Financial Accounting 2 hour time quiz at 7.30pm Singapore time.

profileSharonhy
CopyofFinancialAccounting9thEdDeegan.pdf

CRAIG DEEGAN

ACCOUNNG NANCIAL

9TH EDITION

dee67382_fm_i-xxvi.indd i 10/24/19 04:13 PM

CRAIG DEEGAN

ACCOUNNG NANCIAL

dee67382_fm_i-xxvi.indd ii 10/24/19 04:13 PM

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

dee67382_fm_i-xxvi.indd iii 10/24/19 04:13 PMdee67382_fm_i-xxvi.indd iii 10/24/19 04:13 PM

CRAIG DEEGAN

ACCOUNNG NANCIAL

9TH EDITION

dee67382_fm_i-xxvi.indd iv 10/24/19 04:13 PM

Copyright © 2020 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 (CA) and been granted a licence. For details of statutory educational and other copyright licences contact: Copyright Agency, 11/66 Goulburn 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 Author: Deegan, Craig Michael Title: Financial accounting Edition: 9th edition. ISBN: 9781743767382

Copyright © Commonwealth of Australia 2019 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 National Director, Australian Accounting Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria 8007.

This publication contains copyright material of the AASB. © (2019) Australian Accounting Standards Board (AASB). The text, graphics and layout of this publication are protected by Australian copyright law and the comparable law of other countries. No part of the publication may be reproduced, stored or transmitted in any form or by any means without the prior written permission of the AASB except as permitted by law. For reproduction or publication permission should be sought in writing from the Australian Accounting Standards Board. Requests in the first instance should be addressed to the National Director, Australian Accounting Standards Board, PO Box 204, Collins Street West, Victoria 8007.

This publication contains copyright material of the IFRS® Foundation in respect of which all rights are reserved. Reproduced by McGraw-Hill Education with the permission of the IFRS Foundation. No permission granted to third parties to reproduce or distribute. For full access to IFRS Standards and the work of the IFRS Foundation please visit http://eifrs.ifrs.org

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.

Published in Australia by McGraw-Hill Education (Australia) Pty Ltd Level 33, 680 George Street Sydney NSW 2000 Senior portfolio manager: Simone Bella Content developer: Caroline Hunter Senior production editor: Claire Linsdell Permissions: Debbie Gallagher Copyeditor: Alison Moore Proofreader: Paul Leslie Cover design: Simon Rattray, Squirt Creative Cover image: Shutterstock/Delpixel Typeset in STIX MathJax Main 10/12pt by SPi Global, India Printed in China by 1010 Printing International Ltd on 65gsm matt art

dee67382_fm_i-xxvi.indd v 10/24/19 04:13 PM

v

Craig Deegan is Professor of Accounting in the School of Accounting at RMIT University in Melbourne. He has been teaching at undergraduate and postgraduate levels for nearly thirty years, and before embarking on his distinguished academic career, practised as a chartered accountant. Craig is a Fellow of Chartered Accountants Australia and New Zealand, and was, for approximately a decade, a member of the judging panel of the Australasian Sustainability Reporting Awards. He is currently on the editorial boards of several academic accounting journals and is a former Chairperson of the Triple Bottom Line Issues Group of Chartered Accountants Australia and New Zealand. For many years he assisted in the development of the CPA Program, Australia, with a notable contribution to the Ethics and Governance Module.

An internationally renowned expert in the field of financial accounting, Craig’s work is regularly published in peer-reviewed accounting journals including: Accounting, Organizations and Society; Accounting and Business Research; Accounting, Auditing and Accountability Journal; Accounting and Finance; British Accounting Review; Critical Perspectives on Accounting; Journal of Business Ethics; Australian Accounting Review; Australian Journal of Management; and The International Journal of Accounting. According to Google Scholar, his work has attracted over 22 000 citations, making him one of the most highly cited researchers within the accounting and/or finance literature in the world. On 28 September 2018, and reflective of the extent to which his research has been relied upon by researchers and practitioners, the leading national

newspaper The Australian (in its annual feature on Australian research leaders), identified Craig as Australia’s Research Field Leader in the Field of Accountability and Taxation

Craig’s expertise is frequently sought by corporations, government and industry bodies on issues pertaining to financial accounting, corporate social and environmental accountability, and ethics. The depth of his knowledge with respect to social and environmental accountability is reflected in the impressive Chapter 32, which has been comprehensively updated for this edition. A key tenet of his work, and reflected in his own high standard of professional ethics, is that business organisations have responsibilities to a broader group of stakeholders, beyond their shareholders, for their social and environmental performance, as well as their financial performance.

Craig is the recipient of various teaching and research awards, including teaching prizes sponsored by KPMG and Chartered Accountants Australia and New Zealand. 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 now working on the fifth edition of his leading financial accounting theory textbook, Financial Accounting Theory. His introductory accounting textbook, An Introduction to Accounting: Accountability in Organisations and Society, was published by Cengage Learning in late 2019.

Craig Deegan BCom (UNSW), MCom (Hons) (UNSW), PhD (UQ), FCA

ABOUT THE AUTHOR

dee67382_fm_i-xxvi.indd vi 10/24/19 04:13 PM

vi

CONTENTS IN BRIEF

PART 1 THE AUSTRALIAN ACCOUNTING ENVIRONMENT 1 Chapter 1 An overview of the Australian external reporting environment . . . . . . . . . . . . . . . . . . . . . . . . . 2 Chapter 2 The Conceptual Framework for Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

PART 2 THEORIES OF ACCOUNTING 99 Chapter 3 Theories of financial accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

PART 3 ACCOUNTING FOR ASSETS 159 Chapter 4 An overview of accounting for assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 Chapter 5 Depreciation of property, plant and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 Chapter 6 Revaluations and impairment testing of non-current assets . . . . . . . . . . . . . . . . . . . . . . . . 223 Chapter 7 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 Chapter 8 Accounting for intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283 Chapter 9 Accounting for heritage assets and biological assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327

PART 4 ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY 373 Chapter 10 An overview of accounting for liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374 Chapter 11 Accounting for leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409 Chapter 12 Accounting for employee benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463 Chapter 13 Share capital and reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495 Chapter 14 Accounting for financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527 Chapter 15 Revenue recognition issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599 Chapter 16 The statement of profit or loss and other comprehensive income,

and the statement of changes in equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641

Chapter 17 Accounting for share-based payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687 Chapter 18 Accounting for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 723

PART 5 ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS 769 Chapter 19 The statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770

dee67382_fm_i-xxvi.indd vii 10/24/19 04:13 PM

vii

PART 6 INDUSTRY-SPECIFIC ACCOUNTING ISSUES 813 Chapter 20 Accounting for the extractive industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 814

PART 7 OTHER DISCLOSURE ISSUES 853 Chapter 21 Events occurring after the end of the reporting period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 854 Chapter 22 Segment reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 869 Chapter 23 Related party disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 899 Chapter 24 Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 917

PART 8 ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES 947 Chapter 25 Accounting for group structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 948 Chapter 26 Further consolidation issues I: accounting for intragroup transactions . . . . . . . . . . . . . . 1005 Chapter 27 Further consolidation issues II: accounting for non-controlling interests . . . . . . . . . . . . 1055 Chapter 28 Further consolidation issues III: accounting for indirect ownership interests . . . . . . . . . 1103 Chapter 29 Accounting for investments in associates and joint ventures . . . . . . . . . . . . . . . . . . . . . . 1155

PART 9 FOREIGN CURRENCY 1205 Chapter 30 Accounting for foreign currency transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1206 Chapter 31 Translating the financial statements of foreign operations . . . . . . . . . . . . . . . . . . . . . . . . . 1227

PART 10 CORPORATE SOCIAL-RESPONSIBILITY REPORTING 1249 Chapter 32 Accounting for corporate social responsibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1250

dee67382_fm_i-xxvi.indd viii 10/26/19 12:02 PM

viii

CONTENTS

About the author � � � � � � � � � � � � � � � � � � � � � � � � � � � � � v Contents in brief � � � � � � � � � � � � � � � � � � � � � � � � � � � � �vi Preface � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � � �xix Acknowledgments � � � � � � � � � � � � � � � � � � � � � � � � � � xx

AACSB statement � � � � � � � � � � � � � � � � � � � � � � � � � � � �xxi How to use this book � � � � � � � � � � � � � � � � � � � � � � � xxii Digital resources � � � � � � � � � � � � � � � � � � � � � � � � � � �xxiv

CHAPTER 2 The Conceptual Framework for Financial Reporting . . . . . . . . . 59

2.1 An introduction to the IASB Conceptual Framework 60 2.2 Benefits of a conceptual framework 61 2.3 An overview of the recently revised Conceptual Framework 61 2.4 An overview of the building blocks of the

Conceptual Framework 63 2.5 Definition of general purpose financial reporting and a

reporting entity 64 2.6 Users of general purpose financial statements 65 2.7 Objective of general purpose financial reporting 67 2.8 Qualitative characteristics of useful financial information 68 2.9 Definition and recognition of the elements

of financial statements 74 2.10 Measurement principles 87 2.11 A critical review of conceptual frameworks 90 2.12 The conceptual framework as a normative theory of accounting 93

Learning objectives (LO) 59 Opening questions 60 Summary 93 Key terms 94 Answers to Opening questions 94 Review questions 95 Challenging questions 95 References 97

PART 1 THE AUSTRALIAN ACCOUNTING ENVIRONMENT . . . . . . . . . . . . . . . . . . . 1

1.1 Accounting, accountability and the role of financial accounting 3 1.2 Users’ demand for general purpose financial statements 6 1.3 Australian Securities and Investments Commission 7 1.4 Australian Accounting standards Board 18 1.5 Financial Reporting Council 31 1.6 Australian Securities Exchange 32 1.7 International Accounting Standards Board 34 1.8 Accounting standards change across time 38 1.9 Differential reporting 38 1.10 The use and role of audit reports 41 1.11 What benefits can we expect from all of this international

standardisation? 42 1.12 International cultural differences and the harmonisation of

accounting standards 44 1.13 All of this regulation—is it really necessary? 45 1.14 The reporting of alternative measures of ‘profits’ 48

Learning objectives (LO) 2 Opening questions 3 Summary 53 Key terms 53 Answers to Opening questions 53 Review questions 54 Challenging questions 55 References 57

CHAPTER 1 An overview of the Australian external reporting environment . . . . . . 2

dee67382_fm_i-xxvi.indd ix 10/26/19 12:03 PM

ix

PART 2 THEORIES OF ACCOUNTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

3.1 Introduction to theories applicable to financial accounting 101 3.2 Positive accounting theory 104 3.3 Efficiency and opportunistic perspectives of PAT 105 3.4 Owner–manager contracting 106 3.5 Debt contracting 110 3.6 Political costs 114 3.7 Accounting policy choice and ‘creative accounting’ 120 3.8 Some criticisms of Positive Accounting Theory 122 3.9 Normative accounting theories 124 3.10 Systems-oriented theories to explain accounting practice 128 3.11 Stakeholder Theory 129 3.12 Legitimacy Theory 133 3.13 Institutional Theory 137 3.14 Theories that seek to explain why regulation is introduced 144

Learning objectives (LO) 100 Opening questions 101 Summary 148 Key terms 149 Answers to Opening questions 149 Review questions 150 Challenging questions 151 Further reading 155 References 155

CHAPTER 3 Theories of financial accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

PART 3 ACCOUNTING FOR ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

4.1 Introduction to accounting for assets 161 4.2 Recognition criteria 162 4.3 Measurement of assets 165 4.4 Further consideration of ‘fair value’ 171 4.5 Definition of current assets 178 4.6 How to present a statement of financial position 179 4.7 Accounting for property, plant and equipment—an introduction 182 4.8 Property, plant and equipment acquired with non-cash

consideration 188 4.9 Deferred payments made to acquire an asset 189 4.10 Accounting for borrowing costs incurred when constructing

an item of property, plant and equipment 190 4.11 Assets acquired at no cost 193

Learning objectives (LO) 160 Opening questions 160 Summary 195 Key terms 195 Answers to Opening questions 195 Review questions 196 Challenging questions 197 References 200

CHAPTER 4 An overview of accounting for assets . . . . . . . . . . . . . . . . . . . . . . . 160

CHAPTER 5 Depreciation of property, plant and equipment . . . . . . . . . . . . . . . 201

5.1 Introduction to accounting for the depreciation of property, plant and equipment 202

5.2 Key factors to consider when determining depreciation 204 5.3 Applying different methods of depreciation 205 5.4 Depreciation of separate components 208 5.5 When to start depreciating an asset 209 5.6 Revision of depreciation rate and depreciation method 210 5.7 Land and buildings 210 5.8 Modifying existing non-current assets 212 5.9 Disposition of a depreciable asset 212 5.10 Depreciation as a process of allocating the cost of an

asset over its useful life: some related concerns 214 5.11 Disclosure requirements 215

Learning objectives (LO) 201 Opening questions 202 Summary 216 Key terms 216 Answers to Opening Questions 216 Review questions 217 Challenging questions 218 References 221

dee67382_fm_i-xxvi.indd x 10/24/19 04:13 PM

CONTENTS

x

CHAPTER 6 Revaluations and impairment testing of non-current assets. . . . . 223

6.1 Introduction to revaluations and impairment testing of non-current assets 224

6.2 Measuring property, plant and equipment at cost or at fair value—there’s a choice 224

6.3 The use of fair values 226 6.4 Revaluation increments 226 6.5 Treatment of balances of accumulated depreciation

upon revaluation 228 6.6 Revaluation decrements 231 6.7 Reversal of revaluation decrements and increments 232 6.8 Accounting for the gain or loss on the disposal or

derecognition of a revalued non-current asset 234 6.9 Recognition of impairment losses 239 6.10 Further consideration of present values 244 6.11 Investment properties 246 6.12 Economic consequences of asset revaluations

and impairments 247 6.13 Disclosure requirements 250

Learning objectives (LO) 223 Opening questions 224 Summary 250 Key terms 250 Answers to Opening questions 251 Review questions 251 Challenging questions 253 References 256

CHAPTER 7 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257

7.1 Introduction to inventory 258 7.2 The general basis of inventory measurement 259 7.3 Inventory cost-flow assumptions 267 7.4 Reversal of previous inventory write-downs 275 7.5 Disclosure requirements 275

Learning objectives (LO) 257 Opening questions 257 Summary 276 Key terms 277 Answers to Opening questions 277 Review questions 277 Challenging questions 279 References 282

CHAPTER 8 Accounting for intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283

8.1 Introduction to accounting for intangible assets 284 8.2 Which intangible assets can be recognised and included in the

statement of financial position? 287 8.3 What is the initial basis of measurement of intangible assets? 288 8.4 General amortisation requirements for intangible assets 290 8.5 Revaluation of intangible assets 292 8.6 Required disclosures in relation to intangible assets 294 8.7 Research and development 295 8.8 Accounting for goodwill 303 8.9 Does the way we account for intangible assets provide

useful financial accounting information? 313

Learning objectives (LO) 283 Opening questions 283 Summary 314 Key terms 315 Answers to Opening questions 315 Review questions 316 Challenging questions 319 References 325

dee67382_fm_i-xxvi.indd xi 10/24/19 04:13 PM

CONTENTS

xi

CHAPTER 9 Accounting for heritage assets and biological assets . . . . . . . . . 327

9.1 Introduction to accounting for heritage assets and biological assets 328

9.2 Some arguments for and against recognising heritage assets in financial terms 330

9.3 Do heritage assets provide future economic benefits? 335 9.4 Who controls heritage assets? 337 9.5 Faithful representation: are the benefits measurable

with reasonable accuracy? 338 9.6 Is the information ‘relevant’? The actual demand for

financial information about heritage assets 339 9.7 Measuring heritage assets in financial terms 341 9.8 An introduction to accounting for biological assets:

what is a biological asset? 349 9.9 The unique nature of biological assets 352 9.10 How should biological assets be classified, presented and

measured in financial statements? 352 9.11 When and how should revenue associated with biological

assets be recognised? 358 9.12 Accounting for agricultural produce 360 9.13 Non-financial disclosures 360 9.14 Opposition to AASB 1037 and AASB 141 364

Learning objectives (LO) 327 Opening questions 328 Summary 365 Key terms 365 Answers to Opening questions 365 Review questions 366 Challenging questions 367 References 370

PART 4 ACCOUNTING FOR LIABILITIES AND OWNERS’ EQUITY . . . . . . . . . . 373

10.1 The definition of liabilities 375 10.2 The recognition criteria for liabilities 377 10.3 Classification of liabilities as ‘current’ or ‘non-current’ 379 10.4 Liability provisions 380 10.5 Onerous contracts 383 10.6 Accounting for bonds (debentures) 385 10.7 Contingent liabilities 390 10.8 Contingent assets 394 10.9 Some implications of reporting liabilities 395 10.10 Debt equity debate 397 10.11 Hybrid securities 399

Learning objectives (LO) 374 Opening questions 375 Summary 400 Key terms 400 Answers to Opening questions 400 Review questions 401 Challenging questions 404 References 407

CHAPTER 10 An overview of accounting for liabilities . . . . . . . . . . . . . . . . . . . . 374

CHAPTER 11 Accounting for leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409

11.1 An overview of recent developments in the accounting requirements pertaining to accounting for leases 410

11.2 The core principle and scope of AASB 16 415 11.3 What is a lease pursuant to AASB 16? 417 11.4 When to recognise a lease 420 11.5 Accounting for the service component of a contract

that includes a lease 420 11.6 The meaning of ‘lease term’ 421 11.7 Accounting for leases by lessees 422 11.8 Accounting for leases by lessors 436 11.9 Implications for accounting-based contracts 451

Learning objectives (LO) 409 Opening questions 410 Summary 453 Key terms 455 Answers to Opening questions 455 Review questions 456 Challenging questions 458 References 462

dee67382_fm_i-xxvi.indd xii 10/26/19 12:04 PM

CONTENTS

xii

CHAPTER 12 Accounting for employee benefits . . . . . . . . . . . . . . . . . . . . . . . . . 463

12.1 Overview of employee benefits 464 12.2 Categories of employee benefits 466 12.3 Accounting for employee benefits in the form of salaries

and wages 468 12.4 Annual leave 469 12.5 Sick leave 470 12.6 Long-service leave 471 12.7 Superannuation contributions 476 12.8 Employees’ accrued employee benefits and

corporate collapses 488

Learning objectives (LO) 463 Opening questions 464 Summary 489 Key terms 489 Answers to Opening questions 489 Review questions 490 Challenging questions 491 Reference 494

CHAPTER 13 Share capital and reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495

13.1 Introduction to accounting for share capital and reserves 496 13.2 Creating reserves 498 13.3 Different classes of shares 499 13.4 Accounting for the issue of share capital 500 13.5 Forfeited shares 507 13.6 Rights issues and share options 511 13.7 Share splits and bonus issues 513 13.8 Accounting for distributions 514 13.9 ‘Buyback’ of ordinary shares, and redemption of

preference shares 518 13.10 Required disclosures for share capital and reserves 520

Learning objectives (LO) 495 Opening questions 496 Summary 521 Key terms 522 Answers to Opening questions 522 Review questions 523 Challenging questions 524 Reference 525

CHAPTER 14 Accounting for financial instruments . . . . . . . . . . . . . . . . . . . . . . . 527

14.1 Introduction to accounting for financial instruments 528 14.2 The definitions of financial assets, financial liabilities and

equity instruments, and the difference between primary financial instruments and derivative financial instruments 530

14.3 Debt versus equity components of financial instruments 536 14.4 Set-off of financial assets and financial liabilities 540 14.5 Recognition and measurement of financial instruments on

acquisition 542 14.6 Measurement of financial assets following initial recognition 543 14.7 Initial recognition of financial liabilities 558 14.8 Subsequent measurements of financial liabilities 559 14.9 Derivative financial instruments and their use as

hedging instruments 560 14.10 Accounting for derivatives used within a hedging

arrangement 561 14.11 Futures contracts 572 14.12 Options 578 14.13 Swaps 579 14.14 Compound financial instruments 585 14.15 Disclosure requirements pertaining to financial instruments 588

Learning objectives (LO) 527 Opening questions 528 Summary 590 Key terms 590 Answers to Opening questions 591 Review questions 591 Challenging questions 594 References 598

dee67382_fm_i-xxvi.indd xiii 10/24/19 04:13 PM

CONTENTS

xiii

CHAPTER 15 Revenue recognition issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599

15.1 The definition and recognition of income 600 15.2 Income as ‘revenues’ and ‘gains’ 603 15.3 Background to the release of the accounting standard

on revenue recognition (AASB 15) 603 15.4 Scope of AASB 15 604 15.5 An overview of the five-step model for determining the

recognition of revenue from contracts with customers 605 15.6 Step 1—identify the contract(s) with customers 605 15.7 Step 2—identify the performance obligation(s) in the contract 606 15.8 Step 3—determine the transaction price of the contract 608 15.9 Step 4—allocate a transaction price to each

performance obligation 613 15.10 Step 5—recognise revenue as each performance

obligation is satisfied 615 15.11 Unearned revenue 617 15.12 Accounting for sales with associated conditions–further

considerations 617 15.13 Construction contracts–further consideration 622 15.14 Interest and dividends 631 15.15 Allowance for doubtful debts 631

Learning objectives (LO) 599 Opening questions 600 Summary 634 Key terms 635 Answers to Opening questions 635 Review questions 636 Challenging questions 637 References 640

CHAPTER 16 The statement of profit or loss and other comprehensive income, and the statement of changes in equity . . . . . . . . . . . . 641

16.1 Introduction to the statement of profit or loss and other comprehensive income 642

16.2 Information about significant judgements made when compiling financial statements 643

16.3 The meaning of ‘total comprehensive income’ 645 16.4 Components of other comprehensive income 646 16.5 Format of the statement of profit or loss and other

comprehensive income 647 16.6 Reclassification adjustments 653 16.7 Separate disclosure of ‘material items’ 656 16.8 Changes in accounting estimates can impact profit

or loss and other comprehensive income 658 16.9 Other disclosures specifically required with respect

to particular items of income and expense 661 16.10 Accounting for prior period errors 662 16.11 Changes in accounting policy 665 16.12 Statement of changes in equity 672 16.13 The reporting of alternative (non-complying) measures

of ‘profits’ 674 16.14 Profit as a guide to an organisation’s success 675

Learning objectives (LO) 641 Opening questions 642 Summary 678 Key terms 678 Answers to Opening questions 679 Review questions 680 Challenging questions 681 References 685

dee67382_fm_i-xxvi.indd xiv 10/26/19 12:05 PM

CONTENTS

xiv

CHAPTER 18 Accounting for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 723

18.1 Introduction to accounting for income taxes 724 18.2 The balance sheet approach to accounting for taxation 725 18.3 Temporary differences lead to ‘deferred tax assets’ and/or

‘deferred tax liabilities’ and directly influence ‘income tax expense’ 727

18.4 Calculating the tax base of assets and liabilities 733 18.5 Unused tax losses 740 18.6 Revaluation of non-current assets 743 18.7 Offsetting deferred tax liabilities and deferred tax assets 753 18.8 Change of tax rates 753 18.9 Disclosures pertaining to tax expense and related assets

and liabilities 755 18.10 Evaluation of the assets and liabilities created by AASB 112 760

Learning objectives (LO) 723 Opening questions 724 Summary 761 Key terms 761 Answers to Opening questions 761 Review questions 762 Challenging questions 764 References 767

CHAPTER 17 Accounting for share-based payments . . . . . . . . . . . . . . . . . . . . . 687

17.1 Introduction to accounting for share-based payments 688 17.2 Background to the release of AASB 2 689 17.3 Equity-settled share-based payment transactions 692 17.4 Cash-settled share-based payment transactions 706 17.5 Share-based payment transactions with cash alternatives 711 17.6 Possible economic implications of AASB 2 714 17.7 Disclosure requirements 715

Learning objectives (LO) 687 Opening questions 688 Summary 719 Key terms 719 Answers to Opening questions 720 Review questions 720 Challenging questions 721 Reference 722

PART 5 ACCOUNTING FOR THE DISCLOSURE OF CASH FLOWS . . . . . . . . . 769

19.1 Comparison with other financial statements 771 19.2 The difference between cash flows and profits 772 19.3 Defining ‘cash’ and ‘cash equivalents’ 774 19.4 Classification of cash flows 775 19.5 Format of statement of cash flows 777 19.6 Notes to accompany the statement of cash flows 780 19.7 Calculating cash inflows and outflows 781 19.8 The use of cash flow data by different stakeholders and

within various contractual arrangements 799

Learning objectives (LO) 770 Opening questions 770 Summary 801 Key terms 802 Answers to Opening questions 802 Review questions 803 Challenging questions 805 References 811

CHAPTER 19 The statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770

dee67382_fm_i-xxvi.indd xv 10/24/19 04:13 PM

CONTENTS

xv

PART 6 INDUSTRY-SPECIFIC ACCOUNTING ISSUES . . . . . . . . . . . . . . . . . . . . . 813

20.1 Overview of the extractive industries, and introductory comments about accounting for exploration and evaluation expenditures 815

20.2 Alternative methods to account for exploration and evaluation expenditure 818

20.3 Basis for measurement of exploration and evaluation expenditures 822

20.4 Subsequent impairment and amortisation of costs carried forward 823

20.5 Accounting for restoration costs 825 20.6 Determining sales revenue 828 20.7 Determining the measurement of inventory 829 20.8 Disclosure requirements 829 20.9 Does the area-of-interest method provide a realistic value

for an entity’s reserves? 839 20.10 Research on accounting regulation pertaining to

exploration and evaluation expenditure 839 20.11 Consideration of the social and environmental performance

of organisations within the extractive industries 842 20.12 The development of a new accounting standard for

extractive activities 843

Learning objectives (LO) 814 Opening questions 815 Summary 846 Key terms 847 Answers to Opening questions 847 Review questions 848 Challenging questions 849 References 851

CHAPTER 20 Accounting for the extractive industries . . . . . . . . . . . . . . . . . . . . 814

PART 7 OTHER DISCLOSURE ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 853

21.1 What is an ‘event after the reporting period’? 855 21.2 Why disclose information about events that have occurred

after the end of the reporting period? 856 21.3 Types of events after the reporting period 857 21.4 Events that necessitate adjustments to the financial

statements (adjusting events after the reporting period) 858 21.5 Events that necessitate disclosure but no adjustment

(non-adjusting events) 860 21.6 Disclosure requirements 862

Learning objectives (LO) 854 Opening questions 854 Summary 863 Key terms 864 Answers to Opening questions 864 Review questions 865 Challenging questions 866

CHAPTER 21 Events occurring after the end of the reporting period . . . . . . . 854

CHAPTER 22 Segment reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 869

22.1 Advantages and disadvantages of segment reporting 870 22.2 An introduction to AASB 8 874 22.3 Defining an operating segment 876 22.4 Defining a reportable segment 878 22.5 Measurement of segment items 882 22.6 Required disclosures 883 22.7 Is there a case for competitive harm? 886

Learning objectives (LO) 869 Opening questions 869 Summary 890 Key terms 891 Answers to Opening questions 891 Review questions 892 Challenging questions 894 References 897

dee67382_fm_i-xxvi.indd xvi 10/24/19 04:13 PM

CONTENTS

xvi

CHAPTER 26 Further consolidation issues I: accounting for intragroup transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1005

26.1 Introduction to accounting for intragroup transactions 1006 26.2 Dividend payments from pre- and post-acquisition earnings 1006 26.3 Intragroup sale of inventory 1014 26.4 Sale of non-current assets within the group 1026

Learning objectives (LO) 1005 Opening questions 1005 Summary 1044 Key terms 1045 Answers to Opening questions 1045 Review questions 1046 Challenging questions 1049

CHAPTER 24 Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 917

24.1 Introduction to earnings per share 918 24.2 Computation of basic earnings per share 919 24.3 Diluted earnings per share 930 24.4 Linking earnings per share to other indicators 936

Learning objectives (LO) 917 Opening questions 917 Summary 940 Key terms 941 Answers to Opening questions 941 Review questions 941 Challenging questions 944 References 946

PART 8 ACCOUNTING FOR EQUITY INTERESTS IN OTHER ENTITIES . . . . . 947

25.1 The meaning of ‘consolidated financial statements’, and the rationale for consolidating the financial statements of different legal entities 949

25.2 History of Australian accounting standards that govern the preparation of consolidated financial statements 951

25.3 ‘Investment entities’: exception to consolidation 955 25.4 Alternative consolidation concepts 956 25.5 The concept of control 957 25.6 Direct and indirect control 962 25.7 Accounting for business combinations 964 25.8 Gain on bargain purchase 973 25.9 Subsidiary’s assets not recorded at fair values 975 25.10 Previously unrecognised identifiable intangible assets 981 25.11 Consolidation after date of acquisition 984 25.12 Disclosure requirements 991 25.13 Control, joint control and significant influence 992

Learning objectives (LO) 948 Opening questions 949 Summary 993 Key terms 994 Answers to Opening questions 994 Review questions 995 Challenging questions 1000 Reference 1004

CHAPTER 25 Accounting for group structures . . . . . . . . . . . . . . . . . . . . . . . . . . . 948

CHAPTER 23 Related party disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 899

23.1 Introduction to related party disclosures 900 23.2 Implications of related party transactions 901 23.3 The rationale for requiring related party disclosures 902 23.4 Categories of related party 904 23.5 Disclosure requirements for related parties 907

Learning objectives (LO) 899 Opening questions 899 Summary 913 Key terms 913 Answers to Opening questions 913 Review questions 914 Challenging questions 914 References 915

dee67382_fm_i-xxvi.indd xvii 10/26/19 12:06 PM

CONTENTS

xvii

CHAPTER 27 Further consolidation issues II: accounting for non-controlling interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1055

27.1 Introduction to accounting for non-controlling interests 1056 27.2 Non-controlling interests to be disclosed in the consolidated

financial statements 1057 27.3 Calculating non-controlling interests 1060 27.4 Adjustments for intragroup transactions 1067

Learning objectives (LO) 1055 Opening questions 1055 Summary 1095 Key term 1095 Answers to Opening questions 1095 Review questions 1096 Challenging questions 1099

CHAPTER 28 Further consolidation issues III: accounting for indirect ownership interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1103

28.1 Introduction to accounting for indirect ownership interests 1104 28.2 Calculating the parent entity interest, and the non-controlling

interest, in the presence of indirect interests 1107 28.3 Sequential and non-sequential acquisitions 1134

Learning objectives (LO) 1103 Opening questions 1103 Summary 1148 Key terms 1148 Answers to Opening questions 1148 Review questions 1149 Challenging questions 1151

CHAPTER 29 Accounting for investments in associates and joint ventures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1155

29.1 Introduction to the equity method of accounting 1156 29.2 Significant influence 1158 29.3 Application of the equity method of accounting 1160 29.4 The equity method of accounting in the presence of

inter-entity transactions 1172 29.5 Application of the equity method of accounting when losses

have been incurred by an associate 1179 29.6 Disclosure requirements 1181 29.7 Introduction to accounting for interests in joint arrangements 1182 29.8 Joint ventures 1183 29.9 Joint operations 1184

Learning objectives (LO) 1155 Opening questions 1156 Summary 1195 Key terms 1195 Answers to Opening Questions 1195 Review questions 1196 Challenging questions 1197 References 1203

PART 9 FOREIGN CURRENCY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1205

30.1 Introduction to accounting for foreign currency transactions 1207 30.2 Accounting entry at the date of the original transaction 1209 30.3 Adjustments at the end of the reporting period 1211 30.4 Determination of the presentation currency 1212 30.5 The translation of longer-term receivables, payables

and cash deposits 1214 30.6 Qualifying assets 1216 30.7 Hedging transactions 1218 30.8 Foreign currency swaps 1220

Learning objectives (LO) 1206 Opening questions 1206 Summary 1221 Key terms 1221 Answers to Opening questions 1221 Review questions 1222 Challenging questions 1224

CHAPTER 30 Accounting for foreign currency transactions . . . . . . . . . . . . . . 1206

dee67382_fm_i-xxvi.indd xviii 10/24/19 04:13 PM

CONTENTS

xviii

CHAPTER 31 Translating the financial statements of foreign operations . . . . . 1227

31.1 Introduction to translating the financial statements of foreign operations 1228

31.2 Reporting foreign currency transactions in the functional currency 1228

31.3 Translating the accounts of foreign operations into the presentation currency 1235

31.4 Consolidation subsequent to translation 1242

Learning objectives (LO) 1227 Opening questions 1227 Summary 1245 Key terms 1245 Answers to Opening Questions 1245 Review questions 1246 Challenging questions 1246

PART 10 CORPORATE SOCIAL-RESPONSIBILITY REPORTING . . . . . . . . . . . . 1249

32.1 Introduction to social-responsibility reporting 1251 32.2 Sustainability 1254 32.3 What are the responsibilities of business (to whom and

for what)? 1255 32.4 Evidence of public social and environmental reporting 1260 32.5 The application of an ‘accountability model’ 1261 32.6 Why report? 1262 32.7 To whom will the organisation report? 1275 32.8 What information shall be reported? 1276 32.9 How (and where) will the information be presented? 1278 32.10 United Nations’ Sustainable Development Goals 1301 32.11 Accounting for externalities and ‘full cost accounting’ 1306 32.12 Counter (shadow) accounts 1311 32.13 The critical problem of climate change 1313 32.14 Personal social responsibility 1322 Concluding remarks 1323

Learning objectives (LO) 1250 Opening questions 1251 Summary 1323 Key terms 1324 Answers to Opening Questions 1324 Review questions 1325 Challenging questions 1327 References 1329

CHAPTER 32 Accounting for corporate social responsibility . . . . . . . . . . . . . 1250

Appendix A Present value of $1 in n periods = 1/(1 + k)n, where k is the discount rate . . . . . . . . . . 1334

Appendix B Present value of an annuity of $1 per period for n periods . . . . . . . . . . . . . . 1336

Appendix C Calculating present values . . . . . . . . . . . 1338

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1341

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1353

dee67382_fm_i-xxvi.indd xix 10/24/19 04:13 PM

xix

readers to critically evaluate the various rules and guidelines. The aim is to develop accountants who are able to apply particular accounting requirements, as well as being able to contribute to the ongoing improvement of accounting requirements. The view taken is that it is important for students not only 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 research studies that consider the merit, implications, and costs and benefits of the various accounting requirements. Furthermore, newspaper articles discussing different aspects of the accounting requirements are included for consideration and discussion. This all adds up to give this book a ‘real- world’ perspective. 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 32 focuses on social-responsibility reporting and provides the most up-to-date and comprehensive material available on this important topic, with additional material on the important topic of climate change—from both an accounting and a scientific perspective—as well as 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 ninth edition is equally valuable to students and teachers, and that it has been substantially and thoroughly revised.

This is the ninth edition of a book that was originally published in 1995. Since the first edition 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 that might result from such changes.

In the period of time between when the eighth edition of this book was published, and the writing of this ninth edition was completed (in October 2019) there have been some rather significant changes in regulation and guidance pertaining to external reporting. These changes have been incorporated within this ninth edition. For example, there were some significant changes to the Conceptual Framework for Financial Reporting and a number of new accounting standards have come into effect (such as AASB 15 Revenue from Contracts with Customers and AASB 16 Leases). There have also been a number of significant developments in the area of social and environmental (and sustainability) reporting, and these are addressed in Chapter 32.

Each chapter of this ninth edition contains clear learning objectives, as well as a number of opening questions, which students are encouraged to answer before reading the chapter. Solutions to each opening question are provided at the end of the chapter and students are asked to consider how their answers changed as a result of reading the chapter. Throughout the chapters there are also numerous boxes identifying why students need to know particular material. 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. A glossary of key terms is provided towards the back of the book.

As well as addressing how to apply the various accounting requirements, this text also encourages

PREFACE

dee67382_fm_i-xxvi.indd xx 10/24/19 04:13 PM

xx

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; 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 McGraw-Hill (Australia) team, including Simone Bella, Caroline Hunter, Claire Linsdell, Alison Moore, Paul Leslie, Bethany Ng, Genevieve MacDermott, Debbie Gallagher, Gurdish Gill, Rosemary Gervasi and Katie Miller, also deserve a great deal of thanks for helping in the preparation of this book.

And last, but certainly not least, thanks again go to my 20-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. She is now ‘seven editions’ old.

There are many people who must be thanked for their contribution to the ninth edition of this book. First, thanks must go to the following reviewers of the current edition:

Jahangir Ali, La Trobe University; Peter Baxter, University of the Sunshine Coast; Collette Chesters, University of Western Australia; Scott Copeland, University of South Australia; Omar Faroque, University of New England; Chelsea Liu, University of Adelaide; Meiting Lu, Macquarie University; Wei Lu, Monash University; Lara Meng, Curtin University; Balachandran Muniandy, La Trobe University; YH Tham, Curtin University.

This book has also been improved during the course of the first eight 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;

ACKNOWLEDGMENTS

dee67382_fm_i-xxvi.indd xxi 10/24/19 04:13 PM

xxi

AACSB STATEMENT

McGraw-Hill is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation, Financial Accounting recognises the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the resource and the testbank to the six general knowledge and skill guidelines found in the AACSB standards.

The statements contained in Financial Accounting are provided only as a guide for the users of this textbook. The AACSB leaves content coverage and assessment within the purview of individual school, the mission of the school, and the faculty. While Financial Accounting and the teaching package make no claim of any specific AACSB qualification or evaluation, within Financial Accounting we have identified chapters as containing content and labelled selected activities according to the six general knowledge and skills areas.

dee67382_fm_i-xxvi.indd xxii 10/24/19 04:13 PM

xxii

AASB standards referred to in this chapter and IFRS/IAS equivalents

In each chapter you will find a mini table highlighting the AASB standards referred to in the chapter with the IFRS/ IAS equivalents, to give you a broader understanding of how Australian standards link to the international scene.

dee67382_ch01_001-058.indd 3 10/17/19 07:49 AM

CHAPTER 1: An overview of the Australian external reporting environment 3

1.1 Accounting, accountability and the role of financial accounting

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 apply 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 in turn relates to the notion 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 and 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 impacts, then we, as accountants, should accept a duty to provide ‘an account’ (or a report) to stakeholders in respect of the organisation’s social and environmental performance—perhaps by way of releasing a publicly available corporate social responsibility report. If, by contrast, we consider 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 other stakeholders also have a right to be provided with particular information about an organisation?

Gray, Adams and Owen (2014) 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:

LO 1.1

OPENING QUESTIONS

Below are a number of questions that we want you to consider before reading the material in this chapter. We will ask the same questions again at the end of the chapter and provide respective solutions. The solutions will appear just before the end of chapter review questions but please do not look at the answers until you have read the chapter. Each chapter of this book will have ‘Opening questions’ so that you can assess, or consider, whether your views have changed, and therefore, your knowledge has been advanced, as a result of reading the material provided within the chapter.

1. What is ‘general purpose financial reporting’? LO 1.1, 1.2 2. What is the role of the Australian Accounting Standards Board (AASB) with respect to general purpose financial

reporting within Australia? LO 1.4 3. Does the AASB have legal power to enforce accounting standards within Australia? LO 1.4 4. What is the relevance of the International Accounting Standards Board (IASB) to general purpose financial

reporting within Australia? LO 1.7 5. What power does the IASB have to enforce the accounting standards that it develops, and which are in use

internationally? LO 1.7

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

101 Presentation of Financial Statements IAS 1

108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8

1048 Interpretation of Standards —

1049 Whole of Government and General Government Sector Financial Reporting —

1053 Application of Tiers of Australian Accounting Standards —

Chapter introduction

Each chapter begins with an excellent overview of the material to be covered that places it in the broader context of how topics in various chapters interrelate.

Worked examples

A wide range of detailed scenarios and solutions, some fairly straightforward and some more complex, are provided throughout the text and are a great learning aid, helping to reinforce how the theory is applied in practice and its relevance to actual situations.

dee67382_ch02_059-098.indd 77 10/18/19 07:05 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 77

Assets acquired at no cost To satisfy the definition of an ‘asset’, it is not a prerequisite that the asset be acquired at a cost to the reporting entity. As the Conceptual Framework notes (paragraph 4.18), although there is typically:

a close association between incurring expenditure and acquiring assets, the two do not necessarily coincide. When an entity incurs expenditure, this may provide evidence that the entity has acquired future economic benefits, but it is not conclusive evidence that the entity has obtained an asset. Further, the absence of related expenditure does not preclude an item from meeting the definition of an asset. Assets can include, for example, rights that a government has granted to the entity free of charge or that another party has donated to the entity. Therefore, the key point here is that the presence or absence of expenditure is not a defining factor in determining the existence of an ‘asset’.

Worked Example 2.3 provides insights into how to apply the definition of assets.

WORKED EXAMPLE 2.3: Applying the definition of assets

A reporting entity has been involved with the following transactions and events:

(a) The entity acquired some land at a cost of $1 million. However, after acquiring the land it became known that the land was highly contaminated and was very unlikely to be usable, or be able to be sold.

(b) A satisfied long-term customer decided to give the organisation a delivery truck for free. The organisation expects to use the truck within the business.

(c) The organisation has been given the right by the local government to use a nearby river to transport some of its products to nearby markets.

REQUIRED Which of the above transactions and events would generate a resource that satisfies the definition of an asset?

SOLUTION As we know, the definition of an asset has three key components. In relation to the land described above, while the organisation might control the land as a result of a past transaction or event, it appears that the land does not have the potential to generate economic benefits. Therefore, it does not seem to satisfy the definition of an asset.

The delivery truck does appear to satisfy the definition of an asset. It is controlled as a result of a past event and it does have the potential to generate economic benefits for the organisation. It does not directly matter that the truck was not acquired at a cost to the organisation.

The right to use the nearby river is not an asset of the organisation as the organisation does not have ‘control’ over the river—it just has access to it. The river would not appear in the financial statements of the organisation.

Recognition of an asset As we have already learned, in addition to defining an asset, we also need to consider when we should recognise the existence of an asset and therefore include it within the financial statements.

The Conceptual Framework provides general recognition criteria for all of the five elements of financial accounting (assets, liabilities, income, expenses and equity). Paragraph 5.6 states:

Only items that meet the definition of an asset, a liability or equity are recognised in the statement of financial position. Similarly, only items that meet the definition of income and expenses are recognised in the statement of financial performance. However, not all items that meet the definition of one of those elements are recognised.

Therefore, the first step in the recognition of a particular item in the financial statements (and therefore in our financial accounting system) is determining that the item meets the definition of an element of accounting—which is what we have just discussed. However, as the above paragraph indicates, further criteria (other than meeting the definition of an element of financial accounting) are required to be satisfied before an item shall be recognised for financial accounting purposes.

When the Conceptual Framework was revised and re-released in 2018, it specifically required that accountants must consider the fundamental qualitative characteristics of relevance and faithful representation (which were discussed earlier) when deciding if an item should be recognised within the financial statements. This was a change from the previous recognition criteria, which focused on assessing the probability of future economic benefits, as well as whether the item could be measured reliably. Specifically, the Conceptual Framework now requires that an asset

Figures

Figures provide a graphical representation that shows how events and actions are linked.

dee67382_ch02_059-098.indd 75 10/18/19 07:05 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 75

Figure 2.3 The elements of financial accounting

Assets

The balance sheet which provides information about

the financial position of an organisation at a point in time

Liabilities

Equity

Income The income statement which provides information about

the financial performance of an organisation for a period of timeExpenses

Different approaches can be applied to determining profits (income less expenses) and this has direct implications for how we define the elements of financial accounting. 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. The Conceptual Framework adopts the asset/liability approach. Therefore, within the Conceptual Framework, 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 definitions. This should become apparent as we consider each of the elements of financial 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). (© Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, used with permission.)

As we should know, the elements that appear within the balance sheet—and which relate to an organisation’s ‘financial position’—are assets, liabilities and equity. The elements that appear within the income statement—and which relate to an organisation’s ‘financial performance’—are income and expenses. These elements, and their role, are represented in Figure 2.3.

We will consider each of the five elements 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 According to the Conceptual Framework, an asset is defined as:

a present economic resource controlled by the entity as a result of past events.

The above definition of an asset refers to an economic resource. An ‘economic resource’ is defined in the Conceptual Framework as:

a right that has the potential to produce economic benefits.

asset Defined in the Conceptual Framework as ‘a present economic resource controlled by the entity as a result of past events’.

NEW! Learning objectives

Each chapter starts with a list of the chapter’s learning objectives. These flag what you should know when you have worked through the chapter. Make these the foundation for your exam revision by using them to test yourself. The end-of-chapter assignments also link back to these learning objectives.

dee67382_ch04_159-200.indd 160 10/17/19 08:09 AM

160

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 4.1 Understand and be able to apply the definition of an asset. 4.2 Understand and be able to apply asset recognition criteria. 4.3 Understand how assets are measured, and that different measurement bases can be applicable to

different classes of assets. 4.4 Know the meaning of ‘fair value’ and the reason that a ‘fair-value hierarchy’ has been introduced into the

accounting standards. Also, be aware of some concerns that are attributed to the use of fair values. 4.5 Know how to differentiate between current and non-current assets. 4.6 Be aware of how a balance sheet shall be presented. 4.7 Have knowledge about how to account for property, plant and equipment, including how to account for

related safety and environmental expenditures, repairs and maintenance, and how to allocate costs to individual items of property, plant and equipment.

4.8 Be aware of accounting issues that arise when property, plant and equipment is acquired with assets other than cash.

4.9 Understand how to determine the cost of an asset when the payments for the asset are deferred. 4.10 Know how to account for interest costs associated with the acquisition, or construction, of an item of

property, plant and equipment. 4.11 Be able to account for an asset that has been acquired at no direct cost.

C H A P T E R 4 An overview of accounting for assets

OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1. Is there a requirement that all assets shall be measured on the same basis (for example, at fair value)? LO 4.3 2. What is the meaning of ‘fair value’? LO 4.4 3. What is the ‘fair-value hierarchy’ as it relates to the application of fair value to measuring assets? LO 4.4 4. If an asset is constructed with the use of borrowed funds, how are the related interest costs to be treated? LO 4.10

Videos

A short video by Craig Deegan explains why topics are being discussed and why you need to know particular information.

dee67382_ch01_001-058.indd 2 10/17/19 07:49 AM

2

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 1.1 Understand the meaning of ‘financial accounting’ and its relationship to the broader areas of ‘accounting’ and

‘accountability’. 1.2 Be able to explain who is likely to be a user of general purpose financial statements. 1.3 Understand the role of the Australian Securities and Investments Commission with respect to general purpose financial

reporting within Australia, and 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.

1.4 Understand the role of the Australian Accounting Standards Board with respect to general purpose financial reporting within Australia.

1.5 Understand the role of the Financial Reporting Council with respect to general purpose financial reporting within Australia. 1.6 Understand the role of the Australian Securities Exchange with respect to general purpose financial reporting within

Australia. 1.7 Be able to explain the general functions of the International Accounting Standards Board and its relevance to

Australian general purpose financial reporting. 1.8 Understand that accounting standards change across time, meaning that profits calculated in past years may not be

directly comparable with current profit calculations. 1.9 Be able to explain the idea of ‘differential reporting’. 1.10 Understand the role of the auditor, and the auditor’s report, with respect to general purpose financial reporting. 1.11 Be aware of some of the perceived benefits pertaining to the international standardisation of financial reporting as

espoused by the International Accounting Standards Board. 1.12 Be aware of some research which suggests that the pursuit of international standardisation in general purpose financial

reporting ignores many important impediments, such as international differences in ‘culture’. 1.13 Understand that the practice of general purpose financial reporting is quite heavily regulated within Australia, and

be aware of some of the arguments for and against the regulation of financial accounting. 1.14 Understand that organisations will often include and highlight measures of financial performance within their annual

reports that do not comply with accounting standards.

C H A P T E R 1 An overview of the Australian external reporting environment

Opening questions

At the start of each chapter there are several questions that you should consider before reading the chapter, with solutions provided at the end of the chapter. You can use these questions to assess whether your views have changed, and therefore your knowledge has been advanced, as a result of reading the material provided within the chapter.

dee67382_ch02_059-098.indd 60 10/18/19 07:05 AM

60 PART 1: The Australian accounting environment

OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following seven questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is the difference in role between a conceptual framework for financial reporting and accounting standards? LO 2.1, 2.2

2. What benefits are generated as a result of having a conceptual framework for financial reporting? LO 2.2 3. What qualitative characteristics will useful financial accounting information be expected to possess? LO 2.8 4. What are the five different ‘elements’ of financial accounting? LO 2.9 5. What are the three main components of the definition of assets? LO 2.9 6. Are all assets required to be measured using the same basis of measurement? LO 2.10 7. What role does ‘materiality’ have with respect to deciding whether particular financial information should be

disclosed? LO 2.8

2.1 An introduction to the IASB Conceptual Framework

As noted in Chapter 1, in 2005, Australia started using the accounting standards issued by the International Accounting Standards Board (IASB). As such, there was also a related requirement that we use the Conceptual Framework developed by the IASB. That is, because International Financial Reporting Standards (IFRSs) have been developed in accordance with the IASB Conceptual Framework for Financial Reporting, and as Australia adopted IFRSs, then Australia must also adopt the IASB Conceptual Framework. This meant we had to move away from using the conceptual framework that we had developed within Australia. Other countries that have adopted IFRSs have similarly adopted the IASB Conceptual Framework and abandoned their domestically

developed frameworks. The purpose of the Conceptual Framework can be summarised as follows: (a) assist the IASB to develop accounting standards that are based on consistent concepts (b) assist preparers of financial statements to develop consistent accounting policies when no accounting

standard applies to a particular transaction or other event, or when an accounting standard allows a choice of accounting policy

(c) assist all parties to understand and interpret accounting standards. 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 that useful financial information shall possess (for example, relevance and representational faithfulness); how and when transactions should be recognised; what constitutes an element of financial reporting; and who is the audience of general purpose financial statements. Unless the accounting profession and accounting standard-setters have agreement on such central issues, it is difficult to understand how logically consistent accounting standards could be developed. Conceptual frameworks allow us to have consensus on important issues such as those identified above.

While it is reasonable to accept that we need a conceptual framework for financial reporting 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 financial reporting were released much earlier, 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 on many key and fundamental areas of financial reporting was the high degree of inconsistency between the various accounting standards, with different standards embracing different recognition and measurement

LO 2.1

Conceptual Framework A framework that describes the objective of, and the concepts for, general purpose financial reporting.

AASB no. Title IFRS/IAS equivalent

108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8

138 Intangible Assets IAS 38

1053 Application of Tiers of Australian Accounting Standards —

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

NEW!

NEW!

HOW TO USE THIS BOOK

dee67382_ch02_059-098.indd 94 10/18/19 07:05 AM

94 PART 1: The Australian accounting environment

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.

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 rely upon professional judgements about relevance and representational faithfulness.

We concluded the chapter with a critical analysis of conceptual frameworks.

KEY TERMS

asset 75 Conceptual Framework 60 control (assets) 76

equity 87 expenses 85 future economic benefits 76

income 86 liability 81 reporting entity 64

ANSWERS TO OPENING QUESTIONS

At the beginning of the chapter we asked the following seven questions. As a result of reading this chapter we should now be able to provide informed answers to these questions.

1. What is the difference in role between a conceptual framework for financial reporting and accounting standards? LO 2.1, 2.2 A conceptual framework provides a general framework for general purpose financial reporting and does not deal with individual, or specific types of, transactions or events. Accounting standards, by contrast, deal with specific types of assets or liabilities or transactions or events. Accounting standards take precedence over the conceptual framework. When there is no specifically relevant accounting standard, reference should be made to the conceptual framework.

2. What benefits are generated as a result of having a conceptual framework for financial reporting? LO 2.2 Section 2.2 of this chapter identified the benefits.

3. What qualitative characteristics will useful financial accounting information be expected to possess? LO 2.8 First, the information should be relevant and faithfully represent the underlying transaction or event that it purports to represent. To enhance the relevance and representational faithfulness, the information should also be comparable, verifiable, timely and understandable.

4. What are the five different ‘elements’ of financial accounting? LO 2.9 They are assets, liabilities, income, expenses and equity.

5. What are the three main components of the definition of assets? LO 2.9 The reporting entity controls the resource; the control exists as a result of a past transaction or event; and the resource has the potential to produce economic benefits for the reporting entity.

6. Are all assets required to be measured using the same basis of measurement? LO 2.10 No, assets can be measured using different measurement bases. The measurement basis used should be chosen according to whether it best enables relevant and representationally faithful financial information to be presented to the users of the financial statements.

7. What role does ‘materiality’ have with respect to deciding whether particular financial information should be disclosed? LO 2.8 Materiality considerations impact decisions about the amount of information to be disclosed to financial statement readers. If information is considered not to be material, and therefore unlikely to impact a decision, then it does not need to be disclosed.

dee67382_fm_i-xxvi.indd xxiii 10/24/19 04:13 PM

xxiii

Tables

Tables provide useful checklists.

dee67382_ch04_159-200.indd 166 10/17/19 08:09 AM

166 PART 3: Accounting for assets

that it is appropriate for reporting entities to measure different classes of assets in different ways. This judgement was made on the basis that:

∙ 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 to users of financial reports of a particular measurement approach need to be sufficient to justify the cost associated with compiling the information.

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. The respondents’ views were that historical cost is objective and verifiable; easily understood and widely known; and allows 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 and lacked relevance.

Perhaps the above findings are not surprising. If a firm adopts some form of fair-value-based 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 fair value when it was introduced some years ago. 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.

Houghton and Tan also found that the level of support for historical cost or present value and fair value seemed to depend on the industry to which the respondent belonged. Individuals working in financial institutions had a statistically significant preference for fair-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.

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 the

Asset Measurement rule

Cash Face value

Accounts receivable Face value less an allowance for doubtful debts. Amounts to be received in more than 12 months shall be discounted to present value

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

Exploration and evaluation assets of mining organisation

Initially at cost and thereafter at cost or fair value

Investment properties At cost initially and then at either fair value or cost

Non-current assets held for sale At the lower of carrying amount and fair value less costs to sell

Table 4.1 Some classes of assets and their associated measurement rules

Why do I need to know .  .  .?

These boxes enhance real-world relevance; they help make the content relevant to your working life after university.

dee67382_ch02_059-098.indd 87 10/18/19 07:05 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 87

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. Looking at the above formula, the acquisition of an asset is not income. For example, purchasing assets with cash simply involves substituting one asset for another and does not impact equity. Similarly, borrowing cash leads to an increase in assets (cash), and an increase in liabilities, with no direct effect on equity.

The Conceptual Framework does not include ‘profit’ (or ‘loss’) as one of the elements of financial accounting. As we know, the five elements are assets, liabilities, income, expenses and equity. Profit is simply the difference between income and expenses, both of which are defined, and hence there is no need for separate recognition criteria for ‘profits’.

Definition of equity Paragraph 4.63 of the Conceptual Framework defines equity as ‘the residual interest in the assets of the entity after deducting all its liabilities’. That is:

Equity = Assets − Liabilities

The residual interest is a claim or right to the net assets of the reporting entity held by the owners of an organisation. As a residual interest, equity ranks after liabilities in terms of a claim 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.

equity Defined by the Conceptual Framework as ‘the residual interest in the assets of the entity after deducting all its liabilities’.

2.10 Measurement principles

As we have already indicated, once we have decided that a liability or asset should be recognised, we then need to determine how to measure it. For financial reporting purposes, measurement refers to the process of determining the amounts to be included in the financial statements. Applying a measurement basis to an asset or a liability also creates a basis for measuring any related income or expense.

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. Given the way income and expenses are defined—which relies upon measures attributed to assets and liabilities— this has direct implications for reported profits. For example, liabilities are frequently recorded at present value, face

LO 2.10

WHY DO I NEED TO KNOW ABOUT THE DEFINITIONS AND RECOGNITION CRITERIA FOR THE ELEMENTS OF FINANCIAL ACCOUNTING?

If we do not understand the definitions and recognition criteria, then we will not really understand what the reported financial performance and financial position of an organisation actually represents. For example, as a result of knowing the definitions of the elements of financial accounting, we know that certain aspects of organisational performance will not be reflected within reported profits—for instance, certain impacts on the environment will not be reflected within profits, perhaps because the negative impacts caused by the organisation related to resources that were not ‘controlled’ by the organisation, and which therefore had not ever been recognised as assets of the organisation. We would therefore know that ‘profits’ is a somewhat incomplete measure of overall organisational performance. As another example, through having knowledge of the definitions and recognition criteria, we will also know that certain resources that are used by an organisation will not necessarily appear in the balance sheet if they are not ‘controlled’, or if there is some significant doubt about the relevance, or faithful representation, of the information pertaining to the underlying item.

Exhibits

These features contain extracts from actual company reports or documents, or provide a commonly used format for accounting. They highlight the relevance of the chapter content to the practice of accounting, provide another element to the topics covered and help to reinforce learning.

dee67382_ch04_159-200.indd 168 10/17/19 08:09 AM

168 PART 3: Accounting for assets

Exhibit 4.1 The balance sheet of BHP Billiton Ltd as at 30 June 2019

SOURCE: © BHP Group Ltd

The sources of the future economic benefits As mentioned earlier in this chapter, the Conceptual Framework indicates that the essence of an asset is the ‘future economic benefits’ that the item will generate. Generally speaking, the future economic benefits to be derived from the asset, and which we might try to measure, can 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.

NEW!

Chapter summary

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

dee67382_ch02_059-098.indd 93 10/18/19 07:05 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 93

2.12 The conceptual framework as a normative theory of accounting

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. 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.

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 that chapter 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 and 2018 the IASB released revised frameworks, referred to as the IASB Conceptual Framework for Financial Reporting, and Australia thereafter adopted this framework in place of the previous IASB framework.

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.

LO 2.12

Key terms

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.

dee67382_ch02_059-098.indd 76 10/18/19 07:05 AM

76 PART 1: The Australian accounting environment

Rights can take many forms, including rights to receive cash, rights to receive goods or services, or rights over physical objects, such as property, plant and equipment or inventories (where the right to use the property, plant, equipment or inventories might have been established as a result of buying or leasing the item).

Components of the definition of an asset There are three separate components to the above definition of an ‘asset’ that we need to consider. All three related requirements must exist if we are to consider that a particular transaction satisfies the definition of an asset. The components are:

1. an asset is an economic resource (right) controlled by the entity 2. an asset exists as a result of past events 3. the right has the potential to produce economic benefits.

Let us now consider each of these components separately.

Control 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. For example, many organisations include leased assets (and the associated lease liabilities) in their balance sheets.

There are many resources that generate benefits for an entity but which are not recognised due 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 might provide economic benefits to entities, but to the extent that such entities do not control the waterways, they are not assets of those entities despite the fact that the organisation has a right to use them.

Past events In relation to ‘control’, it therefore follows from the requirement that the relevant transaction must already have occurred that future economic benefits which are not currently controlled are not to be recognised by a reporting entity.

Potential to produce economic benefits The expected future economic benefits can be distinguished from the source of the benefit—a particular object or right. The definition refers to the economic benefit and not the source. Thus, whether an object or right is disclosed as an asset will be dependent upon the potential it has to generate economic benefits for the entity. In the absence of potential to generate economic benefits, the object or right should not be considered to be an asset. Rather, any related expenditure would constitute an expense.

Therefore, cash is an asset owing to the economic 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. That is, the asset is effectively the future economic benefits that

will be generated, not the source of the economic benefits (such as the machine). These economic benefits could come from two broad sources—either from the asset’s use, or from its sale. If the economic benefits are greater from its use by the reporting entity, then the asset would be expected to be retained, otherwise it would likely be sold. That is, the Conceptual Framework 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.

As already noted, the previous definition of an asset and liability had required that the expected future flows of economic benefits be probable, which meant more likely than less likely. This is no longer the requirement. Recognition is now based upon there being a ‘potential’ for economic benefits to flow to the reporting entity. For that potential to exist, it does not need to be certain, or even likely, that the right will produce economic benefits. It is necessary only that the right already exists as a result of a past transaction or event and that, in at least one circumstance, it would produce economic benefits for the reporting entity. However, while there is no longer a requirement that the future economic benefits are judged to be ‘probable’, the assessed probability will nevertheless influence the measurement ultimately attributed to an asset (a resource with a higher likelihood of generating economic benefits would be expected to have a higher value in the ‘market’ compared to a similar asset with lower likelihood).

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.

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.

Review questions

These questions ask you to reflect on key topics within the chapter, and help cement your learning. For this edition they have been graded by difficulty level as Easy, Medium or Hard.

dee67382_ch01_001-058.indd 54 10/17/19 07:49 AM

54 PART 1: The Australian accounting environment

3. Does the AASB have legal power to enforce accounting standards within Australia? LO 1.4 No. The AASB does not directly have any enforcement powers. Within Australia, it is ASIC that enforces the requirements of the Corporations Act, and it is within the Corporations Act that there is a requirement for particular forms of organisations to comply with accounting standards.

4. What is the relevance of the International Accounting Standards Board (IASB) to general purpose financial reporting within Australia? LO 1.7 The IASB is of great relevance to general purpose financial reporting within Australia. The AASB releases accounting standards that have legal force by virtue of the Corporations Act, and the majority of these accounting standards are developed outside of Australia by the IASB.

5. What power does the IASB have to enforce the accounting standards that it develops, and which are in use internationally? LO 1.7 The IASB has no power to enforce its accounting standards. It is a standard­setter, not a standard­enforcer. When a country claims that it is adopting IFRSs, it is the responsibility of local regulators to ensure compliance with the accounting standards. Because some countries have minimal enforcement mechanisms in place, together with poor standards of financial statement auditing, any claims that the financial statements being generated in such countries comply with accounting standards are often questionable, and should be met with scepticism.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Describe the roles of ASIC, the AASB, the ASX and the FRC, and the relationships between these regulatory bodies. LO 1.3, 1.4, 1.5, 1.6 ••

2. What is the IASB and how does it affect financial reporting regulation in Australia? LO 1.4 •• 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 1.10 • 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 1.13 •• 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 1.3, 1.9, 1.13 •• 7. Provide a brief description of the differential reporting requirements in Australia as addressed by AASB 1053.

