deal of this chapter will focus on accounting for derivative financial instruments. Derivative financial instruments include financial options, futures, forward contracts and interest rate swaps and currency swaps. (The accounting treatment of these instruments will be considered later in this chapter.) As an example of a derivative financial instrument consider Worked Example 14.2. Across time, newer forms of financial instruments seem to have been developed with the main focus of reducing risk, particularly where there are high levels of volatility in the values of the underlying instruments. If interest rates or foreign currency exchange rates are predicted to be volatile, financial instruments (typically derivative instruments) are likely to be developed and used

derivative financial instrument Instrument that creates rights and obligations with the effect of transferring one or more of the financial risks inherent in an underlying primary financial instrument.

WORKED EXAMPLE 14.2: Derivative financial instrument Assume that McCoy Ltd imports fibreglass from the United States. On 1 February 2019 it acquires the material at a cost of US$500 000, payable in two months’ time. The exchange rate at the time is A$1 = US$1.05. The actual debt is considered to be a trade payable and a primary financial instrument. REQUIRED (a) As the debt is payable in two months’ time, describe the potential risk to McCoy Ltd. (b) Assuming that McCoy Ltd is worried about possible adverse exchange rate movements, what action could the company take? SOLUTION (a) As the debt is denominated in US dollars, fluctuations in the exchange rate will change the amount that will ultimately be paid in Australian dollars. For example, if the exchange rate falls from A$1 = US$1.05 to A$1 = US$0.90, the payable denominated in Australian dollars will increase from $476 191 (which is 500 000 ÷ 1.05) to $555 556 (which is 500 000 ÷ 0.90). This would be considered to be a foreign exchange loss and would be recognised as an expense within profit or loss. (b) Assuming that McCoy Ltd is worried about possible adverse exchange rate movements, the company could approach a bank on 1 February 2019 with the intention of entering into a forward rate agreement. The bank could agree, for example, to supply McCoy Ltd with US$500 000 in two months’ time at an agreed forward rate of A$1 = US$1.02. This agreement means that if the exchange rate changes, McCoy Ltd will still receive US$500 000 from the bank at an agreed cost of $490 196. Therefore McCoy Ltd has ‘locked in’ the actual price of the material at $490 196 (which is $500 000 ÷ 1.02) and the bank will have to absorb any adverse movements in the exchange rate that might occur in the future. The agreement with the bank is considered to be a derivative financial instrument, with the financial risks inherent in the underlying financial instrument (the trade payable) having been transferred from McCoy Ltd to the bank. McCoy Ltd would have both a foreign currency receivable (a financial asset with its value being linked to the foreign currency exchange rate) with the bank, and a foreign currency payable (a financial liability) with the overseas supplier. It would also have a payable denominated in Australian dollars. From the perspective of McCoy Ltd, gains on one would be offset by losses on the other (and vice versa). McCoy Ltd would be considered to have entered a hedging arrangement. within hedging arrangements to minimise the financial impacts of the potential volatility. Parties that acquire financial instruments might also do so speculatively, with the potential to make substantial gains, or substantial losses. This can be the case particularly for parties that elect to speculate with various forms of futures contracts. At this point in the chapter it is useful to see whether you can differentiate between financial assets, financial liabilities and equity instruments. As such, you should now attempt Worked Example 14.3.

WORKED EXAMPLE 14.3: Determining whether financial instruments are financial assets, financial liabilities or equity instruments REQUIRED Consider the following financial instruments and then determine whether financial assets, financial liabilities or equity instruments are in existence: (a) Company A loans Company B $400 000 repayable in two years. continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  487

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(b) Company C acquires 10 000 shares in Company D at a price of $5.00 per share. (c) Company E acquires 100 000 call options in Company F, which provides Company E with the right to acquire shares in Company F for $11.00 per share in three years’ time. The options cost Company E $2.00 each to buy and were acquired when the market price of Company F’s shares was $10.50. The options were written by Company G, meaning that if Company E decides to exercise the options to buy shares—which would happen if the share price rises above the exercise price of $11.00—then Company G would need to go to the market and acquire the shares in Company F to satisfy its contractual obligation to Company E. SOLUTION (a) Company A would recognise a financial asset as it has a contractual right to receive cash from Company B. Company B would recognise a financial liability as it has a contractual obligation to deliver cash to Company A. These are both primary financial instruments. (b) Company C would recognise a financial asset as it has an equity instrument of Company D. Company D would recognise an equity instrument as it is party to a contract with Company C that provides Company C with a residual interest in Company D’s assets after deducting its liabilities. These are both primary financial instruments. (c) Company E would recognise a financial asset as it has a contractual right to exchange financial assets (cash of $11.00 per share) with another entity (Company G) under conditions that are potentially favourable to Company E. That is, the contract gives Company E the right to acquire shares in the Company F at a favourable price should the share price of Company F rise above the exercise price of $11.00. We do not consider the probability of the shares rising above $11.00 when classifying the options as financial assets. However, obviously this probability would influence the fair value of the options and there is a requirement that such financial assets shall be measured at fair value.   From Company G’s perspective, it would recognise a financial liability because it has a contractual obligation to exchange financial assets (shares in Company F) with another entity (Company E) under conditions that are potentially unfavourable to it.   Company F would not record any transaction as given the facts of this case Company G has written and sold the options and if the options are subsequently exercised, Company G would buy the required shares from other investors (who are shareholders in Company F). A share option would be considered to be a derivative.

LO 14.3 LO 14.5

Debt versus equity components of financial instruments

When financial instruments are issued that are to be placed on the statement of financial position, the reporting entity is required to determine whether the financial instrument should be disclosed as a liability, or as equity (or in some circumstances, perhaps as part liability and part equity). All things being equal, corporate managers would prefer to disclose financial instruments as equity rather than debt. There are many reasons for this. Leverage ratios (for example, total debts divided by total assets) are often used as indicators of corporate risk, hence the lower the reported debt, the lower the apparent risk. Organisations also typically have numerous contracts with their debt providers, which include certain restrictions on the amount of additional debt the organisation can raise (see Chapter 3 for an overview of debt contracts and their related restrictions). In determining whether a financial instrument should be presented as debt or equity, consideration should be given to the economic substance of the instrument, rather than simply its legal form. Specifically, paragraph 15 of AASB 132 states: The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset, or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset, and an equity instrument. Paragraph 16 of AASB 132 provides further guidance on whether a financial instrument should be presented as debt or equity. For a financial instrument to be classified as an equity instrument (the preferred outcome for most reporting entities), it must satisfy the conditions identified at both subparagraph (a) and (b) of paragraph 16, these being: (a) The instrument includes no contractual obligation: (i) to deliver cash or another financial asset to another entity; or

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(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the issuer. (b) If the instrument will or may be settled in the issuer’s own equity instruments, it is: (i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or (ii) a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. For this purpose, rights, options or warrants to acquire a fixed number of the entity’s 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 issuer’s own equity instruments do not include instruments that have all the features and meet the conditions described in paragraphs 16A and 16B or paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the issuer’s own equity instruments. Consistent with subparagraph (b)(i) and (ii) above, paragraph 21 of AASB 132 further emphasises that something is not an equity instrument simply because it may result in the delivery of an entity’s own equity instruments. According to paragraph 21 of AASB 132: A contract is not an equity instrument solely because it may result in the receipt or delivery of the entity’s own equity instruments. An entity may have a contractual right or obligation to receive or deliver a number of its own shares or other equity instruments that varies so that the fair value of the entity’s own equity instruments to be received or delivered equals the amount of the contractual right or obligation. Such a contractual right or obligation may be for a fixed amount or an amount that fluctuates in part or in full in response to changes in a variable other than the market price of the entity’s own equity instruments (e.g. an interest rate, a commodity price or a financial instrument price). Two examples are (a) a contract to deliver as many of the entity’s own equity instruments as are equal in value to CU100 (in this Standard, monetary amounts are denominated in ‘currency units’ (CU)) and (b) a contract to deliver as many of the entity’s own equity instruments as are equal in value to the value of 100 ounces of gold. 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 entity’s assets after deducting all of its liabilities. In considering paragraph 16(b)(i) above, let us assume, for example, that Bombora Ltd has entered an agreement to provide Rocky Outcrop Ltd with $1 million of shares in Bombora Ltd (based on market value at the time of payment). If the price of the shares was $2.50 at the time the instrument was created, Bombora Ltd would have to provide 400 000 shares if the market price remains static. However, if the market price falls to $2.00, Bombora Ltd would have to provide 500 000 shares. The risk remains with Bombora Ltd, and Rocky Outcrop Ltd will receive $1 million worth of shares regardless of the market price. Given these conditions, the instrument that provides that Bombora Ltd will transfer shares to Rocky Outcrop Ltd would fail the test of paragraph 16(b)(i) and therefore would be considered to be a financial liability from Bombora Ltd’s perspective. From Rocky Outcrop Ltd’s perspective, it is a financial asset. AASB 132 provides a great deal of guidance for determining whether a financial instrument is a financial liability or an equity instrument. In further explanation of the above requirement, particularly as it applies to considerations of ‘substance over form’, paragraph 18 of AASB 132 states: The substance of a financial instrument, rather than its legal form, governs its classification in the entity’s statement of financial position. Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity but are liabilities in substance and others may combine features associated with equity instruments and features associated with financial liabilities. For example: (a) a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a financial liability (b) a financial instrument that gives the holder the right to put it back to the issuer for cash or another financial asset (a ‘puttable instrument’) is a financial liability, except for those instruments classified as equity instruments in accordance with paragraphs 16A and 16B or paragraphs 16C and 16D. The financial

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instrument is a financial liability even when the amount of cash or other financial assets is determined on the basis of an index or other item that has the potential to increase or decrease. The existence of an option for the holder to put the instrument back to the issuer for cash or another financial asset means that the puttable instrument meets the definition of a financial liability, except for those instruments classified as equity instruments in accordance with paragraphs 16A and 16B or paragraphs 16C and 16D. For example, open-ended mutual funds, unit trusts, partnerships and some co-operative entities may provide their unitholders or members with a right to redeem their interests in the issuer at any time for cash, which results in the unit holders’ or members’ interests being classified as financial liabilities, except for these instruments classified as equity instruments in accordance with paragraphs 16A and 16B or paragraphs 16C and 16D. However, classification as a financial liability does not preclude the use of descriptors such as ‘net asset value attributable to unitholders’ and ‘change in net asset value attributable to unitholders’ on the face of the financial statements of an entity that has no contributed equity (such as some mutual funds and unit trusts) or the use of additional disclosure to show that total members’ interests comprise items such as reserves that meet the definition of equity and puttable instruments that do not. As we have shown, the critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation on the part of one party to the financial instrument (the issuer) either to deliver cash or another financial asset to, or to exchange another financial instrument with, the other party (the holder). To illustrate the process of determining whether a financial instrument is debt or equity we can consider preference shares. If an entity issues preference shares that give the holder of the security (as opposed to the issuer of the security) an option to redeem the shares for cash, such securities should be classified as debt rather than equity. In further consideration of the issue of preference share disclosures, and the related substance over form issues, paragraph AG26 of AASB 132 states: When preference shares are non-redeemable, the appropriate classification is determined by the other rights that attach to them. Classification is based on an assessment of the substance of the contractual arrangements and the definitions of a financial liability and an equity instrument. When distributions to holders of the preference shares, whether cumulative or non-cumulative, are at the discretion of the issuer, the shares are equity instruments. The classification of a preference share as an equity instrument or a financial liability is not affected by, for example: (a) a history of making distributions; (b) an intention to make distributions in the future; (c) a possible negative impact on the price of ordinary shares of the issuer if distributions are not made (because of restrictions on paying dividends on the ordinary shares if dividends are not paid on the preference shares); (d) the amount of the issuer’s reserves; (e) an issuer’s expectation of a profit or loss for a period; or (f) an ability or inability of the issuer to influence the amount of its profit or loss for the period. A consequence of classifying a financial instrument as debt, rather than equity, is that the related periodic payments would be classified as interest expenses, rather than as dividends (dividends being an appropriation of profits). Hence, not only will the presentation of a financial instrument as a financial liability impact on the statement of financial position, it will also impact negatively on the period’s profit or loss by making the associated payments an expense (interest expense), rather than distributions of profits (dividends). As paragraph 35 of AASB 132 states: Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognised as income or expense in profit or loss. Distributions to holders of an equity instrument shall be recognised by the entity directly in equity. Transaction costs of an equity transaction shall be accounted for as a deduction from equity. Hence, payments related to liabilities impact directly on reported profits or losses. Payments made in relation to equity (dividends) do not impact on profits. The classification of interest, dividends, gains and losses as expenses or income or as direct debits or credits to equity must be consistent with the statement of financial position classification of the related financial instrument or component as at the date on which the interest, dividends, gains or losses are recognised. 490  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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While many financial instruments are wholly financial liabilities or wholly equity instruments, an entity might also issue securities that have both equity and liability characteristics. For example, an organisation might issue convertible notes (or convertible bonds). These can be described as debt that gives the holder the right to convert the securities into ordinary shares of the issuer. Such securities are frequently classified as compound financial instruments, as they can 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 component and the equity component separately on the statement of financial position.

convertible note Debt that gives the holder the right to convert securities into ordinary shares of the issuer.

compound financial instrument Financial instrument with both a liability and an equity component.

As noted previously, if the instrument is classified as a liability, the associated payments would generally be treated as expenses and not dividends. Later in this chapter we will consider how to calculate the debt and equity components of a compound financial instrument. Where ‘interest costs’ are incurred (because the financial instrument is deemed to be a liability) as part of undertaking such activities as constructing assets, AASB 132 does not preclude an entity from treating such costs as part of the cost of the asset under construction. Including interest in the cost of an asset under construction is also specifically permitted in AASB 123 Borrowing Costs. The interest would ultimately be treated as an expense, either in the form of cost of goods sold or as part of an increased depreciation charge. Accounting for borrowing costs is addressed in depth in Chapter 4. AASB 132 does not allow a financial instrument, or the equity and liability components of a compound instrument, to be reclassified by the issuer after initial recognition, unless a transaction or other specific action by the issuer or holder of the instrument alters the substance of the financial instrument. In this regard, paragraph 30 of AASB 132 states: Classification of the liability and equity components of a convertible instrument is not revised as a result of a change in the likelihood that a conversion option will be exercised, even when exercise of the option may appear to have become economically advantageous to some holders. Holders may not always act in the way that might be expected because, for example, the tax consequences resulting from conversion may differ among holders. Furthermore, the likelihood of conversion will change from time to time. The entity’s contractual obligation to make future payments remains outstanding until it is extinguished through conversion, maturity of the instrument, or some other transaction. Hence, while revised probabilities will not lead to a change in classification of a financial instrument, a subsequent transaction may lead to a change in classification. To illustrate a transaction or action that changes the classification of an instrument, we can again consider preference shares. As indicated in AASB 132, if a preference share has no maturity or redemption date but gives an option to the issuer to redeem the share for cash, the share will not satisfy the definition of a financial liability because the issuer does not have a present obligation to transfer financial assets to the shareholder or to take any other specific action. The issuer can keep such shares on issue without redemption. A financial liability arises, however, when the issuer of the shares exercises its option, usually by notifying the shareholders formally of the impending redemption (buy back) of the shares. At that time, the instrument is reclassified from equity to liability. The requirement that the issuer should not reclassify the instrument, unless a transaction or other specific action alters the substance of the financial instrument, represents a departure from the Conceptual Framework for Financial Reporting, which would allow for the debt or equity classification to change from period to period on the basis of revisions of perceived probabilities. As we know, for a liability to be recognised there is a requirement within the conceptual framework that ‘it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably’. For example, if convertible notes are issued giving the holder the right to seek repayment in cash or to convert the notes to equity, and the market price of the shares is high, on the balance of probabilities the likelihood of conversion to equity would be high. The securities would be considered to be ‘equity’ pursuant to the conceptual framework. Conversely, if the share price is low, application of the conceptual framework would see the securities classified as debt. With low share prices, the note holders would be unlikely to convert the notes to shares but would instead seek repayment. CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  491

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By contrast, AASB 132 would require convertible notes to be disclosed on the basis of the holder’s ability to contractually require the company either to repay the principal or convert to shares, regardless of the perceived probabilities of the respective actions. Hence, AASB 132 would require convertible notes to be classified as having both equity and liability components. We will consider the accounting treatment of convertible notes in greater depth later in this chapter. However, at this stage it should be appreciated that when a financial instrument has both a debt and an equity component, as already emphasised, the debt and equity components must be recognised separately for statement of financial position purposes. Since we know that the debt and equity components must be recognised separately we need to determine the respective amounts to be recognised. We must determine the fair value of the liability component—which is recognised within the financial statements—and 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. As paragraphs 31 and 32 of AASB 132 state: 31. AASB 9 deals with the measurement of financial assets and financial liabilities. Equity instruments are instruments that evidence a residual interest in the assets of an entity after deducting all of its liabilities. Therefore, when the initial carrying amount of a compound financial instrument is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. The value of any derivative features (such as a call option) embedded in the compound financial instrument other than the equity component (such as an equity conversion option) is included in the liability component. The sum of the carrying amounts assigned to the liability and equity components on initial recognition is always equal to fair value that would be ascribed to the instrument as a whole. No gain or loss arises from initially recognising the components of the instrument separately. 32. Under the approach described in paragraph 31, the issuer of a bond convertible into ordinary shares first determines the carrying amount of the liability component by measuring the fair value of a similar liability (including any embedded non-equity derivative features) that does not have an associated equity component. The carrying amount of the equity instrument represented by the option to convert the instrument into ordinary shares is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.

Set-off Financial assets and liabilities are offset where there is a legally enforceable right to set-off, and there is an intention to settle on a net basis, or to realise the asset and settle the liability simultaneously.

Dr Cr Cr

Hence, if an entity issued convertible notes (that are compound financial instruments), which effectively are a debt instrument that provides an option for the holder to seek repayment or alternatively to convert the debt to an equity share in the entity, at an issue price of $22 for each convertible note, and it was determined that a debt instrument of similar risk and yielding the same rate of interest—but without the option of converting to equity—could be sold for $18.00 (its fair value), $18.00 would be the liability component of the convertible note. The equity component would be the residual, which is $4.00. Assuming an entity issued 1 million of these compound financial instruments, the accounting journal entry on initial issue would be:

Cash Loan Share options issued (in equity)

22 000 000 18 000 000 4 000 000

We have now considered various issues in relation to whether a financial instrument is of the nature of debt or equity. If a financial instrument has debt characteristics then it shall be disclosed as a liability in the statement of financial position. At this point it should be acknowledged that in certain circumstances financial assets and financial liabilities can be set off against each other and only a net amount is to be shown. This practice, which we now briefly discuss, can have positive benefits for the statement of financial position in terms of reducing reported leverage based on such ratios as debt to equity, debt to assets and so forth.

LO 14.6

Set-off of financial assets and financial liabilities A set-off can be defined as the reduction of an asset by a liability, or of a liability by an asset, in the presentation of a statement of financial position (balance sheet) so that only the net amount is presented.

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The requirements relating to the set-off of assets and liabilities are incorporated in AASB 132 Financial Instruments: Presentation. AASB 132 requires assets and liabilities to be set-off against each other for statement of financial position purposes when a legally enforceable right of set-off for these items exists, and the reporting entity intends to settle on a net basis, or to realise the asset and settle the liability simultaneously. Specifically, AASB 132 paragraph 42 states: A financial asset and a financial liability shall be offset and the net amount presented in the statement of financial position when, and only when, an entity: (a) currently has a legally enforceable right to set-off the recognised amounts; and (b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. A review of the requirements of AASB 132 paragraph 42 shows that a set-off may occur only where the entity has a legally enforceable right of set-off. According to AASB 132, paragraph 45: A right of set-off is a debtor’s legal right, by contract or otherwise, to settle or otherwise eliminate all or a portion of an amount due to a creditor by applying against that amount an amount due from the creditor. In unusual circumstances, a debtor may have a legal right to apply an amount due from a third party against the amount due to a creditor provided that there is an agreement between the three parties that clearly establishes the debtor’s right of set-off. Because the right of set-off is a legal right, the conditions supporting the right may vary from one legal jurisdiction to another and the laws applicable to the relationships between the parties need to be considered. Apart from requiring a legal right of set-off, AASB 132 paragraph 42 also requires that there be an intention to offset. In this regard, AASB 132 paragraph 46 states: The existence of an enforceable right to set-off a financial asset and a financial liability affects the rights and obligations associated with a financial asset and a financial liability and may affect an entity’s exposure to credit and liquidity risk. However, the existence of the right, by itself, is not a sufficient basis for offsetting. In the absence of an intention to exercise the right or to settle simultaneously, the amount and timing of an entity’s future cash flows are not affected. When an entity intends to exercise the right or to settle simultaneously, presentation of the asset and liability on a net basis reflects more appropriately the amounts and timing of the expected future cash flows, as well as the risks to which those cash flows are exposed. An intention by one or both parties to settle on a net basis without the legal right to do so is not sufficient to justify offsetting because the rights and obligations associated with the individual financial asset and financial liability remain unaltered. As an example of a ‘set-off’, assume that Entity A owes Entity B an amount of $1.2 million and Entity B owes Entity A an amount of $1 million. Assume also that both parties intend to settle on a net basis. As a result of the set-off, Entity A would be required to show a payable of only $200 000 in its statement of financial position, and Entity B would show a receivable of $200 000 in its statement of financial position. Whenever a right to offset exists, and it is intended that the right will be exercised, disclosure on a net basis is required. Performing a set-off will improve an entity’s gearing ratio, which might be of importance if a firm is subject to constraints imposed by debt agreements, as shown in Worked Example 14.4.

WORKED EXAMPLE 14.4: Setting off debt Assume that Grommet Ltd has the following statement of financial position before set-off: Grommet Limited Statement of financial position at 30 June 2019 $ Assets Property, plant and equipment (net) Loans receivable

400 000    600 000 1 000 000 continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  493

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Grommet Limited Statement of financial position at 30 June 2019 $ Liabilities Loans payable Net Assets Shareholders’ funds Share capital Retained earnings

500 000 500 000 400 000 100 000 500 000

Assume that Grommet Ltd has an amount of $200 000 owing to Goofyfoot Ltd and an amount of $240 000 receivable from Goofyfoot Ltd. Assume also that a legal right of set-off exists, that there is an intention to exercise the right to settle simultaneously, and that Grommet Ltd offsets the payable of $200 000 against the receivable of $240 000. REQUIRED Prepare a revised statement of financial position that incorporates the set-off. SOLUTION Statement of financial position post-set-off: Grommet Ltd Statement of financial position at 30 June 2019 $ Assets Property, plant and equipment Loans receivable Liabilities Loans payable Net assets Shareholders’ funds Share capital Retained earnings

400 000 400 000 800 000 300 000 500 000 400 000 100 000 500 000

As a result of the set-off, the gearing ratio of debt to total assets has dropped from 50 per cent to 37.5 per cent. Utilising a right of set-off would constitute a reasonably inexpensive method of reducing a firm’s gearing, compared with such activities as buying back the debt. As such, a set-off represents a low-cost way of loosening debt constraints that are linked to accounting numbers (if they exist). More simply, it represents an easy way to produce a statement of financial position that shows an improved financial position in terms of such indicators as leverage.

Having discussed various definitional and presentation issues, we will now consider issues associated with the recognition and measurement of financial instruments. However, as a concluding comment on the presentation of financial instruments, it should now be clear that there are numerous issues to consider in determining whether a financial instrument is a financial liability or an equity instrument. Clearly, too, the determination of whether a financial instrument is a financial liability or an equity instrument will have direct implications for the reported profits of the entity, given that periodic payments associated with financial liabilities will be considered to be expenses. 494  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Recognition and measurement of financial assets As stated previously, AASB 9 Financial Instruments is the accounting standard that addresses how financial instruments are to be recognised and measured. As we also know, financial instruments can be either:

LO 14.7 LO 14.8 LO 14.9

• financial assets; • financial liabilities; or • equity instruments. In this section we will concentrate on financial assets. We will consider various issues associated with financial liabilities later in this chapter. The general principle applied for the initial recognition of financial assets, and financial instruments in general, is detailed in AASB 9 paragraph 3.1.1. This paragraph requires an entity to recognise a financial instrument in its statement of financial position at the point in time ‘when the entity becomes party to the contractual provisions of the instrument’. The general measurement principle applied in AASB 9 is that financial instruments are to be measured initially at fair value. Specifically, paragraph 5.1.1 of AASB 9 states: Except for trade receivables within the scope of paragraph 5.1.3, at initial recognition, an entity shall measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. Given that the initial measurement of financial assets and financial liabilities is to be at fair value (plus in some circumstances, associated transaction costs), we perhaps need to revisit the meaning of ‘fair value’. Fair value is applied within AASB 9 in a manner consistent with other standards. AASB 13 Fair Value Measurement provides the definition of ‘fair value’, which is: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The above definition of fair value uses a number of important terms, for example, ‘orderly transaction’ and ‘market participants’. Pursuant to AASB 13, an ‘orderly transaction’ is: A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale). ‘Market participants’, as applied within the definition of fair value, are deemed to be: • independent of each other, that is, they are not related; • knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information; • able to enter into a transaction for the asset or liability; and • willing to enter into a transaction for the asset or liability, that is, they are motivated but not forced or otherwise compelled to do so. While fair value is the required basis of measurement when an asset is originally recognised, the following discussion explains how financial instruments are to be measured at times subsequent to (following) the initial recognition.

Measurement of financial assets following initial recognition Following initial recognition—which as we now know must generally be at fair value (plus associated transaction costs that are directly attributable to the acquisition of those financial assets not measured at fair value through profit or loss)— the basis for subsequent measurement depends on how the financial assets are classified. Pursuant to AASB 9, financial assets are classified on the basis of: • the entity’s business model for managing its financial assets in order to generate cash flows (for example, the business model might focus upon collecting contractual cash flows, selling financial assets or both), and • the contractual cash flow characteristics of the financial asset. CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  495

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The business model can typically be determined by observing the activities that an entity undertakes to achieve its business objectives. Therefore the ‘business model test’ tends to be based on evidence, rather than assertion. Financial assets are to be classified into one of the following three measurement categories, which in turn will determine how the financial asset will be measured subsequent to its initial recognition (and again, when the financial asset is initially recognised it will be recognised at fair value). Financial assets shall subsequently be measured at either: • amortised cost; • fair value through other comprehensive income; or • fair value through profit or loss. Again, AASB 9 requires that the determination of which one of the three above measurement categories shall be applied to the financial asset will be dependent upon: ( a) the entity’s business model for managing the financial assets; and (b) the contractual cash flow characteristics of the financial asset. While reporting entities are generally required to use particular measurement approaches following initial recognition if they are applying a particular business model, and if the financial assets have particular cash flow characteristics, they do also have the option to designate that all financial assets be measured at fair value through profit or loss if such an election is likely to eliminate or significantly reduce measurement or recognition inconsistencies that might otherwise arise. We will return to this option later in this chapter.

Measurement of financial assets at amortised cost As we can see from the above discussion, this is one of the three options available for measuring financial assets following initial recognition. According to paragraph 4.1.2 of AASB 9, a financial asset shall be subsequently measured at ‘amortised cost’ if both of the following conditions or ‘tests’ are met: • The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows (referred to as the business model test); and • The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding (the cash flow characteristics test). Given the reference to cash flows associated with interest and principal, we can see that the option to use amortised cost is available for debt instruments rather than equity instruments. We will now briefly consider each of the above tests—namely the ‘business models test’ and the ‘contractual cash flow characteristics test’. Financial assets that are investments in debt instruments, that do not meet both of the above ‘tests’, must be measured at fair value either through profit or loss, or through other comprehensive income (and we will discuss these two approaches shortly). Under the ‘business model test’, an entity is required to assess whether its business objective for an investment in a debt instrument is to collect contractual cash flows of the instrument, rather than realising its fair value change from the sale of the instrument prior to its contractual maturity. This is assessed on the basis of the objective of the business model as determined by the entity’s key management personnel. The entity’s business model does not depend on the ‘intentions’ of management for the individual asset. This is explained further by AASB 9 paragraph B4.1.2 as follows: An entity’s business model is determined at a level that reflects how groups of financial assets are managed together to achieve a particular business objective. The entity’s business model does not depend on management’s intentions for an individual instrument. Accordingly, this condition is not an instrument-byinstrument approach to classification and should be determined on a higher level of aggregation. However, a single entity may have more than one business model for managing its financial instruments. Consequently, classification need not be determined at the reporting entity level. For example, an entity may hold a portfolio of investments that it manages in order to collect contractual cash flows and another portfolio of investments that it manages in order to trade to realise fair value changes. Similarly, in some circumstances, it may be appropriate to separate a portfolio of financial assets into subportfolios in order to reflect the level at which an entity manages those financial assets. For example, that may be the case if an entity originates or purchases a portfolio of mortgage loans and manages some of the loans with an objective of collecting contractual cash flows and manages the other loans with an objective of selling them. 496  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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If an entity holds the asset to realise fair value changes, then it should measure the asset at fair value. Conversely, if the asset is held to receive periodic interest payments and principal repayment (which are referred to as ‘contractual cash flows’) then the asset shall be recorded at amortised cost. The above paragraph recognises that an entity may have different business units that are managed differently. For example, an entity may have a business unit (A) where the objective is to collect the contractual cash flows of loan assets, while the objective of another business unit (B) would be to realise fair value changes through the sale of loan assets prior to their maturity. The financial instruments that give rise to cash flows that are payments of principal and interest in business unit (A) may qualify for amortised cost measurement even if similar financial instruments in business unit (B) do not. Instruments that are held for trading would be measured at fair value as they are not held to collect the contractual cash flows of the instrument. It should be noted that although the objective of an entity’s business model may be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those assets until maturity in order to qualify for using amortised cost. This means that if an entity’s business model is to hold financial assets to collect contractual cash flows, this does not preclude the sales of financial assets. As an example, an entity’s assessment that it holds investments to collect their contractual cash flows remains valid even if the entity disposes of the investments to fund capital expenditure. However, if more than an infrequent number of sales are made out of a portfolio, the entity would need to assess whether and how such sales are consistent with an objective of collecting contractual cash flows. Having just considered the ‘business model test’ we will now consider the ‘cash flow characteristics test’ (the other test that must be used before amortised cost can be applied). Having established which financial assets are held for the collection of contractual cash flows, AASB 9 requires that the contractual terms of the financial asset give rise on specific dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. For a financial asset to have contractual cash flows that are solely payments of principal and interest would mean that the contractual terms are consistent with a basic lending agreement. So, as an example, if an entity were to acquire a financial asset, such as a government bond, with the intention of receiving a fixed flow of interest revenue throughout the period, then the bond would be measured at amortised cost in the period after acquisition. Conversely, if an organisation acquired government bonds for the purpose of selling them at a gain in the future, then that financial asset should be recorded at fair value subsequent to acquisition. While we understand what fair value means and we should now have some reasonable understanding of when amortised cost shall be used to subsequently measure a financial asset, some consideration of the actual meaning of ‘amortised cost’ would be useful. AASB 9 defines amortised cost as: • the amount measured at initial recognition • minus principal repayments, • plus or minus the cumulative amortisation using the effective interest method of any difference between the initial amount and the maturity amount, and • minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility. In determining amortised cost as described above we are required to use the effective-interest method. The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the financial asset or financial liability. The requirement to use amortised cost, rather than fair value, for financial assets that are acquired with the intention of holding them to maturity does have merit. Because the reporting entity does not intend to sell (trade) the assets prior to the date at which the principal is to be repaid, it would arguably be inappropriate to include adjustments to fair value from one period to the next within profit or loss. Worked Example 14.5 provides an example of how to determine the amortised cost of a financial asset and how to record the appropriate accounting journal entries. Worked Example 14.5  did not consider the possibility that the financial instrument had been impaired. Where fair values are not used there is nevertheless the requirement that potential impairment losses be recognised. This is consistent with the general requirements for assets that their carrying amount shall not be in excess of their recoverable amount. We will now consider this possibility. Impairment losses could be due to expected ‘credit losses’ where credit losses are defined in AASB 9 as the difference between all contractual cash flows that are due to an entity in accordance with the contract, and all the cash CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  497

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WORKED EXAMPLE 14.5: Determining the amortised cost of a financial asset On 1 July 2018 Jack Ltd acquired some corporate bonds issued by McCoy Ltd. These bonds cost $1 066 242. They had a ‘face value’ of $1 million and offered a coupon rate of 10 per cent paid annually ($100 000 per year, paid on 30 June). The bonds would repay the principle of $1 million on 30 June 2022. At the time the market only required a rate of return on 8 per cent on such bonds. Jack Ltd operates within a business model where government bonds are held in order to collect contractual cash flows and there is no intention to trade them. Assume that there were no direct costs associated with acquiring the bonds. REQUIRED (a) Explain why the company was prepared to pay $1 066 242 for the bonds given that, apart from the interest, they expect to receive only $1 million back in four years. (b) Determine whether Jack Ltd can measure the government bonds at amortised cost. (c) Calculate the amortised cost of the bonds as at 30 June 2019, 2020, 2021 and 2022. (d) Provide the accounting journal entries for the years ending 30 June 2019, 2020, 2021 and 2022. SOLUTION (a) In this instance the market was requiring an 8 per cent return on securities such as these. However, McCoy Ltd was offering a 10% return. When the market’s required rate of return is less than the rate being offered on a bond, the price (fair value) 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 8 per cent. In this case, and using present values, the issue price will be $1 066 242, determined as follows: Present value of interest stream of four payments of $100 000 per year at the end of the next 4 years Present value of the principal to be received in 4 years Fair value at 1 July 2018

$100 000 × 3.312 126 4 = $1 000 000 × 0.735 029 7 =

$331 213    $735 029 $1 066 242

Please note: While we have used present value calculations based on 7 decimal points, there are present value tables in the Appendices to this book that are calculated to 4 decimal points. (b) Jack Ltd can use amortised cost as the basis for measuring government bonds as: • The government bonds are held within a business model whose objective is to hold them in order to collect contractual cash flows; and • The contractual terms of the government bonds give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. (c) To determine the amortised cost of the financial asset we use the effective interest method. With the effective interest method, the interest revenue for the period would be calculated by multiplying the opening present value of the asset by the market rate of interest, which in this case is 8 per cent. The payment of $100 000 received by Jack Ltd each year would constitute both interest revenue and repayment of the principal. In the last period (2022), a total of $1 100 000 is received by Jack Ltd, representing the periodic payment of $100 000 (which is both interest and principal repayment) and the repayment of the principal and the end of the life of the bond, this being $1 million.

Date 1 July 2018 30 June 2019 30 June 2020 30 June 2021 30 June 2022

Opening present value

Interest

Principal repayment

Closing present value

1 066 242 1 051 541 1 035 664 1 018 517

85 299 84 123 82 853 81 483

14 701 15 877 17 147 1 018 517

1 066 242 1 051 541 1 035 664 1 018 517 0

(d) If the bonds are being measured at amortised cost, then the accounting journal entries would be:

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1 July 2018 Dr Investment in corporate bonds Cr Cash

1 066 242 1 066 242

30 June 2019 Dr Cash Cr Investment in corporate bonds Cr Interest income

100 000 14 701 85 299

30 June 2020 Dr Cash Cr Investment in corporate bonds Cr Interest income

100 000 15 877 84 123

30 June 2021 Dr Cash Cr Investment in corporate bonds Cr Interest income

100 000 17 147 82 853

30 June 2022 Dr Cash Cr Investment in corporate bonds Cr Interest income Dr Cash Cr Investment in corporate bonds

100 000 18 517 81 483 1 000 000 1 000 000

flows that the entity actually expects to receive (i.e. all cash shortfalls), discounted at the original effective interest rate. The impairment loss can be offset directly against the asset (that is, by crediting the financial asset), or through the use of an accumulated amortisation account. The impairment loss on a financial asset that is measured at amortised cost shall be recognised as an expense within profit or loss. When AASB 9 was issued, the requirements in relation to impairment were changed relative to the former position within AASB 139. During the global financial crisis there was much criticism of accounting standards—particularly AASB 139/IAS 39—as the standard tended to delay the recognition of credit losses on debt instruments until there was evidence of a ‘trigger event’. AASB 9 now requires a reporting entity to consider potential credit losses at all times, rather than waiting for a trigger event (for example, waiting until a debtor has been declared bankrupt). This is referred to as the ‘expected loss’ model. Pursuant to AASB 9, impairment is either measured on the basis of: • 12-month expected credit losses; or • lifetime expected credit losses. As defined in AASB 9, 12-month expected credit losses are: the portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date. Lifetime expected credit losses are defined in AASB 9 as: the expected credit losses that result from all possible default events over the expected life of a financial instrument.

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The general principal applied in AASB 9 is that if it is considered that that the credit risk on a financial instrument has not increased significantly since the initial recognition of the financial instrument, then the entity shall measure the loss allowance at an amount equal to the 12-month expected credit losses. However, if the credit risk on the financial instrument has increased significantly since initial recognition, then the entity shall measure the loss allowance for the financial instrument at an amount equal to the lifetime expected credit losses.

Measurement of financial assets at fair value through profit or loss As we would recall from earlier chapters (and as also covered in Chapter 16), we have two broad measures of financial performance, these being ‘profit or loss’ and ‘other comprehensive income’ (OCI). In a statement of profit or loss and other comprehensive income, profit or loss is presented first, followed by OCI, with a total then finally being provided of total profit or loss and other comprehensive income (or simply, comprehensive income). It is generally accepted that profit or loss is the primary basis for assessing financial performance, with OCI then providing insights into other factors that have had the effect of increasing equity. Many accounting standards stipulate whether particular expenses/losses and income/gains shall be either included within profit or loss, or within OCI. For example, in Chapter 6 we learned that when the ‘fair value model’ is used for property, plant and equipment (rather than the ‘cost model’), and when there is an upward revaluation that does not reverse a previous revaluation decrement, the upward revaluation shall not be included within profit or loss, but within a reserve (which is part of equity) referred to a ‘revaluation surplus’. The increase in the revaluation surplus would be shown as part of OCI. Turning our attention back to financial instruments, pursuant to AASB 9, fair value must be used as the basis of measurement if a financial asset does not pass the tests required to allow use of amortised cost (and all equity instruments must be measured at fair value given that the cash flow characteristics relating to principal and interest are not applicable to equity instruments). If the fair value through profit or loss approach is used, the gains or losses that arise as a result of measuring the asset at fair value at the end of the reporting period must be included as part of profit or loss. Worked Example 14.6 provides an example of how to account for a financial asset at fair value through profit or loss.

WORKED EXAMPLE 14.6: Accounting for a financial asset at fair value through profit or loss On 1 July 2018 Bear Ltd acquired 100 000 shares in Island Ltd at a price of $10 each. There were brokerage fees of $1500. The closing market price of Island Ltd shares on 30 June 2019—which is the entity’s financial year end—was $12. Bear Ltd has not made the election to account for its equity investments at fair value through OCI. REQUIRED Provide the required accounting journal entries for Bear Ltd to account for the investment in Island Ltd using fair value through profit or loss. SOLUTION 1 July 2018 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. While not shown in this example, any dividends relating to the investment would also be included as part of profit or loss. Dr Dr Cr

Investment in Island Ltd Brokerage fee expense Cash

1 000 000 1 500 1 001 500

30 June 2019 Dr Cr

Investment in Island Ltd Gain in fair value of equity investments (profit or loss)

200 000 200 000

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.

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Measurement of financial assets at fair value through other comprehensive income This is the third approach to measuring a financial asset identified within AASB 9. Pursuant to AASB 9, a reporting entity can make an election to measure debt instruments at fair value through other comprehensive income (meaning the gains or losses on the financial asset do not go directly to profit or loss) if both of the following conditions are met: • the financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets; and • the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Compared to a business model whose objective is to hold financial assets to collect contractual cash flows (and which would allow amortised cost to be used), the business model referred to above will typically involve greater frequency and volume of sales. For financial assets that are not held in the business model required for the use of either amortised cost, or the business model required for the use of fair value through other comprehensive income, measurement at fair value through profit or loss must be used. While the above discussion relates to investments in debt instruments (such as investment in government bonds), for financial assets that are equity instruments there is a requirement that if the equity instruments—such as shares in companies that are listed on a securities exchange—are held for trading then they must be measured at fair value through profit or loss. However, if they are not held for trading, then the reporting entity can make an election to measure the equity instruments at fair value through OCI. Hence, for equity instruments measured at fair value through OCI: • changes in fair value will be included within OCI; • dividends received from the equity instruments will be included within profit or loss (unless they clearly represent a repayment of part of the cost of the investment in which case the dividend would be offset against the carrying amount of the investment); and • changes in fair value of equity instruments that are included within OCI shall not be reclassified to profit or loss on the occurrence of an event such as the sale of the investments. For debt instruments measured at fair value through OCI: • changes in fair value will be included within OCI; • interest revenue, expected credit losses and foreign exchange gains and losses are included within profit or loss; • when the asset is derecognised (sold) the cumulative gain or loss recognised within OCI is reclassified from equity to profit or loss. Worked Example 14.7 provides an example of how to account for an equity instrument at fair value through other comprehensive income.

WORKED EXAMPLE 14.7: Accounting for a financial asset at fair value through other comprehensive income The facts are the same as those in Worked Example 14.6 except this time Bear Ltd has made the decision to measure the equity investment at fair value through other comprehensive income. As with Worked Example 14.6, on 1 July 2018 Bear Ltd acquired 100 000 shares in Island Ltd at a price of $10 each. There were brokerage fees of $1500. The closing market price on Island Ltd shares on 30 June 2019 was $12. REQUIRED Provide the required accounting journal entries for Bear Ltd to account for the investment in Island Ltd using fair value through other comprehensive income. SOLUTION 1 July 2018 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 continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  501

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part of the cost of the asset (and not treated as an expense with profit or loss). While not shown in this example, any dividends relating to the investment would be included as part of profit or loss. Dr Cr

Investment in Island Ltd Cash

1 001 500 1 001 500

30 June 2019 Dr Cr

Investment in Island Ltd Gain in fair value included within OCI

200 000 200 000

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.

So, in summarising the use of the three alternative measurement bases we can state: • equity instruments are to be measured at fair value (either through profit or loss, or through OCI); • dividends on equity investments shall be included within profit or loss regardless of whether the equity investments are valued at fair value through profit or loss, or at fair value through OCI; • if equity investments are held for trading purposes then they must be measured at fair value through profit or loss; • if equity investments are not held for trading then they shall be recorded at fair value through profit or loss unless an election has been made to record them at fair value through OCI; • if the election to record equity investments at fair value through OCI is made, then the gains residing in equity (in a reserve) shall not subsequently be transferred to profit or loss; • debt instruments shall be measured either at amortised cost or fair value (with fair value adjustments being made either through profit or loss, or through OCI); • if a financial asset is of the form of a debt instrument, such as government or corporate bonds, and the objective of the entity’s business model with which the financial assets are held is to collect the contractual cash flows (with the contractual cash flows relating to payments of interest and repayments of principal), then the financial asset can be measured at ‘amortised cost’ (a definition of amortised cost was provided earlier in this chapter). Interest revenue and impairment losses would be included in profit or loss; • by contrast, if the debt instrument is held in a business model that has the objective of both collecting cash flows and also selling the assets, then—unless an election has been made to measure the asset at fair value through profit or loss—the fair value through other comprehensive income approach shall be used wherein the financial asset will be measured at fair value (plus acquisition costs) in the statement of financial position, but changes in fair value will be recognised within other comprehensive income (and not through profit or loss). Interest revenue on debt instruments will be included within profit or loss. The gains and losses can subsequently be transferred from equity to profit or loss on derecognition of the asset; • if the business model for holding debt instruments emphasises trading, then the debt instrument will be measured at fair value through profit or loss meaning that all gains and losses will go directly to profit or loss; • transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability shall, in the case of a financial asset or financial liability not at fair value through profit or loss, be added to, or subtracted from, the measurement of the asset; • the basis of measurement can be reclassified between measurement categories but only when the entity’s business model for managing them changes. If reclassification is requires, AASB 7 Financial Instruments: Disclosures identifies a number of related disclosures about such reclassifications. 502  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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We can also summarise some of the measurement rules in Tables 14.1 and 14.2 below. Equity investments held for trading

Equity investments not held for trading

Measured at fair value through profit or loss meaning that changes in fair value and dividends are both included within profit or loss.

Option 1: Measured at fair value through profit or loss meaning that changes in fair value and dividends are both included within profit or loss.

Table 14.1 Subsequent measurement of equity instruments

Option 2: An entity may irrevocably elect to present changes in fair value within OCI. This means dividend income is included within profit or loss. Changes in fair value are included within OCI and such changes shall not be reclassified subsequently to profit or loss.

The debt instrument is held within a business model whose objective is to collect contractual cash flows and the contractual cash flows give rise to cash flows that are solely payments of principal and interest

The debt instrument is held within a business model whose objective is to both collect contractual cash flows and sell financial assets

Other business models other than those in columns 1 and 2 (to the left)

Option 1: Measured at amortised cost. This means interest revenue, expected credit losses and foreign exchange gains and losses are recognised within profit or loss.

Option 1: Measured at fair value through OCI. This means interest revenue, expected credit losses and foreign exchange gains and losses are recognised within profit or loss. Gains and losses on fair value are included within OCI. When the asset is derecognised (sold) the cumulative gain or loss recognised within OCI is reclassified from equity to profit or loss.

Measured at fair value through profit or loss. This means all income, expenses, gains and losses are recognised within profit or loss.

Option 2: An entity may, at initial recognition, irrevocably designate the asset at fair value through profit or loss if doing so eliminates or significantly reduces an accounting mismatch that would otherwise arise.

Option 2: An entity may, at initial recognition, irrevocably designate the asset at fair value through profit or loss if doing so eliminates or significantly reduces an accounting mismatch that would otherwise arise.

Table 14.2 Subsequent measurement of debt instruments

Election to use fair value through profit or loss to address an ‘accounting mismatch’ As we know, subject to certain requirements, reporting entities shall measure their financial assets at amortised cost, or at fair value through OCI. However, reporting entities can make the irrevocable choice to measure financial assets at fair value through profit or loss if the entity believes that doing so will address a potential ‘accounting mismatch’. Specifically, paragraph 4.1.5 of AASB 9 states: Despite paragraphs 4.1.1–4.1.4, an entity may, at initial recognition, irrevocably designate a financial asset as measured at fair value through profit or loss if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases (see paragraphs B4.1.29–B4.1.32). CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  503

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Therefore, if a financial asset and a financial liability are somehow related, and the gains on one offset the losses on the other, then the argument is that the gains and losses should both be taken to profit or loss, otherwise there would be an ‘accounting mismatch’. The accounting mismatch would remain if the fair value gains on one financial instrument went to profit or loss while the other related financial instrument was measured at amortised cost, or if the related gains or losses went through OCI. The following paragraphs provide more discussion of the potential ‘accounting mismatch’ and the treatment permitted by paragraph 4.1.5 of AASB 9: B4.1.29  Measurement of a financial asset or financial liability and classification of recognised changes in its value are determined by the item’s classification and whether the item is part of a designated hedging relationship. Those requirements can create a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) when, for example, in the absence of designation as at fair value through profit or loss, a financial asset would be classified as subsequently measured at fair value through profit or loss and a liability the entity considers related would be subsequently measured at amortised cost (with changes in fair value not recognised). In such circumstances, an entity may conclude that its financial statements would provide more relevant information if both the asset and the liability were measured as at fair value through profit or loss. B4.1.30  The following examples show when this condition could be met. In all cases, an entity may use this condition to designate financial assets or financial liabilities as at fair value through profit or loss only if it meets the principle in paragraph 4.1.5 or 4.2.2(a):

(a)  an entity has liabilities under insurance contracts whose measurement incorporates current information (as permitted by paragraph 24 of IFRS 4) and financial assets that it considers to be related and that would otherwise be measured at either fair value through other comprehensive income or amortised cost



(b)  an entity has financial assets, financial liabilities or both that share a risk, such as interest rate risk, and that gives rise to opposite changes in fair value that tend to offset each other. However, only some of the instruments would be measured at fair value through profit or loss (for example, those that are derivatives, or are classified as held for trading). It may also be the case that the requirements for hedge accounting are not met because, for example, the requirements for hedge effectiveness in paragraph 6.4.1 are not met



(c)  an entity has financial assets, financial liabilities or both that share a risk, such as interest rate risk, that gives rise to opposite changes in fair value that tend to offset each other and none of the financial assets or financial liabilities qualifies for designation as a hedging instrument because they are not measured at fair value through profit or loss. Furthermore, in the absence of hedge accounting there is a significant inconsistency in the recognition of gains and losses. For example, the entity has financed a specified group of loans by issuing traded bonds whose changes in fair value tend to offset each other. If, in addition, the entity regularly buys and sells the bonds but rarely, if ever, buys and sells the loans, reporting both the loans and the bonds at fair value through profit or loss eliminates the inconsistency in the timing of the recognition of the gains and losses that would otherwise result from measuring them both at amortised cost and recognising a gain or loss each time a bond is repurchased.

We will conclude this section on measuring financial assets with a diagram—Figure 14.1—that will further assist our understanding of how to measure financial assets. We will now consider three worked examples. Worked Example 14.8 explores how to classify financial assets for subsequent measurement; Worked Example 14.9 demonstrates how different business models for a financial asset impact the basis of subsequent measurement; and Worked Example 14.10 addresses how we account for an interestfree loan provided to an employee.

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Figure 14.1 How to account for financial assets pursuant to AASB 9 Is the financial asset an equity investment?

No

Are the financial asset’s contractual cash flows solely principal and interest?

Does the business model being used for this asset focus on collecting contractual cash flows (with sales of the assets only being incidental)?

Yes

Yes

Yes No No

Is the equity investment being held primarily for trading?

Is the entity’s business model’s objective achieved both by collecting contractual cash flows as well as by selling the financial assets?

No

Yes No

Yes

Has the entity elected to present changes in fair value within OCI?

Yes

Has the entity made an irrevocable election to present changes in fair value through profit or loss (because it will eliminate or significantly reduce a measurement or recognition inconsistency)?

Yes

No

Has the entity made an irrevocable election to present changes in fair value through profit or loss (because it will eliminate or significantly reduce a measurement or recognition inconsistency)?

Yes No

No Equity instruments measured at fair value through OCI

Fair value through profit or loss

Debt instruments fair value through OCI



Changes in fair value included within OCI



Changes in fair value will be included in profit or loss



Changes in fair value included within OCI



Dividends included with profit or loss (unless they clearly represent a repayment of part of the cost of the investment)



Interest and dividends (unless they are repayment of part of the cost of the investment) will be included in profit or loss



Interest revenue, expected credit losses, and foreign exchange gains and losses included within profit or loss



Amounts recognised in OCI are never reclassified to profit or loss in the event of sale, however the entity can transfer the cumulative gain or loss within equity, for example, to retained earnings



When the asset is derecognised (eg, sold) the cumulative gain or loss recognised in OCI is reclassified from equity to profit or loss

Amortised cost

• Interest revenue

and impairment losses relating to such things as expected credit losses and foreign exchange gains and losses would be included in profit or loss

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WORKED EXAMPLE 14.8: Classifying financial assets for the purposes of subsequent measurement Fanning Ltd holds the following financial assets: (a) A loan to Jeffries Bay Ltd, which will generate interest at 8% per annum and will provide a repayment of principal in three years’ time. Loans to corporations are held under a business model that prioritises the collection of contractual cash flows. (b) Government bonds that generate an effective rate of return of 5%. Pursuant to Fanning Ltd’s business model, government bonds are generally held to maturity but also sometimes sold if fair values have risen and funds are necessary to fund operations. (c) Shares in companies listed on the Australian Securities Exchange, which are held for trading. (d) Shares in companies that are not listed on a securities exchange and are not held for trading. Rather, they are held for the purposes of deriving dividends. REQUIRED Determine how the above financial assets are to be measured following initial recognition. SOLUTION (a) The loan to Jeffries Bay Ltd shall be recorded at amortised cost unless Fanning Ltd has made an irrevocable election to designate such assets at fair value through profit or loss on initial recognition to eliminate, or significantly reduce, a measurement or recognition inconsistency. (b) The investments in government bonds are being held in a business model that has an objective of both collecting contractual cash flows and selling the assets. As such, the assets shall be measured at fair value through OCI unless Fanning Ltd has made an irrevocable election to designate such assets at fair value through profit or loss on initial recognition to eliminate or significantly reduce a measurement or recognition inconsistency. (c) Because the shares in listed companies—which are equity investments—are being held for ‘trading’ then they are to be measured at fair value through profit or loss. (d) The shares in unlisted companies are not held for trading, therefore they are to be measured at fair value through profit or loss unless Fanning Ltd has made an irrevocable election to measure them at fair value through OCI.

WORKED EXAMPLE 14.9: Different measurement requirements for government bonds Lucky Break has acquired some government bonds on 1 July 2018. The government bonds will generate contractual cash flows that are solely principal and interest. The cash flows comprise: • a return of the principal amount of $1 000 000 in five years’ time; and • payments of interest of $100 000 at the end of each of the next five years (meaning a ‘coupon rate’ of 10 per cent given that the principal to be returned is $1 000 000 and the cash flows related to the interest payment are $100 000 per year). The government bonds were acquired at a price that will generate an effective interest rate of 5 per cent. That is, they were sold when the market required a rate of return of 5 per cent on government bonds with these cash flow characteristics. The required market rates of return for these government bonds decreased to 4 per cent on 30 June 2019 (which caused the fair value of the bonds to rise). Tax implications will be ignored for the purposes of answering this question. REQUIRED (a) Determine the initial purchase price of the government bonds on 1 July 2018. (b) Provide the accounting journal entries for the government bonds for the years ending 30 June 2019 and 30 June 2020 assuming that the business model being used for the asset focuses upon collecting the contractual cash flows. (c) Provide the accounting entries for the government bonds for the year ending 30 June 2019, but now assuming that the business model being used has the objective of both collecting the contractual cash flows from the government bonds as well as selling government bonds.

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(d) Provide the accounting entries for the government bonds for the year ending 30 June 2019 assuming that the business model being used for government bonds focuses upon trading government bonds. SOLUTION (a) To determine the acquisition price of the government bonds we discount the future cash flows at the market’s required rate of return. This will also equate to the fair value of the government bonds. Using the present value tables provided in Appendices A and B of this book, the fair value of the government bonds at the time of acquisition are: Present value of the principal to be received in 5 years Present value of interest to be received at the end of each of the following 5 years Issue price (fair value) of the government bonds on acquisition date

1 000 000 × 0.7835 =

$783 500

100 000 × 4.3295 =

$432 950 $1 216 450

In this case, the government bonds will be issued above their face value of $1 000 000. This is because the coupon rate on the government bonds of 10 per cent is more than what the market required, which we are told was 5 per cent. Because the market required only 5 per cent, the price of the government bonds will be increased to the point that the related cash flows equate to a return of 5 per cent on the purchase price of the government bonds. For more discussion on how differences between market required rates of return and coupon rates influence whether bonds will be issued at a premium or a discount please refer to Chapter 10 of this book. (b) Given that the business model in this part of the question focuses upon collecting contractual cash flows of interest and principal then the entity shall use amortised cost as the basis of subsequent measurement (unless an irrevocable election has been made to measure the assets at fair value through profit or loss in order to eliminate, or significantly reduce, a measurement or recognition inconsistency). To determine the relevant accounting entries for each year using amortised cost we can use the following table: Opening present value

Date 1 July 2018 30 June 2019 30 June 2020 30 June 2021 30 June 2022 30 June 2023

1 216 450 1 177 273 1 136 137 1 092 944 1 047 591

Interest 60 823 58 864 56 807 54 647 52 380

Principal repayment 39 177 41 136 43 193 45 353 1 047 591*

Closing present value 1 216 450 1 177 273 1 136 137 1 092 944 1 047 591 0

*rounding error

1 July 2018 Dr Cr

Government bonds Cash

1 216 450 1 216 450

30 June 2019 Dr Cr Cr

Cash Interest income Government bonds

100 000 60 823 39 177

30 June 2020 Dr Cr Cr

Cash Interest income Government bonds

100 000 58 864 41 136 continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  507

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(c) For parts (c) and (d) we need to determine the fair value at 30 June 2019. To do so we are required to discount the future cash flows at the market’s revised rate of return, this now being 4 per cent (and remember, the government bond will have a life of only four years at 30 June 2019). Present value of the principal to be received in 4 years Present value of interest to be received at the end of each of the following 4 years Fair value of the government bonds 30 June 2019 Carrying amount of government bonds prior to revaluation— see table presented earlier Revaluation increment 1 July 2018 Dr Government bonds Cr Cash 30 June 2019 Dr Cash Cr Interest income Cr Government bonds Dr Government bonds Cr Gain on financial asset (in equity and included within OCI)

1 000 000 × 0.8548 =

$854 800

100 000 × 3.6299 =

$362 990 $1 217 790 $1 177 273 $40 517

1 216 450 1 216 450

100 000 60 823 39 177 40 517 40 517

When the financial assets are measured at fair value through OCI, the amounts recorded in profit or loss (in this case, just interest income) will be the same as those shown when the assets are recorded at amortised cost. This is consistent with paragraph 5.7.11 of AASB 9. When the investment in the government bonds is eventually derecognised, the total amount recorded within equity (through OCI) in relation to fair value adjustments can be transferred out of equity and to profit or loss. (d) 1 July 2018 Dr Cr

Government bonds Cash

1 216 450 1 216 450

30 June 2019 Dr Cr Cr Dr Cr

Cash Interest income Government bonds Government bonds Fair value gain on government bond (included within profit or loss)

100 000 60 823 39 177 40 517 40 517

Some other points that can be raised in relation to this Worked example include: • If the required market rate had stayed at 5 per cent across the life of the government bonds then there would have been no change in fair value and the amount recorded at fair value for the government bonds would have been the same as the amount recorded using amortised cost. • If the required market rate on the government bonds changed across time (meaning changes in the market demand for the bonds, and therefore changes in their fair value), but Lucky Break Ltd held the bonds until the

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expiration of their five-year life, then any initial fair value gains on the government bonds would be reduced across time as the present value of the bonds ultimately becomes equal to the principal outstanding at the end of the life of the bonds. That is, the accumulated net amounts included within profit or loss, or OCI, would be zero at the end of year five.

WORKED EXAMPLE 14.10: Measurement of an interest-free loan provided to an employee On 1 July 2018 Generosity Ltd provides one of its senior executives with an interest-free loan of $1 000 000 for three years with the full amount being payable within three years. On 1 July 2018 the market rates of interest generally charged for loans to such people equals 6 per cent. REQUIRED You are to provide the accounting journal entries for the above loan for the year ending 30 June 2019. SOLUTION As we know, financial instruments are initially to be recorded at fair value. In this case, where there is an interest-free loan, there is also effectively an employee benefit being provided, which needs to be separately accounted for. The loan will be recognised at its present value using an interest rate that would equate to the market rate for a similar loan. As paragraph B5.1.1 of AASB 9 states: The fair value of a financial instrument at initial recognition is normally the transaction price (i.e. the fair value of the consideration given or received, see also paragraph B5.1.2A and IFRS 13). However, if part of the consideration given or received is for something other than the financial instrument, an entity shall measure the fair value of the financial instrument. For example, the fair value of a long-term loan or receivable that carries no interest can be measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating. Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type of asset. Using our present value tables, the present value of the interest free loan would equal: $1 000 000 × 0.8396 = $839 600. The journal entries would be: 1 July 2018 Dr Dr Cr

Loan receivable (employee loan) Employee benefit expense Cash

839 600 160 400 1 000 000

30 June 2019 Dr Cr

Loan receivable Interest revenue ($839 600 × 0.06 = $50 376)

50 376 50 376

Recognition and measurement of financial liabilities Initial recognition of financial liabilities

LO 14.7 LO 14.8 LO 14.9

We will now turn our attention to the recognition and measurement of financial liabilities. As we have already indicated, paragraph 3.1.1 of AASB 9 requires financial instruments, and therefore financial liabilities, to be initially recognised in a statement of financial position ‘when the entity becomes a party to the contractual provisions of the instrument’.

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When a financial liability is initially recognised, it is measured at its fair value in accordance with paragraph 5.1.1 of AASB 9. If the financial liability is not measured at fair value through profit or loss, in other words, it is measured at amortised cost, any transaction costs directly attributable to the issue of the financial liability are deducted. As paragraph 5.1.1 of AASB 9 states: At initial recognition, an entity shall measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability.

Subsequent measurements of financial liabilities AASB 9, paragraph 4.2.1 provides the following rules for subsequent measurement of financial liabilities where it states: An entity shall classify all financial liabilities as subsequently measured at amortised cost, except for: (a) financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be subsequently measured at fair value; (b) financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies. Paragraphs 3.2.15 and 3.2.17 apply to the measurement of such financial liabilities; (c) financial guarantee contracts. After initial recognition, an issuer of such a contract shall (unless paragraph 4.2.1(a) or (b) applies) subsequently measure it at the higher of: (i) the amount of the loss allowance determined in accordance with Section 5.5; and (ii) the amount initially recognised (see paragraph 5.1.1) less, when appropriate, the cumulative amount of income recognised in accordance with the principles of AASB 15; (d) commitments to provide a loan at a below-market interest rate. An issuer of such a commitment shall (unless paragraph 4.2.1(a) applies) subsequently measure it at the higher of: (i) the amount of the loss allowance determined in accordance with Section 5.5; and (ii) the amount initially recognised (see paragraph 5.1.1) less, when appropriate, the cumulative amount of income recognised in accordance with AASB 15. How to measure a financial liability at amortised cost is demonstrated in Worked Example 14.11. Unless the above conditions are satisfied, a financial liability shall be measured at amortised cost.

WORKED EXAMPLE 14.11: Financial liabilities other than those measured at fair value On 1 July 2018, Slater Ltd issued four-year bonds with a total face value of $100 000 and a coupon interest rate of 10 per cent per annum, payable annually in arrears. The market’s required interest rate for Slater’s bonds was 12 per cent and therefore the company had to discount the issue price to the fair value of $93 923. As explained in Chapter 10, whenever the market’s required rate of return exceeds the coupon rate being offered, then bonds will be issued at a discount to their face value. The issue price was determined by calculating the present value of the future cash flows at the market’s required rate of return: $10 000 × 3.0373 = $100 000 × 0.6355 =

$30 373 $63 550 $93 923

REQUIRED Prepare the journal entry to issue the bond at 1 July 2018, and the entry at 30 June 2019 to record the interest paid. SOLUTION Table 14.3 below demonstrates the amortised cost using the effective-interest method.

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1

  Year ended

2 Opening bond payable $

3

4

  Interest at 12% Payment (column 2 × 12%) $ $

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

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

30 June 2019

93 923

10 000

11 272

1272

95 195

30 June 2020

95 195

10 000

11 423

1423

96 618

30 June 2021

96 618

10 000

11 594

1594

98 212

30 June 2022

98 212

10 000

11 788*

1788

100 000

Table 14.3 Determining amortised cost using the effective interest method

*small rounding error

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. Notice the similarity between accounting for financial liabilities at amortised cost using the effective-interest method and accounting for lease liabilities in Chapter 11. Journal entries 1 July 2018 Dr Cash Cr Bond payable (Issuing bonds for $93 923)

93 923 93 923

30 June 2019 Dr Interest expense 11 272 Cr Bond payable 1 272 Cr Bank 10 000 (Interest payment and amortisation of bond payable using effective-interest rate of 12%)

Gains or losses on financial liabilities measured at fair value For those limited situations where a financial liability is measured at fair value through profit or loss, any gain or loss arising from a change in the fair value that is not part of a hedging relationship is generally recognised in profit or loss. However, AASB 9 paragraphs 5.7.7 and 5.7.8 require that gains or losses on financial liabilities designated as at fair value through profit or loss are to be split into the amount of the change in fair value that relates to changes in the credit risk of the liability, which shall be presented in the ‘other comprehensive income’ section of the statement of comprehensive income, and the remaining amount of the change in fair value of the liability shall be presented in profit or loss. The full amount of the change in the fair value of the liability is permitted to be included in profit or loss only if the recognition of changes in the liability’s credit risk in other comprehensive income would create or enlarge an ‘accounting mismatch’ in profit or loss. Such determination is made at the time of initial recognition of the liability. Where the financial liability is measured at amortised cost, any gain or loss arising from derecognition of the financial liability and through the amortisation process is recognised in profit or loss. AASB 9 also prescribes specific accounting treatment for financial assets and financial liabilities that are ‘hedging instruments’ or ‘designated hedged items’. The balance of this chapter will concentrate on derivatives (as previously defined). Unless the derivative has been acquired to ‘hedge’ the value of other financial instruments (and the entity has from the date of acquiring the derivative designated the derivative as a hedge and the hedge passes certain tests in relation to its ‘effectiveness’), the derivative is to be measured at its fair value with any changes therein to be included in the period’s profit or loss. The only exception to this treatment is where the entity designates the derivative as a CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  511

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cash-flow hedge. Where the derivative is a cash-flow hedge, the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge is initially recognised in other comprehensive income, while the ineffective portion of the gain or loss on the hedging instruments is recognised in profit or loss.

LO 14.10 LO 14.11 LO 14.12 LO 14.13 LO 14.14

Derivative financial instruments and their use as hedging instruments

Derivative financial instruments can take many forms and include futures contracts, options contracts, interest rate swaps, foreign currency swaps, and forward rate contracts. We will consider each of these in the text that follows. Derivatives are often used as hedging instruments. AASB 9 incorporates extensive requirements in relation to hedge accounting. Consistent with other financial instruments, derivatives are initially to be recognised at fair value. The value of a derivative is directly related to another underlying item. For example, a share option—which is a derivative—derives its value from the market value of the underlying shares. Forward rate agreements with banks, whereby banks agree to provide other parties with foreign currency at a future date and at an exchange rate agreed to in advance (a forward rate), derive their value from changes in foreign exchange rates. Derivatives can be used to transfer risks between the parties to the derivative-related contract in respect of the underlying securities concerned. According to Appendix A to AASB 9: A derivative is a financial instrument or other contract within the scope of this Standard with all three of the following characteristics: (a) its value 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‘); (b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and (c) it is settled at a future date. From the above definition we can see that there are three characteristics that must all be established before an instrument is considered to be a ‘derivative’.

hedge contract Arrangement with another party in which that other party accepts the risks associated with changing commodity prices, cash flows or exchange rates.

Derivatives used within a hedging arrangement Derivatives are often used as a means of hedging the gains or losses that might arise in the future in relation to other assets and liabilities. A hedge represents a situation where a ‘new’ risk is accepted as part of a process of offsetting or eliminating another existing risk. That is, to minimise the risk associated with particular assets or liabilities, an entity may enter a hedge contract. By entering into an agreement that takes a position opposite to the original transaction, an entity can minimise its exposure to gains and losses on particular assets and liabilities. As an example of a hedging arrangement, we can consider Worked Example 14.12.

WORKED EXAMPLE 14.12: Hedging arrangement An Australian company, Mungo Ltd, orders some inventory from a US supplier, Barry Inc., on 1 May 2018 for US$200 000 (when the exchange rate is A$1.00 = US$0.75) at a cost in Australian dollars of A$266 667 (200 000 ÷ 0.75). The goods are to be supplied and paid for on 30 June 2018. As at 1 May 2018 the forward rate for the delivery of US dollars on 30 June 2018 was A$1.00 = US$0.72. Mungo Ltd enters a forward rate agreement with its bank. REQUIRED (a) How could Mungo Ltd safeguard against exchange rate fluctuations? (b) Identify the ‘hedged item’ and the ‘hedging instrument’.

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(c) What is a ‘forward rate agreement’ and how would having one benefit Mungo Ltd? (d) Assuming that the Australian dollar decreases in value relative to the US dollar so that A$1.00 buys only US$0.60 on 30 June 2018, in the absence of a forward rate agreement, how would this impact Mungo Ltd? SOLUTION (a) To safeguard against exchange rate fluctuations, on the date it placed the order forward rate Mungo Ltd could also enter into a forward exchange rate contract to buy US$200 000 The exchange rate that on 30 June 2018 from another party (typically a bank) at a forward rate of is currently offered for A$1.00 = US$0.72. the future acquisition (b) In this situation the amount to be paid by Mungo Ltd to Barry Inc. is the hedged item or sale of a specific (that is, the item being hedged). This is the source of the original risk that Mungo currency. Ltd wants to address. The forward rate arrangement made by Mungo Ltd with the bank is the hedging instrument and this is the financial instrument that will offset, or eliminate, the risks associated with the hedged item. (c) A forward rate is the exchange rate for delivery of a currency at a specified date in the future. It is a guaranteed rate of exchange that will be provided at a future date regardless of what happens with exchange rates. With this forward rate agreement, the entity has locked in the price of the goods at A$277 778 (200 000 ÷ 0.72). That is, it has hedged the future payment. The entity has contracted to buy a specified number of US dollars at a future date (probably from a bank) at a predetermined rate. This is sometimes referred to as a ‘buy hedge’. (d) Let us assume that the Australian dollar decreases in value relative to the US dollar so that A$1.00 buys only US$0.60 on 30 June 2018. In the absence of a forward rate agreement (which we have designated the hedging instrument), the entity would pay the US supplier A$333 333 (200 000 ÷ 0.60). This is A$66 666 more than the original Australian dollar obligation. However, given the forward exchange rate agreement, the entity can obtain US$200 000 at an agreed cost payable to the bank of A$277 778. This amount is significantly below the fair value of the US dollars given the new exchange rate—so there is a gain on the agreement with the bank (that is, the hedging arrangement with the bank would be considered to have a positive fair value). The gain on the hedging instrument offsets the losses on the hedged item. Both gains and losses have to be accounted for separately.

AASB 9 requirements for ‘hedge accounting’ Pursuant to paragraph 6.1.1 of AASB 9, the objective of hedge accounting is to: represent, in the financial statements, the effect of an entity’s risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss . . . This approach aims to convey the context of hedging instruments for which hedge accounting is applied in order to allow insight into their purpose and effect. In accordance with AASB 9, a reporting entity can elect to designate a hedging relationship between a hedged item and a hedging instrument. If the designated hedging arrangement satisfies particular criteria with AASB 9, then it can apply ‘hedge accounting’ as described within AASB 9, which will enable the effects of changes in the values of the hedged item, and hedging instrument, to effectively be offset against each other. If it does not satisfy the criteria within AASB 9 for ‘hedge accounting’, then the reporting entity shall account for the hedged item and hedging instrument individually in accordance with the requirements of AASB 9. There are three criteria that must be satisfied for a hedging relationship to qualify for hedge accounting pursuant to AASB 9. These are identified at paragraph 6.4.1 of AASB 9 and require that: ( a) the hedging relationship consists only of eligible hedging instruments and eligible hedged items; (b) at the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge; and, (c) the hedging relationship meets specified hedge effectiveness requirements. Hedge effectiveness, as referred to in part c above, is defined at paragraph B6.4.1 of AASB 9 as: the extent to which changes in the fair value or the cash flows of the hedging instrument offset changes in the fair value or the cash flows of the hedged item. Hedge ineffectiveness is the extent to which the changes in the fair value or the cash flows of the hedging instrument are greater or less than those on the hedged item. CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  513

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Three hedge effectiveness requirements are stipulated at paragraph 6.4.1(c) of AASB 9, these being: 1. There is an economic relationship between the hedged item and the hedging instrument, which means that they are both subject to the same risks and their values will be expected to move at the same time, but in opposite directions. 2. The effect of credit risk does not dominate the value changes that result from the above economic relationship. 3. The proposed hedge ratio within the hedging relationship is the same as what actually occurs and is consistent with the purpose of hedge accounting. Assuming that a reporting entity has designated a hedging relationship and determined that it complies with the requirements for ‘hedge effectiveness’, then the hedge shall be classified in accordance with AASB 9 into one of the following types of hedges: 1. fair value hedges; 2. cash flow hedges; and 3. hedges of net investments in a foreign operation. The most common forms of hedges are fair value hedges and cash flow hedges and these are the hedges that we will address in this chapter. These types of hedges are defined at paragraph 6.5.2 of AASB 9 as follows: (a) fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss (b) cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable-rate debt) or a highly probable forecast transaction, and could affect profit or loss. Examples of a fair value hedge would include: • use of a forward contract to buy US$ in order to hedge an amount that is currently payable as a result of a purchase that was made in US$; • use of a forward contract to sell US$ in order to hedge an amount that is currently receivable from a sale that was made in US$; • use of a forward contract to buy US$ in order to hedge (lock in) the price of an unrecognised, but firm, commitment to buy some machinery from the US. Examples of a cash flow hedge would include: • a forward contract to buy US$ in order to hedge a highly probable purchase of machinery; • a forward contract to sell US$ in order to hedge a highly probable sales transaction. Fair value hedges could be used to hedge the value of particular assets or liabilities—for example, to hedge the value of a share portfolio (the value of a share portfolio might be hedged by acquiring share price index (SPI) futures as a hedging instrument; we will look at SPI futures later in this chapter). A cash flow hedge, on the other hand, could be used to hedge a future expected cash flow—for example, to hedge an amount that is payable to a foreign supplier, where that amount is denominated in US dollars. When hedge accounting is employed it does not change the overall performance or profits of the reporting entity over time. Rather, it affects only the timing and presentation of the profits or losses. Hedge accounting allows the gains and losses on the hedge item and the hedging instrument—which will tend to offset each other—to be recognised in profit or loss in the same accounting period. This can help to address potential accounting mismatches in situations where, for example, the general requirements of AASB 9 would otherwise require the gains or losses on a hedging instrument to not be recognised in the same periods as the gains or losses on the hedged item. In our discussion within this chapter we have frequently referred to hedging instruments and hedged items—two terms we considered in Worked Example 14.12. A hedging instrument can be a designated derivative whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. For example, a forward contract with a bank to deliver currency at a specified exchange rate (forward rate) is a hedging instrument that can be used to ‘lock in’ how much it might cost to acquire an asset in the future (the hedged item) where the price of that asset is denominated in a foreign currency. 514  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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A hedged item can be: • A recognised asset or liability. An example of a ‘recognised asset’ would be a receivable that is denominated in a foreign currency and which arose as a result of sales made to an overseas entity. An example of a recognised liability would be an account payable that is denominated in a foreign currency as a result of buying inventory from an overseas supplier. • An unrecognised firm commitment. A firm commitment would exist when an organisation has committed to buying products at a specific price on a particular date. It might be unrecognised because the transfer of control of the underlying products has yet to occur. The definition of a fair value hedge provided earlier specifically refers to unrecognised firm commitments. Paragraph 6.3.3 of AASB 9 requires that for a forecast transaction to be treated as a hedged item for hedge accounting purposes it must be a highly probably forecast transaction. • A forecast transaction. This is an uncommitted but anticipated future transaction. The definition of a cash flow hedge provided earlier specifically refers to forecast transactions. Paragraph 6.3.3 of AASB 9 requires that for a forecast transaction to be treated as a hedged item for hedge accounting purposes it must be a highly probably forecast transaction. • A net investment in a foreign operation. These are defined in AASB 121 The Effects of Changes in Foreign Exchange Rates as the ‘Net investment in a foreign operation is the amount of the reporting entity’s interest in the net assets of that operation’. We will not be considering how to account for these in this chapter. The hedged item can act to expose the entity to risk of changes in fair value or future cash flows. To reduce or eliminate this risk, the reporting entity can enter into a hedge that then creates the hedging instrument. For a fair value hedge, paragraph 89 of AASB 139 requires both the hedged item and the fair value hedge hedging instrument to be valued at fair value, with any gains or losses owing to fair value adjustments A hedge of the to be treated as part of the period‘s profit or loss. If the gains or losses on the hedged item are exposure to changes ‘perfectly hedged’ the gains or losses on the hedging instrument will offset the gains or losses on in fair value of a the hedged item so that the net effect on the period‘s profit or loss would be $nil. recognised asset or liability or an For a cash flow hedge, the gain or loss on measuring the hedged item at fair value is to be unrecognised firm treated as part of the period‘s profit or loss. The gain or loss on the hedging instrument is initially commitment, or a to be transferred to equity (and thereby included in ‘other comprehensive income’—remember, component of any such ‘other comprehensive income’ includes increases and decreases in a variety of equity accounts), item, that is attributable but subsequently transferred to profit or loss as necessary to offset the gains or losses recorded on to a particular risk and the hedged item. At the conclusion of the hedging arrangement, any amount still in equity relating could affect profit or loss. to the hedging instrument is to be transferred to profit or loss. Again, if a cash flow hedge does not satisfy the requirements previously discussed, the gains or losses on the hedging instrument shall go directly to profit or loss. cash flow hedge We will now consider fair value hedges in more detail. This will then be followed by an analysis A hedge of the of cash flow hedges.

Fair value hedges As we know from the material provided above, a fair value hedge arises when a hedging arrangement is undertaken to mitigate the risks associated with an entity being exposed to changes in the fair value of a recognised asset or liability. It can also arise in relation to unrecognised firm commitments to buy or sell resources. In accordance with paragraph AASB 9, for a fair value hedge: • The hedging instrument shall be measured at fair value with any gains or losses going to profit or loss. • The hedged items shall be measured at fair value with any gains or losses going to profit or loss.

exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variablerate debt) or a highly probable forecast transaction, and could affect profit or loss.

As the hedging instrument, and the hedged item, will have values that are impacted by the same risks, and as the change in values of each will move in opposite directions, the gains on one will tend to offset, or eliminate, the losses on the other. The net effect reflects the actions taken by the entity to reduce the risk that has been hedged (such as a change in a commodity price, or a foreign exchange rate). In the case of an ‘unrecognised firm agreement’, which means that the hedging instrument is activated/negotiated before the ultimate recognition of the firm commitment, then when the firm commitment is ultimately recognised CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  515

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(a purchase is made from an overseas supplier) the accumulated changes in the fair value of the hedging instrument are transferred to the cost of the asset, for example, inventory. This is consistent with paragraph 6.5.9 of AASB 9 which states: When a hedged item in a fair value hedge is a firm commitment (or a component thereof) to acquire an asset or assume a liability, the initial carrying amount of the asset or the liability that results from the entity meeting the firm commitment is adjusted to include the cumulative change in the fair value of the hedged item that was recognised in the statement of financial position. However, following the recognition of the firm commitment within the financial statements, any subsequent changes in the value of the hedging instrument are taken to profit or loss. Worked Example 14.13 provides an example of a fair value hedge.

WORKED EXAMPLE 14.13: Fair value hedge of the exposure to changes in fair value of a recognised asset Goldblum Ltd is a gold producer that has an inventory of gold. Concerned about potential market volatility in the market for gold, it wishes to insulate itself from potential adverse changes in the market price of gold. On 1 July 2018, Goldblum Ltd enters in a forward contract that is indexed to move with the market price of gold. The contract is based on the delivery of a certain amount of gold at a pre-specified price. If the market price of gold goes up then a loss would be made on the contract (as effectively Goldblum would notionally be required to buy gold at a higher price to satisfy the delivery, and sell it at the lower agreed price); conversely, if the price of gold decreases then a gain would be made on the contract. The gold contract matures on 30 June 2019. There is no requirement to make any upfront payment on the contract. The hedging instrument is deemed to be effective in protecting the entity from adverse movements in the price of gold (it passes the requirements for ‘hedge accounting’ within AASB 9). For the 6 months to 31 December 2018 the market value of gold has decreased and as a result the fair value of the forward contract—the hedging instrument—has increased by $120 000 whereas the fair value of Goldblum Ltd’s inventory of gold—the hedged item—has decreased by $120 000. In the 6 months to 30 June 2019 the market price of gold has further decreased such that the fair value of the forward contract has increased by $52 000, whereas the fair value of Goldblum Ltd’s inventory of gold has decreased by a further $55 000. REQUIRED Provide the journal entries for the year ended 30 June 2019. SOLUTION 1 July 2018 There is a requirement that a financial asset or financial liability shall initially be measured at fair value. There is no entry made on 1 July 2018 as the fair value of the contract is deemed to be zero and no deposits have been made in relation to the contract. 31 December 2018 Dr Loss on gold inventory (included in profit or loss) Cr Gold inventory Dr Forward contract—gold (an asset) Cr Gain on forward contract (included in profit or loss)

120 000 120 000 120 000 120 000

30 June 2019 Dr Loss on gold inventory (included in profit or loss) 55 000 Cr Gold inventory 55 000 Dr Forward contract—gold 52 000 Cr Gain on forward contract (included in profit or loss) 52 000 Dr Cash at bank 172 000 Cr Forward contract—gold 172 000 (the other party to the forward contract settles their debt with Goldblum Ltd. As with most futures contracts, there is typically no transfer of the underlying commodity—in this case gold. Rather, cash is transferred to close the position. The receipt of cash from the other party to the forward contract acts to offset the losses Goldblum Ltd has incurred from holding the inventory of gold in a period of declining gold prices)

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Worked Example 14.14 provides an example of a fair value hedge of an unrecognised firm commitment. A ‘firm commitment’ is defined in AASB 9 as ‘a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates’. If it is ‘unrecognised’ this means it has not been recognised for financial statement purposes, possibly because the transfer of control of the underlying assets—for example, inventory— has not yet occurred.

WORKED EXAMPLE 14.14: Fair value hedge of an unrecognised firm commitment On 1 June 2018 Melbourne Ltd enters into a firm commitment with Chicago Co. to buy US$ 2 000 000 of inventory. The inventory will be transferred to Melbourne Ltd (making Melbourne Ltd therefore liable for the debt) on 1 August 2018 and payment will be made on that date. The financial year end of Melbourne Ltd is 30 June. We will assume that the hedging arrangements used by Melbourne Ltd qualify for ‘hedge accounting’ pursuant to AASB 9 and that Melbourne has designated the hedging arrangement as a ‘fair value hedge’. The relevant spot rates (a spot rate is the exchange rate in place for immediate delivery of the particular currency) and forward rates are as follows: Date 1 June 2018 30 June 2018 1 August 2018

Spot rate

Forward rate for delivery on 1 August

US$1.00 = $A1.40 US$1.00 = $A1.32 US$1.00 = $A1.48

US$1.00 = $A1.45 US$1.00 = $A1.47 US$1.00 = $A1.48

REQUIRED Provide the journal entries to account for the hedged item and hedging instrument as required on 1 June 2018, 30 June 2018 and 1 August 2018. SOLUTION The firm commitment (which is the hedged item) and the forward contract (which is the hedging instrument) are both to be measured at fair value and these fair values will be calculated on the basis of the forward rates. Changes in the fair values of the hedged item and the hedging instrument are to be recorded within profit or loss. As we can see, on the final day of the transaction, 1 August 2018, the forward rate and the spot rate are the same (this makes sense as the negotiated forward rate for the transfer of a currency today should simply equal today’s exchange rate). Measurements of the fair values of the ‘firm commitment’ and the forward rate contract on the respective dates are: Date 1 June 2018 30 June 2018 1 August 2018 Realised gain/(loss)

Fair value of firm commitment

Gain/(loss) on firm commitment

Fair value of forward contract

Gain/(loss) on forward contract

2 900 000 (2 940 000) (2 960 000)

– (40 000) (20 000) (60 000)

2 900 000 2 940 000 2 960 000

 – 40 000 20 000 60 000

The accounting journal entries would be: 1 June 2018 There would be no journal entries on 1 June as that was the date that both the firm commitment and the forward contract agreement were entered into, and therefore there has not been time for there to be a change in fair value. 30 June 2018 Dr Loss on unrecognised firm commitment (in profit or loss) 40 000 Cr Unrecognised firm commitment (liability) 40 000 Dr Forward contract (asset) 40 000 Cr Gain on forward contract (in profit or loss) 40 000 As we can see, after determining the respective fair values, the gain on the hedging instrument offsets the loss on the hedged item. continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  517

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1 August 2018 We first adjust the fair values of the unrecognised firm commitment and the forward contract: Dr Loss on unrecognised firm commitment (in profit or loss) 20 000 Cr Unrecognised firm commitment (liability) 20 000 Dr Forward contract (asset) 20 000 Cr Gain on forward contract (in profit or loss) 20 000 We then close out the forward contract, which in this case means that the bank will transfer to Melbourne Ltd the gain it has made on the forward contract: Dr Cash at bank 60 000 Cr Forward contract (asset) 60 000 On the transaction date we then offset the accumulated gain or loss on the unrecognised firm commitment against the cost of the inventory. This is consistent with paragraph 6.5.9 of AASB 9, which requires the initial cost of the asset to include the gain or loss on the unrecognised firm commitment that had previously been recognised as an asset or liability. Dr Dr Cr

Unrecognised firm commitment (liability) Inventory Cash at bank

60 000 2 900 000 2 960 000

As we can see above, the ultimate net cost of the inventory, after taking account of the forward rate agreement, is $2 900 000 (the organisation has received cash of $60 000 but paid cash of $2 960 000). This is the amount that was effectively ‘locked in’ by way of the forward contract negotiated with the bank back on 1 June 2018. If the forward contract had not been negotiated the inventory would have cost $2 960 000. By entering the hedge agreement, Melbourne Ltd was able to shift the associated risks on the hedged item to the bank.

Cash flow hedges As we have already indicated, a cash flow hedge is undertaken to hedge the future cash flows associated with a particular recognised asset or liability, or for a highly probable forecast transaction. For example, it could be undertaken to hedge the amount payable to a foreign supplier of goods. In accordance with AASB 9, for a cash flow hedge: • The hedging instrument shall be measured at fair value with any gains or losses on the portion of the hedge deemed as being effective initially going to equity in the form of a transfer to a reserve named something like ‘cash flow hedge reserve’ (and therefore being included in ‘other comprehensive income’ rather than profit or loss). The gains or losses on the portion of a hedging instrument that is deemed to be ineffective shall be recorded within profit or loss. In the examples that follow we will assume that the entire hedging instrument is ‘effective’. • Following the recognition of the hedge item in the financial statements (for example, the recognition of the inventory that was being acquired), the accounting treatment for a cash flow hedge and a fair value hedge is similar. • The hedged items—which will either be a recognised asset or liability, or a highly probably forecast transaction— shall be measured at fair value with any gains or losses going to profit or loss. This is the same as the requirements for a fair value hedge. • The treatment of the amounts recognised in the ‘cash flow hedge reserve’ (that is, within equity and with the movement included within other comprehensive income) in relation to the hedging instrument will be dependent upon whether the hedged item is a highly probably forecast transaction, or an asset or liability that is currently recognised within the financial statements (a highly probable forecast transaction). • If the hedged item is a highly probable forecast transaction, then the balance in the cash flow hedge reserve shall be included within the initial cost of the liability or asset. • Once the hedged item has been recognised in the financial statements (for example, control of some inventory has passed to the purchaser and a liability is now in existence), any further changes in the fair value of the hedging instrument are recognised within profit or loss. 518  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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• Therefore, once the underlying transaction relating to the hedged item has occurred, the gains or losses on the hedging instrument will act to offset the gains or losses on the hedged item. Worked Example 14.15 provides an example of a cash flow hedge.

WORKED EXAMPLE 14.15: Cash flow hedge of a highly probable forecast transaction Oz Ltd manufactures electric cars. On 15 June 2018 Oz Ltd enters into a non-cancellable purchase commitment with Vegas Ltd for the supply of batteries, with those batteries to be shipped on 30 June 2018, at which time control of the assets will be transferred to Oz Ltd. The total contract price was US$2 000 000 and the full amount was due for payment on 30 August 2018. Because of concerns about movements in foreign exchange rates, on 15 June 2018 Oz Ltd entered into a forward rate contract on US dollars with a foreign exchange broker so as to receive US$2 000 000 on 30 August 2018 at a forward rate of $A1.00 = US$0.80 (meaning A$2 500 000 will be payable to the foreign currency broker). We will assume that Oz Ltd elects to treat the hedge as a cash flow hedge and that the hedge arrangement satisfies the criteria within AASB 9 for hedge accounting. As this is a hedge of a highly probable forecast transaction, the entity shall include the associated gains and losses on the hedging instrument that were recognised in other comprehensive income up until 30 June 2018 in the initial cost of the batteries. Other information: The respective spot rates, with the spot rates being the exchange rates for immediate delivery of currencies to be exchanged, are provided below. The forward rates offered on particular dates, for delivery of US dollars on 30 August 2018, are also provided. It should be noted that on 30 August 2018, the last day of the forward rate contract, the spot rate and the forward rate will be the same.

Date 15 June 2018 30 June 2018 30 August 2018

Spot rate

Forward rates for 30 August 2018 delivery of US$

$A1.00 = US$0.83 $A1.00 = US$0.81 $A1.00 = US$0.76

$A1.00 = US$0.80 $A1.00 = US$0.78 $A1.00 = US$0.76

REQUIRED Provide the journal entries to account for the ‘hedged item’ and the ‘hedging instrument’. The financial year end is 30 June 2018. SOLUTION Given that this has been designated as a cash flow hedge, and it has also been assumed that the hedge is ‘effective’, then any gains or losses on the hedging instrument shall initially be recognised in equity (and therefore in ‘other comprehensive income’) and then ultimately transferred to the cost of inventory. It should be noted that as this hedging arrangement relates to a highly probable forecast transaction, which would also be considered in this case to be an unrecognised firm commitment, then AASB 9 permits the hedge arrangement to be treated either as a cash flow hedge or a fair value hedge. In this example, the entity has elected to treat it as a cash flow hedge. Gains/losses on the hedged item (the inventory purchase) are calculated as follows: Date 15 June 2018 30 June 2018 30 August 2018

Spot rate

Amount payable in $A

Foreign exchange gain/(loss)

$A1.00 = US$0.83 $A1.00 = US$0.81 $A1.00 = US$0.76

– $2 469 136 $2 631 579

(162 443)

Note: the purchase is not recognised until such time as the batteries are shipped on 30 June 2018.

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Gains/losses on the hedging instrument (the forward rate contract) are calculated as follows:

Date 15 June 2018 30 June 2018 30 August 2018

Fwd rate for delivery of US$ on 30 Aug 2018

Receivable on fwd contract (a)

Amount payable in A$ on fwd contract (b)

Fair value of fwd contract (c)

$A1.00 = US$0.80 $A1.00 = US$0.78 $A1.00 = US$0.76

$2 500 000 $2 564 103 $2 631 579

$2 500 000 $2 500 000 $2 500 000

0 $64 103 $131 579

Gain/(loss) on fwd contract (d) $64 103   $67 476 $131 579

Notes to the above table (a) Determined by dividing $2.0m by the respective dates’ forward rate. This right refers to the amount of Australian dollars to be received from the bank, the value of which will fluctuate as the forward rate changes. Although Oz Ltd has been able to ‘lock in’ a particular forward rate (being $0.80), because the bank will negotiate different forward rates at different times the fair value of the receivable will change across time. For example, if the forward rate that was available on 30 June had changed from $0.80 to $0.78 then anybody entering a forward rate on 30 June to receive US$2.0m on 30 August would need to ultimately pay $2 564 103. This means that the existing forward rate contract has a fair value of $64 103 because it will provide $2.0m for the ‘old’ negotiated forward rate of $0.80, which is better than what is currently available (being $0.78). Gains or losses in the value of this receivable will act to offset the gains or losses in the value of the amount payable to the overseas supplier. (b) The obligation (amount payable) represents the amount that must be paid to the bank using the forward rate negotiated with the bank and is fixed in absolute terms for the contracted party. This amount is fixed regardless of what happens to spot rates, or what forward rates the bank offers on other forward rate contracts. (c) We have calculated a fair value for the hedging instrument (the hedging instrument being the forward rate contract). It is a requirement of AASB 9 that a fair value be attributed to the hedging instrument. In this situation, the fair value will change as the available forward rate being offered by the bank changes. For example, when the contract is originally negotiated, the bank is assumed to be offering the forward rate of A$1.00 = US$0.80 for the delivery of US dollars on 30 August 2018 to any interested parties. Therefore, the contract itself has no fair value. However, if on 30 June 2018 the bank is only prepared to offer a forward rate for delivery of US dollars of A$1.00 = US$0.78, then if Oz Ltd was able to transfer its contract to another party needing US dollars on that date, then, given the other options available to that other party, that party would be prepared to pay up to $64 103 for the contract, which equates to ($2 000 000 ÷ 0.80) – ($2 000 000 ÷ 0.78). The fair value of the contract would be deemed to be $64 103. There is also a requirement that the financial instrument—in this case the forward contract—be measured at the present value of the future cash flows. Because the life of the forward contract is less than 12 months it has been decided on the basis of materiality not to discount the associated cash flows to present value in this Worked Example. In other examples in this chapter, no discounting will be applied to forward contracts with lives of less than 12 months. (d) The gain or loss on the forward rate contract represents the change in the fair value of the forward rate contract. In the calculations above we have calculated a fair value for the hedging instrument (which in this case, is the forward contract) at each reporting date. It is a requirement of AASB 9 that a fair value be attributed to the forward contract. The changing fair value represents how much it would cost the entity to take out a forward rate agreement for the delivery of US$2 000 000. For example, if the entity, or perhaps another entity, were to negotiate the forward rate agreement at 30 June 2018 it would have cost them $2 564 103 for US$2 000 000 rather than the A$2 500 000 they were able to ‘lock in’ on 15 June 2018. The change in the fair value represents the gain or loss on the forward contract. As we can see from the above table, the amount payable for US$2 000 000 (the commitment) has been locked in at A$2 500 000 regardless of what subsequently happens to spot rates and forward rates. The required journal entries would be as follows: 15 June 2018 No entry is required here as the fair value of the forward rate agreement is assessed as being zero given that the fair value of the foreign currency receivable is the same as the fair value of the commitment, both being $2 500 000.

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30 June 2018 Dr Forward rate contract (financial asset) 64 103 Cr Cash flow hedge reserve (would be a gain recorded 64 103 in other comprehensive income) (to recognise the fair value of the forward contract, which is the difference between the related receivable on the contract and the related commitment) Dr Inventory 2 469 136 Cr Foreign currency payable 2 469 136 (to recognise the acquisition of inventory using the relevant spot rate) Dr Cash flow hedge reserve 64 103 Cr Inventory 64 103 (to transfer the gain/loss on the forward contract to the cost of inventory as at the date of inventory acquisition. According to paragraph 6.5.11(d)(1) of AASB 9, and also consistent with paragraph 96 of AASB 101, this is not a reclassification adjustment and hence it does not affect other comprehensive income) Following the date of acquisition of the inventory, all gains and losses on the forward rate contract and the foreign currency payable with the supplier are transferred directly to profit or loss just as they would be for a fair value hedge. 30 August 2018 Dr Forward rate contract (financial asset) 67 476 Cr Gain on forward contract 67 476 Dr Foreign exchange loss 162 443 Cr Foreign currency payable 162 443 Dr Cash at bank 131 579 Cr Forward rate contract (financial asset) 131 579 (in this situation the other party to the forward rate contract has actually lost money on the transaction and therefore provides funds to the entity) Dr Foreign currency payable 2 631 579 Cr Cash at bank 2 631 579 (this represents the amount paid to the overseas battery supplier. As we can see from the above two entries, the net amount paid for the batteries was $2 500 000 (which is $2 631 579 – $131 579), which equates to the amount originally negotiated in the forward rate contract) We will consider, in what follows, some financial instruments that may (but need not) be used as hedging instruments.

Futures contracts A futures contract can be defined simply as a contract to buy or sell an agreed quantity of a particular item, at an agreed price, on a specific future date. The buy or sell price will be determined on the date the futures contract is entered into, even though the underlying buy or sell agreement will not be finalised for a particular period of time. If prices of a particular item that is subject to the futures contract increase, parties that have entered a contract to buy the items or commodities (that is, have taken a buy position) will record a gain on the futures contract, and those that have entered a contract to sell the items or commodities (that is, have taken a sell position) will record a loss on the futures contract. Futures contracts are traded on a futures exchange and do not normally require delivery of the actual item to which the futures contract relates. Rather, settlement is normally undertaken in the form of a cash payment or cash receipt. In Australia the first futures contracts were introduced in 1960 and related to greasy wool—a rural commodity. Such futures provided a means for farmers to minimise the risk associated with the changing market prices of wool. For example, a farmer might know within particular bounds of certainty the specific quantity of wool of a given standard that their farm will produce for delivery to market on a particular date. Without some form of hedging—and as we know, hedging can be

futures contract A contract to buy or sell an agreed quantity of a particular item at an agreed price on a specific date.

hedging An action taken with the object of avoiding or minimising the possible adverse effects of movements in exchange rates or market prices.

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defined as an action taken with the object of avoiding or minimising the possible adverse effects of movements in such things as exchange rates or commodity market prices—the farmer’s ultimate cash receipt could diverge markedly from what was anticipated. Depending on movements in market prices, the ultimate receipt could be more or it could be less than expected. To eliminate or lessen this risk, the farmer could enter into an agreement on a futures exchange to deliver the wool on a specified date at a predetermined price. Apart from commodity futures, there are also financial futures. Since the 1980s the use of financial futures in Australia has increased significantly. The majority of trading volume in Australian futures exchanges now relates to financial futures. Financial futures currently traded include 90-day bank bill futures, three-year bond futures, ten-year bond futures, share price index futures and futures for shares in specific companies such as ANZ Bank, BHP Billiton Ltd, Foster’s Ltd, News Corp, NAB Ltd, Rio  Tinto Ltd, Telstra and Westpac. With futures contracts, it is unusual for the underlying item to actually be delivered, and traders typically have the ability to close out a position before the maturity of the contract. Because of the high leverage involved, it is essential that parties that use futures for speculative purposes keep a close watch on daily movements in the value of the contracts. There have been numerous cases where individuals have faced bankruptcy or organisations have been wound up because of major losses incurred on the futures market. Huge losses (or gains) can be made, even though the initial cash deposit on the contract can be low—this is why futures contracts are considered to be highly levered instruments. Unless used for hedging purposes, futures trading would not be undertaken by risk-averse individuals or organisations. Notable recent losses involving futures trading include: • A loss of US$9.0 billion by Morgan Stanley of the US in 2008 on credit default swaps. • A loss of US$2.0 billion by UBS in 2011 on an exchange traded fund (ETF) index. • A loss of US$1.5 billion by Metallgesellschaft AG of Germany on oil futures contracts entered into by its US refining and marketing operation. This loss became known in January 1994. • A loss of US$1.4 billion by Barings plc of Britain on Japanese equity index futures trading in 1995. This loss led ultimately to the collapse of the bank. • A loss of $360 million by National Australia Bank on currency options in 2003–04. • A loss of $US7.14 billion by the Paris-based international bank Société Générale in 2008. Parties that trade in futures are typically required to deposit a specific amount before they enter into a futures contract. This amount deposited can then be added to on a daily basis if the futures trader gains, or deducted from if the trader loses. If a significant proportion of the deposit is eroded through losses, the trader will be required to provide the futures exchange with additional funds to reinstate the original deposit. This requirement to provide further funds throughout the life of the contract is frequently referred to as a ‘margin call’. The futures are marked to market on a daily basis, which means that if things are going badly, margin calls could be made on a daily basis. As noted above, because the initial deposit might be low in relation to the underlying value of the futures contract, futures are considered to be ‘highly levered’—that is, they can lead to high percentage gains or losses. Worked Example 14.16 provides an example of a futures contract.

mark to market Valuing assets according to their market prices.

WORKED EXAMPLE 14.16: Use of futures in relation to a specific company’s shares Jill Money had a rich friend who recently passed away in rather unusual circumstances. The rich friend bequeathed 50 000 shares in BHP Billiton Ltd to Jill. Jill has decided to use the money from the sale of the shares to purchase a waterfront home on the Gold Coast in Queensland. The current price of BHP Billiton shares is $36.20. Jill would like to sell the shares immediately, as she has found a particular home she would like to acquire and she is concerned that the share price might fall, thereby preventing her from being able to make the acquisition. However, the shares cannot be legally transferred to her for one month. REQUIRED Since she will not legally own the shares for one month, what action might Jill Money take to ensure that she can acquire the waterfront property?

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SOLUTION Jill could enter a futures contract on BHP Billiton shares in which she takes a ‘sell position’ on 50 000 BHP Billiton shares. The price of BHP Billiton futures is $36.20 per share when she enters the futures contract (meaning that at the expiration of the contract she has an agreement that somebody will buy the shares at $36.20 each). Hence, regardless of what happens to the market price of the futures contract, Jill has ‘locked in’ the price that she will ultimately receive. After the passing of one month, the price of BHP Billiton shares has dropped to $33.20. We will ignore issues such as the time value of the futures and transaction costs. Jill has made a gain on the futures contract, as she has an agreement to sell the shares at a price that is $3.00 above their current market price ($36.20 – $33.20 = $3.00). Rather than buying shares at $33.20 and then selling them at the agreed price of $36.20, the other party to the futures contract will transfer $150 000, which is 50 000 × $3.00. This gain offsets the loss of $3.00 that she has made on the underlying security—the shares in BHP Billiton Ltd. Jill has effectively hedged her potential losses. The other party to the futures contract has made a loss on the futures contract as they have an agreement to buy the BHP Billiton futures for $36.20, a figure over and above the current market price. The total gains and losses can be summarised as follows: Loss on BHP Billiton shares Gain on BHP Billiton futures Total net gain (loss)

50 000 × $3.00 50 000 × $3.00

($150 000) $150 000               0

As another example of a share-related future we can consider Worked Example 14.17 which relates to share price index (SPI) futures. As you probably know, in Australia a measure of the movements in the share market is provided by the All Ordinaries Share Price Index. This index is calculated daily by the Australian Securities Exchange Ltd (ASX) and is based on market prices of particular shares. The ASX has a number of futures available—based, for example, on the market prices of the top 200 shares and on the performance of the top 50 companies. There is also an ASX Property Trust Index Futures. In describing the development of share price index futures, Stoll and Whaley (1997, p. 140) state:

All Ordinaries Share Price Index Provides a measure of the movements in the share market within Australia.

Stock index futures contracts were, perhaps, the most successful financial innovation of the 1980s. The first contract was the Chicago Mercantile Exchange’s S&P 500 futures, which began trading in the US in April 1982. The contract design quickly spread to almost every major financial futures market worldwide—the Sydney Futures Exchange’s Australian All Ordinaries Share Price Index futures first traded in 1983; the London International Financial Futures Exchange’s FTSE 100 futures in 1984; the Hong Kong Futures Exchange’s Hang Seng Index futures in 1986; the MATIF’s CAC-40 index futures in 1988; the Osaka Stock Exchange’s Nikkei 225 futures in 1988; and DTB’s DAX index futures in 1990. The primary reason for the success of stock index futures markets is that index futures provide a fast and inexpensive means of changing stock market risk exposures internationally. The share price index (SPI) provides an indication of movements in the market value of a well-diversified portfolio of shares. SPI futures are directly related to the All Ordinaries SPI in that a unit contract in SPI futures is priced at the All Ordinaries SPI (or a subset thereof—possibly based on 200 or 50 companies on the ASX) multiplied by $25.00 per index point. For example, on 7 September 2015 the S&P/ASX 200 index was 4988. This means that the price of one S&P/ ASX 200 futures contract is $124 700 (4988 × $25). As with other futures, participants can take buy or sell positions. At the end of the contract period no actual shares need to be delivered. The ASX Index Futures trading ends on the third Thursday of the maturity month—with the contract months being March, June, September and December (further details about the ASX Index Futures can be found on the ASX website, www.asx.com.au). Settlement for movements in the price of the index has to be made shortly thereafter. Traders can also ‘close’ positions throughout the life of the futures contract by selling their contract to another party at the available market price for the futures contract. Worked Example 14.17 represents a futures trade where the trader in question has taken a buy position. CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  523

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WORKED EXAMPLE 14.17: Futures trading taking a buy position Johnny Risk believes that the share market is about to increase in value. On 1 March 2019 he acquires one contract in SPI futures in which he agrees to take a ‘buy’ position. The All Ordinaries SPI is 5500 on 1 March, meaning that Johnny Risk has agreed to buy a contract at a price of 5500 × $25. Any subsequent gain or loss will depend directly upon what he can ultimately sell the contract for. This amount will change daily and Johnny will be hoping that share prices will rise. Note that as he might have paid only a small deposit on the contract his gains or losses can represent a significant percentage of the initial deposit. That is, the futures contract is ‘highly leveraged’. Just following his acquisition of the futures contract, there is a general decline in the share market and the All Ordinaries SPI falls to 5050. Worried about potential further falls he decides to close out his position by taking an opposite position—that is, he sells his futures contract. (Johnny originally bought the contract—if he took out a contract in which he had taken a sell position, he would close it out by buying a futures contract, in which case he would have hoped for a falling market.) REQUIRED Calculate the amount that Johnny has lost on the contract. SOLUTION Johnny‘s loss can be calculated as follows: Value of SPI futures at date of acquisition Value of SPI futures at date of position close Loss on the futures contract

5 500 × $25.00 = 5 050 × $25.00 =

$137 500 $126 250   $11 250

SPI futures can be used for hedging purposes or for speculation. If an organisation holds a portfolio of shares, it might hedge movements in those shares by acquiring a ‘sell’ SPI futures contract in which it agrees up front the price at which it will sell the SPI futures. If the share market falls, the party with the sell position will gain on the index because the price at which it contracted to sell the contract would be greater than the market price of the equivalent contract on the date of the subsequent sale. Hence when a hedging strategy is adopted, what would be gained from the futures contract would offset any loss that would be made on the actual portfolio of shares held. Worked Example 14.18 provides another illustration of the use of SPI futures, including associated journal entries. Had the entity in Worked Example 14.18 not acquired the futures contract, it would have lost $180 000 on its share portfolio. However, given the gain of $120 000 on the futures contract, the total result is a loss of $60 000. The hedging activity insulates the entity from the full loss that would otherwise occur.

WORKED EXAMPLE 14.18: Use of share price index futures Boomtime Investments Ltd holds a well-diversified portfolio of shares that has a market value of $2.18 million. Boomtime is concerned about possible downturns in the share market, and on 1 March 2019 decides to take out a sell position in 16 SPI Futures units when the All Ordinaries SPI is 5550. This means that another party has taken a buy position. To enter the contract, Boomtime makes an initial deposit of $100 000 with the futures broker. It is considered that movements in the All Ordinaries SPI, and hence the SPI Futures, will reflect changes in the value of the diversified share portfolio held by Boomtime Investments Ltd. On 29 March the All Ordinaries SPI has fallen to 5400 and the value of the organisation’s share portfolio has fallen to $2.1 million. REQUIRED (a) Explain why the above contract would be considered to be a derivative as defined by AASB 9. (b) Calculate the total gain or loss after hedging as a result of this contract. (c) Provide the accounting entries for Boomtime Investments’ financial futures investments.

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SOLUTION (a) It is deemed to be a derivative as it satisfies the definition of a derivative provided within AASB 9. As we know, Appendix A of AASB 9 defines a derivative in the following manner (the above futures contract is consistent with this definition): A financial instrument or other contract within the scope of this Standard with all three of the following characteristics: (a) its value 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 (sometimes called the ‘underlying’); (b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and (c) it is settled at a future date. (b) The total gain or loss after hedging can be calculated as follows: Loss on share portfolio—the hedged item Market price at 1 March 2019 Market price at 29 March 2019 Gain on SPI Futures—the hedging instrument Price on 1 March 2019 Price on 29 March 2019 Net loss

$2 180 000 $2 100 000 5550 × $25 × 16 units 5400 × $25 × 16 units

$2 220 000 $2 160 000

$80 000

$60 000 $20 000

(c) Accounting entries for Boomtime Investments Ltd‘s investments (i) How should we account for the financial futures contracts of Boomtime Investments Ltd? The use of the above futures would constitute a fair value hedge. The hedging instrument (in this case, the futures contract) would be measured at fair value with changes going to profit or loss. The hedged item, being the share portfolio, would also be valued at fair value with changes also going to profit or loss. The gains or losses on the hedged item would offset the gains or losses on the hedging instrument. The required entries would be as follows: 1 March 2019 On 1 March the entity enters a forward contract. Effectively, on this date Boomtime Investments Ltd has an obligation of $2.22 million payable on the futures contract. It also effectively has a receivable of $2.22 million because that is the amount it could receive from selling the contract on that same date. Since the value of the right and that of the obligation are equal, the net fair value of the contract is zero. Hence, no accounting entry is necessary to record the right and the obligation. Dr Deposit on SPI Futures (asset) 100 000 Cr Cash at bank 100 000 (there is normally a requirement to make a percentage deposit with the futures broker) Initial recognition Under AASB 9, an entity is required to recognise a financial asset or liability on its statement of financial position when, and only when, it becomes a party to the contractual provisions of the instrument. Initial measurement Financial assets and liabilities are initially measured at fair value. Usually this will be the same as the fair value of the consideration given (in the case of an asset) or received (in the case of a liability). continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  525

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(ii) After the initial recognition of the futures contract and the related deposit, the movements in the value of the futures and the share portfolio can be accounted for on the basis of movements in fair value. The entries would be: 29 March 2019 Dr Loss on share portfolio 80 000 Cr Share portfolio 80 000 (to ‘mark to market’ the value of the organisation’s share portfolio and to treat the downward movement as a loss) Dr Deposit held by broker 60 000 Cr Gain on futures contract 60 000 (this entry assumes that the gains are credited to the initial deposit held by the futures broker; it represents an aggregated entry, as in practice the adjustments to the deposit account might be made daily) (iii) If Boomtime Investments Ltd decides to sell its shares and close out its futures contract on 30 March 2019, the accounting entries would be as shown below. We will introduce additional information by assuming that the value of the portfolio of shares has fallen to $2 million and the All Ordinaries SPI has fallen to 5250: 30 March 2019 Dr Cash 2 000 000 Dr Loss on share portfolio 100 000 Cr Share portfolio 2 100 000 Dr Deposit held by broker 60 000 Cr Gain on futures contract 60 000 (these entries again assume that the gains are credited to the initial deposit held by the futures broker; the gain on the futures contract is (5400 – 5250) × 25.00 × 16, which equals $60 000) Dr Cash at bank 220 000 Cr Deposit held by broker 220 000 (this amount represents the total of the original deposit paid to the broker plus the accumulated gains of the SPI Futures since the date of entering the contract; as can be seen, the return represents 120 per cent on the initial deposit)

Apart from SPI Futures, individuals may elect to transact in foreign currency futures. Worked Example 14.19 demonstrates the use of such futures.

WORKED EXAMPLE 14.19: Use of currency futures On 1 July 2019 Hedgy Ltd makes a sale of US$1 million to an overseas organisation. The item cost Hedgy Ltd A$1.1 million to manufacture. The spot rate on 1 July 2019 is A$1 = US$0.7205, so that the value of the receivable converted to Australian dollars on 1 July 2019 is $1 387 925. The amount is due for receipt on 1 September 2019. Hedgy Ltd is aware that it is exposed to fluctuations in exchange rates, which could increase or decrease the amount of Australian dollars that are ultimately received. Being risk averse, Hedgy Ltd decides to sell 10 US-dollar futures contracts on the following terms. Each contract is for an amount of US$100 000 and the market rate for each futures contract on 1 July 2019 is A$1 = 0.7105. This means that Hedgy Ltd has agreed to sell US$1 million for a price of A$1 407 460. In effect this ‘locks in’ the amount of Australian dollars that Hedgy Ltd will receive from the sale. At the time of entering the futures contract, a deposit of A$50 000 is paid by Hedgy Ltd. The futures contract is settled on 1 September 2019, when the value of the Australian dollar has increased, so that the spot rate is A$1 = US$0.7300, and the futures contract rate has moved to A$1 = US$0.7210.

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REQUIRED Provide the accounting entries for the sale made by Hedgy Ltd to the overseas organisation on 1 July 2019 and for the futures contract settled on 1 September 2019. Ignore the time value of money. SOLUTION The futures contracts that Hedgy Ltd has entered would be classified as derivatives. AASB 9 stipulates that derivatives are to be measured at fair value with any changes in fair value to be taken through the profit or loss. An exception to this is where the entity, at its own option, designates an arrangement as a cash-flow hedge. For hedge accounting to be allowed, and for the gain or loss to be included in equity, the hedge must be deemed to be ‘effective’. If a cash flow hedge is not deemed to be effective then the gain or loss on the hedging instrument goes immediately to profit or loss. The hedge in this case could be designated a cash-flow hedge. As already emphasised, where a hedge is designated a cash-flow hedge, AASB 9 requires the gain or loss on the hedging instrument to be transferred initially to equity and subsequently to profit or loss to offset the gains or losses on the hedged item. This can be contrasted with a ‘fair value hedge’, where the gains or losses on the hedging instrument (and the hedged item) are to be transferred to profit or loss as they occur. The accounting entries to record Hedgy Ltd’s transactions on the basis that this is a designated cash flow hedge would be as follows: 1 July 2019 Dr Accounts receivable 1 387 925 Dr Cost of goods sold 1 100 000 Cr Sales revenue Cr Inventory (to record the sale at the spot rate of A$1 = US$0.7205)

1 387 925 1 100 000

On 1 July Hedgy Ltd effectively has a futures receivable measured at $1 407 460, as well as a futures payable of the same amount. As such, the contract on 1 July has a fair value of zero (the receivable and the payable offset one another) and no entries for the futures receivable or payable would be required. Dr Deposit on futures contract Cr Cash at bank (to record the deposit made with the futures broker)

50 000 50 000

1 September 2019 Dr Cash at bank 1 369 863 Dr Loss on foreign exchange 18 062 Cr Account receivable 1 387 925 (Hedgy Ltd receives US$1 000 000 from the overseas purchaser. As the exchange rate of the Australian dollar has risen, the amount received has fallen in value; that is, the US dollars buy fewer Australian dollars: 1 369 863 = 1 000 000 ÷ 0.7300) Dr Cr

Deposit with futures broker 20 497 Cash flow hedge reserve (gain included in other 20497 comprehensive income) (the gain will equal the difference between the value of the futures contract on 1 July 2019 ($1 407 460) and its value on 1 September 2019 ($1 386 963 or 1 000 000 ÷ 0.7210); the gain made on the futures contract acts to offset some of the loss made on the receivable denominated in US dollars) Dr

Cash flow hedge reserve (transfer out of other 20 497 comprehensive income) Cr Gain on futures contract—in profit or loss 20 497 (the gain is transferred from equity to offset the loss on the hedged item, which amounted to $18 062) continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  527

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Dr Cash at bank 70 497 Cr Deposit with futures broker 70 497 (represents the addition of the original deposit made of $50 000 and the gains of $20 497 on the contract)

options Entitles the holder to buy assets at a future time at a prespecified price.

put option Gives its holder the right to sell an asset, at a specified exercise price, on or before a specified date.

call option Provides the holder of the option with the right to buy an asset at a specified exercise price, on or before a specified date.

exercise price The price the holder of an option will pay to buy a company’s shares.

strike price The price the holder of an option will pay to buy a company’s shares.

Options Options are another commonly used form of derivative financial instrument. An options contract is the right, with no obligation for the options buyer, to buy or sell a specified amount of an underlying instrument at a fixed price on or before a specified future date. Options can be classified as put options or call options. A call option on a company’s shares entitles the holder to buy shares at a future time for a 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 shares. The option can be traded and its sale price will fluctuate as the value of the underlying shares changes, with an increase in the price of the actual share 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 shares at a future date for a specified price. The value of the put option will also depend on the market price of the underlying security. When an option is acquired in the market place, from the Australian Securities Exchange for example, an amount is paid for the option. The holder of either a put or a call option acquires the right to exercise the option, but typically does not have to exercise it. The option holder would typically classify the financial instrument as a financial asset. An option holder may elect to let the option lapse, thereby losing the amount that was initially paid for the option. For example, an individual might have paid $0.20 to acquire an option to buy shares in an organisation for an exercise price of $1.00. If the market price of those shares falls below $1.00, the option holder would not exercise the option, as they could obtain the shares at lower cost directly from the market. Options have a finite life, the maximum duration generally being five years. Some options can be exercised at any time up to the date of their expiration, while others can be exercised only on the expiration date. The price of an option is expected to be greater than the difference between the market price of the share and the exercise price of the option. For example, if the market price of a BHP share is $25.00 and the exercise price of the option is $23.50, we would expect the sale price of the option to be greater than $1.50 (which is $25.00 less $23.50). On 7 September 2015, the last sale price of 28 August 2018 $24.00 options was $2.17 (when the share price was $23.99). Investors would be prepared to pay a greater amount, given that there is a possibility that the price of the shares will increase during the remaining life of the option. There is a ‘time value’ element in the option. Generally speaking, the more time until the expiration of the option, the higher we could expect the price of the option to be, all other things being equal. Options can be considered to be ‘wasting assets’ as across time the ‘time value’ of the options will decrease. Worked Example 14.20 provides an illustration of how to account for share options.

WORKED EXAMPLE 14.20: Valuation of options at net market price On 1 December 2019 Trader Ltd acquires a parcel of 10 000 options in BHP Billiton Ltd. The options are acquired on the Australian Securities Exchange at a price of $0.40 each, and they give Trader Ltd the right to acquire shares in BHP Billiton Ltd at any time in the next year for a price of $36.00. Trader Ltd’s reporting date is 30 June. At 30 June 2020 the value of BHP Billiton Ltd shares has increased so that the value of the option has risen to $0.85 each. REQUIRED Provide the accounting entries to record the transactions and subsequent balance date adjustments.

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SOLUTION The above transaction would not be considered to be a hedge. It would be accounted for by taking the changes in fair value directly to profit or loss as such changes occur. The entries to record the transactions and subsequent reporting date adjustments would be as follows: 1 December 2019 Dr Investment in share options 4 000 Cr Cash at bank 4 000 (the investment in the share options would be considered a financial asset as Trader Ltd has the right to exchange financial assets (cash for shares) under conditions that are potentially favourable) 30 June 2020 Dr Investment in share options 4 500 Cr Gain on share options 4 500 (to value the share options at their fair value in accordance with AASB 9 and to treat the increase as part of profit or loss)

Swaps Another form of derivative financial instrument is a swap agreement. Swaps occur when borrowers exchange aspects of their respective loan obligations. Commonly used swaps are interest rate swaps—typically a fixed interest rate obligation is swapped for a variable rate obligation—and foreign currency swaps, where the obligation relating to a loan denominated in one currency is swapped for a loan denominated in another currency. We consider foreign currency swaps first.

Foreign currency swaps

swap agreement Agreement between borrowers to exchange aspects of their respective loan obligations.

interest rate swap Occur when an entity with borrowing subject to variable or floating interest rates is concerned about its exposure to future increases in the variable rate. To reduce this risk, the entity might enter into an interest rate swap.

Why would organisations want to swap a loan denominated in one currency for a loan denominated in another? If an organisation has receivables and payables that are both denominated in a particular foreign currency, changes in the spot rate—a spot rate is the exchange rate for immediate delivery of currencies to be exchanged—will create gains on one but 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). For example, if you owe UK£100 000 to a supplier in the United Kingdom and the exchange rate is A$1.00 = UK£0.40, you would currently owe the equivalent of A$250 000. If you also have a customer in the United Kingdom that owes you UK£100 000, you would have a receivable currently valued at A$250 000. If the exchange rate moves to A$1.00 = UK£0.50, the value of the payable foreign currency swap would fall to A$200 000, which would represent a foreign currency gain of A$50 000. However, this Agreement under gain would be fully offset by the reduction in the value of the receivable, which would also be valued which the obligation at A$200 000. The net result is that no foreign currency exchange gain or loss would be incurred. relating to a loan If an organisation has a number of receivables that are denominated in a foreign currency, denominated in one currency is swapped changes in spot rates might potentially create sizeable foreign currency gains or losses. If that same for a loan denominated organisation is able to convert some of its domestic loans into foreign currency loans of the same in another currency. denomination as its receivables, it will be able to effectively insulate or hedge itself against the effects of changes in spot rates. A gain on one will effectively offset a loss on another, as demonstrated spot rate above. Such an organisation might seek out another entity that is prepared to swap its foreign The exchange rate for currency loans for the organisation’s domestic loans. immediate delivery When a swap is carried out, the primary borrower will still have a commitment to the primary of currencies to be lender should the other party to the swap default on the swap arrangement. Hence it is not correct exchanged. practice to eliminate a particular loan from the financial statements when a swap arrangement has been negotiated. That is, there would be no legal right of set-off. Consider Worked Example 14.21, which illustrates foreign currency swaps. It should be remembered that in swap arrangements the other parties to loans—that is, the overseas and domestic financial institutions—might not know about the swap arrangements that have been negotiated, such as that negotiated between Watego Ltd and Byron Ltd in Worked Example 14.21. The contractual relationship between either company CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  529

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WORKED EXAMPLE 14.21: Foreign currency swap On 1 July 2018 Byron Ltd, an Australian company, borrows US$2 million at a rate of 12 per cent from a US corporation, repayable in US dollars. The loan is for a period of three years. Byron Ltd trades predominantly within Australia. At the same time, Watego Ltd, also an Australian company, borrows A$2.5 million from an Australian bank, also at a fixed rate of 12 per cent and also for a period of three years. Watego Ltd also has a number of receivables denominated in US dollars. As a result of perceived benefits to both parties, Byron Ltd and Watego Ltd decide to enter a swap contract in which they effectively swap their interest and principal obligations on the same date they take out the loans, that is, 1 July 2018. Under the terms of the swap contract, Byron Ltd will take responsibility for the Watego Ltd’s Australian loan and related interest payments (that is, Byron Ltd will effectively have a commitment pegged in Australian dollars), and Watego Ltd will commit to take responsibility for Byron Ltd’s overseas loan and related interest payments (that is, Byron Ltd will effectively have a receivable denominated in US dollars, the value of which will fluctuate as exchange rates change). From Byron Ltd’s perspective, this means that as a result of the swap contract the overall net position will be that it will incur a net-total interest expense each period of $300 000 each year, regardless of what happens to exchange rates, and will also make a loan repayment of $2 500 000 at the end of three years regardless of what happens to exchange rates—that it, it has assumed the responsibilities for the loan originally borrowed by Watego Ltd. To keep this question relatively simple we will assume that the required market rates on both loans are equal to the coupon rates, that is, they are also 12 per cent (meaning there is no discount or premium on the loans), and we will further assume that the market rates remain at 12 per cent throughout the term of the loans. Cash payments related to each loan are to be made on 30 June of each year. The relevant exchange rates are: 1 July 2018 30 June 2019

A$1.00 = US$0.80 A$1.00 = US$0.70

30 June 2020 30 June 2021

A$1.00 = US$0.75 A$1.00 = US$0.77

REQUIRED (a) Provide the accounting entries in the books of Byron Ltd for the years ending 30 June 2019, 2020 and 2021. (b) Provide the accounting entries in the books of Watego Ltd for the year ended 30 June 2020. SOLUTION (a) Accounting entries in the books of Byron Ltd For this illustration it is assumed that the entity has elected to account for the swap as a cash flow hedge. Provided the required criteria within AASB 9 are met, for a cash flow hedge the gains and losses on the hedging instrument would initially be deferred in equity (and included in other comprehensive income) and then transferred to profit or loss to offset gains and losses on the financial instrument. That was the reason for the hedge. As the gains and losses on the hedged item (the loan) and the hedging instrument (the swap) fully offset each other in this example, the net effect on equity or profits is $nil. The foreign loan is considered to be perfectly hedged (the gains fully offset the losses). Hence the gains and losses on the swap agreement shall be taken directly to profit or loss as they arise. These gains or losses will represent the change in the fair value of the swap agreement. We use the following table to determine the fair value of the swap from Byron Ltd’s perspective.

Date

Fair value of the Australian payable Fair value of foreign currency receivable component Fair value Gain/(loss) component of swap of swap* of swap on hedge

[(2 000 000 ÷ 0.8) × 0.12 × 2.401831] + [(2 000 000 ÷ 0.8) × 0.7117801] = 2 500 000 30 June 2019 [(2 000 000 ÷ 0.70) × 0.12 × 1.6900509] + [(2 000 000 ÷ 0.70) × 0.7971938] = 2 857 143 30 June 2020 [(2 000 000 ÷ 0.75) × 0.12 × 0.8928571] + [(2 000 000 ÷ 0.75) × 0.8928571] = 2 666 667 30 June 2021 2 000 000 ÷ 0.77 = 2 597 403

1 July 2018

2 500 000





2 500 000

357 143

357 143

2 500 000

166 667 (190 476)

2 500 000

97 403

(69 264)

*Because the interest paid on the Australian loan (the coupon rate) is 12 per cent, which also matches the required market rate, the face value of the loan also equates to the present value—that is, there is no premium or discount on the loan.

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We will account for the swap agreement and the overseas loan separately 1 July 2018 Dr Cash 2 500 000 Cr Foreign loan 2 500 000 (to recognise, at the 1 July 2018 spot rate, the initial loan received from the US company of $2 500 000 = $2 000 000 ÷ 0.80) There is no entry on 1 July 2018 to recognise the swap as the fair value of the swap agreement is deemed to be zero on 1 July 2018 as shown in the table above.   By virtue of the swap—which we can consider to be a cash flow hedge—Byron Ltd now effectively has a foreign loan and a foreign currency receivable of the same magnitude. The receivable element has arisen because Watego Ltd has agreed to take responsibility for the overseas loan in exchange for Byron Ltd taking responsibility for the Australian loan. Because Byron Ltd effectively has both a payable and a receivable that are of the same amount and denominated in the same foreign currency, it is insulated from any foreign currency gains or losses that might result from changes in the exchange rates. 30 June 2019 Dr Foreign exchange loss 357 143 Cr Foreign loan (to recognise the loss on the loan with the US corporation) Value of loan as at 1 July 2018 Value of loan as at 30 June 2019 Foreign exchange loss

2 000 000 ÷ 0.80 2 000 000 ÷ 0.70

357 143 = 2 500 000 = 2 857 143    357 143

Again, it should be noted that because we have assumed that the respective loans offer a rate that also equates to the required market rate (which would be used for present value purposes using the effective interest method), the present value of the loan with the US corporation is the same as the numbers provided above (that is, the present value of the loan at 30 June 2019 is $2 857 143). Dr Swap asset 357 143 Cr Gain on swap contract 357 143 (to recognise the gain on the swap contract negotiated with Watego Ltd—see table above. The swap would be considered to represent a financial asset) As we can see above, the change in the fair value of the swap contract exactly equals the exchange loss on the foreign loan, meaning that the overseas loan is perfectly hedged. While this might be designated as a cash flow hedge, meaning that gains or losses on the hedging contract (the swap agreement in this case) shall initially go to equity as we explained earlier, because the gains or losses on the hedge contract will exactly match the gains or losses on the foreign loan as to timing and amount, any gains on the hedging contract shall be taken directly to profit or loss such that the total foreign exchange gain or loss will be zero.   As can be seen, because the risk of the foreign currency exposure has been shifted fully to Watego Ltd, Byron Ltd does not have any net foreign currency gains or losses. The gains and losses cancel each other out. Dr Interest expense 342 857 Cr Cash 342 857 (to recognise the payment made to the US corporation of 342 857 = (2 000 000 × 0.12) ÷ 0.7) Dr Cash 42 857 Cr Interest expense 42 857 (to recognise the payment made by Watego Ltd. Byron Ltd has taken responsibility for the Australian loan as part of the swap, whereas Watego has taken responsibility for the US loan. (2 000 000 ÷ 0.7 × 0.12) – (2 500 000 × 0.12) = 42 857) continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  531

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Byron Ltd initially has to make the payment to the US company for the funds it borrowed. That is, even in the presence of the agreement with Watego Ltd, Byron Ltd will still comply with its contractual commitment with the overseas capital supplier. However, Watego Ltd has agreed to take responsibility for the overseas loan, while Byron Ltd has agreed to take responsibility for Watego Ltd’s domestic loan. The interest payment on the domestic loan is $300 000 (that is $2 500 000 × 12 per cent). Watego Ltd will pay Byron Ltd $42 857, with the result that Byron Ltd’s total interest expense ($342 857 – $42 857) is the amount payable on the domestic loan ($300 000), the loan for which Byron has agreed to take responsibility. 30 June 2020 Dr Foreign loan Cr Foreign exchange gain (to recognise the loss on the loan with the US corporation)

190 476 190 476

Value of loan as at 1 July 2019 2 000 000 ÷ 0.70 = 2 857 143 Value of loan as at 30 June 2020 2 000 000 ÷ 0.75 = 2 666 667 Foreign exchange gain 190 476 Dr Loss on swap contract 190 476 Cr Swap asset 190 476 (to recognise the loss on the swap contract negotiated with Watego Ltd—see table provided earlier) Dr Interest expense 320 000 Cr Cash 320 000 (to recognise the payment made to the US corporation of $320 000 = (2 000 000 × 0.12) ÷ 0.75) Dr Cash 20 000 Cr Interest expense 20 000 (to recognise the payment made by Watego Ltd. Byron Ltd has taken responsibility for the Australian loan as part of the swap, whereas Watego has taken responsibility for the US loan. (2 000 000 ÷ 0.75 × 0.12) – (2 500 000 × 0.12) = 20 000) 30 June 2021 Dr Foreign Loan Cr Foreign exchange gain (to recognise the loss on the loan with the US corporation)

69 264 69 264

Value of loan as at 1 July 2020 2 000 000 ÷ 0.75 = 2 666 667 Value of loan as at 30 June 2021 2 000 000 ÷ 0.77 = 2 597 403 Foreign exchange gain 69 264 Dr Loss on swap contract 69 264 Cr Swap asset 69 264 (to recognise the loss on the swap contract negotiated with Watego Ltd—see table provided earlier) Dr Interest expense 311 688 Cr Cash 311 688 (to recognise the payment made to the US corporation of 311 688 = (2 000 000 × 0.12) ÷ 0.77) Dr Cash 11 688 Cr Interest expense 11 688 (to recognise the payment made by Watego Ltd. Byron Ltd has taken responsibility for the Australian loan as part of the swap, whereas Watego has taken responsibility for the US loan. (2 000 000 ÷ 077 × 0.12) – (2 500 000 × 0.12) = 11 688) Dr Loan Cr Cash (repayment of overseas loan)

2 597 403 2 597 403

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Dr Cash 97 403 Cr Swap asset 97 403 (to recognise the completion of the swap contract and to record the amount paid to Byron Ltd by Watego Ltd) The effect of the above two entries is that Byron Ltd will make a net payment of $2 500 000, which equals the commitment relating to the Australian loan. (b) Accounting entries in the books of Watego Ltd 1 July 2018 Dr Cash 2 500 000 Cr Loan (to recognise the domestic loan taken out by Watego Ltd)

2 500 000

There is no entry to recognise the swap as the fair value of the swap agreement is deemed to be zero as shown in the table provided below.

Date 1 July 2018 30 June 2019 30 June 2020 30 June 2021

Fair value of foreign currency payable component of swap

Fair value of the Australian receivable component of swap*

Fair value of swap

Gain/(loss) on hedge

2 500 000 2 857 143 2 666 667 2 597 403

2 500 000 2 500 000 2 500 000 2 500 000

– (357 143) (166 667) (97 403)

– (357 143) 190 476 69 264

30 June 2019 Dr Loss on swap contract 357 143 Cr Swap liability 357 143 Watego Ltd has recorded a loss as a result of entering the swap contract. But, as indicated earlier, the reason Watego Ltd sought to enter the swap was so that it effectively would create a payable denominated in US dollars which in turn could be used to offset any gain or losses on the foreign currency receivables it already has. Adjustments to the value of these receivables (not shown in this example owing to lack of information) will offset, fully or partially, the gains or losses on the hedge contract. Dr Interest expense 300 000 Cr Cash 300 000 (to recognise the interest payment made by Watego Ltd on the domestic loan; as per the swap agreement, however, Byron Ltd will take responsibility for the domestic loan commitments of $300 000 = $250 0000 × 12 per cent) Dr Interest expense 42 857 Cr Cash 42 857 An adjustment payment between Watego Ltd and Byron Ltd is made so that, in total, Watego Ltd will make payments equivalent only to the interest on the overseas loan, the loan for which it has taken responsibility as part of the swap. Cash flows associated with domestic loan = $300 000    $250  0000 × 12 per cent Cash flows associated with overseas loan = $342 857    (200  0000 × 12 per cent) ÷ 0.70 Amount to be transferred to Byron Ltd from   $42 857 Watego Ltd

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and its lending institution remains unchanged by the swap arrangement. Should one party to the swap default on the arrangement, the obligation for repayment vests with the primary borrower. Generally, the interest and principal repayments will be made by the party that entered the initial contract with the financial institution. Cash adjustments will then be made between the parties to the swap.

Interest rate swaps Interest rate swaps occur when an entity with borrowing subject to variable or floating interest rates is concerned about its exposure to future increases in the variable rate. To reduce this risk, the entity might enter into an interest rate swap. When an interest rate swap is made, there is no exchange of principal. Rather, one party exchanges its interest payments of a specified amount with another party. This generally involves swapping one stream of interest payments, which are charged at a variable or floating rate, with another stream of interest payments, which are at a fixed amount. For a swap to proceed, both parties to the swap will need to receive benefits in the form of reductions in total interest payments. In this regard, consider Worked Example 14.22.

WORKED EXAMPLE 14.22: Interest rate swap Beachmere Ltd is able to borrow money at either a fixed rate of 12 per cent or at the 120-day bank bill rate (BBR) (which fluctuates, but is currently 10 per cent). Bombi Ltd can borrow funds either at a fixed rate of 14 per cent or at the 120-day BBR plus 0.5 per cent. In part, the difference in interest rates each organisation is being charged is due to differences in the organisations’ credit ratings. Beachmere Ltd borrows $1 million in funds for four years at a fixed rate of interest on 1 July 2018, whereas Bombi Ltd borrows $1 million for four years at the floating BBR plus 0.5 per cent. After the organisations have committed themselves to their respective lenders, Beachmere Ltd considers that it would prefer a variable interest rate, while Bombi Ltd decides that it would prefer a fixed interest rate. They agree to swap their obligations. We will assume that all interest payments are made at the end of the financial year, which is 30 June 2019. Even though Beachmere Ltd has an interest rate advantage in both the variable and fixed interest rate markets, a swap rate can be agreed upon so that both Beachmere Ltd and Bombi Ltd can benefit. Under the swap agreement, Beachmere will make floating rate payments to Bombi Ltd at the BBR plus 0.5 per cent, and Bombi Ltd will make fixed rate payments to Beachmere Ltd at 13 per cent. REQUIRED What would the net interest payments for each company be after the agreement? SOLUTION The net interest payments of each company after the agreement would be as follows: Beachmere Ltd Pays 12 per cent to primary lender Pays BBR + 0.5 per cent to Bombi Ltd Receives 13 per cent from Bombi Ltd Net interest cost = BBR – 0.5 per cent

Bombi Ltd Pays BBR + 0.5 per cent to primary lender Pays 13 per cent to Beachmere Ltd Receives BBR + 0.5 per cent from Beachmere Ltd Net interest cost = 13 per cent

If we assume that this arrangement has been designated a cash flow hedge, the hedge accounting requirements of AASB 9 would apply. As paragraph B6.5.2 of AASB 9 states: An example of a cash flow hedge is the use of a swap to change floating rate debt (whether measured at amortised cost or fair value) to fixed-rate debt (ie a hedge of a future transaction in which the future cash flows being hedged are the future interest payments). As we know, for a cash flow hedge, changes in the value of the hedging instrument are to be recorded initially in equity (and therefore included in other comprehensive income) and subsequently transferred to profit or loss to offset gains or losses on the hedged item. After the above interest rate swap, both organisations have their preferred type of borrowing (that is, either fixed or variable) and both have made a net saving on the rates that were available in the marketplace on that preferred means of borrowing.

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Compound financial instruments

LO 14.5

As we have noted, a compound instrument is a financial instrument that contains both a financial liability and an equity element. As we also noted earlier in this chapter, AASB 132 requires that the debt and equity components of a compound instrument be accounted for separately. Compound instruments include instruments such as convertible notes (convertible bonds). As paragraph 29 of AASB 132 states, the economic effect of issuing a compound instrument is: substantially the same as issuing simultaneously a debt instrument with an early settlement provision and warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants. Accordingly, in all cases, the entity presents the liability and equity components separately in its statement of financial position. Paragraph 31 of AASB 132 requires that when the initial carrying amount of a compound financial instrument is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined as the fair value of the liability component. The treatment required by AASB 132—that the residual amount be assigned to equity—represents a departure from what many organisations have done in the past. If conversion of the securities to shares is the probable outcome, the securities would not meet the criteria for recognition as liabilities in the Conceptual Framework for Financial Reporting. That is, since it would not be probable that a sacrifice of future economic benefits would be required to settle the present obligation, the securities would, pursuant to the conceptual framework, be classified as equity. If redemption of the securities is the probable outcome, they would be classified as liabilities. As noted previously, however, AASB 132 does not rely upon probabilities and hence, unlike the requirements of the conceptual framework, the classification of securities as debt or equity would not change along with the perceived probabilities of conversion. As we saw earlier in the chapter, paragraph 30 of AASB 132 states: Classification of the liability and equity components of a convertible instrument is not revised as a result of a change in the likelihood that a conversion option will be exercised, even when exercise of the option may appear to have become economically advantageous to some holders. Consistent with the conceptual framework, it would seem logical that when determining how to disclose securities such as convertible notes, consideration should be given to the most likely future outcome. This view has not, however, been adopted by the accounting standard-setters. Do you agree or disagree with the position taken by the accounting standard-setters? Worked Example 14.23 describes how to account for compound instruments.

WORKED EXAMPLE 14.23: Accounting for compound instruments Grommett Ltd issues $10 million of convertible bonds on 1 July 2018. The bonds have a life of four years and a face value of $10.00 each, and they offer interest, payable at the end of each financial year, at a rate of 6 per cent per annum. The bonds are issued at their face value and each bond can be converted into one ordinary share in Grommett Ltd at any time in the next four years. Organisations of a similar risk profile have recently issued debt with similar terms, without the option for conversion, at a rate of 8 per cent per annum. REQUIRED (a) Identify the present value of the bonds and, allocating the difference between the present value and the issue price to the equity component, provide the appropriate accounting entries. (b) Calculate the stream of interest expenses across the four years of the life of the bonds. (c) Provide the accounting entries if the holders of the options elect to convert the options to ordinary shares at the end of the third year of the bonds. continued CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  535

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SOLUTION (a) Identifying the present value of the bonds and providing the appropriate accounting entries Paragraph 28 of AASB 132 requires that: The issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets or equity instruments. In considering how to measure the liability and equity components of the convertible bonds, we can determine the present value of the cash flows at the market’s required rate of return. This amount would represent the liability component of the convertible bonds. The difference between the liability component and the total issue price of the bonds would represent the equity component. This is consistent with the requirements of AASB 132. 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 component and the equity component separately on the statement of financial position, as follows: (a) The issuer’s obligation to make scheduled payments of interest and principal is a financial liability that exists as long as the instrument is not converted. On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows discounted at the rate of interest applied at that time by the market to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option. (b) The equity instrument is an embedded option to convert the liability into equity of the issuer. This option has value on initial recognition even when it is out of the money. Applying the above requirement, we can identify the present value of the bonds and then allocate to the equity component the difference between the present value of these bonds and the issue price of $10 million. In determining the present value, we will use the rate of 8 per cent, which is the rate of interest paid on debt of a similar nature and risk that does not provide an option to convert the liability to ordinary shares. Present value of bonds at the market rate of debt Present value of principal to be received in four years discounted at 8 per cent $10 000 000 × 0.735 03 = $7 350 300 Present value of interest stream discounted at 8 per cent $600 000 × 3.312 113 =   $1 987 268 Total present value $9 337 568 Equity component      $662 432 Total face value of convertible bonds $10 000 000 The accounting entries could therefore be: 1 July 2018 Dr Cash at bank 10 000 000 Cr Convertible bonds (liability) 9 337 568 Cr Convertible bonds (equity component) 662 432 (to record the issue of the convertible bonds and the recognition of the liability and equity components— the equity component in this case would be $662 432) 30 June 2019 Dr Interest expense 747 005 Cr Cash 600 000 Cr Convertible bonds (liability) 147 005 (to recognise the interest expense, where the expense equals the present value of the opening liability multiplied by the market rate of interest; see table below)

536  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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(b) Calculating the stream of interest expenses across the life of the bonds The stream of interest expenses across four years can be summarised as in Table 14.4, where interest expense for a given year is calculated by multiplying the present value of the liability at the beginning of the period by the market rate of interest, this being 8 per cent (this is the effective-interest method).

Date

Payment

Interest expense

Increase in bond liability

01 July 2018

Bond liability   9 337 568

30 June 2019

600 000

747 005

147 005

  9 484 573

30 June 2020

600 000

758 766

158 766

  9 643 339

30 June 2021

600 000

771 467

171 467

  9 814 806

30 June 2022

600 000

785 194

185 194

10 000 000

Table 14.4 Stream of interest expenses over four-year life of debentures

(c) Providing the accounting entries if the holders of the options elect to convert the options to ordinary shares at the end of the third year If the holders elect to convert the options to ordinary shares at the end of the third year of the debentures (after receiving their interest payments), the entries in the third year would be: 30 June 2021 Dr Interest expense Cr Cash Cr Convertible bonds (liability) (to recognise interest expense for the period)

771 467 600 000 171 467

Dr Convertible bonds liability 9 814 806 Dr Convertible bonds (equity component) 662 432 Cr Share capital (to recognise the conversion of the bonds into shares of Grommett Ltd)

10 477 238

Disclosure requirements pertaining to financial instruments

LO 14.15 LO 14.16

As its name would suggest, Accounting Standard AASB 7 Financial Instruments: Disclosure provides disclosure requirements relating to financial instruments. In explaining the rationale for the disclosure requirements now embodied in AASB 7, paragraphs 1 and 2 of AASB 7 state: 1. The objective of this Standard is to require entities to provide disclosures in their financial statements that enable users to evaluate: (a) the significance of financial instruments for the entity’s financial position and performance; and (b) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks. 2. The principles in this Standard complement the principles for recognising, measuring and presenting financial assets and financial liabilities in AASB 132 Financial Instruments: Presentation and AASB 9 Financial Instruments. CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  537

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The disclosure requirements in AASB 7 are extensive. In part, the relatively large number of disclosure requirements is probably a direct consequence of the significant losses many organisations have incurred recently in relation to financial instruments or, more particularly, derivative financial instruments, a notable case being the collapse of the UK merchant bank, Barings plc. As mentioned previously, Barings plc lost US$1.4 billion on Japanese equity index futures as a result of trading undertaken by one of its employees. This loss came to light in February 1995. In the Australian context, National Australia Bank made losses of approximately $360 million on foreign currency options in 2003/2004. Such losses make investors wary and inclined to demand greater disclosures about such instruments. AASB 7 specifies numerous disclosures that entities must make in relation to all financial instruments (to the extent that such information is considered to be material to the users of the entity’s reports). While there are many specific disclosure requirements in the standard, some general principles are also provided at paragraphs 7 and 31 of AASB 7. These paragraphs state: 7. An entity shall disclose information that enables users of its financial statements to evaluate the significance of financial instruments for its financial position and performance. 31. An entity shall disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reporting period. There are numerous disclosure requirements in AASB 7 and the best way to appreciate their extent is to review the standard itself. Nevertheless, while our intention is not to discuss many of the standard’s disclosure requirements, we will briefly consider the disclosures required in relation to ‘risks’ associated with financial instruments. Paragraphs 32 to 34 of AASB 7 state: 32. The disclosures required by paragraphs 33–42 focus on the risks that arise from financial instruments and how they have been managed. These risks typically include, but are not limited to, credit risk, liquidity risk and market risk. Qualitative disclosures 33. For each type of risk arising from financial instruments, an entity shall disclose: (a) the exposures to risk and how they arise; (b) its objectives, policies and processes for managing the risk and the methods used to measure the risk; and (c) any changes in (a) or (b) from the previous period. Qualitative disclosures 34. For each type of risk arising from financial instruments, an entity shall disclose: (a) summary quantitative data about its exposure to that risk at the end of the reporting period. This disclosure shall be based on the information provided internally to key management personnel of the entity (as defined in AASB 124 Related Party Disclosures), for example the entity’s board of directors or chief executive officer; (b) the disclosures required by paragraphs 35A–42, to the extent not provided in (a), (c) concentrations of risk if not apparent from the disclosures made in accordance with (a) and (b). 35. If the quantitative data disclosed as at the end of reporting period are unrepresentative of an entity’s exposure to risk during the period, an entity shall provide further information that is representative. Clearly, the disclosure requirements relating to ‘risks’ associated with financial instruments are quite extensive. AASB 7 imposes further detailed disclosure requirements in relation to credit risk (the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation), liquidity risk (the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities) and market risk (the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices). AASB 7 further explains that market risk comprises three other types of risk, these being currency risk, interest rate risk and other price risk. Disclosures are also required in relation to these components of risk.

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SUMMARY The chapter addressed accounting issues associated with financial instruments. Financial instruments are defined as contracts that give rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Such a definition, in turn, depends on knowledge of the definitions of a financial asset, a financial liability and an equity instrument, all of which are provided in this chapter. The term ‘financial instruments’ encompasses a wide range of items, including cash at bank, bank overdrafts, term deposits, trade receivables and payables, borrowings, loans receivable, notes receivable, notes payable, bonds receivable, options, forward-rate exchange agreements and interest-rate swaps. Financial instruments can be classified as primary financial instruments (such as receivables, payables and equity securities) and derivative financial instruments. There are also compound financial instruments. 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. The value of the derivative contract normally reflects changes in the value of the underlying financial instrument. Derivative financial instruments include currency futures, share price index futures, share options, foreign currency swaps and interest-rate swaps. Accounting Standard AASB 7 provides numerous disclosure requirements for financial instruments, some of which relate specifically to derivative financial instruments. For example, an entity is required to disclose its objectives for holding or issuing derivative financial instruments, the context needed to understand its objectives and the entity’s strategies for achieving its objectives. AASB 9 provides the requirements pertaining to the recognition and measurement of financial instruments. As we learned in this chapter, the general rule is that financial instruments are to be measured at fair value. The requirements incorporated in AASB 7, AASB 9 and AASB 132 include the following: • All derivatives are required to be recognised and measured at fair value. Whether gains and losses on a derivative go directly to profit or loss or to other comprehensive income will be dependent upon whether the derivative is used as a hedging instrument; whether the hedge is a cash flow hedge or a fair value hedge; and whether the hedge 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 (and therefore, the movement is included within other comprehensive income). 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. • AASB 132 stipulates requirements for measuring the debt and equity components of a compound financial instrument, with the equity component to be determined as the residual amount after deducting the fair value of the liability component from the fair value of the instrument in its entirety. • AASB 132 emphasises that a critical feature in distinguishing an equity instrument from a liability is the existence of a contractual obligation. An equity instrument cannot involve a contractual obligation. This requirement caused many financial instruments, such as many preference shares, to be reclassified as debt. • Following on from the above point, AASB 132 confines its assessment of debt versus equity to the contractual terms of the arrangement. Other known factors that are not included in the terms of a financial instrument (such as the probability that an equity option will be exercised) must be ignored. • AASB 7 requires extensive disclosure in relation to the risks associated with financial instruments held or issued by an entity.

KEY TERMS All Ordinaries Share Price Index  523

call option  528 cash flow hedge  515

compound financial instrument  491

CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  539

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convertible note  491 derivative financial instrument  487 equity instrument  484 exercise price  528 fair value hedge  515 financial asset  484 financial instrument  483

financial liability  484 foreign currency swap  529 forward rate  513 futures contract  521 hedge contract  512 hedging  521 interest rate swap  529 mark to market  522

option  528 put option  528 set-off  492 spot rate  529 strike price  528 swap agreement  529

END-OF-CHAPTER EXERCISES On 1 July 2018 Supertubes Ltd issues $50 million of convertible bonds to Magnatubes Ltd. The bonds have a life of three years, a face value of $10.00 each, and they offer interest, payable at the end of each financial year, at a rate of 8 per cent per annum. The bonds are issued at their face value and each bond can be converted into two ordinary shares in Supertubes Ltd at any time in the next three years. Organisations of a similar risk profile have recently issued debt with similar terms, but without the option for conversion. The market requires a rate of return of 10 per cent per annum on such securities. It is considered that investors in Supertubes Ltd are prepared to take a lower return (8 per cent) as a result of the facility to convert the bonds to equity.

REQUIRED Provide the journal entries to account for: (a) the issue of the above securities (b) the payment of the first year’s interest, and (c) the conversion of the securities to equity, assuming that the conversion takes place two years after the bonds are issued. LO 14.15, 14.7

SOLUTION TO END-OF-CHAPTER EXERCISE (a) Journal entries accounting for the issue of the securities As discussed in this chapter, the above financial instruments are convertible bonds, which would be classified as compound financial instruments. A compound instrument is a financial instrument that contains both a financial liability and an equity element. In accordance with AASB 132, the debt and equity components of a compound instrument must be accounted for separately. We can identify the present value of the bonds and then allocate to the equity component the difference between the present value of these bonds and the issue price of $50 million. Present value of bonds at the market rate of debt Present value of principal discounted at 10 per cent for three years: $50 000 000 × 0.7513 = Present value of interest stream discounted at 10 per cent for three years: $4 000 000 × 2.4869 = Total present value Equity component (by deduction) Total face value of convertible bonds

$37 565 000    $9 947 600 $47 512 600    $2 487 400 $50 000 000

If the convertible bonds did not provide an option to convert to ordinary shares, the bonds would be expected to have been issued at a price of $47 512 600. This is considered to represent the present value of the liability component of the compound instrument. 540  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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The accounting entries to account for the above issue would be: 1 July 2018 Dr Cash at bank 50 000 000 Cr Convertible bonds liability 47 512 600 Cr Convertible bonds (equity component) 2 487 400 (to record the issue of the convertible bonds and the recognition of the liability and equity components) (b) Journal entries accounting for the payment of the first year’s interest 30 June 2019 Dr Interest expense 4 751 260 Cr Cash 4 000 000 Cr Convertible bonds liability 751 260 (to recognise the interest expense, where the expense equals the present value of the opening liability multiplied by the market rate of interest—see Table 14.5)

Date

Payment

Interest expense

Increase in bond liability

01 July 2018

Bond liability 47 512 600

30 June 2019

4 000 000

4 751 260

751 260

48 263 860

30 June 2020

4 000 000

4 826 386

826 386

49 090 246

30 June 2021

4 000 000

4 909 025

909 025

50 000 000*

Table 14.5 Stream of interest expenses over three-year life of debentures

*Includes a rounding error of $729 (we used the present value tables in the Appendices to this book and they only go to four decimal places)

The stream of interest expenses across three years can be summarised as in Table 14.5, where interest expense for a given year is calculated by multiplying the present value of the liability at the beginning of the period by the market rate of interest, this being 10 per cent. (c) Journal entries accounting for the conversion of the securities to equity If the holders of the options elect to convert the options to ordinary shares at the end of the second year of the debentures (after receiving their interest payments), the entries in the third year would be:

30 June 2020 Dr Interest expense 4 826 386 Cr Cash Cr Convertible bonds liability (to recognise interest expense for the period) Dr Convertible bonds liability 49 090 246 Dr Convertible bonds (equity component) 2 487 400 Cr Share capital (to recognise the conversion of the bonds into shares of Supertubes Ltd)

4 000 000 826 386

51 577 646

REVIEW QUESTIONS 1. Define ‘financial instrument’. LO 14.1 2. Define a financial asset, a financial liability and an equity instrument. LO 14.2 3. In accordance with AASB 9, the recognition of a financial asset or financial liability will be influenced by considerations as to whether there is a contractual right to exchange financial assets or financial liabilities with another entity under CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  541

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conditions that are potentially favourable, or potentially unfavourable, to the entity. Explain what this requirement means. LO 14.3 4. What is a primary financial instrument? Provide some examples. LO 14.1, 14.4 5. What is a derivative financial instrument? Provide some examples. LO 14.4 6. What factors influence the value of a derivative financial instrument, and how should changes in the value of derivatives be treated from an accounting perspective? LO 14.4, 14.8 7. What is a call option and what is a put option? LO 14.13 8. (a) What are the three general approaches to measuring financial assets that are identified within AASB 9? (b) What factors influence what measurement approach shall be used for a financial asset? LO 14.8 9. Should impairment testing be undertaken for financial instruments that are measured at amortised cost? LO 14.8 10. Would physical assets (such as inventories, property, plant and equipment) be considered to be financial assets? Why? LO 14.2 11. How would you determine the debt component and the equity component of a compound financial instrument? LO 14.5 12. Do you think that a reporting entity would prefer to classify a financial instrument as debt or equity? Why? LO 14.3 13. What is a ‘hedge’ and what is its purpose? LO 14.10 14. An organisation has just acquired some inventory from an overseas supplier and the amount payable is denominated in a foreign currency. What risks does this transaction expose the organisation to, and what can be done to reduce the risk? LO 14.11 15. Would prepayments be considered to be financial instruments? Why? LO 14.2 16. What is a compound financial instrument? Provide some examples. LO 14.5 17. Is there a consequence for reported profit or loss if a particular financial instrument, for example, a preference share, is designated as debt rather than equity? Explain the consequence. LO 14.3 18. What does mark to market mean? LO 14.7 19. Explain what a set-off of assets and liabilities is. LO 14.6 20. When does a ‘right of set-off’ exist? LO 14.6 21. Why would companies perform a set-off of assets and liabilities? LO 14.6 22. What disclosures must be made, pursuant to AASB 132, in the period following a set-off of assets and liabilities? LO 14.6 23. Arthur Ltd has the following statement of financial position: Statement of financial position before set-off Loans payable 1 000 000 Shareholders’ equity   1 000 000 $2 000 000

Loans receivable Non-current assets

1 200 000      800 000 $2 000 000

Assume that Arthur Ltd has an amount owing to Blayney Ltd of $300 000 and an amount receivable from Blayney Ltd of $400 000. Assuming a right of set-off exists, why would Arthur want to perform a set-off? What would be the impact on the debt to assets ratio? LO 14.6 24. Parent Ltd controls two other companies, A Ltd and B Ltd. Parent Ltd owes an outside organisation, Outsider Ltd, an amount of $400 000. Outsider Ltd owes A Ltd $300 000. Can the two amounts be offset? LO 14.6 25. On 1 July 2018 Bob Ltd acquired 100 000 shares in McTavish Ltd at a price of $10 each. There were brokerage fees of $1500. The closing market price of McTavish Ltd shares on 30 June 2019—which is the entity’s financial year end—was $12.

REQUIRED (a) Assuming that Bob Ltd has not made the election to account for its equity investments at fair value through OCI, then provide the required accounting journal entries for Bob Ltd to account for the investment in McTavish Ltd using fair value through profit or loss. (b) Provide the required journal entries for Bob Ltd to account for the investment in McTavish Ltd assuming that Bob Ltd has made the election to account for the equity investment at fair value through OCI. LO 14.8, 14.9 26. Wedding Cake Ltd has its shares listed on a securities exchange. It has entered a contractual agreement to issue $10 million of its ordinary shares to Island Ltd in two years’ time. The number of shares to be ultimately issued 542  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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27.

28. 29. 30. 31. 32. 33. 34.

35.

will depend on the market price of the shares in two years’ time. Should Wedding Cake Ltd recognise a financial liability, or an equity instrument, in relation to this agreement? LO 14.2 Subsequent to initial measurement, financial assets are to be classified as being measured at either fair value through profit or loss, at fair value through OCI, or at amortised cost. What is the basis for determining how a financial asset shall be used? LO 14.7, 14.8 Explain why it is that when the market’s 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. LO 14.7 Explain how a currency swap operates. LO 14.14 Explain how an interest rate swap operates. LO 14.14 Futures contracts are considered to be highly leveraged instruments, with the result that considerable gains or losses can be incurred. What does this mean? LO 14.11 Where are the gains and losses on a futures contract reported? Is the reporting of the gains or losses on a futures contract influenced by whether or not the contract is used as part of a hedging arrangement? LO 14.8, 14.10 AASB 132 requires that when determining whether a financial instrument is debt or equity, consideration should be given to the economic substance of the instrument, rather than simply its legal form. What does this mean? LO 14.3 Reef Ltd wants to sell its portfolio of shares given that the market appears to be at a ‘high point’. However, there are restrictions in place which mean that it must wait for one month before it can sell its shares. Worried about possible movements in the share market, Reef Ltd decides to enter a futures contract. What position would it take in such a contract and how will this insulate it from possible fluctuations in the market prices of its share portfolio? LO 14.11 On 1 July 2018, Kelly Ltd issued five-year bonds with a total face value of $1 000 000 and which paid interest of $100 000 annually in arrears. The market required interest rate for Kelly Ltd’s bonds was 14 per cent.

REQUIRED 36.

37. 38. 39.

40.

Prepare the journal entry to issue the bond at 1 July 2018, and the entry at 30 June 2019 to record the interest paid. LO 14.8 Contrast the presentation requirements of the Conceptual Framework for Financial Reporting and of AASB 132 in relation to such instruments as convertible notes, particularly where they concern the probability of conversion. Are you more inclined to agree with the requirements of AASB 132 or the suggestions provided by the conceptual framework? Why? LO 14.3 Should interest on financial liabilities always be treated as an expense? LO 14.7 Would it ever be appropriate to classify the distributions to holders of preference shares as interest expense rather than dividends? Explain your answer. LO 14.3 AASB 132 requires the issuing entity to classify a financial instrument, or its component parts, as a liability or as equity in accordance with the economic substance of the instrument at the time of initial recognition. What does this requirement actually mean? LO 14.5 Barry Ltd issued some convertible bonds to Bennett Ltd. They have a life of three years and pay interest to Bennett Ltd each six months. The convertible bonds will be converted to shares only if Bennett makes the decision, at any time in the next three years, that it would prefer to receive shares in Barry Ltd, rather than have its funds repaid.

REQUIRED (a) At the time of issue, should Barry Ltd disclose the convertible bonds as debt, equity or part debt and part equity? (b) Does the probability of conversion to equity influence whether the convertible bonds are disclosed as debt or equity? (c) If Bennett Ltd notifies Barry Ltd that it would like to convert the convertible bonds to shares in Barry Ltd then will this influence how the convertible bonds are disclosed in the financial statements of Barry Ltd? LO 14.5, 14.8 41. AASB 7 is concerned primarily with ensuring extensive disclosure of financial instruments. Why do you think this is the case? LO 14.15, 14.16 42. In the past, a number of organisations have disclosed convertible bonds just below the total of shareholders’ equity and therefore have not really disclosed them as debt or equity. (a) Is the approach described above permitted under AASB 132? LO 14.3, 14.5 (b) Would it have been costly for companies to change how they disclose their convertible notes? Explain your answer. LO 14.3 CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  543

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43. Lehman Ltd sells some printed material to an organisation in the United States on 1 July 2019. The price is denominated in US dollars and is US$500 000. It is to be paid on 1 September 2019. The amount is guaranteed by a local bank so that payment is deemed to be very certain. The spot rate on the date of the transaction is A$1 = US$0.70. Worried about fluctuations in the value of the Australian dollar, Lehman decides to enter a forward rate agreement with the bank in which the latter agrees to buy US$500 000 from Lehman Ltd on 1 September at an agreed forward rate of US$0.72. (a) Describe how entering a forward rate agreement will reduce the risk of Lehman Ltd. LO 14.11 (b) How much money, in Australian dollars, will Lehman Ltd ultimately receive from the sale? LO 14.10 44. Dorothy Wax has 10 000 shares in Skeg Ltd. The current price per share in Skeg Ltd is $9.50. Dorothy would like to sell the shares immediately, but certain restrictions have been imposed upon her that mean she will have to wait one month. Concerned about fluctuating prices, she decides to enter a futures contract on Skeg Ltd shares in which she takes a sell position. The price of a Skeg Ltd future is $9.70 and her futures contract is for 10 000 units. One month later the price of Skeg Ltd shares has risen to $12.10, and a Skeg Ltd future costs $12.29. Dorothy closes out her futures contract and sells her shares. How much does Dorothy ultimately receive from the above transactions? LO 14.11, 14.12 45. Holder Ltd purchases an options contract from Issuer Ltd that gives Holder Ltd the right to acquire 100 000 options in Torquay Ltd for a price (exercise price) of $10.00 per share. When the contract was exchanged the price of Torquay Ltd shares was $9.00 each. The option entitles Holder Ltd to exercise the options and buy the shares any time within the next six months. If the options are not exercised within the six-month period, then the options will expire. Determine whether a financial liability or financial asset exists from the perspective of Holder Ltd and Issuer Ltd. Further, if the price of shares in Torquay Ltd falls to $5.00, with the result that it is improbable that Holder Ltd will ever exercise the options, will this change the classification of the options as either financial assets or financial liabilities? LO 14.13 46. On 1 July 2019 Billy Ltd, an Australian company, borrows US$1.54 million at a rate of 6 per cent from a United States bank for a period of three years. On the same date Rip Ltd, also an Australian company, borrows A$2.2 million from an Australian bank at a rate of 6 per cent for three years. Both companies have a 30 June reporting date. The companies decide to swap their interest and principal obligations. It is assumed that the required market rates on both loans is 6 per cent, and remains at 6 per cent throughout the terms of the loans. The relevant exchange rates are: 01 July 2019 30 June 2020

A$1.00 = US$0.70 A$1.00 = US$0.67

Provide the journal entries in the books of both Billy Ltd and Rip Ltd for 1 July 2019 and 30 June 2020. LO 14.10, 14.11, 14.12

CHALLENGING QUESTIONS 47. (a) What is hedge accounting and what are the three types of hedges identified in AASB 9? (b) What is a ‘hedged item’ and what is a ‘hedging instrument’? (c) What criteria must be satisfied before a hedging relationship is deemed to comply for ‘hedge accounting’ pursuant to AASB 9? (d) How are gains and losses on the hedging instrument to be treated for accounting purposes for a fair value hedge and a cash flow hedge respectively? LO 14.12 48. On 1 June 2018 Sydney Ltd enters into a firm commitment with SanFran Co. to buy US$ 1 000 000 of inventory. The inventory will be transferred to Sydney Ltd (making Sydney Ltd therefore liable for the debt) on 1 August 2018 and payment will be made on that date. The financial year end of Sydney Ltd is 30 June. We will assume that the hedging arrangements used by Sydney Ltd qualify for ‘hedge accounting’ pursuant to AASB 9 and that 544  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Sydney Ltd has designated the hedging arrangement as a ‘fair value hedge’. The relevant spot rates and forward rates are as follows: Date 1 June 2018 30 June 2018 1 August 2018

Spot rate

Forward rate

US$1.00 = $A1.35 US$1.00 = $A1.27 US$1.00 = $A1.43

US$1.00 = $A1.40 US$1.00 = $A1.42 US$1.00 = $A1.43

REQUIRED Provide the journal entries to account for the hedged item and hedging instrument as required on 1 June 2018, 30 June 2018 and 1 August 2018. LO 14.12 49. Brisbane Ltd manufactures cars. On 15 June 2018 Brisbane Ltd enters into a non-cancellable purchase commitment with LA Ltd for the supply of engines, with those engines to be shipped on 30 June 2018, at which time control of the assets will be transferred to Brisbane Ltd. The total contract price was US$4 000 000 and the full amount was due for payment on 30 August 2018. Because of concerns about movements in foreign exchange rates, on 15 June 2018 Brisbane Ltd entered into a forward rate contract on US dollars with a foreign exchange broker so as to receive US$4 000 000 on 30 August 2018 at a forward rate of $A1.00 = US$0.80. Brisbane Ltd elects to treat the hedge as a cash flow hedge and the hedge arrangement satisfies the criteria within AASB 9 for hedge accounting. Other information: The respective spot rates are provided below. The forward rates offered on particular dates, for delivery of US dollars on 30 August 2018 are also provided.

Date 15 June 2018 30 June 2018 30 August 2018

Spot rate

Forward rates for 30 August delivery of US$

$A1.00 = US$0.78 $A1.00 = US$0.76 $A1.00 = US$0.71

$A1.00 = US$0.75 $A1.00 = US$0.73 $A1.00 = US$0.71

REQUIRED Provide the journal entries to account for the ‘hedged item’ and the ‘hedging instrument’. The financial year end is 30 June 2018. LO 14.12 50. On 1 July 2019 Busta Ltd holds a well-diversified portfolio of shares that is valued at $1.55 million. On this date it enters into 60 futures contracts on All Ordinaries Share Price Index futures in which it takes a sell position. The All Ordinaries Index on 1 July 2019 is 2500 and the total price of the futures contract is calculated as 2500 × 60 × $10 contracts = $1 500 000. A total deposit of $100 000 is paid on the futures contracts. On 29 July 2019 Busta Ltd decides to sell its portfolio of shares and to close out its futures contract. On this date, the market value of the share portfolio is $1.725 million and the All Ordinaries Index is 2720. Provide the journal entries to record the above transactions assuming that the above transaction is not designated a cash flow hedge. LO 14.10, 14.11, 14.12 51. Tea Tree Ltd has acquired some government bonds on 1 July 2018. The government bonds will generate contractual cash flows that are solely principal and interest. The cash flows comprise: • a return of the principal amount of $2 000 000 in five years’ time; and • payments of interest of $200 000 at the end of each of the next five years. The government bonds were acquired at a price that will generate an effective interest rate of 6 per cent. That is, they were sold when the market required a rate of return of 6 per cent on government bonds with these cash flow characteristics. The required market rates of return for these government bonds decreased to 5 per cent on 30 June 2019 (which caused the fair value of the bonds to rise). Tax implications will be ignored for the purposes of answering this question. CHAPTER 14: ACCOUNTING FOR FINANCIAL INSTRUMENTS  545

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REQUIRED (a) Determine the initial purchase price of the government bonds on 1 July 2018. (b) Provide the accounting journal entries for the government bonds for the years ending 30 June 2019 and 30 June 2020 assuming that the business model being used for the asset focuses upon collecting the contractual cash flows. (c) Provide the accounting entries for the government bonds for the year ending 30 June 2019 assuming that the business model being used has the objective of both collecting the contractual cash flows from the government bonds as well as selling government bonds. (d) Provide the accounting entries for the government bonds for the year ending 30 June 2019 assuming that the business model being used for government bonds focuses upon trading government bonds. LO 14.7, 14.8 52. On 1 July 2018 Midget Ltd acquired some corporate bonds issued by Farrelly Ltd. These bonds cost $2 277 220 and had a life of four years. They had a ‘face value’ of $2 million and offered a coupon rate of 10 per cent paid annually ($200 000 per year, paid on 30 June). The bonds would repay the principle of $2 million on 30 June 2022. At the time, the market required a rate of return on 6 per cent on such bonds. Midget Ltd operates within a business model where government bonds are held in order to collect contractual cash flows and there is no intention to trade them. Assume that there were no direct costs associated with acquiring the bonds.

REQUIRED (a) Explain why the company was prepared to pay $2 277 220 for the bonds given that, apart from the interest, they expect to receive only $2 million back in four years. (b) Determine whether Midget Ltd can measure the government bonds at amortised cost. (c) Calculate the amortised cost of the bonds as at 30 June 2019, 2020, 2021 and 2022. (d) Provide the accounting journal entries for the years ending 30 June 2019, 2020, 2021 and 2022. LO 14.7, 14.8 53. Mamb Ltd has been able to arrange a loan from the bank at either a 10 per cent fixed rate or at the variable 90-day bank bill rate plus 0.5 per cent. Bong Ltd can borrow funds at either 13 per cent or at the bank bill rate plus 2 per cent. The bank bill rate is currently 8 per cent. Mamb Ltd decides to borrow $1 million in funds at a fixed rate of 10 per cent, while Bong Ltd decides to borrow the funds at the variable bank bill rate plus 2 per cent. Immediately following their borrowings, Mamb decides it would prefer a variable interest rate while Bong decides it would prefer a fixed rate. How would the parties agree on an appropriate rate for a swap? Calculate a rate that would be favourable to both parties. LO 14.14 54. Woodie Ltd issues $5 million in convertible bonds on 1 July 2019. They are issued at their face value and pay an interest rate of 4 per cent. The interest is paid at the end of each year. The bonds may be converted to ordinary shares in Woodie Ltd at any time in the next three years. Organisations similar to Woodie Ltd have recently issued similar debt instruments but without the option for conversion to ordinary shares. These instruments issued by the other entities offer interest at a rate of 6 per cent. On 1 July 2020 all the holders of the convertible notes decide to convert the bonds to shares in Woodie Ltd. Provide the journal entries to: (a) record the issue of the securities on 1 July 2019 (b) recognise the interest payment on 30 June 2020, and (c) recognise the conversion of the bonds to ordinary shares on 1 July 2020. LO 14.5, 14.7 55. On 1 June 2019 Safe Boards Ltd invested in five hundred 7 per cent, ten-year Teleco bonds with a face value of $100 each. The bonds were issued at face value. On 30 June 2019 the Teleco bonds, which are traded in an active market, had a market value of $105. Answer each part independently. (a) State whether Safe Boards Ltd can classify the Teleco bonds as being measured at amortised cost. If measured at amortised cost, give the amount at which the bonds should be reported in the statement of financial position at 30 June 2019. LO 14.8 (b) If the bonds were acquired for speculative purposes, then give the amount at which the bonds should be reported in the statement of financial position at 30 June 2019. If a change in fair value is recognised, where should it be recognised? LO 14.8

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56. On 1 November 2018 Sandy Ltd issued 10 000 convertible notes with the following features: Face value Term Issue price Interest Conversion option Market interest rate

$1000 Four years At face value Coupon rate of 10 per cent payable annually in arrears Each note is convertible into 100 ordinary shares 12 per cent for similar debt with no conversion option

(a) Prepare the journal entry to record the issue of the convertible notes. (b) Describe the effect, if any, of the issue of the convertible notes on each of the three components of the statement of financial position, that is, assets, liabilities and equity. LO 14.5, 14.8 57. Malibu Ltd issues $10 million of convertible bonds on 1 July 2018. The bonds have a life of four years and they offer interest, payable at the end of each financial year, at a rate of 7 per cent per annum. The bonds are issued at their face value and each bond can be converted into one ordinary share in Grommett Ltd at any time in the next four years. Organisations of a similar risk profile have recently issued debt with similar terms, without the option for conversion, at a rate of 9 per cent per annum.

REQUIRED (a) Identify the present value of the bonds and, allocating the difference between the present value and the issue price to the equity component, provide the appropriate accounting entries. (b) Calculate the stream of interest expenses across the four years of the life of the bonds. (c) Provide the accounting entries if the holders of the options elect to convert the options to ordinary shares at the end of the third year of the bonds. LO 14.5, 14.8 58. Melbourne Ltd manufactures electric skateboards. On 4 June 2018 Melbourne Ltd enters into a non-cancellable purchase commitment with Miami Ltd for the supply of wheels, with the wheels to be shipped on 30 June 2018. The total contract price was US$3 000 000 and the full amount was due for payment on 30 August 2018. Because of concerns about movements in foreign exchange rates, on 4 June 2018 Melbourne Ltd entered into a forward rate contract on US dollars with a foreign exchange broker so as to receive US$3 000 000 on 30 August 2018 at a forward rate of $A1.00 = US$0.78. Melbourne Ltd prepares monthly financial statements and it elects to treat the hedge as a cash flow hedge. Other information The respective spot rates are provided below. The forward rates offered on particular dates, for delivery of US dollars on 30 August 2018, are also provided. Spot rate

Forward rates for 30 August 2018 delivery of US$

$A1.00 = US$0.80 $A1.00 = US$0.78 $A1.00 = US$0.75 $A1.00 = US$0.72

$A1.00 = US$0.78 $A1.00 = US$0.76 $A1.00 = US$0.74 $A1.00 = US$0.72

Date 4 June 2018 30 June 2018 31 July 2018 30 August 2018

Provide the journal entries to account for the ‘hedged item’ and the ‘hedging instrument’ for the months ending 30 June, 31 July and 30 August 2018. LO 14.7, 14.8, 14.9, 14.10, 14.12

REFERENCES STOLL, H. & WHALEY, R., 1997, ‘Expiration-Day Effects of the All Ordinaries Share Price Index Futures: Empirical Evidence and Alternative Settlement Procedures’, Australian Journal of Management, vol. 22, no. 2, December, pp. 139–74.

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CHAPTER 15

REVENUE RECOGNITION ISSUES LEARNING OBJECTIVES (LO) 15.1 Know the definition and recognition criteria for income. 15.2 Know that income can be further subdivided into revenues and gains. 15.3 Understand the points of an organisation’s operating cycle at which income might be recognised. 15.4 Know how to measure revenue from contracts with customers when the contracted amount to be received is other than cash. 15.5 Appreciate that the amount of income recognised in a particular period will be directly related to the accounting measurement model that has been adopted. 15.6 Understand how the existence of particular conditions associated with a sale (such as attached put and call options, or the right of return) will affect the timing of revenue recognition. 15.7 Understand how to account for dividend and interest revenue. 15.8 Understand how to account for sales where the revenue receipt has been deferred to future periods. 15.9 Understand how to account for unearned revenue. 15.10 Understand the issues associated with recognising revenues for long-term construction projects.

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New accounting standard on revenue recognition

LO 15.1 LO 15.2 LO 15.10

In this chapter we will consider various accounting issues that arise in relation to the recognition of income, as well as looking at some of the ways in which income can be generated. Apart from considering income at its broader level (wherein ‘income’ is currently defined as ‘increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in an increase in equity, other than those relating to contributions from equity participants’), we will also consider a component of income—this being ‘revenue’—and in this chapter we will predominantly focus on revenue that is generated through contracts with one group of stakeholders, these being ‘customers’. As we will learn, ‘revenue’—which is a component of income (the other component being ‘gains’)—is defined as ‘income arising in the course of an entity’s ordinary operations’, while ‘customers’ are defined as parties that have ‘contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration’. In late 2014, a new accounting standard, AASB 15 Revenue from Contracts with Customers, was released. It replaced the former accounting standards, AASB 118 Revenue and AASB 111 Construction Contracts. These former accounting standards had been subject to much criticism because the revenue recognition requirements within these standards were perceived to be inconsistent with the definition and recognition criteria for income as provided within the Conceptual Framework for Financial Reporting. The recognition principles in these former standards utilised recognition criteria dependent upon whether a particular transaction transferred the ‘risks and rewards of ownership’ of the related assets, rather than basing the recognition of revenue on the transfer of control. As we know from material already covered in this book, ‘control’ is central to the definition of an asset. Adopting a view that revenue recognition should be consistent with the conceptual framework, the IASB embraced the position 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). In the process leading to the development of the accounting standard, paragraph 6.7 of IASB (2008) stated: An entity satisfies a performance obligation when it transfers goods and services to a customer. That principle, which the boards think can be applied consistently to all contracts with customers, is the core of the boards’ proposed model for a revenue recognition standard. In further considering the ‘core’ requirement that revenue recognition should be directly linked to the transfer of control of the underlying goods and services, paragraph 4.62 of IASB (2008) stated: Consequently, activities that an entity undertakes in fulfilling a contract result in revenue recognition only if they simultaneously transfer assets to the customer. For example, in a contract to construct an asset for a customer, an entity satisfies a performance obligation during construction only if assets are transferred to the customer throughout the construction process. That would be the case if the customer controls the partially constructed asset so that it is the customer’s asset as it is being constructed. Hence, under the latest thinking, 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 had been the accepted position for many years. This ‘new’ view is embraced within AASB 15. Because the requirements within AASB 15 represented a significant shift in thinking, the development of the accounting standard created much debate and the time taken to finalise the accounting standard was quite long. Indeed, as part of the project to develop the new accounting standard, the IASB released a Discussion Paper entitled Preliminary Views on Revenue Recognition in Contracts with Customers as far back as 2008. Following this, an Exposure Draft Revenue from Contracts with Customers was released in June 2010. Because of the importance of the issues covered in the Exposure Draft—and the fact that it would have widespread implications for most reporting entities—there were many (approximately 1000) written submissions. Following a review of the submissions, and many public meetings, it was decided to issue yet another Exposure Draft Revenue from Contracts with Customers in November 2011. As we now know, the final accounting standard IFRS 15/ AASB 15 was not released until 2014. This reflects how lengthy the process of developing an accounting standard can be, particularly if significant changes to existing practice are being promoted. We will now move on to consider the definition of income and revenue. CHAPTER 15: REVENUE RECOGNITION ISSUES  549

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LO 15.1 LO 15.2

Definition of income and revenue According to the Conceptual Framework for Financial Reporting, ‘income’ is defined as: Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in an increase in equity, other than those relating to contributions from equity participants.

As indicated in the conceptual framework, income can be subdivided into ‘revenues’ and ‘gains’. Specifically: The definition of income encompasses both revenues and gains. Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent. In relation to ‘gains’, the Conceptual Framework for Financial Reporting provides the following: • Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. Gains represent increases in economic benefits and as such are no different in nature from revenue. Hence they are not regarded as constituting a separate element in this Framework. • Gains include, for example, those arising on the disposal of non-current assets. The definition of income also includes unrealised gains, for example, those arising on the revaluation of marketable securities and those resulting from increases in the carrying amount of long-term assets. When gains are recognised in the income statement, they are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions. Gains are often reported net of related expenses. From the above discussion we can see that, generally speaking, revenues relate to the ordinary income-generating activities of an entity—for example, from sales or rental receipts—whereas gains relate to ‘other income’, which does not necessarily constitute part of the ordinary activities of an entity. The differentiation between revenues and gains is based on some degree of professional judgement, and it is very possible that something that is deemed to be a ‘gain’ by one accountant might be deemed to be ‘revenue’ by another (it should be appreciated, however, that the classification of an item as revenue or as a gain will not affect the total of profit or loss and other comprehensive income, as this total incorporates both revenues and gains). Further, because different organisations will be involved in different types of activities, what is an ordinary activity in one business might not be an ordinary activity in another. Hence, an item might be deemed to be revenue in one entity, but a gain within another entity. As a consequence of ongoing efforts by the IASB to develop a new conceptual framework (see earlier chapters of this book, particularly Chapter 2, for an overview of these developments), there is an expectation that the subdivision of income into revenues and gains might be removed, such that in the future, ‘income’ will not be subdivided into these components.

Differentiation between revenue and gains The differentiation between revenue and gains, as presented in the current conceptual framework, is embraced within AASB 15 Revenue from Contracts with Customers, which defines revenue as: Income arising in the course of an entity’s ordinary activities. Returning to the broader concept of income (which incorporates both revenues and gains), income can be earned from a variety of transactions or events including the provision of goods and services; from returns generated from investing in or lending to another entity; from holding and disposing of assets; by receiving non-reciprocal transfers such as grants, donations and bequests; or where liabilities are forgiven. Hence, as already indicated, the recognition of income is not restricted to receiving ‘inflows’ that relate to the ordinary operating activities of an entity. To qualify as income, the inflows or other enhancements or the savings in outflows of economic benefits must have the effect of increasing equity. Therefore, transactions such as the purchase of assets, or the issuance of debt, are not considered income because they do not result in an increase in equity. As already indicated, the accounting standard AASB 15 was released in 2014. In relation to the scope of the standard, paragraph 5 (the Scope Section) of AASB 15 states: An entity shall apply this Standard to all contracts with customers, except the following: (a) lease contracts within the scope of AASB 117 Leases; (b) insurance contracts within the scope of AASB 4 Insurance Contracts; 550  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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(c) financial instruments and other contractual rights or obligations within the scope of AASB 9 Financial Instruments, AASB 10 Consolidated Financial Statements, AASB 11 Joint Arrangements, AASB 127 Separate Financial Statements and AASB 128 Investments in Associates and Joint Ventures; and (d) non-monetary exchanges between entities in the same line of business to facilitate sales to customers or potential customers. For example, this Standard would not apply to a contract between two oil companies that agree to an exchange of oil to fulfil demand from their customers in different specified locations on a timely basis. Therefore, it is emphasised that AASB 15 applies to only a subset (or part) of the income-generating activities of an entity. Paragraph 1 of AASB 15 identifies the objective of the standard as: The objective of this Standard is to establish the principles that an entity shall apply to report useful information to users of financial statements about the nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a customer. Because both the objective and the scope of the accounting standard make reference to ‘contracts’ with ‘customers’ it is useful to consider how these terms are defined. They are defined in the accounting standard as follows: Contract  An agreement between two or more parties that creates enforceable rights and obligations. Customer  A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.

Recognition criteria for revenue from contracts with customers

LO 15.4

At a broader level, pursuant to the conceptual framework there are five elements of accounting, these being assets, liabilities, income, expenses and equity. In relation to when an element of accounting, for example, income, should be recognised, the conceptual framework states: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. As you know from previous chapters, it is generally considered that something is probable if it is more likely than less likely. As we now know from material already provided in this chapter, apart from the requirements pertaining to probability and measurability, which apply to ‘income’ in general, revenue recognition in relation to ‘contracts with customers’ is also dependent upon the additional criteria that the entity has satisfied performance obligations and transferred control of the asset to the customer. As AASB 15, paragraph 31, states:

probable More likely than less likely.

An entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (ie an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. Therefore, transfer of ‘control’ of the asset is a central requirement in the recognition of revenue under the accounting standard. In this regard, paragraph 33 of AASB 15 provides the following information in relation to the meaning of control: Goods and services are assets, even if only momentarily, when they are received and used (as in the case of many services). Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset. The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly in many ways, such as by: (a) using the asset to produce goods or provide services (including public services); (b) using the asset to enhance the value of other assets; (c) using the asset to settle liabilities or reduce expenses; CHAPTER 15: REVENUE RECOGNITION ISSUES  551

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(d) selling or exchanging the asset; (e) pledging the asset to secure a loan; and (f) holding the asset. Depending upon the nature of the activities of the reporting entity, revenue in relation to particular goods or services might be recognised at a point in time, or it might be recognised over a period of time (for example, in relation to a longterm construction contract, revenue might be recognised ‘over a period of time’—a topic that we will discuss later in this chapter). Again, we must remember that the transfer of control is a required precondition before revenue shall be recognised at a point in time, or over a period of time. In relation to situations where performance obligations are satisfied at a point in time (which might, for example, relate to when an item residing in inventory is sold to a customer), paragraph 38 of AASB 15 identifies a number of indicators of the transfer of control, which include, but are not limited to, the following: ( a) (b) (c) (d) (e)

The entity has a present right to payment for the asset; The customer has legal title to the asset; The entity has transferred physical possession of the asset; The customer has the significant risks and rewards of ownership of the asset; The customer has accepted the asset.

Again, the above factors are considered in determining whether revenue from contracts with customers should be recognised at a point in time. Where performance obligations are satisfied over time (rather than as at a point in time as above)—for example, an organisation might be constructing a building for a customer over a number of years—then paragraph 35 of AASB 15 permits revenue to be recognised to the extent that the reporting entity’s performance creates or enhances an asset (for example, work in progress in the form of a building) that the customer controls while the asset is being created or enhanced, or the entity’s performance creates an asset with no alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

LO 15.3 LO 15.4 LO 15.5

Measurement of revenue Where revenue has been recognised, we obviously need to measure it. Paragraph 46 of AASB 15 states: When (or as) a performance obligation is satisfied, an entity shall recognise as revenue the amount of the transaction price (which excludes estimates of variable consideration that are constrained in accordance with paragraphs 56–58) that is allocated to that performance obligation.

The above requirement relating to revenue measurement makes reference to ‘transaction price’. The ‘transaction price’ to be included in revenue from contracts with customers is defined in the accounting standard as: The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. Paragraph 48 of AASB 15 further states: When determining the transaction price, an entity shall consider the effects of all of the following: (a) variable consideration; (b) constraining estimates of variable consideration; (c) the existence of a significant financing component in the contract; (d) non-cash consideration; and (e) consideration payable to a customer. In relation to variable consideration (point (a) above), if the promised amount of consideration in a contract is variable, an entity shall estimate the total amount to which the entity will be entitled in exchange for transferring the promised goods or services to a customer. Paragraph 53 of AASB 15 requires: An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled: (a) The expected value—the expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics. 552  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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(b) The most likely amount—the most likely amount is the single most likely amount in a range of possible consideration amounts (ie the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not). As an example of ‘variable consideration’ as addressed in the above paragraph from AASB 15, let us assume that an entity has a contract to sell 100 bikes to a customer for $500 each and the customer has the right to return the bikes within 30 days for a full refund. Further, let us assume that on the basis of past experience the entity places the following probabilities on the number of bikes the customer is expected to return (and the maximum number expected to be returned is four bikes): Number of bikes returned

Probability of outcome

0

15%

1

20%

2

28%

3

22%

4

15%

Using the ‘expected value’ method referred to above, the amount of revenue from the customer to be recognised would be calculated as (100 × $500 × 0.15) + (99 × 500 × 0.20) + (98 × $500 × 0.28) + (97 × $500 × 0.22) + (96 × $500 × 0.15), which equals $48 990. If, by contrast, the ‘most likely amount’ approach is applied, and if it is assumed that the most likely outcome is that two bikes will be returned, then the revenue to be recognised would be calculated as 98 × $500, which equals $49 000. As can be seen, this is very similar to the amount calculated above using the expected-value method. If it is clear that there is a financing component in the sale (for example, that the entity has provided settlement terms that include an interest cost), that interest revenue should be accounted for separately. Further, if the transaction price is not expected to be paid for more than a year, then the transaction price must be discounted to recognise the time value of money. As paragraphs 60 and 61 of AASB 15 state: 60. In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component. A significant financing component may exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract. 61. The objective when adjusting the promised amount of consideration for a significant financing component is for an entity to recognise revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer (ie the cash selling price). An entity shall consider all relevant facts and circumstances in assessing whether a contract contains a financing component and whether that financing component is significant to the contract, including both of the following: (a) the difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services; and (b) the combined effect of both of the following: (i) the expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services; and (ii) the prevailing interest rates in the relevant market. Where there is no clear finance component within the transaction, and the time between when the entity expects to receive the payment and the time when the goods or services were transferred is less than a year, then discounting can be ignored. CHAPTER 15: REVENUE RECOGNITION ISSUES  553

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When amounts to be received from customers are to be discounted (for example, the amount is to be received beyond 12 months), then the discount rate to be applied is discussed at paragraph 64 of AASB 15, which states: when adjusting the promised amount of consideration for a significant financing component, an entity shall use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. That rate would reflect the credit characteristics of the party receiving financing in the contract, as well as any collateral or security provided by the customer or the entity, including assets transferred in the contract. An entity may be able to determine that rate by identifying the rate that discounts the nominal amount of the promised consideration to the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer. After contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk). Worked Example 15.1 provides an example of a transaction with an interest component.

WORKED EXAMPLE 15.1: Receipt of a deferred payment for the provision of services In July 2018 McTavish Ltd, an organisation involved in the surfing industry, provides two weeks of surfing lessons to a group of middle-aged executives employed by Big Town Ltd. The lessons conclude on 15 July 2018. The contract with Big Town Ltd requires it to make two deferred payments of $20 000 each to McTavish Ltd on July 15, 2019 and July 15, 2020. McTavish typically provides credit arrangements to such customers at a rate of 8 per cent. REQUIRED: Provide the journal entries for McTavish to account for the revenue to be received from the customer. SOLUTION: We first need to work out the present value of the revenue to be received. Using a discount rate of 8 per cent, this can be calculated as: PV of amount to be received on 15 July 2019: $20 000 × 0.92593 PV of amount to be received on 15 July 2020: $20 000 × 0.85734

= =

$18 519 $17 147 $35 666

Effectively, when McTavish Ltd receives the payments it will be receiving the payments for the revenue earned in 2018 (and therefore already recognised) plus some interest revenue that it earns as a result of deferring the receipts of the payments. The interest revenue will be calculated by multiplying the accounts receivable balance at the beginning of each period by the rate of interest, which in this case is 8 per cent. The relevant accounting journal entries would be: 15 July 2018 Dr Accounts receivable Cr Revenue from surf lessons 15 July 2019 Dr Cash at bank Cr Accounts receivable Cr Interest revenue

35 666 35 666 20 000 17 147 2 853

The interest revenue is calculated by multiplying the opening balance of accounts receivable by the rate of interest, which is $35 666 × 8 per cent, which equals $2853. As we know from the extract from AASB 15 provided above, after contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances. 15 July 2020 Dr Cash at bank Cr Accounts receivable Cr Interest revenue

20 000 18 519 1 481

The interest revenue is calculated by multiplying the opening balance of accounts receivable by the rate of interest, which is ($35 666 – $17 147 ) × 8 per cent, which equals $1481.

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Non-cash consideration If the contract price is cash then it is obviously easier to measure the fair value of the consideration relative to the situation where the consideration is in a non-cash form. For example, a customer might pay for a good or service by transferring some land to the reporting entity, rather than paying cash. Where non-cash consideration is received, the consideration shall be measured at fair value. Worked Example 15.2 provides an example of a transaction involving non-cash consideration.

WORKED EXAMPLE 15.2: Provision of services for consideration not in the form of cash Rincon Ltd provides consulting services to The Bowl Ltd. Rather than paying in cash, it is agreed that The Bowl Ltd will transfer some machinery to Rincon Ltd. The machinery is recorded in The Bowl Ltd’s accounts at a cost of $75 000 and with accumulated depreciation of $20 000. The fair value of the machinery is assessed as being $60 000. REQUIRED: Provide the journal entries for Rincon Ltd to recognise revenue to be received from The Bowl Ltd. SOLUTION: It is the fair value of the machinery that is relevant, not the carrying amount of the machinery as recorded in The Bowl Ltd’s accounts (and that carrying amount would be $55 000). The accounting entry for Rincon Ltd would be: Dr Cr

Machinery Consulting revenue

60 000 60 000

Income and revenue recognition points Current and past practice

LO 15.1 LO 15.2 LO 15.3

While now quite dated, a monograph by Coombes and Martin provides some interesting discussion about various issues associated with past practices pertaining to revenue recognition. This discussion still has relevance today. In 1982 Coombes and Martin completed an Accounting Theory Monograph for the Australian Accounting Research Foundation entitled The Definition and Recognition of Revenue under Historic Cost Accounting. They provided a diagram (see Figure 15.1) that identified the possible points in the acquisition–production–marketing cycle at which revenue could be recognised. While Figure 15.1 does apply to transactions that are accounted for in accordance with the historical-cost system (and the sale of inventory is typically accounted for in this way), it does not apply where fair-value accounting is applied, for example, where the gain in the fair value of investments is recognised as income even in the absence of any sales transactions. Recognising income as a result of changes in the fair value of assets was relatively uncommon back in 1982. In relation to the revenue-recognition cycle, Coombes and Martin state (p. 6): Accountants would be indifferent to the point chosen for revenue recognition if there were a constant and repetitive process of purchasing and selling goods or services at set prices. Income would be constant over time and it would not matter whether revenue was recognised at point 8 (delivery of goods to customers) or point 2 (purchase of inventories). However, in a world of change and uncertainty the choice of a revenue recognition point will affect the allocation of revenues (and hence incomes) between accounting periods. In traditional accounting, revenue has been recognised at several points in the earnings cycle, for example: (i) at point 5 in the building industry for long-term construction contracts; (ii) at point 7 where it is the responsibility of the purchaser to collect the goods; (iii) at point 8 in most cases; (iv) at point 9 by some professional practices and for instalment credit sales. Revenue is rarely if ever recognised prior to point 5, possibly because of the uncertainty surrounding the ultimate irrevocable and unconditional claim to cash (or its equivalent) arising from a revenue transaction or event. As one proceeds through the earnings cycle from point 1 to point 9, this uncertainty decreases. However, in practice, point 9 is considered too conservative to be the general criterion. Point 8 is the point at which revenue is normally recognised and the slight amount of uncertainty remaining is accounted for by creating a ‘provision for doubtful debts’. CHAPTER 15: REVENUE RECOGNITION ISSUES  555

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Figure 15.1 The earnings cycle 9. Receipt of cash

1. Devising an idea

8. Delivery of goods to customers

2. Making purchases (e.g. of inventories)

7. Receipt of orders after completing production

3. Receipt of orders before commencing production

6. Completion of production

4. Commencing production

5. Progressively throughout production

SOURCE: Robert J. Coombes & Carrick J. Martin, 1982, The Definition and Recognition of Revenue Under Historic Cost Accounting, Accounting Theory Monograph, No. 3, Australian Accounting Research Foundation, Melbourne. Copyright, reproduced with the permission of CPA Australia and the Institute of Chartered Accountants.

Revenue recognition in practice would still appear to be generally consistent with Coombes and Martin’s approach. Revenue would typically be recorded at point 8, although for long-term construction contracts, revenue can be recognised throughout the project as represented at point 5 (to the extent that the customer has ‘control’ of the item being constructed). However, as already indicated, their approach is based on a traditional historical-cost, transactionbased system of accounting. Income tends now to be also recognised in circumstances where there is no transaction with external parties. That is, we currently have a system of accounting that, while still applying historical cost to many transactions, also makes use of other approaches to valuation, such as using fair values. For example, as Chapter 14 explains, increases in the fair values of marketable securities are recognised as part of income, even in the absence of a transaction. Such a practice represents a departure from traditional historical-cost accounting, but is consistent with the definition of income provided within the Conceptual Framework for Financial Reporting, given that there is an increase in assets that has not been created by a contribution by the owners or by creditors. Different measurement models— such as historical-cost versus a modified historical-cost system, which allows revaluations of non-current assets and ‘marking to market’ of the entity’s marketable securities—will generate different calculations of income (and, hence, of profit or loss and other comprehensive income). As an example of how revenue is affected by a change in the rules governing the measurement of assets, we can consider Accounting Standard AASB 141 Agriculture. This standard—which is discussed in Chapter 9—addresses how we are to account for biological assets (which are defined as living animals or plants). AASB 141 requires that biological assets (other than ‘bearer plants’, which would include trees that are expected to produce fruit for a number of periods), such as forestry assets or livestock, are to be measured on the basis of their fair value, with any increase in fair value being treated as income. This can be contrasted with the previous practice in Australia where many organisations measured their agricultural assets on the basis of historical cost, with revenue not being recognised until the assets were actually sold. Such a fundamental change in measurement approach can have a significant impact on revenues and reported profits. This is an important point. Put in a slightly different way—it is emphasised that different approaches to measuring assets, and to measuring liabilities, will directly affect reported profits or losses. As Figure 15.1 shows for transaction-based revenue, it has traditionally been possible for revenue to be recognised during various phases of the revenue cycle. The following discussion considers the recognition of revenue at the completion of production and at the point of ultimate sale. The possibility of recognising revenue during production (and this applies particularly to construction contracts) will be discussed later in this chapter. 556  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Revenue recognition at completion of production For certain products, such as precious metals or agricultural products, revenue could potentially be recognised at the completion of production (point 6 in Figure 15.1), even when no sale has been made. In the past, revenue has been recognised at this point because when these metals were mined or agricultural crops were harvested, the sale price was reasonably assured, the units were interchangeable and no significant costs were involved in distributing the product. It is often the case that statutory bodies have in place an agreement to buy all materials/ crops produced by an entity at a specified price, hence the likelihood of not receiving the receipts would be minimal once production is complete. While this was common practice for producers of certain minerals and agricultural products, the contents of the accounting standard AASB 15 Revenue from Contracts with Customers will mean that this practice will probably cease as ‘control’ of the good or service has not been transferred to the customer.

Revenue recognition at the time of sale The conditions for recognising revenue in relation to the sale of goods are usually met by the time the product or merchandise is delivered, or the services are rendered to customers (point 8 in Figure 15.1). Where products require transportation, the revenues from manufacturing and selling activities are commonly recognised at the time of sale, normally determined by the shipping f.o.b. shipping point An agreement whereby terms. That is, time of sale is commonly interpreted as the time when title passes. If the goods the price of a purchase are shipped on terms referred to as f.o.b. shipping point (where f.o.b. stands for free on board), typically includes the title passes to the buyer when the seller delivers the goods to a common carrier (the ‘shipping costs necessary to get point’) who acts as an agent for the buyer. Revenue would typically be recognised when the the item to a certain goods reach the carrier. If the goods are shipped f.o.b. destination, title does not pass until the transportation point, at buyer receives the goods from the common carrier (that is, at the destination). In this case, which point title passes to the buyer. revenue would not typically be recognised until the goods reach their destination. ‘Shipping point’ and ‘destination’ are frequently designated by a particular location, for example, f.o.b. Sydney, which would mean the title passes from the seller to the purchaser when the goods arrive in Sydney. f.o.b. destination When revenue is recognised in advance of the actual receipt of cash (or cash substitute), it An agreement whereby is common for the entity to also recognise an allowance for doubtful debts. Logically, if goods the price of a purchase are sold or services are provided on credit terms, not all amounts due from the debtors will typically includes the costs necessary to get ultimately be collected. To ignore this fact would lead to an overstatement of receivables and, the item to a certain therefore, of assets in the statement of financial position. It would also lead to an overstatement destination, at which of profit (or an understatement of losses). When the first Exposure Draft Revenue from Contracts place title to the goods with Customers was released in June 2010 it was proposed that reporting entities should passes to the buyer. recognise revenue at the amount of consideration that the company expects to receive from the customer. Thus, it was initially proposed that when determining the ‘transaction price’ the entity would consider the effect of the customer’s credit risk and record only the net expected allowance for doubtful amount as revenue. This would have represented quite a departure from traditional accounting debts practice. However, when the second Exposure Draft was released in November 2011 the Account that provides requirement was changed back to the traditional approach and this approach has been an estimate of the amount of the accounts incorporated within AASB 15. That is, a reporting entity shall recognise revenue at the amount receivable that will of consideration to which the entity considers it is ‘entitled’. An entity shall exclude expectations ultimately not be of collectability when determining the amount of the transaction price (and thus the amount to received. be recognised as revenue). The amount recognised for doubtful debts is usually determined on the basis of past experience or, perhaps, of industry averages. As an illustration, assume that an organisation starts operations in January 2018 and by the end of June 2018 it has receivables of $100 000. It is very unlikely that all doubtful debts amounts owing by the debtors (the receivables) will ultimately be received, and hence some When it is considered to be doubtful that allowance must be made for debts that might not be recovered. Various approaches may be adopted debtors will pay to calculate the allowance. For example, it may be assumed that, on average, 5 per cent of all the amounts due, debtors within the particular industry will fail to pay their debts. Alternatively, reliance may be placed a doubtful debts on an aged debtors listing. For example, an analysis of the amounts owing might show that the debts expense is recognised. can be classified by age (see Table 15.1). CHAPTER 15: REVENUE RECOGNITION ISSUES  557

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Table 15.1 Outstanding debts classified by age

Table 15.2 Calculation of allowance for doubtful debts

Age

Amount

Less than one month old

 $40 000

Between one month and two months old

 $35 000

Between two months and three months old

 $10 000

Between three months and four months old

 $10 000

More than four months old

   $5 000

Total

$100 000

Age

Amount

Percentage

Allowance

Less than one month old

 $40 000

 1%

 $400

Between one month and two months old

 $35 000

 2%

 $700

Between two months and three months old

 $10 000

 3%

 $300

Between three months and four months old

 $10 000

 5%

 $500

More than four months old

   $5 000

 15%

  $750

Total

$100 000

$2 650

Drawing on past experience in the industry, we will assume that outstanding debts are uncollectable at the following percentages: 1 per cent of all debts less than one month; 2 per cent of those between one month and two months old; 3 per cent of those between two months and three months old; 5 per cent of those between three months and four months old; and 15 per cent of those over four months old. The percentages are based on the general assumption that the longer the receivables have been outstanding the greater the likelihood that the debtors will ultimately not pay the amounts that are due. With the above information, the allowance for doubtful debts can be calculated as shown in Table 15.2. The accounting entry to recognise the allowance for doubtful debts and the associated expense as at 30 June 2018 (the year end) would be: Dr Cr

Doubtful debts expense Allowance for doubtful debts

contra asset Account that typically accumulates data from one period to the next, which is shown as a deduction from another related account.

accounts receivable Amounts owed to an entity by external parties generally as a result of the entity providing goods or services

2 650 2 650

The allowance for doubtful debts would be shown as an offset against accounts receivable in the statement of financial position. That is, the allowance for doubtful debts is recognised as a contra asset. As the above accounting entry shows, when a doubtful debts expense is recognised, with a corresponding increase in the allowance for doubtful debts, there is no adjustment to the accounts receivable balance. Consequently, there is also no adjustment made to the accounts receivables’ subsidiary ledger. The reason for this is that the allowance is recognised in anticipation of the likely non-recoverability of some of the amounts owing to the entity, although the identity of those who will not pay is unknown. Hence, no adjustment is made to the accounts receivables’ control account, or the accounts receivables’ subsidiary ledger. When it becomes known that a particular debtor has, for example, become bankrupt and will not pay the amounts owing to the entity, there will be a reduction in the accounts receivable balance (and associated subsidiary ledger account) and the allowance for doubtful debts, since the amount has been anticipated within the allowance for doubtful debts. For example, if such a debtor owes $500 when it goes bankrupt, and the likelihood of receiving any payment is considered minimal, the accounting entry would be: Dr Cr

Allowance for doubtful debts Accounts receivable

500 500

Within the above entry there is no additional expense recognition, as the expense was recognised at the time the allowance was created or subsequently increased.

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Alternatively, if an account receivable (debtor) is considered unlikely to pay, but the amount has not been anticipated, the entity will recognise a bad debts expense. If such an account receivable owes $5000 and is deemed unlikely to pay owing to bankruptcy or some similar occurrence, and it is also considered that the allowance for doubtful debts will be sufficient to cover only the other remaining accounts receivable, the accounting entry would be: Dr Cr

Bad debts expense Accounts receivable

5 000 5 000

Typically, the bad debts expense account is used when an amount is expensed directly against accounts receivable and the amount has not been previously anticipated as a doubtful debt. As the total of the accounts receivable balance in the ledger account (or control account) must equal the balance of the individual debtors’ accounts in the accounts receivable subsidiary ledger, when a bad debts expense is recognised there will be a write-off of the amount in the accounts receivable subsidiary ledger. Interestingly, as a general principle, the Australian Taxation Office will allow a deduction for taxation purposes only when there is an adjustment against the accounts receivable account, and not when the allowance for doubtful debts is initially credited. In relation to disclosures of doubtful debts and bad debts, the amounts of allowances for doubtful debts would be shown as deductions from the classes of assets to which they relate. It would also be common to show separately the net expense in relation to bad and doubtful debts.