LO 1.9 • 8. Define ‘generally accepted accounting procedures’. LO 1.2 • 9. Who are perceived to be the ‘primary users’ of general purpose financial reports? LO 1.2 • 10. What knowledge of financial accounting are the users of financial statements expected to possess? LO 1.2 • 11. If the auditor provides an opinion that the financial statements comply with accounting standards, does this indicate

that there are no errors in the financial statements? LO 1.10 • 12. 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 1.3 •• 13. 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 1.3 •• 14. How are International Financial Reporting Standards developed and revised? Explain the role of the AASB in that

process. LO 1.4, 1.7 •• 15. What is the relevance to Australia of Interpretations issued by the IFRS Interpretations Committee? LO 1.7 •• 16. 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 1.4, 1.7 •• 17. What are the functions of the IASB? LO 1.7 •

Challenging questions

These questions require detailed problem analysis and help to build problem-solving and critical thinking skills.

dee67382_ch01_001-058.indd 55 10/17/19 07:49 AM

CHAPTER 1: An overview of the Australian external reporting environment 55

18. 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 1.3, 1.4 ••

19. What are some of the possible cultural impediments to the international standardisation of accounting standards? LO 1.12 ••

20. Why did the FRC decide that Australian Accounting Standards needed to be consistent with those being issued by the International Accounting Standards Board? LO 1.5, 1.12 •

21. Explain why the adoption of International Financial Reporting Standards in Australia might have led to material changes to reported profits. LO 1.11 ••

CHALLENGING QUESTIONS

22. 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 1.3

23. Accounting standards change across time. Why? LO 1.8

24. If a company adopted a particular accounting policy that ASIC considered to be questionable, in principle 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 ASIC to prove in court that the company’s financial statements were not true and fair? LO 1.3

25. 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 non­ compliance, evaluate the reasons provided for this non­compliance. LO 1.6

26. 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

27. The decision that Australia would adopt IFRSs 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 1.11

28. 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 1.12

29. 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 of the organisation; otherwise, the costs of the organisation’s operations will rise. What is the basis of this belief? LO 1.13

30. Any efforts towards standardising accounting practices on an international basis imply a belief that a ‘one­size­fits­ all’ 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 as it would be for an Australian surfboard manufacturer. Is this a naive perspective? Explain your answer. LO 1.11, 1.12

31. 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 1.11, 1.12, 1.13

32. Evaluate the claim that ‘accounting is the language of business’. LO 1.1

33. Review a number of accounting standards and then discuss how accounting standards are structured. LO 1.4, 1.7

34. You are a junior executive of a large mining company and had 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

dee67382_fm_i-xxvi.indd xxiv 10/24/19 04:13 PM

To find out more about SmartBook, visit www.mheducation.com.au/higher-education/ digital-learning/smartbook

SmartBook Fuelled by LearnSmart, SmartBook is the first and only adaptive reading experience available today. Starting with an initial preview of each chapter and key learning objectives, students read material and are guided to the topics they most need to practise at that time, based on their responses to a continuously adapting diagnostic. To ensure concept mastery and retention, reading and practice continue until SmartBook directs students to recharge and review important material they are most likely to forget.

Adaptive learning No two students are the same, so why should their learning experience be? Adaptive technology uses continual assessment and artificial intelligence to personalise the learning experience for each individual student. As the global leader in adaptive and personalised learning technologies, McGraw-Hill is pioneering ways to improve results and retention across all disciplines.

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.

LearnSmart Advantage is a series of adaptive learning products fuelled by LearnSmart—the most widely used and adaptive learning resource proven to strengthen memory recall, increase retention and boost grades.

dee67382_fm_i-xxvi.indd xxv 10/24/19 04:13 PM

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!

Visual progress Connect provides you with reports to help you identify what you should study and when your next assignment is due, and tracks your performance. Connect’s Overall Performance report allows you to see all of your assignment attempts, your score on each attempt, the date you started and submitted the assignment, and the date the assignment was scored.

McGraw-Hill Connect® is the only learning platform that continually adapts to you, delivering precisely what you need, when you need it.

To learn more about McGraw-Hill Connect®, visit

www.mheducation.com.au/higher-education/ digital-learning/connect

dee67382_fm_i-xxvi.indd xxvi 10/24/19 04:13 PM

dee67382_ch01_001-058.indd 1 10/24/19 12:37 PM

CHAPTER 1 An overview of the Australian external reporting environment

CHAPTER 2 The Conceptual Framework for Financial Reporting

PART 1 The Australian

accounting environment

dee67382_ch01_001-058.indd 2 10/24/19 12:37 PM

2

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 1.1 Understand the meaning of ‘financial accounting’ and its relationship to the broader areas of ‘accounting’ and

‘accountability’. 1.2 Be able to explain who is likely to be a user of general purpose financial statements. 1.3 Understand the role of the Australian Securities and Investments Commission with respect to general purpose financial

reporting within Australia, and 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.

1.4 Understand the role of the Australian Accounting Standards Board with respect to general purpose financial reporting within Australia.

1.5 Understand the role of the Financial Reporting Council with respect to general purpose financial reporting within Australia. 1.6 Understand the role of the Australian Securities Exchange with respect to general purpose financial reporting within

Australia. 1.7 Be able to explain the general functions of the International Accounting Standards Board and its relevance to

Australian general purpose financial reporting. 1.8 Understand that accounting standards change across time, meaning that profits calculated in past years may not be

directly comparable with current profit calculations. 1.9 Be able to explain the idea of ‘differential reporting’. 1.10 Understand the role of the auditor, and the auditor’s report, with respect to general purpose financial reporting. 1.11 Be aware of some of the perceived benefits pertaining to the international standardisation of financial reporting as

espoused by the International Accounting Standards Board. 1.12 Be aware of some research which suggests that the pursuit of international standardisation in general purpose financial

reporting ignores many important impediments, such as international differences in ‘culture’. 1.13 Understand that the practice of general purpose financial reporting is quite heavily regulated within Australia, and

be aware of some of the arguments for and against the regulation of financial accounting. 1.14 Understand that organisations will often include and highlight measures of financial performance within their annual

reports that do not comply with accounting standards.

C H A P T E R 1 An overview of the Australian external reporting environment

dee67382_ch01_001-058.indd 3 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 3

1.1 Accounting, accountability and the role of financial accounting

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 apply 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 in turn relates to the notion 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 and 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 impacts, then we, as accountants, should accept a duty to provide ‘an account’ (or a report) to stakeholders in respect of the organisation’s social and environmental performance—perhaps by way of releasing a publicly available corporate social responsibility report. If, by contrast, we consider 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 other stakeholders also have a right to be provided with particular information about an organisation?

Gray, Adams and Owen (2014) 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:

LO 1.1

OPENING QUESTIONS

Below are a number of questions that we want you to consider before reading the material in this chapter. We will ask the same questions again at the end of the chapter and provide respective solutions. The solutions will appear just before the end of chapter review questions but please do not look at the answers until you have read the chapter. Each chapter of this book will have ‘Opening questions’ so that you can assess, or consider, whether your views have changed, and therefore, your knowledge has been advanced, as a result of reading the material provided within the chapter.

1. What is ‘general purpose financial reporting’? LO 1.1, 1.2 2. What is the role of the Australian Accounting Standards Board (AASB) with respect to general purpose financial

reporting within Australia? LO 1.4 3. Does the AASB have legal power to enforce accounting standards within Australia? LO 1.4 4. What is the relevance of the International Accounting Standards Board (IASB) to general purpose financial

reporting within Australia? LO 1.7 5. What power does the IASB have to enforce the accounting standards that it develops, and which are in use

internationally? LO 1.7

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

101 Presentation of Financial Statements IAS 1

108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8

1048 Interpretation of Standards —

1049 Whole of Government and General Government Sector Financial Reporting —

1053 Application of Tiers of Australian Accounting Standards —

dee67382_ch01_001-058.indd 4 10/24/19 12:37 PM

4 PART 1: The Australian accounting environment

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.

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, or reports, do not all have to be prepared in financial terms. For example, if an organisation is considered to be accountable for its water consumption (perhaps it is operating in an area with limited rainfall and water reserves) or its greenhouse gas emissions (perhaps it is operating in an industry with relatively high carbon emissions), then such ‘accounts’ may be presented in physical terms (and there are available frameworks for measuring and reporting water consumption and greenhouse gas emissions, which are discussed in Chapter 32). If a company is considered to be responsible for the health and safety of people who are making its products in developing countries, then it might produce ‘accounts’ of how the organisation is ensuring the safety of its employees in factory workplaces in those countries.

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 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 accept that organisations are responsible for their social and their environmental performance, then we would also expect the organisation to produce social and environmental accounts. The social and the 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 and principles 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 is a form of accounting that 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’ or reports released by the entity using broader methods of ‘accounting’. Chapter 32 of this book specifically addresses these other forms of accounts. Specifically, it looks at frameworks used to compile social reports, environmental reports and what are commonly referred to as sustainability reports. That chapter also explores the idea of accountability in greater depth. While Chapter 32—which addresses accounting for corporate social and environmental responsibility—is the last chapter of this book, this should not be interpreted to mean that social and environmental reporting is not as important as financial reporting. Indeed, many people would argue that such reporting is more important. Nevertheless, this book was written to explain financial reporting, hence financial accounting and reporting is the primary focus of the material within it.

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 and to perceptions of organisational responsibilities. We therefore caution against narrow definitions of ‘accounting’, as they appear in many 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 is a much richer process than this.

dee67382_ch01_001-058.indd 5 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 5

Financial accounting defined As we have noted earlier, 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 information will also be used by managers within an organisation.

Financial accounting can be contrasted with management accounting. Management accounting focuses on providing information for decision making—with such information also often 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 is no need generally to protect the information needs or rights of these parties as, being ‘insiders’, they can access the information they require relatively easily.

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 shall be compiled and presented. 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.)

WHY DO I NEED TO KNOW ABOUT THE RELATIONSHIP BETWEEN ORGANISATIONAL RESPONSIBILITY, ACCOUNTABILITY AND ACCOUNTING?

Organisations will be perceived by various stakeholders to have particular responsibilities. These stakeholders will expect the organisation to comply with these expectations held with regard to particular perceived responsibilities. This creates an ‘accountability’ for the managers of the organisation to act in accordance with these perceived responsibilities and to thereafter provide an account of the organisation’s performance with respect to these responsibilities.

Therefore, when it comes to what accounts ‘should’ be prepared, it really is a matter of judgement for managers and often there is no one absolutely right answer. Legislation will require certain reports to be

prepared and presented to particular stakeholders (such as shareholders), but an organisation can go beyond this and present further reports voluntarily. Nevertheless, there is a direct relationship between the responsibilities (or duties) the managers of an organisation believe the organisation has, and the accepted accountabilities. Therefore, by knowing this, we can interpret an absence of disclosures about particular aspects of performance as potentially indicating that the managers do not believe they have a responsibility, or accountability, in relation to such aspects of performance.

The argument is that if the managers of an organisation accept a responsibility to particular stakeholders for cer­ tain aspects of performance, then the managers accept that these stakeholders have a right to information about those aspects of the organisation’s performance. This is represented in the diagram.

Decisions about what accounts to prepare

Views about organisational responsibilities

Views about organisational accountabilities

dee67382_ch01_001-058.indd 6 10/24/19 12:37 PM

6 PART 1: The Australian accounting environment

1.2 Users’ demand for general purpose financial statements

General purpose financial statements may be used by an array of user groups, and for many purposes. However, pursuant to the Conceptual Framework for Financial Reporting issued by the International Accounting Standards

Board (which we address in detail in Chapter 2) and used within Australia (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 useful financial information should possess), general purpose financial statements are primarily directed towards the information needs of ‘existing and potential investors, lenders and other creditors’. Specifically, paragraph 1.2 of the Conceptual Framework for Financial Reporting (hereafter, simply referred to as the Conceptual Framework) 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 decisions about:

(a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s

economic resources.

In identifying the ‘primary users’ of general purpose financial reports, paragraph 1.5 of the Conceptual Frame- work 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 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 1.9 and 1.10 of the Conceptual Framework state:

1.9 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.

1.10 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 have the necessary power to 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 to rely instead on financial statements of a general nature released by the reporting entity to meet the general information 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 statements will often also satisfy the information needs of a broader cross-section of users, which might include employees, government, news media, researchers, interest groups and ‘the public’.

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 of their information needs.

LO 1.2

dee67382_ch01_001-058.indd 7 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 7

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 the accounting standard AASB 101 (equivalent to IAS 1, as we will explain later and show in Table 1.1) 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. (AASB 101)

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 organisation’s website). Our focus in this book will be on general purpose financial reporting practices that would typically be used by private-sector profit-seeking entities. However, governments and government departments often adopt 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).

As should be clear by now, financial accountants cannot just decide to use any accounting method they would like when preparing financial statements that are provided to shareholders and other interested stakeholders. Rather, they are bound by legislation, accounting standards and accounting concepts. In this regard, there are four principal bodies involved in formulating, interpreting and/or enforcing accounting regulations within Australia, these being the:

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

We will now give further consideration to each of the four main bodies involved in formulating and/or enforcing accounting regulations within Australia.

1.3 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 ASIC website (www.asic.gov.au) provides an overview of its role. The information provided on the website about ASIC’s role (as accessed in September 2019) 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 readers interested in reviewing the content of the Corporations Act (as well as other Acts), free access to electronic versions is available at the Federal Register of Legislation (the Legislation Register: www.legislation.gov.au), which, according to the website, is the authorised whole-of-government website for Commonwealth legislation and related documents.

Australian Securities and Investments Commission (ASIC) Body 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.

LO 1.3

dee67382_ch01_001-058.indd 8 10/24/19 12:37 PM

8 PART 1: The Australian accounting environment

Exhibit 1.1 The role of ASIC

WHAT WE DO ASIC is Australia’s integrated corporate, markets, financial services and consumer credit regulator.

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 2001 (Corporations Act).

The ASIC Act requires us to:

• 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 • take whatever action we can, and which is necessary, to enforce and give effect to the law.

OUR VISION AND MISSION Our vision: A fair, strong and efficient financial system for all Australians.

OUR REGULATORY MISSION To realise our vision we will use all our regulatory tools to:

• change behaviours to drive good consumer and investor outcomes • act against misconduct to maintain trust and integrity in the financial system • promote strong and innovative development of the financial system • help Australians to be in control of their financial lives.

OUR REGISTRY MISSION To realise our vision we will: • provide efficient and accessible business registers that make it easier to do business.

OUR STRATEGIC PRIORITIES ASIC’s strategic priorities are outlined in our Corporate Plan, updated each year.

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

dee67382_ch01_001-058.indd 9 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 9

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 the Corporations Act do not apply to organisations outside the ambit of the Act, for example, partnerships or sole traders.) ‘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 Australian Accounting Standards Board (AASB), and which are generally developed at an international level by the International Accounting Standards Board (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. Paragraph 10 of this 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’. (AASB 101)

Across time, the terminology used in relation to financial statements has changed. For example, within AASB 101, reference is made to the ‘statement of financial position’. This is equivalent to what many people traditionally call a balance sheet.

• register auditors and liquidators • grant relief from various provisions of the legislation which 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 which 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: © Australian Securities & Investments Commission. Reproduced with permission.

dee67382_ch01_001-058.indd 10 10/24/19 12:37 PM

10 PART 1: The Australian accounting environment

There are also requirements as to when different forms of organisations must report the required information to their members (for instance, shareholders). For example, for public companies, there are requirements within the Corporations Act (Section 315 (1) (a) and (b)) that the company must report to shareholders by the earlier of:

∙ 21 days before the next Annual General Meeting after the end of the financial year, or ∙ four months after the end of the financial year.

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 (b) if consolidated financial statements are required, the financial position and performance of the con­

solidated 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.

The meaning of ‘materiality’ 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. (AASB 108)

The definition of materiality in AASB 108 is consistent with how the concept of materiality is utilised in the Conceptual Framework (paragraph 2.11) and also consistent with the definition of materiality provided in other accounting standards.

As noted above, determining ‘materiality’ relies upon a great deal of professional judgement. In this regard, in late 2017 the IASB issued Practice Statement 2 on Making Materiality Judgments. Within this document, paragraph 33 identifies four steps that need to be taken when determining whether information is material, and therefore should be disclosed:

The steps identified as a possible approach to the assessment of materiality in the preparation of the financial statements are, in summary:

(a) Step 1—identify. Identify information that has the potential to be material. (b) Step 2—assess. Assess whether the information identified in Step 1 is, in fact, material. (c) Step 3—organise. Organise the information within the draft financial statements in a way that communicates

the information clearly and concisely to primary users. (d) Step 4—review. Review the draft financial statements to determine whether all material information has been

identified and materiality considered from a wide perspective and in aggregate, on the basis of the complete set of financial statements.

The above definition of materiality makes reference to ‘users’. Of particular importance would be the accounting knowledge or expertise in accounting that the users of general purpose financial statements are expected to possess. In this regard, paragraph 2.36 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 well­informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.

dee67382_ch01_001-058.indd 11 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 11

Other reporting obligations within the Corporations Act 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 the material that follows.

As part of its responsibilities, ASIC also undertakes regular surveillance of the reporting practices of Australian entities in terms of whether financial statements comply with the reporting requirements of the Corporations Act, and therefore also with applicable accounting standards. If ASIC has concerns, it invites the reporting entity to explain the reasoning behind its accounting treatment, after which time ASIC might take action against the officers of the organisation. ASIC publishes the results of its ongoing surveillance program, which can be found on its website. Exhibit 1.2 provides details from the results of ASIC’s review of 30 June 2018 financial reports. Specifically, Exhibit 1.2 identifies the issues that caused ASIC the greatest concern, and which resulted in ASIC seeking an explanation and/or taking further action against particular organisations.

Exhibit 1.2 Findings from the ASIC review of financial reporting, 2018

MAIN ISSUES OF CONCERN:

1. ASSET VALUES AND IMPAIRMENT TESTING ASIC continues to identify concerns regarding assessments of the recoverability of the carrying values of assets, including goodwill, exploration and evaluation expenditure, and property, plant and equipment.

2. REVENUE RECOGNITION ASIC is following up 17 matters concerning the recognition of revenue on contracts that involve the provision of goods or services in the future, or multiple deliverables (i.e. both goods and services).

3. TAX ACCOUNTING ASIC is making inquiries of 10 entities concerning their accounting for income tax, including the adequacy of tax expense and whether it is probable that future taxable income will be sufficient to enable the recovery of deferred tax assets relating to tax losses.

4. CONSOLIDATION ACCOUNTING We have made inquiries of several entities on the non­consolidation of other entities, including an entity that has treated an apparent loan securitisation arrangement as off­balance sheet.

5. BUSINESS COMBINATIONS We have made inquiries of three entities in relation to business combinations. In one instance, the transactions have been treated as under common control which may not be appropriate.

6. EXPENSE DEFERRAL We have made inquiries of three entities to ascertain whether amounts deferred as assets should have been charged to the income statement as expenses. In one instance, costs incurred have been capitalised in anticipation of recovery under an insurance claim.

7. ESTIMATES AND ACCOUNTING POLICY JUDGEMENTS We observed instances where entities needed to improve the quality and completeness of disclosures in relation to estimation uncertainties, and significant judgements in applying accounting policies. The disclosure requirements are principle­based and should include all information necessary for investors and others to understand the judgements made and their effect. This may include key assumptions, reasons for judgements, alternative treatments, and appropriate quantification.

The ongoing surveillance program of ASIC helps to ensure that the standard of financial reporting within Australia is maintained at a high level.

SOURCE: © Australian Securities & Investments Commission. Reproduced with permission.

dee67382_ch01_001-058.indd 12 10/24/19 12:37 PM

12 PART 1: The Australian accounting environment

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.

That is, if directors allow the organisation to keep trading when they knew, or ought reasonably to have known, that the company could not pay its debts as and when they fall due (meaning that the organisation is ‘insolvent’), then they can be personally prosecuted and their private funds used to pay the outstanding debts of the company. As some recent examples of this, consider the following:

∙ In a newspaper report of 21 March 2019 entitled ‘Board directors exposed as RCR may have traded while insolvent’ (by Jenny Wiggins, The Australian Financial Review, p. 19), it was noted that the company known as RCR Tomlinson may have been trading while insolvent for at least a month before it went into administration, meaning its Board directors are thereafter potentially personally liable for debts incurred during this time. According to the liquidators, the company filed for administration on 21 November 2018 but had potentially become insolvent at the end of October 2018 or earlier. As the newspaper article emphasises, Board directors have a responsibility to ensure that a company does not trade while it is insolvent; if a company goes into liquidation, and insolvent trading is found to have occurred, the company’s directors are personally liable for the debts incurred during that time. One role of the liquidator is to investigate the exact date that RCR became insolvent, and to report any offences by directors to ASIC.

∙ In a newspaper report of 7 March 2019 entitled ‘Acquire eyed success before fall’ (by Sarah Danckert, The Sydney Morning Herald, p. 5), it was reported that the directors of the education company known as Acquire (which was linked to the former head of the Australian Football League, Andrew Demetriou) had received warnings about the solvency of the company from the organisation’s then chief financial officer (CFO), as well as a suggestion from the CFO that an administrator be appointed to run the company and hopefully enable it to keep trading. However, the company was not placed into administration until several months later, thereby raising the possibility that the directors may have personal liability for debts occurred after they were warned of the potential cash flow problems.

∙ In a newspaper article of 11 February 2019 entitled ‘KPMG gives Rosewalls a serve’ (by Joyce Moullakis, The Australian, p. 19), it was reported that the directors of an organisation linked to former tennis champion Ken Rosewall, which collapsed in 2015, were being pursued for funds lost when the organisation was apparently trading while insolvent. The article reported that this insolvent trading might have been going on for a number of years.

As an example of a ‘real-life’ Directors’ Declaration, Exhibit 1.3 reproduces the Directors’ Declaration that was disclosed within the 2019 Annual Report of BHP Group Ltd.

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

dee67382_ch01_001-058.indd 13 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 13

Exhibit 1.3 Directors’ declaration of BHP Group Ltd (from the 2019 Annual Report)

SOURCE: © BHP Group Ltd

serve to give the material you read a more ‘real-world’ feel. Large, listed Australian companies provide copies of their annual reports on their websites. For example, see the websites of:

∙ BHP (www.bhpbilliton.com) ∙ Westpac Banking Corporation (www.westpac.com.au)

dee67382_ch01_001-058.indd 14 10/24/19 12:37 PM

14 PART 1: The Australian accounting environment

∙ AMP (www.amp.com.au) ∙ Australia and New Zealand Banking Group Limited (ANZ: www.anz.com.au/personal) ∙ National Australia Bank (NAB: www.nab.com.au) ∙ Commonwealth Bank (CommBank: www.commbank.com.au) ∙ Qantas (www.qantas.com).

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.

Directors’ Report Another required disclosure within the annual report is the Directors’ Report. In the Directors’ Report, required pursuant to ss. 298–300A of the Corporations Act, directors must disclose 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 disclosed 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 issue in Chapter 3). For example, it is 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.

The Directors’ Report is also to include an operating and financial review. The review should include information that shareholders of the company would reasonably require in order 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 strateg ies, 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 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 1.3, towards the end, the Directors’ Declaration of BHP specifically notes that the directors received the declaration from 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.

The true and fair view: further considerations As we have already noted, the Corporations Act requires directors to ensure that financial reports are ‘true and fair’. Before the early 1990s, the directors of a company could elect not to comply with an accounting standard on the

dee67382_ch01_001-058.indd 15 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 15

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, with the corporations law being amended, and the override being withdrawn such that s. 296 of the Corporations Act requires that ‘[t]he financial report for a financial year must comply with accounting standards’ (although 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.

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 (the reference to ‘the Framework’ below relates to the Conceptual Framework) 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. (AASB 101)

A current problem is that our qualitative requirement 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, reproduced in Exhibit 1.3, 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 1.4 shows the opinion section of the auditor’s report from the Commonwealth Bank of Australia 2019 Annual Report. The whole independent auditor’s report was actually 11 pages in length; apart from the audit opinion section that we have reproduced, the audit report also included sections about the scope of the audit, materiality thresholds and key audit matters (those matters that in the auditor’s judgement were of significance to the audit of the financial statements).

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).

dee67382_ch01_001-058.indd 16 10/24/19 12:37 PM

16 PART 1: The Australian accounting environment

Exhibit 1.4 Independent auditor’s report to the members of Commonwealth Bank of Australia

dee67382_ch01_001-058.indd 17 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 17

SOURCE: © CBA Commonwealth Bank of Australia

dee67382_ch01_001-058.indd 18 10/24/19 12:37 PM

18 PART 1: The Australian accounting environment

1.4 Australian Accounting Standards Board

While the Corporations Act, which as we know 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. Within Australia, this responsibility is borne by the Australian Accounting Standards Board (AASB).

The AASB began operations on 1 January 1991 and replaced the Accounting Standards Review Board. While its functions, membership and structure were changed in 2000 as a result of amendments included in the Corporate Law Economic Reform Program Act 1999 (Cwlth), the body charged with formulating accounting standards has retained the name ‘Australian Accounting Standards Board’. The functions of the AASB are listed in s. 227 of the ASIC Act and include to:

∙ 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 world­wide 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 ‘sector-neutral’ approach to the development of accounting standards.

We will consider the full list of AASB accounting standards later in this chapter. It is worth emphasising here that the majority of AASB standards underwent changes in 2003 or 2004 as Australia moved towards adopting accounting standards released by the IASB from 2005.

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.

As we have noted a number of times, there is a requirement within the Corporations Act that directors must ensure compliance with accounting standards issued by the Australian Accounting Standards Board (AASB). We will now further consider the functioning of the AASB.

Australian Accounting Standards Board (AASB) Body charged with developing a 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.

LO 1.4

WHY DO I NEED TO KNOW ABOUT THE ROLE OF ASIC WITH RESPECT TO FINANCIAL REPORTING WITHIN AUSTRALIA?

ASIC plays a central role in regulating corporate reporting within Australia, and in enforcing reporting requirements included within the Corporations Act. Therefore, to understand the context of corporate reporting within Australia, it’s important to understand the role that ASIC plays. The more active we believe ASIC to be in monitoring and enforcing corporate reporting requirements, the more we’re inclined to believe that Australian reports are of higher quality (relative to other overseas jurisdictions with less active corporate regulators).

dee67382_ch01_001-058.indd 19 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 19

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 Figure 1.1, the Federal Minister appoints the Chair of the Australian Accounting Standards Board

(AASB). The Chair 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 ‘focus groups’ as part of the AASB structure. These focus groups are further divided into the:

∙ 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 investors, investment professionals and equity and credit 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 about how investors and investment professionals, equity and credit analysts, credit grantors and rating agencies use financial statements, and 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.

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.

Figure 1.1 Diagrammatic representation of the structure of Australian accounting standard-setting

Financial Reporting

Council

The Minister

Organisational structure

Australian Accounting

Standards Board

O�ce of the Australian Accounting

Standards Board

Focus groups

Project advisory panels

Interpretation advisory panels

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

dee67382_ch01_001-058.indd 20 10/24/19 12:37 PM

20 PART 1: The Australian accounting environment

Interpretations advisory panels are another important component of the AASB structure. Panel membership normally includes preparers, users, auditors and regulators in order to represent a wide range of perspectives. Interpretations are required from time to time in respect of how particular accounting requirements are to be 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—functioning 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 Chair 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 the 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 needed 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 also provides a diagram to summarise how it develops pronouncements. It is reproduced as

Figure 1.2. In explaining Figure  1.2, the website of the AASB provides the following information about the various steps

undertaken within the process of developing accounting standards.

1. International organisation identifies a technical issue ∙ A technical issue may be identified by the International Accounting Standards Board (IASB) or the IFRS

Interpretations Committee (IFRIC). ∙ A technical issue may also be identified by the International Public Sector Accounting Standards Board (IPSASB).

The AASB closely monitors the IPSASB work program and undertakes work on selected topics, based on their significance to public sector financial reporting in Australia.

2. AASB identifies a technical issue ∙ AASB Board members and staff can identify technical issues requiring consideration. ∙ Issues identified in relation to for­profit entities are normally referred to the IASB or the IFRIC for consideration. ∙ Issues affecting not­for­profit entities in the public and private sectors may be addressed domestically or referred

to the IPSASB.

dee67382_ch01_001-058.indd 21 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 21

3. Australian organisation/individual identifies a technical issue ∙ Australian stakeholders can advise the AASB of issues that in their view should be considered by the AASB or an

international standard­setter. For example, issues may be raised in the context of improving the relevance and reliability of financial information or reducing the costs of financial reporting.

4. Add issue to the agenda ∙ Once a technical issue has been identified, the AASB will develop a project proposal. ∙ A project proposal contains an assessment of the potential benefits of undertaking the project, the costs of not

undertaking it, the resources available and the likely timing. ∙ The AASB will then review the project proposal and make a decision as to whether the project is worthwhile and

should be placed on its agenda (work program). ∙ If the Board decides not to add a topic to the agenda, the Board may decide to formally report the decision as a

Board Agenda Decision, sometimes called ‘items not taken onto the agenda’ or ‘agenda rejection statements’. The minutes of meetings record the decisions made and whether or not a formal Board Agenda Decision is issued.

5. Research and consider issue ∙ When an issue has been added to the agenda, the AASB will discuss agenda papers developed and presented

by AASB staff. The agenda papers address the scope of issues, alternative approaches, and timing of outputs. They may draw upon relevant material from other standard­setters, including the IASB, the IPSASB and the New Zealand Accounting Standards Board, or from other organisations.

∙ Some issues may be considered jointly with the New Zealand Accounting Standards Board where they are of significance in each country, in order to develop comparable requirements.

6. Consult with stakeholders Once the research has been completed, the AASB makes related documents available for public comment and discussion with stakeholders via one of the following document types.

∙ Exposure Drafts (EDs) An exposure draft typically is a draft of a proposed standard (or other pronouncement) or draft amendment to a

standard. An ED is likely to include more refined proposals in comparison with invitations to comment, discussion papers and consultation papers.

Figure 1.2 Diagrammatic representation of how accounting standards are developed by the AASB

SOURCE: © Australian Accounting Standards Board, 2016. www.aasb.gov.au/About­the­AASB/The­standard­setting­process.aspx

dee67382_ch01_001-058.indd 22 10/24/19 12:37 PM

22 PART 1: The Australian accounting environment

∙ Invitations to Comment (ITCs) Invitations to comment generally seek feedback on broad proposals. An ITC may contain a discussion paper or a

consultation paper. ∙ Draft Interpretations

A draft interpretation is a draft of a proposed interpretation of a standard. ∙ Discussion Papers (DPs) These usually outline a wide range of possible accounting policies on a particular topic. Discussion papers,

consultation papers and similar documents may be issued by the AASB, the IASB, the IPSASB or other standard- setters. The AASB may choose to issue international documents in Australia for comment, perhaps with an Australian preface added to explain the context. The methods the AASB uses to consult with stakeholders may also include the following:

∙ Roundtable discussions The AASB may hold formal discussions with a range of stakeholders in connection with proposals issued for comment. ∙ Consultation through the vehicle of the Focus Groups, Project Advisory Panels, or Interpretation Advisory

Panels (we discussed these groups previously). 7. Issue standard or other pronouncement

The outcome of the AASB’s consideration of an issue may be the issuance of a pronouncement, such as a standard, an interpretation, or a conceptual framework document. Alternatively, the AASB might decide to address an issue by giving its view on the issue in the minutes of a meeting or in a formal Board Agenda Decision.

Pronouncements applicable to for­profit entities will be consistent with International Financial Reporting Standards (IFRSs) issued by the International Accounting Standards Board. This is to ensure that general purpose financial statements prepared by for­profit entities in accordance with AASB standards will also be in accordance with IFRSs.

The AASB has a transaction neutrality policy under which similar transactions and events should be accounted for in a similar manner by all types of entities, whether in the for­profit sector, the not­for­profit private sector, or the public sector—unless there is a sound reason to be different in particular circumstances. The AASB considers the specific needs of not­for­profit entities in the private and public sectors when preparing new and revised IFRSs for adoption in Australia.

8. Submissions to international organisations The AASB takes input received from Australian organisations and individuals into account when preparing its submissions to international organisations. The AASB makes formal submissions on documents issued for comment by the IASB and the IPSASB, to contribute to the setting of high­quality international accounting standards.

9. Comments from stakeholders in Australia The AASB requests formal comment letters (submissions) and other input from stakeholders on the AASB’s own proposals and in relation to various consultative documents issued by the IASB and the IPSASB. The AASB considers this input in making submissions to the IASB and the IPSASB and in developing its own pronouncements.

10. Implementation and compliance The AASB monitors implementation of accounting standards and interpretations in Australia. This may lead to revisions to domestic AASB standards or to submissions to the IASB or the IPSASB to propose changes to international standards.

Compliance with Australian accounting standards and interpretations is also monitored by other organisations, including ASIC, the Australian Prudential Regulation Authority, other Federal, State and Territory Government regulators, CPA Australia, Chartered Accountants Australia and New Zealand, and the Institute of Public Accountants. The AASB receives feedback from the above organisations that assists in assessing whether amendments to standards are required.

As part of the process of developing accounting standards, Section 231 of the ASIC Act also 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 by issuing the text of an international standard (whether or not modified to take account of the Australian legal or institutional environment).

dee67382_ch01_001-058.indd 23 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 23

(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.

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 (when standards are issued there is usually a transitional period such that entities might have at least one accounting period before they have to comply with the new requirements). This is in terms of s. 296 of the Corporations Act, which as we now know 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, 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.

Reporting exemption allowed for ‘small proprietary companies’ Most ‘small’ proprietary companies are exempted from complying with accounting standards released by the AASB. While the thresholds do change from time to time, new thresholds commenced from 1 July 2019 and, 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 $50 million (as determined by applying accounting standards). 2. Its gross assets are less than $25 million (as determined by applying accounting standards). 3. It has fewer than 100 equivalent full-time employees.

Section 296(1A) 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.

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. As noted above, where shareholders make directions for the preparation of financial reports, they can specify that those reports do not have to comply with accounting standards. 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

dee67382_ch01_001-058.indd 24 10/24/19 12:37 PM

24 PART 1: The Australian accounting environment

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.

The process of Australia adopting accounting standards issued by the International Accounting Standards Board 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 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 IFRSs 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 within Australia, 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, and even though we have adopted the accounting standards issued by the IASB, 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 profit-seeking companies). Within Australia, however, AASB standards have general applicability to the not-for-profit and local government sectors too (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 September 2019 with reference also to the equivalent IASs/IFRSs (not all AASB standards have an IAS/IFRS equivalent). 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 of 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 mid-2019, 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 very latest versions of accounting standards.

dee67382_ch01_001-058.indd 25 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 25

AASB No. Title Equivalent IFRS/IAS

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

IFRS 1

2 Share-based Payments 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

17 Insurance Contracts IFRS 17

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

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

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

continued

dee67382_ch01_001-058.indd 26 10/24/19 12:37 PM

26 PART 1: The Australian accounting environment

Compliance with the AASB standard would still mean compliance with the IASB standard. The AASB standards might also require additional disclosures. 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 that the standards concerned are issued by the IASB.

Numbering of Australian Accounting Standards Because we will be referring to accounting standards in this and subsequent chapters, it is worth looking at the numbering system applied to Australian Accounting Standards.

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 First­time 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’. Look at the right-hand column of Table 1.1 for yourself and you will see the use of both ‘IFRS’ and ‘IAS’ as prefixes.

By contrast, when the Australian Accounting Standards Board releases accounting standards they will all have the prefix ‘AASB’. However, the numbering system applied to a particular AASB standard will depend upon whether the ‘adopted’ standard relates to an ‘old’ or ‘new’ international standard. As we can see from the left-hand column of Table 1.1, 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:

SOURCE: © Commonwealth of Australia. Reproduced by permission.

AASB No. Title Equivalent IFRS/IAS

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 –

1058 Income of Not-for-profit Entities –

1059 Service Concession Arrangements: Grantors –

Table 1.1 continued

dee67382_ch01_001-058.indd 27 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 27

AASB Standards 1–99 Series 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.

AASB Standards 100–199 Series Where the adopted AASB standard relates to an international 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 related international standard being IAS 38 Intangible Assets).

Standards 1000 + Series In situations where Australia releases an accounting standard that does not have an international equivalent (the AASB might release standards relating 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. We hope that this explanation of the numbering system will prevent confusion in this, and the following chapters.

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.

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 (earlier in this chapter we covered the processes involved when the AASB develops an accounting standard).

The decision by the FRC (the body that oversees the AASB) 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 entities to prepare financial statements in accordance with IFRSs for accounting periods beginning on or after 1 January 2005. Given the historical 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.

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!).

The AASB 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 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). 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

dee67382_ch01_001-058.indd 28 10/24/19 12:37 PM

28 PART 1: The Australian accounting environment

Exhibit 1.5 Financial Reporting Council’s bulletin on the council’s strategic direction 

dee67382_ch01_001-058.indd 29 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 29

continued

dee67382_ch01_001-058.indd 30 10/24/19 12:37 PM

30 PART 1: The Australian accounting environment

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 standard­setting bodies to develop new or revised standards that will contribute to the development of a single set of accounting standards for world­wide 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 world­wide 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 their reported assets greatly reduced 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 many countries throughout the world now use IFRSs, there are still differences between the United States’ generally accepted accounting principles (US 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 IFRSs, and the aim of the convergence project was to work towards the time when a ‘true’ international standardisation of accounting becomes a reality. The wisdom of this was subsequently questioned within the US by the Securities and Exchange Commission (SEC) and hence it is not at all certain that the US will ultimately adopt IFRSs 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

SOURCE: Bulletin of the Financial Reporting Council 2002/4—3 July 2002

Exhibit 1.5 continued

dee67382_ch01_001-058.indd 31 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 31

1.5 Financial Reporting Council

As noted previously, the Financial Reporting Council (FRC) oversees the activities of the AASB and was instrumental in the decision that Australia adopt the accounting standards issued by the IASB. The website of the FRC (at www.frc.gov.au) provides the names and occupations of those making up the membership of the FRC. Section 235A(1) of the Australian Securities and Investments Commission Act 2001 (ASIC Act)—also available at www.legislation.gov.au—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.

According to the website of the FRC (accessed September 2019), the membership of the FRC was made up of a retired partner from PriceWaterhouse Coopers; a chief financial officer; a deputy secretary of the Department of Finance; the Chief Compliance Officer of ASX; the Under Treasurer of the Treasury and Economic Development Directorate of the ACT Government; the AASB Chairperson; the Australian Auditing Standards Chairperson; and a partner of KPMG. (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, the responsibilities of the FRC include overseeing the activities of the Auditing and Assurance Standards Board (AUASB), which is responsible for developing auditing standards within Australia. 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.

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 (d) to give the Minister reports and advice about the matters referred to in paragraphs (a) and (b); and (e) the functions specified in subsections (2) (specific accounting standards functions), (2A) (specific auditing

standards functions) and (2B) (specific auditor quality functions); 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.

We will now further consider the organisation that oversees the activities of the AASB, this being the Financial Reporting Council.

Financial Reporting Council (FRC) Body that oversees the activities of the AASB and the AUASB.

LO 1.5

WHY DO I NEED TO KNOW ABOUT THE ROLE OF THE AUSTRALIAN ACCOUNTING STANDARDS BOARD?

The AASB is the accounting standard­setter within Australia. In order to understand the practice of financial reporting within Australia, it is important to understand the role of the AASB, and the various pronouncements it releases. If you are a preparer of financial statements, or a company director, you need to ensure that the financial reports you are releasing are in compliance with the standards released by the AASB (these are available on the AASB’s website). You also need to understand that although the AASB does not directly have the power to enforce accounting standards, the accounting standards released by the AASB (whether developed within Australia, or based upon standards developed by the IASB) do have the force of law by virtue of the Corporations Act, as enforced by ASIC. The website of the AASB is also relevant as it provides information about the various activities and projects being pursued by the AASB, and which might be expected to impact future financial reporting within Australia

dee67382_ch01_001-058.indd 32 10/24/19 12:37 PM

32 PART 1: The Australian accounting environment

(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. As we have noted previously, it was the decision of the FRC in 2002 that Australia would adopt IFRSs. 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 we can also see above, 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 state 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 and users of financial statements within Australia as they became familiar with a new set 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’).

1.6 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:

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,

Australian Securities Exchange (ASX) Body that sets uniform trading rules, ethical standards and listing requirements.

LO 1.6

dee67382_ch01_001-058.indd 33 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 33

which are now referred to as Corporate Governance Principles and Recommendations, were most recently amended and re-released in February 2019 (the fourth edition) and can be accessed on the ASX website. As indicated in the principles document (p. 1):

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 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 provide 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 1.6. Disclosure pertaining to the eight essential principles must be made in the annual report in a dedicated corporate governance section.

Exhibit 1.6 The eight essential corporate governance principles identified by the ASX

continued

dee67382_ch01_001-058.indd 34 10/24/19 12:37 PM

34 PART 1: The Australian accounting environment

Exhibit 1.6 continued

SOURCE: © Copyright 2019 ASX Corporate Governance Council

1.7 International Accounting Standards Board

Because the accounting standards being used within Australia emanate overwhelmingly from the IASB in London it is 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 were 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, most developed countries have adopted IFRSs. This was done because of the perceived benefits associated with having globally consistent accounting standards. The IASB provided a diagram on its website relating to the extent of the global adoption of IFRSs as of late 2018. It is reproduced in Figure 1.3.

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 2019 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;

LO 1.7

dee67382_ch01_001-058.indd 35 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 35

∙ 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 1.4 provides a diagrammatic representation of how accounting standards are developed by the IASB. 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 in December 2018) 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 eight members of the IASB, if there are 13 members or fewer, or by nine members if there are 14 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

SOURCE: www.ifrs.org/­/media/feature/about­us/who­we­are/who­we­are­english­2018­final.pdf

Figure 1.3 The number of jurisdictions using IFRSs

SOURCE: IFRS Foundation, Who We Are and What We Do, International Accounting Standards Board (IASB), January 2018.

Figure 1.4 How the IASB develops accounting standards

dee67382_ch01_001-058.indd 36 10/24/19 12:37 PM

36 PART 1: The Australian accounting environment

Basis for Conclusions documents are publicly available. The IASB would also publish dissenting opinions from members of the Board who disagreed with the majority 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 standard-setters 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 2019) came from Australia.

The IASB does not have power to enforce its standards An important point to consider, and remember, is that the IASB is a standard-setting body. It does not have any enforcement powers. For example, in Australia we use IFRSs 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 IFRSs, 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 IFRSs is logically 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, 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?

The above view was also reflected again a decade later in Ball (2016). Ball (2016, p. 554) notes: Does anyone really believe that implementation will be of equal standard in all of the countries? Many of the countries counted among the 116 adopters simply do not have the infrastructure to enforce actual implementation, even if they wanted to. Many will not want to, due to political and economic factors. . . . The emerging consensus is that changes in rules have little effect on reporting quality without incentives of preparers to actually implement them.

Therefore, we should not simply accept claims that the international adoption of IFRSs automatically leads to the adoption of uniform accounting methods globally, and to ‘better’ financial reporting universally.

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

dee67382_ch01_001-058.indd 37 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 37

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 IFRSs, it also provides Interpretations of requirements existing within IFRSs. 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 IFRSs, a central objective of the IFRS Interpretations Committee

is to achieve consistent Interpretations of IFRSs 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 issued 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.

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 for Financial Reporting.

WHY DO I NEED TO KNOW ABOUT THE ROLE OF THE INTERNATIONAL ACCOUNTING STANDARDS BOARD?

While Australia does use some accounting standards that were developed within Australia and which do not have an international counterpart, the vast majority of accounting standards being applied within Australia were developed by the IASB. Therefore, because of the influence that the IASB exerts over Australian general purpose financial reporting, it seems reasonable that you should know about how the IASB functions, and what processes are in place to develop its pronouncements.

dee67382_ch01_001-058.indd 38 10/24/19 12:37 PM

38 PART 1: The Australian accounting environment

1.8 Accounting standards change across time

One other thing we 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 of major changes, 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 in relation to the recognition and measurement of income and expenses 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.

1.9 Differential reporting

In relation to the issue of differential reporting, we know from discussion already provided within this chapter that within Australia 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 of Tiers of Australian Accounting Standards. AASB 1053 introduced a two-tier 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 reduces the disclosure requirements.

Because the Tier 2 requirements do not change the recognition and measurement requirements being applied, the 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, set out the disclosure requirements from which Tier 2 entities are exempt. Complying with Tier 1 requirements will mean compliance with International Financial Reporting Standards (IFRSs) as issued by the IASB. 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:

LO 1.8

LO 1.9

dee67382_ch01_001-058.indd 39 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 39

(a) for­profit private sector entities that have public accountability; and (b) the Australian Government and State, Territory and Local Governments. (AASB 1053)

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. (AASB 1053)

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. (AASB 1053)

The definition of ‘public accountability’ reproduced above provides a general principle. Appendix A to AASB 1053 provides practical application guidance. It states:

A for­profit 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 over­the­counter 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. (AASB 1053)

Paragraph B2 of Appendix B to AASB 1053 further states:

The following for­profit 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) co­operatives 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 deposit­taking institutions. (AASB 1053)

In relation to which entities are permitted 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) for­profit private sector entities that do not have public accountability; (b) not­for­profit private sector entities; and (c) public sector entities, whether for­profit or not­for­profit, 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. (AASB 1053)

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)—as discussed earlier in this chapter—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. (AASB 1053)

dee67382_ch01_001-058.indd 40 10/24/19 12:37 PM

40 PART 1: The Australian accounting environment

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. (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 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); 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 (IFRSs), 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 Medium­Sized Entities. The IASB standard allows small and medium enterprises (SMEs) to depart from various recognition, measurement and presentation requirements incorporated within IFRSs. 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 in 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 at the profession and at the tertiary level

∙ the fact 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

∙ the fact that 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 ∙ the fact that 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 ∙ the fact that 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 did represent a relatively major change for 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

dee67382_ch01_001-058.indd 41 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 41

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. (AASB 1053)

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 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 required by law to follow the majority of AASB accounting standards. This is despite the specific wording of some AASB standards.

1.10 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, this being 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. 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 part of an audit report earlier in this chapter.

In the private sector, decisions relating to the internal affairs of an organisation, 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

LO 1.10

dee67382_ch01_001-058.indd 42 10/24/19 12:37 PM

42 PART 1: The Australian accounting environment

1.11 What benefits can we expect from all of this international standardisation?

As indicated earlier in this chapter, the Australian government decided that Australia would adopt IFRSs because of the perceived benefits. The benefits that were promoted by the FRC included 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 are 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.

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.

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.

LO 1.11

WHY DO I NEED TO KNOW ABOUT THE ROLE OF EXTERNAL FINANCIAL STATEMENT AUDITORS?

Audit reports are typically included within annual reports issued by reporting entities. They provide an insight into the reliability of the information being presented by the managers of the organisation. However, just because an auditor might provide an opinion that the financial statements appear to comply with accounting standards and other generally accepted accounting principles, there is always a chance that the financial statements have been prepared inappropriately. The audit opinion is simply that—an opinion. Sometimes they are wrong, and we need to appreciate that. Nevertheless, if the opinion is provided by a reputable auditor, then our confidence in the information should be enhanced.

dee67382_ch01_001-058.indd 43 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 43

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 variations in the accounting standards issued by different countries, the difficulties in comparing the financial performance of reporting entities from different countries will persist. The variations in accounting rules can have significant implications for profit comparisons. In this regard we can consider research by Nobes and Parker (2004). They undertook a comparison of the results of a small number of European-based multinational 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 £9521 million when reported in conformity with UK accounting rules, but the same set of transactions produced a reported profit of £29 707 million 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 IFRSs of $6043 million became a net income of $4392 million 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 $15 304 million when reported in accordance with IFRSs, but this became $32 467 million 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, 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 of the activity undertaken to standardise accounting standards internationally. What do you think? Certainly, this justification was used by Australian accounting standard-setters.

The view that the 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 took 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 Organization of Securities Commissions (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 and 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 IFRSs without the need to provide a reconciliation to generally accepted accounting

dee67382_ch01_001-058.indd 44 10/24/19 12:37 PM

44 PART 1: The Australian accounting environment

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 which 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 IFRSs as issued by the IASB (without modifications), and they must also provide an auditor’s unqualified report explicitly providing an opinion that the financial statements have been compiled in accordance with IFRSs 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 IFRSs, whereas domestic US companies must lodge their reports in accordance with US GAAP.

In reflecting upon whether the adoption of IFRSs in Australia actually led to benefits for Australia, the AASB undertook a review in 2017 (reported in AASB 2017). The AASB reported that the general view from all stakeholders was that adopting IFRSs was the right decision for Australia. Eighty people were interviewed for the research and they came from various forms of organisations (including listed companies, charities and government departments). Such results are also consistent with a report released in late 2016, also by the AASB.

From an extensive review of existing research, the AASB (2016) reports that available research generally supports the view that IFRS adoption has benefitted the Australian economy and that there is no significant evidence to suggest that any reconsideration of the decision to adopt IFRSs is warranted. While there is some evidence that the way Australia now accounts for intangible assets under IFRSs (relative to how Australia formerly accounted for intangible assets) has deficiencies, the evidence also suggests that the adoption of IFRSs has led to financial reports becoming longer but easier to read. Another positive effect is that the evidence points to the comparability of Australian entities’ financial reporting practices, with their global peers, as being enhanced.

1.12 International cultural differences and the harmonisation of accounting standards

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 the global harmonisation or convergence of accounting standards.

There are a number of potential barriers to global standardisation of accounting standards; these include the influences of different business environments, legal systems, cultures and political environments.

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 society-wide values. Perera (1989, p. 43) argues that culture is a powerful environmental factor affecting the accounting system of a country and, therefore, 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 developed in that country will tend towards conservatism. Conservative accounting policies would rely on traditional measurement practices (such as historical cost) and would be more likely to be used in countries in which the society is generally classified as seeking to minimise uncertainty (Perera 1989). Gray (1988, p. 10) argues that the degree of conservatism varies by country, ranging from a strongly conservative approach in the continental European countries, such as France and Germany, to a much less conservative approach in the US and the UK.

Countries might have cultural attributes that suggest they tend more towards secrecy than transparency, and their accounting disclosure requirements might reflect this cultural bias. As with degrees of conservatism, Gray (1988, p. 11) argues that the extent of secrecy seems to vary between

countries, with lower levels of disclosure—implying greater secrecy—including instances of secret reserves, evident in the continental European countries, for example, compared with higher levels of disclosure in the US and the UK.

LO 1.12

conservative accounting policies Policies that tend to understate the value of an entity’s net assets; a bias towards understating the carrying amount of assets and overstating the carrying amount of liabilities.

dee67382_ch01_001-058.indd 45 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 45

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 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.’

Consistent with the above, Brown (2011) notes that:

Accounting standards have differed from country to country, because of differences across countries in the economic and social forces that have interacted in the past to determine those countries’ accounting standards today.

Much of the diversity in accounting standards across countries results from deeply entrenched differences in legal systems, in relationships between firms and their financiers, in income tax systems, in inflation rates, in historical ties (political and economic), in the extent of economic development and in the level of community education.

Moreover, many of those differences are deep­seated and will not disappear quickly after a country commits to adopting IFRS.

Following from the above discussion, the issue of ‘culture’ and international cultural differences together with differences in political, social and economic systems 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, these 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 topic.

1.13 All of this regulation—is it really necessary?

As preceding sections of this chapter have discussed, financial accounting is fairly heavily regulated in Australia and many other countries. 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 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 managers of an organisation to provide credible information about its operations and performance to certain

LO 1.13

dee67382_ch01_001-058.indd 46 10/24/19 12:37 PM

46 PART 1: The Australian accounting environment

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’.

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

dee67382_ch01_001-058.indd 47 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 47

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 simplest 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.

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 non­purchasers (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.

dee67382_ch01_001-058.indd 48 10/24/19 12:37 PM

48 PART 1: The Australian accounting environment

While proponents of a free-market approach argue that the market, on average, is efficient, it can also be argued that such ‘on­average’ 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.

1.14 The reporting of alternative measures of ‘profits’

In this chapter we have stressed that financial statements, particularly those prepared for large proprietary companies and public companies, are to comply with accounting standards. This means that the financial

statements shall present a measure of profits that has been determined by applying accounting standards. As we will learn in this book, profit (as determined by applying accounting standards) shall include all items of ‘income’ and ‘expense’, unless they are specifically excluded from being included within profit or loss by virtue of a requirement within a specific accounting standard.

While organisations are required to measure and report profit in accordance with accounting standards, it is also becoming quite common to find that many organisations also disclose alternative (additional) measures of profits which are derived in a way that is inconsistent with accounting standards, but which are argued by the managers of the organisation to provide a measure of performance that they believe is more representative of the organisation’s performance. The news media also often refer to these alternative measures of performance.

The motivations for providing these alternative measures of performance might come from a belief that the measure of performance derived by not complying with accounting standards provides a relatively superior indicator of the organisation’s underlying performance and that this measure is more useful to both the managers of the organisation, in terms of effectively managing the organisation, and to the readers of the financial reports. Alternatively, such disclosures might be made opportunistically by managers to generate a result managers think will provide some form of benefits to the organisation, or to themselves. Perhaps it could also be a mixture of both incentives.

The evidence indicates that, when calculating these alternative measures of profits, the most commonly excluded expenses are depreciation and amortisation, the costs assigned to share-based remuneration provided to managers, research and development costs, and major impairments of assets. When referring to these alternative measures of financial performance, organisations often refer to the alternative measure as ‘underlying profit’, ‘underlying earnings’, ‘cash earnings’ or ‘underlying profit after tax’ (CAANZ 2016).

Even though we might feel it is inappropriate to provide these alternative measures of profits in the same financial reports in which accounting standards must be followed, it is permitted unless the disclosures are considered to be

LO 1.14

dee67382_ch01_001-058.indd 49 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 49

misleading. If the alternative measures are reported in a way that is misleading, ASIC can take action against the directors of the company.

In respect to this type of reporting, evidence provided by Chartered Accountants Australia and New Zealand (as reported within CAANZ 2016) shows that:

∙ In 2014 (which was the latest year of data they used to do the study), 42 per cent of large Australian companies listed on the ASX (ASX 500 Australian companies) disclosed within their annual report at least one measure of earnings that was not calculated in accordance with accounting standards.

∙ The majority of organisations provided a reconciliation of the alternative earnings figure (see the exhibits below for examples of this practice) with the result that would be calculated by applying accounting standards.

∙ In general, the measures of earnings reported and derived from not complying with all accounting standards were not as ‘volatile’ as profit calculated using accounting standards.

∙ Evidence suggests that where other measures of profit are presented they tend to be higher than profit calculated in accordance with accounting standards.

∙ The practice of providing disclosures within annual reports that referred to other measures of profits became more common in Australia following the adoption of IFRSs in 2005.

Therefore, the point to be appreciated here is that although organisations are required to comply with accounting standards, it is also becoming common to find that when they discuss their results they might tend to refer to alternative measures of ‘profits’ other than the profits that would be derived from following accounting standards. As a result, when we review financial reports we need to understand whether the financial results that are being emphasised and discussed by the senior management of the organisation are the same as the results that have been reported within their financial statements, and which have been subject to an independent financial audit—or whether the results are based upon non-compliant methods of accounting. If they have been derived from an accounting approach that does not comply with accounting standards, we perhaps need to determine whether we agree with the management’s assertions about the need for an alternative (additional) measure. We also need to consider whether there might be other motivations driving managers to report numbers that deviate from accounting standards. Also, we need to appreciate that the ability to compare the results of different organisations is undermined if organisations use different accounting methods.

As an example of this practice (and again, we emphasise that it is common practice for larger organisations), we can consider the Commonwealth Bank of Australia. In its 2019 Annual Report it refers many times throughout the report to ‘net profits after tax (cash basis)’. According to the Annual Report (page 81):

The Group manages its business performance using a “cash basis” profit measure. The key items that are excluded from statutory profit for this purpose are non­recurring or not considered representative of the Group’s ongoing financial performance.

Exhibit 1.7 reproduces one of the places in the Commonwealth Bank’s 2019 Annual Report where reference is made to its preferred measure of profit (and there are many other references to this number used throughout the Annual Report). Consistent with many other organisations, it also provides a reconciliation of this preferred measure of profit with what profit would be pursuant to the application of accounting standards (which it refers to as profit determined on a ‘statutory basis’). We reproduce this reconciliation in Exhibit 1.8. We stress again here that, regardless of whether the organisation has an alternative measure of profit that it discusses, when it presents the financial statements itself (such as the statement of profit or loss and other comprehensive income), the financial statement must be compiled in accordance with the accounting standards.

As another example, in the 2018 Annual Report of BHP Group Ltd, the Consolidated Income Statement, which, as we know, is to be compiled in accordance with accounting standards, reports a profit after tax (from continuing and discontinued operations) of US$4823 million. However, at various points through the Annual Report, BHP’s managers refer instead to ‘underlying attributable profit’ of US$8933 million. According to BHP’s 2018 Annual Report:

We consider Underlying attributable profit provides better insight into the amount of profit available to distribute to shareholders. It is also the key KPI against which short­term incentive outcomes for our senior executives are measured.

In the case of BHP, we can see (Exhibit 1.9) that the preferred measure of profit that managers elect to discuss (which is US$8933 million) greatly exceeds the measure calculated by use of accounting standards (US$4823 million). However, by contrast, the preferred measure reported by Commonwealth Bank is slightly less than the measure calculated in accordance with accounting standards.

dee67382_ch01_001-058.indd 50 10/24/19 12:37 PM

50 PART 1: The Australian accounting environment

Exhibit 1.8 An example of a reconciliation of a preferred measure of profit with profit calculated applying accounting standards

Exhibit 1.7 An example of the use of a measure of ‘profits’ that deviates from accounting standards

SOURCE: © CBA Commonwealth Bank of Australia

dee67382_ch01_001-058.indd 51 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 51

Exhibit 1.9 A further example of the use of a measure of ‘profits’ that deviates from accounting standards

SOURCE: © CBA Commonwealth Bank of Australia

continued

dee67382_ch01_001-058.indd 52 10/24/19 12:37 PM

52 PART 1: The Australian accounting environment

Exhibit 1.9 continued

SOURCE: © BHP Group Ltd

WHY DO I NEED TO KNOW THAT ORGANISATIONS OFTEN HIGHLIGHT MEASURES OF FINANCIAL PERFORMANCE WHICH ARE CALCULATED IN A WAY THAT FAILS TO COMPLY WITH ACCOUNTING STANDARDS?

One of the reasons why regulators require reporting entities to comply with accounting standards is that this is perceived to increase the ‘comparability’ of the information being produced by different reporting entities. Nevertheless, it is often questioned whether requiring all organisations to apply the same accounting standards (that is, a ‘one­size­fits­all’ approach) allows managers to efficiently, and effectively, report information about the performance of an organisation.

Because of perceptions that other measures of ‘profits’ are more efficient in terms of reflecting organisational performance, managers might prefer to emphasise such non­conforming measures. Therefore, we need to clearly understand that if managers do this, then they are using measures that are not in compliance with accounting standards. While this might be done in good faith by the company, it might also be done because managers have incentives to provide a more favourable view of their performance. We need to appreciate this. Further, such non­complying measures might not have been subject to audit; also, they arguably should not be used as a basis of comparison with other organisations.

The point, therefore, is that if managers are discussing their performance we first need to understand whether they are using measures that comply with accounting standards or whether they are applying their preferred approach to income and expense recognition and measurement. If they are using their preferred approach, we need to assess their possible motivations for using the alternative measures before relying upon such measures.

In concluding the final section of this chapter, we therefore stress that while it is a requirement for directors to ensure that financial statements comply with accounting standards, it is quite common for us to find directors referring to measures of profits derived in a way that is not consistent with accounting standards. We need to take care when assessing such measures of profits.

dee67382_ch01_001-058.indd 53 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 53

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.

The chapter also explored some of the perceived benefits that are attributable to the international standardisation of general purpose financial reporting, together with some of the factors, such as differences in national cultures, that can work against the ongoing application of IFRSs internationally. It was also stressed that the extent to which a country actually applies IFRSs will be dependent upon the extent to which compliance is monitored and enforced within the country. Arguments for and against regulation were also explored, as was the practice of organisations in respect of disclosing measures of performance that deviate from the requirements of accounting standards.

KEY TERMS

Australian Accounting Standards Board (AASB) 18 Australian Securities and Investments Commission (ASIC) 7

Australian Securities Exchange (ASX) 32 conservative accounting policies 44 Financial Reporting Council (FRC) 31

general purpose financial statement 6 special purpose financial statement 6

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is ‘general purpose financial reporting’? LO 1.1, 1.2 General purpose financial reporting generates general purpose financial statements, which are those financial statements that are intended to meet the information needs of users who are not in a position to require an entity to prepare reports tailored to their particular information needs. General purpose financial statements are expected to comply with accounting standards. They can be contrasted with ‘special purpose financial statements’, which will not necessarily comply with accounting standards.

2. What is the role of the Australian Accounting Standards Board (AASB) with respect to general purpose financial reporting within Australia? LO 1.4 The AASB releases the accounting standards that are to be applied within Australia by those reporting entities generating general purpose financial statements. Some of the accounting standards released by the AASB are developed within Australia by the AASB. However, the majority of accounting standards released by the AASB are developed away from Australia by the IASB.

dee67382_ch01_001-058.indd 54 10/24/19 12:37 PM

54 PART 1: The Australian accounting environment

3. Does the AASB have legal power to enforce accounting standards within Australia? LO 1.4 No. The AASB does not directly have any enforcement powers. Within Australia, it is ASIC that enforces the requirements of the Corporations Act, and it is within the Corporations Act that there is a requirement for particular forms of organisations to comply with accounting standards.