Accounting for sales with associated conditions

bad debts expense The amount of expense recognised by writing off an amount that was receivable from a debtor.

bad debts Recognised by reducing the debtor balance and increasing bad debts expense, when it becomes evident that a debtor will not pay its debt.

LO 15.6 LO 15.8

Evidence indicates that numerous companies have engaged in innovative transactions to generate revenues, some of which do not initially result in a transfer of economic benefits. With some transactions, considerable professional judgement must be exercised to determine whether revenue should be recognised and, if so, when it should be recognised. Transactions involving the sale of assets with conditions attached should be reviewed to assess whether control has actually passed from the seller to the purchaser and whether it is probable that the inflow of economic benefits to the seller will occur. For example, merchandise might be sold subject to reservation of title, whereby a stipulation is placed in the sales contract to the effect that ownership of the goods does not pass to the purchaser until the time of payment. The seller, while possessing legal title to the merchandise and therefore the right to reclaim the merchandise if the buyer defaults, has passed to the purchaser effective control over the future economic benefits embodied in the transferred merchandise. Recognition of the revenue would appear appropriate. Goods or other assets might be sold subject to various other conditions, such as the existence of put or call options, a related leaseback, or the right to return the assets. We will consider each of these conditions below.

Call and put options As discussed in Chapter 14, a call option provides the holder of the option with the right to buy call option an asset at a specified exercise price on or before a specified date (in Chapter 14 we considered Provides the holder how to account for share options provided to employees—this type of option can be referred to of the option with the as a call option). The party that writes the call option agrees to deliver a particular asset to the callright to buy an asset option buyer, if that buyer instructs the other party to do so. A call option is considered to have value at a specified exercise when the value of the underlying asset exceeds the option’s exercise price (when such an option is price, on or before a specified date. frequently described as ‘being in the money’). Depending on the time period to expiration, an option might also have value even when the exercise price is above the current value of the underlying asset. However, if at exercise date the exercise price is above or equal to the market value of the exercise price asset, the option has no value. The price the holder Therefore, if the fair value of the underlying asset exceeds the exercise price at the date of of an option will pay expiration of the option, the buyer of the option would typically exercise the option leading to the to buy a company’s delivery of the underlying asset. If, by contrast, the fair value of the asset is below the exercise price shares. at expiration of the call option, the buyer will not exercise the call option and the seller has no further liability. For example, you might have an option (a call option) to buy shares in BHP Ltd, and the price associated with that option (the exercise price) might be $30. That is, regardless of the market price of BHP shares, the writer of the call option has agreed to deliver BHP shares to you—the holder of the option—if you pay the writer $30 per CHAPTER 15: REVENUE RECOGNITION ISSUES  559

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share. If the available market price is below the exercise price of $30—perhaps they are trading at $28—then you would not exercise your option under the contract as that would require you to pay $30 for something that you could buy from the market at $28. A put option, by contrast, operates in the reverse manner to a call option. Its holder has the put option right to sell an asset at a specified exercise price on or before a specified date. The writer (or seller) Gives its holder the of the put option agrees to buy the asset at a future date for the exercise price if the put-option right to sell an asset, holder (buyer) should request it. The holder of the put option (who may also be in possession of at a specified exercise the underlying asset) would typically exercise the option (that is, require the other party to buy price, on or before a the underlying asset) only if the exercise price is above the market price. A put option guarantees specified date. holders a minimum price for their assets. These assets might perhaps be the production output of the option holder. If the market price of the underlying assets should fall below the exercise price, the put-option seller will lose the difference between the market value of the asset and the exercise price of the option. Where a transaction involves the concurrent use of a financial instrument such as an option (as discussed above), it is necessary to evaluate the conditions attaching to the transaction to establish whether, in substance, the transaction is a financing arrangement rather than a sale. For example, a purchaser/lender might ‘acquire’ assets with a call option attached as a means of securing collateral in respect of the ‘sales’ proceeds/borrowings, rather than by obtaining a mortgage over the assets. In such a case the transaction constitutes a financing arrangement rather than a sale from the viewpoint of the vendor/borrower and would not give rise to revenue. In these circumstances, the inflow of economic benefits to the vendor/borrower in the form of ‘sales’ proceeds has resulted from an equivalent increase in liabilities, with the result that equity has not increased. Paragraphs B66 to B69 of AASB 15 provide guidance that requires that where the original owner of an asset has sold an asset, but also holds a call option that allows it to reacquire the asset at a future date at a price less than the original selling price, then no revenue shall be recognised. However, should the option lapse, then revenue can be recognised. Specifically, paragraphs B66 to B69 state: B66 If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset. Consequently, the entity shall account for the contract as either of the following: (a) a lease in accordance with IAS 17 Leases if the entity can or must repurchase the asset for an amount that is less than the original selling price of the asset; or (b) a financing arrangement in accordance with paragraph B68, if the entity can or must repurchase the asset for an amount that is equal to or more than the original selling price of the asset. B67 When comparing the repurchase price with the selling price, an entity shall consider the time value of money. B68 If the repurchase agreement is a financing arrangement, the entity shall continue to recognise the asset and also recognise a financial liability for any consideration received from the customer. The entity shall recognise the difference between the amount of consideration received from the customer and the amount of consideration to be paid to the customer as interest and, if applicable, as processing or holding costs (for example, insurance). B69 If the option lapses unexercised, an entity shall derecognise the liability and recognise revenue. Similarly, if an entity sells an asset to another organisation and the other organisation (customer) has a put option that requires the entity to acquire the asset at a price in excess of the original sale price then no revenue shall be recognised (see paragraphs B73 to B76 of AASB 15).

WORKED EXAMPLE 15.3: Sale of some land with an associated call option Whites Beach Ltd has some land that it uses as part of its farming operations. The fair value of the land is $1 000 000. It requires some funds to expand its operations. With this in mind, on 1 July 2018 it agrees to sell its land to Big Bank Ltd for $800 000. The agreement also includes a call option that gives Whites Beach Ltd the right to reacquire the land, in three years’ time—on 1 July 2021—from Big Bank Ltd for $926 100. Whites Beach Ltd has a reporting year end of 30 June and the effective interest rate in this agreement is 5 per cent.

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REQUIRED Determine whether Whites Ltd should record sales revenue in relation to this agreement and provide the accounting entries for 1 July 2018, 30 June 2019, 30 June 2020, 30 June 2021 and 1 July 2021. SOLUTION Whites Beach Ltd should not record a sale. Effectively this is a financing arrangement with Whites Beach Ltd being able to repurchase the asset for an amount that is more than the original selling price but less than the expected fair value. Because the amount to be paid to exercise the option, which would be $926 100, is likely to be less than the fair value of the land, there would be an expectation that the land will be reacquired by Whites Beach Ltd. The customer (Big Bank Ltd) is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the land, even though for a short period of time it may have physical possession of the asset. The accounting entries would be: 1 July 2018 Dr Cash at bank Cr

800 000

Contract liability—Big Bank Ltd

800 000

(The land has not been removed from the financial statements of Whites Beach Ltd as it is considered that control of the asset has not been lost. Effectively, the land has not been ‘sold’.) 30 June 2019 Dr Interest expense 40 000 Cr Contract liability—Big Bank Ltd 40 000 (Interest expense equals the opening liability multiplied by 5 per cent = $800 000 × 0.05.) 30 June 2020 Dr Interest expense 42 000 Cr Contract liability—Big Bank Ltd 42 000 (Interest expense equals the opening liability multiplied by 5 per cent = $840 000 × 0.05.) 30 June 2021 Dr Interest expense 44 100 Cr Contract liability – Big Bank Ltd 44 100 (Interest expense equals the opening liability multiplied by 5 per cent = $882 000 × 0.05.) 1 July 2021 Dr Contract liability—Big Bank Ltd Cr Cash at bank (Being payment of the call option.)

926 100 926 100

Because Whites Beach Ltd had not been considered to lose ‘control’ of the asset, the land was not initially removed from the financial statements of the entity, and hence there is no need to reinstate it.

Revenue recognition when right of return exists Cash or credit sales present a special problem where there is a ‘right of return’. A ‘right of return’ exists when an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons (such as dissatisfaction with the product) and receive any combination of the following: ( a) a full or partial refund of any consideration paid; (b) a credit that can be applied against amounts owed, or that will be owed, to the entity; and (c) another product in exchange. Alternative accounting treatments available when the seller is exposed to the likelihood that assets will be returned could include: • not recording the sale until all return privileges have expired • recording the sale but reducing sales by an estimate of future returns • recording the sale and accounting for the returns as they occur in future periods. CHAPTER 15: REVENUE RECOGNITION ISSUES  561

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AASB 15 provides guidance. Paragraph B21 states: To account for the transfer of products with a right of return (and for some services that are provided subject to a refund), an entity shall recognise all of the following: (a) revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognised for the products expected to be returned); (b) a refund liability; and (c) an asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability. As noted above, the revenue to be recognised is that to which it ‘expects to be entitled’. For any amounts to which an entity is not expected to be entitled, the entity shall not recognise revenue when it transfers products to customers but shall recognise any consideration received as a refund liability. Subsequently, the entity shall update its assessment of amounts to which the entity is expected to be entitled in exchange for the transferred products and shall recognise corresponding adjustments to the amount of revenue recognised. As noted above, where a sale with a right of return is made then revenue, a refund liability and an asset relating to the right to recover the product could be recognised. Worked Example 15.4  provides an illustration of a sale where a right of return exists. This example has been adapted from an illustration provided in IASB (2011).

WORKED EXAMPLE 15.4: Sale with a right of return An entity sells 100 products for $100 each. Sales are made for cash, rather than on credit terms. The entity’s customary business practice is to allow a customer to return any unused product within 30 days and receive a full refund. The cost of each product is $60. To determine the transaction price, the entity decides that the approach that is most predictive of the amount of consideration to which the entity will be entitled is the most likely amount. Using the most likely amount, the entity estimates that three products will be returned (as indicated earlier in this chapter, where there is ‘variable consideration’—which is the case within this worked example—an entity might use either the ‘expected value’ method, or the ‘most likely amount’ method to estimate the variable consideration; in this case, the entity has elected to use the ‘most likely amount’ method). The entity’s experience is predictive of the amount of consideration to which the entity will be entitled. The entity estimates that the costs of recovering the products will be immaterial and expects that the returned products can be resold at a profit. REQUIRED Provide the accounting entries to record the sale, and the subsequent return of the assets, assuming that the returns occur in accordance with expectations. SOLUTION Upon transfer of control of the products, the entity would not recognise revenue for the three products that it expects to be returned. Consequently, the entity would recognise: (a) Revenue of $9700 ($100 × 97 products expected not to be returned). (b) A refund liability for $300 ($100 refund × 3 products expected to be returned). (c) An asset of $180 ($60 × 3 products) for its right to recover products from customers on settling the refund liability. The assets are recorded at cost as it is assumed there is no cost associated with recovering the assets. Hence, the amount recognised in cost of sales for 97 products is $5820 ($60 × 97). The accounting entries would be: Dr Cash Cr Revenue Cr Refund liability (to recognise the initial sale) Dr Cost of goods sold Dr Right to recover (which is an asset) Cr Inventory (to recognise the transfer of inventory to the customer)

10 000 9 700 300 5 820 180 6 000

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Dr Refund liability 300 Cr Cash 300 (to recognise the refund provided to the customer when the goods are ultimately returned) Dr Inventory 180 Cr Right to recover (to place the returned assets back into inventory when they are returned)

180

Sale and leaseback Entities may enter into transactions whereby non-monetary assets are ‘sold’ and simultaneously leased back to the vendor, frequently by way of a long-run, non-cancellable lease. The substance of these sale and leaseback transactions is that, although legal ownership of the leased property has been transferred to the purchaser/lessor, the vendor/lessee would normally retain control of the future economic benefits embodied in the leased property by virtue of the lease agreement. Because ‘control’ of the asset has not been transferred, it would be inappropriate to recognise revenue. The vendor/lessee has, in effect, entered into a financing arrangement whereby the leased property has been used as collateral for a loan. Payments made by the vendor/lessee under the lease will ensure that the purchaser/lessor recoups the investment in the lease and receives an appropriate return on the investment. The transaction does not constitute a sale and does not give rise to revenue, since the inflow of economic benefits in the form of the proceeds from disposal has resulted from an equivalent increase in liabilities (a lease payable), with the result that there has been no increase in equity. Consistent with this, any gain on a sale and leaseback transaction should be amortised to the statement of profit or loss and other comprehensive income over the term of the lease rather than recognising the profit at the point of sale. Accounting for leases is considered in detail in Chapter 11.

Interest and dividends

LO 15.7

Interest revenue The recognition of interest revenue is usually straightforward, with the revenue being recognised interest revenue over time, as the borrower has the benefit of the borrowings and the lender establishes claims for Revenue derived as interest earned. If the borrower prepays interest, the inflow of future economic benefits represented a result of lending by the prepayment would not constitute an item of revenue to the lender because the lender resources to another has a present obligation (a liability) to the borrower to provide finance for the period to which the entity. prepayment relates. Interest received in advance would be considered to represent a liability. On occasion, interest revenues are implicit in the terms of a transaction. Where, for example, goods are sold on extended credit, the vendor is effectively financing the purchaser. Arguably, the purchase consideration should be discounted to determine the amount of the sales revenue and the amount of the debt financing on which future interest revenues will be earned. The transaction gives rise to two forms of revenue: 1. sales revenue—the present value of the future payments 2. interest revenue from financing activities. To estimate the present value of the proceeds, an applicable interest rate inherent in the agreement must be determined. As already indicated in this chapter, in relation to determining the appropriate interest rate, AASB 15, paragraph 64 provides guidance. Worked Example 15.5 is a further illustration of interest recognition in a sales transaction.

WORKED EXAMPLE 15.5: Recognition of interest inherent in a sales transaction On 1 July 2018, Cassie Ltd sells a computer to Ted Ltd. The computer cost Cassie Ltd $9000. Rather than selling the item for a cash price or a short-term claim for cash of $12 009, Cassie Ltd accepts a promissory note that requires Ted Ltd to make three annual payments of $5000 each, the first one to be made on 30 June 2019. The difference continued CHAPTER 15: REVENUE RECOGNITION ISSUES  563

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between the gross receipts and the current sales price represents interest revenue to be earned by Cassie Ltd over the period of the note. The rate implicit in the arrangement is 12 per cent, which is also the rate Cassie Ltd charges other customers when goods are sold on extended credit terms. (The present value of an annuity of $1 for three years discounted at 12 per cent is $2.4018. Refer to the present value tables provided as an appendix to this book.) REQUIRED Provide the journal entries for Cassie Limited for the years ended 30 June 2019, 2020 and 2021 using: (a) the net-interest method (b) the gross method. SOLUTION To provide the journal entries, we need to determine the interest component of each $5000 payment. The easiest way to do this is to draw up a table, as shown below. The interest element is calculated by multiplying the opening liability for a period by the rate of interest implicit in the arrangement (in this case 12 per cent). Opening liability

Date 01 July 2018 30 June 2019 30 June 2020 30 June 2021

12 009 8 450 4 464

Interest revenue at 12%

Cash payment

Principal reduction

1 441 1 014    536 2 991

5 000 5 000   5 000 15 000

3 559 3 986   4 464 12 009

Outstanding balance 12 009 8 450 4 464 0

Interest revenue equals the outstanding liability at the beginning of the financial period multiplied by the interest rate implicit in the agreement, which in this example is 12 per cent. This approach is often referred to as the effective-interest method. The reduction in the principal is calculated by subtracting the interest revenue from the cash payment. (a) Journal entries using the net-interest method 1 July 2018 Dr Note receivable Cr Sales Dr Cost of sales Cr Inventory (to record the initial sale on 1 July 2018) 30 June 2019 Dr Cash Cr Note receivable Cr Interest revenue (to record the receipt of $5 000 on 30 June 2019) 30 June 2020 Dr Cash Cr Note receivable Cr Interest revenue (to record the receipt of $5 000 on 30 June 2020) 30 June 2021 Dr Cash Cr Note receivable Cr Interest revenue (to record the receipt of $5 000 on 30 June 2021)

12 009 12 009 9 000 9 000

5 000 3 559 1 441

5 000 3 986 1 014

5 000 4 464 536

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(b) Journal entries using the gross method 1 July 2018 Dr Note receivable 15 000 Cr Sales 12 009 Cr Unearned interest 2 991 Dr Cost of sales 9 000 Cr Inventory 9 000 (to record the initial sale on 1 July 2018; unearned interest would be disclosed as a deduction against note receivable) 30 June 2019 Dr Cash Cr Note receivable Dr Unearned interest Cr Interest revenue (to record the receipt of $5 000 on 30 June 2019) 30 June 2020 Dr Cash Cr Note receivable Dr Unearned interest Cr Interest revenue (to record the receipt of $5 000 on 30 June 2020) 30 June 2021 Dr Cash Cr Note receivable Dr Unearned interest Cr Interest revenue (to record the receipt of $5 000 on 30 June 2021)

5 000 5 000 1 441 1 441

5 000 5 000 1 014 1 014

5 000 5 000 536 536

Where the gross method is used, it is typical for the unearned interest to be offset, for statement of financial position purposes, against the total of the note receivable, showing it as a contra asset. The net amount for receivables under the gross method thus equates to the amount shown using the net-interest method.

Dividend revenue The recognition of dividend revenues is complicated by its discretionary nature. Dividends do not accrue over time, but usually result from a decision of the board of directors or another governing body of the dividend-paying entity. Although a final dividend is usually subject to ratification by the ownership group, the receiving entity should recognise revenues when the inflow of future economic benefits is considered probable and when it can be measured reliably. If a dividend needs final approval, perhaps at a meeting of shareholders, then the dividend revenue shall not be recognised until such time as the dividend has been approved (or ratified). In considering dividends being received, one issue that warrants consideration is whether dividends received out of profits earned by the investee before the investment was made (that is, dividends paid after the investment is made but which are sourced from the pre-acquisition profits of the investee) should be treated as revenue by the investor. Or, alternatively, do we treat dividends paid from pre-acquisition profits as a reduction in the cost of the investment? A dividend from pre-acquisition profits will typically occur when an investor acquires an interest in another company and the shares have been acquired ‘cum div’—the 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. CHAPTER 15: REVENUE RECOGNITION ISSUES  565

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An obvious issue is, how do we account for a dividend paid by an investee (which is the organisation in which the reporting entity has shares) out of pre-acquisition profits? Do we treat it as income in the financial statements of the reporting entity or, instead, as a reduction in the cost of the investment? Pursuant to AASB 9, dividends on investments held for trading, and investments in equity instruments that are to be held as long-term investments, are recognised when the entity’s right to receive the payment of dividend is established. However, AASB 9 notes that while the dividends are to be recognised in profit or loss this will not be the case if the dividend clearly represents a recovery of part of the cost of the investment. Hence, if dividends are received from preacquisition earnings they shall be treated as a reduction in the cost of the investment rather than being treated as revenue.

LO 15.9

Unearned revenue

It is not unusual for entities to receive funds for products or services in advance of actually providing the related goods or services. Common examples would include rent or interest received in advance, or unearned revenue the receipt of consulting fees in advance of the provision of services. Since the services or resources When assets are received by a business have not been provided to the customer (and hence ‘control’ of the related good or service has not for services to be passed to the customer), the receipts have not been earned and the customer would not be deemed performed at a future to be in control of the goods or services. The receipts do not constitute revenue but instead are date. termed unearned revenue and considered liabilities. The entity would be under a present obligation to transfer future economic benefits at a future date (see paragraph 106 of AASB 15). Worked Example 15.6 provides an example of the treatment of revenue received in advance.

WORKED EXAMPLE 15.6: Revenue received in advance Renter Co. rents out some premises to Tenant Ltd. Tenant Ltd pays its rent three months in advance and makes the first payment on 1 May 2019. The rent is $2000 per month. Renter Co. has a 30 June reporting date. REQUIRED Provide the accounting entries to record the receipt of the cash and the subsequent reporting date adjustment. SOLUTION 1 May 2019 Dr Cash at bank 6 000 Cr Rent received in advance (which is a liability) 6 000 (to recognise the receipt of the rental income; as the amount has been received in advance, it is credited to the liability account rent received in advance) 30 June 2019 Dr Rent received in advance 4 000 Cr Rental income 4 000 (to recognise two months’ rent earned in 2019 and to reduce the balance of the liability account rent received in advance; a balance of $2000 would remain in rent received in advance and would be shown in the statement of financial position as a liability)

LO 15.10

Accounting for construction contracts

Where construction projects such as buildings, ships, major roads, bridges, dams, pipelines and tunnels take several financial periods to complete, a number of accounting issues arise. For example, should revenue be recognised progressively throughout the contract—that is, at point 5 in Figure 15.1, and, if so, how would the quantum of the revenue be determined? It seems reasonable to assume that firms would prefer to recognise revenue throughout the period of a long-term project, rather than having to defer revenue recognition until project completion, which might take many years. If a firm has a small number of long-term contracts, deferral of revenue recognition until the completion of the projects would result in great volatility of reported revenues and related profits or losses. This might be a problem, particularly if the firm has accounting-based contracts in place that rely on such measures as the number of times that 566  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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interest expense is covered by profits. Further, it could be argued that the results of the period do not reflect the activities and work undertaken if revenues from multi-period contracts are deferred until project completion. AASB 15 addresses whether revenue should be recognised over time, or at a point in time and the accounting standard emphasises that revenue is recognised upon the satisfaction of performance obligations, which occurs when the control of the contracted goods and services transfers to the customer. Control can transfer at a point in time or, as is common in the construction industry, across a period of time. Pursuant to AASB 15, a performance obligation would be considered to have been satisfied ‘over time’ when at least one of the following criteria is met: • the customer receives and controls the benefits of the entity’s performance as the entity performs (examples include routine or recurring services—such as a cleaning service—in which the receipt and simultaneous consumption by the customer of the benefits of the entity’s performance can be readily identified); • the entity’s performance creates or enhances a customer-controlled asset (for example, a work-in-progress asset, such as a building being constructed that is under the control of the customer); • an asset with no alternative use to the entity is being created and the entity has a right to payment for performance completed to date. If it cannot be demonstrated that a performance obligation is satisfied over time—that is, it does not meet any of the above criteria—then an entity recognises revenue at the point of time when it satisfies the performance obligations by transferring control of the completed goods or services to the customer (if, for example, an entity is involved in the construction of an asset that has alternative uses and control of the asset is not held by the customer, then any related profits shall not be recognised until the completion of the project). In accounting for construction contracts, individual construction contracts (for example, different construction contract building sites) would be accounted for separately and the relevant accounting requirements would Contract relating to be applied separately to each contract. If a construction contract carries over across a number of the construction of an accounting periods then there will be a need to determine the appropriate revenue and costs to be asset or a combination allocated to each accounting period. Appropriate methods of measuring progress within each of assets that are accounting period include output methods and input methods. Paragraphs B15 to B19 of AASB 15 closely interrelated in terms of design, describe output and input measures of performance. AASB 15, paragraph 44 requires that an entity technology, function shall recognise revenue for a performance obligation satisfied over time—such as in the case of a or use. long-term construction contract—only if the entity can reasonably measure its progress towards complete satisfaction of the performance obligation. For a number of years within Australia, the now superseded accounting standard AASB 111 Construction Contracts required contractors, if certain criteria were satisfied, to use the percentagepercentage-ofof-completion method to account for their construction contracts. With the percentage-of-completion completion method method (also referred to as the stage-of-completion method), profit on a construction contract is (or stage-ofrecognised in proportion to the work performed in each reporting period in which construction completion method) occurs. This would reflect an ‘input measure’ of progress and would be acceptable under the new Where profits are accounting standard AASB 15. recognised each period based Under the percentage-of-completion method, which many organisations within the construction upon the progress industry use, construction costs plus gross profit earned to date are accumulated in an account that of construction. might be identified as ‘construction in progress’. Pursuant to AASB 15, this would be considered Represents an input to be a ‘contract asset’. When invoices are sent to the customer in accordance with the contract method for measuring then part of the contract asset (construction in progress) account would be transferred to accounts the progress towards completing a contract receivable (that is, one asset would be substituted for another). with a customer. The general requirement that the customer has control of the asset throughout the construction is also a requirement before any revenue can be recognised. If the conditions described above are not satisfied, no profit is to be brought to account until they are satisfied. At the extreme, this will mean no profit may be recognised until project completion. Where the outcome of a construction contract cannot be estimated reliably or where the stage of completion cannot be reliably assessed, costs incurred on the contract are to be recognised as expenses and revenue is to be recognised only to the extent that the costs incurred are recoverable. In order to recognise revenue over time for a construction contract, the firm must have some basis or standard for measuring the progress towards completion at particular interim dates (such as financial year ends). This is discussed in what follows. CHAPTER 15: REVENUE RECOGNITION ISSUES  567

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Measuring performance obligations satisfied over time AASB 15 requires than an entity shall measure progress towards satisfaction of a performance obligation that is satisfied over time by using a method that best depicts the transfer of goods or services to the customer. Methods for recognising revenue when control of the asset transfers over time include: • output measures that recognise revenue on the basis of direct measurement of the value to the customer of the entity’s performance to date (for example, by surveys of goods and services transferred to date, or by appraisals of results achieved); • input measures that recognise revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (for example, perhaps measured by the proportion that contract costs incurred for work performed to date bear to the estimated total contract costs). An entity is required to apply a single method of measuring progress for each performance obligation satisfied over time and that method shall be applied consistently to similar performance obligations and in similar circumstances. As already indicated, paragraphs B15 to B19 of AASB 15 describe output and input measures of performance. Other indicators, such as progress payments made by the customer, would often not reflect the extent of work performed on a contract and hence would not typically be used as a measure of performance. When using the cost basis (an input measure) for a construction contract, the extent of contract completion is measured by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract. Care must be taken in recognising when costs are incurred and which costs are attributable to a specific project. When the extent of contract completion is measured using the cost basis, adjustments have to be made to include only those costs that reflect work performed. When the stage of completion is determined by reference to the contract costs incurred to date, only those contract costs that reflect work performed are included in costs incurred to date. Examples of contract costs that would be excluded are: (a) contract costs that relate to future activity on the contract, such as costs of materials that have been delivered to a contract site or set aside for use in a contract but not yet installed, used or applied during contract performance, unless the materials have been made specially for the contract; and (b) payments made to subcontractors in advance of work performed under the subcontract. The costs incurred on construction contracts can be divided into: (i)  costs related directly to a specific contract such as direct materials, direct labour, depreciation of plant and equipment used on a contract, costs of moving plant and equipment to and from a site, expected warranty costs, costs of design and technical assistance that are directly related to the contract, costs of securing a contract, and costs of hiring plant and equipment used in the construction activity; (ii)  costs that are attributable to contract activity in general and are capable of being allocated on a reasonable basis to specific contracts such as tender preparation, insurance, design and technical assistance, and project overheads; (iii)  costs that relate to the activities of the reporting entity generally, or that relate to contract activity generally and are not normally related to specific contracts such as general administrative and selling costs, finance costs, research and development costs that are not directly related to the contract, and depreciation of idle plant and equipment that is not used in the contract concerned. Costs of the type described in (i) and (ii) above are normally included as part of accumulated contract costs, whereas costs of type (iii) are usually excluded from accumulated contract costs—and treated as costs of the period—because they do not relate to reaching the present stage of completion of a specific contract. Further, any costs that are considered to be ‘wasted’ would also be excluded from being recognised as part of the contract costs carried forward. Under the cost method, which is an example of an input measure of performance, the extent of completion of a contract is measured by comparing costs incurred to date—which satisfy the criteria for recognition—with the most recent estimate of the total costs to complete the contract as shown in the following formula: Costs incurred to the end of current period Percentage complete = _________________________________ ​​           Most recent estimate of total costs 568  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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​​For example, if it is considered that a contract will cost $10 million to complete (and we exclude costs of the type described in (iii) above) and if the costs incurred to date amount to $8.5 million, using the cost basis the contract would be considered 85 per cent complete. The percentage represented by ‘incurred costs’ of total estimated costs is applied to the total revenue or estimated total gross profit on the contract to arrive at the revenue and the gross profit amounts to be recognised to date. The amounts of revenue and gross profit recognised each year are computed using the following formula: Estimated total revenue or gross profit from the contract ___________________________________________ ​            Current period revenue or gross profit = _______________________________________________ multiplied by Percentage complete ​       ​​  less        Total revenue or gross profit recognised in prior periods  ​​In considering the revenue related to the construction contract, the revenue is to be measured at the fair value of the consideration received or receivable by the contractor. Where the revenue is paid in cash, the revenue will be measured at its face value. Where other goods or services are provided to the contractor in full or partial fulfilment of the contract price, fair values must be determined (as discussed earlier in this chapter).

Journal entries for construction contract accounting When performance obligations are satisfied over time within a long-term construction contract, the following journal entries are representative of those that would typically be employed. Dr

Construction in progress (also referred to as ‘contract Asset’)

Cr

Materials, cash, payables, accumulated depreciation etc.

XXX XXX

(to record cost of construction) Dr

Accounts receivable

Cr

Construction in progress (contract asset)

XXX XXX

(to record progress billings; accounts receivable replaces construction in progress) Dr

Cash

Cr

Accounts receivable

XXX XXX

(to record collections of billings) Dr

Construction in progress (contract asset)

XXX

Dr

Construction expenses

XXX

Cr

Revenue from long-term project

XXX

(to recognise contract revenue and contract expenses)

Because of the uncertainty inherent in estimating costs to complete a project, particularly during the early stages of the work on a contract, it is common practice for entities to carry the project at cost and recognise any profits on the contract only after the contract has reached a given level of completion. This is consistent with paragraph 45 of AASB 15, which states: in some circumstances (for example, in the early stages of a contract), an entity may not be able to reasonably measure the outcome of a performance obligation, but the entity expects to recover the costs incurred in satisfying the performance obligation. In those circumstances, the entity shall recognise revenue only to the extent of the costs incurred until such time that it can reasonably measure the outcome of the performance obligation. If progress billings (the amounts invoiced to customers and often referred to as ‘accounts receivable’) exceed the gross amount of construction work in progress (the contract asset), the net amount should be shown as a liability; otherwise it is disclosed as an asset. Worked Examples 15.7 and 15.8 describe the practical application of the method. We restrict our analysis to fixedprice contracts. CHAPTER 15: REVENUE RECOGNITION ISSUES  569

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WORKED EXAMPLE 15.7: Percentage-of-completion method MR Ltd commences construction of a wave-making machine on 1 July 2018 for Merewether Ltd. The construction contract is considered to represent one ‘performance obligation’ and will be the unit of account for contract accounting. It signs a fixed-price contract for total revenues of $20 million. The project is expected to be completed by the end of 2021. The expected total cost, as estimated at the commencement of construction, is $16 million. The expected costs to complete a construction project can change throughout the project (in this example, they do). The following data relates to the project:

Costs for the year Costs incurred to date Estimated costs to complete Progress billings during the year Cash collected during the year

2019 ($000)

2020 ($000)

2021 ($000)

4 000 4 000 12 000 4 500 3 500

8 000 12 000 5 000 8 500 7 500

5 500 17 500 – 7 000 9 000

MR Ltd uses cost (an input measure) as the basis for measuring progress towards satisfaction of the performance obligation. The asset under construction is deemed to be under the control of Merewether Ltd throughout the period of construction. Actual costs to complete the project deviate from expectations. REQUIRED (a) Compute the gross profit to be recognised for each of the three years. (b) Prepare the journal entries for 2019. (c) Prepare the statement of financial position presentation for 2019 and 2020. SOLUTION (a) Computing the gross profit

Contract price less Estimated cost: – Costs to date – Estimated costs to complete – Estimated total cost Estimated total gross profit Percentage complete (%)

2019 ($000)

2020 ($000)

2021 ($000)

20 000

20 000

20 000

4 000 12 000 16 000 4 000 25

12 000 5 000 17 000 3 000 70.6

17 500          – 17 500 2 500 100

Gross profit recognised in: 2019 $4 million × 25 per cent $1 000 2020 $3 million × 70.6 per cent $2 118 less Gross profit already recognised $1 000 Gross profit in 2020 $1 118 2021 $2.5 million × 100 per cent $2 500 less Gross profit already recognised $2 118 Gross profit in 2021    $382 The sum of the profits recognised in each year equals $2.5 million ($1 million + $1.118 million + $382 000), which is the total profit of the contract (i.e. $20 million less $17.5 million). (b) Journal entries for 2019 Dr Construction in progress (contract asset) Cr Materials, cash, payables, accumulated depreciation, etc. (to recognise the costs associated with the contract)

4 000 000 4 000 000

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Dr Construction in progress (contract asset) 1 000 000 Dr Construction expenses (in profit or loss) 4 000 000 Cr Revenue from long-term contract (in profit or loss) 5 000 000 (for the year, and based on using cost as the basis for measuring progress, 25% of the project has been completed. 25% of the total expected revenue of $20 000 000 is $5 000 000) Dr Accounts receivable 4 500 000 Cr Construction in progress (contract asset) 4 500 000 (amount payable unconditionally by the customer following the invoice sent to the customer for $4.5 million. Substitutes an account receivable in place of the contract asset as the entity has transferred control of the contract asset to the customer) Dr Cash Cr Accounts receivable (amount received from customer)

3 500 000 3 500 000

(c) Extract from the statement of financial position for 2019 and 2020

Current assets Accounts receivable Construction in progress (contract asset)

2019 ($000)

2020 ($000)

1 000 500

2 000 1 118

WORKED EXAMPLE 15.8: Construction contract where outcome cannot be reliably estimated Assume the same facts as in Worked Example 15.7, but this time MR Ltd cannot reliably estimate the outcome of the construction contract. REQUIRED (a) Compute the gross profit to be recognised for each of the three years. (b) Prepare the journal entries for 2019. (c) Prepare the statement of financial position presentation for 2019 and 2020. SOLUTION (a) Gross profit for the three years

Gross profit to be recognised

2019 ($000)

2020 ($000)

2021 ($000)





2 500

  If the level of progress or the outcome of the construction contract cannot be reliably estimated, profit should be deferred until such time as reliable estimates can be made. At the extreme, profit recognition may be deferred until project completion. Throughout the contract, contract costs would be recognised as an expense when incurred and revenue would be recognised to the extent of the costs incurred (on the assumption that all expenses will be recouped). (b) Journal entries for 2019 Dr Construction in progress (contract asset) 4 000 000 Cr Materials, cash, payables, accumulated depreciation etc. 4 000 000 (to recognise the costs associated with the contract) Dr Construction expenses 4 000 000 Cr Revenue from long-term contract 4 000 000 (because the progress on the performance obligation is not clear, revenue recognition is restricted to the amount of cost incurred) continued CHAPTER 15: REVENUE RECOGNITION ISSUES  571

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Dr Accounts receivable Cr Construction in progress (contract asset) (amount payable unconditionally by the customer)

4 500 000

Dr Cash Cr Accounts receivable (amount received from customer)

3 500 000

4 500 000

3 500 000

Dr Cr

Construction in progress (contract asset) 500 000 Contract liability—excess of the amount received, or receivable, from the customer over performance 500 000 completed (this is an adjustment to reclassify the balance of the contract asset to a contract liability given that the amount billed to the customer exceeds the cost of the work completed to date. Prior to this entry the contract asset had a credit balance of $500 000) (c) Extracts from the statement of financial position for 2019 and 2020

Current assets Accounts receivable Current liabilities Progress billings in excess of costs incurred on construction contracts (contract liability)

2019 ($000)

2020 ($000)

1 000

2 000

500

1 000

Accounting for loss-making construction contracts When current estimates of total contract costs and revenues for any contract indicate that a loss on the contract is probable, provision should be made immediately for the entire amount of the foreseeable loss on the contract, regardless of the amount of work already performed. The losses should be brought to account as soon as they are foreseeable. Where a contract becomes likely to generate more in costs than it does in revenue this is referred to as an ‘onerous performance obligation’. AASB 15 does not provide specific guidance in relation to such lossmaking contracts. Instead, they are addressed within AASB 137 Provisions, Contingent Assets and Contingent Liabilities, which requires a provision to be recognised for an ‘onerous contract’. An onerous contract is defined in AASB 137 as: a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The ‘unavoidable costs’ under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. In relation to an onerous contract, paragraph 66 of AASB 137 requires: If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision. Therefore, a performance obligation is considered onerous—and this does not just apply to construction contracts but to contracts with customers in general—if the lowest cost of settling the performance obligation exceeds the amount of the transaction price allocated to that performance obligation. An entity would recognise a liability and a corresponding expense if the performance obligation is considered to be ‘onerous’. An entity would present a liability for onerous performance obligations separately from contract assets or contract liabilities. The liability for an onerous performance obligation must be reassessed at each reporting date. 572  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Relating some of the above discussion to long-term construction contracts, where there is an expected loss on a contract—being where there is an expected excess of total contract costs over total contract revenue—an expense and related liability shall be recognised regardless of: • whether work has commenced on the project; • the stage of completion of the activity; or • the difference between total contract costs and total contract revenue expected to arise from other construction contracts. Worked Example 15.9 considers recognition of a loss using the percentage-of-completion method.

WORKED EXAMPLE 15.9: Percentage of completion with recognition of a loss Assume the same facts as in Worked example 15.7, except that, in this example, it becomes evident at the end of the 2020 financial period that the total costs to complete the project have risen to $21 million, which means that a net loss of $1 million will be incurred. The revised cost data is as follows:

Costs for the year (fixed, rather than ‘cost plus’) Costs incurred to date Estimated costs to complete Progress billings during the year Cash collected during the year

2019 ($000)

2020 ($000)

2021 ($000)

4 000

8 000

9 000

4 000 12 000 4 500 3 500

12 000 9 000 8 500 7 500

21 000 – 7 000 9 000

MR Ltd uses the cost method (an input measure) as the basis of measuring progress on performance obligations associated with construction contracts. REQUIRED (a) Compute the gross profit to be recognised for each of the three years. (b) Provide the journal entries for 2019 and 2020. SOLUTION (a) Gross profits for the three years

Contract price less Estimated cost: – Costs to date – Estimated costs to complete – Estimated total cost Estimated total gross profit/(loss) Percentage complete (%)

2019 ($000)

2020 ($000)

2021 ($000)

20 000

20 000

20 000

4 000 12 000 16 000 4 000 25

12 000    9 000 21 000   (1 000) 57.1

21 000  – 21 000  (1 000) 100

Gross profit recognised in: 2019 $4 million × 25 per cent 2020 Expected loss less Profit already recognised in 2019 Loss in 2020 2021 Expected loss less Profit/(Loss) already recognised in previous years Profit/(Loss) to be recognised in 2021

$1 000 ($1 000) ($1 000) ($2 000) ($1 000) ($1 000)        $nil continued CHAPTER 15: REVENUE RECOGNITION ISSUES  573

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The sum of the profits/(losses) recognised in each of the three years adds up to ($1 million), which is the total loss incurred on the project. From Worked Example 15.7 we know that as at the beginning of 2019 there were carried forward debit balances in Construction in progress (contract asset) of $500 000 and in Accounts receivable of $1 000 000. (b) Journal entries for 2019 and 2020 (i) Journal entries for 2019 are the same as the 2019 journal entries in Worked Example 15.7(b), as the cost revision did not occur until 2020. (ii) Journal entries for 2020 Dr

Construction in progress (contract asset)

Cr

Materials, cash, payables, accumulated depreciation etc.

8 000 000 8 000 000

(to recognise the cost of performing work on the contract) Dr

Accounts receivable

Cr

Construction in progress (contract asset)

8 500 000 8 500 000

(once the claim is made against the customer the contract asset becomes a receivable) Dr

Cash

Cr

Accounts receivable

7 500 000 7 500 000

(receipt of cash from customer) Dr

Construction expenses

Cr

Provision for loss on construction contract

1 000 000 1 000 000

(a liability on an ‘onerous contract’ is recognised because the cost of settling the performance obligation ($21m) is expected to exceed the amount of the transaction price allocated to that performance obligation ($20m)) Dr

Construction expenses

Cr

Construction in progress (contract asset)

1 000 000 1 000 000

(reversal of profit recognised in the previous year) Dr

Construction expenses

Cr

Revenue from long-term contract

6 000 000 6 000 000

(recognition of revenues for 2019 and recognition of expenses for the same amount)   Note that a total loss of $2 million (represented by the difference between the construction revenue of $6 million and the construction expense of $8 million (which across three sets of journal entries above is made up of $1 million plus $1 million plus $6 million) must be recognised in the year 2020, as the amount is made up of the total expected contract loss of $1 million plus the reversal of the profit of $1 million, which was previously recognised in 2019. If the costs incurred in 2021 are $9 million as expected, in 2021 revenue of $9 million will be shown (giving total revenue of $20 million across the three years), and construction expenses will also be shown as $9 million in 2021.   Following the above entries, at the end of 2020 the Construction in progress account will have a credit balance of $1 000 000. As such, the following entry might be made: Dr

Construction in progress (contract asset)

Cr

Contract liability

1 000 000 1 000 000

Summary of the steps to be taken when recognising revenue Having read the material in this chapter we can now summarise in Figure 15.2—consistent with AASB 15—the five general steps that shall be applied in order to comply with the standard. 574  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Step 1: Identify the contract(s) with a customer IFRS 15 defines a contract as an agreement between two or more parties that creates enforceable rights and obligations and sets out the criteria that must be met for every contract.

Figure 15.2 Steps to be taken when recognising revenue

Step 2: Identify the separate performance obligations in the contract A performance obligation is a promise in a contract with a customer to transfer a good or service to the customer.

Step 3: Determine the transaction price The transaction price is the amount of consideration (for example, payment) to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. Where a contract contains elements of variable consideration, the entity must estimate the amount of variable consideration to which it will be entitled under the contract.

Step 4: Allocate the transaction price to the separate performance obligations in the contract For a contract that has more than one performance obligation, an entity should allocate the transaction price to each performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying each performance obligation.

Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation Revenue is recognised as control of an asset that is passed to the customer, either over time, or at a point in time. Control of an asset is defined as the ability to direct the use of and obtain substantially all of the remaining benefits from the asset. This includes the ability to prevent others from directing the use of and obtaining the benefits from the asset. An entity recognises revenue over time if one of the following criteria is met: the customer simultaneously receives and consumes all of the benefits provided by the entity as the entity performs; the entity’s performance creates or enhances an asset that the customer controls as the asset is created; or, the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. If an entity does not satisfy a performance obligation over time, it satisfies it at a point in time.

SUMMARY The chapter considered the recognition of income and revenue—income being comprised of revenues and gains. In relation to the recognition of ‘income’—one of the five ‘elements of accounting’—reference is required to be made to the Conceptual Framework for Financial Reporting. The conceptual framework requires that for income (and the other elements of accounting) to be recognised, the associated inflow of economic benefits—or the associated reduction in liabilities—must be both probable and measurable with reasonable accuracy. In relation to revenue from contracts with customers, we have also learned in this chapter that a new accounting standard AASB 15 Revenue from Contracts with Customers was released in 2014 and one key criterion that is now emphasised when determining whether revenue shall be recognised in relation to contracts with customers is whether ‘control’ of the related good or service has been transferred to the customer. Sales transactions are often made with associated conditions, such as call and put options, or rights to return the assets. When such conditions exist, it is necessary to consider whether the conditions have implications for determining whether control of the good or service has been transferred to the customer. If the conditions indicate that control of the asset has not passed to the customer then revenue shall not be recognised. CHAPTER 15: REVENUE RECOGNITION ISSUES  575

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Determining whether income should be recognised will also depend on the system of accounting being used. That is, the amount that is recognised as income in any period will depend on the particular measurement model being adopted. For example, if historical-cost accounting is used, the increase in the value of marketable securities would not be considered income until such time as the securities are sold. However, if a system of accounting based on fair values is used, increased market prices of assets could be treated as part of the period’s income. The chapter also considered how to account for long-term construction contracts. Revenue relating to a construction contract can be recognised ‘over time’ if one of the following criteria is met: the customer simultaneously receives and consumes all of the benefits provided by the entity as the entity performs; the entity’s performance creates or enhances an asset that the customer controls as the asset is created; or, the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. If an entity does not satisfy a performance obligation over time, it satisfies it at a ‘point in time’. Where revenue is recognised over time, an entity shall use a measure of progress that depicts the transfer of goods or services to the customer in order to determine the amount of revenue to be recognised during the period. Methods used to depict performance may be either based on inputs, or based on outputs.

KEY TERMS accounts receivable  558 allowance for doubtful debts  557 bad debts  559 bad debts expense  559 call option  559 construction contract  567

contra asset  558 doubtful debts  557 exercise price  559 f.o.b. destination  557 f.o.b. shipping point  557 interest revenue  563

percentage-of-completion method  567 probable  551 put option  560 stage-of-completion method  567 unearned revenue  566

END-OF-CHAPTER EXERCISES Sun City Ltd commences construction of a multi-purpose water park on 1 July 2018 for Pretoria Ltd. Sun City Ltd signs a fixed-price contract for total revenues of $50 million. The project is expected to be completed by the end of 2021 and Pretoria Ltd controls the asset throughout the period of construction. The expected cost as at the commencement of construction is $38 million. The estimated costs of a construction project might change throughout the project—in this example, they do change. The following data relates to the project (the financial years end on 30 June):

Costs for the year Costs incurred to date Estimated costs to complete Progress billings during the year Cash collected during the year

2019 ($m)

2020 ($m)

2021 ($m)

10 10 28 12 11

18 28 12 20 19

12 40 – 18 20

REQUIRED (a) Using the above data, compute the gross profit to be recognised for each of the three years, assuming that the outcome of the contract can be reliably estimated. LO 15.10 (b) Prepare the journal entries for the 2019 financial year to recognise revenue across the time of the construction contract. LO 15.10 (c) Prepare the journal entries for the 2019 financial year, assuming that the measure of progress on the contract cannot be reliably assessed. LO 15.10 (d) Independently of the above three parts of this exercise, prepare the journal entries for the 2019 and 2020 financial years, assuming that the revised costing data, as shown below, indicates that, overall, the contract 576  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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will make a loss of $2 million. The revision is due to the fact that, during the year ending 30 June 2020, it becomes apparent that the creation of the water park has damaged the local ecosystem and the damage must be rectified immediately at Sun City Ltd’s expense. In providing your answer, please first prepare the journal entries assuming that progress on the contract can be reliably assessed—meaning that the journal entries in part (b) above would already have been made. Then please prepare the journal entries assuming that a measure of progress on the contract cannot be reliably assessed—meaning that the journal entries in part (c) above would already have been made in 2019. LO 15.10 2020 ($m) Costs for the year Total costs incurred to date Estimated costs to complete Progress billings during the year Cash collected during the year

18 28 24 20 19

SOLUTION TO END-OF-CHAPTER EXERCISE (a) Gross profits for the three years

Contract price less Estimated cost: – Costs to date – Estimated costs to complete – Estimated total cost Estimated total gross profit Percentage complete (%)

2019 ($m)

2020 ($m)

2021 ($m)

50

50

50

10 28 38 12 26.32

28 12 40 10 70.0

40     – 40 10 100

Gross profit recognised in: 2019 2020 $12 000 000 × 26.32 per cent $3 158 400 $10 000 000 × 70 per cent $7 000 000 less Gross profit already recognised $3 158 400 Gross profit in 2020 $3 841 600 2021 $10 000 000 × 100 per cent less Gross profit already recognised Gross profit in 2021 The sum of the profits recognised in each year equals $10 000 000 ($3 158 400 + $3 841 600 + $3 000 000), which is the total profit of the contract.

2021

2019 2020

$10 000 000 $7 000 000 $3 000 000

(b) Journal entries for 2019 so as to recognise revenue over time Dr Construction in progress (contract asset) Cr Materials, cash, payables, accumulated depreciation etc. (to recognise the costs associated with the contract)

10 000 000 10 000 000

Dr Dr

Construction in progress (contract asset) 3 158 400 Construction expenses (statement of profit or loss 10 000 000 and other comprehensive income) Cr Revenue from long-term contract (statement of 13 158 400 profit or loss and other comprehensive income) (for the year, and based on the measure of progress on the contract, 26.32% of the project has been completed. 26.32% of the total expected revenue of $50 000 000 is $13 158 400) CHAPTER 15: REVENUE RECOGNITION ISSUES  577

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Dr Accounts receivable 12 000 000 Cr Construction in progress (contract asset) 12 000 000 (amount payable unconditionally by the customer. Part of the contract asset is reclassified to an accounts receivable) Dr Cash Cr Accounts receivable (amount received from customer)

11 000 000 11 000 000

(c) The journal entries for the 2019 financial year, assuming that the extent of progress on the contract cannot be reliably determined Dr Construction in progress (contract asset) Cr Materials, cash, payables, accumulated depreciation etc. (to recognise the costs associated with the contract)

10 000 000 10 000 000

Dr Construction expenses 10 000 000 Cr Revenue from long-term contract 10 000 000 (because the extent of progress on the contract is not clear, revenue recognition is restricted to the amount of cost incurred) Dr Accounts receivable 12 000 000 Cr Construction in progress (Contract asset) 12 000 000 (amount payable unconditionally by the customer. Part of the contract asset is reclassified to an accounts receivable. This entry now means that the contract asset will have a credit balance of $2 million meaning that a subsequent entry will be required to create a contract liability) Dr Cash Cr Accounts receivable (amount received from customer)

11 000 000 11 000 000

Dr Cr

Construction in progress (contract asset) 2 000 000 Contract liability—excess of the amount received from the 2 000 000 customer over performance completed (this is an adjustment to reclassify the balance of the contract asset to a contract liability given that the amount billed to the customer exceeds the cost of the work completed to date) It should be noted that if the extent of progress on the contract cannot be reliably estimated, then in this example the amount invoiced to the customer will exceed the amount of the construction in progress (contract asset), thereby making it necessary for a net liability to be disclosed. (d) Journal entries using revised data which indicate that a loss is foreseeable. When current estimates of future total contract costs and revenues for any contract indicate that a loss is probable, provision should immediately be made for the foreseeable loss on the contract, regardless of the amount of work performed on the contract. That is, losses are to be brought to account as soon as they are foreseeable. Calculations and journal entries assuming that revenue was recognised in 2019 based on using cost as a basis for measuring progress on the contract used and that a cost revision was made in 2020 but no further revision was required in 2021.

Contract price less Estimated cost – Costs to date – Estimated costs to complete – Estimated total cost Estimated total gross profit/(loss) Per cent complete (%)

2019 ($m)

2020 ($m)

2021 ($m)

    50

    50

  50

10     28     38     12 26.32

28     24     52     (2) 53.85

52     –   52   (2) 100

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Gross profit recognised in:       2019

      2020

2019

$12 000 000 × 26.32 per cent

2020

Expected loss

($2 000 000)

less Profit already recognised

 $3 158 400

Loss in 2020

($5 158 400)

2021

      2021

$3 158 400

Expected loss

($2 000 000)

less Total profit/(loss) already recognised in 2019 plus 2020

($2 000 000)

Profit/(loss) in 2021

               $nil

The sum of the profits/(losses) recognised in each of the three years adds up to ($2 000 000), which is the total loss incurred on the project. Journal entries for 2019 The 2019 journal entries are the same as the 2019 journal entries shown in part (b) above, since at that stage it was not apparent that a loss would eventuate and at this point we are assuming that progress on the contract can be reliably measured. At the end of 2019 a contract asset of $1 158 400 was carried forward. Journal entries for 2020 Dr

Construction in progress (contract asset)

18 000 000

Cr

Materials, cash, payables, accumulated depreciation etc.

18 000 000

(to recognise the cost of performing work on the contract) Dr

Accounts receivable

Cr

Construction in progress (contract asset)

20 000 000 20 000 000

(once the claim is made against the customer the contract asset becomes a receivable) Dr

Cash

Cr

Accounts receivable

19 000 000 19 000 000

(receipt of cash from customer) Dr

Construction expenses

2 000 000

Cr

Provision for loss on construction contract (onerous liability)

2 000 000

(onerous liability recognised because the cost of settling the performance obligation ($52m) is expected to exceed the amount of the transaction price allocated to that performance obligation ($50m)) Dr

Construction expenses

Cr

Construction in progress (contract asset)

3 158 400 3 158 400

(reversal of profit recognised in the previous period) Dr

Construction expenses

Cr

Revenue from long-term contract

12 841 600 12 841 600

(recognition of revenues for 2019 and recognition of expenses for the same amount) Note that a total loss of $5 158 400 (represented by the difference between the construction revenue of $12 841 600 and the construction expense of $18 million (which is made up of $2 million plus $3 158 400 plus $12 841 600) must be recognised in the year 2020, as the amount is made up of the total expected contract loss of $2 million plus the reversal of the profit of $3 158 400, which was previously recognised in 2019. If the costs incurred in 2021 are $24 million as expected, in 2021 revenue of $24 million will be shown (giving total revenue of $50 million across the three years), and construction expenses will also be shown as $24 million (giving a total expense of $52 million). CHAPTER 15: REVENUE RECOGNITION ISSUES  579

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Given that there was an opening balance in ‘Construction in progress’ of $1 158 400 at the beginning of the year, then following the above entries, at the end of 2020 the Construction in progress account will have a credit balance of $4 000 000. As such, the following entry might be made: Dr Cr

Construction in progress (contract asset) Contract liability

4 000 000 4 000 000

Journal entries assuming that no profit was recognised in 2019 because stage of completion could not be determined reliably. Journal entries for 2019 The 2019 journal entries are the same as the 2019 journal entries shown in (c) above. Journal entries for 2020 Dr Construction in progress (contract asset) Cr Materials, cash, payables, accumulated depreciation etc. (to recognise the cost of performing work on the contract)

18 000 000 18 000 000

Dr Accounts receivable 20 000 000 Cr Construction in progress (contract asset) (once the claim is made against the customer the contract asset becomes a receivable)

20 000 000

Dr Cash Cr Accounts receivable (receipt of cash from customer)

19 000 000

19 000 000

Dr Construction expenses 2 000 000 Cr Provision for loss on construction contract (onerous liability) 2 000 000 (onerous liability recognised because the cost of settling the performance obligation ($52m) is expected to exceed the amount of the transaction price allocated to that performance obligation ($50m) Dr Cr

Construction expenses Construction revenue

16 000 000 16 000 000

Note that the entire loss must be recognised in the year in which it becomes apparent. Total revenue to be shown across the life of the contract will be $50 million ($10 million in 2019, $16 million in 2020 and $24 million in 2021). Total expenses to be recorded will be $52 million ($10 million in 2019, $18 million in 2020 and $24 million in 2021). Following the above entries, at the end of 2020 the Construction in progress (Contract asset) account will have a credit balance of $2 million. As such, the following entry might be made (and given there was already an opening balance in the liability account of $2 million this will mean there will be a total balance in the Contract liability account of $4 million at the end of 2020, which is the difference between costs incurred to date ($28 million) and total billings to date ($32 million): Dr Cr

Construction in progress (contract asset) Contract liability

2 000 000 2 000 000

REVIEW QUESTIONS 1. Would it be appropriate to recognise revenue at completion of production rather than at the point of sale? LO 15.1, 15.3 2. For several years the IASB and the FASB had been developing an accounting standard entitled Revenue from Contracts with Customers. An original Discussion Paper was released in 2008 but the ultimate accounting standard AASB 15 was not released until 2014. What might be some reasons for the lengthy time period associated with the development of this accounting standard? LO 15.4 3. Coombes and Martin (1982) argue that ‘accountants would be indifferent to the point chosen for revenue recognition if there were a constant and repetitive process of purchasing and selling goods or services at set prices’. Explain this argument. LO 15.3 580  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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4. What is the difference between a bad debt and a doubtful debt? LO 15.8 5. Consider the statement that ‘the measurement model adopted, and its underlying concepts of capital and capital maintenance, are relevant to the timing of the recognition of revenues’. Explain what this means. LO 15.5 6. If a sale is made ‘f.o.b. destination’, when should the associated revenue be recognised? LO 15.3 7. If an organisation received non-cash consideration from a customer in return for providing a good or service then how would the entity determine how much to assign to sales revenue? LO 15.4 8. When organisations sell various goods to customers there is often some uncertainty about the ultimate collectability of the transaction price. Should sales revenue be reduced to take into account the probability that a certain percentage of the sales revenue will never be collected? LO 15.8 9. If the promised amount of consideration on a contract is variable, how shall an entity estimate the total amount to which the entity will be entitled in exchange for transferring the promised goods or services to a customer? LO 15.1 10. When amounts to be received from customers are to be discounted (for example, the amount is to be received for a sale of goods or services will be received beyond 12 months), what discount rate to be applied? LO 15.8 11. Eddie Ltd sells to Mass Marketer Ltd an item of machinery that manufactures identical surfboards. Included in the sale was a put option that gives Mass Marketer Ltd the right to require Eddie Ltd to buy back the machine for a specified price on a specified date. When should Eddie Ltd recognise the sale? LO 15.6 12. If an entity recognises the revenue associated with a contract with a customer over time (rather than at a point in time), would this approach be considered more conservative than an approach that defers profit recognition until the completion of the contract (that is, at a future point in time)? LO 15.10 13. If an organisation receives a large donation from a particular benefactor, would this donation represent income to the organisation? Explain your answer. LO 15.1 14. In accounting for a long-term construction contract, if the billings on a construction in progress exceed the costs assigned to the construction in progress (contract asset), then how should this be disclosed in the statement of financial position? LO 15.10 15. If an entity is performing its responsibilities under a contract to a customer in a manner where the performance obligations are being satisfied ‘over time’ (rather than at a ‘point in time’), then what are the alternative approaches to measuring the level of progress that depicts the transfer of goods and services to the customer? LO 15.10 16. Noosa Ltd owns a pie shop on Hastings Street. The carrying amount of the shop in the accounts of Noosa Ltd is $1.2 million. Because it needs some funds it has decided to sell the shop to Leaseco Ltd. Leaseco Ltd buys the shop for $1.5 million and then immediately leases the shop back to Noosa Ltd for the rest of the economic life of the building. How much profit should Noosa Ltd show in its financial statements in the year of the sale? LO 15.1, 15.6 17. In the presence of the following contractual arrangements, would you expect a firm to prefer to recognise revenue over time (that is, throughout the term of a contract) or to defer profit recognition until the completion of the contract (that is, at a future point in time)? (a) A management compensation scheme tied to reported profits. LO 15.5, 15.10 (b) A debt covenant that is approaching the point of being in technical default. LO 15.5, 15.10 18. A firm believes that it is subject to scrutiny by particular interest groups because it is earning excessive profits. Do you think that this might influence whether the firm prefers to recognise revenue over time for its construction contracts, or whether it would prefer to defer profit recognition until the completion of the project? LO 15.3, 15.10 19. Big Construction Company signs a contract on 1 July 2019, agreeing to build a warehouse for Buyer Corporation Ltd at a fixed contract price of $10 million. Buyer Ltd will be in control of the asset throughout the construction process. Big Construction Company estimates that construction costs will be as follows: 2019 2020 2021

$2.5 million $4 million $1.5 million

The contract provides that Buyer Corporation Ltd will make payments on 31 December each year as follows: 2019 2020 2021

$2 million $5 million $3 million CHAPTER 15: REVENUE RECOGNITION ISSUES  581

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The contract is completed and accepted on 31 December 2021. Assume that actual costs and cash collections coincide with expectations and that cost (an input measure) is used as the basis for assessing progress on the construction contract. Big Construction Company has a financial year ending 31 December.

REQUIRED Provide the journal entries for 2019, 2020 and 2021, assuming that: (a) the level of progress on the contract can be reliably estimated LO 15.10 (b) the level of progress on the contract cannot be reliably estimated. LO 15.10 20. Assume the same facts as in Review Question 19, except that in 2020 it becomes apparent that costs to complete the contract will be $5.5 million in 2020 and $3 million in 2021.

REQUIRED Provide the journal entries for 2019, 2020 and 2021. LO 15.10 21. XYZ signs a contract on 30 June 2019, agreeing to build a bridge for ABC at a contract price of $40 million. ABC will be in control of the asset throughout the construction process. XYZ estimates that construction costs will be as follows: Year ending 30 June 2020 30 June 2021 30 June 2022

Cost $10 000 000 $16 000 000   $6 000 000 $32 000 000

The contract provides that ABC will make payments on 30 June of each year as follows: 2020 2021 2022

$8 000 000 $20 000 000 $12 000 000 $40 000 000

The contract is completed as expected on 30 June 2022. Assume that actual costs and cash collections coincide with expectations and that cost (an input measure) is used as the basis for assessing progress on the construction contract.

REQUIRED (a) Calculate the income recognised each year. LO 15.10 (b) Provide the journal entries for each year, assuming extent of completion on the construction contract cannot be reliably estimated. LO 15.10 (c) Provide the journal entries for each year, assuming that the extent of completion on the construction contract can be reliably estimated. LO 15.10

CHALLENGING QUESTIONS 22. Assume the same facts as in Review Question 21, except that XYZ now estimates at the beginning of the 2021 financial year that construction costs will be as follows: Year ending 30 June 2020 30 June 2021 30 June 2022

Cost $10 000 000 $21 000 000 $15 000 000 $46 000 000

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REQUIRED Provide the journal entries for each year, assuming that cost (an input measure) is used as the basis for assessing progress on the construction contract. LO 15.10 23. On 1 July 2019, Bronzed Aussie Ltd sells a caravan to Cairns Ltd. The caravan has a normal sales price of $19 019. Rather than selling the item for its normal sales price, Bronzed Aussie Ltd sells the caravan for four annual payments of $6000 per year, the first payment to be made on 30 June 2020. The difference between the gross receipts and the current sales price represents interest revenue to be earned by Bronzed Aussie Ltd over the period of the agreement.

REQUIRED (a) Determine what rate of interest is implicit in the agreement. LO 15.1, 15.3, 15.8 (b) Provide the journal entries for Bronzed Aussie Ltd for the years ending 30 June 2020 and 2021, using both the net-interest method and the gross method. LO 15.8 24. When IFRS 15/AASB 15 Revenue from Contracts with Customers was released, the accounting firm BDO issued a short document entitled IFRS Industry Issues: Construction and Real Estate. In the document they stated: The adoption of IFRS 15 may lead to significant changes in the pattern of revenue and profit recognition. Careful consideration and planning will be needed for a range of issues, including the effect on: • Compliance with bank covenants; • Performance based compensation. Explain the possible reasoning behind the above advice. LO 15.1 25. An entity sells 3000 products for $50 each. Sales are made for cash, rather than on credit terms. The entity’s customary business practice is to allow a customer to return any unused product within 30 days and receive a full refund. The cost of each product is $20. To determine the transaction price, the entity decides that the approach that is most predictive of the amount of consideration to which the entity will be entitled is the most likely amount. Using the most likely amount, the entity estimates that 50 products will be returned. The entity’s experience is predictive of the amount of consideration to which the entity will be entitled. The entity estimates that the costs of recovering the products will be immaterial and expects that the returned products can be resold at a profit.

REQUIRED Provide the accounting entries to record the sale, and the subsequent return of the assets, assuming that the returns occur in accordance with expectations. LO 15.6, 15.8 26. In an article by Michaela Boland that appeared in The Australian on 19 March 2015 entitled ‘Careful collector leaves nation an $8m legacy’ it was stated that: HE was a career public servant, a volunteer at the National Gallery of Australia in Canberra and by the time Alan Boxer died last June aged 86, he’d amassed an art collection of 900 works valued at more than $10 million. Yesterday the first two tranches of that collection went to new homes. A group of 19 artworks valued at $8m was gifted to the NGA, one of the most significant acts of generosity in the gallery’s history. The most important artwork in the gift is Rabbit tea party, the first painting from Charles Blackman’s famous Alice series to join the national collection .  .  . Boxer was a bachelor who had once been engaged but never married. He had no children and slept in a single bed. He read widely, listened to classical music and filled his house with artworks. ‘He was obsessive about the work and deeply in love with his collection,’ Mr Pithie [co-executor of Boxer’s will] said. ‘It’s an extremely generous gift from a humble man to a great institution.’

REQUIRED: Determine whether the gallery should treat the donation as income. Further, if the donation is treated as income, how would that income be measured? LO 15.1, 15.4, 15.5

CHAPTER 15: REVENUE RECOGNITION ISSUES  583

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REFERENCES COOMBES, R.J. & MARTIN, C., 1982, The Definition and Recognition of Revenue under Historical Cost Accounting, Accounting Theory Monograph 3, Australian Accounting Research Foundation, Melbourne. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2008, Discussion Paper: Preliminary Views on Revenue Recognition in Contracts with Customers, International Accounting Standards Board, London, December. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2011, Exposure Draft ED/2011/6 A revision of ED/2010/6 Revenue from Contracts with Customers, International Accounting Standards Board, London, November.

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CHAPTER 16

THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME, AND THE STATEMENT OF CHANGES IN EQUITY LEARNING OBJECTIVES (LO) 16.1 Understand how profit is calculated and how the profit of an organisation should be disclosed in the financial statements of a reporting entity. 16.2 Appreciate that the determination of the profits for a given period is heavily dependent upon both professional judgement and on the particular accounting measurement model that has been adopted. 16.3 Understand what ‘other comprehensive income’ comprises and how it shall be disclosed within a statement of profit or loss and other comprehensive income. 16.4 Understand that a reporting entity is required to produce both a statement of profit or loss and other comprehensive income, and a statement of changes in equity, and appreciate that both of these statements need to be read in order to appreciate more fully the financial performance of a reporting entity. 16.5 Understand how we account for changes in accounting estimates. 16.6 Understand what a ‘non-recurring item’ is and how it should be disclosed. 16.7 Understand what constitutes a ‘prior period error’. 16.8 Understand how to account for prior period errors. 16.9 Understand what constitutes a ‘change in accounting policy’. 16.10 Understand how to disclose information about changes in accounting policies. 16.11 Appreciate that while ‘profit or loss’ does provide an indication of the financial performance of an organisation, it does not reveal much about other aspects of performance, such as the social and environmental performance of a reporting entity. 16.12 Be aware of possible future changes in how we shall present information about profit or loss and other comprehensive income. Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  585

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income Defined by the AASB conceptual framework as ‘increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants’.

Introduction to the statement of profit or loss and other comprehensive income A definition of income was provided in Chapter 2. As we learned, income is defined in the Conceptual Framework for Financial Reporting as: increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. As we also know, income is further broken down into revenues and gains. The general principle is that revenues typically relate to the ordinary activities of the entity. As the conceptual framework states: The definition of income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent. Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. Gains represent increases in economic benefits and as such are no different in nature from revenue. Hence, they are not regarded as constituting a separate element in this Conceptual Framework.

revenues A class of income relating typically to the ordinary activities of an entity.

gains A class of income representing other items that meet the definition of income but need not relate to the ordinary activities of an entity.

expenses Defined in the AASB conceptual framework as ‘decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants’.

While we will not further pursue the matter in this chapter, it should be appreciated (as discussed in Chapter 2) that the IASB is currently looking to release a revised Conceptual Framework for Financial Reporting. To this end, an Exposure Draft was released in May 2015. The Exposure Draft of a Conceptual Framework for Financial Reporting has proposed various changes to the definitions and recognition criteria of the elements of accounting. It has also suggested removing the requirement to subdivide income into revenues and gains. Hence, please appreciate that as with many aspects of financial reporting, changes in the definitions of the elements of accounting can be expected to occur in the future. Returning to the existing conceptual framework, to determine the profit or loss of an entity, we need a definition of expenses, as profit is derived by subtracting expenses from income. Expenses are defined in the conceptual framework as: decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Expenses are not further subdivided into subcomponents in the manner in which income is broken into revenues and gains. Consistent with the recognition criteria that apply to the other elements of financial statements, the recognition of an expense or an item of income currently relies upon an assessment of the measurability of the item, and the probability that the item will cause flows of economic benefits to, or from, the entity. More specifically, the conceptual framework states:

An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. Hence the profit or loss for a period is tied to a determination of how future economic benefits are enhanced or diminished throughout the period. Income represents an inflow of future economic benefits (not including capital contributions), while expenses are consumptions or losses of future economic benefits (not including those that relate to distributions to owners). As indicated in Chapter 15, the determination of income and revenues will be influenced by which measurement model is adopted. Different measurement models are based on historical cost, current cost, fair

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value, present values and other alternatives. The different models will generate different income and expenses and, in turn, different profits. In recent years there has been a general trend for accounting standard-setters to issue accounting standards that measure assets and liabilities at ‘fair value’. Nevertheless, other valuation approaches (for example, historical cost, net realisable value and present value) are required for particular classes of assets and liabilities (as stipulated by particular accounting standards), with the result that we have a ‘mixed approach’ to measuring financial performance and financial position. There can be considerable disagreement about how the expense associated with a particular options item or event should be measured. For example, some years ago there was much debate about how Entitles the holder to share options provided to managers should be valued for accounting purposes. Senior managers buy assets at a future or executives are often provided with options to buy shares in the entity that employs them, but they time at a prespecified are often not permitted to exercise the options for a number of years. These options are treated as price. part of the executives’ total remuneration, and as the executives cannot exercise the options for a number of years, the options act as a means of encouraging the executives to stay within the organisation (often, the right to exercise the options is lost if an executive leaves the firm before a pre-specified period). A particular accounting issue is identifying the expenses associated with providing the manager or executive with options. That is, how should the options be measured in order to determine the related expenses? Often options are issued with an ‘exercise price’ (the amount that must be paid to acquire the shares in question, also referred to as a ‘strike price’) that is greater than the current share price. For example, a senior manager might be given an option to buy shares in the company at a future point in time for a price of $1.20 per share, when the shares are currently trading on the securities exchange for only $1.10. Clearly, the manager would not exercise the option under these conditions, but the argument is that the manager will have an incentive to work hard to increase the value of the company’s shares over the time (life) of the options and, therefore, the value of the options they hold. The options are said to have a ‘time value’. In determining the related expense to the organisation, some companies had, in the past, simply looked at the difference between the exercise price and the current share price. This difference is considered to represent the ‘intrinsic value’ of the option. If this difference was negative at the time of issue, traditionally the options were considered to be ‘out of the money’, and no expense was recognised when the options were issued. Conversely, if the difference was positive (there is intrinsic value), the options were considered to be ‘in the money’, and the difference was recognised by some companies as an expense. However, some other companies considered issues associated with the ‘time value’ of the option and used various models to determine the cost of options (such as the Black-Scholes model) so that a cost could be assigned to options even when they are ‘out of the money’. The point is that, in the absence of any specific rules pertaining to a particular type of expense, different entities will have different measurement approaches and will record different expenses and this will have obvious implications for profits. The ability to compare the financial performance of different entities will be eroded where different approaches are taken to account for particular items, such as options. The release of AASB 2 Share-Based Payment (initially released in July 2004) reduced the discretion that companies were able to exercise in relation to placing a cost on share options provided to employees. We will discuss AASB 2 in detail in Chapter 17; however, in general terms, AASB 2 requires that the fair value of options be calculated, and this value will then be deemed to be the cost of the options (again, this requirement for options is consistent with accounting standard-setters’ moves towards using fair value to measure various items). However, when it comes to share options granted to employees, in many cases market prices are not available because the options granted are subject to terms and conditions that do not apply to traded options. AASB 2 requires that if traded options with similar terms and conditions do not exist, the fair value of the options granted are to be estimated by applying an option pricing model. However, AASB 2 does not mandate the use of a particular model and hence the choice of model to use will impact on the price attached to the options. Further, as paragraph B6 of AASB 2 states, a number of factors need to be taken into account—many of which will rely upon professional judgement. The factors to consider would include: • the exercise price of the option • the life of the option • the current price of the underlying shares • the expected volatility of the share price • the dividends expected on the shares (if appropriate) • the risk-free interest rate for the life of the option. Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  587

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Where professional judgement is necessary to determine a particular expense, such as the cost to be assigned to share options, an entity should note within its financial statements the assumptions made and the basis for the assumptions. This is a general principle that should be followed. Indeed, in relation to our example of share-based payments, paragraph 46 of AASB 2 states: An entity shall disclose information that enables users of the financial statements to understand how the fair value of the goods or services received, or the fair value of the equity instruments granted, during the period was determined. While we have looked briefly at determining the expense associated with options, we should appreciate that this is only one of the contentious aspects of how the expenses associated with particular transactions and events should be determined, and that the various judgements made will directly affect the profits or losses reported by an entity. The conceptual framework does not include profit (or loss) as one of its elements of accounting. As noted above, profit is simply the difference between income and expenses, both of which are defined, and hence there is no need for recognition criteria for profits. Without income and/or expenses, there is no profit or loss. In relation to expenses, the judgement about whether or not to recognise assets will have a direct assets impact upon reported profits. The recognition criteria for assets provided in the conceptual framework Resources controlled are the same as those required for other elements of accounting and require that it be probable that by the entity as a result the future economic benefits embodied in the asset will eventuate and that the benefits can be of past events and from measured reliably. At times, it might not be clear whether or not it is probable that future economic which future economic benefits sufficient to absorb the cost of the asset will be derived from an item of expenditure, and thus benefits are expected whether the item of expenditure should be recognised as an expense or as an asset. If there is doubt to flow to the entity. that sufficient future benefits will be derived, the expenditure will be expensed. The degree of probability attached to deriving benefits, and hence the recognition of an expense, will be a matter of expensed professional judgement. As we know, accounting is not an exact science and so different teams of Something is expensed accountants would be unlikely to calculate the same profit or loss for an entity, even if they were given if it is written off. the same details about all the transactions and events that the entity has entered into, or encountered. Potentially, one team of accountants might report a high level of profits, while another team reports losses. This difference will be driven by differences in the assumptions made, and it is very possible true and fair that the alternative sets of results generated by the different teams might both be considered to be Disclosures are regarded as giving true and fair by the auditors of the reporting entity. For example, a judgement must be made about a true and fair view such things as how many periods should be used to fully depreciate an item of plant and equipment, if they provide all or whether there has been an impairment loss on a particular asset (which in turn requires judgements relevant information to be made about the ‘recoverable amount’ of an asset). and comply with It is obviously important for significant assumptions made by accountants to be clearly described applicable standards. in the notes to the financial statements. This is consistent with the requirements of paragraph 125 of AASB 101, which states: An entity shall disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. In respect of those assets and liabilities, the notes shall include details of: (a) their nature; and (b) their carrying amount as at the end of the reporting period. While professional judgement is needed in respect of various forms of expenses, the accounting standard-setters have removed all discretion in relation to some expenses by requiring all expenditure on particular items to be expensed. For example, as we learned in Chapter 8, all expenditure on research is to be written off as incurred (development expenditure can be deferred to subsequent periods subject to certain conditions). Specifically, paragraph 54 of AASB 138 Intangible Assets stipulates 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.

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The problem with such a ‘blanket rule’ that requires all expenditure of a particular type to be written off as incurred is that it does not enable readers of financial statements to differentiate between entities that have generated future economic benefits from particular activities and entities that have not. For example, in relation to research expenditure, an entity that has spent $10 million on a project that looks like ultimately generating significant economic benefits will be required to treat these expenditures as an expense in the same way as an entity that has spent $10 million researching an idea that turned out to be a ‘flop’. Both entities will show an expense of $10 million and neither entity will show an asset pertaining to ‘research’. As noted in Chapter 3, a firm might have numerous agreements in place that rely upon reported profit, for example dividend constraints, management bonus agreements and interest-coverage clauses incorporated within agreements negotiated between debtholders and managers. Hence the timing of the recognition of income or expenses might also be an important factor to managers of a reporting entity. Different stakeholder groups, such as government, the media, consumers, shareholders, consumer groups and employee groups, might also rely upon reported profits to justify their calls for a firm to take particular actions. For example, if profits are high, an employee group might call for an increase in wage rates, or an environmental group might call for the establishment of a recycling plant on the basis of the organisation’s apparent ‘ability to pay’. The profitability of an organisation can also be an important factor in attracting additional investment funds into the organisation. While a great deal of the discussion above refers to ‘profits’, it should be noted that certain gains and certain expenses will not be taken into consideration in calculating a reporting entity’s ‘profits’ or ‘losses’. While this might seem odd, there are a number of accounting standards that specifically stipulate that certain expenses or losses (such as those relating to the correction of prior period accounting errors) and certain gains (such as those relating to asset revaluations) are not to be included in the ‘profit or loss’ for the reporting period. Hence, we must be careful when referring to the ‘profits’ of an entity—it does not include all expenses and income recognised within the financial period. As we will see within this chapter, a more comprehensive measure of financial performance is provided by a measure known as ‘comprehensive income’. As we will also learn in this chapter, ‘comprehensive income’—which is a relatively recently developed concept—includes both ‘profits or losses’ and ‘other items of comprehensive income’. We will define what we mean by ‘other items of comprehensive income’ later in this chapter.

Profit or loss disclosure As already discussed, the profit or loss of an entity is calculated by subtracting the expenses of the entity from its income. Within a financial report, the profit of an entity is disclosed in the statement of profit or loss and other comprehensive income. Until recent times, and by contrast, profit was disclosed in an ‘income statement’. AASB 101, paragraph 88, requires entities to recognise all items of income and expense that arise in a period in profit or loss unless a particular accounting standard requires or permits otherwise. Specifically, paragraph 88 states:

LO 16.1 LO 16.2 LO 16.3 LO 16.5 LO 16.6

An entity shall recognise all items of income and expense in a period in profit or loss unless an Australian Accounting Standard requires or permits otherwise. Two specific exceptions to the requirement that all items of income and expense shall be recognised in profit or loss will be considered in this chapter. These are the correction of prior period errors, and the effect of changes in accounting policies. It should be noted that other accounting standards may also require or permit components of other gains or losses that meet the conceptual framework’s definition of income or expense to be excluded from the calculation of profit or loss. Nevertheless, they would be reflected in a measure of financial performance now referred to as ‘comprehensive income’. As the name would suggest, comprehensive income, which is comprised of profit or loss plus other gains and losses that are recorded directly in various equity accounts and which are referred to as being components of ‘other comprehensive income’, is presented in a ‘statement of profit or loss and other comprehensive income’. The format for disclosing an entity’s statement of profit or loss and other comprehensive income is prescribed within AASB 101 Presentation of Financial Statements. Amendments to AASB 101 in 2007 introduced the statement of profit or loss and other comprehensive income (or, as it was formerly called, the statement of comprehensive income), which in general now replaces the income statement (or statement of financial performance). However, reporting entities do have a choice when presenting information about their financial performance. Entities can either present a statement of profit or loss and other comprehensive income that provides information about the entity’s profit or loss plus ‘other items

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of comprehensive income’, or they can separately provide both an income statement plus a statement of comprehensive income. As paragraph 10A of AASB 101 states: An entity may present a single statement of profit or loss and other comprehensive income, with profit or loss and other comprehensive income presented in two sections. The sections shall be presented together, with the profit or loss section presented first followed directly by the other comprehensive income section. An entity may present the profit or loss section in a separate statement of profit or loss. If so, the separate statement of profit or loss shall immediately precede the statement presenting comprehensive income, which shall begin with profit or loss.

Disclosure of profits or losses and disclosure of changes in equity As we know, the profits or losses, as well as the ‘other comprehensive income’ generated by an entity, will have a direct impact on the equity of an organisation (with a consequential impact on assets and/or liabilities). As a result of the requirements of some accounting standards, some items of expense and revenue are not included within profit or loss, but rather are adjusted directly against equity (perhaps by way of an increase or decrease in retained earnings). For example, as explained later in this chapter, when an error from a prior period is discovered (perhaps the assets recorded last year failed to take account of stock thefts that occurred within that period), the error is to be corrected retrospectively, as required by AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors. This would require a reduction in assets and a reduction in retained earnings to recognise the inventory theft. Although this is an expense that is recognised, it is a case of an expense being recognised directly in equity (retained earnings is an equity account). A number of other accounting standards also require certain income and expense items to be recorded directly in particular equity accounts rather than including them in a period’s profit or loss. These items form part of what is now referred to as ‘other comprehensive income for the year’. Paragraph 7 of AASB 101 defines ‘other comprehensive income’ as follows: Other comprehensive income comprises items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other Australian Accounting Standards. According to AASB 101, paragraph 7, components of ‘other comprehensive income’ would include: (a) changes in revaluation surplus (see AASB 116 Property, Plant and Equipment and AASB 138 Intangible Assets); (b) remeasurements of defined benefit plans (see AASB 119 Employee Benefits); (c) gains and losses arising from translating the financial statements of a foreign operation (see AASB 121The Effects of Changes in Foreign Exchange Rates); (d) gains and losses from investments in equity instruments designated at fair value through other comprehensive income in accordance with paragraph 5.7.5 of AASB 9 Financial Instruments; (da) gains and losses on financial assets measured at fair value through other comprehensive income in accordance with paragraph 4.1.2A of AASB 9. (e) the effective portion of gains and losses on hedging instruments in a cash flow hedge and the gains and losses on hedging instruments that hedge investments in equity instruments measured at fair value through other comprehensive income in accordance with paragraph 5.7.5 of AASB 9 (see Chapter 6 of AASB 9); (f) for particular liabilities designated as at fair value through profit or loss, the amount of the change in fair value that is attributable to changes in the liability’s credit risk (see paragraph 5.7.7 of AASB 9); (g) changes in the value of the time value of options when separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the changes in the intrinsic value (see Chapter 6 of AASB 9); and (h) changes in the value of the forward elements of forward contracts when separating the forward element and spot element of a forward contract and designating as the hedging instrument only the changes in the spot element, and changes in the value of the foreign currency basis spread of a financial instrument when excluding it from the designation of that financial instrument as the hedging instrument (see Chapter 6 of AASB 9).

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Hence if we were to look only at ‘profit or loss’ recorded in the statement of profit or loss and other comprehensive income (or in a separate income statement) we would not get a full picture of all the expenses and income that were recognised in the current period. A joint consideration of the period’s profit or loss, plus a consideration of items impacting ‘other comprehensive income’ (see definition above), allows us to more fully appreciate all of the income and expenses of a financial period.

Statement of profit or loss and other comprehensive income AASB 101 deals with the format that the statement of profit or loss and other comprehensive income should take, as well as identifying those items that are to be disclosed separately in the statement of profit or loss and other comprehensive income, or in the accompanying notes. Specifically, AASB 101, paragraph 82 requires particular disclosures in relation to transactions or events that affect profit or loss while paragraph 82A requires specific disclosures about items or events that affect ‘other comprehensive income’. In relation to information to be presented in the profit or loss section, paragraph 82 of AASB 101 states: In addition to items required by other Australian Accounting Standards, the profit or loss section or the statement of profit or loss shall include line items that present the following amounts for the period: (a) revenue, presenting separately interest revenue calculated using the effective interest method; (aa) gains and losses arising from the derecognition of financial assets measured at amortised cost; (b) finance costs; (ba) impairment losses (including reversals of impairment losses or impairment gains) determined in accordance with Section 5.5 of AASB 9; (c) share of the profit or loss of associates and joint ventures accounted for using the equity method; (ca) if a financial asset is reclassified out of the amortised cost measurement category so that it is measured at fair value through profit or loss, any gain or loss arising from a difference between the previous amortised cost of the financial asset and its fair value at the reclassification date (as defined in AASB 9); (cb) if a financial asset is reclassified out of the fair value through other comprehensive income measurement category so that it is measured at fair value through profit or loss, any cumulative gain or loss previously recognised in other comprehensive income that is reclassified to profit or loss; (d) tax expense; (e) [deleted] (ea) a single amount for the total of discontinued operations (see AASB 5). In relation to information to be presented in the ‘other comprehensive income’ section, paragraph 82A of AASB 101 requires: The other comprehensive income section shall present line items for the amounts for the period of: (a) items of other comprehensive income (excluding amounts in paragraph (b)), classified by nature and grouped into those that, in accordance with other Australian Accounting Standards: (i) will not be reclassified subsequently to profit or loss; and (ii) will be reclassified subsequently to profit or loss when specific conditions are met. (b) the share of the other comprehensive income of associates and joint ventures accounted for using the equity method, separated into the share of items that, in accordance with other Australian Accounting Standards: (i) will not be reclassified subsequently to profit or loss; and (ii) will be reclassified subsequently to profit or loss when specific conditions are met. As we can see, the requirement above refers to items that will be reclassified to profit or loss, and those that will not. We will explain what this means in more depth later in this chapter. In addition to the above disclosure requirements, paragraph 81B requires the profit or loss and the total comprehensive income for the period as disclosed on the face of the statement of profit or loss and other comprehensive income to be disaggregated between the non-controlling interests and the owners of the parent. We will consider issues to do with controlling and non-controlling interests in the chapters of this book that address issues associated with accounting for groups of companies. These chapters (Chapters 25–28) will specifically address how to perform consolidation Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  591

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accounting and how to calculate and present information about controlling and non-controlling ownership interests. However, at this stage we note that AASB 101, paragraph 81B, states that an entity shall: present the following items, in addition to the profit or loss and other comprehensive income sections, as allocation of profit or loss and other comprehensive income for the period: (a) profit or loss for the period attributable to: (i) non-controlling interests, and (ii) owners of the parent. (b) comprehensive income for the period attributable to: (i) non-controlling interests, and (ii) owners of the parent. If an entity presents profit or loss in a separate statement it shall present (a) in that statement. The disclosure on the face of the statement of profit or loss and other comprehensive income of additional line items and subtotals is also encouraged if this information is relevant to an understanding of an entity’s financial performance (see AASB 101, paragraph 85). Regarding the presentation format for the statement of profit or loss and other comprehensive income, AASB 101 permits alternative presentation formats to be used, based either upon the: • nature of expenses being incurred, or • their function within the entity. This requirement is stipulated by paragraph 99, which states: An entity shall present an analysis of expenses in profit or loss using a classification based on either the nature of expenses or their function within the entity, whichever provides information that is reliable and more relevant. In explaining the alternative presentation formats, AASB 101, paragraphs 102 and 103, state: 102. The first form of analysis is the ‘nature of expense’ method. An entity aggregates expenses within profit or loss according to their nature (for example, depreciation, purchases of materials, transport costs, employee benefits and advertising costs), and does not reallocate them among various functions within the entity. This method may be simple to apply because no allocations of expenses to functional classifications are necessary. An example of a classification using the nature of expense method is as follows: Revenue Other income Changes in inventories of finished goods and work in progress Raw materials and consumables used Employee benefits expense Depreciation and amortisation expense Other expenses Total expenses Profit

X X X X X X X (X) X

103. The second form of analysis is the ‘function of expense’ or ‘cost of sales’ method and classifies expenses according to their function as part of cost of sales or, for example, the costs of distribution or administrative activities. At a minimum, an entity discloses its cost of sales under this method separately from other expenses. This method can provide more relevant information to users than the classification of expenses by nature, but allocating costs to functions may require arbitrary allocations and involve considerable judgment. An example of a classification using the function of expense method is as follows: Revenue Cost of sales Gross profit Other income Distribution costs

X (X) X X (X)

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Administrative expenses Other expenses Profit

(X) (X) X

Again, it should be emphasised that entities have a choice between the two presentation formats described above. In deciding which format to use, AASB 101, paragraph 105, requires management to select the most relevant and reliable presentation format. Decisions about relevance and reliability obviously rely to a large extent upon professional judgement. For information to be relevant it must be able to influence the economic decisions of users. This is achieved by assisting them to evaluate past, present or future events, and confirm or correct past evaluations. Reliable information, on the other hand, must be free from material error and bias. Users must be able to depend on it to represent faithfully that which it either purports to represent, or could reasonably be expected to represent. Illustrations of statements of profit or loss and other comprehensive income presented for an entity using both a ‘classification of expense by nature’ and a ‘classification of expenses by function’ are provided in a document entitled Guidance on Implementing IAS 1 Presentation of Financial Statements. This guidance document provides useful presentation formats, which we will reproduce in this chapter. A single statement of profit or loss and other comprehensive income (classified by function) is reproduced in Exhibit 16.1, while the two-statement format (a separate income statement, together with a statement of comprehensive income with expenses classified by nature) is reproduced in Exhibit 16.2. When reviewing the two formats, try to note the differences. At this stage it should be noted that individual items of comprehensive income can be disclosed either on an aggregated basis (Exhibit 16.1), or on a net-of-tax basis (Exhibit 16.2). Again, whichever format is chosen, it should be chosen on the basis of which format is considered by management to be more relevant or reliable. As a general rule, it would be expected that a service provider would disclose its expenses by nature rather than function, whereas a manufacturer would more likely disclose its expenses by function. Looking at the two formats just set out, one (expenses by function, Exhibit 16.1) separately identifies the cost of sales whereas the other (expenses by nature, Exhibit 16.2) does not. Arguably, in some industries cost of sales data could be quite sensitive. While this might not be a problem for organisations producing a variety of products, it could well prove to be a controversial disclosure requirement for single-product entities, especially in the manufacturing sector, given the potentially competitive nature of the information involved (Parker & Porter 2000, p. 67). This might cause some entities to select a presentation format for reasons other than relevance and reliability. Opportunistic selection of accounting options could result if the choice between particular accounting methods or presentation formats is left to professional judgement. However, this could be limited by ensuring compliance with the detailed disclosure requirements of other accounting standards. As indicated earlier, AASB 101 permits entities to present all items of income and expense recognised in a period either in a single statement of profit or loss and other comprehensive income, or in two statements. In the single-statement presentation, all items of income and expense are presented together. Where the two-statement option is chosen, the first statement (the income statement) presents income and expenses recognised in profit or loss. The second statement (the statement of comprehensive income) begins with the profit or loss (from the income statement) and then presents, in addition, the individual components of ‘other comprehensive income’ (items of income and expense) that accounting standards require or permit to be recognised outside of profit or loss. It is important to remember that the statement of profit or loss and other comprehensive income does not include transactions with owners in their capacity as owners (for example, payment of dividends to shareholders or further capital injections by owners in the form of share purchases). These transactions are presented in the statement of changes in equity, which is discussed later in the chapter.

‘Other comprehensive income’ for the year As we have indicated above, and as shown in Exhibit 16.1, ‘other comprehensive income’ is added to ‘profit for the year’ to give ‘total comprehensive income for the year’. AASB 101, paragraph 90, requires entities to disclose the amount of income tax relating to each component of ‘other comprehensive income’, either in the statement of profit or loss and other comprehensive income, or in the notes to the financial statements. Entities are permitted to present the components of other comprehensive income either before tax effects (gross presentation) or after their related tax effects (net presentation). This is confirmed by AASB 101, paragraph 91, which states: An entity may present components of other comprehensive income either: (a) net of related tax effects; or (b) before related tax effects with one amount shown for the aggregate amount of income tax relating to those items. Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  593

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Exhibit 16.1 Single statement of profit or loss and other comprehensive income illustrating the classification of expenses by function

XYZ LTD Statement of profit or loss and other comprehensive income for the year ended 31 December 2019

Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Share of profits of associates Profit before tax Income tax expense Profit for the year from continuing operations Loss for the year from discontinued operations Profit for the year Other comprehensive income: Items that will not be reclassified to profit or loss: Gains on property revaluation Investments in equity instruments Remeasurements of defined benefit pension plans Share of other comprehensive income of associates Income tax relating to items that will not be reclassified Items that may be reclassified subsequently to profit or loss: Exchange differences on translating foreign operations Cash flow hedges Income tax relating to items that may be reclassified Other comprehensive income for the year, net of tax Total comprehensive income for the year Profit attributable to: Owners of the parent Non-controlling interests Total comprehensive income attributable to: Owners of the parent Non-controlling interests

2019 ($000)

2018 ($000)

390 000 (245 000) 145 000 20 667   (9 000) (20 000) (2 100) (8 000)    35 100 161 667   (40 417) 121 250              –  121 250

355 000 (230 000) 125 000 11 300 (8 700) (21 000) (1 200) (7 500)     30 100 128 000    (32 000) 96 000    (30 500)    65 500

933 (24 000) (667) 400     5 834 (17 500)

3 367 26 667 1 333 (700)     (7 667) 23 000

5 334 (667) (1 167)     3 500    (14 000)  107 250

10 667 (4 000)   (1 667)     5 000    28 000   93 500

97 000    24 250 121 250

52 400    13 100 65 500

85 800     21 450  107 250

74 800   18 700 93 500

 46 cents

30 cents

Earnings per share Basic and diluted

SOURCE: IAS 1 2014 Guidance on Implementing IAS 1 Presentation of Financial Statements.

As indicated in Exhibit 16.1, the statement of profit or loss and other comprehensive income provides a total of all income and expenses recognised directly in equity (referred to as ‘other comprehensive income’), which is added to profit for the period to give a total referred to as ‘total comprehensive income’ for the year. At the present time, existing accounting standards do not require all assets and liabilities to be adjusted to fair value. This means that reported measures of financial performance are somewhat incomplete (that is, they are not truly comprehensive). Hence we 594 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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XYZ LTD Income statement for the year ended 31 December 2019

Revenue Other income Changes in inventories of finished goods and work in progress Work performed by the entity and capitalised Raw material and consumables used Employee benefits expense Depreciation and amortisation expense Impairment of property, plant and equipment Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the year from continuing operations Loss for the year from discontinued operations Profit for the year Profit attributable to: Owners of the parent Non-controlling interests Earnings per share Basic and diluted

2019 ($000) 390 000 20 667 (115 100) 16 000 (96 000) (45 000) (19 000) (4 000) (6 000) (15 000)  35 100 161 667  (40 417) 121 250          –  121 250

2018 ($000) 355 000 11 300 (107 900) 15 000 (92 000) (43 000) (17 000) – (5 500) (18 000)   30 100 128 000  (32 000) 96 000  (30 500)  65 500

97 000  24 250 121 250

52 400    13 100   65 500

46 cents

30 cents

2019 ($000) 121 250

2018 ($000) 65 500

933 (24 000) (667) 400  5 834  (17 500)

3 367 26 667 1 333 (700)  (7 667)  23 000

5 334 (667)  (1 167)  3 500  (14 000)

10 667 (4 000)  (1 667)  5 000  28 000

Exhibit 16.2 Twostatement format with expenses classified by nature

XYZ LTD Statement of comprehensive income for the year ended 31 March 2019

Profit for the year Other comprehensive income: Items that will not be reclassified to profit or loss: Gains on property revaluation Investments in equity instruments Remeasurement of defined benefit pension plans Share of other comprehensive income of associates Income tax relating to items that will not be reclassified Items that may be reclassified subsequently to profit or loss: Exchange differences on translating foreign operations Cash flow hedge Income tax relating to items that will not be reclassified Other comprehensive income for the year

continued Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  595

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Total comprehensive income for the year Total comprehensive income attributable to: Owners of the parent Non-controlling interest

107 250

 93 500

85 800  21 450 107 250

74 800  18 700  93 500

SOURCE: IAS 1 2014 Guidance on Implementing IAS 1 Presentation of Financial Statements.

may argue that the statement of profit or loss and other comprehensive income’s title, and the figure shown for ‘total comprehensive income for the period’, could potentially be misleading. It should be noted that an alternative presentation of the various components of comprehensive income could be net of tax. When the various components of comprehensive income are shown net of tax, the income tax relating to each component of other comprehensive income must be disclosed in the notes accompanying the financial statements.

Reclassification adjustments Individual accounting standards specify whether and when amounts previously recognised in ‘other comprehensive income’ are subsequently reclassified to’ profit or loss’. AASB 101 requires an entity to disclose reclassification adjustments relating to components of other comprehensive income in the period that the adjustments are reclassified to profit or loss. AASB 101, paragraph 7, defines a reclassification adjustment as ‘amounts reclassified to profit or loss in the current period that were recognised in other comprehensive income in the current or previous periods’ (in the past this process was commonly described as ‘recycling’). The purpose is to provide users with information to assess the effect of such reclassifications on profit or loss. Examples of situations giving rise to reclassification adjustments include the disposal of a foreign operation, derecognition of a debt instrument that was measured at fair value through other comprehensive income in accordance with AASB 9, and gains on hedging instruments associated with cash flow hedges that were initially recognised within a cash flow hedge reserve. For example, consider a debt instrument—such as a government bond—that is held within a business model whose objective is to both collect contractual cash flows and to sell financial assets. For such assets, and as explained in Chapter 14, the reporting entity has the option, pursuant to AASB 9, to measure the bonds at fair value through other comprehensive income, meaning that any gains or losses initially go to a reserve within equity. On disposal of the bonds, any remaining balance of gains or losses residing in reserves is then to be transferred out of the reserves and into profit or loss. The unrealised gains that have previously been recognised in equity (such as the gains or losses on the government bonds that were measured at fair value through other comprehensive income) must be deducted from other comprehensive income in the period in which the realised gains are reclassified to profit or loss. This will avoid double-counting items in total comprehensive income when those items are reclassified to profit or loss. Without this information, users of the financial statements may find it difficult to assess the effect of reclassifications on profit or loss, or to calculate the overall gain or loss associated with such items as government bonds, hedging instruments associated with cash flow hedges, and on translation or disposal of foreign operations (all of which will have gains and losses initially taken to equity rather than to profit or loss). AASB 101, paragraph 92, requires entities to disclose reclassification adjustments relating to components of other comprehensive income. A review of Exhibit 16.1 shows that within ‘other comprehensive income’ we should be able to see which items may subsequently be reclassified into profit or loss (reclassifications) and those items that will not be reclassified. An illustration of a reclassification adjustment relating financial assets measured at fair value through other comprehensive income is detailed in Worked Example 16.1.

WORKED EXAMPLE 16.1: Reclassification adjustment On 31 December 2018, XYZ Ltd purchased 10 000 government bonds at $12.40 per bond. On acquisition, XYZ Ltd classified this investment as ‘measured at fair value through other comprehensive income’. This means that pursuant to AASB 9, gains or losses will be recognised directly in equity until the item is derecognised (sold), at which point the accumulated gain or loss will be transferred to profit or loss. At 31 December 2019, the fair

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value of the financial assets had increased to $18.60. At 31 December 2020, the fair value of the financial assets had increased to $21.70. All of the instruments were sold on 31 December 2020. The applicable tax rate is 30 per cent. REQUIRED Prepare an extract of the statement of profit or loss and other comprehensive income, and statement of changes in equity, for the reporting period ending 31 December 2020 in which the reclassification adjustment for the government bonds is detailed. SOLUTION Calculation of gains on government bonds

Gains recognised in other comprehensive income: Year ended 31 December 2019 Year ended 31 December 2020 Total gain

Before tax ($)

Income tax ($)

Net of tax ($)

62 000 31 000 93 000

(18 600) (9 300) (27 900)

43 400 21 700 65 100

The amounts will be disclosed in the statement of profit or loss and other comprehensive income, and the statement of changes in equity, for the reporting period ending 31 December 2020 as follows (and only numbers relating to the government bonds are presented): XYZ Ltd Statement of profit or loss and other comprehensive income for the year ended 31 December 2020 Profit or loss: Gain on sale of financial assets (government bonds) Income tax expense Net gain recognised in profit or loss Other comprehensive income: Gain on government bonds, net of tax Reclassification adjustment, net of tax Net gain (loss) recognised in other comprehensive income Total comprehensive income for the year

XYZ Ltd Statement of changes in equity for the year ending 31 December 2020 Balance at 31 December 2018 Changes in equity for 2019 Total comprehensive income for the year Balance at 31 December 2019 Changes in equity for 2020 Total comprehensive income for the year Reclassification adjustment for gain included in profit or loss

2020 ($)

2019 ($)

93 000 (27  900) 65 100

–       –       –

21 700 (65 100) (43 400) 21 700

43 400         – 43 400 43 400

Share capital ($) 500 000

Financial assets measured at fair value through OCI ($) –

Retained earnings ($) –

Total ($) 500 000

            – 500 000

  43 400 43 400

         – –

  43 400 543 400

            –             –

 21 700 (65 100)

65 100          –

  86 800  (65 100)

500 000

            –

65 100

565 100 continued

Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  597

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Alternatively, components of other comprehensive income may be shown in the statement of profit or loss and other comprehensive income gross of tax with a separate line item for tax effects: XYZ Ltd Statement of profit or loss and other comprehensive income for the year ended 31 December 2020 Profit or loss: Gain on sale of instruments Income tax expense Net gain recognised in profit or loss Other comprehensive income: Gain on financial assets measured at fair value through OCI Reclassification adjustment Income tax relating to other comprehensive income Net gain (loss) recognised in other comprehensive income Total comprehensive income for the year

2020 ($)

2019 ($)

93 000 (27  900)  65 100

–         –           –

31 000 (93 000)  18 600 (43  400)  21  700

62 000 – (18 600) 43 400 43 400

Extraordinary items A significant change introduced in Australia from 2005 in terms of income and expense disclosure was the prohibition on the disclosure of extraordinary items. Specifically, paragraph 87 of AASB 101 now states: An entity shall not present any items of income and expense as extraordinary items, in the statements presenting profit or loss and other comprehensive income, or in the notes. By contrast, superseded Accounting Standard AASB 1018 required the separate disclosure of extraordinary items. Extraordinary items were defined in AASB 1018 as ‘items of revenue and expense that are attributable to transactions or other events of a type that are outside the ordinary activities of the entity and are not of a recurring nature’. An item had to be both outside the ordinary operations of the business and of a non-recurring nature before it was to be classified and disclosed as an extraordinary item. The argument previously accepted within Australia was that if an item was extraordinary (and therefore of an unusual nature and not expected to recur) it should perhaps be separately identified for financial statement users who were trying to assess the future profitability of the business. Hence if a financial statement reader wanted to consider the current and future profitability of a business, it was considered that it would be usual for the user to focus on the profits from ordinary activities after tax, which excluded extraordinary items. By their very nature, extraordinary items were not expected to recur, and hence any consideration of future profitability, or the performance of management, required their exclusion. This perspective, however, is not adopted by AASB 101 and it is open to question whether prohibiting the separate disclosure of extraordinary items, as is now required, will improve Australian financial reporting. What do you, the reader, think? While AASB 101 prohibits the disclosure of extraordinary items, the following requirement at paragraph 97 could be used to alert financial report readers to ‘unusual’ items. Paragraph 97 states: When items of income and expense are material, an entity shall disclose their nature and amount separately. This disclosure requirement relies upon professional judgement about the materiality of an item. If something is deemed to be material—and therefore likely to influence decisions—then it should be separately disclosed. ‘Materiality’ is used in accordance with the discussion provided within AASB 101. Within paragraph 7 of AASB 101 it is stated that: Material omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. Assessing whether an omission or misstatement could influence economic decisions of users, and so be material, requires consideration of the characteristics of those users. The Framework for the Preparation and Presentation of Financial Statements states in paragraph 25 that ‘users are assumed to have a reasonable 598 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence.’ Therefore, the assessment needs to take into account how users with such attributes could reasonably be expected to be influenced in making economic decisions. A review of the 2015 Annual Reports of BHP Billiton Ltd reveals that it uses the terminology ‘exceptional items’, and it notes that ‘Exceptional items are those items where their nature and amount is considered material to the financial statements’. This is consistent with the requirements discussed above. Exhibit 16.3 reproduces information from BHP Billiton Ltd’s 2015 annual report in respect of the exceptional items that arose in 2015. BHP BILLITON LTD ANNUAL REPORT 2015 Note 2: Exceptional Items

Exceptional items are those items where their nature and amount is considered material to the financial statements. Such items included within the Group’s profit for the year from Continuing operations are detailed below. Exceptional items attributable to Discontinued operations are detailed in note 29 ‘Discontinued operations’.

Year ended 30 June 2015 Exceptional items by category Impairment of Onshore US assets Impairment of Nickel West assets Repeal of Minerals Resource Rent Tax legislation (a)

Gross US$m

Tax US$m

Net US$m

(2,787) (409) – (3,196)

829 119 (698) 250

(1,958) (290) (698) (2,946)

Exhibit 16.3: Example of disclosure of material items of income and expense

(a) Includes amounts attributable to non-controlling interests of US$(12) million. Impairment of Onshore US assets

The Group recognised an impairment charge of US$1,958 million (after tax benefit) in relation to its Onshore US assets. The gas focused Hawkville field accounts for the substantial majority of this charge, reflecting its geological complexity, product mix, acreage relinquishments and amended development plans. The remainder relates to the impairment of goodwill associated with the Petrohawk acquisition. Impairment of Nickel West assets

On 12 November 2014, the Group announced that the review of its Nickel West business was complete and the preferred option, the sale of the business, was not achieved on an acceptable basis. As a result of operational decisions made subsequent to the conclusion of this process, an impairment charge of US$290 million (after tax benefit) was recognised in the year ended 30 June 2015. Repeal of Minerals Resource Rent Tax legislation

The legislation to repeal the Minerals Resource Rent Tax (MRRT) in Australia took effect on 30 September 2014. As a result, the Group derecognised an MRRT deferred tax asset of US$809 million and corresponding taxation charges of US$698 million related to Continuing operations, and US$111 million related to Discontinued operations were recognised in the year ended 30 June 2015. SOURCE: BHP Billiton Annual Report 2015

Non-recurring items In relation to the separate disclosure of particular items of income and expenses, in addition to relying upon judgements about the ‘materiality’ of particular income and expense items, AASB 101 also specifically identifies items that would typically warrant separate disclosure. Paragraph 98 of AASB 101 provides guidance about when separate disclosure of particular income or expense items would be warranted. It states: Circumstances that would give rise to the separate disclosure of items of income and expense include: (a) write-downs of inventories to net realisable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs; Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  599

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(b) restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring; (c) disposals of items of property, plant and equipment; (d) disposals of investments; (e) discontinued operations; (f) litigation settlements; and (g) other reversals of provisions. The conceptual framework also discusses the need to separately disclose particular items. The conceptual framework states: Income and expenses may be presented in the income statement in different ways so as to provide information that is relevant for economic decision-making. For example, it is common practice to distinguish between those items of income and expenses that arise in the course of the ordinary activities of the entity and those that do not. This distinction is made on the basis that the source of an item is relevant in evaluating the ability of the entity to generate cash and cash equivalents in the future, for example, incidental activities such as the disposal of a long-term investment are unlikely to recur on a regular basis. When distinguishing between items in this way consideration needs to be given to the nature of the entity and its operations. Items that arise from the ordinary activities of one entity may be unusual in respect of another.

Changes in accounting estimates Accounting and, in particular, the preparation of financial statements at the end of the reporting period, relies heavily upon the use of estimates. This is due primarily to the fact that certain information is not available as at the end of the reporting period, and future developments and events cannot be predicted with certainty. As paragraph 33 of AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors states: The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. Many estimates must be made in the accounting process in relation to such things as bad debts, inventory obsolescence and useful lives of assets. As paragraph 32 of AASB 108 states: As a result of the uncertainties inherent in business activities, many items in financial statements cannot be measured with precision but can only be estimated. Estimation involves judgments based on the latest available, reliable information. For example, estimates may be required of: (a) bad debts; (b) inventory obsolescence; (c) the fair value of financial assets or financial liabilities; (d) the useful lives of, or expected pattern of consumption of the future economic benefits embodied in, depreciable assets; and (e) warranty obligations. As the estimation process involves the exercise of professional judgement, it stands to reason that these estimates will require revision as further events occur, more expertise is acquired or additional information is obtained. As new information becomes available, changes in various accounting estimates will be required. AASB 108, paragraph 5, defines a change in accounting estimate as: an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors. The above paragraph makes the point that a change in accounting estimate is not a correction of an error. As we will see shortly, and reflective of this, how we account for a change in an accounting estimate is different from how we account for the correction of a prior period error. One issue we can consider in relation to the use of estimates is whether the use of estimates in the preparation of financial statements undermines the ability of the financial statements to faithfully represent the underlying transactions 600 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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and events (faithful representation being one of the qualitative characteristic of general purpose financial statements). The conceptual framework considers financial information to provide a faithful representation when that financial information represents the substance of an economic phenomenon rather than merely representing its legal form. In other words, information faithfully represents particular transactions and events when it corresponds with actual transactions and events is capable of independent verification and is free from bias. The fact that estimates have been used in the preparation of financial statements does not in itself undermine the ability of the financial statements to represent faithfully the underlying transactions and events. As indicated at paragraphs 33 and 34 of AASB 108, the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. Changes in accounting estimates include, but are not limited to: • changes in the allowance for doubtful debts • changes in expected warranty costs on goods sold under guarantee • changes in the fair value of financial assets and financial liabilities • changes in the expected pattern of consumption of economic benefits of depreciable assets • changes in the provision for inventory obsolescence. As the estimation process involves judgement based on the latest available information, adjustment is necessary when the circumstances on which the original estimate was based have altered, additional experience has been obtained, or there have been subsequent developments. A change in accounting estimate can affect the current accounting period, or both the current and future accounting periods. Examples of changes in accounting estimates that affect only current accounting periods include bad debts, warranty provisions and inventory obsolescence. The appropriate accounting treatment under these circumstances is to recognise the change immediately. Examples of changes in accounting estimates that affect both the current and future accounting periods include changes in the expected useful life of an asset and changes in the method used for calculating depreciation (for example, from the straight-line to the sum-of-digits method). Under these circumstances, the appropriate treatment is to recognise the effect of the change in both the current and future periods. Since a change in estimate arises from new information or developments, does not relate to prior periods and is not the correction of an error, it is not given retrospective effect by restating prior period profit or loss. The reason for this is that the change in estimate is the result of a decision made in the current period and, as a result, should be reflected in the net profit (loss) for the current period. How a change in accounting estimate shall be accounted for is detailed in paragraphs 36 and 37 of AASB 108. These paragraphs state: 36. The effect of a change in an accounting estimate, other than a change to which paragraph 37 applies, shall be recognised prospectively by including it in profit or loss in: (a) the period of the change, if the change affects that period only; or (b) the period of the change and future periods, if the change affects both. 37. To the extent that a change in an accounting estimate gives rise to changes in assets and liabilities, or relates to an item of equity, it shall be recognised by adjusting the carrying amount of the related asset, liability or equity item in the period of the change. In relation to the disclosures required for changes in accounting estimates, paragraphs 39 and 40 of AASB 108 state: 39. An entity shall disclose the nature and amount of a change in an accounting estimate that has an effect in the current period or is expected to have an effect in future periods, except for the disclosure of the effect on future periods when it is impracticable to estimate that effect. 40. If the amount of the effect in future periods is not disclosed because estimating it is impracticable, an entity shall disclose that fact. Worked Example 16.2 details how a change in accounting estimate can be accounted for and disclosed in the notes accompanying the statement of profit or loss and other comprehensive income.

WORKED EXAMPLE 16.2: Change in accounting estimate (changing the useful life of an asset) On 30 June 2019, the end of the current reporting period, Beachley Ltd made a decision, using the information obtained over the past few years, to revise the useful life of a particular item of manufacturing equipment acquired five continued Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  601

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years earlier on 1 July 2014 for $300 000. The useful life was revised from twelve years to eight years. The item of manufacturing equipment was originally depreciated on the straight-line basis over its useful life and it was expected that the asset would have no residual value. No depreciation expense has been recognised within the current period. REQUIRED (a) Prepare the journal entry to account for the change in accounting estimate. (b) Assuming that the change in accounting estimate had a material effect on financial performance for the period, prepare the appropriate supporting note. SOLUTION (a) Journal entry at 30 June 2019 At the beginning of the current reporting period the carrying amount of the asset was $200 000. Based on the revised useful life of the asset, the remaining useful life is four years from the beginning of the financial period and not eight years. The carrying amount of $200 000 is to be depreciated over a four-year period so that the remaining depreciation is charged over the remaining useful life of the asset. Dr Cr

Depreciation Accumulated depreciation—manufacturing equipment

50 000

50 000

(b) Supporting note—change in accounting estimate

Profit before tax has been arrived at after taking into account: Depreciation Original Change in accounting estimate

2019 ($)

2018 ($)

25 000 25 000 50 000

25 000        – 25 000

As a result of a revision during the year of the estimated useful life of the manufacturing equipment from twelve to eight years, the depreciation charge will increase by $25 000 for the remaining three years.

Other disclosure issues Although we have covered a number of the disclosures required by AASB 101 and AASB 108, there are a number of other requirements pertaining to the disclosure of income and expenses. Some of these are identified below. In relation to dividends, paragraph 107 of AASB 101 requires: An entity shall disclose, either in the statement of changes in equity, or in the notes, the amount of dividends recognised as distributions to owners during the period, and the related amount of dividends per share. As already noted, many other accounting standards also require the disclosure of information about various items of income and expense. For example, AASB 138 Intangible Assets requires the disclosure of various items of expenses as they relate to intangible assets, including: • impairment losses recognised in profit or loss during the period • impairment losses reversed in profit or loss during the period • any amortisation recognised during the period • the aggregate amount of research and development expenditure recognised as an expense during the period. In relation to inventories, AASB 102 Inventories requires the disclosure of: • the amount of inventories recognised as an expense in the period (relating to inventories that are sold) • the amount of any write-down of inventories recognised as an expense in the period • the amount of any reversals of any write-downs. In relation to revenue, AASB 15 Revenue from Contracts with Customers also requires a number of disclosures in relation to an entity’s financial performance. Paragraph 110 of AASB 15 provides an overview of the required disclosures in relation to revenue from contracts with customers: The objective of the disclosure requirements is for an entity to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising 602 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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from contracts with customers. To achieve that objective, an entity shall disclose qualitative and quantitative information about all of the following: (a) its contracts with customers (see paragraphs 113–122); (b) the significant judgements, and changes in the judgements, made in applying this Standard to those contracts (see paragraphs 123–126); and (c) any assets recognised from the costs to obtain or fulfil a contract with a customer in accordance with paragraph 91 or 95 (see paragraphs 127–128). We have mentioned only a limited subset of accounting standards in this discussion. However, the discussion has served to emphasise that there are many disclosure requirements pertaining to income and expenses and that these disclosure requirements can be found throughout various accounting standards.

Statement of changes in equity

LO 16.4

In addition to having to present a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of cash flows, and supporting notes to the financial statements, an entity is also required to produce a statement of changes in equity. As we have seen, a number of accounting standards require certain adjustments to be made directly to equity, rather than directly to profit or loss. The statement of changes in equity will highlight these adjustments. The role of the statement of changes in equity is to provide a reconciliation of opening and closing equity, and also to provide details of the various equity accounts that are impacted by the period’s total comprehensive income. It also provides information about the effects of transactions with owners in their capacity as owners. In relation to what is to be presented in the statement of changes in equity, paragraph 106 of AASB 101 now requires: An entity shall present a statement of changes in equity showing in the statement: (a) total comprehensive income for the period, showing separately the total amounts attributable to owners of the parent and to non-controlling interest; (b) for each component of equity, the effects of retrospective application or retrospective restatement recognised in accordance with AASB 108; (c) [deleted]; and (d) for each component of equity, a reconciliation between the carrying amount at the beginning and the end of the period, separately (as a minimum) disclosing changes resulting from: (i) profit or loss; (ii) other comprehensive income; and (iii) transactions with owners in their capacity as owners, showing separately contributions by and distributions to owners and changes in ownership interests in subsidiaries that do not result in a loss of control. In relation to dividends, paragraph 107 of AASB 101 states: An entity shall present, either in the statement of changes in equity or in the notes, the amount of dividends recognised as distributions to owners during the period, and the related amount of dividends per share. Changes in an entity’s equity between the beginning and the end of the reporting period reflect the increase or decrease in its net assets during the period. As shown in Exhibit 16.4, a statement of changes in equity reconciles opening and closing equity, which, as we know, represents the difference between assets and liabilities, and which will comprise multiple accounts, including share capital, retained earnings, revaluation surplus, foreign currency translation reserve, cash flow hedge reserve, general reserve and so on. In addition, within the statement of changes in equity, the distribution to and contributions from owners, individual components of total comprehensive income, and noncontrolling interests are separately disclosed. The statement of changes in equity also provides details of any amounts that were transferred from revaluation surplus to retained earnings when the asset was derecognised. As with other financial statements, comparative information is provided for both the current and preceding financial years. Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  603

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Exhibit 16.4: Statement of changes in equity

XYZ LTD Statement of changes in equity for the year ended 31 December 2019

Translation Share Retained of foreign Capital earnings operations ($000) ($000) ($000) Balance at 1 January 2018 Changes in    accounting    policy Restated    balance Changes in equity    for 2018 Dividends Total    comprehensive    Income for the    year Balance at

   31 December    2018 Changes in    equity for 2019 Issue of share    capital Dividends Total    comprehensive    income for    the year Transfer to

Financial assets at fair value Cash through flow Revaluation OCI hedges surplus ($000) ($000) ($000)

Noncontrolling Total interest ($000) ($000)

Total equity ($000)

600 000 118 100

(4 000)

1 600

2 000

– 717 700

29 800 747 500

            –         400

         –

            –

         –

        –        400

     100         500

600 000 118 500

(4 000)

1 600

2 000

– 718 100

29 900 748 000

(10 000)







– (10 000)

            –     53 200

6 400

 16 000  (2 400)

1 600

 74 800

 18 700   93 500

600 000 161 700

2 400

17 600

(400)

1 600 782 900

48 600 831 500





(10 000)

50 000











50 000



50 000



(15 000)







– (15 000)



(15 000)



96 600

3 200

(14 400)

(400)

800

85 800



200







(200)



650 000  243 500

5 600

21 450 107 250

   retained    earnings Balance at

   31 December    2019

   3 200     (800)

2 200 903 700





70 050 973 750

SOURCE: IAS 1 2014 Guidance on Implementing IAS 1 Presentation of Financial Statements.

LO 16.7 LO 16.8

Prior period errors

Superseded Accounting Standard AASB 1018 provided guidance on accounting for prior period errors. Consistent with accepted practice over many years, it was made explicit within the former Australian Accounting Standard that prior period errors had to be corrected in the period in which they were detected, even if the errors related to an earlier period. Hence the profit or loss for the financial period was to include all items of expense and income arising in the financial year, irrespective of whether they were attributable to the ordinary operations of the business, or whether they related to earlier periods. The profit or loss derived from applying these rules was often referred to as the ‘all-inclusive’profit or loss. So, if a firm had overlooked an item of expense or income in one period, it was required to include the income or expense within the profit or loss of the period in which the omission became apparent. It was not permissible to offset the item against opening retained earnings (or losses). However, this situation changed significantly 604 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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with the required treatment now being stipulated within AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors. Paragraph 5 of AASB 108 defines a prior period error as follows: Prior period errors are omissions from, and misstatements in, the entity’s financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that: (a) was available when the financial statements for those periods were authorised for issue; and (b) could reasonably be expected to have been obtained and taken into account in the preparation and presentation of the financial statements. Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud. Pursuant to AASB 108, the correction of a prior period error is excluded from the profit or loss of the period in which the error is discovered. Specifically, paragraph 46 of AASB 108 states: The correction of a prior period error is excluded from profit or loss for the period in which the error is discovered. Any information presented about prior periods, including any historical summaries of financial data, is restated as far back as is practicable. AASB 108 requires all errors that relate to prior reporting periods to be corrected by adjusting the opening balance of retained earnings, and restating comparative information. For example, if in the year ended 30 June 2019 an entity determined that inventory thought to be on hand at the beginning of the financial year had actually been destroyed in the previous financial period (meaning that there was an error in the previous financial period that resulted in closing inventory of the previous period being overstated, and expenses of the previous period therefore being understated), the accounting entry in 2019 would be: Dr Cr

Retained earnings Inventory

X X

The implication of this requirement that prior period errors are to be accounted for by making an adjustment against retained earnings is that if an entity ‘forgets’ to include an expense in one period and discovers the omission in the next period, then that expense will not appear within profit or loss (because the subsequent recognition will be made by virtue of an adjustment against retained earnings) other than in an adjustment to the previous period’s comparative numbers. Clearly, this might be a desired outcome for some (less than objective) managers. Do you, the reader, think the ‘old’ system whereby prior period errors were included within profit or loss when ultimately discovered was better than the existing situation in which discovered errors will not appear in the statement of profit or loss and other comprehensive income, other than by way of adjustments to prior period comparatives? Bear in mind, again, that the definition of prior period errors provided earlier excludes changes in accounting estimates and changes in accounting policies. Paragraph 5 of AASB 108 provides the relevant definition: A change in accounting estimate is an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors. A change in accounting estimate occurs when different circumstances or assumptions are applied in arriving at a particular estimate. The difference between a change in accounting estimate and a prior period error is considered in Worked Example 16.3.

WORKED EXAMPLE 16.3: Difference between a change in accounting estimate and a prior period error The following two unrelated scenarios apply to Layne Ltd, whose financial year ends on 30 June 2019. Scenario 1: Layne Ltd has, in the past, always made an allowance for doubtful debts equivalent to 2 per cent of accounts receivable outstanding at year end. As a result of new information obtained by the company during the continued Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  605

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current year, a decision was made to increase the doubtful debt allowance to 3.5 per cent of accounts receivable outstanding at year end. Scenario 2: During the preparation of the financial statements it was discovered that an amount of $8 500, incurred in July 2017 and payable to a foreign supplier, was overlooked and not paid or provided for in the financial statements ending 30 June 2018. The amount is considered to be material and will be permitted as a deduction for tax purposes. REQUIRED Identify which of the two scenarios outlined above is a change in accounting estimate, and which is a prior period error. SOLUTION Scenario 1 is a change in accounting estimate. The decision to increase the allowance for doubtful debts involves the application of judgement based on the latest information available to management. Changes in the allowance for doubtful debts is a change in estimate. Scenario 2 is a prior period error. It arose from a material amount not being included when the 2018 financial statements were prepared. In Worked Example 16.3 the increase in the amount provided for doubtful debts results from a change in an accounting estimate. The estimate is the amount to be provided by the company for doubtful debts. The new information available to the company will result in it being in a position to make an improved judgement of the amount to be provided for doubtful debts at year end. However, the amount that was due to the foreign supplier and that was not paid or provided for in the financial statements ending 30 June 2018 was clearly an oversight or omission on the part of the company and, as such, meets the definition of a prior period error.

Correction of prior period errors Material prior period errors are corrected retrospectively in the first set of financial statements authorised for issue after their discovery. Any adjustments are excluded from profit or loss for the period in which the error was discovered. As indicated earlier, this is achieved by adjusting the opening balance of retained earnings and restating the comparative amounts for the prior periods presented. If the error occurred in a period prior to the present period presented, the opening balance of assets, liabilities and equity should be restated for the earliest period presented. Where historical summaries are provided, the amounts relating to prior periods should be restated and this restatement disclosed where practicable. Using the information contained in Worked Example 16.3, and assuming a tax rate of 30 per cent, the following journal entry would be necessary to correct the financial statements: 30 June 2019 Dr Retained earnings Dr Tax payable Cr Accounts payable

5 950 2 550 8 500

Disclosing prior period errors As we know from the discussion above, paragraph 42 of AASB 108 requires that : An entity shall correct material prior period errors retrospectively in the first financial report authorised for issue after their discovery by: (a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or (b) if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented. In applying the above requirements of paragraph 42, paragraph 49 of AASB 108 requires the following disclosures to be made: An entity shall disclose the following: (a) the nature of the prior period error; 606 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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(b) for each prior period presented, to the extent practicable, the amount of the correction: (i) for each financial statement line item affected; and (ii) if AASB 133 applies to the entity, for basic and diluted earnings per share; (c) the amount of the correction at the beginning of the earliest prior period presented; and (d) if retrospective restatement is impracticable for a particular prior period, the circumstances that led to the existence of that condition and a description of how and from when the error has been corrected. Financial statements of subsequent periods need not repeat these disclosures. Worked Example 16.4 details how a prior period error should be accounted for and disclosed at the time the error is discovered.

WORKED EXAMPLE 16.4: Error made in the previous reporting period and discovered in the current reporting period Torquay Ltd is completing its financial statements for the year ended 30 June 2018. In undertaking the accounting work it becomes apparent that an item of machinery that was thought to be on hand at the end of the previous financial year had actually been destroyed in a bushfire on 28 June 2017. The machinery had a cost of $90 000 and accumulated depreciation of $12 000. REQUIRED Provide the accounting entries to account for the discovery of this prior period error. Ignore related tax effects. SOLUTION In this case we will need to reduce opening retained earnings and reduce the value of property, plant and equipment. The accounting entry in 2018 would be: Dr Dr Cr

Opening retained earnings Accumulated depreciation—machinery Machinery

Changes in accounting policy

78 000 12 000 90 000

LO 16.9 LO 16.10

One of the essential qualitative characteristics of general purpose financial statements is comparability. Information is considered to be comparable when users of financial statements of an entity are able to identify trends in financial performance and position over a period of time and when they are able to compare the performance of different entities at a point in time. For comparability to apply, users should be able to effectively compare financial statements of different entities. This can be achieved only if users have knowledge of the accounting policies employed in the preparation of the financial statements, together with information about any changes in those policies and the effects of such changes. AASB 108, paragraph 5, defines ‘accounting policies’ as: the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.

Considerations of comparability would suggest that changes in accounting policy should be infrequent occurrences. AASB 108, paragraph 14, identifies two situations when a change in accounting policy is likely to occur. These are where a change in accounting policy is required to comply with an accounting standard or interpretation, or where a decision to change an accounting policy will result in the financial statements providing reliable and more relevant information. It is often difficult to distinguish between a change in accounting policy and a change in an accounting estimate. For example, the following situations cannot be considered changes in accounting policy: • application of an accounting policy for events or transactions that differ in substance from those previously occurring; • application of a new accounting policy for transactions or other events or conditions that did not occur previously, or were immaterial. In Worked Example 16.5, two scenarios are provided. The first, the adoption of a new policy for an event that did not previously exist, is not a change in policy, while the second is clearly a change in accounting policy. At this stage Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  607

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WORKED EXAMPLE 16.5: Identifying a change in accounting policy and an instance not considered to be a change in accounting policy Scenario 1: Racer Ltd has previously not owned a depreciable building. During the reporting period ending 30 June 2019, a building was constructed. Depreciation was charged for the first time on the building from the 2019 reporting period. Scenario 2: Racer Ltd has previously held land at cost. From the 2019 reporting period, the company made the decision to revalue land to its fair value. REQUIRED Identify, giving reasons, which of the above scenarios is a change in accounting policy and which is not a change in accounting policy. SOLUTION Scenario 1: is not a change in accounting policy as no buildings existed previously and, as a consequence, no depreciation charge was necessary. Scenario 2: is a change in accounting policy. Previously, the policy was to measure the land at its historical cost. The policy is now to measure land at its fair value. you should make sure you understand what constitutes a change in accounting policy and what constitutes a change in an accounting estimate. You should also understand how to account for changes in accounting policies and changes in accounting estimates. Further examples of changes in accounting policy would include: • changing the basis of accounting for equity investments by moving from measuring them at fair value through profit or loss, to measuring them at fair value through other comprehensive income; • capitalising borrowing costs incurred in the construction of an asset when borrowing costs were previously expensed. Changes in accounting policy are to be made retrospectively or prospectively, depending upon the background to the change. On initial application of a new accounting policy, and unless a change in accounting policy is being accounted for in accordance with the specific provisions of an accounting standard or interpretation, the effects of the change in accounting policy is to be accounted for retrospectively. Specifically, paragraph 19 of AASB 108 states: Subject to paragraph 23: (a) an entity shall account for a change in accounting policy resulting from the initial application of an Australian Accounting Standard in accordance with the specific transitional provisions, if any, in that Australian Accounting Standard; and (b) when an entity changes an accounting policy upon initial application of an Australian Accounting Standard that does not include specific transitional provisions applying to that change, or changes an accounting policy voluntarily, it shall apply the change retrospectively. When a change in accounting policy is made retrospectively, AASB 108, paragraph 22, requires the opening balance of each affected component of equity to be adjusted for the earliest prior period presented and the other comparative amounts disclosed for each prior period presented, as if the new accounting policy had always been applied. The new policy is applied to both comparative information and historical data for periods as far back as possible. AASB 108 requires retrospective application to be made for changes in accounting policy, except in those limited circumstances in which it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Where it is not possible to determine the period-specific effects of changes in an accounting policy for one or more of the periods presented, AASB 108, paragraph 24, requires the new policy to be applied to the carrying amounts of assets and liabilities at the beginning of the earliest period for which retrospective application is practicable, which might be the current period. A corresponding adjustment should be made to the opening balance of equity for that period. In noting that retrospective adjustments created by changing accounting policies are typically undertaken by adjusting retained earnings, paragraph 26 of AASB 108 states: When an entity applies a new accounting policy retrospectively, it applies the new accounting policy to comparative information for prior periods as far back as is practicable. Retrospective application to a prior 608 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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period is not practicable unless it is practicable to determine the cumulative effect on the amounts in both the opening and closing statements of financial position for that period. The amount of the resulting adjustment relating to periods before those presented in the financial statements is made to the opening balance of each affected component of equity of the earliest prior period presented. Usually the adjustment is made to retained earnings. However, the adjustment may be made to another component of equity (for example, to comply with an Australian Accounting Standard). Any other information about prior periods, such as historical summaries of financial data, is also adjusted as far back as is practicable. An example of a retrospective change in accounting policy is provided in Worked Example 16.6.

WORKED EXAMPLE 16.6: Retrospective change in accounting policy During 2015, Alpha Ltd commenced the construction of a geothermal power station outside Canberra for its own use. During the reporting period ending 30 June 2019, a change in accounting standards means that the directors are required to change the company’s treatment of borrowing costs incurred in the construction of assets for its own use. In previous periods Alpha Ltd expensed such costs, but must now capitalise them as part of the construction cost in line with the requirement of AASB 123 Borrowing Costs. As a result of the change, the financial statements of Alpha Ltd will be more comparable with other entities in the same industry. The unadjusted statement of profit or loss and other comprehensive income and statement of changes in equity for the reporting period ended 30 June 2019 are detailed below. Alpha Ltd Abridged statement of profit or loss and other comprehensive income for the year ended 30 June 2019 Profit before tax Income tax expense Profit for the year Other comprehensive income Total comprehensive income

2019 ($) 29 200 8 760 20 440          – 20 440

2018 ($) 28 400  8 520 19 880          – 19  880 Total ($) 41 100 19 880 (5 400) 55 580 20 440 (7 400) 68 620 2017 ($) 8 800 32 300 41 100 25 000 16 100 41 100

Alpha Ltd Abridged statement of changes in equity for the year ended 30 June 2019 Balance at 1 July 2017 Profit for the year Distributions to shareholders Balance 30 June 2018 Profit for the year Distributions to shareholders Balance at 30 June 2019

Share capital ($) 25 000 – 25 000 – – 25 000

Retained earnings ($) 16 100 19 880 (5 400) 30 580 20 440 (7 400) 43 620

Alpha Ltd Statement of financial position (extract) at 30 June 2019 Qualifying asset under construction Other assets

2019 ($) 21 400 47 220 68 620 25 000 43 620 68 620

2018 ($) 13 300 42 280 55 580 25 000 30 580  55 580

Share capital Retained earnings

continued Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  609

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ADDITIONAL INFORMATION 1. In 2019 interest of $2 800 relating to the construction of the geothermal power station was expensed. Interest costs of $4 200 were expensed in 2018, $5 600 was expensed in 2017 and $3 700 was expensed in reporting periods prior to 2017. 2. No depreciation has been charged on the geothermal power station, as it has not yet been commissioned. 3. The tax rate has remained at 30 per cent for the past three years. REQUIRED Redraft the statement of profit or loss and other comprehensive income, statement of changes in equity and statement of financial position (extract) so as to comply with generally accepted accounting practice and all relevant accounting standards. SOLUTION Alpha Ltd Abridged statement of profit or loss and other comprehensive income for the year ended 30 June 2019 Profit before tax Income tax expense Profit for the year Other comprehensive income Total comprehensive income

2019 ($)

2018 ($)

32 000 (9 600) 22 400 – 22 400

Restated 32 600  (9 780) 22 820   – 22 820

Alpha Ltd Abridged statement of changes in equity for the year ended 30 June 2019 Balance at 1 July 2017 as previously reported Change in accounting policy resulting from capitalising interest Balance at 1 July 2017 as restated Profit for the year (restated) 2018 Distributions to shareholders Balance 30 June 2018 Profit for the year 2019 Distributions to shareholders

Share capital ($) 25 000 – 25 000 – – 25 000 – –

Retained earnings ($) 16 100 6 510 22 610 22 820 (5 400) 40 030 22 400 (7 400)

Total ($) 41 100 6 510 47 610 22 820 (5 400) 65 030 22 400 (7 400)

Balance at 30 June 2019

25 000

55 030

80 030

Alpha Ltd Statement of financial position (extract) at 30 June 2019 Qualifying asset under construction Other assets Taxation (deferred tax liability)

2019 ($) 37 700 47 220 (4 890) 80 030 25 000 55 030 80 030

2018 ($) 26 800 42 280  (4 050) 65 030 25 000 40 030 65 030

2017 ($) 18 100 32 300 (2 790) 47 610 25 000 22 610 47 610

Share capital Retained earnings

Notes to financial statements x. Change in accounting policy During the year, the accounting policy applicable to borrowing costs for assets constructed for the company’s own use was changed. Previously such costs were expensed. However, AASB 123 Borrowing Costs now requires borrowing costs attributable to the construction of a qualifying asset to be capitalised as part of the cost of the asset.

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This policy will provide more relevant and reliable information, as it is consistent with industry practice, making the financial statements more comparable with those of other entities in the same industry. The change in accounting policy has been accounted for retrospectively and the comparative statements for 2018 have been restated. The effect of the change on 2018 is shown below. Opening retained earnings for 2018 is increased by $9 300 ($6 510 after tax), which is the amount of the adjustment relating to periods prior to 2018.

Decrease in interest expense (Increase) in income tax expense Increase in profit Increase in qualifying assets under construction Increase in retained earnings at 30 June 2018

Effect on 2018 ($) 4 200 (1 260) 2 940 13 500  9 450

Effect on periods prior to 2018 ($) 9 300 (2 790) 6 510 9 300 6 510

At the beginning of an accounting period it is, in certain infrequent circumstances, impossible to determine the cumulative effect of applying a new accounting policy to all prior periods. In this situation the new accounting policy must be applied prospectively from the start of the earliest period possible. A prospective application of a change in accounting policy does not take into account any cumulative adjustments to assets, liabilities and equity that may have arisen before that date. An illustration of a prospective change in accounting policy, based on an example provided in AASB 108, is provided in Worked Example 16.7.

WORKED EXAMPLE 16.7: Prospective change in accounting policy During the reporting period ending June 2019, the directors of Persuader Ltd decided to change the company’s accounting policy for depreciating property, plant and equipment to the components approach and, at the same time, adopt the revaluation model wherein particular classes of assets will be revalued to fair value. Prior to 2019, the details maintained in the assets register were not sufficiently detailed to apply the components approach fully. During June 2018, the directors commissioned an engineering survey to provide comprehensive information on the individual components of the various assets, their fair values, useful lives, estimated residual values and depreciable amounts in effect at 1 July 2018, the beginning of the 2019 reporting period. Prior to the reconstruction of the records there was insufficient information to reliably estimate the cost of components that had not been accounted for separately. Management has determined that it is not practicable to account for the change to the components approach retrospectively, or to account for the change prospectively from any earlier date than the start of the 2019 reporting period. In view of this, management has also decided that the change from the cost model to the revaluation model should also be accounted for prospectively, from the start of the 2019 reporting period. The tax rate for all years is 30 per cent. The following additional information is available: Property, plant and equipment at 30 June 2018 At cost Accumulated depreciation Carrying amount Prospective depreciation expense The engineering survey established the following values: Property, plant and equipment—at fair value Estimated residual value Remaining asset life Depreciation expense on new basis

160 000  89 600  70 400  9 600 108 800  19 200  5 years  17 920 continued

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REQUIRED Prepare the journal entries that would be made in the records of Persuader Ltd at 30 June 2019, together with the note that would appear in the 2019 financial statements. SOLUTION 30 June 2019 Dr Property, plant and equipment 38 400 Cr Revaluation surplus Cr Deferred tax liability (Revaluation of plant as per engineering survey) Dr Depreciation    8 320 Cr Accumulated depreciation (Additional depreciation expense for the year) Dr Tax payable    2 496 Cr Income tax expense (Decrease in tax expense for the year)

26 880 11 520

8320

2 496

Notes to the 2019 financial statements From the start of the 2019 reporting period, Persuader Ltd changed its accounting policy for depreciating property, plant and equipment to the components approach and, at the same time, adopted the revaluation model for property, plant and equipment. The directors believe that this policy provides reliable and more relevant information because it deals more accurately with the components of property, plant and equipment, and is based on up-to-date values. The policy has been applied prospectively from the start of the 2019 reporting period, as it was not practicable to estimate the effects of applying the policy either retrospectively or prospectively from any earlier date. The adoption of the new policy has no effect on prior years. The effect on the current year is to increase the carrying amount of property, plant and equipment at the start of the year by $38 400; increase the opening deferred tax liability by $11 520; create a revaluation surplus at the start of the year of $26 880; increase depreciation expense by $8 320; and reduce tax expense by $2 496.

Disclosures when changes in accounting policy are made Understanding the impact that a change in accounting policy has, or could have, on the financial performance and position of an entity is only possible if users are aware of the accounting policies employed in the preparation of the financial statements, together with any changes in those policies, and the effects of the changes. To assist users’ understanding of the impact that any changes in accounting policy may have, AASB 108, paragraphs 28 to 30, requires the following extensive disclosure requirements: 28. When initial application of an Australian Accounting Standard has an effect on the current period or any prior period, would have such an effect except that it is impracticable to determine the amount of the adjustment, or might have an effect on future periods, an entity shall disclose: (a) the title of the Australian Accounting Standard; (b)  when applicable, that the change in accounting policy is made in accordance with its transitional provisions; (c) the nature of the change in accounting policy; (d) when applicable, a description of the transitional provisions; (e) when applicable, the transitional provisions that might have an effect on future periods; (f)  for the current period and each prior period presented, to the extent practicable, the amount of the adjustment: (i) for each financial statement line item affected; and (ii) if AASB 133 Earnings per Share applies to the entity, for basic and diluted earnings per share; (g) the amount of the adjustment relating to periods before those presented, to the extent practicable; and (h)  if retrospective application required by paragraph 19(a) or (b) is impracticable for a particular prior period, or for periods before those presented, the circumstances that led to the existence of that condition and a description of how and from when the change in accounting policy has been applied. 612 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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Financial statements of subsequent periods need not repeat these disclosures. 29. When a voluntary change in accounting policy has an effect on the current period or any prior period, would have an effect on that period except that it is impracticable to determine the amount of the adjustment, or might have an effect on future periods, an entity shall disclose: (a) the nature of the change in accounting policy; (b) the reasons why applying the new accounting policy provides reliable and more relevant information; (c)  for the current period and each prior period presented, to the extent practicable, the amount of the adjustment: (i) for each financial statement line item affected; and (ii) if AASB 133 applies to the entity, for basic and diluted earnings per share; (d) the amount of the adjustment relating to periods before those presented, to the extent practicable; and (e)  if retrospective application is impracticable for a particular prior period, or for periods before those presented, the circumstances that led to the existence of that condition and a description of how and from when the change in accounting policy has been applied. Financial statements of subsequent periods need not repeat these disclosures. 30. When an entity has not applied a new Australian Accounting Standard that has been issued but is not yet effective, the entity shall disclose: (a) this fact; and (b)  known or reasonably estimable information relevant to assessing the possible impact that application of the new Australian Accounting Standard will have on the entity’s financial statements in the period of initial application. In order to comply with AASB 108, paragraph 30, an entity should disclose the title of the new accounting standard, the nature of the impending change or changes in accounting policy; the date by which application of the accounting standard is required; the date as at which it plans to apply the accounting standard initially; and either (i) a discussion of the impact that initial application of the accounting standard is expected to have on the entity’s financial statements; or (ii) if that impact is not known or reasonably estimable, a statement to that effect. Lastly, AASB 108 requires all significant changes in accounting policies to be disclosed in the summary of significant accounting policies.

Profit as a guide to an organisation’s success

LO 16.1

A central role of accounting is to determine the ‘profit or loss’ of an organisation (as well as identifying items LO 16.11 of ‘other comprehensive income’). As we are aware from media reports, profits or losses often appear to be used as an indicator of the success of an organisation. Similarly, financial performance measures such as gross domestic product (GDP) and inflation rates are often used as a measure of the performance, or success, of a country. We must remember, however, that profit is a measure of financial performance based upon the accounting rules in place at a specific point in time (and as we know, these rules change often). Non-financial issues such as the social and environmental performance of an entity (which we consider more fully in Chapter 30) are not directly incorporated into the calculation of profit or loss (or comprehensive income). If a company is exploiting its workforce, causing environmental damage or producing potentially unsafe goods, this will not directly impact profits—although ultimately community support could wane, causing demand for the organisation’s products to fall.  Also, newspaper articles about how a particular company’s profits have increased or decreased typically do not mention the accounting methods used to calculate the profit or loss. Indeed, reported profits are typically treated as ‘hard facts’ by media journalists with no consideration of the various judgements and estimates that were made in deriving the particular profit. That is, nowhere within media articles is any mention typically made of the accounting methods employed by the respective company or of possible changes therein (any changes in accounting methods can lead to changes in accounting profits). As we know, the profit figure really only makes sense when considered in the light of the accounting policies adopted, and the accounting assumptions made. By not referring to the accounting policies, methods and assumptions, the media tends to treat accounting profits as an objective reality—something we know it is not. The determination of accounting profits is based upon many professional judgements, which makes it unlikely that different teams of accountants would calculate the same profit or loss for a particular entity for a given period. Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  613

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There are various definitions of income in existence (and the term ‘income’ as used in the economics literature often equates with what an accountant would refer to as ‘profit’). Often cited is the one provided by Hicks (1939): The purpose of income calculations in practical affairs is to give people an indication of the amount which they can consume without impoverishing themselves. Following out this idea, it would seem that we ought to define a man’s income as the maximum value which he can consume during a week and still expect to be as well-off at the end of the week as he was at the beginning. Hicks thus introduced the notion of ‘well-offness’ to income determination, which would not necessarily have to be restricted to financial wealth. Being well-off could also include factors such as health, happiness, satisfaction and so on. However, for practical purposes, the determination of these other components of ‘well-offness’ would be extremely difficult, and traditional financial accounting, as applied to business entities, typically ignores personal and social issues associated with an entity’s performance. Bierman and Davidson (1969) adapted Hicks’ definition to argue that the profit of a business entity is ‘the dividend which could be paid and leave the firm as well off at the end as it was at the beginning of the period’. There has been a surge in recent decades in research into social and environmental performance reporting. Many writers have highlighted that although the economic success of an organisation is typically gauged by using the output of the financial accounting system, this generally ignores environmental and other social consequences unless direct cash flows are incurred such as fines, clean-up costs, investments in recycling plant and so on. An entity can be very successful in financial accounting terms, yet be doing extensive damage to the environment (thereby potentially leaving future generations less ‘well-off’). A profitable company therefore is not necessarily a ‘good’ company. As discussed in previous chapters of this book, there are numerous reasons why traditional financial accounting calculations of profit ignore an organisation’s environmental and other social impacts. For example, traditional financial accounting is based on a model that emphasises property rights and market transactions. This means that many ‘costs’ imposed on society—‘social costs’ that do not generate cash flows—are ignored. As we know, the definition of ‘expenses’ (from the conceptual framework) is: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. The definition of expenses relies in turn on a definition of assets. An asset is defined in the conceptual framework as ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. Consequently, if an object or resource is not ‘controlled’ (for example, the air or the ocean and waterways), it is excluded from asset recognition. Therefore, if traditional accounting practices are adopted, any diminution in the non-controlled resource’s value or quality, such as pollution’s adverse effect on air quality, will not be recognised as an expense of the entity. Let us consider a fairly extreme example. Under traditional financial accounting, if an entity pollutes the water in its local environs, thereby killing all local sea creatures and coastal vegetation, there would be no direct impact on reported profits unless fines or other related cash flows were incurred. No externalities—which can be defined as impacts that an entity has on parties external to the organisation where such external parties did not agree or take part in the action causing, or the decisions leading to, the cost or benefit—would be recognised and the reported assets/profits of the organisation would not be affected. Under conventional financial reporting practices, the performance of such an organisation could, depending upon the financial transactions undertaken, be portrayed as being very successful. In this regard Gray and Bebbington (1992, p. 6) reflect on corporate financial reporting practices and note: There is something profoundly wrong about a system of measurement, a system that makes things visible and which guides corporate and national decisions that can signal success in the midst of desecration and destruction. Such views can lead us to question how relevant the existing financial reporting frameworks are to environmental and other social performance reporting activities and to recent debates about the need for society (and business entities) to embrace sustainable development. Another point to be stressed is that ‘profit’ represents the amount that might subsequently be returned to one stakeholder group—the owners—in the form of dividends. Returns to other stakeholders, such as employees, are treated as expenses, yet clearly the payment of salaries generates social benefits. 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above the interests of other stakeholders. It is not uncommon to see a report in the financial press that a particular company generated a sound profit despite increased wage costs. In such a context there is an implication that high returns to one stakeholder (employees in the form of wages) are somehow bad, but gains to other stakeholders (the owners of capital in the form of increased dividends) are good. As Collison (1998, p. 7) states: Financial description of the factors of production in the business media, and even in text books, makes clear that profit is an output to be maximised while recompense to labour is a cost to be minimised. Financial Times contributors are fond of words like ‘ominous’ to describe real wage rises: such words are not used to describe profit increases. Consider the following extract from an article by Angela MacDonald-Smith that appeared in The Australian Financial Review on 4 September 2015 (‘Oil Search to shut Brisbane office and shed jobs in cost-cutting drive’): Oil Search is set to close its Brisbane office and has cut some jobs as part of a restructuring in response to low oil prices, as talk resurfaces that the Papua New Guinea oil and gas player is set to become the target of a takeover approach from Woodside Petroleum . . . Managing director Peter Botten, who is believed to be visiting various Oil Search sites in PNG this week to explain the restructuring to staff, said it was ‘a difficult time’ for affected employees, some of whom were ‘long-term contributors’ to Oil Search. ‘It is a period of change in Oil Search but it is essential that in the current volatile operating environment we make our business sustainable and one that can continue to grow in PNG,’ he said in a statement to employees earlier this week, which referred to ‘a number of redundancies’. Oil Search advised at its first-half results last month that it would roll out a range of initiatives this December half as part of a ‘business optimisation program’ that is targeting a 15 per cent to 20 per cent reduction in operating and capital costs starting in 2016. Obviously, reducing available jobs would generate social costs—but such costs are ignored by financial accounting. Similarly, when an organisation spends resources to support local community initiatives (for example, support of educational initiatives), such expenditure is typically treated as an expense (with an adverse impact on profits), even though the expenditure generates social benefits. The issues associated with recognising the social and environmental implications of an entity’s operations are the subject of ongoing debate, but at this stage it is important to recognise that financial performance indicators, such as profits or losses or ‘total comprehensive income’, are not comprehensive indicators of the overall ‘performance’ of an organisation. For a comprehensive view of an organisation’s performance, financial measures such as profitability should be supplemented with other types of performance-based information, perhaps tied to the social and environmental performance of the entity. Readers who are interested in reading more about the limitations inherent within financial reporting practices with respect to providing information about social and environmental performance may wish to read Deegan (2013, pp. 448–58). A final point to be made in this chapter concerns government departments. Over recent decades they have been required to embrace traditional financial accounting methods. Previously, government departments typically accounted for their operations on a cash basis, with very limited use of accruals and limited attention to profitability. However, greater focus is now being placed on the profitability of government departments. Proponents of this approach argue that it forces managers to be more accountable for their departments’ performance. However, others argue that it is highly inappropriate for institutions such as government-controlled employment agencies, hospitals, museums, art galleries and national parks to be judged on their ability to generate profits—in fact, focusing on accounting profits distracts them from pursuing the proper goals of their organisations: the provision of necessary social services. Do you consider that traditional financial accounting, as used by private-sector, profit-seeking entities, is applicable to government departments? This is an interesting issue and one that is discussed in more depth within Chapter 9 in the discussion of assets known as ‘heritage assets’.

Future changes in the requirements pertaining to how we present information about comprehensive income

LO 16.12

As noted in Chapter 4 of this book, in October 2008 the IASB issued a discussion paper entitled ‘Preliminary Views on Financial Statement Presentation’. The discussion paper proposed some significant changes to how financial statements, including the statement of profit or loss and other comprehensive income, are to be presented. The project was jointly undertaken by the IASB and the US Financial Accounting Standards Board (FASB). In July 2010 a ‘staff draft’ of an

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Exposure Draft of a new Financial Statement Presentation accounting standard was prepared (because it was a ‘staff draft’ it was not open for public comment) and the expectation was that an exposure draft for public comment would be issued some time later. The project seems to have stalled in recent years but could be reactivated in the future. As Chapter 4 explains, the discussion paper and the staff draft represented the initial steps towards creating a new accounting standard that could ultimately replace IAS 1 and, therefore, AASB 101. So that corporations shall provide more useful information, the IASB and FASB intended making the financial statements more ‘cohesive’; that is, the objective was to format the information in financial statements so that a reader can follow the flow of information through the various financial statements. As IASB (2008, p. 16) stated: To present a cohesive set of financial statements, an entity should align the line items, their descriptions and the order of presentation of information in the statements of financial position, comprehensive income and cash flows. To the extent that it is practical, an entity should disaggregate, label and total individual items similarly in each statement. Doing so should present a cohesive relationship at the line item level among individual assets, liabilities, income, expense and cash flow items. IASB (2008, p. 30) further stated: A cohesive financial picture means that the relationship between items across financial statements is clear and that an entity’s financial statements complement each other as much as possible. Financial statements that are consistent with the cohesiveness objective would display data in a way that clearly associates related information across the statements so that the information is understandable. The cohesiveness objective responds to the existing lack of consistency in the way information is presented in an entity’s financial statements. For example, cash flows from operating activities are separated in the statement of cash flows, but there is no similar separation of operating activities in the statements of comprehensive income and financial position. This makes it difficult for a user to compare operating income with operating cash flows—a comparison often made in assessing earnings quality. Similarly, separating operating assets and liabilities in the statement of financial position will provide users with more complete data for calculating some key financial ratios, such as return on net operating assets. Paragraph 60 of IASB (2010) took this further by stating: Financial statements that are consistent with the cohesiveness principle complement each other as much as possible. To that end, an entity shall display and label line items in a way that clearly associates related information across the statements and helps a user understand those relationships. For example, an entity aligns the line item descriptions of information presented in the statements of financial position, comprehensive income and cash flows to help users find an asset or a liability, and the related effects of a change in that asset or liability, in the same place in each financial statement. For example, an entity with long-term debt presents interest expense and cash paid for interest in the same section and/or category as the long-term debt and labels the line items in such a way that a user of the financial statements can understand that the amounts are related. Pursuant to the proposed approach to presentation, an entity would classify income, expenses and cash flows in the same section and category as the related asset or liability. For example, if an entity classifies inventory in the operating category of the statement of financial position, it would classify changes in inventory in the operating category of the statement of profit or loss and other comprehensive income (as part of cost of goods sold) and classify the related cash payments to suppliers in the operating category of the statement of cash flows. The IASB and FASB also proposed that financial statements should be presented in a more disaggregated manner. In particular, it was proposed that financial statements be prepared in a way that separates an entity’s financing activities from its business and other activities, and further separates financing activities into transactions with owners in their capacity as owners and all other financing activities. The discussion paper proposed that an entity should identify and indicate in the statement of profit or loss and other comprehensive income whether the item relates to (or will relate to) an operating activity, investing activity, financing asset or financing liability. It was proposed that the statement of profit or loss and other comprehensive income be presented as follows:

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FINANCING • Financing asset income • Financing liability expenses

INCOME TAXES • On continuing operations (business and financing)

DISCONTINUED OPERATIONS • Net of tax

OTHER COMPREHENSIVE INCOME • Net of tax According to the discussion paper, each entity would decide the order of the sections and categories, but would use the same order in each individual statement. The entity would disclose why it chose those classifications. In explaining the use of the management approach, the discussion paper noted that because functional activities vary from entity to entity, an entity would choose the classification that best reflects management’s view of what constitutes its business (operating and investing) and financing activities. In relation to the presentation format proposed for the statement of profit or loss and other comprehensive income, IASB (2008, p. 17) stated: The proposed presentation model eliminates the choice an entity currently has of presenting components of income and expense in an income statement and a statement of comprehensive income (two-statement approach). All entities would present a single statement of comprehensive income, with items of other comprehensive income presented in a separate section. This statement would include a subtotal of profit or loss or net income and a total for comprehensive income for the period. Because the statement of comprehensive income would include the same sections and categories used in the other financial statements, it would include more subtotals than are currently presented in an income statement or a statement of comprehensive income. Those additional subtotals will allow for the comparison of effects across the financial statements. For example, users will be able to assess how changes in operating assets and liabilities generate operating income and cash flows. In explaining why a single statement of profit or loss and other comprehensive income was proposed, rather than the alternative approach whereby a separate income statement is presented, IASB (2008, p. 61) stated: When it was first introduced, the concept of comprehensive income was new to both entities and users of their financial statements. Permitting alternative formats for displaying the components of comprehensive income for several years allowed preparers and users of financial statements to become familiar with the new concept. The boards concluded that it is time to make the information easier to find and use by requiring it to be presented in a single format that displays all of the components of comprehensive income in the same financial statement. While the above discussion is only a brief overview of some recent ideas, it is nevertheless hoped that this discussion provides an indication of the extent of change that might occur in future years, in terms of how we present financial statements. At the time of writing it is not clear when the project to reformat financial statements will be reactivated.

SUMMARY The chapter considered how to construct a statement of profit or loss and other comprehensive income, and a statement of changes in equity. It is stressed that profit, as well as total comprehensive income, reflects the recognition of various income and expenses and, as such, is influenced directly by the various asset and liability measurement rules being applied. For example, the measurement of liabilities on the basis of present values rather than face values would have a direct consequence for the expenses that would be recognised. Because profit is the difference between income and expenses, there is no need to have a separate recognition criterion for profits (or losses). Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  617

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In Australia, the format of the statement of profit or loss and other comprehensive income and the statement of changes in equity is governed by AASB 101. The statement of profit or loss and other comprehensive income provides details of expenses and income, with such amounts either being incorporated within profit or loss, or ‘other comprehensive income’. The total income/gains and expenses/losses of the period are then reflected in a measure referred to as total comprehensive income (which is the sum of profit or loss and ‘other comprehensive income’). The statement of changes in equity provides information about transactions with owners in their capacity as owners, and also provides a reconciliation of opening and closing equity. The chapter also stressed that profitability is a measure of financial performance and as such should not be used as an all-encompassing measure of organisational performance or success. Profit calculations, using traditional financial accounting, typically ignore many social costs and social benefits attributable to an organisation’s operations.

KEY TERMS assets  588 expensed  588 expenses  586

gains  586 income  586 options  587

revenues  586 true and fair  588

END-OF-CHAPTER EXERCISES 1. Does the statement of profit or loss and other comprehensive income disclose the income and expense items that were recorded directly in equity? LO 16.3 2. If an entity were to discover that an expense of a prior period was omitted (perhaps as a result of a genuine mistake), should it record the error by increasing the expenses in the period in which the error was discovered, or recognise the error by making an adjustment directly to retained earnings? LO 16.7, 16.8 3. What items must be disclosed on the face of the statement of profit or loss and other comprehensive income? LO 16.3, 16.4 4. What are the two alternative classification bases for the disclosure of expenses in a statement of profit or loss and other comprehensive income and what factors should be taken into account when selecting between the two alternative presentation formats? LO 16.1 5. What items must be recorded on the face of the statement of changes in equity? LO 16.4

REVIEW QUESTIONS 1. Within AASB 101 there is a prohibition on disclosing extraordinary items. Provide an assessment of the merits of this prohibition. LO 16.1, 16.3, 16.6 2. Provide some examples of items that would be adjusted directly against equity, rather than being included as part of profit or loss. LO 16.1, 16.3 3. Provide an argument explaining why expenses that were inadvertently omitted in a previous year should be debited directly to retained earnings in the following period in which the error is discovered, rather than recognising them in the profit or loss in the period when the error was discovered. LO 16.7, 16.8 4. How is ‘profit’ defined for accounting purposes? LO 16.1 5. When reviewing the financial statements and supporting notes of a reporting entity, is it possible to find out about all the individual types of expenses and income that the entity has incurred or received? If not, how does management determine which expenses and income should be disclosed? LO 16.1, 16.3, 16.4 6. List some of the expenses and income that must be disclosed according to AASB 101. Do these items have to be disclosed in the body of the statement of profit or loss and other comprehensive income, or can they be disclosed in the notes to the statement? LO 16.1, 16.3, 16.4 618 PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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7. Does the statement of profit or loss and other comprehensive income provide a reconciliation of opening and closing retained earnings? If not, where can such a reconciliation be found? LO 16.4 8. When is it permissible for a reporting entity to treat expenses directly as a reduction to retained earnings, rather than including them as part of the period’s profit or loss? LO 16.3, 16.4 9. What is the role of the statement of changes in equity and how does it complement the disclosures made within the statement of profit or loss and other comprehensive income? LO 16.4 10. Do you consider that traditional financial accounting as used by private-sector, profit-seeking entities is applicable to government departments? Explain your answer. LO 16.1, 16.2, 16.11 11. You are to consider the following two scenarios: Scenario 1: Fishtail Ltd has changed its basis of calculating doubtful debts from 2.5 per cent of gross accounts receivable to 4.0 per cent of gross accounts receivable. Scenario 2: Fishtail Ltd has previously allocated costs to inventory using a weighted average costing approach. It was decided to change to a first-in-first-out inventory cost flow assumption.

REQUIRED Identify, giving reasons, which of the above scenarios is a change in accounting policy and which is not a change in accounting policy. Further, you are required to describe how the above scenarios are to be accounted for. LO 16.9, 16.10 12. In an article that appeared in The Age on 17 March 2011 (‘Billabong downgrades profit forecast after quake’ by Jared Lynch), it was stated that: SHARES in surfwear retailer Billabong fell yesterday after the company predicted the Japanese earthquake and tsunami would dent its full-year profit . . . Company secretary Maria Manning said Billabong’s Japanese warehouses and offices sustained no damage, but almost half the company’s Japanese stores and the wider wholesale account base ‘have been or are likely to be affected’.

REQUIRED How would lost profits resulting from such a disruption be treated for financial accounting purposes? That is, how are such ‘opportunity costs’ recognised? LO 16.1, 16.6 13. On 30 June 2019, the end of the current reporting period, Lynch Ltd made a decision, using the information obtained over the past few years, to revise the useful life of a particular item of its buildings acquired ten years earlier for $2 000 000. The useful life was revised from being a total of 25 years to being a total of 15 years. The building was originally depreciated on the straight-line basis over its useful life and it was expected that the asset would have no residual value. No depreciation has been provided in the current period.

REQUIRED (a) Prepare the journal entry to account for the change in accounting estimate. (b) Assuming that the change in accounting estimate had a material effect on financial performance for the period, prepare an appropriate supporting note. LO 16.5 14. On 30 June 2018, Southside Ltd purchased 5000 corporate bonds in ABC Ltd at $10.00 per bond. On acquisition, Southside Ltd classified this investment in financial assets as being ‘measured at fair value through other comprehensive income’. At 30 June 2019, the fair value of the corporate bonds had increased to $14.00. At 30 June 2020 the fair value of the corporate bonds had decreased to $13.00. All of the corporate bonds were sold on 30 June 2020. At 30 June 2018, the only equity item was paid-up capital of $100 000. And this has not changed. The applicable tax rate is 30 per cent.

REQUIRED Prepare an extract of the statement of profit or loss and other comprehensive income, and statement of changes in equity, for the reporting period ending 30 June 2020 in which the reclassification adjustment for financial assets measured at fair value through other comprehensive income is detailed. LO 16.3, 16.4 15. On 30 June 2019, the end of the current reporting period, Cairns Ltd made a decision, using the information obtained over the past few years, to revise the useful life of an item of plant acquired three years earlier for Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  619

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$3 000 000. The useful life was revised from being a total of eight years to being a total of 12 years. The plant was originally depreciated on the straight-line basis over its useful life and it was expected that the asset would have no residual value. No depreciation has been provided in the current period and tax implications can be ignored.

REQUIRED (a) Prepare the journal entry to account for the change in accounting estimate. (b) Assuming that the change in accounting estimate had a material effect on financial performance for the period, prepare an appropriate supporting note. LO 16.5 16. The following two unrelated scenarios apply to Rabbit Ltd, whose financial year ends on 30 June 2019. Scenario 1: Rabbit Ltd has, in the past, always depreciated its factory buildings over 25 years. As a result of new information obtained by the company during the current year a decision was made to reduce the expected useful life of the buildings to 18 years. Scenario 2: During the preparation of the financial statements it was discovered that a flood occurred in the previous financial year that destroyed some raw materials which were stored off-site and that were expected to have a long useful life. The materials were uninsured. No expense was recorded in the previous year in relation to the flood damage. The material was valued at $75 000 and the expense is considered to be material and will be permitted as a deduction for tax purposes. The tax rate is 30 per cent.

REQUIRED Identify which of the two scenarios outlined above is a change in accounting estimate and which is a prior period error. Also provide any necessary journal entries. LO 16.5, 16.7, 16.8

CHALLENGING QUESTIONS 17. In an article that appeared in The Australian Financial Review on 11 December 2010 (‘Qantas filings damning of Rolls-Royce’, by Andrew Cleary), it was stated that: Filings lodged with the Federal Court this week by Qantas against Rolls-Royce indicate that the relationship between the two companies isn’t as amicable as what they have displayed publically. Qantas is claiming damages from Rolls-Royce for problems associated with the airlines’ A380 fleet due to engine failures. RollsRoyce has been accused of misleading and deceptive behaviour by Qantas over claims the engineering giant made regarding its 900 engines. DLA Phillips Fox partner Robert Crittenden said the legal action is a clear message to Rolls-Royce that if they don’t play ball, then there will be consequences. Qantas also has the option to make a claim under that Trade Practices Act if a resolution can’t be reached. Although Qantas passengers have been able to reach their destinations problems with A380s has brought a halt to selling last minute tickets which chief executive Alan Joyce describes as the cream on top.

REQUIRED How should Qantas and Rolls-Royce respectively account for the above action? LO 16.1, 16.3, 16.5 18. On 30 June 2019, the end of the current reporting period, Kirk Ltd made a decision, using the information obtained over the past few years, to revise the useful life of its building acquired five years earlier on 1 July 2014 for $1 000 000. The useful life was revised from ten years to 15 years. The building was originally depreciated on the straight-line basis over its useful life and it was expected that the building would have no residual value. No depreciation has been provided in the current period.

REQUIRED (a) Prepare the journal entry to account for the change in accounting estimate. (b) Assuming that the change in accounting estimate had a material effect on financial performance for the period, prepare an appropriate supporting note. LO 16.5 19. Noosa Ltd manufactures quality surf clothing. In the 2019 financial year, it reports a profit before tax of $500 000 and an income tax expense of $190 000.

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REQUIRED Consider each of the following items of information, and determine their appropriate treatment in the period’s statement of profit or loss and other comprehensive income. You can assume that each of the items is independent of the others. (a) As of 1 July 2018, the tax rate increases, resulting in an additional expense to Noosa Ltd of $5 000. (b) During recent years, Noosa Ltd has been developing a long-life wetsuit. The project has been in development for the past five years, with total related expenditure of $400 000 being capitalised as at 30 June 2019. In June 2019 the wetsuits are finally tested. The results are not favourable. The wetsuits act like sponges, absorbing a great deal of water and a number of the people testing the garments are drowned. It is decided to abandon the development of the new wetsuits. (c) On 1 July 2019 an agreement is signed to sell a division of Noosa Ltd to another organisation. The sale will generate a profit of $300 000. The sale should be finalised before the completion of the 2019 financial statements (financial statements will generally not be completed until two or three months after year end). (d) Given the influx of tourists into the Noosa area, there has been additional demand for surf clothing in 2019. This has caused wages to increase from $80 000 in 2018 to $170 000 in 2019. (e) In 2019 Noosa Ltd sells goods to England and South Africa. The sales to South Africa are denominated in South African currency. A crash in the value of the South African currency results in a foreign exchange loss of $20 000. LO 16.1, 16.3, 16.5, 16.6 20. An extract from the financial statements of Wedding Cake Island Ltd for the year ended 30 June is provided below. Wedding Cake Island Ltd Abridged statement of profit or loss and other comprehensive income for the year ended 30 June 2019

2019 ($)

2018 ($)

Profit before tax

19 000

23 600

Income tax expense

  5 700

  7 080

Profit for the year

13 300

16 520

Other comprehensive income

       – 13 300

       – 16 520

Share capital

Retained earnings

Total

3 000

3 040

6 040



16 520

16 520

Distributions

       –

 (4 000)

 (4 000)

Balance at 30 June 2018

3 000

15 560

18 560



13 300

13 300

       – 3 000

 (4 000) 24 860

 (4 000) 27 860

Wedding Cake Island Ltd Statement of changes in equity for the year ended 30 June 2019 Balance at 30 June 2017 Profit for the year ending 30 June 2018

Profit for the year ending 30 June 2019 Dividends Balance at 30 June 2019

The following additional information is available: During the preparation of the 2019 financial statements, it became apparent that electricity expenses of $3 000 had been omitted when the 2018 financial statements were prepared. The Tax Office has indicated that electricity expense will be permitted as a deduction for tax purposes. The tax rate is 30 per cent.

REQUIRED Prepare the statement of profit or loss and other comprehensive income and statement of changes in equity so as to comply with all applicable accounting standards. LO 16.3, 16.4

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21. Fergie Ltd records the following expenses and income for the year ended 30 June 2019. $000 Income Interest revenue Sales revenue Expenses Cost of goods sold Administration salaries Depreciation of office equipment Major loss owing to insolvency of customer Damage caused by ‘space junk’ re-entering atmosphere Interest expense Income tax expense Opening equity

200 1 600 550 170 70 110 65 25 150 2 460

The income tax expense of $150 000 is calculated after considering a tax deduction of $21 450, which related to the damage caused by the space junk. The tax rate is 33 per cent. During the year there has also been an increase in the revaluation surplus of $80 000 as a result of a revaluation of land of $80 000. The balance of the revaluation surplus at 1 July 2018 was $nil. A new accounting standard has also been introduced, which has a transitional provision allowing initial write-offs to be recognised as a decrease against retained earnings. The decrease against retained earnings amounts to $50 000. Retained earnings at the beginning of the financial year were $1 950 000, and dividends of $200 000 were paid during the financial year. Issued share capital at 1 July 2018 and 30 June 2019 was $510 000.

REQUIRED Prepare a statement of profit or loss and other comprehensive income (in a single statement with expenses shown by function) and a statement of changes in equity in conformity with AASB 101. Provide only those notes that can be reasonably determined from the above information. LO 16.1, 16.2, 16.3, 16.4, 16.6, 16.9, 16.10 22. During 2016, Point Addis Ltd commenced the construction of a windfarm for its own use. During the reporting period ending 30 June 2019, a change in accounting standards means that the directors are required to change the company’s treatment of borrowing costs incurred in the construction of assets for its own use. In previous periods Point Addis Ltd expensed such costs, but must now capitalise them as part of the construction cost in line with the requirement of AASB 123 Borrowing Costs. The unadjusted statement of profit or loss and other comprehensive income and statement of changes in equity for the reporting period ended 30 June 2019 are detailed below. Point Addis Ltd Abridged statement of profit or loss and other comprehensive income for the year ended 30 June 2019 Profit before tax Income tax expense Profit for the year Other comprehensive income Total comprehensive income

2019 ($)

2018 ($)

14 600 (4 380) 10 220  – 10 220

14 200  (4 260) 9 940      –  9 940

Point Addis Ltd Abridged statement of changes in equity for the year ended 30 June 2019

Share capital ($)

Retained earnings ($)

Total ($)

Balance at 1 July 2017 Profit for the year ended 30 June 2018 Distributions to shareholders Balance 30 June 2018

12 500

8 050 9 940 (2 700) 15 290

20 550 9 940 (2 700) 27 790

– 12 500

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Profit for the year ended 30 June 2019 Distributions to shareholders Balance at 30 June 2019 Point Addis Ltd Statement of financial position (extract) at 30 June 2019 Qualifying asset under construction Other assets Share capital Retained earnings

– – 12 500

10 220 (3 700) 21 810

10 220 (3 700) 34 310

2019 ($) 10 700 23 610 34 310 12 500 21 810 34 310

2018 ($) 6 650 21 140 27 790 12 500 15 290 27 790

2017 ($) 4 400 16 150 20 550 12 500  8 050 20 550

ADDITIONAL INFORMATION 1. In 2019, interest of $4 000 relating to the construction of the windfarm was expensed. Interest costs of $3 000 were expensed in 2018, $3 900 was expensed in 2017 and $2 200 was expensed in reporting periods prior to 2017. 2. No depreciation has been charged on the windfarm as it has not yet been commissioned. 3. The tax rate has remained at 30 per cent for the past three years.

REQUIRED Redraft the statement of profit or loss and other comprehensive income, statement of changes in equity and statement of financial position (extract) so as to comply with generally accepted accounting practice and all relevant accounting standards. LO 16.3, 16.4, 16.9, 16.10 23. Consider the following extract from an article that appeared in The Sunday Times (Perth) on 6 September 2015 (‘Robots to take up jobs’, by Annabel Hennessy): Perth should prepare for a robot job takeover with automated technology and artificial intelligence entering all major industries and creating a ‘ramped-up information revolution’, a leading scientist says. Dr Stefan Hajkowicz, a principal CSIRO scientist, said automated businesses were no longer ‘science fiction’ but a reality that would soon be causing major job loss in Perth and other Australian capitals . . . ‘We shouldn’t be afraid of it, but let’s not underestimate the size of the transition here. The number of people who are in jobs that are likely to be replaced by robotics is high. Initially we may struggle. Long term, the industrial revolution created net jobs growth not destruction. It got rid [of] a lot of the unpleasant jobs. The information revolution we’re moving into will do the same.’ Repetitive, manual jobs in retail, accounting and legal offices will be replaced by more efficient robotics, he said.

REQUIRED (a) Will the move to replace employees with robotics create any externalities? If so, what might be the nature of these externalities? (b) How, if at all, would these externalities impact the reported profits or losses of those organisations that replaced employees with robotics? LO 16.11 24. An article entitled ‘Parent loan puts Parmalat down $165m’ by Andrew Fraser, which appeared in The Australian on 8 June 2004, made reference to two extraordinary items, which at the time required separate disclosure. It stated: Parmalat Australia yesterday filed a net loss of $165.8 million, despite the Australian operations showing a healthy profit of $9.2 million. The reason for the difference was two extraordinary items—the local operation wrote off $145 million lent to the parent company via a bond, and $43.9 million lent to nonAustralian members of the Parmalat group. Of the $43.9 million, $32.5 million had been lent to the global Parmalat group—money which will never be recouped as the parent company owes $4 billion, vastly in excess of its assets. The remaining Chapter 16: THE STATEMENT OF PROFIT/LOSS, OTHER COMPREHENSIVE INCOME AND CHANGES IN EQUITY  623

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$11.5 million was money spent in starting operations in Thailand, Vietnam and Indonesia, which now will be wound down or sold as what the administrators in Italy call ‘the new Parmalat’. The $145 million bond was a cost that came about in Parmalat’s original purchase of Pauls, but managing director David Lord said yesterday that ‘under the circumstances, it’s really worth nothing, so we’ve adjusted our books accordingly’. From 2005, extraordinary items are not to be disclosed separately. Specifically, paragraph 87 of AASB 101 states ‘an entity shall not present any items of income and expense as extraordinary items, in the statement of profit or loss and other comprehensive income or separate income statement (if presented), or in the notes’.

REQUIRED (a) State whether you think this represented an improvement or a backward step for Australian financial reporting. Explain your answer. (b) Pursuant to AASB 101, how would the items of expense referred to in the article be disclosed? LO 16.6

REFERENCES BIERMAN, H. & DAVIDSON, S., 1969, ‘The Income Concept-Value Increment of Earnings Predictor’, The Accounting Review, April. COLLISON, D., 1998, Propaganda, Accounting and Finance: An Exploration, Dundee Discussion Papers, Department of Accountancy and Business Finance, University of Dundee. DEEGAN, C., 2013, ‘The Accountant Will Have a Central Role in Saving the Planet . . . Really? A Reflection on “Green Accounting and Green Eyeshades Twenty Years Later”’, Critical Perspectives on Accounting, vol. 24, no. 6, 2013, pp. 448—58. GRAY, R. & BEBBINGTON, J., 1992, ‘Can the Grey Men Go Green?’, Discussion paper, Centre for Social and Environmental Accounting Research, University of Dundee. HICKS, J.R., 1939, Value and Capital, Oxford University Press, Oxford. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2008,  Discussion Paper: Preliminary Views on Financial Statement Presentation, IASB, London, October. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010, Staff Draft of Exposure Draft IFRS X Financial Statement Presentation, IASB, London, July. PARKER, C. & PORTER, B., 2000, ‘Seeing the Big Picture’, Australian CPA, December, pp. 67–8.

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CHAPTER 17

ACCOUNTING FOR SHARE-BASED PAYMENTS LEARNING OBJECTIVES (LO) 17.1 Understand what a share-based payment represents. 17.2 Know which share-based payments are covered by AASB 2 Share-based Payment. 17.3 Understand the reasons that ultimately led to the development of AASB 2. 17.4 Understand what is meant by ‘equity-settled share-based payments’ and ‘cash-settled share-based payments’ and be able to provide the necessary accounting entries for such transactions. 17.5 Understand how to account for a share-based payment transaction with cash alternatives. 17.6 Understand how to measure share-based payment transactions. 17.7 Understand the effect of various vesting conditions on the accounting treatments required for sharebased payments. 17.8 Explain some of the possible economic implications of AASB 2. 17.9 Describe the disclosure requirements of AASB 2.

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Introduction to accounting for share-based payments In this chapter we discuss how to account for share-based payment transactions. AASB 2 deals with the recognition and measurement of share-based payment transactions. Prior to AASB 2 being released in 2004, it was common for entities to provide share options to their employees as part of their remuneration package, yet not record any accompanying expense. Indeed, shareholders were often unaware of the issue of various equity instruments and the potential dilutive effect such equity issues would have on their own shareholding. Under AASB 2 there is a general requirement for an expense or asset to be recognised in relation to all share-based transactions, regardless of whether the related transactions are with employees or other parties and of whether or not the transaction is ultimately settled with equity instruments or in cash. As paragraph 2 (the ‘Scope’ section of the standard) of AASB 2 states, AASB 2 provides accounting requirements for three types of share-based payment transactions, these being: (a) equity-settled share-based payment transactions, in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options); (b) cash-settled share-based payment transactions, in which the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity’s shares or other equity instruments of the entity; (c) transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity, or the supplier of those goods or services, with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments. AASB 2 does not apply to a number of other share-based transactions that might also arise from time to time. For example, AASB 2 does not apply when a share-based transaction is utilised to acquire goods as part of the net assets acquired in a business combination to which AASB 3 Business Combinations applies.

LO 17.1 LO 17.3

Background to the release of AASB 2 Prior to the release of AASB 2 there was much debate on how some equity-based instruments were to be measured—in particular, share options provided to managers as part of their salary packages. AASB 2 defines a share option as:

a contract that gives the holder the right, but not the obligation, to subscribe to the entity’s shares at a fixed or determinable price for a specified period of time. Senior managers or executives are often provided with options to buy shares in the entity that employs them, but they are often not permitted to exercise such options for a number of years after the options are originally granted. These options are treated as part of the recipient’s total remuneration, and as they often cannot be exercised for a number of years, they can act as a means of encouraging executives to stay with the organisation. Often the right to exercise the options is lost if an executive leaves the firm before a pre-specified period. Options are often referred to as ‘golden handcuffs’ because of their effect of discouraging an employee from leaving the organisation. Apart from their retentional characteristics, share options on offer to employees might serve to attract particular employees (particularly those who believe they have the ability to increase the value of the firm’s securities) and to align the interests of employees with those of the owners of the organisation. The interests would be considered to be aligned because both the manager and the owners would benefit from increases in the entity’s share price. Because the manager would equity instrument be motivated to take action to increase the value of the entity’s shares, their own interests would A contract that be aligned with the owners’ interests. Chapter 3 provides some discussion of the role of equity evidences a residual instruments in motivating managers to maximise the value of the entity. An accounting issue that interest in the assets arises here is how to identify the expenses associated with providing managers or executives with of an entity after options. The use of options is not limited to management of the entity. Some entities also issue deducting all of its liabilities. shares or share options to their suppliers as compensation for goods and services supplied—these would still be considered to be ‘share-based payments’. Often the options are issued with a ‘strike price’ (the amount that must be paid to acquire the shares in question— also referred to as the exercise price) higher than the current share price. For example, a senior manager might be given an option to buy shares in the company for a price of $1.20 per share, when the shares are actually trading on that date 626  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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(the grant date) on the securities exchange for $1.10. Clearly, the manager would not exercise the option under these conditions (because the share could be bought for $0.10 less on the securities exchange—so the options would be deemed to be ‘out of the money’), but the argument is that the manager will have an incentive to work hard to increase the value of the company’s shares over the term (life) of the options and, therefore, the value of the options they hold. The options are said to have a ‘time value’ and, hopefully for the manager and the shareholders, the value of the share options will increase throughout the ‘vesting period’. AASB 2 defines the ‘vesting period’ as: the period during which all the specified vesting conditions of a share-based payment arrangement are to be satisfied. A vesting condition is defined in AASB 2 as: a condition that determines whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a share-based payment arrangement. A vesting condition is either a service condition or a performance condition. When determining the related expense to the organisation from issuing share options, prior to the release of AASB 2, some companies simply looked at the difference between the exercise price and the share price at the time the options were issued. This difference is considered to represent the ‘intrinsic value’ of the option. AASB 2 defines intrinsic value as: the difference between the fair value of the shares to which the counterparty has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price (if any) the counterparty is (or will be) required to pay for those shares. For example, a share option with an exercise price of CU15 (CU being an abbreviation of currency unit) on a share with a fair value of CU20 has an intrinsic value of CU5. If the exercise price was greater than the fair value of the security then the options were considered to be ‘out of the money’, and it was common practice for no expense to be recognised when the options were issued (even though they obviously had value to the managers who were receiving them). They were deemed to have no intrinsic value. Conversely, if the difference were positive (there was intrinsic value), the options were considered to be ‘in the money’ and the difference was recognised by some companies as an expense. However, while this approach was common, there was great variation in treatment. At the same time, other companies considered issues associated with the ‘time value’ of the option and used various (sometimes quite sophisticated) models to determine the cost of the option (such as the Black–Scholes option pricing model) so that a cost could be assigned to the options even when they were ‘out of the money’. This more sophisticated approach is consistent with the approach now required pursuant to AASB 2. The release of AASB 2 has reduced the discretion that reporting entities have with respect to accounting for options and other share-based payments. For example, in relation to options—which were previously accounted for in a multiplicity of ways—AASB 2 requires that the ‘fair value’ of the options be determined and that this value then be deemed to be the ‘cost’ of the options, which are to be recognised as an expense or asset of the entity. In general, companies are not permitted to provide employees with share options without recognising a corresponding expense. The granting of large numbers of share options to senior executives has frequently been a source of much concern in the community, with many people thinking the associated rewards being offered are simply excessive relative to what ‘average’ people earn. Such concerns have often attracted a great deal of negative media attention. Alternatively, many people believe that granting large numbers of share options to executives is necessary to attract and retain the best people, and the options further act to motivate the executives to maximise the value of the organisations. Generally speaking, executive salaries are often divided into three broad categories, these being: • a fixed annual cash-based component; • a component based on short-term incentives; and • a component based on long-term incentives. Often the fixed annual cash-based component constitutes a minority of the total package. The short-term incentives will typically be tied to operational measures, and typically tied to financial performance measures such as profits. Typically, the longer-term incentives will take the form of rights to shares, or share options, and often the ultimate granting of these options or rights will be dependent upon the share price of the organisation reaching particular predetermined amounts. Where the rewards paid to executives are based on the provision of shares or options to them, there will be various issues associated with the recognition and measurement of the related expenses. This chapter will address some of these issues. CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  627

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LO 17.1 LO 17.2 LO 17.3 LO 17.4 LO 17.5

Overview of the requirements of AASB 2 The objective of AASB 2 is stated at paragraph 1 (the ‘Objective’ section) of the standard as follows: The objective of this Standard is to specify the financial reporting by an entity when it undertakes a sharebased payment transaction. In particular, it requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including expenses associated with transactions in which share options are granted to employees.

As already briefly indicated, the above objective represents a significant change from accounting practice in place prior to AASB 2, according to which it was quite common for the share option components of employee remuneration plans to be ignored when calculating profit or loss (particularly when there was no intrinsic value). Within AASB 2, a ‘share-based payment transaction’ (the focus of the standard) is defined as: A transaction in which the entity: (a) receives goods or services from the supplier of those goods or services (including an employee) in a sharebased payment arrangement; or (b) incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement when another group entity receives those goods or services. Thus a ‘share-based transaction’ includes situations in which an entity acquires particular assets in exchange for equity instruments of that entity. It would also include situations in which services are provided (for example, by employees) that are paid for by providing the service provider with equity instruments of the entity. Share-based transactions would further include situations in which an entity agrees to pay for particular goods or services with cash at a price that is related to the equity instruments of the entity. For example, an entity might agree to pay a manager a bonus tied to, say, 10 000 times the amount the entity’s shares increase beyond $5.00 (this might be referred to as a ‘stock appreciation right’). Therefore, if the shares increased to $6.50 the cash bonus would be $15 000—this would be considered to be a share-based payment transaction even though no equity instruments are ultimately transferred to the manager (more specifically, it would be referred to as a ‘cash-settled share-based transaction’). In relation to the scope of AASB 2, paragraph 2 of the standard states that it applies to three specific types of sharebased payment transactions. Specifically, and as indicated earlier in this chapter, AASB 2 (paragraph 2) states: An entity shall apply this Standard in accounting for all share-based payment transactions, whether or not the entity can identify specifically some or all of the goods or services received, including: (a) equity-settled share-based payment transactions; (b) cash-settled share-based payment transactions; and (c) transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity, or the supplier of those goods or services, with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments. AASB 2 requires different treatments depending upon whether share-based transactions are ultimately settled by the issue of shares ((a) above) or the payment of cash ((b) above). Equity-settled share-based payment transactions lead to the recognition of equity whereas cash-settled share-based payment transactions lead to the recognition of a liability, as reflected in Table 17.1. Parties providing goods and services to the entity might also be pre-existing shareholders in the entity. If the entity transacts with those parties in their capacity as providers of goods and services, AASB 2 will apply. However, if the entity transacts with these parties in their capacity as shareholders of the entity, AASB 2 will not apply. As paragraph 4 of AASB 2 states: For the purposes of this Standard, a transaction with an employee (or other party) in his/her capacity as a holder of equity instruments of the entity is not a share-based payment transaction. For example, if an entity grants Table 17.1 Debt or equity?

Debit to:

Credit to:

Equity-settled share-based payment transaction

Asset or expense

Equity

Cash-settled share-based payment transaction

Asset or expense

Liability

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all holders of a particular class of its equity instruments the right to acquire additional equity instruments of the entity at a price that is less than the fair value of those equity instruments, and an employee receives such a right because he/she is a holder of equity instruments of that particular class, the granting or exercise of that right is not subject to the requirements of this Standard.

Recognition criteria As would be expected, AASB 2 separately considers recognition and measurement issues. In relation to when a sharebased transaction is to be recognised, paragraph 7 of AASB 2 states: An entity shall recognise the goods or services received or acquired in a share-based payment transaction when it obtains the goods or as the services are received. The entity shall recognise a corresponding increase in equity if the goods or services were received in an equity-settled share-based payment transaction, or a liability if the goods or services were acquired in a cash-settled share-based payment transaction. It should be noted that the usual test applies in relation to whether the transaction creates an asset or is deemed to be an expense. For example, if the goods or services are used directly to construct an item of inventory that will subsequently be sold, the related fair value of the goods or services will be considered initially as part of the cost of the asset rather than being treated as an expense (as Table 17.1 shows, the debit entry would be to either an asset or an expense). The cost will be recognised as an expense when the asset is ultimately sold. As paragraph 8 of AASB 2 states: When the goods or services received or acquired in a share-based payment transaction do not qualify for recognition as assets, they shall be recognised as expenses. The above requirement is consistent with the general requirements of the Conceptual Framework for Financial Reporting. Hence, a share-based transaction would be recorded in the following ways: Dr Asset or expense X Cr Equity X (to record a share-based transaction where the obligation will be settled by transferring equity in the reporting entity) Dr Asset or expense X Cr Liability X (to record a share-based transaction where the obligation will be settled by ultimately transferring cash, which would be the case for a cash-settled share-based transaction)

In relation to how the share-based payment transaction is to be measured, there is a general requirement for such a transaction to be measured at fair value; however, whether the transaction is measured at the fair value of the goods or services, or the fair value of the equity instrument, depends upon whether the transactions are with employees or with other parties, and whether a fair value can be determined ‘reliably’. AASB 2 divides its specific recognition and measurement requirements into separate sections according to the type of share-based transaction being considered. That is, separate parts of the standard are devoted to: • equity-settled share-based payment transactions • cash-settled share-based payment transactions • share-based payment transactions with cash alternatives.

equity-settled sharebased payment transaction Transaction in which a reporting entity receives goods or services as consideration for equity instruments of the entity, and the equity instruments can include shares or share options.

We will consider each of these types of share-based transactions in turn in what follows.

Equity-settled share-based payment transactions Equity-settled share-based payment transactions are defined as transactions in which the reporting entity receives goods or services in exchange for equity instruments of the entity, and the equity instruments can include shares or share options. In relation to how equity-settled share-based transactions are to be measured, a general rule is provided at paragraph 10, as follows:

LO 17.4 LO 17.6 LO 17.7

For equity-settled share-based payment transactions, the entity shall measure the goods or services received, and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless that CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  629

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fair value For the purposes of AASB 2, fair value is defined as ‘the amount for which an asset could be exchanged, a liability settled or an equity instrument granted between knowledgeable, willing parties in an arm's length transaction’.

fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair value of the goods or services received, the entity shall measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted. In terms of how fair value is defined in AASB 2, paragraph 6A of the standard states: This Standard uses the term ‘fair value’ in a way that differs in some respects from the definition of fair value in AASB 13 Fair Value Measurement. Therefore, when applying AASB 2 an entity measures fair value in accordance with this Standard, not AASB 13. As we might know from previous chapters, in AASB 13 Fair Value Measurement the definition of fair value is: the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date.

For the purposes of AASB 2, however, fair value is defined as: The amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm’s length transaction. There is a general presumption that, apart from transactions with employees, the fair value of the goods and services provided by parties other than employees can be measured reliably. If this is not the case the transactions are to be measured by reference to the fair value of the equity instruments granted. As we will discuss shortly, if market prices are not available because there is no ‘active market’ for the equity instruments—as would often be the case for options being issued to employees—fair value would be assessed by using a valuation approach such as an option pricing model. In relation to the use of fair values, paragraph 13 of AASB 2 states: To apply the requirements of paragraph 10 to transactions with parties other than employees, there shall be a rebuttable presumption that the fair value of the goods or services received can be estimated reliably. That fair value shall be measured at the date the entity obtains the goods or the counterparty renders service. In rare cases, if the entity rebuts this presumption because it cannot estimate reliably the fair value of the goods or services received, the entity shall measure the goods or services received, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted, measured at the date the entity obtains the goods or the counterparty renders service. As indicated above, there is a general assumption that transactions with employees cannot be reliably measured on the basis of the value of the services being provided (refer to paragraph 13 above and you will see that the general requirements relate to ‘transactions with parties other that employees’). Therefore, transactions with employees are typically measured at the fair value of the equity instruments being granted. As paragraph 11 of the standard states: To apply the requirements of paragraph 10 to transactions with employees and others providing similar services, the entity shall measure the fair value of the services received by reference to the fair value of the equity instruments granted, because typically it is not possible to estimate reliably the fair value of the services received, as explained in paragraph 12. The fair value of those equity instruments shall be measured at grant date. The requirements of paragraphs 10 and 11 are summarised in Table 17.2. Table  17.2 Which fair values do we use?

Nature of the transaction

Amount at which the expense (or asset) and equity account are recognised

Transactions where the fair value of the goods or services can be measured reliably

At the fair value of the goods or services received

Transactions with employees (where there is a maintained assumption that the fair value of the services cannot be measured reliably)

At the fair value of the equity instruments being granted

In those ‘rare situations’ where the fair value of goods and services provided by non-employees cannot be measured reliably

At the fair value of the equity instruments being granted

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Worked Example 17.1 considers the case in which the fair value of goods to be received can be measured reliably. Worked Example 17.2 considers the case in which they cannot be measured reliably.

WORKED EXAMPLE 17.1: Provision of goods by a supplier in exchange for equity instruments of the reporting entity On 1 July 2018, Supplier X provides Reporting Entity Ltd with some inventory, which has a fair value of $140 000. In exchange for the inventory, Reporting Entity Ltd provides Supplier X with 10 000 shares in Reporting Entity Ltd. REQUIRED Provide the accounting entry to account for the above equity-settled share-based transaction. SOLUTION As it is considered that the fair value of the inventory can be determined ‘reliably’, this is deemed to be the value of the shares being issued. The accounting entry would be: Dr

Inventory

Cr

Share capital

140 000 140 000

WORKED EXAMPLE 17.2: Provision of services where the value of the services cannot be measured reliably Employee X provides her services to Reporting Entity Ltd in exchange for 10 000 options in the entity. All services have been performed and the options have been granted to Employee X. The options are considered to have a fair value of $1.50 each. REQUIRED Provide the accounting entry to account for the above equity-settled share-based transaction with an employee. SOLUTION In this case, which involves an employee, the reporting entity would not determine the fair value of the services being provided but instead would consider the fair value of the options. The accounting entry would be based on the fair value of the options, and the journal entry would be: Dr

Employee benefits expense

Cr

Share capital

15 000 15 000

Paragraph 7 of AASB 2 requires an entity to recognise the goods or services received or acquired when the goods are obtained or the services provided. If the goods or services were received in an equity-settled share-based payment transaction, an increase in equity is recognised. If they were received as part of a cash-settled sharebased transaction, a liability is to be recognised. Consistent with paragraph 8 of AASB 2, if the goods or services do not meet the Conceptual Framework for Financial Reporting’s criteria for the recognition of an asset, the related expenditure is to be expensed.

Have the entitlements vested? In relation to the provision of services, consideration needs to be given to whether the equity instruments vest immediately or whether they vest at a later time, perhaps conditional on the completion of a particular period of service. This has implications for when the associated asset or expense will be recognised. According to AASB 2, if something vests it has become an unconditional entitlement. Specifically, AASB defines ‘vest’ as: To become an entitlement. Under a share-based payment arrangement, a counterparty’s right to receive cash, other assets, or equity instruments of the entity vests when the counterparty’s entitlement is no longer conditional on the satisfaction of any vesting conditions. CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  631

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The ‘counterparty’, as referred to in the above paragraph, is the party providing the goods or services to the reporting entity. The above definition of ‘vest’ requires in its turn a definition of ‘vesting conditions’. As indicated previously in this chapter, and according to AASB 2, a vesting conditions is: a condition that determines whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a share-based payment arrangement. A vesting condition is either a service condition or a performance condition. The above definition of a ‘vesting condition’ refers to ‘service conditions’ and ‘performance conditions’. These are defined in AASB 2 as: A service condition is a vesting condition that requires the counterparty to complete a specified period of service during which services are provided to the entity. A service condition does not require a performance target to be met. A performance condition is a vesting condition that requires the counterparty to complete a specified period of service (ie, a service condition); the service requirement can be explicit or implicit; and specified performance target(s) to be met (such as a specified increase in the entity’s profit over a specified period of time) while the counterparty is rendering the service. If the equity instruments vest at grant date, the reporting entity will recognise the whole transaction on that date. The reason for this treatment is that the counterparty (the other party to the transaction) is not required to complete a specified period of service before becoming unconditionally entitled to the equity instruments. The reporting entity assumes that the counterparty has rendered services in full in return for the equity instruments. Should the equity instruments not vest at grant date, or where equity instruments are granted subject to vesting conditions, for example, the employee is required to complete a predetermined period of service, paragraph 15 of AASB 2 creates a presumption that they are a payment for services to be received during the vesting period. As paragraphs 14 and 15 of AASB 2 state: 14 If the equity instruments granted vest immediately, the counterparty is not required to complete a specified period of service before becoming unconditionally entitled to those equity instruments. In the absence of evidence to the contrary, the entity shall presume that services rendered by the counterparty as consideration for the equity instruments have been received. In this case, on grant date the entity shall recognise the services received in full, with a corresponding increase in equity. 15 If the equity instruments granted do not vest until the counterparty completes a specified period of service, the entity shall presume that the services to be rendered by the counterparty as consideration for those equity instruments will be received in the future, during the vesting period. The entity shall account for those services as they are rendered by the counterparty during the vesting period, with a corresponding increase in equity. For example: (a) if an employee is granted share options conditional upon completing three years’ service, then the entity shall presume that the services to be rendered by the employee as consideration for the share options will be received in the future, over that three-year vesting period; or (b) if an employee is granted share options conditional upon the achievement of a performance condition and remaining in the entity’s employ until that performance condition is satisfied, and the length of the vesting period varies depending on when that performance condition is satisfied, the entity shall presume that the services to be rendered by the employee as consideration for the share options will be received in the future, over the expected vesting period. The entity shall estimate the length of the expected vesting period at grant date, based on the most likely outcome of the performance condition. If the performance condition is a market condition, the estimate grant date of the length of the expected vesting period shall be consistent with the assumptions Date at which the entity used in estimating the fair value of the options granted, and shall not be subsequently and the counterparty revised. If the performance condition is not a market condition, the entity shall revise agree to a share-based its estimate of the length of the vesting period, if necessary, if subsequent information payment arrangement, indicates that the length of the vesting period differs from previous estimates. being when the parties reach a shared understanding of the terms and conditions of the arrangement.

The requirements just set out refer to ‘grant date’. AASB 2 defines ‘grant date’ as: the date at which the entity and another party (including an employee) agree to a share-based payment arrangement, being when the entity and the counterparty have a

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shared understanding of the terms and conditions of the arrangement. At grant date the entity confers on the counterparty the right to cash, other assets, or equity instruments of the entity, provided the specified vesting conditions, if any, are met. If that agreement is subject to an approval process (for example, by shareholders), grant date is the date when that approval is obtained. To illustrate the above requirements, let us assume that a reporting entity grants its managing director share options with a fair value at grant date of $100 000. We will further assume that the options will vest should the managing director see out his five-year contract. Over the period of the contract, the reporting entity will recognise an employment expense of $20 000 per year and an increase in equity as follows: Dr Cr

Employee benefits expenses Share capital

20 000 20 000

Worked Example 17.3 considers how to account for employee service costs where the ultimate payment vests in full if the employee works for the entity for three years. The example is adapted from one provided in AASB 2.

WORKED EXAMPLE 17.3: Employee costs with a vesting period An entity grants 100 share options to each of its 500 employees. Each grant is conditional upon the employee working for the entity for the next three years. The entity estimates that the fair value of each share option is $15.00 (perhaps this value was determined as a result of applying an option pricing model). At grant date the entity estimates that 20 per cent of employees will leave during the three-year period and therefore forfeit their rights to the share options (that is, the right to the options would not have vested). We will consider applying the requirements of AASB 2 in two scenarios, the first being that everything turns out as expected. In the second scenario there is a revision of employee departures. SCENARIO 1 Assuming everything turns out exactly as expected, the entity recognises the following amounts during the vesting period for services received as consideration for the share options. As can be seen, the total amount of the expense is recognised uniformly over the vesting period. There would be an increase in remuneration expense, and an increase in equity of $200 000 each period.

Year

Calculation

1 2 3

100 × 500 × 80% × $15 × 1 year/3 years 100 × 500 × 80% × $15 × 2 years/3 years – $200 000 100 × 500 × 80% × $15 – $400 000

Remuneration expense for period

Cumulative remuneration expense

$200 000 $200 000 $200 000

$200 000 $400 000 $600 000

The related accounting entries at the end of each of the next three years (assuming the salaries expense is not treated as an asset; perhaps in the form of work-in-progress inventory) would be: Dr Cr

Employee benefits expense Share capital (equity)

200 000 200 000

SCENARIO 2 In this scenario, things do not turn out as expected. During year 1, 20 employees leave, which is fewer than anticipated. In view of this, at the end of year 1 the entity revises its estimate of total employee departures over the three-year period from 20 per cent (that is, 100 employees expected to leave) to 15 per cent (that is, 75 employees expected to leave). During year 2, a further 22 employees leave. So at the end of year 2 the entity revises its estimate of total employee departures over the three-year period from 15 per cent down to 12 per cent (that is, 60 employees expected to leave). During year 3, a further 15 employees leave. Therefore, a total of 57 employees forfeited their rights to the share options during the three-year period, and a total of 44 300 share options (443 employees × 100 options per employee) continued CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  633

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vested at the end of year 3. Knowing the actual number of departures allows the ‘correct’ aggregated amount to be recognised at the end of year 3, with an adjustment to be made for amounts previously recognised. Because the actual number of options to be issued is known at the end of year 3, the final year-3 calculation does not need to take probabilities into account. Employee turnover during the vesting period Year 1

Year 2

Year 3

500

500

500

–20

–20 –22

 –55 425

 –18 440

–20 –22 –15     – 443

Number of employees at grant date Actual resignations Year 1 Year 2 Year 3 Expected resignations Total expected number of employees to vest

Year

Expected number of employees to vest

Shares per employee

Fair value of equity instruments

Portion of vesting period

Remuneration expense for period

Cumulative remuneration expense

425 440 443

100 100 100

$15.00 $15.00 $15.00

1/3 2/3 3/3

$212 500 $227 500 $224 500

$212 500 $440 000 $664 500

1 2 3

The accounting entries would be: End of year 1 Dr Employee benefits expense Cr Share capital (equity)

212 500

End of year 2 Dr Employee benefits expense Cr Share capital (equity)

227 500

End of year 3 Dr Employee benefits expense Cr Share capital (equity)

224 500

212 500

227 500

224 500

As shown in Worked Example 17.3, at the end of each reporting period the cumulative expense must be adjusted to reflect the number of shares or options that are ultimately expected to vest. This process of readjusting the amounts based on the latest available information is referred to as ‘truing up’. It should be noted that in Worked Example 17.3 we treated all of the employees the same and did not try to differentiate between them on the basis of the probabilities of their ultimately leaving the organisation. In practice, reporting entities would consider stratifying their employees into different groups on the basis of the likelihood of their leaving the organisation within the vesting period. For example, management might be deemed to have a lower probability of leaving the organisation relative to other staff. In Worked Example 17.3 the vesting conditions were quite straightforward and depended upon the expiration of time. However, an award may be subject to other conditions, say a certain level of earnings over a particular period, with the award vesting immediately the target is reached. In such cases, the reporting entity is required to estimate the length of the vesting period at grant date. As we have noted, this is explained more fully in paragraph 15(b) of AASB 2, where it stipulates that: if an employee is granted share options conditional upon the achievement of a performance condition and remaining in the entity’s employ until that performance condition is satisfied, and the length of the vesting period varies depending on when that performance condition is satisfied, the entity shall presume that the services 634  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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to be rendered by the employee as consideration for the share options will be received in the future, over the expected vesting period. The entity shall estimate the length of the expected vesting period at grant date, based on the most likely outcome of the performance condition. If the performance condition is a market condition, the estimate of the length of the expected vesting period shall be consistent with the assumptions used in estimating the fair value of the options granted, and shall not be subsequently revised. If the performance condition is not a market condition, the entity shall revise its estimate of the length of the vesting period, if necessary, if subsequent information indicates that the length of the vesting period differs from previous estimates. Worked Example 17.4 illustrates the accounting treatment of an equity-settled share-based payment transaction with performance conditions where the length of the vesting period varies.

WORKED EXAMPLE 17.4: Award with non-market conditions and varying vesting period On 1 July 2019, Point Ltd awards 200 shares each to 300 employees subject to certain non-market vesting conditions. The shares are to vest if: • at 30 June 2020 Point Ltd’s earnings have increased by more than 12 per cent • at 30 June 2021 Point Ltd’s earnings have increased by an average of 10 per cent or more over the two-year period since grant date • at 30 June 2022 earnings have increased by an average of 8 per cent over the three-year period since grant date. The shares have a fair value of $12.00 at 1 July 2019, which equals the share price at grant date. No dividends are expected to be paid over the three-year period. During the year ending 30 June 2020, 20 employees leave the organisation. Based on prior experience, Point Ltd believes that a further 30 employees will leave during the remainder of the vesting period. At 30 June 2020 earnings have increased by 11 per cent. It is expected that earnings will continue at a similar rate of increase for 2021. Point Ltd therefore expects the shares to vest on 30 June 2021. By 30 June 2021, 25 employees have resigned. Point Ltd expects a further 25 employees to leave by the end of the vesting period. During the year ending 30 June 2021 earnings increase by 7 per cent. Point Ltd expects that during the year ending 30 June 2022 earnings will increase by at least 8 per cent, meaning that earnings will have increased by more than the average of 8 per cent over the three-year period. At 30 June 2022, 32 employees had left during the year, and Point Ltd’s earnings had increased by 9 per cent during the year. REQUIRED Prepare the accounting journal entries for the years ending 30 June 2020, 2021 and 2022. SOLUTION Employee turnover during the vesting period is calculated as follows:

Number of employees at grant date Actual resignations Year to 30 June 2020 Year to 30 June 2021 Year to 30 June 2022 Expected future resignations Actual increase in earnings Average increase in earnings Expected average increase over vesting period

30 June 2020

30 June 2021

30 June 2022

300

300

300

(20)

(20) (25)

  (30) 250 11.0% 11.0% 11.0%

  (25) 230 7.0% 9.0% 8.0%

(20) (25) (32)      – 223 9.0% 9.0%

continued CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  635

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Year

Expected Expected Cumulative number of Shares Fair value portion of remuneration Cumulative Remuneration employees per of equity vesting expense up to remuneration expense for to vest employee instruments period previous period expense period

30 June 2020 30 June 2021 30 June 2022

250 230 223

200 200 200

$12.00 $12.00 $12.00

1/2 2/3 3/3

$300 000 $368 000

$300 000 $368 000 $535 200

$300 000 $68 000* $167 200**

* $68 000 = (230 × 200 × $12 × 2/3) — $300 000 ** $167 200 = (223 × 200 × $12 × 3/3) — $368 000 The above calculations are based on the expectations held at the end of each reporting period. For example, at the end of 2020 It was anticipated that the share entitlement would vest at the end of 2021.

The accounting journal entries for the years ending 30 June 2020, 2021 and 2022 30 June 2020 Dr Cr

Employee benefits expense Share capital

300 000

30 June 2021 Dr Cr

Employee benefits expense Share capital

68 000

30 June 2022 Dr Cr

Employee benefits expense Share capital

167 200

300 000

68 000

167 200

Measuring fair value of equity instruments The discussion so far has addressed whether the expenses or assets associated with equity instruments should be recognised at grant date or during a vesting period. We also need to consider the actual amount to be recognised as an asset or expense. Measuring the value of equity instruments is obviously a great deal easier if the instruments are being traded on a recognised securities exchange. If so, reference can simply be made to the quoted market price of the securities. If market prices are not available, estimates of fair value must be made. According to paragraphs 16 and 17 of AASB 2: 16. For transactions measured by reference to the fair value of the equity instruments granted, an entity shall measure the fair value of equity instruments granted at the measurement date, based on market prices if available, taking into account the terms and conditions upon which those equity instruments were granted. 17. If market prices are not available, the entity shall estimate the fair value of the equity instruments granted using a valuation technique to estimate what the price of those equity instruments would have been on the measurement date in an arm’s length transaction between knowledgeable, willing parties. The valuation technique shall be consistent with generally accepted valuation methodologies for pricing financial instruments, and shall incorporate all factors and assumptions that knowledgeable, willing market participants would consider in setting the price. The above requirements are interesting because they allow an organisation to choose which valuation model to adopt. This has obvious implications for inter-firm comparability. While our intention here is not to go into the details of calculating the fair value of share options—for example, by applying the Black–Scholes Option Pricing Model—it is worth noting the issues that should be considered when determining the fair value of equity instruments such as share options. Appendix B to AASB 2 provides guidance. Paragraphs B4 to B8 include some useful discussion, and they are reproduced in what follows. B4. For share options granted to employees, in many cases market prices are not available, because the options granted are subject to terms and conditions that do not apply to traded options. If traded options 636  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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with similar terms and conditions do not exist, the fair value of the options granted shall be estimated by applying an option pricing model. B5. The entity shall consider factors that knowledgeable, willing market participants would consider in selecting the option pricing model to apply. For example, many employee options have long lives, are usually exercisable during the period between vesting date and the end of the option’s life, and are often exercised early. These factors should be considered when estimating the grant date fair value of the options. For many entities, this might preclude the use of the Black—Scholes—Merton formula, which does not allow for the possibility of exercise before the end of the option’s life and may not adequately reflect the effects of expected early exercise. It also does not allow for the possibility that expected volatility and other model inputs might vary over the option’s life. However, for share options with relatively short contractual lives, or that must be exercised within a short period of time after vesting date, the factors identified above may not apply. In these instances, the Black—Scholes—Merton formula may produce a value that is substantially the same as a more flexible option pricing model. B6. All option pricing models take into account, as a minimum, the following factors: (a) the exercise price of the option; (b) the life of the option; (c) the current price of the underlying shares; (d) the expected volatility of the share price; (e) the dividends expected on the shares (if appropriate); and (f) the risk-free interest rate for the life of the option. B7. Other factors that knowledgeable, willing market participants would consider in setting the price shall also be taken into account. B8. For example, a share option granted to an employee typically cannot be exercised during specified periods (e.g. during the vesting period or during periods specified by securities regulators). This factor shall be taken into account if the option pricing model applied would otherwise assume that the option could be exercised at any time during its life. However, if an entity uses an option pricing model that values options that can be exercised only at the end of the options’ life, no adjustment is required for the inability to exercise them during the vesting period (or other periods during the options’ life), because the model assumes that the options cannot be exercised during those periods.

Vesting conditions not to influence fair value attributed to equity instruments It is a general requirement of AASB 2 that vesting conditions are not to influence the calculated fair value of each unit of equity instruments. Rather, vesting conditions are to influence the fair value of the total share-based transaction through influencing the number of equity instruments to be recognised. As paragraphs 19 and 20 of AASB 2 state: 19. A grant of equity instruments might be conditional upon satisfying specified vesting conditions. For example, a grant of shares or share options to an employee is typically conditional on the employee remaining in the entity’s employ for a specified period of time. There might be performance conditions that must be satisfied, such as the entity achieving a specified growth in profit or a specified increase in the entity’s share price. Vesting conditions, other than market conditions, shall not be taken into account when estimating the fair value of the shares or share options at the measurement date. Instead, vesting conditions shall be taken into account by adjusting the number of equity instruments included in the measurement of the transaction amount so that, ultimately, the amount recognised for goods or services received as consideration for the equity instruments granted shall be based on the number of equity instruments that eventually vest. Hence, on a cumulative basis, no amount is recognised for goods or services received if the equity instruments granted do not vest because of failure to satisfy a vesting condition, for example, the counterparty fails to complete a specified service period, or a performance condition is not satisfied. 20. To apply the requirements of paragraph 19, the entity shall recognise an amount for the goods or services received during the vesting period based on the best available estimate of the number of equity instruments expected to vest and shall revise that estimate, if necessary, if subsequent information indicates that the number of equity instruments expected to vest differs from previous estimates. On vesting date, the entity shall revise the estimate to equal the number of equity instruments that ultimately vested. CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  637

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Table 17.3 Market and other than market conditions

Market conditions

Other than market (non-market) conditions

Achieving a specific share price for the entity’s equity instrument

Employees remain in the entity’s employ for a specific period of time, e.g. four years

Achieving a specific target share price relative to an index of market prices

A specific growth in profits is attained

Achieving an annual increase in share price over a period of years

Achieving a specific growth in revenues Achieving a non-financial target Achieving a specific increase in earnings per share

market conditions Conditions upon which the exercise price, vesting or exercisability of an equity instrument depends, related to the market price of an entity’s equity instruments.

Equity-settled share-based payments may also be issued with market conditions. Market conditions are those conditions upon which the exercise price, vesting or exercisability of an equity instrument depends and are related to the market price of the entity’s equity instruments. These include attaining a specified share price or a specified amount of intrinsic value of a share option, or achieving a specified target that is based on the market price of the entity’s equity instruments relative to an index of market prices of equity instruments of other entities. Examples of market and other than market conditions (non-market conditions) are detailed in Table 17.3. In Worked Example 17.5, the accounting treatment of an equity-settled share-based payment transaction with market conditions is set out.

WORKED EXAMPLE 17.5: Options issued with market conditions On 1 July 2018, Cingular Ltd grants each of its nine directors 50 000 share options conditional upon them completing their initial three-year contract under the terms that follow. The share options cannot be exercised unless the share price increases from $5.50 at 1 July 2018 to more than $12.00 by 30 June 2021. Should the share price be higher than $12.00 at 30 June 2021, the share options may be exercised at any time during the next three years; that is, by the end of 2024. Cingular Ltd applies a binomial option pricing model, which takes into account the possibility that: • the share price will exceed $12.00 at 30 June 2021 (meaning the share options will become exercisable); and • the share price will not exceed $12.00 at 30 June 2021 (meaning that the options will be forfeited). The fair value of the share options with this market condition at grant date is expected to be $1.00 per option. During the reporting period ending 30 June 2019, the share price increased to $8.00. At 30 June 2019, Cingular Ltd estimates the fair value of the share options with the market conditions to be $2.50 each. Applying a binomial option pricing model, this fair value takes into account whether the market conditions will be satisfied by 30 June 2021. During the reporting period ending 30 June 2020, the share price decreased to $7.20 but Cingular Ltd is still optimistic about meeting the share price target of $12.00. The fair value of the share options is estimated to be $2.10, taking into account whether or not the share price will reach the targeted $12.00 per share. At 30 June 2021, the share price had reached only $11.00 per share. The fair value of the share options is estimated to be $nil as the market conditions have not been satisfied. REQUIRED Prepare the journal entries that would appear in the records of Cingular Ltd for the reporting periods ending 30 June 2019, 30 June 2020 and 30 June 2021. SOLUTION

Year

Expected number of employees to vest

Options per employee

9 9 9

50 000 50 000 50 000

30 June 2019 30 June 2020 30 June 2021

Fair value of option

Portion of vesting period

Remuneration expense for period

Cumulative remuneration expense

$1.00 $1.00 $1.00

1/3 2/3 3/3

$150 000 $150 000 $150 000

$150 000 $300 000 $450 000

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AASB 2 requires the services performed by the directors to be recognised if they meet all other vesting conditions, irrespective of whether the market condition is satisfied. This is consistent with paragraph IG9 within the Implementation Guidance to AASB 2, which states that: Fair value is estimated at grant date (for transactions with employees and others providing similar services) and not subsequently revised. Hence, neither increases nor decreases in the fair value of the equity instruments after grant date are taken into account when determining the transaction amount. Since in this worked example the directors were required to remain until the end of their initial three-year contract, which they did, it makes no difference whether or not the share-price target is met. The accounting entries for each of the three years would be: Dr

Employee benefits expense

Cr

Share capital

150 000 150 000

(Recognising expense arising from equity-settled share-based payment transaction) Worked Example 17.6 examines the accounting treatment of an equity-settled share-based payment transaction with market conditions where the length of the vesting period varies.

WORKED EXAMPLE 17.6: Award with market conditions and variable vesting period On 1 July 2018, Crash Test Dummy Ltd granted 50 000 share options with a ten-year life to each of its 15 senior managers. The grant is conditional on the employees remaining in Crash Test Dummy Ltd’s employment until the market conditions detailed here are satisfied. Under the market conditions, the share options will vest and become exercisable immediately if and when Crash Test Dummy Ltd’s share price increases from $5.50 to $12.00 per share. Crash Test Dummy Ltd applies a binomial option pricing model, which takes into account the possibility that: • the share price will be achieved during the ten-year life of the options • the share price will not be achieved, meaning that the options will be forfeited. The fair value of the share options with this market condition at grant date is expected to be $1.00 per option. From the option pricing model, the entity determines that the mode of the distribution of possible vesting dates is five years. This means that, of all the possible outcomes, the most likely outcome of the market condition is that the share price target will be achieved at the end of five years: that is, by 30 June 2023. At 30 June 2019, no senior managers had left the company. However, Crash Test Dummy Ltd expects three executives to leave by 30 June 2023. The share price at 30 June 2019 was $6.20. During the reporting period ending 30 June 2020, one senior manager left and the company expects three executives to leave by 30 June 2023. During 30 June 2021, another senior manager had left and an additional three senior managers are expected to leave before 30 June 2023. During 30 June 2022, two senior managers had left. By then no managers are expected to leave before 30 June 2023. Between 1 July 2019 and 30 June 2022, the share price increased to $10.40. During the reporting period ending 30 June 2023, no senior managers left Crash Test Dummy Ltd. At 30 June 2023 the share price was $11.20. At 30 June 2024, a further three executives had left. At that date the share price was $12.30. REQUIRED Calculate the remuneration expense and the cumulative remuneration expense for each reporting period. SOLUTION As Crash Test Dummy Ltd expects to achieve the share price target by 30 June 2023, the expected vesting period is five years. At 30 June 2023, the share price target was not met. continued CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  639

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Year 30 June 2019 30 June 2020 30 June 2021 30 June 2022 30 June 2023 30 June 2024

Expected number of employees to vest

Options per employee

Fair value of option

12 11 10 11 11 8

50 000 50 000 50 000 50 000 50 000 50 000

$1.00 $1.00 $1.00 $1.00 $1.00 $1.00

Portion of vesting period

Remuneration expense for period

Cumulative remuneration expense

1/5 2/5 3/5 4/5 5/5

$120 000 $100 000 $80 000 $140 000 $110 000 $(150 000)

$120 000 $220 000 $300 000 $440 000 $550 000 $400 000

AASB 2 requires Crash Test Dummy Ltd to recognise the services received over the expected vesting period as estimated at the grant date. Crash Test Dummy Ltd is not to revise the fair value estimate after that.

Where fair value cannot be determined If it is not considered possible to determine the fair value of equity instruments, even by using various valuation techniques such as share option pricing models (and this is deemed by the standard to happen only on ‘rare occasions’), the equity instruments may be valued at their ‘intrinsic value’. As indicated previously, intrinsic value is defined in AASB 2 as: The difference between the fair value of the shares to which the counterparty has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price (if any) the counterparty is (or will be) required to pay for those shares. For example, a share option with an exercise price of CU15, on a share with a fair value of CU20, has an intrinsic value of CU5. According to paragraph 24 of AASB 2: The requirements in paragraphs 16–23 apply when the entity is required to measure a share-based payment transaction by reference to the fair value of the equity instruments granted. In rare cases, the entity may be unable to estimate reliably the fair value of the equity instruments granted at the measurement date, in accordance with the requirements in paragraphs 16–22. In these rare cases only, the entity shall instead: (a) measure the equity instruments at their intrinsic value, initially at the date the entity obtains the goods or the counterparty renders service and subsequently at the end of each reporting period and at the date of final settlement, with any change in intrinsic value recognised in profit or loss. For a grant of share options, the share-based payment arrangement is finally settled when the options are exercised, are forfeited (e.g. upon cessation of employment) or lapse (e.g. at the end of the option’s life); and (b) recognise the goods or services received based on the number of equity instruments that ultimately vest or (where applicable) are ultimately exercised. To apply this requirement to share options, for example, the entity shall recognise the goods or services received during the vesting period, if any, in accordance with paragraphs 14 and 15, except that the requirements in paragraph 15(b) concerning a market condition do not apply. The amount recognised for goods or services received during the vesting period shall be based on the number of share options expected to vest. The entity shall revise that estimate, if necessary, if subsequent information indicates that the number of share options expected to vest differs from previous estimates. On vesting date, the entity shall revise the estimate to equal the number of equity instruments that ultimately vested. After vesting date, the entity shall reverse the amount recognised for goods or services received if the share options are later forfeited, or lapse at the end of the share option’s life.

Modification of terms and conditions of equity interests Equity instruments can be modified or cancelled before or after vesting. This typically occurs when the conditions under which the equity instruments were granted become so onerous that it becomes unlikely the employee will ever benefit from them or, in the case of an option, the share price has fallen below the exercise price of the option so that it is unlikely ever to be ‘in the money’ to the holder. In these circumstances the reporting entity may modify the terms and conditions 640  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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under which the equity instruments were granted. A typical example is to reduce the exercise price of, or reprice, options granted to employees. This repricing has the effect of increasing the fair value of the options. Guidance on how modifications should be accounted for is provided at paragraph 27 and paragraphs B42 and B44 of AASB 2. According to paragraph 27: The entity shall recognise, as a minimum, the services received measured at the grant date fair value of the equity instruments granted, unless those equity instruments do not vest because of failure to satisfy a vesting condition (other than a market condition) that was specified at grant date. This applies irrespective of any modifications to the terms and conditions on which the equity instruments were granted, or a cancellation or settlement of that grant of equity instruments. In addition, the entity shall recognise the effects of modifications that increase the total fair value of the share-based payment arrangement or are otherwise beneficial to the employee. Where the modification increases the fair value of the equity instrument granted, for example, by reducing the exercise price, AASB 2 requires the reporting entity to include the incremental fair value granted in the measurement of the amount recognised for services received as consideration for the equity instruments granted. The ‘incremental fair value granted’ is the difference between the fair value of the modified equity instrument and that of the original equity instrument, both estimated as at the date of the modification. The accounting treatment for modifications that increase the fair value of the equity instrument and that occur during and after the vesting period is described by paragraph B43(a) of AASB 2 as follows: If the modification increases the fair value of the equity instruments granted (e.g. by reducing the exercise price), measured immediately before and after the modification, the entity shall include the incremental fair value granted in the measurement of the amount recognised for services received as consideration for the equity instruments granted. The incremental fair value granted is the difference between the fair value of the modified equity instrument and that of the original equity instrument, both estimated as at the date of the modification. If the modification occurs during the vesting period, the incremental fair value granted is included in the measurement of the amount recognised for services received over the period from the modification date until the date when the modified equity instruments vest, in addition to the amount based on the grant date fair value of the original equity instruments, which is recognised over the remainder of the original vesting period. If the modification occurs after vesting date, the incremental fair value granted is recognised immediately, or over the vesting period if the employee is required to complete an additional period of service before becoming unconditionally entitled to those modified equity instruments. Should the modification of the equity-settled share-based transaction arrangement increase the number of equity instruments granted, the reporting entity includes the fair value of the additional equity instruments granted, measured at the date of the modification, in the measurement of the amount recognised for services received as consideration for the equity instruments granted. Where the reporting entity modifies the vesting conditions so as to benefit the employee, either by reducing the vesting period or by modifying a performance condition, the modified vesting conditions should be taken into account by adjusting the number of equity instruments included in the measurement of the transaction amount. An example of a modification to an equity-settled share-based payment arrangement that increases the value of the equity instruments granted is provided in Worked Example 17.7.

WORKED EXAMPLE 17.7: Options granted to employees that are subsequently repriced On 1 July 2019, Janjuc Ltd grants 200 share options to each of its 400 employees. The share options are conditional on the employees remaining in Janjuc Ltd’s employ during the three-year vesting period. At the grant date of 1 July 2019 the fair value of the share price is expected to be $8.00. At 1 July 2019 the fair value of each option is determined as being $6.00. During the year ended 30 June 2020, 20 employees resign from the company. Janjuc Ltd estimates that a further 40 employees will leave before the options expire. At 30 June 2020 the company’s share price drops to $6.50 and, as a result, Janjuc decides to reprice its options. The options will retain the same vesting date, this being 30 June 2022. continued CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  641

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At the date of repricing the options, Janjuc Ltd estimates, using an options pricing model, that the fair value of each of the original share options granted—before taking into consideration the repricing—is $4.00. The repriced share options are considered to have a value of $5.50. By 30 June 2021 a further 40 employees have resigned and the company expects a further 25 employees to resign before the option entitlements vest. A further 32 employees resigned during the year ended 30 June 2022. REQUIRED Calculate the remuneration expense and present the journal entries that would appear in the records of Janjuc Ltd for the years ending 30 June 2020, 2021 and 2022. SOLUTION Employee turnover during the vesting period is calculated as follows: 30 June 2020 Number of employees at grant date Actual resignations 30 June 2020 30 June 2021 30 June 2022 Expected further resignations before vesting date Total expected number of employees at vesting date Repricing of options Fair value of original share options (immediately prior to repricing) Fair value of repriced options Incremental fair value granted

Year

30 June 2021

30 June 2022

400

400

400

(20)

(20) (40)

 (40) 340

  (25) 315

(20) (40) (32)      – 308 $4.00 $5.50 $1.50

Expected Expected Cumulative number of Share Fair value portion of remuneration Cumulative Remuneration employees options per of equity vesting expense up to remuneration expense for to vest employee instruments period previous period expense period

30 June 2020 30 June 2021 Initial issue Incremental fair value granted Total expense for 2021 30 June 2022 Incremental fair value granted Total expense for 2022

340

200

$6.00

1/3

                 

$136 000

$136 000

315

200

$6.00

2/3

$136 000

$252 000

$116 000

315

200

$1.50

1/2

                 

$47 250

  $47 250

        308

        200

           $6.00

       3/3

                  $252 000

                 $369 600

$163 250* $117 600

308

200

$1.50

2/2

$47 250

  $92 400

 $45 150

       

       

          

      

                 

                

$162 750**

* $163 250 = [(315 × 200 × $6.00 × 2/3) – $136 000] + (315 × 200 × $1.50 × 1/2) ** $162 750 = [(308 × 200 × $6.00 × 3/3) – $252 000] + [(308 × 200 × $1.50 × 2/2) – $47 250] The above calculations are based on the expectations held at the end of each reporting period. The cost associated with the options originally issued prior to repricing is shared across the vesting period.

Here the modification increases the fair value of the equity instruments granted, measured immediately before and after the modification. Janjuc Ltd includes the incremental fair value granted in the measurement of the amount recognised for services received as consideration for the equity instruments granted.

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The accounting entries would be: 30 June 2020 Dr Employee benefits expense Cr Share capital

136 000

30 June 2021 Dr Employee benefits expense Cr Share capital

163 250

30 June 2022 Dr Employee benefits expense Cr Share capital

162 750

136 000

163 250

162 750

We now move on from equity-settled share-based payment transactions to a second type of share-based transaction – cash-settled share-based payment transactions.

Cash-settled share-based payment transactions Cash-settled share-based payment transactions happen when equity instruments do not transfer as a result of a transaction but the ultimate cash flow associated with the transaction is tied to some aspect of an equity instrument, such as a change in its fair value. A cash-settled share-based payment transaction is defined in AASB 2 as: A share-based payment transaction in which the entity acquires goods or services by incurring a liability to transfer cash or other assets to the supplier of those goods or services for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity or another group entity. With regard to the required accounting treatment (see Worked Example 17.8), paragraph 30 of AASB 2 requires: For cash-settled share-based payment transactions, the entity shall measure the goods or services acquired and the liability incurred at the fair value of the liability. Until the liability is settled, the entity shall remeasure the fair value of the liability at the end of each reporting period and at the date of settlement, with any changes in fair value recognised in profit or loss for the period.

LO 17.4

cash-settled sharebased payment transaction Transaction in which a reporting entity acquires goods or services by incurring a liability to transfer cash or other assets to the supplier of the goods or services for amounts based on the price (or value) of the entity’s shares or other equity instruments of the entity.

WORKED EXAMPLE 17.8: Accounting for share appreciation rights On 1 July 2019 Coogee Ltd provides its managing director with a share-based incentive, according to which she is offered a bonus that is calculated as 200 000 times the increase in the fair value of the entity’s share price above $2.50. When the bonus was offered the share price was $2.25. If the managing director does not leave the organisation the accrued entitlement will be paid after three years. However, if she leaves the organisation the accrued entitlement will be paid out upon departure—that is, the benefit will not be forfeited. Other information • The share price at 30 June 2020 is $3.00. • The share price at 30 June 2021 is $2.90. • The share price at 30 June 2022 is $4.10. • The managing director stays for three years and is paid the bonus on 1 July 2022. REQUIRED Prepare the journal entries that would appear in the accounting records of Coogee Ltd to account for the issue of the share appreciation rights. continued CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  643

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SOLUTION

Year end 30 June 2020 30 June 2021 30 June 2022

Calculation 200 000 × ($3.00 − $2.50) 200 000 × ($2.90 − $2.50) − $100 000 200 000 × ($4.10 − $2.50) − $80 000

Remuneration expense for period $100 000 ($20 000) $240 000

Cumulative remuneration expense $100 000 $80 000 $320 000

The accounting entries would be: 30 June 2020 Dr Employee benefits expense Cr Accrued salaries payable 30 June 2021 Dr Accrued salaries payable Cr Employee benefits expense recouped (revenue)

100 000 100 000 20 000 20 000

30 June 2022 Dr Employee benefits expense Cr Accrued salaries payable

240 000

1 July 2022 Dr Accrued salaries payable Cr Bank

320 000

share appreciation rights (SARs) Rights entitling employees, generally as part of their remuneration package, to future cash payments based on pre-specified increases in the entity’s share price.

240 000

320 000

An example of a cash-settled share-based payment transaction is share appreciation rights (SARs). SARs are generally granted to employees as part of their remuneration package. They entitle employees to future cash payments based on increases in the entity’s share price from a pre-specified level over a pre-specified period of time. In relation to cash-settled share-based transactions, paragraphs 31, 32 and 33 of AASB 2 elaborate as follows:

31.  For example, an entity might grant share appreciation rights to employees as part of their remuneration package, whereby the employees will become entitled to a future cash payment (rather than an equity instrument), based on the increase in the entity’s share price from a specified level over a specified period of time. Or an entity might grant to its employees a right to receive a future cash payment by granting to them a right to shares (including shares to be issued upon the exercise of share options) that are redeemable, either mandatorily (e.g. upon cessation of employment) or at the employee’s option. 32.  The entity shall recognise the services received, and a liability to pay for those services, as the employees render service. For example, some share appreciation rights vest immediately, and the employees are therefore not required to complete a specified period of service to become entitled to the cash payment. In the absence of evidence to the contrary, the entity shall presume that the services rendered by the employees in exchange for the share appreciation rights have been received. Thus, the entity shall recognise immediately the services received and a liability to pay for them. If the share appreciation rights do not vest until the employees have completed a specified period of service, the entity shall recognise the services received, and a liability to pay for them, as the employees render service during that period. 33. The liability shall be measured, initially and at the end of each reporting period until settled, at the fair value of the share appreciation rights, by applying an option pricing model, taking into account the terms and conditions on which the share appreciation rights were granted, and the extent to which the employees have rendered service to date. In contrast with cash-settled share-based transactions (as described above), for equity-settled share-based transactions (described in the previous section of this chapter) remeasurement of the granted equity instruments does not occur at subsequent reporting dates. That is, with equity-settled share-based transactions any subsequent change in value of the equity instruments is ignored, whereas with cash-settled share-based transactions the related liabilities 644  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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are adjusted to fair value at the end of each reporting period, with a resultant impact on reported profit or loss. This difference in treatment is interesting and it is worth considering whether it is conceptually warranted. This appears to be a clear case of form being applied over substance. Further, the accounting requirements for cash-settled transactions are more onerous than those for equity-settled transactions because of, for example, the requirement to remeasure fair value at the end of each reporting period. Moreover, using cash-settled shared-based transactions could introduce some unwanted volatility into reported profits in the light of the requirement to make fair value adjustments at the end of each reporting period. This potential volatility might act as a disincentive for reporting entities to use them. In Worked Example 17.9, accounting for share appreciation rights is considered.

WORKED EXAMPLE 17.9: Cash-settled share-based payment transaction—share appreciation rights On July 2018, Tickles Clothing Ltd (Tickles) granted 1000 share appreciation rights to each of its 300 employees. Under the terms of the agreement the employees will become entitled to a future cash payment based on the increase in Tickles’ share price over the next three years. Vesting of the share appreciation rights is conditional upon the employees remaining in Tickles’ employment for the next three years. The share appreciation rights can be exercised at any time between 30 June 2021 and 30 June 2023. Tickles estimates the fair value of the rights at the end of each year in which the liability exists, as well as the intrinsic value of the rights at the date of exercise (which equal the cash paid out). The fair value of the rights at the grant date was $5.40. Additional information The fair value of the share appreciation rights at the end of each reporting period: Year 30 June 2019 30 June 2020 30 June 2021

Fair value $5.60 $6.10 $6.90

Employee turnover during the vesting period Number of employees at grant date Actual resignations 30 June 2019 30 June 2020 30 June 2021 Expected resignations 30 June 2020 30 June 2018 Total expected number of employees to vest

30 June 2019 300

30 June 2020 300

30 June 2021 300

–18

–18 –22

–18 –22 –25

 –20 240

      – 235

–15  –15 252

REQUIRED (a) Calculate the liability at 30 June 2019, 30 June 2020 and 30 June 2021. (b) From the information arrived at in (a) above, prepare the journal entries that would appear at the end of each reporting period date assuming that none of the employees had exercised their rights. (c) Assume that on 30 June 2021, 95 employees exercise their rights, another 60 exercise their rights at 30 June 2022, and the remaining employees exercise their rights at 30 June 2023. The fair value and intrinsic value of the shares at the end of each of the reporting period dates are as follows: Year 30 June 2021 30 June 2022 30 June 2023

Fair value $6.90 $7.50 $8.60

Intrinsic value $5.90 $7.30 $9.10

Calculate the cash payments that would be made by Tickles at 30 June 2021, 30 June 2022 and 30 June 2023. continued CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  645

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(d) From the information arrived at in (a) and (c) above, prepare the journal entries at 30 June 2021, 30 June 2022 and 30 June 2023. SOLUTION (a) The liability at the end of each reporting period can be calculated as follows:

Year 30 June 2019 30 June 2020 30 June 2021

Number of employees

Number of share appreciation rights

Fair value at the end of each reporting period

Vesting period

Liability at the end of each reporting period

252 240 235

1 000 1 000 1 000

$5.60 $6.10 $6.90

1/3 2/3 3/3

$470 400 $976 000 $1 621 500

(b) Journal entries 30 June 2019 Dr Employee benefits expense 470 400 Cr Accrued salaries payable 470 400 (Recognising expense arising from cash-settled share-based payment transaction (share appreciation rights)) 30 June 2020 Dr Employee benefits expense 505 600 Cr Accrued salaries payable 505 600 (Recognising expense arising from cash-settled share-based payment transaction (share appreciation rights)) 30 June 2021 Dr Employee benefits expense 645 500 Cr Accrued salaries payable 645 500 (Recognising expense arising from cash-settled share-based payment transaction (share appreciation rights)) (c) Cash payment at date of exercise Year 30 June 2021 30 June 2022 30 June 2023

Number of employees exercising their rights

SARS per employee

Intrinsic value of SARS

Cash payment at the end of each reporting period

95 60 80 235

1 000 1 000 1 000

$5.90 $7.30 $9.10

$560 500 $438 000 $728 000

(d) Journal entries 30 June 2021 Dr Employee benefits expense Dr Accrued salaries payable Cr Cash (Recognising exercise of share appreciation rights)

550 500 10 000 560 500

At 30 June 2021, 140 (235 – 95) employees still have to exercise their rights. The liability at 30 June 2021 based on the fair value of the share appreciation rights at that date would amount to $966 000 ($6.90 × 1000 × 140). As the liability at 30 June 2020 was $976 000, it must be adjusted by $10 000. 30 June 2022 Dr Accrued salaries payable Dr Employee benefits expense Cr Cash (Recognising exercise of share appreciation rights)

366 000 72 000 438 000

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At 30 June 2022, 80 (140 – 60) employees still have to exercise their rights. The liability at 30 June 2022 based on the fair value of the share appreciation rights at that date would amount to $600 000 ($7.50 × 1000 × 80). As the liability at 30 June 2021 was $966 000 it must be adjusted by $366 000. 30 June 2023 Dr Accrued salaries payable Dr Employee benefits expense Cr Cash (Recognising exercise of share appreciation rights)

600 000 128 000 728 000

At 30 June 2023, no employees still have to exercise their rights. The liability at 30 June 2023 based on the fair value of the share appreciation rights at that date would amount to $nil. As the liability at 30 June 2022 was $600 000, it must be reduced to $nil at 30 June 2023.

Share-based payment transactions with cash alternatives This is the third category of share-based transactions covered by AASB 2. According to AASB 2, share-based payment transactions with cash alternatives are transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity, or the supplier of those goods or services, with the choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments. Paragraph 34 of AASB 2 describes the required accounting treatment as follows: For share-based payment transactions in which the terms of the arrangement provide either the entity or the counterparty with the choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments, the entity shall account for that transaction, or the components of that transaction, as a cash-settled share-based payment transaction if, and to the extent that, the entity has incurred a liability to settle in cash or other assets, or as an equity-settled share-based payment transaction if, and to the extent that, no such liability has been incurred. Where the other party to the transaction (the counterparty) has the right to demand cash or equity settlement, the transaction may be considered to give rise to a compound financial instrument with both a liability and an equity component. The equity component would be measured as the difference between the fair value of the goods and services received and the fair value of the liability component as at the date on which the goods and services are provided. Worked Example 17.10 illustrates the treatment of a share-based payment transaction with a cash alternative.

LO 17.5

share-based payment transaction with cash alternatives Transaction in which the entity acquires goods or services on terms that provide either the entity or the supplier of those goods or services with the choice as to whether the entity settles the transaction in cash or by issuing equity instruments.

compound financial instrument Financial instrument with both a liability and an equity component.

WORKED EXAMPLE 17.10: Share-based payment transaction with a cash alternative On 1 July 2019 Winki Ltd granted its managing director the right to choose either 20 000 phantom shares (that is, the right to receive a cash payment equivalent to the value of 20 000 shares), or 25 000 shares in the company. The grant is conditional upon the completion of three years’ service as managing director of Winki Ltd. In addition, should the managing director choose the shares alternative, the shares must be held for an additional two years after vesting date. On 1 July 2019 Winki Ltd’s share price was $16.00. The subsequent share prices were as follows: At the grant date, Winki Ltd did not expect to pay any dividends during the period of the arrangement with the managing director, as all profits are being reinvested. This policy was maintained during the period of the arrangement. 30 June 2020 30 June 2021 30 June 2022

$13.00 $18.00 $22.00 continued CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  647

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After taking into account the effects of the post-vesting restrictions, Winki Ltd estimated that the fair value of the share alternative as at 1 July 2019 was $12.00 per share. REQUIRED (a) Identify the nature of the transaction described above. (b) Determine how the transaction should be treated for accounting purposes. (c) Prepare the journal entries for the years ending 30 June 2020, 2021 and 2022 to account for the transaction. SOLUTION (a) The transaction is a share-based arrangement with a cash alternative at the option of the employee. Vesting is conditional upon the managing director completing three years’ service. (b) The transaction is a compound financial instrument (also discussed in Chapter 14), so the identified debt and equity components of the financial instrument need to be accounted for separately. (c) Journal entries for the years ending 30 June 2020, 2021 and 2022 Fair value of debt component Phantom shares 20 000 Share price at grant date Fair value of compound instrument Shares 25 000 Grant date fair value of share alternative Fair value of equity component

$16.00

Fair value of cash alternative

$320 000

$12.00

Fair value of equity alternative

$300 000 $20 000

A cost based on the following amounts is recognised: Year 30 June 2020 30 June 2021 30 June 2022

Year 30 June 2020 30 June 2021 30 June 2022

Fair value of equity components

Vesting period

Cumulative expense

Expense for year

$20 000 $20 000 $20 000

1/3 2/3 3/3

$6 666 $13 333 $20 000

$6 666 $6 667 $6 667

Phantom shares

Share price at reporting date

Vesting period

Cumulative expense

Expense for year

20 000 20 000 20 000

$13.00 $18.00 $22.00

1/3 2/3 3/3

$86 667 $240 000 $440 000

$86 667 $153 333 $200 000

Journal entries 30 June 2020 Dr Employee benefits expense 93 333 Cr Liability for employee services 86 667 Cr Share capital 6 666 (the combined expense is calculated by adding the equity component to the liability component represented by the phantom shares) 30 June 2021 Dr Employee benefits expense 160 000 Cr Liability for employee services 153 333 Cr Share capital 6 667 30 June 2022 Dr Employee benefits expense 206 667 Cr Liability for employee expenses 200 000 Cr Share capital 6 667

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Scope of AASB 2

Applies to share-based transactions involving both employees and non-employees

Basis of measurement

Fair value

Measurement date

Grant date

When is cost recognised?

If involving a period of service the expense is recognised over the period of the service (vesting period). If shares or options vest immediately the fair value is expensed at the grant date.

What option pricing model is to be used?

If the options are short term, generally the Black–Scholes option pricing model would be used, otherwise other option pricing models might be employed. The models need to take into account the exercise price; current price; expected volatility; expected dividends; risk-free rate of return; and the life of the options.

Cash-settled share-based payment transactions—debt or equity?

Cash-settled share-based payment transactions are to be measured at fair value and disclosed as a liability. Fair value is remeasured at the end of each reporting period and the movement in fair value is to be treated as part of profit or loss.

Table 17.4 Summary of some of the main elements of AASB 2

The terms of an agreement with an employee such as that in Worked Example 17.10 might be such that the entity has a choice of whether to settle in cash or by issuing equity instruments. As indicated at paragraph 34 of AASB 2, in such a situation the entity must establish whether it has a present obligation to settle in cash and account for the sharebased transaction accordingly. Where the entity may choose to settle the share-based payment transaction either in cash or with an equity instrument, paragraph 41 of AASB 2 requires the entity to determine: whether it has a present obligation to settle in cash and account for the share-based payment transaction accordingly. The entity has a present obligation to settle in cash if the choice of settlement in equity instruments has no commercial substance (e.g. because the entity is legally prohibited from issuing shares), or the entity has a past practice or a stated policy of settling in cash, or generally settles in cash whenever the counterparty asks for cash settlement. If the entity has a present obligation to settle in cash, the transaction must be accounted for as a cash-settled sharebased payment transaction. Should the entity have no such present obligation, the transaction is to be accounted for as an equity-settled share-based payment transaction. Before considering the possible economic implications of AASB 2, it would be useful to summarise some of the key points of the standard. This is done in Table 17.4.

Possible economic implications of AASB 2

LO 17.8

With the release of AASB 2, many organisations that did not previously recognise any expenses in relation to certain share-based transactions were subsequently required to do so. This was particularly true of sharebased transactions with employees. While reported expenses increased (although in some cases the share-based transaction might initially be recorded as an asset), if the transactions are classified as cash-settled share-based payment transactions, there was also an increase in reported liabilities. Arguably, it would not be unreasonable to contend that these effects on financial performance and position had implications for the propensity of Australian organisations to undertake share-based transactions, particularly those involving employees. If it were accepted that employee share schemes help to attract, motivate and retain key employees, then a drop in the use of employee-related share-based transactions would have adverse implications for many organisations. There is a chance that alternative forms of remuneration will be used to attract employees—and that these other forms might have greater cost implications than the share-based arrangements of the past. This view is consistent with the position adopted by the Institute of Chartered Accountants in Australia, which in 2004 (as reported in ‘Snapshots’, Business Review Weekly, 24 March 2004) expressed the following reservations: The Institute of Chartered Accountants in Australia (ICAA) warns that executive remuneration could rise because of implementation of international financial reporting standards. The general manager of standards for the CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  649

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ICAA, Bill Palmer, says that under the new rules, which will be in force for the next reporting season, companies will be required to expense the cost of share options. This means that, for the first time, companies’ bottom lines will bear the brunt of any big share-based remuneration packages. ‘This could result in businesses excluding options in their executive remuneration packages, and we may see businesses offering larger salaries in lieu of share options,’ Palmer says. There was a deal of criticism of the requirements of AASB 2 in the lead-up to its implementation in 2005. A number of interested parties’ concerns were reflected in a 2003 submission made to the AASB by the Australian Venture Capital Association Limited (AVCAL) when Exposure Draft 2 Share-based Payments was issued. AVCAL held the view that some organisations were likely to be worse off as a result of AASB 2 than others. Its submission included the following: AVCAL believes that the inclusion of employee share options (ESOs) as an expense is fundamentally flawed and particularly punitive when applied to unlisted, high growth companies. AVCAL cannot support the proposed standard, as we believe that it is inappropriate that ESOs are bundled with share-based transactions for goods and services with clearly attributable value. Our concerns in this area are set out below. Paragraph 20 of the November Exposure Draft specifies that the fair value of options granted shall be either: 1. measured at the market price of traded options with similar characteristics; or 2. estimated by applying an options pricing model, such as the Black–Scholes model or Binomial model. When applied to venture-backed unlisted companies the proposed methodology produces spurious valuations that do not reflect actual costs to the company. It was never intended that the Black–Scholes and Binomial methods should be applied to the valuation of options where the underlying securities are not traded on the open market. Using these models in the context of expensing ESOs in unlisted entities is therefore a misapplication of the theory underlying both methods that will contribute to accounting inaccuracies. Early stage businesses face especially difficult contingencies that require them to attract and retain some of the best and brightest managers that are available. Often these businesses comprise small teams that are attempting to commercialise innovative new products and develop new markets. They have uncertain earnings, and are highly dependent upon the brilliance of individuals to drive the business forward. In these circumstances there is a real risk for managers that the company may prove to be unviable. High calibre individuals will require compensation for accepting this employer risk. Options are the currency that empowers innovative start-up companies to attract skilled managers into high-risk environments. The expensing of options will effectively prevent start-ups from offering competitive remuneration to executives. This will in turn be detrimental to innovation, jobs creation and economic growth. This circumstance is worsened by the proposed methods for valuation. Early stage businesses are characterised by highly volatile revenue and earnings. This affects the inferred volatility of the underlying shares. Therefore options granted to employees of early stage businesses would, under the proposed standard, represent a greater expense than similar options granted to employees of businesses with stable maintainable earnings. Similar effects would be observed across industry sectors. The proposed IASB standard is therefore disproportionately punitive to early stage businesses and should not be adopted.

LO 17.9

Disclosure requirements AASB 2 requires extensive disclosure under three main headings. The entity is required to provide information to enable the users of the financial statements to understand:

• the nature and extent of share-based payment arrangements that existed during the period • how the fair value of the goods or services received or the fair value of the equity instruments granted during the year was determined, and • the effect of expenses arising from share-based transactions on the entity’s profit or loss for the period. To enable users of the financial statements to understand the nature and extent of share-based payment arrangements that existed during the year (the first point above), paragraph 45 of AASB 2 requires disclosure of: (a) a description of each type of share-based payment arrangement that existed at any time during the period, including the general terms and conditions of each arrangement, such as vesting requirements, the maximum term of options granted, and the method of settlement (e.g. whether in cash or equity). An entity 650  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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with substantially similar types of share-based payment arrangements may aggregate this information, unless separate disclosure of each arrangement is necessary to satisfy the principle in paragraph 44; (b) the number and weighted average exercise prices of share options for each of the following groups of options: (i) outstanding at the beginning of the period; (ii) granted during the period; (iii) forfeited during the period; (iv) exercised during the period; (v) expired during the period; (vi) outstanding at the end of the period; and (vii) exercisable at the end of the period; (c) for share options exercised during the period, the weighted average share price at the date of exercise. If options were exercised on a regular basis throughout the period, the entity may instead disclose the weighted average share price during the period; and (d) for share options outstanding at the end of the period, the range of exercise prices and weighted average remaining contractual life. If the range of exercise prices is wide, the outstanding options shall be divided into ranges that are meaningful for assessing the number and timing of additional shares that may be issued and the cash that may be received upon exercise of those options. We know that AASB 2 requires an entity to disclose information that will assist users of the financial statements to understand how the fair value of goods and services received, or the fair value of equity instruments granted during the period, were determined (the second point just listed). If the entity has measured the fair value of goods or services received as consideration for equity instruments of the entity indirectly, by reference to the fair value of the equity instruments granted, paragraph 47 of AASB 2 requires the reporting entity to disclose the following: (a) for share options granted during the period, the weighted average fair value of those options at the measurement date and information on how that fair value was measured, including: (i) the option pricing model used and the inputs to that model, including the weighted average share price, exercise price, expected volatility, option life, expected dividends, the risk-free interest rate and any other inputs to the model, including the method used and the assumptions made to incorporate the effects of expected early exercise; (ii) how expected volatility was determined, including an explanation of the extent to which expected volatility was based on historical volatility; and (iii) whether and how any other features of the option grant were incorporated into the measurement of fair value, such as a market condition; (b) for other equity instruments granted during the period (i.e. other than share options), the number and weighted average fair value of those equity instruments at the measurement date, and information on how that fair value was measured, including: (i) if fair value was not measured on the basis of an observable market price, how it was determined; (ii) whether and how expected dividends were incorporated into the measurement of fair value; and (iii) whether and how any other features of the equity instruments granted were incorporated into the measurement of fair value; and (c) for share-based payment arrangements that were modified during the period: (i) an explanation of those modifications; (ii) the incremental fair value granted (as a result of those modifications); and (iii) information on how the incremental fair value granted was measured, consistently with the requirements set out in (a) and (b) above, where applicable. Reporting entities are also required to disclose sufficient information to enable users of the financial statements to understand the effect of share-based payment transactions on the entity’s profit or loss for the period, and on its financial position (the third point above). Paragraph 51 of AASB 2 requires an entity to disclose at least the following: (a) the total expense recognised for the period arising from share-based payment transactions in which the goods or services received did not qualify for recognition as assets and hence were recognised immediately as an expense, including separate disclosure of that portion of the total expense that arises from transactions accounted for as equity-settled share-based payment transactions; and CHAPTER 17: ACCOUNTING FOR SHARE-BASED PAYMENTS  651

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(b) for liabilities arising from share-based payment transactions: (i) the total carrying amount at the end of the period; and (ii) the total intrinsic value at the end of the period of liabilities for which the counterparty’s right to cash or other assets had vested by the end of the period (e.g. vested share appreciation rights).

SUMMARY The chapter considered how to account for share-based payment transactions. The accounting standard applicable to these transactions is AASB 2 Share-based Payment. This standard is to be applied to: • equity-settled share-based payment transactions • cash-settled share-based payment transactions, and • share-based payment transactions with cash alternatives. The accounting treatment for share-based payment transactions depends on whether they are ultimately settled by the issue of shares or the payment of cash. A reporting entity should recognise the goods and services received in a share-based payment transaction when the goods are obtained or the services received. If goods or services do not qualify for recognition as assets, they should be recognised as expenses. If a share-based payment transaction is equity-settled, the goods or services received and the corresponding increase in equity is measured at the fair value of the goods or services received, unless fair value of the goods or services received cannot be estimated reliably. Where fair value cannot be measured reliably, the fair value of the goods or services received and the corresponding increase in equity is measured indirectly by reference to the fair value of the equity instruments granted. For cash-settled share-based payment transactions, the fair value of the goods or services received and the liability incurred are measured at the fair value of the liability. At the end of each reporting period the fair value of the liability is remeasured. Any changes in the fair value of the liability are recognised in profit or loss. Share-based payment transactions with cash alternatives provide either the entity or the counterparty with the choice as to whether the entity will settle the transaction in cash, in other assets or by issuing equity instruments. If the entity has incurred a liability to settle the transaction in cash or other assets, it must account for the transaction as a cash-settled share-based payment transaction. If no liability is incurred, the entity accounts for the transaction as an equity-settled share-based payment transaction.

KEY TERMS cash-settled share-based payment transaction  643 compound financial instrument  647 equity instrument  626

equity-settled share-based payment transaction  629 fair value  630 grant date  632 market conditions  638

share appreciation rights (SARs)  644 share-based payment transaction with cash alternatives  647

END-OF-CHAPTER EXERCISES 1. Why is the grant date important? LO 17.1, 17.5 2. On 1 July 2016 Lorne Ltd grants 500 share options to its 20 most senior employees. The details of the share-based payment transaction are that the options will vest on 30 June 2019 provided the employees remain in Lorne Ltd’s employment. Another required condition for the options to vest is that the number of faulty products produced is not to exceed 2 per cent on average over the three-year vesting period. Finally, the share price must exceed

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$20 by 30 June 2017. On grant date the share options have a fair value of $3.40 per option. Identify the ‘vesting conditions’. LO 17.1, 17.7 3. Johanna Ltd has awarded its managing director 5000 share options. The vesting of the options is conditional upon the managing director completing three years’ service and meeting certain annual sales forecasts. How should these vesting conditions be accounted for by Johanna Ltd? LO 17.1, 17.2, 17.6, 17.7 4. Trigg Ltd has awarded its managing director 15 000 shares with cash alternatives. What impact will the managing director’s choice have on the statement of financial position at the date of the settlement? LO 17.5 5. One year after the grant date, Margaret Ltd has modified the share options granted to its senior management team. At the date of the modification, the fair value of each original share option granted (before taking into account the modification) is $8.00, and that of each modified share option is $4.00. The share options will vest at the end of year 3. How should Margaret Ltd account for the modification? LO 17.6, 17.7

REVIEW QUESTIONS 1. What is a share-based payment transaction? LO 17.1 2. What are the three types of share-based transactions specifically addressed by AASB 2? LO 17.1, 17.2, 17.4, 17.5 3. Buller Manufacturing Ltd issues 1000 share options to each of its 25 most senior employees. The options can be exercised at the end of a four-year period. Once exercised, the shares may not be sold to another party for another two years, after which time the employees may dispose of the shares.

REQUIRED Identify the type of share-based transaction that has occurred. LO 17.2, 17.4, 17.5 4. How are share-based transactions to be measured? LO 17.6 5. How would an entity determine the fair value of a share-based transaction when the other party to the transaction is a supplier of goods? LO 17.6 6. How would an entity determine the fair value of a share-based transaction when the other party to the transaction is an employee providing their services? LO 17.6 7. If an employee is provided with share options that will not vest for five years, when will the expense related to the granting of the share options be recognised? LO 17.6, 17.7 8. Do equity-settled share-based payment transactions or cash-settled share-based payment transactions lead to the recognition of liabilities? If liabilities are recognised, do they need to be restated at each reporting date and, if so, how would the change in liabilities be treated? LO 17.4, 17.6 9. Cottesloe Ltd has granted its managing director 50 000 share options conditional upon him remaining with the company for a further five years. In addition, the share price must increase by 50 per cent before the end of year 5.

REQUIRED How should Cottesloe Ltd account for the above vesting conditions? LO 17.6, 17.7 10. If no share options of a similar nature were being traded on a securities exchange, what factors would be considered by an options pricing model when trying to place a fair value on options? LO 17.6 11. In article entitled ‘Woodside wages a bit on the high side’ by Ben Butler that appeared in The Australian on 31 March 2015 it was stated: Here’s a tip for Woodside, courtesy of Credit Suisse, as it grapples with slumping commodity prices: take a look at chief executive Peter Coleman‘s pay. The oil and gas group last week slashed jobs and froze remuneration across the company, but according to Credit Suisse Coleman is paid too much and Woodside has dramatically understated the value of shares granted to him . . . In a note to clients, Credit Suisse‘s environmental, social and governance team said Coleman got the maximum bonus available in 2014, $US4.43m—double his base pay. This despite Coleman failing to meet one of his targets: maintaining total shareholder return compared to the ASX50.

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The analysts also had a go at Woodside for using ‘discounted fair value’ to work out how much his share options are worth, rather than simply using the market value of the shares. CS reckons that, even though quite a few companies do it, this is poor practice. In Coleman’s case, the bank says it understates the value of the share options issued to him by 50 per cent, compared to what shares were fetching on the market. On CS’s numbers, the difference is more than $3m.

REQUIRED 12. 13. 14. 15.

Why might a company want to understate the value of share options issued to executives, as Credit Suisse suggests? LO 17.8 In what circumstances would equity instruments associated with a share-based payment transaction be measured at their intrinsic value? LO 17.6 If the fair value of equity instruments changes in the course of a vesting period, will this have implications for the measurement of the value of those instruments? LO 17.6, 17.7 Why could the release of AASB 2 have had an economic impact on reporting entities? LO 17.8 In an article that appeared in Business Review Weekly on 4 March 2004 (entitled ‘Share options trap’), it is stated that under AASB 2 ‘companies must value and record as an expense any options granted to employees in exchange for their services. Previously, Australian companies recorded share-based payments in the notes to financial statements, arguing that share-based payments did not cost the company anything’.

REQUIRED Do you think that there is any logic to the argument that ‘share-based payments did not cost the company anything’? LO 17.1, 17.3, 17.8 16. On 1 July 2019, Supplyco Ltd provides Grove Ltd with some inventory, which has a fair value of $200 000. In exchange for the inventory, Grove Ltd provides Supplyco Ltd with 20 000 shares in Grove Ltd.

REQUIRED Provide the accounting entry to account for the above equity-settled share-based transaction. LO 17.4, 17.6

CHALLENGING QUESTIONS 17. On 1 July 2019, Rottnest Ltd awarded 500 shares each to 200 employees subject to the following non-market vesting conditions: The shares will vest if: • at 30 June 2020 Rottnest Ltd’s earnings have increased by more than 14 per cent • at 30 June 2021, Rottnest Ltd’s earnings have increased by an average of 12 per cent or more over the twoyear period • at 30 June 2022, earnings have increased by an average of 9 per cent over the three-year period. The shares had a fair value of $14.00 at 1 July 2019, which equals the share price at grant date. No dividends are expected to be paid over the three-year period. During the year ending 30 June 2020, 30 employees leave the organisation. On the basis of prior experience, Rottnest Ltd believes that a further 20 employees will leave during the vesting period. At 30 June 2020 earnings have increased by 13 per cent. It is expected that earnings will continue at a similar rate of increase for 2021. Rottnest Ltd therefore expects the shares to vest on 30 June 2021. By 30 June 2021, 30 employees have resigned during the year. Rottnest Ltd expects a further 25 employees to leave by the end of the vesting period. During the year ended 30 June 2021 earnings increase by 10 per cent. Rottnest Ltd expects that during the year ending 30 June 2022 earnings will increase by at least 9 per cent, meaning that earnings will have increased by more than the average of 9 per cent over the three-year period. At 30 June 2022, 35 employees have left during the year, and Rottnest Ltd’s earnings have increased by 9 per cent during the year.

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REQUIRED Prepare the accounting journal entries for the years ending 30 June 2020, 2021 and 2022. LO 17.6, 17.7 18. On 1 July 2019, Coogee Ltd grants 300 share options to each of its 200 employees. The share options are conditional on the employees remaining in Coogee Ltd’s employ during the three-year vesting period. At the grant date of 1 July 2019 the fair value of the share price is expected to be $7.00. At 1 July 2019 the fair value of each option is determined as $5.00. During the year ended 30 June 2020, 15 employees resign from the company. Coogee Ltd estimates that a further 30 employees will leave before the options expire. At 30 June 2020 the company’s share price has dropped to $5.50 and, as a result, Coogee decides to reprice its options. The options will retain the same vesting date, this being 30 June 2022. At the date of repricing the options, Coogee Ltd estimates, using an options pricing model, that the fair value of each of the original share options granted before taking into consideration the repricing is $3.00. The repriced share options are considered to have a value of $5.00. At 30 June 2021 a further 30 employees have resigned and the company expects a further 20 employees to resign before the option entitlements vest. By 30 June 2022, a further 30 employees have resigned during the year ended 30 June 2022.

REQUIRED Calculate the remuneration expense and present the journal entries that would appear in the records of Coogee Ltd for the years ending 30 June 2020, 2021 and 2022. LO 17.6, 17.7 19. On 1 July 2019 Lurline Ltd provides its managing director with a share-based incentive according to which she is offered a bonus that is calculated as 100 000 times the increase in the fair value of the entity’s share price above $5.00. When the bonus was offered the share price was $4.50. If the managing director does not leave the organisation the accrued entitlement will be paid after three years. However, if she leaves the organisation the accrued entitlement will be paid out upon departure—that is, the benefit will not be forfeited. Other information • The share price at 30 June 2020 is $4.00. • The share price at 30 June 2021 is $5.50. • The share price at 30 June 2022 is $6.00. • The managing director stays for three years and is paid the bonus on 1 July 2022.

REQUIRED Prepare the journal entries that would appear in the accounting records of Lurline Ltd to account for the issue of the share appreciation rights. LO 17.4, 17.6, 17.7 20. On 1 July 2019 Maroubra Ltd granted its managing director the right to choose either 30 000 phantom shares (that is, the right to receive a cash payment equivalent to the value of 30 000 shares), or 35 000 shares in the company. The grant is conditional upon the completion of three years’ service as managing director of Maroubra Ltd. In addition, should the managing director choose the shares alternative, the shares must be held for an additional two years after the vesting date. On 1 July 2019 Maroubra Ltd’s share price was $19.00. The subsequent share prices were as follows: • 30 June 2020 • 30 June 2021 • 30 June 2022

$16.00 $21.00 $23.00

At grant date, Maroubra Ltd does not expect to pay any dividends during the term of the arrangement with the managing director, as all profits are being reinvested. This policy is maintained for the duration of the arrangement. After taking into account the effects of the post-vesting restrictions, Maroubra Ltd estimated that the fair value of the share alternative as at 1 July 2019 was $15.00 per share.

REQUIRED Prepare the journal entries for the years ending 30 June 2020, 2021 and 2022 to account for the share-based transaction. LO 17.5, 17.6, 17.7

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CHAPTER 18

ACCOUNTING FOR INCOME TAXES LEARNING OBJECTIVES (LO) 18.1 Understand that there is typically a difference between an organisation’s profit or loss for accounting purposes, and its profit or loss for taxation purposes. 18.2 Be able to identify some of the types of factors that will cause a difference between profit or loss for accounting purposes, and profit or loss for taxation purposes. 18.3 Understand the balance sheet approach to accounting for taxation. 18.4 Understand that a difference between the carrying amount of an asset or a liability and its tax base will lead to a ‘temporary difference’. 18.5 Understand when a ‘temporary difference’ creates a deferred tax asset or a deferred tax liability. 18.6 Understand how deferred tax assets and deferred tax liabilities arise and how they are calculated. 18.7 Understand how changes in tax rates will impact on existing deferred tax balances. 18.8 Understand how to account for taxation losses incurred by companies and understand how, in certain circumstances, taxation losses can lead to the recognition of assets in the form of deferred tax assets. 18.9 Be able to describe how the revaluation of non-current assets should be treated for deferred tax purposes. 18.10 Be able to critically evaluate the balance sheet approach to accounting for taxation and the associated asset (deferred tax asset) and liability (deferred tax liability).

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Introduction to accounting for income taxes Throughout this book, particular accounting rules and conventions related to the recognition of expenses and income are discussed as they pertain to particular types of transactions and events. The application of these different accounting rules, typically incorporated within accounting standards, leads to the determination of accounting profit. accounting profit Accounting profit is defined at paragraph 5 of AASB 112 Income Taxes as: profit or loss for a period before deducting tax expense.

A measure of profit derived by applying generally accepted accounting principles and accounting standards.

Within Australia, profit for taxation purposes, also known as taxable profit, is, however, determined in accordance with the rules embodied in the Australian income tax legislation and not the rules embodied in accounting standards. There are a number of differences between accounting principles of income and expense recognition and taxation principles of income and expense recognition. The result is that accounting profit (derived using accounting rules as embodied in accounting standards) and taxable profit (using the rules incorporated in the income tax legislation) will generally differ. Sometimes the difference can be significant: for example, a firm that generates a large accounting profit could, in certain circumstances, actually derive a loss for taxation purposes (and vice versa). That is, it is possible for a firm that has large accounting profits as disclosed in its statement of profit or loss and other comprehensive income to pay little or no tax. While this can be perfectly legitimate, it has at times created political problems for certain organisations. In this chapter, the main focus is not on the determination of a company’s taxable income or income tax payable. Such a focus would be a subject in itself and would require a detailed analysis of the relevant taxation legislation. Rather, we will be concentrating on the accounting treatment of income tax expense for the purposes of measurement and disclosure in an organisation’s general purpose financial statements. AASB 112 Income Taxes is the accounting standard that determines the accounting treatment of income taxes. AASB 112 applies what is known as ‘the balance sheet method’. AASB 112 focuses on the recognition of assets and liabilities in the balance sheet (or, as we also call it, the statement of financial position) to ensure that the correct levels of future tax benefits, and of sacrifices arising from the differences between the accounting and tax values of assets and liabilities, are recognised. The balance sheet approach has been adopted because it is considered to be consistent with the Conceptual Framework for Financial Reporting. The conceptual framework tends to focus on the balance sheet rather than on the statement of profit or loss and other comprehensive income: for example, the definition of income and expenses is directly related to changes in assets and liabilities. Prior to the release of AASB 112 Income Taxes, and its predecessor accounting standards, companies typically used the ‘taxes payable method’ in accounting for income tax. Pursuant to the taxes payable method—which was much easier to apply than the current approach explored in this chapter—the income tax expense for the period was simply equal to the income tax payable to the taxation authority, with both amounts being equal to the organisation’s taxable income (determined in accordance with the relevant taxation legislation) multiplied by the relevant tax rate. However, as we will see in this chapter, AASB 112 requires us to adopt an approach to accounting for tax which is referred to as ‘tax-effect accounting’. Pursuant to tax-effect accounting, income tax expense is not only equal to the current income tax payable (as it would be under the taxes payable method), but also takes into account the entity’s deferred tax assets and deferred tax liabilities. In accounting for income tax, various events impacting on the entity and various transactions undertaken by the entity will create two separate effects. There will be current liabilities for income tax payable and there will also be tax consequences beyond the next financial period. These future consequences will give rise to deferred tax assets and deferred tax liabilities—which are both the focus of AASB 112. So, at this early stage of the chapter, we emphasise that it needs to be appreciated that the tax expense recorded in the statement of profit or loss and other comprehensive income will not necessarily equal the amount of tax that has been assessed as payable to the Australian Taxation Office (ATO) in relation to that period’s operations. The tax assessed by the ATO, and reflected in the current liability of income tax payable (which appears in an entity’s statement of financial position), will be based on the taxable profit derived by the entity, and this will be determined by applying the rules stipulated in taxation law, rather than the rules incorporated in accounting standards. Tax expense, determined for accounting purposes and shown in the statement of profit or loss and other comprehensive income, however, is calculated after applying the relevant accounting standards. From a financial accounting perspective, the liability ‘income taxes payable’ as appearing in the statement of financial position (balance sheet) will be based on what is owed to the ATO, and this liability will be based on the rules incorporated in the Income Tax Assessment Act. That is, the amount Chapter 18: ACCOUNTING FOR INCOME TAXES  657

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payable to the ATO is derived from what the ATO said the organisation earned based on the ATO’s rules. By contrast, the account ‘income tax expense’ will be based on what the organisation earned from a financial accounting perspective— that is, by applying accounting standards. ‘Income tax expense’ will typically not be the same as ‘income tax payable’ and we will refer to the resulting differences as deferred tax assets, and as deferred tax liabilities.

LO 18.1 LO 18.2 LO 18.3 LO 18.4 LO 18.5 LO 18.6

The balance sheet approach to accounting for taxation

The balance sheet approach to accounting for taxation focuses on comparing the carrying amount of an entity’s assets and liabilities (determined in accordance with accounting rules) with the tax base for those assets and liabilities. That is, we are comparing the balance sheet (statement of financial position), which is derived using accounting rules, with the balance sheet that would be derived if we were to use taxation rules. It should be appreciated, however, that, unlike the practice in some other countries, it is not usual in Australia for entities to prepare tax-based balance sheets. As noted earlier, taxation rules and accounting rules can be very different, with the result that profit calculated for accounting purposes can be very different from profit calculated for taxation purposes (often referred to as taxable profit). As an example of some of the differences in recognition rules, consider the items in Table 18.1. When considering how assets and liabilities would be recognised for taxation purposes, we refer to the tax base of the relevant asset or liability. The tax base is defined in AASB 112 as ‘the amount that is attributed to an asset or liability for tax purposes’. Where the carrying amount of an asset or liability (the carrying amount is determined using accounting rules) is different from the tax base, a ‘temporary difference’ can arise. AASB 112 defines a temporary difference as ‘the difference between the carrying amount of an asset or liability in the statement of financial position and its tax base’.

Table 18.1 Some of the differences between accounting rules and tax rules

Item

Generally accepted accounting rule

Tax rule

Many accrued expenses (for example, long-service leave, warranty costs)

An expense when accrued

Recognised as a tax deduction only when paid

Many prepaid expenses (for example, prepaid rent, prepaid insurance)

Initially an asset—expensed when economic benefits used

Typically a tax deduction when paid

Revenue received in advance (for example, rental revenue)

Treated as a liability—recognised as revenue when subsequently earned

Typically taxed when received

Entertainment and goodwill impairment

Treated as an expense

Not a tax deduction in current or subsequent periods

Government grants

Often recognised as income consistent with AASB 120

Exempt income and therefore not subject to tax

Doubtful debts

Treated as an expense when recognised

Treated as a tax deduction when debtor is actually written off in subsequent period

Goodwill impairment

Treated as an expense when recognised

Not an allowable deduction for tax purposes

Fines

Expensed when payable

Not an allowable deduction for tax purposes

Development expenditure

Often capitalised and subsequently amortised

Typically a tax deduction when paid for (and sometimes the deduction is greater than the amount actually incurred—for example, to encourage investment the deduction might be doubled)

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Paragraph 5 of AASB 112 explains that temporary differences may be either: (a) deductible temporary differences which are temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled, or (b) taxable temporary differences, which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled. Using the information in Table 18.1 as a guide, Worked Example 18.1 provides you with an opportunity to calculate and compare taxable profit with accounting profit.

WORKED EXAMPLE 18.1: Calculating taxable profit and accounting profit You are provided with the following information from the accounts of Big Kahuna Ltd for the year ending 30 June 2019: Cash sales Cost of goods sold Amounts received in advance for services to be performed in August 2019 Rent expense for year ended 30 June 2019 Rent prepaid for two months to 31 August 2019 Doubtful debts expenses Amount provided in 2019 for employees’ long-service leave entitlements Goodwill impairment expense

$100 000 $40 000 $10 000 $10 000 $1 000 $1 000 $6 000 $6 000

REQUIRED Calculate taxable profit and accounting profit for the year ending 30 June 2019. SOLUTION

Cash sales Cost of goods sold Amounts received in advance by Big Kahuna Ltd for services to   be performed in August 2019 Rent expense for year ended 30 June 2019 Rent prepaid for two months to 31 August 2019 Doubtful debts expense Amount provided in 2019 for employees’ long-service leave entitlements Goodwill impairment expense

Accounting profit $100 000 ($40 000) –

Taxable profit $100 000 ($40 000) $10 000

($10 000)   ($1 000) ($6 000)   ($6 000) $37 000

($10 000) ($1 000) – –             – $59 000

As we can see from the calculations in Worked Example 18.1, there can be reasonably significant differences between the profit we calculate by applying accounting rules (as embodied in accounting standards and generally accepted accounting procedures) and the profit we calculate for tax purposes (applying the tax legislation). In the sections that follow we will learn how to account for these differences. Returning to paragraph 5 of AASB 112, as just quoted, something that will lead to an increase in taxable profit in future years (a taxable temporary difference) creates a liability—a deferred tax liability. Something that will lead to a decrease in taxable profit in future years (a deductible temporary difference) creates an asset—a deferred tax asset. While this might seem confusing at first, the distinctions will become clearer in the illustrations that follow. To illustrate a taxable temporary difference that leads to a deferred tax liability, we can consider a depreciable asset—say a machine. Let us assume that an entity acquires a machine at a cost of $200 000 in 2019. For accounting purposes the asset is expected to have a useful life of five years, after which time it is expected to have no salvage value; the benefits Chapter 18: ACCOUNTING FOR INCOME TAXES  659

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are expected to be derived uniformly, meaning that the straight-line method of depreciation will be used. We will also assume a corporate tax rate of 30 per cent. For tax purposes, however, the asset can be depreciated on a straight-line basis over four years. Hence after two years we can determine the carrying amount (which is the amount calculated by applying accounting standards and other generally accepted accounting principles) and the tax base as follows (the determination of the difference between the tax base of a balance sheet item and its carrying value is central to the balance sheet approach for accounting for taxes).   Cost less Accumulated depreciation  

Carrying amount

Tax base

$200 000   $80 000 $120 000

$200 000 $100 000 $100 000

In the above situation, what has effectively happened is that the ATO has given the entity a greater deduction relative to the consumption of the economic benefits (as reflected by depreciating the asset over its useful life). Further, while the entity is given tax deductions for the first four years, and has effectively reduced the tax that is payable in those years, no deduction will be given in the fifth year, as the cost of the asset will have been fully claimed with the ATO by the end of year 4. Because no deduction will be available for taxation purposes in year 5, the entity has effectively deferred the tax to the fifth year—that is, the entity has a deferred tax liability. A deferred tax liability is defined in AASB 112 as ‘the income taxes payable in future reporting periods in respect of temporary differences’. For example, if it is assumed that the entity with the above asset is going to generate accounting profits of $500 000, $600 000, $650 000, $700 000 and $800 000 respectively in each of the next five years (before tax, and assuming that there is only one depreciable asset and no other temporary differences) and that the tax rate is 30 per cent, taxable income can be determined as follows:   Accounting profit Add back accounting depreciation Subtract tax depreciation Taxable profit Tax payable (at 30%)

2019 ($)

2020 ($)

2021 ($)

2022 ($)

2023 ($)

500 000 40 000   (50 000) 490 000 147 000

600 000 40 000  (50 000) 590 000 177 000

650 000 40 000  (50 000) 640 000 192 000

700 000 40 000  (50 000) 690 000 207 000

800 000 40 000             – 840 000 252 000

Taxable profit is the profit derived by the entity determined by applying the current taxation rules. It will typically be different from accounting profit (which is derived by applying accounting standards). To work out taxable profit we have to make adjustments to accounting profit so that we remove the effect of differences between accounting rules and tax rules. In this example we are assuming—somewhat simplistically—that the only difference in rules relates to how we are accounting for depreciation (in practice there will be many differences). As we know, from an accounting perspective an item of property, plant and equipment is to be depreciated over its expected ‘useful life’ (see Chapter 5). However, from a taxation perspective, specific depreciation rates might be stipulated that have no direct relationship to the useful life of an asset (accelerated depreciation rates may be offered by the government to stimulate investment in particular assets). So to determine taxable profit we will adjust for those items of expense and income that are treated differently by taxation rules and accounting rules. In this example therefore we will add back the depreciation calculated from an accounting perspective (using the principles provided in AASB 116 Property, Plant and Equipment), and then subtract the amount that would be allowed by the ATO as a deduction to allow us to arrive at taxable profit. As we can see from the above workings, the excess of the tax depreciation over accounting depreciation in the first four years reduces the taxable profit relative to the accounting profit, and thus the taxes that have to be paid, by a total of $12 000 (which is four years multiplied by the excess of tax depreciation over accounting depreciation of $10 000 multiplied by the tax rate of 30 per cent). However, no depreciation is deductible in the fifth year (for taxation purposes, the asset is fully depreciated at the end of the fourth year and has a tax base of zero), meaning that to determine taxable profit the accounting depreciation has to be added back with no offset of the tax depreciation. Effectively, the entity is given an ‘extra’ deduction in years 1 to 4, which it will have to give back in year 5. There is in effect a ‘timing difference’. A deferred liability is considered to exist throughout the life of the asset. Hence, in year 5 a further $12 000 in taxes will be payable. As we can see, at the end of five years the total depreciation for accounting purposes ($200 000) equals 660  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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the total depreciation allowed for tax purposes ($200 000). Any differences in total depreciation throughout the five years are of a temporary nature. Once the additional taxation of $12 000 is paid in year 5, the deferred tax liability will no longer exist. Let us now consider in Worked Example 18.2 a more detailed example relating to the depreciation of a non-current asset.

WORKED EXAMPLE 18.2: Temporary differences caused by the depreciation of a non-current asset Robert August Ltd commences operations on 1 July 2016. On the same date, it purchases a fibreglassing machine at a cost of $600 000. The machine is expected to have a useful life of four years, with benefits being uniform throughout its life. It will have no residual value at the end of four years. Hence, for accounting purposes the depreciation expense would be $150 000 per year. For taxation purposes, the ATO allows the company to depreciate the asset over three years—that is $200 000 per year. The profit before tax of the company for each of the next four years (for years ending 30 June) is $500 000, $600 000, $700 000 and $800 000 respectively. The corporate tax rate is 30 per cent. We will assume that the only item that has a different treatment for accounting and tax purposes is the machine. REQUIRED Determine the tax expense and taxes payable for the years 2017 to 2020, and provide the necessary accounting journal entries. SOLUTION Year 1 (ending 30 June 2017)

 

Carrying amount ($)

Tax base ($)

Temporary difference ($)

Fibreglassing machine: cost Accumulated depreciation  

600 000 150 000 450 000

600 000 200 000 400 000

              50 000

As the above calculations show, the carrying amount of the asset exceeds its tax base at the end of year 1, which, according to the definition provided in AASB 112, means that there is a temporary difference. Remember, the ‘carrying amount’ represents the net amount that would be shown in the statement of financial position (balance sheet) applying the principles embodied within accounting standards. In this case the temporary difference is $50 000 and will lead to a deferred tax liability. Effectively, tax is being reduced, or ‘saved’, in the early years (years 1 to 3), but the additional tax will need to be paid in year 4 when no deduction for depreciation will be available for tax purposes. The tax payment is being deferred. The excess of the depreciation allowed for tax purposes relative to the accounting depreciation in years 1 to 3 creates a liability that will accumulate and be paid in year 4. The deferred tax liability at the end of the first year will be determined by multiplying the $50 000 by the tax rate of 30 per cent, giving a deferred tax liability of $15 000—which represents the amount of tax the company will pay when it recovers the balance of the carrying amount of the asset. Paragraph 16 of AASB 112 explains why a deferred liability is created in situations such as this. It states: It is inherent in the recognition of an asset that its carrying amount will be recovered in the form of economic benefits that flow to the entity in future periods. When the carrying amount of the asset exceeds its tax base, the amount of taxable economic benefits will exceed the amount that will be allowed as a deduction for tax purposes. This difference is a taxable temporary difference and the obligation to pay the resulting income taxes in future periods is a deferred tax liability. As the entity recovers the carrying amount of the asset, the taxable temporary difference will reverse and the entity will have taxable profit. This makes it probable that economic benefits will flow from the entity in the form of tax payments. If we look at the calculations for year 1, we see that, in essence, the entity has claimed a $50 000 deduction from the ATO in excess of the asset’s recoverable amount. If the asset is sold for its anticipated recoverable amount, this $50 000 would be assessable and $15 000 would consequently be payable ($50 000 × 30 per cent). continued Chapter 18: ACCOUNTING FOR INCOME TAXES  661

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However, accepting that the asset has not been sold, the total tax on the company’s taxable income would be determined as follows: Accounting profit before tax Add back accounting depreciation Subtract depreciation for taxation purposes Taxable profit Tax at 30 per cent

$500 000 $150 000 ($200 000)  $450 000  $135 000

The journal entries at 30 June 2017 would be: Dr Income tax expense 15 000   Cr Deferred tax liability   15 000 (to recognise the tax expense that relates to the temporary difference, which equals $50 000 × 0.30) Dr Income tax expense 135 000   Cr Income tax payable   135 000 (to recognise the tax expense that relates to the entity’s taxable income which equals $450 000 × 0.30) Alternatively, we could do one journal entry, this being: Dr Cr Cr

Income tax expense Income tax payable Deferred tax liability

150 000  

  135 000 15 000

As can be seen from the above journal entries, income tax expense, which will be shown in the statement of profit or loss and other comprehensive income, represents the sum of the tax attributable to the taxable profit (as assessed by the ATO) plus or minus any adjustments relating to temporary differences. It also equates to the accounting profit before tax multiplied by the tax rate, which would be $500 000 multiplied by 30 per cent, which equals $150 000. This is consistent with the definition of tax expense provided in AASB 112, which is ‘the aggregate amount included in comprehensive income for the period in respect of current tax and deferred tax’. Income tax payable is the amount that is generally expected to be paid within the next taxes payable method financial period. If the taxes payable method of accounting for tax is adopted, the tax A method whereby the amount that is expense in a given year simply equals the taxes that were directly payable as a result of payable to the ATO that year’s operations. In this example, the tax expense under the taxes payable method is also treated as the would simply be $135 000. However, while the taxes payable method would be much tax expense of the easier to apply (and probably easier to understand), it is not permitted in Australia and other organisation. countries applying IFRS. Year 2 (ending 30 June 2018)

 

Carrying amount ($)

Tax base ($)

Temporary difference ($)

Fibreglassing machine: cost Accumulated depreciation  

600 000 300 000 300 000

600 000 400 000 200 000

                 100 000

The temporary difference at 30 June 2018 totals $100 000. Applying the tax rate of 30 per cent provides a deferred tax liability of $30 000. Because $15 000 has already been recognised in 2017, an increase (or ‘top up’) of $15 000 is required. The tax on the taxable income would be determined as follows: Accounting profit before tax Add back accounting depreciation Subtract depreciation for taxation purposes Taxable profit Tax at 30 per cent

$600 000 $150 000 ($200 000)  $550 000  $165 000

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The journal entries at 30 June 2018 would be: Dr Income tax expense 15 000 Cr Deferred tax liability   (to recognise the tax expense that relates to the temporary difference)

 

Dr Income tax expense 165 000 Cr Income tax payable   (to recognise the tax expense that relates to the entity’s taxable income)

 

15 000

165 000

Year 3 (ending 30 June 2019)

 

Carrying amount ($)

Tax base ($)

Temporary difference ($)

Fibreglassing machine: cost Accumulated depreciation  

600 000 450 000 150 000

600 000 600 000            0

                150 000

The temporary difference at 30 June 2019 is $150 000. Applying the tax rate of 30 per cent provides a deferred tax liability of $45 000. Because $30 000 has already been recognised in 2017 and 2018, an increase of $15 000 is required. The tax on the taxable income would be determined as follows: Accounting profit before tax $700 000 Add back accounting depreciation $150 000 Subtract depreciation for taxation purposes ($200 000) Taxable profit  $650 000 Tax at 30 per cent  $195 000 The journal entries at 30 June 2019 would be: Dr Income tax expense 15 000 Cr Deferred tax liability   (to recognise the tax expense that relates to the temporary difference) Dr Income tax expense 195 000 Cr Income tax payable   (to recognise the tax expense that relates to the entity’s taxable income)

  15 000   195 000

Year 4 (ending 30 June 2020)

 

Carrying amount ($)

Tax base ($)

Temporary difference ($)

Fibreglassing machine: cost Accumulated depreciation  

600 000 600 000             0

600 000 600 000             0

                            0

The temporary difference at 30 June 2020 is $nil, which means that there should be no deferred tax liability or deferred tax asset recorded in relation to this asset. This means the balance accrued in the deferred tax liability must be reversed in 2020. The tax on the taxable income would be determined as follows: Accounting profit before tax Add back accounting depreciation Subtract depreciation for taxation purposes Taxable profit Tax at 30 per cent

$800 000 $150 000               0 $950 000 $285 000 continued Chapter 18: ACCOUNTING FOR INCOME TAXES  663

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The journal entries at 30 June 2020 would be: Dr Deferred tax liability 45 000   Cr Income tax expense   45 000 (we credit tax expense because this $45 000 has already been recognised in previous years) Dr Income tax expense 285 000 Cr Income tax payable   (to recognise the tax expense that relates to the entity’s taxable income)

  285 000

A review of Worked Example 18.2 indicates that the balance sheet approach to accounting for income tax ‘smooths’ the tax expenses across the four years, as indicated below:   Tax expense based on taxable profit Adjustment for ‘temporary’ difference Total taxation expense as reported in the statement   of profit or loss and other comprehensive income

LO 18.1 LO 18.2 LO 18.3 LO 18.4

Year 1 ($)

Year 2 ($)

Year 3 ($)

Year 4 ($)

Total ($)

135 000 15 000

165 000 15 000

195 000 15 000

285 000 (45 000)

780 000         –

150 000

180 000

210 000

240 000

780 000

Tax base of assets and liabilities: further consideration

As already noted, temporary differences lead to deferred tax assets or deferred tax liabilities. Temporary differences arise because of differences between the carrying amount of an asset and its related tax base. As previously defined, the tax base of an asset is the amount that is attributed to an asset or liability for tax purposes. The tax base represents the amount that an asset or liability would be recorded at if a balance sheet were prepared applying taxation rules. Let us further consider the tax base of assets. According to paragraph 7 of AASB 112: The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset. If those economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount. In relation to the tax base of an asset, and accepting the above definition, the following formula can be applied: Future amount deductible Future taxable Carrying amount  + ​​      ​​  − ​​     ​​  for tax purposes economic benefits

=  Tax base

Applying this formula to the depreciable asset in Worked Example 18.2, as at the end of the first year, gives: Future amount deductible Future taxable Carrying amount  + ​​      ​​  − ​​     ​​  for tax purposes economic benefits

$450 000

+

$400 000



$450 000

= Tax base = $400 000

As we know, the ‘carrying amount’ of an asset is the amount at which the asset is recorded in the accounting records of an entity as at a particular date. The ‘future amount deductible for tax purposes’ represents the allowable tax deductions in future years in respect of the asset, and the ‘future taxable economic benefits’ represents the amount that is expected to be taxed in relation to the asset given existing tax laws and will typically equal the expected cash flows to be generated by the asset, either through use or sale. Where the carrying amount of an asset exceeds the tax base, there will be a deferred tax liability. This is because the taxation payments have effectively been deferred to future periods (a greater deduction has been given in the early years by the ATO and a smaller deduction, or no deduction, will be given in the later periods of the asset’s life, meaning that the required payments to the taxation authority will be relatively higher). Conversely, if the carrying amount of an asset is less than the tax base, there will be a deferred tax asset. In the above illustration the deductible amount at the end of year 1 is $400 000 because that is the remaining amount that the ATO will allow as a deduction 664  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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(the asset cost $600 000, and $200 000 has already been claimed in year 1). Accepting that the carrying amount ($450 000) represents the economic benefits that remain to be derived from the asset, such remaining benefits will be taxable. It should also be appreciated that, although an asset might be expected to give rise to future taxable amounts that exceed the asset’s carrying amount, AASB 112 focuses on the tax consequences of recovering an asset to the extent of its carrying amount only. Worked Example 18.3 takes a closer look at determining the tax base of assets.

WORKED EXAMPLE 18.3: Determining the tax base of assets McTavish Ltd has the following assets in its balance sheet as at 30 June 2018. Machinery Acquired at a cost of $400 000 on 1 July 2016. It has a useful life for accounting purposes of five years, and no expected salvage value. Its carrying value at 30 June 2018 therefore is $240 000. For tax purposes it can be depreciated at 25 per cent per year. Interest receivable McTavish Ltd has recorded interest receivable (interest earned but not yet received) of $100 000. The ATO will not tax the interest until it is received. Accounts receivable McTavish Ltd has made sales on credit terms amounting to $80 000, and at the end of the reporting period the $80 000 is still to be received. The ATO has already included the $80 000 in taxable income. REQUIRED Determine the respective tax bases of the above items as at 30 June 2018. SOLUTION Machinery Given the above details, the tax base of the asset is $200 000, which is the cost of $400 000 less two years’ depreciation of $100 000 per year. The carrying amount will be $400 000 − [2 × ($400 000 ÷ 5)], which equals $240 000. This can be reconciled using the following formula: Future amount deductible Future taxable Carrying amount  + ​​      ​​  − ​​     ​​  for tax purposes economic benefits

= Tax base

$240 000     +         $200  000      −   $240 000    =   $200 000 In relation to the machinery, $200 000 can be claimed for taxation purposes over the future years (the deductible amount). If the asset is going to generate future economic benefits of $240 000 (through its use or sale)—and this is implied by it having a carrying value of $240 000—the $240 000 will be taxable. Assuming a tax rate of 30 per cent, the temporary difference will lead to a deferred tax liability of $40 000 × 30 per cent, which equals $12 000. Interest receivable As the ATO will not tax the interest revenue until it is actually received, from the ATO’s perspective the asset does not currently exist, and it therefore has a zero tax base. This can be verified using the following formula: Future amount deductible Future taxable Carrying amount  +  ​​      ​​  −  ​​     ​​  for tax purposes economic benefits

= Tax base

$100 000     +        $0      −      $100 000    =    $0 In relation to the interest receivable, there are no related deductions. However, when the interest is actually received in a later period it will be taxable—therefore the future taxable amount is $100 000. Because the tax on this amount will be taxed in a future period, this timing difference creates a deferred tax liability of $100 000 × 30 per cent, which equals $30 000. continued Chapter 18: ACCOUNTING FOR INCOME TAXES  665

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Accounts receivable Because the sales have already been taxed, no further amounts are taxable. As the ATO has recognised them, the tax base is $80 000. We will assume that no bad or doubtful debts are expected to arise. Therefore, for accounts receivable there will be no need to recognise a deferred tax asset or deferred tax liability. This can be verified using the following formula: Future amount deductible Future taxable Carrying amount  +  ​​      ​​  − ​​     ​​  for tax purposes economic benefits

= Tax base

$80 000    +        $0           −     $0        =   $80 000

Worked Example 18.3 did not consider the issue of doubtful debts. If we assume that, of the credit sales of $80 000 that were made, the recovery of $6000 is doubtful, the carrying amount of the accounts receivable would be $74 000, with an allowance for doubtful debts of $6000 being raised. For taxation purposes, the amount provided for doubtful debts is not tax-deductible. It is deductible only when the account receivable is actually written off—hence it will be deductible in a future period. As the entire $80 000 has already been taxed, no further amount will be taxable in the future. The tax base of accounts receivable with a doubtful debt allowance of $6000 would be calculated as follows, with the temporary difference of $6000 leading to a deferred tax asset: Future amount deductible Future taxable Carrying amount  + ​​      ​​  − ​​     ​​  for tax purposes economic benefits

=  Tax base

$74 000      +       $6  000     −     $0     =  $80 000 We will now turn our attention to determining the tax base of liabilities (see Worked Example 18.4). According to paragraph 8 of AASB 112 ‘The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods’. If we also consider future taxable amounts, the tax base of a liability can be determined as: Future amount deductible Future taxable Carrying amount  −  ​​      ​​  +  ​​     ​​  for tax purposes economic benefits

= Tax base

AASB 112 provides an exception to the above rule, specifically in relation to revenue received in advance. Paragraph 8 of AASB 112 further states: In the case of revenue which is received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods.

WORKED EXAMPLE 18.4: Determining the tax base of liabilities Scott Dillon Ltd has the following liabilities in its statement of financial position as at 30 June 2018. Revenue received in advance The company has received $100 000 for interest revenue received in advance. The ATO taxes the revenue when it is received by the company. Accrued expenses The company has accrued expenses relating to unpaid salaries amounting to $50 000. The amount of the accrual will be deductible when actually paid. Loan payable The company has a loan with a carrying value of $40 000. The payment of the loan is not deductible. REQUIRED Determine the tax base of Scott Dillon Ltd’s liabilities.

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SOLUTION Revenue received in advance The tax base of a liability that is in the nature of ‘revenue received in advance’ is equal to the carrying amount of the liability where the ‘revenue received in advance’ is taxed in a reporting period subsequent to the reporting period in which it is received. It is equal to zero where the ‘revenue received in advance’ is taxed in the reporting period in which it is received. Hence the tax base of the interest received in advance is: Amount of revenue received in advance that Carrying amount  −  ​​       ​​  =  Tax base will not be subject to tax in future periods $100 000    −         $100  000         =   $0 Accrued expenses The ATO does not recognise the expense until paid. As such, the tax base is $nil. This can be confirmed as: Future amount deductible Future taxable Carrying amount  −  ​​      ​​  +  ​​     ​​  for tax purposes economic benefits

= Tax base

$50 000    −     $50  000     +       $0      =   $0 Loan payable As the loan gives rise to no future tax deductions or to any taxable income, the tax base will be $40 000. Future amount deductible Future taxable Carrying amount  −  ​​      ​​  +  ​​     ​​  for tax purposes economic benefits

=  Tax base

$40 000    −      $0       +     $0     =  $40 000

Deferred tax assets and deferred tax liabilities

LO 18.5

As we have already stated, deferred tax assets and deferred tax liabilities occur because of temporary LO 18.6 differences between the carrying amount of an asset or liability in the balance sheet and the respective tax bases. Whether a deferred tax asset or a deferred tax liability will arise is summarised in Table 18.2. In the above worked examples, we determined the tax base of a number of assets and liabilities. Information about carrying amounts and tax bases is necessary before the deferred tax assets and deferred tax liabilities can be determined. Information about tax rates is also necessary. The general principle applied is that deferred tax liabilities and assets must be measured as: the temporary differences that give rise to recognised deferred tax liabilities and assets and the unused tax losses that can be carried forward and give rise to recognised deferred tax assets multiplied by the tax rates that are expected to apply to the reporting period or periods when the liabilities are settled or assets recovered, based on tax rates (and tax laws) that have been enacted or substantively enacted by the end of the reporting period and that will affect the amount of income tax payable (recoverable).

Deferred tax liability

Deferred tax asset

Assets

Carrying amount > tax base

Carrying amount < tax base

Liabilities

Carrying amount < tax base

Carrying amount > tax base

Table 18.2 Overview of when a deferred tax liability or a deferred tax asset will arise

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We can summarise the above with the following formulas: Carrying amount of ​​    ​​  assets or liabilities

Tax bases of − ​​     ​​  assets or liabilities

Taxable or deductible = ​​     ​​ temporary differences

Taxable or deductible Deferred tax liabilities or    ​​   ​​ ×     Tax rate    = ​​       ​​ temporary differences deferred tax assets As previously explained, a taxable temporary difference results in an increase in tax payable in future years, while a deductible temporary difference results in a decrease in tax payable in future years. Worked Examples 18.5 and 18.6 further illustrate accounting for temporary differences.

WORKED EXAMPLE 18.5: Temporary differences and the recognition of a deferred tax liability Wingnut Ltd’s balance sheet (statement of financial position) shows an item of machinery that cost $150 000 and that has accumulated depreciation of $40 000, giving a carrying amount of $110 000. For taxation purposes the asset has a net value of $90 000. Wingnut Ltd also has interest receivable of $15 000, which will not be taxed by the ATO until it is received (that is, the ATO does not currently recognise its existence). The tax rate is 30 per cent. REQUIRED Calculate Wingnut Ltd’s deferred tax liability and provide the relevant journal entries. SOLUTION

Machinery—cost Accumulated depreciation Interest receivable

Carrying amount   ($)

Tax base ($)

150 000    40 000 110 000   15 000

150 000   60 000   90 000             0

Temporary difference ($)

20 000 15 000 35 000

The respective tax bases can also be confirmed as follows: For machinery Future amount deductible Future taxable Carrying amount  + ​​      ​​  − ​​     ​​  for tax purposes economic benefits

= Tax base

$110 000    +     $90  000     −   $110  000   =  $90 000 For the interest receivable Future amount deductible Future taxable Carrying amount  +  ​​      ​​  −  ​​     ​​  for tax purposes economic benefits

= Tax base

$15 000     +      $0      −     $15  000    =     $0 The deferred tax liability is calculated by multiplying the temporary difference of $35 000 by the tax rate of 30 per cent, giving $10 500. The journal entries would be: Dr Cr

Income tax expense Deferred tax liability

10 500 10 500

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WORKED EXAMPLE 18.6: A deductible temporary difference resulting in a deferred tax asset Farrelly Ltd’s statement of financial position shows that a provision for warranty expenses exists with a balance of $100 000. All of the provision was created in the current financial year and no amounts have been paid. The warranty expense is not deductible until such time as costs associated with the warranty are actually paid. The tax rate is 30 per cent. REQUIRED Determine the balance of the deferred tax asset and provide the relevant journal entries. SOLUTION The ATO will recognise the expense only when it is paid. Therefore it will not have recognised the warranty expenses, and associated provision, of Farrelly Ltd, and the tax base is $nil. Carrying amount ($) 100 000

  Accrued warranty expense

Tax base ($) 0

Temporary difference ($) 100 000

The tax base can be confirmed as follows: Carrying amount 

Future amount deductible - ​​      ​​  for tax purposes

Future taxable + ​​     ​​ = Tax base economic benefits

$100 000   -     $100 000         +     $0     =      $0 While the ATO will not give a deduction in the current period, it will in future years and the taxable income will consequently be reduced in the future by the amount of $100 000 when the related payments are actually made. This means that future tax payments will be reduced by $30 000 ($100 000 × tax rate of 30 per cent)—this represents a benefit and is a deferred tax asset. The journal entry would be: Dr Cr

Deferred tax asset Income tax expense

30 000  

  30 000

When the warranty expense is actually paid in the next year, the above entry will be reversed. This is consistent with the requirement that when temporary differences reverse, the deferred tax asset or deferred tax liability is removed from the financial statements. When recognising a deferred tax asset or a deferred tax liability, a number of assumptions are made. A key assumption is that the entity will remain in business (in other words it is a going concern) and that taxable income will be derived in future years. The recognition criteria for deferred tax assets are the same as those applied to other assets and rely on the ‘probable’ test. AASB 112 provides the general rule that a deferred tax asset must be recognised for all deductible temporary differences that reflect the future tax consequences of transactions and other events that are recognised in the statement of financial position, to the extent that it is probable that future taxable amounts within the entity will be available against which the deductible temporary differences can be utilised. In this regard, paragraph 27 of AASB 112 states: The reversal of deductible temporary differences results in deductions in determining the taxable profits of future periods. However, economic benefits in the form of reductions in tax payments will flow to the entity only if it earns sufficient taxable profits against which the deductions can be offset. Therefore, an entity recognises deferred tax assets only when it is probable that taxable profits will be available against which the deductible temporary differences can be utilised.

Unused tax losses

LO 18.8

As noted previously, deferred tax assets are generated as a result of deductible temporary differences and the benefits must pass the ‘probable’ test before they may be treated as assets for accounting purposes. Deferred tax assets can also arise as a result of tax losses. In Australia, losses incurred in previous years can generally be carried forward to offset taxable income derived in future years. That is, tax losses do not result in cash payments Chapter 18: ACCOUNTING FOR INCOME TAXES  669

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being made to the organisation by the government, but they can be carried forward to offset taxes that might be payable in future years. For example, if a company generates a loss for tax purposes of $100 000 in one year, and in the next year it generates a taxable income of $100 000, the prior period tax loss can be used to offset the taxable income and no tax will be payable. Hence generating a taxable loss can generate subsequent benefits in the form of the tax payments that will be saved in a future profitable period. The benefits will equal the unused tax loss multiplied by the tax rate. Consistent with the test for deferred tax assets generated by temporary differences, deferred tax assets generated as a result of unused tax losses must also be able to satisfy the ‘probable’ test before they are recognised. As paragraph 34 of AASB 112 states: A deferred tax asset shall be recognised arising from the carry forward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised. In relation to unused tax losses, paragraphs 35 and 36 of AASB 112 further provide:

35. The criteria for recognising deferred tax assets arising from the carry forward of unused tax losses and tax credits are the same as the criteria for recognising deferred tax assets arising from deductible temporary differences. However, the existence of unused tax losses is strong evidence that future taxable profit may not be available. Therefore, when an entity has a history of recent losses, the entity recognises a deferred tax asset arising from unused tax losses or tax credits only to the extent that the entity has sufficient taxable temporary differences or there is convincing other evidence that sufficient taxable profit will be available against which the unused tax losses or unused tax credits can be utilised by the entity. In such circumstances, paragraph 82 requires disclosure of the amount of the deferred tax asset and the nature of the evidence supporting its recognition. 36. An entity considers the following criteria in assessing the probability that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised: (a) whether the entity has sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity, which will result in taxable amounts against which the unused tax losses or unused tax credits can be utilised before they expire; (b) whether it is probable that the entity will have taxable profits before the unused tax losses or unused tax credits expire; (c) whether the unused tax losses result from identifiable causes which are unlikely to recur; and (d) whether tax planning opportunities (see paragraph 30) are available to the entity that will create taxable profit in the period in which the unused tax losses or unused tax credits can be utilised. To the extent that it is not probable that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised, the deferred tax asset is not recognised. As a general principle applicable to all deferred tax assets, whether generated as a result of temporary differences or unused tax losses, it is a requirement that they be reviewed at the end of each reporting period to ensure that the assets are not overstated. As paragraph 56 of AASB 112 states: The carrying amount of a deferred tax asset shall be reviewed at the end of each reporting period. An entity shall reduce the carrying amount of the deferred tax asset to the extent that it is no longer probable that sufficient taxable profit will be available to allow the benefit of part or all of that deferred tax asset to be utilised. Any such reduction shall be reversed to the extent that it becomes probable that sufficient taxable profit will be available. Worked Example 18.7 illustrates the utilisation of unused tax losses.

WORKED EXAMPLE 18.7: Utilisation of unused tax losses Grommit Ltd commenced operations in 2019. In the year ending 30 June 2019 it incurred a loss of $1 million. It is expected that the company will not incur losses again and will generate taxable profit in subsequent years. The profits before tax in the following years are as follows: Year 2020 2021 2022

Profit before tax $300 000 $400 000 $600 000

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It is assumed that there are no temporary differences between the carrying values of Grommit Ltd’s assets and liabilities and the respective tax bases. The tax rate is 30 per cent. REQUIRED Provide the journal entries to show the recognition of the asset associated with the tax loss, as well as the journal entries to recognise the use of the loss. SOLUTION 2019 Accepting that it is probable that the entity will be able to recoup the benefits associated with the tax loss, the entry in 2019 would be: Dr Deferred tax asset 300 000   Cr Income tax revenue   300 000 Effectively, the above entry acts to reduce the size of the loss for accounting purposes from $1 million to $700 000, given the recognition of $300 000 in revenue. The size of the deferred tax asset that is recognised can be summarised by the following formula: Unused tax loss × Tax rate = Deferred tax asset 2020 In 2020 the entity generates a profit of $300 000. In the absence of a tax loss, $90 000 would be payable. We still recognise tax expense, but rather than crediting income tax payable, we credit the deferred tax asset. This will reduce the balance of the deferred tax asset account to $210 000, and no amount will be payable to the ATO. Dr Income tax expense 90 000   Cr Deferred tax asset   90 000 2021 In 2021 the entity generates a profit of $400 000. In the absence of a tax loss, $120 000 would be payable. As noted above, we still recognise tax expense, but rather than crediting income tax payable, we credit the deferred tax asset. This will reduce the balance of the deferred tax asset account to $90 000. Dr Income tax expense 120 000   Cr Deferred tax asset   120 000 2022 In 2022 the entity generates a profit of $600 000. In the absence of a tax loss, $180 000 would be payable. We can use the balance of the previously unused tax loss ($90 000) and the remaining amount will then be treated as income tax payable—a current liability. Dr Income tax expense 180 000   Cr Deferred tax asset   90 000 Cr Income tax payable   90 000 The statement of profit or loss and other comprehensive income for the four years is set out below:   Profit/(loss) before tax Tax revenue/(income tax expense) Profit/(loss) after tax

2022 ($) 600 000 (180 000)  420 000

2021 ($) 400 000 (120 000)  280 000

2020 ($) 300 000    (90 000) 210 000

2019 ($) (1 000 000) 300 000  (700 000)

2020 ($)   210 000   –

2019 ($)   300 000   –

Statement of financial position extract for the four years as at 30 June   Assets Deferred tax asset Liabilities Tax payable

2022 ($)   –   90 000

2021 ($)   90 000   –

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LO 18.9

Revaluation of non-current assets

As discussed in Chapter 6, reporting entities often revalue their non-current assets to fair value. For an upward revaluation, the general entry is to debit the relevant asset account, and credit the revaluation surplus (unless the revaluation reverses a previous revaluation decrement). Chapter 6 did not discuss the tax implications of asset revaluations, so we will therefore consider them now. AASB 116 Property, Plant and Equipment, paragraph 42, does specifically require: The effects of taxes on income, if any, resulting from the revaluation of property, plant and equipment are recognised and disclosed in accordance with AASB 112 Income Taxes. According to paragraph 20 of AASB 112, revaluations can create temporary differences. When non-current assets are revalued, the revaluation increment is not deductible for taxation purposes, even though depreciation for accounting purposes will be based on the revalued amount. That is, the tax base is not affected by the revaluation because depreciation for tax purposes will continue to be based on the original cost. However, any increase in the carrying value of a non-current asset through a revaluation undertaken to recognise an increase in fair value implies an expected increase in the future flow of economic benefits. This increase can ultimately be taxable and can lead to a deferred tax liability. The rationale for the creation of a deferred tax liability is provided in paragraph 20 of AASB 112, which states:





The revaluation or restatement of an asset does not affect taxable profit in the period of the revaluation or restatement and, consequently, the tax base of the asset is not adjusted. Nevertheless, the future recovery of the carrying amount will result in a taxable flow of economic benefits to the entity and the amount that will be deductible for tax purposes will differ from the amount of those economic benefits. The difference between the carrying amount of a revalued asset and its tax base is a temporary difference and gives rise to a deferred tax liability or asset. This is true even if: (a) the entity does not intend to dispose of the asset. In such cases, the revalued carrying amount of the asset will be recovered through use and this will generate taxable income which exceeds the depreciation that will be allowable for tax purposes in future periods; or (b) tax on capital gains is deferred if the proceeds of the disposal of the asset are invested in similar assets. In such cases, the tax will ultimately become payable on sale or use of the similar assets.

As an example, let us assume that an entity acquires a depreciable non-current asset, say machinery, for a cost of $1 million. It is expected to have a useful life of ten years and no residual value. After using the asset for four years, the entity decides to revalue the asset to its fair value of $780 000. The depreciation expense for accounting purposes will then be $130 000 a year for each of the next six years ($780 000 ÷ 6). We will assume that, up to the date of the asset revaluation, the depreciation for tax purposes is the same as that for accounting purposes, that is, $100 000 per year, and we will assume that the tax rate is 30 per cent. To record the revaluation, the following journal entry would be made: Dr Cr Dr Cr

Accumulated depreciation Machinery Machinery Revaluation surplus

400 000

 

180 000

 

 

400 000

 

180 000

We can now consider the carrying amount of the asset and its tax base.   Fair value/cost less Accumulated depreciation  

Carrying amount ($)

Tax base ($)

780 000         $nil 780 000

1 000 000 400 000 600 000

Alternatively: Future amount deductible Future taxable Carrying amount  +  ​​      ​​  −  ​​     ​​  for tax purposes economic benefits

=   Tax base

$780 000    +     $600  000      −    $780 000    =  $600 000 672  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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There is therefore a temporary difference of $180 000. Because the carrying amount is greater than the tax base, this will give rise to a deferred tax liability (as summarised earlier in Table 18.2). However, unlike the previous examples in this chapter where a temporary difference is adjusted against income tax expense, asset revaluations give rise to a special case. AASB 112 requires that, to the extent that the deferred tax relates to amounts that were previously recognised in equity as either direct credits or direct debits (as is the case for upward asset revaluations), the journal entry to recognise the deferred tax asset or liability must also be adjusted against the equity account. As we know, the increase in the value of a revalued item of property, plant and equipment is recognised outside of profit or loss. That is, the credit entry is to the revaluation surplus account and not to profit or loss. As paragraph 61A of AASB 112 states:



Current tax and deferred tax shall be recognised outside profit or loss if the tax relates to items that are recognised, in the same or a different period, outside profit or loss. Therefore, current tax and deferred tax that relates to items that are recognised, in the same or a different period: (a) in other comprehensive income, shall be recognised in other comprehensive income (see paragraph 62); and (b) directly in equity, shall be recognised directly in equity (see paragraph 62A).

Changes in the revaluation surplus account shall be included as part of other comprehensive income. Given that the revaluation is adjusted against equity (revaluation surplus), the accounting entry to record the recognition of the deferred tax liability would therefore be: Dr Revaluation surplus 54 000   Cr Deferred tax liability   (54 000 = 180 000 × 0.30. This amount will be recognised in other comprehensive income)

54 000

Hence the recognition of the future tax associated with an asset that has a fair value in excess of its cost, as recognised by a revaluation, acts to reduce the amount of the revaluation surplus (and, therefore, the total amount of equity). The above entries assume that the revalued amount of the asset will be recovered by the entity’s continued use of the asset. The journal entries to record the deferred tax liability will be different if there is an expectation that the revalued asset will be sold. If a non-current asset is sold, in some countries there is often a ‘tax break’ given to the organisation, as the tax base is increased by an index that reflects general price increases. If the tax that will be assessed in the future is to be reduced because of capital gains indexation, the reduction in the amount of tax that would be paid is accounted for by debiting the deferred tax liability and crediting the revaluation surplus. Hence in some countries the tax base of an asset can depend on the manner in which the entity’s management expects to recover the benefits inherent in the asset. Capital gains tax capital gains tax concessions, if available in particular countries, are typically provided when the asset is sold, not if it A tax that is payable on is being used within the organisation. The accounting entries to be made therefore will depend on profits that arise when the intended use of the revalued asset. As paragraph 51A of AASB 112 states: an asset (typically a non-current asset)



is sold at a price in In some jurisdictions, the manner in which an entity recovers (settles) the carrying amount of excess of its cost. an asset (liability) may affect either or both of: (a) the tax rate applicable when the entity recovers (settles) the carrying amount of the asset (liability); and (b) the tax base of the asset (liability). In such cases, an entity measures deferred tax liabilities and deferred tax assets using the tax rate and the tax base that are consistent with the expected manner of recovery or settlement.

Applying an example to the above requirement, let us assume that an item of property, plant and equipment has a carrying amount of $2000 and a tax base of $1200. Let us also assume that a tax rate of 20% would apply if the asset were sold and a tax rate of 30% would apply to other income and expenses. The entity would recognise a deferred tax liability of $160 (20% of $800) if it expects to sell the asset without further use and a deferred tax liability of $240 (30% of $800) if it expects to retain the asset and recover its carrying amount through use. Worked Examples 18.8 and 18.9 examine accounting for a revaluation and Worked Example 18.10  gives a detailed example of accounting for tax. Chapter 18: ACCOUNTING FOR INCOME TAXES  673

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WORKED EXAMPLE 18.8: Accounting for a revaluation Endless Summer Ltd has a building that has just been revalued to its fair value of $450 000. It was initially acquired at a cost of $300 000. The accumulated depreciation for tax purposes is $24 000. The tax rate is 30 per cent. REQUIRED (a) Assuming that there is an expectation that the asset will continue to be used by the company, determine the tax base of the asset. (b) Assuming that there is an expectation that the economic benefits inherent in the asset will be recovered immediately through a sale, determine the tax base of the asset given that the asset was acquired when the index for capital gains tax was 100, while the index at reporting date is 120. SOLUTION (a) The tax base can be determined as follows: Future amount deductible Future taxable Carrying amount  +  ​​      ​​  −  ​​     ​​  for tax purposes economic benefits

=   Tax base

$450 000    +       $276 000        −     $450 000    =  $276 000 (b) The tax base can be determined as follows: Future amount deductible Future taxable Carrying amount  +  ​​      ​​  −  ​​     ​​  for tax purposes economic benefits

=   Tax base

$450 000    +       $336 000        −     $450 000    =  $336 000 The future deductible amount is calculated by multiplying the cost of the asset by the increase in the size of the capital gains index, less the amount of depreciation that has already been claimed, that is, $300 000 × 1.2 − $24 000 = $336 000.

WORKED EXAMPLE 18.9: Accounting for a revaluation Winter Swells Ltd acquired an item of plant with a ten-year useful life, on 1 July 2015, for $200 000. At the end of the item’s useful life, the plant will have a $nil residual value. For accounting purposes, the plant was depreciated on a straight-line basis over its useful life, while, for tax purposes, the plant is depreciated at 20 per cent per annum on the straight-line basis. On 30 June 2019, which is four years after it was acquired, the plant was revalued to $210 000. The life and residual values remain unchanged. The tax rate is 30 per cent. REQUIRED (a) Assuming that the asset is expected to continue to be used by Winter Swells Ltd, determine the tax base of the asset and provide the necessary journal entries at 30 June 2019, assuming the $210 000 is recovered through use. (b) Assuming that Winter Swells Ltd continues to use the asset in subsequent reporting periods, provide the journal entries for the depreciation and deferred tax for 30 June 2020 and 30 June 2021. SOLUTION (a) Determining the tax base and journal entries assuming the $210 000 will be recovered through use   On 30 June 2019, the journal entries to take account of the revaluation for accounting purposes, assuming the $210 000 will be recovered through use, would be as follows: 30 June 2019 Dr Accumulated depreciation Cr Plant and machinery (Eliminating accumulated depreciation on revaluation of asset)

80 000  

80 000

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30 June 2019 Dr

Plant and machinery

90 000

Cr Revaluation surplus (Revaluing asset to fair value)

90 000

Future amount deductible Future taxable economic Tax base  =  ​​      ​​  −  ​​      ​​  + Carrying amount for tax purposes benefits of asset $40 000  =     $40  000     −     $210  000       +    $210 000   Before the revaluation, the temporary difference was $80 000, which represented the difference between the carrying amount of $120 000 and the tax base of $40 000. A deferred tax liability of $24 000 ($80 000 × 30 per cent) would have appeared in the financial records. After the revaluation, the temporary difference is $170 000 (which is calculated at either $80 000 + $90 000, or $210 000 − $40 000), which would require a total deferred tax liability of $51 000 ($170 000 × 30 per cent). As the deferred tax liability already has a balance of $24 000 prior to the revaluation, a further $27 000 must be provided ($90 000 × 30 per cent).   The journal entry to reflect the deferred tax on the revalued amount would be: 30 June 2019 Dr

Revaluation surplus

Cr Deferred tax liability (Allocating deferred tax to revaluation surplus)

27 000

 

 

27 000

  Deferred tax is provided on the full increase in value, which includes the amount above the original cost as the carrying amount is expected to be recovered through the generation of taxable profit. The changes made to the revaluation surplus account would be included as part of other comprehensive income. (b) Provide the journal entries for the depreciation and deferred tax for 30 June 2020 and 30 June 2021 30 June 2020 Dr

Depreciation

35 000

 

Cr Accumulated depreciation   35 000 (Depreciation expense for the reporting period ending 30 June 2020 ($35 000 = $210 000 ÷ 6))   The deferred tax on the increased accounting depreciation must be reversed back to the revaluation surplus, whereas the deferred tax on the depreciation on the original cost will still flow through the statement of profit or loss and other comprehensive income. The entries will be as follows: 30 June 2020 Dr

Income tax expense

Cr

Revaluation surplus

6 000

 

 

4 500

Cr Deferred tax liability   (Deferred tax on depreciation for the reporting period ending 30 June 2020)

1 500

  The total deferred tax liability will now be $52 500 ($24 000 + $27 000 + $1500). This amounts to 30 per cent of the total temporary differences of $175 000 at 30 June 2020. At 30 June 2020 the tax base of the asset would be zero as it has been fully depreciated over the five years for tax purposes at $40 000 per annum, which equates to the original cost of $200 000. For accounting purposes, the carrying amount of the asset would be $210 000 x 5/6 which equals $175 000. $175 000 multiplied by the tax rate of 30% gives the deferred tax liability balance of $52 500.  30 June 2021 Dr

Depreciation

35 000

Cr Accumulated depreciation   (Depreciation expense for the reporting period ending 30 June 2021)

  35 000

continued Chapter 18: ACCOUNTING FOR INCOME TAXES  675

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  The deferred tax on the increased accounting depreciation must be reversed back to the revaluation surplus, whereas the deferred tax on the depreciation on the original cost will still flow through the statement of profit or loss and other comprehensive income. The entries will be as follows: 30 June 2021 Dr Deferred tax liability 10 500 Cr Tax expense   Cr Revaluation surplus   (Deferred tax on depreciation for the reporting period ending 30 June 2021)

  6 000 4 500

  The total deferred tax liability will now be $42 000 ($52 500 − $10 500). This amounts to 30 per cent of the total temporary difference of $140 000 at 30 June 2021.   By the end of the useful life of the asset at 30 June 2025, and with the accounting journal entries in each of the next four years being the same as those above for 30 June 2021, the balance of the deferred tax liability will be $0. This is appropriate as both the tax base of the asset, and the carrying amount of the asset, will be $0 at 30 June 2025 and there will be no remaining timing difference, meaning that there should be no deferred tax asset or deferred tax liability in relation to this specific asset. The balance of the revaluation surplus will be $90 000 at 30 June 2025, at which point there might be a decision to transfer the balance to retained earnings.

WORKED EXAMPLE 18.10: Detailed example of accounting for tax First Point Ltd commences operations on 1 July 2018. One year later, on 30 June 2019, the entity prepares the following information, showing both the carrying amounts for accounting purposes, and tax bases of the respective assets and liabilities.   Assets Cash Accounts receivable (net) Inventory Plant—net Land   Liabilities Accounts payable Provision for long-service leave Provision for warranty Loan payable   Net assets

Extract from accounting balance sheet ($)

Tax bases ($)

 

  50 000 35 000 65 000 160 000 400 000 710 000   40 000 60 000 70 000 350 000 520 000 190 000

50 000 40 000 65 000 150 000 300 000 605 000   40 000 – – 350 000 390 000 215 000

Other information • After adjustments are made for differences between tax rules and accounting rules, it is determined that the taxable profit of First Point Ltd is $400 000. It will be $500 000 in the following year. • There is an allowance for doubtful debts of $5000. • An item of plant is purchased at a cost of $200 000 on 1 July 2018. For accounting purposes it is expected to have a life of five years; however, for taxation purposes it can be depreciated over four years. It is not expected to have any residual value. • First Point has some land, which cost $300 000 and which has been revalued to its fair value of $400 000 in accordance with AASB 116.

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• None of the amounts accrued in respect of warranty expenses or long service leave has actually been paid. • The tax rate is 30 per cent. As demonstrated in the schedule below, given that First Point Ltd commences operations on 1 July 2018, there are no temporary differences at the commencement of the period. At the end of the period we determine whether there are differences between the carrying amounts of assets and liabilities (as reflected in the accounting balance sheet) and their related tax bases. We then determine whether the differences lead to deductible temporary differences or taxable temporary differences. Table 18.2 is useful for this purpose. Extract from accounting balance sheet ($)   50 000 35 000 65 000 160 000 400 000 710 000   40 000 60 000

Deductible temporary differences ($)

Tax bases ($)

  Assets   Cash 50 000 Accounts receivable net 40 000 Inventory 65 000 Plant—net 150 000 Land 300 000   605 000 Liabilities   Accounts payable 40 000 Provision for long–   service leave Provision for warranty 70 000   Loan payment 350 000 350 000   520 000 390 000 Net assets 190 000 215 000 Temporary differences at period end less Prior period amounts Movement for the period Tax effected at 30% Tax on taxable income, 30% × $400 000 Income tax adjustments

               

   

Taxable temporary differences ($)

    5 000    

      60 000   70 000                      135 000            – 135 000 40 500                     40 500

      10 000 100 000        

               110 000            – 110 000 33 000                33 000

Income Revaluation tax surplus payable ($) ($)         (5 000)         10 000     100 000               (60 000)    

Tax expense ($)

(70 000)                    (125 000)             – (125 000) (37 500)  120 000      82 500

                       100 000               – 100 000   30 000                 120 000 30 000 120 000

We then add the differences down the column before multiplying them by the relevant tax rate to determine the balance of deferred tax assets and deferred tax liabilities. The recognition of the deferred tax assets and deferred tax liabilities will also have direct implications for taxation expense, and adjustments to taxation expense will be necessary. The exception to this, however, is where the deferred tax relates to amounts that were previously recognised as direct debits or credits to an equity account. In this case, the adjustment must also be to equity. In this illustration, this exception is relevant to the asset revaluation pertaining to the land. In the column under tax expense, the negative numbers reflect a decrease (or credit) to tax expense, whereas the positive numbers represent an increase in tax expense (a debit). The income tax expense pertaining to taxable income is determined by calculating taxable income and multiplying it by the tax rate of 30 per cent, that is, $400 000 multiplied by 30 per cent, which gives $120 000. To this we add the tax effect of the temporary differences, other than that which relates to the asset revaluation. This total adjustment amounts to $37 500. The required journal entries at 30 June 2019 would be: Dr Dr Dr

Income tax expense Deferred tax asset Revaluation surplus

82 500 40 500 30 000

      continued

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Cr Cr

Deferred tax liability Income tax payable

   

33 000 120 000

Because in most cases the tax is payable to the same authority, AASB 112 requires that the deferred tax liabilities and deferred tax assets be set off against one another and that only the net amount be disclosed in the statement of financial position. Hence for statement of financial position (balance sheet) purposes we would offset the deferred tax liability of $33 000 against the deferred tax asset. The entry on 30 June 2019 would be: Dr Cr

Deferred tax liability Deferred tax asset

33 000

 

 

33 000

We can now consider the second year of operations of First Point Ltd, ending on 30 June 2020. It is expected that the taxable profit for 2020 will be $500 000. The company income tax rate is still 30 per cent. In this year the tax base of accounts receivable is lower than the balance sheet amount. This might be because some income has been recognised for accounting before it is recognised for tax purposes. The new year-end balances for assets and liabilities are provided in the following schedule: Extract from accounting balance sheet ($)

Deductible temporary differences ($)

Tax bases ($)

  Assets Cash 80 000 80 000 Accounts receivable net 55 000 45 000 Inventory 85 000 85 000 Plant—net 120 000 100 000 Land 400 000 300 000   740 000 610 000 Liabilities     Accounts payable 40 000 40 000 Provision for long80 000 –   service leave Provision for warranty 85 000   Loan payable 535 000 535 000   740 000 575 000 Net assets – 35 000 Temporary differences at period end less Prior period amounts Movement for the period Tax effected at 30% Tax on taxable income, 30% × $500 000 Income tax adjustments

               

   

Taxable temporary differences ($)  

      80 000   85 000                   165 000 135 000   30 000 9 000                  9 000

Tax expense ($)  

10 000   20 000 100 000        

             130 000 110 000    20 000 6 000                  6 000

Current tax Revaluation payable surplus ($) ($)

  10 000       20 000         (80 000)  

(85 000)                        (135 000) (125 000)    (10 000) (3 000)  150 000  147 000

        100 000                              100 000 100 000            0            0                         0

        150 000 150 000

The tax journal entries for the year to 30 June 2020 are as follows: Dr Dr Cr Cr

Income tax expense Deferred tax asset Deferred tax liability Income tax payable

147 000 9 000

   

   

6 000 150 000

As we did in the previous year, we set off the deferred tax asset against the deferred tax liability in the statement of financial position presentation on the basis that the reporting entity is operating only within Australia and therefore all income tax amounts relate to the Australian Taxation Office. Dr Cr

Deferred tax liability Deferred tax asset

6 000  

  6 000

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Offsetting deferred tax liabilities and deferred tax assets

LO 18.6

As indicated in Worked Example 18.10, given that in most cases the tax is payable to the same authority, AASB 112 requires that, if certain conditions are met, then both the current tax liabilities and current tax assets as well as the deferred tax liabilities and deferred tax assets be set-off against one another and that only the net amount of each set-off be disclosed in the statement of financial position. In relation to the set-off of current tax assets and current tax liabilities, paragraph 71 of AASB 112 states:

An entity shall offset current tax assets and current tax liabilities if, and only if, the entity: (a) has a legally enforceable right to set-off the recognised amounts; and (b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

As the above paragraph explains, there is a need to have a ‘legally enforceable right of set-off’. This is further explained at paragraph 72 of AASB 112: An entity will normally have a legally enforceable right to set-off a current tax asset against a current tax liability when they relate to income taxes levied by the same taxation authority and the taxation authority permits the entity to make or receive a single net payment. The requirements pertaining to offsetting deferred tax assets and deferred tax liabilities are included at paragraph 74 of AASB 112, which states: An entity shall offset deferred tax assets and deferred tax liabilities if, and only if: (a) the entity has a legally enforceable right to set-off current tax assets against current tax liabilities; and (b) the deferred tax assets and the deferred tax liabilities relate to income taxes levied by the same taxation authority on either: (i) the same taxable entity; or (ii) different taxable entities which intend either to settle current tax liabilities and assets on a net basis, or to realise the assets and settle the liabilities simultaneously, in each future period in which significant amounts of deferred tax liabilities or assets are expected to be settled or recovered. If we are accounting for a group of companies operating across many countries (and the process of accounting for groups of companies—which is referred to as ‘consolidation accounting’—is addressed in Chapters 25 to 27), there will be various ‘taxation authorities’ being dealt with. As such, we will not be able to offset deferred tax assets that arise in some jurisdictions with deferred tax liabilities that arise in others. Hence consolidated financial statements will typically show balances for both deferred tax liabilities and deferred tax assets.

Change of tax rates

LO 18.7

A deferred tax asset or a deferred tax liability is essentially an estimate of a future tax saving or an estimate of a future tax amount owing to a taxation authority. As has been shown, the balance on the deferred tax account is calculated by multiplying the temporary difference by the tax rate in existence at the end of the reporting period. Across time it is likely that governments will change tax rates. Changed tax rates will have implications for the value attributed to pre-existing deferred tax assets and deferred tax liabilities. For example, if an organisation has recognised a deferred tax asset relating to a previous loss for tax purposes and that previously carried-forward tax loss was $1 million, and the tax rate is increased from 30 per cent to 35 per cent, the amount of the deferred tax asset will need to be increased from $300 000 to $350 000. This is because when the organisation subsequently earns a taxable profit of $1 000 000 it will be able to offset the loss against the $350 000 in tax that would otherwise be payable under the revised tax rate. The $50 000 increase in the value of the deferred tax asset (which is calculated as $1 000 000 × [0.35 − 0.30]) would be treated as income, given that the carrying amount of the asset has been increased. Conversely, if the tax rate had been decreased, the value of the asset would be decreased and this would be recognised as an expense. An increase in tax rates will create an expense where an organisation has deferred tax liabilities, whereas a decrease in tax rates will create income in the presence of deferred tax liabilities. Where there are both deferred tax assets and deferred tax liabilities at the time of a change in tax rate, there will be both gains and losses (there will be a gain on the asset and a loss on the liability, or vice versa) and the net amount would be treated as either income or an expense. Worked Example 18.11 and Worked Example 18.12 provide examples of how to account for a change in tax rate. Chapter 18: ACCOUNTING FOR INCOME TAXES  679

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WORKED EXAMPLE 18.11: Change in tax rates As at 30 June 2018, the balance of the deferred tax liability account of Shannon Ltd was $660 000 credit. Assume that at 30 June 2019 the tax rate changed from 33 per cent to 30 per cent. REQUIRED Prepare the journal entries to record the change in tax rates for 2019. SOLUTION The accounting entry at 30 June 2019 would be: Dr Deferred tax liability 60 000   Cr Income tax expense   60 000 Reduction in tax expense resulting from a decrease in tax rate $660 000 − ($660 000/33 × 30) = $60 000 Because there has been a downward revision of the deferred tax liability, a corresponding decrease in the income tax expense for the year ending 30 June 2019 will be reported in the statement of profit or loss and other comprehensive income.

WORKED EXAMPLE 18.12: Impact of changing tax rates Taxi Ltd has the following deferred tax balances as at 30 June 2019: Deferred tax asset Deferred tax liability

$500 000 $300 000

The above balances were calculated when the tax rate was 30 per cent. On 1 August 2019 the government reduced the corporate tax rate to 25 per cent. REQUIRED Provide the journal entries to adjust the carry-forward balances of the deferred tax asset and deferred tax liability. SOLUTION   Deferred tax asset Deferred tax liability

Balance at 30 June 2019 $500 000 $300 000

Balance at 1 August 2019 $500 000 × 25/30 = $416 667 $300 000 × 25/30 = $250 000

Change ($83 333) ($50 000)

The accounting entry at 1 August 2019 would be: Dr Dr Cr

LO 18.8 LO 18.10

Deferred tax liability Income tax expense Deferred tax asset

50 000 33 333  

    83 333

Evaluation of the assets and liabilities created by AASB 112

Throughout this text we have considered the definitions of the financial elements provided in the Conceptual Framework for Financial Reporting. At this point we may consider whether the term ‘deferred tax asset’ or the term ‘deferred tax liability’ as generated by tax-effect accounting actually meet the definitions provided within the conceptual framework. First, let us consider the deferred tax asset. As we know, an asset is defined as a ‘resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. At the end of the reporting period, the company really has no claim against the government for the value of the deferred tax asset. The realisation of the benefit will arise only if the company earns sufficient revenue in the future and if the relevant taxation 680  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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legislation does not change. It is questionable whether the benefits are actually controlled by the entity at the end of the reporting period. There is arguably a contingent element involved. With respect to the deferred tax liability, a liability is defined in the conceptual framework as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. Where a deferred tax liability exists, the company is not currently obliged to transfer funds of an amount equal to the balance of the account. The funds will be transferred in the future only if the company earns sufficient revenue; that is, there is a dependency on future events, not past events. There is also the assumption that the relevant taxation legislation will not change. The earlier discussion of issues associated with the revaluation of non-current assets revealed that the amount recorded in the deferred tax liability account will depend upon determining whether management intends for the entity to continue to use the asset, or whether it intends to sell the asset. If the entity intends to sell the asset, lower tax might be deferred to subsequent periods because of the capital gains allowances that are granted through indexing the cost of the asset. This means that the amount recognised for the liability will be the result of decisions taken by management. To some people it might be inconceivable that a liability is recognised only because management has made a decision to revalue an asset. However, in supporting this treatment under the balance sheet approach, Westwood (2000, p. 318) argues that: The Balance Sheet approach does not necessarily recognise all deferred tax obligations. The basis of the Balance Sheet approach is that deferred tax obligations are recognised to the extent that the underlying assets giving rise to the obligations are recognised. The justification is that when an asset revaluation increment is recognised, the equity of the entity has been increased by the future assessable revenues that it is probable that the asset will generate. A corresponding deferred tax obligation must then be recognised at that point to account for the relevant portion of those future assessable revenues that must be paid in tax. This justification assumes that rights (to future revenues) implicit in assets trigger obligations (to future expenses) implicit in liabilities. As a last general comment, the record-keeping costs associated with applying the balance sheet method are likely to be high, as the accounting is quite complex. Whether this cost is justified in terms of increased usefulness of financial statements is questionable. It will take a very sophisticated reader of financial statements to be able to understand how a deferred tax asset and a deferred tax liability are calculated and what the calculated number actually represents. The following exhibit, Exhibit 18.1, provides extracts from the 2015 annual report of the Commonwealth Bank of Australia (CBA). As we can see, CBA provides a separate income statement and statement of comprehensive income (rather than utilising the other option, which would be one ‘combined’ statement of profit or loss and other comprehensive income). While you would not be expected to understand all of the disclosures being made by CBA in Exhibit 18.1, you will see that: • Tax expenses will be included within profit or loss and also within other comprehensive income (OCI); • The accounting policy note emphasises that tax expense is tied to taxes that are expected to be payable within the next financial period (taxes payable) as well as by the recognition of deferred tax assets and deferred tax liabilities (which, as we know, are payable/receivable beyond the next financial period). The note also emphasises that, as required by the accounting standard, the CBA applies the ‘balance sheet method’ in accounting for tax, and that deferred tax assets are recognised only when it is probable that future taxable profits will be available. Also, consistent with the accounting standard, deferred tax assets and deferred tax liabilities are offset only when there is both a legal right to set-off and an intention to settle on a net basis with the same taxation authority; • In accordance with the standard, deferred tax loss related to tax losses are not carried forward if it is not considered probable that future taxable profit will be available against which they can be realised. Within the CBA financial statements, the total balance of deferred tax assets and deferred tax liabilities, as recognised in the statement of financial position, are $455 million and $351 million respectively. Obviously such amounts are quite material. It would be interesting to know how many readers of the financial statements actually appreciate what these amounts represent and whether they understand that future cash flows associated with the deferred tax assets and deferred tax liabilities will be dependent upon the entity subsequently generating sufficient taxable income, or that the carrying amounts of such assets and liabilities will change if tax rates subsequently change. To many people, deferred tax assets and deferred tax liabilities likely cause some confusion. Chapter 18: ACCOUNTING FOR INCOME TAXES  681

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Exhibit 18.1: An example of disclosures made in relation to current and deferred taxes.

Income statements For the year ended 30 June 2015 Group

Bank

2015 ($m)

2014 ($m)

2013 ($m)

2015 ($m)

2014 ($m)

Interest income

34 100

33 645

34 739

34 937

34 860

Interest expense

(18 305)

(18 544)

(20 805)

(21 006)

(21 494)

15 795

15 101

13 934

13 931

13 366

4 856

4 320

4 172

6 847

6 378

20 651

19 421

18 106

20 778

19 744

2 396

2 356

2 147





618

840

942





(1 011)

(1 162)

(1 242)





Net funds management operating income

2 003

2 034

1 847





Premiums from insurance contracts

2 797

2 604

2 353





543

547

449





(2 326)

(2 118)

(1 879)





1 014

1 033

923





23 668

22 488

20 876

20 778

19 744

(988)

(918)

(1 146)

(837)

(871)

(10 068)

(9 573)

(9 085)

(8 271)

(7 866)

Net profit before income tax

12 612

11 997

10 645

11 670

11 007

Corporate tax expense

(3 429)

(3 221)

(2 899)

(2 694)

(2 565)

(99)

(126)

(112)





9 084

8 650

7 634

8 976

8 442

(21)

(19)

(16)





9 063

8 631

7 618

8 976

8 442

Net interest income Other banking income Net banking operating income Funds management income Investment revenue Claims, policyholder liability and commission expense

Investment revenue Claims, policyholder liability and commission expense from insurance contracts Net insurance operating income Total net operating income before impairment and operating expenses Loan impairment expense Operating expenses

Policyholder tax expense Net profit after income tax Non-controlling interests Net profit attributable to Equity holders of the Bank

The above Income Statements should be read in conjunction with the accompanying notes. Group 2015 Note

2014

2013

Cents per share

Earnings per share:  Basic

6

557.0

533.8

474.2

  Fully diluted

6

542.7

521.9

461.0

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Statements of Comprehensive Income For the year ended 30 June 2015 Group

Bank

2015 ($m) 9 084

2014 ($m) 8 650

2013 ($m) 7 634

2015 ($m) 8 976

2014 ($m) 8 442

398 39

385 (144)

466 (276)

171 106

– (84)

(45)

338

364

(84)

453

392

579

554

193

369

311

42

367

311

42

(3)

6



(3)

6

15 323

26 74

3 370

11 319

24 72

Other comprehensive income net of income tax

715

653

924

512

441

Total comprehensive income for the financial year Total comprehensive income fore the financial year is attributable to: Equity holders of the Bank Non-controlling interests Total comprehensive income net of income tax

9 799

9 303

8 558

9 488

8 883

9 799 21 9 799

9 284 19 9 303

8 542 16 8 558

9 488 – 9 488

8 883 – 8 883

Net profit after income tax for the financial year Other comprehensive income: Items that may be reclassified subsequently to profit/(loss): Foreign currency translation reserve net of tax Gains and (losses) on cash flow hedging instruments net of tax Gains and (losses) on available-for-sale investments net of tax Total of items that may be reclassified Items that will not be reclassified to profit or loss: Actuarial gains and losses from defined benefit superannuation plans net of tax Gains and losses on liabilities at fair value due to changes in own credit risk net of tax Revaluation of properties net of tax Total of Items that will not be reclassified

2015 Note Dividends per share attributable to shareholders of the Bank:   Ordinary shares   Trust preferred securities

5

Group 2014

2013

Cents per share

420 7 387

401 6 498

364 5 767

The above Statements of Comprehensive Income should be read in conjunction with the accompanying notes. NOTE 1 ACCOUNTING POLICIES Taxation p. Income Tax Expense Income tax is recognised in the Income Statement, except to the extent that it relates to items recognised directly in OCI, in which case it is recognised in the Statement of Comprehensive Income. Income tax on the profit or loss for the period comprises current and deferred tax. continued Chapter 18: ACCOUNTING FOR INCOME TAXES  683

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q. Current Tax Current tax is the expected tax payable on the taxable income for the year, using tax rates enacted at the Balance Sheet date, and any adjustment to tax payable in respect of previous years. r. Deferred Tax Deferred tax is calculated using the Balance Sheet method where temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their tax base are recognised. The amount of deferred tax provided is based on the expected manner of realisation or settlement of the carrying amount of assets and liabilities (i.e. through use or through sale), using tax rates which are expected to apply when the deferred tax asset is realised or the deferred tax liability is settled. A deferred tax asset is recognised only when it is probable that future taxable profits will be available for it to be used against. Deferred tax assets are reduced to the extent that it is no longer probable that the related tax benefit will be realised. Deferred tax assets and liabilities are only offset when there is both a legal right to set-off and an intention to settle on a net basis with the same taxation authority. NOTE 4 INCOME TAX The income tax expense for the year is determined from the profit before income tax as follows: Group

Profit before Income Tax Prima facie income tax at 30% Effect of amounts which are non-deductible/ (assessable) in calculating taxable income: Taxation offsets and other dividend adjustments Tax adjustment referable to policyholder income Tax losses not previously brought to account Offshore tax rate differential Offshore banking unit Effect of changes in tax rates Income tax (over) provided in previous years Other Total income tax expense Corporate tax expense Policyholder tax expense Total income tax expense Effective tax rate (%)1 Income tax expense attributable to profit from ordinary activities Australia Current tax expense Deferred tax expense Total Australia Overseas Current tax expense Deferred tax expense/(benefit) Total overseas Total income tax expense

Bank

2015 ($m) 12 612 3 784

2014 ($m) 11 997 3 599

2013 ($m) 10 645 3 193

2015 ($m) 11 670 3 501

2014 ($m) 11 007 3 302

(6)

(6)

(3)

(582)

(574)

69

89

79





(9) (116) (39) 2 (163) 6 3 528 3 429 99 3 528 27.4

(21) (99) (30) 3 (121) (67) 3 347 3 221 126 3 347 27.1

(18) (89) (33) – (50) (68) 3 011 2 899 112 3 011 27.5

(6) (35) (39) 1 (151) 5 2 694 2 694 – 2 694 23.1

(15) (21) (30) 3 (77) (23) 2 565 2 565 – 2 565 23.3

2 865 124 2 989

2 433 389 2 822

2 392 192 2 584

2 591 9 2 600

2 214 247 2 461

547 (8) 539

670 (145) 525

425 2 427

78 16 94

84 20 104

3 528

3 347

3 011

2 694

2 565

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Deferred tax asset balances comprise temporary differences attributable to: Amounts recognised in the Income Statement: Provision for employee benefits Provisions for impairment on loans, bills discounted and other receivables Other provisions not tax deductible until expense incurred Financial instruments Defined benefit superannuation plan Other2 Total amount recognised in the Income Statement Amounts recognised directly in Other Comprehensive Income: Cash flow hedge reserve Other reserves2 Total amount recognised directly in Other Comprehensive Income Total deferred tax assets (before set off)3 Set off to tax pursuant to set-off provisions in Note 1(r) Net deferred tax assets Deferred tax liability balances comprise temporary differences attributable to: Amounts recognised in the Income Statement: Impact of TOFA adoption Lease financing Intangible assets Financial instruments Other Total amount recognised in the Income Statement Amounts recognised directly in Other Comprehensive Income: Revaluation of properties Foreign currency translation reserve Cash flow hedge reserve Defined benefit superannuation plan Available-for-sale investments reserve Total amount recognised directly in Other Comprehensive Income Total deferred tax liabilities (before set off)4 Set off to tax pursuant to set-off provisions in Note 1(r) Net deferred tax liabilities Deferred tax assets opening balance: Movement in temporary differences during the year: Provisions for employee benefits

453 1 008

437 1 044

414 1 177

369 944

360 986

283

160

175

234

134

36 293 207 2 280

9 265 233 2 148

9 199 231 2 205

1 293 184 2 025

2 265 206 1 953

155 6 161

99 2 101

77 6 83

7 3 10

6 3 9

2 441

2 249

2 288

2 035

1 962

(1 986)

(1 663)

(1 372)

(1 264)

(1 166)

455

586

916

771

796

– 341 123 235 600 1 299

– 381 45 184 624 1 234

11 370 73 142 587 1 183

– 170 118 11 61 360

– 187 37 15 151 390

76 40 293 365 264 1 038

85 – 193 229 288 795

82 – 259 180 139 660

76 – 223 365 240 904

84 – 179 229 284 776

2 337

2 029

1 843

1 264

1 166

(1 986)

(1 663)

(1 372)

(1 264)

(1 166)

351 586 16

366 916 23

471 960 33

– 796 9

 – 1 044 13

continued Chapter 18: ACCOUNTING FOR INCOME TAXES  685

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Group 2015 ($m) (36)

2014 ($m) (133)

Bank 2013 ($m) (87)

2015 ($m) (42)

Provisions for impairment on loans, bills discounted and other receivables Other provisions not tax deductible until 123 (15) (17) 100 expense incurred Financial instruments 87 19 (32) (1) Defined benefit superannuation plan 28 66 58 28 Other2 (26) 1 19 (21) Set off to tax pursuant to set-off provisions in (323) (291) (18) (98) Note 1(r) Deferred tax assets closing balance 455 586 916 771 Deferred tax liabilities opening balance: 366 471 338 – Movement in temporary differences during the – (11) 2 – year: Impact of TOFA adoption Lease financing (40) 11 5 (17) Defined benefit superannuation plan 136 49 126 136 Intangible assets 78 (28) (54) 81 Financial instruments 167 125 46 (4) Other (33) 40 26 (98) Set off to tax pursuant to set-off provisions in (323) (291) (18) (98) Note 1(r) Deferred tax liabilities closing balance 351 366 471 – Deferred tax assets have not been recognised in respect of the following items because it is not considered probable that future taxable profit will be available against which they can be realised: Deferred tax assets not taken to account Tax losses and other temporary differences on revenue account: Expire under current legislation 83 50 83 62 Do not expire under current legislation – 12 11 – Total 83 62 94 62

2014 ($m) (135) (11) (55) 66 (11) (115) 796 – (11) 5 49 (25) 105 (8) (115) –

39 – 39

1

Policyholder tax is excluded from both profit before income tax and tax expense for the purpose of calculating the Group’s effective tax rate as it is not incurred directly by the Group. 2 Comparatives have been aggregated to conform to presentation in the current year. 3 The following amounts are expected to be recovered within 12 months of the Balance Sheet date for the Group $1 220 million (2014: $1 151 million) and for the Bank $ 1083 million (2014: $1 031 million). 4 The following amounts are expected to be settled within 12 months of the Balance Sheet date for the Group $552 million (2014: $366 million) and for the Bank $139 million (2014: $189 million). SOURCE: Commonwealth Bank of Australia 2015 Annual Report

SUMMARY In this chapter we explored how to account for taxes. It was established that taxable profit and accounting profit will often be different because expense and recognition rules used in accounting are frequently different from those applied for taxation purposes. 686  PART 4: ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY

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AASB 112 applies the balance sheet method for accounting for taxes. This requires a comparison of the carrying amounts and tax bases of the entity’s assets and liabilities. The comparison of these values is the key to applying the balance sheet method. The difference between carrying amounts and tax bases leads to deductible temporary differences or taxable temporary differences. Multiplying these differences by the tax rate gives deferred tax assets and deferred tax liabilities. Generally speaking, if the carrying amount of an asset is greater than its tax base, there will be a deferred tax liability. Conversely, if the carrying amount of an asset is less than its tax base, there will be a deferred tax asset. If the carrying amount of a liability is greater than its tax base, there will be a deferred tax asset, and if the carrying amount of a liability is less than its tax base, there will be a deferred tax liability. For an entity to recognise deferred tax assets, whether brought about by temporary differences or unused tax losses, there is a requirement that the derivation of the associated economic benefits be probable. In this chapter, it was also established that when the temporary differences associated with the revaluation of a noncurrent asset are taken into account, the balance of the revaluation surplus account is reduced.

KEY TERMS accounting profit  657

capital gains tax  673

taxes payable method  662

END-OF-CHAPTER EXERCISES Wounded Seagull Ltd commences operations on 1 July 2018 and presents its first statement of profit or loss and other comprehensive income and first statement of financial position on 30 June 2019. The statements are prepared before considering taxation. The following information is available: Statement of profit or loss and other comprehensive income for the year ended 30 June 2019 Gross profit   600 000 Expenses     Administration expenses 100 000   Salaries 55 000   Long-service leave 10 000   Warranty expenses 20 000   Depreciation expense—plant 75 000   Insurance   10 000 270 000 Profit before tax 330 000 Other comprehensive income            – Total comprehensive income   330 000 Assets and liabilities as disclosed in the statement of financial position as at 30 June 2019 Assets     Cash   30 000 Inventory   80 000 Accounts receivable   90 000 Prepaid insurance   4 000 Plant—cost 300 000   less Accumulated depreciation 75 000 225 000 Total assets   429 000 Liabilities     Accounts payable   50 000 Chapter 18: ACCOUNTING FOR INCOME TAXES  687

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Assets and liabilities as disclosed in the statement of financial position as at 30 June 2019 Provision for warranty expenses Loan payable Provision for long-service leave expenses Total liabilities Net assets

         

15 000 154 000  10 000 229 000 200 000

Other information • All administration and salaries expenses incurred have been paid as at year end. • None of the long-service leave expense has actually been paid. It is not deductible until it is actually paid. • Warranty expenses were accrued and, at year end, actual payments of $5000 were made (leaving an accrued balance of $15 000). Deductions are available only when the amounts are paid, and not as they are accrued. • Insurance was initially prepaid to the amount of $14 000. At year end, the unused component of the prepaid insurance amounted to $4000. Actual amounts paid are allowed as a tax deduction. • Amounts received from sales, including those on credit terms, are taxed at the time the sale is made. • The plant is depreciated over four years for accounting purposes, but over three years for taxation purposes. • The tax rate is 30 per cent.

REQUIRED Provide the journal entries at 30 June 2019 to account for tax in accordance with AASB 112. LO 18.1, 18.2, 18.3, 18.6

SOLUTION TO END-OF-CHAPTER EXERCISE Our first step will be to determine taxable income. We need to know this to determine income tax payable. Profit before tax (adjust for differences between tax and accounting rules) Long-service leave not yet deductible Warranty expenses Warranty expenses paid Accounting depreciation Tax depreciation Insurance expense Insurance actually paid Taxable profit

  Assets Cash Accounts receivable Inventory Prepaid insurance Plant—net of depreciation Liabilities Accounts payable Provision for warranty Provision for long service leave Loan

Extract from accounting balance sheet ($)   30 000 90 000 80 000 4 000 225 000   429 000   50 000 15 000 10 000 154 000   229 000

Tax bases ($)   30 000 90 000 80 000   200 000 400 000   50 000 – – 154 000 204 000

$330 000   20 000  (5 000) 75 000 (100 000) 10 000  (14 000)  

Deductible temporary differences ($)                   15 000 10 000    

10 000   15 000

       

(25 000)    (4 000)   Taxable temporary differences ($)         4 000 25 000              

      (4 000) $326 000

Tax expense ($)         4 000 25 000       (15 000) (10 000)    

Current tax payable ($)                          

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Net assets Temporary differences at period end less Prior period amounts

200 000

196 000

 

Movement for the period Tax effected at 30% Tax on taxable income 30% × $326 000 Income tax adjustments

 

            25 000          –

  29 000          –

           4 000          –

     

 

 

25 000

29 000

 4 000

 

 

 

7 500

8 700

1 200

 

 

   

         –    7 500

         –  8 700

97 800 99 000

97 800 97 800

Note 1: Increases to the balance of deductible temporary differences will lead to deferred tax assets after applying the tax rate. They also act to decrease income tax expense. Note 2: Increases to the balance of taxable temporary differences will lead to deferred tax liabilities after applying the tax rate. They also act to increase income tax expense. The journal entries for Wounded Seagull Ltd at year end are: Dr Income tax expense Cr Income tax payable (to recognise the tax expense pertaining to taxable income)

97 800  

  97 800

Dr Income tax expense 1 200   Dr Deferred tax asset 7 500   Cr Deferred tax liability   8 700 (to recognise the additional tax expense pertaining to the temporary differences) The above entries have given rise to a deferred tax asset and a deferred tax asset. Assuming that the necessary conditions necessary to perform a set-off are satisfied, then AASB 112 allows these amounts to be offset so that only the net amount is shown (which in this case is a net amount of $1200, which would be disclosed as a deferred tax liability). The required journal entry would be: Dr Cr

Deferred tax liability Deferred tax asset

7 500  

  7 500

In considering the above entries, it should be acknowledged that the tax expense of $99 000 would be shown in the statement of profit or loss and other comprehensive income. The net balance of the deferred tax liability, being $1200 (after offsetting the deferred tax asset of $7500), would be shown in the statement of financial position as a non-current liability. Income tax payable would be disclosed in the statement of financial position as a current liability.

REVIEW QUESTIONS 1. What is a ‘temporary difference’ and why does it arise?  LO 18.4, 18.5 2. How is the tax base of an asset determined? LO 18.4 3. How is the tax base of a liability determined? LO 18.4 4. How do you determine the income tax expense of a company for accounting purposes? LO 18.1, 18.2, 18.3 5. How does a company calculate its current liability, ‘income tax payable’? LO 18.1, 18.2 6. What is the rationale for recognising a deferred tax asset or a deferred tax liability? LO 18.4, 18.5 7. What is the justification for recognising a deferred tax asset because an entity has unused tax losses? LO 18.4, 18.5, 18.6, 18.8 8. Explain why a temporary difference relating to an ‘employee benefits in relation to long-service leave’ account creates a deferred tax asset. LO 18.4, 18.5, 18.6

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9. Will the existence of unused tax losses always lead to the recognition of a deferred tax asset? LO 18.8 10. How will a change in the tax rate impact on the balances of deferred tax assets and deferred tax liabilities? Should any such change be reflected in the reported profit of the reporting entity when the tax rate changes?   LO 18.7 11. Can deferred tax assets be offset against deferred tax liabilities? LO 18.6 12. Assume that for a particular company the only temporary difference for tax-effect accounting purposes relates to the depreciation of a newly acquired machine. The machine is acquired on 1 July 2015 at a cost of $250 000. Its useful life is considered to be five years, after which time it is expected to have no residual value. For tax purposes it can be fully written off over two years. The tax rate is assumed to be 30 per cent.

REQUIRED (a) Determine whether the depreciation of the machine will lead to a deferred tax asset, or a deferred tax liability. (b) What would be the balance of the deferred tax asset or deferred tax liability as at 30 June 2018? LO 18.5, 18.6 13. A company has a depreciable non-current asset that cost $300 and has a carrying amount of $200. For tax purposes, accumulated depreciation amounts to $180.

REQUIRED (a) Assuming that the tax rate is 30 per cent, what is the amount of the temporary difference? (b) Does this give rise to a deferred tax asset or a deferred tax liability, and what is the amount of the deferred tax asset/liability? LO 18.4, 18.5, 18.6 14. A company recognises a liability of $300 for accrued product warranty costs. As is the case for many accrued expenses, the Australian Taxation Office (ATO) does not treat the expenses as deductible until the entity actually meets the claims.

REQUIRED (a) Assuming that the tax rate is 30 per cent, what is the amount of the temporary difference? (b) Does this give rise to a deferred tax asset or a deferred tax liability, and what is the amount of the deferred tax asset/liability? LO 18.4, 18.5, 18.6 15. A company has accounts receivable of $300 000 and an associated doubtful debts allowance of $60 000. The revenue associated with the accounts receivable of $300 000 has already been included in taxable income. The doubtful debts will be deductible when the amount is actually written off as bad with a related deduction to accounts receivable.

REQUIRED (a) Assuming that the tax rate is 30 per cent, what is the amount of the temporary difference? (b) Does this give rise to a deferred tax asset or a deferred tax liability, and what is the amount of the deferred tax asset/liability? LO 18.4, 18.5, 18.6 16. A company has interest receivable with a carrying amount of $400 000. The related revenue will be taxed by the ATO when the amounts are actually received.

REQUIRED (a) Assuming that the tax rate is 30 per cent, what is the amount of the temporary difference? (b) Does this give rise to a deferred tax asset or a deferred tax liability and what is the amount of the deferred tax asset/liability? LO 18.4, 18.5, 18.6 17. A company has prepaid rent with a carrying value of $400 000. A tax deduction was obtained at the time the rent was paid.

REQUIRED (a) Assuming that the tax rate is 30 per cent, what is the amount of the temporary difference?

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(b) Does this give rise to a deferred tax asset or a deferred tax liability, and what is the amount of the deferred tax asset/liability? LO 18.4, 18.5, 18.6 18. A company has a liability for employee benefits (relating to long-service leave) with a carrying value of $500 000, which will be deductible when the amounts are actually paid. The company has also accrued wages with a carrying value of $300 000, which have already been claimed as a deduction for tax purposes.

REQUIRED (a) Assuming that the tax rate is 30 per cent, what is the amount of the temporary difference? (b) Does this give rise to a deferred tax asset or a deferred tax liability, and what is the amount of the deferred tax asset/liability? LO 18.4, 18.5, 18.6 19. A company has interest revenue received in advance with a carrying value of $250 000, which was taxed on a cash basis. It also has a loan payable with a carrying amount of $400 000.

REQUIRED (a) Assuming that the tax rate is 30 per cent, what is the amount of the temporary difference? (b) Does this give rise to a deferred tax asset or a deferred tax liability, and what is the amount of the deferred tax asset/liability? LO 18.4, 18.5, 18.6 20. Main Beach Ltd has a depreciable asset with a carrying amount of $200 000 and a tax base of $120 000 if the asset were sold immediately (which reflects the effects of indexation for capital gains tax purposes). On the other hand, the asset will have a tax base of $100 000 if its economic benefits were to be recovered through use within the organisation.

REQUIRED Assuming a tax rate of 30 per cent, determine the balance of the deferred tax liability for the scenario of the asset being sold immediately and for the alternative scenario of the asset being retained for use within Main Beach Ltd. LO 18.4, 18.5, 18.6 21. Elwood Ltd has the following deferred tax balances as at 30 June 2019: Deferred tax asset Deferred tax liability

$1 000 000 $800 000

The above balances were calculated when the tax rate was 30 per cent. On 1 December 2019 the government raises the corporate tax rate to 35 per cent.

REQUIRED Provide the journal entries to adjust the carry-forward balances of the deferred tax asset and deferred tax liability. LO 18.7 22. Fitzgibbons Ltd has an item of machinery that cost $1 200 000 and has accumulated depreciation of $400 000. The company decides to switch to a revaluation model for machinery. The fair value of the item of machinery is $1 100 000 and the tax rate is 30 per cent.

REQUIRED Provide the journal entries to perform the revaluation. LO 18.9

CHALLENGING QUESTIONS 23. Boiling Pot Ltd commences operations on 1 July 2018. One year after the commencement of its operations (30 June 2019) the entity prepares the following information, showing both the carrying amounts for accounting purposes and the tax bases of the respective assets and liabilities.

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Carrying amounts ($)

Tax bases ($)

 

 

Cash

60 000

60 000

Accounts receivable (net)

50 000

60 000

Prepaid insurance

20 000

– 

Inventory

80 000

80 000

Plant—net

450 000

400 000

   600 000

   400 000

  1 260 000

1 000 000

 

 

Accounts payable

60 000

60 000

Provision for long-service leave

30 000



Provision for warranty

40 000

– 

   400 000

   400 000

     530 000

   460 000

   730 000

   540 000

Assets

Land Liabilities

Loan payable Net assets

Other information • After adjusting for differences between tax rules and accounting rules, it is determined that the taxable income of Boiling Pot Ltd is $700 000. • There is an allowance for doubtful debts of $10 000. • An item of plant is purchased at a cost of $600 000 on 1 July 2018. For accounting purposes it is expected to have a life of four years; however, for taxation purposes it can be depreciated over three years. It is not expected to have any residual value. • Boiling Pot Ltd has some land, which cost $400 000 and which has been revalued to its fair value of $600 000 in accordance with AASB 116. • None of the amounts accrued in respect of warranty expenses or long-service leave has actually been paid. • The tax rate is 30 per cent.

REQUIRED Prepare the year-end journal entries to account for tax using the balance sheet method. LO 18.4, 18.5, 18.6, 18.9 24. MR Ltd commences operations on 1 July 2018 and presents its first statement of profit or loss and other comprehensive income and first statement of financial position on 30 June 2019. The statements are prepared before considering taxation. The following information is available: Statement of profit or loss and other comprehensive income for the year ended 30 June 2019 Gross profit   730 000 Expenses     Administration expenses 80 000   Salaries 200 000   Long-service leave 20 000   Warranty expenses 30 000   Depreciation expense—plant 80 000   Insurance   20 000 430 000 Accounting profit before tax   300 000 Other comprehensive income   Nil

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Assets and liabilities as disclosed in the statement of financial position as at 30 June 2019 Assets     Cash   20 000 Inventory   100 000 Accounts receivable   100 000 Prepaid insurance   10 000 Plant—cost 400 000   less Accumulated depreciation 80 000 320 000 Total assets   550 000 Liabilities     Accounts payable   80 000 Provision for warranty expenses   20 000 Loan payable   200 000 Provision for long-service leave expenses   20 000 Total liabilities   320 000 Net assets   230 000 Other information • All administration and salaries expenses incurred have been paid as at year end. • None of the long-service leave expense has actually been paid. It is not deductible until it is actually paid. • Warranty expenses were accrued and, at year end, actual payments of $10 000 had been made (leaving an accrued balance of $20 000). Deductions are available only when the amounts are paid and not as they are accrued. • Insurance was initially prepaid to the amount of $30 000. At year end, the unused component of the prepaid insurance amounted to $10 000. Actual amounts paid are allowed as a tax deduction. • Amounts received from sales, including those on credit terms, are taxed at the time the sale is made. • The plant is depreciated over five years for accounting purposes, but over four years for taxation purposes. • The tax rate is 30 per cent.

REQUIRED Provide the journal entries to account for tax in accordance with AASB 112. LO 18.4, 18.5, 18.6 25. At 30 June 2018, E-Surfboards Ltd had the following temporary differences: Asset or liability Computers at cost Accumulated depreciation Computers (net) Accounts receivable Allowance for doubtful debts Accounts receivable (net) Provision for warranty costs Provision for employee benefits (LSL)

Carrying amount ($000)

Tax base ($000)

Temporary difference ($000)

300   (60) 240 100  (10)   90 30 20

300 (100)   200 100       0   100 0 0

    40     10 30 20

The following information is available for the following year, the year ending 30 June 2019. Statement of profit or loss and other comprehensive income for E-Surfboards Ltd for the year ending 30 June 2019 Revenue Cost of goods sold expense Depreciation expense Warranty expense Bad and doubtful debts expense

$000 4 000 (1 800) (60) (90) (25)

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Statement of profit or loss and other comprehensive income for E-Surfboards Ltd for the year ending 30 June 2019 Other expenses Profit before tax Other comprehensive income

$000 (1 375) 650 Nil

E-Surfboards Ltd depreciates computers over five years in its accounting records but over three years for tax purposes. The straight-line method is used. During the year, E-Surfboards wrote off bad debts amounting to $15 000. Warranty costs of $70 000 were paid during the year. No amounts were paid for long-service leave during the year. The following information is extracted from the statement of financial position at 30 June 2019:  

$000

Assets Accounts receivable Allowance for doubtful debts Liabilities Provision for warranty costs Provision for employee benefits (LSL)

  120 (20)   50 30

There was no acquisition of plant and equipment during the year. The tax rate as at 30 June 2018 and 30 June 2019 was 30 per cent.

REQUIRED (a) Calculate the amount of each of E-Surfboards’ temporary differences, if any, at 30 June 2018, and state whether it is deductible or taxable. (b) What is the balance of the deferred tax liability and deferred tax asset, if any, as at 30 June 2018? (c) Calculate E-Surfboards’ taxable income for the year ending 30 June 2019. (d) Prepare journal entries to record current tax and deferred tax for the year ending 30 June 2019. LO 18.4, 18.5, 18.6

REFERENCES WESTWOOD, M., 2000, Financial Accounting in New Zealand, Pearson, Auckland.

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PART 5

ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS CHAPTER 19 The statement of cash flows

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CHAPTER 19

THE STATEMENT OF CASH FLOWS LEARNING OBJECTIVES (LO) 19.1 Understand what a statement of cash flows is, and why it is useful. 19.2 Understand the accounting requirements relating to the disclosure of information about an organisation’s cash flows. 19.3 Understand how to construct a statement of cash flows in conformity with AASB 107 and understand how various cash flows are classified for the purposes of presenting a statement of cash flows. 19.4 Understand how the statement of cash flows provides information that is a useful complement to the statement of financial position, the statement of changes in equity, and the statement of profit or loss and other comprehensive income. 19.5 Understand how we define ‘cash’ and ‘cash equivalents’ for the purposes of a statement of cash flows and appreciate that the definitions mean that statements of cash flows address transactions beyond those simply involving ‘cash’. 19.6 Understand the differences between cash flows from operations, cash flows from investing, and cash flows from financing activities, and be able to calculate them. 19.7 Be aware of the various supporting notes that must accompany a statement of cash flows. 19.8 Understand how a statement of cash flows might be used within contractual arrangements negotiated by the organisation. 19.9 Be aware of likely future developments pertaining to the presentation of statements of cash flows.

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Comparison with other financial statements

LO 19.1 LO 19.2 LO 19.4

The statement of cash flows provides a very useful complement to the other statements typically found in a reporting entity’s set of financial statements—that is, the statement of financial position, the statement of changes in equity, and the statement of profit or loss and other comprehensive income. As we know, the statement of financial position shows the assets, liabilities and owners’ equity balances as at a certain date (the end of the reporting period). The statement of changes in equity provides a statement of cash flows reconciliation of opening and closing equity as well as details of the various equity accounts that are A financial statement impacted by the period’s total comprehensive income. It also provides information about the effects that provides a of transactions with owners in their capacity as owners (distributions and capital contributions). The reconciliation of statement of profit or loss and other comprehensive income shows the profit or loss as well as opening and closing the ‘other comprehensive income’ that has been generated for a period of time, typically a year, ‘cash’, including cash on hand and cash adopting the process of accrual accounting. equivalent. The statement of cash flows, on the other hand, concentrates on the movements in cash and cash equivalents for a given period. As such, it provides a reconciliation of the opening and closing total of the cash and cash equivalent balances appearing in the statement of financial position. The statement of cash flows will typically indicate the sources, and uses, of cash in terms of cash flows from operations, cash flows from investing, and cash flows from financing. The information provided in a statement of cash flows may assist in assessing the ability of a company, or an economic entity, to: accrual accounting • generate cash flows; • meet its financial commitments as they fall due, including the servicing of borrowings and the payment of dividends; • fund changes in the scope and/or nature of its activities; and • obtain external finance.

A system of accounting in which revenues are recognised when earned and expenses are recognised when incurred, even in the absence of cash flows.

As we know, ‘profits’ or ‘losses’ are determined by the use of accrual accounting. There are frequently significant differences between cash flows and profits. Profitable firms might actually fail because of poor cash management. For example, a firm might make sales that are recognised as income in the current period. However, the terms of the sale might be such that the amount will not be received for, say, three months. Meanwhile, wages and many other expenses must be paid. If the collection of the sales revenue is deferred, the organisation might not have sufficient funds to meet its expenses. It might therefore face a liquidity crisis even though its profit, which is determined on an accruals basis, might appear to be sound. As an example of how financial statement analysts use information about cash flows, consider Financial Accounting in the Real World 19.1, which is an extract from an article entitled ‘Nine IPO: cash flow problematic’, which appeared in the The Australian Financial Review on 15 November 2013. Within the extract, reference is made to ‘free cash flows’ rather than ‘cash flows from operations’ or ‘total cash flows’. ‘Free cash flows’ is a term often used by analysts. However, it is not a term used within AASB 107, and AASB 107 does not directly provide information about ‘free cash flows’. Nevertheless, ‘free cash flows’ are considered, by various people, to be a useful measure of an organisation’s ability to maintain its current business operations and are a measure of the cash flows being generated from the operations of the business, less the requisite capital expenditures necessary to maintain current growth. To derive this figure, analysts typically utilise some of the information that is

19.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Nine IPO: cash flow problematic Jemima Whyte As more people thumb through the Nine prospectus, there’s an increasing focus on the business’s very poor cash flow and its valuation.  continued CHAPTER 19: THE STATEMENT OF CASH FLOWS  697

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Cash flow is a key measure that institutional investors look at, mainly because it is the cleanest way to understand earnings.  Nine has never shied away from the fact it doesn’t have great cash conversion. But it is surprising how poorly it stacks up against rival Seven.  Given the heavy losses of previous owner CVC Asia Pacific, Nine won’t pay tax for the next two years.  Put another way, free cash flow for next year is forecast to be $121 million but were taxes to be paid that would fall to closer to $70 million. Compare that to rival Seven, which is closer to $200 million—almost three times that. Nine management would argue, of course, that earnings will improve, throwing off more cash over the next few years. SOURCE: Extract from ‘Nine IPO: cash flow problematic’, by Jemima Whyte, The Australian Financial Review, 15 November 2013

publicly available within the statement of cash flows. Specifically, they calculate ‘free cash flows’ by deducting the cash used to acquire non-current assets from the organisation’s cash flows from operations. We will not pursue the discussion of ‘free cash flows’ within this chapter other than to note that such terminology is common within the business sector. With knowledge of both cash flows and accrual profits/losses, investors should be better able to assess the performance and viability of reporting entities. It has been argued (by Tweedie & Whittington 1990; Lee 1981; and Lawson 1985, for example) that the data provided in a statement of cash flows is more reliable than profit data: profit data is typically based on numerous subjective and sometimes ‘creative’ judgments whereas cash-flow data tends to be more ‘factual’ or ‘objective’. As the extract reproduced in Financial Accounting in the Real World 19.1 also noted, institutional investors are often perceived as relying on an analysis of cash flows because ‘it is the cleanest way to understand earnings’. Indeed, paragraph 4 of AASB 107 states:

accrual profits/losses The profits or losses that would be disclosed as a result of applying accrual accounting techniques.

It (the statement of cash flows) also enhances the comparability of the reporting of operating performance by different entities because it eliminates the effects of using different accounting treatments for the same transactions and events. Following a similar viewpoint, in an article that appeared in The Australian newspaper (by Mark Cox, ‘What to do’, 25 August 2010, p. 5), it was stated that: Companies always seem to use different figures when publicising their financial results. How, as a retail investor, do I know which are the most important? Company reports can be filled with a bewildering amount of financial data, graphs and tables, not to mention obscure footnotes. It can be difficult to decipher the figures and ascertain how your investment has performed and what its future prospects could be. So, what should you look at and consider? Always be sceptical of reported profits. Companies can have substantial leeway in managing the profit number. In general, you should follow the cashflow of the company. While reported earnings can be manipulated, it is generally difficult to legally manipulate underlying cashflow. A simple test is to compare cashflow from operations (on the cashflow statement) to reported earnings over time. If cash-flow from operations (CFO) is continually much lower than reported earnings, find out why by looking at the ‘reconciliation of profit to cashflow from operating activities’ footnote. Large figures from esoteric sounding items could be a warning sign. As a retail investor, you should be wary of earnings before interest, tax, depreciation and amortisation as an indicator of stockholder returns. Companies often emphasise EBITDA as a performance measure and even as a proxy for cashflow. However, it is not and can never be an indicator of cashflow, as it is based on accounting earnings and can be managed. Likewise, Walker (1987) claimed that ‘one of the strongest antidotes to creative accounting is a requirement for disclosures of cash flows’. While the above material obviously provides some rather negative perspectives of reported profits and how they may at times be calculated (or manipulated), this is not a view that we necessarily adopt within this 698  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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book. Rather, we can adopt the perspective that the statement of cash flows is a useful addition, or complement, to the other information typically provided in a set of financial statements. While the material provided above suggests that the statement of cash flows is less likely to be manipulated than other financial statements, any suggestion that any form of financial statement—be it a statement of cash flows or other financial statement—is not likely to ever be subject to some form of ‘creative accounting’, or other error or manipulation, is quite naive. Consider Financial Accounting in the Real World 19.2, which represents an extract from a newspaper article that identifies how one organisation’s statement of cash flows was questionable in terms of its reliability. As we will learn, the opening balances of cash and cash equivalents as provided in the statement of cash flows should reconcile directly with particular amounts shown with the statement of financial position. The closing balances of cash can also be matched with externally verified amounts, such as cash at bank balances. The movements within cash are the amounts that are perhaps more likely to be subject to manipulation, as Financial Accounting in the Real World 19.2 suggests. Financial Accounting in the Real World 19.2 again emphasises how analysts place emphasis on cash flows when assessing the financial position and performance of reporting entities.

19.2 FINANCIAL ACCOUNTING IN THE REAL WORLD Slater and Gordon’s financial woes: the tip of the iceberg? The Australian Securities and Investments Commission (ASIC) has queried the financial accounts of Slater and Gordon and the processes followed by Pitcher Partners, the company’s auditor. After Slater and Gordon confirmed the investigation and admitted in a statement to the ASX that it had problems with cash flow statements affecting its operations in the UK, its share price dropped to $3.78, a massive 25 per cent fall. The company said the errors did not affect its net cash situation. After the initial public admissions the company refused to comment other than to say that they were being assisted by the auditors Ernst & Young (EY) in relation to the ASIC matter. In April 2015 after a three-month due diligence process Slater and Gordon bought the British legal group Quindell for $1.3 billion. In the UK shares in Quindell were recently suspended as the regulator there began to examine the company’s accounting practices. The global hedge fund manager, VGI Partners (VGI), based in Sydney, shorted Slater and Gordon’s shares in April because of concerns about the accounts. In a detailed presentation VGI said that Slater and Gordon’s acquisition policy to boost earnings led to a material overstatement of earnings but didn’t add to the company’s organic growth. VGI was founded by Rob Luciano. His partner, Douglas Tynan, had a lot to say about Slater and Gordon after the company acknowledged the ASIC investigation. Both Luciano and Tynan are experienced auditors and accountants with a good knowledge of Slater and Gordon. Tynan stated that ‘It’s highly unusual to see an accidental mis-statement in the cash receipts from customers that coincidentally is the exact same number as the mis-statement in the cash payments’. Slater and Gordon’s work in progress (WIP) accounting where work was un-invoiced to clients needed further examination. Of most relevance, given Monday’s admission by Slater and Gordon of an accounting error, is a note in the presentation ‘that cashflows do not reconcile with the income statement and changes in the balance sheet’. VGI’s April presentation included two slides that focused on ‘cash receipts and cash payments being overstated’ and claimed there was an unexplained variance of $88 million to $98 million evident on the receipts side in the past two financial years, and a $78 million and $82 million variance evident on the payments side. ‘If ‘receipts from customers’ is inflated, we believe that cash ‘payments to suppliers and employees’ would also need to be inflated for the cashflow statement to reconcile with the other financial statements’, the presentation said. VGI said it was concerned ‘inflated cash receipts give the impression that a greater portion of WIP and receivables balances are being collected’. VGI said December 2014’s reported cash balance of $16 million would not have paid a month’s salaries and rent. SOURCE: Adapted from ‘More to come: warning for Slater and Gordon’, by Sarah Thompson, The Australian Financial Review, 30 June 2015

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As accountants or students of accounting, we understand the difference between cash flows—which are shown within the statement of cash flows—and profits. However, it may reasonably be assumed that this difference would not be clearly understood by all users of financial statements. Given the potential confusion that might arise as a result of the differences between cash flows and profits, paragraph Aus 20.1 of AASB 107 had formerly required a note reconciling cash flows from operating activities to profit or loss, as reported in the statement of profit or loss and other comprehensive income (while organisations can still do this, the requirement to do so was withdrawn in 2011). As an example of this kind of reconciliation, consider Exhibit 19.1, which provides the reconciliation of Qantas Ltd’s cash flows from operations to its profits after tax for the year ended 30 June 2015. When reviewing Exhibit 19.1 see whether you can understand why certain amounts are added, while other amounts are subtracted, when reconciling profit or loss to cash flows from operations.

Exhibit 19.1 Reconciliation of cash flows from operations to operating profit after tax provided by Qantas Ltd in its 2015 Annual Report

27. NOTES TO THE CASH FLOW STATEMENT (A) RECONCILIATION OF STATUTORY PROFIT/(LOSS) FOR THE YEAR TO NET CASH FROM OPERATING ACTIVITIES Qantas Group

Statutory profit/(loss) for the year Adjustments for: Non-cash items included in profit/(loss): Depreciation and amortisation Share-based payments Impairment of specific assets and investments Impairment of cash-generating unit Inventory write-off Amortisation of deferred financing fees and lease benefits Net (gain)/loss on disposal of property, plant and equipment Net gain on sale of controlled entity and related assets Share of net loss of investments accounted for under the equity method Other items Cash items not included in profit/(loss) relating to operating activities: Hedging-related activities Dividends received from investments accounted for under the equity method Changes in other items: — Receivables — Inventories — Other assets — Payables — Revenue received in advance — Provisions — Deferred tax assets/(liabilities)     Net cash from operating activities

2015 ($m) 560

2014 ($m) (2 843)

1 096 29 28 – 10 24 (17) (11) 40 30

1 422 12 387 2 560 61 18 1 (62) 66 32

(240) 5

(158) 4

28 (30) (13) 25 360 (103) 227 2 048

274 (28) 35 15 360 46 (1 133) 1 069

SOURCE: Qantas Ltd 2015 Annual Report

The usefulness of cash-flow data relative to revenue and expense data provided by accrual accounting is a matter for debate. The article by Mark Lawson adapted in Financial Accounting in the Real World 19.3 entitled ‘Cash-flow to replace profit as touchstone’ provides one view—that of an audit partner who argues that cash flows will replace profits as the key performance indicator. This article appeared when the requirement to disclose a statement of cash flows first became mandatory within Australia. Therefore it provides a good historical perspective about the introduction 700  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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of the statement of cash flows within the Australian context. The audit partner’s view, however, appears to ignore the benefits associated with accrual accounting. Rather, it focuses on the ‘tricks’ that might be employed to bolster profits. A balanced view would, as previously noted, perhaps see the statement of cash flows as a useful complement to the statement of financial position and the statement of profit or loss and other comprehensive income. Certainly in recent years government has moved away from cash accounting to accrual accounting because of its perception that accrualbased data generates improved information and enables greater accountability.

19.3 FINANCIAL ACCOUNTING IN THE REAL WORLD Healthy cash flow more important than big profits The accountants Price Waterhouse held a media briefing around Accounting Standard AASB 1026, which although not well-publicised, is tipped to change company performance focus towards cash flow rather than profit when it is implemented. Under the Standard cash flow, concentrating on cash given and received in the accounting period, has to be divided into the areas of operation (the business), financing and investment. Martyn Mitchell, a Price Waterhouse Partner, said that the funds-flow statement introduced in the mid-80s had proved inadequate and its inadequacies were highlighted by the spate of corporate failures in the 1980s and early 1990s. The replacement cash-flow statement gave considerably more information than the funds-flow statement and could not be ‘fiddled’ to produce the desired result. He said that, as a result, bankers and investors were likely to concentrate more on the ability of corporations to generate cash, rather than profits. Corporations which had previously received high credit ratings as a result of strong profits might now find themselves facing a credit squeeze unless their cash flows were also favourable. In contrast, corporations reporting small profits but strong cash flows were likely to find more support among bankers and investors. Corporate management, in turn, were then likely to pay more attention to boosting cash flows, rather than simply chasing profit SOURCE: Adapted from ‘Cash-flow to replace profit as touchstone’, by Mark Lawson, The Australian Financial Review, 7 July 1992

Defining ‘cash’ and ‘cash equivalents’ AASB 107 requires the statement of cash flows to provide information about movements in ‘cash’ and ‘cash equivalents’. Specifically, the ‘Objective’ section of AASB 107 (found towards the beginning of the standard) states:

LO 19.2 LO 19.3 LO 19.5

Information about the cash flows of an entity is useful in providing users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows. The economic decisions that are taken by users require an evaluation of the ability of an entity to generate cash and cash equivalents and the timing and certainty of their generation. The objective of this Standard is to require the provision of information about the historical changes in cash and cash equivalents of an entity by means of a statement of cash flows which classifies cash flows during the period from operating, investing and financing activities. AASB 107 defines ‘cash flows’ as ‘inflows and outflows of cash and cash equivalents’ and ‘cash’ as ‘cash on hand and demand deposits’. ‘Cash equivalents’ is defined as ‘short-term, highly liquid investments that are readily convertible to known amounts of cash and that are subject to an insignificant risk of change in value’. Hence, although the statement of cash flows effectively provides a reconciliation of opening and closing ‘cash and cash equivalents’, ‘cash and cash equivalents’ as represented in the statement of cash flows might actually relate to the total of a number of accounts shown in the statement of financial position or accompanying notes, rather than a single CHAPTER 19: THE STATEMENT OF CASH FLOWS  701

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account, such as cash at bank. These accounts may include cash at bank, bank overdrafts, short-term money market deposits, and bank bills. With this in mind, AASB 107 requires that the amount of ‘cash’ and ‘cash equivalents’ as at the end of the financial year, as presented in the statement of cash flows, be reconciled—by way of a note to the financial statements—to the related items in the statement of financial position. Exhibit 19.2 shows the reconciliation provided in the 30 June 2015 Annual Report of Qantas Ltd. AASB 107 requires the disclosure of the policy adopted by the organisation for determining which items are classified as ‘cash’ and ‘cash equivalents’ in the statement of cash flows. Explicit disclosure of this policy would help users to understand the organisation’s statement of cash flows. Importantly, if an entity changes its policy for determining which items are classified as cash in the statement of cash flows, an explanation of the change in policy and the effect of that change would need to be included in the financial report. Refer to the final part of Exhibit 19.2 to see the Qantas policy for defining cash and cash equivalents. The first edition of this text (back in 1995) referred to the ‘reconciliation of cash’ note provided in the 1993 financial statements of the ANZ Banking Group Ltd and noted with interest that the reconciliation of cash note used ‘Liquid assets—less than 90 days’, and ‘Due from other banks—less than 90 days’. We argued back then that amounts due for periods up to 90 days did not seem to fit the definitions of ‘cash’ and ‘cash equivalents’ provided in AASB 1026 (the standard in effect at the time). Interestingly enough, AASB 107, paragraph 7, now states: Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition. The standard-setters would therefore concur with ANZ’s approach. What do you think? Do you think that something that converts into cash in three months is really a ‘cash equivalent’?

Exhibit 19.2 Reconciliation of the cash balance of Qantas Ltd as shown in the statement of cash flows to the respective statement of financial position account balances

10. NOTES TO THE CONSOLIDATED CASH FLOW STATEMENT Cash and cash equivalents Qantas Group

Cash balances Cash at call Short-term money market securities and term deposits Total cash and cash equivalents

2015 ($m) 253 197 2 458 2 908

2014 ($m) 206 137 2 658 3 001

Cash and cash equivalents comprise cash at bank and on hand, cash at call and short-term money market securities and term deposits that are readily convertible to a known amount of cash and are subject to an insignificant risk of change in value. Short-term money market securities of $81 million (2014: $33 million) held by the Qantas Group are pledged as collateral under the terms of certain operational financing facilities when underlying unsecured limits are exceeded. The collateral cannot be sold or repledged in the absence of default by the Qantas Group. SOURCE: Qantas Ltd 2015 Annual Report

As noted above, for an item to be considered to be a cash equivalent, it must be both highly liquid and be used as part of the cash-management function of the company. This means that a cash equivalent in one entity might not be a cash equivalent in another. It all depends on the respective cash-management programs adopted. Bank and non-bank bills are proposed as examples of highly liquid investments that would typically meet the definition of cash. 702  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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As cash equivalents are required to be highly liquid, account items such as accounts receivable, accounts payable, any borrowings subject to a term facility, or equity securities would be excluded from the definition of cash equivalents. Mark Smith’s article ‘WA gold-miner attacks cash statements’ in Financial Accounting in the Real World 19.4 reports an interesting argument advanced some years back by the management of Sons of Gwalia NL that gold bullion should be treated as ‘cash’. If gold bullion is readily convertible into cash, arguably there could have been some merit in including gold in the definition of ‘cash’. What do you think?

operating activities Activities that relate to the provision of goods and services and other activities that are neither investing nor financing activities.

19.4 FINANCIAL ACCOUNTING IN THE REAL WORLD WA gold-miner attacks cash statements Mark Smith Western Australian goldminer Sons of Gwalia NL wants the mandatory cash-flow statements filed with profit reports to be altered to recognise miners’ bullion holdings. The Perth-based miner said the cash-flow statements were deficient and strict compliance could give a misleading impression of a company’s financial position. Sons of Gwalia managing director, Mr Peter Lalor, said the cash-flow statements which have become mandatory for the 1991–92 financial year do not take account of bullion holdings at balance date. . . . Sons of Gwalia said compliance with the statement showed that Sons of Gwalia had a negative cash balance of $1.2 million at 30 June. ‘The company’s true position was a positive cash balance of $18 million,’ it said. ‘The difference is represented by gold on metal accounts at 30 June 1992, amounting to $19.2 million, an item for which there is no provision for inclusion in the statement of cash-flows.’ SOURCE: Extract from ‘WA gold-miner attacks cash statements’, by Mark Smith, The Australian Financial Review, 27 August 1992

Classification of cash flows

LO 19.6

AASB 107 requires that cash flows be separately classified into those relating to the following: • Operating activities, defined as ‘the principal revenue-producing activities of the entity and other activities that are not investing and financing activities’. Operating activities would be activities that relate to the provision of goods and services, and other activities that are neither investing nor financing activities. Such a definition relies in its turn upon definitions of investing and financing activities. • Investing activities, defined as ‘the acquisition and disposal of long-term assets (including property, plant and equipment and other productive assets) and other investments (such as securities) not included in cash equivalents’. • Financing activities, which relate to changing the size and/or composition of the financial structure of the entity, including equity and borrowings not falling within the definition of cash.

investing activities Activities that relate to the acquisition and/or disposal of non-current assets.

financing activities Activities that relate to changing the size and/ or composition of the financial structure of the entity.

In the start-up phase of a business, positive cash flows from financing activities would be likely, as would negative cash flows from both investing and operating activities. Beyond a certain period of time, however, it would be hoped that the majority of cash flows would be generated through the operations of the business, as an entity cannot rely indefinitely on finance from external sources to survive. Table 19.1 classifies various types of cash flows in terms of whether they would typically be classified as relating to the operating, investing or financing activities of an entity. CHAPTER 19: THE STATEMENT OF CASH FLOWS  703

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Table 19.1 Examples of cash flows that would typically be included in the three classifications of cash flows identified in AASB 107

LO 19.2 LO 19.3 LO 19.5 LO 19.6 LO 19.7

Operating activities

Investing activities

Financing activities

Cash inflows relating to: • Sales of goods • Provision of services • Commissions received • Royalties received • Dividends received (could also be classified as part of investing activities pursuant to paragraph 33 of AASB 107) • Interest received (could also be classified as part of investing activities pursuant to paragraph 33 of AASB 107)

Cash inflows relating to: • Sale of property, plant and equipment • Sale of intangible assets • Repayment of loans previously advanced by the entity • Sale of equity and other financial instruments of other entities

Cash inflows relating to: • Issue of shares or other equity instrument of the entity • Borrowing funds through the issue of secured and unsecured loans

Cash outflows relating to: • Goods and services acquired • Employee benefits paid • Interest paid (could also be classified as part of financing activities pursuant to paragraph 33 of AASB 107) • Taxes paid (unless they can be specifically identified with investing and financing activities, see paragraph 35 of AASB 107)

Cash outflows relating to: • Acquisition of property, plant and equipment • Acquisition of intangible assets • Acquisition of equity and other financial instruments of other entities • Loans made to other entities

Cash outflows relating to: • Repayment of borrowed funds (inclusive of various types of debt instruments) • Payment of dividends • Share buybacks

Format of statement of cash flows

The Appendix to AASB 107 provides a suggested format for the statement of cash flows, which is reproduced as Exhibit 19.3. Although no prior year comparatives are shown in Exhibit 19.3, they are required by AASB 107. It is suggested that cash flows from operations be presented first, followed by cash flows from investing and financing respectively. Items representing cash flows from investing and financing are shown separately—that is, they are not netted off against each other. Consider the financing example of a debt issue and subsequent repayment, both of which would be shown separately. Similarly, where plant is sold and subsequently replaced (investing activities), the inflow from the sale and the outflow related to the purchase would be shown separately (and typically as part of cash flows relating to investing activities). A review of Exhibit 19.3 shows that some items, which might ordinarily be considered operating items for statement of profit or loss and other comprehensive income purposes, might not be treated the same for cash-flow purposes, and vice versa. For example, for cash-flow purposes, interest paid is treated as part of operating activity. However, for income purposes, it would be usual to think of interest paid as being related to the financing operations of the business. Paragraph 31 of AASB 107 requires cash flows from interest and dividends received and paid to be disclosed separately. These cash flows should be classified in a consistent manner from period to period as operating, investing or financing activities. In addition, paragraph 35 of AASB 107 requires cash flows from taxes on income to be separately disclosed. These are to be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities. Paragraph 18 of AASB 107 notes that entities have a choice between using the direct method or the indirect method to report cash flows from operating activities. Specifically, paragraph 18 states: An entity shall report cash flows from operating activities using either: (a) the direct method, whereby major classes of gross cash receipts and gross cash payments are disclosed; or (b) the indirect method, whereby profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows. Paragraph 19 states that entities are encouraged to report cash flows from operating activities using the direct method because the direct method provides information that may be useful in estimating future cash flows and which is not available under the indirect method. 704  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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Cash flows from operating activities Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Interest paid Income taxes paid Net cash used in operating activities Cash flows from investing activities Acquisition of Subsidiary X, net of cash acquired Purchase of property, plant and equipment Proceeds from sale of equipment Interest received Dividends received Net cash used in investing activities Cash flows from financing activities Proceeds from issuance of share capital Proceeds from long-term borrowings Payment of finance lease liabilities Dividends paid Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period

  30 150 (27 600) 2 550 (270)     (900)     (550) (350) 20 200      200     250 250 (90) (1 200)        

            1 380             (480)           (790) 110 120   230

Exhibit 19.3 Illustration of a statement of cash flows— from the Appendix to AASB 107

AASB 107, paragraph 21, also requires an entity to report separately major classes of gross receipts and gross payments arising from investing and financing activities, rather than reporting such inflows and outflows as net amounts. There are only a few exceptions to this requirement, and these are provided in paragraphs 22 and 24 of AASB 107. As previously indicated, given the disparity that might arise between cash flows from operations, as reported in the statement of cash flows, and profits, as reported in the statement of profit or loss and other comprehensive income, paragraph Aus20.1 of AASB 107 had formerly required that where the entity uses the direct method then a note to the financial statements is required providing a reconciliation of cash flows from operating activities to profit or loss. Paragraph Aus20.1 was removed in 2011; however, entities can still elect to provide this reconciliation on a voluntary basis, and many do. If the indirect method of reporting is used (instead of the direct method) then the reconciliation of cash flows from operating activities to profit or loss will effectively be provided within the body of the statement of cash flows. Table 19.2 provides a sample of the types of items that might give rise to a difference between cash flows from operations, and operating profit after tax. Items such as depreciation and amortisation are non-cash-flow items; that is, the expense does not relate to a cash flow as these items are allocations of costs that relate to assets that might have been acquired in previous periods. If we start the reconciliation from profit or loss after tax, we would need to add back such non-cash expenses in order to move towards a reconciliation with cash flows from operating activities. Another example of a reconciling item would be the deduction of any increase in receivables. As we know, sales revenue is brought into account on an accrual basis. It is possible for all sales revenue to be earned initially on credit terms. If some of the debtors have not paid, there will be a difference between cash flows from operations and profits after tax. Where items in Table 19.2 move in the opposite direction—that is, they decrease rather than increase—their treatment would be reversed. For example, if accounts receivable decreases, we would add this decrease to net profit or loss, as it would represent a cash inflow of the period (unless the reduction is due to debtor write-offs), but the change in receivables would not be reflected in that period’s earnings. CHAPTER 19: THE STATEMENT OF CASH FLOWS  705

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Table 19.2 Adjustments required to reconcile net profit to cash flows from operations

Operating activities

  XX

Profit/loss after tax Add: Depreciation expense

XX

Amortisation expense

XX

Loss on sale of plant and equipment

XX

Increase in interest payable

XX

Increase in accrued expenses

XX

Increase in accounts payable

XX

Increase in income taxes payable

XX

Increase in deferred taxes payable

XX

Subtract: Gain on sale of plant and equipment

(XX)

Increase in deferred tax asset

(XX)

Increase in accounts receivable

(XX)

Increase in prepaid expenses

(XX)

Increase in interest receivable

(XX)

Increase in inventories

(XX)

Net cash flows from operating activities

 XX 

As an illustration of the reconciliation of net profit to cash flows from operations, consider the following, fairly simple, example. As at 1 July 2019, which is the beginning of the financial year, Skipp Ltd had the following account balances: Cash at bank Bank overdraft Accounts receivable Accounts payable Accrued expenses Inventory

$ 100 20 60 40 70 50

During the year: 1. Skipp Ltd made $1000 in sales—all on credit terms. The closing balance of accounts receivable was $80 and there were no bad or doubtful debt expenses. This means that $980 was collected from debtors, this being the opening balance of accounts receivable plus total credit sales less the closing balance of accounts receivable, which equals 60 + 1000 − 80 = 980. 2. Skipp Ltd acquired $300 of inventory. The accounts payable account in this case is assumed to relate only to inventory purchases. The closing balance of inventory was $80. This means that $270 of inventory was used in the business and is therefore treated as a cost of goods sold expense. Cost of goods sold is determined by adding the opening balance of inventory to the purchases for the period and subtracting the closing balance of inventory. This equals 50 + 300 − 80 = 270. 3. The closing balance of accounts payable was $80. If $300 of inventory was acquired and the opening balance of accounts payable was $40, and the closing balance was $80, $260 must have been paid to the suppliers of the inventory (that is, to the creditors represented by accounts payable). 706  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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4. Other expenses amounted to $400, and it is assumed that these expenses are initially recorded as accrued expenses. The closing balance of accrued expenses was $50. This means that the actual cash payments made in relation to accrued expenses were $420. This equals 400 + 70 − 50 = 420. From the above information we can see that profit for the period was $330. This is calculated by subtracting cost of goods sold and other expenses from total sales. This equals 1000 – 270 − 400 = 330. Working from the above calculations, the cash flows from operations would equal: Cash flows from operating activities Cash receipts from customers Cash paid to suppliers and employees Cash paid on other expenses  

($) 980 (260) (420)  300

We can now reconcile net profit to cash flows from operations as follows: Reconciliation of net cash provided by operating activities to net profit Net profit (Increase) in inventories (Increase) in accounts receivable Increase in accounts payable Decrease in accrued expenses Net cash provided by operating activities

($) 330 (30) (20) 40 (20) 300

Exhibit 19.1 provided earlier in this chapter, reproduces the reconciliation for the statement of cash flows of Qantas Ltd. One potential limitation of a statement of cash flows is that the statement obviously does not include details of transactions that are not cash-based but that could nevertheless have a significant impact on the financial structure of the organisation. We now consider non-cash transactions.

Non-cash financing and investing activities The statement of cash flows reports only transactions that involve cash flows throughout the period. However, there might be numerous non-cash transactions that are part of the investing and financing activities of the reporting entity. For example, the entity might acquire certain non-current assets by issuing additional equity or debt securities. Alternatively, it might convert certain liabilities to equity (convertible notes), or convert certain non-cash assets to other non-cash assets. AASB 107 requires that information about transactions and events that do not result in cash flows during the financial year, but affect assets and liabilities that have been recognised, is to be disclosed in the financial statements or consolidated financial statements where the transactions and other events: • involve parties external to the entity • relate to the financing or investing activities of the entity. Specifically, AASB 107, paragraph 43, states: Investing and financing transactions that do not require the use of cash or cash equivalents shall be excluded from a statement of cash flows. Such transactions shall be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities. Examples of non-cash financing and investing transactions that should be included in a note supporting the statement of cash flows include: ( a) (b) (c) (d)

conversions of liabilities to equity; conversion of preference shares to ordinary shares; acquisitions of entities by means of an equity issue; acquisitions of assets by assumption of directly related liabilities, such as a purchase of a building by incurring a mortgage to the seller; CHAPTER 19: THE STATEMENT OF CASH FLOWS  707

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( e) acquisitions of assets by entering into finance leases; (f) exchanges of non-cash assets or liabilities for other non-cash assets or liabilities; and (g) payments of dividends through a share investment scheme rather than through the payment of cash. Within the 2015 annual report of Qantas Ltd, for example, the company reports (p. 69): During the year, there were non-cash financing activities relating to additions of property, plant and equipment under finance leases of $30 million (2014: $130 million).

Disclosure of financing facilities Apart from requiring the disclosure of cash flows and non-cash financing and investing activities, AASB 107 suggests— but does not require—that the financial statements (by way of a note) should disclose information about the external financing arrangements of the entity, as at the end of the financial year. Specifically, paragraph 50(a) of AASB 107 states: Additional information may be relevant to users in understanding the financial position and liquidity of an entity. Disclosure of this information, together with a commentary by management, is encouraged and may include the amount of undrawn borrowing facilities that may be available for future operating activities and to settle capital commitments, indicating any restrictions on the use of these facilities . . . Exhibit 19.4 is a reproduction of the ‘financing facility’ note provided to the 2015 financial statements of Qantas Ltd.

Exhibit 19.4 Note relating to non-cash financing and investing activities of Qantas Ltd

(B) FINANCING FACILITIES The total amount of financing facilities available to the Qantas Group as at balance date is detailed below: Qantas Group

FINANCING FACILITIES Committed bank overdraft1 Facility available Amount of facility used Amount of facility unused Committed secured funding facility available Amount of facility used Amount of facility unused Committed revolving facility2 Facility available Amount of facility used Amount of facility unused Commercial paper and medium-term notes (subject to Dealer Panel participation) Facility available Amount of facility used Amount of facility unused

2015 ($m)

2014 ($m)

7 – 7 – – –

7 – 7 500 – 500

940 – 940

630 – 630

2 000 (950) 1 050

1 000 (950) 50

1 The bank overdraft facility covers the combined balances of Qantas and its wholly owned controlled entities. Subject to the continuance of satisfactory credit ratings, the bank overdraft facility may be utilised at any time. This facility may be terminated without notice. 2 The revolving facility includes $425 million with a term of three years from 24 April 2015, $425 million with a term of four years from 24 April 2015 and $90 million with a term of five years from 31 July 2014. There is an additional $100 million with a term of five years effective from 7 July 2015. SOURCE: Qantas Ltd 2015 Annual Report

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Calculating cash inflows and outflows

LO 19.3 LO 19.6

Cash flows from operating activities

As stated previously, ‘cash flows from operating activities’ are those that relate to the provision of goods and services and other activities which are neither investing nor financing activities. They would include payments to suppliers and employees for goods and services and receipts for the provision of goods and services. It would be hoped that the majority of the firm’s cash flows would be generated from its operating activities. To determine the cash flows from operations, it might be necessary to reconstruct a number of the entity’s ledger accounts. We will demonstrate below how this can be done, using either a t-account approach or an equations approach. The method used is a matter of personal preference.

Receipts from customers In accrual accounting, revenues are recognised when goods or services are provided, which typically precedes cash collection. To determine cash flows related to sales of goods and services we need to consider any movement in receivables. Accounts receivable will be affected by such items as sales, discount expenses, the direct recognition of bad debts—that is, where bad debts are offset directly against receivables by a debit to bad debts and a credit to accounts receivable—transfers from allowance for doubtful debts and, of course, by cash payments made by debtors. Cash flows from debtors may be determined by considering the relevant t-accounts, as shown below: Sales          

         

Accounts receivable A/c rec. x              



Op. bal. Sales        

x x     – x

Bad debts Allow. d.d. Discounts Cash Clos. bal.  



x x  x  x  x  x 

Allowance for doubtful debts A/c rec. Clos. bal.            

x x x  

Op. bal. D.d. exp.        

x x x      

Alternatively, we can determine the cash flows from debtors using an equation, as shown below: Cash receipts from customers = Sales + Beginning receivables − Ending receivables − Bad debt expense (where bad debts are written off directly against debtors) − Transfer from allowance for doubtful debts (where debts that have previously been considered doubtful have subsequently proved uncollectible) − Any discounts that might have been given to customers for early payment As an illustration of how to compute the cash flows received from customers, consider Worked Example 19.1.

WORKED EXAMPLE 19.1: Calculating cash received from customers Cottesloe Ltd provides you with the following information: Sales for the year (all on credit terms)

$600 000

Discounts provided during the year to customers for early payment Doubtful debts expense for the year Opening balance of accounts receivable Closing balance of accounts receivable Opening balance of the allowance for doubtful debts Closing balance of the allowance for doubtful debts

$15 000 $10 000 $100 000 $110 000 $18 000 $20 000

REQUIRED Determine how much cash was received from customers during the year. continued CHAPTER 19: THE STATEMENT OF CASH FLOWS  709

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SOLUTION We can use the t-account approach, or the equations approach. Using either method, the amount collected from customers was $567 000. Both approaches are shown below. The amounts shown in the t-accounts are in $000.

               

Sales A/c rec.          

600                    



Accounts receivable Op. bal. 100   Sales 600 Allow. d.d.     Discounts     Cash          Clos. bal.   700  

   



8  15  567  110  700 

Allowance for doubtful debts A/c rec. 8 Op. bal. 18 Clos. bal. 20 D.d. exp. 10   28   28                        

Alternatively, we can determine the cash flows from debtors using an equation, as shown below. Cash receipts from customers = $600 000 (sales) + $100 000 (beginning receivables) − $110 000 (ending receivables) − $8 000 (transfer from allowance for doubtful debts, which equals opening balance of the allowance plus the doubtful debts expense less the closing balance of the provision) − $15 000 (discounts that may have been given for early payment) = $567 000

Interest and dividends received In relation to interest and dividends received we first need to determine whether interest and dividends should be treated as operating cash flows, or otherwise. AASB 107, paragraph 33, states: Interest paid and interest and dividends received are usually classified as operating cash flows for a financial institution. However, there is no consensus on the classification of these cash flows for other entities. Interest paid and interest and dividends received may be classified as operating cash flows because they enter into the determination of net profit or loss. Alternatively, interest paid and interest and dividends received may be classified as financing cash flows and investing cash flows respectively, because they are costs of obtaining financial resources or returns on investments. Hence the accounting standard gives a choice as to where interest paid and dividends and interest received are to be presented. For the purposes of the illustration that follows, we will include them as part of the cash flows from operations. Nevertheless, it is worth noting that Appendix A to AASB 107, which provides an illustration of a statement of cash flows, includes interest paid in the cash flows from operating activities, but includes interest and dividends received in the cash flows from financing activities. In relation to dividends paid, paragraph 34 also provides an option. It states: Dividends paid may be classified as a financing cash flow because they are a cost of obtaining financial resources. Alternatively, dividends paid may be classified as a component of cash flows from operating activities in order to assist users to determine the ability of an entity to pay dividends out of operating cash flows. As with sales, dividend and interest revenue may be recognised within the financial statements before the related cash flow occurs. Interest revenue may be recognised in profit or loss, even though the related cash flows may not occur until the next period. For example, an entity purchases the debentures (bonds) of another entity. Let us assume that the reporting entity acquires debentures with a life of four years and a face value of $1 million. The debentures pay interest yearly. Let us further assume that the coupon rate on the debentures is 10 per cent, but the market requires a rate of return of 12 per cent. 710  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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The amount that the reporting entity will pay for the debentures—their fair value—can be worked out from the present value tables provided in the appendices to this book. The amount, using a discount rate of 12 per cent, will be: Present value of the principal Present value of the interest revenue stream    

$1 000 000 × 0.6355 $100 000 × 3.0373

= $635 500 = $303 730 $939 230

Because the debentures would be recorded at their fair value of $939 230, the accounting entry to record the acquisition would be as follows: Dr Cr

Debentures Cash

939 230  

  939 230

To record the interest one year later, assuming the effective interest method is used to determine interest revenue (whereby the opening balance of the debentures is multiplied by the market rate of interest), the entry would be (see Chapter 10 for the use of the effective interest method): Dr Dr Cr

Interest receivable Debentures Interest revenue

100 000 12 708  

    112 708

So to determine the cash flow related to the interest revenue, we would need to deduct, from interest revenue, any increase in interest receivable as well as any increase in the balance of the debentures. In this case the actual cash receipt is: $112 708 − $100 000 − $12 708 = 0 Had the debentures been acquired at a premium, the reduction in the balance of the debentures would be added back to derive the related cash flows. This can be represented in t-account form as: Interest receivable Op. bal. Interest rev. Debentures

x x x x

Debentures Cash Clos. bal.

x x x x

Alternatively, an equation approach can be used as follows: Cash received from interest revenue = Interest revenue + Opening interest receivable − Closing interest receivable  − Increase in debentures + Decrease in debenture The same analysis can be undertaken for dividends. Using an equation approach the cash flow from dividend revenue would be: Cash received from dividends = Dividend income + Opening dividends receivable − Closing dividends receivable

Cash payment of interest As with interest revenue, we might need to adjust for changes in interest payable, and for any increase or decrease in the value of a bond (or a debenture) as a result of using the effective interest method, to determine the cash flows associated with interest expense. Using a t-account approach, the cash flow may be reconciled as the balancing item. Interest payable Increase in bonds Cash Clos. bal.

x x x x

Op. bal. Decrease in bonds Interest expense

x x x x

Alternatively, we can determine cash flows using an equation approach as follows: Interest paid = Interest expense  + Opening interest payable − Closing interest payable  − Increase in bonds + Decrease in bonds CHAPTER 19: THE STATEMENT OF CASH FLOWS  711

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Payment of income taxes AASB 107, paragraph 35, states: Cash flows arising from taxes on income shall be separately disclosed and shall be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities.

taxable profit The profit for a period determined in accordance with rules established by the taxation authorities, upon which income taxes are payable.

With the adoption of tax-effect accounting, there might be a number of adjustments that need to be made to determine the cash flows associated with tax expense. For example, assume that a reporting entity has a pre-tax profit of $100 000 and that there are no permanent differences but there are some timing differences. The tax rate is 30 per cent. Let us further assume that prepayments have increased by $20 000 and that provision for longservice leave has increased by $10 000. There are no other temporary differences. Prepayments are assumed to be tax deductible, whereas any increase in provision for long-service leave is not. To determine the tax entries, we need to determine taxable profit (see Chapter 18 for details of how to account for tax). In this example, taxable income would be calculated as:

Pre-tax accounting income Temporary differences Increase in prepayments (prepayments are assumed to be deductible for tax purposes) Increase in provision for long-service leave (increases in the provision are assumed not to be deductible for tax purposes) Taxable income

$100 000   ($20 000) $10 000 $90 000

The accounting entry would be: Dr Dr Cr Cr

Tax expense Deferred tax asset Deferred tax liability Income tax payable

30 000 3 000    

    6 000 27 000

Therefore to determine the tax that was actually paid, we would need to add to tax expense any increase in deferred tax assets (or subtract any decrease), and subtract any increase in deferred tax liabilities (or add any decrease). We would also need to subtract any increase in income taxes payable (closing balance less opening balance). If we were to assume that this was the first year of operations and therefore opening balances of assets and liabilities were zero, then we would see that the cash flows relating to tax were zero. Using a t-account approach, the cash flow related to taxes would be determined as the balancing item. Income tax payable Deferred tax liability Cash Clos. bal.

6 0 27 33

Op. bal. Tax expense Deferred tax asset

0 30 3 33

Alternatively, we can determine the cash flows associated with tax expense by using the formula: Income taxes paid = Income tax expense  + Opening income tax payable − Closing income tax payable  + Opening deferred tax liability − Closing deferred tax liability + Closing deferred tax asset  − Opening deferred tax asset

Payments to suppliers and employees To determine the cash flows associated with the purchases of inventories, we need to consider such items as cost of goods sold (COGS), changes in inventory levels, changes in accounts payable (also referred to as trade creditors) and any purchase discounts received. If we are using a t-account approach, it is useful to consider the trade creditors and inventory accounts together. 712  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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Accounts payable Disc. rev. Cash Clos. bal.  

x x x x

Op. bal. Inventory    

Inventory x x

Op. bal. Accounts payable    

x

x x x

COGS Stock w/offs Clos. bal.  

x x x x

If we adopt an equation-method approach, cash payments to suppliers would be determined as: Cash payments to suppliers = Opening accounts payable − Closing accounts payable + Cost of sales  + Closing inventory − Opening inventory − Discounts given by suppliers + Stock write-offs For an illustration of how to determine the cash payments made to suppliers, see Worked Example 19.2.

WORKED EXAMPLE 19.2: Calculating cash payments made to suppliers Bogus Ltd has provided you with the following information: Cost of goods sold for the year Purchases for the year (on credit terms) Discounts received for early payment to suppliers Stock write-offs owing to water damage caused by global warming Opening balance of accounts payable Closing balance of accounts payable Opening balance of inventory Closing balance of inventory

$190 000 $220 000 $7 000 $14 000 $50 000 $60 000 $20 000 $36 000

REQUIRED Determine the cash payments made to suppliers during the year. SOLUTION Using the t-account approach, the amount paid to suppliers is $203 000, determined as follows (all amounts are in $000):

Disc. rev. Cash Clos. bal.  

Accounts payable 7 Op. bal. 203 Inventory   60   270  

50 220 270

Inventory Op. bal. 20 COGS Accounts payable 220 Stock w/offs          Clos. bal.   240  

190 14   36 240

If we adopt an equation-method approach, cash payments to suppliers would be determined as follows: Cash payments to suppliers = $50 000 (opening accounts payable) − $60 000 (closing accounts payable) + $190 000 (cost of sales) + $36 000 (closing inventory) − $20 000 (opening inventory) − $7 000 (discounts given by suppliers) + $14 000 (stock write-offs) = $203 000 Interest and tax payments must be separately disclosed. To determine the payments for other expenses (apart from interest and tax payments) such as salaries expense, we need to consider which expenses are accrued and which relate to non-cash-flow items (for example, depreciation). If an expense is accrued, we need to deduct any increase in the accrued liability to determine the related cash flow (or add any decrease in the accrued liability).

Cash flows from investing activities Investing activities include the acquisition and disposal of non-current assets (such as property, plant and equipment and other productive assets) and investments (such as securities not falling within the definition of cash). CHAPTER 19: THE STATEMENT OF CASH FLOWS  713

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To determine the proceeds from the sale of non-current assets, specific information about the sale transaction would be required. It is the actual receipt that is recorded in the statement of cash flows, not any gain or loss that might have resulted. To determine the amount of cash paid for non-current assets, we need to exclude any increase in assets generated by non-cash transactions, such as the acquisition of plant by virtue of a mortgage over the other assets of the business. We also need to deduct from the movement in assets any increases caused by upward asset revaluations. Any assets disposed of need to be considered too. The t-account for non-current assets may be represented as: Non-current assets Op. bal. Revaluation res. Non-cash trans. Cash

x x x x x

Disposal Accumulated deprec. Clos. bal.

x x x x

Using an equation approach, and assuming the assets are not recorded at net values—that is, cost (or revalued amount) less accumulated depreciation—the cash flows associated with the acquisition of non-current assets may be determined as: Cash payments = Closing balance of non-current assets − Opening balance of non-current assets + Original cost of assets sold − Assets acquired through non-cash transactions − Revaluation increases + Accumulated depreciation written back to revalued assets For an illustration of how to determine the cash payments made to suppliers of non-current assets, consider Worked Example 19.3.