4. What is the relevance of the International Accounting Standards Board (IASB) to general purpose financial reporting within Australia? LO 1.7 The IASB is of great relevance to general purpose financial reporting within Australia. The AASB releases accounting standards that have legal force by virtue of the Corporations Act, and the majority of these accounting standards are developed outside of Australia by the IASB.

5. What power does the IASB have to enforce the accounting standards that it develops, and which are in use internationally? LO 1.7 The IASB has no power to enforce its accounting standards. It is a standard­setter, not a standard­enforcer. When a country claims that it is adopting IFRSs, it is the responsibility of local regulators to ensure compliance with the accounting standards. Because some countries have minimal enforcement mechanisms in place, together with poor standards of financial statement auditing, any claims that the financial statements being generated in such countries comply with accounting standards are often questionable, and should be met with scepticism.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Describe the roles of ASIC, the AASB, the ASX and the FRC, and the relationships between these regulatory bodies. LO 1.3, 1.4, 1.5, 1.6 ••

2. What is the IASB and how does it affect financial reporting regulation in Australia? LO 1.4 •• 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 1.10 • 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 1.13 •• 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 1.3, 1.9, 1.13 •• 7. Provide a brief description of the differential reporting requirements in Australia as addressed by AASB 1053.

LO 1.9 • 8. Define ‘generally accepted accounting procedures’. LO 1.2 • 9. Who are perceived to be the ‘primary users’ of general purpose financial reports? LO 1.2 • 10. What knowledge of financial accounting are the users of financial statements expected to possess? LO 1.2 • 11. If the auditor provides an opinion that the financial statements comply with accounting standards, does this indicate

that there are no errors in the financial statements? LO 1.10 • 12. 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 1.3 •• 13. 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 1.3 •• 14. How are International Financial Reporting Standards developed and revised? Explain the role of the AASB in that

process. LO 1.4, 1.7 •• 15. What is the relevance to Australia of Interpretations issued by the IFRS Interpretations Committee? LO 1.7 •• 16. 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 1.4, 1.7 •• 17. What are the functions of the IASB? LO 1.7 •

dee67382_ch01_001-058.indd 55 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 55

18. 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 1.3, 1.4 ••

19. What are some of the possible cultural impediments to the international standardisation of accounting standards? LO 1.12 ••

20. Why did the FRC decide that Australian Accounting Standards needed to be consistent with those being issued by the International Accounting Standards Board? LO 1.5, 1.12 •

21. Explain why the adoption of International Financial Reporting Standards in Australia might have led to material changes to reported profits. LO 1.11 ••

CHALLENGING QUESTIONS

22. 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 1.3

23. Accounting standards change across time. Why? LO 1.8

24. If a company adopted a particular accounting policy that ASIC considered to be questionable, in principle 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 ASIC to prove in court that the company’s financial statements were not true and fair? LO 1.3

25. 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 non­ compliance, evaluate the reasons provided for this non­compliance. LO 1.6

26. 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

27. The decision that Australia would adopt IFRSs 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 1.11

28. 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 1.12

29. 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 of the organisation; otherwise, the costs of the organisation’s operations will rise. What is the basis of this belief? LO 1.13

30. Any efforts towards standardising accounting practices on an international basis imply a belief that a ‘one­size­fits­ all’ 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 as it would be for an Australian surfboard manufacturer. Is this a naive perspective? Explain your answer. LO 1.11, 1.12

31. 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 1.11, 1.12, 1.13

32. Evaluate the claim that ‘accounting is the language of business’. LO 1.1

33. Review a number of accounting standards and then discuss how accounting standards are structured. LO 1.4, 1.7

34. You are a junior executive of a large mining company and had 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

dee67382_ch01_001-058.indd 56 10/24/19 12:37 PM

56 PART 1: The Australian accounting environment

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 1.8

35. Do financial reports provide a good representation of the ‘performance’ of an organisation? LO 1.1, 1.4

36. 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

37. What is the relationship between corporate responsibilities, accountability and accounting? LO 1.1

38. 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 1.11, 1.12

39. 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 $ 11 000 000 $ 24 000 000

Machinery $ 4 000 000 $ 6 000 000

Land $ 16 000 000 $ 40 000 000

Total $31 000 000 $70 000 000

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 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 1.3, 1.4, 1.7

40. In a newspaper article dated 27 April 2019 entitled ‘Flight Centre turbulence as guidance cut, shares hit’ (by Sarah Danckert, The Age, p. 1), it was noted that the travel company Flight Centre expects its ‘underlying profit before tax’ to fall below the range it had previously signalled to the share market (i.e. to fall to between $325 and $360 million, which was below the $390 to $420 million it initially targeted). This ‘underlying profit’ measure was different from the profit to be reported within the financial statements.

REQUIRED Is the organisation allowed to use and disclose this alternative measure even if it fails to comply with accounting standards? Why would the managers do this? LO 1.14

41. 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 1.1

dee67382_ch01_001-058.indd 57 10/24/19 12:37 PM

CHAPTER 1: An overview of the Australian external reporting environment 57

REFERENCES Australian Accounting Standards Board, 2016, AASB Research

Report No. 3: The Impact of IFRS Adoption in Australia: Evidence from Academic Research, AASB, Melbourne.

Australian Accounting Standards Board, 2017, AASB Research Report No. 4: Review of Adoption of International Financial Reporting Standards in Australia, AASB, Melbourne.

Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

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.

Ball, R., 2016, ‘IFRS – 10 Years Later’, Accounting and Business Research, vol. 46, no. 5, pp. 545–71.

Brown, P., 2011, ‘International Financial Reporting Standards: What Are the Benefits?’, Accounting and Business Research, vol. 41, no. 3, pp. 269–85.

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.

Chartered Accountants Australia and New Zealand, 2016, The Rise and Rise of Non-GAAP Disclosure, Chartered Accounts Australia and New Zealand, Sydney.

Commonwealth Government, 1997, Accounting Standards: Building International Opportunities for Australian Business, Corporate Law Economic Reform Program Proposals for Reform: Paper No. 1, Australian Government Publishing 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 Asia­Pacific 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, vol. 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., Adams, C. & Owen, D., 2014, Accountability, Social Responsibility and Sustainability, Pearson, Harlow, UK.

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, vol. 10, no. 3, pp. 325–64.

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, McGraw­Hill International (UK), London.

International Accounting Standards Board, 2017, Making Materiality Judgements: Practice Statement 2, IASB, 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.

Morris, R., 1984, ‘Corporate Disclosure in a Substantially Unregulated Environment’, Abacus, June, pp. 52–86.

Nobes, C. & Parker, R., 2004, Comparative International Accounting, Pearson Education Limited, Harlow, UK.

Perera, M.H.B., 1989, ‘Towards a Framework to Analyze the Impact of Culture in Accounting’, The International Journal of Accounting, vol. 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.

dee67382_ch01_001-058.indd 58 10/24/19 12:37 PM

dee67382_ch02_059-098.indd 59 10/23/19 09:45 AM

59

C H A P T E R 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 Understand the history of the evolution of the Conceptual Framework used within Australia. 2.4 Be able to explain the structure, or building blocks, of a well-designed conceptual framework. 2.5 Understand what is meant by the term ‘reporting entity’ and understand the financial reporting

implications of being classified as a reporting entity. 2.6 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. 2.7 Understand the objective of general purpose financial reporting. 2.8 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. 2.9 Be able to define the elements of financial accounting and be able to explain the recognition criteria for

the various elements of accounting. 2.10 Understand that measurement forms an important component of a conceptual framework and

understand how measurement issues have been addressed within the IASB Conceptual Framework. 2.11 Be able to critically review the existing Conceptual Framework. 2.12 Understand that a conceptual framework for general purpose financial reporting represents a

‘normative’ theory of accounting.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

dee67382_ch02_059-098.indd 60 10/23/19 09:45 AM

60 PART 1: The Australian accounting environment

OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following seven questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is the difference in role between a conceptual framework for financial reporting and accounting standards? LO 2.1, 2.2

2. What benefits are generated as a result of having a conceptual framework for financial reporting? LO 2.2 3. What qualitative characteristics will useful financial accounting information be expected to possess? LO 2.8 4. What are the five different ‘elements’ of financial accounting? LO 2.9 5. What are the three main components of the definition of assets? LO 2.9 6. Are all assets required to be measured using the same basis of measurement? LO 2.10 7. What role does ‘materiality’ have with respect to deciding whether particular financial information should be

disclosed? LO 2.8

2.1 An introduction to the IASB Conceptual Framework

As noted in Chapter 1, in 2005, Australia started using the accounting standards issued by the International Accounting Standards Board (IASB). As such, there was also a related requirement that we use the Conceptual Framework developed by the IASB. That is, because International Financial Reporting Standards (IFRSs) have been developed in accordance with the IASB Conceptual Framework for Financial Reporting, and as Australia adopted IFRSs, then Australia must also adopt the IASB Conceptual Framework. This meant we had to move away from using the conceptual framework that we had developed within Australia. Other countries that have adopted IFRSs have similarly adopted the IASB Conceptual Framework and abandoned their domestically

developed frameworks. The purpose of the Conceptual Framework can be summarised as follows: (a) assist the IASB to develop accounting standards that are based on consistent concepts (b) assist preparers of financial statements to develop consistent accounting policies when no accounting

standard applies to a particular transaction or other event, or when an accounting standard allows a choice of accounting policy

(c) assist all parties to understand and interpret accounting standards. 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 that useful financial information shall possess (for example, relevance and representational faithfulness); how and when transactions should be recognised; what constitutes an element of financial reporting; and who is the audience of general purpose financial statements. Unless the accounting profession and accounting standard-setters have agreement on such central issues, it is difficult to understand how logically consistent accounting standards could be developed. Conceptual frameworks allow us to have consensus on important issues such as those identified above.

While it is reasonable to accept that we need a conceptual framework for financial reporting 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 financial reporting were released much earlier, 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 on many key and fundamental areas of financial reporting was the high degree of inconsistency between the various accounting standards, with different standards embracing different recognition and measurement

LO 2.1

Conceptual Framework A framework that describes the objective of, and the concepts for, general purpose financial reporting.

AASB no. Title IFRS/IAS equivalent

108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8

138 Intangible Assets IAS 38

1053 Application of Tiers of Australian Accounting Standards —

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

dee67382_ch02_059-098.indd 61 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 61

criteria. Accounting standards were also being developed independently in many other countries before they had a conceptual framework for financial reporting. The lack of agreement on central issues prompted a surge of criticism. As Horngren (1981, p. 94) stated at the time:

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.

Reacting to such criticism, the Financial Accounting Standards Board (FASB)—which is the accounting standards-setter for 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. The International Accounting Standards Committee (IASC), which subsequently became the IASB, released its first Conceptual Framework in 1989.

LO 2.2

2.2 Benefits of a conceptual framework

We can summarise some of the benefits of having a conceptual framework for financial accounting as follows: 1. Accounting standards should be more consistent and logical, because they are developed from an orderly

set of agreed concepts. The view is that in the absence of a coherent framework for financial reporting, the development of accounting standards could be somewhat ad hoc.

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. Accounting standard-setters such as 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 defence against political attack if it can be shown that the accounting standards are being prepared in a way that is consistent with a conceptual framework that is broadly accepted and has been carefully and logically developed.

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 financial reporting issue, there might be a lesser need to develop additional accounting standards.

2.3 An overview of the recently revised Conceptual Framework

It is generally accepted that there were numerous shortcomings in the IASB Conceptual Framework, which was released in 1989 and was in operation until 2010. Similarly, the Conceptual Framework developed and used in the US was also considered to have many shortcomings. As a result, in the early 2000s, the IASB and the FASB embarked on a joint project to develop a revised Conceptual Framework for international use.

LO 2.3

WHY DO I NEED TO KNOW ABOUT THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING?

Because the Conceptual Framework provides the basis for the practice of general purpose financial reporting, it makes sense that anybody involved in the production and/or use of financial reports should be aware of the building blocks on which financial reporting is based.

dee67382_ch02_059-098.indd 62 10/23/19 09:45 AM

62 PART 1: The Australian accounting environment

As part of the process, in July 2006 the FASB and the IASB jointly published a discussion paper. The boards then released an Exposure Draft in May 2008. This phase of the project specifically addressed the objective of financial reporting and the qualitative characteristics and constraints of decision-useful financial reporting information. 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 IASB and FASB subsequently stopped working together on the Conceptual Framework; however, the IASB maintained work on further revisions. A further discussion paper was released in 2013 and then an Exposure Draft was released in 2015. Ultimately, a revised Conceptual Framework was released by the IASB in 2018. The respective sections of the Conceptual Framework, as released in 2018, are as follows:

Introduction: the status and purpose of the Conceptual Framework Chapters of the Conceptual Framework

1. The objective of general purpose financial reporting 2. Qualitative characteristics of useful financial information 3. Financial statements and the reporting entity 4. The elements of financial statements 5. Recognition and derecognition 6. Measurement 7. Presentation and disclosure 8. Concepts of capital and capital maintenance

It is generally accepted that conceptual frameworks will evolve over time as information demands and expectations 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 three decades ago, were considered to be in need of significant revision.

In the balance of this chapter we will focus primarily on the IASB Conceptual Framework for Financial Reporting, as revised and released in October 2018, as this is the conceptual framework that, effectively, is applied within Australia (and other countries that have adopted IFRSs; in May 2019 the AASB released its Conceptual Framework for Financial Reporting, which incorporates the IASB Conceptual Framework for Financial Reporting, with Australian-specific paragraphs identified by the prefix ‘Aus’). For the balance of the chapter we will simply refer to it as the Conceptual Framework.

The Conceptual Framework is not an accounting standard It needs to be emphasised that the Conceptual Framework 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. It provides insights into the fundamentals of financial reporting. Specific transactions and events (such as, for example, how to account for the acquisition of inventory, how to revalue property, plant and equipment, or how to account for the acquisition of goodwill) are addressed by particular accounting standards, of which there are many. (See Chapter 1 for a list of the many accounting standards).

When an accounting standard relates to a particular type of transaction or event, then that accounting standard shall be applied even if it appears to somewhat contradict the guidance provided within the Conceptual Framework. That is, accounting standards take precedence over the Conceptual Framework. However, in the absence of a directly relevant accounting standard, preparers of general purpose financial statements are required to follow the Conceptual Framework. In this regard, and in the Australian context, paragraphs 10 and 11 of the accounting standard AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors 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.

dee67382_ch02_059-098.indd 63 11/08/19 11:03 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 63

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. (AASB 108)

Hence, accounting standard AASB 108, which has the force of law within Australia 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.

2.4 An overview of the building blocks of the Conceptual Framework

The development of a Conceptual Framework for Financial Reporting is considered to involve the assembly of a number of ‘building blocks’. The framework must be developed in a particular order, with certain matters necessarily requiring resolution before work can move on to subsequent ‘building blocks’. Figure 2.1 provides an overview of the building blocks of a Conceptual Framework for Financial Reporting.

As represented in Figure 2.1, the first matter to be addressed is the definition of general purpose financial reporting. Unless there is some agreement on this, it would be difficult to construct a framework for general purpose financial reporting. Once we determine what general purpose financial reporting means, we can then turn our attention to the subject of financial reporting, specifically which entities are required to produce general purpose financial statements,

Figure 2.1 Components of a conceptual framework

1. Definition of general purpose financial reporting

4. Objectives of general purpose financial reports

5. Underlying assumptions

2. Definition of the reporting entity 3. Definition of users of general purpose financial reports and their information needs

6. Qualitative characteristics of useful financial information

10. What information shall be disclosed and how it shall be presented to users

7. Elements of financial statements

8. Recognition criteria 9. Measurement basis and techniques

LO 2.4

dee67382_ch02_059-098.indd 64 10/23/19 09:45 AM

64 PART 1: The Australian accounting environment

and the likely characteristics of the users of these statements. Then we need to consider the objective of general purpose financial reporting. 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’ on the basis of that information. Finally, we need to have clear definitions and recognition criteria for the ‘elements’ of financial reporting, as well as some guidance in relation to both measurement and the disclosure and presentation of financial information. We will now consider some of these building blocks.

2.5 Definition of general purpose financial reporting and 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. They are released by reporting entities with the aim of satisfying the general information demands of a varied cross-section of users, many of whom are otherwise unable to gather information about the financial position and financial performance of the entity from other sources. 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 1.6) states:

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 are defined within the Conceptual Framework as a particular form of general purpose financial report that provides information about the reporting entity’s assets, liabilities, equity, income and expenses (which in themselves are the elements of financial statements identified within the Conceptual Framework).

As noted within Chapter 1, 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 produced for a bank that is providing funds to the entity). The guidance that we consider in this chapter, and others, relates to general purpose financial statements.

Clearly, not all entities should be expected to produce general purpose financial statements. 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.

Entities that produce general purpose financial statements are considered to be ‘reporting entities’. (See Worked Example 2.1.) Indeed, the Conceptual Framework defines a reporting entity as an entity that is required, or chooses, to prepare general purpose financial statements. The determination of whether an entity is a ‘reporting entity’ needs to focus on the information needs of primary users. In developing the Conceptual Framework, the IASB acknowledged that it does not have the authority to determine which entities must, or should, prepare general purpose financial statements. This determination is to be made by the governments operating in different jurisdictions.

Further guidance about defining a reporting entity is provided within the Australian context in Appendix A of the accounting standard AASB 1053 Application of Tiers of Australian Accounting Standards. It 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. (AASB 1053)

If an entity is not adjudged to be a ‘reporting entity’, it will not be required to produce general purpose financial statements, and 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 can be considered to be a reporting entity.

LO 2.5

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.

dee67382_ch02_059-098.indd 65 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 65

Organisations such as 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. 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: ∙ consolidated gross operating revenue (as per s. 45A of the Corporations Act) for the financial year of $50 million

or more ∙ consolidated gross assets at the end of the financial year of $25 million or more ∙ full-time-equivalent employees numbering 100 or more at the end of the financial year.

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 accounting standards.

Australia has also introduced the idea of ‘public accountability’ to help assess whether an organisation is a ‘reporting entity’ and therefore should produce general purpose financial statements. As we discussed in Chapter 1, public accountability for Australian accounting standards’ purposes means accountability to those existing and potential resource providers and others external to the entity who make economic decisions but who are not in a position to demand reports tailored to meet their particular information needs. Chapter 1 provides further specific details on what attributes of an organisation would suggest the existence of ‘public accountability’ and therefore the need to produce general purpose financial statements.

LO 2.6

2.6 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 the primary 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 (paragraph 1.5) states:

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

Within the Conceptual Framework there appears to be limited consideration of the ‘public’ being a legitimate user of general purpose financial statements. In the earlier (1989) version of the Conceptual Framework released by the IASC, and thereafter used by the IASB, the ‘public’ had been identified as a user of general purpose financial statements. However, in subsequent revisions to the Conceptual Framework (released in 2010 and 2018), it was proposed that accounting information designed to meet the information needs of investors, creditors and other users would also generally be expected to meet the needs of the other user groups such as the ‘public’. As the Conceptual Framework (paragraph 1.10) states:

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

WORKED EXAMPLE 2.1: The defining characteristics of a reporting entity

Ocean Grove Ltd is a public company with its shares trading on a securities market.

REQUIRED Is Ocean Grove a ‘reporting entity’? Why?

SOLUTION Ocean Grove Ltd is a reporting entity. It would be considered to be a reporting entity because there would be many people or organisations with a significant financial interest in the organisation (for example, there could be many thousands of shareholders as well as many lenders and creditors) but who would be unable to specifically demand and obtain financial information about the organisation to satisfy their own information needs. Such people would be dependent on general purpose financial information produced by the organisation for the purpose of making their various resource allocation decisions. An organisation that produces ‘general purpose financial reports’ is a ‘reporting entity’.

dee67382_ch02_059-098.indd 66 10/23/19 09:45 AM

66 PART 1: The Australian accounting environment

In explaining the reasons the primary users of financial statements were restricted to investors, lenders and other creditors, the Basis for Conclusions that accompanied the revision of the 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 IASB’s responsibilities require it 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.

The issue of which groups of stakeholders should be considered to be legitimate users of financial information is one that has attracted a great deal of debate over the years. There are many people, 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 a view 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. This is a much broader view of ‘accountability’ than that adopted by the IASB.

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, or ‘stake’, 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 perhaps seem a little too simplistic.

Apart from considering the identity of report users, we also need to consider their expected proficiency in interpreting financial accounting information. In considering the level of expertise expected of financial statement readers, it is accepted that readers are expected to have some proficiency in financial accounting. This is not unreasonable. As a result, accounting standards are developed on this basis. The Conceptual Framework, (paragraph 2.36) explains that:

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

So financial statements are written for an audience that is educated to some degree in the workings of financial accounting. This is an interesting observation given the many hundreds of thousands of financial statements being sent to investors annually (typically electronically these days), 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 had to be made. It would appear that those people responsible for developing the Conceptual Framework have accepted that individuals without any expertise in financial 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). Accounting standards are developed on the basis that readers have reasonable knowledge about financial accounting and financial reporting. As we read through this book, we will see that many requirements incorporated with particular accounting standards require that certain assets and liabilities be measured in ways that arguably would not be the same as non-accountants would have thought or assumed. The message that needs to be very clear is that without a sound knowledge of financial accounting, financial statements such as balance sheets and income statements can actually be confusing and even potentially misleading documents. Therefore, people without appropriate financial accounting knowledge should not use financial statements as the basis of making investment and other related decisions unless they receive advice from people educated in financial reporting.

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 objective of general purpose financial reporting.

dee67382_ch02_059-098.indd 67 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 67

2.7 Objective of general purpose financial reporting

In terms of the objective of general purpose financial reporting, paragraph 1.2 of the Conceptual Framework 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 decisions about:

(a) buying, selling or holding equity and debt instruments (b) providing or settling loans and other forms of credit (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s

economic resources.

Parts a) and b) above relate to the information needed to help users of financial statements to assess the prospects for future net cash inflows to the entity and to inform their future investment or lending decisions (resource allocation decisions) with respect to the reporting entity. This is linked to the notion of ‘decision usefulness’. That is, investors and lenders will find it useful to their resource allocation decisions to have information about an organisation’s financial performance and financial position.

When the Conceptual Framework was revised and re-released in 2018, part c) above was added. This additional component relates to what is known as ‘stewardship’. The IASB’s use of the term ‘stewardship’ is consistent with the general understanding of that term, which means the careful and responsible management of something entrusted to one’s care.

The reinstatement of the notion of stewardship follows its previous removal in 2010 when the IASB and the FASB jointly developed the revised Conceptual Framework. The Conceptual Framework now notes that users need information to enable them to assess management’s stewardship so that they can hold them ‘to account’ for the resources entrusted to their care. This is a broader perspective of accountability than was evident in the 2010 Conceptual Framework. Paragraph 1.22 states:

Information about how efficiently and effectively the reporting entity’s management has discharged its responsibilities to use the entity’s economic resources helps users to assess management’s stewardship of those resources. Such information is also useful for predicting how efficiently and effectively management will use the entity’s economic resources in future periods. Hence, it can be useful for assessing the entity’s prospects for future net cash inflows.

Pelger (2016) provides some interesting insights into the previous decision by the IASB and FASB to remove stewardship from the 2010 version of the Conceptual Framework. As he notes, the decision to remove the reference to stewardship was somewhat surprising as stewardship historically was one of the main reasons for the existence of financial accounting and is still considered to shape accounting practices. Pelger (2016) also noted that it was overwhelmingly the US participants from the FASB who were strongly opposed to the retention of stewardship as an explicit part of the objective of general purpose financial reporting. The standard-setters from the US thought the objective that needed to be focused upon was the information needs of external providers of financial capital. Because the IASB worked on the 2018 version of the Conceptual Framework (without the FASB), the members of the IASB were able to reintroduce stewardship without the previous opposition from US participants.

LO 2.7

WHY DO I NEED TO KNOW ABOUT THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING?

The contents of the Conceptual Framework build upon the objective that has been identified. Therefore, whether we would tend to accept, or reject, the contents of the Conceptual Framework would be influenced by whether we agree, or disagree, with the objective of financial reporting on which the Conceptual Framework is based.

dee67382_ch02_059-098.indd 68 10/23/19 09:45 AM

68 PART 1: The Australian accounting environment

2.8 Qualitative characteristics of useful financial information

If it is accepted that financial information should be useful for economic decision making (that is, be ‘decision useful’) and for assessing the stewardship of managers, then a subsequent issue (or building block) to consider

is the qualitative characteristics (attributes or qualities) that financial information should possess if it is to be useful for such purposes (implying that an absence of such qualities would mean that the central objectives of general purpose financial statements would not be met).

The fundamental qualitative characteristics—which are characteristics that financial information must possess to be useful to the primary users of general purpose financial reports—identified in the Conceptual Framework are ‘relevance’ and ‘faithful representation’. In discussing the need for information to be both relevant and faithfully represented, paragraph 2.20 of the Conceptual Framework states:

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

Apart from the ‘fundamental’ qualitative characteristics, the Conceptual Framework 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.

Because the qualitative characteristics guide what reporting entities disclose, it is important that we understand them. Therefore, we will consider each of these qualitative characteristics (two fundamental, and four ‘enhancing’ qualitative characteristics) in turn below.

Relevance As we have just noted, 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 2.6 states:

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

There are two main aspects to relevance. For information to be relevant it should have predictive value and/or confirmatory value (or feedback value). Predictive value might arise, for example, because the information allows a user to predict the future cash flows of the reporting entity. Confirmatory value refers to information’s use in relation to confirming or correcting earlier expectations, for example, whether management has achieved the financial outcomes that were previously advised.

Closely tied to the characteristic of relevance is the notion of materiality. General purpose financial statements are expected to include financial information that satisfies the characteristics of ‘relevance’ and ‘faithful representation’ to the extent that such information is material. Paragraph 2.11 of the Conceptual Framework states that an item is material if:

omitting it or misstating it could influence decisions that the primary users of general purpose financial reports make on the basis of those reports, which provide 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, thereby potentially undermining the potential usefulness and understandability of the whole ‘package’ 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.

LO 2.8

dee67382_ch02_059-098.indd 69 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 69

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. As another example, information that an organisation has made a payment which is construed as a ‘bribe’ might be material because of the political and associated financial problems it could create, even if the monetary amount involved is relatively modest.

Worked Example 2.2 provides an example of how we might determine the materiality of an item.

WORKED EXAMPLE 2.2: Determining the materiality of an item

Cassandra Ltd has the following assets as at 30 June 2022:

$000

Current assets Cash 1 000 Marketable securities 3 000 Accounts receivable 8 000 Inventory    1 100 Total current assets  13 100 Non-current assets Investments 6 000 Property, plant and equipment 12 000 Intangible assets    2 000 Total non-current assets  20 000 Total assets  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.

Recorded amount Possible adjustment Percentage adjustment

Shareholders’ equity 12 000 000 300 000 2.5% Profits 6 000 000 300 000 5.0% Sales 28 000 000 900 000 3.2% Cost of goods sold 12 000 000 600 000 5.0% Accounts receivable 8 000 000 900 000 11.3%

continued

dee67382_ch02_059-098.indd 70 10/23/19 09:45 AM

70 PART 1: The Australian accounting environment

Faithful representation The other fundamental 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 2.13 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 Board’s objective is to maximise those qualities to the extent possible.

Completeness In terms of the characteristics of ‘completeness’ referred to above, paragraph 2.14 of the Conceptual Framework states:

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

Neutrality In terms of the characteristics of ‘neutrality’, paragraph 2.15 of the Conceptual Framework states:

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

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

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

Freedom from error In terms of the characteristics of ‘freedom from error’, paragraph 2.18 of the Conceptual Framework explains that faithful representation does not mean total absence of error in the depiction of particular transactions, events or circumstances. 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. For example, determining the depreciation expense for a reporting period requires various judgements to be made about the life of the asset, the expected pattern of the benefits

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’.

WORKED EXAMPLE 2.2 continued

dee67382_ch02_059-098.indd 71 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 71

to be generated from the asset, and the ultimate residual value of the asset. These judgements are based upon the best available information and cannot be determined with certainty. Nevertheless, if the judgements are based on careful research and consideration, then this is acceptable.

In terms of the sequence in which the two fundamental qualitative characteristics of relevance and faithful representation should be considered (that is, whether one fundamental qualitative characteristic should be considered before the other), the Conceptual Framework states that, subject to the effects of enhancing characteristics and the cost constraint (to be discussed shortly), the most efficient and effective process for applying the fundamental qualitative characteristics would usually be to, first, identify an economic phenomenon, information about which is capable of being useful to users of the reporting entity’s financial information. The second step would then be to identify the type of information about that phenomenon which would be most relevant. Thirdly, we would then determine whether that information is available and can provide a faithful representation of the underlying economic phenomenon. If this is achieved, the process of satisfying the fundamental qualitative characteristics ends at that point. If not achieved, then the process is repeated with the next most relevant type of information.

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. Indeed, such information could lead readers of the reports to make inappropriate decisions. As we have previously indicated, for information to be useful it needs to both be relevant and provide a faithful representation of what it purports to represent. Good decisions cannot be made on the basis of a faithful representation of irrelevant transactions or events. Nor can good decisions be made on the basis of unfaithful representations of relevant transactions and events.

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 back 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 a professional judgement should be made that the information should not be provided to financial statement readers.

Considerations of the costs and benefits of information Another consideration that needs to be addressed when deciding whether to disclose information is the potential costs of producing relevant and representationally faithful information, relative to the associated benefits. In relation to costs, paragraph 2.39 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.

In considering the associated costs and benefits of financial reporting, paragraphs 2.42 and 2.43 of the Conceptual Framework state:

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 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.

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

dee67382_ch02_059-098.indd 72 10/23/19 09:45 AM

72 PART 1: The Australian accounting environment

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 disclosing information should exceed the cost of providing it. This principle is considered by the IASB when new accounting standards are being developed. It is also a principle necessarily considered within the Australian context. For example, in Australia, the AASB shall prepare what is known as a Regulation Impact Statement prior to issuing an accounting standard. As the website of the AASB states (specifically, see www.aasb.gov.au/Pronouncements/specific-document-results/RIS-preamble.aspx):

All proposals undergo a preliminary assessment to establish whether they are likely to involve an impact on business and individuals or the economy. If the preliminary assessment shows that a proposal potentially involves medium compliance costs, an assessment of compliance cost implications is carried out and a regulation impact statement (RIS) is prepared where the impacts include medium or significant compliance costs.

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 enhance the usefulness of information that is both relevant and faithfully represented.

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 can be changed if no longer relevant to an entity’s circumstances.

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, some 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 by the IASB 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-size-fits-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—thereby enhancing comparability— 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 2.30 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.

dee67382_ch02_059-098.indd 73 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 73

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 2.33 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.

Given that the conceptual frameworks have been developed in large part to guide accounting standard-setters in the setting of accounting rules, 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?

The qualitative characteristics of general purpose financial reporting are summarised in Figure 2.2 below. What this figure demonstrates is that the fundamental qualitative characteristics are the first characteristics that typically need to be considered. Once those characteristics have been established as potentially existing for particular information, then the relevance and/or the faithful representation of financial information can be further enhanced by considering issues associated with comparability, verifiability, timeliness and understandability. Efforts to increase the comparability, verifiability, timeliness and understandability of the financial information can also effectively ‘feed back’ to improve the relevance and representational faithfulness of the information (as represented by the broken arrow from enhancing qualitative characteristics back to fundamental qualitative characteristics).

Figure 2.2 An overview of the qualitative characteristics of useful financial information

Predictive value

Confirmatory value

Fundamental qualitative characteristics

Completeness

Relevance

Faithful representation

Neutrality If the information appears likely to satisfy the fundamental qualitative characteristics then the enhancing qualitative characteristics are then to be considered

Freedom from error

Comparability

Verifiability Enhancing qualitative characteristics

Timeliness

Understandability

dee67382_ch02_059-098.indd 74 10/23/19 09:45 AM

74 PART 1: The Australian accounting environment

It is interesting to note that the qualitative characteristics of useful financial information, as described above, are very similar to the qualitative characteristics that are identified within other reporting frameworks, which relate to other forms of reporting, such as reporting relating to various aspects of organisational social and environmental performance. For example, if we look at the reporting frameworks developed by the Global Reporting Initiative (see www.globalreporting.org), the International Integrated Reporting Committee (see www.integratedreporting. org) and the Water Accounting Standards Board (see www.bom.gov.au/water/standards/wasb/), then we will see almost identical qualitative characteristics identified. Therefore, the qualitative characteristics identified within the Conceptual Framework appear to have some acceptance globally and in respect of different types of information.

The Conceptual Framework also notes that financial statements should be prepared using accrual accounting (see paragraph 1.17) as financial performance is best reflected by the application of accrual accounting, rather than information about cash payments and cash receipts. It is also noted (paragraph 3.9) that financial statements are normally prepared on the assumption that the entity is a going concern and will continue to operate for the foreseeable future. However, if there is an intention or need to enter liquidation or cease trading, the financial statements will need to be prepared on a different basis and the financial statements would need to be clear about the alternative basis used.

As we should know from our study of financial accounting in previous subjects or courses, the accrual basis of accounting means that income is recognised when it is earned (and not necessarily when any related cash is received), and expenses are recognised when they are incurred (and not necessarily when any related cash is paid). In relation to the going concern assumption, this means that the organisation is expected to continue in operation for the foreseeable future. If an organisation is not assumed to be a going concern, then this will have implications for how assets and liabilities are measured. More specifically, revisions would need to be made to measure assets and liabilities on the basis of what would be paid or received in the near future.

2.9 Definition and recognition of the elements of financial statements

As we should know from our previous studies of accounting, the five elements of financial accounting are assets, liabilities, equity, income and expenses. For a transaction or event to be considered as belonging to a particular element

of financial accounting, it needs to firstly comply with the respective definitions provided within the Conceptual Framework. Once the definition of the respective element of financial accounting has been satisfied in relation to a particular

transaction or event, the next step is to determine when we should recognise that element in the financial accounting information system. According to the Appendix to the Conceptual Framework:

Recognition is the process of capturing for inclusion in the statement of financial position (balance sheet), or the statement of financial performance (income statement), an item that meets the definition of one of the elements of financial statements—an asset, liability, equity, income or expenses. Recognition involves depicting the item in one of those statements—either alone or in aggregation with other items—in words and by a monetary amount, and including that amount in one or more totals in that statement.

Whatever amount is shown in the statement of financial position (balance sheet) for a particular account, this amount is referred to as its ‘carrying amount’.

In terms of the sequence of events, once we know what an ‘asset’ is in terms of the definition (as well as the other elements of financial accounting), and know when to recognise it, we will then need to determine the monetary amount that we should assign to it. That is, we will need to know how to ‘measure’ it. We will address measurement later in this chapter. Once we know how to define, recognise and measure an element of financial accounting, we then need to know what information we should disclose in respect of the item, and how that information shall be presented within the financial statements.

As noted earlier in this chapter, major revisions were made to the Conceptual Framework in 2018. When these revisions were made, there were some relatively significant changes made in relation to the definitions and the elements of financial statements. There was a removal of reference to ‘expected flow of economic benefits’ from the definition of assets and liabilities and there was a related removal of a probability criterion from the associated recognition criteria. The focus of the revised definitions—as we shall see below—is now on the existence of a ‘right’ (or obligation) that has the potential to produce (or require an entity to transfer) economic benefits. The implication of this is, for example, that a ‘right’ can meet the definition of an economic resource, and hence be an ‘asset’, even if the probability of it producing economic benefits is assessed as being lower than 50 per cent. As noted above, this is a significant departure from previous practice, which relied on establishing that the expected future flow of economic benefits was probable. That is, previously an asset and liability was to be recognised only if the related cash flow was deemed to be ‘probable’ and could be measured with reliability.

LO 2.9

dee67382_ch02_059-098.indd 75 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 75

Figure 2.3 The elements of financial accounting

Assets

The balance sheet which provides information about

the financial position of an organisation at a point in time

Liabilities

Equity

Income The income statement which provides information about

the financial performance of an organisation for a period of timeExpenses

Different approaches can be applied to determining profits (income less expenses) and this has direct implications for how we define the elements of financial accounting. 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. The Conceptual Framework adopts the asset/liability approach. Therefore, within the Conceptual Framework, 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 definitions. This should become apparent as we consider each of the elements of financial 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). (© Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, used with permission.)

As we should know, the elements that appear within the balance sheet—and which relate to an organisation’s ‘financial position’—are assets, liabilities and equity. The elements that appear within the income statement—and which relate to an organisation’s ‘financial performance’—are income and expenses. These elements, and their role, are represented in Figure 2.3.

We will consider each of the five elements 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 According to the Conceptual Framework, an asset is defined as:

a present economic resource controlled by the entity as a result of past events.

The above definition of an asset refers to an economic resource. An ‘economic resource’ is defined in the Conceptual Framework as:

a right that has the potential to produce economic benefits.

asset Defined in the Conceptual Framework as ‘a present economic resource controlled by the entity as a result of past events’.

dee67382_ch02_059-098.indd 76 10/23/19 09:45 AM

76 PART 1: The Australian accounting environment

Rights can take many forms, including rights to receive cash, rights to receive goods or services, or rights over physical objects, such as property, plant and equipment or inventories (where the right to use the property, plant, equipment or inventories might have been established as a result of buying or leasing the item).

Components of the definition of an asset There are three separate components to the above definition of an ‘asset’ that we need to consider. All three related requirements must exist if we are to consider that a particular transaction satisfies the definition of an asset. The components are:

1. an asset is an economic resource (right) controlled by the entity 2. an asset exists as a result of past events 3. the right has the potential to produce economic benefits.

Let us now consider each of these components separately.

Control 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. For example, many organisations include leased assets (and the associated lease liabilities) in their balance sheets.

There are many resources that generate benefits for an entity but which are not recognised due 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 might provide economic benefits to entities, but to the extent that such entities do not control the waterways, they are not assets of those entities despite the fact that the organisation has a right to use them.

Past events In relation to ‘control’, it therefore follows from the requirement that the relevant transaction must already have occurred that future economic benefits which are not currently controlled are not to be recognised by a reporting entity.

Potential to produce economic benefits The expected future economic benefits can be distinguished from the source of the benefit—a particular object or right. The definition refers to the economic benefit and not the source. Thus, whether an object or right is disclosed as an asset will be dependent upon the potential it has to generate economic benefits for the entity. In the absence of potential to generate economic benefits, the object or right should not be considered to be an asset. Rather, any related expenditure would constitute an expense.

Therefore, cash is an asset owing to the economic 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. That is, the asset is effectively the future economic benefits that

will be generated, not the source of the economic benefits (such as the machine). These economic benefits could come from two broad sources—either from the asset’s use, or from its sale. If the economic benefits are greater from its use by the reporting entity, then the asset would be expected to be retained, otherwise it would likely be sold. That is, the Conceptual Framework 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.

As already noted, the previous definition of an asset and liability had required that the expected future flows of economic benefits be probable, which meant more likely than less likely. This is no longer the requirement. Recognition is now based upon there being a ‘potential’ for economic benefits to flow to the reporting entity. For that potential to exist, it does not need to be certain, or even likely, that the right will produce economic benefits. It is necessary only that the right already exists as a result of a past transaction or event and that, in at least one circumstance, it would produce economic benefits for the reporting entity. However, while there is no longer a requirement that the future economic benefits are judged to be ‘probable’, the assessed probability will nevertheless influence the measurement ultimately attributed to an asset (a resource with a higher likelihood of generating economic benefits would be expected to have a higher value in the ‘market’ compared to a similar asset with lower likelihood).

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.

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.

dee67382_ch02_059-098.indd 77 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 77

Assets acquired at no cost To satisfy the definition of an ‘asset’, it is not a prerequisite that the asset be acquired at a cost to the reporting entity. As the Conceptual Framework notes (paragraph 4.18), although there is typically:

a close association between incurring expenditure and acquiring assets, the two do not necessarily coincide. When an entity incurs expenditure, this may provide evidence that the entity has acquired future economic benefits, but it is not conclusive evidence that the entity has obtained an asset. Further, the absence of related expenditure does not preclude an item from meeting the definition of an asset. Assets can include, for example, rights that a government has granted to the entity free of charge or that another party has donated to the entity. Therefore, the key point here is that the presence or absence of expenditure is not a defining factor in determining the existence of an ‘asset’.

Worked Example 2.3 provides insights into how to apply the definition of assets.

WORKED EXAMPLE 2.3: Applying the definition of assets

A reporting entity has been involved with the following transactions and events:

(a) The entity acquired some land at a cost of $1 million. However, after acquiring the land it became known that the land was highly contaminated and was very unlikely to be usable, or be able to be sold.

(b) A satisfied long-term customer decided to give the organisation a delivery truck for free. The organisation expects to use the truck within the business.

(c) The organisation has been given the right by the local government to use a nearby river to transport some of its products to nearby markets.

REQUIRED Which of the above transactions and events would generate a resource that satisfies the definition of an asset?

SOLUTION As we know, the definition of an asset has three key components. In relation to the land described above, while the organisation might control the land as a result of a past transaction or event, it appears that the land does not have the potential to generate economic benefits. Therefore, it does not seem to satisfy the definition of an asset.

The delivery truck does appear to satisfy the definition of an asset. It is controlled as a result of a past event and it does have the potential to generate economic benefits for the organisation. It does not directly matter that the truck was not acquired at a cost to the organisation.

The right to use the nearby river is not an asset of the organisation as the organisation does not have ‘control’ over the river—it just has access to it. The river would not appear in the financial statements of the organisation.

Recognition of an asset As we have already learned, in addition to defining an asset, we also need to consider when we should recognise the existence of an asset and therefore include it within the financial statements.

The Conceptual Framework provides general recognition criteria for all of the five elements of financial accounting (assets, liabilities, income, expenses and equity). Paragraph 5.6 states:

Only items that meet the definition of an asset, a liability or equity are recognised in the statement of financial position. Similarly, only items that meet the definition of income and expenses are recognised in the statement of financial performance. However, not all items that meet the definition of one of those elements are recognised.

Therefore, the first step in the recognition of a particular item in the financial statements (and therefore in our financial accounting system) is determining that the item meets the definition of an element of accounting—which is what we have just discussed. However, as the above paragraph indicates, further criteria (other than meeting the definition of an element of financial accounting) are required to be satisfied before an item shall be recognised for financial accounting purposes.

When the Conceptual Framework was revised and re-released in 2018, it specifically required that accountants must consider the fundamental qualitative characteristics of relevance and faithful representation (which were discussed earlier) when deciding if an item should be recognised within the financial statements. This was a change from the previous recognition criteria, which focused on assessing the probability of future economic benefits, as well as whether the item could be measured reliably. Specifically, the Conceptual Framework now requires that an asset

dee67382_ch02_059-098.indd 78 10/23/19 09:45 AM

78 PART 1: The Australian accounting environment

or liability be recognised—and therefore included within the balance sheet—only if it meets the definition and if recognition of that asset or liability and any resulting income, expenses or changes in equity provides users of financial statements with information that is useful, that is, with:

(a) relevant information about the asset or liability, and about any resulting income, expenses or changes in equity, and

(b) a faithful representation of the asset or liability and any resulting income expenses, or changes in equity.

As we now know, relevance and faithful representation are the two fundamental qualitative characteristics that useful financial accounting information should possess. As we also learned earlier, relevant financial information is information that is capable of making a difference to the decisions made by users, whereas for a faithful representation to be provided, the financial information should ideally be complete, neutral and free from error.

Information must both be relevant and provide a faithful representation of what it purports to represent, if it is to be useful. Therefore, it does seem logical that the Conceptual Framework now stipulates that decisions about recognising assets and liabilities in the balance sheet also require the accountant to make a judgement about whether the disclosure of the respective asset, or liability, will ultimately provide information that is relevant and representationally faithful— and therefore useful to the users of the financial statements. If this conclusion cannot be reached, then the information about the respective asset and liability should not be included (recognised) within the balance sheet. This will then have direct implications for the recognition of income and expenses.

Because the accountant’s decision to recognise a particular transaction or event for financial statement purposes is directly linked to considerations of ‘relevance’ and ‘faithful representation’, much professional judgement is therefore required in terms of when, or if, to recognise an asset, liability, equity, income or expense. The Conceptual Framework, however, provides some general guidance in relation to linking recognition to relevance and faithful representation, which we now consider.

Relevance In relation to the qualitative characteristic of relevance, the Conceptual Framework states (paragraph 5.12):

Information assets, liabilities, equity, income and expenses is relevant to users of financial statements. However, recognition of a particular asset or liability and any resulting income, expenses or changes in equity may not always provide relevant information. That may be the case if, for example:

(a) it is uncertain whether an asset or liability exists, or (b) an asset or liability exists, but the probability of an inflow or outflow of economic benefits is low.

From the above, we can see that if there is sufficient uncertainty about whether a particular right exists—and remember that assets are considered to represent rights (for example, rights to use a particular machine, where those rights might have been obtained as a result of purchasing the machine) that have the potential to produce economic benefits—then an asset should not be recognised. As the Conceptual Framework states (paragraph 4.13):

For example, an entity and another party might dispute whether the entity has a right to receive an economic resource from that other party. Until that existence uncertainty is resolved—for example, by a court ruling—it is uncertain whether the entity has right and, consequently, whether an asset exists.

Therefore, in recognising an asset, a judgement needs to be made about the extent of any possible ‘existence uncertainty’, which is defined in the Conceptual Framework as ‘uncertainty about whether an asset or liability exists’. For example, if an organisation has some farming land, but considerable doubt has been raised about whether it has proper legal title over that land, then it might be appropriate not to recognise the land within the financial statements until such time that there is clarity about who is permitted to occupy the land.

In determining whether information is relevant to the users of financial statements, we can see from the quote provided above that there is also a requirement to consider the probability associated with any expected future inflow, or outflow, of economic benefits. In this regard, the Conceptual Framework states (paragraph 5.17b):

If there is only a low probability that the asset or liability will result in an inflow or outflow of economic benefits, users of financial statements might not regard the recognition of the asset and income, or the liability and expenses, as providing relevant information.

For example, an organisation might have an item of machinery that it no longer uses, and it is very unsure whether any other organisation would buy it. In this case, there might be deemed to be a low probability associated with future

dee67382_ch02_059-098.indd 79 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 79

inflows of economic benefits, and therefore information about the asset might not be relevant to financial statement users, and should not be disclosed within the balance sheet.

Therefore, in considering whether the disclosure of information about an asset would be relevant, two factors for managers and their accountants to consider would include:

∙ ‘existence uncertainty’ ∙ the ‘probability associated with the expected inflow of economic benefits’.

It is emphasised again that it is not a requirement that the future flow of economic benefits be probable, but if the potential to generate economic benefits is deemed to be very low, then it might not be relevant to users for them to have knowledge of the particular ‘right’ in question.

Faithful representation In relation to the other fundamental qualitative characteristic of faithful representation that requires consideration when determining whether to recognise an asset, or other element of financial accounting, the Conceptual Framework states (paragraph 5.18):

Recognition of a particular asset or liability is appropriate if it provides not only relevant information, but also a faithful representation of that asset or liability and of any resulting income, expenses or changes in equity. Whether a faithful representation can be provided may be affected by the level of measurement uncertainty associated with the asset or liability, or by other factors.

As we know, for an asset or liability to be recognised within the financial statements, it must be measured in monetary terms. Many of the measures attributed to assets are based upon estimates, meaning inherently that the amounts being attributed to some assets (and other elements of financial accounting) are often made with some level of uncertainty. As we have already indicated, some level of uncertainty is acceptable; however, if the different measures that could be attributed to an asset (or other element of financial accounting) are all considered to have a high level of measurement uncertainty, then the asset should not be recognised within the financial statements. Measurement uncertainty is defined in the Appendix to the Conceptual Framework as:

uncertainty that arises when monetary amounts in financial reports cannot be observed directly and must instead be estimated.

In relation to the issue of measurement uncertainty referred to in the above quote, the Conceptual Framework stresses (paragraph 5.20) that in some cases, the level of uncertainty associated with estimating a measure of an asset or liability might be so high that it would be questionable whether the estimate would provide a sufficiently faithful representation of that asset or liability and of any resulting income, expenses or changes in equity.

As an example of measurement uncertainty, an organisation might have some machinery that it no longer uses and it is very unsure about how much it could now sell the machinery for. This would be an instance of measurement uncertainty. If the level of measurement uncertainty is sufficiently high, then this might indicate that a faithful representation of the value of the machinery cannot be provided to the users of the financial statements, and the item should not be recognised within the balance sheet.

Therefore, with the above discussion of relevance and faithful representation in mind, we now know that existence uncertainty, probability of expected inflows or outflows of economic benefits and measurement uncertainty are among the key factors to consider before an accountant should recognise an asset, liability, income, expense or equity item within the financial statements. (See Worked Example 2.4.)

Factors relating to existence uncertainty, probability and measurement uncertainty can require a great deal of professional judgement, and as such, different accountants might make different judgements in respect of whether particular items should be included within the financial statements. Any differences in judgements made by accountants would, in turn, ultimately result in different financial statements being prepared, with different profits being reported. The point being made here is that because we require accountants to make judgements about such factors as:

∙ the expected probabilities associated with expected flows of economic benefits ∙ the level of uncertainty associated with the measurement of the expected future economic benefits ∙ whether rights associated with the future economic benefits are clearly in existence

then this necessarily introduces a degree of professional judgement into the accounting process. Conceivably, different accountants will make different judgements. This means that if different accountants were to be provided with the same information, they may process the information differently and therefore, as we say above, produce different financial

dee67382_ch02_059-098.indd 80 10/23/19 09:45 AM

80 PART 1: The Australian accounting environment

WORKED EXAMPLE 2.4: The decision to recognise an asset (or not)

Northshore Company acquired the rights to produce a certain product. Northshore Company paid $2 750 000 for these production rights, which could be considered to be an intangible asset.

The accountants of Northshore Company initially recognised the asset in Northshore Company’s balance sheet. However, the managers of Northshore Company now have a high degree of uncertainty about whether there is any market for the related product when it is produced, and even if there are some sales, which they think probably will occur, they are very uncertain about the price that people would actually be prepared to pay to purchase the product. The managers, however, are confident that they do have the proper legal rights to produce the product.

REQUIRED You are required to advise the managers of Northshore Company about whether they should continue to recognise the production rights as an asset in their balance sheet. They also want to know the implications for the financial statements if a professional judgement is made that they should no longer recognise the asset.

SOLUTION As we know, the first thing to consider is the requirement within the Conceptual Framework that only items that meet the definition of an asset, a liability or equity, are recognised in the balance sheet.

If we consider the production rights, and the definition of an asset, then it would seem that the production rights do satisfy the definition of an asset. Specifically:

• An asset is a resource controlled by the entity. The organisation does seem to be able to control the use of the production rights, so this condition is satisfied.

• An asset exists as a result of past events. Northshore Company has already acquired the production rights, so this condition is therefore satisfied.

• An asset exists where the organisation has a right that has the potential to produce economic benefits for the entity. The expectation is that some products will be sold, and therefore economic benefits generated, so this condition appears to be met.

Therefore, the production rights do seem to satisfy the definition of an asset. As we know, however, not all items that meet the definition of one of the elements of financial accounting are to be recognised within the financial statements. To recognise the asset, accountants then need to make the judgement that the disclosure of the asset will provide information that is both relevant and representationally faithful. Two factors to consider in determining whether the disclosure of information about an asset would be relevant to financial statement users are:

• existence uncertainty • probability associated with the expected inflow of economic benefits.

Northshore Company seems to have a clear legal right to use the production rights, so there appears to be little or no existence uncertainty.

Northshore Company, however, has a high degree of uncertainty pertaining to the probability associated with the expected inflow of economic benefits. Therefore, the information about the production rights might not be very relevant and therefore useful to the users of the financial statements.

In relation to the issue of faithful representation, one factor that we have already identified is measurement uncertainty. The higher the level of measurement uncertainty, the less able accountants are to provide a measurement that faithfully represents the value of the asset. In this case, there does seem to be significant uncertainty in relation to the monetary amounts that will be generated from the production rights.

As a result of the high level of measurement uncertainty (which undermines the faithful representation of the asset, and therefore the usefulness of the information), and the uncertainties pertaining to the probability associated with the expected inflow of economic benefits (which undermines the relevance of information about an asset and therefore the usefulness of the information), it would appear inappropriate to recognise the production rights as an asset in the balance sheet of Northshore Company. The asset should be removed from the balance sheet. This is referred to as ‘derecognition’. To remove the asset, an expense will be recognised, which decreases equity.

dee67382_ch02_059-098.indd 81 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 81

statements. Indeed, if different teams of accountants were given details of all of the transactions and events with which an organisation was involved throughout a particular accounting period, and each team was asked to separately prepare financial statements for that organisation, then it would be quite improbable that they would generate identical financial statements. The preparation of financial statements requires a great deal of professional judgement, and this has direct implications for what appears within the financial statements.

If an asset is recognised within the financial statements at one point in time, it might need to be removed from the financial statements at a future time. For example, accountants might initially make a professional judgement that an item satisfies the criteria necessary to be recognised within the financial statements. However, at a subsequent point, additional information might come to light, or new conditions might arise, that create significant uncertainty about factors such as:

∙ the expected probabilities associated with expected flows of economic benefits ∙ the level of uncertainty associated with the measurement of the associated economic benefits.

If the uncertainties become sufficiently high, then the asset should be removed from the balance sheet, and this would be referred to as ‘derecognition’ of the asset. Derecognition is defined in the Conceptual Framework as ‘the removal of all or part of a recognised asset or liability from an entity’s statement of financial position’.

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). 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 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’.

So, in summarising this discussion, we know that for an item to be included within the balance sheet as an ‘asset’, it must:

∙ satisfy the definition of an asset (meaning it must be controlled by the entity as a result of a past transaction or event and it must have the potential to generate future economic benefits), and

∙ information about the asset must be capable of providing information that is considered as relevant and representationally faithful.

We summarise the conditions necessary for the recognition of assets in Figure 2.4. It needs to be understood that all four of the initial steps identified in Figure 2.4 must be met before an asset is recognised. That is, if one of the requirements is missing, then the item should not be considered to be an asset, and therefore it should not appear within the balance sheet. It should also be emphasised that an asset does not have to have a physical form. An asset might have no physical form, but still be recognised. These assets would be intangible assets, and would include such items as copyrights, goodwill, patents or brand names. We will consider intangible assets in depth in Chapter 8.

Definition and recognition of liabilities Liabilities represent the financial claims against the organisation held by individuals, and organisations, other than by the owners of the organisation in their capacity as owners. Liabilities arise from activities such as borrowing funds, or through acquiring inventory on credit, or incurring other expenses without yet paying for them. Within the Conceptual Framework, a liability is defined as:

a present obligation of the entity to transfer an economic resource as a result of past events.

The above definition of liability refers to an ‘obligation’. An ‘obligation’ is defined in the Conceptual Framework as:

a duty or responsibility that the entity has no practical ability to avoid.

An obligation would be expected to be satisfied at some time in the future.

liability Defined in the Conceptual Framework as ‘a present obligation of the entity to transfer an economic resource as a result of past events’.

dee67382_ch02_059-098.indd 82 10/23/19 09:45 AM

82 PART 1: The Australian accounting environment

Figure 2.4 Conditions to be satisfied before an asset can be recognised for financial accounting purposes

Is the item capable of generating future economic benefits that will flow to the entity?

NO

YES

Does the organisation control the item as a result of some past events?

NO

YES

Is information about the asset considered likely to be relevant to readers of financial statements (which requires accountants to consider factors such as potential ‘existence uncertainty’ as well as ‘probabilities associated with the expected inflows of economic benefits’)?

NO

YES

Is information about the asset considered likely to faithfully represent information about the expected future flows of economic benefits to be generated by the asset (which requires accountants to consider issues such as ‘measurement uncertainty’)?

NO

YES

Item shall appear as an asset in the balance sheet

Item does not appear in the balance sheet and the related expenditure will be treated as an expense

Need to measure the amount to be assigned to the asset

Need to determine what information about the asset shall be disclosed and how this information shall be presented to the users of the financial statements

Components of a liability From the above definition of a liability we can see that—as with assets—there are three separate components to this definition, these being:

1. a liability represents a present obligation of the entity 2. it arises from past events 3. it creates an obligation to transfer economic resources away from the entity.

Let us consider each of these three components separately.

Present obligation For a liability to be recognised and reported within the financial statements, the obligation must currently be in existence, and therefore not be contingent upon some future event. A liability exists when, at a given point in time, an organisation effectively has no reasonable alternative other than to settle the obligation at a future date. The present

dee67382_ch02_059-098.indd 83 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 83

obligation must be to another entity or individual that is external to the organisation. The definition of a liability therefore requires the participation of two separate entities, these being the reporting entity and an outside entity to which the obligation is owed.

Past event The event that creates the obligation must have occurred. For example, if an organisation has placed an order for some inventory, but the inventory has not actually been placed in the control of the organisation, then an obligation to pay for the inventory would typically not be recognised.

Outflow from the entity of resources embodying economic benefits For a liability to be recognised, the organisation has an obligation to ultimately transfer something that has value. That is, it has a responsibility to give up something that constitutes ‘economic benefits’. This outflow of economic benefits does not have to be only in the form of cash. For example, if an organisation has an obligation to transfer some other asset, other than cash, in order to settle an obligation, then that obligation would still constitute a liability.

The 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.

Hence the liabilities that appear within an entity’s balance sheet 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 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.

Apart from satisfying the definition of a liability, the recognition of a liability is—just as with assets—directly linked to professional judgements about whether the information to be disclosed would be relevant to the readers of the financial statements, and whether the information to be disclosed would faithfully represent the underlying obligation.

Relevance As we already learned from our discussion of assets, two important factors to consider when assessing relevance include:

∙ existence uncertainty ∙ assessments about the probabilities of an outflow of economic benefits.

For a liability to be recognised in the financial statements, it needs to be reasonably apparent that an obligation to an external party exists. This will be based on available facts. If there is clearly little option for the reporting entity to avoid making a future transfer of economic benefits to another party, then the level of existence uncertainty might be considered to be low, and the recognition of a liability would, subject to other criteria, be expected. Conversely, if the level of existence uncertainty is high, then it might be inappropriate to recognise the liability in the financial statements.

dee67382_ch02_059-098.indd 84 10/23/19 09:45 AM

84 PART 1: The Australian accounting environment

As an example of a situation where there might be a high level of existence uncertainty, we could consider the situation wherein an organisation has been informed that it is being taken to court for some alleged wrongdoing. Before the court case is held, it might be very uncertain that an obligation exists, and therefore it might be inappropriate to recognise a liability. As the Conceptual Framework notes (paragraph 4.35):

In some cases, it is uncertain whether an obligation exists. For example, if another party is seeking compensation for an entity’s alleged act of wrongdoing, it might be uncertain whether the act occurred, whether the entity committed it or how the law applies. Until that existence uncertainty is resolved—for example, by a court ruling—it is uncertain whether the entity has an obligation to the party seeking compensation and, consequently, whether a liability exists.

In relation to considerations relating to the perceived probability of future outflows of economic benefits, the greater the uncertainties in terms of predicting the likelihood of future cash flows occurring, the less relevant would be the disclosure of information about a liability. For example, if an organisation has broken a particular law in terms of how it should be operating its business, but the managers are completely unable to determine the probability associated with whether they will have to pay a penalty, then no liability for the non-compliance would be recognised.

Faithful representation As we also know, another factor to consider when determining whether to recognise an asset, or a liability, is measurement uncertainty. If there is a high level of uncertainty with regards to the amount of future cash outflows likely to occur in relation to a particular liability—meaning that a faithful representation of the liability is potentially not possible—then it might be inappropriate to recognise the liability in the financial statements. For example, and using the example provided in the above paragraph, if the organisation knows that it will be prosecuted for failure to comply with particular laws, but managers are unable to reasonably determine the magnitude of the future fine even within broad ranges of possible outcomes, then because of the high level of ‘measurement uncertainty’, no liability would be recognised.

Therefore, various factors associated with both the:

∙ ‘probability of an outflow of economic benefits’, and ∙ ‘measurement uncertainty’

require consideration when determining whether to recognise a liability (as they also do with the other elements of accounting). (See Worked Example 2.5.)

WORKED EXAMPLE 2.5: Determining whether to recognise a liability

The managers of an organisation have committed to the following future cash flows:

• The managers have agreed to undertake a full overhaul of the organisation’s machinery in 12 months time at an expected cost of $2 500 000.

• The organisation acquired some machinery at a cost of $3 000 000 and has committed to paying for the machinery in 12 months time.

REQUIRED Which of the above transactions or events could be considered to be a liability?

SOLUTION Because the overhaul of the machinery does not represent an obligation to another (external) party, this is not a liability. The commitment to pay for the machinery, however, satisfies the definition of a liability as it represents a present obligation to transfer economic resources to another organisation as a result of a past transaction or event. It would also appear to satisfy the requirements in relation to relevance and faithful representation as there is no apparent existence uncertainty and the probability of an outflow of economic benefits appears high and there is limited measurement uncertainty.

Since the recognition of liabilities relies upon professional judgements about the probability and measurability of expected future cash flows, this means that, as with the other elements of financial accounting, some managers and their accountants might use potential difficulties, or uncertainties, associated with assessing probabilities and reliable measurements as an ‘excuse’ not to recognise liabilities. That is, they may be ‘creative’ in their assessment of whether

dee67382_ch02_059-098.indd 85 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 85

a liability should be recognised and disclosed within the financial statements. Because professional judgement is involved, it can at times be difficult for other people to determine whether any failure to recognise liabilities is actually justified, or not.