WORKED EXAMPLE 19.3: Calculating cash flows from investing activities Assume that Trigg Ltd provides you with the following information about their holding of plant and equipment: • Opening balance of plant and equipment is $800 000. • Closing balance of plant and equipment is $780 000. • Plant with a carrying amount of $100 000 (cost $130 000; accumulated depreciation $30 000) has been revalued during the year to $150 000. • Shares in the company have been exchanged for plant and equipment with a fair value of $60 000. • Plant with a carrying amount of $50 000 (cost $130 000; accumulated depreciation $80 000) has been sold for $20 000. REQUIRED Determine the amount of plant and equipment acquired for cash. SOLUTION In considering the above data, we should remember (see Chapter 6) that the accounting entries to record the revaluation of plant and equipment would be: Dr Accumulated depreciation 30 000   Cr Plant and equipment   30 000 (to eliminate existing accumulated depreciation in existence at time of revaluation) Dr Plant and equipment 50 000 Cr Revaluation surplus   (to revalue the plant and equipment to $150 000)

  50 000

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As explained in Chapter 18, where there is an asset revaluation we also need to consider the related tax implications. As we learned in Chapter 18, a revaluation increment will lead to the recognition of an associated deferred tax liability. Assuming a tax rate of 30 per cent, the entry would be: Dr Revaluation surplus Cr Deferred tax liability (15 000 = 50 000 × 0.30)

15 000  

  15 000

With the above in mind, we can reconstruct the t-accounts as follows to show that cash payments for plant and equipment amount to $30 000:

Op. bal. Revaluation surplus Non-cash trans. Cash  

Plant and equipment 800 Disposal 50 Accumulated deprec. 60 Clos. bal.    30   940  

130 30 780       940

Cash flows from financing activities

financial structure

The third category of cash flows that needs to be presented (other than cash flows from operations Refers to how the resources of the entity and cash flows from investing activities) are cash flows from financing activities. Financing activities have been funded, for relate to changing the size and composition of the financial structure of the entity, including equity example, how much and borrowings not falling within the definition of cash. debt there is relative For many types of debt, it might be easy to determine the cash inflow. It might simply be the to equity. Financial difference between the opening and closing liability. For items such as debentures (or bonds, as structure information they are also called), however, we might need to consider whether financial assets were issued or can also describe the types of debt and acquired at a discount, or premium to their ‘face value’. For example, assume that an entity raises types of equity in funds by issuing debentures with a life of four years and a face value of $1 million (the ‘face value’ is existence. the amount that will ultimately be paid to the debenture holders at the end of life of the liabilities—in this case, in four years’ time). If we assume that the coupon rate on the debentures is 10 per cent, and the market requires a rate of return of 12 per cent, then the issue price would be $939 230—this is how much would be shown in that period’s statement of cash flows in relation to proceeds from borrowings—which would be presented under cash flows from financing activities. At the end of the first period, $100,000 would be paid to the debenture holders (10 per cent of the face value). Using the effective interest method, this would be allocated to interest expense and repayment of principal. The interest expense would be determined by multiplying the opening balance of the liability by the market rate of interest. In this case, at the end of the first year it would be $939 230 multiplied 12 per cent, which would equal $112 707 such that the accounting entry would be: Dr Cr Cr

Interest expense Cash Debenture liability

112 707 100 000 12 707

So the actual cash flow would not be the change in the liability. Rather, in this case it would be the interest expense recognised for the period, less the increase in the debenture liability. Cash flows relating to payments of interest to debenture holders would typically be shown as part of cash flows from operations. To determine the cash flows from the issue of equity securities, we need to consider whether any share issue has been financed out of reserves, such as retained earnings or revaluation surplus. In such cases there would be no related cash flows. As already discussed, cash payments associated with dividends would typically be treated as part of financing activities. In determining cash payments of dividends, we need to consider the dividend payments, proposed dividends and any increase in dividends payable, determining the associated cash flow as: Payment of cash dividends = Dividends paid + Dividends proposed + Opening dividends payable  − Closing dividends payable CHAPTER 19: THE STATEMENT OF CASH FLOWS  715

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A final point to be made before considering the comprehensive illustration in Worked Example 19.4 is that what we basically need to do in compiling a statement of cash flows is to make sure that we have reconciled the movements in all of the non-cash accounts in the statement of financial position to determine which accounts affect cash. Once we have done this, we will have an overview of all cash movements.

WORKED EXAMPLE 19.4: Preparation of a statement of cash flows The example below uses both the t-account approach and the equation approach. You can use whichever method you prefer. Comparative figures, though required by the standard, are not necessary for this exercise. The account details of Cashco Ltd are shown below. Cashco Ltd Statement of profit or loss and other comprehensive income for the year ending 30 June 2019   Income Sales Expenses Cost of goods sold Depreciation—buildings Depreciation—plant Doubtful debts Electricity and rates Income tax Interest expense Lease rentals Salaries Net profit Other comprehensive income: Increase in revaluation surplus Total comprehensive income

2018 ($000)

2019 ($000)

 

700

 

885

200 20 60 30 20 76 10 40 160  

                616 84

240 20 70 40 45 84 11 70 200  

                780 105

 

 30 135

 – 84

Cashco Ltd Statement of financial position as at 30 June 2019   Current assets Cash Accounts receivable Allowance for doubtful debts Inventory   Non-current assets Land Buildings Acc. depreciation—buildings Plant and equipment Acc. depreciation—P & E Deferred tax asset   Total assets

2018 ($000)   176 220 (30)      90    456   100 400 (40) 400 (40)         –    820 1 276

2019 ($000)   239 280 (40)    100    579   250 400 (60) 420 (40)         4    974 1 553

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Current liabilities Accounts payable Accrued expenses Income tax payable   Non-current liabilities Long-term loans Deferred tax liability   Shareholders’ funds Share capital Revaluation surplus Retained earnings   Total liabilities and shareholders’ funds

  80 10       76     166   100         –     100   400 –     610  1 010 1 276

  70 20       88    178   110       20    130   500 30    715 1 245 1 553

Additional information

• There have been no cash sales. • During the year, $30 000 from allowance for doubtful debts has been written off against accounts receivable. • Land has been revalued upwards by $50 000. • Land with a fair value of $100 000 has been acquired by the issue of 100 000 fully paid ordinary shares for $1.00 per share. • Salaries and lease rentals are accrued prior to payment. • Electricity and rates and interest expense are paid as incurred. • The Accounts payable account is used for purchases of inventory. • During the year, plant that cost $100 000 and that has accumulated depreciation of $70 000 is sold for $30 000 cash. • For tax purposes, allowable depreciation for the year was: – Plant and equipment: $70 000 – Buildings: no deduction allowable in any year. • Tax rate is 40 per cent. REQUIRED Prepare a statement of cash flows for Cashco Ltd for the year ending 30 June 2019. SOLUTION In this example, some expenses (electricity and rates and interest) are accounted for on a cash basis. For the accounts that involve accruals, it may be necessary to reconstruct the accounts to determine relevant cash movements. Note that amounts in all t-accounts in this exercise are shown in $000s. (a) Cash flows from operating activities (i) Receipts from customers We need to reconstruct the allowance for doubtful debts and accounts receivable. The cumulative entry to record sales would be: Dr Cr

Accounts receivable Sales

885 000  

  885 000

The entry to record the doubtful debts expense would be: Dr Cr

Doubtful debts expense Allowance for doubtful debts

40 000  

  40 000 continued

CHAPTER 19: THE STATEMENT OF CASH FLOWS  717

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As the closing balance of allowance for doubtful debts increases by only $10 000, $30 000 must have been written off against accounts receivable. A reconciliation of accounts receivable shows a cash collection of $795 000:

Op. bal. Sales    

Accounts receivable 220 Allow. d.d. 885 Cash   Clos. bal. 1 105  

30 795 280 1 105

Allowance for doubtful debts A/c rec. 30 Op. bal.       Clos. bal. 40 D.d exp.   70  

30   40 70

Alternatively, we can determine the cash flow as: Cash flow = Sales + Opening  accounts  receivable − Transfer  from  allowance  for  doudtful  debts (which would be represented by Opening balance of allowance + Doubtful debts expense − Closing balance of allowance) − Closing balance of accounts receivable = 885 + 220 − (30 + 40 − 40) − 280 = 795 (ii)

Purchases of inventory Cashco Ltd commences the period with $90 000 of inventory. After using $240 000 (COGS), it has a closing balance of $100 000. Given that there are no inventory write-offs, this means that $250 000 of inventory must have been purchased.   Given that accounts payable has an opening balance of $80 000, purchases are $250 000 (above) and the closing balance is $70 000, $260 000 must have been paid in cash. This is shown in the following t-accounts. Inventory Op. bal. 90 COGS Accounts payable 250 Clos. bal.   340  



240 100 340

Cash Clos. bal.  

Accounts payable 260 Op. bal.   70 Inventory 330  

80 250 330

  In this example, there are no inventory write-downs (for example, due to obsolescence/theft). If there are such write-downs, they would be added to the $260 000 to arrive at the inventory purchases. Alternatively, we can use the equation method: Cash flow = Opening accounts payable − Closing accounts payable + Cost of goods sold + Closing inventory − Opening inventory = 80 − 70 + 240 + 100 − 90 = 260

(iii)

Accrued expenses In this example, salary and lease expenses are accrued prior to payment. If the opening balance of accrued expenses is $10 000, salaries and lease expenses total $270 000 and the closing balance is $20 000, then $260 000 must have been paid.

Cash Clos. bal.  

Accrued expenses 260 Op. bal.   20 Sal. & leases 280  

10 270 280

Alternatively, we can use the equation method: Cash flow = Opening balance of accrued expenses + Expenses incurred during the period  − Closing balance of accrued expenses = 10 + 270 − 20 = 260

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(iv)

Taxation The profit before tax is $189 000. There is $20 000 in permanent differences (building depreciation) and a $10 000 temporary difference (the increase in allowance for doubtful debts). Therefore the entry would be (rounded to the nearest $000): Dr Dr Cr



Income tax expense Deferred tax asset Income tax payable

84 000 4 000  

    88 000

A reconciliation of income taxes payable would show:

Cash Clos. bal.  

Income tax payable 76 Op. bal.   88 Tax/DTA 164  

76   88 164

Alternatively, we can use the equation method:



Cash flow = Income tax expense - Closing income tax payable + Opening income tax payable + Opening deferred tax liability - Closing deferred tax liability - Opening deferred tax asset + Closing deferred tax asset + Any increase in deferred tax liability due to a revaluation - Any decrease in deferred tax liability due to a reversal of a devaluation = 84 - 88 + 76 + 0 - 20 - 0 + 4 + 20 = 76 At this stage we can now calculate the total cash flows from operations as:   Receipts from customers Payments to suppliers Payments for accrued expenses Interest payments Electricity and rates Taxation payments  

$000 795 (260) (260) (11) (45) (76) 143

(b) Cash flows from investment activities (i) Land A reconciliation of the movements in land shows that no land has been acquired for cash. There has been a revaluation, with the related recognition of a deferred tax liability (see Chapter 18), as well as an exchange of shares in the entity for land. The entries would be: Dr Cr Dr Cr Dr Cr

Land Revaluation surplus Revaluation surplus Deferred tax liability Land Share capital

Op. bal. Share capital Revaluation surplus  

Land 100   100     50 Clos. bal. 250  

50 000   20 000   100 000  

  50 000   20 000   100 000

    250 250 continued CHAPTER 19: THE STATEMENT OF CASH FLOWS  719

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Alternatively, the equation method can be used: Cash flow = Closing balance of non-current assets - Opening balance of non-current assets - Revaluations + Disposals (at cost or revalued amount) - Non-cash acquisitions = 250 - 100 - 50 - 100 =0

(ii)

Plant and equipment The journal entries for the disposal of the plant and equipment can be summarised as: Dr Dr Cr



Acc. depreciation—plant and equipment Cash Plant and equipment

70 000 30 000  

    100 000

As plant and equipment increases by $20 000, $120 000 must have been acquired during the period, as reconciled below. Accumulated depreciation Disposal 70 Op. bal. Clos. bal.   40 Deprec. exp.   110  

40   70 110

Op. bal. Cash  

Plant and equipment 400 Disposal 120 Clos. bal. 520  

100 420 520

Alternatively, using the equation method: Cash flow = Closing balance of non-current assets − Opening balance of non-current assets − Revaluations + Disposals (at cost or revalued amount) − Non-cash acquisitions = 420 – 400 – 0 + 100 – 0 = 120 Total cash flows from investing activities $000 Payment for property, plant and equipment Proceeds from sale of equipment

(120)    30 (90)

(c) Cash flows from financing activities A reconciliation of movements in share capital would show that there have been no issues for cash.   The only cash flow from financing relates to $10 000 from long-term loans. Total cash flows for the period $000 Opening cash balance Cash from operations Cash from investing Cash from financing Closing cash balance

176 143 (90)   10 239

We are now able to present a statement of cash flows for Cashco Ltd. Cashco Ltd Statement of cash flows for the year ended 30 June 2019 $000 Cash flows from operating activities Receipts from customers Payments to suppliers of goods and services, inclusive of labour

795 (565)

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Interest paid Income taxes paid Net cash provided from operating activities (1) Cash flows from investing activities Payment for property, plant and equipment (2) Proceeds from sale of plant Net cash used in investing activities Cash flows from financing activities Proceeds from borrowings Net cash from financing activities Net increase in cash held Cash at the beginning of the financial year Cash at the end of the financial year

(11)  (76) 143 (120)   30   (90)    10    10 63 176 239

For Cashco Ltd, two notes will accompany the statement of cash flows: Note 1. Reconciliation of net cash provided by operating activities to net profit $000 Operating profit after tax Depreciation Increase in allowance for doubtful debts Increase in income taxes payable Increase in accounts receivable Increase in inventories Decrease in accounts payable Increase in accrued expenses Increase in deferred tax asset Net cash provided from operating activities

105 90 10 12 (60) (10) (10) 10     (4) 143

Note 2. Non-cash financing and investing activities During the financial year, the economic entity also acquired land with an aggregate fair value of $100 000 by means of issuing 100 000 fully paid ordinary shares.

Contractual implications

LO 19.8

Cash flows from operations would seem to provide a reasonable guide to the ability of a firm to service debt, perhaps more so than measures such as interest coverage—that is, profit before interest and taxes, divided by interest expense. For example, a debt contract might require the net cash provided by operating activities to exceed total interest obligations by at least five times. Of course, even before the mandatory requirement to produce statements of cash flows (operative in Australia since 1992), debtholders would have been able to require borrowers to provide statements of cash flows as part of the loan agreement. It could be argued that traditional financial ratios, such as the current ratio—current assets divided by current liabilities—or acid-test ratios, are deficient in monitoring the liquidity of the organisation. As Fadel and Parkinson (1978) indicate, the view that current assets are used to pay current liabilities is false, since these assets ‘never become realised . . . and the total current liabilities never become fully paid’. Sharma (1996) argues that cash flows from operating activities divided by current debt might be a more appropriate measure of short-term liquidity. Sharma also proposes that retained cash flows from operations (RCFFO) might be an important indicator of an entity’s financial flexibility. He states (p. 40): This variable (RCFFO) measures the level of cash retained after meeting all operating costs and priority payments such as interest costs and dividends . . . This variable can therefore be used to assess an entity’s debt-paying CHAPTER 19: THE STATEMENT OF CASH FLOWS  721

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capacity and its investment power without relying on borrowed funds or the sale of assets . . . Retained cash flows from operations divided by total cash inflows and debt cash inflows divided by total cash flows will indicate the degree to which cash is obtained from sources internal and external to the firm. Where the source of funds is largely RCFFO, an entity may be in a sound financial position. However, where the source of cash is largely debt, then an entity would be at high financial risk. Sharma argues, using the example of Brash Holdings Ltd, that the use of cash-flow data, such as that just discussed, would have provided an earlier indication of solvency problems than was possible using conventional financial ratios. He argues (p. 42): Thus, while accrual liquidity analysis would not have raised any concerns among lenders, a cash-flow analysis would certainly have forewarned lenders of Brash’s inability to meet obligations from internally generated cash . . . as early as four years before voluntary administrators were appointed. The results in Sharma (1996) are generally consistent with those provided in Flanagan and Whittred (1992). In a review of Hooker Corporation Ltd, Flanagan and Whittred documented results that indicate that traditional use of financial ratios pertaining to liquidity, solvency and profitability provided poor guides to the probability of corporate failure. Conversely, however, the analysis of trends in cash flows from operations appeared to provide earlier indications of forthcoming financial distress. In more recent research, Orpurt and Zang (2009) found that disclosures made in accordance with AASB 107 tended to enhance forecasts of future profits, cash flows from operations, and future share price returns because useful information, such as certain cash flow receipts or payments, are not otherwise available from the other financial statements prepared for shareholders. Clinch, Sidhu and Sin (2002) also provide evidence that the disaggregated cash-flow data detailed in the statement of cash flows provided additional explanatory power in explaining share price movements. Accepting that parties lending funds to others periodically need to monitor the riskiness of their investments, work such as that of Flanagan and Whittred (1992), Sharma (1996), Orpurt and Zang (2009) and Clinch, Sidhu and Sin (2002) would suggest that efficient contracts necessarily include ratios based on the information shown in the statement of cash flows.

LO 19.9

Potential future changes to the statement of cash flows

In December 2014 the IASB issued an Exposure Draft: Disclosure Initiative: Proposed amendments to IAS 7, which proposed a number of changes to IAS 7/AASB 107. The Disclosure Initiative represents a portfolio of projects being undertaken by the IASB with the aim of improving the effectiveness of disclosures within financial statements. The objectives of the proposed amendments as they relate to statements of cash flow are stated as being to improve: (a) information provided to users of financial statements about an entity’s financing activities, excluding equity items; and (b) disclosures that help users of financial statements to understand the liquidity of an entity. To meet the first objective, the IASB is proposing that an entity should disclose a reconciliation of the amounts in the opening and closing statements of financial position for each item for which cash flows have been, or would be, classified as financing activities in the statement of cash flows, excluding equity items. The result of requiring this reconciliation is that investors will be provided with improved disclosures about an entity’s debt and movements in debt during the reporting period. Exhibit 19.5 provides an example of such a reconciliation. To meet the second objective, the IASB is proposing to extend the disclosures required by IAS 7 about an entity’s liquidity and proposes disclosures about the restrictions that affect the decisions of an entity to use cash and cash equivalent balances, including tax liabilities that would arise on the repatriation of foreign cash and cash equivalent balances. At the time of writing this edition of this book, the above amendments had not yet been incorporated within AASB 107. In terms of other potential changes relating to requirements pertaining to statements of cash flows, and as indicated in earlier chapters of this text, the IASB and US Financial Accounting Standards Board (FASB) undertook a joint project that investigated the presentation of financial statements. The project led to the release in October 2008 of a Discussion Paper entitled Preliminary Views on Financial Statement Presentation. The Discussion Paper suggested significant 722  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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Notes to the statement of cash flows E. Components of financing activities (excluding equity) 20X1 Cash flow Non-cash changes Acquisition New leases Long-term borrowings 1 040 250 200 – Lease liabilities – (90) – 900 Long-term debt 1 040 160 200 900

20X2 1 490 810 2 300

Exhibit 19.5 Example of reconciliation of an item that would appear in the statement of financial position

changes in how the statement of financial position, statement of profit or loss and other comprehensive income, statement of cash flows, and statement of changes in equity should be disclosed. In July 2010 a ‘staff draft’ of an Exposure Draft of a new Financial Statement Presentation accounting standard was prepared (because it was a ‘staff draft’ it was not open for public comment) and the expectation was that an Exposure Draft for public comment would be issued in late 2012 with a final standard to follow that some years later. The Exposure Draft was not released in 2012 and progress on this project seems to have paused. Nevertheless, this work is potentially indicative of future changes in how the statement of cash flows might be presented. In their work, the IASB and FASB emphasised that the three main financial statements (the statement of financial position, the statement of profit or loss and other comprehensive income, and the statement of cash flows) should use an account classification scheme that is consistent throughout the financial statements, with the statement of financial position being the dominant statement in terms of determining the account classifications to be used in the other financial statements. As paragraph 2.29 of IASB (2008) stated: To present information in a cohesive manner, an entity should present changes in its assets, liabilities and equity items in the same section and category in the statement of comprehensive income and the statement of cash flows that the asset or liability is classified in the statement of financial position. In other words, the classification of assets and liabilities in the statement of financial position determines the classification of changes in those assets and liabilities in the statements of comprehensive income and cash flows. For example, an entity would classify its revenues, expenses, gains, losses and cash flows related to operating assets and liabilities in the operating category in the statements of comprehensive income and cash flows. In promoting the view that there is a need for the various financial statements to be more ‘cohesive’ when considered as a set, paragraph S7 of IASB (2008) stated: To present a cohesive set of financial statements, an entity should align the line items, their descriptions and the order of presentation of information in the statements of financial position, comprehensive income and cash flows. To the extent that it is practical, an entity should disaggregate, label and total individual items similarly in each statement. Doing so should present a cohesive relationship at the line item level among individual assets, liabilities, income, expense and cash flow items. It is argued that at the present time there is a general lack of ‘cohesiveness’ in how the various financial statements are presented. Pursuant to the proposed approach to presentation, an entity would classify income, expenses and cash flows in the same section and category as the related asset or liability. For example, if an entity classifies inventory in the operating category of the statement of financial position, it would classify changes in inventory in the operating category of the statement of profit or loss and other comprehensive income (as part of cost of goods sold) and classify the related cash payments to suppliers in the operating category of the statement of cash flows. The IASB and FASB also proposed that financial statements should be presented in a more disaggregated manner. In particular, it was proposed that financial statements should be prepared in a way that separates an entity’s financing activities from its business and other activities and, further, separates financing activities between transactions with owners in their capacity as owners and all other financing activities. It was proposed that the ‘Business’ section of CHAPTER 19: THE STATEMENT OF CASH FLOWS  723

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the financial statements would include all items related to assets and liabilities that management views as part of its continuing business activities. Business activities are those activities conducted with the intention of creating value, such as producing goods or providing services. It was proposed that the ‘Business’ section be further disaggregated into an Operating category and an Investing category. According to the discussion paper: • The Operating category would include assets and liabilities that management views as related to the central purpose(s) for which the entity is in business (and changes in those assets and liabilities). An entity uses its operating assets and liabilities in its primary revenue and expense-generating activities. • The Investing category would include all assets and liabilities that management views as unrelated to the central purpose for which the entity is in business (and any changes in those assets and liabilities). An entity would use its investing assets and liabilities to generate a return, but would not use them in its primary revenue and expensegenerating activities. • The ‘Financing’ section would include only financial assets and financial liabilities that management views as part of the financing of the entity’s business activities (referred to as ‘financing assets and liabilities’). Amounts relating to financing liabilities would be presented in the financing liabilities category and amounts relating to financing assets would be presented in the financing assets category in each of the financial statements. In determining whether a financial asset or liability should be included in the financing section, an entity should consider whether the item is interchangeable with other sources of financing and whether the item can be characterised as independent of specific business activities. Table 19.3 represents the proposed format for presenting information within the financial statements, excluding the notes. (The section names are in bold italics; bullet points indicate required categories within sections.) According to the 2008 IASB Discussion Paper, each entity would decide the order of the sections and categories but would use the same order in each individual statement. Each entity would decide how to classify its assets and liabilities into the sections and categories on the basis of how an item is used (the ‘management approach’). The entity would disclose why it chose those classifications. In explaining the use of the management approach, the Discussion Paper notes that, because functional activities vary from entity to entity, an entity would choose the classification that best reflects management’s view of what constitutes its business (operating and investing) and financing activities. Thus, a manufacturing entity may classify the same asset (or liability) differently from a financial institution because of differences in the businesses in which those entities engage. The Discussion Paper provides an example of how a statement of cash flows might appear if the contents of the Discussion Paper were ultimately adopted. The proposed format is provided in Exhibit 19.6. As can be seen, this format represents a departure from the current disclosure requirements embodied within AASB 107.

Table 19.3 Proposed format for the presentation of financial statements

Statement of financial position

Statement of profit or loss and other comprehensive income

Statement of cash flows

Business • Operating assets and liabilities • Investing assets and liabilities

Business • Operating income and expenses • Investing income and expenses

Business • Operating cash flows • Investing cash flows

Financing • Financing assets • Financing liabilities

Financing • Financing asset income • Financing liability expenses

Financing • Financing asset cash flows • Financing liability cash flows

Income taxes

Income taxes On continuing operations (business and financing)

Income taxes

Discontinued operations

Discontinued operations Net of tax

Discontinued operations

Other comprehensive income Net of tax Equity

Equity

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In terms of other changes that may occur in the future in regard to the presentation of the statement of cash flows, it was proposed that ‘cash equivalents’ no longer be included as part of the statement of cash flows. Specifically, the Discussion Paper states: 3.71 An entity’s statement of cash flows should reconcile the beginning and ending amounts of cash. 3.72  Cash in the statement of financial position will no longer include cash equivalents. To be consistent with their preliminary views on presenting cash in the statement of financial position, the boards propose that the statement of cash flows should reconcile the beginning and ending amounts of cash rather than cash and cash equivalents as in present practice. The elimination of ‘cash equivalents’ would represent a major change to existing accounting standards. Obviously, a clear definition of ‘cash’ will be required. The definition of cash used in the 2010 staff draft of the Exposure Draft is ‘Cash on hand and demand deposits’. The Discussion Paper and the Exposure Draft also propose to mandate the use of the direct method of compiling the statement of cash flows. Under AASB 107 (and IAS 7), entities have an option to use either the direct method or the indirect method. Information about cash flows will be important to various stakeholders including investors and investment analysts. Therefore, as Francis (2010) discusses, any changes to cash flow presentation, or measurement, will require careful thought by the IASB. Francis (2010) undertook a study to investigate whether the proposed approach to presenting a statement of cash flows—as documented in the 2008 Discussion Paper and the 2010 Exposure Draft released by the IASB—provides more or less information content than the approach currently required by AASB 107. One issue considered was the relative information content of the proposed and current (AASB 107) measures for cash flows from operations. Unlike the measure of cash flows from operations currently reported pursuant to AASB 107, the IASB proposed that cash flows from operations should not include interest paid or received, taxes paid and dividends received. Further the proposed measure of cash flows from operations would include net capital expenditures, which are cash inflows and outflows associated with retirements and acquisitions of non-current assets used in the operations of the entity. These are not currently included as part of cash flows from operations as determined in accordance with AASB 107. Francis (2010) reports that the results of his research indicated that the proposed operating cash flow measure has less relative information content than the measure currently prescribed under AASB 107. Francis would therefore question the worth of the new standard. While we would not necessarily question the merit of introducing new accounting standards on the basis of just one study (for example, Francis 2010), if a number of studies were to question the merit of proposed accounting requirements then it would be hoped that the IASB would take such evidence into consideration. It is costly to create changes in accounting standards (from both the perspective of preparers and readers of financial statements), so the benefits to financial statement users must be perceived as exceeding the related costs associated with introducing new reporting requirements. Again, it is emphasised that while the changes suggested by the IASB and FASB might not ultimately come to fruition in the near future, it would be reasonable to expect that there could be major changes in how the statement of cash flows is presented. As with all areas of financial accounting, there is always a need to be vigilant for changes that are about to be made, or have been made, by bodies such as the IASB. Many of the rules/accounting standards that we learn as students of financial accounting will inevitably change.

TOOLCO STATEMENT OF CASH FLOWS For the year ending 31 December 2020 2019 BUSINESS Operating Cash received from wholesale customers Cash received from retail customers   Total cash collected from customers

2 108 754    703 988 2 812 742

Exhibit 19.6 Proposed format for the statement of cash flows

1 928 798    643 275 2 572 073 continued

CHAPTER 19: THE STATEMENT OF CASH FLOWS  725

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TOOLCO STATEMENT OF CASH FLOWS

Cash paid for goods   Materials purchases  Labour  Overhead—transport  Pension  Overhead—other   Total cash paid for goods Cash paid for selling activities  Advertising   Wages, salaries and benefits  Other   Total cash paid for selling activities Cash paid for general and administrative activities   Wages, salaries and benefits   Contributions to pension plan   Capital expenditures   Lease payments   Research and development   Settlement of share-based remuneration  Other   Total cash paid for general and administrative activities    Cash flow before other operating activities Cash from other operating activities   Disposal of property, plant and equipment   Investment in associate A   Sale of receivable   Settlement of cash flow hedge   Total cash received (paid) for other operating activities   Net cash from operating activities Investing Purchase of available-for-sale financial assets Sale of available-for-sale financial assets Dividends received    Net cash from investing activities     NET CASH FROM BUSINESS ACTIVITIES FINANCING   Interest received on cash   Total cash from financing assets Proceeds from issue of short-term debt Proceeds from issue of long-term debt Interest paid Dividends paid   Total cash from financing liabilities    NET CASH FROM FINANCING ACTIVITIES     Change in cash from continuing operations before taxes and equity

For the year ending 31 December 2020 2019     (935 543) (785 000) (418 966) (475 313) (128 640) (108 000) (170 100) (157 500)       (32 160)       (27 000) (1 685 409) (1 552 813)     (65 000) (75 000) (58 655) (55 453)       (13 500)       (12 500) (137 155) (142 953)     (332 379) (314 234) (170 100) (157 500) (54 000) (50 000) (50 000) – (8 478) (7 850) (3 604) (3 335)       (12 960)       (12 000) (631 521) (544 919)     358 659     331 388     37 650 – – (120 000) 8 000 10 000        3 402        3 150       49 052    (106 850)    407 709    224 538     – (130 000) 56 100 51 000       54 000       50 000    110 100     (29 000)    517 809    195 538              8 619          5 500         8 619         5 500 162 000 150 000 – 250 000 (83 514) (82 688)  (86 400) (80 000)        (7 914)    237 312             705     242 812 518 514 438 350

726  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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INCOME TAXES   Cash taxes paid   Change in cash before discontinued operations and equity

     (281 221)     237 293

  (193 786)  244 564

DISCONTINUED OPERATIONS   Cash paid from discontinued operations    NET CASH FROM DISCONTINUED OPERATIONS       Change in cash before equity EQUITY   Proceeds from reissue of treasury shares NET CASH FROM EQUITY   Effect of foreign exchange rates on cash CHANGE IN CASH Beginning cash Ending cash

     (12 582)     (12 582)     224 711         84 240       84 240         3 210 312 161    861 941 1 174 102

   (11 650)  (11 650)  232 914   78 000   78 000      1 027 311 941 550 000 861 941

SUMMARY The chapter considered various issues associated with constructing and interpreting a statement of cash flows. The statement of cash flows is described as being a very useful complement to an entity’s statement of financial position, statement of profit or loss and other comprehensive income, and statement of changes in equity. It provides information that is useful for making assessments of such things as an entity’s ability to generate cash flows; meet financial commitments as they fall due; finance changes in operating activities; and obtain and service external debt. As the statement of cash flows is not based upon accrual accounting, its compilation is not greatly influenced by professional judgement. While different accountants might not agree on what an entity’s profits, assets or liabilities are, they would most likely agree on its cash flows for the purpose of a statement of cash flows. This attribute of the statement of cash flows—the limited professional judgement involved—explains in part why some believe that the statement of cash flows is more credible than the statement of profit or loss and other comprehensive income or the statement of financial position. The statement of cash flows provides a reconciliation of opening and closing cash, with cash being described as cash on hand and cash equivalents. Cash equivalents come in two forms: highly liquid investments with short periods to maturity readily convertible to cash on hand at the investor’s option; and borrowings integral to the cash management function of the entity and not subject to a term facility. As the statement of cash flows may relate to a number of accounts (for example, cash on hand, cash at bank, bank overdraft and short-term money market deposits), Accounting Standard AASB 107 requires a note to the financial statements to be provided reconciling the cash balance to the related statement of financial position items. Regarding the provision of information on cash flows for a period, the accounting standards require cash flows to be subdivided into operating activities, investing activities and financing activities. This subdivision provides further information about the various facets of an organisation’s cash flows. In preparing the statement of cash flows, the direct method, as opposed to the gross method, is recommended by the accounting standard. Under the direct method, the relevant cash inflows are reported in gross terms, rather than being netted off against one another. For example, rather than showing the net cash received on the movements in an entity’s investments, cash inflows from sales of investments are to be shown separately from cash outflows relating to acquisitions of investments. When financial statements are presented to financial statement users, it is possible that cash flows from operations will be very different from profits or losses. The reason for this is that profits or losses are determined on an accrual basis— that is, revenues are recognised when earned, and expenses are recognised when incurred—and not on a cash basis, as is the case for cash flows from operations. To alleviate any confusion this difference might cause, reporting entities typically prepare a note to the statement of cash flows reconciling cash flows from operating activities, as reported in the statement of cash flows, to profit or loss (as reported in the statement of profit or loss and other comprehensive income). CHAPTER 19: THE STATEMENT OF CASH FLOWS  727

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While the statement of cash flows provides information about the cash flows associated with financing and investing activities, financing and investing activities can occur without the direct transfer of any cash. For example, perhaps some assets are acquired as a result of the exchange of shares in the reporting entity. To help ensure that financial statement users are more fully informed, AASB 107 requires that information about material financing and investing transactions, and events that do not result in or from cash flows during the financial period, be disclosed in the notes accompanying the financial statements. The chapter described two of the many approaches to preparing a statement of cash flows: the equation approach and the t-account approach. A number of illustrations of both approaches were provided, while stressing that the method that is adopted is a matter of personal preference. The chapter has also briefly explored work undertaken by the IASB to develop revised rules pertaining to financial statement presentation. While we cannot be certain at this stage about the changes that are likely to be made in terms of how we present statements of cash flows, it does appear inevitable that there could be major changes in how we prepare and present a statement of cash flows.

KEY TERMS accrual accounting  697 accrual profits/losses  698 financial structure  715

financing activities  703 investing activities  703 operating activities  703

statement of cash flows  697 taxable profit  712

END-OF-CHAPTER EXERCISES Crescent Ltd is involved in manufacturing golf clubs with special emphasis on sand irons. Crescent Ltd’s statements of financial position for the years ending 30 June 2019 and 30 June 2020 are presented below.

Assets Cash Accounts receivable Allowance for doubtful debts Property, plant and equipment Acc. depreciation—property, plant and equipment Inventory Total assets Liabilities Bank overdraft Accounts payable Accrued wages Provision for annual leave Loans Total liabilities Net assets Represented by: Shareholders’ funds Share capital Revaluation surplus Retained earnings Total shareholders’ funds

2020 ($000)

2019 ($000)

480 180 (60) 780 (180)    460 1 660

– 300 (40) 600 (100)     260 1 020

– 300 100 40    300    740   920

200 300 80 60        –    640    380

700 140      80    920

100 40    240    380

728  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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The expenses and revenues of Crescent Ltd for the year ending 30 June 2020 are: 2020 ($000) Revenues Sales Interest (no interest receivable at year end) Gain on sale of property (which had a carrying amount of $100 000) Expenses Cost of goods sold Doubtful debts Depreciation Wages Employee entitlements—annual leave Net loss for the year

300 20 40 (200) (40) (100) (100)   (80) (160)

REQUIRED Prepare a statement of cash flows for Crescent Ltd for the year ending 30 June 2020. For the purposes of this exercise, taxation is ignored. LO 19.2, 19.3, 19.5, 19.7

SOLUTION TO END-OF-CHAPTER EXERCISE (a) Cash flows from operating activities (i) Cash receipts from customers Accounts receivable 300 Cash 300 Allow. for d.d.         Clos. bal. 600  

400 20 180 600

Allowance for doubtful debts Accounts receivable 20 Op. bal. Clos. bal.   60 Expense   80  

40   40 80

Op. bal. Sales    

(ii) Cash payments for inventory

Op. bal. Accounts payable  

Cash Clos. bal.  

Inventory 260 Cost of goods sold 400 Clos. bal. 660   Accounts payable 400 Op. bal. 300 Inventory 700  

200 460 660

300 400 700

(iii) Expense provisions/accrued expenses Cash Clos. bal.  

Accrued wages 80 Op. bal. 100 Wages 180  

80 100 180 CHAPTER 19: THE STATEMENT OF CASH FLOWS  729

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Accrued employee entitlements (provision for annual leave) Cash 100 Op. bal. 60 Clos. bal.   40 Employee entitlements   80   140   140 Total cash flows from operating activities From customers Payments to employees (80 + 100) Payments to suppliers Interest received  

($000) 400 (180) (400)     20 (160)

(b) Cash flows from investing activities

Disposal Clos. bal.  

Accumulated depreciation 20 Opening bal. 180 Expense 200  

Property, plant and equipment Op. bal. 600 Disposal Revaluation reserve 100 Clos. bal. Cash 200     900  

100 100 200

120 780         900

To determine the original cost of the asset disposed of, we are told that the carrying amount of the property is $100 000. From the above t-account analysis, we have determined that the accumulated depreciation related to the disposed-of asset is $20 000. Therefore its original cost must have been $120 000. As the property has a carrying amount of $100 000 and as Crescent Ltd records a profit on sale of $40 000, it must have received $140 000 from the disposal. Total cash flows from investing activities From sale of plant Acquisition of plant  

$000 140 (200)   (60)

(c) Cash flows from financing activities In the absence of any information to the contrary, it must be assumed that the increase in share capital of $600 000 is received in cash. There are also additional borrowings of $300 000. Having considered the cash flows associated with the operating, investing and financing activities, we are in a position to compile the statement of cash flows. Crescent Ltd Statement of cash flows for the year ending 30 June 2020   Cash flows from operating activities Receipts from customers Payments to suppliers Payments to employees Interest received Net cash provided by operating activities (1) Cash flows from investing activities Proceeds from sale of plant

$000   400 (400) (180)     20       140

$000             (160)    

730  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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Acquisition of plant

(200)

 

Net cash from investing activities Cash flows from financing activities Proceeds from share issue Proceeds from borrowings Net cash from financing activities Net increase in cash held Cash at the beginning of the year (2) Cash at the end of the year

    600 300        

(60)       900 680 (200) 480

A number of supporting notes are required. Note 1. Reconciliation of net cash provided by operating activities and net profit   Operating profit after tax Add/(subtract): Depreciation expense Increase in receivables Profit on sale of property, plant and equipment Increase in inventories Decrease in annual leave provision Increase in accrued expenses Increase in allowance for doubtful debts Cash flows from operating activities

$000     100 120  (40) (200) (20) 20 20

$000 (160)                     0 (160)

Note 2. Reconciliation statement for cash as shown in statement of cash flows Cash at the end of the year as shown in the statement of cash flows is reconciled to the related items in the statement of financial position as follows:  

2020 ($000) 480    — 480

Cash per statement of financial position Bank overdraft per statement of financial position Cash at year end per statement of cash flows

2019 ($000) — (200) (200)

Note 3. Accounting policy note In the statement of cash flows, ‘cash’ includes cash at bank and bank overdraft. Note 4. Details of credit standby arrangements and used/unused loan facilities This is a required note. For Crescent Ltd there are no such facilities. Note 5. Details of non-cash financing and investing activities This is a required note. For Crescent Ltd there are no such transactions.

REVIEW QUESTIONS 1. Identify and describe the three types of activities that are reported in the statement of cash flows. Why do you think that AASB 107 would require such a breakdown? LO 19.1, 19.6 2. Classify the following cash flows into the respective classifications of operating, financing or investing activity: (a) dividends received CHAPTER 19: THE STATEMENT OF CASH FLOWS  731

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(b) dividends paid (c) interest paid (d) acquisition of plant and equipment (e) repayment of borrowings (f) borrowing costs (g) payments to suppliers (h) payments to employees (i) receipts from the issue of shares ( j) payments made to underwriters. LO 19.6 3. Define ‘cash and cash equivalents’ for the purposes of a statement of cash flows. LO 19.5 4. Pursuant to AASB 107, identify which of the following items would be considered to be a ‘cash equivalent’: (a) accounts receivable (b) accounts payable (c) gold bullion (d) deposits that are available at call (e) deposits on the money market that are available at two months’ notice (f) bank overdraft (g) a loan that is repayable in two months. LO 19.5 5. Is cash-flow data more ‘reliable’ than profit-related data? Explain your answer. LO 19.4 6. Which form of information is more useful for evaluating the financial performance and position of a reporting entity: cash-flow data or information about accounting profits? Explain your answer. LO 19.1, 19.4 7. Discuss the practical difficulties in preparing a statement of cash flows pursuant to AASB 107 and critically appraise its value to the statutory accounts. LO 19.1, 19.3 8. Identify the implications the following have for the preparation of a statement of cash flows and accompanying notes: (a) the sale of a non-current asset (b) an increase in a provision for long-service leave (c) the acquisition of land by way of an issue of shares. LO 19.3, 19.7 9. Pursuant to AASB 107, apart from the statement of cash flows, what other disclosures must be made? LO 19.7 10. Read the article ‘WA gold-miner attacks cash statements’ in Financial Accounting in the Real World 19.4 and answer the following: (a) What is Sons of Gwalia NL’s criticism of the statement of cash flows? (b) Do you think the criticism is justified? Why? (c) What is the definition of cash adopted in AASB 107? LO 19.2, 19.5 11. Fremantle Ltd provides you with the following information: Sales for the year Discounts provided during the year to customers for early payment Doubtful debts expense for the year Opening balance of accounts receivable Closing balance of accounts receivable Opening balance of the allowance for doubtful debts Closing balance of the allowance for doubtful debts

$400 000 $10 000 $5 000 $90 000 $80 000 $9 000 $8 000

REQUIRED Determine how much cash has been received from customers during the year. LO 19.3 12. Rottnest Ltd has provided you with the following information: Cost of goods sold for the year Purchases for the year (on credit terms) Discounts received for early payment to suppliers Stock write-offs owing to water damage caused by melting ice in the Antarctic

$60 000 $80 000 $2 000 $5 000

732  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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Opening balance of accounts payable Closing balance of accounts payable Opening balance of inventory Closing balance of inventory

$40 000 $35 000 $10 000 $25 000

REQUIRED Assuming that accounts payable relate only to the purchase of inventory, you are to determine the cash payments made to suppliers during the year. LO 19.3 13. Margaret River Ltd provides you with the following information about its property, plant and equipment: Opening balance of property, plant and equipment Closing balance of property, plant and equipment Depreciation expense for the year Opening balance of accumulated depreciation Closing balance of accumulated depreciation Gain on sale of property, plant and equipment Carrying value of property, plant and equipment that has been disposed of

$500 000 $650 000 $50 000 $200 000 $210 000 $20 000 $90 000

REQUIRED You are to determine how much cash has been received from the disposal of property, plant and equipment, and how much cash has been used to acquire property, plant and equipment throughout the year. LO 19.3 14. The balances in the accounts of XYZ at 30 June 2019 and 30 June 2020 are:   Sales (all on credit) Cost of goods sold Doubtful debts expense Interest expense Salaries Depreciation Cash Inventory Accounts receivable Allowance for doubtful debts Land Plant Accumulated depreciation Bank overdraft Accounts payable Accrued salaries Long-term loan Share capital Opening retained earnings

2020 ($000) 250 130 25 20 30 10 144 180 270 30 150 100 20 20 200 22 90 120 307

2019 ($000) 350 110 30 30 25 15 139 160 250 35 150 90 30 19 190 18 70 100 187

Other information Share capital is increased by the bonus issue of 20 000 shares for $1.00 each out of retained earnings. Plant is acquired during the period at a cost of $30 000, while plant with a carrying amount of $nil (cost of $20 000; accumulated depreciation of $20 000) is scrapped. CHAPTER 19: THE STATEMENT OF CASH FLOWS  733

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REQUIRED Prepare a statement of cash flows for XYZ Ltd for the year ending 30 June 2020. LO 19.3, 19.6, 19.7 15. Following are extracts from the accounting records of S Ltd at 30 June 2020: S Ltd Statement of financial position as at 30 June 2020   Current assets Cash Inventory Accounts receivable Allowance for doubtful debts   Non-current assets Land Buildings Accumulated depreciation—buildings Plant and equipment Accumulated depreciation—plant and equipment Deferred tax asset   Total assets

2020 ($000)   574 240 672    (96) 1 390   600 960 (144) 1 008 (96)      10 2 338 3 728

2019 ($000)   422 216 528    (72) 1 094   240 960 (96) 960 (96)    — 1 968 3 062

Current liabilities Accounts payable Accrued expenses Income tax payable   Non-current liabilities Long-term loans Deferred tax liability   Shareholders’ funds Share capital Retained earnings Revaluation surplus   Total liabilities and shareholders’ funds

  168 30    218    416      264     48    312   1 200 1 728      72 3 000 3 728

  192 24    182    398   240    —    240   960 1 464       — 2 424 3 062

S Ltd Statement of profit or loss and other comprehensive income for the year ending 30 June 2020   Income Sales Expenses Cost of sales Doubtful debts Depreciation – Buildings – Plant and equipment

2020 ($000)   2 124   576 96   48 168

2019 ($000)   1 680   480 72   48 144

734  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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Interest Lease rental Rates and electricity Salaries Income tax   Net profit Other comprehensive income: Asset revaluation recognised in revaluation surplus Total comprehensive income

26 168 90 480    208 1 860 264

24 96 48 384    182 1 478 202

72 336

 – 202

Additional information • During the year, land with a fair value of $240 000 is acquired through the issue of 240 000 fully paid shares. • There is an upward revaluation by $120 000 of land previously held. • There are no cash sales during the year. • Debtors of $72 000 previously provided for as doubtful were written off during the year. • The following expenses are paid as incurred: – electricity – rates – interest. • Accruals of lease rentals and salaries are made before payment. • Depreciation allowable for tax purposes for the year was: – Buildings: no allowable tax depreciation – Plant and equipment: $168 000 tax depreciation. • Plant costing $240 000 is sold during the year for $72 000. Accumulated depreciation at the time of sale is $168 000. • The accounts payable account is used for inventory purchases. • Assume a tax rate of 40 per cent.

REQUIRED Prepare a statement of cash flows for S Ltd for the year ending 30 June 2020, in accordance with AASB 107 (comparative figures are not required). LO 19.3, 19.5, 19.6, 19.7

CHALLENGING QUESTIONS 16. T Pty Ltd is a manufacturer of tennis equipment and fashion wear. The statement of financial position as at 30 June 2020 and details of expenses and revenues for the year ending 30 June 2020 are as follows: Statement of financial position as at 30 June 2020   Current assets Cash Inventory Prepayments Accounts receivable Allowance for doubtful debts Total current assets Non-current assets Investment—associated company Investments

2020 ($000)   135 2 774 115 2 897   (150) 5 771   1 050 1 216

2019 ($000)     274 2 486 0 2 654 (120) 5 294   0 948

CHAPTER 19: THE STATEMENT OF CASH FLOWS  735

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  Land Buildings Accumulated depreciation—buildings Plant and equipment Accumulated depreciation—plant and equipment Deferred tax asset Total non-current assets Total assets Current liabilities Accounts payable Accruals Lease liability Income tax payable Provision for employee entitlements Provision for deferred payment (relating to investment in Squash Pty Ltd) Provision for warranty Total current liabilities Non-current liabilities Lease liability Deferred tax liability Borrowings Total non-current liabilities Total liabilities Net assets Shareholders’ equity Share capital Retained earnings Revaluation surplus Total shareholders’ equity

2020 ($000) 1 500 800 (200) 1 025 (100)     312 5 603 11 374   1 637 1 575 5 243 205   50    314 4 029   15 240 3 500 3 755 7 784 3 590   2 750 280    560 3 590

2019 ($000)   1 750 800 (160) 768 (548) 302 3 860 9 154   1 483 1 110 0 83 298   0         0 2 974   0 75 3 800 3 875 6 849 2 305   2 000 130    175 2 305

Statement of profit or loss and other comprehensive income for the year ending 30 June 2020   Income Sales Dividends income Expenses Bad debts Cost of sales Doubtful debts Inventory write-off Warranty expenses (taken to provision for warranty) Depreciation – Building – Plant and equipment Interest

2020 ($000)   31 394        51   (90) (28 205) (35) (50) (314)   (40) (100) (315)

2019 ($000)     27 346        47   (85) (24 611) (40) 0 0   (40) (60) (418)

736  PART 5: ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS

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Rent Salaries and wages Finance charges Profit before tax Income tax Profit after tax Other comprehensive income Reduction in revaluation surplus as a result of reduction in fair value of land Increase in revaluation surplus as a result of increase in fair value of plant and equipment Total comprehensive income

(600) (1 324)        (7) 365  (215) 150

(600) (1 231)      (90) 218 (90) 128

(175)



  560   535

   – 128

Retained Revaluation earnings surplus ($000) ($000) 130 175 150 385

Total ($000) 2 305 535

Statement of changes in equity for the year ending 30 June 2020  

Opening balance 1 July 2019 Statement of profit and loss and other comprehensive income Issue of shares as part consideration for acquisition of associated company Balance 30 June 2020

Share capital ($000) 2 000 –

750 2 750

– 280

– 560

– 3 590

Additional information • An additional investment of $80 000 is acquired for consideration of tennis equipment costing $80 000. • Land is devalued against a previous increment in the revaluation reserve. The previous increment is fully reversed. • Plant and equipment with a cost of $700 000 and accumulated depreciation of $500 000 are revalued to $1 000 000 during the year. • Plant and equipment with a fair value of $25 000 are acquired under a finance lease. The residual is guaranteed by the lessee. • Plant and equipment are sold for $20 000 cash. Cost is $68 000 and no profit or loss is made on the sale. • During the year, one line of wooden tennis racquets is scrapped at a loss of $50 000, as there is little demand for this range. • During the year, an investment is made in an associated company, Squash Pty Ltd. Consideration is $1 000 000, funded by cash of $250 000 and the balance by the issue of 500 000 shares at $1.50 per share. The purchase agreement includes a clause stating that if profits exceed $110 000 in the first financial year after purchase, additional amounts are payable. Using the formula, an extra $50 000 is provided. • Provision for warranty is based on 1 per cent of sales. • Rent expense of $600 000 is accrued within ‘Accruals’. • Interest expense is paid during the year and dividends are received. • Salaries and wages expense includes the expense for employee entitlements. • The tax rate is 30 per cent.

REQUIRED Prepare the statement of cash flows in accordance with AASB 107 for the year ending 30 June 2020. Comparatives are not required. LO 19.3, 19.5, 19.6, 19.7

CHAPTER 19: THE STATEMENT OF CASH FLOWS  737

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17. Cabarita Ltd is involved in manufacturing swimming pool accessories. Cabarita Ltd’s statement of financial positions for the years ending 30 June 2019 and 30 June 2020 are presented below.   Assets Cash Accounts receivable Allowance for doubtful debts Property, plant and equipment Accumulated depreciation—property, plant and equipment Inventory Total assets Liabilities Bank overdraft Accounts payable Accrued wages Provision for annual leave Loans Total liabilities Net assets Represented by: Shareholders’ funds Share capital (ordinary shares) Revaluation surplus Retained earnings Total shareholders’ funds

2020 ($000)   96 36 (12) 156 (36)    92  332   – 60 20 8 60  148 184     140 28    16 184

2019 ($000)   – 60 (8) 120 (20)  52 204   40 60 16 12      – 128 76     20 8    48 76

The statement of profit or loss and other comprehensive income (extract) of Cabarita Ltd for the year ending 30 June 2020 is:   Income Sales Interest (no interest receivable at year end) Profit on sale of property (which had a carrying amount of $20 000) Expenses Cost of goods sold Doubtful debts Depreciation Wages Employee entitlements Loss for the year Other comprehensive income: Increase in revaluation surplus in recognition of increase in fair value of property, plant and equipment Total comprehensive income/(loss)

2020 ($000)   60 4 8   (40) (8) (20) (20) (16) (32) 20 (12)

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REQUIRED Prepare a statement of cash flows for Cabarita Ltd for the year ending 30 June 2020. Comparatives are not required. Ignore tax effects. LO 19.3, 19.5, 19.6, 19.7 18. Read the article adapted from Carol Altmann’s in Financial Accounting in the Real World 19.5, ‘Cooking the books the Harris Scarfe way’, and then answer the following questions: (a) What does ‘cook the books’ mean? (b) How would a reader of financial statements know if the books had been ‘cooked’? (c) Is it likely that creative accounting was employed in relation to the statement of cash flows? Why or why not? LO 19.1

19.5 FINANCIAL ACCOUNTING IN THE REAL WORLD Cooking the books the Harris Scarfe way Following the collapse of the Harris Scarfe retail empire in April 2001, Ferrier Hodgson, the receivers, launched an action in the Supreme Court in South Australia, presided over by Judge Bowen Pain, in an attempt to follow the trail of debt accumulation of the company. The company expanded from its Rundle Mall flagship to 31 stores across Australia, six of which are earmarked for closure as a result of the collapse in April. The chairman, Adam Trescowthick, and the managing director, Ron Baker are said to have ordered the former Harris Scarfe financial officer, Alan Hodgson (now unemployed), to provide them with the profit they ordered whether it bore any relationship to reality or not. Mr Hodgson told the court that if he were unable to adjust the profit in a ‘conventional sense’—by making legitimate corrections—he would direct the company’s systems accountant, Michael Johnson, to manipulate the gross profits. ‘I would simply sit down with Michael Johnson and say, “Mike, this is the result I am required to produce this year for whatever reasons” and he would put the adjustment over,’ he said. Under cross-examination by Dick Worthington QC, Mr Hodgson said the ‘unbusinesslike and unconventional’ adjustments started in 1997. ‘So this was profit through the manipulation of accounts,’ Mr Worthington said. ‘That is correct,’ Mr Hodgson replied.   The court was told that for the financial half-year ended January 1999, the company overstated its profits by $1.62 million to $6 million, including $605 000 from adjustments to gross profits across its stores and $1 million worth of adjustments to its general ledger. It appeared from Hodgson’s testimony that the manipulation of accounts was a long-standing practice at Harris Scarfe—Hodgson said it was happening back in 1997. Hodgson said that Trescowthick and Baker would have been well aware of the falsification of the accounts. The two were also due to give evidence in the case. There had been no decision announced by the Australian Securities & Investments Commission (ASIC) as to laying charges against Harris Scarfe officers for breaches of the Corporations Law. SOURCE: Adapted from ‘I was told to cook books, says Harris Scarfe man’, by Carol Altmann, The Australian, 7 August 2001, p. 1

19. Financial Accounting in the Real World 19.2, which was provided earlier in this chapter, provided an extract from an article that appeared in The Australian Financial Review on 30 June 2015. Within the extract it is stated: ‘It’s highly unusual to see an accidental mis-statement in the cash receipts from customers that coincidentally is the same number as the mis-statement in the cash payments’, Tynan told the Financial Review. It is also stated: ‘If “receipts from customers” is inflated, we believe that cash “payments to suppliers and employees” would also need to be inflated for the cashflow statement to reconcile with the other financial statements,‘ the presentation said.

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REQUIRED: In terms of the first quote above, why would it be ‘highly unusual to see an accidental mis-statement in the cash receipts from customers that coincidentally is the same number as the mis-statement in the cash payments’? Also, in terms of the second quote, explain why two amounts would need to be ‘inflated’. LO 19.2, 19.3

REFERENCES CLINCH, G., SIDHU, B., & SIN, S., 2002, ‘The Usefulness of Direct and Indirect Cash Flow Disclosures’, Review of Accounting Studies, vol 7, pp. 383–404. FADEL, H. & PARKINSON, J.M., 1978, ‘Liquidity Evaluation by Means of Ratio Analysis’, Accounting and Business Research, Spring, pp. 101–7. FLANAGAN, J. & WHITTRED, G., 1992, ‘Hooker Corporation: A Case for Cash Flow Reporting’, Australian Accounting Review, May, pp. 48–52. FRANCIS, R., 2010, ‘The Relative Information Content of Operating and Financing Cash Flow in the Proposed Cash Flow Statement’, Accounting & Finance, vol. 50, pp. 829–51. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2008,  Discussion Paper: Preliminary Views on Financial Statement Presentation, IASB, London, October. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010, Staff Draft of Exposure Draft IFRS X, Financial Statement Presentation, IASB, London, July. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2014, Exposure Draft ED/2014/6: Disclosure Initiative: Proposed Amendments to IAS 7, IASB, London, December. LAWSON, G.H., 1985, ‘The Measurement of Corporate Performance on a Cash Flow Basis: A Reply to Mr Eglinton’, Accounting and Business Research, Spring, pp. 85–104. LEE, T.A., 1981, ‘Reporting Cash Flows and Net Realisable Values’, Accounting and Business Research, Spring, pp. 163–70. ORPURT, S. & ZANG, Y., 2009, ‘Do Direct Cash Flow Disclosures Help Predict Future Operating Cash Flows and Earnings?’, The Accounting Review, vol. 84, no. 3, pp. 893–935. SHARMA, D., 1996, ‘Analysing the Statement of Cash Flows’, Australian Accounting Review, vol. 6, no. 2, pp. 37–44. TWEEDIE, D. & WHITTINGTON, G., 1990, ‘Financial Reporting: Current Problems and their Implications for Systematic Reform’, Accounting and Business Research, Winter, pp. 87–102. WALKER, R.G., 1987, ‘Cash Flows Tell the Story’, Australian Business, vol. 8, no. 8, p. 106.

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PART 6

INDUSTRY-SPECIFIC ACCOUNTING ISSUES CHAPTER 20 Accounting for the extractive industries

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CHAPTER 20

ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES LEARNING OBJECTIVES (LO) 20.1 Understand what constitutes the ‘extractive industries’. 20.2 Explain the various phases of operations of entities involved in the extractive industries. 20.3 Understand that the extractive industries pose some unique accounting issues, particularly how to account for the costs incurred in the pre-production phases of operations. 20.4 Understand how to account for exploration and evaluation expenditures according to the ‘area-ofinterest method’ as prescribed by AASB 6 Exploration for and Evaluation of Mineral Resources. 20.5 Understand the tests that must be met before expenditure incurred in the pre-production phases can be carried forward to subsequent periods. 20.6 Understand that if a decision is made to abandon an area of interest, all costs associated with that area must be immediately written off. 20.7 Be able to provide the journal entries necessary to amortise expenditure carried forward by an entity in the extractive industries. 20.8 Understand how and when to account for any restoration costs that might be incurred as a result of an entity’s operations. 20.9 Understand issues associated with the recognition of revenue in the extractive industries. 20.10 Understand how to value inventory within the extractive industries. 20.11 Be aware of the disclosure requirements of AASB 6. 20.12 Be aware of some prior research explaining why entities elected to adopt particular methods to account for exploration and evaluation expenditures. 20.13 Appreciate that entities in the extractive industries will often also make non-financial disclosures in relation to such matters as their environmental performance. 20.14 Be aware of current activities being undertaken to develop a new accounting standard for the extractive industries.

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Overview of accounting for exploration and evaluation expenditures under AASB 6

LO 20.1 LO 20.2 LO 20.3

Until 2005, the relevant accounting standard in Australia for companies operating in the extractive industries was AASB  1022 Accounting for the Extractive Industries. This standard provided relatively comprehensive accounting rules for the various phases of operations of entities involved in the exploration and extraction of mineral resources. AASB 1022 divided extractive industry operations into five separate phases, although in practice it was accepted that more than one phase could occur at the same time in the same area of interest. According to AASB 1022, these phases were: 1. Exploration—the search for a mineral deposit or an oil or natural gas field that appears capable of commercial exploitation by an extractive operation and includes topographical, geological, geochemical and geophysical studies and exploratory drilling. 2. Evaluation—the determination of the technical feasibility and commercial viability of a particular prospect including: • determining the volume and grade of the deposit or field • examining and testing extraction methods and metallurgical or treatment processes • surveys of transportation and infrastructure requirements • market and finance studies. 3. Development—the establishment of access to the deposit or field and other activities involved in establishing access for commercial production, including: • shafts • underground drives and permanent excavations • roads and tunnels • advance removal of overburden and waste rock • drilling of oil or natural gas wells. 4. Construction—the establishment and commissioning of facilities including: • infrastructure •  buildings, machinery and equipment for the extraction, treatment and transportation of product from the deposit or field. 5. Production—the day-to-day activities aimed at obtaining saleable product from the deposit or field on a commercial scale, including extraction and any processing prior to sale.

It has been common for the first four phases identified above to be referred to as the ‘pre-production phase’. In contrast with the broad scope of the former Australian accounting standard (AASB 1022), its replacement, AASB 6 Exploration for and Evaluation of Mineral Resources—dedicated as it is to the extractive industries—restricts its guidance to the initial two phases just identified, these being the exploration and evaluation phases. For rules relating to the other phases of operations, reference must currently be had to other accounting standards (such as AASB 102 Inventories, AASB 116 Property, Plant and Equipment, AASB 136 Impairment of Assets, AASB 137 Provisions, Contingent Liabilities and Contingent Assets and AASB 138 Intangible Assets). Unlike AASB 1022, AASB 6 does not provide separate definitions of ‘exploration’ and ‘evaluation’. Rather it provides a joint definition of ‘exploration for and evaluation of mineral resources’, this being: The search for mineral resources, including minerals, oil, natural gas and similar non-regenerative resources after the entity has obtained legal rights to explore in a specific area, as well as the determination of the technical feasibility and commercial viability of extracting the mineral resource. Again, we should emphasise that AASB 6 restricts its attention to accounting for exploration and evaluation expenditures and provides no guidance on the other three phases of operations as previously identified in AASB 1022. Instead, the rules embodied in other existing accounting standards are to be applied to account for the remaining phases (for example, AASB 102 Inventories is applied when mineral reserves have been extracted and are available for sale, with the usual requirements to measure inventory at the lower of cost and net realisable value). Table 20.1 identifies some of the other Australian Accounting Standards that may need to be applied in accounting for the various activities or phases associated with the extractive industries.

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Table 20.1 Some of the phases of activities in the extractive industries together with details of the respective acccounting standard

Phase of operation/transaction or event Relevant standards Activities that precede exploration for and evaluation of mineral resources

Conceptual Framework for Financial Reporting AASB 116 Property, Plant and Equipment AASB 138 Intangible Assets

Development and construction costs

AASB 116 Property, Plant and Equipment AASB 138 Intangible Assets

Amortisation of capitalised costs

AASB 116 Property, Plant and Equipment

Inventories

AASB 102 Inventories

Revenue recognition

AASB 15 Revenue from Contracts with Customers

Restoration costs

AASB 137 Provisions, Contingent Liabilities and Contingent Assets AASB 116 Property, Plant and Equipment

In terms of the scope of AASB 6, paragraphs 4 and 5 of AASB 6 state: 4. The standard does not address other aspects of accounting by entities engaged in the exploration and evaluation of mineral resources. 5. An entity shall not apply this Standard to expenditures incurred: (a) before the exploration for and evaluation of mineral resources, such as expenditures incurred before the entity has obtained the legal rights to explore a specific area; and (b) after the technical feasibility and commercial viability of extracting a mineral resource are demonstrable. AASB 6 was released as an interim standard while a broader project was undertaken with the intention of developing a new accounting standard. Although the project did start, and a Discussion Paper relating to the extractive industries was released in 2010, a review of the IASB website in early 2016 indicates that the project has been put on hold and no specific reactivation date has been nominated. Specifically, the website states: ‘The IASB is not currently working on this project.’ Hence, a new standard is not expected to be released for a number of years. Later in this chapter we will provide insights into some of the research that is being undertaken as part of the process of developing a new accounting standard.

LO 20.1

Extractive industries defined

Firms in the extractive industries engage in the search for natural substances of commercial value, such as minerals, oil and natural gas, and the extraction of these substances from the ground. Searching for these deposits generally involves considerable expenditure on geological and other studies or exploratory drilling to determine whether areas are suitable for commercial development. Although in many extractive industries cases exploration is unsuccessful and does not lead to future economic benefits, when an area Firms in the extractive is considered a commercially viable proposition, further expenditures are usually required before industries engage in production is possible. the search for and extraction from the The period between the initial exploration of an area and production might be lengthy and ground of natural a change in demand for the product during this period can result in the operation becoming substances of uneconomical or less profitable than originally expected. Determining whether an asset has commercial value. been acquired through the expenditures associated with exploration, evaluation and subsequent development can be very difficult. However, in order to determine profit or loss for accounting purposes, as well as the assets of the organisation, decisions must economically be made about whether such expenditures result in an asset or an recoverable reserves area of interest Estimated quantity Individual geological expense. of product in an area considered or Economically recoverable reserves are the ultimate source of area expected to be proved to constitute revenue for firms in the extractive industries. Economically recoverable profitably extracted, a favourable reserves are defined in Appendix A of AASB 6 as: processed and environment for the sold in current and foreseeable economic conditions.

presence of a mineral deposit or an oil or natural gas field.

The estimated quantity of product in an area of interest that can be expected to be profitably extracted, processed and sold under current and foreseeable economic conditions.

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Costs in the exploration phase are incurred to discover such reserves, while costs in the evaluation phase are incurred to prove the reserves. Costs during the development and construction phases (covered by accounting standards other than AASB 6) are incurred to prepare the areas of interest for effective exploitation of the reserves. As with inventory generally, each unit of product sold by organisations in the extractive industries should bear its proportionate share of costs incurred in producing the inventory. In the case of firms operating in an extractive industry, exploration, evaluation, development and construction costs should—subject to impairment testing—be carried forward and amortised or depreciated during the production phase. On the other hand, if these expenditures are not considered likely to lead to a successful project, the costs should be written off as an expense as soon as it is known that the area of interest is not economically viable. Although the approach of dividing the operations of the firm into the five phases described in the previous section is fairly arbitrary, it nevertheless provides some useful foundations for cost-carry-forward decisions. The costs incurred in the early phases of extractive operations in a particular area (exploration and evaluation) are least likely to lead to benefits, compared with costs incurred in the later stages (construction and development). Hence there would seem to be greater scope for the exercise of judgement in regard to exploration and evaluation expenditure. AASB 6 is principally concerned with whether exploration and evaluation expenditures should be carried forward as assets, or whether they should be expensed.

Alternative methods to account for preproduction costs

LO 20.3 LO 20.4

In the absence of an accounting standard such as AASB 6 (or its predecessor AASB 1022), which restricts the portfolio of available accounting alternatives, there would potentially be at least five alternative methods of accounting for exploration and evaluation expenditures incurred in the extractive industries. These may be labelled the costs-written-off method; costs-written-off-and-reinstated method; successful-efforts method; full-cost method; and area-of-interest method. AASB 6 requires, as did AASB 1022, the use of the area-of-interest method for exploration and evaluation expenditures. However, for the sake of completeness we set out the five different methods in what follows.

Costs-written-off method Under the costs-written-off method, all exploration and evaluation costs are written off as incurred. costs-written-off As there is a low probability of success from exploration and evaluation activities, advocates of this method approach would argue that these costs should not be carried forward as an asset. This argument Method whereby would seem to be consistent with the asset recognition criteria provided in the Conceptual all exploration and Framework for Financial Reporting, which would require that assets be recognised only when future evaluation costs are written off as incurred. economic benefits are deemed to be ‘probable’. No reinstatement of assets is permitted under this approach, even if economically recoverable reserves are subsequently found. The prohibition on the restatement of assets—even if additional information becomes available that indicates that future economic benefits are probable—would not be consistent with the conceptual framework. According to the conceptual framework: An item that, at a particular point in time, fails to meet the recognition criteria in paragraph 4.38, may qualify for recognition at a later date as a result of subsequent circumstances or events. The related asset is the recoverable reserves, not the sunk costs incurred in discovering them. Critics of this approach argue that this method fails to match costs with the benefit that flows from them. It is also argued costs-written-off-andthat this method is overly conservative.

Costs-written-off-and-reinstated method The costs-written-off-and-reinstated method is basically the same as the costs-written-off method, except that exploration and evaluation costs written off may be reinstated and carried forward as an asset where economically recoverable reserves are subsequently confirmed. It has the effect of reversing the expenses recognised in previous periods. Although this method is not permitted in Australia, its use is consistent with the guidance provided by the conceptual framework. That is, once the economic benefits are assessed as ‘probable’ and ‘measurable’,

reinstated method Method whereby all pre-production costs are written off initially but are reinstated and carried forward as an asset if economically recoverable reserves are confirmed.

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the conceptual framework suggests that an asset, and associated revenue, may be recognised, even if the related expenditure has previously been written off. The asset would qualify for recognition even though this might involve amounts that had previously been recognised as expenses of the entity. Because the conceptual framework suggests that only expenditure in respect of which the generation of economic benefits is deemed ‘probable’ should be carried forward as an asset, strict application of the asset definition and recognition criteria provided in the conceptual framework would greatly reduce the asset balances of many organisations involved in the exploration and evaluation of economically recoverable reserves. While the conceptual framework requires that it must be ‘probable’ that the expenditure will lead to future economic benefits, AASB 6, paragraph Aus7.2, does allow exploration and evaluation expenditure to be carried forward prior to the discovery of economically recoverable reserves provided ‘active and significant operations’ in the area are continuing (and remember, accounting standards take precedence over the conceptual framework). Given the low probability of success in exploration and evaluation activities, the requirements of the conceptual framework would lead to greater initial write-offs of exploration and evaluation expenditure than would the requirements of AASB 6. Hence firms in the extractive industries would be unlikely to view the requirements of the conceptual framework favourably.

Successful-efforts method successful-efforts method Method of accounting used in the extractive industries under which only costs resulting directly in the discovery of economically recoverable reserves are carried forward, all others being written off as incurred.

full-cost method In relation to the extractive industries, this method of accounting requires all exploration and evaluation costs incurred by an entity to be matched against revenue from the total economically recoverable reserves discovered by the entity across all sites.

area-of-interest method Method whereby preproduction costs for each area of interest are written off as incurred, but they may (not must) be carried forward provided tenure rights are current and one of two other conditions is met.

Under the successful-efforts method, only exploration and evaluation costs resulting directly in the discovery of economically recoverable reserves are carried forward, all other costs being written off as incurred. However, this method does allow pre-production expenditures to be carried forward if the area has not been abandoned or economically recoverable reserves have been found, as long as activities are ongoing. Because this method does allow expenditures to be capitalised as assets even before the existence of economically recoverable reserves has been established, it constitutes an approach that is inconsistent with the conceptual framework, which would allow an asset to be recognised only to the extent that it is determined at the end of the reporting period that future economic benefits are probable. Through amortisation, the costs carried forward as assets will be matched against the income of the periods that benefit from those costs. However, given the low probability of success, it can be argued that the total costs of exploration and evaluation should be matched against income arising from any successful projects—and the successful-efforts method does not achieve this purpose.

Full-cost method The full-cost method matches all exploration and evaluation costs incurred by an entity, whenever and wherever incurred, against income from the total economically recoverable reserves discovered by the entity across all sites. In effect, all exploration and evaluation costs may be carried forward in one pool as an asset and amortised against production revenue. The costs carried forward should not exceed the expected net realisable value of all economically recoverable reserves. In the early stages of a project, however, there might be no assurance that economically recoverable reserves exist or will be found. Further, this method might result in matching past costs against future revenues, and current period costs against revenue from previously discovered reserves in an entirely different area. Some people argue that this is an incorrect matching of costs and revenues. Although not permitted within Australia, this method is used in a number of countries including the United States, Canada and the United Kingdom. Reporting entities within Australia are not permitted to use the full-cost method due to specific paragraphs (with the prefix ‘Aus’) being inserted within the standard by the AASB. By contrast, for reporting entities outside of Australia, there are limited restrictions on how pre-production costs are to be accounted for—an interesting issue we will return to later in this chapter.

Area-of-interest method It is the area-of-interest method that is used in Australia by virtue of AASB 6. It is very similar to the successful-efforts method described above. An area of interest is an individual geological area that is considered to constitute a favourable environment where there might be a mineral deposit or an oil or natural gas field or that has been proved to contain such a deposit or field (Appendix A of AASB 6). In most cases, the area of interest will comprise a single mine or deposit, or a separate

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oil or gas field. Nevertheless, Accounting Standard AASB 6 does allow for some degree of management discretion in delimiting an area of interest. During exploration, and to some degree during evaluation, an area might be difficult to delimit. AASB 6 requires that each area of interest be considered separately when deciding to what extent costs arising from exploration and evaluation expenditures are to be carried forward (deferred) or written off. With the area-of-interest method, which is applied to accounting for exploration and evaluation expenditures pursuant to AASB 6, the pre-production costs comprising exploration and evaluation expenditures for each area of interest are to be written off as incurred. However, they may—rather than must—be carried forward (capitalised), provided that rights of tenure of the area of interest are current and provided at least one of two conditions is met. Specifically, paragraphs Aus7.1 and Aus7.2 of AASB 6 state (and again, please note these requirements have been inserted by the AASB—as evidenced by the prefix ‘Aus’—and do not appear within IFRS 6, thereby meaning that organisations governed by IFRS 6 have very little restriction on how they account for their pre-production costs): Aus7.1 An entity’s 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. Aus7.2 An 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 end of the reporting period 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. The notion of allowing an organisation to carry forward pre-production costs on the basis that ‘activities in the area of interest have not at the end of the reporting period reached a stage which permits a reasonable assessment of the existence or otherwise of economically recoverable reserves’ is interesting. As we have noted, the conceptual framework’s recognition criteria for assets require that it be ‘probable’ at the end of the reporting period that the future economic benefits embodied in an asset will eventuate. It could perhaps be argued—and this would support the rule in AASB 6—that as the work is ongoing, management must consider it probable that future benefits will eventuate. Because AASB 6 requires exploration and evaluation costs to be either expensed or partially or fully capitalised (subject to the tests in paragraph Aus7.2), the standard effectively provides management with a choice between the costs-written-off method and the area-of-interest method. Because ‘area of interest’ is fairly loosely defined in AASB 6, this further provides management with some latitude in determining whether to carry forward expenditure or to write it off. As Gerhardy (1999, p. 55) states: the area of interest is so broadly defined in geological terms that a wide variety of possible cost centres may be adopted . . . It may therefore be argued that the available treatments of pre-production costs in the Australian extractive industries is much broader than simply a choice between two methods (costs written off method, and the area of interest method). Consistent with the treatment of pre-production costs comprising exploration and evaluation expenditures, the costs arising from other pre-production activities (such as those incurred in the development and construction phases) should be carried forward to the extent that these costs, together with costs arising from exploration and evaluation carried forward in respect of an area of interest, are expected to be recouped through successful exploitation of the area of interest, or by its sale. This is consistent with the general requirements to undertake impairment testing, as prescribed by AASB 136 Impairment of Assets (and as discussed within Chapter 6). Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  747

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The fact that firms have the option of writing off all, or part of, their exploration and evaluation expenditures, even when the deferral conditions are satisfied, can make inter-firm comparisons difficult. It is also possible for management to elect opportunistically to write off pre-production expenditure in periods in which it believes it would be preferable to show reduced profits. Such a desire might arise if the firm is the focus of complaints about excess profits or where it is seeking government funding that might not be forthcoming if the firm is seen to be generating high levels of profit. Allowing firms to choose between expensing or capitalising exploration and evaluation costs will also make comparisons between different organisations difficult if some managers elect to expense all such costs, while other managers elect to capitalise such costs. It should also be noted that while paragraph 8 of AASB 6 requires that exploration and evaluation assets shall be measured at cost at recognition, paragraph 12 requires that after recognition, an entity shall apply either the cost model or the revaluation model to the exploration and evaluation assets. Again, this choice will make it difficult to compare the performance and financial position of different organisations that adopt different accounting policies. Although we have discussed exploration and evaluation expenditures (the expenditures that are addressed by AASB  6) in general terms, a more detailed description of the types of expenditures that would be deemed to be ‘exploration and evaluation expenditures’ would be useful. Paragraph 9 of AASB 6 identifies the types of expenditures that would be deemed to be part of exploration and evaluation. It states: An entity shall determine a policy specifying which expenditures are recognised as exploration and evaluation assets and apply the policy consistently. In making this determination, an entity considers the degree to which the expenditure can be associated with finding specific mineral resources. The following are examples of expenditures that might be included in the initial measurement of exploration and evaluation assets (the list is not exhaustive): (a) acquisition of rights to explore; (b) topographical, geological, geochemical and geophysical studies; (c) exploratory drilling; (d) trenching; (e) sampling; and (f) activities in relation to evaluating the technical feasibility and commercial viability of extracting a mineral resource.

LO 20.6

Abandoning an area of interest

For any area of interest, the exploration, evaluation, development and construction costs are carried forward so long as there is a reasonable probability of success in that area. If the search is unsuccessful or evaluation produces a negative result, a decision might be made to abandon the area. Where an area of interest is abandoned, costs carried forward relating to that area should be expensed in the period in which the decision to abandon is made. That is, impairment losses will need to be recognised. Note that a temporary interruption of operations because of seasonal or climatic factors, or through governmental intervention, is not necessarily considered an abandonment of the area. If some expenditures incurred in relation to an area of interest have alternative uses—for example, machinery has been constructed which can be dismantled and used on other sites—such expenditure would not be expensed when an area is abandoned as, consistent with AASB 116 Property, Plant and Equipment, the useful life of the asset would not be tied to the life of the area of interest.

LO 20.4 LO 20.5

Accumulation of costs pertaining to exploration and evaluation activities

AASB 6 requires that costs, both direct and indirect, arising from exploration and evaluation activities and relating specifically to an area of interest should be allocated to that area of interest. General and administrative costs must relate directly to operations in an area before they may be capitalised. In all other cases, they should be written off as expenses as they are incurred. In this regard, AASB 6 states that general and administrative costs related only indirectly to operational activities should be treated as expenses of the financial period in which they are incurred. These costs include directors’ fees, secretarial and share registry expenses, and salaries and other expenses of general management—none of which should be assigned to areas of interest. According to paragraph Aus9.4 of AASB 6: 748  PART 6: INDUSTRY-SPECIFIC ACCOUNTING ISSUES

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General and administrative costs are allocated to, and included in, the cost of an exploration and evaluation asset, but only to the extent that those costs can be related directly to operational activities in the area of interest to which the exploration and evaluation asset relates. In all other cases, these costs are expensed as incurred. For example, general and administrative costs such as directors’ fees, secretarial and share registry expenses, and salaries and other expenses of general management are recognised as expenses when incurred since they are only indirectly related to operational activities. As operations progress, it is common for the area of interest to contract in size with the identification of a mineral deposit or an oil or natural gas field containing economically recoverable reserves. Costs continue to be accumulated in respect of an area of interest even though its size might contract as operations progress through to production. Where this leads to two or more distinct operations, pre-production costs to date should be apportioned equitably between such operations and future costs accounted for separately (see paragraph Aus7.3 of AASB 6).

Basis for measurement of exploration and evaluation expenditures

LO 20.4 LO 20.5

AASB 6 provides the basis for measurement of the costs incurred in exploration and evaluation activities. Initially, such expenditures must be measured at cost. Specifically, and as indicated previously in this chapter, paragraph 8 of AASB 6 stipulates that ‘Exploration and evaluation assets shall be measured at cost’. However, once exploration and evaluation expenditure has been recognised initially at cost, an entity may subsequently choose to use either the ‘cost model’ or the ‘revaluation model’ to account for exploration and evaluation assets (paragraph 12 of AASB 6). Such models can be applied to tangible and intangible assets, as we have explained in Chapters 6 and 8 of this text. As we know from Chapter 8, if the exploration and evaluation assets are intangible assets, AASB 138 Intangible Assets requires the existence of an ‘active market’ for those intangible assets if they are to be revalued. Consistent with AASB 138, an ‘active market’ exists when: • the items traded in the market are homogeneous • willing buyers and sellers can normally be found at any time • prices are available to the public. ‘Active markets’ often do not exist for intangible assets, thereby restricting the ability of entities to revalue their intangible assets. AASB 138 moreover requires that once an intangible asset has been expensed it may not subsequently be revalued. In relation to the classification of exploration and evaluation assets for presentation purposes, paragraphs 15 and 16 of AASB 6 state: 15. An entity shall classify exploration and evaluation assets as tangible or intangible according to the nature of the assets acquired and apply the classification consistently. 16. Some exploration and evaluation assets are treated as intangible (e.g. drilling rights), whereas others are tangible (e.g. vehicles and drilling rigs). To the extent that a tangible asset is consumed in developing an intangible asset, the amount reflecting that consumption is part of the cost of the intangible asset. However, using a tangible asset to develop an intangible asset does not change a tangible asset into an intangible asset. Where an entity has decided to develop a project beyond the exploration and evaluation phase, subsequent expenditures will not be covered by AASB 6 since AASB 6 confines its focus to exploration and evaluation expenditures. Further, all exploration and evaluation expenditures incurred prior to the decision to develop the site will not subsequently be covered by AASB 6, but will be reclassified as part of project costs that are subject to either AASB 116 Property, Plant and Equipment or AASB 138 Intangible Assets and will be subject to impairment testing as required. As paragraph 17 of AASB 6 states: An exploration and evaluation asset shall no longer be classified as such when the technical feasibility and commercial viability of extracting a mineral resource are demonstrable. Exploration and evaluation assets shall be assessed for impairment, and any impairment loss recognised, before reclassification. Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  749

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When moving from the exploration and evaluation phase to subsequent phases of operations, the reclassified costs are labelled ‘assets under construction’ or something similar. When subsequent development phases are complete and production commences, the development expenditure (which would also typically be classified ‘assets under construction’), together with previous exploration and evaluation expenditures, is reclassified either as property, plant and equipment or as an intangible asset titled ‘mineral assets’ (or something similar).

LO 20.7

Impairment and amortisation of costs carried forward

Where direct and indirect costs for exploration, evaluation and development of a specific area of interest are carried forward, there is a general requirement for them to be amortised against income earned during the production phase. During the exploration and evaluation phase there is typically no income against which capitalised costs can be amortised. Nevertheless, the carried-forward expenditure is required to be subject to regular impairment testing. 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. Because the capitalised exploration and evaluation expenditure has not generated an asset that is currently available for use, it would not be depreciated but, as indicated above, it would need to be tested for impairment. It is not necessarily an easy exercise to determine the existence of impairment losses. Paragraph 20 of AASB 6 provides some guidance: One or more of the following facts and circumstances indicate that an entity should test exploration and evaluation assets for impairment (the list is not exhaustive): (a) the period for which the entity has the right to explore in the specific area has expired during the period or will expire in the near future, and is not expected to be renewed; (b) substantive expenditure on further exploration for and evaluation of mineral resources in the specific area is neither budgeted nor planned; (c) exploration for and evaluation of mineral resources in the specific area have not led to the discovery of commercially viable quantities of mineral resources and the entity has decided to discontinue such activities in the specific area; (d) sufficient data exist to indicate that, although a development in the specific area is likely to proceed, the carrying amount of the exploration and evaluation asset is unlikely to be recovered in full from successful development or by sale. In any such case, or similar cases, the entity shall perform an impairment test in accordance with AASB 136. Any impairment loss is recognised as an expense in accordance with AASB 136. We can refer to AASB 136 Impairment of Assets for further general guidance on determining the existence of impairment losses. Paragraph 12 of AASB 136 identifies seven standard factors that can be considered: In assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications: External sources of information (a) there are observable indications that the asset’s value has declined during the period significantly more than would be expected as a result of the passage of time or normal use; (b) significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated; (c) market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset’s value in use and decrease the asset’s recoverable amount materially; (d) the carrying amount of the net assets of the entity is more than its market capitalisation. 750  PART 6: INDUSTRY-SPECIFIC ACCOUNTING ISSUES

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Internal sources of information (e) evidence is available of obsolescence or physical damage of an asset; (f) significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset belongs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite; and (g) evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected. Hence, and perhaps somewhat obviously, a drop in commodity prices could lead to impairment losses being recognised in some entities, whereas such losses would be less likely to be recognised in times of booming resource prices. In relation to total costs carried forward to the production phase, the costs should generally be allocated over the life of the economically recoverable reserve in terms of production output or, in some cases, in terms of a time period such as a fixed period tenure of the area of interest. Time would be appropriate as the basis of amortisation in cases such as when there is considered to be an abundance of reserves and the major limiting factor is the length of the mining right. The production-output and time methods can be represented, respectively, as: • amortisation based on production output = costs carried forward × (period output ÷ estimate of total available output) • amortisation based on the expiration of time = costs carried forward × (duration of accounting period ÷ estimated life of area) As indicated previously, tangible assets carried forward are subsequently to be accounted for in accordance with the requirements of AASB 116 Property, Plant and Equipment. Consistent with AASB 116, the costs of facilities established, if they are depreciable assets, should be depreciated over the useful life of the area of interest for which they were acquired. The exception to this is where the assets can be transferred to some other area of interest or can be of some further use not necessarily connected with any particular area of interest. Assets that are portable, such as demountable buildings, should be depreciated over their own specific useful lives—which might be different from the life of the area of interest. Amortisation based on production output for costs carried forward is usually the appropriate amortisation method. As indicated above, under this method, amortisation is determined by apportioning costs carried forward in the ratio of the production output for the financial period to the total of this output available. For example, assume that for a particular entity the total carried-forward costs are $100 million and the estimated quantity of reserves is four million tonnes. If 250 000 tonnes are extracted in a particular period, the costs that would be assigned to extracted inventory (and ultimately to cost of goods sold) would be: $100 000 000 × (250 000 ÷ 4 000 000) = $6 250 000 Amortisation based on the expiration of time is relevant where production is limited by time, for example, where the area is under a fixed period of tenure. Assume that a particular entity has found a site that is estimated to hold 100 million barrels of oil and that $250 million in carried-forward costs have been incurred in exploring, evaluating and developing the area. However, the organisation has only a five-year lease and the maximum amount that it can extract per year is 10 million barrels. In such a case it would be common practice to amortise the carried-forward costs on a straight-line basis: for a full year, $50 million (which equals $250 million ÷ 5) would be transferred to the costs of inventory. The tangible and intangible assets carried forward will need to be accounted for separately. As indicated above, the amortisation charges are part of the cost of production, and as such they should ultimately form part of the cost of inventory. The basis of amortisation adopted should be applied consistently from year to year and the rate of amortisation should not lag behind the rate of depletion of reserves. Estimates of recoverable reserves should be reassessed annually, given the possibility of changes in recovery rate, production efficiencies and market conditions. Factors to be considered would include: • security of tenure of the area of interest • the possibility that technological developments or discoveries might make the product obsolete or uneconomical at some future time Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  751

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• changes in technology, market or economic conditions affecting either sales prices or production costs, with a consequent impact on cut-off grades • likely future changes in factors such as recovery rate, dilution rate and production efficiencies during extraction, processing and transportation of products.

LO 20.8

Restoration costs

It is frequently a condition of a permit to engage in extractive operations that the area covered by the permit be restored after the cessation of operations. In any case, it might be the policy of the company involved in the operations to carry out such restoration even if there is no legal obligation to do so. By undertaking restoration work on a voluntary basis, the entity might promote a more positive image of itself or its industry to the community. This might increase its market acceptance and, perhaps relatedly, its profitability. Where there is an expectation that an area of interest will be restored, restoration costs incurred, or to be incurred, should be related to each specific phase of the operation and should be provided for at the time of such activities. The provision carried forward should be reassessed annually in the light of expected future costs. Restoration work in the exploration and evaluation phases is regarded as part of the cost of those phases of operations and may be carried forward. Restoration work during the production phase is typically treated as a cost of production. Guidance on restoration provisions is not provided in AASB 6. Rather, reference needs to be made to AASB 137 Provisions, Contingent Liabilities and Contingent Assets. As 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. As we learned in Chapter 10, 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 the discussion in this chapter. The illustration relates to an offshore oilfield and it is reproduced in Exhibit 20.1.

Exhibit 20.1 Illustration of a provision for restoration as provided in AASB 137

Example: Offshore oilfield An entity operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of production and restore the seabed. Ninety per cent of the eventual costs relate to the removal of the oil rig and restoration of damage caused by building it, and 10 per cent arise through the extraction of oil. At the end of the reporting period, the rig has been constructed but no oil has been extracted. Present obligation as a result of a past obligating event The construction of the oil rig creates a legal obligation under the terms of the licence to remove the rig and restore the seabed and is thus an obligating event. At the end of the reporting period, however, there is no obligation to rectify the damage that will be caused by extraction of the oil. An outflow of resources embodying economic benefits in settlement Probable. Conclusion A provision is recognised for the best estimate of 90 per cent of the eventual costs that relate to the removal of the oil rig and restoration of damage caused by building it. These costs are included as part of the cost of the oil rig (with a corresponding increase in a provision). The 10 per cent of costs that arise through the extraction of oil are recognised as a liability when the oil is extracted.

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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. During various phases of operations within the extractive industries various items of property, plant and equipment will be constructed. As we explained in Chapter 4, paragraph 16(c) of AASB 116 Property, Plant and Equipment requires the cost of an item of property, plant and equipment to include an 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. Therefore, the cost of an item of property, plant and equipment includes the purchase price (inclusive of duties and taxes), other directly attributable costs to the acquisition, and the initial estimates of costs necessary to ‘make good’ the site after the asset is retired. Therefore, the general form of the journal entry would be: Dr Cr Cr

Property, plant and equipment Cash/payables Provision for restoration

X    

X X

As noted previously, AASB 137 requires that the provision be discounted to reflect the present value of the expenditures. A common approach to estimating the expenditure required to restore a site is to obtain a reasonable estimate of the required expenditure in the present day and then to adjust this amount by using inflationary indicators such as the Consumer Price Index (CPI) to obtain the expenditure required in a future reporting period. Where the time value of money is material, the provision will be discounted to reflect the present value of the expenditures (for example, by using relevant government bond rates). Consistent with paragraph 59 of AASB 137, the provision shall be reviewed at the end of each reporting period and adjusted to reflect the current best estimate. If it is no longer deemed probable that an outflow of resources embodying economic benefits will be required to settle the obligation, the provision should be reversed. Worked Example 20.1 provides an illustration of how to account for a restoration provision.

WORKED EXAMPLE 20.1: Accounting for a restoration provision During the reporting period ending 30 June 2018, Nichol Ltd erected an oil rig in Noosa River. The cost of the rig and associated technology amounted to $99 500 000. The oil rig commenced production on 1 July 2018. At the end of the rig’s useful life, which is expected to be five years, Nichol Ltd is required by its resource consent to dismantle the oil rig, remove it, and return the site to its original condition. After consulting its own engineers and environmentalists, Nichol Ltd estimates that if such work was required to be done at the present time it would cost $15 000 000. Anticipating that inflation will average 3 per cent over the next five years, the adjusted cost is expected to be $15 000 000 × (1.03)5, which equals $17 389 111. If we accept that the rate on five-year government bonds reflects the relevant time value of money, and if the rate is 4 per cent, then the present value of the restoration provision would be $17 389 111 ÷ (1.04)5, which equals $14 292 582. REQUIRED Prepare the journal entries necessary to account for the establishment of the rig and the changing balance of the restoration provision for the years ended 30 June 2018, 30 June 2019 and 30 June 2020. Ignore depreciation. SOLUTION 30 June 2018 Dr Oil rig Cr Cash/accounts payable Cr Provision for restoration costs

  113 792 582    

  99 500 000 14 292 582 continued

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Discounting the future obligation for restoration creates interest costs for future years. The borrowing (interest) costs are allocated to specific years as follows: Date 1 July 2018 30 June 2019 30 June 2020 30 June 2021 30 June 2022 30 June 2023

Opening balance _ 14 292 582 14 864 285 15 458 857 16 077 211 16 720 299

Interest at 4% _  571 703 594 572 618 354 643 088 668 812

Balance of site restoration costs 14 292 582 14 864 285 15 458 857 16 077 211 16 720 299 17 389 111

The journal entries to recognise the periodic interest charges are: 30 June 2019    Dr Interest expense Cr Provision for restoration costs

 

30 June 2020    Dr Interest expense Cr Provision for restoration costs

 

 571 703 571 703

 594 572 594 572

As we can see from the above entries, at the end of each period the amount recorded for the provision for restoration costs increases. By the end of the final period of the project the balance of the provision will be $17 389 105. This amount will then be eliminated when Nichol Ltd undertakes the actual restoration work.

LO 20.2 LO 20.9

Sales revenue

Refer to AASB 15 Revenue from Contracts with Customers for the requirements relating to the recognition of revenue in the extractive industries. Generally, sales revenue should not be brought to account until such time that control of the resource has passed to the customer. Where it is probable that there will be a material variation in sales value of product because the ultimate quantity/ price is dependent on assays or other tests after delivery, such proceeds are typically to be brought to account using the most reliable available estimates of quantities and sales prices. Proceeds from the sale of product obtained from activities in the exploration, evaluation or development phases of operations should be accounted for in the same manner as sales of product obtained during the production phase. The estimated cost of producing the quantities concerned would frequently be deducted from the accumulated costs of such activities and be treated as the cost of the product sold. Exhibit 20.2 reproduces the accounting policy note from BHP Billiton Ltd’s 2015 Annual Report that relates to the recognition of sales revenue.

Exhibit 20.2 BHP Billiton Ltd’s policy on recognising sales revenue, as reported in its 2015 Annual Report

SALES REVENUE Revenue from the sale of goods and disposal of other assets is recognised when persuasive evidence (usually in the form of an executed sales agreement) of an arrangement exists and;

• • • • •

there has been a transfer of risks and rewards to the customer; no further work or processing is required by the Group; the quantity and quality of the goods has been determined with reasonable accuracy; the price is fixed or determinable; collectability is reasonably assured.

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Revenue is therefore generally recognised when title passes. In the majority of sales for most commodities, sales agreements specify that title passes on the bill of lading date, which is the date the commodity is delivered to the shipping agent. For these sales, revenue is recognised on the bill of lading date. For certain sales (principally coal sales to adjoining power stations and diamond sales), title passes and revenue is recognised when the goods have been delivered. In cases where the terms of the executed sales agreement allow for an adjustment to the sales price based on a survey of the goods by the customer (for instance an assay for mineral content), recognition of the sales revenue is based on the most recently determined estimate of product specifications. For certain commodities, the sales price is determined on a provisional basis at the date of sale and adjustments to the sales price subsequently occurs based on movements in quoted market or contractual prices up to the date of final pricing. The period between provisional invoicing and final pricing is typically between 60 and 120 days. Revenue on provisionally priced sales is recognised based on the estimated fair value of the total consideration receivable. The revenue adjustment mechanism embedded within provisionally priced sales arrangements has the character of a commodity derivative. Accordingly, the fair value of the final sales price adjustment is re-estimated continuously and changes in fair value are recognised as an adjustment to revenue. In all cases, fair value is estimated by reference to forward market prices. Revenue is not reduced for royalties and other taxes payable from the Group’s production. The Group separately discloses sales of Group production from sales of third party products because of the significant difference in profit margin earned on these sales. SOURCE: BHP Billiton Ltd 2015 Annual Report

Inventory

LO 20.10

In the production phase of extractive operations, materials expected to be converted by further processing to saleable product can accumulate at various stages, and it must be decided if and when such materials should be recognised as inventories. For example, in mining, broken ore can collect at the point where ore-breaking first occurs and on the surface before further processing; saleable product might exist after processing but before the ultimate sale. Similarly, oil and natural gas might be present in bulk storage at or adjacent to the well-head and/or in pipelines en route to storage, treatment or refining facilities. Resources would generally be extracted before being classed as inventory, and their measurement would be consistent with AASB 102 Inventories, which requires inventories to be measured at the lower of cost and net realisable value. These costs would include total costs involved in the production of the resource, inclusive of amortisation and depreciation of capitalised pre-production expenditures.

Disclosure requirements

LO 20.11

Paragraphs 23 to 25 of AASB 6 provide the disclosure requirements for exploration and evaluation expenditures. They are reproduced below. Other accounting standards (such as AASB 102, AASB 116, AASB 136, AASB 137 and AASB 138) also provide disclosure requirements for the other aspects of the operation of entities involved in the extractive industries. In relation to exploration and evaluation expenditures, AASB 6 requires the following:

23. An entity shall disclose information that identifies and explains the amounts recognised in its financial statements arising from the exploration for and evaluation of mineral resources. 24. To comply with paragraph 23, an entity shall disclose: (a) its accounting policies for exploration and evaluation expenditures including the recognition of exploration and evaluation assets; (b) the amounts of assets, liabilities, income and expense and operating and investing cash flows arising from the exploration for and evaluation of mineral resources.

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Aus24.1 In addition to the disclosure required by paragraph 24(b), an entity that recognises exploration and evaluation assets for any of its areas of interest shall, in disclosing the  amounts of those assets, provide an explanation that recoverability of the carrying amount of the exploration and evaluation assets is dependent on successful development and commercial exploitation, or alternatively, sale of the respective areas of interest.

25. An entity shall treat exploration and evaluation assets as a separate class of assets and make the disclosures required by either AASB 116 or AASB 138 consistent with how the assets are classified.

As shown above, AASB 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 Provisions, Contingent Liabilities and Contingent Assets, which includes requirements that are of relevance in relation to disclosing provisions for restoration. Specifically, paragraphs 84 and 85 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; (c) amounts used (that is, incurred and charged against the provision) during the period; (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.

Exhibit 20.3 provides details of how BHP Billiton Ltd accounts for various aspects of its extractive operations. Only those accounting policies particularly relevant to the discussion in this chapter are reproduced in Exhibit 20.3. The accounting policy relating to sales revenue shown earlier is not repeated here. As you will see, the accounting policies adopted by BHP Billiton Ltd are consistent with the requirements described in this chapter. The note from the 2015 Annual Report of BHP Billiton therefore provides a useful basis for summarising many of the requirements discussed in this chapter.

Exhibit 20.3 Significant accounting policies note—extract from the 2015 Annual Report of BHP Billiton Ltd

43. SIGNIFICANT ACCOUNTING POLICIES CONTINUED (e) Depreciation of Property, Plant and Equipment

The carrying amounts of property, plant and equipment are depreciated to their estimated residual value over the estimated useful lives of the specific assets concerned, or the estimated life of the associated mine, field or lease, if shorter. Estimates of residual values and useful lives are reassessed annually and any change in estimate is taken into account in the determination of remaining depreciation charges. Depreciation commences on the date of commissioning. The major categories of property, plant and equipment are depreciated on a unit of production and/or straight-line basis using estimated lives indicated below. However, where assets are dedicated to a mine, field or lease and are not readily transferable, the below useful lives are subject to the lesser of the asset category’s useful life and the life of the mine, field or lease:

• • • • •

Buildings—25 to 50 years Land—not depreciated Plant and equipment—3 to 30 years straight-line Mineral rights and petroleum interests—based on reserves on a unit of production basis Capitalised exploration, evaluation and development expenditure—based on reserves on a unit of production basis.

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(f) Exploration and Evaluation Expenditure

Exploration and evaluation activity involves the search for mineral and petroleum resources, the determination of technical feasibility and the assessment of commercial viability of an identified resource. Exploration and evaluation activity includes:

• • • • • •

researching and analysing historical exploration data; gathering exploration data through topographical, geochemical and geophysical studies; exploratory drilling, trenching and sampling; determining and examining the volume and grade of the resource; surveying transportation and infrastructure requirements; conducting market and finance studies.

Administration costs that are not directly attributable to a specific exploration area are charged to the income statement. Initial payments for the acquisition of intangible lease assets are capitalised and amortised over the term of the permit. Exploration and evaluation expenditure (including amortisation of capitalised licence and lease costs) is charged to the income statement as incurred except in the following circumstances, in which case the expenditure may be capitalised: • In respect of minerals activities: • the exploration and evaluation activity is within an area of interest which was previously acquired as an asset acquisition or in a business combination and measured at fair value on acquisition; or • the existence of a commercially viable mineral deposit has been established. • In respect of petroleum activities: • the exploration and evaluation activity is within an area of interest for which it is expected that the expenditure will be recouped by future exploitation or sale; or • exploration and evaluation activity has not reached a stage which permits a reasonable assessment of the existence of commercially recoverable reserves. Capitalised exploration and evaluation expenditure considered to be a tangible asset is recorded as a component of property, plant and equipment at cost less impairment charges. Otherwise, it is recorded as an intangible asset (such as certain licence and lease arrangements). In determining whether the purchase of an exploration licence or lease is an intangible asset or a component of property, plant and equipment, consideration is given to the substance of the item acquired not its legal form. Licences or leases purchased, which allow exploration over an extended period of time, meet the definition of an intangible exploration lease asset where they cannot be reasonably associated with a known resource (minerals) or reserves (petroleum). All capitalised exploration and evaluation expenditure is monitored for indications of impairment. When a potential impairment is indicated, assessment is performed for each area of interest in conjunction with the group of operating assets (representing a cash-generating unit) to which the exploration is attributed. Exploration areas in which reserves have been discovered but require major capital expenditure before production can begin, are continually evaluated to ensure that commercial quantities of reserves exist or to ensure that additional exploration work is under way or planned. To the extent that capitalised expenditure is no longer expected to be recovered, it is charged to the income statement. (n) Development Expenditure

When proved reserves are determined and development is sanctioned, capitalised exploration and evaluation expenditure is reclassified as assets under construction, and is disclosed as a component of property, plant and equipment. All subsequent development expenditure is capitalised and classified as assets under construction, provided commercial viability conditions continue to be satisfied. Development expenditure is net of proceeds from the sale of ore extracted during the development phase. On completion of development, all assets included in assets under construction are reclassified as either plant and equipment or other mineral assets. continued Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  757

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(q) Closure and Rehabilitation

The mining, extraction and processing activities of the Group normally give rise to obligations for site closure or rehabilitation. Closure and rehabilitation works can include facility decommissioning and dismantling; removal or treatment of waste materials and site and land rehabilitation. The extent of work required and the associated costs are dependent on the requirements of relevant authorities and the Group’s environmental policies. Provisions for the cost of each closure and rehabilitation program are recognised at the time that environmental disturbance occurs. When the extent of disturbance increases over the life of an operation, the provision is increased accordingly. Costs included in the provision encompass all closure and rehabilitation activity expected to occur progressively over the life of the operation and at or after the time of closure, for disturbance existing at the reporting date. Routine operating costs that may impact the ultimate closure and rehabilitation activities, such as waste material handling conducted as an integral part of a mining or production process, are not included in the provision. Costs arising from unforeseen circumstances, such as the contamination caused by unplanned discharges, are recognised as an expense and liability when the event gives rise to an obligation which is probable and capable of reliable estimation. The timing of the actual closure and rehabilitation expenditure is dependent upon a number of factors such as the life and nature of the asset, the operating licence conditions, the principles of Our BHP Billiton Charter and the environment in which the mine operates. Expenditure may occur before and after closure and can continue for an extended period of time dependent on closure and rehabilitation requirements. The majority of the expenditure is expected to be paid over periods of up to 50 years, with some payments into perpetuity. Closure and rehabilitation provisions are measured at the expected value of future cash flows, discounted to their present value and determined according to the probability of alternative estimates of cash flows occurring for each operation. Discount rates used are specific to the country in which the operation is located. Significant judgements and estimates are involved in forming expectations of future activities and the amount and timing of the associated cash flows. Those expectations are formed based on existing environmental and regulatory requirements or, if more stringent, Group environmental policies which give rise to a constructive obligation. When provisions for closure and rehabilitation are initially recognised, the corresponding cost is capitalised as an asset, representing part of the cost of acquiring the future economic benefits of the operation. The capitalised cost of closure and rehabilitation activities is recognised in property, plant and equipment and depreciated accordingly. The value of the provision is progressively increased over time as the effect of discounting unwinds, creating an expense recognised in financial expenses. Closure and rehabilitation provisions are also adjusted for changes in estimates. Those adjustments are accounted for as a change in the corresponding capitalised cost, except where a reduction in the provision is greater than the undepreciated capitalised cost of the related assets, in which case the capitalised cost is reduced to nil and the remaining adjustment is recognised in the income statement. In the case of closed sites, changes to estimated costs are recognised immediately in the income statement. Changes to the capitalised cost result in an adjustment to future depreciation. Adjustments to the estimated amount and timing of future closure and rehabilitation cash flows are a normal occurrence in light of the significant judgements and estimates involved. Factors influencing those changes include:

• • • •

revisions to estimated reserves, resources and lives of operations; developments in technology; regulatory requirements and environmental management strategies; changes in the estimated extent and costs of anticipated activities, including the effects of inflation and movements in foreign exchange rates; and • movements in interest rates affecting the discount rate applied. SOURCE: BHP Billiton Ltd 2015 Annual Report

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Having considered the requirements of AASB 6, as well as some of the requirements of other relevant accounting standards, we can now consider a practical illustration of how to account for expenditure in the extractive industries. In Worked Example 20.2, the area-of-interest method (which must be used pursuant to AASB 6) is contrasted with the full-cost method, which may be used in the United States. Although the full-cost method is not permitted in Australia, this illustration shows how the adoption of one method of accounting instead of another can lead to material differences in accounting numbers. In Worked Example 20.3, we look at a further example of applying the area-of-interest method.

WORKED EXAMPLE 20.2: Comparison of the full-cost method and the area-of-interest method We will assume that Fraser Island Ltd commences operations on 1 January 2017. During 2017, Fraser Island explores two areas and incurs the following costs. Exploration and evaluation expenditure ($m) 17   8 25

Area A B  

Other information • In 2018 oil is discovered at Site B. Site A is abandoned owing to the failure to prove the existence of economically recoverable resources, and an impairment loss is recognised in relation to Site A. Of the $8 million incurred at Site B, $5 million relates to tangible assets and $3 million relates to intangible assets. At Site A, $12 million of the expenditure related to tangible assets and $5 million related to intangible assets. • Development costs of $20 million are incurred at Site B (to be written off on a production basis) in 2018. The development costs include $12 million in property, plant and equipment and $8 million in intangibles. This expenditure will be depreciated/amortised on a production basis. • Development at Site B concludes at the beginning of 2018, and production also commences at Site B at the start of 2019. • It is estimated that the amount of oil at Site B is 8 million barrels. The current sale price is $30 per barrel. • In 2019, Fraser Island Ltd extracts 1.2 million barrels at a production cost of $3.6 million and sells 1.1 million barrels. REQUIRED Provide the necessary journal entries using: (a) the area-of-interest method (b) the full-cost method. SOLUTION (a) Area-of-interest method     $m $m 2017 Dr Exploration and evaluation assets—Site A 17   Dr Exploration and evaluation assets—Site B 8   Cr Cash/payables etc.   25 (to account for the initial exploration and evaluation costs incurred in each site; the exploration and evaluation assets are classified as either property, plant and equipment or intangible assets of the entity. 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) 2018 Dr Dr Cr

Assets under construction—prop., plant and equip. Assets under construction—intangible assets Exploration and evaluation assets—Site B

5 3  

    8 continued

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 Dr  Impairment loss—exploration and evaluation assets  17    Cr Exploration and evaluation assets—Site A   17 (to reclassify the balance of the exploration and evaluation expenditure at Site B to ‘assets under construction’ (or similar account) consistent with paragraph 17 of AASB 6 and to recognise an impairment loss in relation to Site A since the site has been abandoned) Dr Assets under construction—prop., plant and equip. 12   Dr Assets under construction—intangible assets 8   Cr Cash/payables/accumulated depreciation etc.   20 (to recognise the development costs incurred in relation to Site B. 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 entity’s amortisation/depreciation policies) 2019  Dr Property, plant and equipment—Site B 17   Dr Intangible mineral assets 11   Cr Assets under construction—prop., plant and equip.   17 Cr Assets under construction—intangible assets   11 (to reclassify the assets as a result of the movement from the pre-production phase to the production phase) Dr Inventory of crude oil 4.2   Cr Accumulated depreciation—prop., plant and equip.—Site B   2.55 Cr Accumulated amortisation—intangible mineral assets   1.65 (once the production phase is reached the assets are ready for use and can be depreciated or amortised; the total costs transferred to inventory are calculated as 1.2 million × $3.50, where $28 million ÷ 8 million = $3.50 per tonne) Dr Inventory of crude oil 3.6   Cr Cash/payables/accumulated depreciation etc.   3.6 (to recognise the production costs that are treated as a cost of the inventory, rather than being written off directly) Dr Cash/receivables 33   Cr Sales revenue   33 (to recognise sales made, where $33 million = 1.1 million barrels multiplied by $30 per barrel) Dr Cost of goods sold 7.15   Cr Inventory of crude oil   7.15 [to acknowledge the cost of goods sold, which is calculated as ($3.6 million  +  $4.2 million)  ÷ 1.2  million × 1.1 million = $7.15 million] (b) Full-cost method 2017 Dr Exploration and evaluation assets 25 Cr Cash/payables etc.   (to account for the initial exploration and evaluation costs incurred at each site)

25

2018 Dr Assets under construction—prop., plant and equip. 17   Dr Assets under construction—intangible assets 8   Cr Exploration and evaluation assets   25 (to transfer the total balance of the exploration and evaluation assets to the assets under construction account; the total amount is transferred as it is expected that the receipts from the recoverable reserves will exceed the carry-forward costs plus any additional costs that are expected to be incurred)

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Dr Assets under construction—prop., plant and equip. 12   Dr Assets under construction—intangible assets 8   Cr Cash/payables/accumulated depreciation etc.   20 (to recognise the development costs that are recorded in the depletable natural resources account) 2019 Dr Property, plant and equipment 29   Dr Intangible mineral assets 16   Cr Assets under construction—prop., plant and equip.   29 Cr Assets under construction—intangible assets   16 Dr Inventory of crude oil 6.75   Cr Accumulated depreciation—prop., plant and equip.   4.35 Cr Accumulated amortisation—intangible mineral assets   2.40 (amortisation of costs carried forward; the amount is calculated as 1.2 million × $5.625, where $45 million ÷ 8 million = $5.625 per tonne) Dr Inventory of crude oil 3.6   Cr Cash/payables/accumulated depreciation etc.   3.6 (to recognise the production costs, which are treated as a cost of the inventory rather than being written off directly) Dr Cash/receivables 33   Cr Sales revenue   33 (to recognise sales made, where $33 million = 1.1 million barrels multiplied by $30 per barrel) Dr Cost of goods sold 9.4875   Cr Inventory of crude oil   9.4875 (to acknowledge the cost of goods sold, which is calculated as [$3.6 million + $6.75 million} ÷ 1.2 million × 1.1 million = $9.4875 million)

WORKED EXAMPLE 20.3: Application of the area-of-interest method The Armidale Mining Co. Ltd is undertaking a search for oil below Armidale. Exploration and evaluation activity is being undertaken in three areas, these being Newie, Club and Pink. Another site, Tattersals, is currently producing oil on a commercially viable basis. When Tattersals was assessed, it was considered that it would provide 70 million barrels of oil. This is still the case and, to date, 17.5 million barrels of oil have been extracted, of which 500 000 barrels are on hand at 30 June 2018. Production commenced in Tattersals at the beginning of September 2017. Two of the other locations, Newie and Pink, show promising geological formations. Club will be abandoned in 2018, however, owing to poor testing results. The following is an analysis of the expenditure, by major drilling location, incurred by the company during the year ending 30 June 2018.   Tattersals Mine development expenditures—intangible assets Production costs (including royalties of $50 000) paid during production of oil Construction of buildings Construction of plant Club Exploration and evaluation expenditure Newie Exploration and evaluation expenditure Pink Exploration and evaluation expenditure

$   250 000 18 125 000 450 000 1 125 000   875 000   1 155 000   1 342 500 continued

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At 30 June 2017 the following expenditure was carried forward in the accounts.   Tattersals • Exploration and evaluation assets—to be reclassified as mineral assets under construction as exploration and evaluation phase now complete ($1 million tangible, which relates to plant and equipment, and $800 000 intangible) • Assets under construction (this expenditure occurred in the development phase following the exploration and evaluation phase)   –  intangible assets   – buildings   – plant Club Exploration and evaluation expenditure Newie Exploration and evaluation expenditure Pink Exploration and exploration expenditure

$   1 800 000

  875 000 3 125 000 1 567 500   50 000   _   50 000

Other information (i) The non-current assets are to be depreciated as follows: Buildings Plant Intangible assets

production-output basis 15 years production-output basis

  The plant could be transferred to one of the other three sites should successful exploration commence there. It is considered impractical to move the buildings. The intangible assets have no other use outside the area of interest. (ii) There is no other inventory at Tattersals apart from the 500 000 barrels of oil that are on hand at 30 June 2018. (iii) The oil will sell on the open market for $9 a barrel. (iv) Each well is considered a separate area of interest. REQUIRED (a) Determine the appropriate treatment for the 2017 carried-forward expenditure and the 2018 actual expenditure in the accounts as at 30 June 2018. (b) Determine the appropriate valuation of Tattersals’ inventory at 30 June 2018. (c) Determine the result for the company for the year ending 30 June 2018. Non-production expenses (excluding any carry-forward expenditure write-offs) total $5.5 million. SOLUTION (a) Appropriate treatment of the pre-production costs for each area of interest at 30 June 2018 Club Exploration and evaluation assets carried forward at 30 June 2017 Incurred during the year ended 30 June 2018 Total

$ 50 000 875 000 925 000

  The amount should be expensed to the statement of comprehensive income, since the area of interest has been abandoned. Newie Exploration and evaluation assets carried forward at 30 June 2017 Incurred during the year ended 30 June 2018 Total

$ _ 1 155 000 1 155 000

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  The amount should be carried forward, since the area of interest looks promising and activities are continuing. Pink Exploration and evaluation assets carried forward at 30 June 2017 Incurred during the year ended 30 June 2018 Total

$ 50 000 1 342 500 1 392 500

  The amount should be carried forward, since the area of interest looks promising and activities are continuing. Tattersals Total preproduction costs Intangible assets Exploration and evaluation phase—2017 Development phase—2017 Mine development costs incurred (intangible assets) during the   year ended 30 June 2018 Buildings Development phase—2017 Construction phase—2018 Plant Exploration and evaluation phase—2017 Development phase—2017 Construction phase—2018 Total pre-production costs—Tattersals site

$     800 000   875 000    250 000

$       1 925 000

  3 125 000    450 000   1 000 000 1 567 500 1 125 000  

    3 575 000       3 692 500 9 192 500

  The amounts should be depreciated or amortised, since the area of interest has reached the production phase. Depreciation and amortisation are not undertaken until the assets are ready for use—which is when production commences. Impairment testing would be required for the carried-forward expenditures. The preproduction costs relating to construction of the buildings and intangible mining assets should be amortised using the production-output method. The plant should be amortised over its useful life of 15 years, since it has alternative uses. Amortisation and depreciation charges for 2018: Plant ($3 692 500 ÷ 15) × (10 ÷ 12) Buildings ($3 575 000 ÷ 70 000 000) × 17 500 000 Intangible assets ($1 925 000 ÷ 70 000 000) × 17 500 000

  = $205 139 = $893 750 = $481 250

  Note that the plant is amortised using the straight-line method over 15 years, and only 10 months’ depreciation is recorded in the first year since production started in September. (b) Valuation of Tattersals’ inventory Production costs Amortisation of intangible assets Depreciation of buildings Depreciation of plant Cost of goods manufactured Cost per barrel (rounded) 19 705 139 ÷ 17 500 000 Inventory value (500 000) × ($1.126)

$18 125 000 $481 250 $893 750      $205 139 $19 705 139 $1.126 $563 000

(c) Operating result for the year Profit for the year ended 30 June 2018 Sales (17 000 000 × $9) Cost of sales (17 000 000 × 1.126) Gross profit Non-production expenses Write-off of Club area of interest Profit before tax

  $153 000 000   $19 142 000 $133 858 000 $5 500 000        $925 000 $127 433 000

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LO 20.3 LO 20.10

Does the area-of-interest method provide a realistic value for an entity’s reserves?

As we have seen in this chapter, AASB 6 allows the exploration and evaluation expenditures associated with finding reserves to be carried forward in certain circumstances. However, if reserves are found it is quite conceivable that their ultimate value could greatly exceed the costs that have been carried forward. That is, where economically recoverable reserves are discovered, it is quite likely that the costs of assets shown in the statement of financial position (perhaps as ‘mine-site assets in construction’) will effectively understate the actual value of the reserves. While it is quite unusual in Australia, according to Mirza and Zimmer (1999), a limited number of Australian companies involved in the extractive industries did elect to revalue their reserves to their expected fair value. This has obvious implications for profits that are subsequently reported. As Chapter 6 explains, when non-current assets are upwardly revalued, the credit entry goes to the revaluation surplus, and not to profits (although a revaluation increment can be included in ‘other comprehensive income’, thereby increasing total comprehensive income). If the reserves of an organisation involved in the extractive industries are revalued upwards, the cost of sales associated with the reserves will increase, as cost will be based on the revalued amount of the reserves. Consequently, reported profit will be reduced. This reduction in reported profitability might be a disincentive for companies undertaking a revaluation of their reserves. Out of a sample of 128 firms involved in the extractive industries in 1995–96, Mirza and Zimmer (1999) found that only six companies recognised the value of their reserves through the process of undertaking an upward asset revaluation. Mirza and Zimmer provided a number of reasons for companies generally not recognising the expected fair value of their reserves, including the following: • The value of reserves is highly uncertain, and management might prefer not to potentially overstate assets. • Applying the political-cost hypothesis (as indicated in Chapter 3, this hypothesis was initially developed by Watts and Zimmerman (1978), but is still being applied by researchers adopting Positive Accounting Theory), companies in the extractive industries are generally considered to be subject to high levels of political scrutiny, and it is assumed that ‘it is likely that disclosure of reserves values would attract attention from bureaucrats and politicians looking for sources of taxation, as well as trade unions trying to increase salaries and other benefits to their members. In order to mitigate such costs, firms are likely to decide to neither disclose nor recognise reserve values’ (Mirza & Zimmer 1999, p. 49). • The accounting standard pertaining to revaluations prevents the credit ever going to profit or loss. • In relation to the limited number of companies that did revalue their reserves, Mirza and Zimmer (1999) propose: – The revaluing companies had high levels of debt and a revaluation could act to lower their reported leverage (as determined by dividing some measure of assets by liabilities), and possibly their cost of attracting debt (this is based on the ‘debt hypothesis’ proposed by Watts and Zimmerman (1978)—a hypothesis that is still tested by researchers who adopt Positive Accounting Theory as their research paradigm). – ‘Asset revaluation is a regular takeover defence through its positive effect on share prices. This is confirmed by the representative from Washington H. Soul Pattinson, who volunteered that revaluations of reserves are regularly recognised as a takeover deterrent’ (Mirza & Zimmer 1999, p. 49). The logic of this assertion is that if a company reports a higher figure for its assets, this will increase the price that others will need to pay for the shares of the entity in order to gain control.

LO 20.12

Research on accounting regulation pertaining to pre-production expenditures

In the earlier discussion, we considered some research on how organisations account for their pre-production costs and reserves. Let us now broaden that discussion by considering some further research. In the United States an exposure draft was released in 1977 relating to the extractive industries. At the time the draft was released, firms could use their discretion in choosing between a number of alternatives to account for their preproduction costs (which, as we will see, is still currently the case in many countries other than Australia). The exposure draft recommended that firms should no longer be permitted to use the full-cost method. Rather, they were required to use the successful-efforts method, which is very similar to the area-of-interest method employed in Australia. If the exposure draft had culminated in an accounting standard, firms using the full-cost method to account for their pre-production costs would no longer have been permitted to carry forward expenditures relating to ventures that did 764  PART 6: INDUSTRY-SPECIFIC ACCOUNTING ISSUES

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not lead to successful finds. This would have meant that both their assets and their profits would fall, along with their retained earnings. Revaluations were not permitted in the United States. For a firm that had been using the full-cost method, the cash flows (and hence the value of the firm) might have been greatly altered if contractual agreements and associated payments had been affected by the proposed changes. For example, the firm might have had debt-to-asset constraints, interest-coverage clauses or management compensation plans, all of which might have been affected in terms of their related cash flows. (Of course, such contracts might have pre-specified the required accounting methods to be used for contractual purposes, and in such cases the cash flows would not have been affected.) Research in the United States (Collins, Rozeff & Salatka 1982) indicated that the share prices of firms using the fullcost method fell following the release of the exposure draft, even before the standard had been issued. This would indicate that the share prices were impounding the expected future cash-flow effects of the proposed standard. Not surprisingly, given the potential effects on firms’ value, a large number of firms using the full-cost method lobbied against the exposure draft. Deakin (1989) found support for the argument that the degree of opposition was related to, among other things, the level of debt in the firm. Following the exposure draft, SFAS No. 19 was released by the Financial Accounting Standards Board (FASB) in late 1977. Owing to the high degree of opposition to the standard, which continued after its release, the Securities and Exchange Commission overrode the FASB and issued ASR 253, which once more permitted the use of the full-cost method. The events leading to the issue of ASR 253 emphasise how political the accounting standard-setting process can be, particularly when it is apparent that significant effects might be imposed on the cash flows of firms forced by a new standard to change to a different accounting method. Larcker, Reder and Simon (1983) analysed the share trading by insiders after the release of the 1977 exposure draft. The rationale of this approach is that insiders have knowledge of the economic effects of an accounting change that is as good as, if not superior to, that possessed by other market participants. Larcker, Reder and Simon (1983) argued that if corporate insiders believe the security market is not efficient in the strong form, they might trade on the basis of their superior information. The results of Larcker, Reder and Simon indicate the existence of ‘unusual’ and ‘differential’ trading by full-cost and successful-efforts insiders in the period after the issue of the FASB exposure draft on SFAS No. 19. In particular, the full-cost insiders were selling relative to successful-efforts insiders after the exposure draft was released. This is consistent with the view that the removal of an accounting option (in this case, the use of the full-cost method) can have material effects on the value of the firm. In a further study, King and O’Keefe (1986) reviewed the trading positions of individuals who lobbied against the FASB exposure draft. King and O’Keefe reported that insiders of full-cost firms that lobbied FASB regarding this exposure draft were net sellers compared with those that did not lobby. Again, this is consistent with the view that managers are sensitive to the methods of accounting being employed. While the above research relates to the standard-setting process within the USA, we can also consider what happened when the IASB, and its predecessor the International Accounting Standards Committee (IASC), attempted to develop the accounting standard for the extractive industry some years later. In 1998, due to concern about the lack of uniformity in accounting for pre-production costs, the IASC proposed the development of an international accounting standard that would improve consistency and comparability of reporting practices in the extractive industries internationally. To do this they sought to reduce the available alternatives by supporting the use of the successful-efforts method (which is very similar to the areaof-interest method) and the discontinuation of the full-cost method. As part of the process of developing the accounting standard, submissions were sought. In relation to the submissions, Cortese, Irvine and Kaidonis (2007, p. 2) report: There was overwhelming support for the use of the successful efforts method of accounting with 87 percent of respondents commenting on this issue indicating a preference for the successful efforts method only. In contrast, only 13 percent of respondents commenting on this issue indicated their support for having the option of both the successful efforts and full cost methods. Thus, the Steering Committee’s tentative view on this issue was supported, with the majority of respondents preferring a single method of accounting for pre-production costs consistent with the successful efforts concept. However, when the accounting standard—IFRS 6 Exploration for and Evaluation of Mineral Resources—was finally issued in December 2004, the contents were not as expected. Rather than reducing the number of alternative accounting treatments—and thereby moving towards the goals of comparability and consistency that were previously promoted— the accounting standard effectively allowed organisations to use whatever was their preferred approach. Therefore, IFRS 6 effectively ‘codified existing industry practice, perpetuating the disparate methods of accounting for exploration Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  765

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and evaluation, and maintaining the status quo for extractive industries companies’ (Cortese, Irvine & Kaidonis 2007, p. 3). IFRS 6 provides organisations with flexibility by virtue of paragraph 7 of IFRS 6, which states: Paragraphs 11 and 12 of IAS 8 specify sources of authoritative requirements and guidance that management is required to consider in developing an accounting policy for an item if no IFRS applies specifically to that item. Subject to paragraphs 9 and 10 below, this IFRS exempts an entity from applying those paragraphs to its accounting policies for the recognition and measurement of exploration and evaluation assets. The paragraphs within IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors that are referred to above—which IFRS 6 specifically says do not need to be followed in relation to exploration and evaluation assets— would otherwise require an organisation to comply with IFRSs that deal with ‘similar and related issues’, as well as requiring compliance with the conceptual framework. This effectively provides entities applying IFRSs (other than those within Australia, given that AASB 6 deviates from IFRS 6 as a result of the insertion within Australia of paragraphs that require the use of the area-of-interest method) with the flexibility to account for their exploration and evaluation assets in the manner they prefer. If, by contrast, it had been required that the conceptual framework be followed (as would be usual practice), then this would have meant that the use of the full-cost method would have been eliminated. In trying to explain the apparent ‘backflip’ of the IASB, Cortese, Irvine and Kaidonis (2007, 2010) and Cortese (2013) point to the political power of the minerals industry and how that power arguably helped them ultimately see their preferred accounting standard be released. In explaining this power, Cortese, Irvine and Kaidonis (2007) note that the functioning of the IASB is dependent upon funding from external sources and that among those sources are significant contributions from the minerals and petroleum industry. They also point to the fact that the major companies in the extractive industries are richer and more powerful than many of the states and countries that seek to regulate them, and this in itself brings great influence. Cortese, Irvine and Kaidonis (2007) note that in their submissions to the IASC/IASB, both the American Petroleum Institute (a USA-based lobbying group for the extractive industries) and the Oil Industry Accounting Committee (a UK-based lobbying group) argued strongly for the retention of both the full-cost and successful-efforts methods of accounting. Cortese, Irvine and Kaidonis (2007) argue that it was the power of the industry that contributed to the outcome, and that the result was: consistent with Mitchell and Sikka’s (1993, p.29) observation that the ‘institutions and practices of accountancy are collusive and undemocratic’ and that institutions, such as the IASC/IASB, are ‘dedicated to defending the status quo and sectional interests rather than wider interests’. Cortese (2013, p. 55) further reflects on this outcome and cautions that: This places in doubt the proclaimed transparency and independence of the IASB as a standard setting institution, and although it is widely acknowledged that the accounting standard setting process is political, this research highlights the source, nature and effect of this politicisation . . . The potential for the IASB to be ‘captured’ by those companies that are intended to be bound by the standards it issues is of particular concern given that the IASB claims to be an independent organization acting in the public interest seeking worldwide diffusion of its accounting standards that will, ultimately, affect global capital markets. As has been emphasised in a number of chapters in this book, the above material again highlights the political nature of the accounting standard-setting process and how various stakeholders might try to influence the standard-setting process so as to achieve results that are advantageous to themselves. The view that a regulator or standard-setter might be captured by vested interests, as stated in the above quote, is consistent with the central tenets of ‘Capture Theory’—a theory we discussed in Chapter 3. Of course, not all people will believe that the IASB was captured, or that it can be influenced by organisations and industries that provide funding to it. Nevertheless, authors such as Cortese, Irvine and Kaidonis highlight the possibility of political interference within standard-setting—something that is always possible. In the Australian context, and turning our consideration to how individual organisations account for their pre-production costs, Walker (1995) suggested that political costs (see Chapter 3) might influence how an organisation accounts. As we know, firms do not have to capitalise their exploration and evaluation expenditures even if they can satisfy the carryforward requirements of AASB 6 (although they may capitalise). That is, there is still a high degree of flexibility in their accounting policy choice. They can elect to expense all exploration and evaluation expenditures in the period in which they are incurred. Consistent with the Positive Accounting Theory literature, as described in Chapter 3, Walker argues that firms under scrutiny in relation to the magnitude of their profits might elect to reduce their reported profits by changing the method they choose to account for their pre-production costs. 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method from one period to the next, AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors requires them to disclose details of the change and the financial effect of the change in the notes to the financial statements. During the period of her study, Walker proposed that gold producers had incentives to reduce their reported profits. The basis of this view was that at the time the government was considering the removal of the tax-exempt status that existed in relation to profits derived from the extraction and sale of gold. As part of their deliberations, Walker argued, the federal government was reviewing the reported profits of gold producers, and hence it might have been in the interests of these companies to reduce their reported profits. This might have reduced the government’s justification for removing the tax-exempt status. Consistent with her expectations, Walker found that during the financial years of 1985 and 1986—the period of her study—gold producers were more likely to expense their pre-production costs than organisations in other extractive industries. Nevertheless, the tax-exempt status was subsequently removed. Results such as those reported by Walker (1995) provide an interesting view of the perceived efficiency of government. If organisations reduce their accounting profits simply by switching from one method of accounting to another, this implies a perception that government can be fooled by such tactics. What do you think? Do you think that the politicians that we vote for can be easily fooled?

Other developments in extractive industry reporting

LO 20.13

As accountants and students of accounting, we can appreciate that there are many facets to the performance of an entity, and that this is no less true for entities in the extractive industries. So far, this chapter has emphasised the financial performance of companies involved in the extractive industries. However, organisations are also accountable for aspects of their performance other than just their financial performance. They are accountable for their social and environmental performance (we addressed a number of issues associated with ‘accountability’ in Chapter 1). Across time, companies in the extractive industries have been the subject of intense criticism for their social and environmental performance. For example, within Australia a number of mining companies have been criticised for not respecting the interests of indigenous people. They have also received a great deal of criticism about the environmental impacts of their activities, a very notable recent case being the November 2015 tailings dam collapse in Brazil, which was linked to the operations of BHP Billiton and another organisation, Vale. According to a report by Helen Szoke in The Age on 19 November 2015 (entitled ‘Brazil mine disaster exposes BHP’s failures’): The town of Bento Rodrigues​has been hardest hit—more than 600 people have lost their homes, at least 11 people have been killed and 15 are still missing. The muddy red sludge extends 440 kilometres downstream across two states, affecting 635 municipalities and leaving hundreds of thousands with their water supply interrupted and potentially polluted for generations—with significant implications for health and agriculture. Hence, while in this chapter we have focused on the financial performance of mining companies, we should also appreciate that apart from financial implications, organisations within the extractive industries create various social and environmental impacts—many of which are not good. As such, there is a high demand for information about the social and environmental performance of mining companies. As an industry, the extractive industry has for several decades undertaken social and environmental reporting. In the early 1990s many Australian mining companies started releasing stand-alone environmental reports. In the mid- to late 1990s many mining companies also started releasing stand-alone social reports that documented the companies’ impact on particular communities and stakeholders. A number of companies also started releasing triplebottom-line reports—reports that provide information about the economic, social and environmental performance of an organisation. In the mid-2000s many Australian mining companies started releasing what they refer to as sustainability reports and in doing so they tended to be guided by the contents of the Global Reporting Initiative’s Sustainability Reporting Guidelines. For those readers who are interested, Chapter 30 provides a detailed investigation of social and environmental reporting and discusses such organisations as the Global Reporting Initiative. It also provides an insight into why mining companies might elect to voluntarily produce a great deal of information about their social and environmental performance. At this point you should take the opportunity to review a number of sustainability reports being issued by Australian mining companies. The levels of disclosure can be quite extensive, covering aspects such as organisations’: • emission levels • compliance with environmental laws • environmental incidents Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  767

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• environmental management systems • employment policies • health and safety performance • key social and environmental targets • performance against previous targets • environmental awards won • details of contributions to particular community initiatives • offshore operating policies • supply chain policies • description of the environmental impacts of the business • environmental audits. Many Australian mining companies produce such reports and most make them available on their websites. For examples, review the reports of: • BHP Billiton Ltd, which produces the BHP Sustainability Report, available at www.bhpbilliton.com; and • Rio Tinto Ltd, which produces a Sustainable Development Report, available at www.riotinto.com. Public social- and environmental-performance reporting within Australia is subject to limited statutory regulation, so most of the disclosures, such as those considered above, are voluntary. Many people consider that this is very unfortunate and believe that disclosures about social and environmental performance should be just as heavily regulated as financial disclosures (or perhaps even more heavily regulated). What do you, the reader, think? In relation to social and environmental reporting, a conceptual framework such as there is for financial accounting and reporting standards does not yet exist, although a number of guidance documents have been released by international industry associations. The closest thing to a conceptual framework for social and environmental reporting is provided in the Global Reporting Initiative’s Sustainability Reporting Guidelines (although this has many shortcomings). There is, therefore, much variation in the disclosures made by individual companies in their social- and environmentalperformance reports, making inter-company comparison difficult. In 1997 the Minerals Council of Australia (MCA) released the Australian Minerals Code for Environmental Management (which has subsequently been revised and reissued). In 2005, the MCA released a framework entitled Enduring Value: The Australian Minerals Industry Framework for Sustainable Development and requires that all member companies must be signatories. This framework was revised in 2015. In October 2015 there were 58 signatories to the framework, including BHP Billiton, Rio Tinto and Energy Resources of Australia. Most of the major Australian companies involved in the minerals and energy industries are members of the MCA and hence signatories to Enduring Value. The framework’s many requirements include that signatories must publicly report their performance against specifically nominated environmental performance indicators, such as greenhouse gas emissions. The reporting requirements of the framework are additional to, and separate from, statutory reporting requirements. Although reporting on social and environmental performance is voluntary for companies in the minerals and energy industries, failure to elect to do so might raise questions in the minds of the public. In the long run, this may have implications for the level of support an organisation receives from government, industry and the public. As already indicated, these issues and others associated with social-responsibility reporting will be covered in greater detail in Chapter 30. Before concluding this section of the chapter on ‘other developments’, one other initiative we can briefly consider is the Extractive Industries Transparency Initiative (EITI). According to Spoors (2015): The EITI is a voluntary initiative undertaken by governments to bring greater transparency to their natural resource sectors. Originally conceived to address corruption and conflict in resource-rich but ‘cursed’ countries, such as Angola, the EITI involves participating governments publishing the payments they receive from oil, gas and mining companies and in turn for those companies to publish what they pay in order to uncover any discrepancies. In Nigeria the process has uncovered discrepancies involving billions of dollars missing from the national budget. The process is overseen by a multi-stakeholder group of government, industry and civil society representatives. Countries that have signed up to the initiative include Norway and the USA. The UK, France and Italy are in the process of signing up. Australia has been a significant donor to the initiative but has not as at early 2016 implemented the initiative. Because the government has supported the implementation of the initiative in countries such as Burma/Myanmar and Papua New Guinea, it would perhaps be inappropriate not to also sign up. If Australia does sign up to the initiative then we would be able to see what the government receives for the minerals, oil and gas being extracted for profit by various corporations. 768  PART 6: INDUSTRY-SPECIFIC ACCOUNTING ISSUES

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The development of a new accounting standard for extractive activities

LO 20.12 LO 20.14

In 2004 the IASB set up an international project team comprising staff from the national accounting standardsetters of Australia, Canada, Norway and South Africa to research accounting for extractive activities. The release of IFRS 2006 in 2004 was seen as only a temporary solution and the task was to develop a ‘better’ standard that would ultimately replace IFRS 6. Given the material already provided in this chapter about the apparent political nature of the topic, and the inability of standard-setters to mandate particular requirements, it would not be unreasonable to be somewhat dubious about whether a logically developed accounting standard will be the outcome of the project. A Discussion Paper released by the IASB in April 2010 (DP/2010/1 Extractive Activities) presented the international project team’s findings and recommendations as a result of the ongoing research. In explaining the rationale for the efforts to develop a new accounting standard, paragraph P1 of IASB (2010) states: Entities engaged in mineral or oil and gas extractive activities are an important part of international capital markets. However, some extractive activities—and the assets or expenditures associated with these activities— are not comprehensively addressed by International Financial Reporting Standards (IFRSs). There are scope exclusions in IFRSs that might otherwise apply to some of these activities, most notably in IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets. Furthermore, although IFRS 6 Exploration for and Evaluation of Mineral Resources addresses the accounting for exploration and evaluation expenditures, it was developed as an interim measure to allow (with some limitations) entities adopting IFRSs to continue to apply their existing accounting policies for these expenditures. This absence of comprehensive IFRS literature has contributed to continuing divergence in the international financial reporting of extractive activities. Concerns have also been raised that some accounting practices might not be consistent with the IASB Framework for the Preparation and Presentation of Financial Statements. While the project to develop a new accounting standard seemed to have a fair deal of momentum, in 2012 work on the project was put on hold, and as of early 2016, had not been resumed. Hence, it may be quite some time before a new accounting standard pertaining to the extractive industries is released. Perhaps this should not be unexpected given the previous history of standard-setting in this topic area. According to Paragraph 1.16 of IASB (2010), the financial reporting issues that need to be considered in developing a new accounting standard for the extractive activities include:

(a) definitions of reserves and resources for use in the accounting for, and disclosure of, extractive activities; (b) the assets related to extractive activities that should be recognised in financial statements and when they should be recognised; (c) how those assets should be measured on initial recognition—alternatives include the historical cost of acquisition or discovery and fair value or some other current value basis; (d) how those assets should be measured in reporting periods after initial recognition, including issues such as remeasurement, impairment and depreciation; and (e) the information about extractive activities, including reserves and resources information, that should be disclosed in financial statements.

As part of the research conducted for the 2010 Discussion Paper, interviews were held with 34 experts from around the world who specialise in evaluating entities in the extractive industries. According to paragraph 1.23 of IASB (2010), the main survey findings generated from the interviews with these experts indicated:

(a) Historical cost information on minerals or oil and gas properties in the statement of financial position is not perceived to generate useful information. This is true whether the accounting method is full cost, successful efforts or area of interest. The accumulated costs incurred to find a deposit of minerals or oil and gas are not useful in predicting the future cash flows from that property. However, some historical cost information is considered to be useful. For example it was identified that ‘costs per unit of oil reserves found’ is considered useful in evaluating the entity’s ability to find oil reserves efficiently. This information depends on expenditure data rather than on data in the statement of financial position that include expenditures capitalised (but not those recognised as expenses) over many years, and are net of depreciation and impairment. Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  769

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(b) Recording minerals or oil and gas properties at fair value in the statement of financial position would not generate useful information. This response from the experts was not expected, as the value of properties, and particularly the estimates of the underlying reserves and resources, is important information for users in making economic decisions. These users explained that there are many significant variables that go into a valuation and there can be substantial subjectivity involved. They consider it important to apply their own judgement to those factors rather than relying on management’s judgement, and they undertake extensive research in order to do this. As professional users, their judgement and insights are important in determining their valuation of an entity and of its minerals or oil and gas properties. Concerns were also expressed about possible bias in fair values of minerals or oil and gas properties prepared by the entity given the extent of judgement that has to be applied. Most users interviewed said they would not rely on a fair value provided by the entity unless there was extensive disclosure of the assumptions used. Such disclosure would allow users to decide if they agreed with the assumptions, and only in that case would they use the fair value provided. Given the number of assumptions within a fair value estimate, most users thought that it would be unlikely that the fair value would be particularly useful. Some users said they might use a fair value estimate provided by the entity’s management to check their own estimate. (c) Users are looking for information, either within the financial statements or elsewhere, that will be useful in estimating the value of the entity. For an entity in the extractive industries this usually means information about the reserves and resources. Much of the information will be the same whether the user is looking at a minerals entity or an oil and gas entity—for example, information on the quantities of reserves, development and production costs and how those reserve estimates and cost bases change over time. However, some of the information will differ according to the type of mineral or oil and gas—for example, information on by-products and the grades of the minerals.

The finding that some historical cost information is deemed useful by financial statement users but that fair values might not always be considered relevant was interesting. This is not consistent with recent trends in financial reporting, which have been towards measuring assets at fair value. In relation to the potential for historical cost information to provide a faithful representation of underlying activities, and to provide relevant information, paragraphs 4.39 and 4.42 of IASB (2010) state respectively: Historical cost is generally regarded as providing a verifiable measure of the cost of acquiring and developing a property. Often these costs can be observed from a transaction, which suggests that historical cost is an objective measurement. This is not always true as an asset’s historical cost at initial recognition can be influenced by judgements made in, for example, cost allocation decisions relating to the unit of account and determining the initial carrying amount of individual assets acquired in either a business combination or in a multiple asset acquisition. Provided these judgements are exercised in a manner that makes the historical cost complete, neutral and free from material error, the historical cost would be a faithful representation of the cost to acquire, explore and develop a property. The relevance of a property’s historical cost for assessing future cash flows diminishes over time as subsequent exploration and evaluation activities generate more information about the property, including geological information and estimates of the size, quality and economic recoverability of any minerals or oil and gas discovered at the property. While a great degree of expertise and effort enters into exploration decisions, there is still significant uncertainty over the outcome of exploration. Different decisions affect the amount of exploration work required and costs incurred before a mineral or oil and gas reserve is discovered. As a result, the historical cost of exploration is not relevant for assessing future cash flows because there is no correlation with the future cash flows that may be generated from the production of minerals or oil and gas from the property. The above discussion highlights the general issues associated with using historical costs versus fair values to measure any assets—not just in relation to those assets associated with extractive industries. While historical cost might provide a faithful representation of the underlying ‘cost’ of an asset, that cost might not be terribly relevant for making various decisions if the value of the asset is significantly different from cost. The choice between historical cost and fair value measurement will also have direct implications for income recognition. As paragraph 4.79 of IASB (2010) states: The decision to use historical cost or current value as the measurement basis has significant implications for income recognition. The current practice of measuring mineral properties at historical cost means that income 770  PART 6: INDUSTRY-SPECIFIC ACCOUNTING ISSUES

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is generally recognised at the point when revenue is recognised for the sale of the extracted minerals or oil and gas to a third party. It also means that income related to a specific unit of production is generally recognised only once. (If a reserve is impaired but the minerals or oil and gas are subsequently produced and sold, then income may be affected more than once.) In contrast, a current value measurement basis means remeasuring the asset each reporting period. The difference in the current value is accounted for in income. (This might be in profit or loss, or in other comprehensive income.) The choice between historical cost and fair value also has implications for the potential volatility of reported income. As paragraph 4.81 of IASB (2010) states: Over the life of a mine (or oil and gas field) the relevant commodity price may go through one or more cycles of increases and decreases. The fluctuations (together with changes in other assumptions) will cause the current value of the mine also to fluctuate, with year-on-year increases or decreases in current value reported in income. This would be similar to the impact of measuring financial instruments at fair value. The volatility resulting from measuring operating assets such as minerals or oil and gas properties at fair value is often viewed by preparers as reducing the relevance of the statement of comprehensive income and masking current performance. Proponents of current value, on the other hand, argue that the statement of comprehensive income is reflecting the real-world volatility and thus providing a more faithful representation of the entity’s financial performance. However, the faithful representation of financial performance depends on the estimate of the current value of the minerals or oil and gas properties also being representationally faithful—the current value may change because of estimation changes for the inputs used to determine the current value rather than because of changed facts and circumstances. Obviously choosing between fair value and historical cost as the basis for measurement for the purposes of an extractive industries accounting standard is an important decision that the IASB will have to make. After considering the responses provided by various experts, paragraphs 4.83 to 4.85 provide insights into the Project Team’s views in respect of the preferred basis for measurement. These paragraphs state:



4.83 The research does not provide substantive support for either historical cost or fair value as the measurement basis for exploration properties and minerals or oil and gas properties. Historical cost generally does not provide relevant information. Fair value conceptually provides relevant information. However, owing to the subjectivity and degree of estimation involved, users do not view entity-prepared current values as being representationally faithful, and therefore they would make limited use of them. In the project team’s view, information that is not used is not relevant. Preparing current value estimates of these assets involves significant work effort and cost. The project team thinks that measuring these assets at current value would not meet a cost-benefit test. For the reasons discussed above, the project team also does not support measuring the assets in the financial statements at a current value similar to a standardised measure. 4.84 This might suggest that all exploration, evaluation and development expenditures should be recognised as expenses. However, this would seriously misstate the statement of comprehensive income because expenditures that result in future value to the entity would negatively affect income. It would also result in not recognising assets of the entity. An entity that found and developed a minerals or oil and gas property would show negative income until production began. This cannot be considered faithfully representational. The use of historical cost as the measurement basis would address these issues. The statement of comprehensive income would not be negatively affected by expenditures that create or increase the value of assets. Assets would be recognised in the statement of financial position, although this would be at amounts that are not relevant to most users. Historical cost is also a less costly measurement basis for preparers, although existing historical cost practices have developed over many years and are sometimes more complex than they need to be. If historical cost remains the measurement basis for exploration properties and minerals or oil and gas properties, the project team believes a single approach should be developed and that, given the limited relevance of historical cost, one of the principles of that approach should be simplicity. In other words, a historical cost accounting model for these assets should not be complicated by detailed and prescriptive cost allocation and requirements to capitalise or recognise as expense. However, the project team acknowledges that the historical cost measurement of these assets would need to be subject to depreciation calculations and impairment testing. Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  771

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4.85 The project team acknowledges that its choice of historical cost as the measurement basis is based to a large extent on doing the ‘least harm’, and may not meet the objective of financial reporting of providing financial information that is useful for making decisions. The one clear finding is that for financial statements to provide useful information about exploration properties and minerals or oil and gas properties—the core assets for entities engaged in extractive activities—substantive disclosures about the reserves would be required. This is true whether the measurement basis is historical cost or current value. As discussed above, the historical cost of a minerals or oil and gas property does not provide relevant information and thus would have to be supplemented by disclosures. With a current value, users would require disclosure of the main assumptions so that they could evaluate the current value or to adjust it to be consistent with their own assumptions. At this project has been paused and had not been restarted as of early 2016 it is not possible to predict what the ultimate position of the IASB will be. It would be surprising if historical cost were actually embraced as the basis of measurement—despite the conclusions of the 2010 Discussion Paper. The adoption of historical cost would represent a major departure from what has been happening in recent years. As we know, most of the accounting standards released in recent years have embraced fair value rather than historical cost as the basis for measuring various types of assets. Whatever the form of any new accounting standard, it will be interesting to see if, unlike previous attempts internationally, the IASB will elect to reduce the accounting options currently available to organisations within the extractive industries. Failure to provide authoritative guidance will only further strengthen claims by various accounting researchers that the IASB is overly influenced by powerful vested interests.

SUMMARY In this chapter it was explained that the operations of extractive industries pose a number of difficult issues for accountants. One particular issue is how to account for expenditures incurred in the exploration and evaluation phases of operations. At issue is whether the expenditures generate assets or expenses for the reporting entity. Historically, a number of approaches have been adopted to account for pre-production costs in the extractive industries, including the costswritten-off method; the costs-written-off-and-reinstated method; the successful-efforts method; the full-cost method; and the area-of-interest method. Each of these methods is described in this chapter. In Australia, and pursuant to AASB 6, the area-of-interest method must be used. This is more restrictive than the requirements embodied within the standard’s international counterpart, this being IFRS 6. Applying the area-of-interest method, exploration and evaluation expenditures are to be accumulated by area of interest, where an area of interest is defined as an individual geological area that is considered to constitute a favourable environment for the presence of a mineral deposit or an oil or natural gas field, or has been proved to contain such a deposit or field. In most cases, an area of interest will comprise a single mine or deposit, or a separate oil or gas field. With the area-of-interest method, exploration and evaluation costs for each area of interest are to be written off as incurred, except that they may be carried forward provided that rights of tenure of the area of interest are current and provided at least one of the following conditions is met: • Such costs are expected to be recouped through successful development and exploitation of the area of interest or, alternatively, by its sale. • Exploration and/or evaluation activities in the area of interest have not yet reached a stage that 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 are continuing. Where exploration and evaluation expenditures are carried forward in relation to an area of interest, it is a requirement of AASB 6 that these costs be subject to ongoing impairment testing. Amortisation or depreciation of the carried-forward costs would not occur until the assets are ready for use—which is typically at the production phase. The productionoutput basis would typically be used where production is limited by reserves, whereas the time basis is appropriate where production is limited by time (for example, the life of a lease) rather than by the estimated quantity of proven reserves. During the various phases of operations, disturbance to the environment will be caused, which will generally necessitate subsequent restoration work. The costs of this work should be recognised throughout the various phases of 772  PART 6: INDUSTRY-SPECIFIC ACCOUNTING ISSUES

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operations and should ultimately be treated as a part of the cost of production within the production phase of operations. If a decision is made to abandon an area of interest, the costs carried forward in relation to the area must be written off in the period in which the decision to abandon the area is made. While AASB 6 and other relevant standards require the disclosure of financial information about the performance of entities involved in the extractive industries, this chapter has briefly discussed how most large companies involved in the extractive industries elect also to provide information about their social and environmental performance. Such disclosure is not governed by any accounting standard.

KEY TERMS area of interest  744 area-of-interest method  746 costs-written-off-and-reinstated method  745

costs-written-off method  745 economically recoverable reserves  744 extractive industries  744

full-cost method  746 successful-efforts method  746

END-OF-CHAPTER EXERCISES 1. From the perspective of the extractive industries, what are pre-production costs and in what circumstances should they be deferred to future periods? LO 20.2, 20.4 2. If pre-production costs are deferred to future periods in accordance with the area-of-interest method, how are those costs to be subsequently amortised? LO 20.4, 20.5 3. What is an area of interest? LO 20.4 4. When should a production-output basis, or a time basis, be used to amortise costs carried forward in relation to an area of interest? LO 20.7 5. What are restoration costs, and how should an organisation in the extractive industries account for restoration costs? LO 20.8 6. If a decision is made to abandon an area of interest, how should any pre-production costs in respect of that area be treated? LO 20.6 7. Is the rule in AASB 6 that permits exploration and evaluation expenditure to be carried forward (capitalised) in ‘those situations where activities in the area of interest have not yet reached a stage that permits a reasonable assessment of the existence or otherwise of recoverable reserves’ consistent with the asset recognition criteria provided in the Conceptual Framework for Financial Reporting (which relies upon probabilities and measurability)? LO 20.3, 20.4, 20.5

REVIEW QUESTIONS 1. Define ‘area of interest’. LO 20.4 2. Would the full-cost method or the area-of-interest method of accounting for the extractive industries provide a greater volatility of earnings? LO 20.4 3. What method of accounting for exploration and evaluation expenditures would most likely be used if the Conceptual Framework for Financial Reporting were the overriding regulation? LO 20.3, 20.4, 20.5 4. According to the US experience, what would have motivated firms to lobby against the abolition of the full-cost method? LO 20.12 5. When should a company in the extractive industries start accounting for its restoration costs? LO 20.8 6. Assume that a company is not legally required to restore the land after it has ceased mining. Nevertheless, it has determined that it will restore the land because ‘it is the right thing to do’. Would the company recognise a liability? LO 20.8 Chapter 20: ACCOUNTING FOR THE EXTRACTIVE INDUSTRIES  773

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7. Generally speaking, what costs should be included in the cost of inventory of an entity involved in the extractive industries? Explain your answer. LO 20.4, 20.5, 20.10 8. Would you expect the profits of an entity using the full-cost method of accounting (permitted in the USA but not in Australia) to be higher or lower than the profits of an entity that uses the area-of-interest method? LO 20.4 9. When would you use time as the basis for amortising pre-production costs incurred in a mining venture?  LO 20.7 10. For depreciable assets used in a particular area of interest, what factors would you consider in determining the depreciation period (useful life) of the asset? LO 20.4, 20.5 11. Would it be permissible for a company operating in the extractive industries to write off all exploration and evaluation expenditures, regardless of the ultimate success of a site? LO 20.3, 20.4, 20.7 12. ‘Because exploration and mining activities are inherently risky and uncertain, all exploration and evaluation expenditures should be expensed as incurred.’

REQUIRED Evaluate this statement. LO 20.3, 20.4 13. Extracto Ltd commences operations on 1 January 2017. During 2017 Extracto Ltd explores three areas and incurs the following costs:   Good Bad Indifferent

Exploration and evaluation expenditure ($m) 23 16 25

In 2018 oil is discovered at Good Site. Bad Site is abandoned. Indifferent Site has not yet reached a stage that permits a reasonable assessment of the existence or otherwise of economically recoverable reserves, and active and significant operations in the area of interest are continuing. In relation to the exploration and evaluation expenditures incurred at Good Site and Indifferent Site, 80 per cent of the expenditures relate to property, plant and equipment, and the balance relates to intangible assets. In 2018 development costs of $27 million are incurred at Good Site (to be written off on a production basis). $20  million of this expenditure relates to property, plant and equipment, and the balance relates to intangible assets. Good Site is estimated to have 15 000 000 barrels. The current sale price is $30 per barrel. Three million barrels are extracted at a production cost of $4 million and 1.9 million barrels are sold.

REQUIRED Provide the necessary journal entries using: (a) the area-of-interest method (b) the full-cost method. LO 20.2, 20.4, 20.5, 20.6, 20.10 14. Surfcity Mining Ltd incurs the following exploration and evaluation costs at two sites, Ian and Eddie, over the years indicated:   2017 2018 2019

Ian

Eddie

$1 500 $2 000 $3 000

$2 000 $3 000 $4 000

In relation to the above expenditure, in each year 20 per cent relates to intangible assets and the balance of the expenditure relates to property, plant and equipment. At the end of 2019, oil of an economically recoverable nature is discovered at Ian, but Eddie is abandoned. Following the discovery of oil at Ian, roads and other infrastructure of a fixed nature are constructed in 2020 at a cost of $2000. Portable buildings, with a life of 10 years, are also put in place. These buildings cost $500. Production at Ian begins in 2020. It is envisaged that the Ian site would contain 1500 barrels. The sale price of each barrel is $25. The incremental production costs associated with each barrel are $5. During 2020, 400 barrels are extracted, of which 250 are sold.

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Assets are amortised or depreciated using the production-output method, except where such assets can be redeployed elsewhere, in which case their individual useful life is used.

REQUIRED Provide the journal entries for 2017 to 2020 using: (a) the area-of-interest method (b) the full-cost method. LO 20.4, 20.5, 20.6, 20.10

CHALLENGING QUESTIONS 15. Kakadu Ltd commences mining operations on 1 July 2017. During the first year of exploration and mining operations, Kakadu Ltd explores three areas known as Green, Tree and Frog. It incurs the following costs: Exploration and evaluation costs— property, plant and equipment ($m)

Exploration and evaluation costs— intangibles assets ($m)

Total site costs ($m)

Green

3

6

9

Tree

6

4

10

Frog  

 3 12

 7 17

10 29

 

On 10 January 2018, uranium is discovered at Green. Because of damage continually being caused by angry goannas, it is decided in March 2018 that it is too costly to continue operations at Tree. Operations at Tree are abandoned. Operations at Frog are continuing, although no decision has been made about the commercial viability of the site. Up until 30 June 2018, development costs of $12 million are incurred at Green (to be written off on a production basis). This cost relates to the construction of plant and equipment. The site is estimated to have 50 000 tonnes of uranium. The current sale price is $3000 per tonne. Up until 30 June 2018, 5000 tonnes of uranium are extracted at a production cost of $2 million. In June 2018, 4000 tonnes are sold, with 1000 remaining on hand. The reporting date of Kakadu Ltd is 30 June 2018.

REQUIRED Provide the journal entries using the area-of-interest method. LO 20.3, 20.4, 20.5, 20.6, 20.7, 20.9, 20.10 16. As we learned within the chapter, the contents of AASB 6 are different from IFRS 6. In particular, AASB 6 is more restrictive in relation to how pre-production expenditure is to be accounted for.

REQUIRED (a) Considering the insights provided by Cortese, Irvine and Kaidonis, why do you think that the IASB decided not to eliminate the use of the full-cost method? (b) Why do you think that the AASB decided to restrict the methods that could be used to account for preproduction costs within AASB 6? LO 20.12 17. Read the following two extracts from newspaper articles and comment on how you believe any exploration and evaluation costs already incurred by the companies should be treated for accounting purposes. Extract 1: ‘Gold Road’, as reported in Business News on 27 February 2015 Perth-based explorer Gold Road Resources has completed a scoping study for the development of its Gruyere project east of Laverton, which has found it to be a robust, long life and large-tonnage gold project. The study assessed the economics of the Gruyere project, at varying throughput rates, against a number of internal company hurdles. The base case average annual production, following ramp-up, was estimated to be

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190,000 ounces of gold over an initial mine life of 11 years, with an average net pre-tax cash flow of over $80 million per annum, at an assumed gold price of $1350 per ounce. The life of mine gold revenue was forecast at $2.8 billion, producing a net pre-tax cash flow of over $550 million after capital costs. Pre-production capitals costs were estimated at $360 million. Extract 2: ‘Sirius stock jumps on gold discovery’, adapted from The Australian Financial Review, 21 January 2015, by Peter Ker Sirius Resources’ reputation for exploration success continues to grow, after it reported strong gold results from its first drilling of a new area in Western Australia. . . . Sirius said it had found grades of gold as high as 8.68 per tonne beneath a salt lake between Coolgardie and Norseman along with a 33-metre stretch of 3.81 grams per tonne . . . Sirius managing director Mark Bennett said further drilling would follow the discovery. ‘We have been looking forward to drilling this area for a long time,’ he said. ‘It was unexplored, it had been out of bounds during the modern era of gold exploration, and it is in a district with approximately 30 million ounces of gold discovered in relative proximity to the north, west and south of us.’ . . . Construction and development of the Nova project will begin in the coming weeks after Sirius secured a $440 million finance package in December. LO 20.4, 20.5, 20.9, 20.10 18. During the reporting period ending 30 June 2018, Cortese Ltd erected an oil rig off the coast of Wollongong. The cost of the rig and associated technology amounted to $200 million. The oil rig commenced production on 1 July 2018. At the end of the rig’s useful life, which is expected to be 10 years, Cortese Ltd is required by its resource consent to dismantle the oil rig, remove it, and return the site to its original condition. Cortese Ltd estimates that if such work was required to be done at the present time it would cost $25 million. The costs of this work are expected to increase by an average of 3 per cent per year over the next 10 years. The rate on 10-year government bonds reflects the relevant time value of money, and the rate is 4 per cent.

REQUIRED Prepare the journal entries necessary to account for the establishment of the rig and the changing balance of the restoration provision for the years ended 30 June 2018, 30 June 2019 and 30 June 2020. Ignore depreciation. LO 20.4, 20.10

REFERENCES COLLINS, D., ROZEFF, M. & SALATKA, W., 1982, ‘The SEC’s Rejection of SFAS No. 19: Tests of Market Price Reversal’, Accounting Review, January, pp. 1–17. CORTESE, C.L., 2013, ‘Politicisation of the International Accounting Standard Setting Process: Evidence from the Extractive Industries’, Journal of New Business Ideas and Trends, vol. 11, no. 2, pp. 48–57. CORTESE, C.L., IRVINE, H.J. & KAIDONIS, M.A., 2007, ‘Standard Setting for the Extractive Industries: A Critical Examination’, Australasian Accounting Business & Finance Journal, vol. 1, no. 3, pp. 1–11. CORTESE, C.L., IRVINE, H.J. & KAIDONIS, M.A., 2010, ‘Powerful Players: How Constituents Captured the Setting of IFRS 6, an Accounting Standard for the Extractive Industries’, Accounting Forum, vol. 34, no 2, pp. 76–88. DEAKIN, E.B., 1989, ‘Rational Economic Behaviour and Lobbying on Accounting Issues: Evidence from the Oil and Gas Industry’, Accounting Review, January, pp. 137–51. GERHARDY, P., 1999, ‘Accounting for Pre-production Costs: Extracting Consensus’, Australian Accounting Review, vol. 9, no. 2, pp. 51–63. INTERNATIONAL ACCOUNTING STANDARDS BOARD, 2010, Discussion Paper DP/2010/1: Extractive Activities, IASB, London, April.

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KING, R. & O’KEEFE, T., 1986, ‘Lobbying Activities and Insider Trading’, Accounting Review, 61, 1, pp. 76–9. LARCKER, D., REDER, R. & SIMON, D., 1983, ‘Trades by Insiders and Mandated Accounting Standards’, Accounting Review, 58, 3, pp. 606–20. MIRZA, M. & ZIMMER, I., 1999, ‘Recognition of Reserve Values in the Extractive Industries’, Australian Accounting Review, vol. 9, no. 2, pp. 44–50. SPOORS, C., 2015, ‘Where Does the Australian Government Stand on Mining Transparency?’, Australian Institute of International Affairs, 29 October 2015. Available at: http://www.internationalaffairs.org.au/australian_outlook/ where-does-the-australian-government-stand-on-mining-transparency/. WALKER, J., 1995, ‘Accounting for Pre-production Costs’, Unpublished paper, University of Queensland. WATTS, R.L. & ZIMMERMAN, J.L., 1978, ‘Towards a Positive Theory of the Determinants of Accounting Standards’, The Accounting Review, January, pp. 112–34.

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PART 7

OTHER DISCLOSURE ISSUES CHAPTER 21 Events occurring after the end of the reporting period CHAPTER 22 Segment reporting CHAPTER 23 Related party disclosures CHAPTER 24 Earnings per share

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CHAPTER 21

EVENTS OCCURRING AFTER THE END OF THE REPORTING PERIOD LEARNING OBJECTIVES (LO) 21.1 Understand what constitutes an event occurring after the end of the reporting period. 21.2 Understand that, in the time between the end of the reporting period (or ‘balance sheet date’ or ‘reporting date’ as it has previously been known) and the date the financial statements are authorised for issue, new information often becomes available that provides additional evidence of conditions that existed at the end of the reporting period or reveals for the first time a condition that existed at the end of the reporting period. In such circumstances the new information must be reflected in the financial statements, or notes thereto. 21.3 Understand that financial statements are often not released for over 10 weeks after the end of the reporting period, and to make them more ‘relevant’ it is sometimes appropriate to add notes giving additional information about material events that have occurred since the end of the reporting period. 21.4 Understand that events occurring after the end of the reporting period can be classified as either ‘adjusting events’ or ‘non-adjusting events’. 21.5 Know the difference between an adjusting event after the reporting period, and a non-adjusting event after the reporting period, and be aware of how to account for each. 21.6 Be able to describe how dividends declared after the end of the reporting period should be accounted for and disclosed. 21.7 Understand that an entity should not prepare its financial statements on the going concern basis if events after the reporting period indicate that this assumption is no longer valid. 21.8 Be aware of the specific disclosure requirements of AASB 110 Events After the Reporting Period.

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What is an ‘event after the reporting period’? Events after the reporting period are defined at paragraph 3 of AASB 110 Events After the Reporting Period as: those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue.

LO 21.1 LO 21.2 LO 21.3

balance sheet date

The end of the reporting period can also be defined as the end of the financial year to which the The end of the financial period (typically 12 financial statements relate. It is therefore what we would traditionally have referred to as the balance months). Also referred sheet date or reporting date. to as ‘reporting date’ The date financial statements are authorised for issue means, in the case of companies, the or ‘balance date’. date the Directors’ Declaration is signed, which is typically the last thing a company’s directors do before the financial statements are released. As we know from previous chapters of this book, the reporting date Corporations Act has various requirements relating to the contents of the Directors’ Declaration, Often referred to as an important one being that the directors sign a statement that the entity can pay its debts as and ‘balance date’. The when they fall due. Once the Directors’ Declaration is signed, the auditors sign the auditors’ report, end of the financial at which point the reporting process is complete, except for distribution. period (typically 12 The signing of the Directors’ Declaration will occur a number of weeks after the ‘end of the months). In Australia reporting period’. For example, BHP Billiton Ltd has a reporting date of 30 June. Its 2015 Directors’ most companies have a reporting date of Declaration was not signed until 9 September 2015, and this date is deemed to be the date upon 30 June. which the financial statements for the period ended 30 June 2015 were completed. Therefore anything that occurred in the 71-day period between 30 June 2015 and 9 September 2015 would fall into the period covered by AASB 110—a period in which an event after the reporting period date financial can occur. statements are For entities other than companies, the date the financial statements are authorised for issue is authorised for issue For companies, the the date of final approval of the statements by the management or governing body of the entity, date the Directors’ whichever is applicable. Declaration is signed, Worked Example 21.1, based on an example provided in AASB 110, illustrates how the date typically the last thing the financial statements are authorised for issue is determined. a company’s directors To sum up, what AASB 110 addresses is how to treat, for accounting purposes, those events do before releasing the financial statements. or transactions that occur, or about which information becomes available, between the end of the For other entities it reporting period (typically 30 June in Australia) and when the financial statements are authorised for is the date of final issue. This is summarised diagrammatically in Figure 21.1. approval of the report As there is usually a time lag of many weeks or even months between the end of the financial by the management or period and the date that shareholders and other interested parties receive the financial statements, governing body of the data is likely to be out of date by the time it reaches the financial statement users. Many material the entity. events could have occurred after the end of the reporting period. The financial statements are as at a particular date (for the statement of financial position) or for a period of time to reporting event after the date (for the statement of profit or loss and other comprehensive income, statement of changes in reporting period equity, and statement of cash flows) and it is not correct practice to change the financial statements An event or because of events that have occurred after that date. The only exception to this requirement within circumstance that has arisen or information the accounting standard—which we will discuss shortly—is the requirement that relates to afterthat has become reporting-period changes in the entity’s status as a going concern. Nevertheless, the information may available after the end be supplemented by notes to the financial statements that document and describe material events of the reporting period after the reporting period. Failure to disclose material events that arise after the end of the reporting (usually 30 June in period can, in effect, make the financial statements misleading. For example, the year-end statement Australia) but prior to of financial position of a reporting entity might show a value for buildings that are an integral part the time of completion of the report. of the entity’s operations, and yet they are uninsured. If the buildings are destroyed in the period between the end of the reporting period and the date the financial statements are authorised for issue, the year-end financial statements would not be adjusted (because the statements reflect the assets held at the end of the reporting period), but disclosure of the event in the notes to the financial statements would be required to the extent the loss was material. The purpose of the accounting standard on events occurring after the reporting period is to require the effect of material events occurring after the end of the reporting period to be included in the financial statements or accompanying CHAPTER 21: EVENTS OCCURRING AFTER THE END OF THE REPORTING PERIOD  781

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Figure 21.1 Summary guidance in relation to the disclosure of events after the reporting period.

Reporting date 30 June for most companies in Australia

Period of time in which an item or event is considered an ‘event after the reporting period’

Date the financial report is authorised for issue

For companies: date of Directors’ Declaration—could be many weeks after the end of the reporting period For other entities: date of final approval of financial report by management or governing body of entity

WORKED EXAMPLE 21.1:  Establishing the date the financial statements are authorised for issue Surfersam Ltd, whose reporting period ends on 30 June 2019, completes its draft financial statements on 15 September 2019. On 30 September 2019, the Board of Directors reviews the financial statements, approves them and authorises their issue. Earnings announcements are made on 3 October 2019 and the financial statements are made available to shareholders on 12  October  2019. Surfersam Ltd’s annual general meeting is held on 24 October 2019 and the financial statements are filed with ASIC on 26 October 2019. REQUIRED Identify the date the financial statements were authorised for issue and identify the period for which an event would be considered an event occurring after the reporting period for the purposes of AASB 110. SOLUTION In this example, the date the financial statements were authorised for issue is 30 September 2019, as this is the date the directors authorised them for issue to shareholders and other interested parties. Transactions or events that occur between 30 June and 30 September would be considered to be ‘events after the reporting period’.

notes, so that users entitled to rely on those financial statements are not misled. Again, it is stressed that if the event or transaction does not relate to any conditions that existed at the reporting date, it would generally be inappropriate to adjust the financial statements as they are meant to reflect conditions as at the end of the reporting period. Nevertheless, disclosure in the notes to the financial statements might be appropriate, depending on the materiality of the item in question. As we know, a statement of financial position in Australia is typically headed, ‘Statement of financial position as at 30 June 20XX’. If something material happens after 30 June, it would be inappropriate to alter the 30 June statement of financial position. The transaction or event would be reflected in the next period’s financial statements. There is a general requirement that the statement of financial position and the statement of profit or loss and other comprehensive income must be prepared on the basis of conditions existing at the end of the reporting period. Nevertheless, disclosure in the notes to the financial statements might in some circumstances be warranted when the new information pertains to a relevant transaction or event that reflects something that happened in the period after the end of the reporting period, but prior to the date the financial statements are authorised for issue.

LO 21.4 LO 21.5 LO 21.6 LO 21.7

Types of events after the reporting period There are generally two basic types of subsequent events (after-reporting-period events) requiring consideration. First there are those that relate to events that occurred before the end of the reporting period; and second there are those that relate to events that occur after the end of the reporting period. These events are referred to as:

1. adjusting events after the reporting period, and 2. non-adjusting events after the reporting period.

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Event occurring after the end of the reporting period

Does it provide evidence or further elucidate conditions that existed at the end of the reporting period?

No

Does it create a new condition as distinct from any conditions that might have existed at the end of the reporting period?

Yes

Yes

Is the information pertaining to the event occurring after the end of the reporting period ‘material’?

Is the information pertaining to the event occurring after the end of the reporting period ‘material’?

Yes

No No disclosure required

Event/transaction is to be included within the financial statements to the extent that it can be quantified. If it cannot be quantified, it should be included in a note to the financial statements (e.g. a contingent liability).

Figure 21.2 Determining the treatment of an event occurring after the end of the reporting period.

No Yes

No disclosure required

Recognise by way of a note to the financial statements

As paragraph 3 of AASB 110 states: Events after the reporting period are those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. Two types of events can be identified: (a) those that provide evidence of conditions that existed at the end of the reporting period (adjusting events after the reporting period); and (b) those that are indicative of conditions that arose after the reporting period (non-adjusting events after the reporting period). We will consider each of the above types of events in turn. Figure 21.2 provides summary guidance on the treatment of events that occur after the end of the reporting period.

Events that necessitate adjustments to the financial statements (adjusting events after the reporting period) ‘Adjusting events’, both favourable and unfavourable, provide additional evidence of, or further elucidate, conditions that existed as at the end of the reporting period. With regard to such ‘adjusting events’, AASB 110 requires the financial statements to reflect the financial effect of an event occurring after the end of the reporting period that: • provides additional evidence of conditions that existed at the end of the reporting period, or • reveals for the first time a condition that existed at the end of the reporting period. For example, additional information might become available that enables those in charge of preparing the financial statements to estimate more accurately year-end provisions that are used in preparing financial statements. For instance, there might have been a legal claim outstanding at the end of the reporting period that has subsequently been settled. With this information, the year-end provision for this liability could be recorded reliably. Without the information, the potential obligation might be recorded in the notes to the financial statements as a contingent liability.

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Alternatively, new information might come to light that reveals for the first time a condition that existed at the end of the reporting period. For example, it might become apparent before the date the financial statements are authorised for issue that buildings at a remote site were destroyed by flood before year end. In this case, adjustment to the year-end financial statements would be required. Alternatively, it might be discovered that a particular transaction that related to the relevant financial year has been entirely omitted—there might have been a failure in the accounting controls and a liability went unrecorded. The financial statements would require adjustment in this case too. Further examples of events that necessitate adjustments to the amounts that appear in the financial statements, or adjustments to recognise items that were not previously recognised (assuming they are material individually, or in total), are provided at paragraph 9 of AASB 110. These would include: (a) the settlement after the reporting period of a court case that confirms that the entity had a present obligation at the end of the reporting period. The entity adjusts any previously recognised provision related to this court case in accordance with AASB 137 Provisions, Contingent Liabilities and Contingent Assets or recognises a new provision. The entity does not merely disclose a contingent liability because the settlement provides additional evidence that would be considered in accordance with paragraph 16 of AASB 137; (b) the receipt of information after the reporting period indicating that an asset was impaired at the end of the reporting period, or that the amount of a previously recognised impairment loss for that asset needs to be adjusted. For example: (i) the bankruptcy of a customer that occurs after the reporting period usually confirms that the customer was credit-impaired at the end of the reporting period; and (ii) the sale of inventories after the reporting period may give evidence about their net realisable value at the end of the reporting period; (c) the determination after the reporting period of the cost of assets purchased, or the proceeds from assets sold, before the end of the reporting period; (d) the determination after the reporting period of the amount of profit sharing or bonus payments, if the entity had a present legal or constructive obligation at the end of the reporting period to make such payments as a result of events before that date (see AASB 119 Employee Benefits); and (e) the discovery of fraud or errors that show that the financial statements are incorrect. AASB 110 stipulates specific requirements for dividends and the going concern basis for financial statement preparation. These two issues are discussed in turn below.

Dividends declared In relation to dividends, paragraph 12 of AASB 110 requires that dividends proposed or declared after the end of the reporting period shall not be recognised as a liability in the statement of financial position. In explaining this, paragraph 13 of AASB 110 states: If dividends are declared after the reporting period but before the financial statements are authorised for issue, the dividends are not recognised as a liability at the end of the reporting period because no obligation exists at that time. Such dividends are disclosed in the notes in accordance with AASB 101 Presentation of Financial Statements. This requirement represents something of a departure from prior practice in Australia. Before 2005, if dividends were declared after the end of the reporting period they would be included in the liabilities of the reporting entity as at the end of the reporting period. That is, under the former treatment the declaration of dividends would have been treated as an ‘adjusting event’. For example, if dividends were declared in July 2018, and the end of the reporting period was 30 June 2018, the dividends declared in July would actually be treated as part of liabilities as at 30 June 2018. The rationale for this treatment was that there would be an expectation that dividends would be paid from 2018 profits, and the decision by the directors as made in July simply allows a quantification of the amount that is payable. However, this treatment is no longer allowed—dividends declared after the end of the reporting period are not to be treated as liabilities as at the end of the reporting period. Worked Example 21.2 shows how the disclosure of dividends declared after the reporting period shall be made. 784  PART 7: OTHER DISCLOSURE ISSUES

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WORKED EXAMPLE 21.2: Disclosure of declared dividends On 18 August 2019, the directors of Alpha Ltd declared that a dividend of 20 cents per ordinary share be paid to shareholders registered on 30 June 2019, the financial year-end of the company. The financial statements were authorised for issue on 25 August 2019, while the payment of the dividends is likely to be made on 1 September 2019. REQUIRED Illustrate how Alpha Ltd would disclose the declared dividends. SOLUTION The dividend declared after the end of the financial period would be disclosed in the notes to the financial statements as follows: Note xx. Events after the end of the reporting period Dividends declared On 18 August 2019, the directors declared that a dividend of 20 cents per ordinary share be paid to shareholders registered on 30 June 2019. By contrast, if a final dividend of a fixed amount or one based on a percentage of the net profit for the year is declared by the directors before the end of the reporting period and before the financial statements are authorised for issue, this gives rise to a constructive obligation at the end of the reporting period. In this case the dividend should be accrued. The entry for such a dividend would be: Dr Cr

Dividend declared (statement of changes in equity) Dividend payable (statement of financial position)

XXX XXX

Breach of the going concern assumption In relation to the going concern basis of preparation, AASB 110 requires that if after the end of the reporting period it becomes apparent that new events or conditions have resulted that indicate that the entity is no longer a going concern, the financial statements are no longer to be prepared on the basis of the going concern assumption. Specifically, paragraph 14 of the standard requires: An entity shall not prepare its financial statements on a going concern basis if management determines after the reporting period either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so. We should remember that the going concern basis of preparation means that an entity is expected to continue operating for an indefinite period, and not to cease operations in the near future. If an entity is no longer considered to be a going concern it would mean that assets and liabilities would have to be disclosed in the statement of financial position on a liquidation basis. This could mean very significant write-downs in the measurement of assets. The determination of whether an entity is a going concern would be dependent upon professional judgement. An entity would not be considered a going concern if it is perceived to be unable to pay its debts as and when they fall due. Failure to be considered a going concern might be the result of a number of factors. For example, there could be major uninsured fire damage; the entity might have lost major customers; or perhaps there are major unhedged overseas borrowings and the relevant exchange rate moves against the entity. Therefore AASB 110 treats after-reporting-period reassessments of the going concern basis of accounting as ‘adjusting events’, whereas under the ‘old’ accounting standard (which was AASB 1002), any new events that occur after the end of the reporting period, and which bring the organisation’s going concern status into question, would have been treated as ‘non-adjusting events’ (although the ‘old’ standard required certain disclosures to be made in the notes to the financial statements about the amounts for which the assets were expected to be realised and the amounts for which the liabilities were expected to be settled). Therefore, and further emphasising the above requirements, under our post-2005 requirements an entity might be a going concern at the end of the reporting period (at reporting date). However, if something new happens after the end CHAPTER 21: EVENTS OCCURRING AFTER THE END OF THE REPORTING PERIOD  785

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of the reporting period that brings the going concern of the entity into question then management is required to go back and change the way the assets are measured. This is an interesting requirement because, as we know, statements of financial position are prepared to represent conditions as at the end of the reporting period. Under AASB 110, if new conditions arise after the reporting period that create a new situation in which the entity is not a going concern, such new events are effectively ‘backdated’ since we are required to amend the values of assets being shown in the statement of financial position. It is interesting to note that in Exposure Draft 76 Events Occurring After Reporting Date, which preceded the release of the ‘old’ AASB 1002, it was argued that where, before completion of the financial statements, an event occurring after reporting date provided evidence that the going concern assumption was no longer appropriate, the assets and liabilities should be recognised at their realisation and settlement amounts respectively. This is the treatment that we are now accepting under AASB 110. However, in 1997 this treatment was rejected by the AASB on the ground that it is inappropriate to change financial statements to take into account transactions or events that had not occurred on or before the end of the reporting period, regardless of the importance of the information involved. It is interesting to see how this opinion seems now to have been abandoned in favour of a ‘blanket acceptance’ of the contents of standards released by the International Accounting Standards Board.

Events that necessitate disclosure but no adjustment (non-adjusting events) So far, this chapter has concentrated on adjusting events. The second type of subsequent event (a non-adjusting event) is one that occurs after the end of the reporting period. Such events create new conditions and therefore, as they are outside the financial period being reported on, would not lead to changes to the financial statements themselves. These events provide evidence, both favourable and unfavourable, about new conditions, as distinct from any that might have existed at the end of the reporting period. If the nature of the event is deemed to be material, the event should be disclosed in the notes to the financial statements. As indicated before in this book, something is deemed to be material if its omission, non-disclosure or misstatement is likely to affect economic decisions or other evaluations made by users entitled to rely on the financial statements. Again, as the information is new—that is, it does not relate to conditions at the end of the reporting period—it would be inappropriate to adjust the financial statements. Nevertheless, to the extent that the information is deemed to be material, disclosure by way of a note to the financial statements is required. AASB 110, paragraph 22 provides examples of subsequent events that might make note disclosure necessary without adjusting the financial statements. These include: (a) a major business combination after the reporting period (AASB 3 Business Combinations requires specific disclosures in such cases) or disposing of a major subsidiary; (b) announcing a plan to discontinue an operation; (c) major purchases of assets, classification of assets as held for sale in accordance with AASB 5 Non-current Assets Held for Sale and Discontinued Operations, other disposals of operations, or expropriation of major assets by government; (d) the destruction of a major production plant by a fire after the reporting period; (e) announcing, or commencing the implementation of, a major restructuring (see AASB 137); (f) major ordinary share transactions and potential ordinary share transactions after the reporting period (AASB 133 Earnings per Share requires an entity to disclose a description of such transactions, other than when such transactions involve capitalisation or bonus issues, share splits or reverse share splits all of which are required to be adjusted under AASB 133); (g) abnormally large changes after the reporting period in asset prices or foreign exchange rates; (h) changes in tax rates or tax laws enacted or announced after the reporting period that have a significant effect on current and deferred tax assets and liabilities (see AASB 112 Income Taxes); (i) entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees; and ( j) commencing major litigation arising solely out of events that occurred after the reporting period. Having now discussed the difference between an adjusting and adjusting event, we can now consider Worked Example 21.3. 786  PART 7: OTHER DISCLOSURE ISSUES

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WORKED EXAMPLE 21.3: Distinguishing between an adjusting or non-adjusting event after the reporting period Gerry Ltd owes Lopez Ltd an amount of $100 000 at 30 June 2019, the end of its reporting period. On 26 July 2019, Lopez Ltd received a letter from liquidators advising it of the bankruptcy of Gerry Ltd. The letter indicated that Gerry Ltd ceased trading in June 2019 and Lopez Ltd is likely to receive a liquidation dividend of only 15 cents in the dollar. REQUIRED (a) Discuss how the above transaction should be treated. (b) Provide the journal entry that Lopez Ltd would make in its records to account for the transaction. (c) Discuss how the answers to (a) and (b) would differ if a fire on 2 July 2019 destroyed Lopez Ltd’s factory premises. SOLUTION (a) This would be considered an adjusting event after the reporting period, as it relates to conditions existing at the end of the reporting period and improves accounting estimates at that date (namely the solvency and recoverability of the amount owed by Gerry Ltd). (b) Lopez Ltd would, based on the above information, make the following entry to reflect the improved estimate of the accounts receivable at year end: Dr Bad debts expense Cr Accounts receivable Writing off amount owing by Gerry Ltd

85 000 85 000

(c) As the fire that destroyed Lopez Ltd’s premises occurred on 2  July 2019, no adjustments to individual amounts in the financial statements of Lopez Ltd are required. That is, it would be considered to be a nonadjusting event. The reason for this is that the fire was not a condition that existed at the end of the reporting period. Nevertheless, disclosure in the notes to the financial statements would be appropriate. The impact of the fire might be so great that it might be necessary to establish whether it is still appropriate to prepare Lopez Ltd’s financial statements on the going concern basis. If, as a result of the fire, Lopez Ltd has no realistic alternative but to cease trading, its assets and liabilities as at 30 June 2019 would have to be adjusted to reflect a liquidation basis of accounting. In this instance, the fire would be an adjusting event.

Disclosure requirements

LO 21.8

It is important for users to know the date the financial statements were authorised for issue, since the financial statements and accompanying notes do not reflect events after this date. Further, it is useful for users to know who was responsible for authorising the issue of the financial statements. Accordingly, paragraph 17 of AASB 110 states: An entity shall disclose the date when the financial statements were authorised for issue and who gave that authorisation. If the entity’s owners or others have the power to amend the financial statements after issue, the entity shall disclose that fact. Consistent with the view that a financial statement (statement of financial position, statement of profit or loss and other comprehensive income, statement of changes in equity or statement of cash flows) must be prepared on the basis of conditions existing at the end of the reporting period, an ‘adjusting event’ (one that provides additional evidence of, or further elucidates, conditions that existed as at the end of the reporting period) would be recognised in the financial statements either by being brought to account, if it relates to an item that would itself be brought to account, or by being included by way of a note, if it relates to an item that would usually be recognised only by way of a note, such as a contingent liability. In relation to disclosures that would generally appear in the notes to the financial statements, rather than on the face of the financial statements, paragraph 20 states: In some cases, an entity needs to update the disclosures in its financial statements to reflect information received after the reporting period, even when the information does not affect the amounts that it recognises in its financial statements. One example of the need to update disclosures is when evidence becomes available CHAPTER 21: EVENTS OCCURRING AFTER THE END OF THE REPORTING PERIOD  787

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after the reporting period about a contingent liability that existed at the end of the reporting period. In addition to considering whether it should recognise or change a provision under AASB 137, an entity updates its disclosures about the contingent liability in the light of that evidence. For a material ‘non-adjusting’ event (an event that occurs after the end of the reporting period and therefore creates new conditions), paragraph 21 of AASB 110 states: If non-adjusting events after the reporting period are material, non-disclosure could influence the economic decisions that users make on the basis of the financial statements. Accordingly, an entity shall disclose the following for each material category of non-adjusting event after the reporting period: (a) the nature of the event; and (b) an estimate of its financial effect, or a statement that such an estimate cannot be made. Summary guidance in relation to after-reporting-period events is provided in Figure 21.2, as shown earlier in this chapter. Exhibit 21.1 is an example of an event occurring after the reporting date note. The note represents the note disclosures made by Telstra Ltd in its annual report for the year ended 30 June 2015.

Exhibit 21.1 Afterreportingperiod event note from the 2015 Annual Report of Telstra Ltd

NOTE 31. EVENTS AFTER REPORTING DATE We are not aware of any matter or circumstance that has occurred since 30 June 2015 that, in our opinion, has significantly affected or may significantly affect in future years: • our operations • the results of those operations • the state of our affairs other than the following: 31.1 Final dividend

On 13 August 2015, the Directors of Telstra Corporation Limited resolved to pay a fully franked final dividend of 15.5 cents per ordinary share. The record date for the final dividend will be 27 August 2015, with payment being made 25 September 2015. Shares will trade excluding the entitlement to the dividend on 25 August 2015.  A provision for dividend payable amounting to $1894 million has been raised as at the date of resolution.  The final dividend will be fully franked at a tax rate of 30 per cent. The financial effect of the dividend resolution was not brought to account as at 30 June 2015. There are no income tax consequences for the Telstra Group resulting from the resolution and payment of the final ordinary dividend, except for $812 million of franking debits arising from the payment of this dividend that will be adjusted in our franking account balance. The board has determined that Dividend Reinvestment Plan (DRP) will operate for the final dividend for financial year 2015 to be paid in September 2015. The election date for participation in the DRP is 28 August 2015. SOURCE: Telstra Ltd Annual Report 2015

Apart from the general requirements of AASB 110, it should be acknowledged that the Corporations Act also contains requirements related to after-reporting-period events. For example, s. 299(1)(d) requires that a company’s Directors’ Report must give details of any matter or circumstance that has arisen since the end of the financial period that has significantly affected or may significantly affect the entity’s operations in future financial years, the results of those operations in future financial years or the entity’s state of affairs in future financial years. Such disclosures will frequently not have any direct financial implications.

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SUMMARY The chapter considered various issues associated with accounting for events occurring after the reporting period. In accordance with AASB 110, an event occurring after the end of the reporting period is defined as a circumstance that has arisen or information that has become available after the end of the reporting period but before the date when the financial statements are authorised for issue. For a company, the date the financial statements are authorised for issue would be considered to be the time at which the directors sign the Directors’ Declaration. After-reporting-period events can be classified as either adjusting events or non-adjusting events. An adjusting event is one that provides additional evidence or further elucidates conditions that existed at the end of the reporting period. To the extent that the event would typically be reflected in an entity’s financial statements, information about the event must be used to adjust the financial statements (if the effects are material). If it is information of the type that is generally disclosed in the notes to the financial statements (for example, information that comes to light about material contingent liabilities), additional note disclosure is required. A non-adjusting event is an event occurring after the reporting period and one that therefore creates new conditions. If the information about the non-adjusting event is material, disclosure in the notes to the financial statements is required. Because financial statements are often released a number of months after the end of the reporting period, the note disclosure of non-adjusting events assists in making the financial statements more relevant to financial statement users.

KEY TERMS balance sheet date  781 date financial statements are authorised for issue  781

event after the reporting period  781

reporting date  781

END-OF-CHAPTER EXERCISES 1. If an event occurs after the reporting period it is considered that the event has occurred between the ‘the end of the reporting period’ and the ‘date when the financial statements are authorised for issue’. What is the ‘date when the financial statements are authorised for issue’? LO 21.1, 21.2 2. What is the rationale for the inclusion of information pertaining to material after-reporting-period events? LO 21.3 3. After-reporting-period events can be classified as either adjusting events or non-adjusting events. Describe each of these types of events and explain the accounting treatment required for each. (For example, for which type of event is note disclosure appropriate?) LO 21.4, 21.5

REVIEW QUESTIONS 1. What are the different types of after-reporting-period events and how should they be disclosed? LO 21.1, 21.4 2. If an event relates to a period after the reporting period, when and why should it be detailed in the notes to the financial statements? LO 21.3, 21.4 3. Determine whether the following events require adjustment to the financial statements, or disclosure by way of a note to the financial statements: (a) Loss of a major customer after the end of the reporting period. No amount is owing at the end of the reporting period. (b) A debtor owes a material amount and becomes insolvent after the reporting period. (c) Flood loss after the end of the reporting period.

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(d) Settlement of a negligence claim after the reporting period, which relates to operations undertaken before the end of the financial period. (e) Declaration of dividends after the end of the reporting period. LO 21.4, 21.5, 21.6, 21.7 4. Torquay Ltd’s financial year ended in June 2019. The following events occurred between the end of the reporting period and the date the directors of Torquay Ltd expect to authorise the financial statements for issue, namely 15 September 2019.

REQUIRED Classify the following events as either adjusting or non-adjusting events occurring after the reporting period, and indicate (in no more than two sentences) what sort of disclosure is required. Do not provide a detailed note. (a) Loss of a major customer after the reporting period. The customer owed no amount at the end of the reporting period. (b) The bankruptcy after the reporting period of a debtor who suffered a major loss after the reporting period. (c) Before the date the financial statements were authorised for issue, judgement against the company was handed down by the court finding the company was in fact liable for damages incurred by a customer that resulted from a faulty product. The court case commenced before the end of the reporting period. (d) On 31 August 2019, the directors decided to restructure a loss-making division. LO 21.1, 21.4, 21.5, 21.7, 21.8 5. Indicate how Petersen Ltd should treat the following events in its financial statements at 30 June 2019. You are not required to draft the financial statement notes. (a) On 15 August 2019, Michael Ltd, a major customer of Petersen Ltd, indicated that it had found an alternative supplier. At this date Michael Ltd owed no amount to Petersen Ltd. (b) On 30 June 2019, Lynch Ltd owed Petersen Ltd $234 900. On 24 July 2019, Petersen Ltd received notice that Lynch Ltd had become insolvent. It had ceased trading in May 2019. (c) On 31 July 2019, a major flood damaged the premises of Petersen Ltd. Inventory amounting to $324 600 was destroyed and repairs to office equipment and buildings will amount to a further $564 000. (d) On 12 August 2019, Petersen Ltd settled a negligence claim lodged by one of its customers. The claim arose on 7 March 2019, when an employee accidentally removed the customer’s ear while shaving him with a sharp razor. LO 21.4, 21.5, 21.7, 21.8

CHALLENGING QUESTIONS 6. You are finalising the 2018 financial statements of Petrol Ltd, a company involved in the mining, refining and retail distribution of petroleum products. As part of your final review, you have asked the chief executive officer if there are any events that have arisen since the end of the financial year of which you should be made aware. The financial period ends on 30 June 2018. He has advised you of the following events: (a) On 30 August 2018 a meeting of OPEC agreed to increase the Saudi Arabian oil quota by 17 million barrels in 2018–2019. The immediate impact of this decision was to reduce the price of crude oil by $13 a barrel to $56 a barrel. As at 30 June 2018 Petrol Ltd had one million barrels of crude oil in stock at an average cost of $60 per barrel. The price fluctuation is expected to be permanent given the change in attitude by the OPEC nations. (b) On 5 July 2018 an oil tanker owned by the company sank in heavy seas off the coast of northern NSW. The tanker was fully laden and has created an oil spill stretching for 140 km along the northern NSW coastline. The tanker was included in the 30 June 2018 financial statements at a carrying amount of $15 million. The oil that the tanker was transporting was being carried in the financial statements at $2 million. An initial evaluation of the cost of the clean-up operation is estimated at $14 million. There is also a strong possibility that the local oyster farmers will take legal action against the firm for stock losses and related damage to the oyster beds. The risk management team has assessed that the possible costs of litigation could reach $50 million. (c) Having reviewed the draft financial statements as at 30 June 2018, the directors approved a dividend of $5 per share. There are currently five million fully paid ordinary shares on issue. This dividend was declared on 30 September 2018. 790  PART 7: OTHER DISCLOSURE ISSUES

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(d) For the year ended 30 June 2017, the company had a tax provision of $8.5 million. During the year the company was the subject of a taxation audit, which resulted in an amended assessment of $26 million. The increased liability is in respect of the disputed tax treatment on certain share transactions carried out during the 2017 tax year. During 2018 the company lodged an objection against the revised assessment. The company’s tax advisers expected the objection to be successful. As a result the company did not consider it appropriate to recognise a provision in respect of the additional tax. It has, however, included a note explaining the situation and outlining the potential liability in the contingent liability note. On 1 July 2018, the company received notice from the Australian Taxation Office to the effect that the details of the objection had been considered but that the amended assessment was correct and therefore the objection had been declined. The company intends to appeal against the decision and take appropriate legal action if necessary. Taxation advisers, however, are not confident that the court will overturn the commissioner’s ruling. (e) In May 2018 the managing director was sacked because of allegations of fraud and theft. He had a five-year employment contract, of which four years remained, and he commenced legal action against the company for wrongful dismissal. The lawsuit is for $4 million but solicitors expect to settle the case out of court for $2 million, the residual value of the employment contract. Legal action began in August 2018. No provision was recognised in the 30 June 2018 financial statements. (f) At the August 2018 board meeting, the company made a decision to relocate a major oil refinery from Melbourne to Sydney. The possibility of such a move was discussed at the March 2018 board meeting, where it was decided that a review should be conducted into the feasibility of the move and that, if the move proved feasible, it should be undertaken. The report that was tabled at the August board meeting was dated 15 June 2018. The report concluded that the move was feasible and arrangements should be made as soon as possible. The report estimated the following costs to be incurred in respect of the move: • Loss on sale of property: The net book value of the property as at 30 June 2018 was $2.5 million. All research indicates that the net market value of the property after selling expenses would be $1.2 million, creating a loss of $1.3 million. • Redundancy costs: These costs for staff are estimated at $600 000. • Loss on sale of plant and equipment: Owing to the specialised nature of the plant and equipment, a loss of $650 000 is expected on its sale. The report was not tabled at the July board meeting because of the large agenda already planned for that meeting. The chief executive officer agreed that the property, plant and equipment should be put on the market in July, in anticipation of the board’s decision.

REQUIRED Review the information given above, and comment on any adjustments that might need to be made to the financial statements. The financial statements have not been finalised. Also consider the need for any additional disclosures in the financial statements. LO 21.1, 21.4, 21.5, 21.7, 21.8 7. The 30 June 2018 financial statements of ABC Ltd have been prepared in draft form. However, the financial statements have not yet been printed and sent to shareholders. Subsequent to the end of the reporting period, the following events occur: (a) A judgement is handed down in the Victorian Supreme Court on 15 July 2018 in relation to a 2017 product liability case brought by a customer against the company. This judgement renders the company liable for court costs and compensation totalling $240 000. (b) On 14 July 2018 the Commonwealth government enacts legislation altering the company income tax rate from 39 per cent to 42 per cent for all income tax returns from 1 July 2018. (c) On 28 July 2018 the company’s country warehouse is destroyed by fire. The total carrying value of the warehouse, which was uninsured, is $350 000. (d) On 2 August 2018 the financial cost of inventory shipped from overseas is determined. The inventory was received in June 2018 and the cost was estimated for accounting purposes. The revised cost is $900 000 greater than the prior estimate. (e) On 16 July 2018 the company enters into a contract to purchase 25 per cent of the issued capital of a competitor XYZ Ltd for $750 000. Assume all amounts are material for financial statements purposes. CHAPTER 21: EVENTS OCCURRING AFTER THE END OF THE REPORTING PERIOD  791

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REQUIRED Discuss the appropriate accounting treatment of the above events. LO 21.1, 21.4, 21.5, 21.7, 21.8 8. Lombok Ltd is an Australian entity that makes canoes and associated equipment. The end of its financial period is 30 June 2018. It has compiled a set of draft financial statements, which indicate that its net assets are approximately $4 million and its after-tax profit for the year is $650 000. Before the financial statements are finalised, the following transactions and events come to light. Assume that each event or transaction is independent of the rest. (a) On 30 July 2018 the directors recommend a final dividend of $2 per share. (b) At a directors’ meeting held in May 2018 it is decided that in late July the division that makes flotation devices will be closed, as the demand for such devices had fallen. The costs involved in closing down the division amount to $1.5 million. (c) On 5 August 2018 the directors become aware that the oars it has been selling since mid-July 2018 tend to fall apart when placed in water for more than 30 minutes. These oars were purchased by Lombok Ltd on 10 July 2018. By 7 August 2018 there have already been claims made against the company by a number of people who were stranded at sea. (d) Lombok Ltd’s main customer, Eco-Friendly Leisure Company, is declared insolvent on 12 July 2018. Apparently it is declared insolvent because it has been unable to pay damages previously awarded against it. The damages relate to an incident in which tour participants were savaged by some rampaging emus. Eco-Friendly Tours owed Lombok Ltd $600 000 as at 30 June 2018. (e) In July 2018 an out-of-court settlement has finally been reached with one of Lombok Ltd’s material suppliers. Lombok Ltd took action against the supplier two years earlier. The supplier had sold Lombok Ltd canoe paints that tended to wash off when exposed to salt water. Lombok Ltd is expected to receive $1 million in damages.

REQUIRED Determine how and whether each of the above events or transactions should be disclosed in the financial statements or accompanying notes of Lombok Ltd for the year ending 30 June 2018. LO 21.4, 21.5, 21.6, 21.7, 21.8 9. Gunnamatta Ltd has a financial period ending on 30 June 2018 and is expected to complete its financial statements on 10 September 2018. On 24 August 2018 it loses a major customer that has become insolvent. Also, owing to bad media publicity in August 2018 relating to the private life of its managing director, the demand for Gunnamatta Ltd’s products has plummeted. Both of these events have indicated that while the entity was a going concern as at 30 June 2018, this appears no longer to be the case.

REQUIRED (a) Would the reassessment of the entity’s going concern basis be an ‘adjusting event’ or a ‘non-adjusting’ event? (b) How would the assessment that the entity is no longer a going concern impact on the preparation of the entity’s financial statements? (c) Do you agree with the treatment required under AASB 110, or the alternative treatment of its predecessor AASB 1002, for events that occur after the reporting period that create a situation in which the entity is no longer a going concern? Explain your answer. LO 21.7, 21.8 10. Good Vehicles Ltd sells tractors. It does not recognise a provision for warranty because warranty claims for the past five years have been immaterial. Good Vehicles Ltd reported a profit before tax of $500 000 for the year ended 30 June 2019. The company provides the following disclosures in the notes to the financial statements for the year ended 30 June 2019 issued 31 August 2019: (a) In July 2019 a warranty claim was made for a faulty brake system on 10 tractors sold to a large agricultural business in May 2019. The cost of repairing the tractors was $55 000. This amount has not been recognised in the financial statements for the year ended 30 June 2019. (b) A negligence lawsuit has been brought against Good Vehicles Ltd for damages sustained in July 2019 on account of the failure of the braking system in a tractor sold by the company in May 2019. The damages claim is for $400 000, being the cost of replacing a farm shed destroyed by the runaway tractor, but this amount has not been recognised in the financial statements because the event occurred after the reporting period. 792  PART 7: OTHER DISCLOSURE ISSUES

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(c) In August 2019 Good Vehicles Ltd was fined $20 000 for breach of noise emission limits at its tractor assembly plant. This expense and liability has not been provided for in the financial statements as at 30 June 2019.

REQUIRED Discuss whether the note disclosure is adequate for each of the after-reporting-period events reported. Should adjustments have been made to the financial statements for the year ended 30 June 2019?  LO 21.4, 21.5, 21.7, 21.8 11. For each of the following material after-reporting-period events, state whether adjustment or disclosure is required in the 30 June 2019 financial statements. If adjustment is required, state the nature of the adjustment, that is the effect on elements of the financial statements. (a) 2 July 2019: directors proposed a dividend of $10 000. (b) 3 July 2019: the executive directors approved the sale of an off-shore agency to another entity for a profit of $30 000. (c) 4 July 2019: the company received an invoice from a supplier for $85 000 for goods delivered in June; the goods were included in closing inventory at an estimated cost of $100 000. (d) 5 July 2019: the company executed a guarantee in favour of the banks for an outstanding loan of $1 million that the bank made to X Ltd, the company’s major supplier, in January of that year; the guarantee was executed because the bank was demanding payment, which would have disrupted inventory supplies. (e) 6 July 2019: an agreement was signed to take over a production facility in Adelaide at a cost of $5 million, which will be paid for using a long-term finance lease. (f) 7 July 2019: the Australian Taxation Office (ATO) waived fines for the inclusion of incorrect information in the company’s 2017 tax return; the adjusted tax return was reflected in the company’s financial statements and the fine of $30 000 was recognised as an expense and liability at the end of the reporting period. (g) 8 July 2019: the government announced an increase in tax rates from 30 per cent to 33 per cent for the year commencing 1 July 2019; the deferred tax asset account is $90 000 and the deferred tax liability account is $60 000. (h) 9 July 2019: the Remuneration Committee determined the CEO’s bonus for the year ended 30 June 2019 as $300 000; the manager is entitled to an annual bonus based on company profits as determined by the Remuneration Committee. No accrual has been made. LO 21.4, 21.5, 21.6, 21.8

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CHAPTER 22

SEGMENT REPORTING

LEARNING OBJECTIVES (LO) 22.1 Understand that consolidated financial statements provide an aggregated view of the financial performance and financial position of business operations from various industries and geographical locations. 22.2 Understand that to avoid information loss, the consolidated financial statements need to be supplemented by additional disclosures pertaining to the various operating segments in which an organisation operates. 22.3 Understand the disclosures required in relation to separate operating segments and know that segment disclosures provide information to enable a more informed assessment of the performance and associated risks of an organisation’s various activities. 22.4 Understand how ‘operating segments’ are defined. 22.5 Be aware that information about an operating segment’s profit or loss, assets and liabilities must be disclosed in the notes to a reporting entity’s financial statements to the extent that the segments are deemed to be ‘reportable’ pursuant to AASB 8 Operating Segments. 22.6 Know how to determine whether a particular operating segment is of sufficient magnitude or importance to be deemed ‘reportable’. 22.7 Be able to describe the disclosures to be made about an operating segment’s products and services, reliance on major customers, and the entity’s geographical dispersion pursuant to AASB 8.

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Advantages and disadvantages of segment reporting

LO 22.1 LO 22.2 LO 22.3

It is usual for reporting entities to be involved in a number of different activities and for their activities to be located in widely dispersed locations. The consolidated financial statements provided to financial statement users report aggregated results, with some eliminations and adjustments, which are derived from a variety of different activities and locations. As an example of this we can consider the 2015 legal entity financial statements prepared by Westpac Banking Corporation Ltd and Commonwealth Bank An entity that exists Ltd. A  review of the respective annual reports indicates that Westpac and Commonwealth Bank in its own right. Legal controlled 239 and 105 separate legal entities respectively. Therefore, when we talk about Westpac entities often combine to form an economic Banking Corporation Ltd’s or Commonwealth Bank Ltd’s performance as a whole (as reflected in entity. the consolidated financial statements) we are aggregating the results of many individual entities (subsidiaries), some of which might have done very well and some very poorly. Care needs to be taken in interpreting figures that are derived from such a high level of aggregation. The consolidated consolidated statement of profit or loss and other comprehensive income provides an indication of the aggregated statement of financial position financial performance of many dissimilar entities, while the consolidated statement of financial A statement of position is derived from combining the statements of financial position of many organisations, all of financial position which will typically have different financial structures. As a result of this aggregation process there is that combines, with an obvious loss of information. Profitable or unprofitable subsidiaries or divisions are hidden in the various eliminations aggregation process. Subsidiaries that could be considered high risk owing to excessive debt levels and adjustments, the can also escape attention in the consolidated financial statements as their assets and liabilities will statements of financial position of the various be consolidated with those of the parent entity and all of the other subsidiaries. As an example of entities within the this problem, consider the data in Exhibit 22.1. economic entity. From the consolidated data of Streaky Bay Ltd, as provided in Exhibit 22.1, the entity appears to be performing quite satisfactorily with a return on assets of 6 per cent and a return on shareholders’ funds of 15 per cent. However, if we look at the disaggregated segment data, it becomes apparent that one division, retail, is performing quite poorly. The consolidated figures effectively hide the poorly performing division, thereby highlighting the need for segment data. As the Association for Investment Management and Research in the United States stated (1993, p. 59): Segment data is vital, essential, fundamental, indispensable, and integral to the investment analysis process. Analysts need to know and understand how the various components of a multifaceted enterprise behave economically. One weak member of the group is analogous to a section of blight on a piece of fruit; it has the potential to spread rot over the entirety. Even in  the absence of weakness, different segments will generate dissimilar streams of cash flows to which are attached disparate risks and which bring about unique values. Thus, without disaggregation, there is no sensible way to predict the overall amounts, timing, or risks of a complete enterprise’s future cash flows. There is little dispute over the analytic usefulness of disaggregated financial data.

  Assets Liabilities Shareholders’ funds Profit/(loss) for year Return on assets Return on shareholders’ funds

Farming ($000)

Retail ($000)

Entertainment ($000)

Consolidated data ($000)

500 200 300 100 20% 33.3%

400 200 200 (50) n/a n/a

600 500 100 40 6.7% 40%

1 500 900 600 90 6.0% 15%

Exhibit 22.1 Divisional data for Streaky Bay Ltd*

* It is assumed that there are no inter-entity transactions between the entities in the group.

Exhibit 22.2 provides details of the segment disclosure information by the Commonwealth Bank Ltd in its 2015 Annual Report (comparative information for 2014 was also provided by the bank but has not been reproduced here). As we can see, the Commonwealth Bank has divided its business into six operating segments (plus ‘IFS and Other’), these being Retail Banking Services, Business and Private Banking, Institutional Banking and Markets, Wealth Management, New Zealand and Bankwest. You will also note that the Commonwealth Bank provides information on a geographical Chapter 22: SEGMENT REPORTING  795

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segmentation basis. The segment data allows us to understand more about the performance of the various segments and the level of assets and liabilities held within the various segments. When we look at the segment data, we might make various inferences from the data. For example, if we compare net profit after tax with total assets within a particular segment—thereby giving us one measure of ‘return on assets’ for a segment—we can see that in 2015 the ‘Wealth Management’ segment generated a return on assets of approximately 3 per cent, whereas at the other end, the components of the organisation that make up the ‘IFS and Other’ segment provided only approximately 0.21 per cent, which does seem quite low. Interested stakeholders might like to undertake further investigation to understand why that some segments appeared to provide minimal returns.

Exhibit 22.2 Extract from the segment disclosure note provided in the 2015 Annual Report of Commonwealth Bank

NOTE 26 FINANCIAL REPORTING BY SEGMENTS Extract from Description of segments

The principal activities of the Group are carried out in the below business segments. These segments are based on the distribution channels through which the customer relationship is being managed. The primary sources of revenue are interest and fee income (Retail Banking Services, Institutional Banking and Markets, Business and Private Banking, Bankwest, New Zealand, IFS and Other Divisions) and insurance premium and funds management income (Wealth Management, New Zealand, IFS and Other Divisions).

 

Retail Business Institutional Banking & Private Banking & Wealth New Services Banking Markets Management Zealand Bankwest $m $m $m $m $m $m

Net interest income 7 691  Other banking income 1 746  Total banking income 9 437  Funds management income –  Insurance income –  Total operating income 9 437  Investment experience(1) –  Total net operating income before impairment and operating expenses 9 437  Operating expenses (3 293) Loan impairment expense (626) Net profit before income tax 5 518  Corporate tax expense (1 651) Non-controlling interests –  Net profit after income tax (cash basis)(2) 3 867  Hedging and IFRS volatility –  Other non-cash items –  Net profit after tax ‘statutory basis’ 3 867  Additional Information   Amortisation and depreciation (20) Balance sheet   Total assets 310 313  Total liabilities 221 018 

IFS and Other $m

Total $m 15 799  4 839  20 638 

2 827  809  3 636 

1 452  1 367  2 819 

–  –  – 

1 536  253  1 789 

1 594  217  1 811 

699  447 1 146 

–  –  3 636  – 

–  –  2 819  – 

1 846  503  2 349  226 

71  232  2 092  12 

–  –  1 811  – 

21  1 938  57  792  1 224  23 368 (28)  210

3 636  (1 397) (152)

2 819  (1 013) (167)

2 575  (1 726) – 

2 104  (861) (83)

1 811  (785) 50

1 196  23 578 (918) (9 993) (10)  (988)

2 087  (628) – 

1 639  (371) – 

 849  (199) – 

1 160  (295) – 

1 076  (324) – 

268  12 597  29 (3 439) (21) (21)

1 459  – –

1 268  –  – 

650  –  (28) 

865  43 – 

752  – (52)

276  (37) –

9 137  6 (80)

1 459   

1 268   

622   

908   

700   

239   

9 063   

(22)   98 392 71 138

(57)   181 919  162 054 

(26) (78)     20 792  69 608  24 652  62 488 

(89) (420) (712)       79 141  113 281  873 446  49 499  229 604  820 453 

( 1) Investment experience is presented on pre-tax basis. (2) This balance excludes non-cash items, including unrealised gains and losses relating to hedging and IFRS volatility ($6 million gain), Bankwest non-cash items ($52 million expense) and treasury shares valuation adjustment ($28 million expense).

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Year ended 30 June 2015 Geographical information Financial performance and position Income Australia New Zealand Other locations(1) Total revenue Non-current assets(2) Australia New Zealand Other locations(1) Total non-current assets

2015 $m   37 673 5 181 2 456 45 310   14 149 994 297 15 440

%

2014 $m

83.21 11.4 5.4 100.0   91.7 6.4 1.9 100.0

  37 603 4 633 2 076 44 312   13 199 1 057 196 14 452

 

%

2013 $m

84.8 10.5 4.7 100.0   91.3 7.3 1.4 100.0

  39 119 3 890 1 793 44 802   14 211 1 023 188 15 422

 

%   87.3 8.7 4.0 100.0   92.2 6.6 1.2 100.0

(1) Other locations included: United Kingdom, United States, Japan, Singapore, Malta, Hong Kong, Indonesia, China, Vietnam and South Africa. (2) Non-current assets include property, plant and equipment, investments in associates and joint ventures, and intangibles. The geographical segment represents the location in which the transaction was recognised. SOURCE: Commonwealth Bank Annual Report 2015

The practice of consolidating the accounts of diverse organisations has not always been followed in Australia. Previously, and as explained in Chapter 25, Australian companies were allowed to elect not to consolidate certain subsidiaries if it was considered that the particular subsidiaries’ activities were quite different from the activities of the rest of the group. However, with the release of Accounting Standard AASB 1024 Consolidated Accounts in 1991, and subsequently under other accounting standards that replaced AASB 1024, companies have been required to consolidate all of the entities that they control, regardless of the nature of the activities of the respective subsidiaries. Such a requirement necessitates the preparation of segment data. One of the advantages of segment information is therefore that it highlights the performance of the various parts of an organisation. While AASB 8 Operating Segments requires the disclosure of information about the financial performance and position of operating segments (as we will soon see), it is possible that even in the absence of regulation, managers would believe such information to be necessary for the purposes of informed decision making. As a result, management could voluntarily elect to provide financial statement users with disaggregated financial data. Evidence (McKinnon & Dalimunthe 1993; Mitchell, Chia & Loh 1995; Aitken, Hooper & Pickering 1997) shows that many organisations voluntarily provided segment data before mandatory reporting was introduced. Providing such data means managers are able to demonstrate greater accountability, and this in itself might be an effective way to attract additional investment funds. Providing segment data should enable the users of financial statements to better predict the future profitability of an organisation, particularly where the various segments of an organisation are involved in diverse activities. As Aitken, Hooper and Pickering (1997, p. 92) state: Segment (or disaggregated) information can be viewed as a supplement to consolidated (or aggregated) information regarding a firm’s current profit. If a firm diversifies into segments that have highly correlated profit prospects, the aggregated profit will provide useful information for estimation of these future profit prospects. In contrast, if a firm diversifies into segments with low correlations among their profit streams, the aggregated figure is simply a composite of the segments and it may not provide useful information for the estimation of future profits. The view of Aitken, Hooper and Pickering (1997) that segment disclosures are often necessary is driven by concerns about the dissimilarity of profit streams rather than the underlying activities themselves. They suggest that segment Chapter 22: SEGMENT REPORTING  797

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information is likely to be more useful to investors the lower the correlation is between the profit streams of the firm’s various segments. Segment information is considered to be of greatest benefit when a firm’s diversification is such that an investor’s knowledge of the earnings stream of one industry in which the firm operates will not provide knowledge about the earnings stream of the other industries. Conversely, Aitken, Hooper and Pickering further argue that management will have less incentive to provide segment disclosures for related industries owing to a lack of information value in such disclosures. After reviewing the segment disclosures made by Australian companies in 1984—the period before AAS 16 (AAS 16 was the first Australian accounting standard requiring the disclosure of segment information; it was followed by AASB 1005, then by AASB 114 and ultimately by AASB 8) became operative—they concluded that firms that diversify into industries with profit streams with low correlation are more likely to disclose segment data voluntarily than firms that diversify into industries with highly correlated profit streams. Although the above argument presented by Aitken, Hooper and Pickering (1997) is persuasive, users of financial statements of a firm would often also like to have data about proportional investments in particular segments, even when the profit streams are highly correlated. It would be reasonable to expect the different business and geographical segments to be subject to differing levels of risk. Some activities are more exploratory or have higher variance in their returns than others. Also, different locations might be subject to different risks. For example, particular countries might have a volatile political environment or a currency that fluctuates greatly on international markets. Knowledge of entities’ proportional investment in such locations would be useful to investors and potential investors when assessing their resource allocation decisions. That is, investors with segment information should be better able to determine if segments are providing a return that is commensurate with the associated risk. It might also be the case that investors do not want to invest in organisations that have a material part of their group’s assets invested in particular industries or particular countries. For example, some investors might elect, on the basis of their own investment ethics, not to invest in countries that have oppressive political regimes. Similarly, they might elect not to invest in organisations that have material investments in the tobacco, alcohol or armaments industries. Providing segment data that provides industry and geographical data would enable such an assessment to be made. On the negative side, however, it has been argued that providing segment information will create some disadvantage for the organisation. Management might be less inclined to take business risks in particular segments if the results of each segment’s operations are made visible to financial statement readers (rather than merging all the activities together into one set of consolidated financial statements and not providing supplementary segment data). Also, the disclosure of segment data might result in competitors having access to information about the profitability of particular segments of an organisation. For example, providing segment data about an organisation might reveal that its timber segment is particularly successful, with very high rates of return. This information could encourage competitors to find out what the organisation is doing that is different from what other organisations are doing. The additional segment data might also encourage further organisations to enter the industry. That is, providing segment information within the annual report might be a catalyst for existing or potential competitors to inquire further into the operations of a particular segment of another organisation. Whether competitors can successfully come by such information is, of course, a function of many other factors, such as how confidentially the employees of the organisation treat any ‘inside information’. If segment disclosures are made that indicate that particular segments are making a loss, it is possible for such disclosures to lead to takeover bids by other organisations, or to pressure being exerted on management to sell the loss-making segments. According to Emmanuel and Garrod (1992), the disclosure of geographical segment data that points to different profit rates internationally might also attract host government attention, and inter-segment sales might draw unwarranted attention from fiscal agencies. In a survey of some of the leading companies in the United Kingdom, Edwards and Smith (1996) found that one of the main reasons companies might elect not to prepare segment disclosures was competitive disadvantage (as suggested above). Survey respondents indicated that providing segment information in an open and unbiased manner might result in too many costs being imposed upon their company. The level of concern expressed appeared to have implications for the quality of segment disclosures actually being made. That is, the competitive disadvantage concern appeared to result in companies restricting the information they would provide even when providing segment disclosures was mandatory. Some of the survey respondents in the Edwards and Smith study actually conceded that their own segment information could be construed as misleading. In relation to the possible costs of segment disclosures, it could also be argued that providing segment data to groups other than competitors or foreign governments, such as unions or other interest groups, might be costly for an organisation. For example, if unions have knowledge of which operating segments are performing in a highly profitable 798  PART 7: OTHER DISCLOSURE ISSUES

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fashion, they might target such segments for wage increases. Arguably, however, employees are key stakeholders in the organisation and therefore have a right to be informed about the results of the segments in which they are employed. Also, environmental lobby groups might argue that particular segments that are both highly profitable and considered to be damaging to the environment should be made to undertake greater efforts, including research, to reduce the environmental impacts of both their own and their industry’s operations, on the basis of their ‘ability to pay’.

An introduction to AASB 8

LO 22.3

AASB 8 (and IFRS 8) Operating Segments was initially released in February 2007. AASB 8 (IFRS 8) replaced AASB 114 (IAS 14) Segment Reporting. AASB 8 features a number of significant departures from the requirements of the former AASB 114 (IAS 14). In the ‘Basis for Conclusions’ that accompanied the release of IFRS 8, the IASB supported the introduction of the new accounting standard (IFRS 8, upon which AASB 8 is based) in part on the basis of ‘academic research results’. Specifically, paragraph 8 of the Basis for Conclusions (and remember it is common practice for the IASB to release a Basis for Conclusions document, which aims to justify or explain the contents of a newly developed standard, upon the release of an accounting standard) states: Most of the academic research findings on segment reporting indicated that application of SFAS 131 (the US accounting standard that was in existence and which was quite different to IAS 14) resulted in more useful information than its predecessor SFAS 14. According to the research, the management approach of SFAS 131: (a) increased the number of reported segments and provided a greater quantity of information; (b) enabled users to see an entity through the eyes of management; (c) enabled an entity to provide timely segment information for external reporting with relatively low incremental cost; (d) enhanced consistency with the management discussion and analysis or other annual report disclosures; and (e) provided various measures of segment performance. As we will see shortly, the ‘management approach’ referred to in the above quote reflects the fact that the identification of operating segments for disclosure purposes, as now required by AASB 8, is based upon the internal reports that are regularly reviewed by the chief operating decision maker of the entity in order to allocate resources to the segment, and to assess its performance. That is, rather than providing specific criteria to identify the respective operating segments of an entity, AASB 8 requires that the segments identified for internal management purposes should also be the segments that are used for external reporting purposes (subject to some allowed aggregation). In explaining the rationale for this ‘management approach’ to segment identification, paragraph 8 of the Basis for Conclusions that accompanied the release of IFRS 8 states: The Board noted that the primary benefits of adopting the management approach in SFAS 131 (upon which the IFRS is based) are that: (a) entities will report segments that correspond to internal management reports; (b) entities will report segment information that will be more consistent with other parts of their annual reports; (c) some entities will report a greater number of segments; and (d) entities will report more segment information in interim financial reports. In addition, the IFRS will reduce the cost of providing disaggregated information for many entities because it uses segment information that is generated for management’s use. When IFRS 8 was released by the IASB in November 2006 (the equivalent AASB was released in Australia some months later in 2007), it accompanied the standard with a press release. In it the IASB referred to the management approach adopted within IFRS 8 (and AASB 8) as follows: The IFRS requires an entity to adopt the ‘management approach’ to reporting on the financial performance of its operating segments. Generally, the information to be reported would be what management uses internally for evaluating segment performance and deciding how to allocate resources to operating segments. Such information may be different from what is used to prepare the income statement and balance sheet. Chapter 22: SEGMENT REPORTING  799

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operating segment A component of an entity that engages in business activities from which it may earn revenues and incur expenses, whose operating results are regularly reviewed by the entity’s chief operating decision maker and for which discrete financial information is available.

The IFRS therefore requires explanations of the basis on which the segment information is prepared and reconciliations to the amounts recognised in the income statement and balance sheet. The IASB believes that adopting the management approach will improve financial reporting. First, it allows users of financial statements to review the operations through the eyes of management. Secondly, because the information is already used internally by management, there are few costs for preparers and the information is available on a timely basis. This means that interim reporting of segment information can be extended beyond the current requirements. There were numerous changes in the requirements for segment reporting as a result of the release of AASB 8 (relative to the requirements previously included in the superseded AASB 114). One major change relates to how segments are to be identified. The focus of AASB 8 is on operating segments and it requires various disclosures in relation to these ‘operating segments’. ‘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 entity’s 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 entity’s chief operating decision maker in order to allocate resources to the segment and assess its performance. By contrast, identification of segments in our accounting former standard was much more ‘rules based’. The definition of operating segment adopted in AASB 8 allows the inclusion of a component of an entity that sells primarily or exclusively to other operating segments of an entity if the entity is managed that way. By comparison, AASB 114 limited reportable segments of an entity to those that earned a majority of their revenue from sales to external customers. AASB 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 used. By contrast, AASB 114 required segment information to be prepared in conformity with the accounting policies adopted for preparing and presenting the external financial statements. The former accounting standard, AASB 114, provided relatively detailed definitions of segment revenue, segment expense, segment result, segment assets and segment liabilities. Again, by 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 under AASB 8 much professional judgement is being delegated to the management of the reporting entity. Therefore, what should be appreciated is that compared with superseded AASB 114 there is now much less specific guidance on how segment information is to be determined and disclosed. Effectively, AASB 8 is more principles-based than rules-based. Indeed, the core principle of the standard is identified at paragraph 1 of AASB 8, which states in the section entitled ‘Core Principle’: An entity shall disclose information to enable users of its financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates. The balance of the accounting standard is written to support this ‘core principle’. In upholding this principle, AASB 8 requires an entity to disclose: • general information about how the entity identified its operating segments and the types of products and services from which each operating segment derives its revenues 800  PART 7: OTHER DISCLOSURE ISSUES

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• information about the reported segment profit or loss, including certain specified revenues and expenses included in segment profit or loss, segment assets and segment liabilities and the basis of measurement • reconciliations of the totals of segment revenues, reported segment profit or loss, segment assets, segment liabilities and other material items to corresponding items in the entity’s financial statements. There are also prescribed entity-wide disclosures that are required even if an entity has only one reportable segment. These include information about each product and service or group of products and services, and analyses of revenues and certain non-current assets by geographical area. The standard also has a requirement to disclose information about transactions with major customers. Having provided the above brief overview of AASB 8, and its points of difference from early accounting standards (notably AASB 114), we will now go back to consider the following issues in more depth: • definition of an operating segment; • definition of a reportable segment; • the measurement of segment items; • required financial disclosures; • reconciliations between total operating segment revenues, profit and loss, assets to the respective totals provided for the entity; and • other non-financial disclosures pertaining to operating segments.

Defining an operating segment

LO 22.4

We have already provided the definition of operating segment used in AASB 8. The definition is provided in the Appendix to AASB 8 as well as at paragraph 5 of the standard. Hence, as we know, an operating segment is a component of an entity about which separate financial information is available and which is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. So the actions of the chief operating decision maker are of direct relevance in identifying operating segments for external reporting purposes, but what are we to understand by the position of ‘chief operating decision maker’? In this regard, paragraph 7 of AASB 8 states: The term ‘chief operating decision maker’ identifies a function, not necessarily a manager with a specific title. That function is to allocate resources to and assess the performance of the operating segments of an entity. Often the chief operating decision maker of an entity is its chief executive officer or chief operating officer but, for example, it may be a group of executive directors or others. The actions or focus of the chief operating decision maker (whether an individual or a group of individuals) therefore dictate which components of an entity are deemed to be operating segments for the purposes of AASB 8. Not all parts of an entity will be considered to be part of an operating segment. As paragraph 6 of AASB 8 states: Not every part of an entity is necessarily an operating segment or part of an operating segment. For example, a corporate headquarters or some functional departments may not earn revenues or may earn revenues that are only incidental to the activities of the entity and would not be operating segments. For the purposes of this Standard, an entity’s post-employment benefit plans are not operating segments. As we will learn shortly, AASB 8 requires a reconciliation between the total revenues, profit or loss, and assets allocated to all operating segments and the respective amounts reported in the financial statements. The amounts not allocated to segments (for example, amounts relating to corporate headquarters) will be shown in the reconciliation as ‘other revenues’, ‘other profit or loss’ or ‘other assets’. We will return to this point later in this chapter when we discuss the required reconciliations. IFRS 8 (and therefore AASB 8) is based largely on the United States accounting standard SFAS 131 ‘Disclosures about Segments of an Enterprise and Related Information’. The ‘Background Information’ section provided with SFAS 131 when it was initially released (paragraphs 59 and 60) provided some justification for relying upon the internal reporting and monitoring processes for identifying operating segments. It stated:

59. The report of the American Institute of Certified Practising Accountants Special Committee also said that ‘the primary means to improving industry segment reporting should be to align business reporting with internal Chapter 22: SEGMENT REPORTING  801

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reporting’ [page 69], and the Association for Investment Management and Research’s 1993 position paper recommended that: . . . priority should be given to the production and dissemination of financial data that reflects and reports sensibly the operations of specific enterprises. If we could obtain reports showing the details of how an individual business firm is organized and managed, we would assume more responsibility for making meaningful comparisons of those data to the unlike data of other firms that conduct their business differently. [pages 60 and 61] Almost all of the users and many other constituents who responded to the Exposure Draft or who met with Board and staff members agreed that defining segments based on the structure of an enterprise’s internal organization would result in improved information. They said that not only would enterprises be likely to report more detailed information but knowledge of the structure of an enterprise’s internal organization is valuable in itself because it highlights the risks and opportunities that management believes are important. 60. Segments based on the structure of an enterprise’s internal organization have at least three other significant advantages. First, an ability to see an enterprise ‘through the eyes of management’ enhances a user’s ability to predict actions or reactions of management that can significantly affect the enterprise’s prospects for future cash flows. Second, because information about those segments is generated for management’s use, the incremental cost of providing information for external reporting should be relatively low. Third, practice has demonstrated that the term industry is subjective. Segments based on an existing internal structure should be less subjective. While there are many arguments, as we have seen above, that it is appropriate to rely upon the actions of management to determine the basis of identifying their particular operating segments, this nevertheless raises issues about the difficulties in comparing the performance of different entities. The Background Information section provided upon the release of SFAS 131 provides some discussion of this issue:



62. Some respondents to the Exposure Draft opposed the Board’s approach for several reasons. Segments based on the structure of an enterprise’s internal organization may not be comparable between enterprises that engage in similar activities and may not be comparable from year to year for an individual enterprise. In addition, an enterprise may not be organized based on products and services or geographic areas, and thus the enterprise’s segments may not be susceptible to analysis using macroeconomic models. Finally, some asserted that because enterprises are organized strategically, the information that would be reported may be competitively harmful to the reporting enterprise. 63. The Board acknowledges that comparability of accounting information is important. The summary of principal conclusions in FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, [part of the US Conceptual Framework] says: ‘Comparability between enterprises and consistency in the application of methods over time increases the informational value of comparisons of relative economic opportunities or performance. The significance of information, especially quantitative information, depends to a great extent on the user’s ability to relate it to some benchmark.’ However, Concepts Statement 2 also notes a danger: Improving comparability may destroy or weaken relevance or reliability if, to secure comparability between two measures, one of them has to be obtained by a method yielding less relevant or less reliable information. Historically, extreme examples of this have been provided in some European countries in which the use of standardized charts of accounts has been made mandatory in the interest of interfirm comparability but at the expense of relevance and often reliability as well. That kind of uniformity may even adversely affect comparability of information if it conceals real differences between enterprises. [paragraph 116]

Hence, it is acknowledged that leaving it to the firm to determine the criteria for identifying operating segments might make inter-firm comparisons difficult, but it has been decided that the increased relevance of the information outweighs this consideration. Although we have indicated that the operating segments identified internally will form the basis for external segment reporting pursuant to AASB 8, not all operating segments as identified by management for internal evaluation and review (of which there might be many) will necessarily be separately disclosed in the entity’s operating segment note that is included within its financial statements. Only operating segments deemed to be ‘reportable segments’ will be disclosed. We will now consider the meaning of ‘reportable segment’. 802  PART 7: OTHER DISCLOSURE ISSUES

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Defining a reportable segment A reportable segment is an operating segment, or an aggregation of operating segments, that meet specific criteria provided in AASB 8. Again, 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, paragraph 11 of AASB 8 requires:

LO 22.5 LO 22.6 reportable segment An operating segment for which segment information is required to be disclosed by the standard (AASB 8).

An entity shall report separately information about each operating segment that: (a) has been identified in accordance with paragraphs 5–10 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 14–19 specify other situations in which separate information about an operating segment shall be reported.

In relation to the requirements of paragraphs 5 to 10 of AASB 8 (as referred to in paragraph 11 just quoted), paragraph 5 reproduces the definition of an operating segment that is provided in the Appendix to the standard. We have already discussed (in our discussion of what an operating segment is) the contents of paragraphs 6 and 7. Paragraphs 8 to 10 provide further guidance, of a relatively general nature, on identifying an operating segment. For 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; (c) the type or class of customer for their products and services; (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 intersegment 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; Chapter 22: SEGMENT REPORTING  803

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(c) its assets are 10 per cent or more of the combined assets of all operating segments. 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. If the combined result of all segments that earned a profit is $2 million and the combined results of all segments that incurred a loss is $1 million, the threshold for segments reporting either a profit or a loss would be $200 000 in absolute terms (which is the greater of 10 per cent of $1 million and 10 per cent of $2 million). Hence a segment with a loss of $120 000 would not be reportable, but a segment with a profit of $210 000 would be reportable. Only one of the three tests—in (a)–(c) just quoted—needs 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 entity’s 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 entity’s 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 entity’s revenue is included in reportable segments. The rationale for the above requirement is that in order to provide adequate insight into an entity’s operations, reportable segments should represent a substantial proportion of the entity’s 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 entity’s revenues might help ensure that the reported segments constitute a substantial proportion of the entity’s 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. In Worked Example 22.1, we apply the guidelines quoted above from paragraph 13 of AASB 8. We will refer to the tests as (a), (b) and (c) respectively.

WORKED EXAMPLE 22.1: Determination of reportable segments Consider the following segment information in relation to Maldives Ltd. For internal purposes, the chief operating decision maker reviews four components of the organisation when making decisions about the resources to be allocated to the components of the organisation and assessing performance. Data relating to the four components is provided below. Business segment

Segment revenue ($000)

Profit or loss ($000)

Segment assets ($000)

500 125 100    800 1 525

(55) (25) 5  100   25 

100 20 10 150 280

Mining Manufacturing Chemicals Agriculture Total

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The total revenue of Maldives Ltd is $1 600 000—that is, there is $75 000 in revenue that is not allocated to an operating segment. REQUIRED Determine which segments of Maldives Ltd are reportable in accordance with the guidelines provided in AASB 8. SOLUTION As 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 AASB 8. Mining and agriculture qualify as reportable segments as their revenue is more than 10 per cent of total segment revenue, thus satisfying test (a). Mining, manufacturing and agriculture qualify as reportable using test (b), as the absolute-amount total of the profits/losses of the segments that earned a profit is $105 000, whereas the combined reported loss of those that generated a loss total $80 000. Hence for test (b) we need to compare the absolute amount of the profit/loss with $105 000. Using these criteria, mining, manufacturing and agriculture are reportable operating segments. Using test (c), mining and agriculture are reportable operating segments, as their assets are 10 per cent or more of the total segment assets of all segments. Therefore, mining, manufacturing and agriculture are all reportable segments. Chemicals is not a reportable segment as it did not pass any of the three tests. Mining, manufacturing and agriculture also generate more than 75 per cent of the entity’s total revenues (1425/1600 × 100 = 89 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 being reportable.

Across time, an entity’s operating segments may grow or contract relative to the sizes of other operating segments, and this has implications for identifying reportable segments. It could mean that some operating segments that met the quantitative criteria for disclosure in previous periods no longer do so, and vice versa. In this regard, paragraphs 17 and 18 of AASB 8 state: 17. If management judges that an operating segment identified as a reportable segment in the immediately preceding period is of continuing significance, information about that segment shall continue to be reported separately in the current period even if it no longer meets the criteria for reportability in paragraph 13. 18. If an operating segment is identified as a reportable segment in the current period in accordance with the quantitative thresholds, segment data for a prior period presented for comparative purposes shall be restated to reflect the newly reportable segment as a separate segment, even if that segment did not satisfy the criteria for reportability in paragraph 13 in the prior period, unless the necessary information is not available and the cost to develop it would be excessive. In the foregoing discussion on identifying reportable segments we learned that certain percentages have been adopted as the basis for determining the necessity to separately disclose particular operating segments. That is, for individual segments we have a ‘10 per cent test’ (paragraph 13) and to determine whether we have disclosed a sufficient number of operating segments we have a ‘75 per cent test’ (paragraph 15). Obviously, given that thresholds such as 10 per cent and 75 per cent have been selected by the standard-setters, they run the risk of being accused of selecting arbitrary cut-off points. In discussing the use of such quantitative thresholds, the Basis for Conclusions that accompanied the release of SFAS 131 (upon which IFRS 8 and AASB 8 are based) stated (paragraphs 72 and 75): 72. A so-called pure management approach to segment reporting might require that an enterprise report all of the information that is reviewed by the chief operating decision maker to make decisions about resource allocations and to assess the performance of the enterprise. However, that level of detail may not be useful Chapter 22: SEGMENT REPORTING  805

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to readers of external financial statements, and it also may be cumbersome for an enterprise to present. Therefore, this Statement uses a modified management approach that includes both aggregation criteria and quantitative thresholds for determining reportable operating segments. However, an enterprise need not aggregate similar segments, and it may present segments that fall below the quantitative thresholds. 75. In developing the Exposure Draft, the Board had concluded that quantitative criteria might interfere with the determination of operating segments and, if anything, might unnecessarily reduce the number of segments disclosed. Respondents to the Exposure Draft and others urged the Board to include quantitative criteria for determining which segments to report because they said that some enterprises would be required to report too many segments unless specific quantitative guidelines allowed them to omit small segments. Some respondents said that the Exposure Draft would have required disclosure of as many as 25  operating segments, which was not a result anticipated by the Board in its deliberations preceding the Exposure Draft. Others said that enterprises would report information that was too highly aggregated unless quantitative guidelines prevented it. The Board decided that the addition of quantitative thresholds would be a practical way to address respondents’ concerns about competitive harm and proliferation of segments without fundamentally changing the management approach to segment definition.

LO 22.5 LO 22.6

Measurement of segment items

While we have discussed how to define operating segments and reportable segments, we have not addressed how to measure the segment financial information to be disclosed. The previous standard on segment reporting, AASB 114, provided detailed guidance on measuring segments items, such as segment revenue, segment profit, segment assets and segment liabilities. This is no longer the case with AASB 8. Generally, financial information is required to be reported on the same basis as is used internally for evaluating operating segment performance and deciding how to allocate resources to operating segments. According to paragraph 25 of AASB 8: The amount of each segment item reported shall be the measure reported to the chief operating decision maker for the purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and eliminations made in preparing an entity’s financial statements and allocations of revenues, expenses, and gains or losses shall be included in determining reported segment profit or loss only if they are included in the measure of the segment’s profit or loss that is used by the chief operating decision maker. Similarly, only those assets and liabilities that are included in the measures of the segment’s assets and segment’s liabilities that are used by the chief operating decision maker shall be reported for that segment. If amounts are allocated to reported segment profit or loss, assets or liabilities, those amounts shall be allocated on a reasonable basis. Hence, for the purposes of reporting the results of operating segments, entities may depart from the requirements of accounting standards. That is, they may depart from the rules they apply to generate their financial statements and supporting notes. Entities will therefore have more discretion in determining what comprises segment profit or loss pursuant to AASB 8, with their calculations being limited only by their internal reporting practices. This is an interesting concession. Obviously the accounting standard-setters believe it is more efficient for reporting entities to provide information using their preferred accounting approach when it comes to segment disclosures; however, when it comes to disclosing the statement of financial position, statement of profit or loss and other comprehensive income, statement of cash flows, and statement of changes in equity, the accounting standards must be applied. In justifying this apparent concession, the Basis for Conclusions that accompanied the release of SFAF 131 (paragraphs 81, 83 and 84) states: 81. The Board decided that the information to be reported about each segment should be measured on the same basis as the information used by the chief operating decision maker for purposes of allocating resources to segments and assessing segments’ performance. That is a management approach to measuring segment information as proposed in the Exposure Draft. The Board does not think that a separate measure of segment profit or loss or assets should have to be developed solely for the purpose of disclosing segment information. For example, an enterprise that accounts for inventory using a specialized valuation method for internal purposes should not be required to restate inventory amounts for each segment, and an enterprise that accounts for pension expense only on a consolidated basis should not be required to allocate pension expense to each operating segment. 806  PART 7: OTHER DISCLOSURE ISSUES

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83. However, some respondents recommended that information about each segment be provided based on the accounting principles used in the enterprise’s general-purpose financial statements. Some observed that unadjusted information from internal sources would not necessarily comply with generally accepted accounting principles and, for that reason, might be difficult for users to understand. Other respondents argued that comparability between enterprises would be improved if the segment information were provided on the basis of generally accepted accounting principles. Finally, a few questioned the verifiability of the information. 84. The Board decided not to require that segment information be provided in accordance with the same generally accepted accounting principles used to prepare the consolidated financial statements for several reasons. Allowing management to determine the basis of measurement to be used for the purposes of segment disclosures raises some issues about relevance versus representational faithfulness. As we know from Chapter 2, two important qualitative characteristics of financial information are relevance and representational faithfulness—both of which are clearly important. In relation to possible trade-offs between the relevance and the representational faithfulness (although the Basis for Conclusions refers to ‘reliability’) of segment disclosures, paragraph 86 of the Basis for Conclusions released with SFAS 131 comments that ‘it is apparent that users are willing to trade a degree of reliability in segment information for more relevant information’. While entities are required to provide segment disclosures based on the measures utilised internally, some accompanying explanation is required to assist users of financial statements to understand the basis of the measurements used. Specifically, paragraph 27 of AASB 8 requires the following: An entity shall provide an explanation of the measurements of segment profit or loss, segment assets and segment liabilities for each reportable segment. At a minimum, an entity shall disclose the following: (a) the basis of accounting for any transactions between reportable segments; (b) the nature of any differences between the measurements of the reportable segments’ profits or losses and the entity’s profit or loss before income tax expense or income and  discontinued operations (if not apparent from the reconciliations described in paragraph 28). Those differences could include accounting policies and policies for allocation of centrally incurred costs that are necessary for an understanding of the reported segment information; (c) the nature of any differences between the measurements of the reportable segments’ assets  and the entity’s assets (if not apparent from the reconciliations described in paragraph 28). Those differences could include accounting policies and policies for allocation of jointly used assets that are necessary for an understanding of the reported segment information; (d) the nature of any differences between the measurements of the reportable segments’ liabilities and the entity’s liabilities (if not apparent from the reconciliations described in paragraph 28). Those differences could include accounting policies and policies for allocation of jointly utilised liabilities that are necessary for an understanding of the reported segment information; (e) the nature of any changes from prior periods in the measurement methods used to determine reported segment profit or loss and the effect, if any, of those changes on the measure of segment profit or loss; (f) the nature and effect of any asymmetrical allocations to reportable segments. For example, an entity might allocate depreciation expense to a segment without allocating the related depreciable assets to that segment.

Required financial disclosures Having discussed the basis for identifying reportable segments and the basis of measurement for segment items we now need to consider the specific items of financial information that must be disclosed in relation to operating segments. These requirements are provided in paragraphs 23 and 24 of AASB 8:

LO 22.5 LO 22.7

23. An entity shall report a measure of profit or loss for each reportable segment. An entity shall report a measure of total assets and liabilities for each reportable segment if such amounts are regularly provided to the chief operating decision maker. An entity shall also disclose the following about each reportable Chapter 22: SEGMENT REPORTING  807

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segment if the specified amounts are included in the measure of segment profit or loss reviewed by the chief operating decision maker, or are otherwise regularly provided to the chief operating decision maker, even if not included in that measure of segment profit or loss: (a) revenues from external customers; (b) revenues from transactions with other operating segments of the same entity; (c) interest revenue; (d) interest expense; (e) depreciation and amortisation; (f) material items of income and expense disclosed in accordance with paragraph 97 of AASB 101 Presentation of Financial Statements; (g) the entity’s interest in the profit or loss of associates and joint ventures accounted for by the equity method; (h) income tax expense or income; and (i) material non-cash items other than depreciation and amortisation. An entity shall report interest revenue separately from interest expense for each reportable segment unless a majority of the segment’s revenues are from interest and the chief operating decision maker relies primarily on net interest revenue to assess the performance of the segment and make decisions about resources to be allocated to the segment. In that situation, an entity may report that segment’s interest revenue net of its interest expense and disclose that it has done so. 24. An entity shall disclose the following about each reportable segment if the specified amounts are included in the measure of segment assets reviewed by the chief operating decision maker or are otherwise regularly provided to the chief operating decision maker, even if not included in the measure of segment assets: (a) the amount of investment in associates and joint ventures accounted for by the equity method; and (b) the amounts of additions to non-current assets other than financial instruments, deferred tax assets, net defined benefit assets (see AASB 119 Employee Benefits paragraphs 54–58) and rights arising under insurance contracts.

LO 22.5 LO 22.7

Reconciliation of segment information to financial statements

As we know, financial statements, such as the statement of profit or loss and other comprehensive income and the statement of financial position, must be compiled in accordance with accounting standards. However, segment disclosures are reported on the basis of whatever accounting methods the entity utilises to generate information for the ‘chief operating decision maker’. Understandably, some readers might have trouble understanding how segment information relates to that provided elsewhere in the financial reports. To this end, AASB 8 requires reconciling information to be produced. It requires reconciliations of total reportable segment revenues, total profit or loss, total assets, total liabilities and other amounts disclosed for reportable segments to the corresponding amounts shown in the entity’s financial statements. The Implementation Guidance that accompanied the release of IFRS 8 provided some examples of reconciliations of reportable segment revenues, profit or loss, and assets. These examples have been adapted for presentation in Exhibit 22.3.

Exhibit 22.3 Reconciliations of segment revenues, profit or loss, assets and other material items

Revenues Total revenues for reportable segments Other revenues Elimination of intersegment revenues Entity’s revenues

$ 39 000 1 000  (4 500) 35 500

808  PART 7: OTHER DISCLOSURE ISSUES

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Profit or loss Total profit or loss for reportable segments Other profit or loss Elimination of intersegment profits Unallocated amounts: – Litigation settlement received – Other corporate expenses – Adjustment to pension expense in consolidation Income before income tax expense

 

Assets Total assets for reportable segments Other assets Elimination of receivable from corporate headquarters Goodwill not allocated to reportable segments Other unallocated amounts Entity’s assets

$ 79 000 2 000  (1 000) 4 000   1 000 85 000

Other material items Interest revenue Interest expense Net interest revenue (finance segment only) Expenditures for assets Depreciation and amortisation Impairment of assets

$ 3 970  100  (500) 500  (750)     (250)  3 070

Reportable segment totals $

Adjustments $

Entity totals $

3 750 2 750 1 000 2 900 2 950 200

75  (50) –  1 000  –  – 

3 825  2 700 1 000  3 900 2 950 200 

The reconciling item to adjust expenditures for capital assets is the amount incurred for the corporate headquarters building, which is not included in segment information. None of the other adjustments is material.

Non-financial disclosures

LO 22.7

Apart from financial disclosures, AASB 8 requires that other, entity-wide, non-financial information be disclosed. AASB 8 requires the disclosure of information about products or services (or groups of similar products and services); about the countries in which the entity earns revenues and holds assets; and about major customers, regardless of whether the information is used by management in making operating decisions. These disclosures apply to all entities subject to AASB 8, including those that have a single reportable segment. These entity-wide disclosures are required by paragraphs 32–34 of AASB 8, which require that the additional information be provided only if it is not provided as part of the reportable segment information required elsewhere pursuant to AASB 8. The view taken by the accounting standard-setters is that such information is necessary for financial statement readers if they are trying to assess the performance and associated risks of a reporting entity. In relation to entity-wide information about products and services, paragraph 32 requires the following: An entity shall report the revenues from external customers for each product and service, or each group of similar products and services, unless the necessary information is not available and the cost to develop it would be excessive, in which case that fact shall be disclosed. The amounts of revenues reported shall be based on the financial information used to produce the entity’s financial statements.

Chapter 22: SEGMENT REPORTING  809

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If a reporting entity’s reportable segments are based on differences in products and services, no additional disclosures of revenue information about products and services would typically be required. Conceivably, different geographical regions will give rise to different risks. Different countries will have different opportunities for growth, government restrictions, tax treatments, cultural attributes and so forth. Paragraph 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 entity’s 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 entity’s 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 entity’s 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. Exhibit 22.4 provides an example of a form of disclosure that would satisfy the requirements of paragraph 33.

Exhibit 22.4 Geographical information disclosure

Geographical information Australia United States South Africa Indonesia Other countries Total

Revenues(a) $000

Non-current assets $000

8 000 7 000 4 800 2 200   4 000 26 000

9 000 6 000 5 100 –   3 900 24 000

(a) Revenues are attributed to countries on the basis of the customer’s location.

There are also risks associated with having a limited number of major customers. While it is good for a business to have some large customers, reliance on a limited number of major customers can give rise to obvious problems should those customers be lost. In this regard, paragraph 34 of AASB 8 requires entity-wide disclosures to be made about major customers. It states: An entity shall provide information about the extent of its reliance on its major customers. If revenues from transactions with a single external customer amount to 10 per cent or more of an entity’s revenues, the entity shall disclose that fact, the total amount of revenues from each such customer, and the identity of the segment or segments reporting the revenues. The entity need not disclose the identity of a major customer or the amount of revenues that each segment reports from that customer. For the purposes of this standard, a group of entities known to a reporting entity to be under common control shall be considered a single customer, and a government (national, state, provincial, territorial, local or foreign) and entities known to the reporting entity to be under the control of that government shall be considered a single customer. In assessing this, the reporting entity shall consider the extent of economic integration between those entities. Refer to Exhibit 22.5 for an example of the form of disclosure that would satisfy the requirements of paragraph 34. 810  PART 7: OTHER DISCLOSURE ISSUES

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NOTE X. Revenues from one customer of World Surfing Ltd’s wetsuit segment represents approximately $9 600 000 of World Surfing Ltd’s total revenues. No other single customer is responsible for 10 per cent or more of the entity’s total revenues.

Is there a case for competitive harm?

Exhibit 22.5 Information about major customers

LO 22.3 LO 22.4

At the beginning of the chapter we pointed out that some organisations opposed detailed segment disclosures on the ground that competitors might use an entity’s segment information to undermine its profitability— perhaps by targeting segments that appear to be particularly profitable. Now that you have read about the disclosure requirements relating to operating segments, what do you, the reader, think? Would the required disclosures create significant problems for an entity in terms of the divulgence of valuable information that could be utilised by competitors? In addressing concerns about competitive disadvantage it should be appreciated that competitors have many sources of detailed information about an organisation other than the financial statements. Further, the information that is required to be disclosed about an operating segment is no more detailed or specific than the information typically provided by a smaller organisation with a single operation. There are also issues of accountability. Arguably, many users—particularly shareholders—have a right to specific financial information about operating segments, as well as the entity-wide information (geographical, product-related and reliance on major customers) required by AASB 8. When SFAS 131 (upon which IFRS 8 and AASB 8 are based) was developed in the United States, the ‘competitive harm’ argument was raised by many respondents to the Exposure Draft issued prior to the standard’s release. The Basis for Conclusions that accompanied the release of SFAS 131 (paragraph 111) stated: The Board was sympathetic to specific concerns raised by certain constituents; however, it decided that a competitive-harm exemption was inappropriate because it would provide a means for broad noncompliance with this Statement. Some form of relief for single-product or single-service segments was explored; however, there are many enterprises that produce a single product or a single service that are required to issue general-purpose financial statements. Those statements would include the same information that would be reported by single-product or single-service segments of an enterprise. The Board concluded that it was not necessary to provide an exemption for single-product or single-service segments because enterprises that produce a single product or service that are required to issue general-purpose financial statements have that same exposure to competitive harm. The Board noted that concerns about competitive harm were addressed to the extent feasible by four changes made during redeliberations: (a) modifying the aggregation criteria, (b) adding quantitative materiality thresholds for identifying reportable segments, (c) eliminating the requirements to disclose research and development expense and liabilities by segment, and (d) changing the second-level disclosure requirements about products and services and geography from a segment basis to an enterprisewide basis. While arguments relating to competitive harm suggest that organisations might want to limit their disclosure, there is evidence that many organisations are actually disclosing more segment-related information that the accounting standard requires. For example, many organisations are voluntarily disclosing information about corporate governance and compliance auditing with respect to various segments of their organisations.

SUMMARY The chapter addressed segment reporting. Segment reporting provides information about the performance and financial position of various subunits of an organisation, broken up into operating segments. As such, it is a useful supplement to consolidated financial statements, which frequently provide the aggregated results of many subsidiaries operating across diverse geographical locations and across a diverse range of activities. Chapter 22: SEGMENT REPORTING  811

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Various costs and benefits associated with segment reporting have been highlighted by different authors. Some of the benefits of segment reporting are discussed in this chapter: segment reporting allows for more informed decision making regarding the future profitability and risk exposure of an organisation; it allows management to demonstrate greater accountability; and it allows interested parties to know in which sectors and locations the organisation operates. This might be particularly useful if shareholders, consumers or other interested parties favour or oppose operations conducted within specific industries or locations. Some of the perceived costs that have been discussed in relation to the disclosure of segment data include: the creation of a competitive disadvantage, perhaps through the entry of new competitors into segments that have reported high profits; the possible encouragement of takeover bids for poorly performing segments; and the possibility of profitable segments attracting unwelcome attention from government and interest groups. The relevant Australian Accounting Standard pertaining to segment disclosures is AASB 8 Operating Segments, which was released in 2007 and replaced AASB 114 (released in 2004). The standard requires the disclosure of financial information about an entity’s operating segments. Operating segments are identified on the basis of the components of the organisation that the chief operating decision maker reviews in making decisions about resources to be allocated to the segments, and as part of the process of assessing their performance. Once a component of an entity is deemed to be an operating segment, quantitative criteria are provided to determine whether the segment is reportable (any of 10 per cent of total segment revenues; 10 per cent of the absolute amount of the greater of total profitable segments’ profit or the total of the loss-making segments’ losses; 10 per cent of total segment assets). In addition, ‘reportable segments’ are required to constitute not less than 75 per cent of the entity’s total revenues. In providing financial information about operating segments’ revenues, profits, assets and liabilities, the entity is to provide measurements that utilise the amounts used for internal decision making. That is, segment disclosures do not have to be based on the measurements that are required to be used to generate the entity’s financial statements. AASB 8 requires a number of financial disclosures relating to reportable segments. It also requires reconciliations of total reportable segment revenues, total profit or loss, total segment liabilities and total segment assets to corresponding amounts in the entity’s financial statements. AASB 8 also requires a number of entity-wide disclosures. Such disclosures relate to the entity’s products and services, geographical information and information about major customers.

KEY TERMS consolidated statement of financial position  795

legal entity  795 operating segment  800

reportable segment  803

END-OF-CHAPTER EXERCISES McTavish Ltd has six segments that the chief operating decision maker reviews when making assessments of performance and evaluating and making resource allocation decisions. These segments of the organisation are: •  surfing equipment •  fashion •  toys •  building supplies •  information technology •  wave-pool construction. While the sales of the building supplies segment are predominantly external and within Australia, it did make $50 000 inter-segment sales to the toys segment, and these sales generated a profit of $5000. All inter-segment liabilities have been paid and the materials sold between the segments have since been sold externally. No other segments are involved in inter-segment sales. 812  PART 7: OTHER DISCLOSURE ISSUES

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Financial information for the year for the respective segments as provided to the chief operating decision maker is as follows:   Surfing equipment Fashion Toys Building supplies Information technology Wave-pool construction  

  Surfing equipment Fashion Toys Building supplies Information technology Wave-pool construction  

Total sale ($000)

Profit before tax ($000)

Assets ($000)

700 250 150 300 30      20 1 450

65  20  (10) 35  6      4 120

8 000 2 500 2 000 3 500 300     200 16 500

Depreciation and amortisation ($000)

Other noncash expenses ($000)

30 15 25 20 6      4 100

15 10 15 20 3   2 65

Liabilities ($000)

Capital acquisitions ($000)

Interest revenue ($000)

Interest expense ($000)

3 000 1 500 1 000 2 500 150      50 8 200

250 50 100 200 –      – 600

5 – – – –    –    5

– 3 – – –    –    3

Other information •  The above information represents the information that the chief operating decision maker uses in assessing the components of the organisation. •  Taxes are not allocated to individual components of the entity. •  There are no investments in associates or joint ventures. •  The income tax expense for the year is $30 000. •  Unallocated corporate liabilities total $100 000. •  Unallocated corporate expenses total $20 000. •  Total non-current assets of the entity amount to $12 000 000. •  The entity has goodwill of $2 000 000, which is not allocated to operating segments. •  Other unallocated corporate assets total $50 000. •  Head office, which is not treated as an operating segment, earns revenues directly in the amount of $10 000. •  Across the entire entity there was only one customer that accounted for 10 per cent or more of the entity’s total revenues. This customer accounted for revenue totalling $150 000 and made its purchases from the surfing equipment operating segment. •  In terms of the geographical aspects of the entity, all assets are held within Australia; however, one segment, fashion, sells all of its products (which are restricted to Hawaiian shirts) to the United Kingdom.

REQUIRED Prepare the segment information note that would appear in the financial report of McTavish Ltd in accordance with AASB 8. LO 22.3, 22.5, 22.6, 22.7

SOLUTION TO END-OF-CHAPTER EXERCISE Because the chief operating decision maker considers six segments of the entity when making decisions about resource allocations and when assessing performance, these are the six operating segments of the entity pursuant to AASB 8. To determine whether the individual segments are reportable, we need to apply the tests provided in paragraph 13 and paragraph 15 of AASB 8. Paragraph 13 of AASB 8 requires that for each segment it must first be established that:

(a) its reported revenue, including both sales to external customers and intersegment sales or transfers, is 10 per cent or more of the combined revenue, internal and external, of all operating segments; Chapter 22: SEGMENT REPORTING  813

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(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; (c) its assets are 10 per cent or more of the combined assets of all operating segments.

As we have noted, AASB 8, paragraph 13, specifies three tests, and a segment needs to pass any one of these to be deemed to be a reportable segment. Test (a) is whether revenues, including from sales to internal and external customers, account for 10 per cent or more of the total segment revenues of all segments. In this example the total revenue from sales made by all segments, including inter-segment sales, is $1 450 000. Therefore, the materiality threshold is $1 450 000 × 10% = $145 000. Applying this threshold to the four segments: •  Surfing equipment: sales total $700 000, therefore this segment passes the test. •  Fashion: sales total $250 000, therefore this segment passes the test. •  Toys: sales total $150 000, therefore this segment passes the test. •  Building supplies: sales total $300 000, therefore this segment passes the test. •  Neither information technology nor wave-pool construction pass the test. As four segments pass the test, they are all considered to be reportable segments. It does not matter whether or not they pass the remainder of the tests. Test (b) is whether the segment profit or loss is 10 per cent or more of the combined result of all segments that earned a profit or the combined result of all segments that incurred a loss, whichever is the greater in absolute amount. The combined result of all segments that earned a profit is $65 000 + $20 000 + $35 000 + $6000 + $4000 = $130 000. The combined result of all segments that earned a loss is $10 000. The threshold amount is therefore $130 000 × 10% = $13 000. Three segments do not pass the test: toys, information technology and wave-pool construction (but, remember, toys has already passed the previous test). Test (c) is whether assets are 10 per cent or more of the total segment assets of all segments. Total segment assets equal $16 500 000. The threshold amount is therefore $16 500 000 × 10% = $1 650 000. All segments pass this test apart from information technology and wave-pool construction. So we have four reportable segments. Apart from the above tests, we can also see that the total revenues attributable to the reportable segments constitute at least 75 per cent of the entity’s total revenues (the test provided at paragraph 15 of AASB 8). We are now in a position to prepare our note to the financial statements relating to the entity’s operating segments. It should be noted that we will not prepare a separate note from an entity-wide perspective about products and services as required by paragraph 32 of AASB 8 as the identification of the entity’s operating segments is based on differences between products and services.

Note x: Information about operating segments (a) Financial information about operating segments

  Revenue from External sales Inter-segment sales Interest revenue Interest expense Depreciation and amortisation Profit before tax Segment assets Segment liabilities Acquisition of property, plant and equipment and intangible assets Other non-cash expenses other than depreciation

Surfing equipment ($000)   700 – 5   30 65 8 000 3 000

Fashion ($000)   250 –   3 15 20 2 500 1 500

250 15

50 10

Building Toys supplies ($000) ($000)     150  250  –  50         25  20 (10) 35 2 000  3 500 1 000  2 500 100  15 

200 20

All other segments ($000)   50       10 10 500 200 – 5

Total ($000)   1 400 50 5 3 100 120 16 500 8 200 600 65

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(b) Reconciliation of financial information provided in operating segment note to information provided in the financial statements Revenues

($000)

Total revenues from operating segments Other revenues (received by head office) Elimination of inter-segment revenues Total revenue shown in statement of comprehensive income

1 450  10      (50) 1 410

Profit or loss

($000)

Total profit or loss from operating segments Elimination of inter-segment profits Unallocated corporate expenses Profit before income tax expense Tax expense Profit after tax as shown in statement of comprehensive income Assets Total assets of operating segments Goodwill not allocated to reportable segments Other unallocated corporate assets Total assets as shown in statement of financial position Liabilities Total liabilities of operating segments Unallocated liabilities Total liabilities as shown in the statement of financial position

120  (5) (20) 95  (30) 65 ($000) 16 500  2 000        50 18 550  ($000) 8 200     100 8 300

(c) Geographical information McTavish Ltd operates predominantly within Australia; however, some sales are made to customers in the United Kingdom.  

Sales by geographical area ($000)

Non-current assets ($000)

Australia United Kingdom

1 200    250

12 000          –

 

1 450

12 000

(d) Information about major customers Revenues from one customer of McTavish Ltd’s surfing equipment operating segment represents approximately $150 000 of McTavish Ltd’s total revenues. No other single customer is responsible for 10 per cent or more of the entity’s total revenues.

REVIEW QUESTIONS 1. Discuss the benefits of segment disclosure for financial analysis. LO 22.1, 22.2 2. Discuss some of the potential costs that organisations could attract if they are required to provide segment disclosures. LO 22.2 3. Do you think that requiring organisations to provide segment data would stifle the introduction of new ideas or approaches? LO 22.2 Chapter 22: SEGMENT REPORTING  815

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4. Some people argue that providing segment data leads to a competitive disadvantage for firms that are operating successfully. Evaluate this argument. LO 22.3, 22.4 5. Evaluate the argument which holds that concerns about competitive disadvantage lead to lower-quality segment disclosures. LO 22.3, 22.4 6. ‘Providing segment data to financial statement users will enable management to demonstrate greater accountability.’ Discuss this statement. LO 22.1, 22.2 7. How does an entity identify its operating segments for the purposes of applying AASB 8? LO 22.4, 22.6 8. What is the basis of allocating revenue to particular segments? LO 22.5 9. What is the basis of allocating assets to particular segments? LO 22.5 10. Once we have divided the activities of an entity into their respective operating segments, we must determine whether information about these various segments requires separate disclosure. How do we do this? LO 22.5, 22.6 11. When should information about geographical aspects of an entity’s operations be disclosed pursuant to AASB 8, and what specific information needs to be disclosed? LO 22.6, 22.7 12. When are we permitted to combine the information for different segments when making a segment disclosure note? LO 22.5, 22.6 13. What are the disclosure implications for an operating segment that passed the quantitative tests provided in paragraph 13 of AASB 8 in one year but fails to pass the tests the subsequent year? LO 22.5, 22.6 14. The following operating segment information is presented for Ocky Ltd.   Mining Food Chemicals Clothing Total

Segment revenue ($000)

Segment profit ($000)

Segment assets ($000)

700 125 50   90 965

100  20  (35)     5   90

1 000 200 100      90 1 390

REQUIRED Determine which segments are reportable according to the guidelines provided in AASB 8. LO 22.6 15. The following operating segment information is presented for Rocky Ltd.   Timber Steel Cardboard Total

Segment revenue ($000)

Segment profit ($000)

Segment assets ($000)

800 100   60 960

75  25  (15) 85

900 420    180 1 500

REQUIRED Determine which segments are reportable according to the guidelines provided in AASB 8. LO 22.6 16. The following segment information is presented for Raging Bull Ltd.   Clothing Travel Agriculture Motor vehicle manufacture Total

Segment revenue ($000)

Segment profit ($000)

Segment assets ($000)

300 150 60   45 555

130  30  20   (15) 165

900 300 120      80 1 400

REQUIRED Determine which segments are reportable according to the guidelines provided in AASB 8. LO 22.6 816  PART 7: OTHER DISCLOSURE ISSUES

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17. The following segment information is presented for Calm Cow Ltd.  

Segment revenue ($000)

Segment profit ($000)

Segment assets ($000)

330 270      50    650

100 110    (20)   190

800 550   150 1 500

Food Beverages Hotels Total

REQUIRED Determine which segments are reportable according to the guidelines provided in AASB 8. LO 22.6

CHALLENGING QUESTIONS 18. Petersen Ltd operates solely within Queensland. It is involved in four operating segments, namely entertainment, clothing, food and agriculture. Information pertaining to these segments is provided below.   Entertainment Clothing Food Agriculture Total

Sales to outside customers ($000) 600 80 200   40 920

Profit (loss) before income tax by operating segment Entertainment Clothing Food Agriculture General corporate expenses Total

Inter-segment sales ($000) 50     10 60 $000 100  20  (10) 20    (10) 120

Identifiable assets by operating segment

$000

Entertainment Clothing Food Agriculture General corporate expenses Total

800 300 100 110      50 1 360

  Entertainment Clothing Food Agriculture General corporate items Total

Total sales ($000) 650 80 200   50 980

Depreciation ($000)

Other non-cash expenses ($000)

Liabilities ($000)

Capital acquisitions ($000)

20 10 15 25 20 90

10 5 10 15 20 60

200 100 150 100 250 800

50 10 20 10  – 90

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Additional information •  Income tax expense for the year is $40 000. •  There are no investments in associates. • Across the entire entity there was only one customer that accounted for 10 per cent or more of the entity’s total revenues. This customer accounted for revenue totalling $100 000 and made its purchases from the entertainment operating segment.

REQUIRED Determine the reportable segments of Petersen Ltd, and prepare the appropriate segment disclosure note in accordance with AASB 8. LO 22.4, 22.5, 22.6, 22.7 19. Ulluwatu Ltd has six segments that the chief operating decision maker reviews when making assessments of performance and evaluating and making resource allocation decisions. These segments of the organisation are: • travel •  student accommodation • entertainment • consulting • building • sandmining. While the sales of the consulting segment are predominantly external and within Australia, it did make $125 000 in inter-segment sales to the entertainment segment, and these sales generated a profit of $12 500. All inter-segment liabilities have been paid and the materials sold between the segments have since been sold externally. No other segments are involved in inter-segment sales.   Financial information for the year for the respective segments as provided to the chief operating decision maker is as follows:   Travel Student accommodation Entertainment Consulting Building Sandmining  

 

Total sales ($000)

Profit before tax ($000)

Assets ($000)

1 750 625 375 750 75      50 3 625

162.5 50 (25) 87.5 15    10 300

20 000 6 250 5 000 8 750 750      500 41 250

Depreciation and amortisation ($000)

Other noncash expenses ($000)

75  37.5  62.5  50  15  10 250 

37.5  25  37.5  50  7.5      5    162.5 

Travel Student accommodation Entertainment Consulting Building Sandmining

Liabilities ($000)

Capital acquisitions ($000)

Interest revenue ($000)

Interest expense ($000)

7 500 3 750 2 500 6 250 375      125 20 500

625 125 250 500 –        – 1 500

12.5 – – – –      – 12.5

– 7.5 – – –    – 7.5

Other information • The above information represents the information that the chief operating decision maker uses in assessing the components of the organisation. • Taxes are not allocated to individual components of the entity. 818  PART 7: OTHER DISCLOSURE ISSUES

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• • • • • • • • •

There are no investments in associates or joint ventures. The income tax expense for the year is $75 000. Unallocated corporate liabilities total $250 000. Unallocated corporate expenses total $50 000. Total non-current assets of the entity amount to $30 000 000. The entity has goodwill of $5 000 000, which is not allocated to operating segments. Other unallocated corporate assets total $125 000. Head office, which is not treated as an operating segment, earns revenues directly in the amount of $25 000. Across the entire entity there was only one customer that accounted for 10 per cent or more of the entity’s total revenues. This customer accounted for revenue totalling $375 000 and made its purchases from the travel operating segment. • In terms of the geographical aspects of the entity, all assets are held within Australia; however, one segment, sandmining, sells all its product to Kuwait.

REQUIRED Prepare the segment information note that would appear in the financial report of Ulluwatu Ltd in accordance with AASB 8. LO 22.3, 22.4, 22.5, 22.6, 22.7

REFERENCES AITKEN, M., HOOPER, C. & PICKERING, J., 1997, ‘Determinants of Voluntary Disclosure of Segment Information: A Reexamination of the Role of Diversification Strategy’, Accounting and Finance, vol. 37, pp.  89–109. AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, 1994,  Improving Business Reporting—A Customer Focus: Meeting the Information Needs of Investors and Creditors. ASSOCIATION FOR INVESTMENT MANAGEMENT AND RESEARCH, 1993,  Financial Reporting in the 1990s and Beyond, Charlotsville VA. EDWARDS, P. & SMITH, R.A., 1996, ‘Competitive Disadvantage and Voluntary Disclosures: The Case of Segmental Reporting’, British Accounting Review, vol. 28, pp. 155–72. EMMANUEL, C.R. & GARROD, N.W., 1992, Segment Reporting: International Issues and Evidence, Prentice Hall/ICAEW, Hemel Hempstead, UK. MCKINNON, J.L. & DALIMUNTHE, L., 1993, ‘Voluntary Disclosure of  Segment Information by Australian Diversified Companies’, Accounting and Finance, May, pp. 33–50. MITCHELL, J.D., CHIA, W.L. & LOH, A.S., 1995, ‘Voluntary Disclosure of Segment Information: Further Australian Evidence’, Accounting and Finance, November, pp. 1–16.

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CHAPTER 23

RELATED PARTY DISCLOSURES LEARNING OBJECTIVES (LO) 23.1 Understand what a related party is. 23.2 Be aware of some of the categories of related parties. 23.3 Understand what is meant by a related party transaction. 23.4 Be aware of some of the risks and opportunities that accrue as a result of transactions with related parties. 23.5 Understand the rationale behind disclosing extensive information about related party transactions. 23.6 Understand some of the various disclosure requirements included within the Corporations Act 2001 and AASB 124 Related Party Disclosures.

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Introduction to related party disclosures The relevant accounting standard for related party disclosures is AASB 124 Related Party Disclosures. AASB 124 applies to all reporting entities, with reduced disclosure requirements for not-for-profit entities. In addition to those in AASB 124, there are reporting requirements pertaining to related parties in the Corporations Act 2001. Of specific relevance is s. 300A. Transacting with related parties potentially creates various risks for organisations and it is because of such risks that organisations are required to make fairly extensive related party disclosures.

Related party relationship defined

LO 23.1

For accounting purposes, parties are deemed to be related if one party has the ability to significantly influence or control the activities of another, or if both parties are under the common control of another party. That is, related parties are not considered to be independent of each other. According to paragraph 9 of AASB 124 Related Party Disclosures:

related parties Parties are deemed to be related if one party is able to significantly influence or control the activities of another or where both parties are under the common influence of another party.

A related party is a person or entity that is related to the entity that is preparing its financial statements (in this Standard referred to as the ‘reporting entity’). (a) A person or a close member of that person’s family is related to a reporting entity if that person: (i) has control or joint control of 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.

From the above definition of ‘related party’ we can see that related parties would include organisations (that are controlling or controlled by the entity, or are significantly influencing or significantly influenced by the entity) as well as individuals (such as key management personnel or close family members of key management personnel). A related party transaction is defined in AASB 124 as: ‘a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged’. As we have already indicated, the accounting standard relevant to related party disclosures is AASB 124 Related Party Disclosures. Section 300A of the Corporations Act 2001 also contains a number of disclosure requirements regarding related parties. We will consider each of these sources of regulation in turn.

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LO 23.2 LO 23.3 LO 23.4 LO 23.5 LO 23.6

AASB 124 Related Party Disclosures Objectives of the standard Transactions involving related parties cannot be presumed to be carried out on an arm’s length basis, since the requisite conditions of competitive, free-market dealings might not exist. This could lead to transactions occurring at prices not in accord with fair values. Fair value is defined in AASB 13 Fair Value Measurement as:

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The above definition makes reference to ‘market participants’. Pursuant to AASB 13, market participants are deemed to be ‘independent of each other’ as well as being knowledgeable and willing and able to enter the transaction. From the above definition of fair value we can see that a transaction between parties that are not at ‘arm’s length’ (that is, between parties that are related) will not always result in a transaction occurring at the fair value of the item being transacted. Of course, it is possible for the transaction to be at fair value, but the very presence of related parties will bring this into question. The existence of a related party relationship can expose a reporting entity to risks or opportunities that would not have existed in the absence of the relationship. A related party relationship might therefore have a material effect on the performance, financial position and financing and investing activities of a reporting entity. If the performance of an entity and the impact of related party transactions are to be assessed properly, knowledge of such relationships is necessary. This perspective is consistent with the objectives of AASB 124. As paragraph 1 (the ‘Objective’ paragraph) of AASB 124 Related Party Disclosures states: The objective of this Standard is to ensure that an entity’s financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances, including commitments, with such parties. Paragraphs 5 to 8 of AASB 124 discuss the ‘purpose of related party disclosures’. According to these paragraphs: 5. Related party relationships are a normal feature of commerce and business. For example, entities frequently carry on parts of their activities through subsidiaries, joint ventures and associates. In these circumstances, the entity has the ability to affect the financial and operating policies of the investee through the presence of control, joint control or significant influence. 6. A related party relationship could have an effect on the profit or loss and financial position of an entity. Related parties may enter into transactions that unrelated parties would not. For example, an entity that sells goods to its parent at cost might not sell on those terms to another customer. Also, transactions between related parties may not be made at the same amounts as between unrelated parties. 7. The profit or loss and financial position of an entity may be affected by a related party relationship even if related party transactions do not occur. The mere existence of the relationship may be sufficient to affect the transactions of the entity with other parties. For example, a subsidiary may terminate relations with a trading partner on acquisition by the parent of a fellow subsidiary engaged in the same activity as the former trading partner. Alternatively, one party may refrain from acting because of the significant influence of another—for example, a subsidiary may be instructed by its parent not to engage in research and development. 8. For these reasons, knowledge of an entity’s transactions, outstanding balances, including commitments, and relationships with related parties may affect assessments of its operations by users of financial statements, including assessments of the risks and opportunities facing the entity. It should be noted at this point that AASB 124 does not take the position that related party transactions should be restated for disclosure purposes to their fair values if these are different from the amount recorded for the transaction. Rather, the details of actual related party transactions should be disclosed so that readers of the financial statements can make up their own minds about their possible implications. Working out such implications will not necessarily be an easy exercise. 822  PART 7: OTHER DISCLOSURE ISSUES

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In extreme cases, related party transactions might be undertaken to defraud other parties with related party a claim against the firm. For example, a director might sell some of the firm’s assets to a related transactions entity for a price materially below their market value. Directors might also use their position to pay Transactions between themselves excessive salaries. related parties. Related party transactions might also be undertaken to minimise the total taxation payable by a group of related entities. For example, one entity might arrange its activities in such a manner as director to allow the transfer of profits to a related entity that has carry-forward tax losses, or is operating Directors include in a country where it is taxed at a low rate. Further, tax-deductible expenses could also be shifted anyone who directs to countries with a higher tax rate so as to receive a greater deduction relating to those expenses. an entity in its financial Examples include the shifting of R&D expenditure, or interest expenses, to more highly taxed and operating activities jurisdictions. Because of concerns about how Australian companies might structure their transactions independently or with others or anyone so as to avoid making taxation payments, in 2015 the Australian government initiated a Senate occupying or acting in Inquiry into Corporate Tax Avoidance. This inquiry is investigating how some organisations tend to the position of director shift income to subsidiaries operating in various ‘tax havens’ while at the same time maximising the or directing someone expenses being incurred (and related deductions being claimed) in more highly taxed companies, in that position. in particular, Australia. As discussed below, related parties disclosure is highly regulated in Australia. Perhaps one of the driving forces for such regulation has been the occurrence of numerous corporate scandals in Australia, the USA, the United Kingdom and Canada. We would assume that the majority of transactions initiated within a firm, whether or not with related parties, would be in the interests of the business. However, it is the risk that a minority of transactions might not be in the interests of the organisation that, arguably, has contributed to the extensive disclosure requirements now in place for many Australian organisations. Financial Accounting in the Real World 23.1 provides an example of the extent to which related party transactions might be undertaken to benefit those who have control or significant influence over an organisation. It should be noted, however, that the example provided within the adapted newspaper article is quite extreme and not what we would expect to find in most organisations.

23.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Fiat Chrysler Australia alleges financial misbehaviour by CEOs Fiat Chrysler Australia has taken action in the Federal Court against two former CEOs, Clyde Campbell and Veronica Johns. Its suit claims that both former executives made inappropriate use of company monies for their own private purposes. The original writ was taken out against Campbell who is accused of funding a lavish lifestyle including the purchase of a plane and a yacht, to the tune of $30 million. Sam Bond, Campbell’s lawyer, said Campbell denied the allegations and that the charges were scandalous. Johns, who had been the first female CEO of a car company in Australia, was added to the original suit. She is alleged to have used company finances to pay for home renovations by the same company, Madok Group, under the control of Mitchell Knight, that renovated FCA’s offices in Port Melbourne. It is also alleged that three cars donated by FCA as prizes for charitable purposes were given by Johns to her husband and to Knight and the Madok Group. Johns resigned unexpectedly, supposedly for personal reasons, after less than 12 months in the job. SOURCE: Adapted from ‘Car giant adds ex-CEO to lawsuit’, by Mark Hawthorne, The Age, 14 August 2015

Considering what we read in the news media about related party transactions, we are often left with the feeling that there is something intrinsically bad about such transactions. If we reflect upon this, however, we should realise that there can be benefits associated with many related party transactions. Perhaps the very reason we deal with related parties is because they provide us with better services and better prices and they are more reliable because of the close association. This view is reflected in a statement made in the 1996 annual report of FAI Insurances by Rodney Adler, FAI’s  former chief executive officer. (In 2003 charges were brought by ASIC alleging that Mr Adler breached the Corporations Act by buying more than three million HIH shares in the name of his company Pacific Eagle Equities in June Chapter 23: RELATED PARTY DISCLOSURES  823

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2000. The collapse of the HIH Insurance company in March 2001 was at the time the biggest in Australian corporate history, with losses of up to $5.3 billion.) Related party transactions are also the focus of much debate in Australia and in my opinion the debate should not be on the transaction but on the disclosure. There is nothing wrong with related party transactions; there is something wrong in not disclosing them! In the world of business, companies will always err on the side of doing business with associates and that is very much a situation of building trust with people and organisations that you have done business with previously or have invested with in the past. It is much better to transact business with a related party because of your knowledge of that party than otherwise. Just as the best customer is not a new customer but an existing customer, so too is doing business with a company upon whose board one of your directors sits or an associate company or a friend you have built a trusting and valuable relationship with. The benefits are clearly obvious. Applying the disclosure requirements for ‘related parties’ as detailed in AASB 124 Related Party Disclosures obviously requires a definition of ‘related parties’. As we indicated earlier, AASB 124 provides a relatively broad definition of the term, tying it in with terminology such as ‘control’, ‘significant influence’ and ‘key management personnel’. We will consider these terms below. But first, we can consider Figure 23.1, which provides a simple example of some related parties and some associated transactions. In terms of the transactions shown: • Parent Company makes salary and bonus payments to the key management personnel. Because the key management personnel (to be defined shortly) probably have the ability to influence the amounts they are being paid, it would seem reasonable that these related payments be shown separately. This will allow interested parties, such as shareholders, to consider whether they believe the payments appear excessive and to determine what remedial action should be taken. • Parent Company provides fees (directors’ fees) to the director, and in this case also provides a loan. Because of the influence the director would have, this exposes the organisation (and its owners and other key stakeholders, such as employees, creditors, shareholders, etc.) to risks that the fees and the terms of the loan are not commercially reasonable. • In terms of the sales of inventory to the subsidiaries of Parent Company, there can be risks here as well. The sale of inventory might, for example, be structured to minimise taxes in a way that could expose the group to investigation and possible penalties for tax avoidance. Because the parties are related, perhaps Parent Company sells the inventory to Subsidiary A at a loss (thereby reducing the taxes paid by Parent Company). Subsidiary A might then sell the inventory at a further loss to Subsidiary B (thereby reducing the taxes paid by Subsidiary A), and then Figure 23.1 Example of some related party transactions

Key management personnel

Director

Bonuses

Salary

Fees

Parent company (Australia)

Inventory

Subsidiary A (Australia)

Loan

Loans

Inventory

Subsidiary B (Singapore)

Sales

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Subsidiary B might sell the inventory at a relatively large profit, but pay relatively lower taxes because it is a resident of Singapore, where tax rates are lower. This would reduce the total taxes paid by the group, but would put at risk the interests of people who have a stake only in the specific Australian organisations, but not a stake in the group.

Categories of related party We will consider the terms ‘control’, ‘significant influence’, ‘key management personnel’ and ‘close family member’ in turn below. Such terms are used in identifying categories of related parties.

Control An entity that is controlled by another entity is classified as a subsidiary. For the purposes of AASB 124, control is to be defined in the same way that it is defined in AASB 10 Consolidated Financial Statements. AASB 10 defines control as existing where the investor: has exposure, or rights to, variable returns from its involvement with the investee . . . and [has] the ability to . . . affect the amount of the investor’s returns [through its power over the investee]. Because the control of one party by another might affect an entity’s financial performance if one party elects to transact with the other (the organisation in the position to exert control could be in a situation to set transaction terms that are favourable to itself), it would appear reasonable that control be used as a criterion for having to provide related party information. What should be emphasised is that the definition of control that has been adopted relies in part on the power to affect the returns generated by the entity—this power does not necessarily have to be exercised and perhaps never will be, yet the entity with the power to control another entity would be considered to be related to that entity.

control (organisations) With regards to related parties and other organisation within a group (economic entity), control exists where the investor has exposure to, or rights to, variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.

Significant influence An entity that is significantly influenced by another entity is referred to as an associate. As indicated significant influence above, a related party relationship can also be established through the existence of significant influence Capacity of an entity to by one entity over another. Significant influence means the power to participate in the financial and affect substantially but operating policy decisions of an entity, but is not control or joint control of those policies. Significant not control either, or both, the financial and influence is a relationship that falls short of control, but enables one party to substantially affect the operating policies of policies of another. The most common form of relationship based on significant influence is that another entity. between an investor and its associate. If an organisation holds, directly or indirectly (an indirect interest might exist through the control of a subsidiary that has an ownership interest in the organisation), 20 per cent or more of the voting power of the investee (for example, It might own 20 per cent of the ordinary shares), then it is presumed that the entity has significant influence, unless it can be clearly demonstrated that this is not the case. Once the ownership interest extends beyond 50 per cent or more, then ‘control’ is normally considered to exist. In Figure 23.2 the percentages represent equity ownership. C Ltd would be a related party of both A Ltd and B Ltd. As both have an equity ownership of 25 per cent, they would most probably be able to exercise significant influence over C Ltd. A Ltd and B Ltd would not be deemed related to each other, as neither appears to have any direct control or significant influence over the other. D Ltd and E Ltd would both be considered related parties of C Ltd. Being under common control, they would also be considered related to each other (they would be referred to as ‘fellow subsidiaries’). Refer to the definition of related parties provided earlier (from AASB 124).

Key management personnel Key management personnel are considered to be related parties. Being closely involved in the operations of the business, they have the ability to initiate numerous transactions. It is possible for some of these transactions not to be at fair value, given that they are not ‘arm’s length’ transactions. AASB 124, paragraph 9, defines key management personnel as: those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.

key management personnel Persons having authority and responsibility for planning, directing and controlling the activities of an entity, including any director of that entity.

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Figure 23.2 Example of related parties showing percentage of equity ownership

A Ltd

B Ltd

25%

25%

C Ltd

100%

D Ltd

100%

E Ltd

Recent amendments to AASB 124 (and IAS 24) also designated an entity as being a related party if that 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.

Close family members As already indicated, a close member of the family of someone who is key management personnel (or of someone who is able to control or significantly influence an entity) is considered to be a related party. ‘Close members of the family of an individual’ are defined at paragraph 9 of AASB 124 as: those family members who may be expected to influence, or be influenced by, that person in their dealings with the entity and include: (a) that person’s children and spouse or domestic partner; (b) children of that person’s spouse or domestic partner; and (c) dependants of that person or that person’s spouse or domestic partner. We will now apply the definition of a related party provided in AASB 124 to the example given in Worked Example 23.1.

WORKED EXAMPLE 23.1: Identification of related parties Assume that Figure 23.3 represents the structure of some entities in an Australian group. The percentage ownership is shown, and these percentages are deemed to be representative of voting rights. The directors of the entities are as follows: Coolum Ltd Sunrise Ltd Peregian Ltd Marcoola Ltd Castaways Ltd Sunshine Unit Trust

Smith, Jones Green, Black White, Sand Long, Board Short, Wax Reddy, Brown

REQUIRED (a) Identify the related parties of Marcoola Ltd. (b) Identify the entities that are not related to Marcoola Ltd. (c) Identify the related parties of Peregian Ltd. (d) Identify the entities that are not related to Peregian Ltd. SOLUTION To answer this question we need to refer to the definition of related parties provided in AASB 124.

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Figure 23.3 Structure of entities in an Australian group

Coolum Ltd

32%

40%

70%

Sunrise Ltd

Peregian Ltd

Marcoola Ltd

11%

Castaways Ltd

55%

Sunshine Unit Trust

(a) Related parties of Marcoola Ltd Sunrise Ltd would be a related party of Marcoola Ltd if Coolum Ltd also controlled Sunrise Ltd (they would be ‘fellow subsidiaries’). It is possible to ‘control’ another entity with a shareholding of 32 per cent if the balance of the other shareholding is widely dispersed—a condition that must be determined on the basis of additional analysis. However, without sufficient evidence to indicate control, Sunrise Ltd would not be deemed to be a subsidiary of Coolum Ltd in the presence of an ownership interest of just 32 per cent. Therefore, Sunrise Ltd and Marcoola Ltd would not be ‘fellow subsidiaries’ and would not be deemed to be related parties. Peregian Ltd, as with Sunrise Ltd, would be a related party of Marcoola Ltd if Coolum Ltd also ‘controls’ Peregian Ltd. In the absence of evidence to the contrary, an ownership interest of 40 per cent might fall short of constituting control. Hence Peregian Ltd would probably not be a ‘related party’ of Marcoola Ltd. Coolum Ltd is a related party, as it controls Marcoola Ltd. It would be considered a controlling entity. Sunshine Unit Trust is controlled by Marcoola Ltd, and would therefore be considered a controlled entity. Long and Board are directors of Marcoola Ltd, and hence would be classed as ‘key management personnel’. Pursuant to AASB 124, only ‘key management personnel’ of an entity or its parent entity are included as related parties. Hence, we would also include Smith and Jones. (b) Non-related parties of Marcoola Ltd Apart from the entities already discussed, Castaways Ltd would not be considered a related party as it would probably not be subject to significant influence. Nor would the directors of Castaways Ltd be considered related parties. (c) Related parties of Peregian Ltd Coolum Ltd would at the least ‘significantly influence’ Peregian Ltd, and Peregian Ltd would be considered an associate of Coolum Ltd. Hence, Coolum Ltd is a related party. Marcoola Ltd, as it is controlled by Coolum Ltd, would be considered to be a related party of Peregian Ltd only if the 40 per cent ownership held gave control of Peregian Ltd to Coolum Ltd (in which case they would be ‘fellow subsidiaries’). Since Coolum Ltd does not appear to ‘control’ Peregian Ltd, Marcoola Ltd would not be a related party of Peregian Ltd. continued Chapter 23: RELATED PARTY DISCLOSURES  827

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Although it appears that Coolum Ltd controls (indirectly through its control of Marcoola Ltd) Sunshine Unit Trust, and Coolum Ltd significantly influences Peregian Ltd, Sunshine Unit Trust would not be considered a related party under the definition provided in AASB 124. The directors of Peregian Ltd would be related parties of Peregian Ltd. The Directors of Coolum Ltd would not be considered to be related parties of Peregian Ltd as Coolum Ltd does not appear to be a parent (controlling) entity. (d) Non-related parties of Peregian Ltd Apart from the entities already discussed, Sunrise Ltd is not a related party of Peregian Ltd as Coolum Ltd only significantly influences Sunrise Ltd (common significant influence does not constitute related party status under AASB 124). Castaways Ltd is not a related party of Peregian Ltd, nor is Marcoola Ltd or Sunshine Unit Trust. The directors of Castaways Ltd and Sunrise Ltd would not be considered related parties of Peregian Ltd.

Disclosure requirements Up to this point we have been considering how to identify related parties. The next step obviously is to consider the disclosures we must make in relation to related parties. Disclosure is required of transactions between the entity and its related parties, as well as of the general existence of related parties. Broadly speaking, such disclosures would relate to: • the nature of the relationship • the transactions undertaken • outstanding balances. Pursuant to paragraph 19 of AASB 124, related party disclosures are required to be provided separately in the following categories: • transactions with the entity’s parent entity • transactions with entities with joint control of, or significant influence over, the entity • subsidiaries • associates • joint venturers in which the entity is a joint venturer • key management personnel of the entity or its parent • other related parties. AASB 124 requires various items of disclosure. It requires descriptive information about the relationships between various related parties. In relation to situations where one entity controls another (that is, where there is a parent– subsidiary relationship), paragraph 13 of AASB 124 stipulates: Relationships between a parent and its subsidiaries shall be disclosed irrespective of whether there have been transactions between them. An entity shall disclose the name of its parent and, if different, the ultimate controlling party. If neither the entity’s parent nor the ultimate controlling party produces consolidated financial statements available for public use, the name of the next most senior parent that does so shall also be disclosed. Paragraph Aus13.1 (remember, a paragraph number preceded by ‘Aus’ indicates that the paragraph has been added by the AASB to the standard released by the IASB) has additional disclosure requirements in respect of describing related party relationships: When any of the parent entities and/or ultimate controlling parties named in accordance with paragraph 13 is incorporated or otherwise constituted outside Australia, an entity shall: (a) identify which of those entities is incorporated overseas and where; and (b) disclose the name of the ultimate controlling entity incorporated within Australia. 828  PART 7: OTHER DISCLOSURE ISSUES

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In explaining the above disclosure requirements as they relate to the parent–subsidiary relationship that requires disclosure even in the absence of a transaction, paragraph 14 of AASB 124 states: To enable users of financial statements to form a view about the effects of related party relationships on an entity, it is appropriate to disclose the related party relationship when control exists, irrespective of whether there have been transactions between the related parties. There are a number of disclosure requirements in relation to key management personnel. 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; (c) other long-term 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. The categories of ‘compensation’ discussed in paragraph 16 are defined at paragraph 9 of AASB 124 as follows: Compensation includes all employee benefits (as defined in AASB 119 Employee Benefits) including employee benefits to which AASB 2 Share-based Payment applies. Employee benefits are all forms of consideration paid, payable or provided by the entity, or on behalf of the entity, in exchange for services rendered to the entity. It also includes such consideration paid on behalf of a parent of the entity in respect of the entity. Compensation includes: (a) short-term employee benefits, such as wages, salaries and social security contributions, paid annual leave and paid sick leave, profit-sharing and bonuses (if payable within twelve months of the end of the period) and non-monetary benefits (such as medical care, housing, cars and free or subsidised goods or services) for current employees; (b) post-employment benefits such as pensions, other retirement benefits, post-employment life insurance and post employment medical care; (c) other long-term employee benefits, including long service leave or sabbatical leave, jubilee or other long service benefits, long-term disability benefits and, if they are not payable wholly within twelve months after the end of the period, profit-sharing, bonuses and deferred compensation; (d) termination benefits; and (e) share-based payment. The rewards provided to corporate directors and executives, who are included among ‘key management personnel’, is a fairly sensitive issue and one in which many stakeholders take a keen interest. Financial Accounting in the Real World 23.2 provides an adaptation of an article entitled ‘$30m a year: tip of exec pay iceberg’ that appeared in The

23.2 FINANCIAL ACCOUNTING IN THE REAL WORLD Under-reporting of chief executives’ remuneration The Australian Council of Superannuation Investors (ACSI) prepares an annual report, CEO Pay, on remuneration paid to the Australian corporate world’s chief executives. continued Chapter 23: RELATED PARTY DISCLOSURES  829

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The 2015 report on the 2014 financial year found significant under-reporting of executive pay across the board, as companies’ financial statements included salaries but not necessarily all the other financial benefits in cash and equity accruing to their CEOs. In 2014 the top 10 CEOs in Australia supposedly earned the reported total of $99.63 million; in actual fact, the earnings totalled $171.4 million. The shortfall of reported earnings was therefore around $71 million. The difference is the amount of undeclared benefits received by CEOs, like bonuses, and vested and exercised shares. Louise Davidson, from ACSI, stated that current rules around detailing executives’ salaries encourage underreporting as they only look at the cost to the company not the reward to the individual. The company reports only showed what she called ’the tip of the iceberg’ of CEO remuneration. Australia’s highest paid CEO was Chris Rex from Ramsay Health Care whose 2014 reported pay was $9.09 million, but was in fact paid $30.8 million for the year. In 2008 when he was made CEO he was allocated 600 000 ’retention rights’ which were vested in him in July 2013. The issue of CEO pay is a highly contentious one, especially following the global financial crisis, and the ACSI report will inflame those who already believe Australian CEOs are grossly overpaid. This perception needs to be addressed by company boards and investors while deciding on how to reward their CEOs. SOURCE: Adapted from ‘$30m a year: tip of exec pay iceberg’, by Mitchell Bingeman, The Australian, 3 September 2015

Australian on 3 September 2015 (by Mitchell Bingeman). The article is critical of executive pay levels as well as the current disclosure requirements in place (which we are discussing). Now we turn our attention away from ‘key management personnel’ (which includes directors and senior executives) to ‘related parties’ in general. As we have shown, AASB 124 defines related parties. 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; (c) allowances for doubtful debts related to the amount of outstanding balances; and (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. As we have indicated, 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; (c) subsidiaries; (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. Detailed disclosures of particular transactions with individual related parties would frequently be too voluminous to be easily understood. Accordingly, and as shown above, information would be aggregated by type of transaction, nature of terms and conditions and class of related party. However, disclosure on an individual basis might be more informative when there are significant transactions with specific related parties. 830  PART 7: OTHER DISCLOSURE ISSUES

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AASB 124 provides examples of transactions that should be disclosed. According to paragraph 21 of AASB 124: The following are examples of transactions that are disclosed if they are with a related party: (a) purchases or sales of goods (finished or unfinished); (b) purchases or sales of property and other assets; (c) rendering or receiving of services; (d) leases; (e) transfers of research and development; (f) transfers under licence agreements; (g) transfers under finance arrangements (including loans and equity contributions in cash or in kind); (h) provision of guarantees or collateral; (i) commitments to do something if a particular event occurs or does not occur in the future, including executory contracts (recognised and unrecognised); and ( j) settlement of liabilities on behalf of the entity or by the entity on behalf of that related party. In practice, it has often been argued by managers of entities that disclosure of transactions between related parties should not be required if the transactions were made on ‘normal business terms’. In this regard, paragraph 23 of AASB 124 further requires that: ‘Disclosures that related party transactions were made on terms equivalent to those that prevail in arm’s length transactions are made only if such terms can be substantiated’. However, at times it will be very difficult for the organisation to be able to produce substantiating evidence. For example, the types of transactions undertaken with related parties might not be conducted with unrelated parties and hence no evidence can be produced to show that terms and conditions of both sets of transactions were similar. Therefore, a transaction or set of transactions could potentially still be arm’s length, but the firm cannot substantiate the commercial basis of those transactions. AASB 124 provides some relief from the related party disclosure requirements in relation to transactions with a government. Specifically, paragraph 25 states: A reporting entity is exempt from the disclosure requirements of paragraph 18 in relation to related party transactions and outstanding balances, including commitments, with: (a) a government that has control or joint control of, or significant influence over, the reporting entity; and (b) another entity that is a related party because the same government has control or joint control of, or significant influence over, both the reporting entity and the other entity. However, AASB 124 nevertheless does have disclosure requirements in regard to transactions within governments. In this regard, paragraph 26 of AASB 124 states: 26 If a reporting entity applies the exemption in paragraph 25, it shall disclose the following about the transactions and related outstanding balances referred to in paragraph 25: (a)  the name of the government and the nature of its relationship with the reporting entity (ie control, joint control or significant influence); (b)  the following information in sufficient detail to enable users of the entity’s financial statements to understand the effect of related party transactions on its financial statements: (i) the nature and amount of each individually significant transaction; and (ii)  for other transactions that are collectively, but not individually, significant, a qualitative or quantitative indication of their extent. Types of transactions include those listed in paragraph 21.

Section 300A of the Corporations Act 2001

LO 23.6

The Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003 (the CLERP 9 Bill) was passed by parliament in 2004 and came into operation from July 2004. Part of the Bill was introduced to address concerns about the failure to disclose payments made to directors. CLERP 9 included a number of requirements in relation to director and executive remuneration and these are incorporated in s. 300A of the Corporations Act. Section 300A of the Corporations Act provides requirements for listed companies. In summary, s. 300A requires the following: • A ‘remuneration report’ section is to appear in the Directors’ Report. • The remuneration report is to provide information about the remuneration of all directors and the five highest remunerated executives of the listed company and of the consolidated group (that is, up to 10 executives). Chapter 23: RELATED PARTY DISCLOSURES  831

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• The report is to provide information about the board’s policy for determining remuneration. • The report is to discuss the relationship between the remuneration policy and the company’s performance. • Various items of information about the value of options provided to directors and executives are to be disclosed. • If remuneration is dependent upon a performance condition, details are to be provided of that performance condition, the reason for choosing it, how it is assessed and whether it has been satisfied. • If an entity provides remuneration in the form of securities and that remuneration is not dependent upon the satisfaction of a performance condition, an explanation of why that element is not dependent on the satisfaction of a performance condition must be provided. It is particularly interesting to know about the ‘performance conditions’ utilised in the compensation plans provided to key management personnel (in the sixth bullet point above). Organisations will have missions, goals and objectives. Their corporate governance systems (policies and procedures) will be developed to assist in the achievement of these missions, goals and objectives. Arguably, if an organisation is serious about achieving particular objectives, the compensation plans should include key performance indicators (KPIs) that are tied to the objectives (for example, if an organisation is serious about reducing greenhouse gas (GHG) emission levels, some key management personnel should be rewarded on the basis of KPIs tied to reducing corporate GHG emission levels). The disclosures required by s. 300A will help to inform readers about how particular compensation schemes are likely to motivate key management personnel to take certain actions. If particular KPIs are missing from executive remuneration plans, we must question how serious an organisation really is about achieving the goals linked to those KPIs. For example, if a company makes public claims that it is making efforts to reduce the environmental impacts of its operations, but the disclosures required by s. 300A fail to show any use of environment-related KPIs in the compensation plans negotiated with senior management, we must question the organisation’s commitment. In this regard we can consider the results reported in Deegan and Islam (2012). They reviewed the annual reports of a sample of large Australian carbon-intensive companies and collected information about the executive remuneration plans in place within these companies. Their results showed that the performance indicators utilised within these remuneration plans continue to fixate on financial performance despite the importance that the companies publicly attributed to achieving various social and environmental performance benchmarks. The authors argue that their results provide evidence of a disconnection, or ‘decoupling’, between the ‘sustainability-related rhetoric’ of the sample companies, and their ‘real’ organisational practices and priorities. The annual remuneration report of a corporation is to be put to a non-binding vote of the shareholders. Notices of meetings are to inform shareholders that a resolution for adoption of the remuneration report will be voted on. The vote on the remuneration report is merely advisory, since it does not bind the directors of the company. In relation to this nonbinding vote, the relevant sections of the Corporations Act are ss. 250R(2) and (3) and 250 SA. Respectively, they state: 250R(2) At a listed company’s AGM, a resolution that the remuneration report be adopted must be put to the vote. 250R(3) The vote on the resolution is advisory only and does not bind the directors or the company. 250SA At a listed company’s AGM, the chair must allow a reasonable opportunity for the members as a whole to ask questions about, or make comments on, the remuneration report. This section does not limit Section 250 S. While the vote on the remuneration report is non-binding, amendments were made to the Corporations Act in 2011—with the inclusion of Sections 250(U) to 250(Y)—and a mechanism that has become known as the ‘two-strikes policy’ was introduced. Specifically, on 20 June 2011, the Senate approved the Corporations Amendment (Improving Accountability on Director and Executive Remuneration) Bill 2011 and the legislation took effect from 1 July 2011 with the new law applying to resolutions on the remuneration report as put to annual general meetings held from 1 July 2011. Under the section of the Corporations Act, a ‘two-strikes and re-election’ process has been introduced in relation to the non-binding shareholder vote on a listed company’s remuneration report. The ‘first strike’ occurs when a company’s remuneration report receives a ‘no’ vote of 25 per cent or more of the shareholders at the Annual General Meeting. Where this occurs, the company’s subsequent remuneration report—which is included within the annual report— must include an explanation of the board’s proposed action in response to the ‘no’ vote, or if no action was taken, an explanation of why no action was taken. The ‘second strike’ occurs where a company’s subsequent remuneration report receives a ‘no’ vote of 25 per cent or more at the next Annual General Meeting. Where this occurs, shareholders will vote at the same meeting to determine whether the directors will need to stand for re-election. This has become known as a ‘spill resolution’. If this spill resolution passes with 50 per cent or more of eligible votes cast, then the ‘spill meeting’ will take place within 90 days. 832  PART 7: OTHER DISCLOSURE ISSUES

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This reform is intended to provide an additional level of accountability for directors, and to increase the level of transparency provided to shareholders. Arguably, if a company receives significant ‘no’ votes on its remuneration report across two consecutive years, and has not taken steps to adequately address the concerns raised by shareholders, it is appropriate for the board to be held accountable through the re-election process. Directors should accept a responsibility and accountability to shareholders on all aspects of the management of the company, including the amount and composition of executive remuneration. As might be expected, the amendments to the Corporations Law were not overwhelmingly welcomed by company directors. In an article entitled ‘Let the games begin now the two-strikes rule opens boards to challenge over pay’ (Adele Ferguson, Sydney Morning Herald, 17 October 2011), it was reported: The mood and new powers of shareholders has hit a raw nerve with directors, who released a report last week through their lobby group, the Australian Institute of Company Directors (AICD), trying to discredit proxy advisers whose job it is to make recommendations on how shareholders should vote on things—including executive pay packages—at annual general meetings. The report was launched by company director Don Argus, who inflamed the situation by telling investors that if they don’t like executive pay levels and big bonuses, ‘they can sell the shares—it’s as simple as that’. A view supportive of the Corporations Act amendments was also provided in the article: But the renewed focus on executive pay and the anxiety it (the ‘two-strikes policy’) has produced among directors is a huge positive, according to the architect of the two-strikes policy, Professor Allan Fels, the co-author of the Productivity Commission report into executive pay. ‘Last week’s debate highlights the importance of the new law and it seems to have caused some anxiety, which is a good thing given there are still a significant number of excessive pay outcomes,’ he said. On the two strikes rule, Fels is even less coy. ‘It is an extremely well balanced and some would say unduly soft law that sensibly puts pressure on boards to do the job well and better than they did in the past.’ For Fels, the spat between proxy advisers and the AICD keeps the debate alive. But Argus’s comments, well, they were just plain wrong. ‘Most shareholders would resent having to incur significant costs selling shares. It is better to put more pressure on boards to manage pay properly,’ Fels said. ‘And in any case a significant number of shareholders in index funds can’t sell shares.’ The brutal reality is it is incumbent on boards to ensure they do the right thing by the people who own the company—the shareholders—when it comes to remunerating themselves and senior executives. Shareholders should have the power to do something about it, rather than having to dump their shares in protest. AASB 124 requires disclosure by executives and directors based on the definition of key management personnel whereas the Corporations Act relies on the five highest-paid directors and executives of a listed company. The Corporations Act also requires shareholder approval for any agreement to pay a prospective executive or director a retirement benefit greater than their final salary multiplied by their number of years of service (with an upper limit of seven years). There is some duplication between the requirements of s. 300A of the Corporations Act and those of AASB 124. Further, the disclosures required by s. 300A are to be made in the Directors’ Report, whereas the disclosures required by AASB 124 are to be made in the notes to the financial statements. An ASIC Class Order released in 2006 allows listed companies to avoid duplication of remuneration details, making it possible for the Directors’ Report to contain crossreferences to the relevant details within the financial statements. It is interesting to reflect on reactions to the CLERP 9 requirements and to compare how industry reacted with how shareholders and other stakeholders reacted. In November 2003 the Business Council of Australia produced its ‘Submission to the Treasury on the Corporate Law Economic Reform Program’. Exhibit 23.1 contains excerpts from this document. It is clear from Exhibit 23.1 that the BCA was quite opposed to the extensive disclosure requirements for directors’ and executives’ remuneration as incorporated in s.300A of the Corporations Act. Do you think its points of opposition are valid? (The members of the BCA would typically be senior executives and therefore probably subject to any proposed disclosure requirements, so we can speculate on whether ‘self-interest’ might be motivating some of their opposition.) The comments by the BCA are interesting. They reflect the view that the government was simply reacting to ‘current moods’ within the community (which raises the point that if the community expects particular accountability perhaps it is the role of government to ensure that such accountability is provided). The BCA speculates that the greater disclosures will lead to increases in salaries. This seems to be a fairly simplistic argument. The BCA also promotes the view that Chapter 23: RELATED PARTY DISCLOSURES  833

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Exhibit 23.1 Excerpts from the ‘Business Council of Australia Submission to the Parliamentary Joint Committee on Corporations and Financial Services on the Corporate Law Economic Reform Program (Audit Reform & Corporate Disclosure) Bill’

Director and executive remuneration is undoubtedly the current focal point for the corporate governance debate, with rarely a week going by without some commentary on CEO pay or director benefits. Despite a strengthening share market and a return to healthy company profits, views continued to be expressed by media commentators, politicians and trade union leaders that CEO pay is unreasonable and divorced from the reality of corporate results. This has led to calls for further regulation and intervention in the level and type of remuneration paid to CEOs and other senior executives. There is a danger, however, that the current mood will lead governments to take actions that are at best unnecessary and at worst counterproductive. The Business Council accepts that community concerns need to be responded to, but is concerned that some measures proposed in the CLERP 9 Bill go too far. The Business Council is concerned that the disclosure of individual executives’ remuneration has unintended consequences, which will be exacerbated by increasing the number of executives covered. There is strong anecdotal evidence to suggest that the disclosure of individual executives’ remuneration leads to a ‘ratcheting up’ of salaries, as an executive can see how much peers and colleagues within the company, and its competitors, earn. In addition, extended disclosure may, in some cases, result in the remuneration of relatively junior executives being disclosed. Such disclosure requirements also put publicly listed companies at a disadvantage to private or foreign owned corporations, which are able to see the ‘price tag’ of individual executives working for a public company, without having to disclose the remuneration of their own executives. Identifying senior executives and their remuneration levels is also contrary to general privacy principles and the movement towards protecting personal information. It is surprising that companies face financial penalties under the Privacy Act 1988 for revealing personal information, yet have to disclose, and see reported in the media, the details of remuneration of individuals employed by the company. The proposal also raises fundamental questions about the role of Boards and their relationship with shareholders. The concept of a publicly listed company involves shareholders delegating authority for the management of their investment to a Board. It is appropriate that, as is already the case, shareholders vote on the appointment and remuneration of the Board of directors. As noted above, it is also appropriate that shareholders vote on the allocation of equity in the company to executives or others. However, it is the role of the Board, on behalf of shareholders, to determine the remuneration of executive managers. As a matter of principle, there is no difference between the Board’s decision on executive remuneration and its decisions on a wide range of other matters that may affect shareholder value. If a shareholder vote is accepted as a matter of principle on executive remuneration, it is difficult to see why a shareholder vote would not be considered appropriate to verify a wide range of other Board decisions, such as decisions to acquire or divest company assets. Such a principle would, however, undermine the whole basis on which the listed company structure is based. The proposed vote on executive remuneration is effectively a confidence (or no confidence) vote in the Board and its Remuneration Committee. Boards are in the position where they are aware of the skills, experiences and contributions to the company of individual executives. They are also aware of the significance of retaining particular executives and the costs to the company if experienced executives cannot be retained. Boards also seek independent external advice on appropriate remuneration, given the executives involved and the circumstances of the company and the markets in which it operates. Boards may also have access to information about remuneration rates at comparable non-listed and multinational corporations; information that is not readily publicly available. The judgements and decisions of Boards and their Remuneration Committees are therefore based on a sound understanding of all of the factors influencing executive remuneration. Shareholders invariably have considerably less information upon which to base their judgements. If shareholders vote to reject the judgement and decision of the Board, this effectively amounts to a vote of no confidence in the Board and its Remuneration Committee. Such a vote could be expected to lead to the resignation of, at the very least, the Chair of the Remuneration Committee. The Business Council does not condone excesses in the area of executive pay. Nor does it condone what are isolated examples in which pay has clearly not been linked with performance.

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However, it is concerned that what are effectively a small number of instances have become the sole reference point of the debate over executive remuneration. Therefore, it believes the proposal for a non-binding vote on executive remuneration is unnecessary and infringes the basic principle that it is the function of shareholders to approve the remuneration of directors and the function of directors to determine the remuneration of executives. In this regard, the proposal goes beyond the new requirements upon which it is based. Australia already has among the most extensive requirements for disclosing executive remuneration in the world. The new proposal is therefore unwarranted. The proposal also potentially raises legal issues for Boards that do not abide by the shareholders’ vote, even though it is meant to be non-binding. The Business Council believes the proposal to require a shareholder vote on payments to directors above a certain threshold, including retirement or termination payments, needs to be reconsidered. In particular, this proposal does not recognise the potential effect of legitimate superannuation on the total of retirement payments and implies that payments above the threshold are somehow excessive and therefore require specific approval. Should this provision be introduced, however, existing entitlements and agreements should be ‘grandfathered’; that is, excluded from the operation of the new provision. SOURCE: Reproduced with the permission of the Business Council of Australia. The excerpts reproduced here are not in the order in which they appear in the original document.

senior executives deserve greater privacy—this is an interesting position in the light of community concern about the excessive salaries perceived to be paid to many corporate executives. The BCA also questions the rights and ability of shareholders to evaluate directors’ and executives’ remuneration and holds that senior corporate management is best placed to determine how much to pay themselves and fellow managers. In contrast with the above views, the Australian Shareholders’ Association released a document in October 2003 entitled Pave the Way for Effective Disclosure in which the chairperson of the ASA stated the following: Disclosure requirements applying to director and executive remuneration will also be expanded and enhanced. In particular shareholders will have a greater say in the termination benefits of directors and be able to signal their unhappiness with executive remuneration by way of a non-binding vote. While shareholders do not want to be involved in the management of their companies, the hardheads within the Business Council of Australia should be aware of the cynicism that runs deep amongst shareholders. Directors and management have acquiesced in soaring executive remuneration. It is nonsense to blame current disclosure requirements. Shareholder participation and even activism is encouraged throughout the Clerp 9 proposals. Activist shareholders will of course remind their companies that corporate governance is not an end in itself. It needs to be kept in perspective. Like good management it is one, albeit important, cog in the wheel that delivers dividends and share price growth. Smart shareholders will keep the focus on the generation of longterm shareholder value.

Examples of related party disclosure notes

LO 23.6

Rather than this book reproducing numerous related party notes as they appear in annual reports, you should consider reviewing a number of annual reports for yourself to see the extent of disclosures made with regard to related party transactions. As you will see in your review, the disclosures can be quite voluminous. As we know, annual reports must include a ‘remuneration report’ and these can often be 20 pages or more in length. By the time we also consider details provided about transactions with other related party transactions we can see that many pages of Australian annual reports are dedicated to providing information about transactions with related parties. You might like to review the disclosures being made in the following annual reports. Some of the disclosures can actually make for rather interesting reading: • Myer Holdings Ltd’s annual report. The latest annual report can be reviewed at www.myer.com.au. • The annual report of BHP Billiton Ltd. The latest annual report can be reviewed at www.bhpbilliton.com. Chapter 23: RELATED PARTY DISCLOSURES  835

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• The annual report of Qantas Ltd. The latest annual report can be reviewed at www.qantas.com.au. • The annual report of the Commonwealth Bank of Australia Ltd. The latest annual report can be reviewed at www.commbank.com.au.

SUMMARY This chapter considers related party transactions. As demonstrated, related party transactions are subject to a great deal of disclosure regulation within Australia. The rationale for this is that dealings associated with related parties can expose a reporting entity to risks and can provide opportunities that would otherwise not have existed. As such, the accounting regulators are of the view that a proper assessment of the performance of an entity necessarily requires knowledge of its various related party transactions. The accounting standard pertaining to disclosures of related parties and their transactions is AASB 124. The Corporations Act 2001 also requires the disclosure of certain information about related party transactions. To comply with the requirements of the accounting standards and the Corporations Act, listed companies devote many pages of their annual reports to related party transactions. The cost of preparing and reporting this information would be high—as would that imposed on financial statement readers in their efforts to assimilate and understand the voluminous data—but the regulators obviously consider these costs to be outweighed by the associated benefits. As indicated within this chapter, the extensive regulation of related party transactions is arguably due to some of the infamous director rorts that have occurred in recent decades and the perception that extensive disclosure regulation is necessary to maintain—or perhaps restore—confidence in the Australian corporate sector.

KEY TERMS control (organisations)  825 director  823

key management personnel  825 related parties  821

related party transactions  823 significant influence  825

END-OF-CHAPTER EXERCISES 1. For accounting purposes, what is a related party? LO 23.1 2. It is often argued that to properly assess the performance of an entity, knowledge of related party transactions is required. What is a possible basis for such an argument? LO 23.4, 23.5, 23.6 3. Key-management-personnel-related transactions are subject to the highest degree of required disclosure. Why do you think this is the case, and do you think it is justified? LO 23.4, 23.6 4. AASB 124 provides a definition of related parties. The definition relies upon such terms as control, significant influence, key management personnel and close family members. Define these four terms. LO 23.1, 23.2, 23.6

REVIEW QUESTIONS 1. What is a related party? LO 23.1 2. Do you consider that disclosure of related party information is of value to financial statement users? Why? LO 23.5 3. Do you consider that disclosure of related party information is of value to the organisations making the disclosures? Why? LO 23.5, 23.6 4. Do you think that an organisation that provides information about its related party transactions would be more favourably viewed by investors than an organisation that does not provide any such information? Explain your answer. LO 23.5, 23.6 836  PART 7: OTHER DISCLOSURE ISSUES

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5. What are the classes of related parties identified in AASB 124? LO 23.2 6. How are ‘key management personnel’ defined in AASB 124? LO 23.2 7. Briefly identify the types of information that must be disclosed in relation to key management personnel-related transactions. LO 23.5, 23.6 8. A review of key management personnel disclosure notes will often show that a component of the salary executives are paid is linked to corporate performance. Why do you think organisations would not just pay directors a fixed salary rather than one based on performance? LO 23.4, 23.5, 23.6 9. Review the executive and director disclosures made by BHP Billiton Ltd in its most recent annual report (you will need to go to the BHP Billiton website) and identify which transactions would cause you most concern. Explain why this is the case. LO 23.4, 23.6

CHALLENGING QUESTIONS 10. Compare and contrast the views expressed by the Business Council of Australia and by the Australian Shareholders’ Association (provided earlier in this chapter) in relation to the amendments to s. 300A of the Corporations Act. LO 23.6 11. Review a number of corporate annual reports for the contents of their related party disclosures (you are to identify which companies you have reviewed). As you will typically see, the note disclosure is extensive. List the headings of the various related party disclosures being made. Do you think that the costs involved in making such disclosures would exceed the benefits? What would be some of the costs and what would be some of the benefits? LO 23.5 12. Review the related party note provided by BHP Billiton Ltd in its most recent annual report (find it at BHP Billiton Ltd’s website). How many pages are dedicated to related party disclosures, and what are the various headings of the related party disclosures? Do you think that this is a case of too much information being provided—a case of information overload? Explain your answer. LO 23.4, 23.5, 23.6 13. As we indicated in this chapter, changes in 2004 to the Corporations Act 2001 required shareholders to vote, in a non-binding fashion, on remuneration plans. In this regard, the Business Council of Australia stated (in its November 2003 document entitled ‘Submission to Treasury on the Corporate Economic Reform Program’): The introduction of a shareholder vote on executive remuneration raises a number of practical issues for Boards seeking to employ the best executives for their companies. The following hypothetical demonstrates one of the perverse outcomes that will flow from the introduction of a shareholder vote on remuneration, namely that there will be higher barriers for companies wishing to recruit senior executives from outside of their firms. This in turn can reduce the opportunity to bring executives with different experiences, skills and cultures into the recruiting company, with ultimately negative effects on shareholder value. Company A wishes to fill an executive position within the company. They hire an executive placement consultant and undertake a search for the most suitable candidate, both within and from outside of the company. An executive working for a rival firm (Company B) is identified and selected as the most appropriate candidate for the position. The executive agrees to take the position and terms of employment are negotiated. Company A, however, advises that in her new position, the executive will be one of the [five top-paid] executives in Company A and therefore her annual remuneration will need to be disclosed, in accordance with s. 300A of the Corporations Act. Her remuneration arrangements will also therefore be subject to a non-binding shareholder vote at the next annual general meeting. Company A advises the executive that, should the resolution on executive remuneration be rejected by the shareholders, even though the vote is non-binding the company will abide by the vote. The company is concerned that to ignore the vote would expose it to public criticism and may increase the legal risk to its directors. Company A therefore makes the final employment offer to the executive conditional on the passing of the remuneration resolution. This is further complicated as there may be months before the company’s AGM, at which the vote will take place. The executive is placed in an impossible position. Once it becomes known that she is considering a move to Company A, her career at Company B is finished. If her contract with Company A is voted down Chapter 23: RELATED PARTY DISCLOSURES  837

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as part of the non-binding vote, she is left in limbo. To offset this risk, the executive demands an up-front payment in return for her agreement to enter into the employment contract with Company A. The payment will need to be considerable, as the executive is potentially risking her successful career. Company A is now faced with additional risk in employing an executive from outside of the company. If the shareholders vote against the company’s remuneration report, Company A will lose both the new executive, and the up-front payment.

REQUIRED Evaluate the above analysis provided by the Business Council of Australia. Do you consider it to be ‘objective’? Why? LO 23.3, 23.4, 23.5, 23.6

REFERENCES AUSTRALIAN SHAREHOLDERS’ ASSOCIATION, 2003, Pave the Way to Effective Disclosure, 14 October. BUSINESS COUNCIL OF AUSTRALIA, 2003, ‘Submission to the Treasury on the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill’, 12 November. DEEGAN, C. & ISLAM, M.A., 2012, ‘Corporate Commitment to Sustainability—Is It All Hot Air? An Australian Review of the Linkage between Executive Pay and Sustainable Performance’, Australian Accounting Review, vol. 22, no. 4, pp 384–97.

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CHAPTER 24

EARNINGS PER SHARE

LEARNING OBJECTIVES (LO) 24.1 Be able to define and calculate basic earnings per share. 24.2 Know how to adjust the calculation of basic earnings per share to take account of the existence of a bonus or rights entitlement. 24.3 Understand what potential ordinary shares are, and be able to determine whether they are dilutive. 24.4 Understand how and why we calculate diluted earnings per share. 24.5 Know how to link earnings per share to other related indicators

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Introduction to earnings per share The first regulatory body in Australia to require the disclosure of earnings per share was the Australian Securities Exchange (ASX). This requirement was introduced into the Australian Securities Exchange Listing Rules in 1989. At the time, the ASX provided a limited amount of guidance in relation to calculating earnings (the numerator in the ratio), but none in relation to calculating the number of shares to be used for the ratio (the denominator). Three years later an accounting standard containing more specific guidance was released, this being AASB 1027 Earnings per Share, which was issued in 1992. This has since been replaced by AASB 133 Earnings per Share. AASB 133 requires the disclosure of basic earnings per share and diluted earnings per share and applies to: • all companies listed on the Australian Securities Exchange • entities that have on issue ordinary shares and are in the process of listing • entities that voluntarily disclose earnings per share. An entity must disclose earnings per share on the face of the statement of profit and loss and other comprehensive income, and it must do so even if the amounts are negative (that is, where there is a loss per share). Earnings per share of the entity for the previous year must also be shown as a basis for comparison. Where an entity is the parent entity in an economic entity and the financial statements of the parent entity are presented with the consolidated financial statements of that economic entity, the standard need be applied only to the consolidated financial statements. Before the release of AASB 1027 (AASB 133’s predecessor) in 1992, numerous companies were voluntarily providing details of their earnings per share in the notes to their financial statements. This would appear to signal that such companies’ managements considered such information to be of value to financial statement users in their decision making. As previously indicated in this text, classical finance theory suggests that the value of a firm’s securities is a function of the discounted present value of future cash flows. It is conceivable that the higher the firm’s earnings, the higher the value of the future cash flows and hence the higher the value of the firm’s securities. Early research on the relationship between earnings and the value of a firm’s securities was undertaken by Ball and Brown (1968). They found that when unexpected earnings announcements were made, the value of the firm’s securities would change. This was supported on the basis that the unexpected news was not already impounded within the share price. When financial statements are issued—typically a number of months after year end—it is conceivable that the market will already have impounded within the share price the information included in the financial statements. Therefore no additional share price movements will result. For example, the market might have been aware of the firm’s profits through preliminary profit announcements. More recent research by Easton (1990) bears out that accounting earnings affect share prices. If it is accepted that earnings affect share prices, it is not surprising that investors would be interested in information on earnings per share. In this regard it should be noted that the financial press frequently provides summaries of listed companies’ earnings per share.

LO 24.1 LO 24.2 LO 24.3

Computation of basic earnings per share To compute earnings per share—which is calculated by dividing earnings by the number of shares that have been issued—we obviously need to consider at least two factors:

earnings per share (EPS) Determined by dividing the earnings of the company by the weighted-average number of shares of the company outstanding during the financial year.

1.  how earnings are defined 2.  how the number of shares is determined. Before the release of AASB 1027, which was the relevant standard prior to AASB 133, companies were employing a multiplicity of ways to compute their earnings per share (EPS). Different firms had different ways of computing earnings and/or the number of shares that had been issued, and such inconsistencies made inter-firm comparisons of EPS difficult. AASB 133 provides guidance (as did AASB 1027) on how to compute both earnings and the number of shares. Hence it would be reasonable to expect that there would now be uniformity in the methods used to calculate EPS. We must remember though that there will continue to be differences in how firms calculate earnings owing to the numerous assumptions accountants must make throughout the accounting

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process. Therefore care must be taken when comparing EPS, just as it must be when comparing different organisations’ earnings. From previous chapters of this book you will be aware that the accounting process involves many assumptions based on various assessments of probabilities (the recognition criteria of the various elements of accounting rely on considerations of probabilities). You also know that there are a number of alternative accounting techniques that can be applied in accounting for transactions, many of which can have a material effect on profits (relative to the other possible methods). Hence earnings, which directly affects EPS calculations, can be calculated in a number of ways, sometimes depending on who constitutes the team of accountants involved in the accounting process (and, therefore, on the various professional judgements they make). The standard requires that basic EPS and diluted EPS must be disclosed on the face of the statement of profit and loss and other comprehensive income. Specifically, paragraph 66 of AASB 133 states: An entity shall present in the statement of comprehensive income basic and diluted earnings per share for profit or loss from continuing operations attributable to the ordinary equity holders of the parent entity and for profit or loss attributable to the ordinary equity holders of the parent entity for the period for each class of ordinary shares that has a different right to share in profit for the period. An entity shall present basic and diluted earnings per share with equal prominence for all periods presented. Disclosures are required even when EPS is negative (that is, where there is a loss per share). Basic EPS is determined by dividing the earnings of the entity for the reporting period by the weighted-average number of shares of the entity. Earnings are determined after deducting any preference share dividends appropriated for the financial year to the extent that they have not been treated as expenses of the entity (if preference shares are classified as liabilities, the related ‘dividends’ would already have been treated as interest expenses and no further adjustment would be necessary). Preference share dividends are deducted to provide ‘earnings’ on the basis that EPS is calculated from the perspective of ordinary shareholders. That is, EPS relates to earnings per ordinary share. The preference share dividends would reduce the amount of earnings that would potentially be available to pay dividends to ordinary shareholders. In a sense, the dividends relating to preference shares are treated from the ordinary shareholders’ perspective as a cost of capital (in much the same way as interest is a cost of borrowing funds), and therefore they are treated as an expense and deducted from profits before calculating EPS. When considering subtracting preference dividends for the purpose of calculating EPS, it is necessary to determine, in periods in which the preference dividend is not paid, whether or not the preference shares are cumulative. The defining characteristic of a cumulative dividend preference share is that where dividends are not paid in a particular year, they must be paid in later years before ordinary shareholders are entitled to receive any dividends out of profits. If the preference dividend is not cumulative, and no amount has been appropriated for the year, it may be ignored for the purpose of EPS calculation. As paragraph 14 of AASB 133 states:

basic EPS Determined by dividing the earnings of a company by the weighted-average number of shares of the company outstanding during the financial year after deducting any preference share dividends appropriated for the financial year.

diluted EPS Shows the extent to which basic EPS would be diluted if potential ordinary shares were actually converted to ordinary shares.

weighted-average number of shares The weighted-average number of ordinary shares outstanding during the period is the number of ordinary shares outstanding at the beginning of the period, adjusted by the number of ordinary shares bought back or issued during the period multiplied by a time-weighting factor.

cumulative dividend preference shares Preference shares with the attribute that if dividends are not paid in a particular year they must be paid in later years before ordinary shareholders receive any dividends.

The after-tax amount of preference dividends that is deducted from profit or loss is: (a) the after-tax amount of any preference dividends on noncumulative preference shares declared in respect of the period; and (b) the after-tax amount of the preference dividends for cumulative preference shares required for the period, whether or not the dividends have been declared. The amount of preference dividends for the period does not include the amount of any preference dividends for cumulative preference shares paid or declared during the current period in respect of previous periods. Earnings must be calculated to exclude the following:

• any portion attributable to non-controlling interests; and • any costs of servicing equity, paid or provided for, other than dividends on ordinary shares and partly paid shares. The calculation of basic EPS requires the earnings (adjusted as described above) to be divided by the weightedaverage number of ordinary shares. An ordinary share is defined at paragraph 5 of AASB 133 as an equity instrument Chapter 24: EARNINGS PER SHARE  841

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ordinary shares A class of shares that typically ranks last in terms of any distribution of capital.

substance over form Events are accounted for and displayed in accordance with their economic substances, rather than their legal form.

that is subordinate to all other classes of equity instruments. It provides the ‘residual claim’ on the organisation’s profits and assets. For the purposes of the standard, it does not matter what the shares are called. If they have the above characteristics, they are treated as ordinary shares. The standard therefore adopts a substance-over-form test. In determining the ‘weighted-average number of shares’ (the denominator when working out EPS), paragraph 20 of AASB 133 states:

Using the weighted average number of ordinary shares outstanding during the period reflects the possibility that the amount of shareholders’ capital varied during the period as a result of a larger or smaller number of shares being outstanding at any time. The weighted average number of ordinary shares outstanding during the period is the number of ordinary shares outstanding at the beginning of the period, adjusted by the number of ordinary shares bought back or issued during the period multiplied by a time-weighting factor. The time-weighting factor is the number of days that the shares are outstanding as a proportion of the total number of days in the period; a reasonable approximation of the weighted average is adequate in many circumstances.

For example, if a company has 1 000 000 ordinary shares issued at the beginning of the year (say, 1 July 2018) and it issues 200 000 fully paid shares on 1 March 2019, as well as buying back 100 000 shares on 1 April 2019, the weighted-average number of shares would be calculated as:

Proportion of year

Number of shares outstanding

Weighted average

243 ÷ 365 31 ÷ 365 91 ÷ 365 365 days Total weighted-average number of ordinary shares

1 000 000 1 200 000 1 100 000

665 753 101 918 274 247

Period Fully paid ordinary shares 1/7/18–28/2/19 1/3/19–31/3/19 1/4/19–30/6/19

1 041 918

The weighted-average number of ordinary shares, which is the denominator when calculating EPS, also needs to take into account partly paid ordinary shares. However, partly paid shares will be included only to the extent that they carry rights to participate in dividends relative to an ordinary share. As paragraph A15 (from the Application Guidance Appendix to the standard) of AASB 133 states: Where ordinary shares are issued but not fully paid, they are treated in the calculation of basic earnings per share as a fraction of an ordinary share to the extent that they were entitled to participate in dividends during the period relative to a fully paid ordinary share. Where the partly paid ordinary shares carry no rights to participate in earnings, they would not be included in the weighted-average number of ordinary shares. Entities might also have on issue mandatorily convertible securities—that is, securities that must ultimately be converted to ordinary shares. For example, there might be a convertible note that pays interest for two years, after which it converts to a certain number of ordinary shares. According to paragraph 23 of AASB 133: Ordinary shares that will be issued upon the conversion of a mandatorily convertible instrument are included in the calculation of basic earnings per share from the date the contract is entered into. Worked Example 24.1 considers how to determine basic EPS, which necessarily requires a determination of both earnings and the weighted-average number of shares that have been issued by the company. 842 PART 7: OTHER DISCLOSURE ISSUES

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WORKED EXAMPLE 24.1: Calculation of basic EPS For the year ending 30 June 2018, Kirra Ltd reports the following: • net profit after tax of $900 000. As at 1 July 2017 Kirra Ltd had 200 000 fully paid ordinary shares. The following issues and purchases were subsequently made during the year: • 100 000 fully paid ordinary shares issued on 1 September 2017 at the prevailing market price • 25 000 fully paid ordinary shares purchased back on 1 February 2018 at the prevailing market price • 70 000 partly paid ordinary shares issued on 1 April 2018 at an issue price of $2.00. The shares were partly paid to $1.30. The partly paid shares carry the right to participate in dividends in proportion to the amount paid as a fraction of the issue price. For the entire financial year, Kirra Ltd had 1 million $1.00 preference shares, which provide dividends at a rate of 10 per cent per year. The dividend rights are cumulative. Because of their equity characteristics, the preference share dividends were not treated as part of interest expense. REQUIRED Compute the basic earnings per share amount for 2018. SOLUTION Determination of earnings As previously stated, to determine earnings for EPS purposes we exclude preference dividends. It should be noted that, given that the preference dividends are cumulative, it does not matter whether or not they have been paid as the dividend will still need to be deducted. If they are non-cumulative, the right to the preference dividend would be lost if they have not been declared, and hence for non-cumulative preference shares the dividend will be deducted from earnings when calculating EPS only if the dividend has been appropriated. Hence earnings for EPS purposes would be calculated as: Profit after tax less Preference share dividends Earnings for basic EPS

$900 000 ($100 000) $800 000

It should be noted that, while we have assumed that there are no non-controlling interests in Kirra Ltd’s profit, if there had been this would have been deducted when calculating earnings for basic EPS (non-controlling interests are discussed in Chapter 27). Determination of the weighted-average number of ordinary shares Paragraph 19 of AASB 133 requires: For the purpose of calculating basic earnings per share, the number of ordinary shares shall be the weighted average number of ordinary shares outstanding during the period.

Period Fully paid ordinary shares 1/7/17–31/8/17 1/9/17–31/1/18 1/2/18–30/6/18

Proportion of year 62 ÷ 365 153 ÷ 365 150 ÷ 365 365 days

Partly paid ordinary shares 1/4/18–30/6/18 (91 ÷ 365) x ($1.30 ÷ $2.00) Total weighted-average number of ordinary shares Basic EPS therefore is $800 000 ÷ 284 084 = $2.816

Number of shares outstanding

Weighted average

200 000 300 000 275 000

33 973 125 753 113 014

x 70 000

11 344 284 084

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Adjustment for the effect of discontinued operations To address the issues associated with discontinued operations we need first to consider the contents of AASB 5 Non-current Assets Held for Sale and Discontinued Operations. A discontinued operation is defined in the Appendix to AASB 5 as: A component of an entity that either has been disposed of or is classified as held for sale and: (a) represents a separate major line of business or geographical area of operations; (b) is part of a single coordinated plan to dispose of a separate major line of business or geographical area of operations; or (c) is a subsidiary acquired exclusively with a view to resale. Pursuant to AASB 5, in the presence of a discontinued operation, an entity must disclose the profit or loss from continuing operations separately from the profit or loss from discontinued operations. Detailed disclosure requirements relating to the separate disclosure of results for continuing and discontinuing operations are provided in paragraphs 33 to 36 of AASB 5. If an entity has a discontinued operation this has implications for EPS disclosures (hence the relevance of AASB 5 to this chapter). If an entity is required to separately disclose results from discontinued operations pursuant to AASB 5, two EPS figures must be calculated and disclosed pursuant to AASB 133. Specifically, in relation to basic EPS, paragraph 9 of AASB 133 states: An entity shall calculate basic earnings per share amounts for profit or loss attributable to ordinary equity holders of the parent entity and, if presented, profit or loss from continuing operations attributable to those equity holders. Hence, AASB 133 requires the disclosure of two basic EPS figures (as well as two diluted EPS figures, as we will see later). The methods to be used to calculate the two basic EPS figures are: Basic earnings, based upon total profit Basic EPS = ________________________________________ ​​            ​​ Basic weighted-average number of ordinary shares Basic earnings, based upon profit from continuing operations Basic EPS = _______________________________________________ ​​               ​​ Basic weighted-average number of or ordinary shares If there are no discontinued operations, only the top EPS figure needs to be disclosed. Worked Example 24.2 provides an example incorporating discontinued operations.

WORKED EXAMPLE 24.2: Calculation of basic EPS in the presence of discontinued operations The statements of profit or loss and other comprehensive income of Keet Ltd and Keet Group (comprising Keet Ltd and its subsidiaries) for the financial year ending 30 June 2019 are as follows: Statements of profit or loss and other comprehensive income of Keet Ltd and Keet Group for the year ended 30 June 2019

Income Expenses (excluding borrowing costs) Borrowing costs Profit before income tax expense Income tax expense Profit from continuing operations after income tax expense Profit (loss) from discontinuing operations after related income tax

Keet Ltd $ 95 920 000 (83 840 000) (2 730 000) 9 350 000 (3 740 000) 5 610 000 510 000

Keet Ltd and its subsidiaries $ 483 210 000 (352 890 000) (52 470 000) 77 850 000 (31 140 000) 46 710 000 (1 230 000)

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Profit after income tax Other comprehensive income Total comprehensive income Attributable to: Owners of the parent Non-controlling interests

   6 120 000 0 6 120 000

   45  480  000 0 45 480 000    41 220 000 4 260 000 45 480 000

Notes to and forming part of the financial statements Keet Ltd Note x: Retained earnings Retained earnings—1 July 2018 Profit after income tax Profit attributable to members of the parent entity Interim Dividend—ordinary shares Final Dividend—ordinary shares Dividends—preference shares (paid 30 September 2018) Retained earnings—30 June 2019

Keet Ltd and its subsidiaries

5 160 000 6 120 000 (1 520 000) (1 640 000) (900 000) 7 220 000

50 940 000 41 220 000 (1 520 000) (1 640 000) (900 000) 88 100 000

Additional information (i) On 30 June 2018, the share capital of Keet Ltd comprised: Number of shares on issue 11 500 000 1 500 000 13 000 000

Share class Ordinary Preference Total

Share capital $ 27 630 000 15 000 000 42 630 000

(ii) During the financial year ending on 30 June 2019, Keet Ltd made the following share issues: Date of share issue 15 September 2018

Class of share issue Ordinary

27 November 2018

Ordinary

12 April 2019

Ordinary

Details relating to share issue Private placement of 1 200 000 partly paid shares. The partly paid shares were issued for $7.50, which was the current share price at the time of issue. An amount of $2.80 was payable on allotment, and the balance of $4.70 is payable on 15 September 2020. The partly paid shares are entitled to participate in dividends from 15 March 2019. The partly paid shares will entitle shareholders to receive 30 per cent of the dividends received by fully paid ordinary shareholders. Public issue of 2 000 000 fully paid shares. The subscription price for the public issue shares was $8.05, which was the current share price at the time of issue. Share buyback of 650 000 fully paid ordinary shares, purchased at the current share price at the time of purchase of $8.30.

continued Chapter 24: EARNINGS PER SHARE  845

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(iii) The preference shares entitle shareholders to receive an annual fixed dividend of 12 per cent on share capital, payable in two half-yearly instalments on 31 March and 30 September each year (i.e. 6 per cent on share capital every half year). The preference share dividends are cumulative. (iv) The dividend due to preference shareholders on 31 March 2019 was not paid. REQUIRED Calculate basic earnings per share for the financial year ended 30 June 2019, in accordance with the requirements of AASB 133. SOLUTION Calculation of basic earnings Profit attributable to members of the parent entity less Preference share dividends—30 September 2018 less Cumulative preference dividends not paid or provided for—31 March 2019 ($15 000 000 × 0.06) Basic earnings, based upon total profit add Loss from discontinuing operations after related income tax Basic earnings, based upon profit from continuing operations

900 000 39 420 000 1 230 000 40 650 000 Number of shares outstanding

Weighted average

149 ÷ 365 136 ÷ 365 80 ÷ 365 365 days

11 500 000 13 500 000 12 850 000

4 694 521 5 030 137 2 816 438

(108 ÷ 365) × 0.30

1 200 000

106 520 12 647 616

Proportion of year

Period Fully paid ordinary shares 1/7/18–26/11/18 (shares in place at beginning of year) 27/11/18–11/4/19 (share issue) 12/4/19–30/6/19 (share buy-back) Partly paid ordinary shares 15/3/19–30/6/19 Total weighted-average number of ordinary shares

41 220 000 900 000

Calculation of basic EPS, based upon profit from continuing operations Basic earnings, based upon profit from continuing operations Basic EPS = _______________________________________________ ​​               ​​ Basic weighted-average number of ordinary shares 40 650 000 = _________ ​​​​​   ​​​​​  = $3.21 per share 12 647 616 Calculation of basic EPS, based upon total profit Basic earnings, based upon total profit Basic EPS = ________________________________________ ​​            ​​ Basic weighted-average number of ordinary shares

39 420 000 = _________ ​​​​​   ​​​​​  = $3.12 per share 12 647 616

In the balance of this chapter we will assume that the entities in our worked examples do not have discontinued operations and therefore separate figures for EPS based on continuing operations (separate from a figure based on total profits) will not need to be calculated. However, you will need to keep in mind that if the entity does have discontinued operations two calculations for basic EPS will be required. 846 PART 7: OTHER DISCLOSURE ISSUES

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Adjustment for the bonus element in an issue of ordinary shares

bonus issue When shareholders are given extra shares at no cost in proportion to their shareholding. A bonus issue is usually funded from retained profits and has no net effect on owners’ equity.

A bonus issue will have an impact on the weighted-average number of ordinary shares. Assume, for example, that for the year ending 30 June 2019 Greenmount Ltd has earnings after tax of $500 000. On 1 July 2018 the company has 400 000 shares on issue and on 1 June 2019 it gives a one-forfour bonus issue, funded out of retained earnings. That is, for every four shares held, the shareholder receives one more at no cost. The last sale price of the shares is $3.50. The bonus issue does not change total shareholders’ funds. It simply involves a transfer from retained earnings to share capital (assuming the bonus share issue is funded from retained earnings). The accounting standard requires for the purposes of calculating EPS that the number of shares outstanding before the bonus issue should be increased as if the bonus had been in place for the entire year (which also has the effect of reducing EPS). As paragraphs 27 and 28 of AASB 133 state: 27. Ordinary shares may be issued, or the number of ordinary shares outstanding may be reduced, without a corresponding change in resources. Examples include: (a) a capitalisation or bonus issue (sometimes referred to as a stock dividend); (b) a bonus element in any other issue, for example a bonus element in a rights issue to existing shareholders; (c) a share split; and (d) a reverse share split (consolidation of shares). 28. In a capitalisation or bonus issue or a share split, ordinary shares are issued to existing shareholders for no additional consideration. Therefore, the number of ordinary shares outstanding is increased without an increase in resources. The number of ordinary shares outstanding before the event is adjusted for the proportionate change in the number of ordinary shares outstanding as if the event had occurred at the beginning of the earliest period presented. For example, on a two-for-one bonus issue, the number of ordinary shares outstanding before the issue is multiplied by three to obtain the new total number of ordinary shares, or by two to obtain the number of additional ordinary shares.

For example, if there is a one-for-one bonus issue (for every share held the shareholder receives another share at no cost), the number of shares would double. Given that there is no effect on earnings, doubling the number of shares (hence doubling the denominator) will halve the EPS. Prior period comparatives for EPS are also adjusted for the bonus issue so that comparisons are made as if the bonus shares had also been issued in the previous period. Otherwise, it could appear that the performance of the entity had worsened. The adjustment factor for a bonus element is reproduced in Exhibit 24.1. If shares are issued at the prevailing market price there is no bonus element and no adjustment would be necessary. For Greenmount Ltd, the theoretical ex-bonus issue price would be determined by applying the formula: (P × N ) + P

o o r ___________ ​​     ​​ 

No + 1

As there is no issue price (that is, they are bonus shares with no required payment), the theoretical price would be: ($3.50 × 4) + 0

_____________ ​​     ​​  = $2.80

4+1

The adjustment factor in respect of a bonus issue or a rights issue in the current financial year is usually determined using the following variables and formulas. Po = last sale price or, if higher, the last bid price cum rights* No = the number of ordinary shares required for one right Pr = the subscription price of the right (or the present value of the subscription price in the case of a subscription payable in instalments) plus the present value of dividends forgone in respect of ordinary shares required for one right not presently participating in dividends

Exhibit 24.1 Adjustment factor for EPS in respect of the bonus element in an issue of ordinary shares continued

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Px = theoretical ex-rights price



(Po × No) + Pr = ___________ ​​     ​​  No + 1

​​Adjustment factor = Px ÷ Po • To adjust earnings per share for the current financial year, divide the weighted-average number of ordinary shares prior to the rights or other issue by the adjustment factor. • To adjust earnings per share for the prior financial years, multiply the amounts of earnings per share by the adjustment factor. * ‘bid price cum rights’ means the price that would be paid for a share that entitles the holder to participate in the bonus issue

Note that, as the illustrative examples in AASB 133 show, another way to express the calculation of the theoretical ex-rights price is by using the equation: Aggregate market price per share Proceeds from the +[ [ immediately ] prior to exercise of rights exercise of rights ] (Number of shares outstanding after the exercise of rights) For Greenmount Ltd, this would equal: [(400 000 × $3.50) + 0] ÷ 500 000 = $2.80 The above formulas assume that prices fully adjust for the bonus issue, so that the shareholders are no better or worse off following the issue. As we know, a bonus issue has no direct effect on the net assets of a company (one owners’ equity account—share capital—is increased, while another owners’ equity account—typically retained earnings—is decreased), so in a sense it appears reasonable that the value of an individual’s investment in the company would not change. For example, assume that Rob Greenmount has 30 000 shares in Greenmount Ltd before the bonus issue. Based on the price before the bonus issue, the value of the holding would have been market capitalisation $105 000 (which is 30 000 × $3.50). Following the issue, Rob Greenmount would have held 37 500 The total value of shares (which is 30 000 × 5 ÷ 4). The value of Rob’s holding using the theoretical price would a firm’s securities computed by have been 37 500—multiplied by $2.80, or $105 000. That is, it is the same as it was before the multiplying the current bonus issue. In terms of the total market capitalisation of the firm, which is calculated by multiplying market value of each the total number of issued shares by their market price, a bonus issue should, according to the security by the number formula, have no effect. That is, if there were 400 000 shares on issue before the bonus issue, the of securities issued by market capitalisation should be $1.4 million (400 000 × $3.50). After the bonus issue, there would the entity. be 500 000 shares on issue. The market capitalisation of these shares would be assumed to be 500 000 multiplied by $2.80, which also equals $1.4 million. There is some evidence, however, that the total market capitalisation of a firm might indeed alter following a bonus issue. The reasons for this are not clear. Drawing upon the research of others, Whittred and Zimmer (1992, p. 58) state: The economic reasons for share splits or bonus issues are not well understood. Since neither has any direct implications for a firm’s investment policy or future cash flows, such actions should have no effect on a firm’s value. After all, the firm’s assets are not worth any more after the bonus or split than they were beforehand. Yet, somewhat surprisingly, empirical evidence suggests that a firm’s share prices increase following both share splits and bonus issues. One possible explanation for this is that, at the same time, firms often announce a dividend increase. For example, the maintenance of the same nominal percentage on an increased number of shares increases total dividends paid. (The evidence in Ball, Brown and Finn [1977] suggests that approximately 92 per cent of bonus issues and 53 per cent of share splits are accompanied by subsequent dividend increases.) Indeed, the evidence also suggests that when these capitalisation changes are not accompanied by dividend 848 PART 7: OTHER DISCLOSURE ISSUES

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increases there is no impact on share price. While this information effect of dividends hypothesis is appealing, the question still arises as to why it is necessary for a dividend increase to be announced in this way. Returning to Greenmount Ltd, the adjustment factor would be $2.80 ÷ $3.50 = 0.80. This requires the weightedaverage number of shares in place before the issue to be divided by 0.80, thereby inflating the number of shares, and decreasing the EPS. Worked Example 24.3 examines the calculation of EPS in the presence of a bonus issue.

WORKED EXAMPLE 24.3: Calculation of EPS in the presence of a bonus issue For the year ending 30 June 2019, Margaret River Ltd reports a net profit after tax of $700 000. At the beginning of the year, Margaret River Ltd had 500 000 fully paid ordinary shares on issue. It also had 200 000 $1.00, 10 per cent, cumulative preference shares outstanding. The preference shares were classified as equity. On 1 September 2018 the company issued a further 100 000 fully paid ordinary shares. On 1 May 2019 the company issued another 100 000 fully paid shares on the basis of a one-for-six bonus issue. The last sale price per ordinary share prior to the bonus issue was $4.00. The basic EPS for the year ending 30 June 2018 was $2.10. REQUIRED Compute the basic EPS amount for 2019 and provide the adjusted comparative EPS for 2018. SOLUTION Earnings calculation Profit after tax less Preference share dividends Profit after tax less preference dividends

$700 000 ($20 000) $680 000

($4.00)(6) + 0  Theoretical ex-bonus price = ​​​ ​​ ____________     ​​  6+1 ​​​= 3.4286 Adjustment factor = 3.4286 ÷ 4.00 = 0.8571 Calculation of the weighted-average number of ordinary shares and ordinary share equivalents

Period Fully paid ordinary shares 1/7/18–31/8/18 1/9/18–30/4/19 1/5/19–30/6/19

Proportion of year

Multiply by number of shares outstanding

62 ÷ 365 242 ÷ 365 61 ÷ 365

500 000 600 000 700 000

Divide by adjustment factor

Weighted average

0.8571 0.8571

99 092 464 133 116 986 680 211

Basic earnings per share for 2019 would be: $680 000 ÷ 680 211 = $0.9997 The comparative figures for 2018 would be adjusted for the bonus issue. The adjusted figure would be: $2.10 × 0.8571 = $1.80 Failure to adjust the previous period’s earnings per share would be misleading, as it would appear that the company is not performing as well as it had in the previous period, when in fact the reduction in EPS might be due totally to the bonus issue. Note that for the current periods in which the bonus issue is made, we adjust the weightedaverage number of shares by dividing by the adjustment factor for the period prior to the bonus issue. For the prior financial period we multiply EPS by the adjustment factor.

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rights issue An entitlement provided to shareholders giving them the right or option to buy shares in the entity at a future time at a specific price.

Rights issue

Existing shareholders might be provided with rights to acquire additional shares in the company at a price below the current market price of the firm’s shares. In a rights issue, if the exercise price is less than the market price of the shares, the rights issue includes a bonus element. For example, Bombo Ltd might issue a one-for-three rights issue, which requires the holders of the rights to pay $0.80 to acquire an additional share. If those shares were trading in the market at $1.00 before the rights issue, there would be a bonus element of $0.20. The accounting standard requires that whenever there is a bonus element, the weighted-average number of shares needs to be adjusted using the formula provided above. For Bombo Ltd the theoretical ex-rights price—that is, the value of shares without the rights—would be calculated using the formula: (P × N ) + P

o o r ___________ ​​     ​​ 

No + 1

and the theoretical price would be: ($1.00 × 3) + 0.80

_______________ ​​        ​​ = $0.95

3+1

That is, without a $0.20 bonus element, spread over three shares plus the bonus share, share purchasers would be prepared to pay only $0.95 per share. Worked Example 24.4 looks at calculating EPS in the presence of a rights issue with a bonus element.

WORKED EXAMPLE 24.4: Calculation of EPS in the presence of a rights issue with a bonus element For the year ending 30 June 2019, Sandon Point Ltd reports net profit after tax of $500 000. At the beginning of the year, Sandon Point Ltd had 800 000 fully paid ordinary shares. It also had 100 000 $1.00, 10 per cent, cumulative preference shares outstanding. The preference shares were classified as equity. On 1 September 2018 the company issued another 200 000 fully paid ordinary shares by way of a rights issue. The right provided an additional share for each four held, and required the payment of $1.50. The last cum rights share price was $2. The basic EPS for the year ended 30 June 2018 was $1.95. REQUIRED Compute the basic EPS amount for 2019, and provide the adjusted comparative EPS for 2018. SOLUTION Earnings calculation Profit after tax less Preference share dividends Profit after tax less preference dividends

$500 000 ($10 000) $490 000

​  ($2.00)(4) + $1.50 Theoretical ex-bonus price = _______________ ​​        ​​ 4+1 ​​​= $1.90 Adjustment factor = 1.90÷2.00 = 0.95

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Calculation of the weighted-average number of ordinary shares and ordinary share equivalents

Period Fully paid ordinary shares 1/7/18–31/8/18 1/9/18–30/6/19

Proportion of year

Number of shares outstanding

62 ÷ 365 303 ÷ 365

800 000 1 000 000

Adjustment factor

Weighted average

0.95

143 043 830 137 973 180

Basic earnings per share for 2019 would be: $490 000 ÷ 973 180 = $0.5035 The comparative figures for 2018 would be adjusted for the rights issue. The adjusted figure would be: $1.95 × 0.95 = $1.853 Again, remember that in calculating the weighted-average number of shares for the period before the rights issue, we divide by the adjustment factor. After the date of the rights issue, no adjustment is necessary. For comparison with the previous year, we multiply the previous EPS figure by the adjustment factor.

Diluted earnings per share

LO 24.4

AASB 133 also requires that diluted EPS should be calculated and disclosed, together with basic EPS, on the face of the statement of profit and loss and other comprehensive income. As indicated previously in this chapter, if an entity has discontinued operations, disclosure must be made of basic and diluted EPS attributable to profit or loss from continuing operations as well as basic and diluted EPS attributable to total profit or loss. In the examples that follow we will assume that the entities do not have discontinued operations. However, we should remember that if they did, two sets of calculations for basic EPS and diluted EPS would need to be made. AASB 133 requires that diluted EPS be calculated where an entity has on issue potential ordinary shares that are dilutive. Specifically, paragraph 31 of AASB 133 states:

potential ordinary shares An issued security that potentially converts into an ordinary share or results in the calling in of or subscription for ordinary share capital.

For the purpose of calculating diluted earnings per share, an entity shall adjust profit or loss attributable to ordinary equity holders of the parent entity, and the weighted average number of shares outstanding, for the effects of all dilutive potential ordinary shares. Clearly, we need a definition of ‘potential ordinary share’ and an indication of when a potential ordinary share can be considered ‘dilutive’. A potential ordinary share is defined at paragraph 5 of AASB 133 as ‘a financial instrument or other contract that may entitle its holder to ordinary shares’. According to AASB 133, potential ordinary shares are considered dilutive when and only when the conversion to, calling of, or subscription for ordinary shares would decrease (or increase) net profit (or loss) from continuing ordinary operations per share. The view taken within the accounting standard is that, if there are some securities currently on issue that might be converted to ordinary shares (for example, convertible preference shares, share options or convertible bonds), this will increase the number of ordinary shares on issue, and by increasing the denominator used in determining EPS, this will lead to a decrease in EPS. It is considered that users of financial statements need to know about this potential reduction (or dilution) in EPS. The calculation referred to as ‘diluted earnings per share’ will show how EPS would fall if  the potential ordinary shares were actually converted to ordinary shares. That is, diluted EPS is a ‘what if’ measure in the sense that it shows the extent to which basic EPS would be diluted if potential ordinary shares were actually converted to ordinary shares. This helps to inform investors about how EPS could conceivably be affected in the future.

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To determine diluted EPS, the weighted-average number of shares is determined in accordance with the calculations already provided for basic EPS, with the inclusion of an additional factor based on the weighted-average number of potential ordinary shares that the company had on issue throughout all or part of the financial year. There is a general rule that if a potential ordinary share issue would increase EPS (that is, it is ‘antidilutive’), it is not considered to be dilutive and would be excluded from the calculation of diluted EPS. Each type of potential ordinary share (for example, convertible preference shares, convertible notes and share options) must be considered separately. Consideration must also be given to the probability of conversion. If the conversion is at the option of the entity, and the conversion is probable, the potential ordinary shares must be included in the diluted EPS calculation, even if their inclusion does not dilute EPS. It should be noted that if conversion of the potential ordinary shares to ordinary shares is mandatory, they must already have been included in the calculation of basic EPS. We will now consider how to determine earnings and the weighted-average number of shares for the purpose of calculating diluted EPS. As we will see, there are differences relative to the earnings and weighted-average number of ordinary shares used to calculate basic EPS.

Calculation of ‘earnings’ for diluted EPS In calculating earnings for diluted EPS, we have to consider the effects on earnings in the event of those potential ordinary shares that are dilutive being converted to ordinary shares. We work out a revised earnings as if the conversion of the potential ordinary shares had actually occurred. Paragraph 33 of AASB 133 requires that for the purposes of calculating diluted EPS we start with basic EPS and make adjustments for the after-tax effect of: (a) any dividends or other items related to dilutive potential ordinary shares deducted in arriving at profit or loss attributable to ordinary equity holders of the parent entity as calculated in accordance with paragraph 12; (b) any interest recognised in the period related to dilutive potential ordinary shares; and (c) any other changes in income or expense that would result from the conversion of the dilutive potential ordinary shares. As paragraph 32 of AASB 133 explains: The object of diluted earnings per share is consistent with that of basic earnings per share, to provide a measure of the interest of each ordinary share in the performance of an entity, while giving effect to all dilutive potential ordinary shares outstanding during the period. As a result: (a) profit or loss attributable to ordinary equity holders of the parent entity is increased by the after-tax amount of dividends and interest recognised in the period in respect of the dilutive potential ordinary shares and is adjusted for any other changes in income or expense that would result from the conversion of the dilutive potential ordinary shares; and (b) the weighted average number of ordinary shares outstanding is increased by the weighted average number of additional ordinary shares that would have been outstanding assuming the conversion of all dilutive potential ordinary shares. The conversion of potential ordinary shares might also have a number of flow-on effects. As paragraph 35 of AASB 133 states: The conversion of potential ordinary shares may lead to consequential changes in income or expenses. For example, the reduction of interest expense related to potential ordinary shares and the resulting increase in profit or reduction in loss may lead to an increase in the expense related to a non-discretionary employee profitsharing plan. For the purpose of calculating diluted earnings per share, profit or loss attributable to ordinary equity holders of the parent entity is adjusted for any such consequential changes in income or expense.

Calculating the weighted-average number of shares for diluted EPS AASB 133 requires that, in determining the weighted-average number of shares for diluted EPS, we start with the number used to calculate basic EPS and proceed by making adjustments to this number. Specifically, we add the following: • the weighted-average number of shares deemed to be issued for no consideration • the weighted-average number of shares that are contingently issued. 852 PART 7: OTHER DISCLOSURE ISSUES

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The dilutive potential ordinary shares are weighted by the number of days they were outstanding. Dilutive potential ordinary shares that have been issued since the beginning of the reporting period and remain outstanding at the end of the reporting period are weighted by reference to the number of days from their date of issue to the end of the reporting period. Further explanation is necessary in relation to the two adjustment steps just listed.

Shares deemed to be issued for no consideration Shares would be considered to be issued for no consideration if the price to be paid for the shares is less than the market price. If the price to be paid is greater than the market price, rational investors would not be expected to make the payment (they would simply buy the share directly from the market) and the potential ordinary shares can be ignored for determining diluted EPS. Their conversion would not be probable. In relation to shares deemed to be issued for no consideration, paragraphs 46 and 47 of AASB 133 state: 46. Options and warrants are dilutive when they would result in the issue of ordinary shares for less than the average market price of ordinary shares during the period. The amount of the dilution is the average market price of ordinary shares during the period minus the issue price. Therefore, to calculate diluted earnings per share, potential ordinary shares are treated as consisting of both the following: (a) a contract to issue a certain number of the ordinary shares at their average market price during the period. Such ordinary shares are assumed to be fairly priced and to be neither dilutive nor antidilutive. They are ignored in the calculation of diluted earnings per share; and (b) a contract to issue the remaining ordinary shares for no consideration. Such ordinary shares generate no proceeds and have no effect on profit or loss attributable to ordinary shares outstanding. Therefore, such shares are dilutive and are added to the number of ordinary shares outstanding in the calculation of diluted earnings per share. 47. Options and warrants have a dilutive effect only when the average market price of ordinary shares during the period exceeds the exercise price of the options or warrants (i.e. they are ‘in the money’). Previously reported earnings per share are not retroactively adjusted to reflect changes in prices of ordinary shares. If an entity has issued options, the option holders will pay the exercise price only if they are effectively getting some shares for no consideration. Assume, for example, that a company has issued 1000 options that have an exercise price of $2 each. If we assume the market price of the shares subsequently increases to $2.50 per share, the exercise price is less than the market price (the options are referred to as being ‘in the money’) and the options would be expected to be exercised. The option holders would pay 1000 × $2, which equals $2 000, and receive 1000 shares. The number of shares that they would have acquired for $2 000 if they had paid the market price of $2.50 would be 800. Effectively, the number of shares issued for no consideration is 200. This number is added to the number of ordinary shares (to the denominator) in the computation of EPS. Any assumed earnings from the inflow of the $2 000 are not added to the numerator (that is, any such amount is not added to earnings). We also need to consider partly paid shares. As we know, if partly paid shares are entitled to participate in dividends in proportion to their paid-up amount, they would already be included in the weighted-average number of shares used to calculate basic EPS. Paragraph A16 of AASB 133 requires that: To the extent that partly paid shares are not entitled to participate in dividends during the period they are treated as the equivalent of warrants or options in the calculation of diluted earnings per share. The unpaid balance is assumed to represent proceeds used to purchase ordinary shares. The number of shares included in diluted earnings per share is the difference between the number of shares subscribed and the number of shares assumed to be purchased.

Contingently issuable shares According to paragraph 5 of AASB 133, contingently issuable ordinary shares are ordinary shares issuable for little or no cash or other consideration upon the satisfaction of specified conditions in a contingent share agreement. A contingent share agreement is an agreement to issue shares that is dependent upon the satisfaction of specified conditions. For example, Company A might have acquired Company B, with the consideration for B’s shares being shares in Company A. There might be an agreement to issue further shares in Company A if the share price of Company B exceeds a certain level for a specified period (perhaps a few months) before a specified time (within two years of the acquisition of Chapter 24: EARNINGS PER SHARE  853

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Company B perhaps). If the price of Company B’s shares exceeds this price at year end, the shares would be included in the denominator, provided that the price is expected to remain above the minimum threshold for the required period of time. As paragraph 52 of AASB 133 states: As in the calculation of basic earnings per share, contingently issuable ordinary shares are treated as outstanding and included in the calculation of diluted earnings per share if the conditions are satisfied (i.e. the events have occurred). Contingently issuable shares are included from the beginning of the period (or from the date of the contingent share agreement, if later). If the conditions are not satisfied, the number of contingently issuable shares included in the diluted earnings per share calculation is based on the number of shares that would be issuable if the end of the period were the end of the contingency period. Restatement is not permitted if the conditions are not met when the contingency period expires. Worked Example 24.5 considers an example of calculating diluted EPS.

WORKED EXAMPLE 24.5: Calculation of basic and diluted EPS For the year ending 30 June 2019, Lennox Ltd earns a profit after tax of $1.05 million. Dividends on 400 000 convertible, cumulative preference shares amount to $200 000. The preference dividends are not treated as expenses in the financial statements of Lennox Ltd (the preference shares have been disclosed as equity in the statement of financial position). As at 1 July 2018 there were 500 000 fully paid ordinary shares. There were no additional share issues during the year. As at 1 July 2018 there were also: • $250 000 in convertible debentures, which paid interest at a rate of 10 per cent per year and which could be converted to 125 000 ordinary shares, at the option of the debenture holder • 20 000 share options currently on issue, with an exercise price of $2.00 • the 400 000 convertible, cumulative preference shares, which were issued in 2017 and are convertible into 120 000 ordinary shares at the option of the preference shareholders. Assume the tax rate is 33 per cent and that the average market price for ordinary shares during the year was $5. REQUIRED Calculate Lennox Ltd’s: (a) basic EPS (b) diluted EPS. SOLUTION (a) Basic EPS for Lennox Ltd Profit after tax less Preference dividends Profit after tax and preference dividends

$1 050 000 ($200 000) $850 000

Basic EBS = $8 50 000 ÷ 500 000 = $1.70 per share (b) Diluted EPS for Lennox Ltd We need to consider the securities that are potential ordinary shares. The convertible debentures, options and convertible preference shares are potentially dilutive. Each security must be considered separately. Convertible debentures If the debentures are converted to ordinary shares, the pre-tax earnings would be increased by $25 000 (the interest expense that would no longer be payable = $250 000 × 10%). This would lead to an after-tax increase in earnings of $16 750, which is $25 000 × (1 – 0.33).

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As an additional 125 000 shares would be created, the increase in earnings attributable to ordinary shareholders on conversion of the convertible debentures would, on an incremental share basis, be: $16 750 ÷ 125 000 = $0.134 Share options As the options have been on issue for the entire year, we treat them as potentially dilutive as at the beginning of the year. If the options had been exercised, the company would have received $40 000. Obviously such a fund inflow could have earned a return for the company. Should this be factored into a consideration of any increase in earnings? AASB 133 does not consider such earnings—that is, it does not consider notional earnings on fund inflows. With such returns ignored, the exercise of the options will not cause any increase in earnings. The standard requires that we consider the number of shares that would effectively be issued for no consideration if these options are exercised. To determine this we perform the following calculation: Number of shares issuable Number of shares that would be issued at market price for the actual proceeds of $40 000 = $40 000 ÷ $5 Number of shares deemed issued for no consideration

20 000 8 000 12 000

Given that there is no adjustment to earnings recognised in relation to the options, the earnings per incremental share are $nil. Twelve thousand shares will be added to the denominator to calculate diluted EPS. Convertible, cumulative preference shares If the preference shares are converted, dividends of $200 000 would be saved. Their conversion would lead to an increase in ordinary shares by 120 000. The increase in earnings per incremental share (because the preference share dividends were initially excluded when calculating EPS) would be $200 000/120 000 = $1.667. Ranking the potential ordinary shares from greatest to least dilution AASB 133 requires that when we consider whether potential ordinary shares are dilutive, each issue or series of potential ordinary shares must be considered separately, rather than in aggregate. Each issue or series of potential ordinary shares must be considered in sequence from the most dilutive (smallest earnings per incremental share) to the least dilutive (largest earnings per incremental share). As paragraph 44 of AASB 133 states: In determining whether potential ordinary shares are dilutive or antidilutive, each issue or series of potential ordinary shares is considered separately rather than in aggregate. The sequence in which potential ordinary shares are considered may affect whether they are dilutive. Therefore, to maximise the dilution of basic earnings per share, each issue or series of potential ordinary shares is considered in sequence from the most dilutive to the least dilutive, that is, dilutive potential ordinary shares with the lowest ‘earnings per incremental share’ are included in the diluted earnings per share calculation before those with a higher earnings per incremental share. Options and warrants are generally included first because they do not affect the numerator of the calculation. In this example, the order from most dilutive to least dilutive is:

Options Convertible debentures Convertible preference shares

Increase in shares

Earnings per incremental share

12 000 125 000 120 000

$nil $0.134 $1.667

The sequence in which potential ordinary shares are considered might affect whether or not they are dilutive. If potential ordinary shares are not dilutive, the standard generally requires that they be ignored when calculating diluted EPS. continued Chapter 24: EARNINGS PER SHARE  855

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Determining the ‘trigger test’ AASB 133 includes a ‘trigger test’ to determine whether potential ordinary shares are dilutive. If the shares cause EPS to decrease from the initial amount determined for the trigger test, they are considered dilutive. The standard uses profit or loss from continuing operations attributable to the parent entity as the initial amount for the trigger test to determine whether potential ordinary shares are dilutive. The profit or loss from continuing operations attributable to the parent entity is defined as excluding amounts relating to discontinuing operations. Profit used to calculate basic EPS less Adjustments Net profit from continuing operations for the trigger test $850 000 ÷ 500 000 = $1.70

$850 000 $nil $850 000

As previously noted, AASB 133 requires that diluted EPS be presented on the face of the statement of profit and loss and other comprehensive income. It must be disclosed with the same prominence as basic EPS. Applying the trigger test We have already determined the order in which to include potential ordinary shares in the calculation of diluted EPS. Profit and adjustments

Ordinary shares

$850 000 Nil $850 000 $16 750 $866 750 $200 000 $1 066 750

500 000 12 000 512 000 125 000 637 000 120 000 757 000

Net profit from continuing operations Options Convertible debentures Convertible preference shares

EPS

Dilutive?

$1.70 $1.6602

Yes

$1.3607

Yes

$1.4092

No*

* EPS from continuing operations increases from $1.3607 to $1.4092 when the convertible preference shares are included, so they are not dilutive.

In the above calculation, profit or loss from continuing operations is the starting point in the trigger test. After this point, each potential ordinary share is considered in order of smallest earnings per incremental share to largest earnings per incremental share. If a particular security does not dilute EPS, it is not to be included when calculating diluted EPS. Calculation of diluted EPS While net profit from continuing operations is used to assess whether or not potential ordinary shares are dilutive, AASB 133 requires that net profit or loss be used in the calculation of diluted EPS. As noted above, the earnings figure used in the actual calculation of diluted EPS includes discontinuing operations, adjustments for changes in accounting policies and corrections of material errors. As with basic EPS, the preference dividends paid are excluded. As reported for basic EPS Options Convertible debentures

Profit

Ordinary shares

$850 000 Nil 16 750 $866 750

500 000 12 000 125 000 637 000

Diluted EPS = $866 750 ÷ 637 000 = 1.3607. Again, as the preference shares are not dilutive, they are not included in the calculation of diluted EPS.

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Linking earnings per share to other indicators

LO 24.5

In this chapter we have learned how to calculate basic and diluted EPS. Somewhat obviously, we would generally prefer to see a higher EPS for a given organisation. Bonuses paid to key management personnel are often linked to measures of EPS. Higher EPS also provides an indication that dividend payments might be reasonably good, although management might decide to retain the funds for the purpose of reinvesting into the organisation, rather than paying out dividends. In the early years of a firm’s existence—in what we might refer to as the ‘growth phase’—we might anticipate lower EPS. Therefore lower EPS is not a perfect indicator of performance. As we have learned in other chapters, different organisations might apply different accounting methods, or make different assumptions about lives of assets, and so forth. This translates to different measures of profits. Given the flexibility that is available to organisations when calculating profits, this will also influence measures of EPS. Comparing the EPS of different organisations needs to take this into account. Analysts typically use measures of EPS to then derive other indicators, such as measures of ‘price earnings’ and ‘dividend payout’ ratios. Worked Example 24.6 provides an illustration calculating these other ratios and provides a brief insight into what these other ratios represent.

WORKED EXAMPLE 24.6: Calculation of EPS, price earnings ratio and dividend Payout ratio We are comparing two companies that are listed on the ASX and which have the following details:

Granite Bay Ltd • Profit after tax of $40 million for the last financial period. • Pays $2 million in preference share dividends (which are classed as equity). • Had 30 million ordinary shares on issue for the first six months of the year, and 40 million ordinary shares on issue for the last six months of the year. • The dividend paid for the year on its ordinary shares is $0.80 per share. • The latest share price was $15.

Tea Tree Bay Ltd • Profit after tax of $90 million for the last financial period. • Pays $3 million in preference share dividends (which are classed as equity). • Had 50 million shares on issue for the first six months of the year, and 60 million shares on issue for the last six months of the year. • The dividend paid for the year on ordinary shares is $0.60 per share. • The latest share price was $40. REQUIRED (a) Calculated basic EPS, price earnings ratio and dividend payout ratio for each of the companies (b) Compare the calculations made for each company. SOLUTION (a) Granite Bay Ltd Basic EPS = ($40m – $2m) ÷ [(30m x 0.5) + (40m x 0.5)] = $38m ÷ 35m = $1.086 per share Price earnings ratio: This is calculated by dividing the latest price of the share by the EPS. It is a measure of how many times earnings the market is prepared to pay for a share. In this case it equals $15 ÷ $1.086 = 13.81. Dividend payout ratio: Provides an indication of how much of current earnings are being paid out in dividends. It is calculated by dividing dividends per share by earnings per share and in this case will be $0.80 ÷ $1.086 = 73.66 per cent. continued Chapter 24: EARNINGS PER SHARE  857

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Tea Tree Ltd Basic EPS = ($90m – $3m) ÷ [(50m x 0.5) + (60m x 0.5)] = $87m ÷ 55m = $1.582 per share Price earnings ratio: $40 ÷ $1.582 = 25.28 Dividend payout ratio: $0.60 ÷ $1.582 = 37.93 per cent (b) On the basis of the information presented we can see that the EPS of Tea Tree Bay Ltd is almost 1.5 times the EPS of Granite Bay Ltd. While this notionally means that each ordinary share in Tea Tree Bay has a larger share of profits, care must be taken in making such comparisons. For example, we cannot be sure that both organisations used the same accounting methods or how current profits compare to previous periods. We have also not explored whether they are in the same industry and therefore subject to the same pressures, risks and opportunities. Also, one firm might perhaps be in the growth phase while the other organisation might not be. What is being emphasised here is that we need further information to put the EPS calculations into context. When we consider the price earnings ratio we see that the price earnings ratio of Tea Tree Bay Ltd is almost two times that of Granite Bay Ltd. That is, the market is prepared to pay many more times current earnings per share for Granite Bay Ltd. Again, we would probably want further information so as to put this information into context. Generally speaking, a higher price earnings ratio is consistent with the market having a belief that the organisation has relatively high expected future growth prospects and/or is of relatively low risk compared to other organisations. Conversely, a low price earnings ratio might indicate that the market has expectations of low expected profit growth and/or the organisation is deemed to be of higher risk. Alternatively, a low price earnings ratio might be interpreted by some people as indicating that the shares are undervalued and represent a good investment opportunity. At times, price earnings ratios might become very inflated across many companies’ shares and this can sometimes be construed as being representative of an ‘overheated’ market and an indicator that future share price declines might be anticipated. Again, we need to consider various items of information before concluding about the price earnings ratio of particular organisations. In relation to the dividend payout ratio we can see that the dividend payout ratio of Tea Tree Bay Ltd is less than half that of Granite Bay Ltd. This means that Tea Tree Bay is retaining more of the profits for internal use, rather than paying them out in the form of cash distributions. This might indicate that the organisation believes that it has higher potential for growth, which would be consistent with its high price earnings ratio. The dividend payout ratio ignores the other returns to investors, which would be in the form of capital gains (gains due to increasing share prices).

SUMMARY In this chapter we considered various aspects of the calculation and disclosure of earnings per share (EPS). Australian listed entities and those in the process of listing are required, pursuant to AASB 133, to disclose information about their EPS within their annual reports. EPS is calculated from the perspective of ordinary shareholders and is determined by dividing the earnings of the company by the weighted-average number of ordinary shares outstanding during the year. In determining earnings for the purposes of calculating EPS, preference share dividends are to be deducted from profits (and if they are cumulative, they are excluded whether or not they are paid). A number of examples are given of calculating basic EPS, including cases where there is a bonus issue of shares and/or a rights issue. We also considered how to calculate diluted EPS, which is to be disclosed, together with basic EPS, on the face of the statement of profit and loss and other comprehensive income. In calculating diluted EPS, the adjusted earnings (calculated on the notional basis that the various securities have actually been converted to ordinary shares) are to be divided by the weighted-average number of ordinary and potential ordinary dilutive shares. Each type of potential ordinary share must be considered separately when calculating diluted EPS. If a particular type of potential

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ordinary share, for example, convertible notes, convertible preference shares or options, is not considered to be dilutive, it should be excluded from the calculation of diluted EPS. The chapter stressed that care must be taken when comparing various entities’ basic and diluted EPS. Given that the calculations are based directly on accounting profits and that accounting profits themselves are heavily dependent upon professional judgement, if different entities employ different accounting recognition and measurement rules, comparison of EPS can be misleading.

KEY TERMS basic EPS  841 bonus issue  847 cumulative dividend preference shares  841 diluted EPS  841

earnings per share (EPS)  840 market capitalisation  848 ordinary shares  842 potential ordinary shares  851 rights issue  850

substance over form  842 weighted-average number of shares  841

END-OF-CHAPTER EXERCISES For the year ending 30 June 2020, Green Island Ltd reports a net profit after tax of $1 800 000. At the beginning of the financial year Green Island Ltd had 500 000 fully paid ordinary shares outstanding. Green Island Ltd also had 100 000 partly paid shares. These shares were partly paid to 90c and had an original issue price of $2.00. The partly paid shares carry the rights to dividends in proportion to the amount paid relative to the total issue price. They were still partly paid at year end. Apart from the above, Green Island Ltd also has the following securities outstanding: •  $  1 million of 10 per cent debentures issued on 1 August 2019. The debentures have a life of five years and give holders the right to convert the debentures into 400 000 fully paid ordinary shares. •  In 2018, employees were provided with options, at no initial cost, which gave them the right to acquire 250 000 shares at an exercise price of $2.30. The options expire five years after their original issue date. Given the time period to option expiry, the directors believe it is probable that the options will be exercised. •  In 2018 Green Island Ltd issued 200 000 10 per cent, cumulative dividend preference shares. They were issued at $1.00 each and provide the shareholders with the right to convert each two preference shares into one fully paid ordinary share. Other information •  T  he company tax rate is 40 per cent. •  The average market price of the ordinary shares for the financial year is $2.50.

REQUIRED Compute the amounts for 2020 of Green Island Ltd’s: (a) basic earnings per share (b) diluted earnings per share. LO 24.1, 24.2, 24.3, 24.4

SOLUTION TO END-OF-CHAPTER EXERCISE (a) Basic earnings per share for Green Island Ltd Profit after tax less Preference share dividends Profit after tax less preference dividends

$1 800 000    ($20 000) $1 780 000

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Determining the weighted-average number of ordinary shares Period Fully paid ordinary shares 1/7/19–30/6/20 Partly paid ordinary shares 1/7/19–30/6/20 Total weighted-average number   of ordinary shares Basic earnings per share therefore   is $1 780 000 ÷ 545 000

Proportion of year

Number of shares outstanding

Weighted average

365 ÷ 365

500 000

500 000

365 ÷ 365

100 000 ($0.90 ÷ $2.00)

45 000 545 000 = $3.266

(b) Diluted earnings per share for Green Island Ltd As we have noted in this chapter, we need to consider each issue/series separately.

Step 1: Determine earnings per incremental share from the potential ordinary shares Partly paid shares Number of ordinary share equivalents issuable (100 000) ($1.10) ÷ $2.00 Number of shares that would be issued with the proceeds given the average    market price (100 000) ($1.10) ÷ $2.50 Number of shares deemed issued for no consideration

55 000 44 000 11 000



There is no adjustment to earnings for the capital inflow associated with the partly paid shares, and hence the earnings per incremental share are considered to be $nil.



Convertible debentures If the debentures had been converted, Green Island Ltd would have saved paying $100 000 in interest. As the debentures were issued during the year, the weighted-average potential ordinary shares will need to be weighted by the number of days in the financial year for which they were issued.   Had the debentures been converted, Green Island Ltd would have had an after-tax saving of:



(1 000 000) (10 per cent) (334 ÷ 365) (1 – 0.40) = $54 904



Had the conversion been undertaken, the weighted-average ordinary shares from conversion of debentures would have been:



(400 000) (334 ÷ 365) = 366 027



The earnings per incremental share is:



$54 904 ÷ 366 027 = $0.1500



Options Number of shares issuable Number of shares that would be issued with the proceeds given the average   market price (250 000) ($2.30) ÷ $2.50 Number of shares deemed issued for no consideration

250 000 230 000 20 000



There is no adjustment to earnings for the capital inflow associated with the partly paid shares, and hence the earnings per incremental share are considered to be $nil.



Convertible preference shares Had the preference shares been converted, the preference dividend ($20 000) would no longer have been paid. As the preference shares were outstanding for the entire year, the potential ordinary shares will be weighted for the whole year.   Earnings per incremental share is:



$20 000 ÷ 100 000 = $0.20

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Step 2: Rank the potential ordinary shares from greatest dilution (lowest earnings per incremental share) to least dilution (greatest earnings per incremental share) Increase in shares

Earnings per incremental share

20 000 11 000 366 027 100 000

$nil $nil $0.1500 $0.2000

Options Partly paid shares Convertible debentures Convertible preference shares

Step 3: Compute profit to be used in the trigger test The profit from continuing operations is used for the trigger test. Earnings used when calculating basic EPS add Adjustments Net profit from continuing operations to be used for the purpose of the trigger test

$1 780 000 $nil $1 780 000

Step 4: Perform the trigger test Profit and adjustments ($)

Ordinary shares ($)

EPS ($)

1 780 000    Nil 1 780 000    Nil 1 780 000   54 904 1 834 904   20 000 1 854 904

545 000 20 000 565 000 11 000 576 000 366 027 942 027 100 000 1 042 027

3.2661

Net profit from continuing  operations Options Partly paid shares Convertible debentures Convertible preference shares

Dilutive?



3.1504

Yes

3.0903

Yes

1.9478

Yes

1.7801

Yes

Step 5: Compute diluted earnings per share

As reported for basic EPS Options Convertible debentures Convertible preference shares Partly paid shares

Profit ($)

Ordinary shares ($)

1 780 000 0 54 904 20 000     0 1 854 904

545 000 20 000 366 027 100 000   11 000 1 042 027

Diluted EPS = $1 854 904 ÷ $1  042 027 = $1.7801

REVIEW QUESTIONS 1. How do we determine: (a) basic earnings per share? (b) diluted earnings per share? LO 24.1, 24.2, 24.3, 24.4 Chapter 24: EARNINGS PER SHARE  861

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2. How would you determine whether potential ordinary shares are dilutive? LO 24.3 3. If there were a ‘share split’ in the current period, would any adjustment be necessary for the prior period comparative EPS? If so, how would the adjustment be calculated? LO 24.2, 24.3 4. When should both basic and diluted EPS be disclosed? LO 24.1, 24.4 5. If there has been a bonus issue in a particular year, do we need to adjust the previous period’s EPS for comparative purposes? If so, how do we adjust the previous period’s EPS? LO 24.2 6. For the year ending 30 June 2020, Granite Ltd reports the following: (a) Net profit after tax of $1.2 million. (b) Granite Ltd commenced the year with 400 000 fully paid ordinary shares. During the year the company: •  issued 80 000 fully paid ordinary shares on 1 November 2019 at the prevailing market price •  purchased back 50 000 fully paid ordinary shares on 1 March 2020 at the prevailing market price •  issued 100 000 partly paid ordinary shares on 1 June 2020 at an issue price of $2.00. The shares were partly paid to $1.00. The partly paid shares carry the right to participate in dividends in proportion to the amount paid as a fraction of the issue price. (c) For the entire year, Granite Ltd had 500 000 $1.00 preference shares, which provide dividends at a rate of 10 per cent per year. The dividend rights are cumulative. The preference shares were disclosed as equity.

REQUIRED Compute the basic earnings per share for Granite Ltd for 2020. LO 24.1, 24.2 7. For the year ending 30 June 2019, A-Bay Ltd reports net profit after tax of $1 million. At the beginning of the year, A-Bay Ltd had 600 000 fully paid ordinary shares on issue. It also had 100 000 $1.00, 6 per cent, cumulative preference shares outstanding. On 1 October 2018 the company issued another 150 000 fully paid ordinary shares. On 1 May 2019 the company issued further fully paid shares on the basis of a one-for-five bonus issue. The last sale price per ordinary share before the bonus issue was $3.00. The basic EPS for the year ended 30 June 2018 was $2.30.

REQUIRED Compute the basic earnings per share amount for 2019 and provide the adjusted comparative EPS for 2018. LO 24.1, 24.2 8. X Ltd has earnings for the year ending 30 June 2019 of $410 million. Outstanding ordinary shares as at 1 July 2018 were 100 million fully paid ordinary shares. During the year the company issued 15 million partly paid shares. The information relating to the issue is shown below: Issue price Paid Closing date

$2.00 $0.50 31 May 2019

REQUIRED Calculate the basic earnings per share for the year ending 30 June 2019. LO 24.1, 24.2 9. You are given the following information for Y Ltd for the year ending 30 June 2019. Net profit before tax Income tax expense Profit after tax Non-controlling interest Dividends: – Preference – Ordinary Increase in retained earnings

$1 455 000 ($655 000) $800 000 ($100 000) ($100 000) ($300 000) $300 000

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The company has 2.4 million fully paid ordinary shares on issue at July 2018 and 2 million, 5 per cent, $1.00 preference shares. On 1 January 2019 the company issued a further 600 000 ordinary shares at full market price and on 1 May 2019 the company made a one-for-three bonus issue. The last sale price before the issue was $1.50.

REQUIRED Calculate the basic earnings per share of Y Ltd for the year ending 30 June 2019. LO 24.1, 24.2 10. Z Ltd has on issue 2 million ordinary shares and 1 million convertible preference shares of $0.50 each. The holders of the preference shares have the right to convert into ordinary shares at the rate of two preference shares for one ordinary share at a future date. The following figures have been extracted from the statement of profit and loss and other comprehensive income of Z Ltd for the year ending 30 June 2020. Profit after income tax Dividends: – Ordinary – Preference Increase in retained earnings

$290 000 ($160 000) ($20 000) $110 000

REQUIRED Calculate the diluted earnings per share for Z Ltd for the year ending 30 June 2020. LO 24.3, 24.4 11. Outline the requirements in respect of the disclosure of both basic and fully diluted EPS in the financial statements of listed public companies. Discuss the advantages and disadvantages of such disclosure. LO 24.1, 24.4 12. P Ltd is an Australian listed company. Its results for the financial year ending 30 June 2019 have exceeded expectations—profit before tax is $5.597 million and income tax expense is $1.847 million. As at 30 June 2018, there were 9.75 million ordinary shares on issue. On 11 May 2019, 3.25 million further ordinary shares were issued at a price of $2.30—paid to $2.00. The partly paid shares carry rights to dividends in proportion to the amount paid relative to the total issue price.

REQUIRED Calculate the basic EPS for P Ltd for the year ending 30 June 2019. LO 24.1, 24.2 13. C Ltd is an Australian listed company. Results for the year are as follows:

Profit Income tax expense

6 months ended 31/12/18

12 months ended 30/6/19

$7 035 800 $1 756 000

$17 500 000 $5 500 000

Year-end price of the shares is $2.40. Shares Number of fully paid ordinary shares At 1/7/18 At 30/6/19

5 000 000 5 000 000

Ten million options were issued by the company on 15 September 2018. These are exercisable by the holder at $2.50 per option on or before 22 November 2021. One million options were also issued by the company on 15 March 2019. These are exercisable by the holder at $2 per option on or before 11 May 2023.

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Other information Average share price for the year Company tax rate

$2.20 33 per cent

REQUIRED Calculate the basic earnings per share and diluted earnings per share for C Ltd for the year ending 30 June 2019. LO 24.1, 24.2, 24.3, 24.4

CHALLENGING QUESTIONS 14. XYZ Ltd is a public company listed on the Australian Securities Exchange. You are provided with the following information about XYZ: $ Earnings (profit after tax) for six months ended 31 December 2019 Earnings (profit after tax) for six months ended 30 June 2020 Fully paid ordinary shares as at 30 June 2019 Outstanding partly paid shares as at 30 June 2019 – Number – Issue price – Paid to



90 000 000 10 000 000 $2.00 $1.00

These shares were issued on 1 January 2019 and are payable over the following three years. • The allotment of shares pursuant to the Dividend Reinvestment Plan was 1 000 000. ‘Dividend declared to shareholders registered in the books of the company at the close of business on 31 March 2020. The company will mail the dividend on 15 April 2020.’ • Call of partly paid shares during the year: – Previously paid to – Call of – Closing date



10 000 000 13 000 000 23 000 000

• • • • •

$1.00 $0.50 28 February 2020

The current share price at reporting date is $2.50. The average share price for the year is $2.50. Ten million options were issued on 1 January 2018, exercisable at $2.60 on or before 31 December 2022. Ten million options were issued on 30 June 2018, exercisable at $2.10 on or before 30 June 2021. The company income tax rate is 40 per cent.

REQUIRED Calculate basic earnings per share and diluted earnings per share as at 30 June 2020. LO 24.1, 24.2, 24.3, 24.4 15. You are given the following information in respect of XYZ Ltd for the year ending 30 June 2018. Earnings for the year ending 30 June 2018 $70 000 000 Fully paid ordinary shares at 1 July 2017 75 000 000 Ten million options are issued on 30 June 2016, exercisable at $2.00 per option on or before 30 June 2020. The holder of each option has the right to purchase one share. At July 2017, there are 2 million, 10 per cent, convertible notes on issue at face value (also called ‘par’). The face value is $2.50. Interest is paid on 1 September and 1 March each year. Each convertible note is convertible into one fully paid ordinary share on 1 May 2020 and 1 May 2021.

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On 1 May 2018, there is a rights issue of one-for-three ordinary fully paid shares. The price of the rights is $1.00. The last cum rights share price was $2.50. New shares issued do not participate in the interim dividend of 3.5 cents per share. The average share price for the year was $2.50. The company income tax rate is 40 per cent.

REQUIRED Calculate the basic and fully diluted earnings per share for XYZ Ltd for the year ending 30 June 2018. LO 24.1, 24.2, 24.3, 24.4 16. The statements of comprehensive income of PK Ltd, and PK Group (comprising PK Ltd and its subsidiaries), for the financial year ending 30 June 2019 are as follows: Statements of comprehensive income of PK Ltd and PK Group for the year ended 30 June 2019

Income Expenses (excluding borrowing costs) Borrowing costs Profit before income tax expense Income tax expense Profit from continuing operations after income tax expense Profit (loss) from discontinuing operations after related   income tax Profit after income tax Other comprehensive income Total comprehensive income

PK Ltd ($)

PK Ltd and its subsidiaries($)

38 368 000 (33 536 000) (1 092 000) 3 740 000 (1 496 000)

193 284 000 (141 156 000) (20 988 000) 31 140 000 (12 456 000)

2 244 000

18 684 000

204 000 2 448 000 0 2 448 000

(492 000) 18 192 000 0 18 192 000 1 704 000 16 488 000

Profit attributable to non-controlling interest Profit attributable to members of the parent entity Notes to and forming part of the financial statements

Note x: Retained earnings Retained earnings—1 July 2018 Profit after income tax Profit attributable to members of the parent entity Interim dividend—ordinary shares Final dividend—ordinary shares Dividends—preference shares Retained earnings—30 June 2019

PK Ltd ($)

PK Ltd and its subsidiaries ($)

2 064 000 2 448 000

20 376 000

(608 000) (656 000)  (360 000) 2 888 000

16 488 000 (608 000) (656 000) (360 000) 35 240 000

Additional information (i) On 30 June 2018, the share capital of PK Ltd comprised: Share class Ordinary Preference Total

Number of shares on issue 4 600 000 600 000 5 200 000

Share capital ($) 11 052 000 6 000 000 17 052 000

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(ii) During the financial year ending 30 June 2019, PK Ltd made the following share issues: Date of share issue

Class of share issue

1 October 2018

Ordinary

Private placement of 480 000 partly paid shares. The partly paid shares were issued for $3.00, which was the current share price at the time of issue. An amount of $1.12 was payable on allotment, and the balance of $1.88 is payable on 1 October 2020. The partly paid shares rank for (are entitled to participate in) dividends from 1 April 2019. The partly paid shares will entitle shareholders to receive 30 per cent of the dividends received by fully paid ordinary shareholders.

1 December 2018

Ordinary

Public issue of 8 000 000 fully paid shares. The subscription price for the public issue shares was $3.22, which was the current share price at the time of issue.

1 March 2019

Preference

Private placement of 320 000 fully paid shares, issued at the current share price at the time of issue.

1 May 2019

Ordinary

Share buyback of 260 000 fully paid ordinary shares, purchased at the current share price at the time of purchase of $3.32.

Details relating to share issue

(iii) The preference shares entitle shareholders to receive an annual fixed dividend of 12 per cent on share capital, payable in two half-yearly instalments on 31 March and 30 September each year (that is 6 per cent on share capital every half year). The preference share dividends are cumulative. (iv) The dividend due to preference shareholders on 31 March 2019 was not paid.

REQUIRED Calculate basic earnings per share for the financial year ended 30 June 2019 in accordance with the requirements of AASB 133. LO 24.1, 24.2 17. We are comparing two companies that are listed on the ASX and which have the following details: Bells Ltd •  Profit after tax of $50 million for the last financial period. •  Pays $4 million in preference share dividends (the preference shares are classed as equity). •  H  ad 20 million ordinary shares on issue for the first nine months of the year, and 25 million ordinary shares on issue for the last three months of the year. •  The dividend paid for the year on its ordinary shares is $1.00 per share. •  The latest share price was $16.

Southside Ltd •  Profit after tax of $100 million for the last financial period. •  Pays $8 million in preference share dividends (the preference shares are classed as debt). •  Had 60 million shares on issue for the full year. •  The dividend paid for the year on ordinary shares is $0.95 per share. •  The latest share price was $49.

REQUIRED a. Calculate basic EPS, price earnings ratio and dividend payout ratio for each of the companies. b. Compare the calculations made for each company. LO 24.5

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REFERENCES BALL, R. & BROWN, P., 1968, ‘An Empirical Evaluation of Accounting Income Numbers’, Journal of Accounting Research, Autumn, pp. 159–78. EASTON, S., 1990, ‘The Impact of the Disclosure of Extraordinary Items on Returns on Equity’, Accounting and Finance, November, pp. 1–13. WHITTRED, G. & ZIMMER, I., 1992, Financial Accounting: Incentive Effects and Economic Consequences, 3rd edn, Holt, Rinehart and Winston, Sydney.

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PART 8

ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES CHAPTER 25 Accounting for group structures CHAPTER 26 Further consolidation issues I: accounting for intragroup transactions CHAPTER 27 Further consolidation issues II: accounting for non-controlling interests

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CHAPTER 25

ACCOUNTING FOR GROUP STRUCTURES LEARNING OBJECTIVES (LO) 25.1 Understand what it means to ‘consolidate’ financial statements. 25.2 Understand the reasons for preparing consolidated financial statements. 25.3 Understand the alternative consolidation concepts. 25.4 Understand the basics involved in preparing consolidated financial statements. 25.5 Be able to use a consolidation worksheet to perform relatively simple consolidations. 25.6 Understand that control, and not legal form, is the criterion for determining whether or not to consolidate an entity. 25.7 Be able to explain what control means, and be able to explain what factors should be considered in determining the existence of control. 25.8 Understand the meaning of ‘goodwill’, and how to measure it. 25.9 Understand what a ‘gain on bargain purchase’ represents. 25.10 Be able to provide the journal entries necessary to account for any goodwill that arises on consolidation. 25.11 Be aware of some of the history behind the development of Australian Accounting Standards pertaining to consolidated financial statements. 25.12 Be able to differentiate between direct and indirect ownership interests. 25.13 Understand the relative meanings of ‘control’, ‘joint control’ and ‘significant influence’. 25.14 Have acquired the necessary basic knowledge of the consolidation process on which to base an understanding of the further consolidation issues addressed in Chapters 26, 27 and 31.

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Introduction to accounting for group structures In this and the next two chapters we will consider how to account for groups of entities. Specifically, we will consider how to consolidate (or combine) the financial statements of a parent entity and its subsidiaries. In doing so, we will need to make reference to a number of accounting standards. Of particular relevance to our discussion will be the following accounting standards:

• • • • • • • • •

AASB 3 Business Combinations AASB 10 Consolidated Financial Statements AASB 11 Joint Arrangements AASB 12 Disclosure of Interests in Other Entities AASB 13 Fair Value Measurement AASB 116 Property, Plant and Equipment AASB 127 Separate Financial Statements AASB 136 Impairment of Assets AASB 138 Intangible Assets.

It is common in Australia, and elsewhere, for groups of companies to combine in the pursuit of common goals. For example, a company might gain a controlling equity ownership in another company, with the intention of increasing the total assets and, relatedly, the profits of the group (the ‘group’ would comprise the parent entity and group its subsidiaries). Where a reporting entity controls another entity, AASB 10 Consolidated Financial Typically a group of Statements requires that consolidated financial statements be prepared. In this chapter we will entities comprising the consider issues relating to the consolidation process, including: parent entity and each

• • • •

the rationale for presenting consolidated financial statements a brief review of the history of the Australian consolidated accounting requirements the importance of control to the decision to consolidate an entity the basic mechanics of the consolidation process, together with a consideration of how to account for any goodwill or gain on bargain purchases that might arise on consolidation.

of its subsidiaries.

consolidation The aggregation of the accounts of a number of separate legal entities.

Chapters 26, 27 and 31 will consider consolidation issues relating to intragroup transactions, non-controlling interests and indirect ownership interests. Accounting issues relating to consolidations are numerous. In the following chapters we hope to provide a solid foundation for understanding the process of consolidating separate legal entities. There are a number of key terms used in this chapter. We will briefly introduce some key terms now, which we will revisit throughout this and the next two chapters. In defining these key terms we will rely upon definitions provided in AASB 10 Consolidated Financial Statements. Consolidation accounting key terms that we will use include: • consolidated financial statements, which are the financial statements of a group presented as those of a single economic entity • a group, which comprises a parent and its subsidiaries • a parent, which is an entity that controls one or more entities known as subsidiaries • a subsidiary, which is an entity, typically a company but would also include an unincorporated entity such as a partnership or a trust, that is controlled by another entity (known as the parent) • control over an investee, which is defined in AASB 10 as being in existence ‘when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee’. control over an As we can see from the above definitions, an entity must ‘control’ an organisation before the organisation is considered to be a subsidiary of the investor. Consolidated financial statements provide information about the financial performance and position of an entity that exists in an economic, but not a legal, sense. The ‘legal entities’ are the separate organisations within the group. As a simple example of a ‘group’—or an economic entity as it is also called—we can consider Figure 25.1. In Figure 25.1, Company A holds all of the issued capital—and voting rights—in Company B. Company A and Company B would each be considered to be separate legal entities. Company A would be considered to be the ‘parent’ and, because Company B is controlled by Company A, Company B would be considered to be the subsidiary of Company A. Company A and

investee When the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.

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Figure 25.1 A simple parent and subsidiary relationship

Company A (parent) Separate legal entities

Economic entity

100%

Company B (subsidiary)

Company B together would be considered to represent a ‘group’, and while Company  A and Company B might be considered to be separate legal entities, Company A and Company B together would constitute a single economic entity.

LO 25.1 LO 25.2

Rationale for consolidating the financial statements of different legal entities

Virtually every company listed on the Australian Securities Exchange has subsidiaries. Therefore, investors in a parent entity (which has subsidiaries) have effectively invested in the group comprising the parent entity and its subsidiaries. A large number of entities may be controlled by a particular parent entity. For example, consider the 2015 financial statements prepared by Westpac Banking Corporation Ltd. What a lot of people do not appreciate is that when we talk about the results of Westpac or other entities listed on a securities exchange we are actually talking about the combined results and financial positions of many entities all consolidated together. Indeed, a review of the 2015 annual report of Westpac reveals that it controlled 239 separate legal entities, all of which are incorporated within the consolidated financial statements. Therefore, when we are talking about Westpac Banking Corporation Ltd’s performance as a whole (as reflected in the consolidated financial statements), we are aggregating the results of a large number of entities (over 200 in the case of Westpac), some of which might have done very well, and some very poorly. If investors in Westpac Banking Corporation Ltd wish to review the operations of the group under the control of the parent entity concerned, it would be extremely confusing for them to have to study hundreds of separate financial statements, each prepared separately for each entity making up the group. The purpose of providing consolidated financial statements is to show the results and financial position of a group of organisations as if they are operating as a single economic entity; but remember, these consolidated financial statements represent the consolidation of the financial statements of many separate legal entities. That is, the consolidated financial statements represent the combination of the financial statements of all the entities within the group, with the ‘group’ comprising the parent entity and all of its subsidiaries. When consolidated financial statements are prepared we get one set of financial statements (plus supporting notes) that cover the entire group. That is, we get:

• • • •

one consolidated statement of profit or loss and other comprehensive income covering the group one consolidated statement of financial position covering the group one consolidated statement of changes in equity covering the group one consolidated statement of cash flows covering the group.

In terms of the act of preparing consolidated financial statements, paragraph B86 of AASB 10 states (within AASB 10, paragraphs commencing with B are part of the Application Guidance, which is attached to AASB 10): Consolidated financial statements combine like items of assets, liabilities, equity, income, expenses and cash flows of the parent with those of its subsidiaries. For example, if Company A and Company B, as shown in Figure 25.1, have cash of $500 000 and $400 000 respectively, the consolidated financial statements would show cash of $900 000 being controlled by the economic entity. 872  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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As we will see in this and the next two chapters, the process of aggregating items will also often involve undertaking various eliminations and adjustments. As will be stressed in this and the following chapter, the consolidation process does not involve any adjustments to the financial statements of the individual entities making up the group. The effect of previous consolidation adjustments will also not be reflected in the opening balances of the ledger accounts of any entities within the group. Supplementary worksheets are utilised to perform the consolidation, and we will call these ‘consolidation worksheets’. The preparation of consolidated financial statements will not obviate the need for separate entities to prepare their own, separate financial statements. Following the consolidation process, the consolidated statement of profit or loss and other comprehensive income will show the result derived from operations with parties external to the group of entities. The effects of all intragroup transactions—in other words, the transactions between organisations within the economic entity—are eliminated, since from the economic entity’s perspective (that is, the controlling or parent entity and its controlled entities) income will not be derived as a result of transactions within the group, only from transactions with external parties. The consolidated statement of financial position will show the total assets controlled by the economic entity and the total liabilities owed to parties outside the economic entity. Liabilities owing to organisations within the group (that is, within the economic entity) by other group members will be eliminated in the consolidation process and so will not be shown in the consolidated statement of financial position.

consolidated statement of profit or loss and other comprehensive income A statement of profit or loss and other comprehensive income that combines, with various eliminations and adjustments, the statements of profit and loss and other comprehensive income of the various entities within the economic entity.

History of Australian Accounting Standards that govern the preparation of consolidated financial statements

LO 25.6 LO 25.11

In June 1990 the Australian Accounting Research Foundation (now defunct) issued AAS 24 Consolidated Financial Statements. The standard was applicable to all reporting entities in the public and private sector. The standard became operative for financial years ending on or after 30 June 1991. AAS 24 followed the release in June 1987 of ED 40 Consolidated Financial Statements. AAS 24 ultimately became AASB 1024. One aim in releasing first ED 40, and then AAS 24, was to engineer the demise of the practice of using partnerships and trusts to keep debt off the consolidated statement of financial position. consolidated We will discuss this practice below. statement of financial position Prior to the original issue of an accounting standard pertaining to consolidations (AAS 24), A statement of companies had a great deal of freedom in how they accounted for their subsidiaries, and many financial position companies used this freedom opportunistically to present financial statements in the best possible light. that combines, with Sullivan (1985) identified examples of companies using unit trusts to keep debt off the consolidated various eliminations statement of financial position (balance sheet). As shown by Sullivan, the consolidation of the trust and adjustments, the statements of financial itself might not greatly alter the entity’s statement of financial position, but consolidation of the entities position of the various below the trust might have considerable effects. Sullivan showed how, by interposing a unit trust into entities within the a group’s structure, an organisation could effectively keep both the debt incurred by the trust and the economic entity. debt incurred by other entities under the control of the trust off the consolidated statement of financial position. Companies were able to do this because they were able to exploit a legal loophole, which restricted consolidated financial statements to including only ‘companies’. That is, any entity that was not a company could not be legally included within the consolidation process. Where a unit trust, for example, was interposed within a group structure, the parent entity would disclose its investment in the trust at cost—usually a relatively insignificant amount—and none of the assets or liabilities of the trust would be reflected in the consolidated financial statements. Before the Corporations Legislation Amendment Act 1991 came into force, s. 295 of The Corporations Law required group financial statements to be prepared. However, s. 9 defined a ‘group’ as meaning ‘(a) the company; and, (b) its subsidiaries at the end of the financial year’. In explaining why trusts could not be included (and, remember, it is the parent entity’s and its subsidiaries’ financial statements that are included in the consolidated financial statements), subsidiaries were defined in The Corporations Law in such a way that they had to be companies; so any entity that was not a company could not be legally consolidated as it could not be included within the ‘group’. Nor could entities controlled by a non-corporate entity be consolidated—even if the controlled entities happened to be companies. This introduced what Sullivan labelled a partition effect (see Figure 25.2). CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  873

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Figure 25.2 Illustration of the partition effect caused by interposing a unit trust within a group structure

A Ltd (assets 100, liabilities 40)

B Ltd (assets 50, liabilities 20)

A Trust (assets 2, liabilities 1)

C Ltd (assets 60, liabilities 50)

D Ltd (assets 70, liabilities 50)

Hence, before the amendments to The Corporations Law in 1991 (discussed below), group consolidated financial statements could include only entities that were companies. Therefore, by interposing a unit trust (such as A Trust in Figure 25.2), which in turn would own the equities in other companies (C Ltd and D Ltd in Figure 25.2), none of the financial statements of the companies controlled by the trust, or of the trust itself, could legally be included in the consolidation process. This was referred to as a partition effect as everything from the trust down was partitioned off and excluded from the consolidation process. This could have a beneficial impact on the leverage indicators (such as debt to assets) derived from the consolidated financial statements. Referring again to Figure 25.2, if the trust had not been interposed but instead C Ltd and D Ltd were directly controlled by B Ltd, the debt-to-assets ratio of the economic entity would be 57 per cent. By interposing a unit trust and not including C Ltd, D Ltd or the trust itself in the consolidation process, the debt-to-assets ratio falls to a more favourable 40 per cent. As an actual example of the practice of non-consolidation by using non-corporate entities, Sullivan considered CSR Ltd’s use of an interposed unit trust. The arrangement is represented in Figure 25.3. According to Sullivan, CSR Ltd’s investment in Delhi Australia Fund (DAF) was $189 million and in Delhi Petroleum Pty Ltd (DPPL) $60 million by way of redeemable preference shares. This total of $249 million, of which $188 million was loan finance, was separately captioned on CSR’s statement of financial position with a break-up provided in the notes to the financial statements. However, this was the only amount disclosed on CSR’s statement of financial position concerning its DAF–DPPL interests. DAF’s liabilities did not appear on CSR’s consolidated statement of financial position, even though CSR effectively controlled the operations of DAF. This was consistent with the restriction that only the assets and liabilities of companies could be included in the consolidation process. Sullivan (1985, p. 182) stated: DAF is primarily supported by loan finance of $188 million from CSR and $854 million from the bank sources. These funds are basically deployed as equity investments in DPPL of $548 million, a loan to DPPL of $288 million and with various expenses deferred totalling $307 million. DAF being a unit trust is not subject to the Companies Act 1981, and hence no presumption of subsidiary company status can arise. It follows simply that neither can it be a subsidiary under s. 7(i) of the Act. In fact legal opinion sought by CSR supports this view. Nothing turns, therefore, on the 50 per cent holding and the Trustees Act 1925 is silent. By ‘blacking out’ DAF and its investments (that is, excluding them from the consolidation process), CSR’s consolidated statement of financial position provided lower debt ratios than would otherwise have been the case. As Sullivan (p. 186) states: The effect of incorporating the off-balance sheet funds on CSR’s consolidated balance sheet would be quite severe on the gearing ratio. For the past ten years, this ratio has ranged from 25 per cent to 34.3 per cent, being 25 per cent at 31 March 1984. It is possible to perform a consolidation of DAF and DPPL and then 874  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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CSR

WPAC

DAF

Figure 25.3 Illustration of an interposed unit trust arrangement

Lenders

CSRI*

DPPL

Joint venture CSRI* = CSR Investments Pty Limited

to consolidate this DAF ‘group’ into CSR, using publicly available information. This exercise brings a further $854 million in long-term debt, $9 million in current liabilities, $801 million of interests in joint arrangements, $316 million in non-current assets and $48 million in current assets onto the revised consolidated balance sheet. What impact does this have on the gearing ratio? Quite simply, it nearly doubles to 47.6 per cent. The implication for a restrictive trust deed gearing covenant is clear enough. It would appear questionable whether CSR’s consolidated financial statements could present a ‘true and fair’ view without disclosing the activities and financial position of a sizeable and material portion of the group. Consistent with this concern, Sullivan (p. 195) remarks: It is difficult to concede that the preparation of group accounts can proceed to any fulfilment of the true and fair notion, however conceived, when entire segments of a group’s operations can be partitioned from scrutiny and when the accounts of the instrument itself need not be prepared for public purposes. The use of the interposed unit trust instrument is at once antipathetical to common-sense precepts of any system of accounting based on the true and fair concept and espousing corollary doctrines of full and fair disclosure and the duty to report the substance, and not the mere form, of commercial transactions. Another loophole (now closed) to consolidation was provided by the ‘old’ s. 9 of The Corporations Law. Section 9 provided that ‘group accounts’ might be presented as: (a) one set of consolidated accounts for the group; (b) two or more sets of consolidated accounts together covering the group; (c) separate accounts for each body corporate in the group; (d) the combination of one or more sets of consolidated accounts, and one or more sets of separate accounts, together covering the group. Therefore, in the past the entity could be selective about which organisations it included within the consolidated financial statements. Amendments to The Corporations Law deleted the definitions of ‘group’ and ‘group accounts’. The Corporations Act 2001 now adopts the requirements embodied within AASB 10 (which is now the relevant accounting standard). Specifically, s. 295(2)(d) now states that: The financial statements for the year are: (a) the financial statements in relation to the entity reported on that are required by the accounting standards; and (b) if required by the accounting standards—the financial statements in relation to the consolidated entity that are required by the accounting standards.

consolidated entity A combined entity constituted by a parent entity and its controlled entities.

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That is, the Corporations Act now requires consolidated financial statements to be prepared in the manner required by Australian Accounting Standards. AASB 10 does not allow an entity to selectively choose which subsidiaries it will include within the consolidated financial statements. Rather, with limited exceptions (and a specific exception relates to situations where a parent entity is deemed to be an ‘investment entity’; we will consider this limited exception shortly), AASB 10 requires all controlled entities to be incorporated within the consolidated financial statements regardless of their legal form (that is, regardless of whether the subsidiary is a company, partnership, trust or so forth it must be included within the consolidation process), and regardless of whether the subsidiary is involved in dissimilar business activities. Specifically, paragraph 19 of AASB 10 requires that a parent shall prepare consolidated financial statements. A parent is defined in AASB 10 as ‘an entity that controls one or more entities’. As parents are required to prepare ‘consolidated financial statements’, we therefore need a definition of ‘consolidated financial statements’. AASB 10 defines consolidated financial statements as: The financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity. The above definition in turn refers to subsidiaries. A subsidiary is defined in AASB 10 as ‘an entity that is controlled by another entity’. Therefore, to reiterate some of the important points above, it is now a requirement—and has been for many years— that (other than the exception applying ‘investment entities’) the consolidated financial statements shall incorporate the financial statements of the parent entity and all of the entities it controls (that is, all of its subsidiaries) and this is the case regardless of the legal form of the subsidiaries or the nature of the operations of the subsidiaries. These requirements act to eliminate many of the apparently opportunistic accounting practices that were reported by Sullivan (1985), as briefly discussed earlier in this section. In Chapter 1 we considered the requirement that financial statements be ‘true and fair’. This requirement extends to the consolidated financial statements. That is, the Corporations Act has a requirement that the directors are to ensure that both the financial statements of the parent entity, as well as the consolidated financial statements, are prepared in a manner that provides a true and fair view of the financial position and performance of the parent entity and group respectively. In this regard, s. 297 of the Corporations Act states: the financial statements and notes for a financial year must give a true and fair view of: (a) the financial position and performance of the company, registered scheme or disclosing entity and, (b) if consolidated financial statements are required, the financial position and performance of the consolidated entity. This section does not affect the obligation under section 296 for a financial report to comply with accounting standards. It should be noted that when we review the annual reports of corporations we will typically see two columns of numbers for the current year, and two columns for the preceding year. One set will relate to the group (the consolidated numbers) and one set will relate to the parent entity. As emphasised in Chapter 22 (on segment disclosures), consolidated financial statements must be read with care. They frequently provide details of the aggregated financial position and financial performance of a large number of entities that are involved in many different industries and localities. Some organisations within an economic entity might have performed very well, while others might have performed poorly. This information will be lost in the consolidation process. Also, the consolidated statement of financial position represents the consolidation of many entities, which conceivably have vastly different financial structures. As such, it is possible that the consolidated statement of financial position might not be representative of the statements of financial position of individual legal entities. Hence, where consolidated financial data is provided, it is essential that it is supplemented by segment data (that provides information about the different operating segments in the economic entity). Chapter 22 explains how to produce segment disclosures. While ‘control’ of another entity is a central requirement for that entity to be included in the consolidation process, AASB 10 requires that even where control is only temporary, the consolidated statements should incorporate the results of a subsidiary (which as we know is defined as an entity that is controlled by a parent entity) during the time in which

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control existed, even though this might have been for only a small part of the year. If control is lost during the period, the income and expenses of a subsidiary shall be included in the consolidated financial statements until the date on which the parent ceases to control the subsidiary.