Within Australia, Ji and Deegan (2011) investigated actual instances where managers and their accountants might have opportunistically relied upon apparent difficulties in determining reliable measurements of liabilities as a justification for not recognising liabilities. Through an analysis of various sources of information, Ji and Deegan (2011) identified a number of significant and severely environmentally contaminated sites that were controlled by Australian companies, and for which the respective organisations were under a clear legal obligation to remove the contamination and remediate the land. In many cases the expected obligations associated with cleaning and remediating the sites were tens or hundreds of millions of dollars. Once companies were identified as having significant legal obligations (liabilities) to clean and remediate contaminated sites, Ji and Deegan (2011) then reviewed the respective companies’ financial statements to see whether the liabilities were actually recognised within the balance sheet. Overwhelmingly, the authors found that the companies failed to recognise the liabilities in the balance sheet, with the companies noting that they did not recognise the liabilities mainly because they felt they were unable to determine a reliable measurement for the future payments. Ji and Deegan (2011) were of the opinion that the companies were potentially using the claims about ‘measurement uncertainty’ as an excuse not to recognise the liabilities, and the authors questioned the credibility of the claims and arguments that the companies could not reasonably calculate a fairly reliable measure of the costs associated with fixing up the contaminated land. There is a general belief that managers, when given a choice, would prefer not to disclose liabilities in the financial statements, as the greater the reported liabilities, the greater the perceived financial risk that is often associated with an organisation.

The results of the analysis in Ji and Deegan (2011) were very similar to the results of research into Canadian and US mining companies reported some years earlier by Repetto (2004), thereby indicating that internationally some managers and their accountants potentially use issues associated with ‘measurement uncertainty’ and ‘low probabilities of outflows of economic benefits’ as factors to justify the non-recognition of liabilities. So the point of this discussion is that we need to be careful when relying upon balance sheets as it is always possible that certain liabilities have been omitted that arguably should have been recognised. The authors referred to above believed that they had justification for questioning why certain liabilities were not being recognised within the financial statements.

While most managers and accountants would not opportunistically use the recognition criteria associated with relevance and faithful representation as a justification for not recognising liabilities within a balance sheet, we must nevertheless understand that when professional judgements need to be made using such criteria, it is always possible that the judgement criteria will be used in a way that allows managers to present a more favourable picture of an organisation’s financial position, and financial performance, than perhaps should be the case.

We summarise the conditions necessary for the recognition of liabilities in Figure 2.5.

Definition and recognition of expenses The definition of expenses is dependent upon the definitions given to assets and liabilities. Within the Conceptual Framework, expenses are defined (paragraph 4.69) as follows:

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

There are therefore two essential characteristics of expenses, these being:

1. a decrease in assets, or an increase in liabilities 2. a resulting decrease in equity, other than as a result of distributions to owners.

What the above definition of expenses indicates is that unless we understand what assets and liabilities represent, we will not be able to understand what an ‘expense’ is. The recognition of an expense is directly dependent upon the recognition of a change (decrease) in assets and/or a change (increase) in liabilities.

We know that the definition of an asset relies upon the reporting entity having ‘control’ over the resource. 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. The point to be made here is that profitable companies might nevertheless be creating significant and unrecognised environmental damage.

expenses Defined by the Conceptual Framework as ‘decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims’.

dee67382_ch02_059-098.indd 86 10/23/19 09:45 AM

86 PART 1: The Australian accounting environment

Figure 2.5 Conditions to be satisfied before a liability can be recognised for financial accounting purposes

Does the organisation have a present obligation to transfer economic benefits to an outside entity as a result of a past transaction or event?

NO

YES

It is true that the organisation has no practical ability to avoid the obligation?

NO

YES

Is information about the liability considered likely to be relevant to readers of financial statements (which requires accountants to consider factors such as potential ‘existence uncertainty’ as well as ‘probabilities associated with the expected outflows of economic benefits’)?

NO

YES

Is information about the liability considered likely to faithfully represent information about the expected future flows of economic benefits to be generated by the liability (which requires accountants to consider issues such as ‘measurement uncertainty’)?

NO

YES

Item shall appear as a liability in the balance sheet

Item does not appear in the balance sheet

Need to measure the amount to be assigned to the liability

Need to determine how information about the liability shall be presented to stakeholders

income Defined by the Conceptual Framework as ‘increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims’.

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 (paragraph 4.68) defines income as:

increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

Income can therefore be considered to relate to transactions or events that cause an increase in the net assets of the reporting entity (net assets represent assets less liabilities), other than increases in net assets that arise as a result of owner contributions. The recognition of income is directly dependent upon the recognition of a change (increase) in assets and/or a change (decrease) in liabilities.

As we can see from the definition provided above, to qualify as income or expenses, the changes in assets or liabilities must have the effect of changing equity. Equity changes because of either income or expenses, or through contributions from, or distributions to, owners. That is:

Equity end of period = Equity beginning of period + (Income − Expenses) + Contributions − Distributions

dee67382_ch02_059-098.indd 87 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 87

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. Looking at the above formula, the acquisition of an asset is not income. For example, purchasing assets with cash simply involves substituting one asset for another and does not impact equity. Similarly, borrowing cash leads to an increase in assets (cash), and an increase in liabilities, with no direct effect on equity.

The Conceptual Framework does not include ‘profit’ (or ‘loss’) as one of the elements of financial accounting. As we know, the five elements are assets, liabilities, income, expenses and equity. Profit is simply the difference between income and expenses, both of which are defined, and hence there is no need for separate recognition criteria for ‘profits’.

Definition of equity Paragraph 4.63 of the Conceptual Framework defines equity as ‘the residual interest in the assets of the entity after deducting all its liabilities’. That is:

Equity = Assets − Liabilities

The residual interest is a claim or right to the net assets of the reporting entity held by the owners of an organisation. As a residual interest, equity ranks after liabilities in terms of a claim 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.

equity Defined by the Conceptual Framework as ‘the residual interest in the assets of the entity after deducting all its liabilities’.

2.10 Measurement principles

As we have already indicated, once we have decided that a liability or asset should be recognised, we then need to determine how to measure it. For financial reporting purposes, measurement refers to the process of determining the amounts to be included in the financial statements. Applying a measurement basis to an asset or a liability also creates a basis for measuring any related income or expense.

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. Given the way income and expenses are defined—which relies upon measures attributed to assets and liabilities— this has direct implications for reported profits. For example, liabilities are frequently recorded at present value, face

LO 2.10

WHY DO I NEED TO KNOW ABOUT THE DEFINITIONS AND RECOGNITION CRITERIA FOR THE ELEMENTS OF FINANCIAL ACCOUNTING?

If we do not understand the definitions and recognition criteria, then we will not really understand what the reported financial performance and financial position of an organisation actually represents. For example, as a result of knowing the definitions of the elements of financial accounting, we know that certain aspects of organisational performance will not be reflected within reported profits—for instance, certain impacts on the environment will not be reflected within profits, perhaps because the negative impacts caused by the organisation related to resources that were not ‘controlled’ by the organisation, and which therefore had not ever been recognised as assets of the organisation. We would therefore know that ‘profits’ is a somewhat incomplete measure of overall organisational performance. As another example, through having knowledge of the definitions and recognition criteria, we will also know that certain resources that are used by an organisation will not necessarily appear in the balance sheet if they are not ‘controlled’, or if there is some significant doubt about the relevance, or faithful representation, of the information pertaining to the underlying item.

dee67382_ch02_059-098.indd 88 10/23/19 09:45 AM

88 PART 1: The Australian accounting environment

value or on some other basis, depending upon the type of liability in question. Assets are also measured in various ways—for example, inventory is to be measured at the lower of cost and net realisable value; some non-current 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’.

As we know, the IASB and the FASB were engaged for a number of years in joint efforts to develop a new conceptual framework. At the time, they both had their own different frameworks. 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. (© Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, used with permission.)

When the IASB released its Discussion Paper–A Review of the Conceptual Framework for Financial Reporting— it stated (2013, p. 112):

Consideration of the objective of financial reporting, and of the qualitative characteristics of useful financial information, has led the IASB to the following 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.

The Conceptual Framework, when it was released in 2018, grouped existing measurement bases into two broad categories, these being:

(a) historical cost, and (b) current value.

Consistent with previous Exposure Drafts, the Conceptual Framework when revised and re-released in 2018 did not stipulate one basis of measurement for all assets and liabilities. Instead, the Conceptual Framework notes that the selection should be based on which measurement basis provides the most ‘useful’ information to the readers of the financial statements. Paragraph 6.2 of the Conceptual Framework states:

Consideration of the qualitative characteristics of useful financial information and of the cost constraint is likely to result in the selection of different measurement bases for different assets, liabilities, income and expenses.

dee67382_ch02_059-098.indd 89 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 89

Current value

Measurement bases Historical cost Fair value

Value in use/ fulfilment value Current cost

Cost determined by: The cost of the transaction that gave rise to the asset or liability. Includes transaction costs.

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. It reflects market participants’ current expectations about the amount, timing and uncertainty of future cash flows. Transaction costs that would arise on disposal are not deducted.

Reflects entity- specific current expectations about the amount, timing and uncertainty of future cash flows. The present value of transaction costs are deducted. Value in use relates to the present value of the cash flows, or other economic benefits, that an entity expects to derive from the use of an asset and from its ultimate disposal. Fulfilment value is the present value of the cash, or other economic resources, that an entity expects to be obliged to transfer to satisfy a liability.

Reflects the current amount that would be paid to buy an equivalent asset, or received to take on an equivalent liability. Includes transaction costs.

Are transaction costs included?

Yes No No No

The measurement is updated:

To recognise use/ consumption of the asset

To reflect changes in measurement since previous measurement date

To reflect changes in measurement since previous measurement date

To reflect changes in measurement since previous measurement date

Does measurement reflect entry or exit value?

Entry Exit Exit Entry

Table 2.1 A description of different bases of measurement

As the above material indicates, the Conceptual Framework does not stipulate that one basis of measurement should be used for all assets, or for all liabilities. Therefore, in relation to assets, this means that some assets might be measured at cost, some assets might be measured at their present value, and some assets might be measured at their fair value. Therefore, we can be left to question what the amount ultimately attributed to ‘total assets’ for a reporting entity actually equates to given that it represents the addition of different types of assets that have been measured on different bases. We will address this issue further in the chapters of this book that follow. As we shall also learn in subsequent chapters, different types of assets and liabilities will often have specific accounting standards that govern how they shall be measured, and disclosed.

As we noted above, measurement bases can be broadly divided into either historical cost or current value. Current value measurement basis can be further classified into:

∙ fair value ∙ value in use (for assets), or fulfilment value (for liabilities) ∙ current cost.

Table 2.1 provides further information about these different measurement bases.

dee67382_ch02_059-098.indd 90 10/23/19 09:45 AM

90 PART 1: The Australian accounting environment

2.11 A critical review of conceptual frameworks

While it is logical and useful to various stakeholders to have a Conceptual Framework for Financial Reporting, as it would be to have a conceptual framework for other forms of reporting (such as for social and environmental

reporting), a number of people have been critical of the conceptual frameworks for financial reporting that have been developed over recent decades. We will consider some of these criticisms below. Specifically, we will identify four broad criticisms (of course, there would be other criticisms apart from the ones we discuss). Whether we agree with these criticisms will, in part, be a matter of our own personal opinion.

The Conceptual Framework adopts a very restricted view of accountability As we know, according to the IASB Conceptual Framework, the primary audience of general purpose financial reports are deemed to be existing and potential investors, lenders and other creditors.

An individual’s view of an organisation’s responsibilities directly impacts his or her perceptions of organisational accountability. Those responsible for developing the Conceptual Framework appear to take a restricted view of the accountabilities of business given the restricted nature of the ‘primary audience’ of financial statements. By contrast, 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 who should be perceived as a ‘user’ of financial statements. The Corporate Report considered the ‘public’ as a key audience of corporate financial reports. In this regard, the report states (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.

The view taken within The Corporate Report was that as larger organisations within society create a variety of economic, social and environmental impacts, this means that they have an accountability for their financial performance and financial position to a broad group of stakeholders beyond investors, lenders and creditors. That is, beyond those stakeholders with an existing, or potential, financial stake in the organisation.

The definitions of the elements of financial reporting ignore many social and environmental ‘costs’ 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 often 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, or to various societies, caused by organisations, particularly larger business organisations (Gray, Adams & Owen 2014; Deegan 2013, 2017). Let us consider a fairly extreme example. Applying generally accepted accounting principles, if the environmental consequences of a business’ 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 affected. This is because the waterways are not controlled by

LO 2.11

WHY DO I NEED TO KNOW ABOUT HOW ASSETS AND LIABILITIES ARE MEASURED FOR THE PURPOSE OF GENERAL PURPOSE FINANCIAL REPORTING?

A number attributed to an asset or liability will make sense only if we know the basis on which that number has been determined. For example, the decisions we make in relation to the assets of an organisation might be very different if those assets are measured using historical cost or fair value. Also, the income and expenses to be recognised by an organisation are directly influenced by the way assets and liabilities are measured; therefore, some knowledge of the measurement bases being used allows a user of financial statements to better understand the context within which ‘profits’ have been calculated.

dee67382_ch02_059-098.indd 91 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 91

the entity (and remember, according to the Conceptual Framework’s definition of assets, control must be established before something is deemed to be an asset of an entity), and therefore their use (or abuse) is not recorded by financial accounting systems as an expense (and remember, the recognition of expenses is directly related to the definitions of assets). Consistent with the Conceptual Framework, the performance of such a polluting organisation—as reflected by its reported profits—could, depending upon the financial transactions undertaken, be portrayed as being very successful. In this regard, the view of Gray and Bebbington (1992, p. 6) is that:

there is something profoundly wrong about a system of measurement (such as financial accounting), a system that makes things visible and which guides corporate and national decisions that can signal success in the midst of desecration and destruction.

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 guidance and rules incorporated within the Conceptual Framework and within applicable 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 generally accepted financial accounting principles is typically used as a guide to an organisation’s success.

A review of the financial press indicates that the news media, too, generally use financial performance indicators as a guide to the success and health of an organisation. For example, respected daily financial news media throughout the world typically report each day on listed companies’ earnings per share, price–earnings ratio and net asset backing per share. The news media also generally provide 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 32.

The Conceptual Framework simply reflects existing accounting practice Another suggested criticism of conceptual frameworks for financial reporting is that they simply represent 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 generally accepted accounting practices (GAAPs), can such principles logically be used as a rationale for selecting between alternative accounting methods? Perhaps not. In this regard, it is interesting to see how the recent revisions to the Conceptual Framework addressed the issue of ‘measurement’. Many researchers and practitioners were of the view that, for example, the measurement of assets should be based upon one approach—such as fair value—rather than there being a variety of measurement approaches used for different types of assets (thereby causing the aggregate of ‘total assets’ to be somewhat problematic in meaning). However, if only one approach to asset measurement had been prescribed, this would have represented a significant change to financial reporting practices. As we know, when the Conceptual Framework was amended, it suggested that it is appropriate for different measurement approaches to be used for different types of assets—a suggestion that was consistent with current practice and which therefore did not require any form of significant change. To have prescribed one approach to measurement would have potentially created ‘political problems’ for the IASB because many managers in different organisations might have been openly critical of such a significant change in accounting practice. Hines (1989, p. 79) argues that accounting regulations, as generated by the accounting regulators, are heavily impacted by political considerations and this tends to negatively affect the objectivity embraced by accounting standard-setters.

As a related example of how proposed significant changes to existing accounting practice will ultimately not be accepted, we can consider some of the events leading to the development of the US Conceptual Framework Project. In 1961 and 1962, the Accounting Research Division of the American Institute of Certified Public Accountants

dee67382_ch02_059-098.indd 92 10/23/19 09:45 AM

92 PART 1: The Australian accounting environment

(AICPA) commissioned studies by Moonitz, and by Sprouse and Moonitz respectively. These researchers proposed that accounting measurement systems be changed from historical cost to a system based on current values. However, before the release of the Sprouse and Moonitz study, the Accounting Principles Board of the AICPA stated in relation to this study and another Moonitz study that ‘while these studies are a valuable contribution to accounting principles, they are too radically different from generally accepted principles for acceptance at this time’ (Statement by the Accounting Principles Board, AICPA, April 1962).

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 often 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, despite their potential merit. 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.

Conceptual frameworks are a mechanism to legitimise the accounting profession 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. (Reprinted from 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, p. 328, with permission from Elsevier.)

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’.

More recently, the global financial crisis (GFC) of 2007–2009 generated a great deal of discussion about the potential deficiencies in financial accounting practices used in many countries, particularly within the USA. Indeed, many articles appeared in the news media suggesting that financial accountants were somehow, at least partially, responsible for the GFC. Arguably, this provided greater impetus for the accounting profession to look like it was being active in improving the practice of financial reporting that was being criticised, and revised frameworks were released in 2010 and 2018 (however, it should be acknowledged that efforts to develop a revised conceptual framework did commence before the GFC).

dee67382_ch02_059-098.indd 93 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 93

2.12 The conceptual framework as a normative theory of accounting

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. 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.

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 that chapter 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 and 2018 the IASB released revised frameworks, referred to as the IASB Conceptual Framework for Financial Reporting, and Australia thereafter adopted this framework in place of the previous IASB framework.

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.

LO 2.12

dee67382_ch02_059-098.indd 94 10/23/19 09:45 AM

94 PART 1: The Australian accounting environment

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.

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 rely upon professional judgements about relevance and representational faithfulness.

We concluded the chapter with a critical analysis of conceptual frameworks.

KEY TERMS

asset 75 Conceptual Framework 60 control (assets) 76

equity 87 expenses 85 future economic benefits 76

income 86 liability 81 reporting entity 64

ANSWERS TO OPENING QUESTIONS

At the beginning of the chapter we asked the following seven questions. As a result of reading this chapter we should now be able to provide informed answers to these questions.

1. What is the difference in role between a conceptual framework for financial reporting and accounting standards? LO 2.1, 2.2 A conceptual framework provides a general framework for general purpose financial reporting and does not deal with individual, or specific types of, transactions or events. Accounting standards, by contrast, deal with specific types of assets or liabilities or transactions or events. Accounting standards take precedence over the conceptual framework. When there is no specifically relevant accounting standard, reference should be made to the conceptual framework.

2. What benefits are generated as a result of having a conceptual framework for financial reporting? LO 2.2 Section 2.2 of this chapter identified the benefits.

3. What qualitative characteristics will useful financial accounting information be expected to possess? LO 2.8 First, the information should be relevant and faithfully represent the underlying transaction or event that it purports to represent. To enhance the relevance and representational faithfulness, the information should also be comparable, verifiable, timely and understandable.

4. What are the five different ‘elements’ of financial accounting? LO 2.9 They are assets, liabilities, income, expenses and equity.

5. What are the three main components of the definition of assets? LO 2.9 The reporting entity controls the resource; the control exists as a result of a past transaction or event; and the resource has the potential to produce economic benefits for the reporting entity.

6. Are all assets required to be measured using the same basis of measurement? LO 2.10 No, assets can be measured using different measurement bases. The measurement basis used should be chosen according to whether it best enables relevant and representationally faithful financial information to be presented to the users of the financial statements.

7. What role does ‘materiality’ have with respect to deciding whether particular financial information should be disclosed? LO 2.8 Materiality considerations impact decisions about the amount of information to be disclosed to financial statement readers. If information is considered not to be material, and therefore unlikely to impact a decision, then it does not need to be disclosed.

dee67382_ch02_059-098.indd 95 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 95

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is a conceptual framework of accounting? LO 2.1 • 2. If the 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 2.2 •

3. What force of law does the Conceptual Framework have? LO 2.2 • 4. What is the history of conceptual frameworks within Australia? LO 2.3 • 5. Why is it preferable to have a well-developed conceptual framework prior to the development of accounting

standards? LO 2.2, 2.3, 2.4 • 6. Do we need a conceptual framework in Australia? Why? LO 2.1, 2.2, 2.3, 2.11 • 7. What is a general purpose financial statement? LO 2.5 • 8. What is a reporting entity, and what factors would you consider in determining whether an entity is a reporting entity?

LO 2.5 •• 9. Should the general purpose financial statements of a company be compiled in a manner that is understandable to all

investors? LO 2.6 •• 10. Who are the perceived recipients of general purpose financial statements and what knowledge of financial accounting

are they presumed to have? LO 2.6 • 11. What is the objective of having a conceptual framework? LO 2.7 • 12. What are the fundamental qualitative characteristics that financial accounting information should possess? LO 2.8 •• 13. What does a ‘qualitative characteristic’ mean as it relates to financial information? LO 2.8 • 14. What is an enhancing qualitative characteristic, and what role do enhancing qualitative characteristics have relative

to the role of fundamental qualitative characteristics? LO 2.8 •• 15. What does it mean for financial information to be ‘representationally faithful’? LO 2.8 • 16. Define ‘relevance’ and ‘faithful representation’. Is there a trade-off between the two? LO 2.8 •• 17. Which is more important—relevance or representational faithfulness? LO 2.8 •• 18. What are the disclosure implications if an item is deemed to be material? LO 2.8 •• 19. Are dividends paid to the owners of a reporting entity an ‘expense’ of a reporting entity? Why or why not? LO 2.9 •• 20. Is it true that for an asset to be recognised by a reporting entity it needs to be owned? LO 2.9 • 21. Define the elements and recognition criteria of financial statements as per the Conceptual Framework. LO 2.9 • 22. The IASB released a revised Conceptual Framework in 2018. Explain why the changes it made in the definition of

assets and liabilities subsequently had implications for the profits of reporting entities. LO 2.2, 2.4, 2.9 •• 23. Why don’t we need separate recognition criteria for equity? LO 2.9 •• 24. Is it true that for a liability to be recognised the related obligation needs to be legally enforceable? LO 2.9 • 25. Identify and explain some of the perceived shortcomings of the Conceptual Framework. LO 2.11 •• 26. Why would the Conceptual Framework be considered to be a normative theory of accounting? LO 2.12 ••

CHALLENGING QUESTIONS

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? For each of the

dee67382_ch02_059-098.indd 96 10/23/19 09:45 AM

96 PART 1: The Australian accounting environment

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 implications of your decision. LO 2.5

28. 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.

(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.

(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 value of each member’s entitlements. LO 2.5

29. Explain what ‘material’ means, including how to 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 2.8

30. Would the inclusion of immaterial information in the financial statements of a reporting entity reduce the understandability of the financial information? Why? LO 2.8

31. 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 that the organisation known as the ‘Serco Group’ reported a large loss and had liabilities that were $43 million more than its assets—referred to as having negative net assets. The organisation appeared to be technically insolvent and perhaps unable to pay all of its debts as and when they fell due. Despite this, the auditors, Deloitte, did not qualify the financial statements or challenge the managers on the company’s assertion that the organisation was a going concern.

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 2.8

32. If two different teams of accountants were given details of all of the transactions and events with which an organisation was involved throughout a particular accounting period, and each team was asked to separately prepare financial statements for that organisation, then it is unlikely that they would generate identical financial statements. Why? LO 2.8, 2.9

33. 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 2.9

34. 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 2.9

35. Historical cost is an approach to measuring assets. What are some strengths and weaknesses of using historical cost as the basis of measuring assets? LO 2.10

36. 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 2.11

37. Do you believe 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 2.11

dee67382_ch02_059-098.indd 97 10/23/19 09:45 AM

CHAPTER 2: The Conceptual Framework for Financial Reporting 97

REFERENCES Accounting Standards Steering Committee, 1975, The Corporate

Report, ICAEW, London. Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. 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, pp. 448–58.

Deegan, C., 2017, ‘Twenty-Five Years of Social and Environmental Accounting Research within Critical Perspectives of Accounting: Hits, Misses and Ways Forward’, Critical Perspectives on Accounting, vol. 43, pp. 65–86.

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, FASB, Norwalk, CT.

Gray, R., Adams, C. & Owen, D., 2014, Accountability, Social Responsibility and Sustainability, Pearson Education, London.

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, 2018, Conceptual Framework for Financial Reporting, IASB, London. www. ifrs.org

Ji, S. & Deegan, C., 2011, ‘Accounting for Contaminated Sites: How Transparent are Australian Companies?’, Australian Accounting Review, vol. 21, no. 2, pp. 131–53.

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.

Pelger, C., 2016, ‘Practices of Standard-Setting: An analysis of the IASB’s and FASB’s Process of Identifying the Objective of Financial Reporting’, Accounting, Organizations and Society, vol. 50, no. 3, pp. 51–73.

Repetto, R., 2004, ‘Silence is Golden, Leaden, and Copper: Disclosure of Material Environmental Information in the Hard Rock Mining Industry’, Yale School of Forestry and Environmental Studies, Report No. 1.

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.

dee67382_ch02_059-098.indd 98 10/23/19 09:45 AM

dee67382_ch03_099-158.indd 99 10/24/19 12:47 PM

PART 2 Theories of accounting

CHAPTER 3 Theories of financial accounting

dee67382_ch03_099-158.indd 100 10/24/19 12:47 PM

100

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 3.1 Understand what constitutes a ‘theory’, appreciate why students of financial accounting

should know about various theories, and understand the difference between normative and positive theories.

3.2 Understand the central tenets of Positive Accounting Theory and in doing so understand what constitutes an ‘agency relationship’ and be aware of the major aspects of ‘agency theory’.

3.3 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’.

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

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

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

3.7 Understand what is meant by ‘creative accounting’ and why it might occur. 3.8 Understand the basis of the various criticisms of Positive Accounting Theory. 3.9 Be aware of some normative theories of accounting, such as current-cost accounting, exit-price

accounting and deprival-value accounting. 3.10 Know what a ‘systems-based theory’ is and why a systems-based theory would be relevant to the study

of accounting. 3.11 Understand the basic tenets of Stakeholder Theory and its applicability to explaining accounting practice. 3.12 Understand the basic tenets of Legitimacy Theory and its applicability to explaining accounting practice. 3.13 Understand the basic tenets of Institutional Theory and its applicability to explaining accounting practice. 3.14 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.

C H A P T E R 3 Theories of financial accounting

dee67382_ch03_099-158.indd 101 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 101

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. Can the practice of financial reporting be undertaken without knowledge of various theories that can be related to accounting? LO 3.1

2. Can the implications of various aspects of financial reporting be well understood in the absence of knowledge of related theories? LO 3.1

3. What is the difference between a positive theory and a normative theory? LO 3.1 4. Is the IASB Conceptual Framework for Financial Reporting a normative or positive theory of accounting? Why?

LO 3.9 5. Identify three theories that could be used to explain why particular regulation, such as specific regulation

pertaining to financial reporting, has been enacted. LO 3.14

AASB STANDARDS REFERRED TO IN ThIS ChAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

15 Revenue from Contracts with Customers IFRS 15

101 Presentation of Financial Statements IAS 1

102 Inventories IAS 2

108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8

138 Intangible Assets IAS 38

1023 General Insurance Contracts —

LO 3.1 3.1 Introduction to theories applicable to 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 for Financial Reporting. 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 Conceptual Framework) of general purpose financial reporting.

In this chapter we explore some of the many theories—in addition to conceptual frameworks—that can relate to financial accounting. We will see that different theories often have different objectives and can adopt different assumptions about what motivates human behaviour. 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)

∙ explain and predict which stakeholders will be (or perhaps, should be) the intended audience for the reports being released by organisational managers

∙ 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 over and above the interests of others).

The theory overview in this chapter will provide readers with knowledge of some of the various theories that have been developed and that can relate to the practice of accounting. 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

dee67382_ch03_099-158.indd 102 10/24/19 12:47 PM

102 PART 2: Theories of accounting

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 and purpose 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? The study of financial accounting and reporting can be approached in a number of different ways. One approach adopted 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 or appropriateness 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. Other financial accounting texts have introduced a chapter on theory (often driven by a competitive desire to show they have such a chapter) but then subsequently fail to integrate the discussion of theory with the practical material pertaining to accounting standards that follows. 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 theoretical 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 standard-setting environment.

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—that is, accounting is both a technical and a social practice—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 or incentives that drive managers to use particular accounting methods, or 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 reporting requirements.

Definition of ‘theory’ Before we consider some theories, 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 hypothetical, conceptual and pragmatic principles forming the general framework of reference for a field of inquiry’.

Hendriksen’s definition is very similar to the US Financial Accounting Standards Board’s definition of its Conceptual Framework Project, discussed in Chapter 2: ‘a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards’.

It is generally accepted that a ‘theory’ is much more than simply an idea, or a ‘hunch’, which 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 simply have a ‘hunch’).

theory Coherent set of hypothetical, conceptual and pragmatic principles forming the frame of reference for a field of inquiry.

dee67382_ch03_099-158.indd 103 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 103

Theories applicable to accounting 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, or a normative theory might prescribe that particular stakeholders should receive particular accounting-based information. 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. Worked Example 3.1 explores the main differences between a positive and normative theory.

WORKED EXAMPLE 3.1: The differences between a positive theory and a normative theory

REQUIRED What are the main differences between a positive theory and a normative theory?

SOLUTION A positive theory is a theory that, based upon various assumptions, explains and/or predicts particular events, for example, the choice by a manager to disclose particular information. The ‘worth’ of a positive theory is typically assessed on the basis of empirical observation—that is, whether the predictions of the theory are subsequently consistent with the available evidence.

By contrast, a normative theory is a theory that prescribes particular actions, for example, that managers should disclose particular information to certain stakeholders. The prescriptions will be based upon the beliefs or values of the researcher and might represent significant departures from current practice.

WhY DO I NEED TO KNOW ABOUT SOME ThEORIES ThAT PERTAIN TO ThE PRACTICE OF FINANCIAL REPORTING?

Theories allow us to ‘make sense’ of the world in which we live by providing a framework (or a logical basis) to explain what might be occurring at a point in time, or what actions should be implemented at a particular time to achieve particular desired outcomes.

As students of accounting, we arguably need to understand such issues as why managers might select particular approaches to accounting when they have choices available, or why they should select particular accounting methods, as well as understand some possible implications that might flow from the reporting decisions made by managers, or the regulatory decisions made by accounting standard-setters. Theories can provide such insights.

dee67382_ch03_099-158.indd 104 10/24/19 12:47 PM

104 PART 2: Theories of accounting

3.2 Positive Accounting Theory

The first theory we will consider is Positive Accounting Theory. The name Positive Accounting Theory (PAT) can in itself cause confusion. As we now know, 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.

According to Watts (1995, p. 334), the use of the term ‘positive research’ was popularised in economics by Friedman (1953) and was used to distinguish research that sought to explain and predict from research that aimed to provide prescription. Positive Accounting Theory, the theory that was popularised by Watts and Zimmerman, is one of several positive theories of accounting. Legitimacy Theory, Institutional Theory and Stakeholder Theory, all discussed in this chapter, are 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 certain classes of stakeholders 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 relationships involve the delegation of decision making from one party (the principal) to another party (the agent): this is referred to as an agency relationship.

The delegation of decision-making authority can lead to a loss of efficiency and, consequently, increased costs. For example, if the 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. This arguably is not a very ‘favourable’ perspective of humankind, but it is perhaps consistent with the damage we see caused to the environment, and to various societies, by large organisations in their pursuit of profits and greater personal wealth. Notions of loyalty and morality are not incorporated within PAT (nor in many other accounting theories). Organisations are considered collections of self-interested individuals who have agreed to cooperate. Such cooperation does not mean 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.

Positive Accounting Theory (PAT) Theory that seeks to explain and predict accounting practice.

agency relationship Involving the delegation of decision making from the principal to an agent.

LO 3.2

dee67382_ch03_099-158.indd 105 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 105

Given the assumption (again, borrowed from economics literature) that self-interest drives individual actions— an assumption that is disdained by many accounting researchers, and particularly those with concerns about social and environmental sustainability, 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 financial statements to be audited or monitored. Otherwise, assuming self-interest, 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.

Various bonding and monitoring costs might be incurred to address the agency problems that arise within an organisation. If it was assumed, contrary to the assumption of ‘self-interest’ 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).

3.3 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 throughout the world 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 the organisation’s resources to prepare financial statements and have them audited). As a result of the audit, external parties have more 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 as much 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 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.

monitoring cost Cost incurred monitoring the performance of others.

LO 3.3

dee67382_ch03_099-158.indd 106 10/24/19 12:47 PM

106 PART 2: Theories of accounting

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—typically by managers—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 profits even though it might not reflect the actual use of the asset (this can be referred to as an example of ‘earnings management’). 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 embraces the rather pessimistic assumption 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 debtholders 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 greatest economic benefits for themselves (the opportunistic perspective).

3.4 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). Further, because of their position within the firm, managers will have access to information that

LO 3.4

perquisite consumption Consumption by employees of non-salary benefits.

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

dee67382_ch03_099-158.indd 107 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 107

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:

∙ 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 (like the debtholders) 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 because, unlike equity owners whose share of the firm might increase in value, the managers receiving fixed returns will not directly share in any potential gains. 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. Almost all organisations have some form of accounting-based bonus schemes in place.

Bonus schemes generally It is common for managers to be rewarded in terms of:

∙ the profits of the organisation (sometimes after adjustments to exclude some expenses, such as interest and taxes), or on the basis of the profits generated by particular sub-units, or divisions, of an organisation, and/or

∙ on the basis of the sales of the organisation, or sales generated by a component of the organisation, and/ or ∙ on the basis of some measure pertaining to return on assets.

That is, it is common to find that managers’ 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). 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 can affect the bonuses paid. Such changes can

bonus scheme Where the manager receives a bonus that is tied to the performance of the organisation.

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

dee67382_ch03_099-158.indd 108 10/24/19 12:47 PM

108 PART 2: Theories of accounting

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 an accounting standard issued by the IASB—IFRS 15 Revenue from Contracts with Customers (with the Australian equivalent being AASB 15)—affected the timing of when many organisations recognise revenue and this in turn would affect bonuses tied to corporate sales or profits. As another example, consider the consequences if a new rule is issued that requires all research and development expenditure to be written off. (For organisations that apply IFRSs, 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 that changing an accounting rule that affects a measure used within a contract negotiated by the firm might consequently change the value of the firm (through changes in related cash flows). Positive Accounting Theory would argue that if a change in accounting policy had no impact on the cash flows of the firm, the management of the firm would be indifferent to the change.

Incentives to manipulate accounting numbers 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 numbers owing to the presence of accounting-based bonus schemes (that is, they adopt an opportunistic perspective). He found that when schemes existed that rewarded managers after a pre-specified level of profit had been reached, managers would adopt accounting methods consistent with maximising that bonus. In situations where the profits were not expected to reach the minimum level required by the plan, managers appeared to adopt strategies that further reduced profit in that period (frequently referred to as ‘taking a bath’). This leads to higher profit 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. Research has also shown that large asset write-offs (impairment losses) often follow the replacement of chief executive officers, with new CEOs blaming the losses on the past CEOs and taking credit for the improvements in profits that follow.

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 profits in early years, yet still represent the best alternatives available to the firm.

Rewarding managers on the basis of accounting profits (calculated for just one year and, therefore, short term in orientation) 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 countries that have adopted IFRSs). 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

generally accepted accounting principles Body of conventions, rules and procedures that are generally applied by accountants.

accounting-based bonus scheme Employee remuneration scheme where employees receive a bonus tied to accounting numbers.

dee67382_ch03_099-158.indd 109 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 109

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/profits 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 of expected future cash flows. This can be done either by basing a cash bonus on any increases in share prices or by providing managers with shares or options to shares in the firm. If the value of the firm’s shares increases, both managers and owners will benefit and, importantly, managers will be given an incentive to increase the value of the firm.

As with accounting-based bonus schemes, there are problems associated with managers being rewarded in terms of share price movements. First, the share price will not only be affected by factors 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, 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. As a rather extreme example of how news of events beyond the control of the manager can impact an organisation’s share price, there have been instances where it has been wrongly reported within the news media that well-known senior executives have died (when they had not) and this has caused share prices to sharply fall.

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 profits in those firms where:

∙ share returns are relatively more sensitive to general market movements (relatively noisy) ∙ profits have a high association with firm-specific movement in the firm’s share values ∙ profits 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.

net present value The difference between the present value of the future cash inflows and the present value of the future cash outflows relating to a particular project or object.

dee67382_ch03_099-158.indd 110 10/24/19 12:47 PM

110 PART 2: Theories of accounting

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 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.

Worked Example 3.2 provides an example of how we can apply PAT to explain a particular phenomenon—in this case the introduction of a bonus plan.

WORKED EXAMPLE 3.2: Understanding aspects of managerial bonus plans by applying PAT

Quad Fin Company has a bonus plan that rewards the general manager by providing her with a bonus equal to 5 per cent of reported profits.

REQUIRED

(a) Briefly explain using the efficiency perspective of Positive Accounting Theory why the bonus plan was put in place.

(b) Briefly explain using the opportunistic perspective of Positive Accounting Theory whether the general manager could be motivated to try to inflate reported profits.

SOLUTION

(a) Positive Accounting Theory would suggest that the bonus plan was put in place to encourage the general manager—through an economic incentive—to work hard to maximise the profits of the organisation, and therefore also maximise the economic interests of the owners of the organisation. Higher profits are assumed to be in the interests of the owners. The bonus plan would be seen as a mechanism to efficiently align the (self) interests of the owners, and the managers.

(b) Once the bonus plan is in place, to the extent that the general manager can ‘get away with it’, it would be assumed that she will opportunistically attempt to manipulate the reported profits in order to generate the greatest economic benefit to herself.

LO 3.5 3.5 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 to owners (shareholders), 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

dee67382_ch03_099-158.indd 111 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 111

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 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 bond/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 the organisation and one other 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 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) 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 (and total owners’ equity). 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

dee67382_ch03_099-158.indd 112 10/24/19 12:47 PM

112 PART 2: Theories of accounting

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 national accounting standard-setters, such as 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 (the Australian equivalent being AASB 15) 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 .  .  . 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 than 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 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 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:

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.

dee67382_ch03_099-158.indd 113 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 113

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 income-increasing strategies (which also act to increase assets) compared with managers in firms that are not approaching technical default of accounting-based debt covenants. Income-increasing 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 profit- increasing requirements early, and deferred the adoption of accounting methods that would lead to a reduction in reported profits. 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 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 for particular items and, thus, to minimise the effects of existing accounting-based restrictions. Therefore, it might appear optimal for debtholders to stipulate in advance all accounting methods that management must use. However, and as noted previously, it would be too costly and impractical to write ‘complete’ contracts up front. As a consequence, management will always have some 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 (gearing) 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 covenants. Failure to comply with these negotiated covenants (often referred to as a ‘technical breach’ of a covenant 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.

debtholder External party with a claim against an organisation for the repayment of funds previously advanced.

leverage (gearing) Measure of the amount of debt issued by an entity. The greater the use of debt the greater the gearing.

debt covenant Restriction within a trust deed/debt contract on the operations of a borrowing entity.

dee67382_ch03_099-158.indd 114 10/24/19 12:47 PM

114 PART 2: Theories of accounting

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’.

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 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.

3.6 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; Wong 1988; Deegan & Hallam 1991) that the demands placed on firms by interest groups might be affected by the accounting results of the firm. For example, if a firm

records high profits, this might be used as a justification or an excuse for trade unions to take action to increase their members’ share of the profits in the form of increased wages. Publicity, such as media coverage, is not typically given to the accounting methods used to derive particular accounting numbers. Rather, attention 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 proposing the levying of 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.

LO 3.6

political costs Costs that groups external to the firm might be able to impose on the firm as a result of political actions.

dee67382_ch03_099-158.indd 115 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 115

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 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 its 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.

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.

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’ (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 self- interest. 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. 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

dee67382_ch03_099-158.indd 116 10/24/19 12:47 PM

116 PART 2: Theories of accounting

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 ‘short-sighted’ 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.

WhY DO I NEED TO KNOW ABOUT ThE INSIGhTS PROVIDED BY PAT?

Even though PAT is often criticised because of the very negative perspective it embraces with respect to what motivates people (that is, that people are primarily motivated by wealth-maximising self-interest), it does provide useful insights into how numbers generated by financial reporting are used in contractual arrangements negotiated between various stakeholders, such as between owners, managers and debtholders. It also provides a basis for understanding why ‘creative accounting’ might occur and for understanding why and how financial accounting measures, such as profits, are used by different groups in order to justify certain actions being taken against an organisation.

Earnings management We can relate some of the above material from PAT to what is now commonly referred to as ‘earnings management literature’. Where managers and their accountants adopt particular accounting policies, or make particular accounting- based decisions primarily to generate desired measures of profits/earnings, this is often referred to as earnings management. Earnings management can also occur through managers deciding to undertake, or not undertake, certain transactions primarily because of the way those transactions will influence reported profits.

Earnings management can be done to influence the perceptions that some stakeholders might have about an organisation, or to impact certain economic outcomes that are linked to financial accounting numbers. According to Schipper (1989), earnings management occurs when managers use the flexibility inherent within accounting standards to manage an organisation’s reported accounting profits in order to influence some economic outcome to the organisation’s benefit. One of the key factors that drives earnings management is the pressure on managers to report sound short-term performance (profits).

As indicated above, earnings management can be, and often is, undertaken as a result of making (or deferring) various discretionary accruals of income or expenses (often referred to as ‘accrual-based earnings management’), or it can come about as a result of selectively undertaking actual transactions near the end of the financial year (sometimes referred to as ‘real earnings management’). In this regard, and according to Zang (2012), accrual-based earnings management and real earnings management can both be employed by an organisation depending upon the relative costs and benefits of each type of earnings management, with the costs of accrual-based earnings management increasing with the existence of stronger outside monitoring. In this regard, Anagnostopoulou and Tsekrekos (2017) provide evidence that in the presence of high levels of leverage/debt (or changes in debt), the trade-off between real earnings management and accrual-based earnings management turns into a ‘complementary effect’. This evidence is interpreted as an indication that very high leverage is typically accompanied by strong outside scrutiny, making it necessary for firms to use real earnings management in combination with accrual-based earnings management to be able to achieve particular earnings targets. Such findings are deemed to provide evidence that an environment of

dee67382_ch03_099-158.indd 117 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 117

increased monitoring and scrutiny supports a preference by managers for real earnings management as opposed to accrual-based earnings management.

Various organisation-based factors, including internal governance practices, have been found to affect the incidence and type of earnings management employed by managers. For example, it has been argued that the longer the expected remaining working life of senior managers, the less the likelihood that the managers will focus opportunistically on short-term performance. Conversely, the shorter the remaining expected working life of a senior manager, the greater the likelihood of a manager making decisions that generate profits (and rewards to the manager) in the short term. According to Cheng, Lee and Shevlin (2016), senior managers below the level of CEO—who are expected to have a longer remaining working life, which motivates them to care more about long-term value of the organisation—are expected to be less likely to support activities that sacrifice long-term positive net present value investments to meet short-term earnings targets. Conversely, CEOs would typically have fewer years left in their working life and would be relatively more in favour of earnings management that generates higher short-term performance measures. Further, Cheng et al. (2016) also argue that the more influence that key subordinate executives have, the more effective the internal governance will be, and the less likely it is that the company will engage in activities for the sake of impacting short-term profits. However, this ability to reduce the propensity of an organisation to engage in transactions aimed at increasing short-term profits will be reduced the greater the power and authority of the CEO within the organisation. Cheng et al. (2016) also argue that firms that are about to issue debt or equity will benefit more from beating earnings benchmarks or targets as this can increase the ultimate proceeds from debt/equity financing. Therefore, subordinate managers will have weaker incentives to constrain earnings management when an organisation is about to go to the capital market to raise debt or equity.

Research has also shown that managers will undertake earnings management to influence government investigations. This is consistent with our earlier discussion of ‘political costs’. Godsell, Welker and Zhang (2017) examine the earnings management of European Union organisations around the time of the European Union undertaking anti- dumping trade investigations. Accounting data is collected as part of these investigations. ‘Dumping’ is deemed to occur when foreign exporters sell goods into the EU at prices lower than the respective goods’ normal prices when sold in the exporting country market. If dumping is seen to occur, and if it is apparent that the domestic industry has suffered financial injury (perhaps reflected by lower reported profits), then action can be taken against the organisation selling the goods into the EU, inclusive of additional taxes/duties being imposed. Specifically, the EU compares accounting data prior to the initiation of the claim with accounting data in the year and, in some cases, the year after or before the investigation is started.

Godsell et al. (2017) explain that EU firms petitioning for trade remedies in anti-dumping investigations have incentives to engage in profit-decreasing earnings management in the year of, and year subsequent to, their application for trade relief. The results of their study support this view and are consistent with the view that the petitioning organisations manage earnings in a downward direction to enhance their apparent injury from overseas dumping of products into their country, and increase their probability of success in having action taken against the foreign organisation. However, the authors also find that organisations that are about to raise new debt or equity in the year of, and/or the year after the initiation of anti-dumping investigations, moderate the extent to which they embrace decreasing earnings management.

In other related research, Liu, Subramanyam, Zhang and Shi (2018) investigate potential earnings management undertaken by organisations that have been placed on a ‘negative credit watch’. A credit watch occurs when ratings agencies (which provide ratings of various organisations’ credit-worthiness) place particular organisations (that are rated, and which are generally very large) with uncertain changes in credit risk under a formal review process. The organisation is notified by the ratings agency and is placed ‘on watch’ when a downgrade is likely, but not certain. Liu et al. (2018) argue that organisations under negative credit watch have a strong incentive to manage earnings because downgrades in ratings have significant economic implications and because uncertainty in the watch resolution encourages managers to influence the outcome. Liu et al. (2018) find evidence of significant income-increasing accrual management by negative watch firms during the watch period. Further, the income-increasing earnings management is significantly higher than in the respective pre- and post-credit watch periods. Further still, the results indicate that the earnings management during the negative watch favourably influences the outcome of the watch resolution, thereby suggesting that sophisticated users of accounting reports—such as ratings agencies—are actually influenced by opportunistic earnings management. That is, the impacts of the earnings management are not ‘unravelled’ even by such sophisticated users of accounting information.

The presence of strong labour unions has also been found to influence the use of earnings management, with managers often trying to use methods to reduce reported income in an endeavour to reduce unions’ ability to justify calls for higher wages for their members. Further, Hamm, Jung and Lee (2018) also argue that organisations with strong labour unions will adopt accounting strategies that tend to reduce the volatility of reported profits. Employees

dee67382_ch03_099-158.indd 118 10/24/19 12:47 PM

118 PART 2: Theories of accounting

(like debtholders) are deemed to perceive volatile employer earnings as a sign that the organisation is at higher risk of failure and therefore is a higher risk. As compensation for the higher risks associated with potentially losing their jobs, employees will generally demand higher wages. The success of such demands is proposed to be linked to the strength of the labour union to which the employees belong. Consequently, Hamm et al. (2018) predict that managers dealing with a stronger labour union have a greater incentive to avoid reporting volatile earnings and they do this by using various accounting accruals in a way that effectively ‘smooths’ reported profits. The results of their study support the prediction.

While relatively brief, this discussion of earnings management hopefully emphasises the point that accounting numbers, like profits, are used in a variety of ways and, as a result, managers often have incentives to opportunistically manipulate such numbers. This further highlights the fact that we need to have some healthy scepticism when reviewing an organisation’s financial reports.

Worked Example 3.3 considers some incentives associated with earnings management.

WORKED EXAMPLE 3.3: Implications associated with the timing of income and expense recognition

The reported profits of an organisation will be impacted by various factors, including when particular transactions and events are recognised, and how such transactions and events are measured.

REQUIRED Why would managers, especially those who work within large organisations, care about the timing of when income or expenses are recognised?

SOLUTION Obviously, whether and how income and expenses are recognised will in turn impact profits. From an objective perspective, managers should be concerned that income is recognised when it has actually been earned and expenses are recognised when they have been incurred (and when there have been related changes in assets and/or liabilities). In terms of why managers might care about when profit is recognised, there are many reasons, including the following:

• The news media pay a lot of attention to the profits of larger organisations. Many stakeholders have an interest in these profits and, rightly or wrongly, interpret them as a key measure of the ‘success’ of an organisation. Therefore, because of the attention managers believe profit attracts, they might generally prefer to disclose higher profits. The higher profits might indicate that managers have been performing their duties well. However, as we have already noted, high profits can be used by some stakeholders as an excuse to argue that the organisation is making excessive profits, and that it should decrease the prices it charges for its goods or services and/or increase the payments it makes to its employees.

• It is common for managers to receive bonus payments that are linked to profits. For example, the managers might receive a fixed salary plus a bonus that comprises a specified percentage of profit. Because managers would prefer to receive a bonus now rather than later (the present value of a dollar received now is greater than the present value of a dollar received later), managers who have been offered an accounting-based bonus will typically prefer that income (and profits) be recognised earlier than later, and expenses be deferred. However, if the managers believe they will not reach the target level of profits required for a bonus to be paid, they might prefer to defer the recognition of income until the following year, so as to help reach next year’s target and enable a bonus to be paid.

• Organisations that borrow funds often sign debt contracts that include clauses (debt covenants) that are linked to accounting numbers. As we know, managers agree to these contracts because they allow the organisation to attract debt funds at a lower cost, as they provide safeguards to lenders. For example, the debt contract might have a requirement that profits must be maintained at a certain level (for example, a specific multiple of total interest costs)—thereby providing a margin of safety that the debtholders will receive the required interest payments—or that a certain level of profit is earned before dividends can be paid to owners. If organisations are close to breaching these contractual requirements, managers will potentially be motivated to recognise income as early as possible so as to ensure compliance with the restrictive covenants.

We could give many more reasons as to why managers might care about when income and expenses are recognised, but the point to be made again is that profit is a number that attracts much attention, and it is used within many agreements to which an organisation is party. It is a measure of performance that is of interest to many stakeholders. Therefore, the timing of the recognition of income and expenses is an issue that managers do care about.

dee67382_ch03_099-158.indd 119 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 119

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 managers 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 managers 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 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 As noted earlier in this chapter, a firm might be involved in many agreements that use accounting numbers 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 measuring 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 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. (AASB 101)

In explaining the above requirement, paragraph 118 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. (AASB 101)

dee67382_ch03_099-158.indd 120 10/24/19 12:47 PM

120 PART 2: Theories of accounting

Paragraph 119 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. (AASB 101)

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 Accounting Policies, Changes in Accounting Estimates and Errors 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 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. (AASB 108)

3.7 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. (AASB 108)

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 ∙ 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

LO 3.7

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.

dee67382_ch03_099-158.indd 121 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 121

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 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!

WhY DO I NEED TO KNOW ABOUT ThE CONCEPT OF ‘CREATIVE ACCOUNTING’?

According to the Conceptual Framework, general purpose financial reports should provide a representationally faithful portrayal of the transactions and events that have affected the assets and liabilities (and therefore, the equity) of a reporting entity. This means that the depiction of the transactions and events should be complete, neutral and free from error. This in turn means the information is not biased, and there are no material omissions of data.

While this is an ideal, the reality is that this does not always occur. Because of private economics-based incentives, managers with the assistance of accountants will, from time to time, manipulate reported financial information to provide an outcome that is beneficial to the organisation, its managers and also potentially the shareholders. They will often do this ‘creatively’ such that it might not be clear to others that the information has been manipulated through creative accounting. As readers of financial statements, it is important for us to know that creative accounting does occur, and to understand why it might occur and how it might occur. To believe that all financial reports are prepared objectively would be naive.

dee67382_ch03_099-158.indd 122 10/24/19 12:47 PM

122 PART 2: Theories of accounting

3.8 Some criticisms of Positive Accounting Theory

Although PAT received fairly widespread acceptance from a large group of accounting academics, there are nevertheless many researchers who opposed its fundamental tenets. Deegan (1997) 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 (1997). Some of the rather unflattering descriptions of PAT, made by well-regarded accounting academics, have included:

LO 3.8

It is a dead philosophical movement. (Christenson 1983, p. 7)

It has provided no accomplishments. (Sterling 1990, p. 97)

It is marred by oversights, inconsistencies and paradoxes. (Chambers 1993, p. 1)

It is imperiously dictatorial. (Sterling 1990, p. 121)

It is empty and commonplace. (Sterling 1990, p. 130)

It is akin to a cottage industry. (Sterling 1990, p. 132)

It is responsible for turning back the clock of research 1000 years. (Chambers 1993, p. 22)

It provides evidence of doubtful value. (Williams 1989, p. 456)

It suffers from logical incoherence. (Williams 1989, p. 459)

It is a wasted effort. (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 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. (From STERLING, R.R., ‘Positive Accounting: An Assessment’, Abacus, vol. 26, no. 2, p. 130 (c) 1990. Reproduced with permission of John Wiley & Sons Ltd)

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.

dee67382_ch03_099-158.indd 123 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 123

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 accounting-based debt covenants will adopt accounting methods that increase the firms’ 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 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. (STERLING, R.R.,1990. Reproduced with permission of John Wiley & Sons Ltd).

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

dee67382_ch03_099-158.indd 124 10/24/19 12:47 PM

124 PART 2: Theories of accounting

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.

3.9 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

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 developed by the IASB and 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 Conceptual Framework, 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 relating to providing resources to the entity. Those decisions involve decisions about:

(a) buying, selling or holding equity and debt instruments; (b) providing or settling loans and other forms of credit; or (c) exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s

economic resources.

This objective serves as a foundation for the various components that form the Conceptual Framework Project. 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

LO 3.9

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

dee67382_ch03_099-158.indd 125 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 125

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.

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.

Worked Example 3.4 provides an illustration explaining why a particular theory might be considered to be normative in nature.

WORKED EXAMPLE 3.4: The Conceptual Framework as a normative theory of accounting

The Conceptual Framework is an important framework for general purpose financial reporting.

REQUIRED Explain why the Conceptual Framework is considered to be a normative theory of accounting.

SOLUTION First, we can consider it to be a theory because it has been carefully developed based on clear assumptions about the objectives of general purpose financial reporting, the users of such reports and their level of expertise. These assumptions all link together to provide various prescriptions that are logically derived. While there will be various people who disagree with some, or many, aspects of the Conceptual Framework, the framework is nevertheless coherent and provides a clear framework for general purpose financial reporting. It certainly represents much more than a ‘hunch’ about how to report.

It is a normative theory because it provides prescription about how general purpose financial reporting should be undertaken. It does not seek to predict or explain practice, as would a positive theory.

dee67382_ch03_099-158.indd 126 10/24/19 12:47 PM

126 PART 2: Theories of accounting

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:

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 current-cost 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 Behavior, released 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 also 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

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.

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.

capacity to adapt A measure, promoted by Chambers, tied to the cash that could be obtained if an entity sold its assets.

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

dee67382_ch03_099-158.indd 127 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 127

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 on the researcher’s own perceptions about what information is necessary for efficient decision making. (By contrast, an approach that develops models based on asking other individuals what information they seek, perhaps through using questionnaires, would be referred to as a decision-makers emphasis.) Chambers’ decision-models approach considers the decision-making requirements of 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 recorded at their current cash equivalents. Current cash equivalents were represented by the amounts expected to be generated by selling the assets. The net sales or exit prices were to be determined on the basis of an orderly sale. Within the model, the balance sheet should clearly show the expected net selling prices of all of the entity’s assets—net selling prices would acknowledge any costs that would be incurred in making a sale. Adaptive capital would be represented by the 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, 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

current cash equivalents Represented by the amount that would be expected to be generated by selling an asset.

dee67382_ch03_099-158.indd 128 10/24/19 12:47 PM

128 PART 2: Theories of accounting

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. The deprival value of an asset to be reported in the financial statements would be determined by considering: the net selling price of the asset; the present value of the future cash flows that the asset will generate; or the asset’s current replacement cost. The deprival value is the lower of current replacement cost and the greater of the net selling price and present value (value in use). 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 adopt this form of accounting would require all assets and liabilities to be considered separately in terms of their deprival value to the business.

Some criticisms of deprival-value accounting have included the concern that different valuation bases would be used within a single financial statement—such as selling prices, present- value 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 might have to be used for particular assets. It might also not be clear which valuation approach should be adopted for a particular type of asset.

The aim of the above brief discussion of three different normative theories of accounting (which tell us how we should account) is to show the difference between normative and positive theories of accounting.

The following discussion focuses on yet another group of theories, classified as systems-oriented theories.

3.10 Systems-oriented theories to explain accounting practice

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

that try to explain why certain phenomena occur 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 & 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; Deegan 2019), from an Institutional Theory Perspective 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:

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 (or as it is also referred to, a ‘general systems theory’ 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.

According to Gray, Adams and Owen (2014, p. 17), a system is a conception of a part of the world that recognises explicitly that the part is (a) one element of a larger whole with which it interacts (that is, it influences and is itself influenced by); and (b) also contains other parts that are intrinsic to it.

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

present value The value of an item to be received or paid for in the future expressed in terms of its value today.

current replacement cost A valuation method based on the current replacement cost of an item rather than its historical cost.

LO 3.10

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.

net selling price The selling price of an item less the costs that are incidental to making the sale.

dee67382_ch03_099-158.indd 129 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 129

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

The public

Investors

Suppliers

GovernmentMedia

Consumers

Industry bodies

Employees

Interest groups

The organisation

social-responsibility disclosures Disclosures of information about the interaction of an organisation with its physical and social environment.

(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 accounting techniques.

Social-responsibility disclosures themselves can relate, among other things, to information about the interaction of an organisation with its physical and social environment, including the community, the natural environment, human resources, energy and product safety. Stakeholder Theory, Legitimacy Theory and Institutional Theory will be discussed in greater detail in Chapter 32, which considers social disclosures. However, as this chapter considers accounting-related theories, some attention here is warranted. We will briefly consider Stakeholder Theory, Legitimacy Theory and Institutional Theory in turn below.

3.11 Stakeholder Theory

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

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

LO 3.11

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

dee67382_ch03_099-158.indd 130 10/24/19 12:47 PM

130 PART 2: Theories of accounting

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 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 strategies 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

dee67382_ch03_099-158.indd 131 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 131

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 or a sustainability 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 legislate particular disclosures.

Diverse stakeholders and the production of ‘multiple accounts’ (or ‘dialogic accounts’) Following on from the above material, different stakeholder groups will probably have different views about the responsibilities and accountabilities of an organisation. Different stakeholder groups will also probably have different information demands because of different interests in the various aspects of the operation and performance of an organisation.

All forms of accounting typically involve an element of judgement by those making the disclosures, and this is even more so when the form of reporting is largely unregulated, as is the case with much social and environmental/ sustainability reporting (which we address in Chapter 32). Therefore, the managers of an organisation might—through their disclosures—provide a particular perspective of their organisation’s performance (potentially a partisan or biased perspective), but such perspectives of performance might not be shared by other stakeholder groups. Realistically, there could be an element of bias to the reporting being undertaken. For example, financial reporting—which is the focus of this book—provides information that is believed to be particularly relevant to investors, lenders and creditors. Other categories of stakeholders might not be as interested in such information, but might be interested instead in different aspects of the organisation’s performance.

However, there is some argument that when organisations prepare their corporate social responsibility/sustainability reports, and particularly where there are contested perspectives about an organisation’s social and environmental performance (that is, where different stakeholders do not share the same view as management about how ‘well’ the organisation is performing), then the alternative views held by other stakeholders should arguably also be included within the reports being released by the organisation. For example, if an organisation produces social information relating to how it has advanced the interests of its employees, possibly through implementing various educational or training initiatives, or by introducing policies that assist in the employment of people with disabilities, it might also be useful to provide the views of particular labour union officials—who are stakeholders other than management—about whether they also believe the organisation has been successful in promoting the interests of employees.

Brown (2009) provides an insightful discussion of this possibility, referring to the concept of dialogic accounting and focusing on the sustainability area for illustrative purposes. By dialogic accounting, Brown is referring to a situation in which there is typically more than one ‘logic’ that could be employed to assess and subsequently report information about organisational performance, and these different logics (based on different perspectives about what aspects of performance are important, or not, to different stakeholders) could be used to develop different forms of ‘accounts’. Producing dialogic accounts encourages debate and enhances the possibilities for revisions in how managers manage the organisation.

Brown (2009) provides an interesting comparison of dialogic accounting with monologic accounting—monologic accounts represent only one view or logic, this being that of the managers. As she explains, monologic accounting reflects the accounting traditions currently in place, wherein only the manager’s perspective of performance is reported

dee67382_ch03_099-158.indd 132 10/24/19 12:47 PM

132 PART 2: Theories of accounting

to external stakeholders. This is the approach to reporting to which we are accustomed and which is traditional. That is, it is the reports prepared and endorsed by managers that are provided to the stakeholders of an organisation. However, according to Brown, the non-reporting of other stakeholders’ perspectives inevitably provides bias in situations where there are conceivably alternative viewpoints.

According to Brown (2009, p. 317), dialogic accounting, in recognising the existence of different views of organisational performance, allows for a situation where different and sometimes conflicting views are allowed to coexist. Pursuant to this view, corporate reporting could become a vehicle to foster democratic interaction. The aim of dialogic accounting is not necessarily to replace one dominant form of accounting with another, but rather to encourage the development and use of more multidimensional accounting and accountability systems, capable of engaging a variety of perspectives and facilitating wide-ranging discussion and debate about organisational matters. This is a very interesting suggestion, one that runs counter to the views often proffered by many accounting practitioners and researchers, wherein there is presumed to be only one view of the world that can be captured by managers and objectively reflected within accounting reports. As Brown (2009, p. 318) states:

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 nonexperts; ensure effective participatory processes; be attentive to power relations; and recognise the transformative potential of dialogic accounting.

According to Brown (2009), a form of accounting that embraces a dialogical approach will have considerable transformative potential in areas such as sustainable development. Again, the views embodied by Brown (2009) would seem to be of great value in informing debate to extend corporate accountability, and to project different views about corporate performance and success. However, despite its merits, it is probably unlikely that the current monologic practices, which tend to dominate reporting practices, will be displaced any time soon by dialogical approaches.

WhY DO I NEED TO KNOW ABOUT ThE INSIGhTS PROVIDED BY STAKEhOLDER ThEORY?

Stakeholder Theory can be broken down into two broad branches, both of which can provide valuable insights. The ethical branch of Stakeholder Theory prescribes that all stakeholders have rights, including the right

to information, regardless of whether they have ‘power’. The more they are impacted by the operations of an organisation, the more consideration that should be given to the demands and expectations of the stakeholder. It is important that all stakeholders are treated ethically, and a knowledge of the insights provided by the ethical branch of Stakeholder Theory reinforces to us the need to think in an ethical way about different stakeholders.

The managerial branch of Stakeholder Theory seeks to explain the actions of managers, including their reporting decisions. Under this branch of Stakeholder Theory, managers are generally predicted to respond to the demands and expectations of those stakeholders most able to impact the operations of the organisation (those that have ‘power’). Knowledge of this branch of Stakeholder Theory is useful to us in understanding why managers might be making some disclosures and not others.