‘Investment entities’: exception to consolidation

LO 25.3

While the earlier material has stressed that a parent entity has to consolidate all of the entities it controls, or has the capacity to control, there is one exception that we have referred to and this relates to situations where ‘investment entities’ are the parent entity. This exception to the general rules espoused in AASB 10 (IAS 10) was initially introduced by the IASB in late 2012 with further related amendments made in December 2014. Investment entities are defined at paragraph 27 of AASB 10 as: An entity that: (a) obtains funds from one or more investors for the purpose of providing those investor(s) with investment management services; (b) commits to its investor(s) that its business purpose is to invest funds solely for returns from capital appreciation, investment income, or both; and (c) measures and evaluates the performance of substantially all of its investments on a fair value basis. AASB 10 also identifies the typical characteristics of an investment entity. Paragraph 28 states: In assessing whether it meets the definition described in paragraph 27, an entity shall consider whether it has the following typical characteristics of an investment entity: (a) it has more than one investment (see paragraphs B85O–B85P); (b) it has more than one investor (see paragraphs B85Q–B85S); (c) it has investors that are not related parties of the entity (see paragraphs B85T–B85U); and (d) it has ownership interests in the form of equity or similar interests (see paragraphs B85V–B85W). The absence of any of these typical characteristics does not necessarily disqualify an entity from being classified as an investment entity. An investment entity that does not have all of these typical characteristics provides additional disclosure required by paragraph 9A of AASB 12 Disclosure of Interests in Other Entities. With limited exceptions, investment entities are not required to consolidate subsidiaries, or apply AASB 3 consolidation-related measurement requirements. Rather, the investment entity would measure its investment in the subsidiary at fair value with gains and losses going to profit or loss in a manner consistent with the requirements of AASB 9 Financial Instruments. As paragraphs 31 to 33 of AASB 10 state: 31. Except as described in paragraph 32, an investment entity shall not consolidate its subsidiaries or apply AASB 3 when it obtains control of another entity. Instead, an investment entity shall measure an investment in a subsidiary at fair value through profit or loss in accordance with AASB 9. 32. Notwithstanding the requirement in paragraph 31, if an investment entity has a subsidiary that is not itself an investment entity and whose main purpose and activities are providing services that relate to the investment entity’s investment activities (see paragraphs B85C–B85E), it shall consolidate that subsidiary in accordance with paragraphs 19–26 of this Standard and apply the requirements of AASB 3 to the acquisition of any such subsidiary. 33. A parent of an investment entity shall consolidate all entities that it controls, including those controlled through an investment entity subsidiary, unless the parent itself is an investment entity. Therefore, while there is a general requirement that the financial statements of entities controlled by the parent entity (or potentially controlled by the parent entity—an issue that we will discuss shortly) shall be consolidated with those of the parent entity, there is now a limited exception when the parent entity is an investment entity. The view that has been taken by the IASB is that if the investment entity is not playing an active managerial role within the investee, and has acquired the equity interest only for a business purpose, which is to invest funds solely for returns from capital appreciation, investment income or both, then it would be misleading to consolidate the financial statements of the investee with those of the investment entity.

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LO 25.3

Alternative consolidation concepts Generally speaking, there are three main consolidation concepts that have been discussed over time by researchers as being relevant to the consolidation process. These three alternative concepts are:

1. the entity concept 2. the proprietary concept 3. the parent-entity concept. AASB 10 adopts the entity concept (as did its predecessors, AASB 127 and, before that, AASB 1024). Pursuant to the entity concept, the entire group is viewed as a single economic entity, which incorporates all of the assets and liabilities of the parent entity and its subsidiaries (subject to the elimination of the impacts of intragroup transactions). The consolidated financial statements reflect the financial position and financial performance of the economic entity as if it were operating as a single economic unit under common managerial control—the control emanating from the management group of the ultimate parent organisation. The consolidated statement of profit or loss and other comprehensive income reflects the profit or loss and other items of comprehensive income that arise from transactions with parties external to the economic entity. The consolidated statement of financial position shows the assets of the economic entity (and, remember, the ‘economic entity’ means the parent entity and all of its subsidiaries) and all liabilities owing to parties external to the economic entity. No liabilities owing to any member of the economic entity by another member will be shown in the consolidated statement of financial position. What this means is that transactions between the individual entities making up the economic entity, for example, sales and purchases, dividends paid and received, and receivables and payables, must be eliminated as part of the consolidation process. As paragraph B86(c) of AASB 10 states, as part of the consolidation procedures we must: eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full). Intragroup losses may indicate an impairment that requires recognition in the consolidated financial statements. AASB 112 Income Taxes applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions. Pursuant to the entity concept of consolidation, non-controlling interests are treated as part of consolidated equity. Non-controlling interests are defined in Appendix A of AASB 10 as: ‘equity in a subsidiary not attributable, directly or indirectly, to a parent’. For example, if Company A owned 80 per cent of Company B (with Company A therefore being considered to be the ‘parent entity’) and the remaining 20 per cent of the shareholding was owned by an unrelated entity, the non-controlling interest in Company B is 20 per cent. By contrast, under the proprietary concept of consolidation, all assets and liabilities of the parent entity and only a proportionate share of the subsidiaries’ assets and liabilities are included in the consolidation process. Non-controlling interest is not included if the proprietary concept is embraced by virtue of the view that any non-controlling interest is external to the consolidated group. This would mean that if the parent entity holds 70 per cent of the shares in the subsidiary, it would include 70 per cent of the assets, liabilities, revenues and expenses in the consolidation process (and not 100 per cent of the assets and liabilities, as would be the case under the entity concept). That is, under the proprietary concept only 70 per cent of the subsidiary’s assets would be included, although the parent entity would effectively be able to control all of the subsidiary’s assets. Under the final concept—the parent-entity concept—all assets and liabilities of the parent and its subsidiaries are included. The non-controlling interest is treated as a liability, rather than as part of equity. As just indicated, AASB 10 requires the adoption of the entity concept. In rejecting the parent-entity concept, the accounting standard-setters considered that it was inappropriate to classify the interests of outside shareholders, that is, the non-controlling interests, as liabilities because their claim on the net assets of a subsidiary is not of the nature of a liability. In the Basis for Conclusions on IFRS 10 (on which AASB 10 is based), paragraphs BCZ 157 to 159 state (the Basis for Conclusions to IFRS 10 incorporates some material from the Basis for Conclusions that was provided some years earlier for IAS 27. To the extent that the discussion is still relevant to the new accounting standard IFRS 10, the 878  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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older material has been reproduced in the Basis for Conclusions that was released with IFRS 10. Reused material is identified by the use of the initials ‘BCZ’ before the paragraph number): BCZ157 As part of its revision of IAS 27 in 2003, the Board amended the requirement to require non-controlling interests to be presented in the consolidated statement of financial position within equity, separately from the equity of the shareholders of the parent. The Board concluded that a non-controlling interest is not a liability because it did not meet the definition of a liability in the Framework for the Preparation and Presentation of Financial Statements (replaced in 2010 by the Conceptual Framework for Financial Reporting). BCZ158 Paragraph 49(b) of the Framework (now paragraph 4.4(b) of the Conceptual Framework) stated that a liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Paragraph  60 of the Framework (now paragraph 4.15 of the Conceptual Framework) explained that an essential characteristic of a liability is that the entity has a present obligation and that an obligation is a duty or responsibility to act or perform in a particular way. The Board noted that the existence of a noncontrolling interest in the net assets of a subsidiary does not give rise to a present obligation, the settlement of which is expected to result in an outflow of economic benefits from the group. BCZ159 Instead, the Board noted that non-controlling interests represent the residual interest in the net assets of those subsidiaries held by some of the shareholders of the subsidiaries within the group, and therefore met the Framework’s definition of equity. Paragraph 49(c) of the Framework (now paragraph 4.4(c) of the Conceptual Framework) stated that equity is the residual interest in the assets of the entity after deducting all its liabilities. Therefore, the view is that non-controlling interests are to be disclosed as part of owners’ equity. Non-controlling interests will be explored in depth in Chapter 27.

The concept of control As we should now appreciate, the definitions of ‘control’ and ‘subsidiary’ are central to determining the entities to be consolidated and the nature of the group. Paragraph 20 of AASB 10 requires that:

LO 25.4 LO 25.6 LO 25.7

Consolidation of an investee shall begin from the date the investor obtains control of the investee and cease when the investor loses control of the investee. Further, as we also know, the definition of a subsidiary directly relies upon the concept of ‘control’. A subsidiary is defined in Appendix A of AASB 10 as: an entity that is controlled by another entity. Further, a ‘parent’ is defined in AASB 10 as: an entity that controls one or more entities. Hence, the definitions of ‘control’ and ‘subsidiary’ are fundamental to the whole consolidation process, with the definition of subsidiary directly relying upon the concept of ‘control’. AASB 10 defines control as requiring three elements, these being: • power; • exposure to variable returns; and • the investor’s ability to use power to affect its amount of variable returns. Specifically, ‘control of an investee’ is defined in AASB 10 as: An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee (emphasis added). CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  879

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The three elements of control are explained in some detail throughout AASB 10 and in the associated Application Guidance that accompanies AASB 10. For control to be deemed to exist, all three elements just identified must be present. As paragraph 7 of AASB 10 states: an investor controls an investee if and only if the investor has all the following: (a) power over the investee (see paragraphs 10–14); (b) exposure, or rights, to variable returns from its involvement with the investee (see paragraphs 15 and 16); and (c) the ability to use its power over the investee to affect the amount of the investor’s returns (see paragraphs 17 and 18). As we can see, ‘power’ over the investee is essential for there to be ‘control’ over the investee. Power is defined in Appendix A of AASB 10 as ‘existing rights that give the current ability to direct the relevant activities’. Paragraph 10 of AASB 10 further states that: an investor has power over an investee when the investor has existing rights that give it the current ability to direct the relevant activities, i.e. the activities that significantly affect the investee’s returns. Determining the existence of ‘power’ will not always be a straightforward exercise. As paragraph 11 of AASB 10 states: Power arises from rights. Sometimes assessing power is straightforward, such as when power over an investee is obtained directly and solely from the voting rights granted by equity instruments such as shares, and can be assessed by considering the voting rights from those shareholdings. In other cases, the assessment will be more complex and require more than one factor to be considered, for example when power results from one or more contractual arrangements. In deciding whether an entity is a subsidiary it is not necessary that the investor has actually exercised its power. Rather, it is necessary to show it has the capacity to exercise power. As paragraph 12 of AASB 10 states: An investor with the current ability to direct the relevant activities has power even if its rights to direct have yet to be exercised. Evidence that the investor has been directing relevant activities can help determine whether the investor has power, but such evidence is not, in itself, conclusive in determining whether the investor has power over an investee. Where control is considered to exist, the amount of returns to be derived from the interest in the investee would be expected to vary depending upon the efforts and performance of both the investee and the investor. According to paragraph 17 of AASB 10: An investor controls an investee if the investor not only has power over the investee and exposure or rights to variable returns from its involvement with the investee, but also has the ability to use its power to affect the investor’s returns from its involvement with the investee. In much of the discussion above we are using the terms ‘investor’ and ‘investee’. If the investor controls the investee then the investor would also be the ‘parent’ and the investee would be the ‘subsidiary’. In further considering the link between power and returns, paragraph BC68 of IFRS 10 states: To have control, an investor must have power and exposure or rights to variable returns and be able to use that power to affect its own returns from its involvement with the investee. Thus, power and the returns to which an investor is exposed, or has rights to, must be linked. The link between power and returns does not mean that the proportion of returns accruing to an investor needs to be perfectly correlated with the amount of power that the investor has. The Board noted that many parties can have the right to receive variable returns from an investee (e.g. shareholders, debt providers and agents), but only one party can control an investee. The above paragraph raises the important point that only one party can be in ‘control’ of an entity before that controlling entity can be considered to be the parent entity. If an entity ‘jointly controls’ another entity, then that entity cannot be considered to be a subsidiary, and rather than applying AASB 10, another standard—AASB 11 880  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Joint Arrangements—needs to be applied (and this standard—which is discussed in Chapter 32 —does not allow consolidation for jointly controlled entities). As paragraph BC 83 of the Basis for Conclusions to IFRS 10 states: IFRS 11 Joint Arrangements defines joint control as the contractually agreed sharing of control of an arrangement. Joint control exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. When two or more parties have joint control of an investee, no single party controls that investee and, accordingly, the investee is not consolidated. IFRS 11 is applicable to all investees for which two or more parties have joint control. The Basis for Conclusions that accompanied the release of IFRS 10 (and AASB 10) addressed a number of situations that could lead to control, these being: • where a majority of voting rights are held by the investor • where less than a majority of the voting rights are held by the investor (but perhaps where the balance of the voting rights are widely dispersed among many different owners) • where the investor holds some potential voting rights in the investee. We will consider these attributes of ‘control’ in more detail below.

Majority of voting rights It is generally understood that in most circumstances, if the investor holds the majority of the voting rights (for example, the majority of the ordinary shares in a company), then that should provide the investor with control over the investee. In this regard, paragraph BC97 to the Basis for Conclusions to IFRS 10 states: an investor that holds more than half the voting rights of an investee has power over the investee when those voting rights give the investor the current ability to direct the relevant activities (either directly or by appointing the members of the governing body). The Board concluded that such an investor’s voting rights are sufficient to give it power over the investee regardless of whether it has exercised its voting power, unless those rights are not substantive or there are separate arrangements providing another entity with power over the investee (such as through a contractual arrangement over decision making or substantive potential voting rights).

Less than the majority of voting rights It is quite common that an investor can control an investee even of it does not hold the majority of the voting rights. As paragraphs BC99, BC 107 and BC 108 of the Basis for Conclusions to IFRS 10 state: BC99 The Board decided that in Exposure Draft 10 (which preceded the release of IFRS 10) it would explain clearly that an investor can control an investee even if the investor does not have more than half the voting rights, as long as the investor’s voting rights are sufficient to give the investor the current ability to direct the relevant activities. ED 10 included an example of when a dominant shareholder holds voting rights and all other shareholdings are widely dispersed, and those other shareholders do not actively cooperate when they exercise their votes, so as to have more voting power than the dominant shareholder. BC107 In response to the concerns raised by respondents to ED 10, the Board clarified that its intentions were neither to require the consolidation of all investees, nor to require an investor that owns a low percentage of voting rights of an investee (such as 10 per cent or 15 per cent) to consolidate that investee. An investor should always assess whether its rights, including any voting rights that it owns, are sufficient to give it the current ability to direct the relevant activities. That assessment requires judgement, considering all available evidence. BC108 The Board decided to add application requirements setting out some of the factors to consider when applying that judgement to situations in which no single party holds more than half the voting rights of an investee. In particular, the Board decided to clarify that it expects that: (a) the more voting rights an investor holds (i.e. the larger its absolute holding), the more likely it will have power over an investee; (b) the more voting rights an investor holds relative to other vote holders (i.e. the larger its relative holding), the more likely the investor will have power over an investee; and (c) the more parties that would need to act together to outvote the investor, the more likely the investor will have power over an investee. CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  881

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Potential voting rights Another factor that requires consideration when determining whether an investor might control an investee (and remember, what is important is the existence of capacity to control, and not necessarily whether the control has yet to be used) is the existence of potential voting rights. Potential voting rights are financial instruments that do not in themselves have voting rights but they can potentially be converted into other financial instruments—such as ordinary shares—that would then provide voting rights. For example, the investor might hold share options, or preference shares, that in themselves do not have voting rights, but they can potentially be converted to ordinary shares that would provide voting rights. An increase in voting rights would increase the potential for an investor to control the investee. Therefore, where the ‘potential voting rights’ are currently exercisable they should be taken into account when assessing the existence of ‘control’. In relation to potential voting rights, paragraphs BC 120, 121 and 124 of the Basis for Conclusions to IFRS 10 state: BC120 Potential voting rights can give the holder the current ability to direct the relevant activities. This will be the case if those rights are substantive and on exercise or conversion (when considered together with any other existing rights the holder has) they give the holder the current ability to direct the relevant activities. The holder of such potential voting rights has the contractual right to ‘step in’, obtain voting rights and subsequently exercise its voting power to direct the relevant activities—thus the holder has the current ability to direct the activities of an investee at the time that decisions need to be taken if those rights are substantive. BC121 The Board noted that the holder of such potential voting rights is, in effect, in the same position as a passive majority shareholder or the holder of substantive kick-out rights. The control model would provide that, in the absence of other factors, a majority shareholder controls an investee even though it can take time for the shareholder to organise a meeting and exercise its voting rights. In a similar manner, it can take time for a principal to remove or ‘kick out’ an agent. The holder of potential voting rights must also take steps to obtain its voting rights. In each case, the question is whether those steps are so significant that they prevent the investor from having the current ability to direct the relevant activities of an investee. BC124 Some constituents were concerned about whether the proposed model would lead to frequent changes in the control assessment solely because of changes in market conditions—would an investor consolidate and deconsolidate an investee if potential voting rights moved in and out of the money? In response to those comments, the Board noted that determining whether a potential voting right is substantive is not based solely on a comparison of the strike or conversion price of the instrument and the then current market price of its underlying share. Although the strike or conversion price is one factor to consider, determining whether potential voting rights are substantive requires a holistic approach, considering a variety of factors. This includes assessing the purpose and design of the instrument, considering whether the investor can benefit for other reasons such as by realising synergies between the investor and the investee, and determining whether there are any barriers (financial or otherwise) that would prevent the holder of potential voting rights from exercising or converting those rights. Accordingly, the Board believes that a change in market conditions (i.e. the market price of the underlying shares) alone would not typically result in a change in the consolidation conclusion. As we can see from the above paragraphs, as with control generally, professional judgement needs to be employed to determine whether the existence of potential voting rights impacts on the assessment of whether an entity has control over another entity. Worked Example 25.1 provides a number of scenarios adapted from the Implementation Guidance accompanying AASB 10 that illustrate individual aspects of potential voting rights.

WORKED EXAMPLE 25.1: Consideration of potential voting rights Part A Options are out of the money A Ltd and B Ltd own 70 per cent and 30 per cent respectively of the ordinary contributed equity that carries voting rights in C Ltd. A Ltd sells 70 per cent of its interest in C Ltd to D Ltd. At the same time, A Ltd purchases call options from D Ltd that are exercisable at any time at a premium to the market price when issued. If the options are exercised, they give A Ltd its original 70 per cent ownership interest and voting rights in C Ltd.

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Part B Possibility of exercise or conversion A Ltd, B Ltd and C Ltd own 40 per cent, 30 per cent and 30 per cent respectively of the ordinary contributed equity that carries voting rights in D Ltd. A Ltd also owns call options that are exercisable at any time at the fair value of the underlying shares. If the options are exercised, A Ltd receives an extra 20 per cent of the voting rights in D Ltd, while B Ltd and C Ltd interests are reduced to 20 per cent each. Part C Management intention A Ltd, B Ltd and C Ltd each own 33.33 per cent of the ordinary contributed equity that carries voting rights in D Ltd. A Ltd, B Ltd and C Ltd each have the right to appoint two directors to the Board of D Ltd. A Ltd also owns call options that are exercisable at a fixed price at any time and, if exercised, would give it all the voting rights in D Ltd. The management of A Ltd does not intend to exercise the call options, even if B Ltd and C Ltd do not vote along the same lines as A Ltd. Part D Financial ability A Ltd and B Ltd own 55 per cent and 45 per cent respectively of the ordinary contributed equity that carries voting rights in C Ltd. B Ltd also holds debt instruments that are convertible into ordinary shares of C Ltd. The debt can be converted at a substantial price, in comparison with B Ltd’s net assets, at any time. If the debt instruments were converted, B Ltd would be required to borrow additional funds to make the payment. Should the debt be converted, B Ltd would hold 70 per cent of the voting rights and A Ltd’s interest would reduce to 30 per cent. REQUIRED Taking the potential voting rights into consideration in each of the above scenarios, explain which entity has control over the other. SOLUTION Part A In this scenario, the options are out of the money. However, because A Ltd can exercise its options now (they are currently exercisable), A Ltd has the power to continue to set the operating and financial policies of C Ltd. The existence of the potential voting rights means that A Ltd controls C Ltd. Part B If the options are exercised, A Ltd will have control over more than half of the voting over D Ltd. The existence of the potential voting rights means that A Ltd controls D Ltd. Part C The existence of the potential voting rights means that A Ltd controls D Ltd. The intention of A Ltd’s management does not influence the assessment of control. Part D Although the debt instruments are convertible at a substantial price, they are currently convertible. This conversion feature gives B Ltd the power to set the operating and financial policies of C Ltd. The existence of the potential voting rights means that it is B Ltd and not A Ltd that controls C Ltd. The financial ability of B Ltd to pay the conversion price does not influence the assessment of control.

Delegated power (agency relationships) Pursuant to AASB 10, another factor to consider in determining whether to consolidate an entity is whether any power to be exerted over the entity is being used in the context of an agency relationship, or whether the power is being exercised to benefit the investor directly. In defining an ‘agency relationship’, paragraph BC129 of the Basis for Conclusions to IFRS 10 states: The Board decided to base its principal/agent guidance on the thinking developed in agency theory. Jensen and Meckling (1976) define an agency relationship as ‘a contractual relationship in which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent. CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  883

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If an entity has power, but is acting under the direction of another entity—perhaps as an ‘agent’ of that other entity— then control would not be deemed to exist and the entity would not be required to consolidate the entity over which it had power. As paragraph 18 of AASB 10 states: Thus, an investor with decision-making rights shall determine whether it is a principal or an agent. An investor that is an agent in accordance with paragraphs B58–B72 does not control an investee when it exercises decision-making rights delegated to it. In explaining the above requirement, paragraph BC133 of the Basis for Conclusions to IFRS 10 states: The Board concluded that the guidance in IFRS 10 that addresses control should apply to agency relationships, i.e. when assessing control, a decision maker should consider whether it has the current ability to direct the relevant activities of an investee that it manages to affect the returns it receives, or whether it uses the decisionmaking authority delegated to it primarily for the benefit of other parties. In relation to the various factors to consider in determining whether decision-making authority has been delegated to an agent, paragraph B60 of AASB 10 states: A decision maker shall consider the overall relationship between itself, the investee being managed and other parties involved with the investee, in particular all the factors below, in determining whether it is an agent: (a) the scope of its decision-making authority over the investee (paragraphs B62 and B63). (b) the rights held by other parties (paragraphs B64–B67). (c) the remuneration to which it is entitled in accordance with the remuneration agreement(s) (paragraphs B68–B70). (d) the decision maker’s exposure to variability of returns from other interests that it holds in the investee (paragraphs B71 and B72). Different weightings shall be applied to each of the factors on the basis of particular facts and circumstances. So in summarising the discussion on agency relationships, if an organisation has power over another entity but it is acting as an agent, then the agent is not to consolidate the accounts of the controlled entity. As stated earlier, it is possible for control to be passive—that is, it might be possible to exert control over another entity even though the option to exert such control might never have been exercised. Nevertheless, capacity to control a subsidiary is sufficient to require consolidation of that subsidiary (although there is an exception where the parent entity is an investment entity as discussed earlier in this chapter). Where control is ‘passive’, and perhaps another entity is formulating the policies of the subsidiary, a particular entity would nevertheless be considered to be in ‘control’ to the extent that it ultimately has the ability to modify or change the policies being applied by another entity if it deems it necessary to step in and make such a change. As emphasised earlier in this chapter, by adopting the criterion of control (and not legal form) as the basis for determining the necessity to consolidate, the economic entity may include organisations of a corporate and non-corporate form. That is, adoption of the criterion of control will enable a complete economic entity to be reflected in consolidated financial statements even though, for example, some of the subsidiaries might be in the form of partnerships or trusts. Including entities such as trusts and partnerships in the consolidation process prevents entities from opportunistically omitting certain key (non-corporate) entities from the consolidation process—the practice that was investigated by Sullivan and discussed earlier in this chapter. As we have noted, another necessary attribute of control (see paragraph 15 of AASB 10) is that there is an expectation that the investor will be exposed to variable returns from its involvement with the investee. Specifically, paragraph 15 states:

controlled entity An organisation that is controlled by another entity; often called a subsidiary.

An investor is exposed, or has rights, to variable returns from its involvement with the investee when the investor’s returns from its involvement have the potential to vary as a result of the investee’s performance. The investor’s returns can be only positive, only negative or both positive and negative. This requirement means that parties such as receivers and managers of financially troubled organisations, as well as trustees, would not be required to consolidate a controlled entity’s financial statements with their own statements because, apart from the professional fees being received, those concerned would not be managing such organisations for their own benefit, but on behalf of owners and creditors. 884  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Loss of control As we noted earlier in this chapter, just as control can be established, it can also be lost. That is, a parent entity might subsequently lose control over its subsidiary. It is not necessary for a change in the level of ownership to occur for control to be lost. Once an entity has lost control, the consolidated statement of profit or loss and other comprehensive income is to include only the results of the subsidiary for the period during which control existed. The article by Heather Killen adapted in Financial Accounting in the Real World 25.1  was published while AAS 24—the first accounting standard on consolidations released in Australia—was being developed. It notes some of the benefits associated with compiling consolidated financial statements, many of which we have already discussed. While this article is rather dated, it is useful in understanding some of the issues associated with the development of accounting for economic entities in the Australian context. It also provides an interesting historical perspective on the practice of consolidation accounting.

25.1 FINANCIAL ACCOUNTING IN THE REAL WORLD New accounting standard proposed for consolidation of accounts In the past, various strategies have been used by companies as a means of avoiding a consolidation of all assets and liabilities within their group, which might include trusts and subsidiaries. However, times are changing. The Australian Accounting Research Foundation (the Foundation) has proposed a new accounting standard for consolidation of accounts which has wider provisions than those of the Companies Code in that the standard will apply to both private and public companies, and does not require that a subsidiary be a company. Reporting entities will be required to consolidate their group’s accounts to include those of any entity over which they have control, even if the company does not have a majority shareholding in the other entity. John Miles, the chairman of the Foundation’s Accounting Standards Board, said the proposed standard would overcome the criticism of the Companies Code for not requiring entities to show all liabilities on their financial statements. The concept of control, which has been refined since the issue of the pre-exposure draft a few months ago, will be based on the ability to dominate decision making. Miles said the concept had to be based on economic fact and not on legal form to be successful. The proposed definition in the new standard is: ‘Control means the capacity of an entity to dominate decision making, directly or indirectly, in relation to the financial and operating policies of another entity, so as to enable that entity to operate with it as part of an economic unit in achieving the objectives of the controlling entity’. According to Miles, this control needs to be based on economic fact not legal niceties. The standard will not apply in cases where, although a company may have more than a 50 per cent interest in another entity, it doesn’t control that entity’s decision making. The standard means that a group will have to have consistent accounting practices throughout the group and the same reporting date. Inter-group transactions, including ownership interest by the parent company in its subsidiary, will have to end. Examples of companies that may be affected by the new standard include Adelaide Steamship, the Australian company whose group of interlinking companies have shareholdings in each other of 40 to 50 per cent, and CSR whose Delhi structure of unincorporated entities was created to contain its oil and gas concerns. SOURCE: Adapted from ‘Companies required to bare all under new accounting standard’, by Heather Killen, The Australian Financial Review, 17 June 1988

Direct and indirect control A number of scenarios are possible to illustrate the concept of control. Control can exist by virtue of direct ownership interests, indirect ownership interests, or perhaps a combination of the two. Consider Figure 25.4, which provides an illustration of direct control—in this case Company A’s ownership (and voting) interest

LO 25.7 LO 25.12 LO 25.13

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Figure 25.4 An example of direct control

Company A

70% 30%

Non-controlling Interests

Company B

Figure 25.5 An example of indirect control

Company A

75%

Company B

25%

Non-controlling interests

40%

Non-controlling interests

60%

Company C

in Company B. Company A owns 70 per cent of the issued capital of Company B. This would be expected to lead to Company A having control of B directly. Company A’s 70 per cent voting interest in Company B will also amount to a 70 per cent beneficial interest in the profits being generated by Company B. For example, with a 70 per cent ownership interest in Company B, for each $1 of dividends paid by Company B, 70 cents will go to Company A, while 30 per cent will go to non-controlling interests. The voting interest and beneficial interest will not always be the same, as some of the examples that follow will demonstrate. If we turn our attention to Figure 25.5, we may contemplate the case in which Company A has control of Company C by virtue of its control of Company B. This form of control would be considered to be indirect control—something we referred to earlier in this chapter. Because Company B is considered to control Company C, and because Company A controls Company B, Company A therefore effectively controls Company C even though it has no direct shareholding in Company C. The beneficial interest of Company A in Company C’s profits will equate to 0.75 × 0.60, which equals 45  per cent. That means that for every dollar of dividends paid by Company C, 45 cents will find its way back to Company A. This can be explained as follows: when Company C pays a dividend, 60 per cent of the dividend will flow to Company B. Hence, for every dollar of dividends paid by Company C, 60 cents goes to Company B. If Company B in turn pays this amount to its shareholders, 75 per cent (or 45 cents) will go to Company A, and 25 per cent (or 15 cents) will go to those parties holding the non-controlling interest in Company B. Moving on to Figure 25.6, we can see that control of another entity may also be achieved in a combination of direct and indirect ownership interests. Company A has direct voting interests in Company C of 40 per cent, as well as indirectly controlling 25 per cent of the voting interests through its control of Company B. The economic entity would be considered to be constituted by all three companies. Company A’s beneficial interest in Company C would be 40 per cent, plus 65 per cent of 25 per cent (which equals 16.25 per cent), which amounts to 56.25 per cent in total. 886  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Company A

Non-controlling interests

65%

Non-controlling Interests

40%

35%

35% Company B

25%

Figure 25.6 Situation where control is established through a mix of direct and indirect ownership interests

Company C

Accounting for business combinations To this point we have discussed when we should consolidate particular entities (when they are controlled), but we have not discussed how to actually undertake the consolidation process. We will start addressing this issue within this section. According to AASB 3, a ‘business combination’ is defined as:

LO 25.4 LO 25.5 LO 25.8 LO 25.10

A transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as ‘true mergers’ or ‘mergers of equals’ are also business combinations as that term is used in this Standard. AASB 3 Business Combinations and AASB 10 Consolidated Financial Statements must both be considered when compiling and presenting consolidated financial statements. The objectives of the respective standards are identified within the standards as: AASB 10: The objective of this standard is to establish principles for the preparation and  presentation of consolidated financial statements when an entity controls one or more other entities. AASB 3: The objective of this IFRS is to improve the relevance, reliability and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects. To accomplish that, this IFRS establishes principles and requirements for how the acquirer: (a) recognises and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree; (b) recognises and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and (c) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. As a central requirement, AASB 3 requires an entity to determine whether a transaction or other event is a business combination, as defined above. When we consolidate other entities we are consolidating businesses and we can recognise the goodwill of the business being acquired. This requires that the assets acquired and liabilities assumed constitute a ‘business’. Guidance on what constitutes a business is provided in the Application Guidance accompanying AASB 3. According to paragraph B7 of AASB 3: A business consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business. The three elements of a business are defined as follows: (a) Input: Any economic resource that creates, or has the ability to create, outputs when one or more processes are applied to it. Examples include non-current assets (including intangible assets or rights to use non-current assets), intellectual property, the ability to obtain access to necessary materials or rights and employees. (b) Process: Any system, standard, protocol, convention or rule that when applied to an input or inputs, creates or has the ability to create outputs. Examples include strategic management processes, operational processes and resource management processes. These processes typically are documented, but an CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  887

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organised workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs. (Accounting, billing, payroll and other administrative systems typically are not processes used to create outputs.) (c) Output: The result of inputs and processes applied to those inputs that provide or have the ability to provide a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. If the assets acquired do not fit the description of business considered above, the transaction shall represent the acquisition of a group of assets and the appropriate accounting treatment would be covered by AASB 116 Property, Plant and Equipment and AASB 138 Intangible Assets rather than AASB 3 Business Combinations. If we are not acquiring a business then we would not recognise goodwill. AASB 3 requires entities to account for business combinations using what is referred to as the acquisition method. The acquisition method requires four steps to be taken, these being: 1. identifying the acquirer; 2. determining the acquisition date; 3. recognising and measuring the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree; and 4. recognising and measuring goodwill or a gain from a bargain purchase. These four steps will be considered in turn below.

Identifying the acquirer For each business combination, AASB 3 requires one of the combining entities to be identified as the acquirer. An acquirer might obtain control of an acquiree in a variety of ways. These include:

• • • • •

transferring cash, cash equivalents or other assets (including net assets that constitute a business); incurring liabilities; issuing equity interests; providing more than one type of consideration; or without transferring consideration, including by contract alone.

In a business combination, the acquirer is usually the entity that transfers the cash, cash equivalents or other assets, incurs the liabilities or issues the equity interests. There are, however, occasions where, in some business combinations, known as ‘reverse acquisitions’, the issuing entity is the acquiree. Determining the acquirer in a business combination involving more than two entities shall include a consideration of, among other things, which of the combining entities initiated the combination, as well as the relative size of the combining entities. Where the relative size (measured in, for example, assets, revenues or profit) of one entity is significantly greater than that of the other combining entity or entities, the acquirer is usually the combining entity whose relative size is the greater.

Determining the acquisition date Paragraph 8 of AASB 3 identifies the acquisition date as the date on which the acquirer obtains control of the acquiree. This is usually the date on which the acquirer legally transfers the consideration, acquires the assets and assumes the liabilities of the acquiree—the closing date. However, AASB 3 acknowledges that the acquirer may obtain control on a date other than the closing date.

Recognising and measuring the identifiable assets acquired and the liabilities assumed At the acquisition date, the acquirer is required to recognise: • goodwill separately from the identifiable assets acquired; • the liabilities assumed; and • any non-controlling interest in the acquiree. To qualify for recognition as part of applying the acquisition method, at the acquisition date the identifiable assets acquired and liabilities assumed must meet the definitions of assets and liabilities in the Conceptual Framework for Financial Reporting. 888  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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By applying the recognition principles contained in AASB 3 it is possible for the acquirer to recognise assets and liabilities that the acquiree had not previously recognised in its own financial statements. Examples of assets that may be recognised by the acquirer, but not previously by the acquiree, would include identifiable intangible assets, such as a brand name, a patent, publishing titles, customer lists and so forth. These assets may not have been recognised by the acquiree in its financial statements because it developed them internally and expensed the related costs in the period in which they were incurred, in compliance with AASB 138 Intangible Assets, as explained in Chapter 8 of this text. In Chapter 8 we discussed how certain internally developed intangible assets, such as brand names or publishing titles, shall not be recognised. Specifically, paragraph 63 of AASB 138 states: Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets. However, should another entity (the acquirer) subsequently acquire the business of another entity (the acquiree), then the acquirer is permitted to recognise such assets at their fair value. To the acquiring entity, such assets would not have been ‘internally generated’; rather, they would have been ‘acquired’ as part of the business combination and therefore be eligible for recognition within the consolidated financial statements. The general rule for measuring the identifiable assets acquired and the liabilities assumed is provided by AASB 3. Under paragraph 18, the acquirer measures each identifiable asset acquired (including identifiable intangible assets) and liability assumed, at their acquisition-date fair values. ‘Fair value’ is defined in AASB 3 (and in other accounting standards) as: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (See AASB 13.) Specifically, paragraph 18 of AASB 3 states: The acquirer shall measure the identifiable assets acquired and the liabilities assumed at their acquisition-date fair values. An exception to the recognition principle is contingent liabilities. Contingent liabilities are defined in AASB 137 Provisions, Contingent Liabilities and Contingent Assets as: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability. As indicated in paragraph 23 of AASB 3, the requirements in AASB 137 do not apply in determining which contingent liabilities to recognise at the acquisition date. On acquisition date a contingent liability in a business combination is recognised if it is a present obligation that arises from past events and its fair value can be measured reliably. In other words, a contingent liability is recognised at the acquisition date even if it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation.

Recognising and measuring goodwill Goodwill is defined in AASB 3 Business Combinations as: An asset representing the future economic benefits arising from assets acquired in a business combination that are not individually identified and separately recognised. In the context of business combinations, AASB 3, paragraph 32, requires that: 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 CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  889

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(iii) in a business combination achieved in stages (see paragraphs 41 and 42), the acquisition-date fair value of the acquirer’s 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. This can be simplified as follows: FAIR VALUE OF CONSIDERATION TRANSFERRED plus Amount of non-controlling interest plus Fair value of any previously held equity interest in the acquiree less Fair value of identifiable assets acquired and liabilities assumed GOODWILL ON ACQUISITION DATE

XXX XXX XXX XXX (XXX) XXX

Calculated in the manner shown above, the net figure for goodwill will be a positive number. If the number is negative, then rather than it being considered as goodwill, the amount would be considered as a gain on bargain purchase. As paragraph 34 of AASB 3 states: Occasionally, an acquirer will make a bargain purchase, which is a business combination in which the amount in paragraph 32(b) exceeds the aggregate of the amounts specified in paragraph 32(a). If that excess remains after applying the requirements in paragraph 36, the acquirer shall recognise the resulting gain in profit or loss on the acquisition date. The gain shall be attributed to the acquirer. According to the Basis for Conclusions in IFRS 36 Impairment of Assets, paragraph BC134, goodwill acquired in a business combination represents: a payment made by the acquirer in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognised. Goodwill does not generate cash flows independently of other assets or groups of assets and therefore cannot be measured directly. Instead, it is measured as a residual amount, being the excess of the cost of a business combination over the acquirer’s interest in the net fair value of the acquiree’s identifiable assets, liabilities and contingent liabilities. Moreover, goodwill acquired in a business combination and goodwill generated after that business combination cannot be separately identified, because they contribute jointly to the same cash flows. In determining goodwill, the fair value of both the assets acquired and the liabilities assumed, and the purchase consideration given in exchange must be considered.

Consideration transferred In a business combination the consideration transferred is measured at fair value. AASB 3, paragraph 37, expands on this requirement. AASB 3, paragraph 37, states that the fair value of consideration transferred is calculated as: the sum of the acquisition-date fair values of the assets transferred by the acquirer, the liabilities incurred by the acquirer to former owners of the acquiree and the equity interests issued by the acquirer. The calculation of goodwill in line with the requirements of AASB 3, paragraph 32, is detailed in Worked Example 25.2.

WORKED EXAMPLE 25.2: Calculation of goodwill on acquisition On 1 July 2019, Ying Ltd acquired for cash all of the issued share capital of Yang Ltd for an amount of $650 000. On the date of the acquisition, the assets, liabilities and contingent liabilities of Yang Ltd are as follows:  

Cash Accounts receivable Inventory Land

Carrying amount ($) 15 000 68 000 112 000 360 000

Fair value ($) 15 000 68 000 131 000 420 000

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Plant Loans payable Accounts payable Contingent liabilities

220 000 (170 000) (58 000) –

240 000 (170 000) (58 000) (46 000)

REQUIRED Calculate the goodwill on acquisition. Ignore any deferred tax considerations. SOLUTION The difference between the fair value of the identifiable assets acquired and the liabilities assumed, and the consideration transferred is the goodwill. From the information provided, the goodwill on acquisition date is calculated as follows:   Fair value of consideration transferred less Fair value of identifiable assets acquired and  liabilities assumed Cash Accounts receivable Inventory Land Plant Loans payable Accounts payable Contingent liabilities Total fair value of net assets acquired Goodwill on acquisition date

$

$ 650 000

15 000 68 000 131 000 420 000 240 000 (170 000) (58 000)   (46 000) 600 000   50 000

As Ying Ltd paid cash for the equity interest in Yang Ltd, the fair value of the purchase consideration is easily determined as the amount of cash given in exchange. Based on the fair value of the assets of Yang Ltd, the goodwill acquired by Ying Ltd would be $50 000. Consistent with the requirements of paragraph 48 of AASB 138 Intangible Assets that internally generated goodwill not be recognised as an asset, no goodwill would be brought to account by Yang Ltd (the acquiree) in Worked Example 25.2 as only ‘purchased goodwill’, and not internally generated goodwill, is recognised for accounting purposes. The purchased goodwill may be brought to account by Ying Ltd as part of the consolidation process. The view taken is that although the acquiree might not be able to reliably measure the value of internally generated goodwill, another entity that acquires the entity (the acquirer) is able to attribute reliably a value to goodwill being acquired. In the above example, Yang (the acquirer) was able to attribute a cost of $50 000 to the goodwill. Unlike internally generated goodwill, which may not be brought to account in the separate financial statements of a reporting entity or in the consolidated financial statements, purchased goodwill is to be brought to account in the consolidation process. The goodwill acquired in a business combination is not amortised. Rather, after its initial recognition, goodwill should be measured at cost less any accumulated impairment losses. Impairment testing should be conducted at least annually, but can be performed more frequently if events or changes in circumstances indicate that the goodwill might be impaired. Unlike many other assets, goodwill shall not be revalued. Therefore, impairment losses must be recognised immediately in profit and loss. AASB 136, paragraphs 80 to 99, provides further guidance on impairment testing of goodwill. According to AASB 3, only the goodwill acquired by the parent entity is recognised on consolidation. Where the parent acquires all of the shares of the subsidiary, all of the goodwill of the subsidiary is shown in the consolidated financial statements. However, where the parent does not acquire all the shares—that is, there is a non-controlling interest in the subsidiary (perhaps the parent entity acquired 80 per cent of the issued capital of the subsidiary meaning that the non-controlling interest is 20 per cent), then—AASB 3 permits a parent to recognise either its share of the goodwill only, or to recognise the total goodwill in the consolidated financial statements. That is, a parent has a choice CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  891

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as to whether to disclose goodwill attributable to non-controlling interests. This matter will be considered more fully in Chapter 27, which focuses on various aspects of accounting for non-controlling interests. At this point it should simply be appreciated that parent entities have a choice in how to account for goodwill on acquisition—a choice that was not available within the accounting standards prior to amendments being made in 2008. To undertake the consolidation of the parent and subsidiaries’ financial statements, a worksheet is typically used (as will be shown here). It is usual to set up the worksheet so that the entities to be consolidated are arranged side by side in the left-hand columns. To the right there are debit and credit columns for the consolidation adjustment entries. A final column on the right-hand side of the worksheet will provide the consolidated figures to then be used to compile the consolidated financial statements. What should also be noted is that the individual account balances included in the ledgers of the separate legal entities are not adjusted as a result of consolidating the financial statements of the various entities within the group. The consolidation entries are made outside of their individual ledgers. The consolidation journal entries are written into a consolidation journal and are then typically posted to a consolidation worksheet. A new worksheet is prepared each time consolidated financial statements are required. As indicated above, the consolidation worksheet provides the numbers that are used directly to construct the consolidated financial statements. This is a VERY IMPORTANT point to remember.

Group members to use consistent accounting policies When consolidated financial statements are being prepared, they are required to be prepared on the basis that all entities within the group are adopting the same accounting policies. Where separate entities do not apply the same accounting methods, adjustments are necessary on consolidation to remove the impact of different accounting policies. As AASB 10, paragraphs 19 and B87, state: 19. A parent shall prepare consolidated financial statements using uniform accounting policies for like transactions and other events in similar circumstances. B87. If a member of the group uses accounting policies other than those adopted in the consolidated financial statements for like transactions and events in similar circumstances, appropriate adjustments are made to that group member’s financial statements in preparing the consolidated financial statements to ensure conformity with the group’s accounting policies. The ends of the reporting periods of all the entities in the group are also expected to be the same. Where this is not possible, adjustments will be required on consolidation. However, adjustments are possible only if the different ends of reporting periods are reasonably close together; for example, no more than three months apart.

Eliminating parent’s investment in subsidiary The first step in the consolidation process is substituting the assets and liabilities of the subsidiary for the investment account that currently exists within the financial statement of the parent company. Where the fair value of the net assets (inclusive of an amount attributed to contingent liabilities) does not equal the fair value of the investment, this will lead to a difference on consolidation. This difference will either be goodwill, or a bargain gain on purchase. (In Worked Example 25.3, it will lead to a difference of $20 000, this being the goodwill acquired.) The investment account will be eliminated in full against the pre-acquisition equity of the subsidiary. This will avoid double counting of the assets, liabilities and equity of Subsidiary Ltd. AASB 10 details a number of the procedures required in preparing consolidated financial statements (some, but not all, of which will be considered in this chapter). Paragraphs B86–B99 set out guidance for the preparation of consolidated financial statements. Some of these paragraphs, to the extent they are relevant to the material covered in this chapter, are reproduced below: B86 Consolidated financial statements: (a) combine like items of assets, liabilities, equity, income, expenses and cash flows of the parent with those of its subsidiaries. (b) offset (eliminate) the carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary (AASB 3 explains how to account for any related goodwill). (c) eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full). Intragroup 892  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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losses may indicate an impairment that requires recognition in the consolidated financial statements. AASB 112 Income Taxes applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions. B88 An entity includes the income and expenses of a subsidiary in the consolidated financial statements from the date it gains control until the date when the entity ceases to control the subsidiary. Income and expenses of the subsidiary are based on the amounts of the assets and liabilities recognised in the consolidated financial statements at the acquisition date. For example, depreciation expense recognised in the consolidated statement of profit or loss and other comprehensive income after the acquisition date is based on the fair values of the related depreciable assets recognised in the consolidated financial statements at the acquisition date. We start our consolidation illustrations with a simple case in which one company acquires a 100 per cent interest in another company, and the consolidation is undertaken immediately subsequent to the share acquisition. This is shown in Worked Example 25.3.

WORKED EXAMPLE 25.3: A simple consolidation Parent Ltd acquires all of the issued capital of Subsidiary Ltd for a cash payment of $500 000 on 30 June 2019. The statements of financial position of both entities immediately following the purchase are:

Current assets Cash Accounts receivable Non-current assets Plant Land Investment in Subsidiary Ltd

Current liabilities Accounts payable Non-current liabilities Loans Shareholders’ equity Share capital Retained earnings

Parent Ltd ($000)

Subsidiary Ltd ($000)

10 150

5 55

800 200    500 1 660

500 100      – 660

Parent Ltd ($000)

Subsidiary Ltd ($000)

60

30

400

150

1 000    200 1 660

200 280 660

REQUIRED Provide the consolidated statement of financial position for Parent Ltd and Subsidiary Ltd as at 30 June 2019. We will provide the answers to this Worked Example in the text that follows as we explain associated consolidation processes.

Determination of goodwill Paragraph 52 of AASB 3 states that: Goodwill acquired in a business combination represents a payment made by the acquirer in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognised. CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  893

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As this is a simple consolidation at the date of acquisition, and as the parent has acquired 100 per cent of the subsidiary, there is no need to consider the amount of the non-controlling interest and the fair value of any previously held equity interest in the acquiree. These issues will be considered in the chapters that follow. In determining the amount of goodwill acquired, as indicated above, consideration needs to be given to the fair value of the assets acquired. Fair value measurement is addressed in AASB 13 Fair Value Measurement, and other accounting standards that require the use of fair values therefore require the preparer of the financial statements to also refer to the requirements embodied within AASB 13. Fair value is defined in AASB 13, and therefore also within other accounting relevant standards (including AASB 3), as: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The above definition makes use of two key terms in determining fair value, these being ‘orderly transaction’ and ‘market participants’. If certain conditions do not exist, then the resulting transaction cannot be deemed to have been at fair value. In relation to the expectations relating to an ‘orderly transaction’ AASB 13 defines an orderly transaction as: A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g. a forced liquidation or distress sale). In relation to the attributes of the ‘market participants’ that must exist before a transaction can be deemed to have taken place at ‘fair value’, AASB 13 defines market participants as: Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics: (a) They are independent of each other, ie they are not related parties as defined in AASB 124, although the price in a related party transaction may be used as an input to a fair value measurement if the entity has evidence that the transaction was entered into at market terms. (b) They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary. (c) They are able to enter into a transaction for the asset or liability. (d) They are willing to enter into a transaction for the asset or liability, ie they are motivated but not forced or otherwise compelled to do so.

purchased goodwill Goodwill that has been acquired through a transaction with an external party, as opposed to goodwill that is generated by the reporting entity itself. In Australia purchased goodwill must be shown as an asset of the reporting entity.

internally generated goodwill Goodwill that is generated by the reporting entity itself, not purchased from an external entity.

Returning to the accounting procedures required in consolidation, we must consider the fair value of both the assets acquired, and the purchase consideration given in exchange. For example, as Parent Ltd pays cash for the equity interest in Subsidiary Ltd, the fair value of the purchase consideration is easily determined as the amount of cash given in exchange. If we assume that the assets in Subsidiary Ltd are fairly valued, and there are no contingent liabilities to consider, then goodwill acquired by Parent Ltd would be determined as: Fair value of purchase consideration

$500 000

Less Fair value of identifiable assets acquired and liabilities assumed

$480 000

Goodwill on acquisition

  $20 000

As we know from previous discussions in this chapter and in Chapter 8, goodwill cannot be brought to account by Subsidiary Ltd, as only purchased goodwill and not internally generated goodwill is permitted to be recognised for accounting purposes. However, it may be brought to account by Parent Ltd as part of the consolidation process. That is, the consolidated statement of financial position will show goodwill of $20 000. To undertake the consolidation of the parent and subsidiaries’ financial statements, a worksheet is typically used. We call this a consolidation worksheet. It is usual to set up the worksheet so that the entities to be consolidated are arranged side by side in the left-hand columns. To the right we have debit and credit columns for the consolidation adjustment entries. It should be noted once again—and this is a VERY IMPORTANT point—that we ARE NOT altering the account balances in the ledgers of the separate legal entities. The consolidation entries are

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made outside of the individual ledgers of the respective entities. The consolidation journal entries are written into a consolidation journal and are then typically posted to a consolidation worksheet, which is prepared each time consolidated financial statements are required. The consolidation worksheet provides the numbers that are used directly to construct the consolidated financial statements. The consolidation entry to eliminate the investment in Subsidiary Ltd would be: Dr Share capital 200 000   Dr Retained earnings 280 000 Dr Goodwill 20 000 Cr Investment in Subsidiary Ltd (to eliminate the investment in Subsidiary Ltd and to recognise the goodwill on acquisition)

500 000

The above entry would be posted to the consolidation worksheet and the final column of the worksheet would provide the information to present the consolidated statement of financial position. The above entry is not made in the journal of either Parent Ltd or Subsidiary Ltd but rather in a separate consolidation journal, which is then posted to the consolidation worksheet. A review of the consolidation worksheet below reveals the following points about the worksheet: • The first column provides the names of the accounts that will be recognised in the consolidation process. • The second and third columns represent the account balances of the individual entities. There are only two columns here because there are only two entities involved in the group. Additional columns would be required for each additional subsidiary in the group. • The following two columns are then provided for the consolidation eliminations and adjustments. These adjustments will be in journal entry form, with the journal entries often being made in a separate consolidation journal. Remember that these consolidation entries are not made in the accounts of the separate entities and the consolidation eliminations and adjustments do not impact on the amounts shown in the ledger accounts of the separate entities making up the group. Because the adjustments are not recorded in the accounts of the individual entities, where consolidated financial statements are prepared over a number of periods there will be a need every year to repeat certain consolidation adjustments and eliminations such as the entry that eliminates pre-acquisition share capital and reserves of the subsidiaries. • The final column on the right-hand side of the worksheet represents the information that will be used directly to construct the consolidated financial statements. The numbers are derived by working across the worksheet and taking account of the various eliminations and adjustments. Again, it should be emphasised that the consolidated financial statements are drawn up from the worksheet. There is no ledger as there would be for the separate entities in the group. Consolidation worksheet for Parent Ltd and its controlled entity for the period ending 30 June 2019  

Current assets Cash Accounts receivable Non-current assets Plant Land Investment in Subsidiary Ltd Goodwill on acquisition

 

 

Eliminations and adjustments Dr ($000)

Cr ($000)

Consolidated statement ($000)

Parent Ltd ($000)

Subsidiary Ltd ($000)

10 150

5 55

15 205

800 200 500       – 1 660

500 100 –      – 660

1 300 300 –     20 1 840

500 20

continued CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  895

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Current liabilities Accounts payable Non-current liabilities Loans Shareholders’ equity Share capital Retained earnings

 

 

Eliminations and adjustments Dr ($000)

Subsidiary Ltd ($000)

60

30

90

400

150

550

1 000   200 1 660

200  280 660

200  280 500

Cr ($000)

Consolidated statement ($000)

Parent Ltd ($000)

        500

1 000   200 1 840

A review of the data to be included in the consolidated statement of financial position (the right-hand column) provides some useful information. It reveals that the economic entity controls assets with a total value of $1.84 million and that it has liabilities to parties external to the group totalling $640 000. The consolidated statement of financial position would appear as follows: Consolidated statement of financial position for Parent Ltd and its controlled entity as at 30 June 2019  

Parent entity ($000)

Group ($000)

10    150    160

15   205   220

800 200 500        – 1 500  1 660

1 300 300 –     20  1 620  1 840

    60

    90

  400   460 1 200

  550   640 1 200

1 000   200 1 200

1 000   200 1 200

Current assets Cash Accounts receivable Non-current assets Plant Land Investment in Subsidiary Ltd Goodwill Total assets Current liabilities Accounts payable Non-current liabilities Loans Total liabilities Net assets Represented by: Shareholders’ equity Share capital Retained earnings

Because the consolidated statement of financial position is prepared immediately after the acquisition, it does not include any share capital or reserves of the subsidiary given that all pre-acquisition share capital and reserves were eliminated on consolidation. Only the parent’s pre-acquisition share capital and reserves will be shown. In subsequent periods the consolidated retained earnings will include the post-acquisition earnings of the subsidiary. 896  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Gain on bargain purchase

LO 25.4 LO 25.9

Although not common, it is possible for a company to gain control of an entity for an amount less than the fair value of the proportional share of the identifiable assets acquired and the liabilities assumed. Bargain purchases are considered to be anomalous transactions because business entities and their owners generally do not knowingly and willingly sell assets or businesses at prices below their fair values. However, a number of circumstances exist where bargain purchases occur. These include a forced liquidation or distress sale (for example, after the death of a founder or key manager) in which owners need to sell a business quickly, which may result in a price less than fair value. A gain arising from a bargain purchase occurs when the acquisition-date fair values of the identifiable assets acquired and liabilities assumed exceeds the acquisition-date fair value of the consideration transferred plus the amount of any non-controlling interest in the acquiree plus the acquisition-date fair value of the acquiree’s previously held equity interest in the acquiree. When a bargain purchase occurs, the acquirer recognises a gain in the profit or loss on the acquisition date. Before a gain on a bargain purchase is recognised, AASB 3, paragraph 36, requires that: the acquirer shall reassess whether it has correctly identified all of the assets acquired and all of the liabilities assumed and shall recognise any additional assets or liabilities that are identified in that review. The acquirer shall then review the procedures used to measure the amounts this Standard requires to be recognised at the acquisition date for all of the following: (a) the identifiable assets acquired and liabilities assumed; (b) the non-controlling interest in the acquiree, if any; (c) for a business combination achieved in stages, the acquirer’s previously held equity interest in the acquiree; and (d) the consideration transferred. The objective of the review is to ensure that the measurements appropriately reflect consideration of all available information as of the acquisition date. An example of a gain on bargain purchase is provided in Worked Example 25.4.

WORKED EXAMPLE 25.4: Acquisition of a subsidiary at a discount Assume the same information as in Worked Example 25.3, except that this time Parent Ltd acquires Subsidiary Ltd for $400 000. Fair value of purchase consideration Fair value of net assets acquired Gain on bargain purchase

$400 000 $480 000   $80 000

REQUIRED Provide the consolidation worksheet for Parent Ltd and its controlled entity for the year ending 30 June 2019. SOLUTION As stated above, and in accordance with AASB 3, to the extent that a reassessment of the identification and measurement of the acquiree’s identifiable assets, liabilities and contingent liabilities and measurement of the cost of the combination indicates that the values attributable to the acquisition are reasonable, any excess is to be treated as a gain on bargain purchase, and included in the profit or loss for the reporting period. Where Parent Ltd has acquired Subsidiary Ltd for $400 000, the elimination of the investment in Subsidiary Ltd would be recorded as: Dr Share capital 200 000   Dr Retained earnings 280 000 Cr Gain on bargain purchase 80 000 Cr Investment in Subsidiary Ltd 400 000 (to eliminate the investment in Subsidiary Ltd and to recognise the bargain purchase on acquisition) continued CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  897

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Consolidation worksheet for Parent Ltd and its controlled entity for the year ending 30 June 2019  

 

Current assets Cash Accounts receivable Non-current assets Plant Land Investment in Subsidiary Ltd Current liabilities Accounts payable Non-current liabilities Loans Shareholders’ equity Share capital Retained earnings

Eliminations and adjustments

 

Dr ($000)

Cr ($000)

  Consolidated statement ($000)

Parent Ltd ($000)

Subsidiary Ltd ($000)

110 150

5 55

115 205

800 200

500 100

1 300 300

   400 1 660

     – 660

60

30

90

400

150

550

1 000    200 1 660

200 280 660

400

200 280 480

   80 480

     – 1 920

1 000   280 1 920

Note 1: When completing a consolidation worksheet, the aggregate of the debits in the eliminations and adjustments columns should equal the aggregate of the credits. Note 2: In this worked example, the gain has been taken directly to retained earnings in the absence of a consolidated statement of profit or loss and other comprehensive income. The gain would be included in the period’s profits.

LO 25.4 LO 25.5

Subsidiary’s assets not recorded at fair values

As has been established, on acquisition date, goodwill is measured as the acquisition-date fair value of the consideration transferred plus the amount of any non-controlling interest in the acquiree plus the acquisitiondate fair value of the acquiree’s previously held equity interest in the acquiree less the acquisition-date fair values of the identifiable assets acquired and liabilities assumed. Frequently, a subsidiary’s assets are not recorded at fair value (perhaps the subsidiary uses the cost model to account for its property, plant and equipment), hence adjustments will be required so that a reliable figure for goodwill (or the bargain on a purchase) can be calculated. As AASB 3 indicates, if at acquisition the subsidiary’s assets are not recorded at fair value we can either revalue the identifiable assets in the accounting records of the subsidiary before consolidation, or we can recognise the necessary adjustments on consolidation. In undertaking the revaluations we would need to consider the requirements pertaining to revaluations as stipulated in AASB 116 Property, Plant and Equipment and AASB 138 Intangible Assets. As we know from Chapter 8, there are some major restrictions in relation to upward revaluations of intangible assets. A further consideration is that where non-current assets are revalued upwards, an adjustment for deferred tax should also be made in accordance with AASB 112. Further details in respect of this can be found in Chapter 18. With the first approach, all of the non-current assets of the subsidiary would be revalued to their fair values in the accounting records of the subsidiary in accordance with AASB 116 and AASB 138. This would require the following

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entry to be made in the accounting records of the subsidiary (which would need some cooperation from the subsidiary, which might not always be forthcoming prior to acquisition): Dr Non-current assets XX Cr Revaluation surplus Cr Deferred tax liability (revaluing assets to fair value and recognising deferred tax)

  XX XX

With the second approach—where we recognise the increment in the value of the assets in the consolidation process rather than in the accounts of the subsidiary—the above entry would be made in the consolidation worksheet. Following the entries to recognise the fair value of the non-current assets (either in the books of the subsidiary or in the consolidation worksheet), a consolidation entry would be processed to eliminate the investment and the corresponding equity in the subsidiary. The equity in the subsidiary would include the revaluation surplus, that is, it would be treated the same as other pre-acquisition capital and reserve accounts. This might require the following entries on consolidation: Dr Share capital XX   Dr Retained earnings XX Dr Revaluation surplus XX Dr Goodwill XX Cr Investment in subsidiary XX (eliminating the investment in subsidiary, as well as the revaluation surplus created in the previous entry)

Worked Example 25.5 provides the entries necessary to account for the assets of a subsidiary when those assets are not recorded at fair value at the date of acquisition.

WORKED EXAMPLE 25.5: Consolidation where subsidiary’s assets are not recorded at fair value Assume the same information as provided in Worked Example 25.3, except this time Parent Ltd acquires Subsidiary Ltd for $550 000. At this date, all assets were fairly valued except for land, which had a fair value of $130 000. The tax rate is 30 per cent. REQUIRED Provide the journal entries necessary to consolidate Parent Ltd and its controlled entity for the year ended 30 June 2019, assuming: (a) Subsidiary Ltd revalued its land (b) Subsidiary Ltd did not revalue its land. SOLUTION (a) As we explained in Chapter 18, an entity revaluing its non-current assets creates a tax effect, which needs to be recognised in accordance with AASB 112 Income Taxes (you may need to go back and read Chapter 18 if you have forgotten the requirements of tax-effect accounting). The revaluation creates a difference between the carrying amount and the tax base of the asset, which in turn creates a deferred tax difference.   If Subsidiary Ltd revalued its land at the date of its acquisition by Parent Ltd, and with a tax rate of 30 per cent, the journal entry in the books of Subsidiary Ltd would have been: 30 June 2019 Dr Land 30 000   Cr Revaluation surplus 21 000 Cr Deferred tax liability 9 000 (revaluing the asset to fair value and recognising the associated deferred tax liability) As the revaluation surplus is part of pre-acquisition reserves of the subsidiary (because the revaluation relates to increases in fair value up until the point in time when the parent entity acquires the interest in continued CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  899

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the subsidiary), it needs to be taken into account when calculating goodwill. Goodwill is calculated to be $49 000, determined as follows: Share capital

$200 000

Retained earnings

$280 000

Revaluation surplus

  $21 000

Total pre-acquisition capital and reserves

$501 000

Fair value of consideration

$550 000

Goodwill

  $49 000

From the above workings, the consolidation entry to eliminate the investment in Subsidiary Ltd would be: 30 June 2019 Dr

Share capital

200 000

Dr

Retained earnings

280 000

Dr

Revaluation surplus

21 000

Dr

Goodwill

49 000

Cr

Investment in Subsidiary Ltd

 

550 000

It should be noted that when a consolidation adjustment is made to depreciable assets, a consolidation journal entry is required to adjust future depreciation expenses. This is considered in more detail in Chapter 26. (b) Had Subsidiary Ltd chosen not to revalue its land when it was acquired by Parent Ltd, Parent Ltd would still have needed to make an adjustment to recognise the actual value of land purchased by it when the equity was acquired. It would have been necessary for the revaluation to have been made as a consolidation adjustment prior to the elimination of the pre-acquisition share capital and reserves of Subsidiary Ltd. This would create a revaluation surplus in the consolidation worksheet, which would be treated as a pre-acquisition reserve of the subsidiary. The above entry would be required.

Subsidiary’s assets not recorded at fair value at date of acquisition together with a gain on bargain purchase It is possible, even if the assets of the subsidiary are recognised at their fair value at the date of acquisition, for a gain to result on acquisition. Where there is a gain on bargain purchase, this shall be recognised as a gain in the statement of profit or loss and other comprehensive income in the period in which the acquisition occurred. Any depreciable non-monetary assets should be depreciated at their cost to the economic entity. A comparison of the depreciation charge in the books of the subsidiary with the amount required in the consolidated financial statements will provide the amount of the adjustment. In Worked Example 25.6 we consider the joint situation where a gain on bargain purchase is calculated following a fair value adjustment being undertaken in relation to a subsidiary’s assets.

WORKED EXAMPLE 25.6: Revaluation to fair value with a resulting gain on bargain purchase On 30 June 2019 Kite Ltd acquired 100 per cent of the issued capital of Surfer Ltd for $3 920 000. At that date, the statement of financial position of Surfer Ltd showed share capital and reserves of: Share capital Retained earnings Total share capital and reserves

$2 500 000    $900 000 $3 400 000

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At the date of acquisition, the statements of financial position of Kite Ltd and Surfer Ltd were as follows:  

Kite Ltd ($000)

Surfer Ltd ($000)

15

6

   175

     64

   190

     70

Land

2 890

2 700

Plant and equipment

1 905

900

Investment in Surfer Ltd

3 920

        –

8 715

3 600

8 905

3 670

   140

     55

Loans

1 145

   215

Total liabilities

1 285

   270

Net assets

7 620

3 400

Current assets Cash Accounts receivable Non-current assets

Total assets Current liabilities Accounts payable Non-current liabilities

Shareholders’ equity Share capital

5 500

2 500

Retained earnings

2 120 7 620

   900 3 400

Additional information • At the date of acquisition, all of the assets acquired and the liabilities assumed were valued at fair value except certain non-monetary assets that have the following fair values: Carrying amount

Fair value

Land

2 700 000

3 200 000

Plant at cost

3 700 000

1 300 000

Accumulated depreciation

(2 800 000)

 

    900 000 • The plant and equipment of Surfer Ltd is expected to have a remaining useful life of four years and no residual value. • The tax rate is 30 per cent. REQUIRED (i) Prepare the consolidation journal entries necessary to consolidate Kite Ltd and Surfer Ltd at 30  June 2019 assuming that Surfer Ltd did not revalue its non-monetary assets in its own financial statements as at the date of the acquisition. Prepare the consolidated statement of financial position. (ii) Assuming that the plant will be depreciated on the straight-line basis over its remaining useful life of four years, prepare the consolidation journal entries at 30 June 2020 to account for the depreciation. continued

CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  901

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SOLUTION (i)

Consolidation journal entries 30 June 2019 (a)     (b)   (c)    

Dr Cr Cr Dr Cr Dr Cr Cr

Land Revaluation surplus Deferred tax liability Accumulated depreciation Plant Plant Revaluation surplus Deferred tax liability

500 000

  350 000 150 000

2 800 000 2 800 000 400 000 280 000 120 000

Having revalued the assets, and therefore having restated the pre-acquisition reserves of the subsidiary, we can determine the goodwill or gain on bargain purchase as follows:            

           

Share capital Retained earnings Revaluation surplus Total pre-acquisition capital and reserves Cost of investment in Surfer Ltd Gain on bargain purchase

2 500 000 900 000   630 000 4 030 000 3 920 000   110 000

(d)        

Dr Dr Dr Cr Cr

Share capital Retained earnings Revaluation surplus Gain on bargain purchase of Surfer Investment in Surfer

2 500 000 900 000 630 000

             

110 000 3 920 000

As we can see from the above journal entries, the entire revaluation surplus that was created in entries (a) and (c) above is then eliminated in entry (d). It is therefore effectively being used so that we can attribute appropriate valuations (fair value) to the identifiable assets (in this case, plant and land) as well as to goodwill. What some organisations do, by contrast, is to accumulate these valuation adjustments in a temporary account entitled something like ‘business combination valuation reserve’. That is, rather than using the revaluation surplus account that would subsequently be eliminated they would use an alternatively titled ‘business combination valuation reserve’ that would subsequently be eliminated. Within this text we will not utilise a ‘business combination valuation reserve’, but readers should be aware that some organisations do use such an account. Consolidation worksheet for Kite Ltd and its controlled entity for the period ending 30 June 2019  

Retained earnings Share capital Revaluation surplus Current liabilities Accounts payable

 

 

Kite Ltd ($000) 2 120 5 500

Surfer Ltd ($000) 900 2 500

140

Eliminations and adjustments Dr ($000) 900(d) 2 500(d) 630(d)

55

Cr ($000) 110(d) 350(a), 280(c)

Consolidated statement of financial position ($000) 2 230 5 500 –

195

902  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Non-current liabilities Deferred tax liability Loans Current assets Cash Accounts receivable Non-current assets Plant Accumulated depreciation Land Investment in Surfer Ltd

150(a), 120(c)

270

1 145 8 905

    215 3 670

1 360 9 555

15 175

6 64

21 239

4 000 (2 095) 2 890 3 920 8 905

3 700 (2 800) 2 700         – 3 670

400(c) 2 800(b) 500(a)          7 730

2 800(b)

3 920(d) 7 730

5 300 (2 095) 6 090         – 9 555

(ii) Additional depreciation expense adjustment at 30 June 2020 (one year later) While the carrying amount of the asset in the accounts of Surfer Ltd was $900 000 (with remaining depreciation of $225 000 per year), the asset is measured at its fair value of $1 300 000 in the consolidated financial statements (which means a related depreciation of $325 000 per year). Hence, from the group’s perspective we need to increase depreciation by $100 000 per year. Fair value of plant acquired Carrying amount of plant in accounting records of Surfer Ltd Additional depreciation to be recognised in total over next 4 years Additional depreciation per year ($400 000 ÷ 4)

$1 300 000 $900 000 $400 000 $100 000

30 June 2020—consolidation journal entries to recognise additional depreciation expense Dr Cr Dr Cr

Depreciation expense Accumulated depreciation—plant Deferred tax liability Income tax expense

100 000

  100 000

30 000 30 000

The additional depreciation charge results from the additional amount paid by Kite Ltd for the item of plant. As the value of the asset is recovered through use, the deferred tax liability recognised at the date of acquisition, 30 June 2019, which was $120 000, is reversed. At the end of four years, the remaining useful life of the item of plant, the balance of the deferred tax liability, will be $nil (it will be reduced by $30 000 each year). It should also be noted that the consolidated journal entries performed in 2019 would also need to be repeated in 2020.

Previously unrecognised identifiable intangible assets

LO 25.5 LO 25.10

In the above examples we assumed that the subsidiary did not have any other assets that existed at acquisition but were precluded from being recognised in the subsidiary’s financial statements. As we know, many internally generated intangible assets are not permitted to be recognised by the entity creating the asset. For example, if an organisation had expended considerable resources developing a particular publishing title, for example, a leading novel, then while the title would be considered an identifiable intangible asset, because it had been internally developed it could not be recognised as an asset for financial statement purposes. This is consistent with paragraph 63 of AASB 138, which states: Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets. CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  903

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However, if another entity acquired the entity with the unrecognised identifiable intangible assets, on consolidation the publishing title would be recognised at fair value. This is consistent with the general recognition criteria within AASB 3 (paragraph 10), which states: As of the acquisition date, the acquirer shall recognise, separately from goodwill, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree. Recognition of identifiable assets acquired and liabilities assumed is subject to the conditions specified in paragraphs 11 and 12. As we also know, and in accordance with paragraph 18 of AASB 3, the acquirer shall measure the identifiable assets acquired at their acquisition-date fair values. Paragraph 24 of AASB 3 also notes that the acquirer shall recognise a deferred tax liability, or asset, arising from assets acquired in a business combination. Once fair values have been attributed to all identifiable assets acquired in a business combination—including those intangible assets that had previously been unrecognised within the financial statements of the subsidiary—any excess of the fair value of the purchase consideration over the fair value of the net assets acquired would then be considered to be of the nature of goodwill. Consider Worked Example 25.7 below:

WORKED EXAMPLE 25.7: Recognition on consolidation of previously unrecognised identifiable intangible assets On 30 June 2019 Larry Ltd acquired 100 per cent of the issued capital of Blair Ltd for $4 000 000. At that date, the statement of financial position of Blair Ltd showed share capital and reserves of: Share capital Retained earnings Total share capital and reserves

$3 000 000    $400 000 $3 400 000

At the date of acquisition, the statements of financial position of Larry Ltd and Blair Ltd were as follows:   Current assets Cash Accounts receivable Non-current assets Land Plant and equipment Investment in Blair Ltd Total assets Current liabilities Accounts payable Non-current liabilities Loans Total liabilities Net assets Shareholders’ equity Share capital Retained earnings

Larry Ltd ($000)

Blair Ltd ($000)

100    200    300

25     45      70

3 500 1 700 4 000 9 200 9 500

3 000 600        – 3 600 3 670

   100

     50

1 400 1 500 8 000

   220    270 3 400

5 500 2 500 8 000

3 000    400 3 400

Additional information • At the date of acquisition, all of the assets acquired and the liabilities assumed were valued at fair value. • Blair Ltd had a successful publishing title that had a fair value of $400 000 at 30 June 2019, but which had been internally developed and therefore was not recognised in its statement of financial position. • The tax rate is 30 per cent.

904  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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REQUIRED Prepare the consolidation journal entries necessary to consolidate Larry Ltd and Blair Ltd at 30 June 2019. Prepare the consolidated statement of financial position. SOLUTION Determination of goodwill Share capital Retained earnings Total pre-acquisition capital and reserves Cost of investment in Surfer Ltd

3 000 000    400 000 3 400 000 4 000 000 600 000    280 000

Less: Fair value of publishing title (net of associated deferred tax liability of $120 000, which equals $400 000 × 0.30) Goodwill

   320 000

Consolidation journal entries Dr Dr Dr Dr Cr Cr

Share capital Retained earnings Publishing title Goodwill Deferred tax liability Investment in Blair Ltd

3 000 000 400 000 400 000 320 000

 

120 000 4 000 000

Consolidation worksheet for Larry Ltd and its controlled entity for the period ending 30 June 2019  

Retained earnings Share capital Current liabilities Accounts payable Non-current liabilities Deferred tax liability Loans Current assets Cash Accounts receivable Non-current assets Plant Land Publishing title Goodwill Investment in Surfer Ltd

 

 

Eliminations and adjustments

Larry Ltd ($000)

Blair Ltd ($000)

Dr ($000)

2 500 5 500

400 3 000

400 3 000

100

50

Cr ($000)

 Consolidated statement of financial position ($000) 2 500 5 500 150

120 1 400 9 500

   220 3 670

120 1 620 9 890

100 200

25 45

125 245

1 700 3 500

600 3 000

2 300 6 500 400 320

400 320 4 000 9 500

       – 3 670

          4 120

4 000 4 120

       – 9 890

CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  905

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LO 25.4

Consolidation after date of acquisition

As we have noted, the pre-acquisition shareholders’ funds of the subsidiary are eliminated on consolidation (against the investment in the subsidiary). This then typically provides goodwill on consolidation (which is, in effect, a balancing item). Occasionally it will result in a gain on bargain purchase. In the period following acquisition, the subsidiary will generate profits or losses. To the extent that these results have been generated in the period after acquisition, and therefore reflect, in part, Pre-acquisition shareholders’ funds the efforts of the management team of the parent entity, they should be reflected in the results of the Shareholders’ funds that economic entity. That is, unlike pre-acquisition earnings, post-acquisition earnings of the subsidiary were in existence in are considered to be part of the earnings of the economic entity (the group of entities) and are an organisation before not eliminated on consolidation. Accounting post-acquisition is examined more closely in Worked an entity acquired an Example 25.8. ownership interest in that organisation.

WORKED EXAMPLE 25.8: Consolidation in a period subsequent to the acquisition of the subsidiary Assume the same facts as in Worked Example 25.3, in which Parent Ltd acquires all the shares in Subsidiary Ltd for $500 000 on 30 June 2019, leading to goodwill of $20 000 being recognised. We will assume that there is no tax to be paid, and that there are no intragroup transactions. The accounts for Parent Ltd and Subsidiary Ltd at 30 June 2020 (one year after acquisition) are provided here. Reconciliation of opening and closing retained earnings   Sales revenue Cost of goods sold Other expenses Profit Retained earnings opening balance Retained earnings—30 June 2020

Parent Ltd ($000)

Subsidiary Ltd ($000)

300 (100)   (60) 140  200  340

100 (40)  (30) 30 280 310

Parent Ltd ($000)

Subsidiary Ltd ($000)

340 1 000

310 200

60

40

   600 2 000

250 800

50 250

25 75

200 1 000    500 2 000

100 600      – 800

Statements of financial position as at 30 June 2020   Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Non-current assets Land Plant Investment in Subsidiary Ltd

906  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Additional information Directors have determined that goodwill acquired in 2019 has been impaired by $5000, so that its value at 30 June 2020 is $15 000. There are no intragroup transactions. REQUIRED Prepare the consolidation worksheet for Parent Ltd and its controlled entity as at 30 June 2020. SOLUTION There are three parts to preparing the consolidation worksheet for Parent Ltd and Subsidiary Ltd. (a) Elimination of investment We need to perform the same entry to eliminate the investment as we did in the previous year. This is an IMPORTANT point to remember. As we are performing the consolidation in a worksheet and as we DO NOT adjust the ledger accounts of the individual legal entities making up the economic entity, the effects of past consolidation adjustments and eliminations are not incorporated in any opening balances and need to be replicated across successive years. Dr Share capital 200 000   Dr Retained earnings 280 000 Dr Goodwill 20 000 Cr Investment in Subsidiary Ltd 500 000 (to eliminate the investment in Subsidiary Ltd and to recognise the goodwill on acquisition) (b) Impairment of goodwill AASB 136 requires us to consider whether goodwill acquired is subsequently impaired. In this illustration we have assumed that goodwill is the subject of an impairment loss, hence the adjusting entries for goodwill are: Dr Impairment loss—goodwill Cr Accumulated impairment—goodwill (to recognise the impairment loss for 2020)

5000

  5000

(c) Preparation of worksheet Consolidation worksheet for Parent Ltd and its controlled entity for the period ending 30 June 2020  

Reconciliation of opening and closing retained earnings Sales revenue Cost of goods sold Other expenses Profit Retained earnings opening balance Retained earnings closing balance Statements of financial position Retained earnings—30 June 2020 Share capital Current liabilities Accounts payable Non-current liabilities Loans

 

 

Eliminations and adjustments Dr ($000)

Parent Ltd ($000)

Subsidiary Ltd ($000)

300 (100)    (60) 140    200    340

100 (40)  (30) 30 280 310

340 1 000

310 200

60

40

100

   600 2 000

250 800

   850 2 315

5(b) 280(a)

200(a)

Cr ($000)

Consolidated statement ($000)

400 (140)    (95) 165    200    365 365 1 000

continued CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  907

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Current assets Cash Accounts receivable Non-current assets Plant Land Investment in Subsidiary Ltd Goodwill on acquisition Accum. impairment—goodwill

 

Eliminations and adjustments Dr ($000)

Cr ($000)

Consolidated statement ($000)

Parent Ltd ($000)

Subsidiary Ltd ($000)

50 250

25 75

75 325

1 000 200 500 –        – 2 000

600 100 – – – 800

1 600 300 – 20     (5) 2 315

500(a) 20(a) – 505

  5(b) 505

As can be seen from the above worksheet, the consolidated retained earnings balance at the end of the 2020 financial year will equal the parent entity’s retained earnings, plus the post-acquisition earnings of the controlled entity. You will notice the letter markers next to the adjusting entries. These allow us to trace the journal entries back to the consolidation journal. The above worksheet then provides the data necessary to produce the required consolidated financial statements in accordance with AASB 3, AASB 10, AASB 112 and AASB 101.

LO 25.3

Disclosure requirements

While AASB 10 stipulates the accounting procedures to be adopted in consolidating the financial statements of a parent and its subsidiaries, and AASB 3 stipulates various recognition and measurement requirements relating to the assets, liabilities and non-controlling interests arising from business combinations, we also need to look to AASB 12 Disclosure of Interests in Other Entities for the disclosures required in relation to interests in subsidiaries (and other entities). Paragraphs 10, 11 and 12 of AASB 12 require the following disclosures: Interests in subsidiaries 10. An entity shall disclose information that enables users of its consolidated financial statements (a) to understand: (i) the composition of the group; and (ii) the interest that non-controlling interests have in the group’s activities and cash flows (paragraph 12); and (b) to evaluate: (i) the nature and extent of significant restrictions on its ability to access or use assets, and settle liabilities, of the group (paragraph 13); (ii) the nature of, and changes in, the risks associated with its interests in consolidated structured entities (paragraphs 14–17); (iii) the consequences of changes in its ownership interest in a subsidiary that do not result in a loss of control (paragraph 18); and (iv) the consequences of losing control of a subsidiary during the reporting period (paragraph 19). 11. When the financial statements of a subsidiary used in the preparation of consolidated financial statements are as of a date or for a period that is different from that of the consolidated financial statements (see paragraphs B92 and B93 of AASB 10), an entity shall disclose: (a) the date of the end of the reporting period of the financial statements of that subsidiary; and (b) the reason for using a different date or period. 908  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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The interest that non-controlling interests have in the group’s activities and cash flows 12. An entity shall disclose for each of its subsidiaries that have non-controlling interests that are material to the reporting entity: (a) the name of the subsidiary. (b) the principal place of business (and country of incorporation if different from the principal place of business) of the subsidiary. (c) the proportion of ownership interests held by non-controlling interests. (d) the proportion of voting rights held by non-controlling interests, if different from the proportion of ownership interests held. (e) the profit or loss allocated to non-controlling interests of the subsidiary during the reporting period. (f) accumulated non-controlling interests of the subsidiary at the end of the reporting period. (g) summarised financial information about the subsidiary (see paragraph B10). AASB 12 also stipulates a number of disclosure requirements in relation to: • the nature and extent of significant restrictions (see paragraph 13) • the nature of the risks associated with an entity’s interests in consolidated structured entities (see paragraphs 14–17) • the consequences of changes in a parent’s ownership interest in a subsidiary that do not result in a loss of control (see paragraph 18) • the consequences of losing control of a subsidiary during the reporting period (paragraph 19).

Control, joint control, and significant influence

LO 25.13

An investor can have various degrees of influence over an investee. For example, an investor might control an investee, in which case the investee would be considered to be a subsidiary. Alternatively it might have joint control, or significant influence over an investee. Lastly, its level of influence might fall short of significant influence. The degree of influence, or power, over an investee has direct implications for how the investor shall account for the investment. As we know from reading this chapter, if an investor controls an investee then it must consolidate the investee in accordance with AASB 10. It must also make disclosures in accordance with AASB 12. This is reflected in Figure 25.7. We have also learned in this chapter that if an organisation is jointly controlled then the accounts of that jointly controlled organisation are not to be incorporated in the consolidated financial statements. Other chapters of this book describe how to account for an investment when the investor has joint control or significant influence over an investee. A summarised overview of the how the degree of influence or power over an investee influences how an investor accounts for an equity investment is provided in Figure 25.7. As Figure 25.7 indicates, if there is deemed to be joint control then such a situation would be referred to as a ‘joint arrangement’. Joint arrangements are addressed in Chapter 32 of this book. As Chapter 32 explains, joint arrangements are classified as either ‘joint operations’ or ‘joint ventures’. The classification depends upon the rights and obligations of the parties to the arrangement. A joint operation is defined at paragraph 15 of AASB 11 Joint Arrangements as: a joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement. Those parties are called joint operators. By contrast, a joint venture is defined at paragraph 16 of AASB 11 as: a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. Those parties are called joint venturers. The classification as a ‘joint operation’ or ‘joint venture’ in turn impacts how the investor accounts for its interest in the investee. If the investment is deemed to be a joint operation then the investor’s interest in the respective assets, liabilities, expenses and revenues will be recognised in the consolidated financial statements. By contrast, if the investment is deemed to be a joint venture then the equity method of accounting—which is explained in Chapter 32—is to be used to account for the investment. As paragraphs 21 and 24 of AASB 11 respectively require: 21. A joint operator shall account for the assets, liabilities, revenues and expenses relating to its interest in a joint operation in accordance with the Standards applicable to the particular assets, liabilities, revenues and expenses. CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  909

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Figure 25.7 Accounting for investments in which the investee has control, joint control, or significant influence over the investee

Does the investor control the investee? Yes

No

Consolidate the investee in accordance with AASB 10 Consolidated Financial Statements and make disclosures in accordance with AASB 12 Disclosure of Interests in Other Entities

Is there joint control?

Yes

Define type of joint arrangement in accordance with AASB 11 Joint Arrangements

No

Is there significant influence?

Yes Joint venture

Account for assets, liabilities, revenues and expenses. Disclose in accordance with AASB 12 Disclosure of Interests in Other Entities

No

Joint venture

Account for an investment in accordance with AASB 128 Investments in Associates and Joint Ventures and provide disclosures in accordance with AASB 12

Apply AASB 9 Financial Instruments

24. A joint venturer shall recognise its interest in a joint venture as an investment and shall account for that investment using the equity method in accordance with AASB 128 Investments in Associates and Joint Ventures unless the entity is exempted from applying the equity method as specified in that Standard. If an investee is not controlled, or subject to joint control, but is significantly influenced (which is defined in AASB 128 Investments in Associates and Joint Ventures as influence that falls short of control, or joint control, but is the power to participate in the financial and operating policy decisions of the investee), then the investee would be classified as an ‘associate’ and the equity method of accounting is to be employed to account for the investment. Accounting for investments in associates is addressed within Chapter 32 of this book. Where an investor does not have control, joint control or significant influence over an investee—and therefore does not even have the power to participate in the financial and operating policy decisions of the investee—then the interest in the investee is to be accounted for in accordance with AASB 9 Financial Instruments. AASB 9 is considered in depth in Chapter 14.

SUMMARY This chapter introduces the three chapters in this book that address consolidation issues. Consolidated financial statements are described as statements that present aggregated information about the financial performance and financial positions of various separate legal entities. Consolidated financial statements provide a single set of financial statements that are prepared to represent the financial position and performance of the group as if it were operating as a single economic entity. In determining which organisations should be included in the consolidation process, control is the determining factor. The group itself comprises the parent entity and its subsidiaries (controlled entities). The chapter looked at the history of consolidation accounting. Before the introduction of AASB 1024, and subsequently AASB 127 and now AASB 10, various forms of business entities other than companies—such as partnerships and trusts—were used to circumvent the requirement to include respective entities in the consolidation process. AASB 1024 910  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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closed this loophole (as does AASB 10) and required all controlled entities to be included in the consolidation process, regardless of their legal form and their field of activities. In performing the consolidation of different entities’ financial statements, the investment in a subsidiary must be eliminated, on consolidation, against the pre-acquisition capital and reserves of the subsidiary. Any required adjustment has to be made first to reflect the fair value of the subsidiaries’ identifiable assets as at the date of acquisition, and any difference between the fair value of the net identifiable assets and contingent liabilities acquired and the purchase consideration will be of the nature of either goodwill, or gain on bargain purchase. If the balance represents goodwill, the goodwill must be periodically reviewed for any impairment losses in accordance with Accounting Standard AASB 136 Impairment of Assets. If a bargain on purchase is calculated on consolidation, the bargain is to be accounted for as a gain in the consolidated financial statements. Following consolidation, the consolidated retained earnings balance represents the parent entity’s retained earnings, plus the economic entity’s share of the post-acquisition earnings of the controlled entities (subsidiaries). The balance in the various consolidated reserve accounts will represent the balance of the parent entity’s reserve accounts, plus the parent entity’s share of the post-acquisition movements of the subsidiaries’ reserve accounts. This chapter also stresses that consolidation entries are to be performed in a separate consolidation worksheet or journal, rather than in the journals of any of the entities within the group.

KEY TERMS consolidated entity  875 consolidated statement of financial position  873 consolidated statement of profit or loss and other comprehensive income  873

consolidation  871 control over an investee  871 controlled entity  884 group  871 internally generated goodwill  894

pre-acquisition shareholders’ funds  906 purchased goodwill  894

END-OF-CHAPTER EXERCISES Stubbs Ltd acquires all of the shares in Billa Ltd on 30 June 2018. The financial statements for Stubbs Ltd and Billa Ltd at 30 June 2019 (one year after acquisition) are provided below. Reconciliation of opening and closing retained earnings   Sales revenue Cost of goods sold Other expenses Profit Retained earnings opening balance Retained earnings at 30 June 2019

Stubbs Ltd ($000)

Billa Ltd ($000)

2 000 (800)   (300) 900 1 100 2 000

610 (240)   (70) 300 500 800

Stubbs Ltd ($000)

Billa Ltd ($000)

2 000 1 100

800 350

Statements of financial position   Shareholders’ equity Retained earnings Share capital

continued CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  911

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  Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Non-current assets Land Plant Accumulated depreciation—plant Investment in Billa Ltd

Stubbs Ltd ($000)

Billa Ltd ($000)

700

150

1 100 4 900

   700 2 000

150 450

200 250

1 200 2 600 (600) 1 100 4 900

750 1 000 (200)        – 2 000

Additional information •  Stubbs Ltd acquires Billa Ltd on 30 June 2018 for $1.1 million in cash. •  T  he directors of Stubbs Ltd consider that in the year to 30 June 2019 the value of goodwill has been impaired by an amount of $20 000. •  There are no intragroup transactions. •  Billa Ltd did not issue any shares during 2019. •  The tax rate is 30 per cent. •  On the date at which Stubbs Ltd acquires Billa Ltd, the carrying amount and fair value of the assets of Billa Ltd are:  

Carrying amount ($000)

Fair value ($000)

150 200 750

150 200 800

   800 1 900

   900 2 050

Cash Accounts receivable Land Plant (cost of $1000 000,   accumulated depreciation of $200 000)

No revaluations are undertaken in Billa Ltd’s accounts before consolidation. •  A  t the date of acquisition of Billa Ltd, Billa Ltd’s liabilities amount to $1.050 million and there are no contingent liabilities. •  T  he plant in Billa Ltd is expected to have a remaining useful life of 10 years from 30 June 2018, and no residual value.

REQUIRED Provide the consolidated accounts of Stubbs Ltd and Billa Ltd as at 30 June 2019. LO 25.4, 25.5, 25.8, 25.10

SOLUTION TO END-OF-CHAPTER EXERCISE We need to determine goodwill (the difference between the fair value of the net assets acquired and the fair value of the purchase consideration). Fair value of purchase consideration Carrying amount of net assets acquired:   Carrying amount of assets   Carrying amount of liabilities

 

 

$1 900 000 $1 050 000

$850 000

$1 100 000

912  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Fair value adjustment:   Excess of fair value of land over carrying amount   Excess of fair value of plant over carrying amount  Tax effect of revaluation (deferred tax liability) $150 000 × 0.30 Fair value of net assets acquired Goodwill acquired

$50 000   $100 000 $150 000  ($45 000)

$105 000 $955 000 $145 000

The consolidation journal entries would be as follows. (a) To revalue the assets of Billa Ltd so that goodwill can subsequently be accounted for Dr Cr Cr

Land Revaluation surplus Deferred tax liability

50 000

Dr Cr

Accumulated depreciation Plant

200 000

Dr Cr Cr

Plant Revaluation surplus Deferred tax liability

100 000

  35 000 15 000 200 000 70 000 30 000

(b) To eliminate the investment in Billa Ltd and the pre-acquisition capital and reserves of Billa Ltd Dr Dr Dr Dr Cr

Share capital Retained earnings Revaluation surplus Goodwill Investment in Billa Ltd

350 000 500 000 105 000 145 000

 

1 100 000

(c) To recognise impairment of goodwill In this illustration there is a $20 000 impairment of goodwill and hence the adjusting entry required is: Dr Cr

Impairment loss—goodwill Accumulated impairment—goodwill

20 000

  20 000

(d) Additional depreciation From the perspective of the group, the plant in Billa Ltd has a carrying amount of $900 000, which needs to be depreciated over its useful life. To recognise the depreciation of the fair value of adjustment of $100 000 over the remaining useful life of 10 years, the following adjusting entry is necessary: Dr Depreciation 10 000   Cr Accumulated depreciation 10 000 Dr Deferred tax liability 3000 Cr Income tax expense 3000 Consolidation worksheet for Stubbs Ltd and its controlled entity for the period ending 30 June 2019  

Reconciliation of opening and closing retained earnings Sales revenue Cost of goods sold Other expenses Profit Retained earnings—30 June 2018 Retained earnings—30 June 2019

 

Eliminations and adjustments

Stubbs Ltd ($000)

Billa Ltd ($000)

2 000 (800)    (300) 900 1 100 2 000

610 (240)    (70) 300  500 800

Dr ($000)

Cr ($000)

10(d), 20(c)

3(d)

500(b)



Consolidated statement ($000)

2 610 (1 040)   (397) 1 173 1 100 2 273 continued

CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  913

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Statements of financial positions Shareholders’ equity Retained earnings Share capital Revaluation surplus Current liabilities Accounts payable Non-current liabilities Loans Deferred tax liability Current assets Cash Accounts receivable Non-current assets Land Plant Accumulated depreciation Goodwill Accumulated impairment—goodwill Investment in Billa Ltd

 

Eliminations and adjustments

Stubbs Ltd ($000)

Billa Ltd ($000)

Dr ($000)

2 000 1 100 –

800 350 –

350(b) 105(b)

700

150

1 100            4 900

700            2 000

150 450

200 250

1 200 2 600 (600)

750 1 000 (200)

1 100 4 900

        – 2 000

Cr ($000)

Consolidated statement ($000)

70(a), 35(a)

2 273 1 100 – 850

3(d)

1 800    42 6 065

15(a), 30(b)

350 700 50(a) 100(a) 200(a) 145(b)           1 483

2000 3 500 (610) 145 (20)        – 6 065

200(a) 10(d) 20(c) 1 100(b) 1 483

The consolidated statement of financial position of the Stubbs group can now be provided as follows. Consolidated statement of financial position for Stubbs Ltd and its controlled entity as at 30 June 2019   Current assets Cash Accounts receivable Non-current assets Land Plant Accumulated depreciation Goodwill Accumulated impairment—goodwill Investment in Billa Ltd Total assets Current liabilities Accounts payable Non-current liabilities Loans Deferred tax liability Total liabilities Net assets Represented by: Shareholders’ equity Retained earnings Share capital

Stubbs Ltd ($000)

Group ($000)

150    450    600

350    700 1 050

1 200 2 600 (600) – – 1 100 4 300 4 900

2 000 3 500 (610) 145 (20)        – 5 015 6 065

   700

   850

1 100        – 1 100 1 800 3 100

1 800      42 1 842 2 692 3 373

2 000 1 100 3 100

2 273 1 100 3 373

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REVIEW QUESTIONS 1. (a) What is the role of consolidated financial statements? (b) In a newspaper article entitled ‘Bank boss paid $8.3m’ that appeared in The Advertiser on 18 August 2015 it was stated: Commonwealth Bank chief Ian Narev earned double the average annual Australian wage every week over the past year as the value of his pay and perks package hit $8.3 million. The bank last week revealed a record full-year profit of $9.06 billion. The bank’s annual report, published yesterday, reveals Mr Narev’s base wage was $2.6 million and also included benefits of $3.2 million. The average Aussie earns about $77,000 a year. Would this ‘full-year profit’ referred to above relate to the profit derived by the parent entity (company) or by the entire group of companies in the Commonwealth Bank Group? LO 25.1, 25.2 2. When we are preparing consolidated financial statements: (a) Do we make consolidation adjustments and eliminations directly to the parent entity’s and/or the subsidiaries’ accounts? Why? (b) Will the financial statements of the parent entity, or the subsidiary companies, as at the beginning of the financial period reflect prior period consolidation adjustments? Why? (c) Will we have to eliminate the parent entity’s investment in the subsidiaries each year as part of our consolidation entries, or will we have to do the elimination only in the first year following acquisition, but not thereafter? Why? (d) While there is a general requirement that all parent entities must consolidate the financial statements of subsidiaries over which they have the capacity to control, there is an exception for ‘investment entities’. What is the basis of this exception, and do you think it is a justified exception? LO 25.4 3. The consolidated statement of financial position will show the total assets controlled by the economic entity (group) and the total liabilities owed to parties outside the economic entity. As such, will liabilities owing to, and amounts receivable from, organisations within the group (that is, within the economic entity) be eliminated in the consolidation process, and not be shown in the consolidated statement of financial position? Why? LO 25.4 4. There is one asset that appears in the consolidated statement of financial position, but probably does not appear in the parent entity’s or subsidiaries’ separate accounts, and there is also one asset that will appear in the statement of financial position of the parent entity, but will not appear in the consolidated financial statements. Which accounts would these be?  LO 25.4 5. Define: (a) a legal entity (b) an economic entity (c) a parent entity (d) a subsidiary. LO 25.4 6. On consolidation, how is the goodwill on acquisition or the bargain gain on purchase determined?  LO 25.4, 25.8, 25.9 7. Collapse Ltd has severe financial problems and has agreed with its creditors that its activities will be placed in the hands of XYZ Chartered Accountants, which has been appointed to govern the financial and operating policies of the organisation. Explain whether XYZ Chartered Accountants needs to prepare consolidated financial statements, which include those of Collapse Ltd.  LO 25.2, 25.7 8. What is ‘fair value’ and why is it relevant to consolidation accounting?  LO 25.4, 25.8 9. Briefly explain the differences between the entity, proprietary and parent-entity consolidation concepts and identify which concept is to be applied in Australia.  LO 25.3 10. If a parent entity acquires a controlling interest in a subsidiary, and the subsidiary’s assets are not measured at fair value, there is a requirement to make an adjusting entry to record the assets at fair value. Why do we need to do this adjusting entry? What would be the implications if we do not do the adjusting entry?  LO 25.4, 25.8 CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  915

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11. On consolidation we need to eliminate the investments in controlled entities. Against which accounts do we eliminate these investments?  LO 25.4 12. What is the primary criterion for determining whether or not to consolidate an entity?  LO 25.2, 25.6 13. What are ‘potential voting rights’ and what part do they play in determining whether an entity is under the control of another entity?  LO 25.5, 25.6 14. If Rip Ltd controls Curl Ltd, but is acting as an agent for Quik Ltd in relation to its dealings with Curl Ltd, would Rip Ltd be required to include Curl Ltd’s accounts within its consolidated financial statements?  LO 25.6, 25.7 15. If there are non-controlling interests, will all of the goodwill of the subsidiary be recognised in the consolidated statements of financial position?   LO 25.3 16. Would it be possible for an organisation to be required to consolidate another entity in which it has no equity interest? Explain why.  LO 25.6 17. What is the rationale for including the post-acquisition movements in retained earnings and other reserves of a subsidiary in the consolidated financial statements?  LO 25.4, 25.12 18. The management of one of your clients has told you that they intend not to consolidate the financial statements of one of their subsidiaries because it is involved in mining, whereas all of the other organisations in the group are involved in service industries. How would you respond to this position?  LO 25.4, 25.11 19. What forms of entities may be consolidated (for example partnerships, trusts, companies)? Has this requirement changed across the years?  LO 25.6, 25.11 20. When we are preparing consolidated financial statements, why don’t we make any of the consolidation adjustments in the ledger accounts of the subsidiaries or the parent entity?  LO 25.4, 25.5 21. According to AASB 3, how should a bargain gain on purchase arising on consolidation be treated?  LO 25.3 22. This chapter refers to the work of Sullivan (1985). He investigated how organisations such as CSR Ltd used interposed unit trusts so that certain controlled entities were omitted from the consolidation process.

REQUIRED (a) Could this practice be employed today and, if not, why not? (b) Before the revisions to The Corporations Law, if an organisation such as CSR had elected not to consolidate the accounts of trusts and the trusts’ controlled entities, do you think that the resulting financial statements would have been considered true and fair? Explain your answer.  LO 25.6, 25.11 23. Biggin Ltd acquires 100 per cent of the shares of Smallin Ltd on 1 July 2018 for a consideration of $730 000. The share capital and reserves of Smallin Ltd at the date of acquisition are: Share capital Retained earnings Revaluation surplus

$200 000 $100 000 $150 000 $450 000

There are no transactions between the entities and all assets are fairly valued at the date of acquisition. The financial statements of Biggin Ltd and Smallin Ltd at 30 June 2019 (one year after acquisition) are:  

Biggin Ltd ($000)

Smallin Ltd ($000)

300   (100) 200    200    400

100   (30) 70 100 170

400

170

Reconciliation of opening and closing retained earnings Profit before tax Tax Profit after tax Retained earnings—1 July 2018 Retained earnings—30 June 2019 Statements of financial positions Shareholders’ equity Retained earnings

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Share capital Revaluation surplus Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Non-current assets Land Plant Investment in Smallin Ltd

1 000 300

200 200

60

40

   600 2 360

250 860

80 350

45 95

200 1 000    730 2 360

120 600      – 860

REQUIRED Prepare the consolidated financial statements for Biggin Ltd and Smallin Ltd as at 30 June 2019.  LO 25.4, 25.5, 25.8, 25.10 24. Michael Ltd acquires all the issued capital of Petersen Ltd for a cash payment of $600 000 on 30 June 2019. The statements of financial position of both entities immediately following the purchase are:   Current assets Cash Accounts receivable Non-current assets Plant Land Investment in Petersen Ltd Current liabilities Accounts payable Non-current liabilities Loans Shareholders’ equity Share capital Retained earnings



Michael Ltd ($000)

Petersen Ltd ($000)

10 150

5 55

700 200   600 1 660

500 100      – 660

60

30

400

150

1 000     200 1 660

200 280 660

Additional information • All assets of Petersen appearing in the 30 June 2019 statement of financial position are fairly valued. • At 30 June 2019 Petersen had two internally developed identifiable intangible assets with the following fair values: Fair value Patent Publishing Title

($000) 100 25

REQUIRED Provide the consolidated statement of financial position for Michael Ltd and Petersen Ltd as at 30 June 2019.  LO 25.4, 25.5, 25.8, 25.10

CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  917

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25. Largey Ltd acquires 100 per cent of the shares of Smalley Ltd on 1 July 2018 for a consideration of $650 000. The share capital and reserves of Smalley Ltd at the date of acquisition are: Share capital Retained earnings Revaluation surplus

$300 000  $150 000 $150 000 $600 000

The directors consider that any goodwill acquired has not been the subject of an impairment loss. There are no transactions between the entities and all assets are fairly valued at the date of acquisition. The financial statements of Largey Ltd and Smalley Ltd at 30 June 2019 (one year after acquisition) are:  

Largey Ltd ($000)

Smalley Ltd ($000

300   (100) 200    400    600

150     (50) 100    150    250

600 1 200 300

250 300 200

100

100

   600 2 800

   250 1 100

100 350

145 155

700 1 000    650 2 800

200 600        – 1 100

Reconciliation of opening and closing retained earnings Profit before tax Tax Profit after tax Retained earnings—1 July 2018 Retained earnings—30 June 2019 Statements of financial position Shareholders’ equity Retained earnings Share capital Revaluation surplus Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Non-current assets Land Plant Investment in Smalley Ltd

REQUIRED Prepare the consolidated accounts for Largey Ltd and Smalley Ltd at 30 June 2019.  LO 25.4, 25.5, 25.8, 25.9, 25.10 26. Whopper Ltd acquires 100 per cent of the shares of Weenie Ltd on 1 July 2018 for a consideration of $1.25 million. The share capital and reserves of Weenie Ltd at the date of acquisition are: Share capital Retained earnings Revaluation surplus

$750 000 $375 000   $375 000 $1 500 000

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Additional information There are no transactions between the entities and all assets are fairly valued at the date of acquisition. No land or plant is acquired or sold by Weenie Ltd in the year to 30 June 2019. The financial statements of Whopper Ltd and Weenie Ltd at 30 June 2019 (one year after acquisition) are:   Reconciliation of opening and closing retained earnings Profit before tax Tax Profit after tax Retained earnings at 30 June 2018 Retained earnings at 30 June 2019 Statements of financial position Shareholders’ equity Retained earnings Share capital Revaluation surplus Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Non-current assets Land Plant Investment in Weenie Ltd

Whopper Ltd ($000)

Weenie Ltd ($000)

750   (250) 500 1 000 1 500

375   (125) 250    375    625

1 500 3 000 750

625 750 500

250

250

1 500 7 000

   625 2 750

250 875

200 300

1 750 2 875 1 250 7 000

750 1 500        – 2 750

REQUIRED Prepare the consolidated accounts for Whopper Ltd and Weenie Ltd as at 30 June 2019.  LO 25.4, 25.5, 25.8, 25.10

CHALLENGING QUESTIONS 27. P Ltd is a public company that is listed on the Australian Securities Exchange. P Ltd has numerous small shareholders. P Ltd owns 35 per cent of the issued ordinary shares of B Ltd. The remaining shares of B Ltd are widely distributed among numerous small shareholders, none of which owns more than 4 per cent of B Ltd. B Ltd’s constitution provides that at general meetings of the company, ordinary shareholders are entitled to vote on resolutions and elect directors, on the basis of one vote per ordinary share. At general meetings of B Ltd, resolutions proposed by P Ltd are invariably passed, and candidates for directorships nominated by P Ltd are invariably elected, because many small shareholders in B Ltd do not exercise their right to attend general meetings and vote. P Ltd does not own any investments in other entities.

REQUIRED Advise P Ltd whether it is required to produce consolidated financial statements. Give reasons for your answer.  LO  25.4, 25.7 CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  919

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28. FXL Pty Ltd (FXL) is a private company with many strategic investments. The finance director is concerned that he might be required to consolidate some of these investments, pursuant to AASB 10. Details of the investment relationships are as follows: (a) FXL has a 25 per cent interest in the share capital of LBX Pty Limited (LBX), which is a company involved in the same industry as FXL. The remaining 75 per cent of the share capital is owned by LBX’s founders, Mr and Mrs T. Mr and Mrs T are unfamiliar with the industry and so have given FXL three out of the five seats available on the board of directors. FXL takes the lead on all decisions, but the business is closely monitored by Mr and Mrs T, who hold the other two board positions. (b) FXL has a substantial loan receivable from BBT Pty Ltd (BBT). BBT, as a result of the current economic climate, has experienced significant trading problems. BBT has failed to make its regular payments under the loan agreement. FXL has become concerned about the recoverability of the loan and has reached an agreement with the management of BBT that FXL executives will take control of the company’s finances for a period of five years. An executive of FXL has been given control of BBT’s cheque book and makes all payments. FXL has not gained any seats on BBT’s board of directors, which is still dominated by BBT shareholders. (c) FXL owns 50 per cent of A Pty Ltd (A), with the other 50 per cent being owned by B Pty Ltd (B). Both companies have equal voting rights and an equal share of seats on the board of directors. Under an agreement with B, FXL supplies the finance to the company on normal commercial terms. The loan is fully secured against the assets of the company. B provides the management and entrepreneurial flair to A. Under the agreement forged, B will receive a management fee in respect of the net profits of A after allowing for interest payments on the FXL loan. In times of no profits, the interest payments will still be met, but B will not receive any remuneration. (d) FXL operates as the trustee company for the FXL trading trust. The trust is a discretionary trust with the nominated beneficiaries being the directors of FXL. These directors are Mr F, Mrs X and Mr L. Over the years, the trust has distributed its income in the following proportions: Mr F Mrs X Mr L

70 20 10

Under the terms of the trust deed, FXL has complete control over the operating and financing decisions of the trust. (e) FXL holds a 75 per cent interest in JIB Pty Ltd (JIB). The interest was created when FXL converted a substantial loan it made to JIB into equity at the invitation of JIB when JIB began to trade poorly and recovery of the loan seemed uncertain. JIB has a large deficiency in net assets and has been consolidated for many years. FXL is a passive investor, having no seats on the board of directors and no say in the financing or operating decisions of JIB.

REQUIRED Advise the finance director of FXL of the requirements of AASB 10 in respect of the control criterion. For each of the above investments, indicate where the control rests and whether or not consolidation will be required.  LO 25.6, 25.7 29. The following are independent situations: (a) SPG Ltd, a supplier of sailing equipment, was incorporated 10 years ago and is 60 per cent owned by GPS Ltd. SPG has been a very successful business, averaging annual profits of $500 000. However, during the past two years the company has run into financial difficulties and has defaulted on its loan with its bank. Consequently, the bank has used the powers in the loan agreement to monitor the company’s activities closely in order to obtain repayment of its debt. The company must now obtain the bank’s authorisation for any expenditure over $5000 and no changes in operations of the company are permitted without the bank’s approval. (b) ZYX Pty Ltd is a family-run book publisher that has purposely refrained from using high-technology equipment over the past five years as the directors (the L family) considered it to be a ‘fad’ and a waste of the company’s resources. As a result, the company’s antiquated equipment has failed to produce quality material and has been very inefficient compared with ZYX’s competitors. During the current year, the company’s bankers took possession of the company’s assets, converted all the debt into equity and two directors of the bank were appointed to ZYX’s board, which now totals four people. The bank is undecided on whether it should sell the company’s assets, which have little recoverable value, or inject further equity into the company, purchase more advanced equipment and attempt to trade on and sell the business as a going concern. 920  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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(c) M Ltd is a 30 per cent shareholder of Investment Co. Pty Ltd. The other shareholders have smaller shareholdings (around 8 to 12 per cent) and are always too busy to attend annual general meetings. M Ltd has two nonexecutive seats on the board and the remaining three are held by other shareholders—one chief executive officer who is a shareholder and two non-executives—who do make an attempt to attend board meetings. (d) S Ltd is owned 50 per cent by B1 Ltd and 50 per cent by B2 Ltd (the founding shareholders). Each has two seats on the board, with no party having a casting vote, although B1 Ltd appoints the managing director. Profits are split 50–50 after the provision of the managing director’s salary. B2 Ltd has agreed that it will pay a management fee to B1 Ltd, equivalent to 50 per cent of the results for the year, in the event of a loss. B1 Ltd is the holder of 10 options, which are exercisable at any time at a 10 per cent discount to the fair value of the shares as at the exercise date. (e) B Ltd is a 51 per cent shareholder in C Ltd and currently has two out of five board seats. R Ltd is the remaining 49 per cent shareholder and currently has the other three seats. B Ltd is a passive shareholder as it is happy with the way R Ltd has been running the company. (f) J Ltd, P Ltd and G Ltd are each 33.3 per cent shareholders of GH Pty Ltd, a small proprietary company that is involved in the music industry. J Ltd and G Ltd are passive shareholders with one board seat each out of a total of three. P Ltd has one board seat and is also involved in the day-to-day running of the business.

REQUIRED For each of the above independent situations, determine whether or not control exists and, if so, by which party (pursuant to AASB 10). Discuss the reasons for your answers.  LO 25.6, 25.7 30. On 30 June 2018, Bells Ltd acquired all of the issued capital of Winkipop Ltd for a cost of $950 000. At the date of acquisition the acquired shares had the right to share in a dividend that had been declared on 30 June, the total amount of the dividend being $200 000. Bells Ltd will not recognise the dividend until it is received. It was ultimately received on 1 August 2018. The statement of financial position of Winkipop at 30 June 2018 was as follows: Balance sheets of Winkipop Ltd as at 30 June 2018   Current assets Cash Accounts receivable Inventory Non-current assets Plant and equipment Accumulated depreciation—plant and equipment Land Current liabilities Accounts payable Non-current liabilities Loan Share capital and reserves Share capital Retained earnings Revaluation surplus



$000 50 40 110 720 (120)    800 1 600 100    500    600 700 200    100 1 000

Additional information • The plant and equipment of Winkipop Ltd has a fair value of $750 000. All other assets were recorded at fair value. • The tax rate is 30 per cent.

REQUIRED Prepare the consolidation worksheet journal entries immediately after the above acquisition.  LO 25.5, 25.8, 25.10 CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  921

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31. On 30 June 2018 Anglesea Ltd acquired 100 per cent of the shares in Lorne Ltd for a cost of $500 000. The account balances of the two entities at the date of acquisition were:  

Anglesea Ltd ($000)

Lorne Ltd ($000)

100 130 200 400 (120) 300 500 110 200 900 300

50 90 110 350 (90) 100 – 70 190 200 150

Cash Accounts receivable Inventory Property, plant and equipment Accumulated depreciation Land Investment in Lorne Ltd Accounts payable Loans Share capital Retained earnings

Additional information • All assets of Lorne Ltd were fairly valued at acquisition except the land, which had a fair value of $140 000. • The tax rate is 30 per cent.

REQUIRED Prepare the consolidation journal entries, consolidated worksheet and consolidated statement of financial position for the above entities.  LO 25.4, 25.5, 25.8, 25.10 32. Slowsilver Ltd is listed on the Australian Securities Exchange and has a large number of shareholders, each with relatively small parcels of shares. Slowsilver holds shares in one other entity, this being Quickgold Ltd. Slowsilver owns 30 per cent of the issued ordinary shares of Quickgold Ltd. The remaining 70 per cent of shares in Quickgold Ltd are dispersed among a large number of shareholders none of whom has an ownership interest of more than 3 per cent of Quickgold Ltd. Each share in Quickgold Ltd and Slowsilver Ltd entitles the shareholder to one vote at annual general meetings.

REQUIRED Determine whether Slowsilver Ltd would be required to prepare consolidated financial statements.  LO 25.6, 25.7 33. Sandy Ltd acquired 100 per cent of the issued capital of Beach Ltd on 30 June 2018 for $900 000, when the statement of financial position of Beach Ltd was as follows: Statement of financial position of Beach Ltd as at 30 June 2018   Assets Accounts receivable Inventory Land Property, plant and equip. Accumulated depreciation





$000 70 100 400 700   (270) 1 000

  Liabilities Loan Shareholders’ equity Share capital Retained earnings

$000 300

500    200 1 000

Additional information • The tax rate is 30 per cent. • As at the date of acquisition, all assets of Beach Ltd were at fair value, other than the property, plant and equipment, which had a fair value of $530 000. Beach Ltd adopts the cost model for measuring its property, plant and equipment. The property, plant and equipment is expected to have a remaining useful life of 10 years, and no residual value. • One year following acquisition it was considered that Beach Ltd’s goodwill had a recoverable amount of $60 000.

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• Beach Ltd declared a dividend of $40 000 on 10 July 2018, with the dividends being paid from pre-acquisition retained earnings. • The statements of financial position and statements of comprehensive income of Sandy Ltd and Beach Ltd one year after acquisition are as follows: Statements of financial position of Sandy Ltd and Beach Ltd as at 30 June 2019   Assets Cash Accounts receivable Inventory Land Property, plant and equipment Accumulated depreciation Investment in Beach Ltd Total assets Liabilities Accounts payable Dividends payable Loan Shareholders’ equity Share capital Retained earnings Reconciliation of opening and closing retained earnings Profit after tax Retained earnings—30 June 2018 Interim dividend Final dividend Retained earnings—30 June 2019

Sandy Ltd ($000)

Beach Ltd ($000)

80 50 140 600 900 (300)    900 2 370

40 50 123 400 700 (313)        – 1 000

100 100 670

10 50 140

1 000    500 2 370

500    300 1 000

400 300 (90)   (110)    500

190 200 (40)     (50)    300

REQUIRED Prepare the consolidated statement of financial position for the above entities as at 30 June 2019.  LO 25.4, 25.5, 25.8, 25.10

REFERENCES SULLIVAN, G., 1985, ‘Accounting and Legal Implications of the Interposed Unit Trust Agreement’, Abacus, 21(2), pp. 174–96.

CHAPTER 25: ACCOUNTING FOR GROUP STRUCTURES  923

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CHAPTER 26

FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS LEARNING OBJECTIVES (LO) 26.1 Understand the nature and meaning of intragroup transactions. 26.2 Understand how and why to eliminate intragroup dividends on consolidation from both postacquisition and pre-acquisition earnings. 26.3 Know how to account for intragroup sales of inventory inclusive of the related tax effects. 26.4 Know how to account for intragroup sales of non-current assets inclusive of the related tax effects.

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Introduction to accounting for intragroup transactions During the financial period it is common for separate legal entities within an economic entity (group) to transact with each other. In preparing consolidated financial statements, the effects of ALL transactions between entities within the economic entity—which we refer to as intragroup transactions—are eliminated IN FULL, even where the parent entity holds only a fraction of the issued equity. As paragraph B86c of AASB 10 stipulates: Consolidated financial statements eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full). Intragroup losses may indicate an impairment that requires recognition in the consolidated financial statements. AASB 112 Income Taxes applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions. Remember, in rare circumstances it might be necessary to consolidate an entity even when no equity is owned if it is determined that there is a capacity to control the other organisation. Intragroup transactions include: • the payment of dividends to group members • the payment of management fees or interest costs to a group member • the transfer of tax losses between entities with or without consideration • intragroup sales of inventory • intragroup sales of non-current assets • intragroup loans.

intragroup transaction Transaction undertaken between separate legal entities within an economic entity.

In performing the consolidation adjustments for intragroup transactions within the consolidation worksheet we would typically eliminate these intragroup transactions by reversing the original accounting entries made to recognise the transactions in the accounts of the separate legal entities. In the discussion that follows we will consider how to account for various intragroup transactions.

Dividend payments from pre- and post-acquisition earnings

LO 26.1 LO 26.2

In the consolidation process it is necessary to eliminate all dividends paid/payable to other entities within the group, and all intragroup dividends received/receivable from other entities within the group. Even though the separate legal entities in the group might be paying dividends to each other, it does not make sense for such dividends to be shown when we consider the group as a single economic entity. That is, you cannot pay ‘dividends’ to yourself. The only dividends that should be shown in the consolidated financial statements would be dividends paid to parties external to the group, that is to the shareholders of the parent entity and to the non-controlling interests. We will discuss noncontrolling interests in depth in the next chapter. The elimination of intragroup dividends is consistent with the general principle espoused in AASB 10—and set out above—that intragroup (within the group) transactions are to be eliminated in full on consolidation.

Dividends out of post-acquisition profits Only dividends paid externally should be shown in the consolidated financial statements. In Figure  26.1, for example, we see that the subsidiary, which we will say is 100 per cent owned by Parent Entity, pays $1 000 in dividends to Parent Entity, and Parent Entity pays $4 000 in dividends to its shareholders. The only dividends being paid externally (that is, which leave the ‘boundary’ of the economic entity), and hence the only dividends to be shown in the consolidated financial statements, will be the dividends paid to the shareholders of Parent Entity; that is, the $4 000 in dividends. The dividends paid to the parent entity by the 100-per-cent-owned subsidiary will be eliminated on consolidation. Worked Example 26.1 illustrates the consolidation of accounts when a dividend has been paid by a subsidiary company after acquisition.

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  925

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Figure 26.1 Dividends paid by members of an economic entity

Shareholders of Parent Entity

$4000 dividends

Economic entity

Parent Entity

$1000 dividends

Subsidiary

WORKED EXAMPLE 26.1: Dividend payments to a subsidiary out of post-acquisition earnings Company A owns all of the issued capital of Company B. Company A acquired its 100 per cent interest in Company B on 1 July 2018 at a cost of $800 000. The share capital and reserves of Company B on the date of acquisition are: $ Share capital Retained earnings

$500 000 $300 000 $800 000

Dividends of $50 000 paid by Company B come from profits earned since 1 July 2018 (that is, they are paid out of post-acquisition earnings). The assets of Company B are fairly stated at the date that Company A acquires its shares, and therefore there is no goodwill to be recognised on consolidation. Company A recognises dividend income when it is declared by the investee (that is, by Company B). The financial statements of Company A and Company B as at 30 June 2019 reveal the following:

Reconciliation of opening and closing retained earnings Profit before tax Tax expense Profit after tax Opening retained earnings—1 July 2018 less Dividends proposed Closing retained earnings—30 June 2019 Statement of financial position Shareholders’ funds Retained earnings Share capital Liabilities Accounts payable Dividends payable

Company A ($000)

Company B ($000)

200   50 150   400 550      70 480

100   40 60 300 360   50 310

480 500

310 500

1 000      70 2 050

100    50 960

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Assets Cash Accounts receivable Dividends receivable Inventory Plant and equipment Investment in Company B

100 50 50 200 850    800 2 050

70 130 – 160 600      – 960

REQUIRED (a) Provide the journal entries that would have appeared in the separate accounts of Company A and Company B to account for the dividends proposed by Company B. (b) Prepare the consolidation worksheet for Company A and its controlled entity. SOLUTION (a) Journal entries to account for dividends The entry in Company B’s journal would be: Dr Cr

Dividend declared (statement of changes in equity) Dividend payable (statement of financial position)

50 000 50 000

As Company A recognises dividend income when the dividend is declared by the investee, it would have the following entry in its own accounts: Dr Cr

Dividend receivable (statement of financial position) Dividend income (statement of profit or loss and other comprehensive income)

50 000 50 000

As it does not make sense to retain the intercompany payables and receivables in the consolidated financial statements (from the group’s perspective you cannot owe money to yourself), these will be eliminated on consolidation. Remember, only dividends payable to entities outside the group (that is, outside the economic entity) should be shown in the consolidated financial statements. (b) Consolidation worksheet for Company A and its controlled entity From the economic entity’s perspective, no dividends have been paid by Company B to external parties. So they will also need to be removed. The elimination entries to be made as part of the consolidation process, which would be the reverse of those shown above, would be: Elimination entry for dividends proposed by Company B (i) Dr Dividend payable (statement of financial position) Cr Dividend declared (statement of changes in equity)

50 000 50 000

Elimination entry for dividends receivable by Company A

(ii) Dr Dividend income (statement of profit or loss and other comprehensive income) Cr Dividend receivable (statement of financial position)

50 000 50 000

As stressed in Chapter 25, it must be remembered that the consolidation journal entries are NOT written in the individual journals of either company, but in a separate consolidation journal, which is then posted to the consolidation worksheet. We would also need to eliminate the investment in Company B. The elimination entry would be: Consolidation entry to eliminate investment in Company B (iii) Dr Share capital Dr Retained earnings Cr Investment in Company B

500 000 300 000 800 000 continued

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  927

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The consolidation worksheet can now be presented as follows: Consolidation worksheet for Company A and its controlled entity Eliminations and adjustments

Reconciliation of opening and closing retained earnings Profit before tax Tax expense Profit after tax Opening retained earnings less Dividends declared Closing retained earnings Statement of financial position Shareholders’ funds Retained earnings Share capital Liabilities Accounts payable Dividends payable Assets Cash Accounts receivable Dividends receivable Inventory Plant and equipment Investment in Company B

Company A ($000)

Company B ($000)

Dr ($000)

200    50 150    400 550      70    480

100   40 60 300 360    50 310

50(b)

480 500

310 500

1 000      70 2 050

100    50 960

100 50 50 200 850    800 2 050

70 130 – 160 600      – 960

Cr ($000)

300(c) 50(a)

250      90 160    400 560      70    490

490 500

500(c)

1 100       70 2 160

50(a)

50(b)

      900

Consolidated statements ($000)

800(c) 900    

170 180 – 360 1 450         – 2 160

A review of the retained earnings balance provided in the consolidated financial statements reveals a balance of $490 000 as at 30 June 2019. This balance represents the retained earnings of Company A ($480 000) plus the increment in retained earnings of Company B ($10 000) after the acquisition of Company B (the post-acquisition increment).

Dividends out of pre-acquisition profits In the situation illustrated in Worked Example 26.1, the dividends are paid out of post-acquisition profits. By contrast, a dividend from pre-acquisition profits will typically occur when an investor acquires an interest in another company and the shares have been acquired ‘cum div’—the term used to refer to shares being bought with an existing dividend entitlement. If an entity pays dividends out of profits earned before the date of acquisition, it is, in effect, returning part of the net assets originally acquired by the acquirer. An obvious issue is how do we account for the dividend paid by a subsidiary out of pre-acquisition profits? Do we treat it as income in the financial statements of the parent entity or, instead, in the financial statements of the parent entity, do we treat it as a reduction in the cost of the investment in the subsidiary? The correct treatment is to treat dividends paid by a subsidiary, which were sourced from pre-acquisition profits of the subsidiary, as a return of part of the cost of the original investment. This is consistent with AASB 9, which notes that while 928  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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in general dividends received on equity investments are to be recognised in profit or loss, this will not be the case if the dividend clearly represents a recovery of part of the cost of the investment. Pursuant to this requirement, there are two ways in which we can account for the receipt of a dividend paid from pre-acquisition earnings, these approaches being: • When the amount of the dividend is received, in the parent entity’s accounts there would be a debit entry to cash (or to dividends receivable if the dividends are being proposed), and a credit entry against the cost of the investment in the subsidiary (thereby reducing the cost of the investment). This treatment is logical as, if we were to acquire an investment today and then shortly thereafter we received a dividend payment, then we are in effect receiving back some of the investment we had just acquired, and hence it seems very reasonable for the dividend that is paid out of earnings made before the investment was acquired to be treated as a return of part of the cost of that investment. • An alternative treatment, and one that we will adopt here (which is consistent with the above bullet point), is that if the shares were acquired with an existing dividend entitlement, then that entitlement is accounted for separately from the investment in the subsidiary. For example, if all 1 million shares in a subsidiary were acquired for $20 each, and each share came with an existing dividend entitlement of $1 per share (the shares were acquired on a ‘cum div’ basis), then the initial entry in the parent entity’s accounts would be: Dr Dr Cr

Shares in subsidiary Dividend receivable Cash

19 000 000 1 000 000 20 000 000

When the dividend is subsequently received, the entry in the parent entity’s accounts would be: Dr Cr

Cash Dividend receivable

1 000 000 1 000 000

In this example, no dividend income is being recognised. Dividends paid out of pre-acquisition earnings are considered in Worked Example 26.2.

WORKED EXAMPLE 26.2: Dividends paid out of pre-acquisition earnings Sunshine Ltd acquires all the issued capital of Sunrise Ltd for a cash payment of $500 000 on 30 June 2019. The shares are acquired with a dividend entitlement of $200 000 (that is, they were acquired with a ‘cum div’ entitlement). The statements of financial position of both entities immediately following the purchase are:

Current assets Cash Accounts receivable Dividend receivable Non-current assets Plant Investment in Sunrise Ltd Current liabilities Accounts payable Dividend payable Non-current liabilities Loans Shareholders’ equity Share capital Retained earnings

Sunshine Ltd ($000)

Sunrise Ltd ($000)

20 300 200

15 45 –

1 480 300 2 300

600

100

30 200

800

180

1 000    400 2 300

200   50 660

660

continued CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  929

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The financial statements provided above reflect the existing dividend entitlement. In the financial statements of Sunshine Ltd the dividend receivable is treated as a separate asset at the time of acquisition, and the cost of the investment in Sunrise Ltd represents the total payment made by Sunshine Ltd less the amount attributed to the dividend entitlement. REQUIRED Provide the consolidated statement of financial position of Sunshine Ltd and Sunrise Ltd as at 30 June 2019. SOLUTION Before making any adjusting entries in the consolidation worksheet it is useful to consider how the parent entity and subsidiary accounted for particular transactions in their own accounts. Recognition of the dividend in the accounts of Sunrise Ltd Prior to completing its financial statements, Sunrise Ltd would have recorded the dividend payable to shareholders by means of the following journal entry: Dr Cr

Dividend declared (reduces retained earnings) Dividend payable

200 000 200 000

Therefore, the dividend proposed has already been recognised and pre-acquisition retained earnings have already been reduced to take account of the future dividend payment. Recognition of the dividend in the accounts of Sunshine Ltd Sunshine Ltd would have recorded the ‘dividend receivable’ out of the pre-acquisition earnings of Sunrise Ltd, and the investment in Sunrise Ltd, in the following way: Dr Dr Cr

Dividend receivable Investment in Sunrise Ltd Cash

200 000 300 000 500 000

Again, and as we have just noted, where an equity investment is acquired with an existing dividend entitlement then the dividend entitlement will be recognised separately from the equity investment. Again, it is emphasised that the above journal entries (unlike the consolidation entries provided below) were made in the journals of the respective companies. Consolidation journal entries Journal entries to eliminate intragroup receivable and payable We need to eliminate the intercompany payables and receivables as, from the group perspective, the group cannot owe itself any money. (a) Dr Cr

Dividend payable Dividend receivable

200 000 200 000

Elimination of investment in Sunrise Ltd To determine the acquired goodwill that will be recognised on consolidation, we can perform the following calculation: Share capital of Sunrise Ltd at acquisition Retained earnings of Sunrise Ltd at acquisition Cost of investment in Sunrise Ltd Goodwill (b)      

Dr Dr Dr Cr

Share capital Retained earnings Goodwill Investment in Sunrise Ltd

($) 200 000    50 000 250 000 300 000  50 000 200 000 50 000 50 000 300 000

The consolidated statement of financial position can then be prepared as follows:

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Consolidation worksheet for Sunshine Ltd and its controlled entity for the period ending 30 June 2019 Eliminations and adjustments Sunshine Ltd ($000)

Sunrise Ltd ($000)

20 300 200

15 45

1 480 300         – 2 300

600 –      – 660

100

30 200

Current assets Cash Accounts receivable Dividend receivable Non-current assets Plant Investment in Sunrise Ltd Goodwill Current liabilities Accounts payable Dividend payable Non-current liabilities Loans Shareholders’ equity Share capital Retained earnings

800

180

1 000 400 2 300

200 50 660

Dr ($000)

Cr ($000)

Consolidated statements ($000)

200(a)

35 345 – 2 080 –    50 2 510

300(b) 50(b)

130 –

200(a)

980 200(b) 50(b) 500

1 000 400 2 510

500

The consolidated statement of financial position would be as follows: Consolidated statement of financial position of Sunshine Ltd and its controlled entities as at 30 June 2019 Current assets Cash Accounts receivable Dividend receivable Non-current assets Plant Investment in Sunrise Ltd (net) Goodwill Total assets Current liabilities Accounts payable Non-current liabilities Loans Total liabilities Net assets Represented by: Shareholders’ equity Share capital Retained earnings

Sunshine Ltd ($000)

Economic entity ($000)

20 300    200    520

35 345        –    380

1 480 300       – 1 780 2 300

2 080 –      50 2 130 2 510

100

130

800 900 1 400

980 1 110 1 400

1 000   400 1 400

1 000   400 1 400

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  931

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LO 26.3

Intragroup sale of inventory

Entities that are related often sell inventory to one another in what is known as an intragroup sale of inventory. From the group’s perspective, revenues should not be recognised until an external sale of inventory has taken place, that is, when inventory has been sold to parties outside the group. For example, Company A might sell $100 000 of inventory to Company B, which, in turn, sells it to a party outside the economic entity for an amount of $150 000 (see Figure 26.2). If we simply aggregate the sales of Company A and Company B in the consolidation process, it would appear that the economic entity’s total sales are $250 000. From the economic entity’s perspective, this would be incorrect. The only sales that should appear in the consolidated statements are those made to parties external to the group, in this case one sale of $150 000. It is possible at year end for some, or all, of the inventory sold within the group to still be on hand. Let us assume that half of the inventory sold by Company A to Company B is still on hand at year end and, further, that the total amount of inventory transferred from Company A to Company B at a sales price of $100 000 actually cost Company A $70 000 to manufacture. With half of the inventory still on hand, this would mean that effectively there is inventory on hand in Company B’s accounts, at a cost to Company B of $50 000, that cost the group only $35 000 to manufacture. As we know, pursuant to international financial reporting standards, an entity is to record inventory at the lower of cost and net realisable value (see Chapter 7 for an explanation of how to measure inventory), so the inventory needs to be written down by $15 000 for the purposes of the consolidated financial statements (which have as their focus the economic entity). In the financial statements of Company B, as a separate legal entity, it would be correct to leave the inventory at its cost to Company B, that is $50 000. What we must remember is that, although we are eliminating unrealised profits from the consolidated financial statements, from Company A’s perspective the profits have been earned, leading to a liability for taxation. The economic entity does not necessarily pay tax on a collective basis if the group has not notified the tax office that it wants to be treated as a ‘tax consolidated entity’. If the companies have not notified the tax office that they want to be treated as a single entity for tax purposes, the individual legal entities pay tax on their own account. For the balance of this chapter it will be assumed that the companies have not elected to be taxed as a group, and therefore the tax office would assess profits earned by the separate legal entities without any consideration of consolidation adjustments. Returning to the inventory discussed above, from the group’s perspective, an amount of profit related to the sale has not been realised and should not be included in the economic entity’s profits. Therefore, if tax has been paid by one of the separate legal entities (for example, Company A), from the group’s perspective this represents a prepayment of tax (a deferred tax asset), as this income will not be earned by the economic entity until the inventory is sold outside the group. Worked Example 26.3 considers how to account for unrealised profit in closing inventory.

Figure 26.2 Intragroup and external sales of inventory

Economic entity Company A

$100 000

Outside entity

$150 000

Company B

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WORKED EXAMPLE 26.3: Unrealised profit in closing inventory Big Ltd owns 100 per cent of the shares of Little Ltd. These shares are acquired on 1 July 2018 for $1 million when the shareholders’ funds of Little Ltd are: Share capital Retained earnings

$500 000 $400 000 $900 000

All assets of Little Ltd are fairly stated at acquisition date. The directors believe that during the financial year ending 30 June 2019 the value of goodwill has been impaired by an amount of $10 000. During the 2019 financial year, Little Ltd sells inventory to Big Ltd at a sale price of $200 000. The inventory cost Little Ltd $120 000 to produce. At 30 June 2019 half of the stock is still on hand with Big Ltd. The tax rate is assumed to be 33 per cent. The financial statements of Big Ltd and Little Ltd at 30 June 2019 are as follows:

Reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold less Other expenses Other revenue Profit Tax expense Profit after tax Retained earnings—30 June 2018 Dividends paid Retained earnings—30 June 2019 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Inventory Non-current assets Land Plant Investment in Little Ltd Deferred tax asset

Big Ltd ($000)

Little Ltd ($000)

1 200 (500) (60)      70 710    200 510 1 000 1 510    200 1 310

400 (140) (30)      25 255    100  155    400 555      40    515

1 310 4 000

515 500

100

85

   600 6 010

   250 1 350

250 150 600

25 175 300

1 440 2 470 1 000    100 6 010

400 400 –      50 1 350 continued

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  933

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REQUIRED Provide the consolidated statement of financial position and statement of profit or loss and other comprehensive income, together with a note reconciling opening and closing retained earnings for Big Ltd and its controlled entities, for the year ending 30 June 2019. SOLUTION Determination of goodwill At date of acquisition: Share capital of Little Ltd Retained earnings Cost of investment in Little Ltd Goodwill on acquisition

500 000    400 000 900 000 1 000 000    100 000

Consolidation journal entries Elimination of investment in controlled entity (a) Dr Dr Dr Cr

Share capital Retained earnings Goodwill Investment in Little Ltd

500 000 400 000 100 000 1 000 000

Recognition of the impairment of goodwill As we know, pursuant to AASB 3 Business Combinations there is a prohibition on the amortisation of goodwill acquired in a business combination. Rather, AASB 3 requires such goodwill to be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired, in accordance with AASB 136 Impairment of Assets. Extensive discussion on calculating impairment losses attributable to goodwill is provided in AASB 136 Impairment of Assets. The journal entry to record the impairment of goodwill would be: (b) Dr Cr

Impairment loss—goodwill Accumulated impairment losses—goodwill

10 000 10 000

In relation to changes in the carrying amount of goodwill, which would be brought about by the recognition of impairment losses, paragraph 61 of AASB 3 states: The acquirer shall disclose information that enables users of its financial statements to evaluate the financial effects of adjustments recognised in the current reporting period that relate to business combinations that occurred in the period or previous reporting periods. With regard to operationalising the requirements of paragraph 61 just quoted, paragraph B67(d) of AASB 3 requires: a reconciliation of the carrying amount of goodwill at the beginning and end of the reporting period showing separately: (i) the gross amount and accumulated impairment losses at the beginning of the reporting period. (ii) additional goodwill recognised during the reporting period, except goodwill included in a disposal group that, on acquisition, meets the criteria to be classified as held for sale in accordance with AASB 5 Non-current Assets Held for Sale and Discontinued Operations. (iii) adjustments resulting from the subsequent recognition of deferred tax assets during the reporting period in accordance with paragraph 67. (iv) goodwill included in a disposal group classified as held for sale in accordance with AASB 5 and goodwill derecognised during the reporting period without having previously been included in a disposal group classified as held for sale.

934  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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(v) impairment losses recognised during the reporting period in accordance with AASB 136. (AASB 136 requires disclosure of information about the recoverable amount and impairment of goodwill in addition to this requirement). (vi) net exchange rate differences arising during the reporting period in accordance with AASB 121 The Effects of Changes in Foreign Exchange Rates. (vii) any other changes in the carrying amount during the reporting period. (viii) the gross amount and accumulated impairment losses at the end of the reporting period. Elimination of intragroup sales We need to eliminate the intragroup sales because, from the perspective of the economic entity, no sales have in fact occurred. This will ensure that we do not overstate the turnover of the economic entity. (c) Dr Cr

Sales Cost of goods sold

200 000 200 000

Under a periodic inventory system, the above credit entry would be to purchases, which would ultimately lead to a reduction in cost of goods sold. (Cost of goods sold equals opening inventory plus purchases less closing inventory—so any reduction in purchases leads to a reduction in cost of goods sold.) Elimination of unrealised profit in closing inventory The total profit earned by Little Ltd on the sale of the inventory is $80 000. Since some of this inventory remains in the economic entity, this amount has not been fully earned from the perspective of the group. In this case, half of the inventory is still on hand, so unrealised profit amounts to $40 000. In accordance with AASB 102 Inventories, we must value the inventory at the lower of cost and net realisable value. Hence on consolidation we must reduce the value of recorded inventory, as the amount shown in the accounts of Big Ltd exceeds what the inventory cost the economic entity (that is, we must remove the profit element). (d) Dr Cr

Cost of goods sold Inventory

40 000 40 000

Under a periodic inventory system, the above debit entry would be to closing inventory—profit and loss. We would increase cost of goods sold by the unrealised profit in closing inventory because reducing closing inventory effectively increases cost of goods sold. (Remember, cost of goods sold equals opening inventory plus purchases less closing inventory.) The effect of the above entries is to adjust the value of inventory so that it reflects the cost of the inventory to the group. Consideration of the tax paid on the sale of inventory that is still held within the group From the group’s perspective, $40 000 has not been earned. However, from Little Ltd’s individual perspective (as a separate legal entity), the full amount of the sale has been earned. This will attract a tax liability in Little Ltd’s accounts of $26 400 (33 per cent of $80 000). However, from the group’s perspective, some of this will represent a prepayment of tax as the full amount has not been earned by the group even if Little Ltd is obliged to pay the tax. Specifically, the tax paid on the unrealised profit component is considered to be a prepayment. (Remember that unless the wholly owned companies in an economic entity have satisfied various requirements and have elected to be taxed as a single entity, and have informed the tax office of their intention, tax is assessed on the separate legal entities and not on the consolidated profits.) (e) Dr Deferred tax asset Cr Income tax expense ($40 000 × 33 per cent)

13 200 13 200

continued

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  935

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Elimination of intercompany dividends As we know, any intragroup dividends must be eliminated on consolidation (as an entity cannot pay itself a dividend). (f) Dr Cr

Dividend income Dividends paid

40 000 40 000

Consolidation worksheet for Big Ltd and its controlled entity for the year ending 30 June 2019 Eliminations and adjustments

Reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold less Other expenses Other revenue Profit Tax expense Profit after tax Retained earnings—30 June 2018 Dividends paid Statement of financial position Shareholders’ equity Retained earnings—30 June 2019 Share capital Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Inventory Non-current assets Land Plant Investment in Little Ltd Deferred tax asset Goodwill Accumulated impairment loss

Little Ltd ($000)

Dr ($000)

1 200 (500) (60) 70 710 200 510  1 000 1 510 200

400 (140) (30) 25 255    100 155    400 555       40

200(c) 40(d) 10(b) 40(f)

1310 4 000

515 500

100

85

185

   600 6 010

   250 1 350

      850 6 423.2

250 150 600

25 175 300

275 325 860

1 440 2 470 1 000 100 –

400 400 – 50 –

6 010

1 350

Cr ($000)

Consolidated statements ($000)

Big Ltd ($000)

200(c)

13.2(e) 400(a) 40(f)

1 388.2 4 000

500(a)

40(d)

1000(a) 13.2(e) 100(a)            1 303.2

1 400 (480) (100)          55 875    286.8 588.2    1 000 1 588.2       200

         10(b) 1 303.2

1 840 2 870 – 163.2 100      (10) 6 423.2

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Consolidated statement of profit or loss and other comprehensive income of Big Ltd and its controlled entities for the year ended 30 June 2019

Sales Cost of good sold Gross profit Other revenue Other expenses Profit before tax Income tax expense Profit for the year Other comprehensive income Total comprehensive income for the year

The Group ($)

Big Ltd ($)

1 400 000 (480 000) 920 000 55 000 (100 000) 875 000 (286 800) 588 200              – 588 200

1 200 000 (500 000) 700 000 70 000 (60 000) 710 000 (200 000) 510 000            – 510 000

Big Ltd and its controlled entity Consolidated statement of changes in equity for the year ended 30 June 2019

Balance at 1 July 2018 Total comprehensive income for the year Distributions—dividends Balance at 30 June 2019

Share capital ($)

Group retained earnings ($)

Group total equity ($)

4 000 000

1 000 000 588 200   (200 000) 1 388 200

5 000 000 588 200   (200 000) 5 388 200

Share capital ($)

Retained earnings ($)

Total equity ($)

4 000 000

1 000 000 510 000   (200 000) 1 310 000

5 000 000 510 000   (200 000) 5 310 000

4 000 000

Big Ltd Statement of changes in equity for the year ended 30 June 2019

Balance at 1 July 2018 Total comprehensive income for the year Distributions—dividends Balance at 30 June 2019

4 000 000

Consolidated statement of financial position of Big Ltd and its controlled entities as at 30 June 2019

Current assets Cash Accounts receivable Inventory Non-current assets Land Plant and equipment

The Group ($)

Big Ltd ($)

275 000 325 000    860 000 1 460 000

250 000 150 000    600 000 1 000 000

1 840 000 2 870 000

1 440 000 2 470 000 continued

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  937

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Investment in Little Ltd Goodwill less Accumulated impairment loss Deferred tax asset Total assets Current liabilities Accounts payable Non-current liabilities Loans Total liabilities Shareholders’ equity Share capital Retained earnings Total shareholders’ equity Total equities

The Group ($)

Big Ltd ($)

100 000 (10 000)    163 200 4 963 200 6 423 200

1 000 000 – –    100 000 5 010 000 6 010 000

   185 000

   100 000

   850 000 1 035 000

   600 000    700 000

4 000 000 1 388 200 5 388 200 6 423 200

4 000 000 1 310 000 5 310 000 6 010 000

Unrealised profit in opening inventory Given that there were unrealised profits in the closing inventory of Big Ltd at 30 June 2019, when it is time to do the consolidation adjustments at the end of the next financial year for Big Ltd and its controlled entity (from Worked Example 26.3), there will be unrealised profits in opening inventory. Remember that the consolidation journal entries do not affect the accounts of the individual legal entities and hence do not carry forward, and therefore the cost of the opening inventory held by one of the entities within the group will be overstated from the group’s perspective, as at the beginning of the financial period. The closing retained earnings of Little Ltd in the last year (opening retained earnings this year) will also be overstated from the group’s perspective as it will include a gain on the intragroup sale of inventory. In the consolidation adjustments, we need to shift the income from the previous period, in which the inventory was still on hand, to the period in which the inventory will ultimately be sold to parties external to the economic entity. The inventory is assumed to be sold in the following period. Hence the consolidation adjustment entries at the end of the following year—that is, at 30 June 2020— would be: Dr Cr

Opening retained earnings—1 July 2019 Cost of goods sold

40 000 40 000

Remember that reducing the value of opening inventory will reduce cost of goods sold. This entry will effectively shift the income from 2019 to 2020 (the period in which the sale to an external party actually occurs). With higher profits this will lead to a higher tax expense, which, as we know, is based upon accounting profits with the adoption of tax-effect accounting. Dr Cr

Income tax expense Opening retained earnings—1 July 2019

13 200 13 200

Any profits in closing inventory in 2020 will also need to be accounted for. You will note in the above that we have not reversed the deferred tax asset account of $13 200 raised in the previous year. Have we made a mistake? No! Remember that all consolidation adjustments are undertaken on a worksheet, which is started ‘fresh’ each year. Prior adjustments DO NOT accumulate in any ledger accounts. So in 2020 there is no amount residing in a deferred tax asset account that needs to be reversed. The treatment of unrealised profit in opening inventory is shown in Worked Example 26.4. 938  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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WORKED EXAMPLE 26.4: Unrealised profit in opening inventory This worked example is a continuation of Worked Example 26.3. During the 2020 financial year, Little Ltd sold $220 000 worth of inventory to Big Ltd. The inventory cost Little Ltd $160 000 to produce. At 30 June 2020, Big Ltd had inventory worth $55 000 on hand that had been purchased from Little Ltd. In addition, the directors believe that at 30 June 2020 goodwill has been impaired by a further $20 000. The financial statements of Big Ltd and Little Ltd at 30 June 2020 are as follows:

Reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold less Other expenses Other revenue Profit Tax expense Profit after tax Retained earnings—30 June 2019 Dividends paid Retained earnings—30 June 2020 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Inventory Non-current assets Land Plant Investment in Little Ltd Deferred tax asset

Big Ltd ($000)

Little Ltd ($000)

1 500 (800) (70)     90 720    320 400 1 310 1 710    200 1 510

550 (180) (40)     30 360    130 230    515 745      50    695

1 510 4 000

695 500

140

90

   590 6 240

   240 1 525

270 220 750

35 190 455

1 440 2 450 1 000    110 6 240

400 390 –      55 1 525

REQUIRED Provide the consolidated worksheet for Big Ltd and its controlled entity for the year ended 30 June 2020. SOLUTION Elimination of investment in controlled entity (a) Dr Share capital Dr Retained earnings Dr Goodwill Cr Investment in Little Ltd

500 000 400 000 100 000 1 000 000 continued

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  939

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Recognition of the impairment of goodwill The entry below recognises the goodwill impairment loss for the period. Note that the cumulative effect of previous goodwill impairment losses must also be taken into account—as we know, the effects of previous consolidation entries do not carry forward. To make the adjustment we will debit opening retained earnings with the cumulative goodwill impairment losses to the beginning of the current financial period. (b) Dr Dr Cr

Impairment loss—goodwill Retained earnings—1 July 2019 Accumulated impairment losses—goodwill

20 000 10 000 30 000

Elimination of intercompany sales We need to eliminate the intercompany sales because, from the perspective of the economic entity, no sales have in fact occurred. This will ensure that we do not overstate the turnover of the economic entity. (c) Dr Cr

Sales Cost of goods sold

220 000 220 000

Under a periodic inventory system, the above credit entry would be to purchases, which would ultimately lead to a reduction in cost of goods sold. (Cost of goods sold equals opening inventory plus purchases less closing inventory, so any reduction in purchases leads to a reduction in cost of goods sold.) Eliminating unrealised profit in opening inventory Remember, from the previous Worked Example, there were unrealised profits in closing inventory. Therefore, in the consolidation adjustments, we need to shift the income from the previous period, in which the inventory was still on hand, to the period in which the inventory will ultimately be sold to parties external to the economic entity. The effect of reducing cost of goods sold is to increase profits in the current year. (d) Dr Cr

Opening retained earnings—1 July 2019 Cost of goods sold

40 000 40 000

Consideration of the tax on the sale of inventory held within the group at the beginning of the reporting period Reducing the value of opening inventory will reduce the cost of goods sold. This entry will effectively shift the income from 2019 to 2020 (the period in which the sale to an external party actually occurs). Higher profits will lead to a higher tax expense, which, as we know, is based upon accounting profits with the adoption of tax-effect accounting. (e) Dr Income tax expense 13 200 Cr Retained earnings—1 July 2019 13 200 Elimination of unrealised profit in closing inventory The total profit earned by Little Ltd on the sale to Big Limited of the $220 000 inventory is $60 000. Since 25 per cent of this inventory ($55 000 of $220 000) remains in the economic entity, this amount has not been fully earned. In this case, the unrealised profit amounts to $15 000. In accordance with AASB 102 Inventories, we must value the inventory at the lower of cost and net realisable value. Hence on consolidation we must reduce the value of recorded inventory, as the amount shown in the accounts of Big Ltd exceeds what the inventory cost the economic entity. (f) Dr Cost of goods sold 15 000 Cr Inventory 15 000 Under a periodic inventory system, the above debit entry would be to closing inventory—profit and loss. We increase cost of goods sold by the unrealised profit in closing inventory because reducing closing inventory effectively increases cost of goods sold. The effect of the above entries is to adjust the value of inventory so that it reflects the cost of the inventory to the group. Consideration of the tax paid on the sale of inventory that is still held within the group From the group’s perspective, $15 000 has not been earned. However, from Little Ltd’s individual perspective (as a separate legal entity), the full amount of the sale has been earned. This will attract a tax liability in Little Ltd’s accounts of $4 950 (33 per cent of $15 000). However, from the group’s perspective, some of this will

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represent a prepayment of tax, as the full amount has not been earned by the group even if Little Ltd is obliged to pay the tax. (g) Dr Deferred tax asset Cr Income tax expense ($15 000 × 33 per cent)

4950 4950

Elimination of intercompany dividends As we know, any intragroup dividends must be eliminated on consolidation (as an entity cannot pay itself a dividend). (h) Dr Cr

Dividend income (statement of profit or loss and other comprehensive income) Dividends paid (statement of changes in equity)

50 000 50 000

Consolidation worksheet for Big Ltd and its controlled entity for the year ending 30 June 2020 Eliminations and adjustments Big Ltd ($000)

Little Ltd ($000)

Dr ($000)

Reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold

1 500 (800)

550 (180)

220(c) 15(f)

less Other expenses Other revenue Profit before tax Tax expense Profit after tax Retained earnings—30 June 2019

(70)       90 720    320 400 1 310

(40)      30 360    130 230    515

20(b) 50(h)

1 710    200

745      50

1 510 4 000

695 500

140

90

   590 6 240

   240 1 525

270

35

Dividends paid Statement of financial position Shareholders’ equity Retained earnings—30 June 2020 Share capital Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash

Cr ($000)

1 830 40(d) 220(c)

13.2(e)

4.95(g)

400(a) 10(b) 40(d)

13.2(e)

50(h)

500(a)

Consolidated statements ($000)

(735) (130)     70      1 035   458.25 576.75

 1 388.2 1 964.95 200

1 764.95 4 000 230 830 6 824.95 305

continued

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  941

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Eliminations and adjustments

Accounts receivable Inventory Non-current assets Land Plant Investment in Little Ltd Deferred tax asset Goodwill Accumulated impairment loss

LO 26.4

Big Ltd ($000)

Little Ltd ($000)

220 750

190 455

1 440 2 450 1 000 110 –

400 390 – 55 –

6 240

1 525

Dr ($000)

Cr ($000) 15(f)

1 000(a) 4.95(g) 100(a) 1 373.15

       30(b) 1 373.15

Consolidated statements ($000) 410 1 190 1 840 2 840 – 169.95 100 (30)  6 824.95

Sale of non-current assets within the group

Intragroup sales are not limited to the sale of inventory. It is common for non-current assets to be sold within a group. As with inventory, for the purposes of preparing the consolidated financial statements for the economic entity, we need to value the assets as if any intragroup sale had not occurred. This means that we will need to reinstate non-current assets to their original cost or revalued amount. Any unrealised gains on the sale will need to be eliminated. Because the separate entity that acquires the asset would be depreciating the asset on the basis of the cost to itself, which might be more or less than the cost to the economic entity, there will also be a need for adjustments to depreciation as a result of intragroup sales of non-current assets. Further, from the economic entity’s perspective, no gain or loss on sale should be recorded in the accounts—in the consolidated financial statements there should be no tax expense relating to any gain on the sale. In the separate legal entity’s accounts, however, there will be tax implications. Hence, temporary differences pertaining to tax expense can also arise as a result of intercompany sales of non-current assets. In Worked Example 26.5 we discuss the intragroup sale of a non-current asset (again, this discussion of tax effects assumes that you are familiar with the requirements of tax-effect accounting as described in Chapter 18).

WORKED EXAMPLE 26.5: Intragroup sale of a non-current asset On 1 July 2018 Eddie Ltd acquired a 100 per cent interest in Sandy Ltd for $850 000, when the equity of Sandy Ltd was as follows: Share capital Retained earnings

$500 000 $300 000 $800 000

All assets of Sandy Ltd were fairly stated at acquisition date. On 1 July 2018 Eddie Ltd sells an item of plant to Sandy Ltd for $780 000. This plant cost Eddie Ltd $1 million, is four years old and has accumulated depreciation of $400 000 at the date of the sale. The remaining useful life of the plant is assessed as six years, and the tax rate is 30 per cent. At 30 June 2019 it was estimated that goodwill acquired in Sandy Ltd had been impaired by $5 000.

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The Group has a policy of measuring its property, plant and equipment using the ‘cost model’. The financial statements of Eddie Ltd and Sandy Ltd at 30 June 2019 provided the following information:

Reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold Gross profit Other income Gain on sale of fixed asset Expenses Depreciation Other expenses Profit before tax Tax expense Profit after tax Retained earnings—1 July 2018 Retained earnings—30 June 2019 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory Non-current assets Land Plant, at cost Plant—accumulated depreciation Investment in Sandy Ltd

Eddie Ltd ($000)

Sandy Ltd ($000)

2 000  (1 400) 600 

900    (350) 550 

180 

– 

–  (280) 500  (150) 350      400     750

(130)   (100) 320    (96) 224   300   524

750 1 000

524 500

150

96

    400 2 300

   250 1 370

300 420

180 220

730 – –     850 2 300

320 780 (130)        – 1 370

REQUIRED Provide the consolidated worksheet of Eddie Ltd and its controlled entity for the year ended 30 June 2019. SOLUTION Consolidated financial statements for 2019 Elimination of investment in controlled entity (a) Dr Dr Dr Cr

Share capital Retained earnings Goodwill Investment in Sandy Ltd

500 000 300 000 50 000 850 000

continued CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  943

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Reversal of gain recognised on sale of asset and reinstatement of cost and accumulated depreciation First, as we know from Chapter 5, when an item of property, plant and equipment is sold, the difference between the carrying amount of the asset and the sale proceeds is shown as a gain or loss on sale. The net amount of the gain is to be included within profit or loss. The gross proceeds from the sale is not to be shown as revenue (see paragraph 68 of AASB 116 Property, Plant and Equipment). The result of the sale of the item of plant to Sandy Ltd is that the gain of $180 000—the difference between the sale proceeds of $780 000 and the carrying amount of $600 000—will be shown in Eddie Ltd’s financial statements. However, from the economic entity’s perspective there has been no sale and therefore no gain on sale given that there has been no transaction with a party external to the group. The following entry is necessary so that the accounts reflect the balances that would have applied had the intragroup sale not occurred. (b) Dr Gain on sale of plant 180 000 Dr Plant 220 000 Cr Accumulated depreciation 400 000 The result of this entry is that the intragroup gain is removed and the asset and accumulated depreciation accounts revert to reflecting no sales transaction. The gain of $180 000 will be recognised progressively in the consolidated financial statements of the economic entity by adjustments to the amounts of depreciation charged by Sandy Ltd in its accounts. As the service potential or economic benefits embodied in the asset are consumed, the $180 000 gain will be progressively recognised from the economic entity’s perspective. This is shown in journal entry (d). Impact of tax on gain on sale of item of plant From Eddie Ltd’s individual perspective it would have made a gain of $180 000 on the sale of the plant and this gain would have been taxable. It is assumed that gain on sale of the plant is taxed at the corporate rate of tax of 30 per cent. At a tax rate of 30 per cent, $54 000 would be payable in tax by Eddie Ltd and $54 000 would similarly have been included in the income tax expense account. However, from the economic entity’s perspective, no gain has been made, which means that the related ‘tax expense’ must be reversed and a related deferred tax asset recognised. A deferred tax asset is recognised because, from the economic entity’s perspective, the amount paid to the tax office represents a prepayment of tax. (c) Dr Deferred tax asset 54 000 Cr Income tax expense 54 000 Reinstating accumulated depreciation in the statement of financial position Sandy Ltd would be depreciating the asset on the basis of the cost it incurred to acquire the asset. Its depreciation charge would be $780 000 ÷ 6 = $130 000. From the economic entity’s perspective, the asset had a carrying amount of $600 000, which was to be allocated over the next six years, giving a depreciation charge of $600 000 ÷ 6 = $100 000. An adjustment of $30 000 is therefore required. (d) Dr Accumulated depreciation 30 000 Cr Depreciation expense 30 000 Consideration of the tax effect of the reduction in depreciation expense The increase in the tax expense from the perspective of the economic entity is due to the reduction in the depreciation expense. The additional tax expense is $9 000, which is $30 000 x 30 per cent. This entry represents a partial reversal of the deferred tax asset of $54 000 recognised in the earlier entry. After six years the balance of the deferred tax asset relating to the sale of the item of plant will be $nil. (e) Dr Income tax expense 9000 Cr Deferred tax asset 9000 Recognition of the impairment of goodwill This entry recognises the goodwill impairment loss for the period. (f) Dr Impairment loss—goodwill 5000 Cr Accumulated impairment losses—goodwill

5000

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Eliminations and adjustments

Detailed reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold Gross profit Other income Gain on sale of fixed asset Total income Expenses Depreciation Other expenses Profit before tax Tax expense Profit after tax Retained earnings—1 July 2018 Retained earnings—30 June 2019 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory Non-current assets Land Plant, at cost Plant—accumulated depreciation Investment in Sandy Ltd Deferred tax asset Goodwill—at cost Goodwill—accum. impairment loss

Dr ($000)

Cr ($000)

Consolidated statement ($000)

Eddie Ltd ($000)

Sandy Ltd ($000)

2 000 (1 400) 600

900   (350) 550

    180 780

        – 550

–    (280) 500 150 350     400     750

(130)   (100) 320      96 224    300    524

750 1 000

524 500

150

96

246

    400  2 300

   250 1 370

   650 2 760

300 420

180 220

480 640

730 – – 850 – –         –  2 300

320 780 (130) – – –        – 1 370

2 900 1 750 1 150 180(b)

        – 1150 30(d)

5(f) 9(e)

54(c)

300(a)

864 1 000

500(a)

220(b) 30(d) 54(c) 50(a) 1 348

(100)   (385) 665    201 464    400    864

400(b) 850(a) 9(e)      5(f) 1 348

1 050 1 000 (500) – 45 50      (5) 2 760

To ensure that we know how to take account of prior period adjustments (such as adjustments relating to a prior period sale of a non-current asset) when we undertake a consolidation in periods subsequent to the first consolidation, in Worked Example 26.6 we undertake the consolidation of Eddie Ltd and its controlled entity as at 30 June 2020—that is, two years after control of the subsidiary was established.

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WORKED EXAMPLE 26.6: Consolidation two years after acquisition in the presence of a prior period intragroup sale of a non-current asset The financial statements of Eddie Ltd and its controlled entity, Sandy Ltd, at 30 June 2020 are as follows:

Detailed reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold Gross profit Expenses Depreciation Other expenses Profit before tax Tax expense Profit after tax Retained earnings—1 July 2019 Retained earnings—30 June 2020 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory Non-current assets Land Plant, at cost Plant—accumulated depreciation Investment in Sandy Ltd

Eddie Ltd ($000)

Sandy Ltd ($000)

2 700 (1 550) 1 150

1 100   (440) 660

– 410 740 222 518    750 1 268

130  120 410   123 287    524 811

1 268 1 000

811 500

222

123

    390 2 880

   245 1 679

300 820

280 559

910 – –       850 2 880

320 780 (260)        – 1 679

REQUIRED Prepare the consolidated statement of financial position and consolidated statement of profit or loss and other comprehensive income of Eddie Ltd and its controlled entity for the year ended 30 June 2020, assuming that the directors believe that goodwill on acquisition has been impaired by a further $5 000. In undertaking the consolidation you will need to take account of the sale of plant made in the prior period, as discussed in Worked Example 26.5. SOLUTION Elimination of investment in controlled entity (a) Dr Dr Dr Cr

Share capital Retained earnings Goodwill Investment in Sandy Ltd

500 000 300 000 50 000 850 000

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Reversal of gain recognised in prior period on sale of asset and reinstatement of cost and accumulated depreciation (b) Dr Dr Dr Cr

Retained earnings Deferred tax asset Plant Accumulated depreciation

126 000 54 000 220 000 400 000

Reinstating accumulated depreciation in the statement of financial position (c) Dr Accumulated depreciation 60 000 Cr Depreciation expense Cr Retained earnings

30 000 30 000

Consideration of the tax effect of current and previous period’s depreciation (d) Dr Income tax expense 9000 Dr Retained earnings 9000 Cr Deferred tax asset 18 000 Recognition of the impairment of goodwill in current and previous period (e) Dr Impairment loss—goodwill 5000 Dr Retained earnings 5000 Cr Accumulated impairment losses—goodwill

10 000

The consolidated financial statements can be prepared from the following worksheet: Eliminations and adjustments

Detailed reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold Gross profit Expenses Depreciation Other expenses Profit before tax Tax expense Profit after tax Retained earnings—1 July 2019

Retained earnings—30 June 2020 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Tax payable

Eddie Ltd ($000)

Sandy Ltd ($000)

2 700 (1 550) 1 150

1 100 (440) 660

– 410 740   222 518    750

130   120 410   123 287 524

 1 268

 811

1 268 1 000

811 500

222

123

Dr ($000)

Cr ($000)

Consolidated statement ($000)

3 800 1 990 1 810 30(c) 5(e) 9(d) 300(a) 126(b) 9(d) 5(e)

500(a)

100   535 1 175   354 821

30(c)

  864  1685

1 685 1 000 345

continued CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  947

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Eliminations and adjustments Sandy Ltd ($000)

   390 2 880

   245 1 679

  635 3 665

300 820

280 559

580 1 379

910 – – 850 – –        – 2 880

320 780 (260) – – –        – 1 679

1 230 1 000 (600) – 36 50 (10) 3 665

Non-current liabilities Loans Current assets Accounts receivable Inventory Non-current assets Land Plant, at cost Plant—accumulated depreciation Investment in Sandy Ltd Deferred tax asset Goodwill—at cost Goodwill—accum. impairment loss

Dr ($000)

Cr ($000)

Consolidated statement ($000)

Eddie Ltd ($000)

220(b) 60(c)

400(b) 850(a) 18(d)

54(b) 50(a)

     10(e) 1 338  

1 338

Consolidated statement of profit or loss and other comprehensive income of Eddie Ltd and its controlled entity for the year ended 30 June 2020

Sales Cost of good sold Gross profit Depreciation Other expenses Profit before tax Income tax expense Profit after tax Other comprehensive income Total comprehensive income for the year

The Group ($)

Big Ltd ($)

3 800 000 (1 990 000) 1 810 000 (100 000)   (535 000) 1 175 000     354 000     821 000                 –     821 000

2 700 000 (1 550 000) 1 150 000 –   (410 000) 740 000    (222 222)     518 000                 –     518 000

Eddie Ltd and its controlled entity Statement of changes in equity for the year ended 30 June 2020

Balance at 1 July 2019 Total comprehensive income for the year Distributions—dividends Balance at 30 June 2020

Share capital

Group retained earnings

Group total equity

1 000 000

864 000 821 000                – 1 685 000

1 864 000 821 000                – 2 685 000

                  1 000 000

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Eddie Ltd Statement of changes in equity for the year ended 30 June 2020

Balance at 1 July 2019 Total comprehensive income for the year Distributions—dividends Balance at 30 June 2020

Share capital

Retained earnings

Total equity

1 000 000

750 000 518 000                – 1 268 000

1 750 000 518 000                – 2 268 000

1 000 000

Consolidated statement of financial position of Eddie Ltd and its controlled entity as at 30 June 2020

Current assets Accounts receivable Inventory Non-current assets Land Plant and equipment Accumulated depreciation Investment in Sandy Ltd Deferred tax asset Goodwill less Accumulated impairment loss Total assets Current liabilities Tax payable Non-current liabilities Loan Total liabilities Shareholders’ equity Share capital Retained earnings Total shareholders’ equity Total equities

The Group ($)

Eddie Ltd ($)

580 000 1 379 000 1 959 000

300 000    820 000 1 120 000

1 230 000 1 000 000 (600 000) 36 000 50 000     (10 000) 1 706 000 3 665 000

910 000 – – 850 000 – –                – 1 760 000 2 880 000

   345 000

   222 000

   635 000    980 000

   390 000    612 000

1 000 000 1 685 000 2 685 000 3 665 000

1 000 000 1 268 000 2 268 000 2 880 000

SUMMARY This chapter considered the consolidation process and, in particular, how to account for intragroup transactions—that is, intragroup dividend payments, sales of inventory and sales of non-current assets. Only dividends paid externally should be shown in the consolidated financial statements, so that intragroup dividends paid by one entity within the group are offset against dividend revenue recorded in another entity. Further, for intragroup dividends, the liability associated with dividends payable is to be offset against the asset dividend receivable, as recorded by other entities within the group.

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Individual entities within a group often provide goods and services to one another at a profit. From the economic entity’s perspective, however, revenue related to the sale of goods and services should be shown only where the inflow of economic benefits has come from parties external to the group. As a result, on consolidation it is often necessary to provide adjusting entries, which eliminate the effects of the intragroup sales. Where there have been intragroup sales and some of the inventory is still on hand within the group at year end, consolidation adjustments will need to be made, which reduce the consolidated balance of closing inventory. This is required to ensure that the consolidated financial statements measure inventory at the lower of cost and net realisable value from the group’s perspective (consistent with AASB 102). Where there is a sale of non-current assets within the group, consolidation adjustments are to be made to eliminate any intragroup gain on the sale of the assets and to adjust the cost of the asset to reflect its cost to the economic entity. Where there are intragroup sales of non-current assets, there is also typically a requirement to adjust depreciation as part of the consolidation process.

KEY TERMS intragroup transaction  925

END-OF-CHAPTER EXERCISES PART A 1. Following consolidation, should dividends paid to the parent entity by its subsidiaries be shown in the economic entity’s financial statements? 2. Will dividends paid by subsidiaries out of their pre-acquisition earnings affect the amount of goodwill that will be calculated on consolidation? 3. If a subsidiary sells inventory to the parent entity and some of the inventory is still on hand at year end, what adjustments are necessary at year end? Will adjustments be required to restate the balance of opening inventory as at the beginning of the next financial period? LO 26.2, 26.3 PART B The following financial statements of Mungo Ltd and its subsidiary Barry Ltd have been extracted from their financial records at 30 June 2019. Mungo Ltd ($000) Detailed reconciliation of opening and closing retained earnings Sales revenue Cost of goods sold Gross profit Dividends received from Barry Ltd Management fee revenue Gain on sale of plant Expenses Administrative expenses Depreciation Management fee expense Other expenses Profit before tax

Barry Ltd ($000)

1 380   (928)   452 186 53 70

1 160   (476)   684 – – –

(98.8) (49) –   (202.2) 411  

(77.4) (113.6) (53)   (154)   286

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Tax expense Profit for the year Retained earnings—30 June 2018 Dividends paid Retained earnings—30 June 2019

Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory Non-current assets Land and buildings Plant—at cost Accumulated depreciation Investment in Barry Ltd

   123     288    638.8 926.8   (274.8)    652   

     84.4 201.6    478.4 680   (186)      494   

Mungo Ltd ($000)

Barry Ltd ($000)

652 700 109.4   82.6    347     1 891   

494 400 92.6 50    232     1 268.6

118.8 184

124.6 58

448     599.7    (171.5)    712     1 891   

652 711.6 (277.6)       –      1 268.6

Other information • Mungo Ltd acquired its 100 per cent interest in Barry Ltd for $712 000 on 1 July 2015, that is four years earlier. At that date the capital and reserves of Barry Ltd were: Share capital Retained earnings

$400 000 $250 000 $650 000

At the date of acquisition all assets were considered to be fairly valued. • During the year Mungo Ltd made total sales to Barry Ltd of $130 000, while Barry Ltd sold $104 000 in inventory to Mungo Ltd. • The opening inventory in Mungo Ltd as at 1 July 2018 included inventory acquired from Barry Ltd for $84 000 that had cost Barry Ltd $70 000 to produce. • The closing inventory in Mungo Ltd includes inventory acquired from Barry Ltd at a cost of $67 200. This cost Barry Ltd $52 000 to produce. • The closing inventory of Barry Ltd includes inventory acquired from Mungo Ltd at a cost of $24 000. This cost Mungo Ltd $19 200 to produce. • The management of Mungo Ltd believe that goodwill acquired was impaired by $5 000 in the current financial year. Previous impairments of goodwill amounted to $10 000. • On 1 July 2018 Mungo Ltd sold an item of plant to Barry Ltd for $100 000 when its carrying amount in Mungo Ltd’s accounts was $80 000 (cost $120 000, accumulated depreciation $40 000). This plant is assessed as having a remaining useful life of six years from the date of sale. The Group has a policy of measuring its property, plant and equipment using the ‘cost model’. CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  951

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• Barry Ltd paid $20 000 in management fees to Barry Ltd. • The tax rate is 30 per cent.

REQUIRED Provide the consolidated financial statements of Mungo Ltd and Barry Ltd as at 30 June 2019. LO 26.1, 26.2, 26.3, 26.4

SOLUTION TO END-OF-CHAPTER EXERCISE Elimination of the investment in Barry Ltd and the recognition of goodwill on consolidation Barry Ltd ($) 400 000 250 000 650 000 712 000  62 000

Share capital at acquisition date—1 July 2015 Retained earnings at acquisition date—1 July 2015 Investment in Barry Ltd Goodwill on consolidation

As shown above, the net assets of Barry Ltd are $650 000 at acquisition date. As $712 000 is paid for the investment, the goodwill amounts to $62 000. The consolidation entry to eliminate the investment is: (a) Dr Dr Dr Cr

Share capital Retained earnings Goodwill Investment in Barry Ltd

400 000 250 000 62 000 712 000

Elimination of intercompany sales We need to eliminate the intragroup sales because, from the perspective of the economic entity, no sales have in fact occurred. This will ensure that we do not overstate the turnover of the economic entity. Sale of inventory from Barry Ltd to Mungo Ltd (b) Dr Sales Cr Cost of goods sold

104 000 104 000

Under the periodic inventory system, the above credit entry would instead be to purchases, which would ultimately lead to a reduction in cost of goods sold. (Cost of goods sold equals opening inventory plus purchases less closing inventory, so any reduction in purchases leads to a reduction in cost of goods sold.)

Elimination of the unrealised profit in the closing inventory of Mungo Ltd In this case, the unrealised profit in closing amounts to $15 200. In accordance with AASB 102 Inventories, we must value the inventory at the lower of cost and net realisable value. Therefore on consolidation we must reduce the value of recorded inventory as the amount shown in the accounts of Mungo Ltd exceeds what the inventory cost the economic entity. (c) Dr Cost of goods sold 15 200 Cr Inventory 15 200

Under the periodic inventory system, the above debit entry would be to closing inventory—profit and loss. We increase cost of goods sold by the unrealised profit in closing inventory because reducing closing inventory effectively increases cost of goods sold. (Remember, cost of goods sold equals opening inventory plus purchases less closing inventory.) The effect of the above entries is to adjust the value of inventory so that it reflects the cost of the inventory to the group.

Consideration of the tax paid or payable on the sale of inventory that is still held within the group From the group’s perspective, $15 200 has not been earned. However, from Barry Ltd’s individual perspective (as a separate legal entity), the full amount of the sale has been earned. This will attract a tax liability in Barry Ltd’s accounts of $4 560 (30 per cent of $15 200). However, from the group’s perspective

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some of this will represent a prepayment of tax as the full amount has not been earned by the group even if Barry Ltd is obliged to pay the tax. (d) Dr Deferred tax asset 4 560 Cr Income tax expense 4 560 ($15 200 × 30 per cent) Sale of inventory from Mungo Ltd to Barry Ltd During the current financial period Mungo Ltd sold inventory to Barry Ltd at a price of $130 000. The unrealised profit component is $4 800. (e) Dr Sales 130 000 Cr Cost of goods sold 130 000 (eliminating intragroup sales) Elimination of unrealised profits in the closing inventory of Barry Ltd In this case, the unrealised profit in closing inventory amounts to $4 800. In accordance with AASB 102 Inventories, the inventory must be valued at the lower of cost and net realisable value. Therefore, on consolidation, the value of inventory must be reduced as the amount shown in the financial statements of Barry Ltd exceeds what the inventory cost the economic entity. (f) Dr Cost of goods sold 4 800 Cr Inventory 4 800 (eliminating unrealised profit in closing inventory) Consideration of the tax paid on the sale of the inventory that is still held within the group From the group’s perspective, $4 800 has not been earned. However, from Mungo Ltd’s individual perspective (as a separate legal entity) the full amount of the sale has been earned. This will attract a tax liability in Mungo Ltd’s financial statements of $1 440, which is 30 per cent of $4 880. However, from the group’s perspective some of this will represent a prepayment of tax, as the full amount has not been earned by the group even though Mungo Ltd is obliged to pay the tax. (g) Dr Deferred tax asset Cr Income tax expense ($4 800 × 30 per cent)

1 440 1 440

Unrealised profit in opening inventory At the end of the preceding financial year, Mungo Ltd had $84 000 of inventory on hand, which had been purchased from Barry Ltd. The inventory had cost Barry Ltd $70 000 to produce. Assume that the inventory has been sold to an external party in the current period and is therefore realised—so there is no need to adjust the closing balance of inventory. (h) Dr Dr Cr

Retained earnings—30 June 2018 Income tax expense Cost of sales

9 800 4 200 14 000

Adjustments for intragroup sale of plant On 1 July 2018 Mungo Ltd sold an item of plant to Barry Ltd for $100 000 when its carrying amount in Barry Ltd’s accounts was $80 000 (cost of $120 000 and accumulated depreciation of $40 000). This item of plant was being depreciated over a further six years from acquisition date, with no expected residual value. Reversal of gain recognised on sale of asset and reinstatement of cost and accumulated depreciation The result of the sale of the item of plant to Barry Ltd is that the gain on sale of $20 000—the difference between the sales proceeds of $100 000 and the carrying amount of $80 000—will be shown in Mungo Ltd’s financial statements. However, from the economic entity’s perspective there has been no sale and, therefore, no gain on sale given that there has been no transaction with a party external to the group. The following entry is necessary for the accounts to reflect the balances that would have applied had the intragroup sale not occurred. (i)

Dr Dr Cr

Gain on sale of plant Plant Accumulated depreciation

20 000 20 000 40 000

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  953

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The result of this entry is that the intragroup gain on sale is removed and the asset and accumulated depreciation accounts revert to reflecting no sales transaction. The gain of $20 000 will be recognised progressively in the consolidated financial report of the economic entity by adjustments to the amounts of depreciation charged by Barry Ltd in its accounts. As the service potential or economic benefits embodied in the asset are consumed, the $20 000 gain will be progressively recognised from the economic entity’s perspective. This is shown in journal entry (k). Effect of tax on profit on sale of item of plant From Mungo Ltd’s individual perspective it would have made a gain of $20 000 on the sale of the plant and this gain would have been taxable. At a tax rate of 30 per cent, $6 000 would then be payable by Mungo Ltd. However, from the economic entity’s perspective, no gain has been made, which means that the related ‘tax expense’ must be reversed and a related deferred tax benefit be recognised. A deferred tax asset is recognised because, from the economic entity’s perspective, the amount paid to the tax office represents a prepayment of tax. ( j) Dr Cr

Deferred tax asset Income tax expense

6 000 6 000

Reinstating accumulated depreciation in the statement of financial position Mungo Ltd would be depreciating the asset on the basis of the cost it incurred to acquire the asset. Its depreciation charge would be $100 000 ÷ 6 = $16 667. From the economic entity’s perspective, the asset had a carrying value of $80 000, which was to be allocated over the next six years, giving a depreciation charge of $80 000 ÷ 6 = 13 333. An adjustment of $3 334 is therefore required. (k) Dr Cr

Accumulated depreciation Depreciation expense

3 334 3 334

Consideration of the tax effect of the reduction in depreciation expense The increase in the tax expense from the perspective of the economic entity is due to the reduction in the depreciation expense. The additional tax expense is $1 000, which is $3 334 × 30 per cent. This entry represents a partial reversal of the deferred tax asset of $6 000 recognised in an earlier entry. After six years the balance of the deferred tax asset relating to the sale of the item of plant will be $nil. (l)

Dr Cr

Income tax expense Deferred tax asset

1 000 1 000

Impairment of goodwill (m) Dr Dr Cr

Retained earnings Impairment loss—goodwill Accumulated impairment losses—goodwill

10 000 5000 15 000

Elimination of intragroup transactions—management fees All of the management fees paid within the group will need to be eliminated on consolidation. (n) Dr Cr

Management fee revenue Management fee expense

20 000 20 000

Dividends paid We eliminate dividends paid within the group. Only dividends paid to parties outside the entity (noncontrolling interests) are to be shown in the consolidated accounts. (o) Dr Cr

Dividend revenue Dividend paid

186 000 186 000

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We can now post the consolidation journal entries to the consolidation worksheet. Eliminations and adjustments Mungo Ltd ($000)

Barry Ltd ($000)

Detailed reconciliation of opening and closing retained earnings Sales revenue

1 380

1 160

Cost of goods sold

  (928)  

   (476)  

452

684 – –

Gross profit Other revenue Dividends received from Barry Ltd Management fee revenue Gain on sale of plant Expenses Administrative expenses Depreciation Management fee expense Other expenses Profit before tax Tax expense

(98.8) (49) –   (202.2) 411    123    

(77.4) (113.6) (53)    (154)   286      84.4

Profit for the year Retained earnings—30 June 2018

288    638.8

201.6    478.4

926.8   (274.8)    652   

680    (186)       494   

652 700

494 400

Dividends paid Retained earnings—30 June 2019 Statement of financial position Shareholders equity Retained earnings Share capital Current liabilities Accounts payable Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory

186 53 70

109.4 82.6

92.6 50

   347    1 891   

    232     1 268.6 

118.8 184

124.6 58

Dr ($000)

104(b) 130(e) 15.2(c) 4.8(f)

Cr ($000)

Consolidated statement ($000)

2 306 104(b) 130(e) 14(h)

1 176       

1130 186(o) 20(n) 20(i)

– 33 50

3.334(k) 20(n) 5(m) 4.2(h) 1(l)

4.56(d) 1.44(g) 6( j)

(176.2) (159.266) (33)   (361.2)    483.334    200.6    

282.734    847.4    

250(a) 9.8(h) 10(m) 186(o)

1 130.134   (274.8)        855.334

855.334 700

400(a)

202 132.6    579         2 468.934

15.2(c) 4.8(f)

243.4 222

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Eliminations and adjustments Mungo Ltd ($000)

Barry Ltd ($000)

Non-current assets Deferred tax asset

Land and buildings Plant—at cost Accumulated depreciation Investment in Barry Ltd Goodwill Accumulated amortisation

Dr ($000)

Cr ($000)

4.56(d) 1.44(g) 6( j) 448 599.7 (171.5) 712 –        –    1 891   

652  711.6 (277.6) – –        –    1 268.6

20(i) 3.334(k)

1(l)

40(i) 712(a)

62(a) 1 257.334

     15(m)    1 257.334

Consolidated statement ($000) 11

1 100 1 331.3 (485.766) – 62     (15)        2 468.934

The next step would be to present the consolidated financial statements. A suggested format for the consolidated accounts would be as follows (prior year comparatives for the accounts of the parent entity, both of which would be required in practice, have not been provided): Consolidated statement of profit or loss and other comprehensive income of Mungo Ltd and its subsidiaries for the year ended 30 June 2019

Sales Cost of goods sold Gross profit Dividend income Management fee revenue Gain on sale of plant Administrative expenses Depreciation Goodwill amortisation Management fee expense Other expenses Profit before income tax expense Income tax expense Profit after tax Other comprehensive income Total comprehensive income

The Group ($)

Mungo Ltd ($)

2 306 000  (1 176 000) 1 130 000  –  33 000  50 000  (176 200) (159 266) (5 000) (33 000)    (356 200) 483 334     (200 600) 282 734                  –     282 734 

1 380 000     (928 000) 452 000  186 000  53 000  70 000  (98 800) (49 000) – –    (202 200) 411 000    (123 000) 288 000                –    288 000

Mungo Ltd and its controlled entity Statement of changes in equity for the year ended 30 June 2019

Balance at 1 July 2018 Total comprehensive income for the year Distributions—dividends Balance at 30 June 2019

Share capital

Group retained earnings

Group total equity

700 000

847 400  282 734  (274 800) 855 334 

1 547 400  282 734    (274 800) 1 555 334 

700 000

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Mungo Ltd Statement of changes in equity for the year ended 30 June 2019

Balance at 1 July 2018 Total comprehensive income for the year Distributions—dividends Balance at 30 June 2019

Share capital

Retained earnings

Total equity

700 000

638 800  288 000  (274 800) 652 000

1 338 800  288 000    (274 800) 1 352 000

700 000

Consolidated statement of financial position of Mungo Ltd and its subsidiaries as at 30 June 2019

Current assets Accounts receivable Inventory Non-current assets Land and buildings Plant and equipment less Accumulated depreciation Investment in Barry Ltd Goodwill less Accumulated impairment loss Deferred tax asset Total assets Current liabilities Accounts payable Tax payable Non-current liabilities Loan Total liabilities Shareholders’ equity Share capital Retained earnings Total shareholders’ equity Total equities

The Group ($)

Mungo Ltd ($)

243 400    222 000    465 400

118 800    184 000    302 800

1 100 000 1 331 300 (485 766) 62 000 (15 000) 11 000 2 003 534 2 468 934

448 000 599 700 (171 500) 712 000 – –               – 1 588 200 1 891 000

202 000    132 600    334 600

109 400      82 600    192 000

   579 000    913 600

   347 000    539 000

700 000    855 334 1 555 334 2 468 934

700 000    652 000 1 352 000 1 891 000

REVIEW QUESTIONS 1. What is an intragroup transaction and why do we need to know about them? LO 26.1 2. When does an intragroup inventory transaction require us to perform a consolidation adjustment to tax expense? LO 26.3 3. In the consolidated financial statements, which dividends are to be shown as paid, declared, payable and receivable? LO 26.2 4. How would dividends that have been paid out of pre-acquisition earnings of a subsidiary be treated in the accounts of the parent entity? LO 26.2 CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  957

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5. What effect, if any, would the payment of dividends by a controlled entity, out of its pre-acquisition earnings, have on the amount of goodwill that would be recognised on consolidation? LO 26.2 6. If one entity sells inventory to another entity, which is 80 per cent owned, what percentage of the sales revenue needs to be eliminated in the consolidation process? LO 26.3 7. A Ltd owns 100 per cent of B Ltd, which in turn owns 100 per cent of C Ltd. During the financial year, A Ltd sells inventory to B Ltd at a sale price of $150 000. The inventory cost A Ltd $100 000 to produce. Within the same financial year, B Ltd subsequently sells the same inventory to C Ltd for $200 000 without incurring any additional costs. At the end of the financial year, C Ltd has sold half of this inventory to companies outside the group for a sale price of $180 000. At year end C Ltd still has half the stock on hand.

REQUIRED From the economic entity’s perspective (that is, the group’s perspective), determine: (a) the sales revenue for the financial year (b) the value of closing inventory. LO 26.3 8. Big Company owns all of the issued capital of Small Company. Big Company acquires its 100 per cent interest in Small Company on 1 July 2018 for a cost of $2 000. All assets are fairly stated at acquisition date. The share capital and reserves of Small Company on the date of acquisition are: Share capital Retained earnings

$ 1 250    750 2 000

The reconciliation of retained earnings and statement of financial positions of Big Company and Small Company, as at 30 June 2019, are as follows:

Reconciliation of opening and closing retained earnings Profit before tax Tax Profit after tax Opening retained earnings less Dividends declared Closing retained earnings Statement of financial position Shareholders’ funds Retained earnings Share capital Liabilities Accounts payable Dividends payable Assets Cash Accounts receivable Dividends receivable Inventory Plant and equipment Investment in Small Company

Big Company ($)

Small Company ($)

500    125 375 1 000 1 375    175 1 200

250    100 150 750 900    125    775

1 200 1 250

775 1 250

2 500    175 5 125

250    125 2 400

250 125 250 375 2 125 2 000 5 125

175 325 – 400 1 500        – 2 400

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REQUIRED Provide the consolidated statement of profit or loss and other comprehensive income, statement of financial position and statement of changes in equity for Big Company and its controlled entity for the year ending 30 June 2019. LO 26.2 9. Bernie Boffin Ltd owns 100 per cent of Computer Ltd. On 1 July 2017 Bernie Boffin Ltd sells an item of plant to Computer Ltd for $3.6 million. This plant cost Bernie Boffin Ltd $4.5 million and had accumulated depreciation of $1.8 million at the date of the sale. The remaining useful life of the plant is assessed as 12 years and the tax rate is 33 per cent.

REQUIRED Provide the consolidation journal entries for 30 June 2018 and 30 June 2019 to adjust for the above sale. LO 26.4 10. Bigger Company owns all the issued capital of Smaller Company. The financial statements of Bigger Company and Smaller Company at 30 June 2019 are as follows: Bigger Company ($)

Smaller Company ($)

500    125 375 4 000 4 375    175 4 200

500   200 300 1 500 1 800    250 1 550

4 200 1 250

1 550 2 500

2 500    175 8 125

500    250 4 800

250 125 250 375 2 125 5 000 8 125

350 650 – 800 3 000        – 4 800

Reconciliation of opening and closing retained earnings Profit before tax Tax Profit after tax Opening retained earnings less Dividends proposed Closing retained earnings Statement of financial position Shareholders’ funds Retained earnings Share capital Liabilities Accounts payable Dividends payable Assets Cash Accounts receivable Dividends receivable Inventory Plant and equipment Investment in Smaller Company

Bigger Company acquired its 100 per cent interest in Smaller Company on 1 July 2018 for a cost of $5 000. The share capital and reserves of Smaller Company on the date of acquisition are:

Share capital Retained earnings

$ 2 500 1 500 4 000

The directors believe that goodwill has been impaired by 20 per cent in the year to 30 June 2019. CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  959

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REQUIRED Provide the consolidated statement of profit or loss and other comprehensive income and statement of financial position for Bigger Company and its controlled entity for the year ending 30 June 2019. LO 26.2 11. Nat Ltd acquires all of the issued capital of Midget Ltd for a cash payment of $1.5 million on 30 June 2019. The statements of financial position of both entities immediately following the purchase are: Nat Ltd ($000)

Midget Ltd ($000)

60 900

45 135

4 440 1 500 6 900

1 800        – 1 980

300

90

2 400

540

3 000 1 200 6 900

600    750 1 980

Current assets Cash Accounts receivable Non-current assets Plant Investment in Midget Ltd Current liabilities Accounts payable Non-current liabilities Loans Shareholders’ equity Share capital Retained earnings

Additional information Immediately following the acquisition, a dividend of $600 000 is declared by Midget Ltd. The accounts provided here do not reflect this dividend payment.

REQUIRED Provide the consolidated statement of financial position of Nat Ltd and Midget Ltd as at 30 June 2019. LO 26.2

CHALLENGING QUESTIONS 12. Jacko Ltd owns 100 per cent of the shares of Jackson Ltd, acquired on 1 July 2018 for $3.5 million when the shareholders’ funds of Jackson Ltd were:

Share capital Retained earnings

$ 1 750 000 1 400 000 3 150 000

All assets of Jackson Ltd are fairly stated at acquisition date. The directors believe that there has been an impairment loss on the goodwill of $35 000 for the year ended 30 June 2019. During the 2019 financial year, Jackson Ltd sells inventory to Jacko Ltd at a sale price of $700 000. The inventory cost Jackson Ltd $420 000 to produce. At 30 June 2019, half of the inventory is still on hand with Jacko Ltd. The tax rate is 33 per cent.

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The financial statements of Jacko Ltd and Jackson Ltd at 30 June 2019 are as follows: Jacko Ltd ($000) Reconciliation of opening and closing retained earnings Sales revenue less Cost of goods sold less Other expenses Other revenue Profit Tax expense Profit after tax Retained earnings—1 July 2018 Dividends paid Retained earnings—30 June 2019 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Inventory Non-current assets Land Plant Investment in Ltd Future income tax benefit Goodwill

Jackson Ltd ($000)

4 200 (1 750) (210)      245 2 485      700 1 785    3 500 5 285       700    4 585

     1 400   (490)   (105)       87.5 892.5   350      542.5 1 400    1 942.5    140       1 802.5

  4 585 14 000

   1 802.5    1 750       297.5       875    4 725       87.5 612.5      1 050           1 400       1 400            –        175          –    4 725   

350   2 100 21 035 875 525 2 100 5 040 8 645 3 500 350           – 21 035

REQUIRED Provide the consolidated financial statements for Jacko Ltd and its controlled entity for 2019. LO 26.2, 26.3 13. The following financial statements of Andy Ltd and its subsidiary Irons Ltd have been extracted from their financial records at 30 June 2019.

Reconciliation of opening and closing retained earnings Sales revenue Cost of goods sold Gross profit

Andy Ltd ($)

Irons Ltd ($)

839 250   (580 000) 259 250

725 000 (297 500) 427 500

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Dividends received from Irons Ltd Management fee revenue Gain on sale of plant Expenses Administrative expenses Depreciation Management fee expense Other expenses Profit before tax Tax expense Profit for the year Retained earnings—30 June 2018 Dividends paid Retained earnings—30 June 2019 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory Non-current assets Land and buildings Plant—at cost Accumulated depreciation Investment in Irons Ltd

Andy Ltd ($)

Irons Ltd ($)

116 250 33 125 43 750



(38 500) (30 625) –   (126 375) 256 875      76 875 180 000    399 250 579 250   (171 750)    407 500

(48 375) (71 000) (33 125)    (96 250) 178 750     52 750 126 000  299 000 425 000  (116 250)  308 750

407 500 437 500

308 750 250 000

– 100 000

57 875 31 250

   236 000 1 181 000

 145 000   792 875

74 250 115 000

77 875 36 250

198 750 400 000 (107 000)    500 000 1 181 000

407 500 444 750 (173 500)              –   792 875

Other information • Andy Ltd acquired its 100 per cent interest in Irons Ltd on 1 July 2012—that is, seven years earlier. The cost of the investment was $500 000. At that date the capital and reserves of Irons Ltd were:

Share capital

$ 250 000

Retained earnings

200 000 450 000

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At the date of acquisition all assets were considered to be fairly valued. • During the year Andy Ltd made total sales to Irons Ltd of $81 250, while Irons Ltd sold $65 000 in inventory to Andy Ltd. • The opening inventory in Andy Ltd as at 1 July 2018 included inventory acquired from Irons Ltd for $52 500 that cost Irons Ltd $43 750 to produce. • The closing inventory in Andy Ltd includes inventory acquired from Irons Ltd at a cost of $42 000. This cost Irons Ltd $35 000 to produce. • The closing inventory of Irons Ltd includes inventory acquired from Andy Ltd at a cost of $15 000. This cost Andy Ltd $12 000 to produce. • The management of Andy Ltd believe that goodwill acquired was impaired by $3 750 in the current financial year. Previous impairments of goodwill amounted to $20 000. • On 1 July 2018 Andy Ltd sold an item of plant to Irons Ltd for $145 000 when its carrying amount in Andy Ltd’s accounts was $101 250 (cost $168 750, accumulated depreciation $67 500). This plant is assessed as having a remaining useful life of six years. The Group has a policy of measuring its property, plant and equipment using the ‘cost model’. • Irons Ltd paid $33 125 in management fees to Irons Ltd. • The tax rate is 30 per cent.

REQUIRED Prepare the consolidated statement of financial position and consolidated statement of profit or loss and other comprehensive income of Andy Ltd and Irons Ltd as at 30 June 2019. Also provide a statement of changes in equity. LO 26.2, 26.3, 26.4 14. The following financial statements of Joel Ltd and its subsidiary Parko Ltd have been extracted from their financial records at 30 June 2019.

Reconciliation of opening and closing retained earnings Sales revenue Cost of goods sold Gross profit Dividends received from Parko Ltd Management fee revenue Gain on sale of plant Expenses Administrative expenses Depreciation Management fee expense Other expenses Profit before tax Tax expense Profit for the year Retained earnings—30 June 2018 Dividends paid Retained earnings—30 June 2019

Joel Ltd ($000)

Parko Ltd ($000)

671.4 (464)   207.4 93   26.5 40  

540   (238)    302   –

(30.8) (29.5) – (101.1) 205.5 61.5 144  3 19.4 463.4 (137.4)   326    

(38.7) (56.8) (26.5)   (72)   143   42.2 100.8  239.2 340     (93)    247   

35  

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Joel Ltd ($000)

Parko Ltd ($000)

Statement of financial position Shareholders’ equity Retained earnings

326  

247  

Share capital

350  

200  

Accounts payable

54.7

46.3

Tax payable

41.3

25  

173.5  

116   

945.5  

634.3

Accounts receivable

59.4

62.3

Inventory

92  

29  

Land and buildings

224  

326  

Plant—at cost

299.85

355.8

Current liabilities

Non-current liabilities Loans Current assets

Non-current assets

Accumulated depreciation Investment in Parko Ltd

(85.75)

(138.8)

356     

     –    

945.5  

634.3

Other information • Joel Ltd acquired its 100 per cent interest in Parko Ltd on 1 July 2014, that is, five years earlier. At that date the capital and reserves of Parko Ltd were: Share capital

$200 000

Retained earnings

$180 000 $380 000

At the date of acquisition all assets were considered to be fairly valued. • During the year Joel Ltd made total sales to Parko Ltd of $60 000, while Parko Ltd sold $50 000 in inventory to Joel Ltd. • The opening inventory in Joel Ltd as at 1 July 2018 included inventory acquired from Parko Ltd for $40 000 that cost Parko Ltd $30 000 to produce. • The closing inventory in Joel Ltd includes inventory acquired from Parko Ltd at a cost of $33 000. This cost Parko Ltd $28 000 to produce. • The closing inventory of Parko Ltd includes inventory acquired from Joel Ltd at a cost of $12 000. This cost Joel Ltd $10 000 to produce. • On 1 July 2018 Parko Ltd sold an item of plant to Joel Ltd for $116 000 when its carrying value in Parko Ltd’s accounts was $81 000 (cost $135 000, accumulated depreciation $54 000). This plant is assessed as having a remaining useful life of six years. The Group has a policy of measuring its property, plant and equipment using the ‘cost model’.

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• Parko Ltd paid $26 500 in management fees to Joel Ltd. • The tax rate is 30 per cent.

REQUIRED Prepare a consolidated statement of financial position, a consolidated statement of profit or loss and other comprehensive income and a consolidated statement of changes in equity for Joel Ltd and Parko Ltd as at 30 June 2019. Also prepare a consolidated statement of changes in equity.   LO 26.2, 26.3, 26.4

CHAPTER 26: FURTHER CONSOLIDATION ISSUES I: ACCOUNTING FOR INTRAGROUP TRANSACTIONS  965

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CHAPTER 27

FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS LEARNING OBJECTIVES (LO) 27.1 Understand the meaning and nature of non-controlling interests. 27.2 Know how to calculate the non-controlling interests’ share in share capital and reserves, and current period profit or loss and other comprehensive income. 27.3 Know how to calculate goodwill or bargain gain on purchase in the presence of non-controlling interests. 27.4 Know how to disclose non-controlling interests within consolidated financial statements.

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Introduction to accounting for non-controlling interests In Chapters 25 and 26 we performed consolidations in cases where one entity, the parent entity, owned all of the share capital of the other entity—the subsidiary. In this chapter we introduce the accounting procedures required where the parent entity holds less than 100 per cent of the share capital of the subsidiary. The equity interests in the subsidiary that are not held by the parent entity are referred to as the non-controlling interests (they were previously referred to as minority interests or outside equity interests).

What is a non-controlling interest?

LO 27.1

As we noted in Chapters 25 and 26, the requirement to consolidate an entity is based on the criterion of control. One entity can control another with less than 100 per cent ownership. This is illustrated in Figure 27.1. In Figure 27.1 Big Company owns 75 per cent of Little Company. Big Company is referred to as the parent entity. The remaining 25 per cent is held by investors who are not part of the economic parent entity entity. These outside investors—who could be numerous—are called ‘non-controlling interests’. An entity that controls A non-controlling interest exists when a subsidiary is partly owned by the parent entity. Accounting another legal entity. Standard AASB 10 Consolidated Financial Statements defines a non-controlling interest as ‘the equity in a subsidiary not attributable, directly or indirectly, to a parent’. The holders of the non-controlling interest have an entitlement to share in the net assets and profit of the subsidiary and their share is determined by their percentage ownership of the share capital of the subsidiary. For disclosure purposes, the profits and net assets that are attributable to the non-controlling interest are required to be measured. We determine the non-controlling interest in three stages: 1. the non-controlling interest in the current period’s profit or loss and other comprehensive income 2. the non-controlling interest in share capital and reserves at the date of the acquisition of the subsidiary by the parent entity 3. the non-controlling interest in post-acquisition changes in share capital and reserves. The term ‘non-controlling interests’ can sometimes be a little confusing. As we learned in Chapters 25 and 26, a parent entity does not have to hold 50 per cent or more of the equity capital of a subsidiary to control it. Hence, the noncontrolling interest, which includes all of the shareholders of the subsidiary other than the parent entity, might actually represent more than 50 per cent (that is, the majority) of the shareholding of the subsidiary. As discussed in Chapter 25, the three main concepts that can be applied in the consolidation process are: 1. the entity concept 2. the proprietary concept 3. the parent-entity concept. Under the entity concept, which is the concept adopted by AASB 10, if subsidiaries are partly owned by the parent entity (that is, the parent entity holds less than a 100 per cent interest), both the parent entity and the non-controlling interests will have an ownership interest in the subsidiary’s profits, dividend payments, share capital and reserves. The non-controlling interests will not be shown as a liability, as they would under the proprietary concept, but rather, as with the parent entity’s interest, the non-controlling interests are considered as contributors of equity capital to the economic entity.

Figure 27.1 Simple group structure that includes a noncontrolling interest

Big Company

75%

Little Company

25%

Non-controlling Interests

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The non-controlling interests’ proportional share of the net assets of the subsidiary is considered to be part of the group, and 100 per cent of the subsidiary’s assets, liabilities, income and expenses—subject to adjustments for intragroup transactions—are still to be consolidated in the presence of non-controlling interests. If a parent entity controls a subsidiary, it controls all of the assets even though it does not have a 100 per cent ownership interest in the subsidiary. Therefore, it is appropriate for the consolidated financial statements to show all of the assets under the control of the parent entity, and how profitably those assets have been used by the parent entity’s management. In Chapters 25 and 26 we considered various consolidation journal entries. Even though those journal entries were made in cases where the parent entity owned 100 per cent of the subsidiary, all such journal entries would remain the same in the presence of non-controlling interests, except for the following: • We eliminate only the parent’s share of the subsidiaries’ pre-acquisition share capital and reserves against the investment in the subsidiary. Hence, the non-controlling interest in share capital and reserves will be included in the statement of financial position. • In relation to the dividends paid and declared by the subsidiary, only the parent’s share of such dividends are treated as intragroup transactions and therefore eliminated as part of the consolidation process. The dividends paid, or payable, to non-controlling interests are shown in the consolidated financial statements (as are the dividends paid and payable by the parent entity). • In relation to dividends payable by subsidiaries, only those payable to the parent entity are eliminated against the dividends receivable in the accounts of the parent entity. Dividends payable by the subsidiary to non-controlling interests are included in the consolidated financial statements (as are the dividends payable by the parent entity to its shareholders).

LO 27.4

Non-controlling interests to be disclosed in the consolidated financial statements

Before we consider how to calculate non-controlling interests, let us look at some of the disclosure requirements pertaining to such interests. In relation to the separate disclosure of non-controlling interests in the statement of financial position, paragraph 22 of AASB 10 requires that: A parent shall present non-controlling interests in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent. Non-controlling interests have a share in the profit or loss and other comprehensive income of the group, not just in the profit or loss of the subsidiary. Paragraph B94 of AASB 10 states: An entity shall attribute the profit or loss and each component of other comprehensive income to the owners of the parent and to the non-controlling interests. The entity shall also attribute total comprehensive income to the owners of the parent and to the non-controlling interests even if this results in the non-controlling interests having a deficit balance. AASB 101 Presentation of Financial Statements includes a number of disclosure requirements relating to noncontrolling interests. These are consistent with the requirements of AASB 10. Paragraph 83 of AASB 101 requires: An entity shall disclose the following items in the statement of profit or loss and other comprehensive income as allocations of profit or loss for the period: (a) profit or loss for the period attributable to: (i) non-controlling interest; and (ii) owners of the parent; and (b) total comprehensive income for the period attributable to: (i) non-controlling interest; and (ii) owners of the parent. Paragraph 54(q) of AASB 101 requires a separate line item on the face of the statement of financial position showing the non-controlling interest in equity. The Appendices to AASB 101 formerly provided some suggested disclosures that incorporate the information required in relation to non-controlling interests. However, when AASB 101 was re-released, these disclosure examples 968  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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were removed (even though they would still be useful in explaining the current disclosure requirements). Exhibit 27.1 shows the suggested disclosures in the equity component of the statement of financial position, while Exhibits 27.2 and 27.3 provide suggested disclosures in relation to the statement of profit or loss and other comprehensive income and statement of changes in equity respectively. All of these suggestions are adapted from the previous version of AASB 101. In the statement of profit or loss and other comprehensive income, and as explained in Chapter 16, profits (or losses) for the year are added to ‘other comprehensive income’ to then provide a total known as total comprehensive income. As we learned in Chapter 16, there are a number of gains that are excluded from profit or loss, such as gains on asset revaluations, but such gains are included in ‘other comprehensive income’, and therefore in total comprehensive income (with total comprehensive income being the sum of ‘profit or loss’ and ‘other comprehensive income’). XYZ Group Ltd Statement of financial position as at 30 June 2019 (extract) The Group

EQUITY Share capital Other reserves Retained earnings Total equity Parent interest Non-controlling interest Total equity

Parent

2019 ($000)

2018 ($000)

2019 ($000)

2018 ($000)

X X X X X X X

X X X X X X X

X X X X X – X

X X X X X – X

Exhibit 27.1 Non-controlling interest disclosures in statement of financial position

Exhibit 27.2 gives an example of a consolidated statement of profit or loss and other comprehensive income. As can be seen, the non-controlling interests are not allocated on a ‘line-by-line’ basis throughout the statement of profit or loss and other comprehensive income. A separate allocation of individual reserves in the statement of financial position is also not required. Rather, only the consolidated aggregate balance is apportioned to the shareholders of the parent entity and to the non-controlling interests. The calculation of non-controlling interests will be considered shortly. AASB 101, paragraph 106(a), requires the statement of changes in equity to disclose—not on a line-by-line basis, but on an aggregated basis as shown in Exhibit 27.3—total comprehensive income for the period, showing separately the total amounts attributable to owners of the parent and to non-controlling interests.

Calculating non-controlling interests

LO 27.2 LO 27.3

As we now know from the earlier discussion, AASB 10 and AASB 101 require non-controlling interests to be disclosed in the statement of financial position, the statement of profit or loss and other comprehensive income, and the statement of changes in equity. Therefore, in the presence of non-controlling interests (that is, where the parent entity does not hold 100 per cent of the issued capital of the subsidiary), a key step in preparing consolidated financial statements is working out the amounts to be attributed to non-controlling interests. As paragraph B86 of AASB 10 states in relation to the steps involved in preparing consolidated financial statements, we must: (a) combine like items of assets, liabilities, equity, income, expenses and cash flows of the parent with those of its subsidiaries; (b) offset (eliminate) the carrying amount of the parent’s investment in each subsidiary and the parent’s portion of equity of each subsidiary (AASB 3 explains how to account for any related goodwill); (c) eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full). Intragroup losses may indicate an impairment that requires recognition in the consolidated financial statements. AASB 112 Income Taxes applies to temporary differences that arise from the elimination of profits and losses resulting from intragroup transactions. CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  969

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Exhibit 27.2 Non-controlling interest disclosures in the statement of profit or loss and other comprehensive income

XYZ Group Ltd Statement of profit or loss and other comprehensive income for the year ended 30 June 2019 The Group

Revenue Expenses Profit before income tax Income tax expense Profit for the period Other comprehensive income: Exchange differences on translating foreign operations Gains on property revaluation Other comprehensive income for the year Total comprehensive income for the year Profit attributable to: Owners of the parent entity Non-controlling interest Total comprehensive income attributable to: Owners of the parent entity Non-controlling entity

Exhibit 27.3 Non-controlling interest disclosures in the statement of changes in equity

Parent

2019 ($000)

2018 ($000)

2019 ($000)

2018 ($000)

XXX  (XXX) XXX (XXX) XXX

XXX (XXX) XXX  (XXX) XXX

XXX  (XXX) XXX  (XXX) XXX

XXX  (XXX) XXX  (XXX) XXX

XXX  XXX XXX XXX

XXX  XXX XXX XXX

XXX  XXX XXX XXX

XXX  XXX XXX XXX

X X X

X X X

X – X

X – X

X X X

X X X

X – X

X – X

XYZ Group Ltd Statement of changes in equity for the year ended 30 June 2019 Attributable to owners of the parent

Balance at 1 July 2018 Changes in accounting policy Restated balance Changes in equity for 2019 Issue of share capital Dividends Total comprehensive income   for the year Transfer to retained earnings Balance at 30 June 2019

Share capital ($000)

Retained earnings ($000)

Translation of foreign operations ($000)

Revaluation surplus ($000)

Total ($000)

Noncontrolling interest ($000)

Total equity ($000)

XXX      – XXX

XXX XXX XXX

(XXX)      – (XXX)

XXX      – XXX

XXX XXX XXX

XXX XXX XXX

XXX XXX XXX

XXX – –

(XXX) XXX

– XXX

– XXX

XXX (XXX) XXX

(XXX) XXX

XXX (XXX) XXX

     – XXX

XXX XXX

     – (XXX)

XXX XXX

     – XXX

     – XXX

     – XXX

As this paragraph indicates, even in the presence of non-controlling interests we combine all of the assets, liabilities, equity, income and expenses of the entities of the parent and the subsidiaries as part of the consolidation process. The only exception to this is where the assets, liabilities, equity, income or assets have been impacted by transactions within the group, in which case the effects need to be eliminated in full. When eliminating the investment in subsidiaries we eliminate only the parent entity’s interest in each subsidiary’s equity account. The remaining amounts in the subsidiaries’ equity accounts will relate to the non-controlling interests in the economic entity. 970  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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The non-controlling interests are identified but not eliminated as part of the consolidation process. They are identified for disclosure purposes. Non-controlling interest is calculated by taking three elements into account: 1. Non-controlling interests’ share in the net assets (equity) of subsidiaries at the dates the parent entity acquired the subsidiaries. This requires the non-controlling interests’ share of the pre-acquisition balances of contributed equity, retained earnings and reserves to be determined. 2. Non-controlling interests’ share in the changes in equity since acquisition date. This is achieved through calculating the non-controlling interests’ share of the post-acquisition movements in retained earnings and reserves. 3. Non-controlling interests’ share in the profit or loss of the subsidiaries in the current period. At the end of the reporting period the non-controlling interests’ share in profit for the year, distributions and transfers made, and movements in reserves for the year must be determined. Apart from the above calculations, AASB 3 provides preparers of financial statements with a choice in the measurement of non-controlling interest. The choice relates to the amount of goodwill in the subsidiary we allocate to the non-controlling interests. According to paragraph 19 of AASB 3, for each business combination the acquirer shall measure any non-controlling interest in the acquiree either at fair value (including non-controlling interests’ share of goodwill) or at the non-controlling interests’ proportionate share of the acquiree’s identifiable net assets (excluding noncontrolling interests’ share of goodwill). Specifically, paragraphs 18 and 19 of AASB 3 state: 18. The acquirer shall measure the identifiable assets acquired and the liabilities assumed at their acquisitiondate fair values. 19. For each business combination, the acquirer shall measure at the acquisition date components of noncontrolling interests in the acquiree that are present ownership interests and entitle their holders to a proportionate share of the entity’s net assets in the event of liquidation at either: (a) fair value; or (b) the present ownership instruments’ proportionate share in the recognised amounts of the acquiree’s identifiable net assets. All other components of non-controlling interests shall be measured at their acquisition-date fair values, unless another measurement basis is required by Australian Accounting Standards. Again, it is emphasised that preparers of financial statements have the choice of which measure to use in each business combination. For example, reporting entities can use ‘fair value’ for one business combination and the ‘proportionate share of the acquiree’s identifiable net assets’ for another business combination. This provides reporting entities with significant flexibility when accounting for business combinations, particularly where further acquisitions of ownership interests are expected to be acquired. If the non-controlling interests are calculated on the basis of the fair value of the subsidiary, then an amount representing the non-controlling interest’s share of goodwill will be calculated. This will be in addition to the amount of goodwill allocated to the parent entity’s interest. This means, in effect, that the full amount of the goodwill of the subsidiary is being recognised, which is in basic accordance with the entity concept of consolidation, as discussed in Chapter 25. This approach is referred to by some people as the ‘full goodwill method’. Pursuant to the entity concept of consolidation, all of the assets and liabilities of the subsidiary are included within the consolidated financial statements. By contrast, if the parent entity elects to account for the non-controlling interest in accordance with the second option—this being the non-controlling interests’ proportionate share of the acquiree’s identifiable net assets—then no goodwill will be calculated as being attributable to the non-controlling interests (which is perhaps somewhat obvious given that this second option explicitly refers to the non-controlling interests’ proportionate share of identifiable net assets, which explicitly excludes goodwill given that goodwill is an unidentifiable intangible asset). Hence, if this option is taken then only a portion of the subsidiary’s goodwill—the amount attributable to the parent entity’s interest— will be reflected in the consolidated financial statements, which is not consistent with a ‘pure’ application of the entity concept of consolidation. This is often referred to as the ‘partial goodwill method’. Therefore, when we said in Chapter 25 that AASB 10 adopts the entity principle of consolidation, this is correct, with the specific exception in relation to goodwill if the non-controlling interest in the subsidiary is measured as their proportionate share in the subsidiary’s identifiable net assets. In relation to the choice between using the ‘full goodwill method’ and the ‘partial goodwill method’, it is interesting to consider how the joint work undertaken by the IASB and the US Financial Accounting Standards Board (FASB) ultimately led to this option being available within IFRS 3 (and, therefore, within AASB 3). The revised version of IFRS 3 was issued at CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  971

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the same time as the revised version of the US accounting standard, Statement of Financial Standards No. 141 Business Combinations. Both Boards had issued exposure drafts on the revised standards and within both of the exposure drafts only the ‘full goodwill method’ was supported. However, when the accounting standards were ultimately released, the FASB retained only the ‘full goodwill method’, whereas the IASB introduced the option to use either the full goodwill method or the partial goodwill method. In understanding the reasoning behind this change, we can refer to the Basis for Conclusions that was released with IAS 3. Paragraphs BC209 and 210 state: BC209 The IASB concluded that, in principle, an acquirer should measure all components of a business combination, including any non-controlling interest in an acquiree, at their acquisition-date fair values. However, the revised IFRS 3 permits an acquirer to choose whether to measure any non-controlling interest in an acquiree at its fair value or as the non-controlling interests’ proportionate share of the acquiree’s identifiable net assets. BC210 Introducing a choice of measurement basis for non-controlling interests was not the IASB’s first preference. In general, the IASB believes that alternative accounting methods reduce the comparability of financial statements. However, the IASB was not able to agree on a single measurement basis for non-controlling interests because neither of the alternatives considered (fair value and proportionate share of the acquiree’s identifiable net assets) was supported by enough board members to enable a revised business combinations standard to be issued. The IASB decided to permit a choice of measurement basis for non-controlling interests because it concluded that the benefits of the other improvements to, and the convergence of, the accounting for business combinations developed in this project outweigh the disadvantages of allowing this particular option. Hence, the choice of two options within the IASB standard was the outcome of a political exercise to make sure the standard was approved, rather than on the basis that the approach was conceptually sound. We really have to ponder the impacts such decisions have on the ultimate quality of financial information being generated in compliance with accounting standards. In considering the differences in final outcomes that will arise as a result of allowing either option to be used, the Basis for Conclusions to IFRS 3 stated: BC217 The IASB noted that there are likely to be three main differences in outcome that occur when the noncontrolling interest is measured as its proportionate share of the acquiree’s identifiable net assets, rather than at fair value. First, the amounts recognised in a business combination for non-controlling interests and goodwill are likely to be lower (and these should be the only two items affected on initial recognition). Second, if a cash-generating unit is subsequently impaired, any resulting impairment of goodwill recognised through income is likely to be lower than it would have been if the non-controlling interest had been measured at fair value (although it does not affect the impairment loss attributable to the controlling interest). Paragraph BC218 provides insights into a third difference—but this difference goes beyond issues addressed in this book so we will not further complicate our discussion by detailing it. This text uses consolidation journal entries to account for the non-controlling interest. These consolidation journal entries are posted to the consolidation worksheet in the same way as the consolidation journal entries considered earlier. This ensures that the whole consolidation worksheet takes into account the consolidation workings, line by line combinations of assets, liabilities, equity, income and expenses. In addition, making use of consolidation journals to account for non-controlling interests consolidates all adjustments into a one-line statement of financial position total (see Exhibit 27.1). Turning our attention to dividends, in the presence of non-controlling interests, the dividends received by the parent from the subsidiary are eliminated against the parent’s share of the subsidiary’s dividend distributions. The dividends paid by the subsidiary to the non-controlling interests are to be shown in the consolidated financial statements, as are the dividends paid to the shareholders of the parent entity. These dividends will flow from the economic entity, as illustrated in Figure 27.2 and would not be considered to be intragroup transactions. Likewise, dividends receivable by the parent entity will be eliminated against the parent entity’s share of the subsidiary’s dividend payable as part of the usual consolidation adjustments. The balance of dividends payable by the subsidiary to the non-controlling interest will be included in the consolidated financial statements. Dividends paid or payable to non-controlling interests will act to reduce their interest in the net assets of the subsidiary. 972  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Dividends distributed to parent

Shareholders of Parent Entity

Economic Entity Parent Entity

Shareholders’ investment in parent Parent entity’s shareholding in subsidiary

Non-controlling interest’s shareholding Dividends paid to parent

Subsidiary

Non-controlling interests

Figure 27.2 A diagrammatic representation of equity investments and dividend flows within an economic entity in the presence of non-controlling interests

Dividends paid to non-controlling interests

The non-controlling interest is determined as the non-controlling interest’s proportion of the fair value of the recognised identifiable assets, liabilities and contingent liabilities at the date of the original acquisition. Post-acquisition non-controlling interest in the identifiable assets and liabilities of a subsidiary comprises the non-controlling interest’s share of movements in equity since the date of the original controlling acquisition, after eliminating intragroup transactions. As we know, where there are intragroup transactions, any related profit or loss should be eliminated in the consolidation process, not merely the percentage of the profit or loss equal to the parent entity’s interest in the subsidiary. When we calculate the non-controlling interest it is necessary first to determine the subsidiary’s contribution to the profit and equity of the group. In doing so we must adjust the reported profit and equity of the subsidiary for any unrealised profits or losses, as they relate to the subsidiary.

Elimination of pre-acquisition share capital and reserves in the presence of non-controlling interests In Chapters 25 and 26 we learned that the carrying amounts of subsidiaries’ assets must be adjusted to fair value prior to the elimination of the parent entity’s investment. This is necessary to prevent the amount of goodwill acquired by the parent entity from being wrongly stated, as would be the case if the equity (net assets) of the subsidiary were undervalued. The existence of non-controlling interests does not change the requirement for the assets and liabilities of a subsidiary to be measured at fair value as at acquisition date. This is confirmed by paragraph 18 of AASB 3, which states: The acquirer shall measure the identifiable assets acquired and the liabilities assumed at their acquisition-date fair values. Again, reiterating an earlier important point, as far as the non-controlling interest is concerned, AASB 3, paragraph 19, provides the acquirer with two alternative measurements for non-controlling interests in the acquiree. This measurement can be either at the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets (Worked Example 27.1) or at fair value (Worked Example 27.2). The main difference is in the amount of goodwill recognised, and the total amount attributed to the non-controlling interest. It should be noted that the choice is available for each business combination. Again, this means that the entity can use fair value for one business combination and the proportionate share of the acquiree’s net identifiable assets for another. Reporting entities will thus have a significant amount of flexibility when accounting for business combinations, particularly where further acquisitions of ownership interests are expected. The calculation of non-controlling interests is detailed in Worked Examples 27.1 and 27.2. CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  973

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WORKED EXAMPLE 27.1: Non-controlling interest in pre-acquisition capital and reserves On 1 July 2019, Parent Entity acquired 70 per cent of the share capital of Subsidiary Ltd for $800 000, which represented the fair value of the consideration paid, when the share capital and reserves of Subsidiary Ltd were: Share capital Revaluation surplus Retained earnings

$700 000 $200 000    $100 000 $1 000 000

All assets of Subsidiary Ltd were recorded at fair value at acquisition date, except for some plant that had a fair value $50 000 greater than its carrying amount. The cost of the plant was $250 000 and it had accumulated depreciation of $180 000. The tax rate is 30 per cent. REQUIRED Prepare the consolidation eliminations and adjustments to recognise the pre-acquisition capital and reserves of Subsidiary Ltd, assuming that the non-controlling interest was measured at the proportionate share of the acquiree’s identifiable net assets. SOLUTION The elimination of the investment in Subsidiary Ltd and recognition of goodwill on acquisition date is determined as follows: Subsidiary Ltd ($)

Elimination of investment in Subsidiary Ltd Fair value of consideration transferred less Fair value of identifiable assets acquired   and liabilities assumed:    Share capital on acquisition date    Revaluation surplus on acquisition date    Retained earnings on acquisition date    Fair value adjustment ($50 000 × (1 − tax rate)) Goodwill on acquisition date Non-controlling interest

Parent Ltd’s 70% interest ($)

30% Noncontrolling interest ($)

800 000

700 000 200 000 100 000      35 000 1 035 000

490 000 140 000 70 000   24 500 724 500   75 500

210 000 60 000 30 000 10 500             – 310 500

The same answer can be derived by an alternative method of calculating goodwill on acquisition, which focuses on the net fair value of the identifiable assets and liabilities acquired as follows: Share capital and reserves Fair value adjustment (after tax) Proportional interest at 70 per cent Cost of investment Goodwill acquired

$1 000 000      $35 000 $1 035 000 $724 500    $800 000      $75 500

What should be appreciated from this Worked Example is that the calculation of goodwill on acquisition is determined by comparing the fair value of the consideration paid or transferred with the proportional interest in the net value of the identifiable assets, liabilities and contingent liabilities acquired in the subsidiary. This provides the parent entity’s share of the subsidiary’s goodwill. As in this example, when the non-controlling interest is measured at the proportionate share of the acquiree’s identifiable net assets, any share of goodwill attributable to the noncontrolling interest’s share is not recognised. It is ignored. In a sense, therefore, the consolidated financial statements will understate the value of goodwill controlled by the parent entity.

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The consolidation journal entries for Parent Entity and its controlled entities to eliminate Parent Entity’s share of pre-acquisition capital and reserves of Subsidiary Ltd would be: Dr Accumulated depreciation—plant 180 000 Cr Plant 180 000 (to close off accumulated depreciation in accordance with the net method of asset revaluation) Dr Plant Cr Revaluation surplus Cr Deferred tax liability (to recognise the revaluation increment after tax)

50 000 35 000 15 000

Dr Share capital (70% of 700 000) 490 000 Dr Revaluation reserve (70% of 235 000) 164 500 Dr Retained earnings (70% of 100 000) 70 000 Dr Goodwill 75 500 Cr Investment in Subsidiary Ltd 800 000 (to recognise the goodwill acquired by Parent Entity and to eliminate the parent’s interest in pre-acquisition capital and reserves) Dr Share capital 210 000 Dr Revaluation surplus 70 500 Dr Retained earnings 30 000 Cr Non-controlling interest 310 500 (to recognise the non-controlling interest in contributed equity and reserves at date of acquisition. This entry acts to eliminate the entire balance of the pre-acquisition capital and reserves of the subsidiary and to allocate the proportion—30%—to the non-controlling interest. The non-controlling interest of $310 500 would be shown as part of equity.) Following the above entries, the consolidated financial statements would include Parent Entity’s share capital and reserves, plus the non-controlling interest’s share of Subsidiary Ltd’s pre-acquisition share capital and reserves.

WORKED EXAMPLE 27.2: Non-controlling interest in Subsidiary Ltd measured at fair value Assume the same information as in Worked Example 27.1 above, except this time we will apply the other option available within the accounting standard and value the non-controlling interest in the acquiree at fair value. REQUIRED Prepare the consolidation journal entry to recognise the non-controlling interests in the pre-acquisition capital and reserves of Subsidiary Ltd, assuming that the non-controlling interest is measured at the fair value. SOLUTION The recognition of goodwill on acquisition and its allocation between Parent Ltd and Subsidiary Ltd can be calculated as follows:

Elimination of investment in Subsidiary Ltd Fair value of consideration transferred plus Non-controlling interest measured at fair value   ($800 000 × 30/70)

Subsidiary Ltd ($)

Parent Ltd’s 70% interest ($)

800 000    342 857

800 000

30% Noncontrolling interest ($) 342 857

1 142 857 less Fair value of identifiable assets acquired   and liabilities assumed Share capital on acquisition date

700 000

490 000

210 000 continued

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Elimination of investment in Subsidiary Ltd Revaluation surplus on acquisition date Retained earnings on acquisition date Fair value adjustment ($50 000 × (1 − tax rate)) GOODWILL ON ACQUISITION DATE

Subsidiary Ltd ($)

Parent Ltd’s 70% interest ($)

30% Noncontrolling interest ($)

200 000 100 000      35 000 1 035 000    107 857

140 000 70 000   24 500 724 500   75 500

60 000 30 000   10 500 310 500   32 357

The logic behind the above calculations is that it is assumed that if 70 per cent of Subsidiary Ltd could be acquired for $800 000 then 100 per cent could have been acquired for $1 142 857. If the fair value of the identifiable net assets of Subsidiary Ltd at the date of acquisition amounted to $1 035 000, then total goodwill of Subsidiary Ltd must be $107 857. Journal entry Dr Share capital 210 000 Dr Revaluation surplus ($60 000 + $10 500) 70 500 Dr Retained earnings 30 000 Dr Goodwill 32 357 Cr Non-controlling interest 342 857 (to recognise non-controlling interest in contributed equity, reserves and goodwill at date of acquisition) The entry to eliminate the parent entity’s interest would be the same as that shown in Worked Example 27.1, and would be: Dr Share capital (70% of 700 000) 490 000 Dr Revaluation reserve (70% of 235 000) 164 500 Dr Retained earnings (70% of 100 000) 70 000 Dr Goodwill 75 500 Cr Investment in Subsidiary Ltd 800 000 (to recognise the goodwill acquired by Parent Entity and to eliminate Parent’s interest in pre-acquisition capital and reserves)

Adjustments for intragroup transactions As we learned in Chapters 25 and 26, AASB 10 requires the elimination of the effects of all intragroup transactions before the consolidated financial statements are presented. The requirement to eliminate in full the effects of intragroup transactions holds whether or not there are non-controlling interests. That is, the consolidation entries that relate to eliminating intragroup transactions, which we learned about in Chapters 25 and 26, will also be required when there are non-controlling interests. Further, the actual amount of the eliminations will not change if there are non-controlling interests since AASB 10 requires the effects of intragroup transactions to be eliminated ‘in full’. We will now consider various intragroup transactions and their related treatments.

Intragroup payment of dividends In relation to dividends paid by a subsidiary, the consolidation worksheet journal entries will eliminate the proportion of the dividends that relates to the parent entity’s entitlement. The non-controlling interest’s share of the dividends paid by the subsidiary will be shown in the consolidated financial statements. That is, the non-controlling interest’s share in the dividends paid or proposed by the subsidiary will not be eliminated on consolidation. This is appropriate because the dividends paid to the non-controlling interests represents a flow of resources away from the group, as indicated in Figure 27.2. The dividends distributed to the non-controlling interests will act to reduce the non-controlling interests’ share in the equity of the subsidiary. The consolidated statement of financial position will show any dividends payable 976  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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to the non-controlling interests as a liability (although, as we know, no liability will be shown in the consolidated financial statements for dividends payable to the parent entity). For example, let us assume that Subsidiary Ltd declares a dividend of $1 000 and that Parent Entity (from Worked Example 27.1) recognises dividend income when it is declared by its investees. In this case the consolidation adjusting entries would be: Dr Cr Dr Cr

Dividend income—statement of profit or loss and other comprehensive income Dividend receivable—statement of financial position Dividend payable—statement of financial position Dividend declared—statement of changes in equity

700 700 700 700

Intragroup sale of inventory When we calculate the non-controlling interest’s share of the profits of the subsidiary we need to calculate the subsidiary’s profit after adjustments to eliminate income and expenses of the subsidiary that are unrealised from the economic entity’s perspective. If the gains or losses have been realised, no adjustment is necessary when calculating non-controlling interest. For example, if a subsidiary sold inventory to the parent at a gain, and the parent entity has in turn sold all of the inventory to external parties, the non-controlling interest’s share of profit would not need to be reduced as the related gain would be deemed to have been realised from the perspective of the group. For example, let us assume that Subsidiary Ltd sold inventory to Parent Ltd for $1 000 when Subsidiary Ltd had a related cost of sales of $700. Let us further assume that Parent Ltd then sold all of the inventory to an external customer for $1 500. Subsidiary Ltd would record a profit on sale of $300 and Parent Ltd would record a profit on sale of $500 in their individual accounts. The total profit to the economic entity would be $800 ($1 500 less $700) and therefore all profits would be realised. An adjustment needs to be made only to the extent that the asset sold within the economic entity, such as inventory, is still on hand at the end of the reporting period (that is, where profits recorded in the individual accounts of a group member have not been realised from the perspective of the economic entity). Adjustments to the calculation of the non-controlling interest’s share of the subsidiary’s profits will be needed where some or all of the inventory sold by the subsidiary is still on hand with the parent entity at the end of the reporting period. Our remarks so far relate to sales made in the current reporting period by the subsidiary. If there are unrealised profits in closing inventory, this will mean that in the next financial period there will be unrealised profits in opening inventory. In the next financial period we would need to adjust the non-controlling interest’s share of opening retained earnings (by reducing it) and provide a corresponding increase in the non-controlling interest’s share of that period’s profits.

Intragroup sale of non-current assets As with inventory, if a subsidiary sells a non-current asset, such as an item of property, plant and equipment, to another entity within the group, to the extent that the asset stays within the group, the gain or loss on sale has not been recognised from the group’s perspective and the non-controlling interests’ share of profits will need to be adjusted. However, the gain or loss is considered to be realised across the life of the asset as the asset is used up, that is, as it is depreciated. As the assets, such as plant, are used, perhaps to produce inventory, the intragroup profit is considered to be realised as the service potential of the plant becomes embodied in goods produced by the plant, for example, in inventory. Therefore, if a subsidiary sold an item of plant to another entity at the beginning of the financial year at a gain of $1 000 and if that asset is to be depreciated over 10 years, only $100 of the gain could be recognised in the first year and $900 would be deemed to be unrealised. It would be realised over the next nine years.

Intragroup service and interest payments There will also be other intragroup transactions that affect the profit or loss of the subsidiary. For example, management fees and interest payments. To the extent that there is no related asset that is retained in the economic entity upon which any profit has accrued, no adjustments are necessary in calculating the non-controlling interest in the subsidiary’s profit (of course, consolidation adjustments will still be required but this discussion is about calculating the non-controlling interest’s share of profits for presentation purposes and not for the purpose of generating consolidation journal adjustments). If we assume that any related profits have been realised immediately we need not go to the lengths CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  977

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required to determine when such profits should be adjusted. There is no adjustment for such things as management fees when we are determining non-controlling interests—they are considered to be realised. This is consistent with paragraph B86 of AASB 10, as previously quoted.

Intragroup transaction that creates gains or losses in parent entity In calculating non-controlling interests we do not need to adjust for gains or losses in the parent entity’s accounts that are unrealised as non-controlling interests have an interest only in the subsidiary’s profit contribution. As we know, it is only the unrealised intragroup profits or losses accruing to the subsidiary that need to be eliminated before we calculate non-controlling interests. Hence, if a subsidiary has acquired inventory from the parent entity, no adjustment is required if the inventory is still on hand (and hence the profit is unrealised from the perspective of the economic entity) when calculating non-controlling interests as the purchase of inventory has no implications for the equity of the subsidiary— they are simply acquiring one asset in exchange for another (if paid for by cash), or acquiring one asset by incurring a liability (accounts payable)—and in either case the equity of the subsidiary does not change. The related profit is in the accounts of the parent entity.

Summary of some general principles for calculating non-controlling interests in profits or losses From the discussion so far we can summarise some rules to use when calculating non-controlling interests in profits or losses. We apply these rules in Worked Example 27.3 below. The general principles are: • We only need to make adjustments to non-controlling interests’ share of profits where an intragroup transaction affects the subsidiary’s profit or loss. • We make adjustments for profits or losses made by the subsidiary to the extent they are unrealised from the economic entity’s perspective; that is, the respective asset is still on hand at the end of the reporting period. • For profits relating to transactions that do not involve the transfer of assets, such as those relating to interest, management fees and so forth, no adjustments are necessary. The related profits are deemed to be realised at the point of the transaction. • We do not need to make adjustments for unrealised gains or losses made by the parent entity when calculating the non-controlling interest in profits. If the non-controlling interest in the acquiree is measured at the proportionate share of the subsidiary’s identifiable net assets, only the parent entity’s share of goodwill is recognised on consolidation. No goodwill is recognised in relation to the non-controlling interest in the subsidiary. In this situation no goodwill impairment losses are recognised in relation to a non-controlling interest in goodwill when the non-controlling interest in profits is calculated. However, and by contrast, if the non-controlling interest in a subsidiary is measured at fair value (the other adoption available under paragraph 19 of AASB 3), then the goodwill attributable to both the parent and non-controlling interest is recognised on consolidation. Any goodwill impairment losses are allocated between the parent and the non-controlling interest on the same basis as that on which profit or loss is allocated. We consider how to present consolidated financial statements in the presence of non-controlling interests in Worked Example 27.3. This quite detailed example demonstrates a number of issues that we face when calculating non-controlling interests. It should be noted that AASB 10 provides very little guidance on calculating non-controlling interests so Worked Example 27.3 usefully sets out generally accepted procedures as discussed above.

WORKED EXAMPLE 27.3: Consolidated financial statement presentation in the presence of non-controlling interests On 1 July 2018 Bells Ltd acquires 80 per cent of the equity capital of Torquay Ltd at a cost of $2 million. All assets of Torquay Ltd were fairly stated, and the total shareholders’ funds of Torquay Ltd were $2.2 million, as follows: Share capital Retained earnings

$1 500 000    $700 000 $2 200 000

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As at 30 June 2020 (that is, two years after the date of acquisition) the financial statements of the two companies are as follows:

Detailed reconciliation of opening and closing retained earnings Sales revenue Cost of goods sold Other expenses Other revenue Profit before tax Tax expense Profit for the year Retained earnings—30 June 2019 Dividends paid Dividend declared Retained earnings—30 June 2020 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Dividends payable Non-current liabilities Loans Total of liabilities and equity Current assets Cash Accounts receivable Dividends receivable Inventory Non-current assets Land Plant Accumulated depreciation Investment in Torquay Ltd Total assets

Bells Ltd ($000)

Torquay Ltd ($000)

480 (100) (80)      70 370      60 310 1 000 1 310 (160)     (40) 1 110 

115 (40) (15)       25 85        30 55     800 855 (30)      (10)    815

1 110 4 000

815 1 500

20 40

30 10

   600 5 770

   250 2 605

150 242 8 500

25 175 – 300

1 400 1 870 (400) 2 000 5 770

1 105 1 300 (300)        – 2 605

Other information • The management of Bells Ltd values any non-controlling interest in Torquay Ltd at fair value. • During the current financial year Torquay Ltd pays management fees of $10 000 to Bells Ltd. This item is included in ‘other’ expenses and income. • During the current financial year Bells Ltd sold inventory to Torquay Ltd at a price of $30 000. The inventory cost Bells $22 000 to produce. Fifty per cent of this inventory is still on hand with Torquay Ltd at the end of the financial year. (Hint: as this unrealised profit relates to sales made by Bells Ltd then no adjustments are necessary when calculating non-controlling interests in Torquay Ltd.) continued CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  979

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• During the current financial year, Torquay Ltd sold inventory to Bells Ltd at a price of $20 000. The inventory cost Torquay Ltd $14 000 to produce. Forty per cent of this inventory is still on hand with Bells Ltd at the end of the financial year. (Hint: as this unrealised profit relates to sales made by Torquay Ltd then adjustments will be necessary when calculating non-controlling interests in Torquay Ltd.) • In the preceding financial year, Torquay Ltd sold inventory to Bells Ltd at a price of $11 000. The inventory cost Torquay Ltd $8 000 to produce. At 30 June 2019, 20 per cent of this inventory was still held by Bells Ltd. (Hint: this information will be used to create an adjustment to non-controlling interests in Torquay Ltd.) • The management of Bells Ltd believe that goodwill acquired has subsequently been impaired. It was impaired by $12 000 in the year to 30 June 2019, and by a further $12 000 in the year to 30 June 2020. (Hint: because the non-controlling interest in Torquay is being valued at fair value, then this will mean that the non-controlling interest will incorporate a proportional share of goodwill. Therefore, any impairment in goodwill will impact the non-controlling interest in Torquay Ltd.) • On 1 July 2019 Torquay Ltd sold an item of plant to Bells Ltd for a price of $45 000 when its carrying amount in Torquay Ltd’s accounts was $25 000 (cost $50 000, accumulated depreciation $25 000). This item of plant was being depreciated over a further 10 years, with no expected residual value. (Hint: as this unrealised profit relates to a sale of plant made by Torquay Ltd then adjustments will be necessary when calculating non-controlling interests in Torquay Ltd.) • On 30 June 2020, the directors of Torquay Ltd declared and communicated to their shareholders that they would pay a final dividend amounting to $10 000. (Hint: dividends paid by Torquay will act to reduce the non-controlling interest in Torquay.) • The tax rate is 30 per cent. REQUIRED Prepare the consolidated financial statements of Bells Ltd and its controlled entity for the reporting period ending 30 June 2020. SOLUTION Workings to eliminate the investment in the subsidiary and recognise goodwill on acquisition date (a) Elimination of the investment in Torquay Ltd and recognition of goodwill on acquisition date

Elimination of investment in Torquay Ltd Fair value of consideration transferred plus Non-controlling interest at fair value   ($2 000 000 × 20/80)

Torquay Ltd ($)

Bells Ltd’s 80% interest ($)

2 000 000    500 000

2 000 000

20% Noncontrolling interest ($) 500 000

2 500 000 less Fair value of identifiable assets acquired   and liabilities assumed Share capital on acquisition date Retained earnings on acquisition date Goodwill on acquisition date

1 500 000    700 000 2 200 000    300 000

1 200 000    560 000 1 760 000    240 000

300 000 140 000 440 000   60 000

The entry to eliminate Bells Ltd’s investment in Torquay Ltd at acquisition date is: Dr Dr Dr Cr

Share capital Retained earnings Goodwill Investment in Torquay Ltd

1 200 000 560 000 240 000 2 000 000

Eliminating investment in Torquay Ltd and recognising goodwill on acquisition

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Elimination of intercompany sales We need to provide consolidation journal entries to eliminate the intercompany sales because, from the perspective of the economic entity, the sales did not involve external parties. This will ensure that we do not overstate the total sales of the economic entity. Sale of inventory from Torquay Ltd to Bells Ltd Dr (b) Cr

Sales Cost of goods sold

20 000 20 000

Under the periodic inventory system, the above credit entry would be to purchases, which would ultimately lead to a reduction in cost of goods sold. (Cost of goods sold equals opening inventory plus purchases less closing inventory, so any reduction in purchases leads to a reduction in cost of goods sold.) Elimination of unrealised profit in closing inventory We are told that the total profit earned by Torquay Ltd on the sale of the inventory is $6 000. Since some of this inventory remains in the economic entity, this amount has not been fully earned. In this case, 40 per cent of the inventory is still on hand, so the unrealised profit amounts to $6 000 × 0.4, which equals $2 400. In accordance with AASB 102 Inventories, we must value inventory at the lower of cost and net realisable value. So on consolidation we must reduce the value of inventory, as the amount shown in the accounts of Bells Ltd exceeds what the inventory cost the economic entity. It should be noted that the entire amount of the unrealised profit must be eliminated on consolidation regardless of the level of equity ownership of the non-controlling interests. As we have already learned, paragraph B86 of AASB 10 stipulates that intragroup balances, transactions, income and expenses shall be eliminated in full. Dr (c) Cr

Cost of goods sold Inventory

2 400 2 400

Under the periodic inventory system, the above consolidation debit entry would be to closing inventory— profit and loss. We increase cost of goods sold by the unrealised profit in closing inventory because reducing closing inventory effectively increases cost of goods sold. (Remember, cost of goods sold equals opening inventory plus purchases less closing inventory.) The effect of the above entries is to adjust the value of inventory so that it reflects the cost of the inventory to the group. Consideration of the tax paid or payable on the sale of inventory that is still held within the group From the group’s perspective, $2 400 has not been earned. However, from Torquay Ltd’s individual perspective (as a separate legal entity), the full amount of the sale has been earned. This will attract a tax liability in Torquay Ltd’s accounts of $720 (30 per cent of $2 400). However, from the group’s perspective, some of this will represent a prepayment of tax, as the full amount has not been earned by the group even if Torquay Ltd is obliged to pay the tax. (Remember that unless the wholly owned companies in an economic entity have elected to be taxed as a single entity, and have informed the tax office of their intention, tax is assessed on the separate legal entities, not on the consolidated profits.) (d) Dr Cr

Deferred tax asset Income tax expense

720 720

($2 400 × 30 per cent) Sale of inventory from Bells Ltd to Torquay Ltd During the current financial period Bells Ltd sold inventory to Torquay Ltd at a price of $30 000. The inventory cost Bells Ltd $22 000 to produce. We are informed that 50 per cent of this inventory is still on hand with Torquay Ltd at the end of the financial year. The respective consolidation adjustment journal entries are: Dr (e) Cr

Sales Cost of goods sold

30 000 30 000 continued

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Elimination of unrealised profit in closing inventory The total profit earned by Bells Ltd on the sale of the inventory is $8 000. Since some of this inventory remains in the economic entity, this amount has not been fully earned from the group’s perspective. In this case, 50 per cent of the inventory is still on hand, so the unrealised profit amounts to $8 000 × 50 per cent, which equals $4 000. In accordance with AASB 102 Inventories, the inventory must be valued at the lower of cost and net realisable value. So, on consolidation, the value of inventory must be reduced, as the amount shown in the financial statements of Bells Ltd exceeds what the inventory cost the economic entity. (f) Dr Cr

Cost of goods sold Inventory

4 000 4 000

Consideration of the tax paid or payable on the sale of inventory that is still held within the group From the group’s perspective, $4 000 has not been earned. However, from Bells Ltd’s individual perspective (as a separate legal entity), the full amount of the sale has been earned. This will attract a tax liability in Bells Ltd’s financial statements of $1 200 (30 per cent of $4 000). However, from the group’s perspective, some of this will represent a prepayment of tax, as the full amount has not been earned by the group, even if Bells Ltd is obliged to pay the tax. (g) Dr Cr

Deferred tax asset Income tax expense

1 200 1 200

($4 000 × 30 per cent) Subsequently, when we calculate non-controlling interests we will need to remember that in relation to the above consolidation adjustments (e), (f) and (g), even though the profit has not been recognised from the perspective of the economic entity, the unrealised profits were recorded in the books of the parent entity and not the subsidiary. In calculating the non-controlling interest in group profits we will not make adjustments for unrealised profits made by the parent entity. Unrealised profit in opening inventory We are told that in the preceding financial year, Torquay Ltd sold inventory to Bells Ltd at a price of $11 000. The inventory cost Torquay Ltd $8 000 to produce. At the beginning of the financial year (1 July 2019), 20 per cent of this inventory was still held by Bells Ltd. Therefore, the unrealised profit component at the end of the previous financial year was ($11 000 – $8 000) × 0.2 = $600. Therefore, in the preceding year we would have taken through entries like those provided above, which would have had the impact of reducing closing retained earnings at 30 June 2019 and reducing income tax expense for the 2019 financial year. It is assumed that the inventory has been sold to an external party in the current period and is therefore realised—so there is no need to adjust closing balance of inventory. However, we will transfer an amount from opening retained earnings to current period profits. (h) Dr Dr Cr

Retained earnings—30 June 2019 Income tax expense Cost of sales

420 180 600

Adjustments for intragroup sale of plant and associated depreciation adjustments On 1 July 2019 Torquay Ltd sold an item of plant to Bells Ltd for $45 000 when its carrying value in Torquay Ltd’s accounts was $25 000 (cost of $50 000 and accumulated depreciation of $25 000). This item of plant was being depreciated over a further 10 years, with no expected residual value. Reversal of profit recognised on sale of asset and reinstatement of cost and accumulated depreciation The result of the sale of the item of plant to Bells Ltd is that the gain of $20 000—the difference between the sales proceeds of $45 000 and the carrying amount of $25 000—will be shown in Torquay Ltd’s financial statements. However, from the economic entity’s perspective there has been no sale and, therefore, no gain on sale given that there has been no transaction with a party external to the group. The following consolidation entry is necessary in the consolidation worksheet so that the consolidated financial statements will reflect the balances that would have applied had the intragroup sale not occurred.

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(i) Dr Dr Cr

Gain on sale of plant Plant Accumulated depreciation

20 000 5 000 25 000

The result of this entry is that the intragroup gain on sale of the non-current asset is removed and the asset and accumulated depreciation account reverts to reflecting no intragroup sales transaction. The gain of $20 000 will be recognised progressively in the consolidated financial statements of the economic entity by adjustments to the amounts of depreciation expensed by Bells Ltd in its accounts. As the service potential or economic benefits embodied in the asset are consumed, the $20 000 gain will be progressively recognised from the economic entity’s perspective. This is shown in journal entry (k). Tax implications of the intragroup sale of plant From Torquay Ltd’s individual perspective, it would have made a gain of $20 000 on the sale of the plant and this gain would have been taxable. At a tax rate of 30 per cent, $6 000 would be payable by Torquay Ltd. However, from the economic entity’s perspective, no gain has been made, which means that the related ‘tax expense’ must be reversed and a related deferred tax benefit be recognised. A deferred tax asset is recognised because, from the economic entity’s perspective, the amount paid to the tax office represents a prepayment of tax. ( j) Dr Cr

Deferred tax asset Income tax expense

6 000 6 000

Reinstating accumulated depreciation in the statement of financial position Bells Ltd would be depreciating the asset on the basis of the cost it incurred to acquire the asset. Its depreciation charge would be $45 000 divided by 10, which equals $4 500. From the economic entity’s perspective, the asset had a carrying value of $25 000, which was to be allocated over the next 10 years, giving a depreciation charge of $25 000 divided by 10, which equals $2 500. An adjustment of $2 000 is therefore required. Dr (k) Cr

Accumulated depreciation Depreciation expense

2 000 2 000

Consideration of the tax effect of the reduction in depreciation expense The increase in the tax expense from the perspective of the economic entity is due to the reduction in the depreciation expense. The additional tax expense is $600, which is $2 000 × 30 per cent. This entry represents a partial reversal of the deferred tax asset of $6 000 recognised in an earlier entry. After 10 years, the balance of the deferred tax asset relating to the sale of the item of plant will be $nil. Dr (l) Cr

Income tax expense Deferred tax asset

600 600

Impairment of goodwill (m) Impairment of goodwill—Torquay Ltd As Bells Ltd measures the non-controlling interest in Torquay Ltd at fair value, goodwill of $300 000 was recognised, $60 000 of which has been allocated to the non-controlling interest (see earlier calculation). Where goodwill has been impaired, paragraph 6 of Appendix C to AASB 136 requires goodwill impairment losses to be allocated between the parent and the non-controlling interest on the same basis as that on which profit or loss is allocated.   Two years have elapsed since the original acquisition. In each reporting period an impairment loss of $12 000 is recognised by Bells Ltd, with $2 400 (20 per cent of $12 000) allocated to the non-controlling interest. (See calculation of non-controlling interest in Torquay Ltd. The impact of the allocation of the impairment has been taken into account in journal entries (s) and (t) below.) Had Bells Ltd valued any noncontrolling interest at the proportionate share of Torquay Ltd’s identifiable net assets, there would be no necessity to allocate any goodwill impairment expense between the parent and the non-controlling interest as the goodwill impairment would relate only to goodwill attributed to the parent’s interest. continued CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  983

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Dr Retained earnings—1 July 2019 12 000 Dr Other expenses—impairment goodwill 12 000 Cr Accumulated impairment losses—goodwill Recognising current and previous years’ impairment of goodwill expense

24 000

Elimination of intragroup transactions—management fees All of the management fees paid within the group will need to be eliminated on consolidation. Dr (n) Cr

Management fee revenue Management fee expense

10 000 10 000

It is not necessary to make any adjustments to non-controlling interest in profits, as the related profits or losses associated with the payment of management fees are assumed to be realised from the perspective of the economic entity. Dividends paid We eliminate the dividends paid within the group. Only the dividends paid to parties outside the entity (to the shareholders of the parent entity and to the non-controlling interests) are to be shown in the consolidated accounts. Dr (o) Cr

Dividend revenue Dividend paid

24 000 24 000

Dividend declared Dr (p) Cr

Dividend payable Dividend declared

8 000

Dr (q) Cr

Dividend revenue Dividend receivable

8 000

8 000

8 000

Recognising non-controlling interest in contributed equity, reserves and earnings It must be remembered that in order to recognise the non-controlling interest’s share in contributed equity and reserves at the end of the reporting period, three calculations need to be made: (i) The non-controlling interests on acquisition date. (ii) The non-controlling interest in movements in contributed equity and reserves between the date of the parent entity’s acquisition and the beginning of the current reporting period. (iii) The non-controlling interest in the current period’s profit, as well as movements in reserves in the current period. In determining the non-controlling interest’s share of current period profit or loss, gains and losses of the subsidiary that are unrealised from the economic entity’s perspective will need to be adjusted for. The steps above are used to calculate the non-controlling interest.   The calculations below are completed so that the relative proportions of consolidated profits and consolidated share capital and reserves that are attributable to parent entity interests and non-controlling interests can be journalised in the consolidation worksheet and subsequently disclosed in the consolidated financial statements. Earlier in the chapter some possible formats for the disclosure of non-controlling interests (see Exhibits 27.1 to 27.3) were provided.



(i)

Calculation of non-controlling interests in Torquay Ltd Non-controlling interests and goodwill on acquisition date Share capital Retained earnings—on acquisition Goodwill on acquisition

Torquay Ltd ($)

20% Noncontrolling interest ($)

1 500 000 700 000                   2 200 000

300 000 140 000   60 000 500 000

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(ii)

(iii)

Non-controlling interest in movements in share capital and  reserves between the date of the parent entity’s acquisition and the beginning of the current reporting period:   Retained earnings—since acquisition ($800 000 – $700 000)   less Unrealised profits in inventory—1 July 2019   Tax effect on unrealised profits   Goodwill impairment—2019 Non-controlling interest in the current period’s profit and  movements in reserves in the current period Profit for the year add Unrealised profit in inventory—1 July 2019 now realised Tax effect on unrealised profit now realised less Unrealised profits in inventory—30 June 2020 Tax effect on unrealised profit less Unrealised profit on sale of non-current asset Tax effect on unrealised profit add Depreciation Tax effect on depreciation Goodwill impairment—2020 Profit Torquay contributed to the economic entity Dividends paid by Torquay Ltd Dividends declared by Torquay Ltd

100 000 (600) 180      (12 000)       87 580

                 17 516

55 000 600 (180) (2 400) 720 (20 000) 6 000 2 000 (600)    (12 000)     29 140     (30 000)     (10 000)

     5 828     (6 000)     (2 000) 515 344

(r) Non-controlling interests and goodwill on acquisition date The non-controlling interest in the share capital and reserves of Torquay is transferred to non-controlling interest. The non-controlling interest will be disclosed as part of total equity in the consolidated statement of financial position. As paragraph 22 of AASB 10 states: A parent shall present non-controlling interests in the consolidated statement of financial position within equity, separately from the equity of the owners of the parent. Dr Share capital 300 000 Dr Retained earnings 140 000 Dr Goodwill 60 000 Cr Non-controlling interest Recognising non-controlling interests and goodwill on acquisition date

  500 000

(s) Non-controlling interest in movements in contributed equity and reserves between the date of the parent entity’s acquisition and the beginning of the current reporting period The retained earnings at the date of acquisition is deducted from the retained earnings at the beginning of the current reporting period ($800 000 – $700 000). A number of adjustments may need to be made to this figure. This is consistent with AASB 10 paragraph B86(c), which requires that we ‘eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full)’.   In this worked example, the unrealised profit on the sale of inventory at 1 July 2019 amounted to $600. The reduction in profits will lead to a lower tax expense. At a tax rate of 30 per cent an adjustment of $180 ($600 × 30 per cent), the tax effect on the unrealised profits, must be made. An adjustment for the 2019 goodwill impairment allocated to the non-controlling interest needs to be made. The 20 per cent non-controlling interest share in interest in movements in contributed equity, reserves and for goodwill continued CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  985

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impairment between the date of the parent entity’s acquisition and the beginning of the current reporting period amounted to $17 516, as shown in calculations provided earlier. Dr Retained earnings 17 516 Cr Non-controlling interest Recognising non-controlling interest and non-controlling interest in earnings

17 516

(t) Non-controlling interest in the current period’s profit and movements in reserves in the current period The profit of the subsidiary for the current reporting period as reported in the financial statements of the subsidiary is $55 000. This is the starting point that will subsequently be adjusted for unrealised profits and losses. A number of adjustments are then made to take account of any unrealised components—from the perspective of the subsidiary’s profits—that are included within the $55 000. Unrealised profit in opening inventory on 1 July 2019 now realised At 1 July 2019 the profit on sale of the inventory in the previous period was considered unrealised from the perspective of the non-controlling interest. However, from the economic entity’s perspective, it is considered realised in the current period. This requires the adjustments made in the previous period to be reversed in the current period. Unrealised profit in inventory—30 June 2020 This sale was made by the subsidiary and is unrealised (the related assets are still on hand within the group) and therefore requires the non-controlling interest’s share of current period profits to be adjusted. The unrealised profit on the sale of inventory at 30 June 2020 amounted to $2 400. The reduction in profits will lead to a lower tax expense. At a tax rate of 30 per cent an adjustment of $720 ($2 400 × 30 per cent), the tax effect on the unrealised profits, must be made. Intragroup sale of a non-current asset As there had been no transaction with a party outside the economic entity, the intragroup gain of $20 000 on the sale of the plant must be reversed. This gain was recognised in the financial statements of the subsidiary and, from the perspective of the economic entity, is unrealised at the end of the reporting period. As no gain has been made, a tax expense of $6 000 ($20 000 × 30 per cent) must be reversed.   As the depreciation expense charged by Bells Ltd would be greater than that charged by Torquay Ltd, the additional depreciation charge of $2 000 ($4 500 – $2 500) should be adjusted for. The decrease in depreciation results in an increase in profits. This would lead to an increase in tax of $600 ($2 000 × 30 per cent).   An adjustment for the 2020 goodwill impairment allocated to the non-controlling interest must be made. This amounts to $12 000 for 2020.   The 20 per cent non-controlling interest in the current period’s profit and movements in reserves in the current period amounted to $5 828, as shown in the calculations provided earlier. Dr Non-controlling interest in earnings 5828 Cr Non-controlling interest 5828 Non-controlling interest in the current period’s profit and movements in reserves in the current period (u) Dividends paid by Torquay Ltd The impact of the dividends on non-controlling interests needs to be considered. The payment and declaration of dividends by the subsidiary act to reduce the interest of the non-controlling entity/entities in the subsidiary’s closing retained earnings. 30 June 2020 Dr Non-controlling interest Cr Dividends paid Cr Dividends declared Dividends attributable to non-controlling interest

8 000 6 000 2 000

Next we transfer the above consolidation journal entries to the consolidation worksheet. As we see from the four sets of consolidation journal entries above, the total amount of the non-controlling interest in Torquay Ltd is $515 344 (which equals $500 000 + $17 516 + $5 828 – $8 000, and which is the total amount shown in the table provided earlier). 986  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Bells Ltd and its controlled entity Eliminations and adjustments Bells Ltd ($000)

Torquay Ltd ($000)

Reconciliation of opening and closing retained earnings Revenue

480

115

Cost of goods sold

(100)

(40)

Other expenses

(80)

(15)

12(m)

Other income

70

25

           370 (60)

           85 (30)

20(i) 10(n) 24(o) 8(q)

           310

           55

Profit before tax Income tax expense

Profit for the year Non-controlling interest in earnings Retained earnings—1 July 2019

Dividends paid Dividend declared Retained earnings 30 June 2020 Statement of financial position Equity Share capital Retained earnings b/d Non-controlling interest

1 000

800

           1 310 (160)

           855 (30)

(40)            1 110

(10)              815

4 000

1 500

1 110

815

Dr ($000)

20(b) 30(e) 2.4(c) 4(f)

0.18(h) 0.6(l)

20 40

30 10

Consolidated statements ($000)

545 20(b) 30(e) 0.6(h) 2(k) 10(n)

(95.8) (95)

33    387.2 0.72(d) 1.2(g) 6( j)

5.828(t) 560(a) 0.42(h) 12(m) 140(r) 17.516(s)

(82.86) 304.34 (5.828)

1 070.064 1 368.576 24(o) 6(u) 8(p) 2(u)

1 200(a)   300(r)

(160)    (40) 1 168.576

4 000 1 168.576

8(u) Current liabilities Accounts payable Dividends payable

Cr ($000)

8(p)

500(r) 17.516(s) 5.828(t)

515.344 50 42 continued

CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  987

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Eliminations and adjustments

Non-current liabilities Loans Current assets Cash Accounts receivable Dividend receivable Inventory

Bells Ltd ($000)

Torquay Ltd ($000)

   600 5 770

   250 2 605

150 242 8 500

25 175 – 300

Non-current assets Deferred tax asset

Land Plant Accumulated depreciation Investment in Torquay Ltd Goodwill Accumulated impairment loss—goodwill

Dr ($000)

           5 770

1 105 1 300 (300) – –

           2 605

Consolidated statements ($000)    850 6 625.92

8(q) 2.4(c) 4(f) 0.72(d) 1.2(g) 6( j)

1 400 1 870 (400) 2 000 –

Cr ($000)

5(i) 2(k)

793.6

0.6(l)

25(i) 2 000(a)

240(a) 60(r)                   2 697.864

175 417 –

7.32 2 505 3 175 (723) – 300

  24(m) 2 697.864

    (24) 6 625.92

  The above worksheet provides the data for the consolidated statement of profit or loss and other comprehensive income and consolidated statement of financial position. As can be seen, the Bells Ltd dividend paid and declared totals $200 000. In the consolidated financial statements, dividends payable amount to $208 000 ($200 000 by Bells Ltd, and 20 per cent of the $40 000 paid and declared by Torquay Ltd).   The consolidated financial statements can now be presented. A suggested format for the consolidated financial statements would be as follows (prior-year comparatives for the financial statements of the parent entity and the group, both of which would be required in practice, have not been provided): Bells Ltd and its controlled entity Consolidated statement of profit or loss and other comprehensive income for the year ended 30 June 2020

Revenue Cost of good sold Gross profit Other income Other expenses Profit before tax Income tax expense Profit for the year Other comprehensive income Total comprehensive income

Group ($) 545 000   (95 800) 449 200   33 000 482 200   (95 000) 387 200   (82 860) 304 340             – 304 340

Bells Ltd ($) 480 000 (100 000) 380 000     70 000 450 000    (80 000) 370 000    (60 000)   310 000              –   310 000

988  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Profit attributable to: Owners of the parent Non-controlling interest Total comprehensive income attributable to: Owners of the parent Non-controlling interest

298 512      5 828 304 340

310 000              –   310 000

298 512     5 828 304 340

310 000              –   310 000

Bells Ltd and its controlled entity Consolidated statement of changes in equity for the year ended 30 June 2020 Attributable to owners of the parent

Balance at 1 July 2019 Total comprehensive income for the year Dividends Balance at 30 June 2020

Share capital ($)

Retained earnings ($)

4 000 000                     4 000 000

1 070 064 298 512   (200 000) 1 168 576

Total ($)

Noncontrolling interest ($)

Total equity ($)

5 070 064 298 512    (200 000) 5 168 576

517 516 5 828      (8 000) 515 344

5 587 580 304 340   (208 000) 5 683 920

Bells Ltd Statement of changes in equity for the year ended 30 June 2020

Balance at 1 July 2019 Total comprehensive income for the year Distributions Balance at 30 June 2020

Share capital ($) 4 000 000

                4 000 000

Retained earnings ($) 1 000 000 310 000   (200 000) 1 110 000

Total equity ($) 5 000 000 310 000   (200 000) 5 110 000

Group ($)

Bells Ltd ($)

793 600 417 000 –     175 000 1 385 600

500 000 242 000 8 000     150 000    900 000

2 505 000 3 175 000 (723 000) 300 000 (24 000) –

1 400 000 1 870 000 (400 000) – – 2 000 000

Bells Ltd and its controlled entity Consolidated statement of financial position at 30 June 2020

Assets Current assets Inventory Accounts receivable Dividends receivable Cash Total current assets Non-current assets Land Plant and equipment Accumulated depreciation Goodwill Accumulated impairment loss Investment in Torquay Ltd

continued CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  989

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Deferred tax asset Total non-current assets Total assets Current liabilities Accounts payable Dividends payable Total current liabilities Non-current liabilities Loans Total non-current liabilities Total liabilities Net assets Equity Share capital Retained earnings Non-controlling interest Total equity

Group ($)          7 320 5 240 320 6 625 920

Bells Ltd ($)                – 4 870 000 5 770 000

50 000       42 000       92 000

20 000     40 000     60 000

   850 000    850 000    942 000 5 683 920

   600 000    600 000    660 000 5 110 000

4 000 000 1 168 576 5 168 576    515 344 5 683 920

4 000 000 1 110 000 5 110 000                – 5 110 000

SUMMARY In this chapter we learned about how to calculate and disclose non-controlling interests in the profits and capital and reserves of an economic entity. Non-controlling interests are defined as ‘that portion of the profit or loss and net assets of a subsidiary attributable to equity interests that are not owned, directly or indirectly through subsidiaries, by the parent’. AASB 10 and AASB 101 require us to separately disclose the amount of profit attributable to non-controlling interests and parent interests. There is also a requirement to separately disclose parent entity interests and non-controlling interests in share capital and reserves of the economic entity. We learned that in calculating non-controlling interests in the profits of the economic entity we start with the reported after-tax profit of the subsidiary and calculate a proportionate share in this unadjusted amount. We then make adjustments for profits made in the accounts of the subsidiary that are unrealised at year end from the perspective of the economic entity. In calculating non-controlling interests, we do not make any adjustments for unrealised profits that were recorded in the accounts of the parent entity. Following the consolidation process we will see that the dividends included in the consolidated financial statements show the dividends paid and declared by the parent entity, as well as the non-controlling interests in the dividends paid and declared by the subsidiary. The parent entity’s interest in the dividends paid and declared by the subsidiaries is eliminated as part of the consolidation process and therefore will not be shown in the consolidated financial statements. In relation to share capital and reserves, the consolidated financial statements will include, within total share capital and reserves, the parent entity’s share capital and reserves, as well the share capital and reserves of the subsidiary that are attributable to the non-controlling interest. The parent entity’s interest in pre-acquisition share capital and reserves will be eliminated on consolidation.

KEY TERMS parent entity  967 990  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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END-OF-CHAPTER EXERCISES PART A 1. What is a non-controlling interest and how should it be disclosed in the financial statements? LO 27.1 2. If there is a purchase transaction between the parent entity and a 60 per cent-owned subsidiary, which generates a payable in the accounts of the parent entity and a receivable in the accounts of the controlled entity, what percentage of the intragroup payable and receivable should be eliminated on consolidation? LO 27.2 3. If less than 100 per cent of a subsidiary is owned by the parent entity, will less than 100 per cent of the assets and liabilities of the subsidiary be included within the consolidated financial statements? LO 27.2, 27.3 PART B The following financial statements of Hogwarts Ltd and its subsidiary Gryffindor Ltd have been extracted from their financial records at 30 June 2019. Hogwarts Ltd ($000) Detailed reconciliation of opening and closing retained earnings Sales revenue Cost of goods sold Gross profit Dividends received—from Gryffindor Management fee revenue Profit on sale of plant Expenses Administrative expenses Depreciation Management fee expense Other expenses Profit before tax Tax expense Profit for the year Retained earnings—30 June 2018 Dividends paid Retained earnings—30 June 2019 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory Non-current assets Land and buildings Plant—at cost Accumulated depreciation Investment in Gryffindor Ltd

Gryffindor Ltd ($000)

690  (464)   226  74.4 26.5 35 

580  (238) 342  –  –  – 

(30.8) (24.5) –  (101.1) 205.5    61.5 144     319.4 463.4 (137.4)  326   

(38.7) (56.8) (26.5)     (77) 143     42.2 100.8   239.2 340    (93)     247

326  350 

247 200 

54.7 41.3

46.3 25

 173.5  945.5

  116   634.3

59.4 92 

62.3 29 

224     299.85 (85.75)  356     945.5 

326  355.8 (138.8)         –    634.3

CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  991

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Other information • Hogwarts Ltd had acquired its 80 per cent interest in Gryffindor Ltd on 1 July 2010, that is, nine years earlier. At that date the capital and reserves of Gryffindor Ltd were: Share capital Retained earnings

$200 000 $170 000 $370 000

At the date of acquisition all assets were considered to be fairly valued. • The management of Hogwarts Ltd values any non-controlling interest at the proportionate share of Gryffindor Ltd’s identifiable net assets. (Hint: this means that unlike Worked Example 27.3, in this worked example no goodwill in the subsidiary will be attributed to the non-controlling interest.) • During the year Hogwarts Ltd made total sales to Gryffindor Ltd of $65 000, while Gryffindor Ltd sold $52 000 in inventory to Hogwarts Ltd. • The opening inventory in Hogwarts Ltd as at 1 July 2018 included inventory acquired from Gryffindor Ltd for $42 000 that had cost Gryffindor Ltd $35 000 to produce. • The closing inventory in Hogwarts Ltd includes inventory acquired from Gryffindor Ltd at a cost of $33 600. This cost Gryffindor Ltd $28 000 to produce. • The closing inventory of Gryffindor Ltd includes inventory acquired from Hogwarts Ltd at a cost of $12 000. This cost Hogwarts Ltd $9 600 to produce. • The management of Hogwarts Ltd believe that goodwill acquired was impaired by $3 000 in the current financial year. Previous impairments of goodwill amounted to $22 500. • On 1 July 2018 Hogwarts Ltd sold an item of plant to Gryffindor Ltd for $116 000 when its carrying value in Hogwarts Ltd’s accounts was $81 000 (cost of $135 000, accumulated depreciation of $54 000). This plant is assessed as having a remaining useful life of six years. • Gryffindor Ltd paid $26 500 in management fees to Gryffindor Ltd. • The tax rate is 30 per cent.

REQUIRED Provide the consolidated financial statements of Hogwarts Ltd and Gryffindor Ltd for the reporting period ending 30 June 2019. LO 27.2, 27.3, 27.4

SOLUTION TO END-OF-CHAPTER EXERCISE Eliminating the investment in Gryffindor Ltd and recognising goodwill on acquisition date

Elimination of investment in Gryffindor Ltd Fair value of consideration transferred less Fair value of identifiable assets acquired and liabilities assumed Share capital on acquisition date Retained earnings on acquisition date

Gryffindor Ltd ($)

200 000 170 000 370 000

Goodwill on acquisition date Non-controlling interest at date of acquisition

Hogwarts Ltd’s 80% interest ($) 356 000

20% Noncontrolling interest ($)

160 000 136 000 296 000   60 000

40 000 34 000           – 74 000

As shown, the net assets of Gryffindor Ltd are $370 000 at acquisition date. The parent entity’s proportional interest acquired in these net assets (80 per cent) amounts to $296 000. As $356 000 is paid for the investment, the goodwill amounts to $60 000. As we know, this represents only the portion of goodwill acquired by Hogwarts Ltd and not the entire goodwill of Gryffindor Ltd at acquisition date. The consolidation entry to eliminate the investment is: (a) Dr Dr Dr Cr

Share capital Retained earnings Goodwill Investment in Gryffindor Ltd

       

160 000 136 000 60 000 356 000

992  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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What should be noted at this point is that because we have been told that the management of Hogwarts Ltd values any non-controlling interest at the proportionate share of Gryffindor Ltd’s identifiable net assets, this means that only the goodwill that has been purchased by Hogwarts Ltd is recognised. However, had the non-controlling interest been measured at fair value, this would have amounted to $89 000 ($356 000 × 20 ÷ 80). The goodwill attributable to the non-controlling interest would have amounted to $15 000 ($89 000 − $74 000). Because no amount of goodwill has been attributed to the non-controlling interest, this also means that no portion of any subsequent impairment of goodwill will be attributed to (deducted from) the non-controlling interests.

Elimination of intragroup sales of inventory We need to eliminate the intragroup sales because, from the perspective of the economic entity, no sales have in fact occurred. This will ensure that we do not overstate the turnover of the economic entity. Sale of inventory from Gryffindor Ltd to Hogwarts Ltd Dr (b) Cr

Sales Cost of goods sold

52 000 52 000

Under the periodic inventory system, the above credit entry would be to purchases, which would ultimately lead to a reduction in cost of goods sold. (Cost of goods sold equals opening inventory plus purchases less closing inventory, so any reduction in purchases leads to a reduction in cost of goods sold.)

Elimination of unrealised profit in closing inventory In this case, the unrealised profit in closing inventory amounts to $5 600. In accordance with AASB 102 Inventories, we must value the inventory at the lower of cost and net realisable value. Hence on consolidation we must reduce the value of recorded inventory, as the amount shown in the accounts of Hogwarts Ltd exceeds what the inventory cost the economic entity. Dr (c) Cr

Cost of goods sold Inventory

5 600 5 600

Under the periodic inventory system, the above debit entry would be to closing inventory—profit and loss. We increase cost of goods sold by the unrealised profit in closing inventory because reducing closing inventory effectively increases cost of goods sold. (Remember, cost of goods sold equals opening inventory plus purchases less closing inventory.) The effect of the above entries is to adjust the value of inventory so that it reflects the cost of the inventory to the group.

Consideration of the tax paid or payable on the sale of inventory that is still held within the group From the group’s perspective, $5 600 has not been earned. However, from Gryffindor Ltd’s individual perspective (as a separate legal entity), the full amount of the sale has been earned. This will attract a tax liability in Gryffindor Ltd’s accounts of $1 680 (30 per cent of $5 600). However, from the group’s perspective, some of this will represent a prepayment of tax, as the full amount has not been earned by the group even if Gryffindor Ltd is obliged to pay the tax. (d) Dr Deferred tax asset Cr Income tax expense ($5 600 × 30 per cent)

1 680 1 680

Eliminating sale of inventory from Hogwarts Ltd to Gryffindor Ltd During the current financial period Hogwarts Ltd sold inventory to Gryffindor Ltd at a price of $65 000. At year end, Gryffindor Ltd has $12 000 of this inventory on hand, which cost Hogwarts Ltd $9 600 to produce. Dr (e) Cr

Sales Cost of goods sold

65 000 65 000

Unrealised profit in closing inventory held by Gryffindor Ltd In this case, the unrealised profit in closing inventory amounts to $2 400 ($12 000 × 25 ÷ 125). In accordance with AASB 102 Inventories, the inventory must be valued at the lower of cost and net realisable value. This means that on consolidation the value of recorded inventory must be reduced, as the amount shown in the financial statements of Gryffindor Ltd exceeds what the inventory cost the economic entity. CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  993

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(f) Dr Cr

Cost of goods sold Inventory

2 400 2 400

Tax attributable to unrealised profit in closing inventory held by Gryffindor Ltd From the group’s perspective, $2 400 has not been earned. However, from Hogwarts Ltd’s individual perspective (as a separate legal entity), the full amount of the sale has been earned. This will attract a tax liability in Hogwarts Ltd’s financial statements of $720 ($2 400 × 30 per cent). However, from the group’s perspective, some of this will represent a prepayment of tax, as the full amount has not been earned by the group even if Hogwarts Ltd is obliged to pay the tax. Dr Deferred tax asset 720 (g) Cr Income tax expense 720 ($2 400 × 30 per cent) We do not need to make any adjustments to non-controlling interests as profit was not recorded in the accounts of the subsidiary. Unrealised profit in opening inventory If unrealised profit in opening inventory is not eliminated, opening inventory will be overstated from the group perspective. At the end of the preceding financial year, Hogwarts Ltd had $42 000 of inventory on hand, which had been purchased from Gryffindor Ltd. The inventory cost Gryffindor Ltd $35 000 to produce.   It is assumed that the inventory has been sold to an external party in the current period and hence is realised—so there is no need to adjust the closing balance of inventory. (h) Dr Dr Cr

Retained earnings—30 June 2018 Income tax expense Cost of sales

4900 2 100 7 000

Adjustments for intragroup sale of plant On 1 July 2018 Hogwarts Ltd sold an item of plant to Gryffindor Ltd for $116 000 when its carrying value in Gryffindor Ltd’s accounts was $81 000 (cost of $135 000 and accumulated depreciation of $54 000). This item of plant was being depreciated over 10 years, with no expected residual value. Reversal of gain recognised on sale of asset and reinstatement of cost and accumulated depreciation The result of the sale of the item of plant to Gryffindor Ltd is that the gain of $35 000—the difference between the sales proceeds of $116 000 and the carrying amount of $81 000—will be shown in Hogwarts Ltd’s financial statements. However, from the economic entity’s perspective there has been no sale and, therefore, no gain on sale given that there has been no transaction with a party external to the group. The following entry is necessary so that the accounts will reflect the balances that would have been in place had the intragroup sale not occurred. (i) Dr Dr Cr

Gain on sale of plant Plant Accumulated depreciation

35 000 19 000 54 000

The result of this entry is that the intragroup gain is removed and the asset and accumulated depreciation accounts revert to reflecting no sales transaction. The gain of $35 000 will be recognised progressively in the consolidated financial statements of the economic entity by adjustments to the amounts of depreciation charged by Gryffindor Ltd in its accounts. As the service potential or economic benefits embodied in the asset are consumed, the $35 000 gain will be progressively recognised from the economic entity’s perspective. This is shown in journal entry (k).

Impact of tax on gain on sale of item of plant From Gryffindor Ltd’s individual perspective it would have made a gain of $35 000 on the sale of the plant and this gain would have been taxable. At a tax rate of 30 per cent, $10 500 would be payable by Hogwarts Ltd. However, from the economic entity’s perspective no gain has been made, which means that the related ‘tax expense’ must be reversed and a related deferred tax benefit recognised. A deferred tax asset is recognised because, from the economic entity’s perspective, the amount paid to the tax office represents a prepayment of tax. 994  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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( j) Dr Cr

Deferred tax asset Income tax expense

10 500 10 500

Reinstating accumulated depreciation in the statement of financial position Hogwarts Ltd would be depreciating the asset on the basis of the cost it incurred to acquire the asset. Its depreciation charge would be $116 000 ÷ 6 = $19 333. From the economic entity’s perspective, the asset had a carrying value of $81 000, which was to be allocated over the next six years giving a depreciation charge of $81 000 ÷ 6 = $13 500. An adjustment of $5 833 is therefore required. Dr (k) Cr

Accumulated depreciation Depreciation expense

5 833 5 833

Consideration of the tax effect of the reduction in depreciation expense The increase in the tax expense from the perspective of the economic entity is due to the reduction in the depreciation expense. The additional tax expense is $1 750, which is $5 833 × 30 per cent. This entry represents a partial reversal of the deferred tax asset of $10 500 recognised in the earlier entry. After six years the balance of the deferred tax asset relating to the sale of the item of plant will be $nil. Dr (l) Cr

Income tax expense Deferred tax asset

1 750 1 750

Impairment of goodwill The total impairment of goodwill amounts to $25 500. Of this amount $3 000 must be recognised in the current period, with $22 500 relating to a previous period’s impairment being offset against opening retained earnings. (m) Dr Dr Cr

Retained earnings—30 June 2018 Impairment loss—goodwill Accumulated impairment losses—goodwill

22 500 3 000 25 500

As Hogwarts Ltd values the non-controlling interest at the proportionate share of Gryffindor Ltd’s identifiable assets, there is no necessity to allocate any goodwill impairment expense between the parent and the noncontrolling interest. There are no implications for non-controlling interest as this relates only to the parent entity’s share.

Elimination of intragroup transactions—management fees All of the management fees paid within the group will need to be eliminated on consolidation. (n) Dr Cr

Management fee revenue Management fee expense

26 500 26 500

Implications for non-controlling interests: Intragroup payment of management fees It is not necessary to make any adjustments to non-controlling interest of profits as the profits associated with the management are deemed to be realised. Dividends paid We eliminate the dividends paid within the group. Only the dividends paid to parties outside the entity (the non-controlling interests) are to be shown in the consolidated financial statements. Dr (o) Cr

Dividend revenue Dividend paid

74 400 74 400

Recognising non-controlling interest in contributed equity and earnings It must be remembered that in order to recognise the non-controlling interest’s share in contributed equity and reserves at the end of the reporting period, three calculations need to be made: (i) The non-controlling interests on acquisition date. (ii) The non-controlling interest in movements in contributed equity and reserves between the date of the parent entity’s acquisition and the beginning of the current reporting period. CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  995

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(iii) The non-controlling interest in the current period’s profit, as well as movements in reserves in the current period. In determining the non-controlling interest’s share of current period profit or loss, gains and losses of the subsidiary that are unrealised from the economic entity’s perspective will need to be adjusted for.

The steps above are used to calculate the non-controlling interest.

Calculation of non-controlling interest in Gryffindor Ltd (i)

(ii)

Non-controlling interests on acquisition date Share capital Retained earnings—on acquisition Non-controlling interest in movements in share capital and reserves between the date of the parent entity’s acquisition and the beginning of the current reporting period Retained earnings—since acquisition ($239 200 – $170 000) less Unrealised profits in inventory—1 July 2018 Tax effect on unrealised profits

(iii) Non-controlling interest in the current period’s profit and movements in reserves in the current period Profit for the year add Unrealised profit in inventory—1 July 2018—now realised Tax effect on unrealised profit now realised less Unrealised profits in inventory—30 June 2019 Tax effect on unrealised profit Profit Gryffindor contributed to the economic entity Dividends paid by Gryffindor Ltd



Gryffindor Ltd ($)

20% Noncontrolling interest ($)

200 000 170 000 370 000

40 000  34 000  74 000

69 200 (7 000)    2 100   64 300

              12 860

100 800 7 000 (2 100) (5 600)      1 680 101 780   (93 000)

              20 356 (18 600)  88 616

In the above calculation of non-controlling interests, the subsidiary’s profits have not been reduced by any amount related to goodwill impairment. As indicated earlier, only the parent entity’s share of goodwill is brought to account given that the management of Hogwarts Ltd values any non-controlling interest at the proportionate share of Gryffindor Ltd’s identifiable assets. It would therefore be inappropriate to allocate any goodwill impairment expense against the profits of the subsidiary.

(p) Non-controlling interests on acquisition date The non-controlling interest in contributed equity and reserves is transferred to non-controlling interest.



Dr Share capital Dr Retained earnings Cr Non-controlling interest Recognising non-controlling interests on acquisition date

40 000 34 000 74 000

(q) Non-controlling interest in movements in retained earnings between the date of the parent entity’s acquisition and the beginning of the current reporting period The retained earnings at the date of acquisition is deducted from the retained earnings at the beginning of the current reporting period ($239 200 − $170 000). A number of adjustments may need to be made to this figure.   In this end-of-chapter exercise, the unrealised profit on the sale of inventory at 1 July 2018 amounted to $7 000. The reduction in profits will lead to a lower tax expense. At a tax rate of 30 per cent, an adjustment of $2 100 ($7 000 × 30 per cent), the tax effect on the unrealised profits, must be made. The 20 per cent 996  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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non-controlling share in interest in movements in contributed equity and reserves between the date of the parent entity’s acquisition and the beginning of the current reporting period amounted to $12 860.



Dr Retained earnings 12 860 Cr Non-controlling interest 12 860 Recognising non-controlling interest in movements in retained earnings between the date of the parent entity’s acquisition and the beginning of the current reporting period

(r) Non-controlling interest in the current period’s profit and movements in reserves in the current period The profit of the subsidiary for the current reporting period as reported in the financial statements of the subsidiary is $100 800. This is the starting point that will subsequently be adjusted for unrealised profits and losses. A number of adjustments are then made to take account of any unrealised components—from the perspective of the subsidiary’s profits—that are included within the $100 800. Unrealised profit in opening inventory—1 July 2018 now realised At 1 July 2018 the profit on sale of the inventory in the previous period was considered unrealised from the perspective of the non-controlling interest. However, from the economic entity’s perspective it is considered realised in the current period. This requires the adjustments made in the previous period to be reversed in the current period. Unrealised profit in inventory—30 June 2019 This sale was made by the subsidiary and is unrealised (the related assets are still on hand within the group) and therefore requires the non-controlling interest’s share of current period profits to be adjusted. The unrealised profit on the sale of inventory at 30 June 2019 amounted to $5 600. The reduction in profits will lead to a lower tax expense. At a tax rate of 30 per cent an adjustment of $1 680 ($5 600 × 30 per cent), the tax effect on the unrealised profits, must be made.   The 20 per cent non-controlling interest in the current period’s profit and movements in reserves in the current period amounted to $20 356.



Dr Non-controlling interest in earnings 20 356 Cr Non-controlling interest 20 356 Recognising non-controlling interest in the current period’s profit and movements in reserves in the current period

(s) Dividends paid by Gryffindor Ltd The impact of the dividends on non-controlling interests needs to be considered. The payment and declaration of dividends by the subsidiary reduces the interest of the non-controlling entity/entities in the subsidiary’s closing retained earnings.



Dr Non-controlling interest Cr Dividends paid Recognising dividends paid by Gryffindor Ltd

18 600



Now we can post the consolidation journal entries to the consolidation worksheet.

18 600

Eliminations and adjustments Hogwarts Ltd ($000)

Gryffindor Ltd ($000)

Detailed reconciliation of opening and closing retained earnings Sales revenue

690

580

Cost of goods sold

(464)

(238)

Gross profit

226

342

Dr ($000)

52(b) 65(e) 5.6(c) 2.4(f)

Cr ($000)

Consolidated statements ($000)

1 153 52(b) 65(e) 7(h)

   586

567 continued

CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  997

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Eliminations and adjustments Hogwarts Ltd ($000) Other revenue Dividends received—from Gryffindor Management fee revenue Gain on sale of plant Expenses Administrative expenses Depreciation Management fee expense Other expenses Profit before tax Tax expense

Profit for the year Non-controlling interest in profit after tax Parent entity interest in profit after tax Retained earnings—30 June 2018

Dividends paid Retained earnings—30 June 2019 Statement of financial position Shareholders’ equity Retained earnings Share capital Non-controlling interest Current liabilities Accounts payable Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory

74.4 26.5 35

Gryffindor Ltd ($000) – –

(30.8) (24.5) – (101.1) 205.5 61.5

(38.7) (56.8) (26.5) (77) 143   42.2

144

100.8

Dr ($000)

Cr ($000)

74.4(o) 26.5(n) 35(i)

– – –

5.833(k) 26.5(n) 3(m) 2.1(h) 1.75(l)

1.68(d) 0.72(g) 10.5( j)

239.2

463.4 (137.4) 326  

340   (93) 247

326 350

247 200

54.7 41.30

136(a) 4.9(h) 22.5(m) 34(p) 12.86(q) 74.4(o), 18.6(s)

160(a), 40(p) 18.6(s)

74(p), 12.86(q) 20.356(r)

46.3 25

173.5 945.5

116 634.3

59.4 92

62.3 29

Non-current assets Deferred tax asset

(69.5) (75.467) – (181.1) 240.933 94.65

    146.283 (20.356) 125.927 348.34  

20.356(r) 319.4

Consolidated statements ($000)

474.267   (137.4)       336.867

336.867 350 88.616

101 66.3 289.5 1 232.283

5.6(c) 2.4(f) 1.68(d) 0.72(g) 10.5( j)

1.75(l)

121.7 113

11.15

998  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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05/18/16 06:57 AM

Land and buildings Plant—at cost Accumulated depreciation Investment in Gryffindor Ltd Goodwill Accumulated impairment loss

224 299.85 (85.75) 356 –      –  945.5

326 355.8 (138.8) – –      –   634.3

19(i) 5.833(k)

54(i) 356(a)

60(a)             814.699

  25.5(m) 814.699

550 674.65 (272.717) – 60 (25.5) 1 232.283

Summary of non-controlling interest 20% Noncontrolling interest Profit Profit of Gryffindor Ltd Adjustments Unrealised profit in opening inventory Unrealised profit in closing inventory Opening retained earnings Opening retained earnings of Gryffindor Ltd Unrealised profit in opening inventory Dividends Paid by Gryffindor Ltd Non-controlling interest in closing retained earnings Non-controlling interest in share capital Total non-controlling interest

100 800

20 160

4 900 (3 920)

980      (784)

239 200 (4 900) (93 000)

47 840 (980)               (18 600)

200 000

40 000

20 356

46 860  (18 600) 48 616 40 000 88 616

We are now in a position to present the consolidated financial statements. A suggested format for the consolidated accounts would be as follows: Consolidated statement of profit or loss and other comprehensive income of Hogwarts Ltd and its subsidiaries for the year ended 30 June 2019

Sales Cost of good sold Gross profit Dividend revenue Management fee revenue Gain on sale of plant Administrative expenses Depreciation Other expenses Profit before income tax expense Income tax expense Profit after income tax expense Other comprehensive income Total comprehensive income

The Group ($)

Hogwarts Ltd ($)

1 153 000 (586 000) 567 000

690 000 (464 000) 226 000 74 400 26 500 35 000 (30 800) (24 500) (101 100) 205 500 (61 500) 144 000 – 144 000

(69 500) (75 467) (181 100) 240 933    94 650 146 283              – 146 283

continued CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  999

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Profit after income tax attributable to: Owners of the parent Non-controlling interest Total comprehensive income attributable to: Owners of the parent Non-controlling interest

The Group ($)

Hogwarts Ltd ($)

125 927 20 356 146 283

144 000

              144 000

125 927 20 356 146 283

Consolidated statement of financial position of Hogwarts Ltd and its subsidiaries as at 30 June 2019 The Group  ($) Current assets Accounts receivable Inventory Non-current assets Land and buildings Plant and equipment less Accumulated depreciation Goodwill less Accumulated impairment loss Investment in Gryffindor Ltd Deferred tax asset Total assets Current liabilities Accounts payable Tax payable Non-current liabilities Loan Total liabilities Shareholders’ equity Share capital Retained earnings Total parent entity interest in equity Non-controlling interest in equity Total equity

Hogwarts Ltd ($)

121 700 113 000 234 700

59 400   92 000 151 400

550 000 674 650 (272 717) 60 000 (25 500) –      11 150    997 583 1 232 283

224 000 299 850 (85 750) – – 356 000             – 794 100 945 500

101 000      66 300    167 300

54 700   41 300   96 000

   289 500    456 800

173 500 269 500

350 000    336 867 686 867      88 616    775 483 1 232 283

350 000 326 000 676 000             – 676 000 945 500

Hogwarts Ltd and its controlled entity Consolidated statement of changes in equity for the year ended 30 June 2019 Attributable to owners of the parent

Balance at 1 July 2018 Total comprehensive income for the year Distributions Balance at 30 June 2019

Share capital ($)

Retained earnings ($)

350 000

348 340 125 927 (137 400)  336 867

                350 000

Total ($)

Noncontrolling interest ($)

Total equity ($)

698 340 125 927 (137 400)  686 867

86 860 20 356 (18 600)  88 616

785 200 146 283 (156 000)  775 483

1000  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Hogwarts Ltd Statement of changes in equity for the year ended 30 June 2019

Balance at 1 July 2018 Total comprehensive income for the year Distributions Balance at 30 June 2019

Share capital ($)

Retained earnings ($)

Total equity ($)

350 000

319 400 144 000 (137 400) 326 000

669 400 144 000 (137 400) 676 000

              350 000

REVIEW QUESTIONS 1. Where only a proportion of a subsidiary’s shares are owned by a parent entity, what proportion of the intragroup transactions between the parent entity and the subsidiary will need to be eliminated on consolidation? LO 27.2 2. What is a non-controlling interest, and how should it be disclosed? LO 27.1 3. How are non-controlling interests affected by intragroup transactions? LO 27.2 4. In working out the non-controlling interest in current period profits we start with the reported profit of the subsidiary and then make a number of adjustments. What sorts of things do we need to make adjustments for? LO 27.2 5. Assume that Company A acquires 70 per cent of Company B for a cash price of $10 million when the share capital and reserves of Company B are: Share capital Retained earnings

$8 million   $2 million $10 million

(a) What amount will be shown in the consolidated statement of financial position for goodwill pursuant to AASB 3 assuming that any non-controlling interest in the acquirer is measured at fair value? LO 27.3 (b) What amount will be shown in the consolidated statement of financial position for goodwill pursuant to AASB 3, assuming that any non-controlling interest in the acquirer is measured at the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets? LO 27.3 (c) What are some of the implications of allowing the group to have two options in accounting for goodwill on consolidation? LO 27.3 6. Backbeach Ltd acquired a 70 per cent interest in another entity, Frontbeach Ltd, in 2015 for a cost of $5 million. There was no goodwill or bargain gain on purchase. The consolidated worksheet for Backbeach Ltd and its controlled entity as at 30 June 2019 included the following:

Revenue Cost of goods sold Dividend revenue Interest expense Depreciation expense Other expenses

Parent ($000)

Consolidated ($000)

2 000 400 1 000 50 100 50

5 000 1 500 200 100 50 10

REQUIRED Prepare a consolidated statement of profit or loss and other comprehensive income for Backbeach Ltd and its controlled entities that conforms with the disclosure requirements of AASB 101 Presentation of Financial Statements. LO 27.2, 27.3, 27.4 CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  1001

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7. Kelly Ltd acquired 70 per cent of the share capital of Slater Ltd on 1 July 2018 for a cost of $300 000. At the date of acquisition all assets were fairly valued, and the balance of share capital and reserves was as follows: Share capital Retained earnings Revaluation surplus

$ 180 000 50 000   60 000 290 000

On 15 August 2018 Slater Ltd paid a $50 000 dividend out of pre-acquisition earnings to all shareholders that held shares at 10 July 2018. Non-controlling interest in the acquirer is measured at fair value.

REQUIRED Using the above information, prepare the consolidation adjustments and eliminations required for the year ended 30 June 2019. LO 27.2, 27.3 8. Layne Ltd acquired 90 per cent of the share capital of Beachly Ltd on 1 July 2018 for a cost of $500 000. As at the date of acquisition all assets of Beachly Ltd were fairly valued, other than land that had a carrying amount $50 000 less than its fair value. The recorded balances of equity in Beachly Ltd as at 1 July 2018 were: $ Share capital Retained earnings

350 000 100 000 450 000

Additional information • The management of Layne Ltd values any non-controlling interest at the proportionate share of Beachley Ltd’s identifiable net assets. • Beachly Ltd had a profit after tax of $70 000 for the year ended 30 June 2019. • During the financial year to 30 June 2019 Beachly Ltd sold inventory to Layne Ltd for a price of $60 000. The inventory cost Beachly Ltd $30 000 to produce, and 25 per cent of this inventory was still on hand with Layne Ltd as at 30 June 2019. • During the year Beachly Ltd paid $10 000 in management fees to Layne Ltd. • On 1 July 2018 Beachly Ltd sold an item of plant to Layne Ltd for $40 000 when it had a carrying amount of $30 000 (cost of $50 000, accumulated depreciation of $20 000). At the date of sale it was expected that the plant had a remaining useful life of four years, and no residual value. • The tax rate is 30 per cent.

REQUIRED Prepare the consolidation adjustments for the year ended 30 June 2019 and, based on the information provided above, calculate the non-controlling interests in the 2019 profits. LO 27.2, 27.3 9. On 1 July 2017 Anderson Ltd acquires 70 per cent of the equity capital of Thruster Ltd at a cost of $4 million. At the date of acquisition all assets of Thruster Ltd are fairly stated, and the total shareholders’ funds of Thruster Ltd are $4.4 million, consisting of: Share capital Retained earnings

$3 000 000 $1 400 000 $4 400 000

As at 30 June 2019 (two years after the date of acquisition) the financial statements of the two companies are as follows: Anderson Ltd ($000)

Thruster Ltd ($000)

Sales revenue

800

200

Cost of goods sold

(200)

(80)

Other expenses

(120)

(60)

Detailed reconciliation of opening and closing retained earnings

1002  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Other revenue Profit Tax Profit after tax Retained earnings—30 June 2018 Dividends paid Retained earnings—30 June 2019 Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Non-current liabilities Loans Current assets Cash Accounts receivable Inventory Non-current assets Land Plant Investment in Thruster Ltd

     310 790      170 620 2 000 2 620     (400)   2 220

     85 145      35 110 1 600 1 710      (80) 1 630

2 220 8 000

1 630 3 000

120

80

  1 200 11 540

   500 5 210

300 500 1 000

50 350 600

2 800 2 940   4 000 11 540

2 210 2 000        – 5 210

Additional information • The management of Anderson Ltd measures any non-controlling interest in Thruster Ltd at fair value. • During the 2019 financial year, Thruster Ltd sells $45 000 of inventory to Anderson Ltd. At year end, Anderson Ltd has sold all of this inventory. • The tax rate is 30 per cent.

REQUIRED Prepare the consolidated statement of financial position, consolidated statement of profit or loss and other comprehensive income, and consolidated statement of changes in equity for Anderson Ltd and its controlled entity. LO 27.2, 27.3, 27.4

CHALLENGING QUESTIONS 10. On 1 July 2017 Borris Ltd purchased 80 per cent of the shares of Natasha Ltd for $8 million. On 1 July 2017 the shareholders’ funds of Natasha Ltd were: Share capital Retained earnings

$5 500 000 $3 500 000 $9 000 000

Additional information • The management of Borris Ltd measures any non-controlling interest in Natasha Ltd at fair value. • At acquisition date, all assets of Natasha Ltd were fairly stated, except land that had a fair value $225 000 in excess of its book value. CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  1003

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• On 30 June 2019 the recoverable amount of goodwill of Borris Ltd was assessed to be $500 000. There had been no previous impairment losses recognised in relation to goodwill. • During the financial year ending 30 June 2019 Natasha Ltd sold inventory to Borris Ltd at a sales price of $290 000. The inventory cost Natasha Ltd $200 000 to produce. At 30 June 2019, half of this inventory had been sold by Borris Ltd. • On 1 July 2018 Natasha Ltd sold an item of plant to Borris Ltd for $250 000 when it had a carrying amount of $200 000 (cost of $400 000, accumulated depreciation of $200 000). The item of plant was expected to have a remaining useful life of five years from the date of sale. • Natasha pays $30 000 per year in management fees to Borris Ltd. • The income tax rate is 30 per cent. Statement of profit or loss and other comprehensive income of Borris Ltd and Natasha Ltd for the year ended 30 June 2019

Sales Cost of goods sold Gross profit Other revenues Other expenses Profit before income tax expense Income tax expense Profit after income tax expense

Borris Ltd ($)

Natasha Ltd ($)

5 200 000 3 000 000 2 200 000 200 000   (400 000) 2 000 000   (500 000) 1 500 000

1 550 000    500 000 1 050 000 150 000 (200 000) 1 000 000 (350 000) 650 000

Borris Ltd ($)

Natasha Ltd ($)

250 000 650 000 40 000 2 800 000

300 000 250 000 – 1 200 000

4 910 000 7 500 000 (1 500 000) 8 000 000      250 000 22 900 000

3 450 000 5 000 000 (1 000 000) –   1 100 000 10 300 000

250 000 –

100 000 50 000

     650 000      900 000

    150 000     300 000

15 000 000   7 000 000 22 000 000 22 900 000

5 500 000   4 500 000 10 000 000 10 300 000

Statement of financial positions of Borris Ltd and Natasha Ltd as at 30 June 2019

Current assets Cash Accounts receivable Dividends receivable Inventory Non-current assets Land Plant Accumulated depreciation Investment in Natasha Ltd Deferred tax assets Total assets Current liabilities Accounts payable Dividends payable Non-current liabilities Loans Total liabilities Shareholders’ equity Share capital Retained earnings Total equity

1004  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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Borris Ltd Statement of changes in equity for the year ended 30 June 2019

Balance at 1 July 2018 Total comprehensive income for the year Distributions—interim Balance at 30 June 2019

Share capital ($) 15 000 000                  15 000 000

Retained earnings ($) 6 000 000 1 500 000   (500 000) 7 000 000

Total ($) 21 000 000 1 500 000     (500 000) 22 000 000

Retained earnings ($) 4 000 000 650 000 (100 000)    (50 000) 4 500 000

Total ($) 9 500 000 650 000 (100 000)      (50 000) 10 000 000

Natasha Ltd Statement of changes in equity for the year ended 30 June 2019

Balance at 1 July 2018 Total comprehensive income for the year Distributions—interim Distributions—final Balance at 30 June 2019

Share capital ($) 5 500 000

                  5 500 000

REQUIRED (a) Prepare the consolidation worksheet journal entries for Borris Ltd and its controlled entity as at 30 June 2019 and post them to a consolidation worksheet. LO 27.2 (b) Calculate the non-controlling interest in profit and equity as at 30 June 2019. LO 27.3 (c) Prepare the consolidated statement of financial position, consolidated statement of profit or loss and other comprehensive income and consolidated statement of changes in equity for Borris Ltd and its controlled entities, clearly showing non-controlling interests. LO 27.4 11. The following financial statements of Mark Ltd and its subsidiary Richards Ltd have been extracted from their financial records at 30 June 2019.

Detailed reconciliation of opening and closing retained earnings Sales revenue Cost of goods sold Gross profit Dividend revenue—from Richards Ltd Management fee revenue Profit on sale of plant Expenses Administrative expenses Depreciation Management fee expense Other expenses Profit before tax Tax expense Profit for the year Retained earnings—1 July 2018 Dividends paid Retained earnings—30 June 2019

Mark Ltd ($)

Richards Ltd ($)

1 725 000 (1 160 000) 565 000 186 000 66 250 87 500

1 450 000    (595 000) 855 000 – – –

(77 000) (61 250) –    (252 750) 513 750     153 750 360 000     798 500 1 158 500    (343 500)     815 000

(96 750) (142 000) (66 250) (192 500) 357 500    105 500 252 000    598 000 850 000   (232 500)    617 500 continued

CHAPTER 27: FURTHER CONSOLIDATION ISSUES II: ACCOUNTING FOR NON-CONTROLLING INTERESTS  1005

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Statement of financial position Shareholders’ equity Retained earnings Share capital Current liabilities Accounts payable Tax payable Non-current liabilities Loans Current assets Accounts receivable Inventory Non-current assets Land and buildings Plant—at cost Accumulated depreciation Investment in Richards Ltd

Mark Ltd ($)

Richards Ltd ($)

815 000 875 000

617 500 500 000

136 750 103 250

115 750 62 500

    433 750  2 363 750

   290 000 1 585 750

148 500 230 000

155 750 72 500

560 000 749 625 (214 375)     890 000  2 363 750

815 000 889 500 (347 000)                – 1 585 750

Other information • Mark Ltd had acquired its 80 per cent interest in Richards Ltd on 1 July 2010, that is, nine years earlier. At that date the capital and reserves of Richards Ltd were: Share capital Retained earnings

$500 000 $425 000 $925 000

At the date of acquisition all assets were considered to be fairly valued. • The management of Mark Ltd measures any non-controlling interest at the proportionate share of Richards Ltd’s identifiable net assets. • During the year, Mark Ltd made total sales to Richards Ltd of $162 500, while Richards Ltd sold $130 000 in inventory to Mark Ltd. • The opening inventory in Mark Ltd as at 1 July 2018 included inventory acquired from Richards Ltd of $105 000 that had cost Richards Ltd $87 500 to produce. • The closing inventory in Mark Ltd includes inventory acquired from Richards Ltd at a cost of $84 000. This had cost Richards Ltd $70 000 to produce. • The closing inventory of Richards Ltd includes inventory acquired from Mark Ltd at a cost of $30 000. This had cost Mark Ltd $24 000 to produce. • The management of Mark Ltd believe that goodwill acquired was impaired by $7 500 in the current financial year. Previous impairments of goodwill amounted to $56 250. • On 1 July 2018 Mark Ltd sold an item of plant to Richards Ltd for $290 000 when its carrying value in Mark Ltd’s accounts was $202 500 (cost of $337 500, accumulated depreciation of $135 000). This plant is assessed as having a remaining useful life of six years. • Richards Ltd paid $66 250 in management fees to Mark Ltd. • The tax rate is 30 per cent.

REQUIRED Provide the consolidated statement of financial position, consolidated statement of profit or loss and other comprehensive income, and consolidated statement of  changes in equity of Mark Ltd and Richards Ltd as at 30 June 2019. LO 27.2, 27.3, 27.4 1006  PART 8: ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES

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PART 9

FOREIGN CURRENCY

CHAPTER 28 Accounting for foreign currency transactions CHAPTER 29 Translating the financial statements of foreign operations

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CHAPTER 28

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS LEARNING OBJECTIVES (LO) 28.1 Understand why it is necessary to translate transactions that are denominated in foreign currencies. 28.2 Understand that all transactions denominated in overseas currencies must initially be translated at the exchange rate in place as at the date of the transaction (the transaction date’s spot rate) using the entity’s ‘functional currency’. 28.3 Understand that at the end of the reporting period all foreign currency monetary items must be translated at the reporting date spot rate. 28.4 Understand the difference between a functional currency and a presentation currency. 28.5 Know how to account for foreign exchange gains or losses on monetary items and receivables and payables. 28.6 Understand what a qualifying asset is and be able to provide the appropriate accounting entries relating to a qualifying asset. 28.7 Understand the nature of, and the reason for entering, a hedging transaction. 28.8 Understand the difference between a fair-value hedge and a cash flow hedge, and be able to provide the appropriate accounting entries in respect of both. 28.9 Understand what a foreign currency swap is and why it might be undertaken, and be able to provide the relevant journal entries to account for a foreign currency swap.

1008  PART 9: FOREIGN CURRENCY

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Introduction to accounting for foreign currency transactions The accounting standard on foreign currency transactions is AASB 121 The Effects of Changes in Foreign Exchange Rates. A number of other accounting standards are also relevant when accounting for foreign currency transactions, in particular, AASB 9 Financial Instruments and AASB 123 Borrowing Costs. In considering foreign currency translations, reporting entities must consider two general issues. First, business entities frequently transact with overseas entities in currencies other than their domestic currency. Where debts, receivables or other monetary items are denominated in currencies other than the domestic currency, there is an obvious need to convert the transactions into a single currency. Unless the transactions are converted into a common currency, financial statements would include account balances denominated in a number of different currencies, and the totals of such balances would be meaningless. Were we to add, say, amounts denominated in Australian dollars to amounts denominated in New Zealand, United States, Singapore, Hong Kong and Canadian dollars, the total would have no real meaning, just as would be the case if we were to add different measures of weight, such as kilograms and pounds. Second, where an entity controls a foreign subsidiary, there is a need to translate the accounts of that subsidiary into a common currency before the consolidation process. We will defer a discussion of the translation of foreign subsidiaries’ financial statements until Chapter 29.

Foreign currency transactions

LO 28.1

AASB 121  The Effects of Changes in Foreign Exchange Rates defines an exchange rate as ‘the ratio of LO 28.2 exchange for two currencies’. Exchange rates for major currencies typically change continuously throughout the day, with the changes being driven by many factors, including the demand for, and supply of, a particular currency. Sometimes exchange rates seem to change for no apparent reason. For exchange rate The rate at which example, the exchange rate for the Australian dollar greatly dropped in 2015 relative to currencies one currency can be such as the British pound and the US dollar. Relative to the US dollar, the exchange rate fell to exchanged for another. approximately A$1.00 = US$0.71 in December 2015. That is, for every Australian dollar we would receive about 71 US cents. This compared with one year earlier when one Australian dollar would buy US$0.92 (and US$1.10 two years before that). The fall in the value of the Australian dollar had various implications. People travelling overseas found that they were typically able to buy far less for a given amount of Australian dollars. The costs for importers also rose, while the relative prices of exports fell. Parties that had borrowed overseas, with the debt denominated in the overseas currency, found that the amount of the debt, when translated to Australian dollars, increased significantly. An accounting issue here would be whether changes in the level of debt caused by changes in exchange rates should be included with profit or loss. We will address this issue shortly. People often question whether a currency is correctly valued, but it is very difficult to provide any definitive evidence to prove that a currency is over or undervalued. The relative prices of various currencies (as reflected in exchange rates) will fluctuate across time for a variety of reasons, many of which are sometimes hard to explain. An interesting index that has been used in recent years is the Big Mac index, which was invented by The Economist. The Big Mac Index is a lighthearted guide that provides suggestions about whether currencies are overvalued or undervalued on the basis of the prices of Big Mac hamburgers in various countries when the cost is translated into US dollars. In an extract from an article that appeared in the Australian Financial Review on 10 October 2014 (entitled ‘Hybrid model tracks $A in real time’ by Mark Mulligan) it was stated: . . . The theory is that in the long-run, exchange rates should move towards a point where the same basket of goods costs the same in any given pair of countries. The equation is crude because it fails to account for different production input costs—particularly wages— but has been used to great effect by The Economist magazine in its famous ‘Big Mac’ index, a light-hearted guide to whether currencies are at their ‘correct’ level. For example, the average price of a Big Mac in the US in July this year was $4.80; in China it was only $2.73 at market exchange rates. So the ‘raw’ Big Mac index says that the yuan was undervalued by 43 per cent at that time. The Economist smooths out this flawed equation with a second, adjusted comparison that ‘addresses the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower’. CHAPTER 28: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS  1009

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translation of foreign currency transactions Translation of transactions denominated or requiring settlement in a currency other than the functional currency of the entity.

By the adjusted measure, the yuan was undervalued by 6.4 per cent in July this year. In the case of Australia, the raw Big Mac index found the $A a mere 0.4 per cent too high in July, when it was trading around US94¢. Adjusted, the Aussie looks nearly 12 per cent undervalued.

We will not pay any further attention to considering whether exchange rates are appropriate, or how they are determined. Such issues are more appropriately addressed in a course on economics. Rather we will concentrate on how to account for movements in exchange rates. As an illustration of some of the issues relating to the translation of foreign currency transactions, consider Worked Example 28.1. In Worked Example 28.1, the value of the obligation, as denominated in Australian dollars, has fallen by $16 025, although it clearly has not changed when denominated in UK pounds. The Australian entity is better off.

WORKED EXAMPLE 28.1: Acquisition of goods from a foreign supplier where the transaction is denominated in a foreign currency On 1 June 2018 Michaela Ltd acquires goods on credit from a supplier in Northern Ireland. The goods are shipped FOB Belfast on 1 June 2018. (FOB is the abbreviation for ‘free on board’ and signifies the point at which title and control passes from the seller to the purchaser. Once control passes, the purchaser has an obligation that must be recorded.) The cost of the goods is UK£100 000 and this amount remains unpaid at 30 June 2018. On 1 June 2018 the exchange rate is A$1.00 = UK£0.48. On 30 June 2018 it is A$1.00 = UK£0.52. So the value of the Australian dollar has increased relative to the UK pound. REQUIRED Determine the amount of the debt, denominated in Australian dollars, as at: (a) 1 June 2018 (b) 30 June 2018 SOLUTION (a) As at 1 June 2018, the debt would be equal to A$208 333 (100 000 ÷ 0.48). That is, if the debt is paid on 1 June, the required payment, in Australian dollars, would be A$208 333. (b) As at 30 June 2018, the debt would be equal to A$192 308 (100 000 ÷ 0.52). That is, if the debt is paid on 30 June, the required payment, in Australian dollars, would be A$192 308. Because of the movement in foreign exchange rates, Michaela Ltd has made a foreign exchange gain due to the fact that the entity has to pay less for the goods following the exchange rate movement. A number of issues arise in relation to such a reduction in a liability. For example, should the $16 025 be treated as a gain, or should the cost of the inventory be adjusted downwards? As we know from previous chapters, the Conceptual Framework for Financial Reporting suggests that if the value of a liability decreases other than through repayment, the reduction in the liability should be recognised as income. For example, if a debt is forgiven, the value of the debt that is no longer payable will be treated as income. If services or goods are supplied to another entity in return for the extinguishment of a liability, the value of the liability would typically be treated as income. Where exchange gains arise on translation of loans denominated in a foreign currency, these gains would also traditionally be treated as part of income. As we know, however, where there is an accounting standard that addresses a particular issue, such as foreign currency translations, that accounting standard will take precedence over guidance presented in documents such as the conceptual framework. In the discussion that follows, we consider whether or not a movement in the value of a foreign currency obligation, such as that in Worked Example 28.1, should be treated as part of the profit or loss of the financial period.

Accounting entry at the date of the original transaction Paragraph 21 of AASB 121 The Effects of Changes in Foreign Exchange Rates requires that: 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. 1010  PART 9: FOREIGN CURRENCY

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The above requirement uses a number of terms that require definition. First of all, the spot exchange rate is defined in AASB 121 as ‘the exchange rate for immediate delivery’. We also need to consider what a ‘functional currency’ is and how this differs from the ‘presentation currency’. AASB 121 defines ‘functional currency’ as ‘the currency of the primary economic environment in which the entity operates’. Determining the functional currency is important as this identifies the currency into which the transactions will initially be converted. In explanation of how to determine an entity’s functional currency, paragraph 9 of AASB 121 states:

functional currency The currency of the primary economic environment in which the entity operates.

The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining its functional currency: (a) the currency: (i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and (ii) of the country whose competitive forces and regulations mainly determine the sales price of its goods and services; (b) the currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled). Should the functional currency not be apparent even after considering the above factors, paragraph 10 of AASB 121 suggests that the following additional indicators can be utilised by management to assist them in the determination of the entity’s functional currency: (a) the currency in which funds from financing activities (i.e. issuing debt and equity instruments) are generated; and (b) the currency in which receipts from operating activities are usually retained. Apart from determining the functional currency of the reporting entity itself, there will also be a necessity to determine the functional currency of entities that are controlled or significantly influenced by the entity. In this regard, paragraph 11 of AASB 121 states: The following additional factors are considered in determining the functional currency of a foreign operation, and whether its functional currency is the same as that of the reporting entity (the reporting entity, in this context, being the entity that has the foreign operation as its subsidiary, branch, associate or joint arrangement): (a) whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy. An example of the former is when the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it. An example of the latter is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in its local currency; (b) whether transactions with the reporting entity are a high or low proportion of the foreign operation’s activities; (c) whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it; (d) whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity. In situations where the functional currency is not obvious, AASB 121, paragraph 12, requires management to use its judgement in determining the functional currency that best represents the economic effects of the underlying transactions, events and conditions. Paragraph 13 of AASB 121 further states: An entity’s functional currency reflects the underlying transactions, events and conditions that are relevant to it. Accordingly, once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions. Therefore, to this point we have provided factors that can be used to determine the functional currency, which is the currency in which transactions are initially recorded. However, we then need to determine the presentation currency, which may or may not be the same as the functional currency. If the presentation currency is different from the functional currency then further adjustments will be necessary.

presentation currency The currency in which the financial statements are presented.

CHAPTER 28: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS  1011

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‘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 entity’s 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. While the above paragraph indicates that any currency can be used for a presentation currency, the currency generally required for presentation in Australia is Australian dollars. However, relief from this requirement is given to some entities. Regarding the selection of a presentation currency, it is interesting to note that BHP Billiton Ltd presents its financial statements using US dollars rather than Australian dollars as its presentation currency. This choice is noted in the accounting policy note in the 2015 Annual Report of BHP Billiton Ltd as follows: Currency of presentation: All amounts are expressed in millions of US dollars, unless otherwise stated, consistent with the predominant functional currency of the Group’s operations. Returning to Worked Example 28.1, for Michaela Ltd the initial entry on 1 June 2018 would be: Dr Cr

Inventory Accounts payable

208 333 208 333

Adjustments at the end of the reporting period Paragraph 23 of AASB 121 requires that, at the end of each reporting period, foreign currency monetary items are to be translated using the closing rate. Closing rate is defined in AASB 121 as ‘the spot exchange rate at the end of the reporting period’. As we already know, the spot rate is defined as ‘the exchange rate for immediate delivery’. Foreign currency monetary items would include accounts payable and accounts receivable, as well as cash, interest receivable, notes receivable, loans receivable, dividends receivable, bank overdraft, income taxes payable, wages payable, notes payable and/or debentures payable. In the case of Michaela Ltd this would mean that the obligation would need to be restated to $192 308. The entity effectively owes A$16 025 less than it did at the date of the original transaction owing to the fluctuation in the exchange rate. Of course, the exchange rate could have moved in the opposite direction. As we will show, to insulate themselves from potentially unfavourable foreign currency fluctuations, firms frequently enter into hedging arrangements. An exception to the above rule (that foreign currency monetary items outstanding at the end of the reporting period must be translated at the spot rate in existence at the end of the reporting period) would be those few cases where, according to a contractual arrangement, the exchange rate has been fixed for a particular transaction. A general principle applied is that the exchange differences relating to monetary items are to be recognised as part of profit or loss in the reporting period in which the exchange rates change. This is reflected in the requirements of paragraph 28 of AASB 21, 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. There are some exceptions to this general rule, which we will address shortly (to do with ‘qualifying assets’ and certain hedges), although these exceptions would not apply to Michaela Ltd. For Michaela Ltd, the entry on 30 June 2018 would be: Dr Cr

Accounts payable Foreign exchange gain

16 025 16 025

The amount of the liability is reduced to take account of a change in the foreign exchange rate. The reduction in the Australian dollar equivalent of the foreign debt is treated as part of the period’s profit or loss (as income) and not as a reduction in the cost of the inventory. 1012  PART 9: FOREIGN CURRENCY

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Determination of functional currency and presentation currency

LO 28.2 LO 28.3 LO 28.4

In the discussion so far we have considered the difference between functional currency and presentation currency. As we noted, there are a number of factors to consider in determining the appropriate functional currency. The functional currency is the currency of the primary economic environment in which the entity operates. Paragraph 9 of AASB 121 (referred to above) provides a number of factors to consider in determining the functional currency. In determining the presentation currency, consideration needs to be given to the currency in which the general purpose financial statements are to be prepared. If the entity’s shareholders primarily reside within Australia there would be an expectation that the presentation currency would be Australian dollars. As already indicated, the presentation currency might not be the same as the functional currency. This might happen, for example, when a parent company residing within Australia controls a subsidiary company that resides in a foreign country, for example, South Africa. If the subsidiary operates within South Africa, and sells its goods and purchases its factors of production in South African currency (the rand) its functional currency is South African rand and the financial statements would initially be prepared with South African rand as the functional currency. However, for the purposes of translating the results for Australian use, the presentation currency would be Australian dollars. The South African entity’s financial statements would then be translated from the functional currency (rand) into the economic entity’s presentation currency (Australian dollars) prior to consolidation. The difference between functional currency and presentation currency is considered in Worked Example 28.2.

WORKED EXAMPLE 28.2: Determination of functional currency and presentation currency Kahuna Ltd is an Australian company that is listed on the Australian and London securities exchanges. The company has established a number of sportswear factories in the Philippines, Indonesia, Vietnam, China and Australia. Materials and labour are typically acquired in the local currencies; however, all acquisitions of plant and machinery are denominated in UK pounds. All sales of clothing are denominated in UK pounds and all borrowing tends to be done in UK pounds and come from UK-based banks. Most equity capital has been raised within Australia, although in recent years there has been a trend towards issuing new shares on the London Stock Exchange. In terms of current shareholding, 82 per cent of issued shares are held by Australian shareholders. The balance is held by UK residents (12 per cent) and Chinese residents (6 per cent). REQUIRED (a) Determine the functional currency of Kahuna Ltd. (b) Determine the presentation currency of Kahuna Ltd. SOLUTION (a) Determination of functional currency It would be expected that the functional currency would be UK pounds. Factors to support this decision would be the following: •  Sales are denominated in UK pounds. •  Plant and machinery are acquired in UK pounds. •  Bank finance is denominated in UK pounds. •  Recent share issues have been undertaken within the UK. Given the above facts, it would appear that the UK is the primary economic environment in which the entity operates. Therefore, the financial statements would initially be prepared in UK pounds. (b) Determination of presentation currency AASB 121 does not provide much guidance on determining the presentation currency. We need to determine the currency in which the financial statements would, or should, be presented. Given that most shares are held by Australian residents and that employees are dispersed throughout the world (with no one group of employees dominating), it would seem appropriate for the presentation currency to be Australian dollars. continued CHAPTER 28: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS  1013

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While most borrowing comes from UK organisations, the banks would be expected to be able to demand financial statements to satisfy their own requirements and so would not be dependent upon general-purpose financial statements for their information needs. Hence even though all transactions would initially be recorded in UK pounds, which would in turn mean that the financial statements would initially be prepared in UK pounds, it will be necessary for the financial statements to then be translated from UK pounds to Australian dollars. The next chapter, Chapter 29, concentrates on the translation of financial statements from one currency to another—the presentation currency. Therefore we will defer further issues associated with translating financial statements to the next chapter. In this chapter we concentrate on the accounting entries made in an entity’s functional currency.

LO 28.5

Longer-term receivables and payables

The transactions of Michaela Ltd, introduced in Worked Example 28.1 and referred to since, led to the recognition of a short-term payable. Reporting entities can also have long-term monetary items, spot rate many of which might be denominated in a foreign currency. According to AASB 121, at the end of The exchange rate for immediate delivery the reporting period, all monetary items must be translated using the reporting-date spot rates. of currencies to be The exchange gain or loss that results from translating both current and non-current payables and exchanged. receivables at reporting-date spot rates must be included in the profit or loss for the financial period (subject to a limited number of exceptions, as briefly mentioned above). Across time, the requirement to recognise the gains or losses that result from exchange rate movements as part of profit or loss has been quite unpopular with Australian reporting entities, particularly as it relates to non-current monetary items. Companies have argued that the recognition of a profit or loss on the translation of non-current monetary items at the end of each reporting period is inappropriate, since the exchange rate fluctuates in the long term and there is significant doubt about whether the unrealised profit or loss will ever be realised. If the long-term monetary items are translated at the end of each reporting period, it has been argued that we should establish a deferred account that would be amortised into operating profit or loss over the term of the long-term monetary asset or liability. This view has not been endorsed by the accounting standard setters. In Worked Example 28.3, we consider the translation of a non-current liability from a foreign currency into Australian dollars.

WORKED EXAMPLE 28.3: Translation of a non-current liability On 1 July 2018 Noosa Ltd enters into an agreement to borrow £500 000 from Fistral plc (UK). Fistral plc sends the loan money to Noosa Ltd’s Australian bank account. The loan is for five years and requires the payment of interest at the rate of 10 per cent on 30 June each year. We will also assume this equates to Noosa Ltd’s normal borrowing rate such that the carrying amount of the debt would also equal its fair value. Noosa Ltd’s reporting date is 30 June. The relevant exchange rates are: A$1.00 = £0.50 A$1.00 = £0.40

01 July 2018 30 June 2019

REQUIRED Provide the journal entries in the books of Noosa Ltd for the year ending 30 June 2019 to account for the above transaction. SOLUTION 1 July 2018 Dr Cr

Cash Loan payable

1 000 000 1 000 000

(to recognise the foreign currency loan at the 1 July 2018 spot rate: 1 000 000 = 500 000 ÷ 0.50. Again, remember that throughout the period the transactions are recorded in the entity’s functional currency)

1014  PART 9: FOREIGN CURRENCY

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30 June 2019 Dr Cr

Interest expense Cash

125 000 125 000

(to recognise year-end interest payment 125 000 = (500 000 × 10 per cent) ÷ 0.40)  Dr Cr

Foreign exchange loss Loan payable

250 000 250 000

(to recognise the effect of retranslation of the loan at the 30 June 2019 spot rates; the increase in the amount of the loan payable is to be treated as an expense in the period in which the exchange rate moves) Balance of payable at 1 July 2018: 500 000 ÷ 0.50 Balance of payable at 30 June 2019: 500 000 ÷ 0.40 Increase in loan payable

1 000 000 1 250 000   250 000

Translation of other monetary assets such as cash deposits

LO 28.5

In Worked Example 28.3 we translated a foreign currency payable. The same principles apply to other monetary items such as cash, money market deposits and the like, as we will see in Worked Example 28.4.

WORKED EXAMPLE 28.4: Translation of cash denominated in a foreign currency On 1 July 2018 Peregian Ltd provides some consulting advice to Miami Co., a US organisation, for an agreed fee of US$400 000. The amount is paid into the US bank account of Peregian Ltd on 1 July 2018. Peregian Ltd has left the amount in the US bank account, which pays interest each year on 30 June at a rate of 12 per cent. The relevant exchange rates are: 01 July 2018 30 June 2019

A$1.00 = US$0.75 A$1.00 = US$0.80

REQUIRED Provide the journal entries in the books of Peregian Ltd for the year ending 30 June 2019 to account for the above transaction. SOLUTION The accounting entries in the books of Peregian Ltd would be: 1 July 2018 Dr Cr

Cash Consulting revenue

533 333 533 333

(to recognise consulting revenue at the 1 July 2018 spot rate: 533 000 = 400 000 ÷ 0.75) 30 June 2019 Dr Cr

Cash Interest revenue

60 000 60 000

(to recognise the interest revenue at the 30 June 2019 spot rate: 60 000 = (400 000 × 12 per cent) ÷ 0.80) Dr Cr

Foreign exchange loss Cash

33 333 33 333

(to adjust for the change in the Australian dollar equivalent of the overseas bank deposit using the 30 June 2019 spot rates) continued CHAPTER 28: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS  1015

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Balance of cash at 1 July 2018: 400 000 ÷ 0.75 Balance of cash at 30 June 2019: 400 000 ÷ 0.80 Reduction in cash

LO 28.6

533 333 500 000 33 333

Qualifying assets

qualifying asset Asset under construction or otherwise being made ready for future productive use of the company or for the use of another entity under a contract, that necessarily takes a substantial period of time to get ready for its intended use or sale.

As we have noted, there is a general rule within AASB 121 that exchange differences relating to monetary items (both current and non-current) are to be brought to account as expenses or income in the period in which the exchange rate changes. One exception to the above rule relates to exchange differences for monetary items that relate to qualifying assets. In determining how to account for qualifying assets we must refer to another accounting standard, this being AASB 123 Borrowing Costs. A ‘qualifying asset’ is defined in AASB 123 as ‘an asset that necessarily takes a substantial period of time to get ready for its intended use or sale’. AASB 123 does not provide guidance on what constitutes a ‘substantial period of time’, although it is generally accepted that it would be a period greater than 12 months. Qualifying assets would include inventories that require a substantial period of time to bring to a saleable condition, assets resulting from development and construction activities in the extractive industries, manufacturing plants, power generation facilities and investment properties. Other investments and inventories that are routinely manufactured or mass-produced in a short period of time are not qualifying assets. Nor are assets that are ready for their intended use or sale when acquired. As paragraph 7 of AASB 123 states:

Depending on the circumstances, any of the following may be qualifying assets: (a) inventories (b) manufacturing plants (c) power generation facilities (d) intangible assets (e) investment properties (f) bearer plants. Financial assets, and inventories that are manufactured, or otherwise produced, over a short period of time, are not qualifying assets. Assets that are ready for their intended use or sale when acquired are not qualifying assets. Exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs are considered to be borrowing costs under AASB 123. For qualifying assets, the core principle contained in AASB 123, paragraph 1, is detailed as follows: Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognised as an expense. In relation to the borrowing costs, AASB 123 provides their accounting treatment. Paragraph 8 of AASB 123 stipulates that: An entity shall capitalise borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset. An entity shall recognise other borrowing costs as an expense in the period in which it incurs them. There is a general requirement that the capitalisation of such borrowing costs as part of the cost of the asset is allowed only when it is probable that such costs will result in future economic benefits to the entity and the costs can be measured reliably. As noted above, exchange rate differences would be included as part of borrowing costs and hence can be included in the cost of a qualifying asset. An asset ceases to be a qualifying asset when its construction has been completed, even if the associated liability has not been paid. According to AASB 123, paragraph 22: an entity shall cease capitalising borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete. 1016  PART 9: FOREIGN CURRENCY

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The exchange differences included in the cost of qualifying assets for the financial year are the amounts that would otherwise have been credited/debited to profit or loss. The amount capitalised as the cost of the asset is not to exceed the recoverable amount of the asset. If exchange differences cause the recoverable amount of a qualifying asset to be exceeded, the excess should be treated as an expense within profit or loss. As paragraph 16 of AASB 123 states: When the carrying amount or the expected ultimate cost of the qualifying asset exceeds its recoverable amount or net realisable value, the carrying amount is written down or written off in accordance with the requirements of other Standards. In certain circumstances, the amount of the write-down or write-off is written back in accordance with those other Standards. Worked Example 28.5 provides an illustration of how to account for exchange differences that arise while an asset is considered to be a qualifying asset.

WORKED EXAMPLE 28.5: Foreign currency transaction relating to a qualifying asset On 1 March 2017 Greenough Ltd enters into a binding agreement with a Singapore company to construct an item of machinery that manufactures spoons. The cost of the machinery is S$250 000. The construction of the machinery is completed on 1 June 2018 and shipped FOB Singapore on that date. The debt is unpaid at 30 June 2018. Greenough Ltd’s end of reporting period is 30 June. The exchange rates at the relevant dates are: 01 March 2017 30 June 2017 01 June 2018 30 June 2018

A$1.00 = S$1.10 A$1.00 = S$1.05 A$1.00 = S$1.02 A$1.00 = S$1.00

REQUIRED Provide the required journal entries for the years ending 30 June 2017 and 30 June 2018. To keep the example relatively simple, present values can be ignored. SOLUTION Being under construction, the item would appear to be a qualifying asset under AASB 123 for the period from 1 March 2017 to 1 June 2018. Therefore, the movement in exchange rates to 1 June 2018 shall be incorporated in the cost of the asset. Once an asset ceases to be a qualifying asset, any subsequent movements would be treated as an expense or part of income and be included as part of the period’s profit or loss. 1 March 2017 Dr Cr

Machinery Accounts payable

227 273 227 273

(to recognise the cost of the asset on 1 March 2017: 250 000 ÷ 1.10) 30 June 2017 Dr Cr

Machinery Accounts payable

10 822 10 822

(to recognise the change in the Australian dollar equivalent of the foreign currency monetary item during some of the period in which the asset is a qualifying asset: (250 000 ÷ 1.05) – 227 273) 1 June 2018 Dr Cr

Machinery Accounts payable

7 003 7 003

(to recognise the change in the Australian dollar equivalent of the foreign currency monetary item during the balance of the period in which the asset is a qualifying asset: (250 000 ÷ 1.02) – 238 095) continued CHAPTER 28: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS  1017

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30 June 2018 Dr Cr

Foreign exchange loss Accounts payable

4 902 4 902

(to recognise the change in the Australian dollar equivalent of the foreign currency monetary item in the period after which the asset ceases to be a qualifying asset: (250 000 ÷ 1.00) – (227 273 + 10 822 + 7003))

LO 28.7 LO 28.8

Hedging transactions

As shown above, where amounts are owed to or owed by entities in foreign currencies, it is possible that exchange rates will vary, leading to a change in the Australian dollar value of the receivable/payable. That is, the reporting entity will be exposed to the risk of losses (and also possible gains) that might be generated owing to movements in exchange rates. To minimise the risk associated with foreign currency monetary items, an entity can enter into a hedge contract hedge contract, or a ‘hedging arrangement’ as it is also referred to. By entering into an agreement Arrangement with that assumes a position opposite to the original transaction, an entity can minimise its exposure to another party in foreign currency movements. Although AASB 121 relates to foreign currency transactions, it does which that other not address foreign currency hedges. As paragraph 5 of AASB 121 explains: ‘This Standard does party accepts the not apply to hedge accounting for foreign currency items, including the hedging of a net investment risks associated with in a foreign operation. AASB 9 applies to hedge accounting’. changing commodity prices, cash flows or Hence for foreign currency hedges we must refer to AASB 9 Financial Instruments (again, as exchange rates. indicated earlier, this means that within Australia when accounting for foreign currency transactions/ translations we now need to refer to three accounting standards—AASB 121, AASB 123 and AASB 9). A foreign currency hedge occurs when action is taken, whether by entering a foreign currency hedge contract or otherwise, with the objective of avoiding or mitigating possible adverse financial effects Action taken to of movements in exchange rates. minimise possible To illustrate a hedge agreement, let us assume that an Australian company orders some inventory adverse financial from a US supplier on 1 May 2018 for US$200 000 (when the exchange rate is A$1.00 = US$0.75) effects of movements in exchange rates or at a cost in Australian dollars of A$266 667 (200 000 ÷ 0.75). The goods are to be supplied and other market values. paid for on 30 June 2018. To safeguard against exchange rate fluctuations, on the date it placed the order the company also entered into a forward-exchange-rate contract to buy US$200 000 on 30 June 2018 from another party (typically a bank) at a forward rate of A$1.00 = US$0.72. forward rate A forward rate is the exchange rate for delivery of a currency at a specified date in the future. The exchange rate that It is a guaranteed rate of exchange that will be provided at a future date. With this forward-rate is currently offered for agreement, the entity has locked in the price of the goods to A$277 778 (which is 200 000 ÷ 0.72). the future acquisition or sale of a specific The entity has contracted to buy a specified number of US dollars at a future date (probably from a currency. bank) at a predetermined rate. This is sometimes referred to as a ‘buy hedge’. Let us assume that the Australian dollar decreases in value relative to the US dollar so that A$1.00 buys only US$0.60 on 30 June 2018. In the absence of a forward-rate agreement, the entity would pay the US supplier A$333 333 (200 000 ÷ 0.60). This is A$66 666 more than the original Australian dollar obligation. However, given the forward-exchange-rate agreement, the entity can obtain US$200 000 at an agreed cost of A$277 778. The supplier of the US currency is a different party from the overseas inventory supplier and, as the other party to the forward-rate agreement bears the cost of the currency fluctuation, it would have received the gains if the exchange rate had moved in the opposite direction. The above hedging arrangement involves a situation where a third party agrees to sell a fixed amount of a particular overseas currency on a fixed future date (or during a period expiring on a fixed future date) at the rate of exchange quoted in the contract (the forward rate). This is sometimes simply referred to as a ‘forward contract’. Conversely, it is also possible to enter into an arrangement called a ‘sell hedge’ to sell an overseas currency to another entity, on or before a particular date, at an agreed rate. This could be particularly useful to an entity that sells goods overseas with the sales price denominated in foreign currencies. The Australian entity can lock in at the outset the amount of Australian dollars it will ultimately receive from the sale. 1018  PART 9: FOREIGN CURRENCY

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To illustrate a ‘sell hedge’, let us assume that an entity agrees on 1 January 2018 to sell some plant (to be constructed) to a UK company at a price of UK£500 000, payable on 30 June 2018. The exchange rate on 1 January 2018 is A$1.00 = UK£0.46. At the same date it signs the contract with the UK organisation, the Australian entity also enters into a forward-rate contract with a bank in which it agrees to sell UK£500 000 to the bank at an exchange rate of A$1.00 = UK£0.48. The bank charges a premium, in this case equal to A$45 290 [(500 000 ÷ 0.46) – (500 000 ÷ 0.48)], to compensate it for the risk it will be exposed to as a result of the agreement. In effect the company has locked in the amount in Australian dollars it will receive for the sale. It will receive A$1 041 667 regardless of what the exchange rate does. The company will deliver UK£500 000 to the bank, which has agreed by way of a forward-rate contract to convert the amount to A$1 041 667. With the hedge, the value of the sales receipts is certain and the Australian entity is prepared to pay (or forgo) the A$45 290 to create this certainty and therefore insulate itself from possible adverse impacts of foreign exchange rate movements. Of course, if the entity does not hedge the sale it could earn a greater amount of Australian dollars. For example, if the exchange rate drops to UK£0.40, the entity would receive A$1.25 million. Conversely, if the exchange rate moves in the opposite direction, the receipts in Australian dollars would be less. To shield themselves from the risk of adverse exchange-rate movements, entities frequently hedge the foreign currency payable or receivable through a contract with a bank. Where there is a hedge, the foreign exchange gains or losses on one transaction (for example, the hedge contract) will be offset by gains or losses on another (for example, on a transaction with a purchaser of the entity’s inventory). This is the very reason for the entity to enter the hedge agreement. For the above sales transaction, if the exchange rate falls—that is, UK pounds buy more Australian dollars or, alternatively, Australian dollars buy fewer UK pounds—the entity will make gains on the sales contract with the overseas purchaser, which is denominated in UK pounds that have increased in value when translated to Australian dollars, but will make losses on the contract with the bank. The loss is made on the contract with the bank because the overseas currency has increased in value, but the entity has already agreed to a forward rate with the bank, which is based on a previous exchange rate. If the exchange rate rises, the opposite holds. Where the hedge arrangement completely eliminates the consequences of adverse exchange-rate fluctuations, the purchase or sales arrangement is considered to be perfectly hedged. Otherwise, it is considered to be partially hedged.

Accounting for hedging transactions As we already know, hedge accounting is addressed within AASB 9  Financial Instruments. Accounting for foreign currency hedges was examined in-depth in Chapter 14, in our discussion of ‘financial instruments’. Hence, rather than reproducing the material here, reference should be made to Chapter 14. Chapter 14 discusses how to account for cash flow hedges and fair-value hedges, both of which might use ‘hedging instruments’ that are forward-rate agreements for the supply of foreign currencies.

Foreign currency swaps

LO 28.9

Foreign currency swaps were also considered in Chapter 14, which referred to various financial instruments. Since we are looking at foreign currency transactions in this chapter, it would be useful to revisit issues associated with foreign currency swaps. Swaps occur when borrowers exchange aspects of their respective loan obligations. Commonly foreign currency swap used swaps are: • interest-rate swaps (typically a fixed-interest-rate obligation is swapped for a variable-rate obligation—see Chapter 14) • foreign currency swaps (where the obligation related to a loan denominated in one currency is swapped for a loan denominated in another currency).

Agreement under which the obligation relating to a loan denominated in one currency is swapped for a loan denominated in another currency.

In this section we will be looking at foreign currency swaps. The rules already discussed in this chapter apply generally to swap arrangements. Let us look first, however, at why organisations would want to swap a loan denominated in one currency for a loan denominated in another. As we know, if we have 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 CHAPTER 28: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS  1019

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monetary item (perhaps the foreign currency payable) will be offset by gains on the other monetary item (perhaps the foreign currency receivable). If a particular organisation has a number of receivables that are denominated in a foreign currency, changes in spot rates can potentially create sizeable foreign currency gains or losses. If that same organisation is able to convert some of its domestic loans into foreign currency loans of the same denomination as its receivables, 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 loans for the organisation’s domestic loans.

Accounting for foreign currency swaps Foreign currency swaps are addressed by AASB 9  Financial Instruments. Accounting for foreign currency swaps was examined in-depth in Chapter 14, in our discussion of financial instruments. Hence, rather than reproducing the material here, reference should be made to Chapter 14 for details about how to account for foreign currency swaps.

SUMMARY In this chapter we considered various aspects of the translation of transactions that are denominated in a foreign currency. We learned that we need to refer to three accounting standards, these being AASB 121 The Effects of Changes in Foreign Exchange Rates, AASB 123 Borrowing Costs and AASB 9 Financial Instruments. In terms of specific requirements, we learned the following: • Foreign currency transactions should initially be translated at the spot rate in place at the date of the transaction using the functional currency as the basis of the translation. • The functional currency might be different from the presentation currency. • Any changes in the Australian dollar equivalents of foreign currency monetary amounts (such as foreign currency receivables, foreign currency payables and foreign currency monetary deposits) are, with some limited exceptions, to be recognised as part of the profit or loss as disclosed in the statement of comprehensive income, whether or not the amounts have been realised. • Gains or losses on foreign currency receivables and payables are not to be offset against related purchases or sales amounts. • We need to ascertain whether a foreign currency movement relates to a qualifying asset. If the movement relates to a qualifying asset, AASB 123 requires the movement to be adjusted against the cost of the asset. The foreign currency movements will be adjusted against the cost of the asset only as long as the asset’s adjusted book value does not exceed its recoverable amount. Once an asset ceases to be a qualifying asset, all movements in related monetary items are to go to the statement of comprehensive income. • Where hedge contracts have been entered into, the forward-rate contracts (the hedging instruments) and the purchase or sales transactions (the hedged items) must be accounted for separately. With a fair-value hedge, the risk being hedged is any change in the fair value of an asset or liability that will have an effect on profit or loss. Provided a fair-value hedge satisfies the criteria necessary for ‘hedge accounting’ within AASB 9, any gain or loss arising from remeasuring the hedging instrument at fair value, and any gain or loss on the hedged item attributable to the hedged risk, is recognised in profit or loss. • In a cash flow hedge, the risk being hedged is the potential volatility in future cash flows. If a cash flow hedge meets the criteria for ‘hedge accounting’ stipulated within AASB 9, the portion of the gain or loss on the hedging instrument deemed to be an effective hedge is initially recognised directly in equity (and included in ‘other comprehensive income’). The ineffective portion of the gain or loss on the hedging instrument is recognised directly in profit or loss. • Foreign currency swaps may be undertaken as a form of hedging. Where a swap occurs, the primary borrower will still have a commitment to the primary lender should the other party to the swap default on the swap arrangement. Hence it is not correct practice to eliminate a loan from the accounts once a swap arrangement has been negotiated. 1020  PART 9: FOREIGN CURRENCY

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KEY TERMS exchange rate  1009 foreign currency swap  1019 forward rate  1018 functional currency  1011

hedge  1018 hedge contract  1018 presentation currency  1011 qualifying asset  1016

spot rate  1014 translation of foreign currency transactions  1010

END-OF-CHAPTER EXERCISES On 1 March 2019 Narrabeen Ltd, an Australian company, enters a purchase transaction with Huntington Ltd (USA) for the supply of US$1 million in inventory. The goods are purchased FOB New York on 1 March 2019. The amount is payable on 1 August 2019. To cover this exposure and other related foreign exchange exposures, a forward-exchange contract for the delivery of US$1 million is taken out with The Bank on 1 May 2019. It requires delivery of the US dollars on 1 August 2019. Narrabeen Ltd uses fair-value hedge accounting. Narrabeen Ltd’s year end is 30 June. The relevant exchange rates are: Date 1 March 2019 1 May 2019 30 June 2019 1 August 2019

Spot rate

Forward rate

0.75 0.70 0.65 0.60

0.67 0.63 0.60

REQUIRED Provide the necessary accounting journal entries to record the above transactions from 1 March 2019 to 1 August 2019, inclusive. Provide evidence of whether or not hedge accounting was effective in the above situation. LO 28.5, 28.8

SOLUTION TO END-OF-CHAPTER EXERCISE The solution assumes that the hedge arrangement meets the conditions necessary to permit Narrabeen Ltd to apply hedge accounting.

Date

Spot rate

Forward rate

Receivable on forward contract

Amount payable on forward contract

Fair value of forward contract

Gain/(loss) on forward contract

1 March 2019 1 May 2019 30 June 2019 1 Aug. 2019

0.75 0.70 0.65 0.60

0.67 0.63 0.60

1 492 537 1 587 302 1 666 667

1 492 537 1 492 537 1 492 537

0 94 765 174 130

94 765 79 365

1 March 2019

Dr Inventory Cr Accounts Payable Recording purchase of inventory (US$1 000 000 ÷ 0.75)

1 333 333 1 333 333

1 May 2019

Dr Foreign exchange loss 95 238 Cr Accounts payable 95 238 Recording foreign exchange loss on accounts payable [(US$1 000 000 ÷ 0.75 = $1 333 333) – (US$1 000 000 ÷ 0.70 = $1 428 571) = ($95 238)]

1 May 2019

No journal entries for forward contract because right and obligation are the same

30 June 2019

Dr Forward contract Cr Gain on forward contract Recording gain on forward contract

94 765 94 765

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30 June 2019

Dr Foreign exchange loss 109 891 Cr Accounts payable 109 891 Recording loss on accounts payable denominated in foreign currency [(US$1 000 000 ÷ 0.70 = $1 428 571) – (US$1 000 000 ÷ 0.65 = $1 538 462) = ($109 891)]

1 August 2019

Dr Forward contract Cr Gain on forward contract Recording loss on forward contract

79 365 79 365

1 August 2019

Dr Foreign exchange loss 128 205 Cr Accounts payable 128 205 Recording loss on accounts payable denominated in foreign currency [(US$1 000 000 ÷ 0.60 = $1 666 667) – (US$1 000 000 ÷ 0.65 = $1 538 462) = $128 205]

1 August 2019

Dr Accounts payable Cr Forward contract Cr Bank Settlement of forward rate contract and accounts payable

1 666 667 174 130 1 492 537

Total foreign exchange loss incurred on the purchase contract and forward rate contract $ Amount paid on 1 August 2019 Accounts payable as at 1 March 2019 (date of purchase) Total foreign exchange loss

1 492 537 1 333 333 (159 204)

Foreign exchange loss recorded in the respective financial periods $ For year ending 30 June 2019 Foreign exchange loss on accounts payable on 1 May 2019 Foreign exchange gain on forward contract on 30 June 2019 Foreign exchange loss on accounts payable on 30 June 2019 For year ending 30 June 2020 Foreign exchange gain on forward contract on 1 August 2019 Foreign exchange loss on accounts payable on 1 August 2019 Total foreign exchange loss recorded

(95 238) 94 765 (109 891) (110 364) 79 365 (128 205)  (48 840) (159 204)

If the purchase was not hedged: $ Amount paid on 1 August 2019 (US$1 000 000 ÷ 0.60) Accounts payable as at 1 March 2019 (date of purchase) Total foreign exchange loss

1 666 667 1 333 333   333 334

Hedging is therefore beneficial in this case.

REVIEW QUESTIONS 1. Explain why it is necessary to translate foreign currency transactions into Australian dollars. LO 28.1 2. At the end of the reporting period of a reporting entity, are any adjustments necessary in relation to the reporting entity’s foreign currency monetary items? How should any adjustments (if necessary) be treated within the statement of profit or loss and other comprehensive income purposes? LO 28.2 1022  PART 9: FOREIGN CURRENCY

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3. When initially recognising a transaction that is denominated in a foreign currency, what exchange rates should be used to translate the transaction to Australian dollars? LO 28.2, 28.3 4. Some inventory is acquired from an overseas supplier with the debt denominated in a foreign currency. In the absence of a hedge arrangement, if the exchange rate moves against the Australian dollar while the debt is outstanding, how should this movement be treated for accounting purposes? LO 28.5 5. What is a qualifying asset and how do we treat exchange rate differences relating to the acquisition of qualifying assets? Contrast this with the treatment for assets that are not qualifying assets. LO 28.6 6. What is a hedge transaction and how does it reduce foreign currency risk exposure? LO 28.7 7. When is a foreign currency monetary item considered to be perfectly hedged? LO 28.7 8. Why are the definitions of a hedging instrument and a hedged item important? LO 28.7 9. What are foreign currency swaps and why are they undertaken? LO 28.9 10. On 5 June 2018 Perth Ltd acquires goods on credit from a supplier in London. The goods are shipped FOB London on 5 June 2018. The cost of the goods is UK£250 000 and the debt remains unpaid at 30 June 2018. On 5 June 2018 the exchange rate is A$1.00 = UK£0.46. On 30 June 2018 it is A$1.00 = UK£0.44. Hence the value of the Australian dollar has decreased relative to the UK pound. Perth Ltd’s reporting date is 30 June.

REQUIRED Provide the accounting entries necessary to account for the above purchase transaction for the year ending 30 June 2018. LO 28.2, 28.5 11. On 1 July 2018 Double Island Ltd enters into an agreement to borrow £2 million from Point plc (UK). Point plc sends the loan money to Double Island Ltd’s Australian bank account. The loan is for four years and requires the payment of interest at the rate of 8 per cent on 30  June each year. Double Island Ltd’s reporting date is 30 June. The relevant exchange rates are: 1 July 2018 30 June 2019

A$1.00 = UK£0.48 A$1.00 = UK£0.50

REQUIRED Provide the necessary journal entries that would be made in the books of Double Island Ltd to account for the above transaction for the year ending 30 June 2019. LO 28.5 12. On 10 July 2018 Coolum Ltd provides some consulting advice to Florida Inc. (US) for an agreed fee of US$1 million. The amount is paid into the US bank account of Coolum Ltd on 10 July 2018. Coolum Ltd elects to leave the amount in the US bank account, which pays interest each year on 30 June at a rate of 10 per cent. The relevant exchange rates are: 10 July 2018 30 June 2019

A$1.00 = US$0.78 A$1.00 = US$0.75

REQUIRED Provide the journal entries that would need to be made in the books of Coolum Ltd to account for the above transaction for the year ending 30 June 2019. LO 28.5 13. On 1 March 2017 Drouyn Ltd enters into a binding agreement with a New Zealand company, which requires the New Zealand company to construct an item of machinery for Drouyn Ltd. The cost of the machinery is NZ$750 000. The machinery is completed on 1 June 2018 and shipped FOB Auckland on that date. The debt is unpaid at 30 June 2018, which is also Drouyn Ltd’s reporting date. The exchange rates at the relevant dates are: 1 March 2017 30 June 2017 1 June 2018 30 June 2018

A$1.00 = NZ$1.20 A$1.00 = NZ$1.15 A$1.00 = NZ$1.30 A$1.00 = NZ$1.25

REQUIRED Provide the required journal entries of Drouyn Ltd for the years ending 30 June 2017 and 30 June 2018.  LO 28.5 CHAPTER 28: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS  1023

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14. On 1 March 2018 Possum Ltd, an Australian entity, purchases US$1.5 million of inventory from Lincoln Inc., a US entity. The amount is payable on 1 August 2018. A forward-exchange contract for the delivery of US$1 million is taken out with The Bank on 1 May 2018. It requires delivery of the foreign currency to Possum Ltd on 1 August 2018. Possum Ltd has a 30 June financial year end and designates the hedge as a cash flow hedge. Additional information Date 1 March 2018 1 May 2018 30 June 2018 1 August 2018

Spot rate

Forward rate

$0.70 $0.75 $0.72 $0.70

$0.73 $0.70 $0.70

REQUIRED Prepare the journal entries for Possum Ltd to account for the above transaction. LO 28.8 15. On 1 March 2018 Kanga Ltd, an Australian entity, places an order for UK£1.5 million of inventory with Ferrett plc, a UK supplier. The goods will be purchased FOB Liverpool. A decision is made to take out a foreign exchange forward-rate contract for UK£1.5 million on 1 March 2018 with The Bank in which The Bank agrees to supply Kanga Ltd with UK£1.5 million on 1 August 2018. The goods are shipped on 1 June 2018 and are paid for on 1 August 2018. Additional information Date 1 March 2018 1 June 2018 30 June 2018 1 August 2018

Spot rate

Forward rate

£0.45 £0.43 £0.39 £0.41

£0.42 £0.40 £0.36 £0.41

REQUIRED Assuming that the hedging arrangement satisfies the requirements for hedge accounting as stipulated in AASB 9, and the management of Kanga Ltd adopts cash flow hedge accounting, provide the necessary journal entries for Kanga Ltd to account for both the purchase transaction with Ferrett plc and the forward-rate contract with The Bank. LO 28.8 16. Platypus Ltd exports goods to Harlom Inc. All sales contracts are denominated in US dollars. Sales of US$5 million are made on 1 May 2018, FOB Sydney. The amount is due for payment by Harlom Inc. on 1 September 2018. A sell-hedge contract for US$5 million is taken out on 1 June 2018 with The Bank. It matures on 1 September 2018. Platypus Ltd’s reporting date is 30 June. Additional information Date

Spot rate

Forward rate

1 May 2018 1 June 2018 30 June 2018 1 September 2018

$US0.84 $US0.82 $US0.85 $US0.86

– $US0.84 $US0.87 $US0.86

REQUIRED Prepare the journal entries for Platypus Ltd to account for the above transaction. LO 28.8 17. On 1 July 2018 Crescent Ltd, an Australian company, borrows US$15 million at a rate of 8 per cent from a US corporation, repayable in US dollars. The loan is for a period of five years. The loan is on more favourable terms than Crescent Ltd is able to obtain within Australia. Crescent Ltd trades predominantly within Australia. At the same time Plummer Ltd, also an Australian company, borrows A$18.75 million from an Australian bank at a fixed rate of 8 per cent. The loan is for a period of five years. Plummer Ltd also has a number of receivables denominated in US dollars. 1024  PART 9: FOREIGN CURRENCY

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As a result of perceived benefits to both parties, Crescent Ltd and Plummer Ltd decide to swap their interest and principal obligations on the same date that they take out the loans, that is, 1 July 2018. Under the swap terms each party agrees to take control of the other party’s principal and interest obligations. The required market rates of return on both loans is assumed to be 8 per cent and these market rates remain at 8 per cent throughout the terms of the loans. The relevant exchange rates are: 01 July 2018 30 June 2019

A$1.00 = US$0.80 A$1.00 = US$0.70

REQUIRED Provide the journal entries for the year ending 30 June 2019 in the books of Crescent Ltd and Plummer Ltd to account for the swap. LO 28.9

CHALLENGING QUESTIONS 18. You are the finance director of ME Ltd. The company specialises in importing classic foreign vehicles from overseas countries and then selling these vehicles cheaply on the open market. The company’s financial year ends on 30 June 2018. The company enters into the following transactions during the year: (a) The company purchases inventories from Hong Kong for HK$300 000. The order is placed on 22 April 2018, with delivery due by 30 April 2018. Under the conditions of the contract, title to the goods passes to the company on delivery. Payment in respect of these inventories is due in equal instalments on 30 May 2018, 30 June 2018 and a final payment on 31 July 2018. The following exchange rates are applicable: HK$8.00 = A$1.00 HK$8.50 = A$1.00 HK$8.56 = A$1.00 HK$8.59 = A$1.00 HK$8.94 = A$1.00

22 April 2018 30 April 2018 31 May 2018 30 June 2018 31 July 2018

(b) The company enters into a long-term construction contract with a Japanese company. Under the terms of the contract the Japanese firm will manufacture an engine diagnosis machine, which can be used on all classic cars. The contract is entered into on 30 April 2017 for a fixed price of ¥5 million. The equipment is delivered on 31 May 2018, subject to a two-month credit period after the date of delivery to ensure that the company is satisfied with the equipment. Payment falls due on 31 July 2018. The following exchange rates are applicable: ¥160 = A$1.00 ¥160 = A$1.00 ¥240 = A$1.00 ¥245 = A$1.00 ¥260 = A$1.00

30 April 2017 30 June 2017 31 May 2018 30 June 2018 31 July 2018

(c) The company arranges a US-dollar interest-only loan on 1 January 2018 for US$20 million. The loan is for a 10-year period at an interest rate of 11.5 per cent per annum. Interest is payable annually. Concerned about the volatility of the Australian dollar against the US dollar, the company takes out a hedge contract on the loan, payable on 1 January 2018. The hedge contract covers the first two years’ interest payments. The hedge rate is set at A$1.00 = US$0.65. The following exchange rates are applicable: Date

Spot rate

Forward rate

1 January 2018 30 June 2018

$US0.69 $US0.64

$US0.65 $US0.60

(d) The company has agreed to purchase 10 new handmade sports cars from an English supplier. The official order for the vehicles is placed on 31 January 2018. The contract price is established at £350 000 and CHAPTER 28: ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS  1025

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delivery takes place on 30 May 2018, as agreed. Payment is due in respect of these vehicles on 31 August 2018. In anticipation of the contract on 31 January 2018, the company enters into a foreign currency contract to receive £350 000 at a forward rate of £0.46 = A$1.00. The following exchange rates are applicable: Date 31 January 2018 31 May 2018 30 June 2018 31 August 2018

Spot rate

Forward rate

£0.49 = A$1.00 £0.47 = A$1.00 £0.43 = A$1.00 £0.40 = A$1.00

£0.46 = A$1.00 £0.44 = A$1.00 £0.40 = A$1.00 £0.40 = A$1.00

REQUIRED Prepare the journal entries to reflect the effects of the above transactions in accordance with AASB 121, AASB 123 and AASB 9. Explain the treatment adopted in respect of each of the above transactions. LO 28.3, 28.6, 28.8 19. ABC Pty Ltd purchases inventory from DEF plc, a listed British company. Relevant events and the spot rates at each date are shown as follows: Date

Event

Spot rate

15 March 2018 11 May 2018 30 June 2018 02 July 2018 14 August 2018

Order £300 000 of inventory Purchase takes place as inventory shipped to ABC Ltd (FOB) End of financial year Inventory arrives at warehouse Payment of £300 000 to supplier

A$1.00 = 37p A$1.00 = 41p A$1.00 = 43p A$1.00 = 42p A$1.00 = 39p

REQUIRED (a) Prepare appropriate journal entries for each relevant event. LO 28.5 (b) Assume that, instead of inventory, the purchase is plant and equipment, which is installed ready for use on 15 July 2018 when the rate is still A$1.00 = 42p. Prepare appropriate journal entries for each relevant event. LO 28.6 (c) Assume that the inventory purchase prompts the taking out of a forward-rate contract on 15 March 2018 to purchase £300 000 on 14 August 2018 at an agreed rate of A$1.00 = 34p. Prepare appropriate journal entries for each relevant event. LO 28.8 The forward rates applicable at each of the dates are: Date 15 March 2018 11 May 2018 30 June 2018 2 July 2018 14 August 2018

Forward rate A$1.00 = UK£0.34 A$1.00 = UK£0.38 A$1.00 = UK£0.40 A$1.00 = UK£0.38 A$1.00 = UK£0.39

(d) Explain the effect of an ‘effective’ hedge contract on ABC Pty Ltd’s profit or loss. LO 28.5, 28.6, 28.8 20. You are the finance director of URS Ltd, an Australian manufacturer of colour televisions. Because of local regulations and high labour costs, URS Ltd has determined that it is more cost-effective to purchase some components utilised in the manufacturing of television sets from a Singapore company on three-month, interest-free terms. URS Ltd obtains title to the goods when they leave the Singapore factory. The financial year of URS Ltd ends on 30 June 2018. Additional information • The development within the television industry of three-dimensional pictures has meant that URS  Ltd has upgraded some of its plant and equipment. In particular, URS Ltd has imported specialised machinery from the USA to enable the company to construct 3D screens.

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The machinery is purchased on 30 April 2018 at a price of US$250 000. The amount is payable in two instalments, on 31 July 2018, and on delivery on 31 August 2018. The machinery is to be depreciated from the delivery date (31 August 2018) at a rate of 10 per cent per annum. The exchange rates applicable at the above dates are as follows: 30 April 2018 30 June 2018 31 July 2018 31 August 2018

A$1.00 = US$0.76 A$1.00 = US$0.74 A$1.00 = US$0.72 A$1.00 = US$0.74

• The company purchases S$500 000 worth of spare parts from the Singapore company on 30 May 2018. As URS Ltd has three-month interest-free terms, the amount is payable in full on 31 August 2018. On 30 May 2018, in order to reduce the company’s exposure to adverse foreign exchange fluctuation, the company enters into a forward contract to purchase S$500 000 in exchange for A$362 319—that is, at a rate of S$1.38 = A$1.00. The contract expires on 31 August 2018. The exchange rates applicable at the above dates are as follows: Date 30 May 2018 30 June 2018 31 August 2018

Spot rate

Forward rate

A$1.00 = S$1.40 A$1.00 = S$1.25 A$1.00 = S$1.15

$A1.00 = S$1.38 $A1.00 = S$1.23 $A1.00 = S$1.15

REQUIRED Prepare the journal entries to account for the above transactions. LO 28.8

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CHAPTER 29

TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATIONS LEARNING OBJECTIVES (LO) 29.1 Understand why it is necessary to translate the accounts of foreign subsidiaries to a specific presentation currency before the consolidation process is performed. 29.2 Be able to translate the financial statements of a foreign operation into a particular functional currency. 29.3 Be able to translate the financial statements of a foreign operation into a particular presentation currency. 29.4 Understand what exchange rates to use when translating the accounts of a foreign operation. 29.5 Understand how to perform a consolidation subsequent to the translation of a foreign subsidiary’s financial statements.

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Introduction to translating the financial statements of foreign operations In the consolidation process we combine the financial statements of a parent entity (defined in AASB 10 as an entity that controls one or more entities) and its controlled entities (or subsidiaries, with a subsidiary being defined within AASB 10 as an entity that is controlled by another entity, and which would include unincorporated entities such as partnerships and trusts), subject to a number of adjustments and eliminations. If some of the controlled entities are foreign entities with account balances denominated in foreign currencies, it would be necessary to translate these accounts to a given presentation currency (Australian dollars, for example) before the consolidation process is undertaken. It would not make sense to consolidate financial statements that are in different currencies. As 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 entity’s 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. The accounting standard pertaining to the translation of foreign subsidiaries is AASB 121 The Effects of Changes in Foreign Exchange Rates. As we saw in Chapter 28, this accounting standard also provides rules for translating foreign currency transactions. In this chapter we will consider how to translate the financial statements from a particular local currency into a particular functional currency, and we will also consider how to translate the financial statements from a particular functional currency into a specific presentation currency. In the preceding sentence, reference was made to three different types of currencies, these being local currency, functional currency, and presentation currency. These currencies can be defined as follows: • Local currency: the currency used in the country in which the foreign operation is located. • Functional currency: AASB 121, paragraph 8, defines functional currency as ‘the currency of the primary economic environment in which the entity operates’. • Presentation currency: AASB 121, paragraph 8, defines the presentation currency as ‘the currency in which the financial statements are presented’. A detailed discussion of the factors management needs to consider when determining the functional currency of an entity and of how to establish its presentation currency is provided in Chapter 28. We now consider how to translate the accounts of a foreign operation in accordance with the requirements of AASB 121.

Reporting foreign currency transactions in the functional currency

LO 29.1 LO 29.2 LO 29.4

In this chapter we will consider two situations. First, we will consider translating the financial statements of an entity into a particular functional currency. Next, we will consider how to translate the financial statements of an entity from a particular functional currency into a particular presentation currency. This section reviews how transactions undertaken in a foreign currency are translated into an foreign currency entity’s functional currency. If the functional currency is the same as the local currency, then there will A currency other than be no need to translate the financial statements of the foreign operation into the functional currency, the functional currency as the financial statements prepared in the local currency will already have been prepared in the of the entity. functional currency. In such circumstances we will need only to translate the foreign operation’s financial statements into the group’s presentation currency (that is, we could ignore the requirements detailed in this section and move directly to the next section of the chapter). As noted above, the functional currency of an entity is, according to AASB 121, ‘the currency of the primary economic environment in which the entity operates’. According to paragraph 12 of AASB 121, management uses its judgement

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‘to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions’. Paragraph 12 of AASB 121 further states: As part of this approach to determining the functional currency, management gives priority to the primary indicators in paragraph 9 before considering the indicators in paragraphs 10 and 11, which are designed to provide additional supporting evidence to determine an entity’s functional currency. Paragraphs 9, 10 and 11 of AASB 121 state the following (and remember, from the above paragraph, that management is required to give priority to paragraph 9 when determining an entity’s functional currency):









 9.  The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining its functional currency: (a) the currency: (i)  that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and (ii)  of the country whose competitive forces and regulations mainly determine the sales price of its goods and services; (b)  the currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled). 10. The following factors may also provide evidence of an entity’s functional currency: (a)  the currency in which funds from financing activities (i.e. issuing debt and equity instruments) are generated; (b)  the currency in which receipts from operating activities are usually retained. 11. The following additional factors are considered in determining the functional currency of a foreign operation, and whether its functional currency is the same as that of the reporting entity (the reporting entity, in this context, being the entity that has the foreign operation as its subsidiary, branch, associate or joint venture): (a)  whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy. An example of the former is when the foreign operation only sells goods imported from the reporting entity and remits the proceeds to it. An example of the latter is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in its local currency; (b)  whether transactions with the reporting entity are a high or low proportion of the foreign operation’s activities; (c)  whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it; (d)  whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity.

Therefore, if a parent entity has a subsidiary located in another country then the first task to be undertaken prior to the consolidation process is to determine the functional currency of the overseas subsidiary. For example, if an Australian parent has a subsidiary that is located in New Zealand then it is likely that the subsidiary would maintain its accounts in the local currency, which is New Zealand dollars. However, the functional currency of that subsidiary would probably either be Australian dollars or New Zealand dollars. For the functional currency of the subsidiary to be Australian dollars there would be an expectation that there is a high degree of dependence between the subsidiary and the parent entity such that the subsidiary is effectively operating as a direct branch of the Australian operation. Perhaps the entity acquires products directly from the parent entity and sells the products at prices based on the Australian dollar. If the functional currency is determined to be Australian dollars then there will be a need to translate the New Zealand accounts from New Zealand dollars into Australian dollars. In contrast, if the subsidiary operates quite independently from the Australian parent, perhaps because it produces the goods locally, and sells its products at prices based on New Zealand dollars, then the functional currency might be the same as the local currency of the subsidiary, in this case, New Zealand dollars. In this example, financial statements prepared in New Zealand dollars are automatically also presented in the functional currency. A parent entity may have many subsidiaries in many different countries, many of which have different functional currencies. The more subsidiaries that operate independently of the parent entity, the more likely there will be various functional currencies used by the subsidiaries. 1030  PART 9: FOREIGN CURRENCY

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Following on from the above discussion, if it is determined that the functional currency of the New Zealand subsidiary is New Zealand dollars, then the financial statements of the subsidiary would already be presented in the functional currency. However, if the functional currency of the New Zealand subsidiary is deemed to be Australian dollars, then the accounts of the New Zealand subsidiary will need to be translated into the functional currency of Australian dollars. Paragraphs 21 and 23 of AASB 121 provide the rules for translating one currency into another currency. In relation to items included within the statement of profit or loss and other comprehensive income, paragraph 21 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. From the above paragraph we can see that there is a general requirement that each item of expense and revenue shall be translated at the spot exchange rate between the functional currency and the local currency on the dates the respective transactions took place. However, this would be an extremely time-consuming and difficult task and, as such, AASB 121 allows average rates to be used. For example, an average exchange rate between the local currency and the functional currency for a month may be used to translate transactions that occurred within that month. As paragraph 22 of AASB 121 states: For practical reasons, a rate that approximates the actual rate at the date of the transaction is often used, for example, an average rate for a week or a month might be used for all transactions in each foreign currency occurring during that period. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate. The above requirements relate to accounts contained within the statement of profit or loss and other comprehensive income. In relation to accounts that would generally be presented within the statement of financial position, paragraph 23 of AASB 121 states: At each reporting date: (a) foreign currency monetary items shall be translated using the closing rate; (b) non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated using the exchange rate at the date of the transaction; and (c) non-monetary items that are measured at fair value in a foreign currency shall be translated using the exchange rates at the date when the fair value was determined. The above paragraph makes reference to monetary items. Monetary items are defined in paragraph 8 of AASB 121 as: units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. In relation to monetary assets, paragraph 16 of AASB 121 also states: The essential feature of a monetary item is a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples include: pensions and other employee benefits to be paid in cash; provisions that are to be settled in cash; and cash dividends that are recognised as a liability. Similarly, a contract to receive (or deliver) a variable number of the entity’s own equity instruments or a variable amount of assets in which the fair value to be received (or delivered) equals a fixed or determinable number of units of currency is a monetary item. Conversely, the essential feature of a non-monetary item is the absence of a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples include: amounts prepaid for goods and services (e.g. prepaid rent); goodwill; intangible assets; inventories; property, plant and equipment; and provisions that are to be settled by the delivery of a non-monetary asset. In relation to non-monetary assets, such as plant and equipment, AASB 116 Property, Plant and Equipment allows that either cost or fair value can be used as the basis of measurement. If the cost basis is used, and consistent with paragraph 23 reproduced above, the rate to be used to translate the local currency to the functional currency is the spot rate as at the date the asset was originally recognised by the subsidiary. If fair values are used by way of undertaking revaluations, then the exchange rate to be used between the foreign currency and the functional currency will be the exchange rate in place when the valuation was made. CHAPTER 29: TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATIONS  1031

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The rates to be used to translate financial statements into a given functional currency are summarised in Table 29.1. Applying the rates in Table 29.1 to the translation of the foreign operation’s financial statements into the functional currency results in exchange differences. These arise because the foreign operation’s monetary items are translated at the closing rate, while profit or loss items (sales, purchases and other expenses) are translated at the spot exchange rate at the date of the transaction or, for practical purposes, at a rate (average rate) that approximates the actual rate. The translation of non-monetary items does not give rise to exchange differences as the spot exchange rate at the date of the transaction is used from year to year. AASB 121, paragraph 28, explains this as follows: 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. Applying the requirements of AASB 121 as they relate to translating the accounts from a local currency to a particular functional currency means that the final accounts, after translation, will reflect amounts that would be recorded had the transactions or events been originally recorded in the functional currency. As paragraph 34 of AASB 121 states: When an entity keeps its books and records in a currency other than its functional currency, at the time the entity prepares its financial statements, all amounts are translated into the functional currency in accordance with Table 29.1 Summary of rates used when translating financial statements into the functional currency

Category

Rate

Assets Monetary

Translate at the spot exchange rate at reporting rate (that is, at the closing rate)

Non-monetary—held at historical cost

Translate at the spot rate at the day the asset was recorded by the subsidiary

Non-monetary—fair value

Translate at the exchange rate at the date of valuation

Liabilities Monetary

Translate at the closing rate

Non-monetary

Translate at the exchange rate at the date of valuation

Equity Contributed equity—at acquisition

Translated at the rate when the investment acquired

Reserves—at acquisition

Translated at the rate when the investment was acquired

Reserves—post-acquisition

If the transfer to the reserves is the result of, say, a revaluation of property, plant and equipment, the rate used is the rate at the date of revaluation

Retained earnings—at acquisition

Translated at the rate when the investment was acquired

Revenues and expenses Revenue and expenses

Translated at the rate of the transaction. For practical purposes, a rate that approximates the actual rate of the transaction can be used

Non-monetary-related expenses. e.g. depreciation

Translated at the rate used to translate the related non-monetary item

Distributions Dividends paid

Translated at the current rate at the date of payment

Dividends declared

Translated at the current rate at the date the dividends are declared

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paragraphs 20–26. This produces the same amounts in the functional currency as would have occurred had the items been recorded initially in the functional currency. For example, monetary items are translated into the functional currency using the closing rate, and non-monetary items that are measured on a historical cost basis are translated using the exchange rate at the date of the transaction that resulted in their recognition. The translation from a foreign currency into a functional currency is explored in Worked Example 29.1.

WORKED EXAMPLE 29.1: Translation from a foreign currency into a functional currency On 1 July 2018, Kiwi Ltd, a New Zealand company whose shares are listed on the New Zealand Securities Exchange, acquired all the equity in Bulldog plc, a company incorporated in England. Because of the high level of dependence of Bulldog plc on Kiwi Ltd, the functional currency is deemed to be the New Zealand dollar. The exchange rates for the reporting period ending 30 June 2019 are shown below. 1 July 2018 Average rate for the year Ending inventory (acquired before year end) 30 June 2019

UK£1 = NZ$3.00 UK£1 = NZ$3.10 UK£1 = NZ$3.20 UK£1 = NZ$3.30

The statement of profit or loss and other comprehensive income, the statement of changes in equity and the statement of financial position of Bulldog plc, stated in UK pounds, are detailed below. Bulldog plc Statement of profit or loss and other comprehensive income for the year ending 30 June 2019 UK£000 Sales Cost of sales: – Inventory—1 July 2018 – Purchases – Inventory—30 June 2019 Administration expenses Depreciation expense Profit before tax Income tax expense Profit for the year Other comprehensive income Total comprehensive income

2 500 (500) (2 000) 450 (75)  (100) 275  (125) 150  –   150

Bulldog plc Statement of changes in equity for the year ending 30 June 2019

Balance at 30 June 2018 From statement of profit or loss and other comprehensive income Balance at 30 June 2019

Share capital UK£000

Retained earnings UK£000

500

150

  – 500

150 300 continued

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Bulldog plc Statement of financial position as at 30 June 2019

Assets Property, plant and equipment Cash and debtors Inventory Total assets Liabilities Bank loan Trade creditors Total liabilities Net assets Equity Share capital Retained earnings

1 July 2018 UK£000

30 June 2019 UK£000

1 050 100    500 1 650

950 800    450 2 200

1 000         – 1 000    650

1 000    400 1 400    800

500    150    650

500    300    800

REQUIRED Translate the financial statements of Bulldog plc into the functional currency and provide a statement of profit or loss and other comprehensive income and a statement of financial position. SOLUTION Bulldog plc Statement of profit or loss and other comprehensive income for the year ending 30 June 2019

Sales Cost of sales: – Inventory—1 July 2018 – Purchases – Inventory—30 June 2019 Administration expenses Depreciation expense Foreign exchange loss Profit before tax Income tax expense Profit for the year Other comprehensive income Total comprehensive income

UK£000

Exchange rate

NZ$000

2 500

3.10

7 750.0

(500) (2 000) 450 (75) (100)         – 275    (125) 150         –     150

3.00 3.10 3.20 3.10 3.00

(1 500.0) (6 200.0) 1 440.0 (232.5) (300.0)    (210.0) 747.5    (387.5) 360.0         –        360    

UK£000

Exchange rate

NZ$000

950 800    450 2 200

3.00 3.30 3.20

2 850 2 640 1 440 6 930

3.10

Bulldog plc Statement of financial position as at 30 June 2019 Assets Property, plant and equipment Cash and debtors Inventory Total assets

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Liabilities Bank loan Trade creditors Total liabilities Net assets Equity Share capital Retained earnings   Opening balance    From statement of profit or loss and OCI

1 000    400 1 400    800

3.30 3.30

3 300 1 320 4 620 2 310

500

3.00

1 500

150    150    800

3.00  

   450    360 2 310

In this worked example the exchange differences have arisen, in the main, from the translation of the foreign operation’s monetary items at current rates in the same way as for the foreign currency monetary items of the entity. The non-monetary items, for example, property, plant and equipment and inventory, are translated at the spot rate at the day the asset was recorded by the subsidiary. This rate will be used in subsequent years unless the item is sold, in which case an exchange difference will arise. Profit or loss items, for example, sales and purchases, give rise to monetary items in the form of cash, accounts receivable and accounts payable. The exchange differences are established by comparing the changes in the monetary items for the reporting period. This is achieved by comparing the difference between the exchange rate used in the translation process and the closing rate at the end of the reporting period.

Net monetary assets at 1 July 2018 – Bank loan – Cash and debtors Movements during the year Increases in monetary assets—sales Decreases in monetary assets resulting from: – Purchases – Cash expenses – Income tax expense Net monetary assets (liabilities) at 30 June 2019

UK£000

UK£000

Current rate less rate applied

NZ$ gain/(loss)

    (1 000)    100 

 (900)

(3.30 – 3.00)

(270)

2 500

(3.30 – 3.10)

500

(2 000) (75)   (125)   (600)

(3.30 – 3.10) (3.30 – 3.10) (3.30 – 3.10)

(400) (15)   (25) (210)

Reconciled to net monetary items at 30 June 2019 as follows: Bank loan Creditors Cash and debtors

       

(1 000) (400)    800   (600)

The result of translating the financial statements maintained in UK pounds into the functional currency, New Zealand dollars, is that the same result is obtained as would have been if Bulldog plc had maintained its books and records in New Zealand dollars.

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LO 29.3 LO 29.4

Translating the accounts of foreign operations into the presentation currency

As an example, a subsidiary of an Australian company might prepare its financial statements in a functional currency that is different from the parent entity’s presentation currency. Indeed, there might be many subsidiaries using a variety of functional currencies. Before consolidating the financial statements of the parent entity and its subsidiaries it will be necessary to convert the financial statements of the various foreign subsidiaries spot rate from their respective functional currencies into the presentation currency of the parent entity. That is, The exchange rate for we will need to ensure that prior to consolidation, all of the financial statements of the entities within immediate delivery the group are presented in the one currency, which will be the group’s presentation currency. of currencies to be exchanged. Under the approach required by AASB 121, all assets and liabilities of a foreign operation are to be translated from the functional currency to the presentation currency using the spot rate applicable at the end of the reporting period. Income and expenses are translated at the exchange rates in place at the dates of the various transactions. If expense and revenue transactions are exchange rate considered to occur uniformly throughout the period, average rates may be used. Any resulting The rate at which translation gains or losses are taken directly to reserves (rather than to profit or loss, which was the one currency can be case when we translated the financial statements from a local currency to the functional currency). exchanged for another. Specifically, paragraph 39 of AASB 121 states: The results and financial position of an entity whose functional currency is not the currency of a hyperinflationary economy shall be translated into a different presentation currency using the following procedures: (a) assets and liabilities for each statement of financial position presented (i.e. including comparatives) shall be translated at the closing rate at the date of that statement of financial position; (b) income and expenses for each statement presenting profit or loss and other comprehensive income (i.e. including comparatives) shall be translated at exchange rates at the dates of the transactions; and (c) all resulting exchange differences shall be recognised in other comprehensive income. Note from (c) above that the exchange differences are not to be treated as part of profit or loss but are to be transferred to a reserve—a foreign currency translation reserve—and the increase or decrease in this reserve are included as part of ‘other comprehensive income’, and therefore included within ‘comprehensive income’ (rather than in profit or loss). With reference to the requirement at paragraph 39(b) above, it would obviously be very difficult and time-consuming to determine the rates for each and every transaction. This being so, and as indicated earlier in relation to translations to a particular functional currency, average rates are often used. As paragraph 40 of AASB 121 puts it: For practical reasons, a rate that approximates the exchange rates at the dates of the transactions, for example an average rate for the period, is often used to translate income and expense items. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate. With regard to the requirement at paragraph 39(c) above that all exchange differences are to go to equity (rather than be included as part of the profit or loss of the financial period), paragraph 41 of AASB 121 states: These exchange differences are not recognised in profit or loss because the changes in exchange rates have little or no direct effect on the present and future cash flows from operations. The cumulative amount of the exchange differences is presented in a separate component of equity until disposal of the foreign operation. To illustrate simplistically the use of the required method for translating foreign operation accounts, let us assume that a foreign operation has assets of £1 500 000 and liabilities of £1 000 000 at the beginning of a financial period and, further, that it does not trade during the financial period. We will also assume that, during the financial period, the value of the Australian dollar moves from £1.00 = A$2.00, to £1.00 = A$2.20. Using the method of translation required by AASB 121, the translation gain on holding the assets would be $300 000, which is 1 500 000 × ($2.20 − $2.00). There would be a loss on the liabilities amounting to $200 000, which is 1 000 000 × ($2.20 − $2.00). That is, in terms of Australian dollars, the foreign operation owes a greater amount in Australian dollars because of the devaluation of the Australian dollar. What we must remember, however, is that the foreign operation could operate independently, in which case Australian currency would not be used to pay the debt and therefore the loss would not be treated as being realised. The net gain of $100 000 would be transferred 1036  PART 9: FOREIGN CURRENCY

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to a foreign currency translation reserve and not be treated as an income or expense of the period. In a sense, the net amount of $100 000, which is the difference between $300 000 and $200 000, is the balancing item—that is the difference between the respective gain and loss. The foreign exchange exposure of the parent entity in relation to its foreign operations relates only to its net investment in the operation—that is, to the net assets of the foreign operation. In the above example, the net gain is simply calculated as: (1 500 000 − 1 000 000) × ($2.20 − $2.00) = $100 000 This example demonstrates that if the assets of the foreign operation exceed its liabilities (which means that shareholders’ funds are positive) and if the value of the Australian dollar falls relative to the currency of the foreign operation, there will be a credit to the foreign currency translation reserve. Otherwise, there will be a debit to the foreign currency translation reserve. While paragraph 39 of AASB 121 (provided earlier) does outline the method for translating the assets, liabilities, income and expenses of a foreign entity, the standard is silent on the translation of: • equity at the date of the investment, that is, pre-acquisition capital and reserves • post-acquisition movements in equity other than retained earnings or accumulated losses • distributions from retained earnings. This is in contrast with the former standard, AASB 1012, which did indicate how to translate the above account types. The treatment required by the superseded AASB 1012 (using what was referred to as the current-rate method) is consistent with the requirements of AASB 121 and hence will be adopted in the following illustrations. In relation to all accounts (including those covered by paragraph 39 of AASB 121), the approach to translating the accounts of a foreign subsidiary from a particular functional currency to a particular presentation currency is as follows: ( a) Assets and liabilities are translated at the exchange rate current at the end of the reporting period. (b) Equity at the date of the investment, including in the case of a corporation, share capital at acquisition and preacquisition reserves, is translated at the exchange rate current at that date of investment. (c) Post-acquisition movements in equity, other than retained earnings (surplus) or accumulated losses (deficiency), are translated at the exchange rates current at the dates of those movements, except that, where a movement represents a transfer between items within equity, the movement is translated at the exchange rate current at the date that the amount transferred or returned was first included in equity. (d) Distributions from retained earnings (that is, dividends paid or declared, or their equivalent) are translated at the exchange rates current at the dates when the distributions were first declared. (e) Revenue and expense items are translated at the exchange rates current at the applicable transaction dates. Table 29.2 summarises the approach to translating the accounts of a foreign subsidiary.

Item

Table 29.2 Summary of the method to be applied for translating financial statements from a given functional currency to a specific presentation currency

Rate

Assets Monetary assets

Translated at closing rate

Non-monetary assets—measured at historical cost

Translated at closing rate

Non-monetary assets—measured at fair value

Translated at closing rate

Liabilities Monetary

Translated at closing rate

Non-monetary

Translated at closing rate

Equity Share capital and reserves at date of acquisition

Translated at spot rate when investment was acquired

Post-acquisition movements in share capital and reserves (excluding retained earnings/accumulated losses)

Translated at the spot rate at the date they were recognised in the accounts

continued CHAPTER 29: TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATIONS  1037

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Item

Rate

Post-acquisition retained earnings

Amount determined from translating the statement of profit or loss and other comprehensive income

Revenues and expenses Revenues

Translated at the rate in place as at the time of the transaction. For practical reasons, however, it is acceptable to use a rate that approximates the rate in place when the transactions took place (for example, to use an average rate for the year)

Expenses (apart from the amortisation or depreciation of non-current assets)

Translated at the rate in place as at the time of the transaction. For practical reasons, however, it is acceptable to use a rate that approximates the rate in place when the transactions took place (for example, to use an average rate for the year)

Depreciation/amortisation

Translated at the average rate for the year

Income tax expense

Translated at the average rate for the year

Distributions Dividends paid/declared

Translated at the spot rate when paid/declared

Worked Example 29.2 provides an illustration of the translation of a foreign subsidiary’s financial statements.

WORKED EXAMPLE 29.2: Translation of a foreign operation’s financial statements from a functional currency into a presentation currency On 1 July 2018 Bruce Ltd, an Australian company, acquires all of the issued shares in Nigel plc, a company incorporated in England. Exchange rates for the year ending 30 June 2019 are as follows: £1.00 = A$2.00 £1.00 = A$2.10 £1.00 = A$2.20 £1.00 = A$2.30

01 July 2018 Average rate for year Ending inventory acquired (before year end) 30 June 2019

The statement of profit or loss and other comprehensive income, the statement of changes in equity and the statement of financial position of Nigel plc are shown below. The accounts are stated in UK£, which is Nigel plc’s functional currency. Abbreviated statement of profit or loss and other comprehensive income for Nigel plc for the year ending 30 June 2019 UK£ Sales Cost of sales – Inventory—01 July 2018 – Purchases – Inventory—30 June 2019 Administration expense Depreciation expense Profit Income tax expense Profit after tax Other comprehensive income Comprehensive income

2 500 (500) (2 000) 450 (75)   (100) 275   (125) 150        –    150

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Nigel plc Statement of changes in equity for the year ending 30 June 2019

Balance at 30 June 2018 From statement of profit or loss and other comprehensive income Balance at 30 June 2019

Share capital UK£000 500

Retained earnings UK£000 150

     – 500

150 300

Statement of financial position for Nigel plc as at 30 June 2019 01 July 2018 (UK£)

30 June 2019 (UK£)

1 050 100    500 1 650

950 800    450 2 200

1 000         – 1 000    650

1 000    400 1 400    800

500    150    650

500    300    800

Assets Plant and equipment Cash and debtors Inventory Total assets Liabilities Bank loan Trade creditors Total liabilities Net assets Represented by: Shareholders’ funds Share capital Retained earnings

REQUIRED Translate the financial statements of the foreign operation from the function currency of the subsidiary into the presentation currency of the group. SOLUTION To determine which rates should be used for the various items we can refer to Table 29.2. Statement of profit or loss and other comprehensive income for Nigel plc for the year ending 30 June 2019 Sales Cost of sales – Inventory—01 July 2018 – Purchases – Inventory—30 June 2019 Administration expense Depreciation expense Profit Income tax expense Profit after tax Other comprehensive income Increase in foreign currency translation reserve Total comprehensive income

(UK£) 2 500

(Rate) 2.10

(A$) 5 250

(500) (2 000) 450 (75)  (100) 275  (125) 150

2.00 2.10 2.20 2.10 2.10

(1 000) (4 200) 990 (157.5)  (210)  672.5  (262.5) 410

   – 150

2.10

130* 540

*See calculation provided

continued CHAPTER 29: TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATIONS  1039

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Bulldog plc Statement of changes in equity for the year ending 30 June 2019

Balance at 30 June 2018 From statement of profit or loss and   other comprehensive income Balance at 30 June 2019

Share capital UK£000 1 000

Retained earnings UK£000 300*

       – 1 000

Foreign currency translation reserve UK£000 –

410 710

130 130

*$150 000 × 2.00 where 2.00 is the opening exchange rate on 1 July 2018

Statement of financial position for Nigel plc as at 30 June 2019 01 July 2018 (UK£)

30 June 2019 (UK£)

1 050 100   500 1 650

950 800    450 2 200

2.30 2.30 2.30

2 185 1 840 1 035 5 060

1 000        – 1 000   650

1 000    400 1 400   800

2.30 2.30

2 300    920 3 220 1 840

500

500

2.00

   150   650

   300   800

1 000 130*    710 1 840

Assets Plant and equipment Cash and debtors Inventory Liabilities Bank loan Trade creditors Net assets Represented by: Shareholders’ funds Share capital Foreign currency translation reserve Retained earnings

(Rate)

(A$)

*See calculation provided

Foreign currency translation reserve As we have noted, all assets and liabilities of the foreign subsidiary are translated at the spot rate in place at the end of the reporting period. Because we know that assets less liabilities equals owners’ equity, it follows that in effect the total of owners’ equity is translated at the reporting date spot rate. However, the individual components of owners’ equity will be translated differently. The share capital will be translated using the rate in place when the investment was acquired. Retained earnings will be the balance provided from the statement of profit or loss and other comprehensive income (which might use a variety of rates). The translation gain, which does not go to profit or loss but is included as part of ‘other comprehensive income’, remains part of equity and is in effect the balancing item. When the foreign operation is ultimately disposed of, the amount accumulated in equity as the foreign currency translation reserve will be treated as part of profits. The transfer to the foreign currency translation reserve is determined as follows: Net assets at 30 June 2019 at closing rate (800 × $2.30) less Components of net assets at their historical rates – Share capital 500 × $2.00 – Retained earnings Translation gain—to foreign currency translation reserve

$1840 ($1000)    ($710)     $130

1040  PART 9: FOREIGN CURRENCY

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Note that the exchange rate has moved against the Australian dollar in Worked Example 29.2. In such a case, a gain would arise on the assets and a loss would arise on the liabilities. Since the assets of Nigel plc exceed its liabilities, a net gain would be credited to the foreign currency translation reserve. The movement in the foreign currency translation reserve will be included as part of ‘other comprehensive income’ in the consolidated statement of comprehensive income.

Consolidation subsequent to translation

LO 29.5

Having translated the foreign subsidiary’s financial statements into the presentation currency, we can consolidate these financial statements, adopting normal consolidation principles (as explained in Chapters 25, 26 and 27). AASB 121, paragraph 45, however, explains that intragroup monetary items, assets or liabilities cannot be eliminated against the corresponding intragroup asset or liability without the result of the currency fluctuations being shown in the financial statements. AASB 121, paragraph 45, explains the reason for this as follows: The incorporation of the results and financial position of a foreign operation with those of the reporting entity follows normal consolidation procedures, such as the elimination of intragroup balances and intragroup transactions of a subsidiary (see AASB 127 and AASB 131 Interests in Joint Ventures). However, an intragroup monetary asset (or liability), whether short-term or long-term, cannot be eliminated against the corresponding intragroup liability (or asset) without showing the results of currency fluctuations in the consolidated financial statements. This is because the monetary item represents a commitment to convert one currency into another and exposes the reporting entity to a gain or loss through currency fluctuations. Accordingly, in the consolidated financial statements of the reporting entity, such an exchange difference is recognised in profit or loss or, if it arises from the circumstances described in paragraph 32, it is recognised in other comprehensive income and accumulated in a separate component of equity until the disposal of the foreign operation. As with consolidations generally, the cost of the investment is eliminated against the pre-acquisition capital and reserves of the controlled entities, with a resultant goodwill or bargain purchase on acquisition being recognised. Paragraph 47 of AASB 121 requires goodwill on the acquisition of a foreign subsidiary and any fair value adjustments in the carrying value of assets and liabilities arising on the acquisition of a foreign operation to be treated as assets and liabilities of the foreign operation. Specifically, paragraph 47 states: Any goodwill arising on the acquisition of a foreign operation and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation shall be treated as assets and liabilities of the foreign operation. Thus they shall be expressed in the functional currency of the foreign operation and shall be translated at the closing rate in accordance with paragraphs 39 and 42. The above requirement means that they must be translated at the closing rate at the end of the reporting period. How this should occur is detailed in Worked Example 29.3. The non-controlling interests will be determined following the translation of the financial statements. A foreign currency translation reserve will reside in the subsidiaries’ statements of financial position before the consolidation adjustments and the non-controlling interests will be allocated a proportion of this reserve.

WORKED EXAMPLE 29.3: Accounting treatment of goodwill arising on acquisition On 1 July 2017, Manly Ltd, an Australian entity, acquired 100 per cent of the equity of Jeffreys Bay Ltd, a South African company, for $1 550 000. At that date, the equity of Jeffreys Bay Ltd was as follows: ZAR Share capital Retained earnings

4 800 000    800 000 5 600 000 continued CHAPTER 29: TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATIONS  1041

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At the date of acquisition, all of the assets and liabilities were valued at fair value except for land, which was as follows: Carrying amount ZAR

Fair value ZAR

2 800 000

3 400 000

Land

The relevant exchange rates are as follows: 1 July 2017                        A$1 = ZAR 4 30 June 2018                    A$1 = ZAR 5 Jeffreys Bay Ltd’s functional currency is the South African rand while the presentation currency is the Australian dollar. The tax rate in Australia is 30 per cent, while the tax rate in South Africa is 40 per cent. REQUIRED Prepare the consolidation journal entries at 1 July 2017 and 30 June 2018. SOLUTION Elimination of investment in Jeffreys Bay Ltd

Share capital (4 800 000 ÷ 4) Retained earnings—at acquisition (800 000 ÷ 4) Revaluation surplus (600 000 ÷ 4 = $150 000 net of deferred tax at 40% of $60 000)

Jeffreys Bay Ltd (A$)

Eliminate parent 100% (A$)

1 200 000 200 000      90 000

1 200 000 200 000    90 000 1 490 000 1 550 000      60 000

Investment in Jeffreys Bay Ltd Goodwill on acquisition

From the above workings, the consolidation entry to eliminate the investment in Jeffreys Bay Limited would be: 1 July 2017 Dr Share capital 1 200 000 Dr Retained earnings 200 000 Dr Revaluation surplus 90 000 Dr Goodwill on acquisition 60 000 Cr Investment in Jeffreys Bay Limited    1 550 000 Eliminating the investment in Jeffreys Bay Limited and recognising goodwill at date of acquisition At 30 June 2018, the exchange rate had moved to A$1 = ZAR 5. The revaluation surplus and other equity items are translated at the rate at acquisition, while goodwill is translated at the closing rate at the end of the reporting period. The following additional entry should be made at 30 June 2018. 30 June 2018 Dr Cr

Foreign currency translation reserve Goodwill on acquisition

12 000 12 000

Recognising decrease in value of goodwill resulting from movements in exchange rate At 1 July 2017, goodwill expressed in South African rand amounted to ZAR 240 000 ($60 000 × 4). At 30 June 2018, the goodwill translated at the closing rate amounted to $48 000 (ZAR 240 000 ÷ 5). The difference is allocated to the foreign currency translation reserve.

1042  PART 9: FOREIGN CURRENCY

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As indicated in Chapter 26, on consolidation we need to eliminate inter-entity sales of inventory. If the foreign operation has acquired inventory from the parent entity, the inventory (as with all assets) is translated at the exchange rate in place at the end of the reporting period, which might lead to an adjustment to the foreign currency translation reserve. As the inventory on hand at year end has to be recorded as though no inter-entity transaction has occurred, if we assume that the value of foreign currency has increased relative to the domestic currency, a journal entry of the following form would be required to eliminate the adjustment to inventory: Dr Cr

Foreign currency translation reserve Inventory

X X

SUMMARY In this chapter we considered why and how we translate the accounts of foreign operations. We learned how to translate financial statements into a particular functional currency and we also learned how to translate financial statements from a particular functional currency into a presentation currency. If the financial statements of a foreign operation are translated into the functional currency, which is the currency of the primary economic environment in which the entity operates, any gain or loss on translation is treated as part of the entity’s profit or loss for the period and disclosed in the statement of profit or loss and other comprehensive income. We also learned that where the financial statements of the foreign operation are translated from its functional currency into the presentation currency, the net exchange difference on translation is treated as part of equity. The equity account has been referred to as a foreign currency translation reserve (although the accounting standard does not actually give the reserve a name).

KEY TERMS exchange rate  1036

foreign currency  1029

spot rate  1036

END-OF-CHAPTER EXERCISES On 1 July 2018, Barry Ltd, an Australian company, acquires all of the issued shares in Chuck Inc., a company incorporated in the USA. The presentation currency is the Australian dollar. Exchange rates for the year ending 30 June 2019 are as follows: 01 July 2018 Average rate for year Ending inventory acquired (before year end) 30 June 2019

US$1.00 = A$1.40 US$1.00 = A$1.50 US$1.00 = A$1.55 US$1.00 = A$1.60

The statement of profit or loss and other comprehensive income and statement of financial position of Chuck Inc. are shown below. The financial statements are stated in US dollars, which is the functional currency of Chuck Inc.

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Statement of profit or loss and other comprehensive income for Chuck Inc. for the year ending 30 June 2019 US$000 Sales Cost of sales – Inventory—01 July 2018 – Purchases – Inventory—30 June 2019 Administration expense Depreciation expense Profit Income tax expense Profit after tax Other comprehensive income Comprehensive income

5 000 (1 000) (4 000) 900 (150)    (200) 550    (250) 300         –    300

Statement of financial position for Chuck Inc. as at 30 June 2019

Share capital Retained earnings Bank loan Trade creditors Plant and equipment Cash and debtors Inventory

01 July 2018 (US$000)

30 June 2019 (US$000)

1 000 300 2 000        – 3 300 2 100 200 1 000 3 300

1 000 600 2 000    800 4 400 1 900 1 600    900 4 400

REQUIRED Translate the financial statements of Chuck Inc. into Australian dollars. LO 29.2, 29.3, 29.4

SOLUTION TO END-OF-CHAPTER EXERCISE We can refer to Table 29.1 for a summary of which rates to use for the various items. Statement of profit or loss and other comprehensive income for Chuck Inc. for the year ending 30 June 2019

Sales Cost of sales – Inventory—01 July 2018 – Purchases – Inventory—30 June 2019 Administration expense Depreciation expense Profit Income tax expense Profit after tax Other comprehensive income Increase in foreign currency translation reserve Total comprehensive income

(US$000)

Rate

(A$000)

5 000

1.50

7 500

(1 000) (4 000) 900 (150)   (200) 550   (250) 300

1.40 1.50 1.55 1.50 1.50

(1 400) (6 000) 1 395 (225)   (300) 970   (375) 595

        –    300

1.50

   145    740

1044  PART 9: FOREIGN CURRENCY

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Statement of financial position for Chuck Inc. as at 30 June 2019 01 July 2018 (US$000)

30 June 2019 (US$000)

(Rate)

(A$000)

1 000

1 000

1.40

300 2 000        – 3 300 2 100 200 1 000 3 300

600 2 000    800 4 400 1 900 1 600    900 4 400

1 400 145* 1 015** 3 200 1 280 7 040 3 040 2 560 1 440 7 040

Share capital Foreign currency translation reserve Retained earnings Bank loan Trade creditors Plant and equipment Cash and debtors Inventory

1.60 1.60 1.60 1.60 1.60

*See calculation provided below **Equal to translated profit after tax ($595 000) plus the opening retained earnings adjusted at the opening exchange rate ($300 000 × 1.4 = $420 000)

Foreign currency translation reserve The transfer to the foreign currency translation reserve is determined as follows: Net assets at 30 June 2019 at closing rate (1600 × $1.60) less Components of net assets at their historical rates: share capital (1000 × $1.40) Retained earnings Translation gain—to foreign currency translation reserve

$2 560 ($1 400) ($1 015)     $145

REVIEW QUESTIONS 1. Why do we need to translate the financial statements of a foreign operation? LO 29.1 2. Explain why foreign currency gains or losses in relation to the translation of the accounts of a foreign operation into a particular presentation currency are not treated as part of the period’s profit or loss, but instead are transferred to an equity account referred to as the foreign currency translation reserve. LO 29.3 3. What is the difference between the presentation currency and the functional currency and how would an organisation determine the appropriate presentation currency? LO 29.2, 29.3 4. Explain what rates should be used for the assets, liabilities and equity items of a foreign entity when translating the financial statements from a functional currency to a particular presentation currency. LO 29.4 5. What rates should be used to translate the expense and income items of a foreign entity’s financial statements? When would average rates be acceptable? LO 29.4

CHALLENGING QUESTIONS 6. On 1 July 2018 Sheila Ltd, an Australian company, acquires all of the issued shares in Felicity plc, a company incorporated in England. Exchange rates for the year ending 30 June 2019 are as follows: 01 July 2018 Average rate for year Ending inventory acquired (before year end) 30 June 2019

£1.00 = A$2.00 £1.00 = A$2.10 £1.00 = A$2.20 £1.00 = A$2.30

CHAPTER 29: TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATIONS  1045

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The statement of profit or loss and other comprehensive income and statement of financial position for Felicity plc are shown below. The accounts are stated in UK£. Statement of profit or loss and other comprehensive income for Felicity plc for the year ending 30 June 2019 UK£ Sales Cost of sales – Inventory—01 July 2018 – Purchases – Inventory—30 June 2019 Administration expense Depreciation expense Profit Income tax expense Profit after tax Other comprehensive income Total comprehensive income

5 000 (1 000) (4 000) 900 (150)   (200) 550   (250) 300         –     300

Statement of financial position for Felicity plc as at 30 June 2019 01 July 2018 (UK£)

30 June 2019 (UK£)

1 000 300 2 000        – 3 300 2 100 200 1 000 3 300

1 000 600 2 000    800 4 400 1 900 1 600    900 4 400

Share capital Retained earnings Bank loan Accounts payable Plant and equipment Cash and debtors Inventory

REQUIRED Translate the financial statements of the foreign operation, assuming: LO 29.2, 29.3, 29.4 (a) The Australian dollar is the functional currency of Felicity plc and the Australian dollar is also the presentation currency of the group. (b) UK pounds are the function currency of Felicity plc and the Australian dollar is the presentation currency of the group. 7. Bazza Ltd, an Australian company, acquires all of the shares of Ching Ltd, a Hong Kong company, on 1 July 2018. Ching Ltd had a $nil balance in retained earnings as at the date of acquisition. The financial statements for Ching Ltd are presented below: Statement of profit or loss and other comprehensive income for Ching Ltd for the year ending 30 June 2019 HK$ Sales Cost of sales – Inventory—01 July 2018 – Cost of goods manufactured – Inventory—30 June 2019 Gross profit Selling and administrative expenses

(25 000) (152 500)    27 500

HK$ 250 000

(150 000) 100 000 (20 000)

1046  PART 9: FOREIGN CURRENCY

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Depreciation Profit before tax Income tax expense (20 per cent) Profit after tax Other comprehensive income Total comprehensive income

  (30 000) 50 000    (10 000) 40 000              –    40 000

Statement of financial position for Ching Ltd as at 30 June 2019 (HK$) Cash Accounts receivable Inventory (cost) Plant and equipment less Accumulated depreciation Land Total assets Share capital Retained earnings Current liabilities Accounts payable Dividends payable Non-current liabilities Long-term bonds Total shareholders’ equity and liabilities

34 000 46 000 27 500 125 000 (30 000)   50 000 252 500 150 000 30 000 12 500 10 000    50 000 252 500

Additional information • Relevant exchange rates are: 1 July 2018 Plant, equipment and inventory acquired Long-term bonds issued Land acquired Average rate for 2019 financial year Average rate for June 2019 quarter 30 June 2019

A$1.00 = HK$4.00 A$1.00 = HK$4.00 A$1.00 = HK$3.50 A$1.00 = HK$3.50 A$1.00 = HK$3.00 A$1.00 = HK$2.25 A$1.00 = HK$2.00

• Plant, equipment and inventory are acquired on 1 July 2018. There were no monetary assets or liabilities at the commencement of business. • Long-term bonds are issued on 1 August 2018, with the principal to be repaid in full in five years. The bonds are issued in exchange for land, which is to be developed as a factory site. • Inventory on hand at the end of the financial year has been manufactured throughout the June 2019 quarter. • All revenue and expense items are incurred evenly throughout the year.

REQUIRED Translate the financial statements of Ching Ltd into Australian dollars in preparation for group consolidation in accordance with AASB 121, assuming that HK dollars are the functional currency of Ching Ltd and the Australian dollar is the presentation currency of the group. LO 29.3, 29.4

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PART 10

CORPORATE SOCIALRESPONSIBILITY REPORTING CHAPTER 30 Accounting for corporate social responsibility

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CHAPTER 30

ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY LEARNING OBJECTIVES (LO) 30.1 Be aware of alternative perceptions about the role of ‘accounting’ and about the accountability and social responsibility of business. 30.2 Know what ‘social-responsibility reporting’ is. 30.3 Understand how social-responsibility reporting relates (if at all) to financial reporting. 30.4 Understand the regulatory requirements for the disclosure of social and environmental performance information. 30.5 Be aware of the trends towards sustainability reporting. 30.6 Understand the extent to which Australian organisations currently disclose information about their social and environmental performance. 30.7 Be aware of user demands for, and market responses to, the disclosure of social-performance and environmental-performance information. 30.8 Be aware of theoretical perspectives on what motivates organisations to present social and environmental information. 30.9 Appreciate some of the limitations of conventional financial accounting in relation to the recognition of social and environmental costs and benefits. 30.10 Understand some of the various frameworks for social-performance and environmental-performance reporting. 30.11 Be aware of climate change and its relevance to society, to the environment, and to accounting. 30.12 Be aware of how new forms of ‘accounting’ might be produced that can assist organisations to become more transparent about their impacts on societies and environments. 30.13 Aside from the notion of corporate social responsibility, appreciate the central importance of personal social responsibility.

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Introduction to social-responsibility reporting Throughout this book we have been considering numerous financial reporting standards. Within most countries, the accounting standards issued by the IASB, in conjunction with the Conceptual Framework for Financial Reporting, govern the generation of information about various facets of an organisation’s financial performance. That is, so far in this book we have focused on financial performance reporting (although at various points in this book we have emphasised that financial measures of performance—such as ‘profits’—fail to reflect social-responsibility many of the positive and negative social and environmental impacts, or externalities, caused by reporting The provision of organisations). In this chapter we will consider a number of issues associated with corporate social information about and environmental reporting, as well as sustainability reporting. First, we will define corporate socialthe performance of responsibility reporting and the associated terms social reporting and environmental reporting. an organisation with We will consider different views about the responsibilities of business entities and whether such regard to its interaction responsibilities are considered to encompass the entity’s social and environmental performance, with its physical and social environment. and also whether they include the responsibility to publicly disclose information about the entity’s social and environmental performance. Traditionally, it was considered by most (but not all) people that business entities were simply responsible for their financial performance, and that their principal stakeholders were the owners of the entity (for a company, its shareholders). Such views prioritise the interests of some groups stakeholder of stakeholders (those with a financial interest in the organisation—such as investors/owners) over Any group or individual who can affect or and above the interests of other stakeholders. However, such views have changed somewhat, is affected by the and it has become more widely accepted—but not universally accepted (unfortunately)—that achievement of a firm’s business organisations have responsibilities to a broader group of stakeholders beyond their objectives. shareholders (this broader group of stakeholders might include local communities, customers, suppliers, employees, creditors, government, ‘the environment’ and even future generations) for their social and environmental performance, as well as their financial performance. The following statement made by the chairperson of Shell a number of years ago (as reported within the Chairman’s Statement in Shell UK’s Report to Society, 1998) reflects this view: The days when individual companies were judged solely in terms of economic performance and wealth creation have long disappeared. Today, companies have far wider responsibilities to the community, to the environment and to improving the quality of life for all. The above opinion is echoed by more recent statements by other company representatives. For example, consider the following material that appeared in the BHP Billiton Ltd 2015 Sustainability Report (at page 3): Sustainability is core to our strategy, ensuring we integrate health, safety, environmental, social and economic factors into our decision-making. Our priority is to identify and manage the material risks within our Company, ensuring our people, suppliers, contractors and the communities in which we operate remain safe and healthy. We are committed to being responsible stewards of the natural resources we develop and use in our operations and seek to minimise our environmental impact. We strive to be part of the communities in which we operate, and seek to foster meaningful, long-term relationships that respect local cultures and create lasting benefits. Our BHP Billiton Charter defines our purpose, strategy and values, and how we measure success. This includes our Sustainability value of putting health and safety first, being environmentally responsible and supporting our host communities. The BHP Billiton Code of Business Conduct guides us in our daily work and assists us to practically apply the values set out in Our Charter. Of course, whether such public statements or commitments made by companies, such as those provided above, reflect what actually happens within an organisation is not something of which we can be sure. Indeed, many researchers suggest there is a ‘decoupling’ (or a ‘disconnection’) between what organisations publicly say and commit to (in order to garner community support) and how they actually operate their business. This chapter embraces a position that the accountabilities of an organisation do extend beyond ensuring sound financial performance, and hence the view being embraced here is that other forms of ‘accounts’, other than just financial accounts, should be produced by organisations. Such a belief is not shared by all ‘accountants’.

CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1051

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In this chapter we will consider the regulation and guidance relating to public social and environmental reporting, and we will see that the accounting profession and those bodies in charge of regulating ‘accounting’ disclosures have been relatively silent on formulating guidelines or standards that address the social and environmental aspects of corporate performance. We will see that existing generally accepted accounting principles, as embodied within accounting standards and the Conceptual Framework for Financial Reporting, typically act to exclude from measurement many social and environmental costs and benefits generated by a business entity. Hence, moves to provide social and environmental information require an entity to go outside conventional financial accounting practices. We will specifically consider the limitations of traditional financial accounting with respect to providing information about an entity’s social and environmental performance. As we will see, traditional financial accounting has treated ‘environmental goods’ (for example, air and water) as being in infinite supply and free, with the consequence that the use or abuse of the externality environment is not reflected in accounting performance indicators such as ‘profits’ (unless fines or An impact that an entity other penalties have been imposed). Also, traditional financial accounting practices have tended to has on parties external ignore the social costs that an entity might have imposed upon the societies with which it interacts. to the organisation. For example, while retrenching thousands of people from a workforce can have positive effects on Externalities can be viewed as accounting profits (as has been the case for a number of large Australian companies in recent years positive externalities as they replaced people with various labour-saving technologies), there are associated social costs (benefits) or negative that are ignored by the organisation when calculating ‘profits’. externalities (costs). Although this chapter establishes that there are limited mandatory rules requiring organisations to publicly disclose information about their social and environmental performance, it will be shown that many organisations are producing such information and, increasingly, this information is being social auditing A process whereby an provided in stand-alone social and environmental reports—often quite extensive in length and enterprise can account typically available on corporate websites (frequently in the form of interactive reports). Because for its performance there is a general lack of regulation in this area of reporting, there is much variation in how the against its social reporting is being done. Some reporting approaches represent quite radical changes from how objectives and report financial accounting has traditionally been practised. As will be seen, some approaches (these are on that performance to evaluate observance in the minority) attempt to put a ‘cost’ on the social and environmental externalities caused by of the principles of business entities (such externalities are typically ignored by financial accountants). accountability. Related to the practice of social reporting is the practice of social auditing, which we will also briefly consider. Social auditing is undertaken by many large multinational companies, and typically provides the basis for information to be included in a social report, or the social performance section of a socialresponsibility or sustainability report. There have been noticeable trends in social and environmental reporting, which we will discuss. In the early 1990s environmental reporting came to greater prominence, initially more as a public relations exercise (such reports were often referred to as greenwash and were often thought to be simply part of an organisation’s public relations exercise). Throughout the 1990s the quality of reporting appeared to improve and organisations started to seek verification of the information (just as financial information is verified by an independent external party, it is common to find that the information in a sustainability report or corporate social responsibility report is also subject to some form of independent verification or assurance). In the late 1990s social reporting tended to increase, with a trend through the early 2000s towards sustainability reporting (which provides information about the economic, social and environmental performance of an entity). Because social and environmental accounting is predominantly voluntary, there has been a deal of research exploring the motivations for such disclosure. We will consider some of the motivations, and related theoretical perspectives, that have been suggested as driving the practice of social and environmental reporting. We will also consider evidence of how different stakeholder groups react to social and environmental information. The chapter will conclude with some discussion of the perceived future of social and environmental reporting as well as a discussion of various issues associated with the important topic of climate change. The material provided in this chapter emphasises a very important area of accounting—social and environmental accounting—an area that unfortunately receives fairly minimal attention within most accounting programs. As we would be aware, although organisations have many social and environmental impacts, accounting educators (as well as accounting standard-setters and practitioners) tend to fixate on procedures aimed at providing information about financial performance and this continues despite the great damage being done to the environment (with much of the harm being caused by business organisations) and the many social problems that prevail. Logically, the question can be social cost Cost imposed on society as a result of the operations or activities of a particular entity. Often referred to as ‘externalities’, and typically ignored by conventional accounting procedures.

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asked: how have we reached and maintained a situation where interest in the financial performance of organisations continues to swamp interest in the social and environmental performance of organisations? Global problems, such as climate change, suggest that there does need to be a profound change in focus, with greater emphasis given to corporations providing unbiased ‘accounts’ of their social and environmental performance and related impacts.