WORKED EXAMPLE 3.5: Identification of stakeholders and their information needs

Organisations are often said to have many and varied stakeholders with different information demands.

REQUIRED

(a) Who is a stakeholder? (b) How will the managers of an organisation determine what information to disclose to which stakeholders?

Worked Example 3.5 is an illustration that applies a consideration of stakeholders to the decision to report information.

dee67382_ch03_099-158.indd 133 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 133

SOLUTION

(a) We defined a stakeholder earlier as ‘any group or individual who can affect or is affected by the achievement of the firm’s objectives’. Some stakeholders will have power over the organisation, others will not.

(b) The answer to this is linked to the responsibilities and accountabilities that managers accept towards the stakeholders of an organisation. If managers are preoccupied with satisfying the information demands of powerful stakeholders, they will simply determine, through some form of engagement, what information the powerful stakeholders want, and supply that. However, if managers take a more ethical perspective towards their stakeholders, they will think about the impacts created for, or to, a wider group of stakeholders and will provide a variety of information about the various economic, social and environmental impacts upon those stakeholders together with information about what is being done to address or control such impacts.

LO 3.12 3.12 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 ‘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 time-specific 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’. That is, they rely on the notion that there is a social contract between an organisation and the society in which it operates. An organisation is deemed to be operating with ‘legitimacy’ when its operations are perceived by society to be complying with the terms or requirements of the ‘social contract’. The social contract is not easy to define, but the concept is used to represent the multitude of implicit and explicit expectations that society has about how an organisation should conduct its operations. The law is considered to provide the explicit terms of the social contract, while other, non-legislated 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

Legitimacy Theory Theory which proposes that organisations always seek to ensure that they operate within the bounds and norms of their societies.

social contract Considered to be an implied contract constituted by the expectations that society holds about the conduct of an organisation.

dee67382_ch03_099-158.indd 134 10/24/19 12:47 PM

134 PART 2: Theories of accounting

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.

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 many 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.

In a more recent newspaper article addressing banks, and following the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (also known as the Hayne Royal Commission), it was reported in an article entitled ‘Greed defined but little else to report’ (by Adele Ferguson, The Sydney Morning Herald, 29 September 2018, p. 13) that:

Australians have waited years for a royal commission. Customers ripped off by the banks have waited even longer as the banks dragged their heels on remediation programs and made low-ball offers. This misconduct has been going on for years. There is nothing new in that.

A decade ago Commonwealth Bank whistleblower Jeff Morris became a financial planner and encountered a culture focused on sales and profits. As Hayne found, ‘It was at the expense of basic standards of honesty.’ Morris found that profits equalled greed due to metricated bonuses at all levels. The same was going on at the other banks. They had become sales machines and by doing so they had broken their social contract with their customers and callously destroyed lives.

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.

dee67382_ch03_099-158.indd 135 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 135

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 self-interest (tied to wealth maximisation), and it emphasises how the organisation is part of the social system in which it operates.

A number of studies, five of which are described briefly below (relevant studies will be discussed more fully in Chapter 32), 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. 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 EPAs’ 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

dee67382_ch03_099-158.indd 136 10/24/19 12:47 PM

136 PART 2: Theories of accounting

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 recognized symbol of legitimacy. (Reprinted from 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, with permission from Elsevier).

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. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier).

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 then responded to the legitimacy crisis by providing disclosures within their annual report that focused particularly on working conditions and the use of 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 started 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.

In related research, Deegan and Islam (2014) show how various social and environmental interest groups (NGOs) use contacts within the news media as part of their strategy to bring particular social and environmental issues to the attention of the community, thereby hoping to create some change in the social and environmental practices applied by organisations.

WhY DO I NEED TO KNOW ABOUT ThE INSIGhTS PROVIDED BY LEGITIMACY ThEORY?

Legitimacy Theory is a theory that has been used to explain voluntary reporting, particularly the voluntary reporting by organisations of social and environmental information. What the application of the theory has shown is that managers frequently make disclosures to portray a view that their activities are conforming with community expectations. Also, the evidence shows that managers often respond to crises by reporting information to help maintain, or restore, the legitimacy of an organisation. As such, application of the theory seems to support the view that managers make certain disclosures for survival reasons and not necessarily because of a belief that they owe some level of accountability to stakeholders. This is an important insight.

dee67382_ch03_099-158.indd 137 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 137

Worked Example 3.6 applies Legitimacy Theory to explain why managers might make particular disclosures.

WORKED EXAMPLE 3.6: Explaining organisational disclosures from a Legitimacy Theory perspective

Following major crises or events of a social or environmental nature, organisations often respond by making a range of public disclosures in media such as annual reports or sustainability reports.

REQUIRED From a Legitimacy Theory perspective, why would managers make such disclosures?

SOLUTION Legitimacy Theory would suggest that disclosures will be made to bring legitimacy to an organisation. This is particularly important when it appears that the legitimacy of an organisation has potentially been eroded. As such, corporate disclosures are seen more as a strategy for corporate survival than as a mechanism for demonstrating accountability.

LO 3.13 3.13 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 ‘organisational 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 (2001, p. 565):

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). (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier).

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 Theory that considers the forms organisations assume and explains why organisations within particular ‘organisational fields’ tend to take on similar characteristics and forms.

Apart from Stakeholder Theory and Legitimacy Theory, another theory that embraces a systems-oriented perspective and which can be applied to analyse 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 often tend to become similar in their forms and practices.

dee67382_ch03_099-158.indd 138 10/24/19 12:47 PM

138 PART 2: Theories of accounting

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 the organisation and the practices adopted by different organisations tend to become similar to conform with what is considered to be ‘normal’ or ‘legitimate’. Organisations that deviate from the form that has become ‘normal’ or expected within certain institutional contexts 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. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier).

Dillard, Rigsby and Goodman (2004, p. 509) explain that ‘isomorphism refers to the adaptation of an institutional practice by an organization’. 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.

dee67382_ch03_099-158.indd 139 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 139

The company is therefore coerced (in this case usually informally) by its influential (or powerful) stakeholders into adopting particular 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. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier).

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 operating within the institutional environment. 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 mechanisms designed to

dee67382_ch03_099-158.indd 140 10/24/19 12:47 PM

140 PART 2: Theories of accounting

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. (Reprinted from 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), with permission from Elsevier).

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. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier).

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

dee67382_ch03_099-158.indd 141 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 141

nearly impossible to determine which form of institutional pressure was more potent in all cases. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier).

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, V. & FEROZ, E., (2001), with permission from Elsevier).

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. (CARPENTER, V. & FEROZ, E., (2001), with permission from Elsevier).

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 that is 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 stakeholders) as they provide a warning not to believe that public disclosures made

dee67382_ch03_099-158.indd 142 10/24/19 12:47 PM

142 PART 2: Theories of accounting

by organisations necessarily always reflect what is occurring within them. For example, just because an organisation publicly discloses various missions, values and policies which seem to indicate that the managers adopt the 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.

While Institutional Theory has been applied to explain why organisational structures and processes might take on similar forms, it has also been applied by some researchers to explain why particular processes might not work, or be applicable, within particular institutional settings. For example, governance policies or reporting practices that might work or be expected to be in place within a developed country context might not be appropriate within a developing country context. That is, we learn from Institutional Theory that there is a need when implementing particular reporting (and other) processes to consider the broader institutional context of each organisation (see, for instance, Tilt 2016, 2018). For example, greater consideration of the normative, cultural/cognitive and regulative influences in place within different social/institutional contexts, and how these different contexts then influence the propensity of managers to make (potentially legitimising) social and environmental disclosures, is warranted before it is suggested that particular policies that ‘work’ in one context should be applied in another.

As Tilt (2016, 2018) discusses, expecting particular reporting guidance, regulations or approaches that have been developed within a developed country context (with particular regulative, cultural/cognitive and normative influences) to work, or be embraced, within both a developed country context and a developing country context is rather naive. There can be different institutional pressures in the different contexts and this influences which practices the organisation will adopt—including reporting practices—and how those practices will be perceived by stakeholders within those institutional contexts.

As institutional contexts change, the acceptance of, and motivations for, particular disclosure approaches also likely change. Tilt (2016, 2018) specifically notes the need to recognise how contextual factors such as the level of economic development, extent of civil liberties, national focus on economic growth versus sustainability, level and type of government control, religion, government ideology, media freedom and prevailing language might impact the propensity to which managers elect to report various forms of social and environmental performance information.

Worked Example 3.7 applies Institutional Theory to explain why particular organisational practices might work in some institutional contexts but not others.

WORKED EXAMPLE 3.7: The application of Institutional Theory

It is often suggested that particular practices—such as specific reporting practices or occupational health and safety practices—that are applied in economically developed countries can be ‘exported’ and applied successfully within the context of developing countries.

REQUIRED From an Institutional Theory perspective, is it always sensible to expect something that works in a developed country context to also work within a developing country context?

SOLUTION No, it is not sensible. A developing country context will have a different regulatory environment (which might allow a high degree of non-compliance with the law), a different culture and a different perspective of professional conduct. To expect the rules and regulations that work in a developed country context to also work when exported to a different institutional environment is naive.

WhY DO I NEED TO KNOW ABOUT ThE INSIGhTS PROVIDED BY INSTITUTIONAL ThEORY?

Institutional Theory emphasises that the way organisations are structured and the way they operate is greatly influenced by the institutional environments in which they operate. Knowledge of this theory will emphasise to us that policies and procedures which are appropriate or legitimate in some institutional environments will not be appropriate or legitimate in others. This theory therefore provides important insights that enable us to understand why we should not expect certain policies—including reporting and auditing practices—to be appropriate in different industries, countries or cultures. The theory is also useful as it highlights that while certain structures might appear to be in place within an organisation in order to bring legitimacy, there might actually be a decoupling or disconnection between the apparent existence of such policies and procedures and the actual activities of the organisation.

dee67382_ch03_099-158.indd 143 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 143

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 utilises 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 3.1 Summary of theories described so far within this chapter

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 (or not 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 3.1.

dee67382_ch03_099-158.indd 144 10/24/19 12:47 PM

144 PART 2: Theories of accounting

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.

3.14 Theories that seek to explain why regulation is introduced

As indicated in Chapter 1, general purpose financial reporting—which is the focus of this book—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 or stakeholders 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 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:

LO 3.14

dee67382_ch03_099-158.indd 145 11/01/19 10:29 AM

ChAPTER 3: Theories of financial accounting 145

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.

As another possible example of industry capture, a newspaper article that appeared in The Australian on 17 July 2019 (by Michael Rodden, entitled ‘Overseas watchdogs can end “cosy” alliance’, p. 2) argued that senior representatives in the Australian Securities and Investments Commission (ASIC) became too close to the banking sector and as a result Australia’s corporate watchdog ‘too often failed to regulate the banking sector properly because they were captured by the industry’. The concerns were raised because many senior officers within ASIC were ultimately offered senior appointments within banking organisations, and therefore, knowing that banks would make such appointments, the senior ASIC officials were perceived to be less inclined to make tough decisions against the industry when acting as regulators, because to do so might mean they would be shunned from appointments on leaving ASIC.

In another related article entitled ‘Bank boards are full of former regulators’, which appeared in The Australian Financial Review on 23 October 2018 (by John Kehoe, p. 8), it was reported that Graeme Samuel, former chairperson of the Australian Competition and Consumer Commission, stated that Australian economic regulators are ‘at risk of capture from the financial services industry because of the potential lure of working in a highly paid and powerful job at a big bank in their post-public service career’. It was also reported that Samuel was of the view that:

there is a risk that regulatory personnel may pull their regulatory punches, knowing a future employer could be on the receiving end. Samuel said there was a danger of the ‘vulnerable regulator’—junior or senior—‘feeling the need to be liked’ and wanting to feel they are ‘mixing it with the big end of town’. ‘The most serious risk for regulators is industry capture,’ said Samuel. ‘Industry is adept at implementing regulatory capture strategies.’

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. (WALKER, R.G., (1987) Reprinted by permission of the publisher, Taylor & Francis Ltd, http://www.tandfonline.com)

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 standard-setting 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. (WALKER, R.G., (1987) Reprinted by permission of Taylor & Francis Ltd.)

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 profession and putting it under the control of a government body. As indicated then, the motivation for the changes seemed, at least

dee67382_ch03_099-158.indd 146 11/01/19 10:29 AM

146 PART 2: Theories of accounting

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. (WALKER, R.G., (1987) Reprinted by permission of the publisher, Taylor & Francis Ltd, http://www.tandfonline.com)

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. (WALKER, R.G., (1987) Reprinted by permission of Taylor & Francis Ltd.)

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. (WALKER, R.G., (1987) Reprinted by permission of Taylor & Francis Ltd.)

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.

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.

dee67382_ch03_099-158.indd 147 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 147

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.

In keeping with 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):

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?

dee67382_ch03_099-158.indd 148 10/24/19 12:47 PM

148 PART 2: Theories of accounting

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.

WhY DO I NEED TO KNOW ABOUT ThE INSIGhTS PROVIDED BY SOME OF ThE ThEORIES OF REGULATION?

The practice of financial reporting—the focus of this book—is heavily regulated. Therefore, as students of accounting it is important that we understand some of the potential reasons why the regulation might have been introduced. As we learned, while regulation is often assumed to be in place for the ‘public interest’, this will not always be the case. We should be aware of this.

Lastly, it should be noted that in our discussion of theories we have not addressed another branch of theories that are often applied in the accounting literature, which are often referred to broadly as critical theories of accounting. Critical accounting theories involve a perspective that goes beyond questioning whether particular methods of accounting should be employed but instead focuses on the role of accounting—including financial accounting—in sustaining the privileged positions of those in control of particular resources (capital) while undermining or restraining the voice of those without capital. The view promoted by researchers operating within a critical theoretical perspective is that accounting, far from being a practice that provides a neutral or unbiased representation of underlying economic facts, actually provides the means of maintaining the powerful positions of some sectors of the community while suppressing the position and interests of those without wealth. Critical theorists explore how accounting potentially contributes to elements of society that are not equitable for some stakeholders, such as employees or particular communities.

While quite fascinating, and in many respects very illuminating in highlighting inequities, the discussion of critical accounting theories is beyond the ambit of this book. Nevertheless, interested readers are encouraged to read further material on the topic (for example, see Chapter 12 in Deegan 2014, which is dedicated to the topic).

SUMMARY

This chapter has described various theories that can be applied to the practice of financial accounting. It is stressed that no single 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 for Financial Reporting, which was considered in some depth in Chapter 2 and revisited in other chapters throughout this book, is classified as a normative theory of accounting.

One positive theory of accounting that we described in some detail 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 accounting-based 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

dee67382_ch03_099-158.indd 149 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 149

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’).

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 108 accounting policy notes 120 agency relationship 104 bonus scheme 107 capacity to adapt 126 Continuously Contemporary Accounting (CoCoA) 126 creative accounting 120 current cash equivalents 127 current-cost accounting 126 current replacement cost 128 debt covenant 113

debtholder 113 exit-price theory 126 generally accepted accounting principles 108 information asymmetry 107 Institutional Theory 137 Legitimacy Theory 133 leverage (gearing) 113 monitoring cost 105 net present value 109 net selling price 128 normative accounting theories 124

perquisite consumption 106 political costs 114 Positive Accounting Theory (PAT) 104 present value 128 rational economic person assumption 106 social contract 133 social-responsibility disclosures 129 Stakeholder Theory 129 systems-oriented theories 128 theory 102

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. Can the practice of financial reporting be undertaken without knowledge of various theories that can be related to accounting? LO 3.1 Yes, we can prepare financial reports without knowing about various theories of accounting (although at a minimum we should know about the Conceptual Framework, which can be considered to be a normative theory of accounting). However, to understand various issues such as: why managers and their accountants might apply particular accounting practices; how particular stakeholders might react to particular disclosures; why particular stakeholders arguably have a right to particular information; or why regulators favour particular reporting requirements, we need theory to provide a framework to understand such questions.

dee67382_ch03_099-158.indd 150 10/24/19 12:47 PM

150 PART 2: Theories of accounting

2. Can the implications of various aspects of financial reporting be well understood in the absence of knowledge of related theories? LO 3.1 Arguably not. Various theories provide logical insights into the implications that result from managers making particular disclosure decisions. These theories are typically developed, tested and refined over many years. Without knowledge of these theories, our own insights about the practice of accounting would be limited.

3. What is the difference between a positive theory and a normative theory? LO 3.1 Generally speaking, a positive theory seeks to explain and/or predict certain phenomena (such as managers’ choice of accounting policies), whereas a normative theory prescribes what actions should be undertaken (for example, that managers should disclose particular information to stakeholders using specific reporting frameworks).

4. Is the IASB Conceptual Framework for Financial Reporting a normative or positive theory of accounting? Why? LO 3.9 The Conceptual Framework is a normative theory of accounting given that, based upon various perspectives about the objectives of general purpose financial reporting, it provides various prescriptions about how financial reports should be prepared.

5. Identify three theories that could be used to explain why particular regulation, such as specific regulation pertaining to financial reporting, has been enacted. LO 3.14 Three theories that could be used, and which were described in this chapter, include Public Interest Theory, Capture Theory and the Economic Interest Group Theory of Regulation. Each of these theories provides different perspectives about how, and why, particular regulations might be introduced.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. 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 3.1, 3.9 ••

2. Can Positive Accounting Theory explain the existence of creative accounting? LO 3.2, 3.7 • 3. What is a systems-oriented theory of accounting? LO 3.10 • 4. Why is it useful for students of financial accounting to consider theories such as those discussed in this chapter?

LO 3.1 • 5. Why and how might management not act in the interests of the firm? LO 3.2, 3.4, 3.5 • 6. 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 •• 7. How can management expropriate the wealth of debtholders? LO 3.2, 3.5 • 8. What is corporate social reporting? LO 3.10 • 9. Why would firms voluntarily present certain information, such as information about their performance with regard to

the environment? LO 3.10, 3.11, 3.12, 3.13 •• 10. 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 3.10, 3.11, 3.12 ••

11. What are debt covenants and why are they put in place? LO 3.5 • 12. What might be a goal of a well-designed management compensation scheme? LO 3.4 • 13. What mechanisms could be put in place to motivate management to consider the interests of: (a) the owners? (b) the debtholders? LO 3.4, 3.5 • 14. What role does the auditor play in financial reporting? LO 3.3, 3.7 • 15. Why would a change in accounting policy affect a contractual agreement between a firm and a manager or

debtholder? LO 3.4, 3.5 •

dee67382_ch03_099-158.indd 151 11/07/19 11:21 AM

Chapter 3: Theories of financial accounting 151

16. 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 3.6 ••

17. Explain why a firm’s management might be prepared to expend considerable resources to lobby ‘for’ or ‘against’ a proposed accounting standard. LO 3.3, 3.4, 3.5 ••

18. 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 3.9 •

19. Contrast the role of Positive Accounting Theory with the role of normative accounting theories. LO 3.1, 3.9 •

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 3.2, 3.3, 3.4, 3.5 ••

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 3.2, 3.3, 3.4 ••

22. 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 •

23. Using Institutional Theory as your theoretical basis, explain why an organisation might voluntarily elect to make particular financial disclosures. LO 3.13 ••

24. Within Institutional Theory, reference is made to isomorphism and decoupling. What do these terms mean? LO 3.13 •

25. 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 3.2, 3.3, 3.5, 3.7 •••

26. The IASB’s Conceptual Framework for Financial Reporting indicates that financial statements should provide unbiased representations of the underlying transactions. Is this realistic? LO 3.2, 3.3, 3.9 ••

27. Provide some arguments to explain what motivates regulators to introduce particular regulations. LO 3.14 •

28. Identify three potential limitations or shortcomings of Positive Accounting Theory. LO 3.8 •

CHALLENGING QUESTIONS

29. Does the teaching of Positive Accounting Theory act to instil inappropriate values within the minds of students? LO 3.8

30. Read the following text, which has been adapted from ‘Reserve Bank put heat on Lehman over accounting’, by Kate Lahey and Leonie Wood, (The Age, 13 March 2010, Web). This article is about the collapse of the financial institution Lehman Brothers.

The Reserve Bank of 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, 2200-page report into Lehman’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 Lehman 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

dee67382_ch03_099-158.indd 152 10/24/19 12:47 PM

152 PART 2: Theories of accounting

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 the use of Repo 105 that the RBA had questioned. These 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 window-dressing’.

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.

REQUIRED

(a) What does ‘window dressing’ mean in the context of this article? (b) What qualitative characteristics of the IASB Conceptual Framework would they have potentially breached? (c) 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, 3.5

31. 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

32. Do you expect that we will ever have a single universally accepted theory of accounting? If not, why not? LO 3.1

33. 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 3.2, 3.3, 3.4, 3.5, 3.6, 3.7

34. How could accounting regulators use the research conducted by Positive Accounting theorists? LO 3.4, 3.5, 3.6, 3.7, 3.14

35. According to Positive Accounting Theory, why could a change in the existing set of accounting standards affect the value of a firm? LO 3.3

dee67382_ch03_099-158.indd 153 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 153

36. 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 3.5

37. 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 underlying 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 3.2, 3.5

38. Read the brief extract from Anthony Hughes’ article ‘Credit card profit soars but ANZ feels no guilt’ (The Sydney Morning Herald, 27 April 2001, p.3) and answer the following questions (be specific about the theories you are using when providing your answers).

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.’

REQUIRED

(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 3.2, 3.6, 3.10, 3.12

39. Read the brief extract from an article by Sue Mitchell entitled ‘Retailers face multibillion-dollar hit from proposed lease accounting changes’ (The Canberra Times, 22 April 2015, Web) and answer the questions that follow.

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.

dee67382_ch03_099-158.indd 154 10/24/19 12:47 PM

154 PART 2: Theories of accounting

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.

REQUIRED

(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 the 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 3.2, 3.3, 3.4, 3.5

40. 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 3.2, 3.3, 3.4, 3.5, 3.6

41. 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 organisations, 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 3.14

42. Read the following extract from an article by Greg Barnes entitled ‘Time for a free market in Tasmanian tourism’, The Mercury, 8 December 2014. Web) and then answer the questions that follow.

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.

dee67382_ch03_099-158.indd 155 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 155

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.

REQUIRED

(a) Pursuant to Capture Theory, why would the Tasmanian Government respond to the demands of the tourism industry?

(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 3.14

FURTHER READING The following texts are dedicated to financial accounting theory and are useful references for readers who want to gain additional insights into the topic: Deegan, C., 2014, Financial Accounting Theory, 4th edn, McGraw-

Hill, Sydney (new edition forthcoming).

Gray, R., Adams, C. & Owen, D., 2014, Accountability, Social Responsibility and Sustainability, Pearson Education, London.

Scott, W., 2015, Financial Accounting Theory, 7th edn, Pearson Education, Toronto.

REFERENCES Anagnostopoulou, S. & Tsekrekos, A., 2017, ‘The Effect of

Financial Leverage on Real and Accrual-based Earnings Management’, Accounting and Business Research, vol. 47, no. 2, pp. 191–236.

Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

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, vol. 14, no. 5, pp. 565–86.

Brown, J., 2009, ‘Democracy, Sustainability and Dialogic Accounting Technologies: Taking Pluralism Seriously’, Critical Perspectives on Accounting, vol. 20, pp. 313–42.

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, vol. 29, no. 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.

Cheng, Q., Lee, J. & Shevlin, T., 2016, ‘Internal Governance and Real Earnings Management’, The Accounting Review, vol. 91, no. 4, pp. 1051–85.

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, vol. 49, no. 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., 1997, ‘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., 2019, ‘Legitimacy Theory: Despite Its Enduring Popularity and Contribution, Time Is Right for a Necessary Makeover’, Accounting, Auditing and Accountability Journal, forthcoming.

dee67382_ch03_099-158.indd 156 10/24/19 12:47 PM

156 PART 2: Theories of accounting

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, ‘NGOs’ Use of the Media to Create Changes in Corporate Social Responsibilities and Accountabilities: Evidence from a Developing Country’, 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 and Accountability Journal, vol. 17, no. 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, vol. 48, pp. 147–60.

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).

Godsell, D., Welker, M. & Zhang, N., 2017, ‘Earnings Management During Antidumping Investigations in Europe: Sample-Wide and Cross-Sectional Evidence’, Journal of Accounting Research, vol. 55, no. 2, pp. 407–57.

Gordon, M.J., 1964, ‘Postulates, Principles, and Research in Accounting’, The Accounting Review, April, pp. 251–63.

Gray, R., Adams, C. & Owen, D., 2014, Accountability, Social Responsibility and Sustainability. Pearson Education, London.

Gray, R., Owen, D. & Adams, C., 1996, Accounting and Accountability, Prentice Hall, Europe.

Griffiths, I., 1987, Creative Accounting: How to Make Your Profits What You Want Them to Be, Unwin Hyman Limited, London.

Hamm, S., Jung, B. & Lee, W., 2018, ‘Labour Unions and Income Smoothing’, Contemporary Accounting Research, vol. 35, no. 3, pp. 1201–28.

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., 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.

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.

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.

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.

Liu, A., Subramanyam, K., Zhang, J. & Shi, C., 2018, ‘Do Firms Manage Earnings to Influence Credit Ratings? Evidence from Negative Credit Watch Resolutions’, The Accounting Review, vol. 93, no. 3, pp. 267–98.

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, ‘Institutionalized 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.

dee67382_ch03_099-158.indd 157 10/24/19 12:47 PM

ChAPTER 3: Theories of financial accounting 157

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, vol. 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.

Schipper, K., 1989, ‘Commentary on Earnings Management’, Accounting Horizons, vol. 3, pp. 91–102.

Scott, W.R., 1995, Institutions and Organizations, 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.

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.

Tilt, C., 2016, ‘Corporate Social Responsibility Research: The Importance of Context’, International Journal of Corporate Social Responsibility, vol. 1, no. 2, pp. 1–9.

Tilt, C., 2018, ‘Making Social and Environmental Accounting Research Relevant in Developing Countries: A Matter of Context’, Social and Environmental Accountability Journal, vol. 38, no. 2, pp. 145–50.

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, vol. 29, no. 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, Organizations 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.

Zang, A., 2012, ‘Evidence on the Trade-off Between Real Activities Manipulation and Accrual-Based Earnings Management’, The Accounting Review, vol. 87, no. 2, pp. 675–803.

dee67382_ch03_099-158.indd 158 10/24/19 12:47 PM

dee67382_ch04_159-200.indd 159 10/23/19 09:55 AM

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

dee67382_ch04_159-200.indd 160 10/23/19 09:55 AM

160

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 4.1 Understand and be able to apply the definition of an asset. 4.2 Understand and be able to apply asset recognition criteria. 4.3 Understand how assets are measured, and that different measurement bases can be applicable to

different classes of assets. 4.4 Know the meaning of ‘fair value’ and the reason that a ‘fair-value hierarchy’ has been introduced into the

accounting standards. Also, be aware of some concerns that are attributed to the use of fair values. 4.5 Know how to differentiate between current and non-current assets. 4.6 Be aware of how a balance sheet shall be presented. 4.7 Have knowledge about how to account for property, plant and equipment, including how to account for

related safety and environmental expenditures, repairs and maintenance, and how to allocate costs to individual items of property, plant and equipment.

4.8 Be aware of accounting issues that arise when property, plant and equipment is acquired with assets other than cash.

4.9 Understand how to determine the cost of an asset when the payments for the asset are deferred. 4.10 Know how to account for interest costs associated with the acquisition, or construction, of an item of

property, plant and equipment. 4.11 Be able to account for an asset that has been acquired at no direct cost.

C H A P T E R 4 An overview of accounting for assets

OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1. Is there a requirement that all assets shall be measured on the same basis (for example, at fair value)? LO 4.3 2. What is the meaning of ‘fair value’? LO 4.4 3. What is the ‘fair-value hierarchy’ as it relates to the application of fair value to measuring assets? LO 4.4 4. If an asset is constructed with the use of borrowed funds, how are the related interest costs to be treated? LO 4.10

dee67382_ch04_159-200.indd 161 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 161

4.1 Introduction to accounting for assets

This book covers a range of issues associated with accounting for assets. In this chapter we will consider a number of issues, including:

∙ how we define, and when we recognise, assets ∙ how we determine the ‘acquisition cost’ of assets ∙ how we might measure various classes of assets subsequent to initial acquisition. In doing so, we will also devote

a number of pages to the issue of how ‘fair value’ is determined ∙ how assets are classified and presented within the statement of financial position (balance sheet).

The material provided in this chapter has general application to all assets. Nevertheless, in the latter half of this chapter we do address a number of issues specifically related to property, plant and equipment. In subsequent chapters we will examine how to account for other 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 (such as goodwill, patents and brand names); 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 can be 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 the measurement rules to be applied will vary depending upon the type of asset in question.

Across time, the future economic benefits, or value, that can be attributed to the majority of assets will either increase or decrease. Where the value decreases, we need to understand how to allocate the cost (or revalued amount) of an asset across its useful life. To this end, Chapter 5 will address why, and how, we depreciate non-current assets for accounting purposes. We 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’). We will commence this chapter with the definition of assets.

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.

According to the Conceptual Framework, an asset is defined as: a present economic resource controlled by the entity as a result of past events.

The above definition of an asset refers to an economic resource. An ‘economic resource’ is defined in the Conceptual Framework as:

a right that has the potential to produce economic benefits.

Using the above asset definition, an ‘asset’ of an entity should therefore have three fundamental attributes. Specifically, an asset: 1. is an economic resource (right) controlled by the entity

LO 4.1

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

5 Non-current Assets Held for Sale and Discontinued Operations IFRS 5

13 Fair Value Measurement IFRS 13

101 Presentation of Financial Statements IAS 1

107 Statement of Cash Flows IAS 7

116 Property, Plant and Equipment IAS 16

136 Impairment of Assets IAS 36

137 Provisions, Contingent Liabilities, and Contingent Assets IAS 37

138 Intangible Assets IAS 38

141 Agriculture IAS 41

dee67382_ch04_159-200.indd 162 10/23/19 09:55 AM

162 PART 3: Accounting for assets

2. exists as a result of past event 3. is a right that has the potential to produce economic benefits.

As we can see from the definition of assets provided above, ‘potential to produce 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.

Some assets, such as property, plant and equipment, have a physical form. However, having a physical form is not essential to the existence of an asset; for example, patents and copyrights are assets if the future economic benefits would potentially flow to the entity, and if they are controlled by the entity.

Assets can take a variety of forms. For instance, 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 (debtors) 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 future services. Plant and equipment are assets because they can be used to provide goods or services, which in turn will generate economic benefits.

We can draw a distinction between the future economic benefits and the source of those benefits. The definition of an asset refers to the economic benefits; therefore, in the absence of potential economic benefits, the object or right is not 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 deemed to have the potential to generate future economic benefits, if it becomes obsolete or unusable, or it is abandoned, and this potential to generate economic benefits is no longer apparent, then the building would no longer represent an ‘asset’ (an example here might be a mining town that is subsequently abandoned as a result of no economically recoverable reserves remaining within the mine site).

As indicated in relation to the definition of an asset provided earlier, a reporting entity does not have to have legal ownership of an asset to record the asset within its statement of financial position. What is important is that the entity is able to ‘control’ the item’s use. As we learned in Chapter 2, control represents the capacity of the entity to benefit from the asset in the pursuit of the entity’s objectives and to deny or regulate the access of others to that benefit. Therefore, because ownership is not essential, items such as leased assets are often included as part of the assets of entities, even though another organisation has legal title to them. That is, many leased assets will be shown in an entity’s statement of financial position (a leased asset is often referred to as a ‘right-of-use asset’), even though legal title to the assets rests with another party (the lessor). Leased assets will be discussed further in Chapter 11, where we will learn that the recognition of the right-of-use asset will also be accompanied in the balance sheet by the recognition of the related obligation (liability) for future lease payments.

4.2 Recognition criteria

As we learned in Chapter 2, for an asset to be recognised within the financial statements, it not only needs to first satisfy the definition of assets (provided above), but it also needs to satisfy the recognition criteria stipulated for

assets. The Conceptual Framework provides criteria for the recognition of assets (and the other elements of financial reports). Specifically, paragraph 5.7 states:

An asset or liability is recognised only if recognition of that asset or liability and of any resulting income, expenses or changes in equity provides users of financial statements with information that is useful, ie with:

(a) relevant information about the asset or liability and about any resulting income, expenses or changes in equity; and (b) a faithful representation of the asset or liability and of any resulting income, expenses or changes in equity.

As indicated above, an asset, or liability, is recognised and therefore included within the financial accounts only if the information is adjudged to be ‘useful’ to financial report readers. This in turn requires a professional judgement to be made about whether the information can be considered as relevant and representationally faithful, these being the two fundamental qualitative characteristics that useful financial information possesses.

For information to be relevant to the users of the financial statements—meaning it has the potential to impact the decisions they make—there must be limited ‘existence uncertainty’. This means that it needs to be clear that the reporting entity has the rights to use the asset, and to benefit from its use. The probability associated with future

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.

LO 4.2

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.

dee67382_ch04_159-200.indd 163 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 163

flows of economic benefits also must not be assessed as too low, although it is not a strict requirement that the future flows of economic benefits are ‘probable’. The probability associated with the future flow of economic benefits will be reflected in the financial measurement attributed to the asset. The point being made here is that if there is a relatively high degree of uncertainty about whether the entity has the appropriate rights to use the asset, or if the entity has difficulty in assessing the likelihood that future flows of economic benefits will actually occur, or assesses the likelihood of future economic benefits as low, then it might not be relevant to provide related information to the financial statement readers. Indeed, providing such information in the presence of such uncertainties might make the financial reports misleading, thereby inappropriately influencing the decisions of financial report readers.

As we saw above, the other requirement for recognition is that the information available shall provide a ‘faithful representation’ of the asset. As explained in Chapter 2, one factor to consider here is the extent of any measurement uncertainty. Some level of uncertainty is acceptable in measuring potential economic benefits; however, if the different measures that could be attributed to a particular asset (or other element of financial accounting) are all considered to have a high level of measurement uncertainty, then the asset should not be recognised within the financial statements. That is, the level of uncertainty associated with estimating a measure of an asset might be so high that it would be questionable whether the estimate would provide a sufficiently faithful representation of that asset and of any resulting income, expenses or changes in equity.

While an asset might satisfy the recognition criteria at a particular point in time, a change in company operating policies, or a change in market conditions, 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 been developed. As a result of particular circumstances, a decision might be made by the organisation to subsequently 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, and are not in demand by any other party, 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 that the recognition criteria for assets (and the other elements of accounting) are directly linked to considerations relating to the relevance and representational faithfulness of the underlying data, professional judgement is necessarily required. It is, therefore, possible that transactions and events that are deemed to create an asset by one group of financial statement preparers might be considered to create an expense by another. Such differences of opinion will have obvious consequences for the financial performance and financial position of reporting entities. They will also have implications for asset-based ratios such as net asset backing per share (see Worked Example 4.1).

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. This standard requires that if the recoverable amount of an asset (‘recoverable amount’ is defined as the higher of an asset’s fair value less the costs of disposal, 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), then the carrying amount of the asset must be reduced to its recoverable amount. The reduction is referred to as an ‘impairment loss’.

WORKED EXAMPLE 4.1: Asset recognition and consideration of measurement uncertainty

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 journal entry for the construction of the machinery, assuming that the machinery satisfies the criteria for recognition of an asset.

(b) Provide the accounting journal entry, assuming that the machinery is subsequently revealed not to be an asset because there is a high level of measurement uncertainty about the future economic benefits, thereby meaning that it does not appear to be possible to provide a representationally faithful measure of the asset.

continued

dee67382_ch04_159-200.indd 164 10/23/19 09:55 AM

164 PART 3: Accounting for assets

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 a relevant and representationally faithful measure of the asset’s economic benefits can be made, then, 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 as something like ‘gain from asset previously derecognised’ or ‘gain from reversal of previous 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 which 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:

SOLUTION

(a) For this expenditure to be recognised as an asset (that is, for it to be capitalised), it must satisfy the definition of an asset and the information to be presented to the users of the financial statements must be assessed as both relevant and representationally faithful. If there is a view that, on the balance of available information, the economic benefits to be generated from the asset are at least $150 000, then the aggregated accounting entry would be:

Dr Machinery—fin-making machine (an asset) 150 000

Cr Wages payable 90 000

Cr Raw materials inventory 35 000

Cr Accumulated depreciation—plant and machinery 25 000

(to recognise the construction of the machine)

Net assets will not change as a result of treating the expenditure as an asset. That is, before the expenditure, net assets were $700 000 (which equals assets less liabilities = $1 000 000 − $300 000). After the expenditure on the machine, 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 there is sufficiently high ‘existence uncertainty’ and/or sufficiently high uncertainties about the likelihood of future flows of economic benefits (which brings into question the potential relevance of the information) and/or there are significant measurement uncertainties associated with the flows of economic benefits likely to be generated from the assets (which undermines the representational faithfulness of the information), then the asset should not be recognised. Rather, the expenditure on the machine would be treated as an expense at the time when such an assessment is made. The loss would typically be referred to as an impairment loss. In this instance, there does appear to be a high level of measurement uncertainty:

Dr Impairment loss—machinery 150 000

Cr Accumulated impairment loss—machinery 150 000

(recognition of an impairment loss on the machine)

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.

Dr Accumulated impairment loss—machinery 150 000

Cr Gain from reversal of previous impairment loss 150 000

(reversal of a previous impairment loss)

WORKED EXAMPLE 4.1 continued

dee67382_ch04_159-200.indd 165 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 165

WHY DO I NEED TO KNOW ABOUT THE RECOGNITION CRITERIA FOR ASSETS?

Knowing the recognition criteria for assets helps us to understand why some resources are considered to be assets of an organisation and appear in the balance sheet, while other resources might not appear in the balance sheet. As an example, an organisation might utilise a number of valuable resources as part of its business operations, but because it does not control them, or is unable to measure them without a high level of uncertainty, it will not recognise them within the balance sheet. By knowing the recognition criteria, we are better able to understand why certain assets are presented within the balance sheet (or in the notes to the financial statements) while other assets/resources are not.

As noted in Chapter 3, an organisation 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 requirements that organisations must meet. Hence the decision to expense or capitalise an item might be one that has direct implications for the value of the organisation, and potentially for the wealth of the managers and owners. 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.

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

4.3 Measurement of assets

Up to this point we have discussed the definition of assets and the recognition criteria for assets. Once we have determined that an asset shall be recognised (that is, it satisfies the definition and the recognition criteria), the next step is to determine the amount to attribute to the asset. That is, once we have decided we shall recognise an asset, the next step is to determine the amount to be recognised.

As we have noted above, for an asset to be recognised, it is required to possess a cost or other value that can be measured reliably (specifically, measurement uncertainty is linked to the qualitative characteristic of ‘faithful representation’). 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. For several years now, 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 many classes of assets is required to be measured at fair value, many other assets are still measured at 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 measured at the lower of cost and net realisable value ∙ property, plant and equipment may be measured at either cost, or at fair value ∙ 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 measured at cost less accumulated depreciation and any accumulated impairment losses (that is, they cannot be revalued to fair value)

∙ marketable securities will typically be measured at fair value ∙ agricultural assets, such as living animals and plants used to generate ‘agricultural produce’, shall be measured

at fair value less costs to sell, with any gain or loss being included within profit or loss in the period in which the gain or loss occurs.

Because different classes of assets are typically measured in different ways (and some intangible assets are not ever permitted to be recognised as assets), 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 required to be applied to different asset classes.

Therefore, while conceptually it would seem to make good sense for one method of measurement to be applied to all assets, such as 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), this is not the view of the IASB. When the IASB revised the Conceptual Framework in 2018, it prescribed

LO 4.3

dee67382_ch04_159-200.indd 166 10/23/19 09:55 AM

166 PART 3: Accounting for assets

that it is appropriate for reporting entities to measure different classes of assets in different ways. This judgement was made on the basis that:

∙ 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 to users of financial reports of a particular measurement approach need to be sufficient to justify the cost associated with compiling the information.

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. The respondents’ views were that historical cost is objective and verifiable; easily understood and widely known; and allows 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 and lacked relevance.

Perhaps the above findings are not surprising. If a firm adopts some form of fair-value-based 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 fair value when it was introduced some years ago. 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.

Houghton and Tan also found that the level of support for historical cost or present value and fair value seemed to depend on the industry to which the respondent belonged. Individuals working in financial institutions had a statistically significant preference for fair-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.

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 the

Asset Measurement rule

Cash Face value

Accounts receivable Face value less an allowance for doubtful debts. Amounts to be received in more than 12 months shall be discounted to present value

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

Exploration and evaluation assets of mining organisation

Initially at cost and thereafter at cost or fair value

Investment properties At cost initially and then at either fair value or cost

Non-current assets held for sale At the lower of carrying amount and fair value less costs to sell

Table 4.1 Some classes of assets and their associated measurement rules

dee67382_ch04_159-200.indd 167 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 167

same basis of measurement such as fair value. The views of individuals working within financial institutions differed significantly from those employed elsewhere.

In other related research, Foster and Shastri (2010) report that managers of 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.

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. Exhibit 4.1 shows the assets (and liabilities and equity) held by the large global miner BHP (in US dollars), as reflected in BHP’s balance sheet as at 30 June 2019. Consistent with generally accepted accounting procedures, 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?) to arrive at total assets. 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 to financial reporting.

If we look at the balance sheet of BHP, we will see that total assets amount to US$100 861 million. Again, keep in mind that the different classes of assets will have particular measurement requirements (included in various accounting standards) that might differ from other classes of assets. So we always need to be careful in interpreting the meaning of ‘total assets’.

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, what would be the appropriate basis of asset measurement for a building such as a museum or an art gallery? How would, or should, we measure the value of a botanical garden or a collection of ancient artefacts? The Conceptual Framework definition of assets, as we know, requires the potential for future economic benefits. Do museums, art galleries, botanical gardens or artefact collections potentially generate ‘economic benefits’? Certainly, many people accept that they provide social and cultural benefits. Such items are frequently referred to as heritage assets, which are typically held by government authorities for the use of current and future generations. There is usually no expectation that they will ever be sold, and any receipts, for example from visitors, are generally less than the ongoing expenses of maintaining such resources. They are therefore often considered to generate negative net cash flows. Are such resources assets in accordance with the 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 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 items 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, an organisation might plant some pine tree seedlings with the expectation that they will generate commercially saleable timber in 14 years’ time. To assess the financial position of the business, there might be an expectation that the trees should be shown as assets in the statement of financial position, but how would we measure their value? Should they be valued at the cost of the seedlings; at the cost of the seedlings plus further direct costs such as water, fertilisers and so on; or at present value, which will include assumptions about the timing of the milling, cash receipts, tree survival rate and appropriate discount rates? If the same sort of tree is in a botanical garden, or on the side of a road maintained by a local council, as opposed to being in a timber forest, would or should it have the same value? Should it be considered to be an asset? You might be interested to know that various city councils do include trees as part of the assets reported within their balance sheets (often included within the broader classifications of assets known as infrastructure assets). But what does the attributed financial measure actually represent? Why are trees on the side of the road considered to be assets? The chapter that addresses heritage assets, Chapter 9, will also consider issues associated with accounting for biological assets—a tree would be considered to be a biological asset (which is defined in AASB 141 Agriculture as a living animal or plant).

heritage assets Variously defined. For example: ‘non-current assets that a government intends to preserve indefinitely because of their unique historical, cultural or environmental attributes’ (Auditor-General of NSW).

dee67382_ch04_159-200.indd 168 10/23/19 09:55 AM

168 PART 3: Accounting for assets

Exhibit 4.1 The balance sheet of BHP Billiton Ltd as at 30 June 2019

SOURCE: © BHP Group Ltd

The sources of the future economic benefits As mentioned earlier in this chapter, the Conceptual Framework indicates that the essence of an asset is the ‘future economic benefits’ that the item will generate. Generally speaking, the future economic benefits to be derived from the asset, and which we might try to measure, can 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.

dee67382_ch04_159-200.indd 169 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 169

If the expected benefits to be derived from the use of the asset within the organisation—often referred to as ‘value in use’—exceed the market value, it would be expected that the entity would retain the asset. Conversely, if the expected sales price less costs of disposal exceeds the asset’s expected value in use, it would be expected that the entity would dispose of the asset (although this might not always happen).

Typically, assets are recorded on initial recognition at ‘cost’. Some assets, such as property, plant and equipment, may then subsequently be revalued upwards if the net amount that is expected to be recovered through the cash inflows and outflows arising from their use and subsequent disposal exceeds their cost. (Revaluations are covered in Chapter 6.) Where the recoverable amount of an asset is less than the asset’s carrying amount, which might be based on cost (‘recoverable amount’ is defined in AASB 136 Impairment of Assets as the higher of its fair value less costs of disposal and its value in use), then according to generally accepted accounting practice, the asset should be written down to its recoverable amount. This write-down is referred to as the recognition of an ‘impairment loss’.

Where the recoverable amount of an asset is to be based on its ‘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’, then 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 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 as:

the present value of the future cash flows expected to be derived from an asset or cash-generating unit. (AASB 136)

Therefore, value in use, according to paragraph 31, is 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. (AASB 136)

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 net present value of only $18 000, after which time the asset will be scrapped. Let us also assume that the asset cannot be readily sold. 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 carrying amount, and the write-down will be treated as an impairment loss of the reporting entity. This write-down would not be considered as 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 years, 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 decrease in assets. 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).

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 the costs of disposal, and its value in use.

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. The terms can also be used interchangeably, though.

dee67382_ch04_159-200.indd 170 10/23/19 09:55 AM

170 PART 3: Accounting for assets

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 (there is a high level of measurement uncertainty), 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 linked to the criteria for asset recognition in the Conceptual Framework, this being ‘faithful representation’. However, 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. If a firm capitalises certain expenditures, rather than expensing them (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 (deferring) them. This is because there is less to depreciate/amortise in subsequent years. Firms that capitalise expenditures will report higher depreciation/ amortisation charges, and therefore lower profits in future periods.

It is not unusual to find that when there is a change in the senior management of an organisation, the new management will often quickly act to recognise impairment losses on various assets. This

is often referred to as a ‘big bath’. New senior management teams sometimes use the ‘big bath’ approach, commonly blaming the company’s poor performance on the previous managers—and thereafter taking credit for the next year’s improvements in financial performance.

Acquisition cost of assets We will now briefly consider how particular classes of assets are measured on acquisition, and subsequent to acquisition. We will consider property, plant and equipment, intangibles, inventory and biological assets.

AASB 116 Property, Plant and Equipment requires that an item of property, plant and equipment that qualifies for recognition as an asset shall, on acquisition, be measured at its ‘cost’. The accounting standard further stipulates that the ‘cost’ of an item of property, plant and equipment comprises:

∙ its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates

∙ any costs directly attributable to bringing the asset to the location and in a condition necessary for it to be capable of operating in the manner intended by management

∙ 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.

While property, plant and equipment shall initially be measured at ‘cost’, measurement can subsequently be at cost, or at fair value.

In relation to intangible assets, for those intangible assets that are permitted to be recognised, they shall be measured initially at ‘cost’. According to the accounting standard AASB 138 Intangible Assets, the cost of a separately acquired intangible asset comprises:

∙ its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates, and

∙ any directly attributable cost of preparing the asset for its intended use.

Subsequent to initial recognition, those intangible assets with an ‘active market’ can be revalued to fair value, although they can also be left at cost.

In relation to inventories, inventory shall initially be recorded at cost. According to AAB 102 Inventories, 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. Subsequent to initial recognition, inventories shall be measured at the lower of cost and net realisable value.

In relation to biological assets, AASB 141 Agriculture requires that a biological asset (a living animal or plant) shall be measured on initial recognition and at the end of each reporting period at its fair value less costs to sell. The accounting standard also requires 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.

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.

dee67382_ch04_159-200.indd 171 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 171

4.4 Further consideration of ‘fair value’

As we have just noted, many accounting standards require particular classes of assets to be recorded initially at cost (although a limited number of accounting standards require initial recognition to be at fair value). For those assets that are initially measured at cost, we know that some accounting standards require, or provide an option for, the assets subsequently to be measured at fair value.

Because fair value has become such a pervasive basis of measurement in financial accounting for so many classes of assets (and some liabilities), we will now spend some time further exploring how ‘fair value’ is determined. If we are using fair value and are required to update the fair values of assets at the end of each reporting period, then this adjustment has potential implications for reported profits. As we know, the basic accounting equation is:

Assets = Liabilities + Equity

If, for example, we increase the fair value of an asset, this will not directly impact liabilities. Rather, it will increase equity. As we would also know, equity increases as a result of income and as a result of contributions from owners (and decreases as a result of expenses and distributions to owners). The recognition of an upward revaluation to fair value is not an owners’ contribution, and therefore, from a Conceptual Framework perspective, an increase in the fair value of an asset would be considered to constitute ‘income’. Paragraph 5.4 of the Conceptual Framework states:

the recognition of income occurs at the same time as: (i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or (ii) the derecognition of a liability, or a decrease in the carrying amount of a liability.

As we already know from material provided earlier in this chapter, accounting standards require some types of assets to be measured at fair value, whereas other accounting standards do not. Further, when fair-value adjustments are made, some accounting standards require the increase (or decrease) to be included in profit or loss, whereas other accounting standards require gains to go to a measure of income known as ‘other comprehensive income’. We will return to these issues throughout this book. At this stage, however, we will concentrate on the meaning of ‘fair value’, particularly as it relates to non-financial assets (such as property, plant and equipment).

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 (AASB 13).

Paragraph 24 further states:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (ie an exit price) regardless of whether that price is directly observable or estimated using another valuation technique. (AASB 13)

Three points can be made about the above definition of ‘fair value’:

∙ it is based on current exit prices ∙ the hypothetical sale would occur via an ‘orderly transaction’ ∙ the transaction occurs between ‘market participants’.

A number of terms therefore require further consideration, in particular ‘exit price’, ‘orderly transaction’ and ‘market participants’. The meaning of each term is as follows:

∙ exit price the price that would be received to sell an asset or paid to transfer a liability; this price is based upon expectations about future cash flows to be generated by the asset subsequent to the sale

∙ orderly transaction 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 buyers and sellers are independent of each other, are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, and are willing and able to enter into a transaction for the asset or liability.

LO 4.4

dee67382_ch04_159-200.indd 172 10/23/19 09:55 AM

172 PART 3: Accounting for assets

In relation to the requirement of an ‘orderly transaction’, the view is that it would be inappropriate to determine fair value based on ‘discounted sale prices’ or based on forced liquidation values. If there is an active and liquid market in which assets are traded that are identical to the asset to be valued, then the fair value will be equivalent to the quoted price (market value) of the asset. However, there will be instances where assets for which fair-value measurements are required (perhaps by particular accounting standards) do not have markets where identical assets are actively traded, so a directly comparable market value might not always be available. In these circumstances, the market price of a very similar asset or liability can be used or, where there is not an active market for the form of asset that is to be fair valued (so market values for an identical or similar asset cannot be observed), an alternative is to use an accepted valuation model to infer the fair value. As paragraph 3 of AASB 13 states:

When a price for an identical asset or liability is not observable, an entity measures fair value using another valuation technique that maximises the use of relevant observable inputs and minimises the use of unobservable inputs. Because fair value is a market-based measurement, it is measured using the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. As a result, an entity’s intention to hold an asset or to settle or otherwise fulfil a liability is not relevant when measuring fair value. (AASB 13)

As noted in the above quote, the use of ‘observable inputs’ is, where possible, to be maximised when determining fair value (and conversely, the use of ‘unobservable inputs’ is ideally to be minimised). AASB 13 provides the following definitions:

Observable inputs: Inputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability. Unobservable inputs: Inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability. (AASB 13)

Techniques that rely upon observable market values (market prices) are often referred to as mark-to-market approaches, whereas techniques that rely upon valuation models are often known as mark-to-model approaches and require the identification of both an accepted valuation model and the inputs required by the model to arrive at a valuation.

In terms of the objective of fair-value measurement, paragraph B2 of AASB 13 states:

The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. A fair value measurement requires an entity to determine all the following:

(a) the particular asset or liability that is the subject of the measurement (consistently with its unit of account) (b) for a non-financial asset, the valuation premise that is appropriate for the measurement (consistently with its

highest and best use) (c) the principal (or most advantageous) market for the asset or liability (d) the valuation technique(s) appropriate for the measurement, considering the availability of data with which

to develop inputs that represent the assumptions that market participants would use when pricing the asset or liability and the level of the fair value hierarchy within which the inputs are categorised. (AASB 13)

We will now consider the above points in more detail.

Identification of the asset (or liability) to be measured When measuring fair value, an entity shall take into account the characteristics of the asset or liability if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the following:

∙ the condition and location of the asset, and ∙ restrictions, if any, on the sale or use of the asset.

It is anticipated that market participants will take the above factors into account when determining the market price of an asset.

Determination of the valuation premise that is most appropriate The goal is to determine the price that would be paid by a ‘market participant’. Fair value is based upon the ‘highest and best use’ of the asset, which is defined in AASB 13 as the use of a non-financial asset by market participants that would maximise the value of the asset.

dee67382_ch04_159-200.indd 173 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 173

What is the most advantageous market for the asset? The most advantageous market for the asset would be the market that maximises the amount that would be received to sell the asset or which minimises the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs.

What is the most appropriate valuation technique to apply? According to AASB 13, an entity shall use valuation techniques that are:

∙ appropriate in the circumstances, and ∙ for which sufficient data are available to measure fair value ∙ maximising the use of relevant observable inputs and minimising the use of unobservable inputs.

In relation to valuation techniques, three widely used valuation techniques are:

∙ the market approach ∙ the cost approach ∙ the income approach.

According to AASB 13:

∙ the market approach represents a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of assets and liabilities, such as a business. This would typically be the preferred approach to valuation if the required markets exist

∙ the cost approach represents a valuation technique that reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost)

∙ the income approach represents a valuation technique that converts future amounts (e.g. cash flows or income and expenses) to a single current (i.e. discounted) amount. The fair-value measurement is determined on the basis of the value indicated by current market expectations about those future amounts.

The technique to be applied is the one that is considered to be the most suitable given the circumstances and available data, and the relative reliance on observable and unobservable inputs. As we will see below, there is a ‘fair-value hierarchy’ and the goal is to maximise the use of ‘observable inputs’ as well as minimising the use of ‘unobservable inputs’ when determining fair value.

In comparing fair value to historical cost as a basis of measurement, fair value is typically considered to be more relevant to the intended users of general purpose financial reports. However, it is a more subjective measurement basis (potentially undermining ‘faithful representation’) if an active market does not exist for an item. If a valuation model is applied—because there is not an active market for the asset—then many assumptions and professional judgements must be made. Determining fair value can be problematic when markets are volatile, for example, when there is a serious financial crisis, or when an asset is of a type that is not regularly traded. In such a situation, management’s own judgements and assumptions will impact measurement.

AASB 13 establishes a ‘fair-value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. As paragraph 72 states:

To increase consistency and comparability in fair value measurements and related disclosures, this Standard establishes a fair value hierarchy that categorises into three levels the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). (AASB 13)

Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations, with the highest level, Level 1 inputs, being quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Level 2 are directly observable inputs other than Level 1 market prices (Level 2 inputs could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets). As paragraph 81 states:

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. (AASB 13)

dee67382_ch04_159-200.indd 174 10/23/19 09:55 AM

174 PART 3: Accounting for assets

Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead. Level 3 inputs are unobservable inputs for the asset or liability. Paragraph 87 states:

Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. (AASB 13)

It is interesting to note that the above paragraph makes reference to a ‘market participant’—basing measurement on a market participant’s perspective is conceptually different from the value that a firm would otherwise attribute to an asset. Worked Example 4.2 provides an illustration of where the ‘fair value hierarchy’ is assigned to particular valuations.

AASB 13 requires a number of disclosures to be made in the notes to the financial statements in relation to how the fair value of assets has been determined. These disclosures include:

∙ the level of the fair-value hierarchy within which the fair-value measurements are categorised in their entirety (Level 1, 2 or 3)

∙ the amounts of any transfers between Level 1 and Level 2 of the fair-value hierarchy, the reasons for those transfers and the entity’s policy for determining when transfers between levels are deemed to have occurred. Transfers into each level shall be disclosed and discussed separately from transfers out of each level

∙ for fair-value measurements categorised within Level 2 and Level 3 of the fair-value hierarchy, a description of the valuation technique(s) and the inputs used in the fair-value measurement

∙ for fair-value measurements categorised within Level 3 of the fair-value hierarchy, an entity shall provide quantitative information about the significant unobservable inputs used in the fair-value measurement.

Exhibit 4.2 provides the fair-value note from the Harvey Norman Annual Report for the year ending 30 June 2018.

WORKED EXAMPLE 4.2: Classing fair-value measurements using the ‘fair-value hierarchy’

Fair Go Company has three classes of assets that it measures at fair value. The three classes of assets, and the bases of how fair value was determined for each class, are:

• Shares in a public company listed on a securities exchange. Fair value was based on the market price available from the securities exchange.

• A large truck. It is two years old and in average condition for its age. This particular type of truck does not come on the market often, but three have been sold in the past 12 months, all of which were aged almost the same as the truck in question. The organisation used the average of the three prices as the basis for determining the fair value of the truck.

• A specialised piece of equipment that was purpose-built for the organisation. This equipment would not be in demand by other organisations, so has no apparent sales price. The fair-value measurement was based upon determining the net present value of future cash flows, which necessarily required judgements about various factors including future demand, future sales price and future operating costs

REQUIRED You are to determine the level of inputs (1, 2 or 3) used for each of the valuations, and decide whether the valuations were based on observable or unobservable inputs.

SOLUTION The shares were measured using Level 1 inputs using observable data. This would be a ‘market approach’ to measurement.

The truck was measured using Level 2 inputs using observable data. This would be a ‘market approach’ to measurement.

The equipment was measured using Level 3 inputs using unobservable data. This would be an ‘income approach’ to measurement.

dee67382_ch04_159-200.indd 175 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 175

Exhibit 4.2 An example of a fair-value note—from Harvey Norman Annual Report 2018

continued

dee67382_ch04_159-200.indd 176 10/23/19 09:55 AM

176 PART 3: Accounting for assets

SOURCE: Harvey Norman Annual Report 2018, pp 102–04

Exhibit 4.2 continued

dee67382_ch04_159-200.indd 177 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 177

Some concerns about fair values While reporting fair values for various classes of assets is generally perceived as being useful to readers of financial statements, permitting, and in some cases requiring, certain categories of assets and liabilities to be valued at fair value has not been without controversy. Two key features of fair value that have attracted some heated debate over the past two decades (as the application of fair value within accounting standards has increased) are the volatility and procyclicality that some argue can be (and has been) introduced into net asset and profit figures when the underlying markets used to determine an asset’s fair value are themselves volatile.

In using market prices, rather than costs, fair-value measurements provide valuations for assets (and for any fair- valued liabilities) that are influenced by the market conditions in place at the end of the reporting period. One key outcome of this is that if the underlying asset markets that are used to derive the information about fair values are themselves suffering from high levels of volatility, then this volatility will be reflected in the measures of the fair- valued assets (and liabilities) shown in the statement of financial position (balance sheet). In other words, at times, using fair values can result in considerable volatility in the statement of financial position.

As we know, when applying the Conceptual Framework definitions, income and expenses (and profit) reflect differences between the net asset figure in the statement of financial position at the start of the accounting period and the net asset figure at the end of the reporting period (after adjusting for contributions by, and distributions to, owners). Therefore, where use of ‘fair value’ for a particular type of asset or liability introduces volatility into figures in the statement of financial position, this will also lead to volatility in figures in the statement of profit or loss and other comprehensive income.

The subprime banking crisis was a financial crisis that occurred between 2007 and 2010; it created recessional pressures in national economies throughout the world and was initially triggered by falling housing prices in the US, which in turn led to pressures on various international banking and lending institutions and thereafter across entire economies. During the financial crisis, it was claimed by many (especially managers of banks themselves) that accounting requirements—as reflected in various accounting standards—that require reporting entities to measure many of their assets at fair value actually exacerbated the crisis (Laux & Leuz 2009; Power 2010). This is a phenomenon termed procyclicality. It is argued that when markets for financial assets (such as shares, bonds and derivatives) are booming, the value of these assets held by banks, and shown at fair value within their statements of financial position, will similarly rise significantly above their historical cost—thus increasing the reported profits and net assets and capital and reserves of the bank. As banking regulations usually set bank lending limits in terms of a proportion (or multiple) of capital and reserves, this increase in the reported fair value of the assets of a bank will enable a bank to lend more. Some of this additional lending will fuel further demand in the markets for financial assets—thus further increasing the market values/prices of these assets held by banks, and thereby potentially further increasing their reported capital and reserves. This, it is argued, will enable banks to lend even more and thus will help to create an upward spiral in financial asset prices, and in bank lending, which becomes increasingly disconnected from the underlying real economic values of the assets in these markets (Laux & Leuz 2009).

Conversely, it was argued by many at the time of the subprime banking crisis that when markets for financial assets are in ‘free-fall’ (as they were at times during the crisis), fair-value accounting exacerbates a downward spiral of asset prices and bank lending that is equally unreflective of (and significantly overstates) decreases in real underlying economic values (Laux & Leuz, 2009). The basis of this viewpoint is that in times of a financial crisis, requirements to mark- to-market financial assets held by banks may lead to a rapid erosion in the capital and reserves shown in the banks’ statements of financial position. This will reduce their lending limits (where these are tied to their reported levels of capital and reserves) and will both reduce bank lending (thus reducing demand in financial markets, putting further downward pressure on the assets prices in these markets) and possibly require the banks to sell some of the financial assets they hold to release liquidity. This will put further downward pressure on the asset prices, leading to a downward price spiral as these reduced prices further reduce the reported net assets of the banks. Views such as these emphasise the key role that financial accounting plays within broader society—with proponents of the above view emphasising that the choice of an accounting measurement approach such as ‘fair value’ can, according to them, have widespread negative economic and social implications for society (reinforcing the view that the accountant is a very powerful member of society).