Social and environmental reporting defined

LO 30.1 LO 30.2 LO 30.5

Environmental reporting and social reporting are considered to represent components of the broader form of reporting commonly known as social-responsibility reporting. It is difficult to provide a precise definition of socialresponsibility reporting (or in the case of companies, it is often referred to as ‘corporate social-responsibility reporting’). Such a definition requires some consideration of, and perhaps consensus on, the social responsibilities of organisations. So, what is ‘corporate social responsibility’? There really is no consensus, but obviously it is central to the content and focus of this chapter. As the Australian Corporations and Markets Advisory Committee noted in its report titled The Social Responsibility of Corporations (2006, p. 13): The term ‘corporate social responsibility’ does not have a precise or fixed meaning. Some descriptions focus on corporate compliance with the spirit as well as the letter of applicable laws regulating corporate conduct. Other definitions refer to a business approach by which an enterprise takes into account the impacts of its activities on interest groups (often referred to as stakeholders) including, but extending beyond, shareholders, and balances longer-term societal impacts against shorter-term financial gains. These societal effects, going beyond the goods and services provided by companies and their returns to shareholders, are typically subdivided into environmental, social and economic impacts.

The above quote highlights that definitions of corporate social responsibilities typically extend the responsibilities of corporations beyond their shareholders alone, and incorporate activities over and above those relating to the usual provision of goods and services. Corporate social responsibilities also relate to measures of economic, social and environmental performance. One generally accepted definition of corporate social responsibility, and one that is consistent with the perspective adopted within this chapter, was provided by the Commission of European Communities (2001, p. 6) in which they stated that CSR is: . . . a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis. Being socially responsible means not only fulfilling legal expectations, but also going beyond compliance and investing more into human capital, the environment and the relations with stakeholders. Corporate social-responsibility reporting, perhaps somewhat obviously, provides information about how an organisation has addressed its corporate social responsibilities. Once we start discussing organisations’ choices to disclose information about their social and environmental performance, we accept, at least implicitly, that organisations have a responsibility, and associated accountability, not only for their financial performance but also for their environmental and social performance. The perceived responsibilities of organisations will conceivably differ from individual to individual within the community and, again, from culture to culture and period to period. Nevertheless, we will define social-responsibility reporting 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 providing information about an organisation’s: • interaction with the local community; • level of support for community projects; • level of support for developing countries; • level of support for employees within the supply chain; • health and safety record; • training, employment and education programs; • emissions of greenhouse gases; • water usage; • release of effluents into water courses; and • results with respect to minimising waste. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1053

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Social reporting, which is a component of corporate social-responsibility reporting, provides information about an organisation’s interaction with, and associated impacts on, particular societies. It would include the first six points just listed. According to the Global Reporting Initiative (2013): The social dimension of sustainability concerns the impacts the organization has on the social systems within which it operates. The Social Category includes the sub-Categories: • Labor Practices and Decent Work • Human Rights • Society • Product Responsibility. Environmental reporting is the communication of environmental-performance information by an organisation to its stakeholders and would include the last four bullet points of the ten provided above. According to the Global Reporting Initiative (2013): The environmental dimension of sustainability concerns the organization’s impact on living and non-living natural systems, including land, air, water and ecosystems. The Environmental Category covers impacts related to inputs (such as energy and water) and outputs (such as emissions, effluents and waste). In addition, it covers biodiversity, transport, and product and service-related impacts, as well as environmental compliance and expenditures. triple-bottom-line reporting Reporting that provides information about the economic, environmental and social performance of an entity.

sustainable development Development that meets the needs of the present world without compromising the ability of future generations to meet their own needs.

In the mid to late 1990s, more and more corporations throughout the world started discussing aspects of what has commonly become termed triple-bottom-line reporting. This term is still frequently used today. Triple-bottom-line reporting had been defined by Elkington (1997) as reporting that provides information about the economic, environmental and social performance of an entity. At the time it represented a departure from previous ‘bottom-line’ perspectives, which had traditionally focused solely on an entity’s financial or economic performance. The notion of reporting against the three components (or ‘bottom lines’) of economic, environmental and social performance was tied directly to the concept and goal of sustainable development—something that from the beginning of the 1990s began to appear on the agenda of many countries and large corporations. According to Elkington (1997): Sustainable development involves the simultaneous pursuit of economic prosperity, environmental quality, and social equity. Companies aiming for sustainability need to perform not against a single financial bottom line, but against the triple bottom line.

Sustainability

The above definition of triple-bottom-line reporting makes reference to sustainability. There are various definitions of sustainable development, but the one most commonly cited is ‘development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’ (World Commission on Environment and Development—The Brundtland Report 1987). It is an interesting exercise to consider how many corporations’ operations that we know of are actually ‘sustainable’ (or anywhere remotely close to it). Triple-bottom-line reporting, as well as sustainability reporting, will, if properly implemented, provide information that enables report readers to assess how sustainable an organisation’s or a community’s operations are. The perspective taken is that for an organisation (or a community) to be sustainable (a long-term perspective) it must be financially secure (as evidenced through such measures as profitability); it must minimise (or, ideally, eliminate) its negative environmental impacts; and it must act in conformity with societal expectations or else lose its ‘community licence to operate’. These three factors are obviously highly interrelated. Many people have linked the notion of ‘sustainable development’ with corporate responsibilities—that is, corporations should consider, or evaluate, how their operations are likely to impact (positively or negatively) on the ability of future generations to meet their own needs. The Shell 2014 Sustainability Report (p. 5) provides an insight into how Shell publicly promotes what sustainability means to Shell: 1054  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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Sustainability at Shell includes our being a respected and valued member of society, which is essential to the longevity of our business. It informs our business decisions and is embedded in our company culture and has long been part of our Business Principles and our day-to-day operations. What is interesting is that most companies do not seem to embrace ‘sustainable development’ in the ‘purest sense’, which would require some major changes to how they operate and a reduction in efforts to create ongoing business growth. Rather, they embrace it in such a way that they seek to reduce the negative impacts of their operations while still effectively embracing a ‘business-as-usual’ operating philosophy, wherein economic considerations, economic growth and the maximisation of shareholder value are of the utmost importance. As this chapter will demonstrate, social and environmental reporting, or sustainability reporting, are quite new forms of reporting, compared with financial reporting. There are generally accepted frameworks for general-purpose financial reporting, which are encapsulated within our accounting standards and the Conceptual Framework for Financial Reporting—as referred to in the previous chapters of this book. However, while there are numerous guidance documents for social and environmental reporting (and sustainability reporting), to date there is no uniform approach that is generally adopted by all organisations. There is no ‘conceptual framework’ for social and environmental reporting (although the Sustainability Reporting Guidelines developed by the Global Reporting Initiative—which we will discuss later in this chapter—have attracted widespread usage on an international basis), which means that there is limited consensus on such issues as the objectives, required qualitative characteristics, appropriate formats and the audience of social and environmental reporting. Hence there is much variation in how entities are providing social and environmental information—with obvious implications when trying to compare different entities’ performance. We will consider some of the various approaches to disclosing social and environmental information later in this chapter. At this point it is again emphasised that there is great variability in reporting approaches and terms such as corporate social reporting, social-responsibility reporting, triple-bottom-line reporting and sustainability reporting all seem to be used interchangeably. Indeed, when defining ‘sustainability reporting’, the Global Reporting Initiative states (as accessed in November 2015 at www.globalreporting.org): Sustainability reporting can help organizations to measure, understand and communicate their economic, environmental, social and governance performance, and then set goals, and manage change more effectively. A sustainability report is the key platform for communicating sustainability performance and impacts – whether positive or negative. Sustainability reporting can be considered as synonymous with other terms for non-financial reporting; triple bottom line reporting, corporate social responsibility (CSR) reporting, and more. It is also an intrinsic element of integrated reporting; a more recent development that combines the analysis of financial and non-financial performance. Now we will examine the responsibilities of business and whether these responsibilities can reasonably be expected to extend to providing information about corporate social and environmental performance.

What are the responsibilities of business (to whom and for what)?

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The issue of corporate social responsibility is very topical. For example, in Australia, and over the past decade, much media publicity has been given to the company James Hardie Ltd and its expected responsibilities to sufferers of illnesses associated with the asbestos previously used in some James Hardie products. There was a view within the community that despite the asbestos-related products having been sold decades earlier, when perhaps the health impacts of asbestos were relatively unknown, James Hardie Ltd nevertheless now had a social responsibility to help sufferers of the asbestos-related disease known as mesothelioma. Ultimately, James Hardie Ltd paid fairly large amounts of money into a fund to support sufferers (although many people believed they were too slow in making the payment and that the payments themselves were not large enough). As another example, and at an international level, there has been much media attention on the clothing trade being operated within various developing countries. Over time, and as discussed in Financial Accounting in the Real World 30.1, there have been many deaths and injuries in factories within developing countries such as Bangladesh. Many such factories manufacture clothes that are then sold by major international clothing brands to Western consumers. Read CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1055

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the newspaper article below and consider your own views about whether large global clothing organisations should have a responsibility to protect the health and safety of people employed within their supply chains—even though the Bangladeshi supply companies might not be directly related to, or employed by, the international clothing brands (they are effectively ‘outsourcing’ the clothing manufacture). The issue of how far corporate responsibilities should extend is a very subjective issue and people’s views on this will vary.

30.1 FINANCIAL ACCOUNTING IN THE REAL WORLD Are cheap clothes worth the cost? In October 2013 a fire in a garment factory in Gazipur, Bangladesh, killed seven workers. The Palmal Group, who owned Aswad Composite Mills, had ignored government inspectors and their warnings about the poor condition of the factory. Palmal denied culpability and said allegations about their labour practices were untrue. Palmal has 25 000 employees working in similar unsavoury conditions. Order forms for textiles from Australian companies including Just Jeans, Big W, Target and Kmart were found in the rubble after the fire.  Big W and Target distanced themselves from a relationship with Palmal but Kmart who is being proactive around producing clothes under fair, safe conditions, offered compensation to the fire victims’ families. This fire followed an earlier disaster in 2013 at Rana Plaza when 1100 workers died in a Greater Dhaka factory collapse.  Again order forms were found after the collapse that demonstrated the large mark-up on cheap garments when they were sold in first world countries. Although Benetton, an Italian brand, denied any connection to the Rana Plaza collapse, its labels were found on clothing in the debris. After the low wages of the Bangladeshi workers were revealed (less than $60 per month) the Pope said they were working as ‘slave labour’. After the Rana Plaza factory collapse NGOs and retailers that used Bangladeshi factories were shocked into action. An Accord on Factory and Building Safety in Bangladesh was created and signed by many companies that operated in Bangladesh. As reported in the Sunday Age, ‘The accord is clearly a step in the right direction. But concerns remain. An agreement such as the accord may struggle in a labyrinthine world of subcontractors and unscrupulous factory owners, unless Western companies take more responsibility for their entire supply chains. Second, we, as consumers, should vote with our wallets. That does not mean boycotting Bangladeshi products: that would only shift production to their competitors in China and leave impoverished families even worse off. It’s a start to choose products from companies that sign the accord over those that don’t. Furthermore, we could encourage companies to improve conditions in Bangladesh by making it worth their while. Many of us pay a premium for Fair Trade coffee and chocolate (not to mention free-range eggs); surely we would pay a few dollars more to guarantee that a T-shirt or dress had been made safely, and for a fair wage.’ The companies that signed the accord agreed to work for improved working and safety conditions in the country by the payment of a special subscription. Well-known Australian companies selling cheap clothing signed up to the accord: Kmart, Target, Cotton On, Forever New, Woolworths (for Big W) and Pacific Brands (for Bonds and Jockey). SOURCE: Adapted from ‘Onus is on us to help Bangladesh’s exploited workers’, Editorial, The Sunday Age, 5 January 2014

Having read Financial Accounting in the Real World 30.1, please reflect again upon your own views about corporate responsibilities. In the case of international clothing brands, do you think companies should be accountable for the health, safety and equitable treatment of employees in the organisations to which they have outsourced their

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production requirements? Should they provide a publicly available ‘account’ of what they are doing to ensure workers within their supply chain are treated ethically? While in the past many corporate managers might have given little direct consideration to stakeholders other than shareholders, this seems to have changed. An online global survey of corporate executives and institutional investors undertaken in October 2004 by The Economist Intelligence Unit (EIU), which investigated the perceived importance of corporate responsibility, found the following: • Eighty-five per cent of the responding executives and investors said that corporate social responsibility was a ‘central’ or ‘important’ consideration in their investment decisions. • Eighty-four per cent of those surveyed believed that corporate-responsibility practices could help the company’s bottom line; executives rated the most important aspects of corporate responsibility as the ethical behaviour of staff (67 per cent); and good corporate governance (58 per cent). Institutional investors alternatively emphasised transparency (62 per cent) over the ethical behaviour of staff (46 per cent). In a subsequent global survey of chief financial officers, investment professionals, institutional investors and CSR professionals by McKinsey & Company entitled ‘Valuing corporate social responsibility: McKinsey Global Survey Results’ (accessed at www.mckinsey.com in October 2015), there was: • general agreement among the people surveyed that social and environment-focused programs create shareholder value, though in times of economic crisis—such as the Global Financial Crisis—the importance attributed to social and environmental issues tends to decrease. It is of concern that social and environmental issues do tend to diminish in priority when economic problems arise. A long-term view would suggest that environmental and social issues should always be kept at the forefront of business decision making; • a view that maintaining a good corporate reputation or ‘brand’ is the most important way for social and environmental programs to create value. Perhaps it is also of concern that social and environmental initiatives are likely to be supported only if they ‘create value’ for an organisation. Arguably, doing the ‘right thing’ should be a core objective regardless of whether ‘value creation’ can be directly attributed to the actions; • agreement also among respondents that environmental and social programs create value over the long term as well as helping to attract, motivate and retain talented employees. Again, the respondents tended to think primarily of the business benefits when arguing in support of corporate social and environmental initiatives. There has long been much discussion about what information organisations should provide in relation to the various facets (for example, financial, social and environmental implications) of their performance. Many arguments are tied to subjective opinions about stakeholders’ rights to know (which if they are to carry any weight would seem to require some identification of the stakeholders involved), and associated opinions on the extent of an organisation’s accountability. Indeed, once we open a debate about the information that an entity should disclose, we are, in effect, entering a debate about the responsibilities and associated accountabilities of organisations. Is the sole function of a company to make a profit, or do companies have wider responsibilities to the societies in which they operate? What do you, the reader, think? As explained in Chapter 1 of this book, different people will have different views about the accountability that organisations should accept and demonstrate and therefore will have different views about what ‘accounts’ should be prepared and distributed to ‘stakeholders’. If we believe a company is responsible only for its financial performance and for providing financial returns to its shareholders (and this, unfortunately, does seem to be a view held by many accounting practitioners and educators), we might accept that there is only a need to produce financial accounts and that it is inappropriate, and indeed wasteful, to produce social and environmental performance information—unless doing so is expected to enhance the profitability of the organisation. There are many views on the responsibilities of business. At one extreme are the views of the famous economist Milton Friedman. In his widely cited book Capitalism and Freedom, Friedman rejects the view that corporate managers have any moral obligations or responsibilities. He notes (1962, p. 133) that such a view: shows a fundamental misconception of the character and nature of a free economy. In such an economy, there is one and only one social responsibility of business [and that is] to use its resources and engage in activities designed to increase its profits as long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud. At the other end of the ‘responsibility spectrum’ are those who hold the view that managers should manage the organisation for the benefit of all stakeholders, not just those with control over scarce resources. Taking a broader

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perspective on the responsibilities of business, an entity’s stakeholders have been defined by Freeman and Reed (1983, p. 91) as ‘any identifiable group or individual who can affect the achievement of an organisation’s objectives, or is affected by the achievement of an organisation’s objectives’. If we accept that an organisation has a responsibility to its ‘stakeholders’, then the broader an organisation defines its stakeholders the greater the responsibilities and associated accountabilities it will tend to accept. If we consider how organisations might define their stakeholders we can consider the 2015 Sustainability Report of the global mining company BHP Billiton Ltd. On page 61 of the report, BHP Billiton defines its stakeholders as follows: Our stakeholders can be defined as those who are potentially affected by our operations or who have an interest in, or influence, what we do. This definition is very similar to the definition of stakeholders provided by Freeman and Reed (1983)—as shown above. Again, how we define our stakeholders will in turn impact what responsibilities and accountabilities we accept. Indeed, in the same report, BHP Billiton states (p. 2): We regularly engage with our stakeholders to understand their areas of interest and to address their potential concerns about our operational activities. This would imply that BHP Billiton is accepting an accountability to a broad group of stakeholders. Of course, as we have already noted, whether the positions projected in such public statements actually reflect the ‘real’ operations of an organisation is not something about which we can be sure (and arguably, some cynicism is advisable). Divergent views on the responsibilities of business are nothing new and it is not likely there will ever be agreement on how far, and to whom, the social responsibilities of an organisation should extend. Reflective of this, and in an Australian report by the Corporations and Markets Advisory Committee (December 2006), it was stated (p. 19): In a famous debate in the 1930s, Professor Adolf Berle, in supporting the ‘shareholder primacy’ view, argued that the powers and duties given to directors of a corporation should be exercisable only for the benefit of, and to maximise the profits for, the shareholders, given that they are the investors who have put their capital at risk, and that the directors should be answerable only to them. Any attempt to broaden these responsibilities to persons other than shareholders may result in directors having no legally enforceable responsibilities to anyone. In reply, Professor Merrick Dodd argued that larger corporations owe duties to the broader community, not just shareholders, and that directors should have greater leeway to take non-shareholder interests into account. An argument in support was that, as the act of incorporation confers significant privileges (including perpetual succession and limited liability), society is entitled to expect that a corporation will act in the general public interest, not just out of self-interest. At the community level, community-based surveys seem to clearly indicate that a vast number of individuals within society, both in Australia and overseas, believe that corporations are responsible and accountable for their social and environmental performance (that is, their accountability extends beyond their financial performance). Again, we must appreciate the link between perceived corporate responsibilities and associated accountabilities. If an entity is not considered to have a responsibility in relation to a particular aspect of its performance, it would not be expected to provide an ‘account’ of that performance. Because different teams of managers will have different views about corporate social responsibilities and associated accountability, they will inevitably provide different sets of ‘accounts’. If an organisation adopts a broad perspective in identifying its stakeholders (as opposed to a narrow perspective, which might admit only shareholders), this will normally mean that it will choose to provide information about quite a diverse range of the organisation’s activities in order to satisfy the information needs and expectations of the various stakeholder groups. By contrast, if an entity has a narrow perspective on identifying its stakeholders, it might produce a limited amount of performance information, perhaps restricted just to information about financial performance. social benefits However, not all segments of the community embrace broad perspectives on corporate Benefits generated by responsibility. For example, we could be excused for thinking that many individuals working within the an entity for society, or a segment thereof, contemporary financial press hold the same view as Friedman (a restricted view of responsibilities, such as provision of as noted above). The financial press continues to praise companies for increased profitability and to education, clean water, criticise companies who are subject to falling profitability. They often do this with little or no regard safe products and to the social costs or social benefits (which are not directly incorporated within reported profit) health care. generated by the operations of the entities concerned. 1058  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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Examine your own opinions: what sort of information do you think organisations should disclose, and to whom should they make the disclosures (who are the stakeholders)? Do you think your views about organisations’ accountabilities would be the same as those of your fellow students? Perhaps ask them. It is easy to see just how subjective such assessments are. Somewhat surprisingly, and as already alluded to, many students of accounting complete their accounting qualifications without ever considering issues associated with the accountability of business. Often, a study of accounting starts with a detailed introduction to debits and credits. A better approach (surely?) would be to concentrate initially on ‘accountability’ and its relationship to ‘accounting’ with an acceptance that ‘accounting’ and ‘accounts’ do not have to be restricted to ‘financial accounting’, and to ‘financial accounts’. But the practice of accounting, which, at a fairly simplistic level, can be defined as the provision of information about the performance of an entity to a particular group of report readers (or stakeholders), cannot be divorced from a consideration of the extent of an entity’s accountability responsibility and accountability. This linkage should always be considered. If we accept that an The duty to provide an entity has a responsibility for its social and environmental performance, we, as accountants, should account or reckoning accept a duty to provide an ‘account’ of an organisation’s social and environmental performance. If of those actions for we don’t accept this, then we won’t feel obliged to provide such an account. which one can be held At this point it would be useful to consider a definition of accountability. Let us adopt the responsible. definition of accountability provided by Gray, Adams and Owen (2014, p. 50), which is: a duty to provide an account (by no means necessarily a financial account) or reckoning of those actions for which one is held responsible. According to Gray, Adams and Owen, accountability involves two responsibilities or duties, these being: 1. the responsibility to undertake certain actions (or to refrain from taking certain actions) 2. the responsibility to provide an account of those actions. Accepting the above simple but useful definition, we can again see that perceptions of accountability depend on subjective perceptions of the extent of an organisation’s responsibility. Are businesses responsible to their direct owners (shareholders) alone, or do they owe a duty to the wider community in which they operate? Certainly, many organisations make public statements to the effect that they consider that they do have responsibilities to parties other than just their shareholders. Accounting researchers often link the practice or role of social and environmental accounting with the concept of accountability. For example, Gray and Laughlin (2012, p. 240) state: Social accounting is concerned with exploring how the social and environmental activities undertaken (or not, as the case may be) by different elements of a society can be—and are—expressed. In essence, how they are made speakable—even knowable. So the process of social accounting then offers a means whereby the nonfinancial might be created, captured, articulated, and spoken. The analysis of such accounts—and their absence (Choudhury, 1988)—provides a basis through which social accountability can clarify how the relationships which are largely dominated by the economic (Thielemann, 2000) might be renegotiated to accommodate—or even to prioritise—the social and the environmental within these relationships. Gray, Adams and Owen (2014, p. 4) further note that the resulting social and environmental ‘accounts’ that emanate from this form of accounting: may serve a number of purposes but discharge of the organisation’s accountability to its stakeholders must be clearly dominant of those reasons and the basis upon which the social account is judged. But corporations do have some constraints on the extent to which they can pursue various social responsibility activities. Within the corporations legislation in place within many countries there is a specific requirement that corporate managers manage the company for the benefits of the owners, or in the ‘best interests’ of the company. For example, within Australia, the major guiding principal within the Corporations Act pertaining to the responsibility of corporate officers in terms of the strategies used to run a business is provided by Section 181(1). This section, which is often referred to as the ‘good faith requirement’, requires: A director or other officer of a corporation must exercise their powers and discharge their duties: (a) in good faith in the best interests of the corporation; and (b) for a proper purpose. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1059

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As Deegan and Shelly (2014) note, however, there is much ambiguity in the above requirement as it pertains to corporate social responsibilities. Many people believe that the ‘best interests of the corporation’ necessarily require corporate officers to consider the needs of a broad group of stakeholders and the environment. However, many other individuals reject such a view and believe that Section 181(1) actually discourages companies from considering the needs of stakeholders (other than shareholders), and the needs of the environment. Such ambiguity in the law is obviously not helpful. Financial Accounting in the Real World 30.2 provides different perspectives on how current corporate laws might impact corporate social responsibility and how there is a potential need for changes in the laws.

30.2 FINANCIAL ACCOUNTING IN THE REAL WORLD Corporate social responsibility v. the bottom line: the impact of social media In Australia, under the law, company directors have to prioritise their shareholders over everything, including consumers and the environment. Rod McGeoch, a director of Ramsay Health Care and Sky City, regretted the situation where the law did not recognise community interests. He mentioned a recent planning decision where the community impact of a Rio Tinto mine expansion had to be ignored.  With the rise of social media, directors are torn as a company’s activities are open to scrutiny by the public far more than in the past. Consumers and customers can interact directly with a company or via social media to express their opinions. If a company doesn’t respond to negative feedback its image may be tarnished. Directors who want to react in a socially responsible way may, in doing so, breach their duties. The former Australian Securities and Investments Commission chairman, Tony D’Aloisio, discussed the issue and described how things had changed since 10 years previously when two government reports from the Corporations and Markets Advisory Committee and the Parliamentary Joint Committee on Corporations and Financial Services, had dismissed the need to update the duties of company directors. D’Aloisio said that taking a social position after customer reaction on social media could lead to breach of director’s duty. The controversial Abbot Point coal port expansion, subject to a negative social media campaign because of its proximity to the Great Barrier Reef in Queensland has seen a flurry of withdrawal of financial support from Citi, Morgan Stanley, Goldman Sachs and JPMorgan Chase. A social media campaign created by Australian Youth Climate Coalition with methods like an online postcard petition and the tag #riskingthereef targeted Westpac, NAB, ANZ and Commonwealth Bank over the same issue. Leeora Black, managing director at the Australian Centre for Corporate Social Responsibility told a Governance Institute of Australia forum that one director had said to her that if he was socially responsible he could go to gaol. A spokesperson for Governance Institute, Judith Fox, stated that it was time, in the digital age, for a change to director’s duties. A discussion paper by the Governance Institute’s proposed means by which social responsibility can be included as part of directors’ duties. The most prescriptive is a legislative change which will make consideration of the social and environmental effect of company behaviour by directors compulsory.  The exercise of corporate social responsibility can be expensive and time-consuming when companies have to tackle big issues like fast food companies around obesity and miners around damage to ground water. The more likely result is that the government will allow directors to consider the social and environmental impacts rather than compel them to, as is the case in the UK. SOURCE: Adapted from ‘Directors’ boundaries tested by social media’, by Misa Han, The Australian Financial Review, 31 October 2014, p. 32

Another issue is whether the responsibility of business is restricted to current generations, or whether the implications for future generations should be factored into current management decisions. That is, are future generations a stakeholder of an organisation? If sustainability is embraced, our current production patterns should not compromise 1060  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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the ability of future generations to satisfy their own needs. Such a view is being publicly embraced throughout the world by many organisations. For example, consider the following statement made a number of years ago by General Motors (US) in its 1997 Environmental, Health and Safety Report: Business opportunities and social responsibility go hand-in-hand. Corporations must act responsibly in regard to their business and to the natural environments in which they operate; successful companies do not separate the two. The balance of economic and environmental benefit is the cornerstone of sustainable development. It is for the subsequent generation that we must focus on sustainable development efforts. Sentiments such as these reflect the public positions being promoted by many organisations. Again, whether these public positions actually inform decision making within the firm is another matter—we clearly cannot be sure (arguably, and as already noted, we should always be somewhat cynical of the public statements made by corporate managers). That is, there could be a decoupling (or a disconnection) between the public positions being projected, and the internal workings of the organisation. The article ‘Meeting the social need’ adapted in Financial Accounting in the Real World 30.3 supports the view that business organisations do have social responsibilities.

30.3 FINANCIAL ACCOUNTING IN THE REAL WORLD The case for Corporate Social Responsibility It is undoubtedly the case that nowadays there are far higher expectations of the behaviour of companies than in the past. The need for companies to exhibit corporate social responsibility (CSR) has created challenges and opportunities. CSR initiatives offered by companies in Australia include providing pro bono services, philanthropic partnerships, educational and volunteering programs and policies to minimise their environmental footprint. These are sometimes regarded as ‘token’ policies, but real commitment can pay off. Many consumers and customers want to support companies with socially and environmentally responsible agendas. These can change over time as issues become more or less prominent. A case in point is the interest in climate change and global warming which now has to inform the practices of many companies; no one considered global warming an issue only decades ago. Companies, because of their access and resources, are expected to lead the way in combating global warming and show more than tokenism in their actions. However, with the economic downturn, following CSR principles will cost money that companies may be tempted to spend elsewhere. Sensible accountants will make a case for continuing CSR commitments; socially responsible conduct can lead to greater financial benefits for organisations, as ‘enhanced reputation, competitive advantages, better risk management, equity and debt capital attraction, greater employee satisfaction and enhanced global expansion possibilities . . . add to the bottom line’. The commitment to social reponsibility can be an advantage over less socially responsible companies and a good way to differentiate organisations to potential investors. Organisations exist and thrive in the space that society creates for them and they consequently have a responsibility to support and improve that society, particularly during times of economic downturn. SOURCE: Adapted from ‘Meeting the social need’, by Jim Psaros, The Newcastle Herald, 23 February 2009, p. 20

Evidence of public social and environmental reporting As already noted in this chapter, the dominant focus for external corporate reporting has traditionally been financial reporting. Financial reporting is heavily regulated, and rules within the Corporations Act 2001 and accounting standards must be followed by corporations (securities exchange disclosure requirements must also be followed by listed companies).

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Since the early 1990s, many Australian companies have increased their output of public information on their environmental performance. Initially, this information was voluntarily included within annual reports. However, from the mid-1990s many Australian companies began producing stand-alone environmental reports. In the late 1990s a number of Australian companies started producing stand-alone social reports and, more recently, companies have been producing publicly available sustainability reports (also commonly referred to as socialresponsibility reports). While reports in the early 1990s were typically not subject to any independent verification, it is now becoming common for social and environmental reports to be subject to some form of verification or assurance. However, as with the reporting itself, there is much variation in what the verification, or audit, reports actually do and say. At an international level, we can consider the KPMG International Survey of Corporate Responsibility Reporting 2013. KPMG surveyed 4100 companies across 41 countries. From their survey, they report (p. 10): • there have been recent increases in the corporate responsibility (CR) reporting rates in the Asia Pacific region. Almost three-quarters of companies based in Asia Pacific publish corporate responsibility (CR) reports, which is an increase of 22 per cent since 2011; • the Americas have overtaken Europe as the leading CR reporting region, largely due to an increase in CR reporting in Latin America. Seventy-six per cent of companies in the Americas report on CR, 73 per cent in Europe and 71 per cent in Asia Pacific; • CR reporting is now undeniably a mainstream business practice worldwide and is undertaken by almost threequarters of the 4100 companies surveyed in 2013; • among the world’s largest 250 companies, the CR reporting rate is 93 per cent. While KPMG (2013) provide evidence that CR reporting has increased, there were nevertheless numerous perceived shortcomings with the way the information was reported. The major shortcomings identified by KPMG (2013) were: • more transparency was needed in relation to the ‘materiality process’ (that is, more information needs to be provided in terms of why some social and environmental performance-related items were disclosed, but others were not); • targets and indicators were not well defined; • reporting on suppliers’ policies and performance and the value chain is lacking; • companies often fail to explain their stakeholder engagement processes; • few large companies appear to link CR performance to executive remuneration; • transparency and balance is limited for most companies. Therefore, while the incidence of social and environmental reporting is increasing internationally, there are still numerous issues to address in terms of increasing the quality of the reporting. In the KPMG study, Australia ranked 12th out of 41 countries surveyed (compared to 23rd out of the 34 countries surveyed in 2011), with 82 per cent of the top 100 companies in the sample producing a stand-alone corporate responsibility report (up from 57 per cent in 2011, 45 per cent in 2008, 23 per cent in 2005, 14 per cent in 2002 and 5 per cent in 1996). So, to this point of the chapter we have provided insights into the meaning of corporate social responsibility, and social and environmental reporting. We have also considered different perceptions about the social responsibilities of business as well as the relationship between corporate responsibility, accountability and accounting. Evidence of the extent of organisations preparing social and environmental reports has also been provided. Having established this necessary foundation for our discussion we will now examine, in turn, what might be considered as four stages of reporting. Specifically we will now consider: 1. Why report? That is, we will consider some possible explanations for why managers would voluntarily elect to produce publicly available information about their organisation’s social and environmental performance. 2. To whom will the organisation report? This issue will be directly related to the issue above and will be influenced by decisions about who are the ‘stakeholders’ of the organisation. 3. What information shall be produced? This will be linked to the above points and to the information needs and expectations of the identified stakeholders of the organisation. 4. How (and where) will the information be presented? As we will see, there are various guidelines and approaches to reporting social and environmental information. 1062  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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Why report?

LO 30.7 LO 30.8

The first issue any organisation needs to consider before it sets out on a journey of reporting social and environmental information is ‘why’ are they going to report? This is not necessarily a straightforward question. As noted previously in this chapter, there is a general lack of regulation requiring organisations to publicly disclose information about their social and environmental performance. Nevertheless, as we have seen already, many organisations voluntarily elect to publicly disclose information about their social and environmental performance, albeit in a variety of ways. What motivates organisations to voluntarily disclose particular information, including social and environmental information, is an issue that has been the subject of much research. It is an interesting question. In an article entitled ‘Social responsibility has a dollar value’ that was written by Chip Goodyear, CEO of BHP Billiton Ltd, and which was printed in The Age on 27 July 2006, Goodyear refers to the ‘business case’ as the motivating factor for corporate social responsibility and related reporting. In the article, he states: For BHP Billiton, corporate social responsibility isn’t a case of a stockholder versus stakeholder argument, but is a critical part of maximising shareholder returns. Simply, corporate social responsibility is in the best interests of our shareholders and is fundamental to profit creation and sustainability. . . . These days, the benefits BHP Billiton gets from achieving a high standard of corporate social responsibility are indisputable. Without our reputation as a corporate citizen contributing positively to our communities, there is no doubt our profitability would be hampered and shareholder value destroyed. Access to natural resources would be more difficult: what government wants a socially irresponsible mining company creating unrest among its constituents? . . . BHP Billiton realised a long time ago that working in partnership with communities is more than about being a good corporate citizen. It’s a powerful competitive differentiator. It has the potential to establish us as the company of choice, giving us better access to markets, natural resources and the best and brightest employees. By doing so, we can maximise profits for our shareholders while also ensuring we do the right thing by those who are impacted by our business. The above perspective of doing the ‘right thing’ because it benefits the organisation is increasingly being referred to as ‘enlightened self-interest’. To derive the business benefits from ‘doing the right thing’ requires the community to know about the activities of the organisation and this is one of the roles of corporate reporting. Many activities can occur within an organisation, but unless the organisation makes public disclosures, then the community might not know about such activities—the community’s attitude towards the company will not be influenced unless the community actually knows about particular corporate initiatives, and this can be one of the roles of corporate reporting. Depending on the theoretical perspective adopted, different motivations can be attributed to particular actions. We will consider some possible motivations that might drive organisations to produce social and environmental information. However, we must keep in mind that we can never be sure what the real motivation might be nor can we ever hope to provide a comprehensive list of motivations. Further, in practice there will likely be multiple motivations driving corporate reporting. With this said, motivations for disclosing social and environmental information could include: • to comply with with legal requirements; • to forestall efforts to introduce more onerous disclosure regulations; • to influence the perceived legitimacy of the organisation; • to manage particular (and possibly powerful) stakeholder groups; • to increase the wealth of the shareholders and the managers of the organisation; and/or • a belief on the part of managers that the entity has an accountability (or a duty) to provide particular information. In the material that follows, we will consider each of the above motivations in turn.

Compliance with legal requirements One reason why organisations might publicly report particular information is that there is a legal requirement to do so. However, in the case of social and environmental reporting this is generally not the case as there are very few mandatory public reporting requirements. We will now consider some of the few requirements that do exist.

Reporting requirements within accounting standards Within accounting standards there are a limited number of requirements for specific financial information to be disclosed in relation to environment-related aspects of performance. A specific requirement for companies to provide environmental CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1063

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information in their annual reports can be found in AASB 116 Property, Plant and Equipment, which 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. A further accounting standard that has some relevance to accounting for the environment is AASB 137 Provisions, Contingent Liabilities and Contingent Assets. Obligations relating to environmental performance could be considered to be either included in ‘provisions’ or ‘contingent liabilities’, depending upon the circumstances. Appendix C to AASB 137 provides an example of an environment-related liability. It is reproduced in Exhibit 30.1. AASB 137 Provisions, Contingent Liabilities and Contingent Assets also states that ‘constructive obligations’ will often require recognition in an entity’s financial statements. Paragraph 10 of AASB 137 defines constructive obligations, while paragraph 21 provides some discussion of constructive obligations.

10.  A constructive obligation is an obligation that derives from an entity’s actions where: (a)  by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and (b)  as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. 21.  An event that does not give rise to an obligation immediately may do so at a later date, because of changes in the law or because an act (for example, a sufficiently specific public statement) by the entity gives rise to a constructive obligation. For example, when environmental damage is caused there may be no obligation to remedy the consequences. However, the causing of the damage will become an obligating event when a new law requires the existing damage to be rectified or when the entity publicly accepts responsibility for rectification in a way that creates a constructive obligation.

Exhibit 30.1 Example of how AASB 137 is applied to environmentrelated liabilities

An entity operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of production and restore the seabed. Ninety per cent of the eventual costs relate to the removal of the oil rig and restoration of damage caused by building it, and 10 per cent arise through the extraction of oil. At the end of the reporting period, the rig has been constructed but no oil has been extracted. Present obligation as a result of a past obligating event: The construction of the oil rig creates a legal obligation under the terms of the licence to remove the rig and restore the seabed and is thus an obligating event. At the end of the reporting period, however, there is no obligation to rectify the damage that will be caused by extraction of the oil. An outflow of resources embodying economic benefits in settlement: Probable. Conclusion: A provision is recognised for the best estimate of 90 per cent of the eventual costs that relate to the removal of the oil rig and restoration of damage caused by building it (see paragraph 14). These costs are included as part of the cost of the oil rig. The 10 per cent of costs that arise through the extraction of oil are recognised as a liability when the oil is extracted.

While there is limited coverage of environmental issues in accounting standards—as detailed above—what coverage there is is restricted to the financial consequences of various actions, rather than being driven by a desire to provide readers with information about the social and environmental performance of a reporting entity.

Corporate law disclosure requirements Apart from accounting standards, we can also consider specific requirements of the Corporations Act. Within Australia, Section 299(1)(f) of the Corporations Act requires that if an entity’s operations are subject to any significant environmental 1064  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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regulation under a law of the Commonwealth or of a state or territory, details of the entity’s performance in relation to the environmental regulation must be provided in the company’s Directors’ Report. Exhibit 30.2 provides the required disclosure from the Directors’ Report appearing in the 2015 Annual Report of BHP Billiton Ltd.

Performance in relation to environmental regulation BHP Billiton seeks to be compliant with all applicable environmental laws and regulations relevant to its operations. We monitor compliance on a regular basis, including through external and internal means, to ensure that the risk of non-compliance is minimised. Fines and prosecutions In FY2015, BHP Billiton received 13 fines at our operated assets, with a total value of US$32,454. Two fines totalling US$17,963 were received in respect of the Cannington silver-lead-zinc mine for contravention of permit conditions at the port facility. One fine was for particulates from a dust collector baghouse stack being above release limit, and the other fine was for failure to notify the event in the timeframe required. Actions including real-time monitoring and process interlocks were implemented to prevent such an incident recurring. BHP Billiton Mitsubishi Alliance received two fines totalling US$11,371 for separate noncompliances at the Caval Ridge Mine and Saraji Mine. Both incidents were related to uncontrolled releases of mine-affected water that did not meet the conditions of each operation’s Environmental Authority governed by the Queensland Environmental Protection Act (1994). Corrective and preventative actions have been implemented to prevent these events recurring. The nine other fines, totalling US$3,120, were levied in North America and South Africa where our operations were cited for activities including exceeding discharge quality levels, unauthorised land disturbance, failure to update facility contact information and a delinquent mechanical integrity test. The impacted assets are reviewing measures, or have implemented actions, to prevent these incidents from occurring in the future.

Exhibit 30.2 Example of disclosure required pursuant to Section 299(1)(f)

Greenhouse gas emissions The UK Companies Act 2006 requires the Company, to the extent practicable, to obtain relevant information on the Company’s annual quantity of greenhouse gas emissions, which is reported in tonnes of carbon dioxide equivalent. The Company’s total FY2015 greenhouse gas emissions and intensity are set out in sections 1.10 and 1.14.4 of this Annual Report. Further information in relation to environmental performance, including environmental regulation, can be found in section 1.14 of this Annual Report and in the Sustainability Report, which is available online at www.bhpbilliton.com.

Subsections 1013(A) to (F) of the Corporations Act require providers of financial products that have an investment component to disclose the extent to which labour standards, and environmental, social and/or ethical considerations are taken into account within investment decision making. Section 299A of the Corporations Act is also relevant. Under this provision, listed companies are required to include in the Directors’ Report any information that shareholders would reasonably require to make an informed assessment of: • the operations of the company reported on; • the company’s financial position; and • the company’s business strategies and its prospects for future financial years. An exception applies to any material the publication of which would result in unreasonable prejudice to the company. The Explanatory Memorandum to s. 299A (released by ASIC) stated that the provision was intentionally expressed in broad terms in order to: • enable directors to make their own assessment of the information needs of shareholders of companies and tailor their disclosures accordingly; and CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1065

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• provide flexibility in form and content of the disclosures as the information needs of shareholders, and the wider capital market, evolve over time. The Explanatory Memorandum also indicated that directors are expected to consider best practice guidance such as the Guide to the Review of Operations and Financial Condition prepared and published by the Group of 100 Inc. This guide refers to the disclosure of financial as well as non-financial information and to the inclusion, where appropriate, of sustainability measures, including social and environmental performance indicators. Apart from these requirements provided above, there are no other annual report disclosure requirements that relate specifically to a corporation’s environmental performance or any environment-related expenditures or obligations. Going beyond corporate annual reports, at both the federal and state levels, certain organisations are required to make disclosures to such bodies as environmental protection agencies (perhaps in relation to compliance with particular licensing requirements), but such information does not have to appear in a publicly released report such as an annual report or CSR/sustainability report. Some examples of required disclosures are provided below.

National Pollutant Inventory At a national level we have the National Pollutant Inventory (NPI). This mechanism requires details to be provided by entities about emissions to air, water and land of a defined list of substances, where such emissions or releases exceed a particular threshold. This requirement effectively applies to only a limited number of organisations. The NPI does not require reporting on greenhouse gas emissions or ozone-depleting substances—these are required by the National Greenhouse and Energy Reporting Scheme, which we consider below. The rationale behind the creation of publicly assessable databases such as the NPI is that communities have a ‘right to know’ about the hazards that are potentially created by nearby facilities, and that in making the information publicly available this will generate an incentive for organisational change through a combination of public pressure and heightened corporate awareness. The information submitted to the NPI is publicly available via the NPI’s website (www.npi.gov.au). The organisations that make disclosures to the NPI are not required to disclose the information in any public documents they release—such as annual reports or sustainability reports. However, many interested stakeholders would be unaware of the NPI. The purpose of having a database such as the NPI is effectively to ‘name and shame’ high-emitting organisations and to create pressures for them to change. But pressure for change is dependent upon people in the community actually knowing about the NPI (and how many of you readers actually know about this database?). Media coverage of the NPI is scarce (Weng et al 2012) and evidence would seem to suggest that the NPI has been ineffective in changing corporate behaviour within Australia, particularly relative to other countries that have implemented similar schemes.

National Greenhouse and Energy Reporting Act 2007 (Cwlth) (NGER Act) Also at a national level, the National Greenhouse and Energy Reporting Act 2007 (Cwlth) (NGER Act) is a national framework for the reporting and dissemination of information about the greenhouse gas emissions, greenhouse gas projects, and energy use and production of corporations. Businesses are required to apply for registration with the Greenhouse and Energy Data Officer if they meet a reporting threshold for greenhouse gases or energy use or production for a reporting (financial) year. Corporate groups that meet an NGER threshold must report their: • greenhouse gas emissions; • energy production; • energy consumption; and • other information specified under NGER legislation. The data must be provided on behalf of the corporate group by its registered holding company (known as the ‘controlling corporation’). For these purposes, a corporate group includes the following, in addition to the controlling corporation itself: • subsidiaries of the controlling corporation; • unincorporated joint ventures in which a member of the corporate group is a participant; • partnerships in which a member of the corporate group is a partner. Aggregated greenhouse gas emissions and energy consumption data for the group will be published by the Greenhouse and Energy Data Officer for each reporting period (financial year). In addition, the Greenhouse and 1066  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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Energy Data Officer may choose to publish such information for each member or business unit of the group. According to the website: The data is published to inform the Australian public about greenhouse gas emissions and energy usage in Australia. It provides a snapshot of greenhouse gas emissions and energy consumption by corporations in Australia, and will be used to inform the development of government policy, assist government programs and activities, and meet international reporting obligations. Again, it is questionable whether many people are aware of this website and the data that is available (for example, are you the reader aware of it?).

Energy Efficiency Opportunities Act 2006 (Cwlth) The Energy Efficiency Opportunities Program, established under the Energy Efficiency Opportunities (EEO) Act, encourages large energy-using businesses to improve their energy efficiency. It does this by requiring businesses to identify, evaluate and report publicly on cost-effective energy savings opportunities. Participation in the Energy Efficiency Opportunities Program is mandatory for corporations that use more than 0.5 petajoules (PJ) of energy per year. This is approximately equivalent to the energy used by 10 000 households. Australian businesses participating in the Energy Efficiency Opportunities Program are required to undertake detailed energy assessments in order to identify opportunities to improve energy use and to report publicly on the outcomes. That is, participants in the program are required to assess their energy use and report publicly on the results of the assessment and the business response. Corporations must report publicly on the results of their energy efficiency assessments and the opportunities that exist for projects with a financial payback of up to four years. The focus is on the energy-saving opportunities identified in the assessment and the business response to those opportunities. While the disclosures required by the various regulatory regimes discussed above (for example, NGER Act, NPI, EEO Act) are mandatory for certain organisations, the organisations are not compelled to disclose the information in their own annual reports or sustainability reports, or on their websites. Although the information is publicly accessible, it would be reasonable to argue that many people would be unaware of the various databases available. Hence the likelihood that the information will shape community attitudes seems low. Perhaps more publicity should be given to the various databases available through government advertising of the respective sites. Again, the idea behind establishing these sites is that public reporting will create public pressures on organisations to change if their performance appears to be relatively poor—but this obviously requires that the public actually know about these websites in the first place.

Requirements of the Australian Securities Exchange Corporate Governance Council Each ASX-listed entity is required to include in its annual report either a corporate governance statement or a link to the page on its website where such a statement is located. The corporate governance statement must disclose the extent to which the entity has followed the recommendations set by the Corporate Governance Council during the reporting period. These recommendations are included within the ASX Corporate Governance Principles and Recommendations, 3rd edition (2014). Under the ASX Principles and Recommendations, if the board of a listed entity considers that a Council recommendation is not appropriate to its particular circumstances, it is not required to adopt it—but it must explain why it has not adopted the recommendation. That is, the AX requires the ‘if not, why not’ approach to disclosures about corporate governance. Recommendation 7.4 of the ASX Principles and Recommendations is that: A listed entity should disclose whether it has any material exposure to economic, environmental and social sustainability risks and, if it does, how it manages or intends to manage those risks. The commentary suggests that, in part, the purpose of more detailed economic, environmental and social sustainability disclosures is to allow investors to properly assess investment risk and encourages companies to disclose the benchmarks they use to measure performance and their achievement against those benchmarks. As with environmental performance—which has been the main focus of the preceding discussion—organisations are generally not required to publicly disclose in their annual reports information about their social performance. For example, there is no requirement for a company to disclose information about its support of local communities, its employment or education policies or its support of charitable organisations. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1067

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If we consider existing mandatory corporate reporting frameworks as constituted by accounting standards, corporations law reporting requirements and securities exchange reporting requirements, it would appear that external reporting requirements have focused predominantly on providing financial-performance information to parties with a financial stake in the corporation. Such a narrow approach to accountability by Australian regulators, according to which attention is primarily focused on the needs and expectations of shareholders (rather than stakeholders generally), is commonly referred to as the ‘shareholder primacy’ view of corporate reporting. This approach to reporting is found in many other countries too. The shareholder primacy approach generally adopted within Australia is increasingly being challenged by various interest groups. Up to now, however, government has tended to leave corporations, their industry bodies and ‘the market’ to determine the extent of corporate social and environmental disclosure. This is evidenced by the very limited disclosure requirements pertaining to non-financial performance issues associated with social and environmental issues. In this regard, Frank Cicutto, former chief executive officer of National Australia Bank, stated (as quoted in the Journal of Banking and Financial Services, December 2002, p. 17): In recent decades the efficient use of shareholder funds has been carefully protected by the creation of ASIC and the continuing development of the ASX listing rules. In a regulatory sense the focus of legislative change has been around accountability to investors rather than to the community. While the statement above was made as far back as 2002, it would seem that it is just as relevant today. This is unfortunate. Having discussed some of the very few public reporting requirements that exist within Australia as they pertain to social and environmental performance, we are probably safe to conclude that the extent of reporting currently occurring within Australia is not being driven by a motivation to comply with legal requirements. Before we consider some other possible motivations for reporting, it should be noted that there are some countries that have taken the lead on mandating greater amounts of public social and environmental reporting. For example: • France—pursuant to the French Economic Regulations Law (NRE), there is a legal obligation for French corporations to provide information within their annual reports about their social and environmental performance. Such disclosures are to include information about their use of energy, water and raw materials; levels of emissions to air, land and water; development of environmental management systems; and details of certifications and compliances with standards. Information pertaining to specific qualitative and quantitative indicators is to be disclosed. From 2003, French companies listed on the ‘premier marche’ (those with the largest market capitalisation) are also to include in their annual report ‘information on how the company takes into account the social and environmental consequences of its activities’. • Denmark— a requirement for CSR reporting was incorporated within the Danish Financial Statements Act in 2008. The requirements are that large companies must either disclose their CSR policies, how they implement them, and what they have achieved or state explicitly that they do not have CSR policies. Companies with CSR policies—just about all of the large companies—must include the following information in their report: • the company’s CSR policies, including any CSR standards, guidelines or principles applied by the company; • how the company translates its CSR policies into actions, including any systems or procedures used; • the company’s assessment of what it has achieved as a result of CSR initiatives during the financial year; and • any future expectations to these initiatives. The CSR report is part of the management review section of the annual report: • Norway—the Accounting Act 1999 requires specific disclosures to be made in the Directors’ Report that is included in the annual report. Information must be disclosed about the organisation’s impact on the environment (for example, through the use of particular resources), together with activities that have been undertaken to reduce the impact of the organisation upon the environment. A detailed list of social and environmental indicators is provided. • South Africa—companies listed on the Johannesburg Stock Exchange have, since 2003, been required to report annually on their social and environmental performance using the Global Reporting Initiative Sustainability Reporting Guidelines. In contrast with some overseas governments, it is interesting to speculate on why Australian regulators have appeared loath to introduce specific sustainability-related disclosure requirements in corporate annual reports. As already indicated, there was a government inquiry into the social responsibilities of corporations, but the decision of the Parliamentary Joint Committee on Corporations and Financial Services was that additional legislation was not required. 1068  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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In its final report (June 2006), the committee indicated that corporations already know it is in their own self-interest to do the ‘right thing’ in relation to their social and environmental performance because a failure to do so would jeopardise their future profits (this is known as ‘enlightened self-interest’). In making its decision the committee supported the view of the business community that no further regulation was necessary and that a voluntary framework is preferable. This was not a view embraced by the majority of other (non-corporate) respondents. As the government committee stated (PJCCFS 2006, p. xiv): This ‘enlightened self-interest’ interpretation is favoured by the committee. Evidence received suggests that those companies already undertaking responsible corporate behaviour are being driven by factors that are clearly in the interests of the company. . . . Maintaining and improving company reputation was cited as an important factor by companies, many of whom recognise that when corporate reputation suffers there can be significant business costs. Evidence also strongly suggested that an ‘enlightened self-interest approach’ assists companies in their efforts to recruit and retain high quality staff, particularly in the current tight labour market. We can only wonder why the Australian government thinks that ‘enlightened self-interest’ is the panacea for our social and environmental performance and reporting ills given that freely operating ‘enlightened self-interest’ has led to the many social and environmental problems that currently abound.

To forestall efforts to introduce more onerous disclosure regulations Another possible motivation for voluntarily producing social and environmental performance information might be that the management of particular firms, and officials within particular industry bodies, introduce social and environmental reporting policies in an endeavour to forestall the possibility of government imposing potentially more onerous reporting requirements upon them. This view of the motivation for social and environmental reporting is consistent with some of the responses provided by representatives of the minerals industry, as documented in Deegan and Blomquist (2006). In 1996 the minerals industry introduced an Environmental Code of Management, which included a reporting requirement. A number of respondents from the minerals industry noted that, had the industry not taken the initiative of introducing a code, the government, in response to pressure from various non-government organisations (such as the Australian Conservation Foundation), might have imposed its own code and reporting requirements upon the industry. Deegan and Blomquist asked representatives of the Minerals Council of Australia about what they believed might have motivated the minerals industry to develop the original Code of Environmental Management (initially issued in 1996). Responses included: I guess to be frank, it [the Code] was developed to try and stop somebody else developing it . . . The Australian Conservation Foundation had specifically developed its own code and that had quite a bit of support from a number of other NGOs [non-government organisations] and they were putting pressure on the Federal Government to do something, and there was some murmurings that the Federal Government might do something, so really I guess from that perspective it forced the Minerals Council’s hand. Hence, perhaps a motivation for voluntarily reporting social and environmental information might be that if information is not reported then government might mandate particular reporting requirements, and these mandated requirements could potentially be quite onerous.

To influence the perceived legitimacy of the organization One motivation often cited for why organisations voluntarily produce information about their social and environmental performance is a desire to maintain or improve the legitimacy of the organisation. Chapter 3 discussed Legitimacy Theory. Consistent with Legitimacy Theory, organisations undertake actions, including disclosing information, in an endeavour to appear legitimate to the societies in which they operate. Pursuant to Legitimacy Theory, accounting disclosure policies are considered to constitute a strategy for influencing an organisation’s relationships with the parties, or stakeholders, with which it interacts. The organisation is seen as part of a wider social system in which the organisation’s continued operation and success are dependent on it complying with the expectations of the society in which it operates. Failure to comply with particular expectations might lead to sanctions being imposed by society on the organisation in the form of legal restrictions on its operations, limited provision of resources such as financial capital and labour, and reduced demand for its products. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1069

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social contract Considered to be an implied contract constituted by the expectations that society holds about the conduct of an organisation.

Legitimacy Theorists often utilise the theoretical notion of a social contract. This notion is very similar to the idea of a ‘community licence to operate’, a phrase that has become part of the vocabulary of business organisations in recent decades. Basically, the ‘social contract’ (or ‘community licence to operate’, or simply ‘licence to operate’) is considered to be an implied contract constituted by the expectations that society holds about the conduct of an organisation. Failure to comply with the terms of the ‘social contract’ will be detrimental to the ongoing existence of the organisation. As an example of reference to the ‘licence to operate’ (or ‘social contract’), BHP Billiton Sustainability Report 2015 states (p. 4):

We take the issue of risk management seriously because the nature of our operations means that HSEC incidents have the potential to adversely affect our people, our business, our host communities or our licence to operate. Consistent with the above quote, in research undertaken by the Australian Centre for Corporate Social Responsibility (ACCSR), which comprised a survey of 332 Australian companies undertaken in 2012, 83 per cent agreed that one of the drivers of their CSR activities was a desire to ‘meet community expectations about how we deal with our impacts’. Shocker and Sethi (1974) provide a good description of the social contract. As they explain (p. 67): Any social institution—and business is no exception—operates in society via a social contract, expressed or implied, whereby its survival and growth are based on: (1) the delivery of some socially desirable ends to society in general; and (2) the distribution of economic, social or political benefits to groups from which it derives its power. In a dynamic society, neither the sources of institutional power nor the needs for its services are permanent. Therefore, an institution must constantly meet the twin tests of legitimacy and relevance by demonstrating that society requires its services and that the groups benefiting from its rewards have society’s approval. Given the view that business organisations maintain their right to exist by compliance with their social contract, they must, according to Dowling and Pfeffer (1975, p. 122), establish congruence between ‘the social values associated with or implied by their activities and the norms of acceptable behaviour in the larger social system of which they are a part’. As community expectations change, organisations must also adapt and change. The process of maintaining the congruence referred to above leads to what is known as ‘organisational legitimacy’ (Dowling & Pfeffer 1975). The process of legitimation can be related to the accounting process. Hurst (1970) suggests that one of the functions of accounting, and consequently accounting reports, is to legitimate the existence of the corporation. Legitimacy Theory proposes that organisations may continue to exist only if the society in which they operate perceives those organisations to be operating according to a value system consistent with the society’s own (Gray, Owen and Adams 1996). Legitimacy Theory posits that the organisation must appear to consider the rights of the public at large, not merely those of its investors. Consistent with the above sentiment, the Minerals Council of Australia notes on its website (as assessed April 2016): The minerals industry continues to be actively engaged in the practical and effective integration of environmental, social and economic aspects of resource development. Earning and maintaining a social licence to operate and the practical implementation of sustainable development principles are defining features of modern mining operations. Consequently, companies with a poor social performance record might find it increasingly difficult to obtain the necessary resources and support to continue operations within a community that values a clean environment. That is, society might revoke the ‘social contract’ with such companies unless they use particular strategies to ensure their legitimacy. They must be able to demonstrate accountability in the areas of performance in which the community has the greatest interest. As noted earlier, accountability involves two responsibilities or duties: the responsibility to undertake certain actions (or refrain from taking actions), and the responsibility to provide an account of those actions. Accountability and legitimacy are closely related concepts and both will rely on some form of public reporting. The concepts embodied within Legitimacy Theory reflect the public positions being adopted by Australian corporate executives. Management does appear to consider the expectations of the community in which it operates and realises that failure to do so will be detrimental to the ongoing operations of its entity. 1070  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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If an organisation perceives that its legitimacy is in question, it can adopt numerous strategies. Lindblom (1994) identifies four courses of action an organisation can take to obtain or maintain legitimacy. The organisation can seek to: 1. educate and inform its ‘relevant publics’ about (actual) changes in the organisation’s performance and activities; 2. change the perceptions of the relevant publics—but not change their actual behaviour; 3. manipulate perception by deflecting attention from the issue of concern to other related issues through an appeal to, for example, emotive symbols; or 4. change external expectations of its performance. The public disclosure of information is one strategy that an organisation can adopt to establish or maintain its state of legitimacy. Certainly this is a perspective that many researchers of social-responsibility reporting have adopted. Disclosure of information concerning the organisation’s effect on or relationship with society can be employed in each of Lindblom’s four strategies. For example, a firm might provide information to counter or offset negative news that might be publicly available, or it might simply provide information to inform interested parties about attributes of the organisation that were previously unknown. In addition, organisations might focus attention on strengths, such as environmental awards won, while sometimes avoiding or downplaying any negative effects of their activities, such as pollution. We will now draw upon some of the available research which supports the view that the disclosure of social and environmental performance information might be motivated by a desire to maintain or improve the legitimacy of an organisation. Deegan and Rankin (1996) studied the disclosure practices of a sample of companies that were known to have negative information available to disclose in their annual reports (although they might have elected not to do so). The authors examined the environmental-reporting practices of a sample of 20 companies that were successfully prosecuted by the NSW or Victorian Environmental Protection Authorities (EPA) for offences under various environmental protection laws. The results showed a significant increase in the reporting of favourable environmental information in the year in which prosecutions were proven. Also, using a sample of non-prosecuted companies (matched on size and industry), it was found that the prosecuted companies provided a significantly greater amount of positive environmental disclosures than the non-prosecuted companies. For all companies, the amount of positive environmental information presented was significantly greater than the amount of negative environmental disclosure. Only two companies in the sample reported the existence of a proven environmental offence. Some firms that had proven environmental prosecutions against them failed to disclose these prosecutions, yet provided details of environmental awards they had received for particular sites. Deegan and Rankin argue that this is consistent with a legitimation motive by the sample corporations. The results of their study are consistent with a strategy by which organisations voluntarily disclose particular ‘favourable’ information in an effort to deflect attention away from other potentially damaging news. In a further study of corporate environmental-disclosure practices, Brown and Deegan (1999) conducted research that drew upon both Legitimacy Theory and Media Agenda-Setting Theory. Briefly, Media Agenda-Setting Theory posits a relationship between the relative emphasis given by the media to various topics and the degree of importance these topics have for the general public (Ader 1995, p. 300). In terms of causality, increased media attention is believed to lead to increased community concern about a particular issue. The media are not seen as mirroring public priorities; rather they are seen as shaping them. Brown and Deegan argue that if there is raised community concern about environmental issues, driven by increased media attention, the increased concern should be matched by increased disclosures (if, consistent with Legitimacy Theory, disclosure policies are a function of community concern). Results were generally consistent with expectations. Higher levels of media attention focused on the environmental consequences and performance of particular industries were generally associated with higher levels of annual report environmental disclosures on the part of firms within those industries, a finding the authors considered to be consistent with Legitimacy Theory. Brown and Deegan’s results were also consistent with those of O’Donovan (1999). O’Donovan interviewed senior executives from three large Australian companies. The executives confirmed that, from their perspective, the media do shape community expectations and that corporate disclosures of environmental-performance information is one way to correct ‘misperceptions’ held or presented by the media. Such results are consistent with Deegan and Islam (2014). In a study of garment supply chains emanating from developing countries, Deegan and Islam show that social activist groups/NGOs strategically use/collaborate with the news media to highlight their concerns about labour practices in developing countries. The use of the news media is considered to lead to positive changes in workplace practices and associated reporting. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1071

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In another related study, Deegan, Rankin and Tobin (2002) focused on the disclosure policies of one large Australian company across a number of periods. Specifically, they investigated the social and environmental disclosure policies of BHP Ltd (now BHP Billiton) for the years 1983 to 1997. They were interested in determining whether the extent of community concern pertaining to particular social and environmental issues associated with BHP Ltd’s operations (based on the amount of media attention devoted to particular issues) functions to elicit particular disclosure reactions from the company. The underlying proposition was that changes in society concerns, reflected by changes in the themes of print media articles, will be mirrored by changes in the social and environmental themes disclosed and by the extent of disclosure being made. The findings show that the issues that attracted the most media attention were also those associated with the greatest amount of annual report disclosure. Deegan, Rankin and Tobin (2002) highlight the potential power of the media in influencing corporate disclosure policies and underline the dilemma that unless community concerns are somehow raised (perhaps by the media embracing a particular agenda), managers may elect not to provide information about particular aspects of their organisation’s social and environmental performance. In another study, Islam and Deegan (2010) investigate the social and environmental disclosure practices of two large multinational companies, specifically Nike and Hennes & Mauritz. They investigate the linkage between negative media attention and positive corporate social and environmental disclosures. Their results generally support a view that for those industry-related social and environmental issues attracting the greatest amount of negative media attention, these two corporations reacted by providing positive social and environmental disclosures. The results were particularly significant in relation to labour practices in developing countries—the issue attracting the greatest amount of negative media attention for the companies in question. Considering the research studies cited above, we start to appreciate that organisations are conscious of how the community views their operations and impacts. The public disclosure of information is an important strategy for managing public perceptions. The fact that corporations have been found to provide information in order to legitimise their existence is something that is a potential cause for concern. The results of the research papers above tell us that in the absence of a heightened level of concern from society—which otherwise might have been brought about by adverse media publicity—companies might well make no disclosures at all (that is, disclosures are a reaction to community concern). As Deegan, Rankin and Tobin (2002, p. 334) state: Arguably, companies that simply react to community concerns are not truly embracing a notion of accountability. Studies providing results consistent with Legitimacy Theory (and there are many of them) leave us with a view that unless specific concerns are raised then no accountability appears to be due. Unless community concern happens to be raised (perhaps as a result of a major social or environmental incident which attracts media attention), there will be little or no corporate disclosure . . . To the extent that the corporate social and environmental disclosures reflect or portray management concern as well as corporate moves towards actual change, the corporate disclosures may be merely forestalling any real changes in corporate activities . . . Legitimising disclosures are linked to corporate survival. In jurisdictions such as Australia, where there are limited regulatory requirements to provide social and environmental information, management appear to provide information when they are coerced into doing so. Conversely, where there is limited concern, there will be limited disclosures. The evidence suggests that higher levels of disclosure will only occur when community concerns are aroused, or alternatively, until such time that specific regulation is introduced to eliminate managements’ disclosure discretion. However, if corporate legitimising activities are successful then perhaps public pressure for government to introduce disclosure legislation will be low and managers will be able to retain control of their social and environmental reporting practices. Hence, the evidence does seem to suggest that many organisations are motivated to publicly disclose social and environmental performance information in an endeavour to gain community support. The research also suggests that the information is often of a biased nature—therefore as a general caution, we must be careful when reading voluntarily produced information.

To manage particular (and possibly powerful) stakeholder groups In Legitimacy Theory, the audience of interest is typically defined as ‘the community’. A related theoretical perspective is Stakeholder Theory. In Stakeholder Theory, the organisation is also considered to be part of the wider social system, but this theory specifically considers the different stakeholder groups within society. Like Legitimacy Theory, Stakeholder Theory holds that the expectations of the various stakeholder groups will affect the operating and disclosure (reporting) 1072  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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policies of the organisation. Stakeholder Theory is considered to have two main branches, these being the managerial branch and the ethical branch (see Deegan 2014). The organisation will not respond to all stakeholders equally— from a practical perspective, it cannot—but rather (in the managerial branch of Stakeholder Theory) it will respond to the groups that are deemed to be ‘powerful’. The power of stakeholders such as owners, creditors or regulators to influence corporate management is viewed as a function of stakeholders’ degree of control over resources required by the organisation (Ullmann 1985). The more critical the stakeholder resources are to the continued viability and success of the organisation, the greater the expectation that stakeholder demands will be addressed. Power in itself will be stakeholder/organisation-specific, but might be tied to such things as the stakeholder’s: • command of limited resources (for example, finance, labour); • access to influential media; • ability to legislate against the company; or • ability to influence the consumption of the organisation’s goods and services. The behaviour of the various stakeholder groups is considered a constraint on the strategy developed by management to best match corporate resources with its environment. Freeman (1984) discusses the dynamics of stakeholder influence on corporate decisions. A major role of corporate management is to balance stakeholder demands with achieving the strategic objectives of the firm. As the level of stakeholder power increases, so does the importance of meeting stakeholder demands. These demands may include the provision of information about the activities of the organisation. According to Ullmann (1985), the greater the importance to the organisation of a particular stakeholder’s resources/ support, the more likely it is that the stakeholder’s expectations will be met within the organisation’s operations. According to this perspective, various social-responsibility activities undertaken by organisations, including related public reporting, will be directly related to the expectations of particular stakeholder groups. Furthermore, organisations will have an incentive to disclose information about their programs to indicate clearly that they are conforming with the expectations of stakeholders. Organisations must necessarily balance the expectations of different stakeholder groups. As these expectations and power relativities can change, organisations must continually adapt their operating and reporting behaviours. According to the basic tenets of Stakeholder Theory, an organisation needs to identify the stakeholders that it seeks to satisfy. This is clearly not an easy exercise. If stakeholders are selected on the basis of the managerial branch of Stakeholder Theory, the organisation will seek to satisfy the stakeholders that have the greatest relative power—which in itself requires much consideration. Alternatively, if we adopt the ethical branch of Stakeholder Theory, the organisation may seek to provide information to the stakeholders with the greatest ‘right to know’ about the organisation’s operations, perhaps on the basis of which stakeholders are most affected by the impacts of the organisation’s operations. A choice needs to be made. An organisation might seek simply to provide information aimed at satisfying, at least partially, the needs of all interested parties through the vehicle of a general purpose report. However, it is possible—and arguably probable—that such a report will fail to meet the specific information needs of particularly important groups. In research that looked at how the expectations of powerful stakeholders impact on corporate social and environmental reporting, Islam and Deegan (2008) show how pressures exerted by multinational buying companies affected the disclosure practices of the Bangladesh Garment Manufacturers and Exporters Association (BGMEA), the body responsible for organising the activities of entities involved in the export of garments from Bangladesh. The study showed a linkage between issues that were affecting the legitimacy of the buying companies, which would include companies such as NIKE, Reebok, Gap and Hennes & Mauritz (for example, issues to do with the use of child labour and poor employment conditions in organisations supplying garments) and the disclosure policies of BGMEA. According to Islam and Deegan (2008, p. 870): It was clear that multinational buying companies are very important and a primary focus of the social responsibility initiatives (social compliance) and associated reporting of BGMEA. The evidence provided suggests that the perceived social pressures were able to encourage changes in BGMEA annual report social disclosures. Stakeholder theory would suggest that an organisation will respond to the concerns and expectations of powerful stakeholders, and some of the response will be in the form of strategic disclosures. Consistent with this perspective, BGMEA noted that its operating and disclosure policies reacted to the expectations of multinational buying corporations—the group deemed to be the most powerful stakeholder. Given the global nature of the clothing industry, it was the global community’s expectations which the BGMEA officials believed influenced the operations of the Bangladesh clothing industry. 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western communities imposed their expectations on multinational buying companies who in turn, imposed the expectations on the industry. This paper has demonstrated the existence of a power imbalance. It appeared that, unlike the Bangladesh workforce, stakeholders such as multinational buying companies were able to dictate the behaviour they expected the Bangladesh clothing industry to embrace. Whilst this might have ultimately led to improved conditions for local workers (from a Western perspective), and greater accountability of the industry, it does raise issues about the responsibilities of powerful stakeholders when dealing with industries in developing countries. Their power to create change is real, and ideally should be used in a manner that provides real benefits for local industries and communities. Therefore, another potential motivation for the voluntary disclosure of social and environmental performance information is to manage powerful stakeholders in a way that benefits the organisation. Again such a motivation will lead to some bias in the information being presented.

To increase the wealth of managers of the organisation Chapter 3 discusses Positive Accounting Theory. This theory assumes that all people are driven by self-interest. Such an assumption of self-interest is central to many economic theories. In fact, the rational economic person—a core assumption of many economic theories—is deemed to be someone who seeks to serve his or her own interests to the full, with the emphasis on wealth maximisation. If we were to accept the rather pessimistic assumption (as used within various economic and accounting theories) that all people are driven by self-interest, managers would decide to make social and environmental disclosures if such disclosures would ultimately increase the wealth of the managers (perhaps as a result of increasing the profitability or value of their organisation). While it would perhaps be foolish to dismiss ‘self-interest’ as a motivation for disclosing social and environmental information, hopefully it is not the only motivation. Theories, such as Positive Accounting Theory, which assume that selfinterest drives all actions, can arguably not be considered to offer a great deal of hope for moves towards sustainable development—moves that, if we accept the Brundtland Report (World Commission on Environment and Development 1987) definition of sustainability, would require current generations to consider forgoing consumption and wealth creation to ensure that future generations’ needs are met. The sacrifice of current consumption and wealth creation for the benefit of future generations and the self-interest that is central to Positive Accounting Theory could well be deemed to be mutually exclusive.

The belief that the entity is accountable to provide information One last motivation that we can consider, and one that ideally would motivate managers to make disclosures, is that disclosures are made because different stakeholders, particularly those most affected by an organisation’s operations, have a right to know about the activities and impacts of an organisation (and, importantly, about efforts to minimise those impacts). The view that managers might accept that they are accountable for their operations (which includes a responsibility to report) can be contrasted with the view that managers are driven by self-interest, or related efforts to ‘manage’ powerful stakeholders, or bolster corporate legitimacy. While the above discussion has identified some possible motivations for disclosure of social and environmental performance information, it should again be emphasised that any given organisation might have several motivations, some of which might not have been considered in the above material.

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To whom will the organisation report?

Once we have considered the motivations for reporting—that is, we have answered the ‘why report?’ question— then we are better informed to be able to determine ‘to whom’ the reporting entity will report social and environmental information. If, for example, reporting appears to be based upon the motivation of satisfying the expectations of powerful stakeholders, then an organisation might try to engage (communicate with) such stakeholders to find out what information they want. Conversely, if the decision to report is based more upon ‘ethical reasoning’ and by a motivation to provide information to those stakeholders most impacted by the organisation’s activities, then some form of audit (social audit) would be taken of various stakeholders to see how they are impacted. In practice, the operations of all organisations are likely to have some form of impact on many people, animals and other elements of nature, and to try to take account 1074  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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of all of these potential effects, and to seek to communicate to all of those potentially affected, would be an impossible task. Some prioritisation is therefore necessary to identify which stakeholders seem to be most impacted and therefore have the greatest right to know. These stakeholders would then be surveyed to determine what information they need in order to make informed decisions about whether to support, or oppose, the organisation. For an organisation whose managers are motivated exclusively by the maximisation of shareholder value, and who therefore might use social and environmental reporting to win or maintain the approval of economically powerful stakeholders, the stakeholders to be addressed by social and environmental reporting might be restricted to the economically powerful stakeholders. What is being emphasised is that the question about to whom the social and environmental reports will be targeted will ultimately be dependent on managers’ views about corporate responsibilities and accountabilities, and hence dependent upon views held about the initial issue of why the organisation has decided to produce a report. Again, views will vary from manager to manager. In practice, whichever approach to stakeholder prioritisation is taken by an organisation—whether prioritising stakeholders on the basis of those stakeholders most able to exert an influence on the organisation’s profits (or shareholder value), prioritising stakeholders on the basis of those whose lives are most affected by the organisation’s activities, or adoption of a position somewhere on the continuum between these extreme positions—once the organisation has identified the stakeholders whose social and environmental needs and expectations it will address, it then has to identify what the information needs and expectations of these identified stakeholders are. This takes us to the third stage of the why report–to whom to report–what to report–how to report process of social and environmental reporting.

What information shall be reported?

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As we have just learned, in determining what information to produce we have to consider ‘to whom’ we are going to direct the disclosures. For example, if we are going to direct our reporting to satisfy the needs of particular identified stakeholders, then we might seek to specifically ask such stakeholders (perhaps either through interviews or surveys) what information they want to know. At an aggregated, or broad, level, research studies show that there is a demand for corporate social and environmental performance information. This demand has been evidenced in a number of ways, including through surveys with particular stakeholder groups, or through the vehicle of capital markets studies. For example, in terms of surveys, Deegan and Rankin (1997) demonstrated that a broad cross-section of stakeholders want or demand information about the social and environmental performance of business organisations. Another approach to determining whether people demand or react to certain disclosures efficient-markets is to review share price reactions to particular disclosures. That is, to undertake capital markets hypothesis research. The underlying theory used in such research is based upon the use of the efficientA hypothesis holding markets hypothesis, which proposes that the information content of news announcements, if that the market relevant to the marketplace (investors), will be immediately and unbiasedly impounded within share price of a particular prices. That is, if an item of information about an organisation can be associated with a change in security is directly affected by all relevant the share price of that organisation, it is assumed that the information is of importance to investors information that is and they have reacted to the disclosure of the information (with the reaction being reflected by the publicly available to the change in share price). Numerous studies (for example, Ingram 1978; Anderson and Frankle 1980; market. The hypothesis Belkaoui 1976; Jaggi and Freedman 1982; Griffin and Sun 2012) have shown that investors do assumes that the react to the release of corporate social and environmental performance information. Hence, as a market is efficient group, investors find such information ‘useful’. in disseminating information. However, identifying that stakeholders do use, and therefore that there is a demand for, social and environmental information, does not tell us precisely for what issues the stakeholders of a particular organisation will hold that organisation responsible and accountable. To identify these issues at the level of an individual organisation requires the organisation to enter into some form of dialogue, or engagement, with its stakeholders. But such engagement needs to be undertaken with caution, as stakeholders might not actually know what information is potentially available and hence might not know what information to ask for, or what information could be potentially useful for the various decisions they might make. According to Gray, Owen and Maunders (1991, p. 15), and adopting a broader ethical perspective, even if particular stakeholders do not read particular ‘accounts’, the entity nevertheless has a responsibility to provide an account. Hence, just because a stakeholder group has not identified a need for particular information does not necessarily mean that it ought not to be provided. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1075

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As seen earlier, managers motivated to engage in CSR (or sustainability) reporting for strategic managerial economic reasons (in accordance with the managerial branch of Stakeholder Theory) will tend to identify relevant stakeholders as being those who are able to exert the most influence over their company’s ability to generate profits (or maximise shareholder value). Such managers will seek to convince these economically powerful stakeholders that their organisation’s policies and actions accord with the social, environmental, economic and ethical views and expectations of these stakeholders, with social and environmental reporting being one of the mechanisms that might be used to convince (manage) these stakeholders. For social and environmental reporting to be effectively used to convince these stakeholders that the organisation has operated in accordance with their expectations, the organisation will need to know and understand these expectations—which will define what information is provided in the organisation’s social and environmental reports. Conversely, following the ethical branch of Stakeholder Theory, managers who seek to minimise their organisation’s negative impact on a wide range of stakeholders will need to know and understand how their organisation is likely to impact the lives of a range of stakeholders. The attitudes and experiences of these stakeholders regarding actual and potential organisational impacts are an important element of developing this knowledge and understanding. With an awareness of these views and expectations, managers can then focus their social responsibility policies and actions accordingly, and direct their social and environmental reporting towards providing an ‘account’ to these stakeholders regarding how the organisation has acted in relation to these responsibilities. Furthermore, ethical reasoning indicates that people should be allowed to participate in making decisions on matters that are likely to affect their lives. Therefore, where managers are motivated by broader ethical considerations, they will actively encourage all those stakeholders who are (or might be) affected by the organisation’s activities to participate in decision making regarding these activities. To be able to participate in this manner, a wide range of stakeholders will need information about the effects the organisation has (or is likely to have) on them, and managers will need to provide this information. Managers need to understand their relevant stakeholders’ views, needs and expectations to determine ‘for what’ economic, social and environmental issues they will provide an account. Ascertaining these views, needs and expectations is likely to be more straightforward where CSR has been motivated by a strategic economic desire to maintain or increase the support of economically powerful (or influential) stakeholders, as many of these stakeholders will often be close to, and therefore relatively easily identifiable by, the organisation. For many commercial organisations, these powerful stakeholders will often be located in developed nations and will be accessible through commercial mass media such as television/radio, newspaper articles and the internet. However, for organisations whose social responsibility and social and environmental reporting are motivated by ethical reasoning in order to minimise the organisation’s impact on those most affected by its operations (and to allow these stakeholders to participate in decision making on issues that significantly affect their lives), ascertaining these stakeholders’ views, needs and expectations is likely to be more problematic. First, it is probable that there will be a broader range of stakeholders whose views need to be ascertained. Second, while many of the stakeholders who are significantly affected by an organisation’s activities (such as employees) might be close to the organisation, many others (such as those affected indirectly but substantially by environmental damage caused by the organisation’s operations, or workers of subcontractors in remote parts of the world) are likely to be remote from the organisation itself. Third, as demonstrated by O’Dwyer (2005), some of the stakeholders who are considerably affected by an organisation’s operations might feel constrained by concerns about the consequences of ‘upsetting’ the organisation if they express their ‘true’ feelings, in which case the organisation can be regarded as being in a position of power, which prevents open and honest dialogue with some stakeholders. Fourth, Adams (2004, p. 736) reports that there is often a ‘lack of stakeholder awareness of, and even concern for, corporate impacts’, and this can reduce the capacity of some stakeholders to engage in dialogue with the organisation. Finally, if, following the reasoning discussed earlier in the chapter, we include future generations, non-humans and nature within our definition of stakeholders who are potentially significantly negatively affected by an organisation’s current operations, it is difficult to conceive of how an organisation could engage in dialogue effectively with these stakeholders to ascertain directly their views, needs and expectations regarding current organisational policies and practices. To overcome some (but not all) of these difficulties, organisations need to use a variety of channels of communication to engage in active (and not just reactive) dialogue with their stakeholders (Unerman, 2007). For example, some companies have made use of the interactive communication facilities of the internet to solicit the views of anyone worldwide regarding the social, environmental, ethical and economic responsibilities that should be applied to their organisation (Rinaldi and Unerman 2009). 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is not available to all those potentially affected by an organisation’s activities (particularly in many developing nations), internet-based communication with stakeholders needs to be supplemented with other channels of communication that, between them, are accessible (and likely to be accessed by) a large proportion of the stakeholders on whom an organisation’s operations might have an impact. Such communications can include, for example, face-to-face meetings with a variety of stakeholders, questionnaire surveys, opinion polls, focus groups and invitations to write to the company about specific issues. O’Dwyer (2005, p. 286) indicates that, whatever channels of communication are used to engage stakeholders in a dialogue, to be effective these communication channels need to be adapted to the ‘cultural differences encountered’ between different groups of stakeholders. Another approach to discovering stakeholder expectations—and which relates to the above discussion—is to undertake a ‘social audit’. Social audits are discussed later in the chapter. In practice, many organisations are faced with a variety of values and expectations held by different stakeholders, and often these values and expectations will be incompatible with each other—so the organisation will not be able to meet all of the expectations. As indicated by the managerial branch of Stakeholder Theory, where an organisation is motivated to engage in these practices for strategic economic reasons (for example, to maximise shareholder value), managers will usually choose to address the social, environmental and economic values, expectations and concerns of their most economically powerful stakeholders. Conversely, and consistent with the ethical branch of Stakeholder Theory, if an organisation’s social responsibility and sustainability reporting is motivated by a desire to address the interests of those stakeholders on whom the organisation has the largest impact, it will need to identify and select the interests of those stakeholders on whom the organisation’s activities have the largest negative impact. Given that there may be incompatible views among different stakeholders regarding the nature and extent of an organisation’s impacts, and regarding the priority among different stakeholders’ interests, in practice the process of arriving at a consensus set of social, environmental and economic responsibilities is highly problematic. Before concluding this section on ‘what information to produce’ it should be noted that the demand for social and environmental performance information by some specific stakeholder groups has been documented as increasing across time. In recent years, banking and insurance institutions have become a key user of social and environmental information, particularly about organisations’ environmental performance. In some countries, banks will not provide funds to organisations unless information about their environmental policies and performance is provided (Bhimana and Soonawalla 2010; Coulson 2007). The reason for this, in part, would be that an organisation which has demonstrated poor environmental performance is considered to be a higher risk in terms of compliance with environmental laws and in terms of potential costs associated with rectifying any environmental damage caused. Further, in some industries it is possible that collateral provided for loans (such as land) might be contaminated because of poor environmental management systems. An increasing number of analysts also evaluate the social and environmental performance of corporations as part of their investment analysis (Brigham et al 2010). Another increasing source of demand for corporate social and environmental information is the growing socially responsible investment (SRI) market, and fund managers are also using their power to demand that corporations provide social and environmental performance information (Brigham, Kiosse and Otley 2010). As the financial benefits of good social and environmental governance (for example, through improved risk management) have begun to be recognised by mainstream (non-SRI) investment managers, they have also started to demand higher levels of information about the social and environmental sustainability risks, policies and practices of the companies in which they invest (or in which they are considering investing). Due to supply chain pressures, many organisations are also now demanding that suppliers provide them with details of their social and environmental performance prior to entering supply arrangements (Unerman and O’Dwyer 2010). Supply chain considerations have in the past negatively impacted on a number of organisations, with a corporation such as Nike being a prime example. The next section moves on from a discussion of ‘what to report’ to consider some perspectives regarding how social and environmental reports can be constructed to meet a ‘set’ of prioritised (or consensus) stakeholder expectations.

How (and where) will the information be presented? Because there is a general lack of regulation in the area of social and environmental reporting, as well as an absence of an accepted conceptual framework for social and environmental reporting, there is much variation in how this reporting is being conducted. Some reporting approaches represent quite radical changes from how financial accounting has traditionally been practised. This section of the chapter starts

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by analysing whether the rules and procedures of financial accounting alone could provide suitable mechanisms for capturing and reporting the social and environmental impacts of organisations. We do this because many people trained in financial accounting believe that what they have learned can also be applied to report information about social and environmental performance, and also because some organisations that develop CSR reporting frameworks tend to rely upon financial reporting conventions and principles when developing the frameworks. If, as we show, financial accounting practices are unable to capture and report on these social and environmental impacts effectively, it is necessary to develop other (or additional) social and environmental reporting mechanisms. The discussion then focuses on one of the more influential (and more detailed) sustainability reporting guidelines— the Global Reporting Initiative’s Sustainability Reporting Guidelines, which can be regarded as a form of conceptual framework for social and environmental reporting. Attention will then be directed to initiatives being undertaken by the International Integrated Reporting Committee into the relatively new topic of ‘integrated reporting’, before we conclude the section with a brief discussion about how to account for the social and environmental externalities caused by business entities.

traditional financial accounting Practices that have been applied for a long time and are considered to be generally accepted by the majority of accountants. Would emphasise measures associated with historical costs.

Limitations of traditional financial accounting in respect of its ability to reflect social and environmental performance Financial accounting, which is what this book has focused on, is often criticised on the basis that it ignores many of the externalities caused by reporting entities. This has already been emphasised in the earlier chapters of this book. Externalities can be defined as impacts that an entity has on parties (not necessarily restricted to human beings) that are external to the organisation, parties that typically have no direct relationship with the organisation. Some of these effects or impacts relate to the social and environmental implications of the reporting entity’s operations and include such things as the adverse health effects of pollution produced by the entity, or injuries caused to consumers by the entity’s products, or the adverse social effects of retrenchment of part of a workforce. Some of the perceived limitations of traditional financial accounting, which acts to exclude these externalities, will be considered below. Specifically, financial accounting:

• tends to focus on the information needs of stakeholders with a financial interest; • applies the ‘entity assumption’; • excludes from expenses the impacts on resources not controlled by the entity; • focuses on short-term results; • applies the recognition criteria of ‘measurability’ and ‘probability’; • applies the concept of ‘materiality’; and • adopts the practice of discounting liabilities. Because accounting standards and the conceptual framework dictate the content of a great deal of an annual report, it would seem important that you understand the limitations of such standards when it comes to requiring organisations to be more accountable for their social and environmental performance. We will now consider some of the shortfalls of financial accounting in more depth.

Focusing on the information needs of stakeholders with a financial interest Financial accounting focuses on the information needs of parties involved in making resource allocation decisions. That is, the focus tends to be restricted to stakeholders with a financial interest in the entity, and the information that is provided tends consequently to be primarily of a financial or economic nature. In the Conceptual Framework for Financial Reporting the objective of general purpose financial reporting is identified as being: to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Such a definition has the effect of denying or restricting access to information by those parties or individuals who are affected in any way that is not financial. However, as we can appreciate, companies may elect voluntarily to provide social and environmental information. Publications such as The Corporate Report (issued in 1975 by the Accounting Standards Steering Committee of the Institute of Chartered Accountants in England and Wales) have clearly indicated 1078  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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that information about corporate performance (including information of a non-financial nature) should be provided to a wider group than simply those with a financial interest. As paragraph 25 of The Corporate Report states: The public’s right to information arises not from a direct financial or human relationship with the reporting entity but from the general role played in our society by economic entities. Such organisations, which exist with the general consent of the community, are afforded special legal and operational privileges, they compete for resources of manpower, materials and energy and they make use of community owned assets such as roads and harbours.

The entity assumption 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. The entity assumption or concept is typically taught to students of accounting at the introductory stages. 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 organisation’s 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. We can relate the entity principle to the profits that might be reported by a tobacco manufacturer. It is generally accepted that cigarettes cause many health problems, yet externalities that relate to the products of a reporting entity are ignored for financial reporting purposes. That is, reported profits are not affected by such externalities. In a similar vein, we can consider the operations of casinos. They are often very ‘profitable’; however, such profit measures ignore the social costs gambling causes in the community, and how the actions of gambling providers in supplying gambling opportunities contributes to such social costs. Arguably, any moves towards accounting for sustainability would require a modification to, or a move away from, the entity assumption. A related area in which our traditional financial accounting system generates a rather strange outcome is that of the treatment of tradeable pollution permits. In a number of countries, certain organisations are provided with permits, often free of charge, that allow the holder to release a pre-specified amount of a particular pollutant. If the original recipient of the permit is not going to emit as much pollution as the licence allows, that party is allowed to sell the permit to another party. What happens in some jurisdictions is that particular organisations are treating tradeable pollution permits as assets. This might make sense from an ‘economic’ perspective—but it is questionable whether something that allows an organisation to pollute is an asset from a broader ‘societal’ perspective.

The way we define the elements of financial accounting acts to exclude many social and environmental costs 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 for Financial Reporting, expenses are defined as follows: expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. An understanding of expenses therefore requires an understanding of assets. An asset is defined in the conceptual framework as: a resource controlled by the entity as a result of past events and from which economic benefits are expected to flow to the entity (emphasis added). CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1079

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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. As discussed in Deegan (1996), and using a rather extreme example, imagine that an entity destroys the quality of water in its local environment, thereby killing all local sea creatures and coastal vegetation. Under conventional financial accounting, if the entity incurs no fines or other related cash flows as a result of its actions, no externalities would be recognised. Reported profits, calculated by applying generally accepted accounting principles, would not be directly affected, nor would reported assets. The reason no expenses would be recognised is that resources such as the local waterways are not controlled by the reporting entity, and therefore they would not be recognised as the entity’s assets. Thus the use (or abuse) of resources would go unrecognised. If conventional financial reporting practices were followed, the performance of such an organisation could, depending on the financial transactions undertaken, be portrayed as very successful. In this regard, Gray and Bebbington (1992, p. 6) provide the following opinion of traditional financial accounting: there is something profoundly wrong about a system of measurement, a system that makes things visible and which guides corporate and national decisions, that can signal success in the midst of desecration and destruction. Motivated by their concern about the limitations of traditional financial accounting, Gray and Bebbington have sought to develop alternative methods of accounting—methods that embrace the sustainability agenda and which calculate a notional sustainable cost, which is subtracted from accounting profits to provide a measure of performance known as sustainable profits. We will consider Gray and Bebbington’s prescriptions later in this chapter. As an example of how accounting profits ignore social and environmental costs, we could consider the many newspaper articles that are regularly published which document how organisations cut jobs in order to cut costs. This perspective ignores the obvious social costs associated with the unemployed people that will result from the organisations’ decisions. It also emphasises the perceived relative importance attributed to maximising returns to investors, rather than to other stakeholders. As another example of the difference between the externalities caused by an organisation and the costs (expenses) that it actually recognises, we can consider the Just in Time (JIT) approach to acquiring raw materials and other inventory (this method is typically taught in undergraduate management accounting courses). Under this approach, an organisation may acquire its inventories by way of many deliveries rather than ordering in large quantities and having high average amounts of inventory on hand. Many deliveries means greater use of the roads and fuels, as well as greater levels of pollution through emissions. However, the costs associated with traffic congestion, pollution and so forth are not recognised by the organisation (they are treated as ‘free goods’) and hence, they are encouraged to embrace JIT because of the savings it creates in terms of reducing warehousing costs, insurance costs, stock obsolescence costs and so forth. If we were to incorporate the unrecognised costs into profit calculations then perhaps we might question how cost-effective the JIT system really is. While we will consider climate change in more depth later in this chapter, it is argued by many that the failure to place a cost on the externalities created by organisations is one of the contributing factors to current problems associated with climate change. Until recently, carbon emissions have not been incorporated in the production costs of organisations, and hence there has not been great motivation for organisations to reduce carbon emissions. The advent of emissions trading schemes (such as the ‘cap and trade’ approach that we will discuss later in the chapter) and carbon taxes will mean that carbon emissions will be priced, typically, on the basis of tonnes of emissions. Pricing the emissions will then effectively turn an unrecorded externality into an internal recognised cost. This will lead to incentives for firms to reduce their emissions, and therefore their emission-related costs. Emission trading schemes will create winners and losers within the marketplace. The threats that emission trading and carbon taxes create for many carbon-intensive industries is one of the reasons that the introduction of emissions trading schemes and taxes have been so contentious internationally. Also, if there is not uniformity internationally in the introduction of emission trading schemes, or tax regimes, then production will become more expensive in some countries, and this may lead to those countries no longer being internationally competitive from a price perspective.

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The recognition criteria of ‘measurability’ and ‘probability’ We have just considered the definitions of two elements of financial reporting (assets and expenses) and discussed how these definitions act to preclude the inclusion of various ‘externalities’. The Conceptual Framework for Financial Reporting also provides recognition criteria for the elements of financial reporting (the elements being Assets, Liabilities, Equity, Expenses and Income), and these recognition criteria are: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. Hence, for all the five elements of financial accounting, both probability and measurability are key considerations. Evidence suggests that many liabilities—particularly those related to the environment—are 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 liabilities— and using 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. As the authors (p.20) state: Australian companies do not provide sufficient disclosure in relation to contaminated sites. From our evidence, reviewing corporate annual reports will not allow us to identify the contaminated sites under their control, or the financial costs associated with remediation obligations. This might lead to the misperception from stakeholders that because little remediation obligation was disclosed, such information must not have been material . . . Such a result can be viewed with some concern given that a multitude of stakeholders review corporate annual reports to gather information about a corporation’s financial, social, and environmental performance. The results of the analysis in Ji and Deegan (2011) showed that the sample companies, known to have contaminated sites, used arguments about the difficulty of providing a reliable measurement of the liability, and also issues about the likelihood of ultimate payment (probability) to justify not recognising obligations for cleaning up contaminated sites. The failure to recognise provisions in relation to contaminated sites occurred despite the fact that ‘provisions’ are to be created in situations where there is some uncertainty about the ultimate payment. Indeed, the defining characteristic of a ‘provision’, as opposed to other ‘liabilities’, is that the timing of the ultimate payment, and perhaps the amount of the ultimate payment, are uncertain. In describing provisions, paragraph 11 of AASB 137 Provisions, Contingent Liabilities and Contingent Assets states: Provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement. Such a description would arguably coincide with the obligations many entities would have in relation to contaminated sites. The accounting standard makes it explicit that some uncertainty about timing and amount is acceptable when recognising a provision. Paragraph 25 of AASB 137 notes that: The use of estimates is an essential part of the preparation of financial statements and does not undermine their reliability. This is especially true in the case of provisions, which by their nature are more uncertain than most other statements of financial position items. Except in extremely rare cases, an entity will be able to determine a range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a provision. Therefore, if a present obligation exists in relation to a contaminated site, only with exceptions ‘in extremely rare cases’ should the obligation not be recognised as a provision and, hence, not recognised in the statement of financial position. Thus, and based on the above reporting requirements, Ji and Deegan (2011) expected to find that the companies identified from publicly available information as having significant obligations associated with remediating

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contaminated sites would recognise and disclose associated provisions for remediation—again, a failure to do so should occur only in ‘extremely rare cases’. Nevertheless, the companies in question used the issue of ‘measurability’ in a number of situations as a rationale for non-disclosure. Indeed, some organisations used this as the basis for not recognising a provision in relation to numerous sites known to be contaminated. In reflecting on their results, Ji and Deegan (2011, p. 21) state: The results indicate that there is clearly a lack of accountability in relation to the impacts of organisations in terms of creating contaminated sites. Whilst many authors suggest various reporting approaches be embraced to advance corporate accountability beyond the minimum required by regulation, our results show that the sample companies do not even provide a minimum level of accountability that would reasonably be expected through compliance with existing corporate reporting requirements. With little information being available it is very possible that various stakeholder groups will continue to support organisations that they might not otherwise support if they were by contrast to know how corporate activities were impacting upon the physical environment, or if they knew that the organisations were not recognising the associated financial obligations necessary to remediate the various sites. The general lack of disclosure, and therefore lack of available public information, in effect might act to sustain a ‘business as usual’ approach with organisations potentially not being challenged as they might otherwise be about their environmental performance. It is of interest that the organisations in our sample produce publicly available sustainability reports in which they all publicly embrace sustainable development (in the sustainability reports there is little or no discussion of contaminated sites). Any movement by societies towards sustainable development requires people to make informed choices about the activities and organisations they should support. In part, such choices will be based on the ecological sustainability of organisations’ operations. In the absence of greater disclosure about acts contributing to land contamination, damaging activities may—on the basis of lack of information—continue to be supported by various (uninformed) stakeholder groups. Any organisation that publicly commits to sustainable development—as our sample companies have publicly done—has a responsibility to be open and transparent about its environmental performance—our evidence suggests that companies in our sample have not been as open and transparent as we would hope (and perhaps as future generations require).  Yankelovich (1972) also addressed the ‘measurement issue’ and his opinion is still pertinent today. He described a four-step hypothetical decision process that may be faced by an accountant in attempting to report a variety of environmental issues (p. 72): The first step is to measure whatever can be easily measured. This is OK as far as it goes. The second step is to disregard that which can’t be easily measured or give it an arbitrary quantitative value. This is artificial and misleading. The third step is to presume that what can’t be measured easily really isn’t important. This is blindness. The fourth step is to say that what can’t be easily measured really doesn’t exist. This is suicide. As Deegan (2011) explains, an example of the situation that Yankelovich (1972) described is the assessment of the reported costs incurred after the Exxon Valdez grounding and oil spill in Alaska in 1989. In terms of the various steps: Step 1: The financial costs of clean-up were relatively easily measured, and provided information on some of the financial loss caused by the disaster. Step 2: Some costs, such as the depreciation of specialised clean-up equipment or head office overheads, were difficult to measure, so arbitrary allocations were made. Depreciation and cost allocation are artificial calculations that can be misleading to information users who seek to know the ‘real’ expenses incurred in reducing the effects of the disaster. Step 3: Items that could not be easily measured included the destruction of the local fishing industry and the breakdown of social systems in a previously close-knit community. These costs would not pass the ‘reliable measurement’ test of accounting, and would be excluded from reported expenses. Step 4: The US$4.1 billion reported clean-up cost ignored the deaths of 3000 sea otters, 156 bald eagles, estimates of up to 400 000 water birds and an unknown number of seals. The ‘suicide’ that Yankelovich (1972) wrote about might well be a direct result of such unwillingness to value life. 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Focus on short-term results Another problem inherent in financial reporting is its focus on the short term. As we would appreciate, the focus of the media is typically on the annual, or perhaps at times on the half-yearly and quarterly, financial results of an entity. 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.

The concept of ‘materiality’ Related to the focus on the information needs of stakeholders with a financial interest (discussed previously) is one of the cornerstones of financial accounting: the notion of ‘materiality’. This has tended to preclude the reporting of social and environmental information, given the difficulty of quantifying social and environmental costs. ‘Materiality’ is an issue involving the exercise of a great deal of professional judgement. If something is not considered to be material, it does not need to be disclosed in the financial statements or supporting notes. Unfortunately, this has meant that if something cannot be quantified (as is the case for many social and environmental externalities), it is generally not considered to be ‘material’ and therefore does not warrant separate disclosure. This obviously implies that ‘materiality’—as used by accountants—might not be a relevant criterion for the disclosure of environmental performance data. Social performance and environmental performance are quite different from financial performance. Yet many accountants have been conditioned through their education and training to adopt the materiality criterion to decide whether information should be disclosed. In a review of British companies, Gray et al (1998) indicate that companies frequently provide little or no information about environmental expenses (however defined) because individually the expenditure is not considered to be material. ‘Materiality’ is indeed something that can be interpreted very subjectively. The 2000 version of Global Reporting Initiative’s Sustainability Reporting Guidelines provided a useful comment on materiality: The application of the materiality concept to economic, environmental, and social reporting is more complex than in financial reporting. In contrast to financial reporting, percentage-based or other precise quantitative materiality yardsticks will seldom be appropriate for determining materiality [for sustainability reporting purposes]. Instead, materiality is heavily dependent upon the nature and circumstances of an item or event, as well as its scale or magnitude. For example, in environmental terms, the carrying capacity of the receiving environment (such as a watershed or airshed) will be just one among several factors in the materiality of the release of one tonne or one kilogram of waste, air emissions, or effluent. Similarly, health and safety information is likely to be of considerable interest to sustainability report users despite its typical insignificance in traditional financial accounting terms.

The practice of discounting liabilities to present value In respect of liabilities, there is a general requirement that liabilities to be repaid in more than 12 months should be discounted to their present value. Specifically, paragraph 45 of IAS 137 Provisions, Contingent Liabilities and Contingent Assets states: 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. While discounting liabilities to their present value makes good economic sense (indeed it is not questionable that a dollar in the future is worth less than a dollar now), it does not necessarily make good ecological sense because it effectively downplays the importance of the future clean-up. Perhaps it encourages the entity to undertake activities that will damage the environment but that will not need to be remedied for many years. In a sense, the practice of discounting encourages us to shift problems of an  environmental nature onto future generations—something that is arguably inconsistent with the sustainability agenda. If we discount future obligations, then, in the current period, they often are not considered to be ‘material’ (as just discussed) and will not even be seen on corporate balance sheets. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1083

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Nevertheless, future generations will be left with obligations to remediate the environment. For example, imagine that we are an organisation whose current activities are creating a need for future environmental expenditure of a remedial nature, but that such work will not be undertaken for many years. As a result of discounting, we will recognise little or no cost now (which appears to be at odds with the sustainability agenda). For example, if we were anticipating that our activities would lead to a clean-up bill of $100 million in 30 years’ time, and if we accept that our normal earnings rate is 10 per cent, the current expenses to be recognised in our financial statements under generally accepted accounting principles would be $5.73 million. Gray, Owen and Adams (1996) argue that discounting future obligations, such as future clean-up costs, might encourage an entity to undertake activities that will damage the environment but that will not need to be remedied for many years. This view is consistent with Perks (1993, p. 100), who suggests that the use of costing approaches that rely upon such factors as present values has the effect of hindering the introduction of renewable energy and other sources of ‘cleaner’ energy. He states: Accountancy is also implicated in the environmental crisis in advocating investment appraisal techniques that emphasize the short term rather than the long term, particularly in relation to electricity generation. Energy from renewable resources such as wind, wave, tide and water tend to have heavy capital expenditure and are seen to be economic only over a very long period. Accountants’ methods, particularly where high discount rates are used in discounted cash flow calculations, tend to favour the quick and dirty types of power generation. While the above discussion of the limitations of financial reporting is lengthy, it has identified a number of principles and conventions of financial reporting that limit the ability of financial reporting to provide meaningful information about an organisation’s social and environmental performance. As we learned, these conventions and principles related to: • the objective of general purpose financial reporting; • the entity assumption; • the definitions of the elements of financial reporting; • the recognition requirements relating to measurability and probability; • the short-term focus of financial reporting; • materiality as utilised by the accountant; and • the practice of discounting liabilities. Reflecting upon the above bullet points allows us to understand why financial accounting measures such as ‘profits’ ignore many social and environmental effects caused by business organisations. Therefore, we can reasonably argue that financial accounting does not provide an appropriate vehicle for CSR reporting. In this regard, Deegan (2013) states: Financial accounting simply was not designed to incorporate considerations of the social and environmental impacts of organisations. Financial accounting calculates the financial position and performance of an entity as a result of recording measurable and probable transfers of economic benefits in conformity with generally accepted financial accounting procedures . . . Financial reporting conventions do not provide a platform for any argument that financial reporting is a sound or even sensible vehicle through which to account for the social and environmental externalities generated by an entity. Therefore I do find it frustrating to often hear people suggesting that financial reporting provides a potential panacea for important social and environmental problems, such as climate change. My concern is the extent to which such people understand the many obstacles/road blocks that financial reporting puts in the way of recognising social and environmental costs. That is not to say that financial accounting does not provide useful information for some decision makers. It certainly does. But let us not kid ourselves that it provides a viable platform for accounting for the social and environmental impacts of a reporting entity – it simply does not. Hence, in discussing ‘how’ to report social and environmental information—the focus of this section of the chapter— we justifiably have concerns about doing it through existing financial reporting systems. Financial accounting and reporting alone is therefore unsuitable as a mechanism to provide an account of these social and environmental impacts and to meet stakeholders’ information needs and expectations. Consequently, other mechanisms need to be employed to provide a suitable social and environmental ‘account’ to stakeholders. In the discussion that follows we will consider the guidelines produced by two well-known bodies, these being the Global Reporting Initiative and the International Integrated Reporting Committee. Questions will be raised about the suitability of these guidelines. We will also consider some other approaches to reporting that have merit. 1084  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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The Global Reporting Initiative Despite (or perhaps because of) the deficiencies in the ability of traditional financial reporting to capture and reflect the social and environmental impacts of organisational activities, many organisations have developed a variety of practices that seek to report on these broader impacts. At an international level, one source of reporting guidance that has taken a dominant position in the social and environmental (and sustainability) reporting domain is the Global Reporting Initiative’s Sustainability Reporting Guidelines (commonly referred to as the GRI Guidelines). These guidelines are generally accepted by many people (but not all people) as representing current ‘best practice’. The first version of the GRI Guidelines was released in 2000. We now have version 4 (referred to as G4), which was released in 2013. According to the website (www.globalreporting.org) of the Global Reporting Initiative (GRI) as accessed in January 2016: GRI has pioneered and developed a comprehensive Sustainability Reporting Framework that is widely used around the world. The Framework enables all organizations to measure and report their economic, environmental, social and governance performance—the four key areas of sustainability. The Reporting Framework—which includes the Reporting Guidelines, Sector Guidelines and other resources— enables greater organizational transparency about economic, environmental, social and governance performance. This transparency and accountability builds stakeholders’ trust in organizations, and can lead to many other benefits. Thousands of organizations, of all sizes and sectors, use GRI’s Framework in order to understand and communicate their sustainability performance. GRI’s is a multi-stakeholder, network-based organization. Its Secretariat is headquartered in Amsterdam, the Netherlands. The Secretariat acts as a hub, coordinating the activity of GRI’s many network partners. GRI has Focal Points—regional offices—in Australia, Brazil, China, India and the USA. Its global network includes more than 600 Organizational Stakeholders—core supporters—and some 30,000 people representing different sectors and constituencies. GRI also enjoys strategic partnerships with the United Nations Environment Programme, the UN Global Compact, the Organisation for Economic Co-operation and Development, International Organization for Standardisation and many others. GRI’s Guidelines are developed with the expertise of the people in its network. International working groups, stakeholder engagement, and due process—including Public Comment Periods—help make the Guidelines suitable and credible for all organizations. According to GRI, the latest version of the Sustainability Reporting Guidelines (G4) is designed to be universally applicable to all organisations, large and small, across the world. The GRI Guidelines are presented in two parts, these being: • Reporting Principles and Standard Disclosures • Implementation Manual. These parts are available for free on the GRI’s website. The first part of the guidelines, the Reporting Principles and Standard Disclosures, contains Reporting Principles, Standard Disclosures and the criteria to be applied by an organisation to prepare its sustainability report ‘in accordance’ with the guidelines. Definitions of key terms are also included. The second part of the guidelines, the Implementation Manual, contains explanations of how to apply the ‘Reporting Principles’, how to prepare the information to be disclosed, and how to interpret the various concepts in the guidelines. References to other sources of guidance, a glossary and general reporting notes are also included. As the GRI Guidelines state, at the core of preparing a sustainability report is a focus on the process of identifying material aspects—based, among other factors, on the Materiality Principle. Pursuant to the guidelines, material aspects are those that reflect the organisation’s significant economic, environmental and social impacts; or substantively influence the assessments and decisions of stakeholders. Organisations that apply the guidelines, and who make a specific claim to be ‘in accordance’ with the guidelines, are required to select one of two ‘in accordance options’. As page 8 of the G4 Sustainability Reporting Guidelines states (2013): The Guidelines offer two options for an organization to prepare its sustainability report ‘in accordance’ with the Guidelines. The two options are Core and Comprehensive. These options designate the content to be included for the report to be prepared ‘in accordance’ with the Guidelines. Both options can apply for an organization of any type, size, sector or location. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1085

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Page 11 of GRI (2013) further states: The focus of both options is on the process of identifying Material Aspects. Material Aspects are those that reflect the organization’s significant economic, environmental and social impacts; or substantively influence the assessments and decisions of stakeholders. The Core option contains the essential elements of a sustainability report. The Core option provides the background against which an organization communicates the impacts of its economic, environmental and social and governance performance. The Comprehensive option builds on the Core option by requiring additional Standard Disclosures of the organization’s strategy and analysis, governance, and ethics and integrity. In addition, the organization is required to communicate its performance more extensively by reporting all Indicators related to identified Material Aspects. An organization, whether it is a new or experienced reporter, has to choose the option that best meets its reporting needs and, ultimately, enables it to meet its stakeholders’ information needs. The GRI identifies a number of reporting principles. In explaining the background to the reporting principles, GRI (2013, p.16) states: The Reporting Principles are fundamental to achieving transparency in sustainability reporting and therefore should be applied by all organizations when preparing a sustainability report. The Implementation Manual outlines the required process to be followed by an organization in making decisions consistent with the Reporting Principles. The Principles are divided into two groups: Principles for Defining Report Content and Principles for Defining Report Quality. The Principles for Defining Report Content describe the process to be applied to identify what content the report should cover by considering the organization’s activities, impacts, and the substantive expectations and interests of its stakeholders. The Principles for Defining Report Quality guide choices on ensuring the quality of information in the sustainability report, including its proper presentation. The quality of the information is important to enable stakeholders to make sound and reasonable assessments of performance, and take appropriate actions. There are four principles identified for ‘Defining Report Content’, and these are: • Stakeholder inclusiveness: The organization should identify its stakeholders, and explain how it has responded to their reasonable expectations and interests. • Sustainability context: The report should present the organization’s performance in the wider context of sustainability. • Materiality: The report should cover aspects that: reflect the organization’s significant economic, environmental and social impacts; or substantively influence the assessments and decisions of stakeholders. • Completeness: The report should include coverage of material Aspects and their Boundaries, sufficient to reflect significant economic, environmental and social impacts, and to enable stakeholders to assess the organization’s performance in the reporting period. G4 identifies six principles for ‘Defining Report Quality, these being: • Balance: The report should reflect positive and negative aspects of the organization’s performance to enable a reasoned assessment of overall performance. • Comparability: The organization should select, compile and report information consistently. The reported information should be presented in a manner that enables stakeholders to analyze changes in the organization’s performance over time, and that could support analysis relative to other organizations • Accuracy: The reported information should be sufficiently accurate and detailed for stakeholders to assess the organization’s performance. • Timeliness:  The organization should report on a regular schedule so that information is available in time for stakeholders to make informed decisions. • Clarity: The organization should make information available in a manner that is understandable and accessible to stakeholders using the report. • Reliability: The organization should gather, record, compile, analyze and disclose information and processes used in the preparation of a report in a way that they can be subject to examination and that establishes the quality and materiality of the information.

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As we can see, the principles and qualitative characteristics are very similar to the qualitative characteristics that are typically promoted in relation to financial reporting. It is interesting to consider whether sustainability reporting should have similar attributes to financial reporting. What do you think (and keep in mind our earlier discussion of financial reporting)? Organisations that are applying the GRI Guidelines are required to produce what are referred to as ‘standard disclosures’—which are divided into general standard disclosures and specific standard disclosures. They are also required to disclose information relating to various performance indicators. The general standard disclosures relate to: • Strategy and Analysis; • Organizational Profile; • Identified Material Aspects and Boundaries; • Stakeholder Engagement; • Report Profile; • Governance; and • Ethics and Integrity. The specific standard disclosures relate to: • Disclosures on Management Approach; and • Indicators. The Disclosures on Management Approach referred to above (under the specific standard disclosures) is intended to give the organisation an opportunity to explain how the economic, environmental and social impacts related to material Aspects are managed. The sustainability performance indicators that are required to be disclosed pursuant to the guidelines are organised under the categories of economic performance, environmental performance and social performance (with the social indicators being further subdivided into labour practices and decent work performance indicators, human rights indicators, society indicators and product responsibility performance indicators). Exhibit 30.3 provides the categories (which are economic, environmental and social), subcategories (of which the category ‘social’ is the only one to have subcategories), and aspects (which are components of performance attributed to specific categories or subcategories). Interested readers are encouraged to visit the website of the GRI to review the Sustainability Reporting Guidelines for themselves. While many argue that the GRI Guidelines have brought about improvements to sustainability reporting, it must be acknowledged that, not being mandatory, many companies are selective about which indicators they choose to use in their reporting. Nevertheless, such companies might still indicate that they are using the GRI Guidelines and therefore gain the ‘legitimacy’ that is associated with using the guidelines. This possibility is supported by Boiral (2013), who reviewed

Category

Economic

Environmental

Aspects

• Economic Performance • Market Presence • Indirect Economic Impacts • Procurement Practices

• Materials • Energy • Water • Biodiversity • Emissions • Effluents and Waste • Products and Services • Compliance • Transport • Overall • Supplier Environmental Assessment • Environmental Grievance Mechanisms

Exhibit 30.3 Categories and Aspects in the GRI Sustainability Reporting Guidelines

continued

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Category

Social Labor Practices Subcategories and Decent Work Aspects

• Employment • Labor/ Management Relations • Occupational Health and Safety • Training and Education • Diversity and Equal Opportunity • Equal Remuneration for Women and Men • Supplier Assessment for Labor Practices • Labor Practices Grievance Mechanisms

Human Rights

Society

• Investment • Nondiscrimination • Freedom of Association and Collective Bargaining • Child Labor • Forced or Compulsory Labor • Security Practices • Indigenous Rights • Assessment • Supplier Human Rights Assessment • Human Rights Grievance Mechanisms

• Local Communities • Anti-corruption • Public Policy • Anti-competitive Behavior • Compliance • Supplier Assessment for Impacts on Society • Grievance Mechanisms for Impacts on Society

Product Responsibility • Customer Health and Safety • Product and Service Labeling • Marketing Communications • Customer Privacy • Compliance

the sustainability reports of 23 mining and energy companies that were identified as being highly compliant with the GRI reporting (also meaning compliance with the GRI principles of completeness, balance, reliability and accuracy). Boiral utilised various publicly available information about the social and environmental performance of the companies and then compared it to the information produced in the GRI-compliant sustainability reports. His results showed that 90 per cent of the significant adverse events identified from alternative publicly available sources were either not discussed at all in the sustainability reports, or were discussed in a biased manner. The reports were also found to be very biased in terms of providing information about positive achievements and in terms of prioritising ‘self-praise’. Hence, we really need to be careful in assuming that just because a reporting guideline exists, and is apparently being applied, that the reports themselves are credible reflections of actual performance.

Integrated reporting Another development in CSR reporting is integrated reporting. The International Integrated Reporting Committee (IIRC) was created in August 2010 and is a joint initiative of The Prince’s Accounting for Sustainability Project (A4S) and the GRI. According to the website of the IIRC, the aim is to create a globally accepted framework that brings together financial, environmental, social and governance information in a clear, concise, consistent and comparable format—put briefly, in an ‘integrated’ format. The website (www.integratedreporting.org, as accessed January 2016) also identifies the mission and vision of the IIRC as: Mission The IIRC’s mission is to establish integrated reporting and thinking within mainstream business practice as the norm in the public and private sectors. Vision The IIRC’s vision is to align capital allocation and corporate behaviour to wider goals of financial stability and sustainable development through the cycle of integrated reporting and thinking. 1088  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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A concern of the IIRC was that there currently is a lack of integration in the ways many organisations currently report. Many organisations produce an annual report with various items of financial information as required by accounting standards, corporations law and securities exchange listing requirements together with a separate CSR or sustainability report. But there is often little or no linkage between the various reports. It is argued by the IIRC that we need a form of reporting in which various types of relevant information for assessing and evaluating a company’s performance are reported in a comprehensive and integrated way. Corporate reporting should follow directly from its corporate strategies and targets, which in themselves will need to be clearly elaborated. Integrated reporting is not simply combining the annual report with a CSR report and will require new ‘conceptual frameworks’ in which CSR-related information is reported with the same quality as financial information. The IIRC released its International Integrated Reporting Framework, referred to as the International Framework, in December 2013. It is a principles-based document rather than being one that stipulates lists of required disclosures. A review of the framework reveals a number of interesting (and some worrying) aspects to the guidelines, some of which are discussed below. According to page 33 of IIRC (2013), Integrated Reporting is defined as: A process founded on integrated thinking that results in a periodic integrated report by an organization about value creation over time and related communications regarding aspects of value creation. The above definition is interesting. The focus seems to be on ‘value creation’ rather than on accountability. This will be of concern to many people who had hoped that the emphasis of integrated reporting would be on increasing the transparency of companies to a broad group of interested stakeholders—many of which are not directly interested in ‘value creation’. The IIRC also emphasises the centrality of ‘materiality’ to the reporting process. In terms of ‘Guiding Principle’ of ‘Materiality’ IIRC (2013, p. 18) states: An integrated report should disclose information about matters that substantively affect the organization’s ability to create value over the short, medium and long term. IIRC (2013, p. 18) further states: To be most effective, the materiality determination process is integrated into the organization’s management processes and includes regular engagement with providers of financial capital and others to ensure the integrated report meets its primary purpose as noted in paragraph 1.7. When we then review the IIRC Framework to see the primary purpose we find (paragraph 1.7, p. 7): The primary purpose of an integrated report is to explain to providers of financial capital how an organization creates value over time. To many people, the restricted definition of the perceived users of integrated reports would be disappointing. It seems to embrace a focus very similar to a ‘shareholder primacy perspective’—something that we have discussed elsewhere in this chapter. It is also very similar to the focus of general purpose financial reporting, which is to assist financial stakeholders to make resource allocation decisions. As we noted earlier in this chapter, this acts to limit the usefulness of a reporting framework to provide ‘accountability’ to a broader group of stakeholders. In explaining the principles-based approach (as opposed to a rules-based approach) that has been adopted within the framework, IIRC (2013, p. 4) states: The intent is to strike an appropriate balance between flexibility and prescription that recognizes the wide variation in individual circumstances of different organizations while enabling a sufficient degree of comparability across organizations to meet relevant information needs. It does not prescribe specific key performance indicators, measurement methods, or the disclosure of individual matters, but does include a small number of requirements that are to be applied before an integrated report can be said to be in accordance with the Framework. Organisations often prefer to have flexibility in reporting, rather than having prescribed reporting requirements imposed upon them, and hence generally favour ‘principles-based’ approaches. As Deegan and Shelly (2014) note, reporting entities typically favour flexibility of reporting as it enables them to be selective about what issues to report, and the business sector has a history of lobbying against the introduction of legislation that constrains such flexibility. Deegan and Shelly (2014) also note that other stakeholders with a specific interest in the social and environmental CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1089

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performance of organisations would tend to prefer that organisations do not have a high degree of flexibility, but, rather, are required to comply with specific social and environmental disclosure requirements. A particularly interesting aspect of the framework is that it makes reference to six different types of capitals. According to IIRC (2013, paragraphs 2.10–2.12, p. 11):





2.10 All organizations depend on various forms of capital for their success. In this Framework, the capitals comprise financial, manufactured, intellectual, human, social and relationship, and natural, although as discussed in paragraphs 2.17–2.19, organizations preparing an integrated report are not required to adopt this categorization. 2.11  The capitals are stocks of value that are increased, decreased or transformed through the activities and outputs of the organization. For example, an organization’s financial capital is increased when it makes a profit, and the quality of its human capital is improved when employees become better trained. 2.12  The overall stock of capitals is not fixed over time. There is a constant flow between and within the capitals as they are increased, decreased or transformed. For example, when an organization improves its human capital through employee training, the related training costs reduce its financial capital. The effect is that financial capital has been transformed into human capital. Although this example is simple and presented only from the organization’s perspective, it demonstrates the continuous interaction and transformation between the capitals, albeit with varying rates and outcomes. In relation to changes in ‘capital’, it is further stated (IIRC, 2013, p. 12): Although organizations aim to create value overall, this can involve the diminution of value stored in some capitals, resulting in a net decrease to the overall stock of capitals. Figure 30.1 below reproduces the ‘value creation process’ as it is depicted within the IIRC Framework. Natural capital (the environment) is defined in the framework as (IIRC 2013, p. 12): All renewable and non-renewable environmental resources and processes that provide goods or services that support the past, current or future prosperity of an organization. It includes: — air, water, land, minerals and forests — biodiversity and eco-system health.

Again, there are some broader philosophical issues to consider. As we can see from the above definition of ‘natural capital’, the environment seems to be considered on the basis to which it supports the ‘past, future or current prosperity Figure 30.1 The value creation process as depicted in the IIRC’s International Framework

Financial

Mission and vision Governance

Manufactured Intellectual

Risks and opportunities

Financial Manufactured

Strategy and resource allocation

Intellectual

Business model Inputs

Business activities

Outputs

Human Social and relationship

Outcomes

Human Performance

Outlook

Social and relationship Natural

Natural

External environment

SOURCE: The IIRC’s International Framework, December 2013 1090  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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of an organization’. Many people would question whether the environment should be considered in such an organisationcentric manner. Is not this one of the very reasons that the planet has the environmental and social problems that it currently has? Referring to the environment as part of ‘capital’ also seems to promote a view that it can be ‘drawn down’ to support growth in other capitals. Again, this view that the environment can justifiably be utilized and degraded in exchange for economic gains is a major contributory factor to our current global problems. In relation to the various trade-offs, IIRC (2013, p. 31) states: It is important, however, that an integrated report disclose the interdependencies that are considered in determining its reporting boundary, and the important trade-offs that influence value creation over time, including trade-offs: • between capitals or between components of a capital (e.g., creating employment through an activity that negatively affects the environment) • over time (e.g., choosing one course of action when another course would result in superior capital increment but not until a later period) • between capitals owned by the organization and those owned by others or not at all. However, it is again emphasised that many people would argue that when it comes to the environment then there should be no ‘trade-off’. We could provide further comment on the IIRC International Integrated Reporting Framework as released in December 2013, but suffice it to say that the framework is disappointing to many people who initially hoped that integrated reporting would provide improvements in the social and environmental accountability of corporations. Like the GRI’s Sustainability Reporting Guidelines, the IIRC Framework has also explicitly adopted various financial reporting conventions (including materiality—which in the document is linked to ‘assessing the organization’s ability to create value’, reliability, completeness, consistency, comparability). Coupled with this, and as already noted, the IIRC also notes that an integrated report should be prepared primarily for providers of financial capital in order to support their financial capital allocation assessments. This primary focus on the information demands of capital providers, the linkage of materiality to ‘creating value’, and the adoption of key financial reporting conventions does not, at least in the minds of some concerned parties, indicate that the future of provides much hope with regard to extending the accountability of organisations in terms of the various non-financial aspects of their operations. Again, the adoption of key financial reporting conventions counters any real likelihood of providing a useful framework for broad-based accountability. There are also concerns that the process being undertaken by the IIRC has already been captured by large-scale corporate interests, who see this form of reporting as being more about enhancing corporate value than about increasing transparency. At this point, however, we will not pursue this matter further other than to encourage interested readers to critically review and comment on the project as it ‘progresses’ across time.

Other reporting approaches Apart from the reporting models developed by organisations such as the GRI and IIRC, there are a number of other approaches to reporting, some of which are quite imaginative and innovative. We will now consider some of these approaches.

Full cost accounting One approach to accounting for social and environmental impacts is to place a cost on the externalities generated by the organisation and then deduct these costs from ‘accounting profits’. We can call this a ‘full cost’ approach because it would more fully ‘cost’ the activities being undertaken by an organisation. Reporting guidance such as that provided by the GRI provides numerous sustainability-related key performance indicators (KPIs) but does not consider the issue of trying to ‘cost’ the externalities caused by businesses. For example, the GRI does not provide guidance about placing a cost on such things as the pollution being generated by an organisation, or any adverse health effects caused by the products or processes of a reporting entity. As explained earlier, generally accepted financial accounting practices also ignore the social and environmental externalities generated by a reporting entity in large part because of the way we define the elements of accounting. Externalities can be viewed as positive (benefits) or negative (costs) and represent impacts that an entity has on parties external to the organisation where such external parties did not agree or take part in the action causing, or the decisions leading to, the cost or benefit. In most market transactions, the prices paid for goods or services do not fully reflect all of the ‘costs’ and ‘benefits’ generated by their production and consumption (which in itself brings into question CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1091

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measures of performance such as corporate ‘profits’). The implication of this is that the ‘cost’ of goods or services might be understated and, as a result, a greater amount of a particular good or service might be produced and consumed than might otherwise be the case if the overall costs to society were considered. For example, if the air is treated as a ‘free good’ and a heavily polluting organisation does not pay, or incur liabilities, for the pollution it creates, then its measure of profit—based on generally accepted accounting principles—may be considered inflated relative to what it would be if costs were assigned to the pollution. In a freely operating market that does not place a cost on pollution, the obvious implication is that production will increase, profits will rise and, at the same time, the environment will become degraded for current and future generations. Financial Accounting in the Real World 30.4 provides an example of a situation where otherwise ‘hidden costs’ have—through an innovative approach to accounting—been identified as being associated with the use of coal to generate power. As the article discusses, the generation of ‘cheap’ power through the use of coal is not really cheap once we consider the various social costs associated with the burning of coal. The article discusses how costs can be attributed to the use of coal and notes that if organisations had to account for their social and environmental costs, then there might have been a greater shift towards cleaner energy sources. The article also discusses how such calculations are often criticised by potentially affected organisations—in this case, the criticisms come from an energy producer that uses coal—as a means of trying to attack the credibility or legitimacy of the ‘accounting’.

30.4 FINANCIAL ACCOUNTING IN THE REAL WORLD The impact of coal-generated electricity The impact of coal-generated electricity on the environment and its effect on society for good or ill continue to stir debate. There are passionate opponents of coal and proponents who put forward strong arguments to keep the status quo. There are calls for coal-fired plants to be closed because Australia has excess electricity supplies but governments seem loath to take action. The Federal Government, in a White Paper, has said it won’t pay for closure of plants. Tony Abbott, as Prime Minister, supports the use of coal. The Victorian Government, although claiming it would back the use of renewables, still keeps open power stations like Hazelwood and Loy Yang A as they generate massive amounts of electricity (85% of Victoria’s power comes from coal) and employ a lot of Victorians. Although the Hazelwood plant has been the target of environmentalists for many years because of the carbon it emits, it has a licence to continue operating at least until 2026. Two Harvard researchers, Mick Power and Jordan Ward, used a method created by the National Academy of Science in the United States, as the basis for an analysis of Hazelwood and other Victorian power plants. Their estimate of the annual cost of the Hazelwood plant on the environment at $900M was in their paper released by Environment Victoria. The estimate is of damage from global warming on the agricultural sector, on property, and on health because of the reduced air quality. According to the researchers’ report, renewable or clean energy sources could compete on an equal footing with polluters like Hazelwood and the other coal power plants they investigated if the power companies had to account for the total costs of creating coal-generated electricity. Rather than coal being a cheap form of power, Nick Aberle from Environment Victoria says it is not. The formula for pricing the social costs of carbon emissions used by Power and Ward has been widely accepted and was used as the science behind carbon pricing which was introduced by Labor in 2012 and abolished by the Liberals under Tony Abbott in 2014. Steven Chu, winner of the Nobel Prize (Physics) and also Present Obama’s Secretary of Energy from 2009– 2013, assisted with the promotion and development of the formula, and it has been the basis for Obama’s policies around climate change. The well-respected economist Professor Ross Garnaut, who had been an adviser to Labor governments, lauded the Harvard technique for measuring the costs of emissions as ‘rigorous’. However, the managing Director of Frontier Economics, Danny Price, took a more cautious approach. Although he appreciated the Harvard method he thought accounting costs of emissions exactly was very difficult.

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GDF Suez Australian Energy—Hazelwood’s owner—rejected the report as uninformed and full of assumptions. They stated that the report ignored the economic benefits of coal-generated electricity, particularly Hazelwood’s role in producing up to a quarter of Victoria’s electricity. SOURCE: Adapted from ‘The hidden cost of Hazelwood’, by Tom Arup and Adam Morton, Sunday Age, 19 April 2015, p. 12 

Government intervention can be employed as a means of placing costs on the use of resources that might otherwise go unrecorded. For example, we can consider carbon-related taxes and emission trading schemes where organisations incur expenses on the basis of the amount of carbon dioxide released into the atmosphere. Such releases would otherwise be ‘free’. By placing a cost on emissions, a government effectively acts to make organisations internalise costs that would otherwise be ‘externalities’. This can in turn motivate profit-seeking organisations to find ways to reduce their emission levels. The higher the price per tonne of carbon dioxide emissions, the harder we might expect organisations who are affected by the tax to try to reduce their level of emissions. There are also many organisations that create social benefits which are not recorded in income or ‘profits’. For example, there might be a wildlife park that breeds threatened and endangered species of animals and then releases surplus animals back into the wild to regenerate local populations. If this organisation was assessed purely on its financial results (perhaps based on the fees charged to visitors and the expenses of running the park) then, unless some income is attributed to the positive externalities generated by the organisation (related to the released animals), the reported results of the organisation might be considered to be understated. While we might attempt to describe various costs and benefits generated by an entity in qualitative terms, many costs and benefits will not be recorded in financial terms. Because corporate profits will not incorporate many externalities, and as emphasised elsewhere in this chapter, we must treat such financial numbers with caution when considering the overall ‘performance’ of an entity. Perhaps we can question whether a profitable company is also necessarily a ‘good’ company. For example, a large financial institution may close many smaller regional branches to reduce financial costs, which might improve financial performance (e.g. reported profits). This measure of performance (profits) will not reflect many of the externalities caused by the decision to close regional branches (e.g. the costs associated with unemployed workers thereafter receiving benefits from government, or the inconvenience caused to regional communities from no longer having a local bank). However, a very limited number of organisations have attempted to put a cost on the environmental externalities and benefits caused by their operations. From an accounting perspective, an ‘externality’ is not generally recognised in the financial statements. Where ‘sustainable costs’ are notionally calculated—which happens within only a very small minority of entities—these costs and benefits are then usually taken from (or added to) traditionally calculated profits to come up with some measure of ‘real profit’. This is an interesting approach, which represents a departure from generally accepted accounting principles, and is based on many estimates and ‘guesstimates’. Again, however, it needs to be emphasised that there are only a very limited number of companies worldwide that voluntarily place a cost on externalities. For example, a number of years ago the Dutch computer consultancy organisation BSO/Origin produced some environmental accounts in which a notional value was placed on the environmental costs imposed by the organisation on society. (The last set of accounts prepared by BSO/Origin addressing ‘environmental costs’ was released back in 1995.) This value was then deducted from profits determined using conventional financial accounting to provide a measure of ‘net value added’. Obviously, quantifying environmental effects/impacts in financial terms requires many assumptions. As BSO/Origin stated in its 1994 environmental report: This is the fifth year that BSO/Origin has presented an environmental account as well as a financial report. This is done on the basis of the ‘extracted value’ concept, the burden a product places on the ecosystem from the moment of its manufacture until the moment of its decomposition. This burden is expressed in terms of the costs which would have been incurred either to undo the detrimental effect to the point where the natural ecosystem could neutralise it, or to develop a responsible alternative. The entries are based on absolute data as supplied by the cells, educated guesstimates and extrapolations. The purpose is not to provide precise calculations accurate to the last decimal point, but to fulfil the principle of complete accounting, in which extracted as well as value added is included. By including social and environmental costs and benefits in their profit calculations, organisations can contribute to ongoing debates questioning the validity of profitability calculations that omit important social costs such as environmental CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1093

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damage. A number of companies are now experimenting with methods designed to determine the notional costs of the externalities being generated by their activities. Companies that have adopted some form of ‘full-cost’ accounting currently include Baxter International Inc. (USA), IBM (UK), Interface Europe, Anglian Water (UK), Wessex Water (UK), PUMA (USA) and Landcare Ltd (NZ). The approaches adopted by some of these organisations include determining a notional ‘sustainable cost’. This is explained by Gray and Bebbington (1992, p. 15) as follows: Sustainable cost can be defined as the amount an organisation must spend to put the biosphere at the end of the accounting period back into the state (or its equivalent) it was in at the beginning of the accounting period. Such a figure would be a notional one, and disclosed as a charge to a company’s profit or loss. Thus we would be presented with a broad estimate of the extent to which the accounting profits had been generated from a sustainable source . . . our estimates suggest that the sustainable cost calculations would produce the sort of answer which would demonstrate that no Western company had made a profit of any kind in the last 50 years or so. According to Bebbington and Gray (2001, p. 567), the sustainable cost calculation involves two elements: (i) a consideration of the costs required to ensure that inputs to the organisation have no adverse environmental impacts in their production. These are costs that arise in addition to those costs already internalised in the most environmentally sound products and services that are currently available; and (ii) the costs required to remedy any environmental impacts that arise, even if the organisation’s inputs had a zero environmental impact. One company to embrace the ‘sustainability cost’ calculation is Interface Europe. In discussing how the financial reports of Interface Europe (a leading producer of floor coverings) adopt the ‘sustainability cost’ calculation, Environmental Accounting and Auditing Reporter (September 2000, p. 6) made the following comments: The environmental impacts disclosed in the accounts have been valued where possible on the basis of their avoidance or restoration costs. That is, on the basis of what Interface would need to spend in order to either avoid the impacts in the first place or to restore the environmental damage caused by the activities and operations if they are unavoidable. Costs, as far as possible, are based on ‘real’ or market based prices. The emissions associated with Interface’s significant use of electricity, for example, have been valued based on an estimated premium for the company to switch to electricity generated from renewable, and hence (more or less) carbon neutral energy sources. Carbon emissions from transport and gas consumption have been valued based on the market price to sequester carbon and a significant proportion of non carbon dioxide transport related emissions have been valued on the cost of converting the company’s car fleet to liquid petroleum gas (LPG). Whilst emissions of carbon dioxide remain about the same or slightly higher with LPG, other emissions are reduced substantially. The total valuation is based on what it would cost to reduce emissions or impacts to a ‘sustainable level’. Although we don’t really know what a sustainable level may be for each of the impacts/emissions, a pragmatic approach based on current scientific understanding and opinion has been used. In the case of carbon, a sustainability standard of zero has been adopted. For non carbon transport related emissions, for example, the sustainability standard has been based on reducing emissions by at least 50% to meet health based guidelines for air quality. The sustainability cost therefore represents the financial cost of closing the sustainability gap of the company’s operations. Another related and innovative approach to reporting has been developed by the German sports apparel and footwear brand PUMA. From 2012 it commenced producing its Environmental Profit & Loss (E P&L) account wherein it places a financial value on its use of ‘natural capital’. The E P&L seeks to quantify not only PUMA’s direct environmental impacts, but those of its suppliers too. In doing so, primary information is often non-existent or disaggregated. Many statistics, for instance, are available only at a national level rather than being location-specific. As such, the methodology relies heavily upon the use of various estimation techniques. Exhibit 30.4  provides an extract from a press release produced by PUMA in 2012 when it released its first E P&L. Exhibits 30.5 and 30.6 provide the E P&L for shoes and T-shirts as presented in PUMA’s  2012 Business and Sustainability Report. Puma does not produce an E P&L every year and 2012 was the latest one available as of late 2015. 1094  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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Our PUMA Product E P&L cleverly values these environmental impacts and attaches a price tag. We do not expect our customers to absorb the costs of these impacts, but we believe it is necessary to make their extent clear for consumers. By showing environmental costs in Euros and Cents, our new PUMA Product E P&L visualizes the environmental impacts PUMA products cause and makes comparing products in terms of sustainability easy for everyone.  ‘Just as the calorie and nutrition information table on your cereal box helps you compare the dietary impacts of one breakfast choice to another, our new PUMA Product E P&L helps you to judge whether one shoe or shirt is more environmentally-friendly than another,’ said PUMA’s Chairman Jochen Zeitz. ‘Our job is not only to lessen the impact our products have on the environment, but also to engage our customers and help them make better and more sustainable choices for the benefit of our planet.’ Dr. Richard Mattison, Chief Executive of Trucost said:  ‘Environmental impacts traditionally have different units of measurement, making it difficult to compare the overall environmental impact of different products and this can be confusing for consumers. One product may have a high water impact, another may be more carbon intensive or cause more pollution. Measuring the environmental impact in Euros and Cents allows companies to create an overall metric for each product that takes into account many different environmental factors. The PUMA Product E P&L allows company managers to embed sustainability within everyday product design and procurement decisions and provides consumers with information on which products are better for the planet.’

Exhibit 30.4 Press Release by PUMA: New PUMA Shoe and T-Shirt impact the Environment by a third less than Conventional Products (Munich/ London, 8 October 2012)

SOURCE: PUMA (Munich/London, 8 October 2012)

Product Conventional PUMA Suede Biodegradable PUMA InCycle Basket InCycle Savings in %

Greenhouse gas €

Air Water Waste pollution € € €

Land Environmental use costs € €

Retail price €

2.16

0.61

0.30

0.74

0.48

4.29*

85

1.41

0.49

0.12

0.84

0.09

2.95*

95

−35% −21% −60%

+14% −20%

Exhibit 30.5 PUMA 2012 E P&L: Environmental costs of shoes

−31% +12%

*These environmental costs are provided as units of comparison and are not related in any way to the retail price of the product.

Product Conventional PUMA T-shirt Biodegradable PUMA InCycle Basket InCycle Savings in %

Air Waste pollution € €

Land Environmental use costs € €

Retail price €

Greenhouse gas €

Water €

1.79

0.33

0.10

1.00

0.20

3.42*

20

1.20

0.34

0.06

0.70

0.06

2.36*

20

−33%

+2%

−36%

−30% −70%

−31%

0%

Exhibit 30.6 PUMA 2012 E P&L: Environmental costs of T-shirts

*These environmental costs are provided as units of comparison and are not related in any way to the retail price of the product.

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Another company to produce an environmental profit or loss is the French-based organisation Kering. In explaining the need for such an ‘account’, the CEO of Kering states (Kering 2015, p. 5) that business and society rely ‘on natural resources and ecosystem services to function’ and that for business to be successful those natural systems need to thrive. While business has not integrated the ‘cost’ of the degradation of these natural systems in the past, as they are seen as externalities, ‘this needs to change given the realities confronting us as natural resources decline and the impacts of climate change increase’. We can perhaps contrast the sentiment above with the sentiment that seems to have been embraced by those responsible for the development of the IIRC Framework.  In explaining the nature of their pioneering E P&L Kering details (Kering 2015, p. 7) that it was developed ‘to help measure and understand our impact on natural capital across our supply chain, from raw materials to the delivery of products to our customers’. The E P&L is presented in monetary terms to allow the business to understand environmental impact in a language they understand, as well as to compare different types of impact and locations and facilitate comparisons between brands and business units. ‘The results are not related to Kering’s financial results, past present or future, and do not represent a financial liability or cost to Kering. Rather, they are a new way of estimating the cost to society of the changes in the environment as a result of our business activities and those of the whole of our supply chain. In contrast to financial accounting there are currently no established and agreed standards for estimating this value’ (Kering 2015, p. 7). Further details of Kering’s ‘accounting’ approach can be found at http://www.kering.com/en/sustainability. Figure 30.2 is a reproduction of Kering’s 2013 E P&L as released in 2015.

Other innovative approaches to reporting Other innovative approaches to presenting information about social and environmental performance include the approach adopted by the US organisation Baxter International Inc. Baxter International Inc. is an organisation that produces, develops and distributes medical products and technologies. In the mid-1990s Baxter decided to develop what it labelled its Environment Financial Statement (EFS)—a practice that it continues to the present day. According to Bennett and James (1998, p. 295): the purpose of the EFS is to collect together in a single report, annually, the total of the financial costs and benefits that could be attributed not only to the environmental programme itself but to the environmentally beneficial activities across the corporation. Its aim is to demonstrate that, contrary to the preconception of many, the environment need not be only a burden on business performance but could make a positive contribution. Baxter’s approach represents a departure from ‘normal’ financial accounting practice in that it explicitly records information about savings—something that financial reports typically do not identify—but it is still a relatively conservative approach to accounting. Baxter’s Environmental Financial Statement focuses on environmental costs and benefits that directly relate to actual cash flows, while the remainder of the company’s sustainability report provides more information on its overall environmental footprint. Exhibit 30.7 provides details of Baxter’s 2014 EFS. In the EFS, ‘Income’ refers to actual monies received in the report year; ‘Savings’ refers to reductions in costs between the report year and prior year (an increase in actual costs is negative savings); and ‘Cost avoidance’ refers to additional costs other than the report year’s savings that were not incurred but would have been incurred if the waste-reduction activity had not taken place. In principle, all of the figures presented in Baxter’s EFS would be available from the organisation’s main accounting system. For example, where electricity costs have fallen as a result of decreasing use pursuant to specific energyreduction initiatives, this reduction in cost is shown as a saving. No consideration is given to the fact that the electricity consumption is still resulting in the emission of harmful greenhouse gases. However, and importantly, it demonstrates that by explicitly considering the environment, actual cost savings can be made. Without such an analysis, these savings may be unknown and more emphasis may be placed on the cost of putting in place recycling initiatives, cleaner production techniques, and so on. By considering only the costs and savings incurred by the organisation, and by excluding recognition of externalities (impacts of greenhouse emissions and so on), Baxter is still applying the usual ‘entity assumption’ when producing its EFS. Nevertheless, the organisation should be commended for its initiative in producing such an ‘account’. 1096  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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Figure 30.2 Kering Environmental Profit and Loss TIER 0: STORES WAREHOUSE OFFICES

TIER 1: ASSEMBLY

TIER 2: MANUFACTURING

TIER 3: RAW MATERIAL PROCESSING

TIER 4: RAW MATERIAL PRODUCTION

AIR POLLUTION

TOTAL IN MILLIONS

8% €64.5

GREENHOUSE GAS EMISSIONS

35% €272.2

LAND USE

27% €209.9

WASTE 5% €37.0

WATER CONSUMPTION

11% €83.2

WATER POLLUTION

TOTAL:

14% €106.2

7% €56.0

13% €100.0

4% €33.70

26% €197.6

50% €385.7

100% €773.0

SOURCE: Adapted from Kering 2013 E P&L, released in 2015. http://www.kering.com/sites/default/files/document/kering_epl_methodology_and_2013_group_results_0.pdf

A number of accounting researchers have also suggested some interesting approaches to reporting various types of social and environmental information. For example, Brown (2009) suggested the use of ‘dialogic accounting’. Such an approach represents a view that there is often more than one way to see organisational performance—particularly social and environmental performance (by contrast, ‘monologic accounting’ would show only one perspective of performance, and this would typically be the perspective of corporate managers). According to Brown (2009), the views of different stakeholders in relation to specific aspects of social and environmental performance should be publicly reported, even if they are quite different. For example, different stakeholders might have different views about the social performance CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1097

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Exhibit 30.7 Environmental Financial Statement as shown in the 2014 Environmental, Health and Safety Performance Report of Baxter International

Baxter 2014 Environmental Financial Statement Estimated Environmental Costs, Income, and Savings and Cost Avoidance Worldwide (dollars in millions)1 Environmental Costs

2014

2013

2012

Corporate Environmental—General and Shared Business Unit Costs2

3.1

3.1

2.7

Auditors’ and Attorneys’ Fees

0.5

0.4

0.4

Energy Professionals and Energy Reduction Programs

1.5

1.4

1.3

Corporate Environmental—Information Technology

0.4

0.3

0.3

12.2

11.9

10.6

6.1

5.6

5.3

Basic Program

Business Unit/Regional/Facility Environmental Professionals and Programs Pollution Controls—Operations and Maintenance Pollution Controls—Depreciation Basic Program Total

2.7

2.5

2.3

26.5

25.2

22.9

0.2

0.3

0.3

0

0

0

9.1

10.3

9.9

1.0

0.9

0.8

Remediation, Waste and Other Response Costs (Proactive environmental action will minimize these costs) Attorneys’ Fees for Cleanup Claims and Notices of Violations Settlements of Government Claims Waste Disposal 3

Carbon Taxes, Credit and Offsets

4

Environmental Fees for Packaging

0.8

0.9

0.9

Environmental Fees for Electronic Goods and Batteries

0.0

0.0

0.1

Remediation/Cleanup—On-site

1.9

0.2

0.2

Remediation/Cleanup—Off-site

1.0

1.2

1.5

Total Remediation, Waste and Other Response Costs

14.0

13.8

13.7

Total Environmental Costs

40.5

39.0

36.6

(0.5)

0.1

0.6

(11.2)

(4.9)

(1.7)

Non-hazardous Waste Disposal

0.5

0.2

1.2

Non-hazardous Materials

(0.2)

2.8

9.6

Recycling Income

6.1

7.2

6.6

Energy Conservation

(4.4)

3.4

3.6

(1.0)

0.0

0.4

(10.7)

8.8

20.3

−40%

35%

89%

Cost Avoidance from Initiatives Started in the Six Years Prior to and Realized in Stated Year6, 7

13.3

34.2

38.4

Total Environmental Income, Savings and Cost Avoidance in Stated Year

$2.6 $43.0 $58.7

Environmental Income, Savings and Cost Avoidance (see Detail on Income, Savings and Cost Avoidance from 2011 Activities online) From Initiatives in Stated Year Regulated Waste Disposal 5

Regulated Materials

Water Conservation 6

From Initiatives in Stated Year Total

As a Percentage of the Costs of Basic Program

Detail on Income, Savings and Cost Avoidance from 2014 Activities (dollars in millions)

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Regulated Waste Disposal Cost Reduction Regulated Waste Materials Cost Reduction Non-hazardous Waste Disposal Cost Reduction Non-hazardous Waste Materials Cost Reduction Recycling Income Energy Consumption Cost Reduction Water Consumption Cost Reduction Total

Income and Savings

Cost Avoidance

Total Financial Benefits

$(0.2) (6.3) 1.4 (2.3) 6.1 (9.6) (1.3) $(12.2)

$(0.3) (4.9) (0.9) 2.1 n/a 5.2 0.4 $1.6

$(0.5) (11.2) 0.5 (0.2) 6.1 (4.4) (0.9) $(10.6)

Cost Avoidance Detail from Efforts Initiated in the Six Years Prior to Report Year (dollars in millions) 2011 2010 Regulated Waste Disposal $1.4 $0.8 Regulated Waste Materials (18.6) (11.8) Non-hazardous Waste Disposal 2.3 2.0 Non-hazardous Waste Materials 6.8 8.6 Energy Consumption 19.0 29.8 Water Consumption 2.4 4.8 Total $13.3 $34.2

2009 $0.8 (5.8) 2.6 5.3 29.9 5.6 $38.4

. Financial numbers rounded to nearest US$100 000 to reflect appropriate degree of data accuracy. 1 2. Corporate environmental costs comprise total environmental costs related to operating corporate environmental programs that report into Baxter manufacturing and legal groups. While corporate Environment, Health and Safety (EHS) and certain business unit EHS groups were integrated in 2003, total business unit program costs remain in the Business Unit/Regional/ Facility Environmental Professionals and Programs line, as those environmental costs more directly support facility programs. 3. Carbon taxes, expenses associated with purchasing renewable energy from electric utilities, renewable energy certificates, and carbon credits purchased on the European Union ETS and Chicago Climate Exchange (CCX), through the U.S. Intercontinental Exchange. 4. Following completion of the 1996–2005 packaging-reduction goal, Baxter discontinued tracking program costs and financial savings associated with packaging-reduction initiatives at the corporate level. Baxter may reinstitute this line item in future financial statements. 5. Reflects change (positive for decrease and negative for increase) for purchases of raw materials due to changes in material use efficiency and associated generation of waste. 6. In calculating savings and cost avoidance for waste-, energy- and water-reduction activities, it is assumed that production and distribution activities grew proportionately with Baxter’s publicly stated cost of goods sold, adjusted for changes in inventory and the average of three inflation indexes. Baxter uses a three-year rolling average of the annual percentage change in adjusted growth in the cost of goods sold to determine the financial values for each stated year. For 2014, the three-year rolling average was 2%; for 2013, 5%; for 2012, 3%; for 2011, 3%; and for 2010, 2%. This rolling average helps avoid distortions due to certain acquisitions/divestitures and the delayed environmental effects from changes in production. 7. To be conservative, the accumulation of reported cost avoidance from conservation activities in prior years is terminated after seven years, the approximate duration of many facility continued

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conservation and process-improvement projects, after which additional process improvements and changes are possible. Undetermined (and Unreported) Environmental-related Costs and Savings The following undetermined costs are not included in the environmental financial statement (EFS): • Environmentally driven materials research and other research and development. These are typically offset by increased sales and other non-environmental benefits not reported in the EFS; • Capital costs of modifying processes other than adding pollution controls. These are typically offset by increased production rates, efficiencies and other non-environmental benefits not reported in the EFS; • Cost of substitutes for ozone-depleting substances and other hazardous materials. This cost is estimated to be relatively minor; and • Time spent by non-environmental employees on environmental activities. Environmental training and responsibilities are a part of every employee’s job. Baxter’s global environmental program also produces undetermined savings and other benefits that are not easily measured and are not included in the EFS. Examples include the following: • Decreased liability exposure related to the operation of external regulated waste management sites by maintaining a program (launched in the 1980s) requiring a detailed audit of any such site before use by Baxter and periodic re-audits after the initial assessment; • Reduced risk due to other risk-management programs, including performance of environmental due diligence on all business acquisitions and divestitures, use of a common set of EHS policies throughout Baxter operations, auditing those operations regularly against these policies and using a tracking system to resolve any audit findings; • Decreased regulatory burden by reducing waste generation at Baxter below certain thresholds, which decreases training, recordkeeping, reporting, and administrative costs; • Avoided costs for environmental problems that did not occur due to Baxter’s proactive efforts; • Enhanced ability for employees to focus on higher value tasks due to the reduction of waste, possible spills and other potential environmental problems; • Increased good will and brand value, improved company reputation and employee morale, and possible additional sales; and • Attraction and retention of key personnel in part due to Baxter’s strong environmental program.

of a large multinational sportswear company with respect to its supply chains operating within developing countries. The diverse perspectives from different stakeholders might be due to varying outlooks on corporate responsibilities, different philosophies about the role of business and so on (that is, there will be more than one ‘logic’—hence the use of the term ‘dialogic accounting’). There is also a view that reporting different perspectives about social performance will stimulate constructive debate between various stakeholders who hold contrasting perspectives. The views of Brown (2009) are very interesting and are counter to those often proffered by many accounting practitioners and researchers wherein there is one ‘view of the world’, which can be objectively reflected (‘faithfully represented’) within accounting reports. As Brown states (2009, p. 318): Given the essentially contestable nature of sustainability, new accountings should not be aimed at producing incontrovertible accounts. Societal worth should be judged not in terms of the expert production of the ‘right answer’ but in the facilitation and broadening of debate . . . Accountants need to develop systems that prevent premature closure and which infuse debate and dialogue, facilitating genuine and informed citizen participation in decision making processes . . . A framework of a dialogical approach would: recognise ideological assumptions; avoid monetary reductionism; be open about the objective and contestable nature of calculations; enable accessibility of non-experts; ensure effective participatory processes; be attentive to power relations; and recognise the transformative potential of dialogic accounting. Cooper, Coulson and Taylor (2011) also provide insights which are similar to those of Brown (2009). Cooper, Coulson and Taylor (2011) discuss alternative approaches to providing information about corporate performance in relation to 1100  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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the protection of human rights and workplace safety. They suggest that different stakeholders should be permitted to provide their perspectives, or ‘accounts’, about particular workplace practices so that no one view is privileged over another. Cooper, Coulson and Taylor (2011, p. 755) suggest: We have set out a case that a new form of human and safety account should be produced by a balanced team comprising of the Health, Safety and Environment team, workers’ representatives, staff from a newly formed Scottish Hazards Advice Centre and/or Trade Union representative and a member of management. This collaboration serves to legitimise the role of information provision by actors who may normally be seen to be contributing to a social audit process and bring them into the accounting function. The resulting health and safety account should contain unabridged HSE Inspectors’ reports, the company risk assessment, a commentary by Scottish Hazards Advice Centre, workers and trade unions, together with a financial report containing both previous expenditure by the company on health and safety and costings of remedial work which have been highlighted in the HSE Inspectors’ report and workers’ response. A team approach to such collaboration will help to self-regulate the process of accounting and ensure transparency is achieved. Therefore, both Cooper, Coulson and Taylor (2011) and Brown (2009) call for ‘multiple voices’ and an acceptance that providing the views or perspectives of different stakeholders in relation to the same situations or events—particularly in relation to matters of a social or environmental nature that can be evaluated from numerous perspectives—is preferable to simply providing one view (perhaps the views of managers), which inevitably is biased and privileges the rights of some members of society over others. Clearly, after considering the overview provided above, we can conclude that there is great diversity in how organisations do account, or could account, for the social and environmental aspects of their operations. Our discussion has certainly not been exhaustive as there are many other approaches to reporting social and environmental performance information that are, or could be, applied and that we have not considered. Indeed, the options available for reporting, and the imagination that could be used to provide improved ‘accounts’ makes this a potentially very exciting area in which to work. This section has demonstrated that financial reporting conventions act to exclude many of the social and environmental impacts caused by an organisation. We have explored reporting frameworks developed by the GRI and IIRC and we have identified some potential problems associated with such frameworks. We have also discussed ‘full cost accounting’ as well as other innovative approaches to reporting. Because there are many social and environmental problems confronting us now, and in the future, it is necessary that continued ‘imagination’ be directed to this area of reporting and it is hoped therefore that people with passion focus on improving this important area of reporting and in developing insightful approaches to ‘accounting’. The balance of this chapter will consider four further areas. We will consider some other international initiatives that are aimed at enhancing corporate social and environmental performance and/or reporting. We will then consider the practice of social auditing, before discussing the phenomenon of climate change and its implications for accounting. We will then conclude the chapter with a brief discussion of ‘personal social responsibility’.

Other international initiatives to assist corporate social and environmental performance

LO 30.10

Global Compact The Global Compact is an initiative of the United Nations (see www.unglobalcompact.org). This initiative facilitates a network of UN agencies, governments, business, labour and non-government organisations to put in place plans to encourage organisations to adopt 10 principles in the areas of human rights, labour, environment and anticorruption. It is a voluntary initiative that seeks to promote responsible corporate citizenship measured against 10 universal principles drawn from the Universal Declaration of Human Rights, the International Labour Organisation (ILO) Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development and the UN Convention against Corruption. As of 2015 there were over 8000 business participants and 4000 non-business participants (of which there are over 124 in Australia, including nine universities) from over 170 countries, which are expected to publish, in their annual report or sustainability report, descriptions of the actions they have taken to support the Global Compact and its 10 principles. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1101

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Equator Principles Pursuant to the Equator Principles, financial institutions attempt to help ensure that the projects they finance will be developed in a socially responsible manner that reflects sound environmental standards (see www.equator-principles .com). In Australia, ANZ Bank, Commonwealth Bank, National Australia Bank and Westpac have all committed to the principles. As of late 2015 there were 81 signatories internationally. The Equator Principles (EPs) are a voluntary set of standards for determining, assessing and managing social and environmental risk in project financing. The third version of the principles were released in June 2013. Project financing is defined in the EPs (2013, p. 18) as: . . . a method of funding in which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the exposure.  Equator Principles Financial Institutions (EPFIs) commit to not providing loans to projects where the borrower will not, or is unable, to comply with the respective social and environmental policies and procedures that are incorporated within the EPs. The EPs apply to all new project financings globally with total project capital costs of US$10 million or more, and across all industry sectors. In addition, while the EPs are not intended to be applied retrospectively, EPFIs will apply them to all project financings covering expansion or upgrade of an existing facility where changes in scale or scope may create significant environmental and/or social impacts, or significantly change the nature or degree of an existing impact. The EPFI will report publicly, at least annually, on transactions that have reached ‘Financial Close’ and on its Equator Principles implementation processes and experience, taking into account appropriate confidentiality considerations. Included in its reporting on its implementation of the Equator Principles, the EPFI will provide: • the mandate of the Equator Principles Reviewers (e.g. responsibilities and staffing); • the respective roles of the Equator Principles Reviewers, business lines and senior management in the transaction review process; • the incorporation of the Equator Principles in its credit and risk management policies and procedures.

International Organization for Standardization The International Organization for Standardization (ISO) has also developed a series of standards that organisations can seek accreditation against on a voluntary basis. Some of these have direct relevance to issues of corporate social responsibility (see www.iso.org); for example, the ISO 14000 series on environmental management systems, against which many Australian entities have been certified. The ISO has also developed the ISO 26000 series Guidelines for Social Responsibility, which was published in 2010. It addresses issues under the four ‘clusters’ of environment; human rights and labour practices; organisational governance and fair operating practices; and consumer issues and community involvement/ society development. There is also the ISO 50000 series on Energy Management, which was released in 2011.

Carbon Disclosure Project The Carbon Disclosure Project (CDP) was formed in 2000. CDP is based in New York and London and focuses on the implications of climate change on shareholder value and commercial operations. CDP seeks information on the business risks and opportunities presented by climate change and greenhouse gas emissions from the world’s largest companies and it publishes emissions data for over 3000 of the world’s largest corporations (which are thought to account for nearly a third of the world’s anthropogenic emissions). According to its website (www.cdproject.net, accessed January 2016), the CDP represents 822 institutional investors with a combined US$95  trillion under management. The view of the CDP is that carbon emissions and climate change represent significant business risks and, therefore, an organisation’s policies and performance in relation to climate change should be factored into investment decisions. Further, the CDP takes the view that information about greenhouse gas emissions is useful to investors, corporations and regulators in making informed decisions that take into account corporate risk from future government legislation, possible future lawsuits and shifts in consumers’ perceptions towards heavy emitters. The overall organisational goal of the CDP is promoted as being to reduce the problem of global warming, and according to the CDP website (accessed January 2016): CDP works to transform the way the world does business to prevent dangerous climate change and protect our natural resources. We see a world where capital is efficiently allocated to create long-term prosperity rather than short-term gain at the expense of our environment. 1102  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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Evidence and insight is vital to driving real change. We use the power of measurement and information disclosure to improve the management of environmental risk. By leveraging market forces including shareholders, customers and governments, CDP has incentivized thousands of companies and cities across the world’s largest economies to measure and disclose their environmental information. We put this information at the heart of business, investment and policy decision making. We hold the largest collection globally of self reported climate change, water and forest-risk data. Through our global system companies, investors and cities are better able to mitigate risk, capitalize on opportunities and make investment decisions that drive action towards a more sustainable world. Organisations wishing to publicly report their greenhouse gas emissions and climate change strategies can do so through the CDP, and interested parties can do searches on the CDP website by company name. Researchers within the CDP also use the Carbon Disclosure Leadership Index (CDLI) to score company responses based on the quality of their reporting to CDP. According to the CDP website, the scores provide a valuable perspective on the range and quality of responses to CDP’s questionnaire.

AccountAbility AA1000 series AccountAbility is an organisation that promotes itself as a global, not-for-profit organisation, which states as its vision: . . . a world where people have a say in the decisions that have an impact on them, and where organisations act on and are transparent about the issues that matter. (AccountAbility.org, accessed January 2016) AccountAbility was founded in 1995 and has offices in London, New York, Zurich, Dubai and Riyadh. At the centre of AccountAbility’s work is the AA1000 series of Standards, which according to its website, is based on the following principles: • Inclusivity—people should have a say in the decisions that impact on them. • Materiality—decision makers should identify and be clear about the issues that matter. • Responsiveness—organisations should be transparent about their actions. The AA1000 series has been designed with the stated intention of helping ‘organisations become more accountable, responsible and sustainable’. At the present time, the AA1000 series consists of: • The AA1000 AccountAbility Principles Standard (AA1000APS), which according to AccountAbility’s website, provides a ‘framework for an organisation to use in order to better identify, understand, prioritise and respond to its sustainability challenges’. • The AA1000 Assurance Standard (AA1000AS), which is a standard used to provide assurance on publicly available sustainability information, particularly CSR/sustainability reports. • The AA1000 Stakeholder Engagement Standard (AA1000SES), which ‘provides a framework to help organisations ensure stakeholder engagement processes are purpose driven, robust and deliver results’ (AccountAbility.org).

The Greenhouse Gas Protocol The Greenhouse Gas Protocol (GHG Protocol) is one of the most widely used international accounting tools for quantifying greenhouse gas emissions. The GHG Protocol represents a partnership between the World Resources Institute (which is an environmental ‘think tank’ located in Washington DC and which receives funding from a large number of corporate donors) and the World Business Council for Sustainable Development (which is a coalition of 200 international companies). The GHG Protocol provides the accounting framework used by many GHG standards and programs throughout the world. The GHG Protocol consists primarily of seven standards. A Corporate Accounting and Reporting Standard (Corporate Standard) provides methodologies for businesses and other organisations to report all of their GHG emissions. It covers the accounting and reporting of the seven greenhouse gases covered by the Kyoto Protocol: • carbon dioxide (CO2) • methane (CH4) • nitrous oxide (N2O) CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1103

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• hydrofluorocarbons (HFCs) • perfluorocarbons (PFCs) • sulphur hexafluoride (SF6) • nitrogen trifluoride (NF3). The GHG Protocol standards was designed with the following objectives in mind: • To help companies prepare a GHG inventory that represents a true and fair account of their emissions, through the use of standardised approaches and principles. • To simplify and reduce the costs of compiling a GHG inventory. • To provide businesses with information that can be used to build an effective strategy to manage and reduce GHG emissions. • To increase consistency and transparency in GHG accounting and reporting among various companies and GHG programs (ghgprotocol.org, accessed January 2016). Project Accounting Protocol and Guidelines (Project Protocol) were designed to calculate reductions in GHG emissions from specific GHG-reduction projects. According to the GHG Protocol, the Project Protocol is the most comprehensive, policy-neutral accounting tool for quantifying the greenhouse gas benefits of climate change mitigation projects. The GHG Protocol is widely used. While the above discussion of international initiatives is far from exhaustive (there are many others as well), it does provide insights into some of the numerous initiatives that have been instigated in different parts of the world to address the varied issues associated with the social and environmental performance of organisations.

LO 30.1 LO 30.6 LO 30.10 LO 30.12

Social auditing

Closely linked to social accounting is the practice of social auditing—something that we will now discuss. The importance of organisations complying with community expectations has been discussed earlier in this chapter (when we discussed some of the possible motivations driving organisation to voluntarily produce social and environmental information). As noted then, if an organisation does not comply with community expectations (often referred to as breaching the ‘social contract’) or the expectations of particularly powerful stakeholders, this can have negative implications for the survival of the organisation. One way of seeing whether the organisation’s performance is conforming with the expectations of various stakeholder groups is to undertake what is commonly referred to as a ‘social audit’. According to Elkington (1997, p. 88), the purpose of social auditing is for an organisation to assess its performance in relation to society’s requirements and expectations. This is often done by directly soliciting the views of various stakeholder groups. Obviously, different management teams will be interested in the views of different stakeholder groups. Managers who take a broader ethical perspective to identifying their stakeholders will typically seek the opinions and views of a broader cross-section of stakeholders. Social audits allow a company to examine its social impacts and establish whether it is meeting its own social objectives. The results of a social audit often form the basis of an entity’s publicly released social accounts (thereby increasing the apparent transparency of the organisation), and the outcomes of social audits can be considered an important part of the ongoing dialogue with various stakeholder groups. At an international level, many organisations within the garments industry, for example, undertake social audits, particularly if their products are being sourced from factories located in developing countries where, over the past decade, many instances of poor labour practices and unsafe factories have been highlighted by the international news media. Organisations such as Nike, Reebok, Gap, H&M, Adidas and Uniqlo have performed social audits for a number of years. Such social audits often employ independent third parties to visit various supply factories in developing countries, and to seek the views of employees and other local stakeholders. The social audits formed the basis for the establishment of various operating policies and social reports. To see some of the disclosures Nike makes in relation to its social audits, please go to www.nikeresponsibility.com. The use of questionnaires and interviews with affected stakeholders is a common approach to determining stakeholders’ concerns and expectations. Such actions provide details of where improvements are necessary from the perspective of the stakeholders. Financial Accounting in the Real World 30.5 provides a commentary of social audit activities implemented by Uniqlo.

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30.5: FINANCIAL ACCOUNTING IN THE REAL WORLD Uniqlo acts on allegations of labour rights abuses Uniqlo, a Japanese clothing retailer, is owned by Fast Retailing Company, which has a very successful and profitable business both in Asia and elsewhere. In January 2015 Fast Retailing reported a massive increase of 65 per cent net profit in the period September—November 2014 from the same quarter in 2013. The success partly rests on the cheap labour it uses to produce its clothing range in Chinese factories. Fast Retailing was given a sharp wake-up when a damning report on conditions in clothing factories in Guangdong controlled by suppliers of Uniqlo apparel was released by a Hong-Kong group, Students and Scholars Against Corporate Misbehaviour (Sacom) on 11 January. The Sacom report was focused on two factories in the Southern China province. Pacific (Pan Yu) Textiles, a unit of Pacific Textiles Holdings, supplies textiles to garment factories and Dongguan Tomwell Garment, part of Luen Thai Holding, makes Uniqlo clothes. It was alleged that both factories used fines to punish workers, operated in dangerous working conditions, forced workers to work excessive overtime, and paid them very poorly. Fast Retailing acted swiftly after the Scom report was released and conducted an independent inspection of the factories. Yukihiro Nitta, executive charged with implementation of the company’s corporate social responsibility policies, said that Fast Retailing would work with the Guangdong factories’ owners to immediately remedy any deficiencies in working conditions. The factories were ordered to get rid of their fines systems, to ensure safety equipment was provided and used, to improve air quality and to review working schedules. One of the factories was required to begin a union by March. Fast Retailing said it would monitor suppliers more closely in future. Although Uniqlo accepted the findings of Sacom’s report overall, it had some issues with the allegations against Pacific (Pan Yu) and would continue its investigations. The companies at the centre of the scandal reacted differently to requests for comment. Pacific Textiles didn’t make any comment but Luen Thai promised that it would comply with Uniqlo’s standards in future. SOURCE: Adapted from ‘Uniqlo vows to clean up China unit’, by Chun Han Wong, The Australian, 17 January 2015, p. 26 

Reflective of the interest in social accounting and social auditing, a social accounting standard was released in 1998 by the organisation known as Social Accountability International, which was previously known as the Council on Economic Priorities Accreditation Agency (Social Accountability International is a non-profit affiliate of the Council on Economic Priorities). The standard, entitled SA8000 (‘SA’ stands for ‘Social Accountability’) focuses on issues associated with human rights, health and safety, and equal opportunities. SA8000 requires the audit of site performance against the principles of the UN Declaration of Human Rights, the International Labour Organization conventions and the UN Convention on the Rights of the Child. According to the website of Social Accountability International, the requirements necessary to comply with SA8000 can be summarised into nine areas, these being: 1. Child Labor: No workers under the age of 15; minimum lowered to 14 for countries operating under the ILO Convention 138 developing-country exception; remediation of any child found to be working 2. Forced or Compulsory Labor: No forced labor, including prison or debt bondage labor; no lodging of deposits or identity papers by employers or outside recruiters 3. Health and Safety: Provide a safe and healthy work environment; take steps to prevent injuries; regular health and safety worker training; system to detect threats to health and safety; access to bathrooms and potable water 4. Freedom of Association and Right to Collective Bargaining: Respect the right to form and join trade unions and bargain collectively; where law prohibits these freedoms, facilitate parallel means of association and bargaining 5. Discrimination: No discrimination based on race, caste, origin, religion, disability, gender, sexual orientation, union or political affiliation, or age; no sexual harassment 6. Disciplinary Practices: No corporal punishment, mental or physical coercion or verbal abuse

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7. Working Hours: Comply with the applicable law but, in any event, no more than 48 hours per week with at least one day off for every seven day period; voluntary overtime paid at a premium rate and not to exceed 12 hours per week on a regular basis; overtime may be mandatory if part of a collective bargaining agreement 8. Remuneration: Wages paid for a standard work week must meet the legal and industry standards and be sufficient to meet the basic need of workers and their families; no disciplinary deductions 9. Management Systems: Facilities seeking to gain and maintain certification must go beyond simple compliance to integrate the standard into their management systems and practices. Social Accountability International’s approach can be contrasted with the approach adopted by some organisations, which structure their social audit to issues that are developed ‘in house’, rather than considering issues specified by an external body, such as those responsible for the development of SA8000. Developing an organisation-specific social audit can be time-consuming and relatively expensive—but it does allow an organisation to tailor its stance so that it is effective in determining stakeholder expectations. Standardised approaches, such as SA8000, in a sense adopt a ‘onesize-fits-all’ position on social audits. However, such approaches provide an efficient system for organisations that elect not to develop their own social audit methodologies. In relation to SA8000 requirements, strict procedures are laid down to ensure that those carrying out the audit (who must receive special training to qualify) will get to learn of local opinion and operations. Auditors are to consult trade unions, workers and local non-government organisations. People living close to a site have the right to appeal against an SA8000 award if they disagree with it. If an organisation can have its operations (particularly those being undertaken in developing countries) certified to SA8000 standards by an independent party, it is conceivable that its legitimacy from the perspective of its stakeholders will be enhanced relative to that of its competitors. This in itself should generate business benefits (and of course, more importantly, it should generate real benefits for the employees involved). Apart from SA8000, we also have the AA1000 series that we discussed earlier in this chapter, which has direct relevance to social audits. There are also a number of organisations that perform social audit (or as they also call it ‘social compliance’) services. For example, one organisation known as WRAP (Worldwide Responsible Accredited Producers) is—according to its website at wrapcompliance.org—the world’s largest independent certification program mainly focused on the apparel, footwear and sewn products sectors. Accounting firms are also known to offer social audit/compliance services in developing countries. Reflective of the view that accounting firms are involved with social auditing, Financial Accounting in the Real World 30.6 is an extract from an article entitled ‘Human rights a business priority’ and provides details of activities undertaken by KPMG Australia.

30.6: FINANCIAL ACCOUNTING IN THE REAL WORLD KPMG on board with human rights John Ruggie developed the United Nations Guiding Principles on Business and Human Rights (Protect, Respect, Remedy) which have been adopted by numerous companies operating out of Australia, including some of those that have the biggest impact on the environment and society. Rio Tinto was a world leader when it published its human rights policy based on Ruggie’s Principles  BHP Billiton is another giant miner to have signed up to and implemented them. There is no longer a belief in the corporate world that profit should be achieved at any cost. Business is expected to be guided by ethical principles, including those upholding human rights. The social impact of any corporate activity needs to be carefully managed by a company. The Global Compact Network is the means by which Australian corporations participate in global discussions around human rights. KPMG Australia has recently bought Banarra, the human rights consultancy created by Richard Boele, a leading organiser of the Global Compact Australia annual conference. Banarra was one of eight small acquisitions in an 18-month period. Over the past 18 months, KPMG has acquired eight small firms, including social media risk consultancy SR7, Pacific Strategy Partners and the cyber security consultant First Point Global.

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KPMG’s CEO, Gary Wingrove, said that the acquisitions were for the expertise they brought to KPMG in corporate and social responsibility rather than the additional profit. It would have taken KPMG too long to build the expertise from inside. Adrian King, head of KPMG’s Climate Change and Sustainability Services, said that acquisition of Banarra will give KPMG a leadership role globally. He believes that human rights is not just an issue for the banking, mining and retailing sectors, but for all companies. Boele assured Banarra’s clients that the acquisition was a positive move as KPMG would assist in the growth of the company’s services around human rights risk assessment, ethical sourcing and management of supply chains. SOURCE: Adapted from ‘Human rights a business priority’, by Tony Boyd, The Australian Financial Review, 4 August 2015, p. 44

Once activities such as social audits are undertaken, they can act as a catalyst for organisations, and, importantly, for senior management to embrace new values. A ‘sustainable organisation’ needs to ensure that it complies with community expectations. As such, activities like social audits make good business sense. With the power of the media to beam information about an organisation’s international operations into our lounges, an organisation must consider not only the expectations of the local community in which it operates (whether gained through the process of a social audit, or otherwise) but its stakeholders worldwide—many of which will focus on social issues. (In the 1997 Health Safety and Environmental Report of Shell International, the chairperson refers to the world in which we live as a ‘CNN world’—a world in which global news networks will very quickly let us know about corporate misdemeanours, no matter where they occur.) Organisations must be able to indicate that they are not exploiting particular communities or subgroups—even though they might be complying with local laws. Undertaking social audits on a periodic basis is becoming accepted as a necessary part of a well-functioning governance system. An organisation’s operations can have many social impacts. A social audit (and related report) can obviously not cover all such impacts. Some prioritisation is necessary, and this prioritisation will be dependent on professional judgements. Consideration must be given to stakeholder needs, selection of appropriate performance indicators to satisfy information needs and so on—issues that were covered earlier in the chapter. Ideally, management should explain the reasons for selecting particular social areas for subsequent review. We will now turn out attention to the penultimate issue we will cover, an issue that is arguably one of the most important issues confronting the planet—climate change.

The critical problem of climate change

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An environmental crisis that is increasingly being seen as likely to have major impacts on the planet is climate change. To understand human beings’ contribution to climate change, one must understand the ‘greenhouse effect’ by which natural gases in the earth’s atmosphere allow infrared radiation from the sun to warm the earth’s surface. These gases prevent heat escaping from the earth’s atmosphere. Human actions are increasing the concentrations of these gases, which is causing changes in the earth’s climate—changes that are projected to intensify as greenhouse gas emissions continue to rise. One important greenhouse gas is carbon dioxide, which is believed to represent approximately 75 per cent of Australia’s greenhouse gas emissions. Carbon dioxide is generated through oil and gas production, the use of oil and gas and other fossil fuels, the burning of biomass, as well as being generated by animals, plants, micro-organisms and so forth. For readers who have an interest in information about the science of climate change, the Australian Academy of Science published a relatively succinct and easy to understand overview. This report is available on the Academy’s website and is called The Science of Climate Change: Questions and Answers—February 2015 (see https://www. science.org.au/learning/general-audience/science-booklets-0/science-climate-change, accessed January 2016). The report concludes (at p. 16) that: If society continues to rely on fossil fuels to the extent that it is currently doing, then carbon dioxide (CO2) concentrations in the atmosphere are expected to double from pre-industrial values by about 2050, and triple by about 2100. This ‘high emissions’ pathway for CO2, coupled with rises in the other greenhouse gases, would be expected to result in a global average warming of around 4.5˚C by 2100, but possibly as low as 3˚C or as high as 6˚C. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1107

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As the report emphasises, such temperature rises will have dramatic economic, environmental and social impacts. In part, one of the reasons for our current environmental problems is that for many years companies have treated the atmosphere as a ‘free good’ and have released emissions with no direct implications for reported profit or loss (or for the various types of rewards linked to reported profits). This has meant that economic activity has developed and corporate profits and economic growth have occurred at the same time that climate change has become a reality, thereby creating serious problems for future generations. Had organisations had direct expenses imposed upon them for their emissions then this might have encouraged them to develop ways to reduce their emissions—and their expenses. As Financial Accounting in the Real World 30.4 discussed, if we were, for example, to place a cost on the externalities generated from burning coal to create electricity, then we might have made bigger steps towards generating greater amounts of ‘clean’ energy. The introduction of carbon taxes and emissions trading schemes in some parts of the world has meant that many organisations now have to internalise aspects of the environmental impacts of their business that were previously ignored. The philosophy behind the introduction of carbon taxes and related regimes is that, if organisations are required to pay for the amount of pollution they create (which would otherwise be treated as an externality), this will have behavioural implications. Specifically, motivated by efforts to improve corporate profitability, companies would need to focus on reducing emission levels, and therefore the amount of (carbon) taxes they are required to pay. However, whether the tax rates are or would be set at amounts that are high enough to create necessary change is an issue to ponder. Climate change is obviously an issue attracting much attention globally, and one that we would expect organisations to address in their CSR reports. Indeed, many organisations consider it to represent one of their biggest risks. As Woolworths Ltd stated some years ago in its 2009 Sustainability Report (p. 52): Climate change and its impact on food production is the most critical environmental issue facing Woolworths and the sustainability of our business. Also, in a survey of 332 Australian companies undertaken in 2012, ACCSR (2012) report that in terms of priority, 46 per cent of companies attached a ‘high or very high’ priority to ‘managing the impact of climate change on our organisation’. Of course, many people would challenge whether such organisations are seriously trying to manage the problem. One or two decades ago, many companies challenged the science associated with climate change, but now there is a general acceptance that human activity is changing the climate. As the Chief Executive of BHP Billiton, Marius Kloppers, stated (BHP Billiton, Sustainability Report 2010, p. 2): Following the United Nations Climate Change Conference in Copenhagen in November 2009, it is evident that there are significant challenges in the quest to gain consensus on a global approach to this issue. While views differ across the sector about climate change, BHP Billiton accepts the science. Our climate is changing and humans are contributing to this change. An important organisation in relation to identifying and measuring climate change is the Intergovernmental Panel on Climate Change. In their Fifth Assessment Report (2014), the IPCC predicted temperature increases of 1.8°C to 4.8°C with associated sea level rises of between 26 and 55 centimetres as a result of activities that are predominantly manmade. IPCC (2014) shows how countries such as Australia are experiencing increased frequency and intensity of droughts, heat waves, fires and floods, all of which are linked to carbon emissions and climate change. Further, IPCC (2014) stresses that unless significant actions are taken now to reduce GHG emissions, then we can expect significant threats to food and water security, increasing species extinction and an associated loss of biodiversity, together with a loss of coastal habitat and infrastructure due to rising sea levels. In a commentary by Henry Paulson, the former United States treasury secretary and CEO of Goldman Sachs, entitled ‘Short-termism and the threat from climate change’ (April 2015, accessed on the McKinsey & Company website November 2015, www.mckinsey.com), he makes the following observations: The greenhouse-gas crisis, however, won’t suddenly manifest itself with a burst, like that of a financial bubble. Climate change is more subtle and cruel. It’s cumulative. And our current actions don’t just exacerbate the situation—they compound it. Indeed, our failure to make decisions today to avert climate disaster tomorrow is even more serious than our failure to avert the credit crisis in 2008. The carbon dioxide and other greenhouse gases that we emit into the atmosphere today will remain there for centuries, and government will not be able to avert catastrophe at the last minute . . . Fewer than ten years ago, scientists projected that melting Arctic sea ice would result in virtually ice-free Arctic summers by the end of this century. Now, the ice is melting so rapidly 1108  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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that such a result could be a reality in the next decade or two. More troubling, two new studies reveal that one of the biggest thresholds has already been crossed. The West Antarctic ice sheet has begun to melt, a process that scientists say may take centuries but that could eventually raise sea levels by as much as 14 feet. Now that the melting has begun, we can’t undo the underlying dynamics, which scientists say are ‘baked in.’ . . . We can’t afford to ignore this crisis. It’s as if we’re watching as we fly slow motion toward a giant mountain. We can see the crash coming, but we’re sitting on our hands instead of altering course. The effect climate change and associated mitigation efforts will have on organisations will differ depending upon the carbon intensity of the organisation’s operating practices, as well as on the location of the organisation’s operations (some locations will be more affected by weather and temperature changes and associated sea-level changes than others). Companies involved in electricity generation, resource extraction and manufacturing would be expected to be particularly affected. Nevertheless, given the initiatives aimed at reducing the use of carbon, and the apparent changes in weather patterns that are occurring, it is hard to imagine that any organisations will be immune from climate change issues. From a corporate reporting perspective, it is easy to accept that organisations should be required to make disclosures pertaining to the implications for business of climate-change mitigation policies. Various stakeholders, including investors, will increasingly consider risks associated with climate change when making investment, consumption and other decisions. But are corporations responding quickly enough? Evidence would suggest not. From an Australian perspective, Haque and Deegan (2010) explored the climate change-related governance disclosures practices of five major companies that were particularly exposed to risks associated with climate change. The companies were BHP Billiton (manufacturing/mining), Caltex (oil refinery), Origin Energy Limited (oil, gas, electricity), Rio Tinto (manufacturing/mining) and Santos Ltd (oil and gas). The companies’ annual reports and corporate social responsibility (sustainability) reports were reviewed. In relation to their findings, the authors state (p. 330): In this exploratory research we expected that there might be an increasing trend in corporate climate changerelated governance practice disclosures over the period of our analysis. Consistent with this expectation our finding suggests an increasing trend in companies’ climate change-related disclosures. However, from this research we can conclude that corporate reporting by major Australian companies on climate change-related practices appear to be still at a low level. While there are several items that have been relatively well disclosed (for example, issues under ‘emissions accounting’ and ‘research and development’ categories), none of the companies has provided disclosures across all, or nearly all, of the issues identified from our review of ‘best practice’. Further, some of the companies in our sample provided very limited disclosures across the period of our analysis, leading us to question the quality of their disclosures. While inter-governmental negotiations to create international agreements on climate change have been continuing for years, the outcomes have been modest. The most recent science indicates that global emissions will need to peak and begin to decline between 2015 and 2020 at the latest if we are to have any prospect of restricting global average temperature rises to safe levels. Time for making changes appears to be running out. Interested readers can review a website of the United Nations Framework Convention on Climate Change (UNFCCC) referred to as its ‘newsroom’. See Newsroom.unfccc.int. This website provides insights into the various international conventions on climate change.

Cap-and-trade schemes and their reliance upon ‘accounting’ One approach that has been advocated as a means of addressing climate change is to put in place a ‘cap-and-trade’ scheme. The existence of emission trading schemes relies upon giving carbon a price per tonne so that products can be more fully costed. 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) Emissions Trading Scheme, each carbon allowance permits the holder to emit one tonne of carbon dioxide (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, the amount of permits (or units) made available is reduced by the government in line with the quest to reduce carbon emissions. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1109

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The ‘trade’ aspect of the program occurs when a company’s 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 whose emissions 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-andtrade programs provide companies with added flexibility to choose the most cost-effective way to manage their emissions. The introduction of an ETS raises a number of financial accounting issues. While there is no definitive guidance as yet, it appears from international experience that the following financial accounting approaches would be acceptable to account for the related financial assets and liabilities: • 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 recognised would be subject to periodic impairment tests. • The difference between the price paid and fair value of permits received from the government would initially be 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 would be reported in shareholders’ equity (perhaps through a revaluation surplus) and decreases in fair value 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 in much the same way that a non‑current asset would be depreciated over time. • Should organisations emit at levels beyond their permits, the related financial obligation would be of the nature of a liability. In December 2012 the IASB formally reactivated a project on the accounting issues associated with emissions trading schemes (ETS). The project is expected to result in the publication of a Discussion Paper some time after 2016 and will address the financial reporting consequences of government-developed schemes designed to encourage reductions in the production of greenhouse gases. The project is expected to address how to account for allowances awarded by a scheme administrator and when, and how, to account for liabilities associated with the emission of greenhouse gases. In the absence of clear guidance, different organisations will account for emission rights and associated liabilities in a variety of ways. Initiatives such as ETSs are likely to have varying effects on different organisations and industries. This creates various risks and opportunities. It is essential that the reporting processes of organisations clearly provide interested stakeholders with insights into the risks and opportunities of such initiatives. Moreover, interested stakeholders should be provided with information about how overseas initiatives pertaining to climate change also create risks and opportunities for the entity. In relation to the European Emissions Trading Scheme, Deegan (2013) provides the following perspective: We can reflect on the use of a market-based mechanism throughout Europe, namely the European Emission Trading Scheme—which is an example of a cap-and-trade scheme where pollution rights are traded within a specifically designated market. To many people, this appeared to be a strange situation of using the very instrument that created the problem (this being the ‘market place’ which has allowed climate change to increase as a result of ‘free trade’ of various goods and services) to then try to solve the problem. This potential absurdity aside, the prices of the ‘pollution rights’ have fluctuated widely thereby creating much uncertainty for organisations considering whether to invest in cleaner technologies, or to buy pollution rights. For example, the price of a permit to emit a tonne of carbon dioxide hit a peak of €32 in April 2006 but hit a recent record low of €2.81 per tonne in April 2013. There are also the issues associated with having a ‘right to pollute’ being considered as a financial asset that sits in a balance sheet—that does look strange, doesn’t it? It should be emphasised that the above discussion relates to how we measure the associated assets and liabilities and not how we measure emissions or related offset allowances. We will now consider the measurement of actual emissions.

Accounting for the levels of actual emissions Various regulatory requirements have been introduced throughout the world that require organisations to ‘account’ for their emissions and any ‘offsets’ they receive (e.g. an organisation might calculate how much carbon is absorbed by a forest they control and this amount can be offset against the emissions relating to the organisation’s production operations). There are various initiatives that have been developed to enable an organisation to measure its emissions, 1110  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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for example, the Greenhouse Gas Protocol, which we briefly discussed earlier in this chapter. Emissions can be divided into three categories: Scope 1, Scope 2 and Scope 3: Scope 1—are those emissions directly occurring from sources that are owned or controlled by an institution, including: • combustion of fossil fuels; • mobile combustion of fossil fuels in vehicles owned/controlled by the organisation; and • fugitive emissions. Fugitive emissions, referred to above, result from intentional or unintentional releases of greenhouse gases (e.g. the leakage of hydrofluorocarbons from refrigeration and air-conditioning equipment). Scope 2—are emissions generated in the production of electricity consumed by the organisation where that electricity is generated outside the organisation’s measurement boundary (that is, the electricity is generated by a different entity, namely an electricity generator). Scope 3—are all the other indirect emissions that are a consequence of the activities of the organisation, but occur from sources not owned or controlled by the organisation, such as: • commuting; • air travel for work-related activities; • waste disposal; • embodied emissions from extraction, production and transportation of purchased goods; • outsourced activities; • contractor-owned vehicles; and • line loss from electricity transmission and distribution. In Australia, for example, entities and corporate groups that meet certain reporting thresholds (that is, large emitters) must report their Scope 1 and Scope 2 emissions under the National Greenhouse and Energy Reporting Act (NGER). The NGER was discussed earlier in this chapter.

Personal social responsibility

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While this chapter has focused on corporate social responsibility (CSR) and associated mechanisms to improve CSR, we arguably cannot, or perhaps, should not conclude the chapter without a brief reflection upon our own personal social responsibility (PSR). As individual consumers, or as members of an organisation, we can all make choices that will either increase, or decrease, our own contribution to various social and environmental outcomes. Rather than relying solely on CSR and/ or the government, we must also consider PSR, which would require ongoing judgements, such as the necessity for particular travel and the mode of travel being used, how much energy we consume, how much waste our activities are generating, how social and environmental responsibilities were embraced by the suppliers of our clothing and so forth. The emphasis here is that tackling important issues such as climate change and poverty alleviation requires ‘the community’ also to embrace the need for change and not simply to rely upon (or blame) organisations for all of the necessary improvements. One can also argue for PSR on the grounds that asking for or demanding CSR becomes a way of ‘passing the buck’—of evading personal responsibility for ‘doing good’. This is the flip side of blaming corporations for everything from obesity to scalding from spilled coffee—both the subject of lawsuits in recent years. As Chandler (2010) states: Let’s get beyond the idea that firms are inherently evil. Such a perspective does not absolve firms of responsibility, but recognizes that for-profit organizations add considerable social value in producing products and services that are in demand. It also recognizes that the relationship between firms and society is symbiotic and, as a result, the responsibility to ensure socially responsible outcomes is shared. In the same way that we deserve the politicians we vote for, we also deserve the companies we purchase from. While this is all pretty obvious, how many of us actually seriously embed PSR considerations into the various decisions we make. Further, how do accounting and business lecturers embed considerations of PSR within the courses they teach? Arguably, because business educators have an audience of future business leaders, it is even more important that they try to increase consciousness about the role of individual choice in addressing social and environmental issues and problems. CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1111

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In a related point, lecturers within economics departments typically continue to teach models of economics that have at their core the ‘rational economic person’ driven by self-interest towards the goal of maximising wealth. Many accounting theories also embrace a maintained assumption that ‘self-interest’ is the guiding principle for human behaviour. This is inconsistent with the view that people should embrace PSR. Nothing could be more antipathetical to the goal of sustainable development than the notion of the ‘rational economic person’. Teaching students that this is how most people act can make it a self-fulfilling prophecy that they will also behave like this when choices confront them. So how many of us have challenged economics and accounting lecturers on this? Should we? We can see that there are many interesting and important issues when it comes to both CSR and PSR!

Concluding remarks What has happened over the past decade or two with regard to social and environmental reporting (also frequently referred to as social responsibility reporting or sustainability reporting) is quite remarkable—and entirely necessary. Indeed, even more is required. The shift towards environmental reporting in the early 1990s, followed by a trend towards social reporting and ultimately sustainability reporting, has changed how companies produce information on their performance. Arguably, this trend will only grow, as stakeholders begin to expect to know more about the social and environmental performance of the organisations that operate within their communities. To keep up with this trend, the professional accounting bodies can be expected to embrace social environmental and environmental reporting as part of the duties of accountants, and (hopefully) to incorporate social accounting and environmental accounting issues in their educational programs in a meaningful way. While some An approach to universities already have entire units devoted to social and environmental accounting, they are currently external reporting in the minority. It is expected that to reflect the role that accountants can play in the provision of social that incorporates and environmental information, more universities will develop social and environmental accounting the impacts of the organisation on its and reporting units, thereby recognising the fact that organisations are accountable beyond their physical surroundings. financial performance. It is also hoped that eventually the Australian Accounting Standards Board and the International Accounting Standards Board will accept the trend and enter the arena of social and environmental reporting. In this regard, and accepting the scientific evidence that globally the environment is in crisis, Spence, Chabrak and Pucci (2013) make an interesting observation. They note (p. 470): Financial accounting standard-setters have had little to say about the ecological crisis. They were quick to set up a financial crisis advisory group, but no such equivalent has ever been suggested for the ecological crisis. It is worth emphasising that this chapter has provided only an overview of various issues associated with social and environmental reporting. However, hopefully it has been able to demonstrate the significant moves towards a more holistic form of reporting as opposed to the traditional fixation on financial performance reporting alone. In concluding this section of the chapter, the following quotation from the Oxford Dictionary of Proverbs (2009) seems very pertinent: When the last tree is cut down, the last fish eaten, and the last stream poisoned, you will realize that you cannot eat money.  (Native American saying)

SUMMARY The chapter considered various issues associated with social-responsibility reporting. The practice of social-responsibility reporting relates to the provision of information about various facets of an organisation’s social performance, including information about its environmental performance, health and safety record, training and education programs and support of the local community. Unlike financial reporting, the provision of information about an organisation’s social and environmental performance is largely unregulated. Hence corporate social disclosures within annual reports or separate sustainability reports are typically provided on a voluntary basis. As social and environmental disclosures are 1112  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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predominantly voluntary, many researchers have undertaken studies to explain the various motivations driving corporate management to make such disclosures. We identified a number of possible motivations. The consideration of social-responsibility disclosures necessarily requires some consideration of the social responsibilities of business. Within this chapter, various perspectives of the social responsibilities of business are provided. Some perspectives limit the responsibility of business to a responsibility to investors (the ‘Friedman perspective’), whereas other broader perspectives of the social responsibilities of business encompass a range of stakeholder groups. Various approaches or frameworks for social and environmental reporting were explored. In doing so, this chapter has emphasised the somewhat obvious fact that financial accounting is useful only for assessing the financial performance of an entity. It is certainly not an all-encompassing measure of organisational performance (even though the financial press often appears to act as though it is). Financial accounting typically disregards the social and environmental impacts/performance of an entity’s operations. The GRI and IIRC frameworks were discussed and limitations identified. The important problem of climate change was addressed and accounting issues associated with climate change were also highlighted. The chapter concluded with a discussion of personal social responsibility that highlighted the need for us all to accept responsibility for the social and environmental problems confronting the planet now—and in the future.

KEY TERMS accountability  1059 efficient-markets hypothesis  1075 environmental accounting  1112 externality  1052 social auditing  1052

social benefits  1058 social contract  1070 social cost  1052 social-responsibility reporting  1051 stakeholder  1051

sustainable development  1054 traditional financial accounting practices  1078 triple-bottom-line reporting  1054

END-OF-CHAPTER EXERCISES In Financial Accounting in the Real World 30.5, entitled ‘Uniqlo vows to clean up China unit’, the efforts of clothing retail company Uniqlo were discussed in relation to improving workers’ conditions. Read the article and then attempt to answer the questions that follow below. No model answers are provided to the questions. Rather, the intention in setting the questions is for you to see if you can use the material in this chapter (much of which is theoretical) to explain an actual initiative undertaken by a major multinational corporation. 1. What do the developments discussed in the article imply about Uniqlo’s perspectives on the social responsibilities of business (responsibilities to whom and for what)? LO 30.1 2. Could you apply any of the theoretical perspectives discussed in this chapter (for example, Legitimacy Theory) to explain Uniqlo’s actions? LO 30.8

REVIEW QUESTIONS 1. What is social-responsibility reporting? LO 30.2 2. What is meant by the term ‘accountability’? LO 30.1 3. What is the relationship between ‘accountability’ and ‘accounting’? LO 30.1 4. What would you consider to be the social responsibilities of business? LO 30.1 5. What is the Carbon Disclosure Project? LO 30.10, 30.11 6. If an organisation is concerned about its perceived legitimacy, is it more important for that organisation to actually do the right thing, or to communicate that it is doing the right thing? Give reasons for your answer. LO 30.8 CHAPTER 30: ACCOUNTING FOR CORPORATE SOCIAL RESPONSIBILITY  1113

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7. What are some of the central premises of Legitimacy Theory? LO 30.8 8. According to Legitimacy Theory, what are the implications for an organisation that fails to comply with the expectations held by society? LO 30.8 9. What is the IPCC? LO 30.11 10. In relation to schemes aimed at reducing carbon emissions, briefly explain how a ‘cap-and-trade’ system operates. LO 30.11, 30.12, 30.13 11. Legitimacy Theory relies upon the theoretical notion of a ‘social contract’. What is a ‘social contract’ and why is it linked to Legitimacy Theory? LO 30.8 12. What are some of the motivations that might drive corporate managers to voluntarily disclose social and environmental performance information? LO 30.8 13. As used within this chapter, what does ‘full cost accounting’ involve? LO 30.10 14. What is personal social responsibility and what is the role of business educators in instilling the idea of personal social responsibility within students? LO 30.13 15. The following statement was made in the 1997 environmental report of WMC Ltd: WMC understands that its access to land and its public licence to operate depend to a considerable extent on informing and involving the communities in which it operates. The company recognises the need for local communities to be more involved in decision making. Over time, community expectations change. WMC is looking to develop policies and processes to foster community consultation at all its operations. What do you think WMC Ltd means by the term ‘public licence to operate’? LO 30.8 16.   (a) If a bank’s lending policies lead to foreclosures, then why would such foreclosures be considered to be ‘externalities’ of the bank? LO 30.9 (b) How might a bank report information about such foreclosures? LO 30.10 17. The following statement was made in the 2003 annual report of Westpac: Westpac’s aim is to manage its business in a way that produces positive outcomes for all stakeholders and maximises economic, social and environmental value simultaneously. In doing so, Westpac accepts that the responsibilities flowing from this go beyond both the strict legal obligations and just the financial bottom line.

18.

19. 20. 21. 22. 23.

Do you think that the simultaneous maximisation of economic, social and environmental value is an achievable goal? Give reasons for your answer. LO 30.8 Many expectations will be held by various stakeholder groups in relation to how an organisation should conduct its operations. Suggest how the expectations of different stakeholders, such as environmentalists, creditors, visitors to a national park, employees and businesses in neighbouring towns, might differ for an entity engaged in logging activities in and around a national park. Further, according to Stakeholder Theory, which stakeholders will an organisation be more concerned about satisfying? LO 30.8 What is climate change and what are some of the accounting issues associated with climate change? LO 30.12 What does PUMA’s Environmental Profit and Loss attempt to do? Do you think it does it successfully? LO 30.9, 30.10 What implications would a failure to provide balanced, unbiased social and environmental-performance data have for the perceived credibility of the other information provided in an annual report? LO 30.1, 30.8 What is a social audit, and how might a social audit be undertaken? LO 30.12 On the website of the Carbon Disclosure Project (CDP) (accessed in January 2016), there is a quote from Lord Adair Turner, Chairman of UK Financial Services Authority, in which he states: The first step towards managing carbon emissions is to measure them because in business what gets measured gets managed. The Carbon Disclosure Project has played a crucial role in encouraging companies to take the first steps in that measurement and management path. Evaluate this statement. LO 30.10, 30.11

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24. In this chapter it was stated: When we then review the IIRC Framework to see the primary purpose of integrated reporting we find (paragraph 1.7, p. 7): The primary purpose of an integrated report is to explain to providers of financial capital how an organization creates value over time. To many people, the restricted definition of the perceived users of integrated reports would be disappointing.

REQUIRED Explain why some people would find the above ‘purpose’ disappointing. LO 30.9, 30.10 25. Deegan and Rankin (1996) found that, within a sample of companies that were prosecuted by the Environmental Protection Authorities of NSW and Victoria, the prosecuted companies provided a significantly greater amount of positive (or self-laudatory) environmental-performance information in the years in which they were prosecuted. Why do you think this might have been the case? LO 30.8 26. Evaluate the following statement: ‘The annual report issued to the public is a very important document of the organisation from a strategic perspective’. LO 30.8 27. Brown and Deegan (1999) provided results which showed that companies operating within industries that are subject to higher levels of media attention because of their environmental implications and impacts are more inclined to produce higher levels of environmental-performance disclosures within their annual reports. Why do you think this might be the case? LO 30.8 28. Why might it be argued that ‘environmental accounting’ is an oxymoron? LO 30.3, 30.9 29. On page 3 of the BHP Billiton 2010 Sustainability Supplementary Information Report (which is a separate document to the Sustainability Report), the following statement is made under the heading ‘Our Stakeholders’: BHP Billiton defines key stakeholders as those who have an interest in what we do, or have an influence over what we do, or who are potentially impacted by our operations. All BHP Billiton operations are required to identify their key stakeholders and to consider their expectations and concerns for all activities throughout the lifecycle of operations. Operations are also required to specifically consider any minority groups (such as indigenous groups) and any social and cultural factors that may be critical to stakeholder engagement. A regular review process is also a central requirement of stakeholder identification, to ensure that all appropriate groups and individuals are effectively identified and suitably engaged. Is the above definition of stakeholders consistent with a managerial (based on advancing the interests of shareholders and increasing company value) or ethical (based on considering impacted stakeholders’ needs and expectations) perspective of stakeholder theory? LO 30.8 30. The following extract comes from an article entitled ‘Big banks defend coal loans’, by Peter Kerr and Neil Chenoweth (Australian Financial Review, 23 November 2010, p. 6). Financial institutions providing $150 million in loans to Verve Energy for the company’s project to, with Inalco, recommission Western Australia’s Muja coal-fired power station, have denied trying to hide their involvement. Verve chief executive Shirley In’t Veld had said at least one of its lenders had required the company to not disclose its involvement. That lender was revealed as Australia and New Zealand Banking Group on the weekend, with National Australia Bank and GE Capital also revealed as involved yesterday. ANZ recently topped the Dow Jones Sustainability Index as the best bank on sustainable issues globally, leading Greenpeace to yesterday label the bank as ‘hypocritical’. A spokesperson for ANZ said ‘we recognise the importance of coal in Australia’s energy security while transitioning to a lower carbon future.’ Westpac Banking Corporation last week said it would avoid providing funding to coal-fired power stations. Having read the above extract, answer the following questions: (a) With the concept of the ‘social contract’ in mind, why would banks prefer not to disclose information about funding coal-fired power plants? LO 30.8 (b) Do you think that the perceived legitimacy of the banks would be impacted by the information provided in the article? LO 30.8 (c) How do you think the banks would respond to the information provided within the article? LO 30.8

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31. In relation to efforts to restrict accountability, Gray, Adams and Owen (2014, p. 325) note: Powerful people the world over appear to know just how transformative a full accountability and transparency would be—and work very hard to prevent it coming to fruition. It seems difficult to avoid this conclusion—however unsettling it might be.

REQUIRED Explain the reasoning behind the above statement. LO 30.1, 30.5, 30.9 32. On page 12 of the BHP Billiton annual report of 2010 it is stated that ‘Despite our best efforts and best intentions there remains a risk that health, safety, environmental and/or community incidents or accidents may occur that may negatively impact our reputation or licence to operate’. What does the organisation mean by ‘licence to operate’? LO 30.8 33. Comment on the following statement, which appeared in The Australian (11 December 2000, p. 12): LO 30.1 Minimising tax within the framework of the law is not only normal corporate behaviour, it is responsible. Company directors have a duty to maximise profits and deliver the largest possible returns to shareholders. Limiting tax, legitimately, is part of the role. Nevertheless, revelations that Telstra has a shelf company headquartered in the tax haven of Bermuda will make Australians feel uneasy. The reason is the potential that association harbours for a conflict of interest.

CHALLENGING QUESTIONS 34. How does the decision about ‘what’ and ‘to whom’ to report relate to considerations of ‘why’ report? LO 30.1, 30.2 30.8 35. There are a number of reasons why the practice of financial accounting tends to ignore the social and environmental impacts caused by organisations. In this regard, explain: (i) how and why the way we define assets and expenses tends to exclude the recognition of social and environmental impacts; (ii) why the ‘entity principle’ is inconsistent with the principle of sustainable development; (iii) why the recognition criteria for the elements of accounting can lead to organisations not recognising environment-related obligations and associated costs; (iv) why periodic (12-month) reporting can act to discourage a business organisation from taking a longer-term view of its operations. LO 30.9 36. As indicated in this chapter, Gray and Bebbington (1992, p. 6) provide the following opinion in relation to traditional financial accounting: there is something profoundly wrong about a system of measurement, a system that makes things visible and which guides corporate and national decisions, that can signal success in the midst of desecration and destruction. Critically evaluate Gray and Bebbington’s statement. LO 30.9 37. On the ‘function’ of accounting, Gray (2013, p. 467) makes the following comment in relation to the role of accounting: A world in which the larger organisations disclosed such things as eco-balances and ecological footprints; in which the interactions in all relationships between organisations and stakeholders were exposed, warts and all; when society could know the full extent of an organisation’s compliance with law and quasi law; would be unlikely to look a great deal like the world we now inhabit. This, I suggest, is the function of social, environmental and sustainability accounting—or, as I prefer to call it, ‘accounting’.

REQUIRED Explain and evaluate the above comment. LO 30.1 1116  PART 10: CORPORATE SOCIAL-RESPONSIBILITY REPORTING

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38. Lehman (1995, p. 408) provides a very interesting definition of accounting—that it is ‘both the means for defending actions and the means for identifying which actions one must defend’. He also states that accounting information should ‘form part of a public account given by a firm to justify its behaviour’.

REQUIRED You are to note whether you agree or disagree with Lehman, and to explain the basis of your agreement or disagreement. LO 30.1, 30.2 39. In the March 2001 edition of Australian CPA there was an article by Ian Nash and Adam Awty entitled ‘Just clowning around?’. The following is a quote from the article: Basically, environmental and social reporting is when the accounting profession eases into its Birkenstock sandals and becomes green, fluffy and friendly. It’s the type of reporting that nobody in the market could possibly take seriously, and, even if it’s on the horizon, it’s a long way from becoming a regulatory and legal issue. True or false? Critically evaluate the above quotation and provide an opinion on the ‘true or false’ question. LO 30.2, 30.3 40. Within this chapter, a quote from Brown (2009, p. 318) is provided, which states: Given the essentially contestable nature of sustainability, new accountings should not be aimed at producing incontrovertible accounts. Societal worth should be judged