In considering issues of relevance versus representational faithfulness in fair-value accounting, Ronen (2008, p. 186) argues that fair values do not measure the value of assets to the specific firm. Therefore, despite the rationale of fair values being that they provide relevant decision-useful information, Ronen claims that fair values do not always provide the most relevant measures:

Since the fair value measurements . . . are based on exit values, they do not reflect the value of the assets’ employment within the specific operations of the firm. In other words, they do not reflect the use value of the asset, so they do not inform investors about the future cash flows to be generated by these assets within the firm, the present value of which is the fair value to shareholders. Thus, these exit values fall short of meeting the informativeness objective of financial statements. In a similar vein, they do not do well in serving the stewardship function, as they do not properly measure the managers’ ability to create value for shareholders.

dee67382_ch04_159-200.indd 178 10/23/19 09:55 AM

178 PART 3: Accounting for assets

Nonetheless, exit value measures have partial relevance. Specifically, they quantify the opportunity cost to the firm of continuing as a going concern, engaging in the specific operations of its business plan; the exit values reflect the benefits foregone by not selling the assets. (From RONEN, J., ‘TO FAIR VALUE OR NOT TO FAIR VALUE: A BROADER PERSPECTIVE’, Abacus, 44 (2), p 186 (c) 2008. Reproduced with permission of John Wiley & Sons Ltd.)

In assessing the reliability or representational faithfulness of fair-value information, Ronen (2008, p. 186) explains that under fair-value accounting, Level 1 measurements can generally be considered reliable, but for Level 2 and 3 measurements:

Level 2 involves estimations of fair value based on predictable relationships among the observed input prices and the value of the asset or liability being measured. The degree of reliability one can attach to these derived measures would depend on the goodness of the fit between the observed input prices and the estimated value. Measurement errors and mis-specified models may compromise the precision of the derived estimates. Nonetheless, Level 2 is not as hazardous as Level 3. In the latter, unobservable inputs, subjectively determined by the firm’s management, and subject to random errors and moral hazard [moral hazard potentially arises when one party to a transaction has more information than another, and the party with more information about a particular event or item has the potential or incentive to behave inappropriately from the perspective of the party with less information], may cause significant distortions both in the balance sheet and in the income statement. Moreover, discounting cash flows to derive a fair value invites deception. (From RONEN, J. (2008). Reproduced with permission of John Wiley & Sons Ltd.)

So, in summing up this section, while most people with a knowledge of accounting favour the use of fair-value measurements, there are nevertheless others who have concerns about its application.

WHY DO I NEED TO KNOW ABOUT THE MEANING OF FAIR VALUE AND THAT INFORMATION IS AVAILABLE ON HOW FAIR VALUE HAS BEEN DETERMINED?

Many assets (and some liabilities) are measured at fair value; it is therefore important that we appreciate the meaning of fair value so that we can put the reported measures in context. Different approaches can be used to measure fair value, and these can have different levels of relevance and/or representational faithfulness. As reporting entities are required to provide a note about their use of fair values, and how the valuations sit within the ‘fair-value hierarchy’, knowledge of this information will enhance the usefulness of the information being presented to financial statement readers.

4.5 Definition of current assets

Having discussed the definition and recognition criteria for assets, and having discussed the measurement of assets generally (and with some detailed discussion of fair value measurement), the next issue to consider is

how information about the assets might be classified and therefore presented to the readers of financial statements.

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:

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. (AASB 101)

current assets 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 12 months after the reporting period; or (d) the asset is cash or a cash equivalent (as defined in AASB 107 Statement of Cash Flows) unless the asset is restricted from being exchanged or used to settle a liability for at least 12 months after the reporting period.

LO 4.5

dee67382_ch04_159-200.indd 179 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 179

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. 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. (AASB 101)

Some professional judgement is called for in determining the entity’s ‘normal operating cycle’. The classification 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.

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. 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. (AASB 101)

Something might 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 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. (AASB 101)

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. As we noted earlier in this chapter, assets may, for example, also be classified as ‘tangible’ and ‘intangible’, both of which could be current or non-current.

4.6 How to present a statement of financial position

As the discussion below will demonstrate, 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. (AASB 101)

As we can see from the above requirement, relevance and reliability are important considerations in determining how the statement of financial position (balance sheet) shall be presented. That is, relevance and reliability considerations

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

LO 4.6

dee67382_ch04_159-200.indd 180 10/23/19 09:55 AM

180 PART 3: Accounting for assets

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.

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:

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/non-current presentation because the entity does not supply goods or services within a clearly identifiable operating cycle. (AASB 101)

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 non-current 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 have typically elected for some years to adopt the liquidity approach to presentation. Exhibit  4.3 shows how Commonwealth Bank of Australia structured its statement of financial position (which it referred to as a ‘balance sheet’) in its 2019 Annual Report. Please compare this with Exhibit 4.1 provided earlier in this chapter, which presented the balance sheet in a way that separates current assets from non-current assets and current liabilities from non-current liabilities.

In Exhibits 4.1 and 4.3, the organisations both chose to present their balance sheets in the form of total assets less total liabilities equals net assets/equity (A – L = OE). Entities may choose to provide other subtotals in addition to those shown in the above exhibits. For example, the statement of financial position could also be presented to show total assets equals total liabilities plus total equity (A = L + OE).

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. (AASB 101)

Additional line items can also be presented on the face of the statement of financial position other than those identified above.

dee67382_ch04_159-200.indd 181 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 181

Exhibit 4.3 Illustration of the liquidity approach to statement of financial position disclosure—from Commonwealth Bank of Australia Annual Report 2019

SOURCE: © CBA Commonwealth Bank of Australia. Reproduced with permission.

dee67382_ch04_159-200.indd 182 10/23/19 09:55 AM

182 PART 3: Accounting for assets

4.7 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 information about property, plant and equipment. It 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. (AASB 116)

The requirement that the future economic benefits be ‘probable’—as required above—is stricter than the recognition requirements for assets provided in the Conceptual Framework (as revised in 2018). As we know, the Conceptual Framework requires an asset to have the ‘potential’ to produce future economic benefits. As we also know, however, when there is a disparity between the Conceptual Framework and an accounting standard, then the requirements of the accounting standard shall prevail.

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, and as noted earlier within this chapter, after the initial recognition of the asset at cost, the entity may decide to adopt either the ‘cost model’ or the revaluation (‘fair-value’) model in measuring a class of property, plant and equipment.

Paragraphs 30 and 31 note:

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. (AASB 116)

We will consider the cost model versus the revaluation model in Chapter 6. However, at this stage it should be appreciated that property, plant and equipment, and some other types of assets, can be measured at cost, or at their fair value.

Since property, plant and equipment shall initially be measured at cost, and thereafter can continue to be measured at cost, we need to understand what is meant by ‘cost’. According to paragraph 16 of AASB 116, and as noted earlier in this chapter, 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. (AASB 116)

According to paragraph 17, ‘directly attributable costs’ would include:

(a) costs of employee benefits arising directly from the construction or acquisition of the item of property, plant and equipment;

(b) costs of site preparation;

LO 4.7

dee67382_ch04_159-200.indd 183 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 183

(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. (AASB 116)

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. Worked Example 4.3 provides an example of how to determine the ‘cost’ of property, plant and equipment.

Our discussion so far, and subsequently in this chapter, of property, plant and equipment is based on the view that it is the intention of the organisation to use the assets as part of the organisation’s normal operations. However, and briefly, it needs to be appreciated that there is an accounting standard, namely AASB 5 Non-current Assets Held for Sale and Discontinued Operations, that applies to property, plant and equipment that is held for sale. An entity shall classify a non-current asset (or disposal group) as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use.

WORKED EXAMPLE 4.3: Determining the cost of acquired property, plant and equipment

Cabarita Ltd acquired a parcel of farming land in exchange for the following consideration:

Cash $125 000 Shares in Cabarita Ltd 200 000 ordinary shares with a fair value of $1.50 per share Computing machinery Cost of $50 000; accumulated depreciation of $15 000; fair value of $20 000

As part of the acquisition, the organisation also incurred the following costs, all paid in cash:

• Legal fees: $15 000 • Stamp duty on the purchase contract: $20 000 • Cost to modify the land to enable safe access to the property: $40 000

REQUIRED

(a) What is the cost of the land? (b) Provide the accounting journal entry in the books of Cabarita Ltd.

SOLUTION

(a) The cost of the land is calculated as follows:

Fair value of the purchase consideration $ Cash 125 000 Shares at fair value—200 000 at $1.50 300 000 Computing machinery at fair value 20 000

445 000 Other costs directly attributable to the acquisition Legal fees Stamp duty Initial required modification of the land

15 000 20 000

40 000 520 000

continued

dee67382_ch04_159-200.indd 184 10/23/19 09:55 AM

184 PART 3: Accounting for assets

AASB 5 requires that an entity shall measure a non-current asset classified as held for sale at the lower of its carrying amount and fair value less costs to sell. Any movement in this amount from one period to the next will typically be included within profit or loss in the period in which the change occurs.

For the balance of this chapter, we will not be considering assets that are held for sale.

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. (AASB 116)

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 and therefore able to generate future economic benefits. An illustration of this is provided in Worked Example 4.4.

Therefore, the land will be measured at $520 000.

(b) The accounting entry in the books of Cabarita Ltd is:

Dr Land 520 000

Dr Loss on disposal of computer 15 000

Dr Accumulated depreciation—computers 15 000

Cr Cash 200 000

Cr Share capital 300 000

Cr Computer machinery 50 000

(to recognise the acquisition of land)

WORKED EXAMPLE 4.3 continued

dee67382_ch04_159-200.indd 185 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 185

WORKED EXAMPLE 4.4: Capitalisation of expenditure to be incurred subsequent to the acquisition of an asset

During the reporting period ending 30 June 2022, 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:

$

Costs incurred in obtaining access to the site 2 324 900 Transportation of rig 856 300 Erection 445 640 Resource consent 1 657 000 Engineers’ fees 900 200

6 184 040

The oil rig was ready to start production on 1 July 2022, with actual production starting on 1 October 2022. 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 199 400 Transportation of rig 355 800 Environmental clean-up costs 4 854 500 Replacement of flora and fauna 690 300

6 100 000

The organisation uses a discount rate of 8 per cent for future expenditures.

REQUIRED Prepare the journal entries necessary to account for the oil rig for the years ended 30 June 2022, 30 June 2023 and 30 June 2024.

SOLUTION

30 June 2022 Dr Oil rig 16 902 598

Cr Cash/accounts payable (6 567 000 + 6 184 040) 12 751 040 Cr Provision for restoration costs 4 151 558

(to recognise the creation of the oil rig)

As we can see above, at the end of the reporting year of 30 June 2022, 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 AASB 137 Provisions, Contingent Liabilities, and Contingent Assets.

In accordance with AASB 116, the estimated site restoration costs of $4 151 558 ($6 100 000, payable in five years, discounted at 8 per cent, which equals $6 100 000 × 0.6805832) 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 a borrowing cost. (AASB 137)

continued

dee67382_ch04_159-200.indd 186 10/23/19 09:55 AM

186 PART 3: Accounting for assets

The borrowing (interest) costs are allocated to specific years as follows:

Date Opening balance Interest at 8%* Balance of site

restoration costs 1 July 2022 – 4 151 558

30 June 2023 4 151 558 332 125 4 483 683 30 June 2024 4 483 683 358 695 4 842 378 30 June 2025 4 842 378 387 390 5 229 768 30 June 2026 5 229 768 418 381 5 648 149 30 June 2027 5 648 149 451 851 6 100 000

*The interest expense is determined by multiplying the opening balance of the liability by the interest rate.

The journal entries to recognise the periodic interest charges are:

30 June 2023 Dr Interest expense 332 125

Cr Provision for restoration costs 332 125

(to recognise interest expenses for 2023)

30 June 2024 Dr Interest expense 358 695

Cr Provision for restoration costs 358 695

(to recognise interest expenses for 2024)

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.

Although we will cover depreciation in the following chapter, there would also be a need to depreciate the rig at the each of reporting period. If we assume a useful life of five years, and no residual value at the end of the asset’s useful life, then the depreciation could be calculated simply as $16 902 700 ÷ 5 = $3 380 540. The accounting journal entry would be:

30 June 2023 Dr Depreciation expense—rig 3 380 540

Cr Accumulated depreciation—rig 3 380 540

(to recognise the depreciation of the rig)

Repairs and improvements 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 improvements. The major problem in this area is the decision over 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 to 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.

WORKED EXAMPLE 4.4 continued

dee67382_ch04_159-200.indd 187 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 187

WORKED EXAMPLE 4.5: Allocation of cost to individual assets

On 15 July 2023, 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 based on their respective fair values:

%

Land 55 Building 35 Machinery 8 Inventory 2

100

REQUIRED Prepare the journal entry as at 15 July 2023 to record the acquisition of the assets.

SOLUTION Allocation of purchase price:

% $

Land 55 2 145 275 Building 35 1 365 175 Machinery 8 312 040 Inventory 2 78 010

100 3 900 500

15 July 2023 Dr Land 2 145 275

Dr Building 1 365 175

Dr Machinery 312 040

Dr Inventory 78 010

Cr Bank 3 900 500

(to recognise the acquisition of various assets)

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, the 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.

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.

dee67382_ch04_159-200.indd 188 10/23/19 09:55 AM

188 PART 3: Accounting for assets

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. (AASB 116)

In explaining the above requirement, paragraph 44 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, (AASB 116)

4.8 Property, plant and equipment acquired with non-cash consideration

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 the initial ‘cost’ of the asset. As we know, property, plant and equipment is initially recorded at ‘cost’.

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.

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 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 paragraph 6, which states:

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 Accounting Standards. (AASB 116)

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, 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 Land 750 000

Dr Accumulated depreciation—ship 200 000

Cr Ship 800 000

Cr Gain on disposal of ship 150 000

(to record the acquisition of land and the disposal of a ship)

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.

LO 4.8

dee67382_ch04_159-200.indd 189 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 189

WORKED EXAMPLE 4.6: Determining the acquisition costs of assets

Assume that Joy Ltd is acquiring a portable building from Davies Ltd for the following consideration:

Cash $150 000 Shares 100 000 shares with a market value per share of $1.90 Land Joy is going to transfer title of some rural land to Davies (carrying amount of

$120 000; fair value of $95 000)

Liabilities Joy has agreed to take legal responsibility for Davies’ bank loan of $65 000 Legal fees Pertaining to the acquisition: $9000, which will be paid one month later

REQUIRED Determine the acquisition cost of the asset and provide the required journal entries.

SOLUTION In determining the cost of the acquisition, it is the fair value of the consideration that is relevant, not the historical book values.

Joy Ltd should account for the cost of the building as follows:

Cost $ Cash 150 000 Shares at fair value 190 000 Land at fair value 95 000 Legal fees 9 000 Liabilities 65 000

509 000

The journal entry to record the acquisition would be:

Dr Building 509 000 Dr Loss on disposal of land 25 000 Cr Bank loan 65 000 Cr Cash 150 000 Cr Legal fees accrued 9 000 Cr Land 120 000 Cr Share capital 190 000

(to record the acquisition of a building)

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.

Worked Example 4.6 gives another example of how to determine the acquisition cost of assets.

As indicated in Worked Example 4.6, 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.

4.9 Deferred payments made to acquire an asset

It is possible for an entity to acquire an item of property, plant and equipment and arrange with the vendor that the 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. (AASB 116)

LO 4.9

dee67382_ch04_159-200.indd 190 10/23/19 09:55 AM

190 PART 3: Accounting for assets

4.10 Accounting for borrowing costs incurred when constructing an item of property, plant and equipment

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. The general principle is that costs relating directly to a ‘qualifying asset’ (to be defined shortly) or costs that can be allocated on a reasonable basis to an asset should be included in the cost of the contract. Such costs might include borrowing costs. Therefore it would

WORKED EXAMPLE 4.7: Accounting for the deferred payment of an asset

On 1 July 2022, 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 2023. Double Island Point Ltd could borrow funds at 9 per cent per annum. The sale price without deferral would be $930 220.

REQUIRED Prepare the journal entries as at 1 July 2022, 30 June 2023 and 30 June 2024 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 $100 000 Present value of $150 000 for 8 years discounted at 9% ($150 000 × 5.5348—see Appendix B)

$830 220 $930 220

1 July 2022

Dr Sand-dredging machine 930 220

Cr Bank 100 000

Cr Loan 830 220

(to record the acquisition of the sand-dredging machine)

30 June 2023

Dr Interest expense—($830 220 × 9%) 74 720

Dr Loan 75 280

Cr Bank 150 000

(to recognise the payment of loan instalment)

30 June 2024

Dr Interest expense—([$830 220 – $75 280] × 9%) 67 945

Dr Loan 82 056

Cr Bank 150 000

(to recognise the payment of loan instalment)

We will consider the requirements of AASB 123 Borrowing Costs 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 4.7.

LO 4.10

dee67382_ch04_159-200.indd 191 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 191

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. The standard defines borrowing costs as ‘interest and other costs incurred by an entity in connection with the borrowing of funds’. It provides a general rule (which it refers to as the ‘core principle’). This core principle is provided at paragraph 1, 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. (AASB 123)

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. (AASB 123)

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 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. (AASB 123)

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 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. (AASB 123)

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.

dee67382_ch04_159-200.indd 192 10/23/19 09:55 AM

192 PART 3: Accounting for assets

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 2023 Fraser Island Ltd borrowed $500 000 at 12 per cent per annum, for two years, for the specific purpose of constructing an item of plant. The amount of interest capitalised as at June 2024 would be $60 000, which is $500 000 × 12%. The journal entry to capitalise the interest borrowed would be:

Dr Plant 60 000

Cr Interest payable 60 000

(to recognise interest expenses as part of the cost of plant)

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. (AASB 123)

For example, assume the same example above where on 1 July 2023 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 ($) Interest rate (%) Interest ($)

1 000 000 13 130 000

2 000 000 10 200 000

330 000

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 Plant 55 000

Cr Interest payable 55 000

(to recognise interest expense as part of the cost of plant)

Research on interest capitalisation While borrowing costs relating to assets that are constructed over a substantial period of time are to 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. Evidence has suggested that the choice to expense or capitalise interest was previously 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. 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. This would encourage managers to capitalise interest costs.

Bowen, Noreen and Lacey (1981) found that organisations which 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 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, by contrast, to expense interest, rather than capitalise it.

dee67382_ch04_159-200.indd 193 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 193

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.

4.11 Assets acquired at no cost

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, paragraph 4.18, which states that:

There is a close association between incurring expenditure and acquiring assets, but the two do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that the entity has sought future economic benefits, but does not provide conclusive proof that the entity has obtained an asset. Similarly, the absence of related expenditure does not preclude an item from meeting the definition of an asset. Assets can include, for example, rights that a government has granted to the entity free of charge or that another party has donated to the entity.

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 assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims’. 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. Further supporting the view that the receipt of an asset at no cost (which is not of the form of an equity contribution) creates income, the Conceptual Framework further provides that:

the recognition of income occurs at the same time as: (i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or (ii) the derecognition of a liability, or a decrease in the carrying amount of a liability.

Worked Example 4.8 considers how to account for an asset acquired at no cost. 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 assuming that the organisation adopts the ‘revaluation model’ for that particular class of assets. 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 not-for-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. (AASB 137)

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 4.11

dee67382_ch04_159-200.indd 194 10/23/19 09:55 AM

194 PART 3: Accounting for assets

WORKED EXAMPLE 4.8: 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.

SOLUTION

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

Dr Truck 90 000 Cr Donation income (or something similar) 90 000

(to recognise the receipt of a truck from another entity at no cost)

(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 that the recognition of expenses occurs at the same time as:

• the initial recognition of a liability, or an increase in the carrying amount of a liability, or • the derecognition of an asset, or a decrease in the carrying amount of an asset.

Hence the accounting entry in the books of Crescent Head Ltd:

Dr Donation expense (or something similar) 80 000

Dr Accumulated depreciation—truck 20 000

Cr Asset—truck 100 000

(to recognise the transfer of a truck to another entity for no consideration)

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.

WHY DO I NEED TO KNOW THE INFORMATION I HAVE JUST LEARNED ABOUT PROPERTY, PLANT AND EQUIPMENT?

Property, plant and equipment is a non-current asset that often accounts for a significant proportion of the total assets of most organisations. Therefore, it is important to know what the assigned amounts include, and what they do not include. In understanding financial performance, it is also important to understand why some expenditure relating to property, plant and equipment impacts profits, whereas other expenditure might not.

dee67382_ch04_159-200.indd 195 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 195

SUMMARY

The chapter explored a number of general issues that relate to assets. Assets, we saw, are defined as a present economic resource controlled by the entity as a result of past events. To apply the asset definition, recognition criteria are necessary. The Conceptual Framework states that for an asset to be recognised, the related information must be both relevant and representationally faithful.

Given that the recognition criteria are based on assessments of relevance and representational faithfulness, 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’). Many assets are measured at fair value. The chapter explored the meaning of fair value and the different ways in which it can be determined. The ‘fair-value hierarchy’ was also discussed, and the use of Level 1, 2 and 3 inputs was explained.

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.

KEY TERMS

amortisation 169 capitalise 170 control (assets) 162 current assets 167

current ratio 179 future economic benefits 162 heritage assets 167 intangible assets 165

recoverable amount 169 useful life 169

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following four questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. Is there a requirement that all assets shall be measured on the same basis (for example, at fair value)? LO 4.3 No. As this chapter has demonstrated, different measurement bases are to be applied to different classes of assets. For example, some assets shall be measured at cost, some shall be measured at fair value, and some shall be measured on the basis of the net present value of expected future cash flows. As a result, we need to be mindful that the ‘total assets’ of an organisation are simply a mixture of different measurement approaches.

2. What is the meaning of ‘fair value’? LO 4.4 Fair value is defined in AASB 13 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’.

3. What is the ‘fair-value hierarchy’ as it relates to the application of fair value to measuring assets? LO 4.4 AASB 13 establishes a fair-value hierarchy that categorises into three levels the inputs to valuation techniques used to measure fair value. The fair-value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).

4. If an asset is constructed with the use of borrowed funds, how are the related interest costs to be treated? LO 4.10 To the extent that the asset is a qualifying asset, then the interest costs are to be included within the ‘cost’ of the 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.

dee67382_ch04_159-200.indd 196 10/23/19 09:55 AM

196 PART 3: Accounting for assets

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Differentiate between the ‘definition of assets’ and the ‘criteria for recognition of assets’ provided in the Conceptual Framework. LO 4.2 •

2. Should all expenditure carried forward to future periods be amortised/depreciated? Why? LO 4.1, 4.2, 4.3 •

3. Identify three classes of assets that shall be measured at fair value. LO 4.3, 4.4 •

4. If an asset is expensed in one financial year because future economic benefits were subject to a high degree of ‘measurement uncertainty’, can the same asset be reinstated in future periods if the benefits are subsequently assessed as reliably measurable? In this respect, does the ability to reinstate assets apply to all assets? LO 4.3, 4.4 ••

5. Why would advertising expenditure typically be expensed in the period incurred? What would be an exception to this general rule? LO 4.2 •

6. 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 •

7. There are three key components to the definition of fair value. What are these? LO 4.4 •

8. What are three valuation techniques that can be used to determine fair value? LO 4.4 •

9. What is the ‘fair-value hierarchy’? Why do we need it, and what do each of the three levels of the hierarchy represent? LO 4.4 •

10. What do we mean with respect to assets when we say we need to draw a distinction between the economic benefits and the source of the economic benefits? LO 4.1 ••

11. If a reporting entity acquires an asset in exchange for another asset that is not cash, then how is the cost of the acquired asset determined? LO 4.8 ••

12. List some concerns that have been raised about the use of fair values. LO 4.4 •

13. 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 4.3, 4.4 ••

14. Explain the essential characteristics of an asset according to the Conceptual Framework for Financial Reporting. LO 4.1, 4.2 •

15. When should an ‘impairment loss’ be recognised? LO 4.3 •

16. What is the difference between value-in-use and net sales price less cost of disposal? 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, 4.3 ••

17. Can an entity include an asset in its statement of financial position that it does not legally own? Justify your answer. LO 4.1 •

18. 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 very low. As a result of changed circumstances in a subsequent year, the outlook is that the potential economic benefits to be generated by the asset are highly likely.

REQUIRED Explain whether the patent may be recognised as an asset i) when acquired or ii) when the potential economic benefits are assessed as highly likely. LO 4.1, 4.2, 4.3 ••

19. How are current assets defined for the purpose of presentation in a statement of financial position (balance sheet)? LO 4.5 •

dee67382_ch04_159-200.indd 197 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 197

20. Tea Tree Bay Ltd acquires a Gizmo Machine from Jetsons Ltd for the following consideration:

Cash $20 000

Land 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 4.8 •• 21. What are some of the various asset measurement rules currently utilised within accounting standards? LO 4.3 •• 22. 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 •• 23. 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 4.6 •• 24. 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 ••

25. According to AASB 116, would you expense or capitalise expenditure incurred in repairing an asset? Explain your answer. LO 4.7 •

26. 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 ••

27. 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).

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 4.11 •• 28. 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 4.7 ••

CHALLENGING QUESTIONS

29. 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 4.2, 4.3

dee67382_ch04_159-200.indd 198 10/23/19 09:55 AM

198 PART 3: Accounting for assets

30. 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

31. During the reporting period ending 30 June 2022, 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 2 500 500

Power permits 400 500

Engineers’ fees 1 100 500

4 001 500

The plant was ready to start generating power on 1 July 2022, with actual generation starting on 1 October 2022. At the end of the power plant’s useful life, which is expected to be 10 years, Midnight Boil Ltd is required by the 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 750 500

Environmental remediation costs 1 249 500

Replacement of flora and fauna 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 2022, 30 June 2023 and 30 June 2024. Ignore depreciation. LO 4.3, 4.7

32. 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 4.3

33. On 1 July 2022, 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 2023. Point Lookout Ltd can borrow funds at 8 per cent per annum.

REQUIRED Prepare the journal entries as at 1 July 2022 and 30 June 2023 to account for the acquisition of the asset. LO 4.9

34. 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 4.3

dee67382_ch04_159-200.indd 199 10/23/19 09:55 AM

CHAPTER 4: An overview of accounting for assets 199

35. Deebar Ltd has constructed an item of machinery at a cost of $220 000. Construction began on 1 January 2022 and was completed on 30 April 2022. 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 2022 and were repaid on 30 June 2022. 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.

(b) Provide the accounting entry, assuming that in June 2022 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.

(c) Provide the accounting entry, assuming that on 1 August 2022 the demand for the surfboards suddenly increases because Rick Manning, a surfing champion, won a world title event on a prototype of the 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, 4.3, 4.4, 4.7, 4.10

36. Does the statement of financial position item ‘Total assets’ represent the value of a reporting entity’s assets? Explain your answer. LO 4.3

37. Double Island Ltd constructed a Whizbang Machine and incurred the following costs in doing so:

Amounts paid to employees to build the machine $120 000

Raw materials consumed in building the machine $45 000

Depreciation of manufacturing equipment attributed to the construction of the Whizbang Machine $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, 4.7

38. 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 $1 000 000

Stamp duty and legal fees $80 000

Removal of pre-existing buildings $20 000

Application to local government bodies for development $10 000

Expenses incurred in evaluating a different site found to be unsuitable $30 000

Architects’ fees $100 000

Construction of spa buildings $1 500 000

Salary of manager overseeing the Lighthouse Point project for 18 months $120 000

Borrowing costs (interest) incurred in relation to the project $180 000

dee67382_ch04_159-200.indd 200 10/23/19 09:55 AM

200 PART 3: Accounting for assets

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, 4.7, 4.10

39. On 15 September 2020, 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

31 December 2020 $110 000 $130 000

30 June 2021 $90 000 $120 000

31 December 2021 $80 000 $90 000

30 June 2022 $120 000 $110 000

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 2022 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 value of expected future benefits of operating the resort. How should Tweed Ltd account for this event? LO 4.2,  4.3

40. Does the balance sheet provide an insight into all of the valuable resources available for use by an organisation? LO 4.1, 4.2

41. If the Conceptual Framework had a paragraph inserted that addressed measurement and that paragraph suggested that one basis of measurement, such as fair value, should be used by all reporting entities for all assets, 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 fair values as the basis for the measurement of all assets? LO 4.3

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. 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. 20–5.

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, 2018, Conceptual Framework for Financial Reporting, IASB, London.

Laux, C. & Leuz, C., 2009, ‘The Crisis of Fair-Value Accounting: Making Sense of the Recent Debate’, Accounting, Organizations, and Society, vol. 34, nos 6–7, pp. 826–34.

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.

Ronen, J., 2008, ‘To Fair Value or Not to Fair Value: A Broader Perspective’, Abacus, vol. 44, no. 2, pp. 181–208.

Watts, R.L. & Zimmerman, J.L., 1986, Positive Accounting Theory, Prentice Hall, Englewood Cliffs, New Jersey.

201

dee67382_ch05_201-222.indd 201 10/23/19 09:57 AM

C H A P T E R 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 Be aware that calculating depreciation expense requires a number of key decisions to be made,

including determining the ‘depreciable base’ of the asset, its ‘useful life’ and the appropriate method of cost apportionment.

5.3 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.

5.4 Know how to depreciate an asset that can be subdivided into separate components. 5.5 Understand when to start depreciating a depreciable asset. 5.6 Know how and when to revise depreciation rates and methods. 5.7 Be aware of the requirements in relation to the depreciation of land and buildings. 5.8 Know the implications for depreciation when existing assets are modified. 5.9 Know how to account for the disposal of a depreciable asset. 5.10 Be aware of some concerns about the relevance of depreciation expense, particularly when it is

calculated based on the historical costs of assets. 5.11 Know the disclosure requirements of AASB 116 Property, Plant and Equipment as they pertain to

depreciation.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

202 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 202 10/23/19 09:57 AM

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is depreciation expense? LO 5.1 2. Does depreciation reflect the change in the fair value of an asset that occurred within a reporting period?

LO 5.1, 5.10 3. Will depreciation always be treated as an expense within the reporting period in which it was calculated? LO 5.1 4. What are three main issues to consider when determining depreciation expense? LO 5.3 5. When should we start recognising depreciation expense? LO 5.5

depreciation Allocation of the cost of an asset, or its revalued amount, over the periods in which benefits are expected to be derived.

depreciable asset A non-current asset having a limited useful life.

5.1 Introduction to accounting for the depreciation of property, plant and equipment

The previous chapter considered how to account for the acquisition cost of assets. Following their acquisition, non-current assets with limited useful lives will typically need to be depreciated over the period during which the related 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 an asset across time. When non-current assets (apart from land perhaps) are acquired, there is a general expectation that the economic benefits related to the acquisition will not last indefinitely. Rather, the benefits will be consumed. With this in mind, a proportion of the acquisition cost of the asset will be allocated to particular financial periods throughout the asset’s useful life.

As the depreciable assets of an organisation might comprise a significant proportion of the firm’s total assets, the choice of depreciation policies can have a significant impact on the profits of a business. The potential magnitude of depreciation expense is evident from, for example, a review of BHP’s consolidated results for the 2019 financial year, which indicated that the total of the depreciation and amortisation expenses amounted to US$5829 million, in a year when profit after tax—and therefore after consideration of amortisation and depreciation—was US$9185

million, and when total assets were US$110 861 million (BHP reports its results in US dollars). Another example, in the 2019 financial year, is Qantas Ltd’s depreciation and amortisation expenses, which totalled $1665 million in a year when profit after tax was $891 million, and reported assets amounted to $19 377 million. As we can see, depreciation expense can be quite significant in absolute terms and also when compared to the profit of an organisation.

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 and  impairment of property, plant and equipment (which we address in Chapter 6), depreciation, 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.

LO 5.1

AASB no. Title IFRS/IAS equivalent

108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8

116 Property, Plant and Equipment IAS 16

136 Impairment of Assets IAS 36

138 Intangible Assets IAS 38

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

CHAPTER 5: Depreciation of property, plant and equipment 203

dee67382_ch05_201-222.indd 203 10/23/19 09:57 AM

From an accountant’s perspective, depreciation represents the allocation of the cost of an asset, or its revalued amount, over the periods in which economic 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 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. (AASB 116)

In determining how to allocate the cost of the asset to the period’s profit or loss, three key 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 typically 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 accounting 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’.

As an example of the above requirement, consider Worked Example 5.1.

WHY DO I NEED TO KNOW WHAT DEPRECIATION REPRESENTS?

Depreciation can be a significant expense for many organisations. It is important that we therefore understand what this expense represents. For example, it is important that we realise that depreciation is an allocation of cost (or fair value) of an asset over the accounting periods expected to benefit from its use. Depreciation expense does not represent a change in the value—for example, fair value—of an asset from one period to the next. It is simply the result of an allocation process, not a valuation process.

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, a high-powered sander was used. The cost of the sander is $900 000 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 high-powered sander.

SOLUTION The depreciation expense in this case would be based on the expected life of 500 hours and would equal $900 000 × 50/500 = $90 000.

The journal entry would be:

Dr Boat—inventory 90 000

Cr Accumulated depreciation—sander 90 000

(to recognise the depreciation of the sander)

204 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 204 10/23/19 09:57 AM

5.2 Key factors to consider when determining depreciation

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. We will explore these issues now.

Depreciable amount (base) of an asset 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 6 of AASB 116 defines residual value as:

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. (AASB 116)

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 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 in time. 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 $8000. 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 $6000. 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 until such time that 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. Useful life is defined as: (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. (AASB 116)

In Worked Example 5.1 we utilised production hours as the basis of the asset’s useful life (as in part (b) above). 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. (AASB 116)

depreciable amount 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.

LO 5.2

CHAPTER 5: Depreciation of property, plant and equipment 205

dee67382_ch05_201-222.indd 205 10/23/19 09:57 AM

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.

LO 5.3

The possibility of obsolescence, both technical and commercial, is a factor that needs to be considered regardless of the actual 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 (non-monetary 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.

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.

5.3 Applying different methods of depreciation

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 throughout its useful life, 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.

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.

206 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 206 10/23/19 09:57 AM

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 $5000 at the end of its 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 – $5000) ÷ 5 = $4000 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 declining- balance 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 5 ÷ 15 × ($25 000 − $5 000) = $ 6 667 2 4 ÷ 15 × ($25 000 − $5 000) = $ 5 333 3 3 ÷ 15 × ($25 000 − $5 000) = $ 4 000 4 2 ÷ 15 × ($25 000 − $5 000) = $ 2 667 5 1 ÷ 15 × ($25 000 − $5 000) = $ 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

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—that is, it should provide a ‘neutral depiction’ of the underlying transaction or event—directly links to one of the fundamental qualitative characteristics that useful financial information is expected to possess according to the Conceptual Framework. This characteristic is ‘faithful representation’ (as we learned in Chapter 2, apart from providing a neutral depiction of an underlying transaction or event, for information to be ‘faithfully represented’ it would also be expected to be ‘neutral’ and ‘complete’).

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 Ltd’s 2019 Annual Report.

CHAPTER 5: Depreciation of property, plant and equipment 207

dee67382_ch05_201-222.indd 207 10/23/19 09:57 AM

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

Year Depreciation

1 0.27 523 × ($25 000) = $ 6 881 2 0.27 523 × ($25 000 − $6 881) = $ 4 987 3 0.27 523 × ($25 000 − $11 868) = $ 3 614 4 0.27 523 × ($25 000 − $15 482) = $ 2 620 5 0.27 523 × ($25 000 − $18 102) = $ 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 ÷ 1000) × (25 000 – 5000) = $4200.

Exhibit 5.1 Details of the accounting policy note for depreciation of property, plant and equipment from BHP Ltd’s 2019 Annual Report

SOURCE: © BHP Group Ltd

208 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 208 10/23/19 09:57 AM

LO 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 Ltd’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 ($)

Airframe 15 1 830 000

Engines 10 1 324 000

Interior fixtures and fittings 5 415 000

3 569 000

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

Component cost ($) Useful life (years)

Depreciation expense ($)

Airframe 1 830 000 15 122 000

Engines 1 324 000 10 132 400

Interior fixtures and fittings 415 000 5 83 000

3 569 000 337 400

The journal entry would be:

Dr Depreciation expense 337 400

Cr Accumulated depreciation—airframe 122 000

Cr Accumulated depreciation—engines 132 400

Cr Accumulated depreciation—interior fixtures and fittings 83 000

(to recognise the depreciation expense of aircraft components)

5.4 Depreciation of separate components

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 shall 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 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. (AASB 116)

An example of the components approach to depreciation is provided in Worked Example 5.4. Worked Example 5.5 provides another example of calculating depreciation in the presence of a combined asset

that has separate components.

CHAPTER 5: Depreciation of property, plant and equipment 209

dee67382_ch05_201-222.indd 209 10/23/19 09:57 AM

WORKED EXAMPLE 5.5: A further example of calculating depreciation in the presence of a separate component

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 2021: $ 70 000 • Cost to deliver the machine to the site: $ 5 000 • Amount paid to an engineer to make the machine work: $ 35 000

$110 000

The engineer completes her work on 31 December 2021. 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 2022, an additional component is acquired at a cost of $60 000 and is attached to the blank-

making machine acquired on 1 July 2021. 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 2023.

SOLUTION 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 straight-line 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 ($60 000) allocated over 20 years. This gives an amount of $3000. Hence, the total depreciation expense for the year to 30 June 2023 is $14 000.

LO 5.5 5.5 When to start depreciating an asset

Having considered three key issues associated with determining depreciation expense (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 factors such as technical or commercial obsolescence. As paragraph 55 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. (AASB 116)

210 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 210 10/23/19 09:57 AM

5.6 Revision of depreciation rate and depreciation method

The depreciation expense charged to each accounting period is an estimate that involves the exercise of professional 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. 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 demand for the products generated by the asset might reduce the useful life of the asset. Changes in the repair and maintenance policy of the entity might also impact 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. (AASB 116)

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 also 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. (AASB 116)

Revisions of depreciation rates, perhaps as a result of changed expectations about the useful lives of an asset, can have very significant impacts on profits. For example, if we review the 2019 Annual Report of Telstra, the large Australian telecommunications organisation, we will see within the notes to the financial statements that ‘a review of useful lives during the year resulted in a $253 million decrease in depreciation’.

AASB 116 requires that, if a revision of useful life or of the amounts expected on disposal (the residual amount) 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.

5.7 Land and buildings

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 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. (AASB 116)

Paragraph 59 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. (AASB 116)

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).

LO 5.7

LO 5.6

CHAPTER 5: Depreciation of property, plant and equipment 211

dee67382_ch05_201-222.indd 211 10/23/19 09:57 AM

Managers 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.

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 sometimes 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 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 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. (AASB 138)

Conversely, if an intangible asset is considered to have an indefinite useful life, AASB 138 Intangible Assets, 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 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 5.6 further illustrates some of the issues that we need to consider when determining how to depreciate assets.

WORKED EXAMPLE 5.6: 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 fruit-canning 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 100 000 less Accumulated depreciation (85 716)

14 284

continued

212 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 212 10/23/19 09:57 AM

However, a review by Ochillupo Ltd now indicates that the machine can be used effectively within the business for a further five years. It has been established that the expected residual amount of the asset in five years would be zero.

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 recognised 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 now believes that the asset has a useful life of five years and that the residual amount in five years would be zero. Therefore, the carrying value of $14 284 should be depreciated over a revised estimated useful life of five years, providing a revised depreciation charge of $2857 per year.

LO 5.8 5.8 Modifying existing non-current assets

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.

5.9 Disposition of a depreciable asset

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 from the accounts the cost (or revalued amount) and the accumulated depreciation ∙ record the consideration received (if any) ∙ record the gain or loss on disposal.

LO 5.9

WORKED EXAMPLE 5.6 continued

CHAPTER 5: Depreciation of property, plant and equipment 213

dee67382_ch05_201-222.indd 213 10/23/19 09:57 AM

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. (AASB 116)

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 just noted, AASB 116 adopts the term ‘derecognition’. The term incorporates the retirement and disposal of an asset. 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. (AASB 116)

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 $2000. Hence the net effect on profits over the three years would be negative $13 000 (profit on sale of $2000 less the accumulated depreciation of $15 000). If the item is not depreciated (which would not be in compliance with the accounting standards), 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 5.7 looks at the disposal of a depreciable asset.

WORKED EXAMPLE 5.7: Disposal of a depreciable asset

Sandon Point Ltd acquires an item of machinery on 1 July 2020 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 2022 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 = $33 333 Second year depreciation = 4 ÷ 15 × $100 000 = $26 667 Total accumulated depreciation at 1 July 2022 = $60 000

Therefore, the carrying amount of the asset is $40 000 as at 30 June 2022, made up of the 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 and the carrying amount of the asset at the time of sale would not be shown as a related cost. Rather, just the net amount (the profit or loss on sale) is recognised.

continued

214 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 214 10/23/19 09:57 AM

The accounting entry would be:

Dr Cash at bank 70 000 Dr Accumulated depreciation—machinery 60 000 Cr Gain on sale of machinery 30 000 Cr Machinery 100 000

(to record the disposal of machinery)

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.

LO 5.10

5.10 Depreciation as a process of allocating the cost of an asset over its useful life: some related concerns

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 machine for $1 000 000 that has an

expected useful life of 10 years with no expected residual value we would recognise $100 000 in depreciation each year (assuming that the pattern of benefits is expected to be uniform across the useful life of the asset and assuming we have not revalued the asset). The effect of this is that across the useful life of the asset we have reduced profits by the cost of the machine, which was $1 000 000. What must be appreciated, however, is that the subsequent cost of replacing the machine might have increased across time so that it is greater than the aggregate amount that we have recognised as a depreciation expense. For example, if the cost of replacing the machine after 10 years has doubled to $2 000 000, it could be argued that we have not recognised sufficient depreciation expenses and might have distributed to shareholders too much in dividends (dividends 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 this cost as an expense) is appropriate when the replacement cost of that asset might be significantly increasing across time due to factors such as inflation or shortages in the raw material necessary to construct an asset, and so forth. That is, would the associated depreciation expense that is disclosed within the financial statements satisfy the fundamental qualitative characteristics of relevance and faithful representation? Obviously the accounting standard-setters must believe it would.

The modified contents of an article that appeared several years ago (by Roger Montgomery in The Australian Financial Review of 19 December 2003 and entitled ‘Airline losses masked as profits’) is provided in Exhibit 5.2. While quite old, the article usefully summarises 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 exhibit.

WORKED EXAMPLE 5.7 continued

Exhibit 5.2 A reflection of some problems associated with the depreciation of assets that are reported at cost rather than fair value

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

CHAPTER 5: Depreciation of property, plant and equipment 215

dee67382_ch05_201-222.indd 215 10/23/19 09:57 AM

WHY DO I NEED TO KNOW THAT THE AMOUNT OF DEPRECIATION EXPENSE IS INFLUENCED BY WHETHER THE DEPRECIABLE ASSETS ARE MEASURED AT COST, OR AT FAIR VALUE?

The argument that does have some merit is that if depreciation is based on the cost of an asset, then the depreciation expense being recognised might be considered to be relatively low, with the consequence that reported profits might, in a sense, be somewhat inflated. By contrast, if assets have been revalued upwards to their fair value (we will consider this issue in Chapter 6), then depreciation expenses will be higher, and profit will be lower.

Therefore, when we do an analysis of financial statements, we need to consider whether depreciation expense has been based on asset costs that are low relative to what the replacement cost would currently be for the assets.

5.11 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; and office equipment. Paragraph 73 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;

LO 5.11

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 a total of $1 million in depreciation. If we assume that total accumulated profits over the 25 years were $2.5 million, and 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 later be $2.7 million. If the machinery is to be replaced so that the business is in the same position, the cost to the business is 2.7 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 aggregated 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.

SOURCE: Adapted from ‘Airline losses masked as profits’, by Roger Montgomery, The Australian Financial Review, 19 December 2003, p. 23.

216 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 216 10/23/19 09:57 AM

(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. (AASB 116)

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.

This chapter also noted that when depreciation expense is calculated on the basis of the cost of an asset, concerns are sometimes raised that depreciation expense potentially understates the actual ‘cost’ relating to the use of the asset.

KEY TERMS

declining-balance method 205 depreciable amount 204 depreciable asset 202

depreciation 202 straight-line method 205 sum-of-digits method 205

useful life 214

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter, we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—suggested solutions are shown below.

1. What is depreciation expense? LO 5.1 Depreciation represents the allocation of the cost (or fair value) of an asset, less any residual value, over the expected useful life of the asset. It is an allocation process, not a valuation process.

CHAPTER 5: Depreciation of property, plant and equipment 217

dee67382_ch05_201-222.indd 217 10/23/19 09:57 AM

2. Does depreciation reflect the change in the fair value of an asset that occurred within a reporting period? LO 5.1, 5.10 No, it does not represent the change in the fair value of the asset. It is an allocation of cost, or fair value.

3. Will depreciation always be treated as an expense within the reporting period in which it was calculated? LO 5.1 No, not always. If a depreciable asset is being used to construct another asset, then the depreciation of the asset being used can become part of the cost of the asset being constructed.

4. What are three main issues to consider when determining depreciation expense? LO 5.3 Three key issues to consider include:

(a) What depreciable base should be used for the asset? (b) What is the asset’s useful life? (c) What method of cost apportionment is most appropriate for the asset?

5. When should we start recognising depreciation expense? LO 5.5 Depreciation expenses are to be recognised from the date when a depreciable asset is first put into use, or is 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.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

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 5.1, 5.2, 5.10 •

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.

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 5.2, 5.3 •

5. What is the difference between amortisation and depreciation? LO 5.1 ••

6. If managers assign a relatively high residual value to a depreciable asset, will this increase profits? LO 5.2 ••

7. In the 2019 Annual Report of Telstra, it was reported that a ‘Review of useful lives during the year resulted in a $253 million decrease in depreciation’. Can you provide a possible explanation for this decrease in depreciation expense? LO 5.2 ••

8. 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 5.2, 5.3, 5.4, 5.5 ••

9. 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, 5.3, 5.6 •••

10. 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, 5.4 ••

218 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 218 10/23/19 09:57 AM

11. 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 • 12. What could motivate management to use one method of depreciation in preference to another? LO 5.1, 5.3 • 13. How is the gain or loss on the disposal of a non-current asset determined? LO 5.9 • 14. Winkipop Ltd acquires an item of machinery on 1 July 2019 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 2022, 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 2022. LO 5.1, 5.2, 5.3, 5.9 • 15. 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 5.1, 5.2 •• 16. If a company depreciates its property, plant and equipment, what are the associated disclosure requirements? LO 5.11 • 17. Can an organisation switch depreciation methods from one financial period to the next? LO 5.1, 5.6 • 18. On 1 July 2021, 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 2022. LO 5.1, 5.2, 5.3 ••

CHALLENGING QUESTIONS

19. 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 the reporting date is only $110 000. How would you respond to his query? LO 5.1, 5.3, 5.10

20. Is depreciation an allocation process or a valuation process? Provide reasons for your answer. LO 5.1, 5.2

21. Can profit be considered to be overstated if depreciation is calculated on the basis of the historical cost of an asset? LO 5.10

22. An item of inventory is sitting idle. Should it be depreciated? LO 5.5

23. Does depreciation expense represent an accounting number that can be relatively easily manipulated as part of the manager’s strategy of earnings management? How would managers do this, and why? LO 5.1, 5.2

24. At the beginning of 2019, 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 2021 financial year, the depreciation expense was recognised on a straight-line basis. At the beginning of the 2022 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 2020, 2021 and 2022 financial years. LO 5.3, 5.4, 5.6

CHAPTER 5: Depreciation of property, plant and equipment 219

dee67382_ch05_201-222.indd 219 10/23/19 09:57 AM

25. Anglesea Ltd constructed a building in 2018 at 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 2022 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 2022 financial year.

REQUIRED Calculate the depreciation cost for the 2021, 2022 and 2023 financial years. LO 5.2, 5.3, 5.8

26. Lonsdale Ltd has a machine that makes one type of fin for surfboards. The machine was acquired in 2020 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 2023 financial year, an attachment for the machine is acquired at a cost of $5000, 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 2023 the fin-making machine is expected to be able to produce a further 1000 fins in total. The numbers of fins produced in 2020, 2021, 2022 and 2023 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 2020 to 2023 and discuss whether the expense would be included as part of the cost of inventory. LO 5.2, 5.3

27. Wastewater Ltd acquired an item of plant on 1 July 2020 for $3 660 000. When the item of plant was acquired, it was initially assessed as having a life of 10 000 hours. During the reporting period ending 30 June 2021, the plant was operated for 3000 hours.

At 1 July 2021 the plant had a remaining useful life of 7000 hours. On 1 July 2021 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 2022 the plant was operated for 4000 hours.

On 1 July 2022 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 2023, the plant was operated for 3800 hours.

REQUIRED Prepare all of the journal entries that Wastewater Ltd would prepare for the years ending 30 June 2021, 30 June 2022 and 30 June 2023 to account for the acquisition, subsequent expenditure and depreciation on the asset. LO 5.2, 5.3, 5.8

28. On 1 July 2019 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 $5000. 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 5.2, 5.3

(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 Kilometres

2020 28 000

2021 34 000

2022 42 000

2023 55 000

2024 68 000

2025 19 000

246 000

220 PART 3: Accounting for assets

dee67382_ch05_201-222.indd 220 10/23/19 09:57 AM

29. On 1 July 2019, Bear Island Ltd acquired a computer for an initial cost of $50 000. To make the computer more efficient in the workplace, a number of hardware modifications were necessary before installation. These modifications cost $40 000. The computer was ready for use on 1 January 2020. 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 2021, a high-speed disk drive was 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 2022, using the straight-line method, and provide the required journal entries. LO 5.2, 5.3, 5.8

30. Gazza Ltd acquired 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 $7000 at the end of its useful life.

REQUIRED Calculate the depreciation charge for each of the first three years, using the following methods: LO 5.3

(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 6 000 hours

Year 2 7 000 hours

Year 3 5 500 hours

31. First Point Ltd acquired an item of machinery on 1 July 2019 for a cost of $250 000. When the asset was acquired, it was 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 2022 the asset was sold for $110 000. The amount is to be received as follows: $60 000 on 30 June 2023 and $50 000 on 30 June 2024. The applicable interest rate is 6 per cent.

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 5.2, 5.3, 5.9

32. 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, 5.4

33. On 1 July 2020 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 2021 and 3400 in the year ended 30 June 2022. On 1 July 2022 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 2021 and 30 June 2022 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 2022.

(b) Prepare journal entries to record depreciation of the printing machine for each of the years ended 30 June 2021 and 30 June 2022 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 2022.

(c) Prepare journal entries to record depreciation of the printing machine for each of the years ended 30 June 2021 and 30 June 2022 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 2022.

(d) Prepare journal entries to record depreciation of the printing machine for each of the years ended 30 June 2021 and 30 June 2022 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 2022. LO 5.2, 5.3, 5.5, 5.9

CHAPTER 5: Depreciation of property, plant and equipment 221

dee67382_ch05_201-222.indd 221 10/23/19 09:57 AM

34. Malibu Ltd acquired a building on 1 July 2015 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 2021 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 2020, 2021 and 2022, and state the carrying amount of the building at the end of each of the three reporting periods. LO 5.4

35. As we know, AASB 116 requires reporting entities to disclose details about the useful lives and depreciation rates used for each class of property, plant and equipment. The information provided below is from the 2019 Annual Report of Telstra. You are to evaluate whether you think this information would be ‘useful’ to financial statement readers. LO 5.6

SOURCE: Telstra Annual Report 2019, https://www.telstra.com.au/content/ dam/tcom/about-us/investors/pdf%20F/2019-Annual-Report.PDF

36. 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 5.1, 5.2, 5.10

37. Possoes Ltd acquired an aeroplane in 2022 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, 5.10

REFERENCE Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

dee67382_ch05_201-222.indd 222 10/23/19 09:57 AM

dee67382_ch06_223-256.indd 223 10/24/19 12:43 PM

223

C H A P T E R 6 Revaluations and impairment testing of non-current assets

LEARNING OBJECTIVES (LO) 6.1 Have an understanding of the requirements within accounting standards pertaining to the

revaluation of non-current assets. 6.2 Understand that managers often have a choice between measuring their non-current assets at either

‘cost’ or ‘fair value’. 6.3 Understand the meaning of ‘fair value’ and the requirement that asset revaluations, if undertaken, must

be based upon fair value and not some other basis of measurement. 6.4 Understand how to account for revaluation increments (increases in the carrying amount of non-current assets). 6.5 Understand how to account for accumulated depreciation when a non-current depreciable asset is revalued. 6.6 Understand how to account for revaluation decrements (decreases in the carrying amount of non-

current assets). 6.7 Understand how to account for revaluations that reverse previous revaluation increments or decrements. 6.8 Be able to calculate the gain or loss on the sale of a revalued non-current asset. 6.9 Be able to explain the meaning of an ‘impairment loss’, and describe when an impairment loss should be

recognised. 6.10 Know some of the factors that are considered in determining the discount rate to be applied when

calculating the present value of the future cash flows associated with a non-current asset. 6.11 Be aware that the requirements for revaluing ‘investment properties’ are somewhat different from

requirements pertaining to other non-current assets. 6.12 Be aware that the recognition of impairment losses and the utilisation of asset revaluations can create

economic consequences for an organisation, which in turn might motivate managers’ accounting policy choices.

6.13 Be aware of the disclosure requirements associated with asset revaluations and impairments.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

dee67382_ch06_223-256.indd 224 10/24/19 12:43 PM

224 PART 3: Accounting for assets

OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. For financial reporting purposes, should property, plant and equipment be reported at cost or at fair value? LO 6.1, 6.2

2. If the fair value of an item of property, plant and equipment increases, is this increase included within profit or loss? LO 6.1, 6.4

3. For financial reporting purposes, is there a need to determine the recoverable amount of non-current assets? LO 6.9 4. How is the recoverable amount of a non-current asset to be determined? LO 6.9 5. When is an impairment loss recognised? LO 6.9

6.1 Introduction to revaluations and impairment testing of non-current assets

Financial statements prepared under the historical-cost accounting convention are frequently criticised on the grounds that 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 revaluation of certain types of assets is specifically excluded by virtue of some accounting standards. For example, AASB 138 Intangible Assets will not permit most intangible assets to be revalued. 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.

Revaluations of property, plant and equipment are permitted in those countries—such as Australia—that have adopted the accounting standards issued by the IASB. Interestingly, upward asset revaluations are not permitted in the US. As we know, the US does not use the accounting standards issued by the IASB.

In those situations where the carrying amount 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 this chapter, should not be confused with depreciation (which was covered in the previous chapter). Depreciation—which is the allocation of the cost (or revalued amount) of an asset over its expected useful life—is recognised even if the recoverable amount of an asset exceeds its carrying amount.

6.2 Measuring property, plant and equipment at cost or at fair value— there’s a choice

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, derecognition and revaluation of property, plant and equipment. In this chapter we will concentrate on revaluations and impairments of property, plant and equipment.

LO 6.1

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 the costs of disposal, and its value in use.

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

LO 6.2

AASB no. Title IFRS/IAS equivalent

13 Fair Value Measurement IFRS 13

102 Inventories IAS 2

116 Property, Plant and Equipment IAS 16

136 Impairment of Assets IAS 36

138 Intangible Assets IAS 38

140 Investment Property IAS 40

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

dee67382_ch06_223-256.indd 225 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 225

When an item of property, plant and equipment is initially recognised, it is measured at cost, where ‘cost’ is the purchase price plus those costs directly attributable to the acquisition, plus the expected costs associated with the subsequent dismantling, removal and restoration of the related site. Once an item of property, plant and equipment has been recognised at ‘cost’ by an entity, AASB 116 requires each class of property, plant and equipment to either continue to be measured at cost (referred to in the standard as the ‘cost model’), or alternatively 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 of a particular type of asset 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.

There are two main benefits that can be identified in relation to the requirement that revaluations shall be undertaken with respect to an entire class of assets, rather than on an individual asset basis. First, the ability of managers and their accountants to be selective about which assets to revalue will be reduced. Further, as an entire class of assets will be measured on the same basis, there will be a consistent measure for that class, and this might help make that total more meaningful.

When the ‘cost method’ is used, depreciation expenses would be recognised, as might impairment losses such that the carrying amount of the asset shall be its cost less any accumulated depreciation and any accumulated impairment losses. The carrying amount of an item of property, plant and equipment that has been revalued will also be reduced by any subsequent accumulated depreciation, and by subsequent impairment losses.

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, or the cost basis to the fair value basis, as long as the change generates financial information that is relevant and representationally faithful, and as long as adequate disclosures of the change in accounting policy are made within the notes to the financial statements.

If an organisation switches from the cost model to the fair value model, then there would be a general expectation that the relevance of the information would be enhanced because more current information about asset values would be presented to the readers of the financial statements. Nevertheless, a potential downside is that the information might be less reliable because the determination of fair value might require a great deal of professional judgement. The potential increase in relevance needs to be balanced against any diminution in representational faithfulness. By comparison, a change from the revaluation model to the cost model would generally be considered to lead to less relevant information being presented about asset values. However, this might be justified on the basis that it has perhaps become difficult to reliably determine fair values. Again, managers and accountants need to consider the trade-off between enhanced representational faithfulness and reduced relevance before making their accounting policy choice decision.

Clearly, by permitting some classes of non-current assets to be valued at cost and others to be valued at fair value, we have not eliminated the potential confusion associated with understanding what the total balance of all non-current assets actually represents. It is neither cost nor fair value, but a combination of the two.

WHY DO I NEED TO KNOW THAT A REPORTING ENTITY HAS A CHOICE TO MEASURE ITS PROPERTY, PLANT AND EQUIPMENT AT COST, OR AT FAIR VALUE?

The accounting policy choice of measuring property, plant and equipment at cost, or at fair value, can have significant impacts on the total assets reported within the balance sheet. Therefore, it is important that we know about this available choice, and whether a particular reporting entity has elected to use cost or fair value. Apart from its impact on the total assets reported within the balance sheet, the choice of accounting method will also influence reported profits—for example, it will potentially impact depreciation expenses and the profits from the sale of non-current assets. When comparing the financial statements of different organisations, it is important that we know whether they are using cost, or fair value, as comparing the financial position and financial performance of an entity that uses the cost model with another that uses the revaluation model can potentially be misleading.

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.

dee67382_ch06_223-256.indd 226 10/24/19 12:43 PM

226 PART 3: Accounting for assets

6.3 The use of fair values

Where a revaluation of an item of property, plant and equipment is undertaken, the revaluation must be to fair value rather than to any other value. 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’.

How does an entity determine fair value? Both AASB 116 and 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 that 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.

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. (AASB 116)

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 standard 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 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. (AASB 116)

6.4 Revaluation increments

The basic accounting equation that we would have learned in our introductory accounting education is of the form:

Assets = Liabilities + Equity

As we know, this equation, which is the foundation of double-entry accounting, must always balance. Therefore, if we increase total assets, which we would do if we were upwardly revaluing our assets, then we must also increase the right side of the equation. As liabilities would not increase, then a revaluation has the consequence of increasing equity. As we know, equity will increase as a result of income, or as a result of contributions from owners (and will decrease as a result of expenses and as a result of distribution to owners). As it would not represent a contribution from owners, the increase in the fair value of the asset would therefore belong to ‘income’. While almost all items of ‘income’ and ‘expense’ are included in profit or loss, a very limited number of items of income are specifically excluded from inclusion within profit or loss and, in accordance with accounting standards, must instead be included

in a component of income that is known as ‘other comprehensive income’. AASB 116 specifically requires that a revaluation increment be recognised as part of ‘other

comprehensive income’ (which is not part of ‘profit or loss’), and the total of all revaluation increments shall be subsequently aggregated in (posted to) an equity account referred to as a ‘revaluation surplus’ account, which, for a company, would be part of the total shareholders’ funds (equity). The profit or loss for an accounting period together with the ‘other comprehensive income’ for the period are disclosed within the ‘statement of profit or loss and other comprehensive income’ and added together to give the ‘total comprehensive income’.

revaluation increment When an asset is revalued upwards, the revaluation increment represents the difference between the carrying amount of the asset and its fair value at the date of revaluation.

LO 6.3

LO 6.4

dee67382_ch06_223-256.indd 227 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 227

The format of the statement of profit or loss and other comprehensive income is explored and discussed in depth in Chapter 16. However, at this stage you need to remember that while most items of income and expense are required to be included in the measure of financial performance known as ‘profit or loss’, a very limited set of income and expenses are explicitly excluded from being part of profit or loss by virtue of particular accounting standards. The excluded income items (sometimes referred to as gains) or expense items (sometimes referred to as losses) are to be included in ‘other comprehensive income’, which comes below profit or loss. Again, the revaluation increment is a specific example of a gain that is not permitted to be included in profit or loss, but which must be included within ‘other comprehensive income’. Exhibit 6.1 provides an example of a statement of profit or loss and other comprehensive income and shows where the gains associated with a revaluation increment would be shown. In relation to the increase in the revaluation surplus, paragraph 39 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 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. (AASB 116)

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’ (OCI) 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 Asset X

Cr Gain on revaluation (part of OCI) X

Exhibit 6.1 Example of a statement of comprehensive income

XYZ LTD

Statement of comprehensive income for the year ended 31 December 2022 2022

($000) 2021

($000)

Revenue 390 000 355 000

Cost of sales (245 000) (230 000)

Gross profit 145 000 125 000

Distribution costs (9 000) (8 700)

Administrative expenses (20 000) (21 000)

Other expenses (2 100) (1 200)

Finance costs (8 000) (7 500)

Profit before tax 105 900 86 600

Income tax expense (31 770) (25 980)

Profit for the year 74 130   60 620

Other comprehensive income

Items of comprehensive income that will be reclassified subsequently to profit or loss: Exchange differences on translating foreign operations 5 000 10 667

Items of comprehensive income that will not be reclassified subsequently to profit or loss: Gains on property revaluation 20 000 4 000

Income tax relating to components of other comprehensive income

(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

dee67382_ch06_223-256.indd 228 10/24/19 12:43 PM

228 PART 3: Accounting for assets

The above entry would be made at the time the revaluation is undertaken. Again, the increase represents a gain and is considered ‘income’, but the gain is not permitted by the accounting standard to be included in profit or loss—so it is included within ‘other comprehensive income’, with ‘other comprehensive income’ being presented below profit or loss in the statement of profit or loss and other comprehensive income. At the end of the accounting period, all of the gains associated with revaluations that had been recognised during the accounting period would ultimately be transferred to (posted to) an equity account in the balance sheet, with this equity account being labelled ‘revaluation surplus’ (or something similar). This process is very similar to how we use closing entries to post (or ‘close off’) income and expense accounts to a temporary account, such as the ‘profit and loss summary account’, before ultimately being posted to retained earnings (you would have learned about ‘closing entries’ in your introductory accounting education). The general entry to transfer the gains on revaluation to an equity account at the end of the accounting period would be:

Dr Gain on revaluation (part of OCI) X

Cr Revaluation surplus (part of equity) 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. (Interested readers can refer to Section 18.6 now.)

6.5 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, thereby initially reducing the amount of the asset. The asset accounts are then to be increased or decreased by the amount of the revaluation increments or revaluation decrements.

For example, assume we have a machine with a cost of $10 000 and accumulated depreciation of $1000 (giving a carrying amount of $9000). Let us further assume that we revalue the machine to its fair value of $14 000. To take account of the accumulated depreciation we would initially debit accumulated depreciation by $1000—thus causing the balance of accumulated depreciation as it relates to this asset to be zero—and credit the asset account by $1000. That is, the journal entry would be:

Dr Accumulated depreciation—machine 1 000

Cr Machine 1 000

( journal entry to eliminate the balance of accumulated depreciation and to offset it against the related asset)

We would then debit the machine account by $5000 and credit the gain on revaluation (part of OCI) by $5000. 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 Machine 5 000

Cr Gain on revaluation (part of OCI) 5 000

(to recognise the revaluation of the asset to fair value and recognise the related gain in OCI)

We already know the definition of income from Chapter 2. Therefore, the increase in the value of the asset satisfies the definition of income. However, as we have already

stressed, the accounting standard AASB 116 specifically requires that this increase in value be included in the measure of financial performance known as ‘other comprehensive income’ rather than in the measure of financial performance known as ‘profit or loss’. One of the reasons for this is that such a gain has not effectively been ‘realised’ and therefore it could be inappropriate to include it within profits given that profits can potentially be distributed away from the organisation to owners in the form of dividend payments.

All of the gains on revaluation that have been recognised during the accounting period are transferred to (closed off against) the equity account known as ‘revaluation surplus’ at the end of the accounting period, similar to how

LO 6.5

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.

revaluation decrement When an asset is revalued downwards, the revaluation decrement represents the difference between the carrying amount of the asset and its fair value at the date of revaluation.

dee67382_ch06_223-256.indd 229 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 229

income and expense accounts that are included in profit or loss are transferred to retained earnings at the end of the accounting period. The closing entry in this instance would be:

Dr Gain on revaluation (part of OCI) 5 000

Cr Revaluation surplus 5 000

(to transfer the total of ‘gain on revaluation’ to the ‘revaluation surplus’)

Subsequent depreciation (after a revaluation) is then 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.

We can summarise some of the above steps as follows in Figure 6.1. 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

WORKED EXAMPLE 6.1: Revaluation of a depreciable asset using the net-amount method

Assume that, as at 1 July 2022, Farrelly Ltd has an item of machinery that originally cost $40 000 and has accumulated depreciation of $15 000. Its remaining useful 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 2022 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:

Fair value – carrying amount = revaluation increment $45 000 − ($40 000 − $15 000) = $20 000 The appropriate journal entries on 1 July 2022 would be:

Dr Accumulated depreciation—machinery 15 000 Cr Machinery 15 000

(to offset the balance of accumulated depreciation against the related asset account)

Dr Machinery 20 000 Cr Gain on revaluation of machinery (part of OCI) 20 000

(to increase the carrying amount of the machinery by the amount of the revaluation and recognise the gain as part of OCI)

At the end of the accounting period, the accumulated gains on revaluation would then be transferred to the revaluation surplus account (an equity account) as follows:

30 June 2023

Dr Gain on revaluation of machinery (part of OCI) 20 000 Cr Revaluation surplus (an equity account) 20 000

(transfer of accumulated gains on revaluation to the ‘revaluation surplus’ account)

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 2023 would be $9000 (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.

dee67382_ch06_223-256.indd 230 10/24/19 12:43 PM

230 PART 3: Accounting for assets

Figure 6.1 Steps to be taken when revaluing non-current assets using the net- method

Ensure that depreciation expense has been recognised up until the date of the revaluation

Close the accumulated depreciation o� against the related non-current asset

Revalue the non-current asset to fair value

Calculate subsequent depreciation expense based upon the new revalued amount and the remaining useful life

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 2022 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 2022 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: GA − AD = $45  000 We know from STEP 1 that: AD = 0.375 × GA Therefore: GA − (0.375GA) = $45 000

0.625GA = $45 000 GA = $72 000

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.

dee67382_ch06_223-256.indd 231 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 231

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 Machinery 32 000 Cr Accumulated depreciation 12 000 Cr Gain on revaluation of machinery (in OCI) 20 000

(to recognise a revaluation to fair value using the ‘gross method’)

The gain of revaluation would be transferred to the revaluation surplus account (part of equity) at the end of the accounting period (not shown here). It should be noted that whether the net-amount method or the gross method is used, the carrying amount of the non-current assets will be the same. For example, the balances under both methods after revaluation would be:

Net-amount method Gross method

$ $

Machinery 45 000 72 000 Accumulated depreciation          0 27 000

Carrying amount 45 000 45 000

WORKED EXAMPLE 6.3: A revaluation decrement

Young Ltd acquires some machinery at a cost of $150 000 on 1 July 2021. On 30 June 2022, 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.

LO 6.6 6.6 Revaluation decrements

The treatment of revaluation decrements is different from revaluation increments. While, as we have just learned, revaluation increments are not to be included in profit or loss (rather, they are to go to ‘other comprehensive income’ and are ultimately transferred to an equity account known as ‘revaluation surplus’), AASB 116 requires that a revaluation decrement should be treated as an expense of the period that is included in profit or loss and which might be referred to as a loss on revaluation. The first part of paragraph 40 of AASB 116 requires that: ‘If an asset’s carrying amount is decreased as a result of a revaluation, the decrease shall be recognised in profit or loss’. The asymmetric treatment of revaluation increments and decrements reflects a bias towards a conservative approach to measuring profit or loss. That is, gains on revaluation are not included in profit or loss, but losses on revaluation are.

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. In the balance of this chapter, we will be applying the ‘net method’ of asset revaluations.

continued

dee67382_ch06_223-256.indd 232 10/24/19 12:43 PM

232 PART 3: Accounting for assets

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 Accumulated depreciation 20 000 Cr Machinery 20 000

(to close off accumulated depreciation to the machinery account)

Dr Loss on revaluation of machinery (P&L) 30 000 Cr Machinery 30 000

(to recognise the loss on revaluation)

The loss of $30 000 represents the difference between the pre-existing 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 (which ultimately impacts retained earnings). Again, it is stressed that the loss associated with the reduction in fair value is treated as an expense and reduces profits, whereas if it had been a gain related to an increase in fair value, then it would not be treated as part of profit or loss (rather, the gain is included as part of ‘other comprehensive income’ and therefore increases ‘total comprehensive income’). Subsequent depreciation will be based on the revised fair value and the remaining useful life of the asset.

WHY DO I NEED TO KNOW THAT GAINS ON REVALUATION ARE INCLUDED WITHIN OCI, BUT LOSSES ON REVALUATION ARE INCLUDED WITHIN PROFIT OR LOSS?

Profit is a performance measure that attracts a great deal of attention. Therefore, it is important that we understand which transactions and events are reflected within profits (and which are not). The amount reported in the equity reserve known as ‘revaluation surplus’ (or similar) can, in some organisations, be quite material, so it is also important that we understand how this reserve is created, and what it represents.

6.7 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 shown as a negative item in ‘other comprehensive income’ (and ultimately offset against the ‘revaluation surplus’ previously created for that asset), rather than being debited to the period’s profit or loss. 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 treated as a loss within other comprehensive income and subsequently adjusted—through the end-of-period closing entries—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. (AASB 116)

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 treated as part of ‘other comprehensive income’ and ultimately credited to the revaluation surplus.

Worked Example 6.4 gives an example of reversals of previous revaluation increments and decrements.

LO 6.7

WORKED EXAMPLE 6.3 continued

dee67382_ch06_223-256.indd 233 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 233

WORKED EXAMPLE 6.4: Reversals of previous revaluation increments and decrements

PK Ltd acquires a block of land on 1 January 2021 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 2022. 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 2023.

REQUIRED Assuming the firm makes revaluations on both 30 June 2022 and 30 June 2023, 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 2021 Dr Land 200 000 Cr Cash

(to record the initial acquisition of land) 200 000

30 June 2022 Dr Land 90 000 Cr Gain on revaluation of land (part of OCI) 90 000

(to represent the increment in the fair value of land. This increase would be treated as part of ‘other comprehensive income’ and would ultimately be transferred to equity)

Dr Gain on revaluation of land (part of OCI) 90 000 Cr Revaluation surplus 90 000

(at the end of the accounting period, the gain would ultimately be transferred by way of the closing journal entries to the equity account known as ‘revaluation surplus’)

30 June 2023 Dr Loss on revaluation of land (OCI)  90 000 Dr Loss on revaluation of land (P&L) 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)

Dr Revaluation surplus 90 000 Cr Loss on revaluation of land (part of OCI) 90 000

(at the end of the accounting period, the loss recognised in OCI would ultimately be transferred by way of the closing journal entries to the equity account known as ‘revaluation surplus’, meaning that the balance in the account with respect to this asset would then be zero)

While all of 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.

It should be noted that if the above land had not been revalued in June 2022—that is, if it had been recorded at cost—impairment testing would be required pursuant to AASB 136. 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.

continued

dee67382_ch06_223-256.indd 234 10/24/19 12:43 PM

234 PART 3: Accounting for assets

PK LTD

Statement of comprehensive income for the year ended 30 June 2023

2023 ($000)

2022 ($000)

Revenue xx xxx xx xxx Cost of sales (xx xxx) (xx xxx) Gross profit xx xxx xx xxx Distribution costs (xx xxx) (xx xxx) Administrative expenses (xx xxx) (xx xxx) Loss on revaluation of land (60 000)      – Profit before tax xx xxx xx xxx Income tax expense (xx xxx) (xx xxx) Profit for the year xx xxx xx xxx Other comprehensive income Items of comprehensive income that will not be reclassified subsequently to profit or loss: Gains/(losses) on property revaluation (90 000) 90 000 Income tax relating to components of other comprehensive income

(xx xxx) (xx xxx)

Other comprehensive income for the year, net of tax (xx xxx) xx xxx Total comprehensive income for the year xx xxx xx xxx

LO 6.8

6.8 Accounting for the gain or loss on the disposal or derecognition of a revalued non-current asset

A non-current asset might be sold in a subsequent reporting period. If it is sold, we need to determine the gain (or profit) that has been made in relation to the sale of the 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. (AASB 116)

In relation to the timing of the gain or loss, AASB 116, paragraph 68, requires 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 disclosed. 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, 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 arose as a result of the revaluation undertaken on 1 July 2022. 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? 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. (AASB 116)

WORKED EXAMPLE 6.4 continued

dee67382_ch06_223-256.indd 235 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 235

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 states: ‘Transfers from revaluation surplus to retained earnings are not made through profit or loss’. That is, the gain on revaluation is an example of a gain that shall not be reclassified subsequently to profit or loss. By contrast, some accounting standards require specific items of other comprehensive income to be reclassified subsequently to profit or loss when specific conditions are met.

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 2025 there would have been two years of accumulated depreciation since the revaluation was undertaken in 2023. 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 2023, the carrying amount would have been $60 000 in 2025 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 again be stressed at this point that reporting entities 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, as we now know, 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 an entity not revalue its assets to their fair value? Conversely, what would motivate a company to perform an upward revaluation? We will return to this issue later in this chapter.

WORKED EXAMPLE 6.5: Accounting for a gain or loss on disposal of a revalued non-current asset

On 1 July 2021, Bombo Ltd acquires a block of land at a cost of $60 000. On 1 July 2022 it is revalued to $75 000. On 30 June 2023 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 90 000 Cr Gain on sale of land 15 000 Cr Land 75 000

(to recognise the sale of land)

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 Revaluation surplus 15 000 Cr Retained earnings 15 000

(to recognise the transfer of the balance of the revaluation surplus to retained earnings upon the sale of the non-current asset)

dee67382_ch06_223-256.indd 236 10/24/19 12:43 PM

236 PART 3: Accounting for assets

WORKED EXAMPLE 6.6: Sale of a revalued item of property, plant and equipment

Gunnamatta Ltd acquired a printing machine on 1 July 2021 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 2023 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 2025.

REQUIRED Provide the journal entries necessary to account for the above transactions and events.

SOLUTION

30 June 2022 Dr Depreciation expense 10 000 Cr Accumulated depreciation—printing machine 10 000

(to recognise depreciation expense for the year)

30 June 2023 Dr Depreciation expense 10 000 Cr Accumulated depreciation—printing machine 10 000

(to recognise depreciation expense for the year)

1 July 2023 Dr Accumulated depreciation 20 000

Cr Printing machine 20 000 (to offset two years’ depreciation against the cost of the asset)

Dr Printing machine 16 000 Cr Gain on revaluation of printing machine (OCI) 16 000

(to revalue the asset to its fair value of $96 000)

30 June 2024 Dr Depreciation expense 12 000 Cr Accumulated depreciation—printing machine 12 000 Dr Gain on revaluation of printing machine (OCI) 16 000 Cr Revaluation surplus 16 000

(to transfer the gain on revaluation to the revaluation surplus account. All other expenses such as depreciation would also be closed off to a profit or loss summary account at the end of the reporting period—that step is not shown here)

30 June 2025 Dr Depreciation expense 12 000 Cr Accumulated depreciation—printing machine 12 000

(to recognise depreciation expense for the year)

1 July 2025 Dr Cash at bank 89 000 Dr Accumulated depreciation 24 000 Cr Printing machine 96 000 Cr Gain on sale of printing machine (in P&L) 17 000

(to account for the sale of the asset)

dee67382_ch06_223-256.indd 237 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 237

1 July 2025 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 profit on sale (the profit 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 profit generated 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 following an upward revaluation. 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. 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 2021, 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 recognised in OCI and ultimately 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, managers might prefer to show lower profits; perhaps because they are being accused of being monopolistic and of earning excessively high profits. In such cases, an asset revaluation might be a preferred

WORKED EXAMPLE 6.7: Profit comparison with and without a revaluation

Drouyn Ltd acquires a truck for a consideration of $100 000 on 1 July 2021. The asset has an expected life of 10 years and no expected residual value. As at 1 July 2024, 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 2026.

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 With a revaluation

(a) Years 1 to 3 30 June 2022/2023/2024 30 June 2022/2023/2024 Dr Depreciation expense 10 000 Dr Depreciation expense 10 000

Cr Accumulated depreciation 10 000 Cr Accumulated depreciation 10 000

(b) Year 4 30 June 2025 1 July 2024 Dr Depreciation expense 10 000 Dr Accumulated depreciation 30 000 Cr Accumulated depreciation 10 000 Cr Truck 30 000

(to eliminate accumulated depreciation for previous three years)

continued

dee67382_ch06_223-256.indd 238 10/24/19 12:43 PM

238 PART 3: Accounting for assets

Without a revaluation With a revaluation

1 July 2024 Dr Truck 20 000 Cr Gain on revaluation (OCI) 20 000

(to recognise revaluation)

30 June 2025 Dr Depreciation expense 12 857 Cr Accumulated depreciation 12 857

(depreciation is based on revalued amount, $90 000 ÷ 7)

30 June 2025 Dr Gain on revaluation (OCI) 20 000 Cr Revaluation surplus 20 000

(to transfer the gain to equity)

(c) Year 5 30 June 2026 30 June 2026 Dr Depreciation expense 10 000 Dr Depreciation expense 12 857 Cr Accumulated depreciation 10 000 Cr Accumulated depreciation

($90 000 ÷ 7) 12 857

Dr Accumulated depreciation 50 000 Dr Accumulated depreciation 25 714 Dr Cash 80 000 Dr Cash 80 000 Cr Truck 100 000 Cr Truck 90 000 Cr Gain on sale 30 000 Cr Gain on sale 15 714

Dr Revaluation surplus 20 000 Cr Retained earnings 20 000

option, even though a decision to revalue made on this basis would constitute ‘creative accounting’ or ‘earnings management’ and would therefore not be consistent with the basic tenets espoused in the Conceptual Framework.

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. That is, it provides a faithful representation of the property, plant and equipment. It might also make the organisation less likely to be taken over owing to undervalued assets. Directors might also consider that undertaking periodic revaluations provides relevant information for financial statement readers (and remember that relevance and faithful representation are the two fundamental qualitative characteristics of useful financial information).

A last point for us to consider in our discussion of revaluations is that prior to the release of AASB 116, 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 include the $1 million as a gain within other comprehensive income, which will ultimately be transferred to increase the revaluation surplus, and recognise a loss on revaluation of $800 000 in respect of the other block of land, with this loss being included within profit or loss.

While we focus in this text on for-profit entities, it is interesting to note that paragraphs Aus 40.1 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.

WORKED EXAMPLE 6.7 continued

dee67382_ch06_223-256.indd 239 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 239

6.9 Recognition of impairment losses

Having just discussed asset revaluations, we will now consider the related topic of impairment testing and related losses. This discussion is particularly relevant to situations where the cost model is in use, and there has been a decline in the value of an asset.

AASB 136 imposes the general requirement that the carrying amount of a non-current asset should be reduced (written down) to its recoverable amount whenever its carrying amount is greater than its recoverable amount. An impairment loss is defined at paragraph 6 of AASB 136 as:

the amount by which the carrying amount of an asset or a cash-generating unit exceeds its recoverable amount. (AASB 136)

From time to time, impairment costs can be very significant. For example, in 2017 the large mining company Santos reported an impairment loss of $1.1 billion in relation to some mining- related assets. In 2015 BHP reported an impairment loss of approximately $10 billion in relation to oil and gas-related assets, and in 2014 Qantas reported an impairment loss of about $2.6 billion, a good proportion of which was related to its airline fleet.

To be able to apply the above requirement we therefore need to clearly understand the meaning of ‘carrying amount’ and ‘recoverable amount’. We should already know that the ‘carrying amount’ of an asset is the amount at which an asset is recognised in the accounts after deduction and accumulated depreciation (and any accumulated impairment losses).

The meaning of recoverable amount Within AASB 136, ‘recoverable amount’—which relates the cash flows expected to be generated from an asset—is defined at paragraph 6 as:

the higher of its fair value less costs of disposal and its value in use. (AASB 136)

As the definition of recoverable amount provided above indicates, the cash flows can come from one of two broad sources—either from selling the asset, or from holding onto it and using it (value in use). The above definition of recoverable amount further requires definitions of:

∙ fair value less costs of disposal, and ∙ value in use.

As we know from earlier in the chapter, ‘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’. ‘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’. Such costs would include the legal costs associated with making a sale, and the costs associated with removing the asset and getting the asset to the condition necessary to facilitate the sale.

‘Value in use’ is defined at paragraph 6 of AASB 136 as:

the present value of the future cash flows expected to be derived from an asset or cash-generating unit. (AASB 136)

The above definition pertaining to value in use requires us to consider the meaning of ‘cash-generating unit’ as well as considering how ‘present value’ should be determined for the purpose of determining value in use. We will return to ‘cash-generating units’ shortly.

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 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. (AASB 136)

Paragraph 56 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

accumulated impairment losses Total amount of impairment losses 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

dee67382_ch06_223-256.indd 240 10/24/19 12:43 PM

240 PART 3: Accounting for assets

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. (AASB 136)

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 to calculate a present value.

Worked Example 6.8 provides an illustration of the use of the cost model with an associated impairment loss.

WORKED EXAMPLE 6.8: Use of the cost model and determination of an impairment loss

Point Lookout acquired some machinery at a cost of $1 million, which it accounts for using the cost method. As at 30 June 2022 the machinery had accumulated depreciation of $200 000.

On 30 June 2022 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 2022, 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 Impairment loss—machinery 61 964 Cr Accumulated impairment losses—machinery 61 964

(recognition of an impairment loss on machinery)

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. Another point to be made here is that when we use the cost model and we recognise an impairment loss, we do not close off the pre-existing balance of accumulated depreciation. This can be contrasted to the process we used to account for asset revaluations.

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 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. (AASB 136)

dee67382_ch06_223-256.indd 241 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 241

If the cost model is used—as it just was in Worked Example 6.8—then an impairment loss shall be accounted for by recognising an impairment loss (to be included within profit or loss as in Worked Example 6.10) and an increase to accumulated impairment losses (which reduces the carrying amount of the asset). If the revaluation model was used, and an asset has previously been revalued upwardly, the subsequent impairment loss will be recognised by recording a loss on revaluation (as part of ‘other comprehensive income) and ultimately reducing (debiting) the balance of the revaluation surplus as it pertains to the previous revaluation. 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

Scenario 1

Coogee Ltd has an accounting policy of measuring property, plant and equipment at cost. It has a parcel of land that has a carrying value of $500 000. However, as at the end of the reporting period, the recoverable amount of the asset has been determined as being equal to $350 000. The journal entry to recognise the impairment would be:

Dr Impairment loss 150 000 Cr Accumulated impairment losses—land 150 000

(to recognise the impairment of land)

Scenario 2

Coogee Ltd measures its land at fair value. The land, which cost $500 000, had been revalued to $560 000 previously (which would have meant a debit of $60 000 to land, and an equivalent credit to revaluation surplus). To acknowledge that the land now has a value of $350 000, we would first eliminate the respective balance in the revaluation surplus and then recognise the additional loss as follows:

Dr Loss on revaluation (part of OCI) 60 000 Dr Loss on revaluation (part of profit or loss) 150 000 Cr Land 210 000

(to recognise the revaluation decrement)

The above entry was made in accordance with the requirement in AASB 136 that any impairment loss of a revalued asset shall be treated as a revaluation decrease in accordance with AASB 116. At the end of the accounting period, we would need to transfer the loss on revaluation that was recorded within OCI to the revaluation surplus. This would effectively remove the revaluation surplus that related to the land.

Dr Revaluation surplus 60 000 Cr Loss on revaluation (part of OCI) 60 000   (to transfer the loss on revaluation to revaluation surplus)    

A point to be stressed here is that where a non-current asset is measured using 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 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;

dee67382_ch06_223-256.indd 242 10/24/19 12:43 PM

242 PART 3: Accounting for assets

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. (AASB 136)

Part (d) above is often used as a basis for people from outside an organisation arguing that the assets of the organisation are being shown at an amount that is greater than their recoverable amount. We will return to this ‘indicator’ later in this chapter.

Following an impairment loss, future depreciation charges will also need to be adjusted just as was the case following asset revaluations. Specifically, paragraph 63 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. (AASB 136)

Recognising an impairment loss when an entity has elected to change accounting policy from the cost model to the fair-value model Where an entity elects to change from the cost basis to the fair-value basis for measuring a class of non-current assets, and that class has previously been the subject of an impairment loss, 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 previously recognised is to be transferred to equity (revaluation surplus). As we already know, the revaluation surplus is part of the owners’ equity.

For example, let us assume that we have an item of land acquired in 2019 for $1 million, which is accounted for using the cost method. If the recoverable value of the land in 2021 is considered to be $800 000, an expense of $200 000 would be recognised in 2021 (an impairment loss). If the value of the land had then increased to $1.3 million in 2023, and the managers had elected to switch to the fair-value basis of measurement, then a revaluation would be undertaken. $200 000 would be recognised as income that is included within profit or loss (effectively reversing the previous $200 000 impairment loss) and $300 000 would be recognised as a gain in ‘other comprehensive income’ and ultimately transferred to the revaluation surplus.

Worked Example 6.10 provides an illustration of an asset revaluation where there has been a previous impairment loss.

WORKED EXAMPLE 6.10: Reversal of a previous impairment loss

Point Impossible Ltd acquired some land in 2021 at a cost of $2.5 million. In 2022 it was determined that the recoverable amount of the land was $2 million. In 2023 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, when 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.

2022 Dr Impairment loss—land (to be included in profit or loss) 500 000 Cr Accumulated impairment loss—land 500 000

(to recognise an impairment loss. Impairment losses are aggregated in an ‘accumulated impairment account’—a ‘contra account’—in the same manner that depreciation is aggregated in ‘accumulated depreciation’)

dee67382_ch06_223-256.indd 243 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 243

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 $ 100 000 Asset 2 $ 200 000 Asset 3 $ 300 000 Asset 4 $ 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 Impairment loss 200 000

Cr Accumulated impairment losses—Asset 1 20 000

Cr Accumulated impairment losses—Asset 2 40 000

Cr Accumulated impairment losses—Asset 3 60 000

Cr Accumulated impairment losses—Asset 4 80 000

(to recognise the impairment loss on a cash-generating unit)

2023

In 2023 the organisation has switched to the ‘revaluation model’

Dr Land 300 000 Dr Accumulated impairment loss—land 500 000 Cr Reversal of previous impairment loss—land (to be

included in P&L) 500 000

Cr Revaluation gain (to be included in OCI) 300 000

(the land is increased by the amount of the revaluation from original cost. The accumulated impairment loss account is closed off to zero, the previous impairment loss is reversed and treated as income with profit or loss, and the revaluation above cost is treated as part of ‘other comprehensive income’. The revaluation gain would ultimately be transferred to ‘revaluation surplus’ at the end of the reporting period)

A consideration of cash-generating units 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 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 unit.

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 2019 Annual Report of BHP Group Ltd.

dee67382_ch06_223-256.indd 244 10/24/19 12:43 PM

244 PART 3: Accounting for assets

Exhibit 6.2 Accounting policy note from BHP Ltd 2019 Annual Report

SOURCE: © BHP Group Ltd

6.10 Further consideration of present values

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 amount of $5 million, but a current fair 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 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 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 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,

LO 6.10

dee67382_ch06_223-256.indd 245 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 245

unless an increasing rate can be justified. This growth rate shall not exceed the long-term 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. (AASB 136)

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.

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 2021, 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 2023 the machinery had a carrying amount of $682 000.

At the end of the 2023 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 and it uses the cost model to account for property, plant and equipment.

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.

Calculation of value in use:

Value in use is calculated by discounting the net cash flows at 12 per cent.

$85 000 at 12% for 8 years ($85 000 × 4.9676) = $ 422 246

$10 000 in 8 years at 12% ($10 000 × 0.4039) = $ 4 039

$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 $682 000 Less: Recoverable amount ($426 285) Amount of impairment to be recognised $255 715

Journal entry: 30 June 2023 Dr Impairment loss—plant 255 715 Cr Accumulated impairment losses—plant 255 715

(to recognise an impairment loss on the plant)

dee67382_ch06_223-256.indd 246 11/01/19 10:31 AM

246 PART 3: Accounting for assets

Figure 6.2 A summary of steps involved in impairment testing

� Calculate recoverable amount based upon either ‘fair value less costs of disposal’, or ‘value in use’. � Recoverable amount is determined as the greater of the above two. � There is not always a need to calculate both measures. If the first measure calculated is greater than the carrying amount, then that is enough to determine that the asset is not impaired and no impairment loss needs to be recognised. � As fair value less costs of disposal is typically the easier measure to calculate, this is often the first measure calculated.

Compare the ‘recoverable amount’ (which is the greater of fair value less costs of disposal and value in use) with the ‘carrying amount’ of the asset. Is the recoverable amount greater than or equal to the carrying amount?

No action necessary An impairment loss needs

to be recognised

YES NO

6.11 Investment properties

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 property: AASB 140 Investment

Property. 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—which is not considered to be an ‘investment

LO 6.11

WHY DO I NEED TO KNOW WHAT AN IMPAIRMENT LOSS REPRESENTS, AND WHEN AN IMPAIRMENT LOSS IS RECOGNISED?

The requirement that assets shall not have a ‘carrying amount’ above their ‘recoverable amount’ is a central foundation of financial reporting and it is therefore important that users of financial statements understand this. Knowing about impairment losses also informs us that the reported assets should ultimately generate economic benefits that are at least equivalent to their ‘carrying amount’. If the cost model is used by an organisation, then it is very possible that the recoverable amount of assets might be significantly above the amount reported in the balance sheet. It is very important that we clearly understand this.

As briefly noted previously, the apparent necessity for recognising an impairment loss is often highlighted when an organisation’s publicly listed share price is well below the net asset backing per share (which is calculated by dividing the total reported equity of a company by the number of shares on issue. The reported equity equals the carrying amount of assets less the carrying amount of the liabilities). One recent example (2017) relates to the Nine television network in Australia. Within the news media there were expectations reported that the organisation would, or should, recognise an impairment loss given that its share price was well below the net book value per share. Following this media speculation, the organisation did ultimately recognise an impairment loss of $260 million.

Figure 6.2 provides a summary of when to recognise an impairment loss.

dee67382_ch06_223-256.indd 247 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 247

property’—where the related cash flows would not only be attributable 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 and therefore AASB 102 inventories would apply. Also, property that is held for the purpose of long-term rentals (which have traditionally been known as ‘finance leases’) 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.

6.12 Economic consequences of asset revaluations and impairments

Let us now consider some of the ‘real-world’ implications associated with asset revaluations and the recognition of impairment losses. Some academic researchers suggest 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 (part of ‘relevance’), tends to be more neutral in nature and increases the timeliness, comparability and consistency of the data (which are enhancing qualitative characteristics linked to representational faithfulness).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 (it is undertaking ‘earnings management’), 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 default’ of the agreement and could, at the extreme, be subject to closure. Now assume that, before finalising the financial statements, the firm revalues its non-current assets by $15 million. The effect of this would be to increase assets to $115 million. Liabilities would remain at $55 million (the credit side of the journal entry would be to the revaluation surplus, which is part of shareholders’ funds) and 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 often restrictions placed on revaluations. Many loan agreements restrict which types of assets can be revalued and the identity, or qualifications, of those who can do the valuations.

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.

debt-to-assets ratio Derived by dividing the total liabilities of an organisation by its total assets.

LO 6.12

dee67382_ch06_223-256.indd 248 10/24/19 12:43 PM

248 PART 3: Accounting for assets

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, labour 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.

Revaluations of non-current assets can be made on the basis of valuations made by directors or by independent valuers. Logically, there might be expected to be a perception that independent valuations would, on average, be more reliable than valuations made by directors. Further, there would conceivably be differences in the competence, and reputation, of different independent valuers and therefore in the perceived reliability of their valuations. AASB 116 requires that where a class of non-current assets has been revalued to fair value in accordance with an independent valuation, this must be disclosed within the notes to the financial statements. Conceivably, this would be useful information to the readers of financial statements as an independent valuation would arguably be deemed to be more impartial or objective than a valuation undertaken by employees of the entity.

Considering issues such as the competence of the valuer, Goodwin and Trotman (1996) undertook a study of external auditors’ judgements in relation to non-current asset revaluations

undertaken by their clients. The results indicated that the amount of time spent on the audit of the revalued non-current 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 management with an incentive to revalue non-current assets to ‘strengthen the balance sheet prior to issue’, thereby

independent valuation For non-current assets, a valuation made by an expert in valuations of that class of assets whose pecuniary or other interests could not be capable of affecting that person’s ability to give an unbiased opinion on that valuation.

dee67382_ch06_223-256.indd 249 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 249

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.

More recently, Chen and Tang (2017) provide evidence of how the adoption of IAS 40 Investment Properties (equivalent of AASB 140) affected the managers of property companies’ choice to revalue non-current assets. IAS 40 specifically requires the gain on revaluation of investment properties to go directly to profits, rather than to the revaluation surplus as was the previous requirement. The authors found that the propensity for managers to revalue the investment properties increased once the new accounting standard was introduced, which allowed the gains to go directly to profits. Further, they found that, somewhat inefficiently, management bonus plans failed to adjust for the changing accounting standards, meaning that managers receiving a certain percentage of profit as a bonus were able to increase this bonus simply by performing a revaluation. This failure to adjust for the changing accounting method was higher for those organisations identified as having weaker governance controls in place. The authors therefore provided clear evidence of managerial opportunism in relation to the use of asset revaluations.

In relation to asset impairments, Bond, Govendir and Wells (2016) provide evidence that managers appear to delay the timing of asset impairments beyond the point in time when they should recognise them. In a study of Australian firms, the authors identify companies that have share prices that are significantly lower than the net asset backing per share (total carrying amount of assets less the total carrying amount of liabilities divided by the number of shares on issue). Such companies would be expected to report impairment losses (as we discussed earlier in this chapter). The authors report that not only do many of the sample organisations fail to recognise an impairment loss when they apparently should, but for those that do recognise an impairment loss, they typically do so some years after they should, thereby indicating that the timing of the loss recognition is somewhat discretionary. The authors see this as an indicator that impairment losses are being recognised opportunistically by corporate managers and that there seems to be large-scale non-compliance with the accounting standards that would require impairment losses to be recognised as soon as evidence of an impairment becomes available. It was also reported that impairments were more likely to be recognised immediately following a change in the Chief Executive Office of the organisation. In this way, the loss could be opportunistically blamed upon the departing CEO, and not the current management team.

Impairment losses can create problems for companies in terms of potentially causing them to breach debt covenants. In a newspaper article entitled ‘Macquarie on Myer loan deal warning’ (Sue Mitchell, Financial Review, 30 January 2018, p. 15), it was reported that the financial services organisation known as Macquarie Equities had provided warnings that the large Australian retailing organisation Myer will be at risk of breaching debt covenants when it ultimately recognises a likely impairment loss. Myer had a share price that was well below the net book value per share. Consistent with the argument in Bond, Govendir and Wells (2016), as discussed above, this was perceived as an indication that some assets within the balance sheet were likely to be overvalued.

Macquarie Equities was of the view that goodwill and brand names were potentially in need of being written down by means of the recognition of impairment losses. The newspaper article also noted that Myer had an existing debt covenant in which it agreed with its lenders that it would maintain shareholder equity of at least $500 million. If Myer wrote down the value of intangible assets including goodwill (which had a carrying amount of $465 million) and brand names (carrying amount of $422 million), it could fail to meet the contractual requirement to have total equity of $500 million, thereby placing the future of the organisation in some doubt if the lenders required immediate repayment of their loans (because of a ‘technical default of the loan covenant’). Therefore, it is stressed here that the recognition of certain expenses can have implications for an organisation’s contractual agreements, and that this can potentially influence how managers (creatively) account for certain transactions and events.

WHY DO I NEED TO KNOW ABOUT THE ECONOMIC CONSEQUENCES OF REVALUATIONS AND IMPAIRMENTS?

When the managers, and their accountants, have a choice as to how they account for the assets of an organisation (for example, the choice to apply the ‘revaluation model’), it is important that various stakeholders understand what might motivate managers to make particular accounting policy choices that in turn could have significant impacts upon the financial statements. This might indicate which items in the financial statements are particularly vulnerable to manipulation.

It is also useful for various stakeholders to have a general understanding of how different accounting choices or adjustments can ultimately create subsequent economic impacts, perhaps through their impacts on the various accounting-based contracts and associated cash flows that an entity has negotiated.

dee67382_ch06_223-256.indd 250 10/24/19 12:43 PM

250 PART 3: Accounting for assets

SUMMARY

The chapter discussed the revaluation of non-current assets and the recognition of impairment losses, with an emphasis on property, plant and equipment.

We learned that 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. Reporting entities were shown to have a choice between using the cost model or the revaluation model to account for their property, plant and equipment. An entity can use cost or fair value for different classes of assets but must consistently measure assets within a class of non-current assets.

Where an asset is revalued upwards, the increase in the value of the asset is treated as part of ‘other comprehensive income’ and is ultimately transferred to a revaluation surplus. 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 ultimately debited against (deducted from) the existing revaluation surplus and the related movement included as a reduction to ‘other comprehensive income’.

This chapter also explained that if an organisation is using the cost model, and a non-current asset has a recoverable amount in excess of its carrying amount, then there is no requirement to adjust the accounts to reflect the increased value. On the other hand, if the recoverable amount falls below the carrying amount, a non-current asset shall be the subject of an impairment loss. The recoverable amount of an asset is defined as the higher of an asset’s fair value less the costs of disposal (net selling price) and its value in use. Value in use is calculated based on the present value of the expected future net cash flows relating to the asset.

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 explained how the recognition of impairment losses and asset revaluation can create various economic consequences.

KEY TERMS

accumulated depreciation 228 accumulated impairment losses 239 asset revaluation 224

carrying amount 224 debt-to-assets ratio 247 independent valuation 248 recoverable amount 224

revaluation decrement 228 revaluation increment 226

6.13 Disclosure requirements

AASB 116 includes a number of disclosure requirements pertaining to the revaluation of non-current assets. Information such as dates of revaluation, whether an independent valuer was involved in determining valuations,

and the approach used in determining fair value, must be disclosed in the notes to the financial statements. Disclosures relating to the depreciation methods used, and assumptions made about the useful lives of property,

plant and equipment are also required. 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.

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. These disclosure requirements include information about: total impairment losses and reversals of impairment losses within the accounting period; the events that led to the recognition of impairment losses; the nature of the assets that have been the subject of impairment losses; whether the recoverable amount was determined on the basis of fair value less costs of disposal, or value in use; if the recoverable amount was based upon fair values less costs of disposal, details of the approach used to determine fair value; if the recoverable amount is determined on the basis of value in use, what discount rates were applied, and why.

LO 6.13

dee67382_ch06_223-256.indd 251 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 251

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—suggested answers are shown below.

1. For financial reporting purposes, should property, plant and equipment be reported at cost, or at fair value? LO 6.1, 6.2 A reporting entity has a choice between measuring a class of property, plant and equipment at cost or fair value. The decision will often require a trade-off to be made between relevance and faithful representation.

2. If the fair value of an item of property, plant and equipment increases, is this increase included within profit or loss? LO 6.1, 6.4 Unless an increase in fair value reverses a previous revaluation decrement, an increase in fair value shall be included in other comprehensive income and will ultimately be transferred to an equity account, known as revaluation surplus (or something similar).

3. For financial reporting purposes, is there a need to determine the recoverable amount of non-current assets? LO 6.9 Yes, the recoverable amount of a non-current asset must be considered at the end of the reporting period, and if it is lower than the carrying amount of the asset, then an impairment loss must be recognised.

4. How is the recoverable amount of a non-current asset to be determined? LO 6.9 Recoverable amount is the higher of sales price less costs of disposal, and value in use.

5. When is an impairment loss recognised? LO 6.9 An impairment loss is recognised when the recoverable amount is less than the carrying amount of an asset.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What effect will an asset revaluation have on subsequent periods’ profits? Explain your answer. LO 6.1, 6.4, 6.8 •• 2. Explain the difference in the accounting treatment for revaluation increments and revaluation decrements. Do you

consider that this difference is ‘conceptually sound’? LO 6.4, 6.6 •• 3. When should a revaluation increment be included as part of profit or loss? LO 6.4, 6.7 • 4. For the purposes of AASB 136, how is ‘recoverable amount’ determined? LO 6.9 • 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 6.9 •• 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 6.4, 6.6, 6.7 •••

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 6.1, 6.9 ••

8. If a reporting entity decides to revalue its property, plant and equipment, what basis of valuation must be adopted? LO 6.1, 6.2 •

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 6.1, 6.2 •

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 6.1, 6.2 •

11. How is the revaluation of an investment property treated differently from the revaluation of an item of property, plant and equipment? LO 6.11 •

12. Describe some disclosures that are to be made in relation to:

• the revaluation of assets

• impairment losses. LO 6.13 • 13. How could a revaluation of a non-current asset minimise or loosen the effects of a restrictive debt covenant? LO 6.12 ••

dee67382_ch06_223-256.indd 252 10/24/19 12:43 PM

252 PART 3: Accounting for assets

14. Ignoring reversals of previous revaluations, do you think that requiring revaluation decrements to be part of the period’s profit or loss but requiring that revaluation increments go to comprehensive income is consistent with the requirements of the Conceptual Framework? Explain your answer. LO 6.1, 6.6 •••

15. An item of depreciable machinery is acquired on 1 July 2019 for $120 000. It is expected to have a useful life of 10 years and a zero residual value. On 1 July 2023, it is decided to revalue the asset to its fair value of $110 000.

REQUIRED Provide journal entries to account for the revaluation. LO 6.4, 6.5 •

16. What does the ‘impairment of an asset’ mean? How should an impairment of an item of property, plant and equipment be accounted for? LO 6.9 ••

17. How could the recognition of an impairment loss cause an organisation to default on a loan agreement? LO 6.12 ••

18. How should the reversal of an impairment loss be accounted for? LO 6.4, 6.6, 6.9 •

19. How is the gain or loss on the disposal of an item of property, plant and equipment determined? LO 6.8 •

20. 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 300 000

Revaluation surplus 45 000

Capital profits reserve 85 000

Retained earnings   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 6.1, 6.2, 6.3, 6.4, 6.5 ••

21. Townend Ltd has the following assets in its statement of financial position as at 30 June 2022.

$

Plant and equipment, at independent valuation 2 000 000

Less: Accumulated depreciation    400 000

Carrying amount 1 600 000

The plant and equipment originally cost Townend $600 000 in 2020, 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 6.1, 6.2, 6.12 ••

22. Bad Company Ltd has some machinery that it acquired in 2021 at a cost of $4 000 000. In 2022 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 2021. 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 2021 at a cost of $4 000 000. Is this an appropriate course of action? LO 6.1, 6.2, 6.3, 6.6 ••

23. Petersen Ltd has the following land and buildings in its financial statements as at 30 June 2022:

$

Residential land, at cost 1 000 000

Factory land, at valuation 2020 900 000

Buildings, at valuation 2020 800 000

Accumulated depreciation (100 000)

dee67382_ch06_223-256.indd 253 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 253

At 30 June 2022, 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 buildings are obtained. In relation to the above assets, the assessed fair values at 30 June 2022 are:

$

Residential land, previously recorded at cost 1 100 000

Factory land, previously revalued in 2020 700 000

Buildings, previously revalued in 2020 900 000

REQUIRED Provide the journal entries to account for the revaluation on 30 June 2022. Petersen Ltd classifies the residential land and the factory land as different classes of assets. LO 6.1, 6.2, 6.3, 6.4, 6.5, 6.6 •••

CHALLENGING QUESTIONS

24. 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 6.1, 6.9

25. Kanga Cairns Ltd owns two blocks of beachfront land, acquired in 2019 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 2021 and 30 June 2023. The assessed values are:

2021 valuation ($)

2023 valuation ($)

Block A 230 000 290 000

Block B 370 000 340 000

REQUIRED Assuming asset revaluations were undertaken for the land in both 2021 and 2023, provide the journal entries for both years. LO 6.1, 6.2, 6.4, 6.6

26. Warren Ltd acquires a four-wheel-drive bus on 1 July 2019 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 2021 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 2022 it is unexpectedly sold for $220 000.

REQUIRED Provide the journal entries to record the revaluation on 1 July 2021 and the subsequent sale on 1 July 2022. LO 6.1, 6.2, 6.4, 6.8

27. Crescent Head Co. acquired some land in 2021 at a cost of $4.2 million. It measures land at cost. In 2022 it was determined that the recoverable amount of the land was $5.2 million. In 2023 it was determined that the recoverable amount of the land was $3 million. In 2024 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 $5 million.

REQUIRED Provide the journal entries to record the above movements in value in each of the respective years. LO 6.9

28. 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

29. On 1 July 2021, 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

dee67382_ch06_223-256.indd 254 10/24/19 12:43 PM

254 PART 3: Accounting for assets

residual value of $200 000. Ocean Grove Ltd depreciates machinery on a straight-line basis over its useful life and uses the cost method. At 30 June 2023 the machinery had a carrying amount of $1 000 000. At the end of the 2023 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 eight 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 6.9, 6.10

30. On 1 July 2020 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:

Net selling price ($)

Value in use ($)

Fair value ($)

30 June 2021 900 000 1 050 000 950 000

30 June 2022 900 000 960 000 950 000

30 June 2023 920 000 900 000 970 000

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 6.1, 6.4, 6.5, 6.6, 6.9

31. Endless Summer Ltd purchased two parcels of land (Bruce and Brown) for $2 000 000 each on 1 July 2020. Subsequent to initial measurement, Endless Summer revalued the land. Fair values are as follows:

Parcel of land Fair value ($)

30 June 2021 Fair value ($)

30 June 2022

Bruce 1 800 000 1 600 000

Brown 2 500 000 2 200 000

REQUIRED

(a) Prepare journal entries to record the revaluations on 30 June 2021 and 30 June 2022. (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 2022’. Explain whether this is consistent with accounting standards. LO 6.2, 6.3, 6.5, 6.6, 6.7

32. 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 6.1, 6.4, 6.6, 6.12

33. On 1 July 2021, Cosy Corner Ltd acquired and installed an item of plant for use in its manufacturing business. When acquired, the item cost $900 000, had an estimated useful life of 10 years, and had an expected residual value of $30 000. Cosy Corner Ltd depreciates manufacturing plant on a straight-line basis over its useful life. Cosy Corner Ltd measures property, plant and equipment at cost. At the end of the 2023 reporting period, the annual review of manufacturing plant found that the item of plant had incurred significant damage. 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 $500 000. As the plant can operate in a limited

dee67382_ch06_223-256.indd 255 10/24/19 12:43 PM

CHAPTER 6: Revaluations and impairment testing of non-current assets 255

capacity, and apart from the residual value of $10 000, it could be expected to provide annual net cash flows of $100 000 for the next eight years. The expected residual value will remain unchanged. The management of Cosy Corner Ltd uses a discount rate of 6 per cent for calculations of this kind.

REQUIRED Provide the accounting journal entries to record the change in the value of the asset. LO 6.9, 6.10

34. Bronte Ltd has an accounting policy of measuring property, plant and equipment at cost. It has a parcel of land, which it acquired in 2021 at a cost of $500 000. In 2022 it was determined that the recoverable amount was $450 000. In 2023 the organisation switched to the fair-value model. The land was considered to have a fair value of $510 000 in 2023.

REQUIRED Provide the accounting journal entries to account for the changes in the value of the land in 2022 and 2023. LO 6.1, 6.4, 6.9

35. Superbank Ltd acquired some machinery at a cost of $2 000 000. As at 30 June 2022 the machinery had accumulated depreciation of $400 000 and an expected remaining useful life of four years. On 30 June 2022 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 2022 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 2022. Also provide the journal entry to account for depreciation in 2023. LO 6.1, 6.4, 6.6, 6.9, 6.10

36. 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:

Carrying amount  ($)

Current fair value ($)

Property, plant and equipment

Factory (NSW)

Land 100 000 150 000

Buildings

– Cost 70 000 80 000

– Accumulated depreciation (20 000) –

Factory (Qld)

Land 150 000 120 000

Buildings

– Cost 125 000 70 000

– Accumulated depreciation (45 000) –

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, 6.4, 6.6

37. Why could a revaluation of a non-current asset by a company with shares listed on a securities exchange change the cash flows of the organisation and impact its share price? LO 6.12

dee67382_ch06_223-256.indd 256 10/24/19 12:43 PM

256 PART 3: Accounting for assets

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. Bond, D., Govendir, B. & Wells, P., 2016, ‘An Evaluation of Asset

Impairments by Australian Firms and Whether They Are Impacted by AASB 136/IAS 36’, Accounting and Finance, vol. 56, pp. 259–88.

Brown, P., Izan, H.Y. & Loh, A., 1992, ‘Fixed Asset Revaluations and Managerial Incentives’, Abacus, vol. 28, no. 1, pp. 36–57.

Chen, K. & Tang, F., 2017, ‘Post-IFRS Revaluation Adjustments and Executive Compensation’, Contemporary Accounting Research, vol. 34, no. 2, pp. 1210–31.

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.

dee67382_ch07_257-282.indd 257 10/23/19 10:03 AM

257

C H A P T E R 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, and know how to apply

the ‘lower of cost and net realisable value rule’ for measuring inventory. 7.3 Understand why there is typically a necessity to make inventory cost-flow assumptions and be able to

apply the inventory cost-flow assumptions permitted by AASB 102.  7.4 Understand how and when to reverse a previous inventory write-down. 7.5 Know the disclosure requirements of AASB 102.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. For financial reporting purposes, what are inventories? LO 7.1 2. What costs should be included as part of the ‘cost’ of inventory? LO 7.2 3. For financial reporting purposes, how should inventory be measured? LO 7.2 4. What is an inventory cost-flow assumption, and which cost-flow assumptions are permitted to account for the

cost of inventory? LO 7.3

dee67382_ch07_257-282.indd 258 10/23/19 10:03 AM

258 PART 3: Accounting for assets

7.1 Introduction to inventory

Information about inventories ultimately impacts two key components of an organisation’s financial reports. Specifically, it influences the total assets of the organisation as reported in the balance sheet, and it influences

cost of sales and therefore the profit or loss of the organisation. For a large proportion of businesses, the asset known as inventory—which is also sometimes known as stock or merchandise—accounts for a significant proportion of total assets as reported within the balance sheet. The related expense, cost of goods sold, accounts for a significant amount of the total expenses of many firms, as reported in the statement of profit or loss. For example, the 2018 consolidated financial statements of Wesfarmers Ltd (see www.wesfarmers.com.au) indicate that inventories totalled $6011 million. Wesfarmers’ cost of goods sold in 2018 was $46 718 million when profits after tax amounted to $1197 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 on profits.

The relevant accounting standard in Australia is AASB 102 Inventories. As stated within the accounting standard, the standard: applies to all inventories, except:

(a) [deleted]; (b) financial instruments (these are addressed in 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

(these are addressed in AASB 141 Agriculture). (AASB 102)

As further indicated at paragraph 3, nor does the standard 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. (AASB 102)

Definition of inventory 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. (AASB 102)

Therefore, ‘inventories’ include finished goods, raw materials and stores, and work in progress. The inventory of Wesfarmers Ltd, discussed in the Introduction, as reported in its 2018 Annual Report, was categorised as shown in Exhibit 7.1.

The above definition of inventory 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.

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.

AASB no. Title IFRS/IAS equivalent

5 Non-Current Assets Held for Sale and Discontinued Operations IFRS 5

141 Agriculture IAS 41

102 Inventories IAS 2

123 Borrowing Costs IAS 23

132 Financial Instruments: Presentation IAS 32

LO 7.1

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

dee67382_ch07_257-282.indd 259 10/23/19 10:03 AM

CHAPTER 7: Inventory 259

Exhibit 7.1 The inventory of Wesfarmers as at 30 June 2018

WHY DO I NEED TO KNOW ABOUT THE MEANING OF INVENTORY?

As we saw earlier, for some organisations (such as Wesfarmers), ‘inventory’ can represent an asset that constitutes a significant or material amount of the total assets of an organisation. Further, cost of goods sold— which is the recognition of the cost of inventory used to make sales—can also be a very material expense for an organisation. Therefore, because of its potential significance it makes sense that we clearly know, from a financial accounting perspective, what ‘inventory’ represents.

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.

LO 7.2 7.2 The general basis of inventory measurement

Normally, it would be expected that inventory will be measured and reported within financial statements (the balance sheet) at ‘cost’. However, in those situations—which would not be hoped for by managers—where the net realisable value of inventory falls below cost, then the amount reported for inventory shall be reduced to net realisable value.

Specifically, 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 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)

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.

lower of cost and net realisable value A rule for the measurement of inventory that requires the cost and net realisable value to be calculated for different items of inventory and that the lower of the two amounts be chosen to measure inventory. Should the net realisable value be lower than cost, then inventory write-down expenses would be recognised.

SOURCE: Wesfarmers Ltd 2018 Annual Report, p. 112

dee67382_ch07_257-282.indd 260 10/23/19 10:03 AM

260 PART 3: Accounting for assets

The meaning of 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 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. (AASB 102)

Effectively, the above requirement means that the cost of inventory includes all those costs that are necessary to get the inventory ready for use, or for sale. So, in applying the requirements of paragraph 10 above, we need to know that:

∙ 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 are the costs that arise when, for example, a manufacturing process converts the various raw materials into finished goods, and 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 As we noted, the cost of inventories is to include those costs necessary to bring the inventories to their present location and condition. This means that costs subsequent to the point of their current location and condition shall be expensed as incurred.

In relation to what should not be included in the cost of inventory, paragraph 16 of AASB 102 specifically requires that costs of inventory shall 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, and ∙ 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’.

Allocating costs to inventory In allocating costs to inventories, a decision must be made about 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 production (or manufacturing) costs between different products. As paragraph 14 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

fixed production costs Costs of production that are not expected to fluctuate as levels of production change.

dee67382_ch07_257-282.indd 261 10/23/19 10:03 AM

CHAPTER 7: Inventory 261

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. (AASB 102)

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 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. (AASB 102)

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.

As an example of determining the cost of inventory, consider Worked Example 7.1.

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 expensed 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.

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 10 Bad debts 15 Depreciation—administrative equipment 20 Depreciation—factory equipment 30 Directors’ salary 90 Electricity—administration building 10

continued

dee67382_ch07_257-282.indd 262 10/23/19 10:03 AM

262 PART 3: Accounting for assets

Item of expenditure $000

Electricity—factory 30 Freight in of raw material 30 Freight out of inventory 20 Insurance—administration building 10 Insurance—factory 15 Interest expense 30 Purchase of materials used to make pop-outs 400 Purchase of office stationery and supplies 70 Rates—administration building 20 Rates—factory 20 Rent—administration building 100 Rent—factory 200 Repairs and maintenance—administration building 10 Repairs and maintenance—factory 30 Salaries—administrative personnel 150 Sales commissions 180 Wages—factory personnel    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 $400 000 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 Costs that relate to inventory

($000) Other costs

($000)

Advertising 10 Bad debts 15 Depreciation—administrative equipment 20 Depreciation—factory equipment 30 Directors’ salary 90 Electricity—administration building 10 Electricity—factory 30 Freight in of raw material 30 Freight out of inventory 20 Insurance—administration building 10 Insurance—factory 15 Interest expense 30 Purchase of materials used to make pop-outs 400 Purchase of office stationery and supplies 70 Rates—administration building 20 Rates—factory 20

WORKED EXAMPLE 7.1 continued

dee67382_ch07_257-282.indd 263 10/23/19 10:03 AM

CHAPTER 7: Inventory 263

Item of expenditure Costs that relate to inventory

($000) Other costs

($000)

Rent—administration building 100 Rent—factory 200 Repairs and maintenance—administration building 10 Repairs and maintenance—factory 30 Salaries—administrative personnel 150 Sales commissions 180

Wages—factory personnel 300

Total 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  Ltd 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’. The standard 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 Ltd more than 12 months to complete–as would often be the case–the cost of inventory would exclude the interest expenses.

Determining net realisable value As we have noted, for financial reporting purposes, the rule is that inventory is to be measured 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 at paragraph 6 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. (AASB 102)

There is a general principle in financial accounting that assets should not have a carrying amount in excess of their recoverable amount. The application of the lower of cost and net realisable value is consistent with this principle. A determination of net realisable value requires estimates (and therefore, professional judgements) to be made of the:

∙ future selling price ∙ costs necessary to complete the inventory (if necessary) ∙ future selling costs.

The managers of a profit-seeking organisation would always hope that the net realisable value of inventory would remain above cost. However, the net realisable value might drop below cost for a number of reasons, for example:

∙ the price customers are prepared to pay might have declined (perhaps due to changing preferences of customers) ∙ the inventory might have deteriorated (perhaps due to age or some form of damage)

dee67382_ch07_257-282.indd 264 10/23/19 10:03 AM

264 PART 3: Accounting for assets

∙ the inventory might have become technologically obsolete (for example, more advanced products might now be available from competitors)

∙ a decision might have been made to drop the selling price of the inventory (perhaps funds are urgently needed, or dropping the price of one product might be part of a broader marketing strategy to draw attention to the organisation’s products).

WORKED EXAMPLE 7.2: Lower of cost and net realisable value

Rayday Ltd holds four lines of inventory. The total costs of each item of inventory—which as we know includes costs of purchase, costs of conversion and other costs incurred in bringing the inventory to their location and condition—on hand at the end of the financial period are shown below. Apart from the inventory 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 Cost of inventory

($000) Transport costs

($000) Packaging costs

($000) Expected sales proceeds

($000)

Gidgets 20 2 3 35 Widgets 30 4 4 30 Didgets 15 1 1.5 22 Sidgets 25 2.5 2.5 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 Net realisable

value ($) Cost

($) Lower of cost and net realisable

value ($)

Gidgets 30 000 20 000 20 000 Widgets 22 000 30 000 22 000 Didgets 19 500 15 000 15 000 Sidgets 30 000 25 000 25 000

Total 101 500 90 000 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 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 conceptual framework, which generally requires that financial information should represent faithfully the underlying transactions and events, which in itself requires a degree of neutrality, and therefore a lack of bias, in the measurement. 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’.

We can summarise the requirements pertaining to the use of cost or net realisable value in Figure 7.1.

dee67382_ch07_257-282.indd 265 10/23/19 10:03 AM

CHAPTER 7: Inventory 265

Figure 7.1 An overview of the lower of cost and net realisable value rule

Determine ‘cost’ of inventory which includes: � Costs of purchase � Costs of conversion � Other costs to bring inventory to present location and condition

Determine ‘net realisable’ value of inventory which is 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

Is net realisable value greater than or equal to cost?

Measure inventory at cost Measure inventory at NRV and recognise

an inventory write-down expense

YES NO

Worked Example 7.3 provides another example of inventory cost determination.

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:

Normal operating capacity (units) 100 000 Goods produced (units) 100 000 Opening finished goods inventory (units) Nil Closing finished goods inventory (units) 20 000 Opening value of raw materials inventory Nil Closing value of raw materials inventory $100 000 Factory salaries $250 000 Administration salaries $90 000 Factory rent $120 000 Depreciation of factory equipment $80 000 Rental of office equipment $60 000 Raw materials purchased $300 000 Sales price per unit $9.00 per unit Delivery costs of finished goods $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. 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.

continued

dee67382_ch07_257-282.indd 266 10/23/19 10:03 AM

266 PART 3: Accounting for assets

The company in this illustration is operating at normal capacity of 100 000 units.

Costs of inventory

Variable costs Factory salaries $250 000 Raw material purchased $300 000 less Closing inventory $100 000 $200 000

$450 000 divided by Units produced 100 000 Per unit variable costs $4.50 Fixed costs Factory rent $120 000 Factory depreciation $ 80 000

$200 000 divided by Normal operating capacity 100 000 Per unit fixed costs $2.00 Total cost per unit $6.50 Net realisable value Sales price per unit $9.00 less Delivery costs per unit $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

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 write-down, 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 it is a requirement for 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.

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. AASB 123 Borrowing Costs requires that interest be included in the cost of inventory to the extent that the inventories are qualifying assets. Paragraph 8 states:

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. (AASB 123)

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 this requirement, and hence borrowing costs would not be included in the

write-down Reducing the carrying value of an asset.

WORKED EXAMPLE 7.3 continued

dee67382_ch07_257-282.indd 267 10/23/19 10:03 AM

CHAPTER 7: Inventory 267

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 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. (AASB 123)

Further discussion relating to accounting for borrowing costs is provided in Chapter 4.

WHY DO I NEED TO KNOW THAT INVENTORY IS MEASURED AT THE LOWER OF COST AND NET REALISABLE VALUE?

Inventory can be a very material asset in many organisations; however, the monetary amount assigned to inventory can potentially be misleading. For example, if inventory is reported at $50 million, it might actually be able to be sold for $200 million. Therefore, it needs to be appreciated by readers of financial statements that the amount reported for inventory is typically well below its fair value. So, although inventory might be reported at a particular monetary amount, the amount of economic benefits it ultimately generates could be significantly more.

7.3 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 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 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.

LO 7.3

dee67382_ch07_257-282.indd 268 10/23/19 10:03 AM

268 PART 3: Accounting for assets

If the production costs or purchase prices of inventory items did not change, the above three methods would generate the same costs, but steady prices would rarely be expected across time. The method adopted should be appropriate to the circumstances (that is, there is some correspondence between the cost-flow assumption and the physical flow of inventory) and be applied consistently from one accounting period to the next. An entity is to use the same method for all inventories having a similar nature or use. For inventories with a different nature or use, different methods may be applied (as long as the method chosen is one of the three options just listed).

Under the specific-identification method of inventory valuation, and assuming items being sold are similar or identical, the seller determines which item is sold and the cost of that specific item is expensed to cost of sales. This could lend itself to profit manipulation. The ending inventory is costed 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, 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. AASB 102 requires that specific identification be used to assign costs to inventory items that are:

(a) not ordinarily interchangeable; and (b) goods or services produced and segregated for specific projects.

As noted above, 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.

For goods that are ordinarily interchangeable, and are not produced and segregated for specific projects, AASB 102 requires that the costs be assigned using the weighted-average cost or the first- in, first-out (FIFO) methods.

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 (FIFO) cost-flow method 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, 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 (LIFO) cost-flow method of inventory valuation is not acceptable under AASB 102; however, it is discussed here for the sake of completeness. Under the LIFO cost-flow method, the most recent items purchased or manufactured are assumed to be the first goods sold. Therefore, ending inventory is assumed to be composed of the oldest goods. This could result in inventory being valued at costs that were paid or incurred some years before. The cost of sales contains relatively current costs, thus achieving a potentially better matching of current costs to revenues. In a period of rising prices, LIFO adopters would show lower profits and lower

specific-identification method Method of accounting for the cost flow of inventory. Significant dollar value items are often accounted for in this way, particularly where they have a unique characteristic such as a unique product number.

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.

first-in, first-out (FIFO) cost-flow method Method of assigning costs to inventory where it is assumed that the first inventory that enters an organisation’s stock is the first inventory that is sold.

last-in, first-out (LIFO) cost-flow method Method of assigning costs to inventory where it is assumed that the last inventory item that enters an organisation’s stock is the first inventory that is sold.

dee67382_ch07_257-282.indd 269 10/23/19 10:03 AM

CHAPTER 7: Inventory 269

closing inventory than FIFO adopters. Allowing the adoption of LIFO would potentially open the door to profit manipulation, as acquiring inventory at year end might alter the period’s profit, even if those 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 the purposes of calculating the entity’s taxation liability. In a period of rising prices, adopting LIFO effectively results in higher cost of goods sold, lower profits and, consequently, lower taxes. Further, the choice of an inventory cost-flow assumption does not have to reflect the underlying physical flow of inventory. LIFO is prohibited in countries that adopt the standards produced by the IASB.

The benefits of lower taxes that are available to US firms that adopt LIFO have to be traded off against other implications of reporting lower profits. Conceivably, reporting lower profits and lower closing inventory might have implications for certain accounting-based contractual arrangements, such as accounting-based management bonus schemes, and debt-to-asset constraints or interest-coverage clauses contained in negotiated debt agreements.

As discussed in previous chapters of this book, management can often choose between particular accounting procedures, for example:

∙ 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 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 in income (for example, an organisation might elect to upwardly revalue its non-current assets, thereby increasing future depreciation charges and reducing any profits on sale). Therefore, it can be misleading to try to explain a particular accounting choice in isolation rather than as part of an organisation’s entire portfolio of accounting policy choices. Although one choice of accounting method might, on its own, increase reported income, other methods voluntarily chosen by the firm might act to reduce income. When various ‘positive’ research studies are considered throughout this book, this potential research limitation should be borne in mind.

The perpetual and periodic inventory systems 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 allowable cost-flow assumptions further depends on the method used to record movements in the inventory, that is, whether the periodic or perpetual inventory system is used. We use either the perpetual or periodic inventory method to work out the number of units of inventory on hand. So in determining cost of goods sold (for the statement of profit or loss and other comprehensive income) and the cost of closing inventory (for the statement of financial position), we not only need to consider what cost-flow assumptions have been made (for example, FIFO, specific-identification or weighted-average approach), we also need to determine whether the perpetual or periodic system is being employed to determine the actual number of units of inventory on hand. Under the periodic inventory system, inventory is counted periodically (for example, at year end) and then costed. In contrast, under the perpetual inventory system, a running total is kept of the units on hand (and possibly their value) by recording all increases and decreases as they occur. Some inventory cost- flow examples and methods are reviewed in Worked Examples 7.4 and 7.5.

perpetual inventory system Also known as the continuous method, this is a method of accounting for inventory where a running total is kept of the units on hand by recording all increases and decreases in inventory as they occur.

periodic inventory system Also known as the physical inventory method, this is a method of accounting for inventory where inventory is counted periodically and then priced.

dee67382_ch07_257-282.indd 270 10/23/19 10:03 AM

270 PART 3: Accounting for assets

WORKED EXAMPLE 7.4: Inventory cost-flow example using the periodic inventory system

Bernie Ltd has the following inventory transactions for the year ending 30 June 2022:

Opening inventory at 1 July 2021 2 000 units @ $5 $ 10 000

Purchases on 1 October 2021 6 000 units @ $6 $ 36 000

Purchases on 1 February 2022 8 000 units @ $8 $ 64 000

Purchases on 1 June 2022 4 000 units @ $10 $ 40 000

Total 20 000 units $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 2000 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 5000 units purchased.

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 2021.

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 using the perpetual inventory system

Bakehouse Ltd begins selling rolling pins in 2021. 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 ($)

10 July 2021 100 2.50

10 Aug. 2021 300 2.70

5 Dec. 2021 250 2.80

1 Mar. 2022 300 3.00

1 June 2022   200 3.10

1150

dee67382_ch07_257-282.indd 271 10/23/19 10:03 AM

CHAPTER 7: Inventory 271

Details of sales are as follows:

Date of sale Number sold Unit price ($)

12 July 2021 90 5.00

15 Aug. 2021 210 5.00

10 Dec. 2021 300 5.10

25 Mar. 2022 200 5.00

15 June 2022 150 5.20

950

REQUIRED What is the cost of sales for the year ended 30 June 2022 and what is the value of inventory for statement of financial position purposes as at 30 June 2022?

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 cost-flow assumption. With this assumption, cost of goods sold would be $2660, reconciled as follows (assuming a perpetual inventory system is employed in which inventory records are updated each time an item is sold or manufactured):

Date Manufactured Sold Balance

10 July 100 @ 2.50 = $250 100 @ $2.50

12 July 90 @ $2.50 = $225   10 @ $2.50

10 Aug. 300 @ 2.70 = $810 10 @ $2.50

300 @ $2.70

15 Aug. 10 @ $2.50 = $ 25 100 @ $2.70

200 @ $2.70 = $540                      

5 Dec. 250 @ 2.80 = $700 100 @ $2.70

250 @ $2.80

10 Dec. 100 @ $2.70 = $270 50 @ $2.80

200 @ $2.80 = $560                      

1 Mar. 300 @ 3.00 = $900 50 @ $2.80

300 @ $3.00

25 Mar. 50 @ $2.80 = $140 150 @ $3.00

150 @ $3.00 = $450                     

1 June 200 @ 3.10 = $620 150 @ $3.00

200 @ $3.10

15 June                              150 @ $3.00 = $450 200 @ $3.10 1 150           $3 280 950                $2660

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.

dee67382_ch07_257-282.indd 272 10/23/19 10:03 AM

272 PART 3: Accounting for assets

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 2021 Trigger Ltd had 60 Malibu surfboards that cost $600 each. During the year the following transactions took place:

(a) On 10 July 2021 Trigger Ltd sold 50 Malibus for cash at $800 each. (b) On 5 August 2021 Trigger Ltd purchased 70 Malibus at $700 each and this cost included freight costs. (c) On 10 August 2021 Trigger Ltd paid for the purchases and received a 2 per cent discount for early payment. (d) On 5 September 2021 Trigger Ltd sold 60 Malibus at $900 each. (e) On 15 September 2021 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. (f) On 1 December 2021 Trigger purchased 40 Malibus at $720 each and this cost included freight costs. (g) On 10 December 2021 Trigger Ltd paid for the purchases and received a 2 per cent discount for early payment. (h) On 10 June 2022 Trigger Ltd sold 40 Malibus at $1000 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 2022) that cost $720 each.

REQUIRED

(a) Provide the journal entries to account for the above transactions using first the perpetual system and then the periodic 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 Purchased/(returned) Sold Balance

Op. bal. 60 @ $600

10 July 50 @ $600 10 @ $600

5 Aug. 70 @ $700 10 @ $600

70 @ $700

5 Sept. 10 @ $600

50 @ $700 20 @ $700

15 Sept. (10) @ $700 10 @ $700

1 Dec. 40 @ $720 10 @ $700

40 @ $720

10 June 10 @ $700 10 @ $720

30 @ $720

  $70 800 $99 600

dee67382_ch07_257-282.indd 273 10/23/19 10:03 AM

CHAPTER 7: Inventory 273

(a) Perpetual inventory system Periodic inventory system

10 July 2021

Dr Cash 40 000 Dr Cash 40 000

Cr Sales revenue 40 000 Cr Sales revenue 40 000

Dr Cost of goods sold (50 @ $600)

30 000

Cr Inventory 30 000

5 Aug. 2021

Dr Inventory (70 @ $700) 49 000 Dr Purchases 49 000

Cr Accounts payable 49 000 Cr Accounts payable 49 000

10 Aug. 2021

Dr Accounts payable 49 000 Dr Accounts payable 49 000

Cr Cash 48 020 Cr Cash 48 020

Cr Discount revenue 980 Cr Discount revenue 980

5 Sept. 2021

Dr Cash 54 000 Dr Cash 54 000

Cr Sales revenue 54 000 Cr Sales revenue 54 000

Dr Cost of goods sold (10 @ $600, 50 @ $700)

41 000

Cr Inventory 41 000

15 Sept. 2021

Dr Cash 7 000 Dr Cash 7 000

Cr Inventory 7 000 Cr Purchase returns 7 000

1 Dec. 2021

Dr Inventory (40 @ $720) 28 800 Dr Purchases 28 800

Cr Accounts payable 28 800 Cr Accounts payable 28 800

10 Dec. 2021

Dr Accounts payable 28 800 Dr Accounts payable 28 800

Cr Cash 28 224 Cr Cash 28 224

Cr Discount revenue 576 Cr Discount revenue 576

10 June 2022

Dr Cash 40 000 Dr Cash 40 000

Cr Sales revenue 40 000 Cr Sales revenue 40 000

Dr Cost of goods sold (10 @ $700, 30 @ $720

28 600

Cr Inventory 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

continued

dee67382_ch07_257-282.indd 274 10/23/19 10:03 AM

274 PART 3: Accounting for assets

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.

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 36 000

plus Purchases 77 800

113 800

less Purchase returns    (7 000)

106 800

less Closing inventory 7 200

Cost of goods sold   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 system because— as we see above—with the perpetual system the cost of goods sold is updated each time a sales transaction occurs):

Dr Inventory (that is, closing inventory, which would be 10 units at $720 each using FIFO)

7 200

Dr Cost of goods sold (this is the balancing item) 99 600

Dr Purchase returns (we close off purchase return account) 7 000

Cr Inventory (we remove the balance of the opening inventory from the inventory account)

36 000

Cr Purchases (we close off the purchases account so as to include it in COGS)

77 800

(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 purchase returns 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 $134 000

less Cost of goods sold (99 600)

Gross profit 34 400

WORKED EXAMPLE 7.6 continued

dee67382_ch07_257-282.indd 275 10/23/19 10:03 AM

CHAPTER 7: Inventory 275

WHY DO I NEED TO KNOW ABOUT INVENTORY COST-FLOW ASSUMPTIONS?

The cost-flow assumption adopted can impact the measurement of inventories as reported in the balance sheet, and the cost of goods sold as reported in profit or loss. Therefore, as readers of financial statements, we should know which cost-flow assumptions are being used by the reporting entity so that we can understand the context of the numbers being reported (and perhaps how they might be different if an alternative inventory cost-flow assumption had been adopted).

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 2021, 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 2021 the following entry would be required:

Dr Inventory write-down expense 300 000 Cr Inventory 300 000

(to recognise an inventory write-down expense)

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 Inventory 300 000 Cr Reversal of previous inventory write-down (income) 300 000

(to reverse an inventory write-down expense)

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.

LO 7.4

LO 7.5 7.5 Disclosure requirements

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. (AASB 102)

dee67382_ch07_257-282.indd 276 10/26/19 11:59 AM

276 PART 3: Accounting for assets

Exhibit 7.2 Accounting policy note from the 2018 Annual Report of Wesfarmers Ltd— Summary of significant accounting policies

SOURCE: Wesfarmers Ltd 2018 Annual Report, p. 112

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.

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.

See Exhibit 7.2 for an example of an accounting policy note, in this case provided by Wesfarmers Ltd in its 2018 Annual Report.

dee67382_ch07_257-282.indd 277 10/23/19 10:03 AM

CHAPTER 7: Inventory 277

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 (FIFO) method. Use of the last-in, first-out (LIFO) 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 261 cost of goods sold 258 direct costing 261 first-in, first-out (FIFO) cost-flow method 268 fixed costs 261 fixed production costs 260

inventory 258 last-in, first-out (LIFO) cost-flow method 268 lower of cost and net realisable value 259 period costs 261 periodic inventory system 269

perpetual inventory system 269 specific-identification method 268 standard costs 261 weighted-average approach 268 write-down 266

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following four questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions.

1. For financial reporting purposes, what are inventories? LO 7.1 Inventories are assets:

(a) held for sale in the ordinary course of business (b) in the process of production for such sale, or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

2. What costs should be included as part of the ‘cost’ of inventory? LO 7.2 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.

3. For financial reporting purposes, how should inventory be measured? LO 7.2 Inventory is to be measured at the lower of cost and net realisable value on an item-by-item basis.

4. What is an inventory cost-flow assumption, and which cost-flow assumptions are permitted to account for the cost of inventory? LO 7.3 An inventory cost-flow assumption is an assumption made about which particular units of inventory were sold at a particular point in time. Such an assumption is necessary to assign a cost to the sale of the inventory, as well as to calculate a closing value for inventory for balance sheet purposes. The cost of inventories of items that are not ordinarily interchangeable, and goods or services produced and segregated for specific projects, shall be assigned by using specific identification of their individual costs. The cost of other inventories shall be assigned by using the first-in, first-out (FIFO) or weighted-average cost methods. An entity shall use the same method for all inventories having a similar nature and use to the entity. For inventories with a different nature or use, different cost formulas may be justified.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is inventory? LO 7.1 • 2. Outline arguments for and against the use of the lower of cost and net realisable value rule. LO 7.2 •

dee67382_ch07_257-282.indd 278 10/23/19 10:03 AM

278 PART 3: Accounting for assets

3. 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 ••

4. What should be included in the ‘cost’ of inventories? LO 7.2 •

5. What does net realisable value mean as it pertains to inventory? LO 7.2 •

6. What is an inventory cost-flow assumption and why is one necessary? LO 7.3 ••

7. What inventory cost-flow assumptions are permitted in Australia? LO 7.3 ••

8. Distinguish between the periodic and perpetual inventory methods. LO 7.3 ••

9. What disclosures need to be made with respect to reported inventory? LO 7.5 ••

10. Explain the difference between absorption and direct costing. LO 7.2 •

11. Assuming that costs of inventory are rising over 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 and the highest measure of closing inventory. LO 7.3 •••

12. What is a ‘standard cost’? According to AASB 102, when may standard costs be used to assign costs to inventory? LO 7.2 ••

13. If inventory was written down from cost to net realisable value, which financial accounts would be affected? Further, if subsequently it was determined that the organisation could in fact sell the inventory for well above its original cost, what financial accounts would be adjusted? LO 7.2, 7.4 ••

14. AASB 102 prohibits the use of the LIFO method. What is the argument against the use of LIFO? LO 7.3 ••

15. 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 Sales proceeds

($) ($) ($) ($)

Wet-suits 5 000 1 000 1 000 9 000

Blocks of wax 3 000 1 000 2 000 5 000

Flippers 10 000 2 000 1 500 13 000

Board shorts 20 000 2 000 2 500 25 000

REQUIRED Determine the closing value of inventory for Moondoggie Ltd. LO 7.2, 7.3 ••

16. Shelley Ltd starts selling bowling balls in 2021. 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 ($)

2 July 2021 200 75

1 Aug. 2021 300 80

24 Dec. 2021 150 88

15 Mar. 2022 200 90

15 June 2022   200 88

1050

dee67382_ch07_257-282.indd 279 10/23/19 10:03 AM

CHAPTER 7: Inventory 279

Details of sales are as follows:

Date of sale Number sold Unit price ($)

5 July 2021 100 100

10 Aug. 2021 230 110

30 Dec. 2021 100 105

16 Mar. 2022 300 120

25 June 2022 100 130

830

REQUIRED What is the cost of sales for the year ended 30 June 2022 and what is the value of inventory as at 30 June 2022? LO 7.2, 7.3 ••

CHALLENGING QUESTIONS

17. Explain how it is possible for profits to be manipulated through the use of the specific-identification and LIFO inventory cost-flow assumptions. LO 7.3

18. 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 (FIFO) assumption. LO 7.3

19. Lynch Ltd has some inventory of wet-suits on hand at 30 June 2022. 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.

On 30 June 2022, 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 2022 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

(a) As at 30 June 2022, at what amount should inventory be recorded in the accounts of Lynch Ltd? (b) Assuming inventory was still measured at cost, what accounting entry would be required to adjust the amount

recorded for inventory at 30 June 2022? (c) Assuming that in the next financial year (starting 1 July 2022) Wayne Ltd does not acquire the inventory as

indicated, but rather, in late September 2022 it becomes apparent that there is actually another customer, Torquay Ltd, who is prepared to purchase the inventory for $40 000 without any modifications to the inventory, then what adjusting entries would need to be made? LO 7.2, 7.4

20. Horan Ltd has the following inventory transactions for the year ending 30 June 2022. All inventory items are identical.

Opening inventory at 1 July 2021 1 000 units @ $10

Purchases on 1 Sept. 2021 3 000 units @ $12

Purchases on 12 Feb. 2022 4 000 units @ $14

Purchases on 21 June 2022 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

dee67382_ch07_257-282.indd 280 10/23/19 10:03 AM

280 PART 3: Accounting for assets

21. The following list relates to expenditure incurred by Warm Buttered Ltd for the year ended 30 June 2022. Warm Buttered Ltd makes a standard, one-size-fits-all hat.

Item of expenditure $000

Advertising 20

Amortisation of franchise licence 15

Depreciation—administrative equipment 30

Depreciation—factory equipment 50

Directors’ salaries 100

Electricity—administration building 20

Electricity—factory 50

Factory supervisor’s salary 60

Freight in of raw material 10

Freight out of inventory 30

Income tax expense 100

Insurance—administration building 20

Insurance—factory 30

Purchase of materials used to make hats 200

Purchase of office stationery and supplies 50

Rates—administration building 10

Rates—factory 20

Rent—administration building 100

Rent—factory 300

Repairs and maintenance—administration building 20

Repairs and maintenance—factory 40

Salaries—administrative personnel 100

Sales commissions 120

Wages—factory personnel 200

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

22. Capetown Ltd started business at the commencement of the current financial year. The company manufactures rugby balls. Costs did not fluctuate during the year. The following information is available in relation to its production activities:

Normal operating capacity (units) 200 000

Goods produced (units) 200 000

Opening finished goods inventory (units) Nil

Closing finished goods inventory (units) 50 000

Opening value of raw materials inventory Nil

Closing value of raw materials inventory $200 000

Factory wages $1 550 000

Administration salaries $100 000

Salespersons’ salaries ($1 per unit sold) $150 000

Factory rent $150 000

Depreciation of factory equipment $100 000

dee67382_ch07_257-282.indd 281 10/23/19 10:03 AM

CHAPTER 7: Inventory 281

REQUIRED Determine the value at which inventory should be disclosed in the year-end statement of financial position. LO 7.2, 7.3

23. 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) 5 000

Opening finished goods inventory $40 000

Closing finished goods inventory (units) 15 000

Opening value of raw materials inventory $20 000

Closing value of raw materials inventory $10 000

Raw materials purchased $290 000

Factory wages (V) $90 000

Factory supervisor’s salary (F) $35 000

Administration salaries (F) $80 000

Cleaning of factory (V) $5 000

Maintenance of factory equipment (V) $25 000

Selling expenses (F) $30 000

Depreciation of factory equipment (F) $65 000

Rental of office equipment (F) $15 000

Factory insurance (F) $50 000

Freight outward (V) ($0.16 per unit sold) $8 000

Sales price per unit $12

Coolum Pty Ltd uses the first-in, first-out (FIFO) 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

24. As at 30 June 2022, 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 2022, 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 2022, 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 2022 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 2022 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

25. Billybang Pty Ltd imports surf shorts and sells them to department stores throughout Australia. At 1 July 2021 opening inventory comprised 10 units @ $22.00 each. Throughout the quarter ended 30 September 2021, the sales price of

Factory supervisor’s salary $50 000

Rental of office equipment $50 000

Raw materials purchased $600 000

Sales price per unit $13.00 per unit

Delivery and advertising costs per unit sold $2.00

At the end of the year there are no partly finished goods.

dee67382_ch07_257-282.indd 282 10/23/19 10:03 AM

282 PART 3: Accounting for assets

surf shorts was $30.00 and distribution costs were $0.50 per unit. Extracts from Billybang’s inventory record reveal the following transactions:

Date Purchases Sales

31 July 20 units @ $20.00

2 Aug. 5 units

4 Aug. 16 units

31 Aug. 15 units @ $18.00

3 Sept. 12 units

10 Sept. 10 units @ $21.00

29 Sept. 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

26. 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, 7.3

27. Provide an opinion on whether you consider that the way we measure inventory for financial reporting purposes enables the financial accountant to provide information which satisfies the qualitative characteristic that useful information shall be ‘relevant’. LO 7.1, 7.2, 7.3, 7.4

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. 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.

dee67382_ch08_283-326.indd 283 10/24/19 12:49 PM

283

LEARNING OBJECTIVES (LO) 8.1 Understand the differences between intangible and tangible assets and be able to explain the

importance that intangible assets can have within many organisations. 8.2 Understand which intangible assets are permitted to be recognised within financial statements. 8.3 Understand the general measurement principles that apply to intangible assets. 8.4 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.

8.5 Know when, and how, to revalue an intangible asset. 8.6 Be able to describe some of the disclosures required in relation to intangible assets. 8.7 Understand how to account for research and development expenditure and be able to describe some

empirical research that has been undertaken on corporate accounting practices relating to research and development.

8.8 Be able to define goodwill and explain how it is measured and reported for accounting purposes, as well as be able to explain some of the economic implications associated with alternative goodwill accounting policy choices.

8.9 Be able to evaluate whether the accounting standards pertaining to intangibles actually provide information that is useful to financial statement users.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

C H A P T E R 8 Accounting for intangibles

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is an intangible asset? LO 8.1 2. Do intangible assets really contribute that much to the overall value of an organisation? LO 8.1 3. Will the balance sheet report the economic value of all of an organisation’s intangible assets? LO 8.2,

8.3, 8.9 4. What is goodwill, and how is it measured for financial reporting purposes? LO 8.8

dee67382_ch08_283-326.indd 284 10/24/19 12:49 PM

284 PART 3: Accounting for assets

8.1 Introduction to accounting for intangible assets

Intangible assets are generally defined as non-monetary assets without physical substance. Common forms of intangible assets include patents, 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 (balance sheet). For example, the 2018 statement of financial position of Orica Ltd shows that within the Orica Group there was $1697.9 million in intangible assets in 2018 (classified under non-current assets). Exhibit 8.1 provides the details about intangibles as shown at Note 8 to Orica Ltd’s 2018 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’. As we will see in this chapter, however, many valuable intangible assets will not be shown within the financial statements because of the restrictions placed on their recognition by our accounting standards. Therefore, total intangible assets as reported by organisations will typically be understated relative to what the ‘true’ value of intangible assets might be to an organisation.

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 brand name of an organisation is considered to be an intangible asset. The top ten values attributed to various global brand names in 2018 were the following: Apple, US$214.48 billion; Google, US$155.506 billion; Amazon, US$100.764 billion; Microsoft, US$92.715 billion; Coca-Cola, US$68.341 billion; Samsung, US$59.89 billion; Toyota, US$53.404 billion; Mercedes Benz, US$48.601 billion; Facebook, US$45.168 billion; and McDonald’s, US$43.417 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 Intangible Assets specifically excludes such recognition.

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—amounts expended on most 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.

Unidentifiable intangible assets, on the other hand, would be those intangible assets that cannot be sold separately. For example, an organisation might be particularly successful because

LO 8.1

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.

AASB no. Title IFRS/IAS equivalent

3 Business Combinations IFRS 3

6 Exploration for and Evaluation of Mineral Resources IFRS 6

13 Fair Value Measurement IFRS 13

101 Presentation of Financial Statements IAS 1

136 Impairment of Assets IAS 36

138 Intangible Assets IAS 38

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

unidentifiable intangible assets Intangible assets that cannot be separately sold, such as loyal customers and established reputation. Goodwill is an example of an unidentifiable intangible asset.

dee67382_ch08_283-326.indd 285 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 285

Exhibit 8.1 Intangible asset note provided in the 2018 Annual Report of Orica Ltd

SOURCE: Orica Ltd 2018 Annual Report, p. 79

dee67382_ch08_283-326.indd 286 10/24/19 12:49 PM

286 PART 3: Accounting for assets

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.

The major accounting standard dealing with intangible assets is AASB 138. 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’, the standard 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 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. (AASB 138)

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. (IAS 38)

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.

Apart from the intangible assets dealt with in AASB 138, AASB 6 Exploration and Evaluation of Mineral Resources addresses ‘exploration and evaluation assets’, which are classified as being either tangible or intangible in nature. We will address these assets in Chapter 20.

In recent decades the total recorded amount of assets reported by large organisations is being based increasingly on their intangible assets, rather than on their tangible assets. That is, a number of decades ago the value of an organisation was very much linked to its property, plant and equipment (tangible assets) and the goods and services these assets generated. However, with changing technologies and markets, the value of many organisations is more linked to various knowledge-based assets, rather than to assets with physical form. For example, consider organisations such as Facebook, eBay, Twitter and Google. The value of these organisations—which can be in the many billions of dollars—is due to knowledge that has been used to develop the various technologies/platforms they use. Hence, issues associated with the recognition and measurement 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.

goodwill An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised. These ‘other assets’ would include the future economic benefits associated with an existing customer base, efficient management, reliable suppliers and the like.

dee67382_ch08_283-326.indd 287 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 287

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 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 those intangible assets that can be generated by ‘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.

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 whether we amortise the asset in subsequent years (as we explain in what follows).

WHY DO I NEED TO KNOW THE MEANING OF ‘INTANGIBLE ASSETS’?

Intangible assets are becoming increasingly important to the value and operations of many organisations. This is in contrast to several decades ago. Intangible assets can also now represent a significant proportion of the total assets of an organisation. Because of their central importance to so many organisations, it is important that we understand what they represent.

8.2 Which intangible assets can be recognised and included in the statement of financial position?

As indicated above, and pursuant to AASB 138, 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 states that no intangible asset arising from research (or from the research phase of an internal project) shall be recognised. Expenditure on research 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. (AASB 138)

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.

Pursuant to AASB 138, intangible assets (other than goodwill, which is excluded as an intangible asset in AASB 138 but is 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.

Consistent with the recognition requirements in many other accounting standards, 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 8.2

dee67382_ch08_283-326.indd 288 10/24/19 12:49 PM

288 PART 3: Accounting for assets

8.3 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 states:

The cost of a separately acquired intangible asset comprises: (a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts

and rebates; and (b) any directly attributable cost of preparing the asset for its intended use. (AASB 138)

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 defines a business combination as ‘a transaction or other event in which an acquirer obtains control of one or more businesses’.

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 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. (AASB 138)

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

We therefore 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 book publisher has developed a successful list of publishing titles internally, they are not to recognise the list as an asset. However, if the organisation is acquired, the list of publishing titles may in fact be recognised by the acquiring party as an asset. 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 subsequently acquired by another entity its (unrecognised) assets should be recognised by the acquirer. On why internally developed intangible assets cannot be recognised within the original entity, paragraph 64 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. (AASB 138)

LO 8.3

dee67382_ch08_283-326.indd 289 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 289

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.

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.

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?

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 permitted 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 either recorded in Dromana’s accounts at cost of acquisition (the acquired publishing title), or were not recognised at all by Dromana Ltd (the customer list was internally developed and therefore was not permitted to be recognised as an asset) but had the following fair values:

Carrying amount in Dromana Ltd’s financial statements Fair value

Land (cost) $400 000 $800 000

Customer lists (internally generated) Nil $100 000

Publishing titles (acquired) $50 000 $200 000

continued

dee67382_ch08_283-326.indd 290 10/24/19 12:49 PM

290 PART 3: Accounting for assets

8.4 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 later). 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. (AASB 138)

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 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

REQUIRED You are required to determine the amount at which the assets acquired by Pines Ltd, both (a) and (b), 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 in Pines Ltd’s financial statements. The fact that it might have a fair value of $800 000, or more, is not relevant. The general principle is that acquired intangible assets shall be recorded at cost. As we will see shortly, there are major restrictions 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. This means that the customer list will be recognised as an asset by Pines Ltd, even though Dromana Ltd was not permitted to recognise the asset. A well-developed customer list is an asset as such a list has the potential to generate future economic benefits because it might provide a focused list of people/organisations that are deemed more likely to acquire particular goods and services relative to a random list of potential customers.

WHY DO I NEED TO KNOW HOW INTANGIBLE ASSETS ARE MEASURED FOR FINANCIAL REPORTING PURPOSES?

The value of many organisations is very much linked to their intangible assets. However, it needs to be appreciated that financial reports will not necessarily provide a useful, or relevant, indicator of the financial value of all of the intangible assets under the control of an organisation. If we did not know that financial reports tend to understate the value of intangible assets, then we could be misled by the numbers being reported. As a rule, the ‘real’ value of intangible assets to an organisation will be much greater than the measure reported in their financial statements. Therefore, we need to understand that great care needs to be taken when interpreting the financial measures attributed to intangible assets.

LO 8.4

WORKED EXAMPLE 8.2 continued

dee67382_ch08_283-326.indd 291 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 291

WORKED EXAMPLE 8.3: Determining amortisation expense

During the year ending 30 June 2022, 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 2022, 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. There is no time restriction on how long the name can be used. 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 2022, 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 2022.

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. (AASB 138)

In determining the amortisation expense, 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. (AASB 138)

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).

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.

continued

dee67382_ch08_283-326.indd 292 10/24/19 12:49 PM

292 PART 3: Accounting for assets

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, they were generally not pleased with the 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).

8.5 Revaluation of intangible assets

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 in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

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 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. (AASB 138)

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 treated as part of other comprehensive income and subsequently credited to a revaluation surplus account, except where it reverses a previous revaluation decrement, in which case the revaluation increment would be recognised as income and

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.

LO 8.5

WORKED EXAMPLE 8.3 continued

dee67382_ch08_283-326.indd 293 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 293

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 treated as a loss within ‘other comprehensive income’ and ultimately debited to the revaluation surplus. 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 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. (AASB 138)

Revaluations of goodwill are not permitted. 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 McDingbat franchise 170 000

Cr Gain on revaluation (part of OCI) 170 000

(to recognise a revaluation of the franchise. At the end of the accounting period the gain would be transferred to an equity account—Revaluation surplus)

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).

dee67382_ch08_283-326.indd 294 10/24/19 12:49 PM

294 PART 3: Accounting for assets

8.6 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 [see also IFRS 5] and other disposals; (iii) increases or decreases during the period resulting from revaluations and from impairment losses

recognised or reversed in other comprehensive income; (iv) impairment losses recognised in profit or loss during the period; (v) impairment losses reversed in profit or loss during the period; (vi) any amortisation recognised during the period; (vii) net exchange differences arising on the translation of the financial statements into the presentation

currency, and on the translation of a foreign operation into the presentation currency of the entity; and (viii) other changes in the carrying amount during the period. (AASB 138)

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 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 carrying amounts of

intangible assets pledged as security for liabilities; and (e) the amount of contractual commitments for the acquisition of intangible assets. (AASB 138)

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 goodwill.

LO 8.6

dee67382_ch08_283-326.indd 295 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 295

8.7 Research and development

AASB 138 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.

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 at paragraph 8 as:

original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. (AASB 138)

Development, which generally follows research, is defined in paragraph 8 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. (AASB 138)

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. According to paragraph 59 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. (AASB 138)

The tests for deferral of research and development changed considerably in Australia with the adoption of 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 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. (AASB 138)

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 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. (AASB 138)

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 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

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 8.7

dee67382_ch08_283-326.indd 296 10/24/19 12:49 PM

296 PART 3: Accounting for assets

(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. (AASB 138)

The test for deferral is the same as applies to other intangible assets. Specifically, paragraph 21 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. (AASB 138)

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.

Development expenditure may lead to the creation of different types of intangible assets. For example, assume that a company is researching and subsequently developing computer software. The amounts spent on the research phase of the project would be expensed as incurred. However, the costs associated with developing the computer software may be capitalised as an intangible asset to the extent that the six requirements for deferral, as referred to above, are satisfied. Similarly, if the development phase of a project leads to the registration of certain patents that satisfy the requirements for deferral, then development expenditure can lead to the recognition of ‘patents’ for financial statement purposes (a patent can be considered to be a legal right for a defined period of time to exclude others from making, using or selling the particular invention).

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 of 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, or most, of its research and development as it occurs. For example, in 2018, Cochlear Ltd expensed $167 700 000 of research and development.

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

dee67382_ch08_283-326.indd 297 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 297

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. As paragraph 66 suggests, 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 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. (AASB 138)

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 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. (AASB 138)

The amortisation period and the amortisation method are also required to be reviewed regularly. Paragraph 104 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. (AASB 138)

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.

WORKED EXAMPLE 8.6: Amortisation of deferred development costs

Streaky Bay Ltd is involved in research and development. For the year ended 30 June 2022, research and development on Project X is incurred as follows:

Research $185 000

Development $300 000

Project X is expected to return total net cash flows of $250 000 over the next four years (with $62 500 expected to be recognised each year), starting from 1 July 2022. Streaky Bay Limited uses a discount rate of 8 per cent.

continued

dee67382_ch08_283-326.indd 298 10/24/19 12:49 PM

298 PART 3: Accounting for assets

REQUIRED

(a) How much research and development should be expensed in the year to 30 June 2022? (b) How much research and development should be amortised in the year to 30 June 2023?

SOLUTION

(a) As noted above, AASB 138 requires that research be expensed 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 185 000

Development 300 000

Amount expected to be recouped (207 006) 92 994

Research and development expensed in 2022 277 994

The aggregated accounting entry for 2022 therefore would effectively be:

Dr Research expenditure expense 185 000

Dr Development expenditure expense 92 994

Dr Development asset 207 006

Cr Cash, payables, accumulated depreciation, etc. 485 000

(to recognise research and development expenditure incurred in 2022)

Of relevance to this Worked Example is paragraph 60 of AASB 138, which requires an entity to assess 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 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 equal or exceed the carrying amount (cost) of the development expenditure, then it is usual to amortise the development asset on a straight-line basis over the life of the asset.

The amount of amortisation therefore is:

$207 006 ÷ 4 = $51 752

The accounting entry is:

Dr Development amortisation expense 51 752

Cr Accumulated amortisation—development asset 51 752

(to recognise the amortisation of development expenditure)

WORKED EXAMPLE 8.6 continued

dee67382_ch08_283-326.indd 299 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 299

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 US FASB is a 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 IFRS requirements, which allow 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 judgement 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 expensed, 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 incentives were less likely to cut research and development expenditures. Assuming that managers are motivated by a desire to maximise their own wealth, 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

It should be noted that it is also possible that rather than treating the amortisation of development expenditure as an expense of the accounting period, the amortisation might also be treated as part of the cost of another asset that is being generated as a result of the development.

dee67382_ch08_283-326.indd 300 10/24/19 12:49 PM

300 PART 3: Accounting for assets

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 IFRS-adopting countries have 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 expensed 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 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 (1997) 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 amortises the resulting asset over the anticipated life of the asset, which

dee67382_ch08_283-326.indd 301 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 301

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. (Reprinted from GOODACRE, A. & MCGRATH, J., 1997, ‘An Experimental Study of Analysts’ Reactions to Corporate R & D Expenditure’, British Accounting Review, vol. 29, pp. 159–79, with permission from Elsevier).

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 within the notes to the financial statements about the accounting methods employed. 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.

WORKED EXAMPLE 8.7: Calculating deferred development balances

As at the end of the 2023 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) Budgeted ($000)

Project 2022 2023 2024 2025 2026

A. R & D expenditure 15 15 20 20 0

Expected revenue inflows 10 10 10 0 0

B. R & D expenditure 40 40 70 0 0

Expected revenue inflows 0 0 100 250 100

C. R & D expenditure 300 100 50 0 0

Expected revenue inflows 0 0 350 350 150

D. R & D expenditure 0 300 0 0 0

Expected revenue inflows 0 0 100 50 50

continued

dee67382_ch08_283-326.indd 302 10/24/19 12:49 PM

302 PART 3: Accounting for assets

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 2022 was considered to represent research and the expenditure in 2023 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 2023 caused the researchers to believe that all costs would be recouped through future production and sales. Before 2023, the viability of the project had appeared doubtful. Only $50 000 of the expenditure in 2022 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 2023.

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 expensed as incurred. As such, there is no need to determine the recoverable amount.

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 × 0.9174 = $   91 740 $250 000 × 0.8417 = $ 210 425 $100 000 × 0.7722 = $   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 2023 that the future economic benefits are deemed to be probable, none of the expenditure incurred before 2023 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 × 0.9174 = $ 321 090 $350 000 × 0.8417 = $ 294 595 $150 000 × 0.7722 = $ 115 830

$ 731 515

WORKED EXAMPLE 8.7 continued

dee67382_ch08_283-326.indd 303 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 303

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 × 0.9174 =   $   91 740 $ 50 000 × 0.8417 =   $  42 085 $ 50 000 × 0.7722 =   $   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 2023, the remaining recoverable amount is $172 435.

Therefore, for Projects A, B, C and D, as at the end of 2023, the amount of $312 435 can be deferred to future periods, summarised as follows:

Project Amount carried forward ($)

A 0

B 40 000

C 100 000

D 172 435

312 435

WHY DO I NEED TO KNOW HOW RESEARCH AND DEVELOPMENT IS TO BE ACCOUNTED FOR?

The future economic success of many organisations will be influenced by the quantum and type of research and development they are undertaking. As such, it is useful to understand how the information about their research and development is recognised, measured and disclosed for financial reporting purposes. It is important to understand that all research is expensed as incurred and that development may be carried forward as an intangible asset to the extent that certain requirements are met. This allows us to attribute greater meaning to the numbers being reported.

Having considered how to account for research and development, we will now focus our attention on another intangible asset, this being goodwill.

8.8 Accounting for goodwill

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,

LO 8.8

dee67382_ch08_283-326.indd 304 10/24/19 12:49 PM

304 PART 3: Accounting for assets

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 is consistent with the definition provided in Appendix A of AASB 3, 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. (AASB 3)

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. Pursuant to 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 of the amount paid for it than internally generated goodwill, which is not capable of being reliably measured. Consequently, the accounting treatment for purchased goodwill differs from that for internally generated goodwill.

Therefore, goodwill can be recognised only when it is acquired as part of a business acquisition. This means that an organisation 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 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 strict requirement that no internally generated goodwill shall be recognised for accounting purposes.

How is goodwill measured? Pursuant to AASB 3, 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 in Appendix A of the standard 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. (AASB 3)

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.

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.

WORKED EXAMPLE 8.8: Calculation of goodwill

Horan Ltd purchases the Coolum Store for the consideration of:

Cash $150 000 Land 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)

dee67382_ch08_283-326.indd 305 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 305

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. 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 accounting standards, the next issue to consider is how (or if) to amortise it.

Goodwill 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 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.

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 150 000

Land (at fair value) 195 000 345 000

Fair value of net assets acquired

Carrying amount of assets 290 000

Excess of fair value over carrying amount   25 000

315 000

less Liabilities   95 000 220 000

Goodwill 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.

dee67382_ch08_283-326.indd 306 10/24/19 12:49 PM

306 PART 3: Accounting for assets

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 cash- generating 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 cash-generating 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 purchased goodwill is assessed as being greater than its carrying amount, 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 2022 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 Ltd are determined as follows:

($000)

Patent rights 200

Machinery 1 000

Buildings 1 500

Land 2 300

5 000

Less Bank loan    600

Net assets at fair value 4 400

At the end of the reporting period of 30 June 2023, 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, which excludes 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 or smaller ‘cash-generating unit’? A cash-generating unit is defined at Paragraph 6 of 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. (AASB 136)

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 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

dee67382_ch08_283-326.indd 307 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 307

shall determine the recoverable amount of the cash-generating unit to which the asset belongs (the asset’s cash-generating unit). (AASB 136)

In providing further explanation for the above requirement, paragraphs 67 and 68 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. (AASB 136)

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. (AASB 136)

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 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. (AASB 136)

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 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

continued

dee67382_ch08_283-326.indd 308 10/24/19 12:49 PM

308 PART 3: Accounting for assets

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. (AASB 136)

(a)

Goodwill of Curl Ltd ($000)

Net identifiable assets ($000)

Total ($000)

Carrying amount 600 4 400 5 000

Recoverable amount 4 500

Impairment loss    500

Journal entry

Dr Impairment loss—goodwill 500

Cr Accumulated impairment loss—goodwill 500

(b)

Goodwill of Curl Ltd ($000)

Net identifiable assets ($000)

Total ($000)

Carrying amount 600 4 400 5 000

Recoverable amount 4 100

Impairment loss    900

AASB 136, paragraph 104, requires the impairment loss of $900 000 to be allocated to the assets in the cash-generating 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 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. (AASB 136)

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. Once the goodwill has been fully impaired, 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)

Carrying amount 600 4 400 5 000

Impairment loss (600) (300)   (900)

          4 100 4 100

WORKED EXAMPLE 8.9 continued

dee67382_ch08_283-326.indd 309 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 309

Allocating the $300 000 balance of the impairment loss pro rata against the identifiable assets of the cash- generating unit on the basis of carrying amounts provides the following calculations:

($000) Allocation of impairment loss

Patent rights 200 × 300/5000 12

Machinery 1 000 × 300/5000 60

Buildings 1 500 × 300/5000 90

Land 2 300 × 300/5000 138

5 000 300

Journal entry:

Dr Impairment loss—goodwill 600

Dr Impairment loss—identifiable assets 300

Cr Accumulated impairment losses—goodwill 600

Cr Accumulated impairment losses—patent rights 12

Cr Accumulated impairment losses—machinery 60

Cr Accumulated impairment losses—buildings 90

Cr Accumulated impairment losses—land 138

(to recognise the impairment in value of the cash-generating unit)

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

Worked Example 8.9 provides insights into how to account for an impairment of goodwill. In the ‘real world’ the amounts recognised for goodwill impairment losses can be extremely material in amount. For example, when the South African organisation Woolworths acquired the Australian retailer David Jones it paid approximately $2.2 billion dollars for the organisation, of which $712 million (approximately one-third) was for goodwill. In 2018 Woolworths recognised a full goodwill impairment loss of $712 million, with various analysts arguing that this was evidence that Woolworths had actually paid too much for David Jones some years earlier.

Evidence suggests that managers often seem to defer the recognition of goodwill impairments to periods that are later than might be expected given the available evidence. For example, as reported by Eli Greenblat (in an article entitled ‘ASIC queries Myer over $1bn book value’, The Australian, 29 March 2018, p. 19), the corporate regulator ASIC had raised concerns over the goodwill reported by the large Australian retailer Myer. After these concerns had been raised, Myer did ultimately recognise a large goodwill impairment loss of $524.5 million. There was some speculation that Myer deferred the recognition of the large impairment loss to help ensure it did not breach lending agreements (debt covenants) that had been negotiated with its bank. In early 2018, Myer’s market capitalisation (the market value of its issued shares) was $480.45 million. That is, the capital market placed a value on the organisation of $480.45 million. However, the carrying amount of Myer’s intangible assets as reported within its balance sheet was $986 million (almost twice the market capitalisation), most of which related to its brand names and goodwill. Many analysts questioned why the company had not already expensed much of its goodwill. Certainly, the view was that the capital market had recognised the reduction in the value of the company, as reflected by the reduced market capitalisation, well in advance of the company recognising impairment losses.

Determining the value of goodwill, and the potential need for impairment losses, relies upon many assumptions and professional judgements. Significant judgements need to be made in estimating related future cash flows, as well as delimiting the relevant cash-generating units. Reflective of the various judgements that need to be made when determining the reasonableness of the amounts attributed to goodwill, it is interesting to note that calculating and suggesting adjustments to the value of an organisation’s reported goodwill (and also to brand names) is the issue that

dee67382_ch08_283-326.indd 310 10/24/19 12:49 PM

310 PART 3: Accounting for assets

apparently takes up most of independent financial statement auditors’ time. According to a review undertaken by the large accounting firm KPMG (2017, p. 2):

The most common reason communicated as driving auditor attention was the entity’s responsibility in the accounting standards to test goodwill annually for impairment. There is significant judgment associated with forward-looking estimations in these valuation models, and when combined with the quantum of the balances, garnered attention. These assessments can be particularly challenging in sectors experiencing constrained or volatile economic conditions.

Worked Example 8.10 provides another example of how to calculate purchased goodwill.

WORKED EXAMPLE 8.10: Determination of goodwill

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 10 000

Accounts receivable 60 000

Provision for doubtful debts (10 000) 50 000

Inventory 140 000

Total current assets 200 000

Non-current assets

Land and buildings, at cost 700 000

Accumulated depreciation—land and buildings (150 000) 550 000

Plant and equipment 400 000

Acc. depreciation—plant and equipment (100 000) 300 000

Total non-current assets 850 000

Total assets 1 050 000

Liabilities

Current liabilities

Accounts payable 70 000

Bank overdraft 30 000

Total current liabilities 100 000

Non-current liabilities

Bank loan 200 000

Total liabilities 300 000

Net assets 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.

dee67382_ch08_283-326.indd 311 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 311

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 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 organisations (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 respect of 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

• 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.

SOLUTION

$

Acquisition cost at fair value 1 000 000

Net assets shown in the statement of financial position as at the date of acquisition 750 000

Adjustments

Excess of fair value of land and buildings over the carrying amount 150 000

Excess of carrying value of inventory over the fair value (30 000)

Patent at fair value, unrecorded in the statement of financial position   80 000

Fair value of the identifiable net assets being acquired   950 000

Goodwill acquired in transaction   50 000

Notes

1. Although the acquisition cost of assets would normally include legal fees, AASB 3, 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.

dee67382_ch08_283-326.indd 312 10/24/19 12:49 PM

312 PART 3: Accounting for assets

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 reporting 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 & 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 sample 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.

These results are also consistent with insights provided within an Agenda Paper (Agenda Paper 8.1) on ‘Goodwill and Impairment’ released by the AASB in June 2018. In the Agenda Paper, the AASB notes that the recognition of impairments tends to occur after the share market has already made downward adjustments in share prices that potentially reflect the declining value of goodwill. Further, the AASB reports that there is evidence not only of the impairment of goodwill being deferred, but that there is a commonly held view among analysts that in years when there is a change in senior leadership, organisations are often seen to ‘take a big bath’ and recognise large impairments. This is perceived as representing a situation wherein past management teams seek to safeguard themselves against accusations of poor decision making in respect of past acquisitions, and new management teams are motivated to ‘start with a clean slate’ and to be able to report higher profits in future years (when some impairments might have otherwise been recognised). A key point raised in the 2018 AASB Agenda Paper was also that the process of impairment testing needs to be simplified as the way it is required to be done presently is too difficult and relies upon many professional judgements.

The Australian Securities and Investments Commission (ASIC) released a Media Release in January 2019 (19- 014 MR—see www.asic.gov.au/about-asic/news-centre/find-a-media-release/2019-releases/19-014mr-findings-from- 30-june-2018-financial-reports/) in which it also noted that the carrying amount of goodwill (as well as exploration and evaluation expenditure—another form of intangible asset) as reported by a number of Australian corporations was an issue creating a great deal of concern for ASIC. In ASIC’s view, the way that organisations were forecasting future cash flows for the purpose of evaluating goodwill did not appear reasonable, and the estimates of future cash flows used in the calculations often exceeded the actual cash flows for a number of reported periods. Further, ASIC noted that corporations often identify cash-generating units at a level that is too high, despite cash inflows being largely independent, resulting in cash flows from one asset or part of the business being incorrectly used to support the carrying values of other assets. ASIC also reported some entities not having sufficient regard to impairment indicators, such as significant adverse changes in market conditions, or situations where the reported net assets far exceed market capitalisation.

As we have also stressed in this chapter, when an organisation acquires another organisation as part of a business combination, the amount attributed to goodwill will be the difference between the fair value of the consideration paid

dee67382_ch08_283-326.indd 313 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 313

8.9 Does the way we account for intangible assets provide useful financial accounting information?

In a paper written for CPA Australia (August 2003), Colin Parker made the following comment in relation to AASB 138 just prior to the time it was being implemented within Australia:

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

LO 8.9

and the fair value of the identifiable net assets acquired. As Hellman, Andersson and Froberg (2016) note, management often appear to choose (somewhat opportunistically) not to recognise identifiable intangible assets (or understate their value) and this will lead to greater goodwill being recognised. Because the identifiable intangible assets will generally need to be amortised over their useful life, whereas goodwill (which is an unidentifiable intangible asset) shall not be amortised but rather will be subject to impairment testing (which is often done later than perhaps it should be, if it is done at all), then the choice to recognise greater goodwill and fewer identifiable intangible assets will have positive implications for future reported profits. This is also consistent with Shalev et al. (2013), who found that where Chief Executive Officers’ compensation packages are, relatively, based more upon accounting earnings, they are more likely to over-allocate the purchase price to goodwill, relative to identifiable intangible assets.

While the above paragraph notes that preparers of financial statements appear to be biased towards allocating acquisition premiums to goodwill, rather than to identifiable intangibles, what would be of interest is whether this opportunistic choice impacts the decisions ultimately made by the readers of the financial statements. In this regard, Hellman et al. (2016) found that a sample of financial analysts were inclined to view the acquisition of a subsidiary more favourably when the premium was allocated to goodwill, relative to it being allocated to amortisable identifiable intangible assets. In doing so, analysts seemed to rely upon the impacts of the accounting choice on reported profits. In discussing their results, Hellman et al. (2016, p. 139) state:

We believe the empirical findings have implications for standard setters, as analysts appear to be using financial statements information in a potentially misleading way. The application of IFRS leaves room for management discretion with regard to the identification of intangibles, and based on the analyst behavior reported in this article, there is a risk that management will aim for allocating acquisition premiums to goodwill in order to achieve favourable equity valuation judgements by financial analysts.

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 standard-setters assert.

WHY DO I NEED TO KNOW HOW GOODWILL IS ACCOUNTED FOR?

Goodwill is an asset that appears in many financial statements and it often has a large monetary value attributed to it. The reported goodwill represents an amount attributed to purchased goodwill. It does not represent the amount of any goodwill that has been internally developed and which might actually be quite valuable to parties interested in acquiring the organisation. Because of the way goodwill is measured (which relies upon many judgements), and because of the available evidence (which suggests that goodwill impairments are often recognised later than they arguably should be, or that excessive amounts might be allocated to goodwill rather than to other identifiable intangible assets acquired as part of a business combination), it is very important to be careful in interpreting or considering the actual value of goodwill relative to what is being reported.

dee67382_ch08_283-326.indd 314 10/24/19 12:49 PM

314 PART 3: Accounting for assets

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 has been introduced into accounting. Rather than amortising goodwill over a set period of time (which could in itself be deemed to be somewhat arbitrary), assessments are now made about whether the value of goodwill has been ‘impaired’. Given the nature of goodwill, determining whether its value has been impaired is not 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.

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 value of the information being produced under the accounting standards. The qualitative characteristic of ‘relevance’—one of the two fundamental qualitative characteristics that useful financial accounting information is expected to possess—seems to have been somewhat 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 and other countries that have adopted IFRSs have 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.

dee67382_ch08_283-326.indd 315 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 315

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 286 identifiable intangible assets 284

purchased goodwill 304 research and development 295

unidentifiable intangible assets 284

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following four questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is an intangible asset? LO 8.1 An intangible asset is defined in AASB 138 as an identifiable non-monetary asset without physical substance.

2. Do intangible assets really contribute that much to the overall value of an organisation? LO 8.1 Intangible assets can contribute significantly to the overall value of an organisation. Increasingly, the economic benefits that are generated come more from an organisation’s intangible assets than from its tangible assets, such as property, plant and equipment.

3. Will the balance sheet report the economic value of all of an organisation’s intangible assets? LO 8.2, 8.3, 8.9 No, the balance sheet typically will not report the actual economic value of an organisation’s intangible assets. Many intangible assets will not be recognised within the financial statements (often due to a prohibition on the recognition of many internally developed intangible assets). Further, for those intangible assets that are permitted to be recognised within the financial statements, there is a prohibition on revaluation to fair value (unless it can be shown that an ‘active market’ exists for the assets, which is seldom the case).

4. What is goodwill, and how is it measured for financial reporting purposes? LO 8.8 Goodwill 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. Generally speaking, goodwill is measured as the difference between the fair value of the consideration provided for the acquisition, the acquisition-date fair values of the identifiable assets acquired, and the liabilities assumed.

dee67382_ch08_283-326.indd 316 10/24/19 12:49 PM

316 PART 3: Accounting for assets

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. We have a separate accounting standard, AASB 138, that specifically deals with intangible assets and which 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 8.3, 8.7, 8.9 ••

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 8.2, 8.3 •

4. What activities should be included in the cost of research and development? In your answer, differentiate between research activities and development activities. LO 8.3, 8.7 •

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, 8.9 ••

7. What is the difference between an unidentifiable intangible asset and an identifiable intangible asset? LO 8.1, 8.2, 8.8 •

8. How is the value of goodwill determined for accounting purposes? LO 8.8 • 9. Would goodwill be considered an ‘asset’ according to the Conceptual Framework for Financial Reporting? LO 8.8 • 10. For each class of intangible assets, a reporting entity is required to disclose a reconciliation of the opening and

closing carrying amount. What items are to be included within this reconciliation? LO 8.6 •• 11. 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 8.4, 8.9 •• 12. 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 • 13. What are possible arguments for and against the prohibition of recognition of internally generated goodwill? LO 8.2,

8.3, 8.9 • 14. 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 8.5 • 15. 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 •

dee67382_ch08_283-326.indd 317 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 317

16. Tamarama Ltd acquires 100 per cent of Bronte Ltd on 1 July 2021. Tamarama Ltd pays the shareholders of Bronte Ltd the following consideration:

Cash $70 000

Plant and equipment fair value $250 000; carrying amount in the books of Tamarama Ltd $170 000

Land 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 2021 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 8.8 •

17. 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

Plant and equipment 510 000

Accumulated depreciation—plant and equipment (100 000) 410 000

Total non-current assets 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 300 000

Net assets 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.

dee67382_ch08_283-326.indd 318 10/24/19 12:49 PM

318 PART 3: Accounting for assets

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, 8.5, 8.8 •• 18. 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 8.3, 8.4, 8.8 ••

19. 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) Budgeted ($000)

Project 2022 2023 2024 2025 2026

Alpha R & D expenditure 75 75 100 100 0

Expected revenue inflows 50 50 50 0 0

Beta R & D expenditure 200 200 350 0 0

Expected revenue inflows 0 0 500 1 250 500

Gamma R & D expenditure 1 500 500 250 0 0

Expected revenue inflows 0 0 1 750 1 750 750

Delta R & D expenditure 0 1 500 0 0 0

Expected revenue inflows 0 0 500 250 250

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 2022 was considered to represent research, while the balance of the related expenditure 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 2023, surfers changed their minds and large-scale demand for the product was created. Only $250 000 of the expenditure in 2022 was deemed to represent research and the balance of all other expenditure was deemed to be development.

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 2023. LO 8.7 •••

20. 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 ••

dee67382_ch08_283-326.indd 319 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 319

21. 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 8.4, 8.5 ••

22. State whether the following assets may be revalued. Prepare journal entries for any revaluations permitted by accounting standards (you can ignore taxation effects). 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 they ever put it on the market.

(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, 8.7 ••

CHALLENGING QUESTIONS

23. Mam Ltd acquired Bo Ltd on 1 July 2022 for $7 000 000 in cash. 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 50

Machinery 1 450

Buildings 1 500

Land 3 000

6 000

Less: Bank loan   200

Net assets 5 800

At the end of the reporting period of 30 June 2023, 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 8.4, 8.8

24. In 2021 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 traditionally used on surfboards. In 2021 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 2022 McGoy Ltd developed a prototype of its surfboard. It asked several leading surfers to ride its surfboard at the annual Rip Curl Pro Event at Bells Beach. The costs involved in developing the prototype in 2022 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 2023 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 had been received. McGoy Ltd employed a firm of accountants to

dee67382_ch08_283-326.indd 320 10/24/19 12:49 PM

320 PART 3: Accounting for assets

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 at a price of $150 million.

REQUIRED Describe how to account for the above transactions and events and provide appropriate journal entries. LO 8.7

25. (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, 8.7

26. Should computer software be classified as an intangible asset or as part of property, plant and equipment? LO 8.1, 8.2, 8.3

27. In a report by KPMG (Key Audit Matters: Auditor’s Report Snapshot, 20 September 2017), it was noted that calculating and suggesting adjustments to the value of an organisation’s reported goodwill (and also to brand names) is the issue that takes up most of financial statement auditors’ time. Why do you think this is the case? LO 8.8

28. When an organisation acquires another organisation as part of a business combination, what impact on recognised goodwill will occur if greater value is attributed to identifiable intangible assets acquired as part of the acquisition? LO 8.2, 8.3, 8.8

29. If the managers of an organisation that acquires another organisation either do not recognise previously unrecorded intangible assets of the acquired company, or underestimate their fair value, how could this potentially impact future reported profits? LO 8.2, 8.8

30. The following information appeared in the notes to the financial statements as reported in the 2019 Annual Report of Qantas Airways. You are required to explain the nature of each of these intangible assets and to evaluate whether the accounting treatment appears to be in compliance with accounting standards. LO 8.1, 8.2, 8.3, 8.4, 8.5, 8.6, 8.7, 8.8

SOURCE: Qantas Airways Ltd

31. 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, 8.9

dee67382_ch08_283-326.indd 321 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 321

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.

32. As goodwill is not to be amortised, does this mean that the balance of goodwill can be carried forward indefinitely? LO 8.4, 8.8

33. IP Ltd reports the following intangible assets:

$m

Patents at fair value 160

less Accumulated amortisation (40)

120

Trademarks, at cost    15

Goodwill, at cost 50

less Accumulated amortisation (10)

  40

Brand name 100

Licence at cost 10

less Accumulated amortisation  (1)

    9

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, 8.4, 8.5, 8.7, 8.8

34. 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, 8.9

35. In 1999 the Group of 100 (G100), 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

dee67382_ch08_283-326.indd 322 10/24/19 12:49 PM

322 PART 3: Accounting for assets

companies would clearly be disadvantaged economically by mandatory amortisation. The economic impact cannot be understated.

REQUIRED Evaluate the above statement. LO 8.2, 8.7, 8.8, 8.9

36. At its September 2000 meeting, the AASB decided to provide interested parties with access to the document Strategy Paper—Intangible Assets through its website, www.aasb.gov.au. 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 8.9

37. In a 2018 media release from ASIC (18-310MR ‘Premier Investments writes down brand name assets’, http://www. asic.gov.au/about-asic/news-centre/find-a-media-release/2018-releases/18-310mr-premier-investments-writes- down-brand-name-assets/), it is noted that:

ASIC notes the decision by Premier Investments Limited (Premier) to write down the value of its casual wear brand name assets by $30 million in its financial report for the year ended 28 July 2018.

ASIC had raised concerns on the value of these assets in Premier’s financial report for the year ended 29 July 2017. ASIC questioned the reasonableness and supportability of royalty rate assumptions and sales growth forecasts used in testing the assets for impairment.

Premier has referred to the increasingly competitive retail landscape and structural changes impacting the apparel industry in Australia and New Zealand.

The impairment of non-financial assets remains a focus area of ASIC’s financial reporting surveillance program . . . (© Australian Securities & Investments Commission. Reproduced with permission)

REQUIRED Explain why the determination of the value of brand names relies upon a great deal of professional judgement and why this is likely to be an area of ‘focus’ for ASIC. LO 8.4

38. In a newspaper article by Bridget Carter and Scott Murdoch (‘Myer writedown on cards’, The Australian, 12 February 2018, p. 18) it was reported that the total market value of Myer shares was $480.45 million at the same time as its intangible assets—primarily the value of its brand names and goodwill—were reported at $986 million. Would this seem to indicate that the carrying amounts are too high and therefore do not provide a faithful representation of their actual value? Explain your reasoning. LO 8.2, 8.3, 8.4, 8.8, 8.9

39. Innovator Ltd incurred expenditure researching and developing a cure for a common disease found in turnips. At the end of 2021, management determined that the research and development project was unlikely to succeed because trials of the prototype had been unsuccessful. During 2022 a breakthrough in agricultural science improved chances of the product succeeding and development resumed. The project was completed in 2022. At the end of 2022 costs incurred on the project were expected to be recoverable. Innovator expects that 10 per cent of the project revenue will be received in 2023, 20 per cent in 2024, 30 per cent in 2025, 30 per cent in 2026 and 10 per cent in 2027. 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:

Research ($000) Development ($000)

2021 40 10

2022 12 60

dee67382_ch08_283-326.indd 323 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 323

REQUIRED

(a) How much research expenditure and development expenditure should be recognised as an expense in 2021? (b) How much research and development expenditure should be recognised as an expense in 2022? (c) State how much expenditure should be carried forward (deferred) and reported in the statement of financial

position at the end of 2021 and 2022. (d) Prepare journal entries for the amortisation of deferred costs in 2023 and 2024, 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 2022 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

40. As explained within the chapter, accounting standards 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 8.4, 8.8, 8.9

41. 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 8.8, 8.9

42. 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 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.

dee67382_ch08_283-326.indd 324 10/24/19 12:49 PM

324 PART 3: Accounting for assets

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 8.4, 8.9

43. ASIC issued a media release in January 2019 (19-014MR) in which it noted that numerous large Australian organisations are not properly accounting for the possible impairment of their intangible assets. Specifically, ASIC noted some entities as not having sufficient regard to impairment indicators, such as significant adverse changes in market conditions, and reported net assets exceeding market capitalisation.

REQUIRED Explain why it is that impairment losses are potentially required to be recognised when the market capitalisation of an organisation exceeds the net assets reported in its balance sheet. LO 8.4, 8.8

44. In an article by Paul Smith entitled ‘Telstra takes $500m hit’ that appeared in The Australian Financial Review on 3 February 2018 (p. 25), it was reported that Telstra was writing down the value of its investment in a video-streaming firm (named Ooyala) it bought for more than $500 million to zero. The company provides a software platform that allows videos to be streamed on websites and smartphones. Telstra would recognise an impairment loss of $273 million against goodwill and other non-current assets. This follows a previous year write-down of $246 million.

REQUIRED

(a) How would Telstra have originally calculated the carrying amount of goodwill? (b) How do you think investors might react to the large goodwill impairment loss? LO 8.8, 8.9

45. 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 8.6, 8.8

46. 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 which 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 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.

dee67382_ch08_283-326.indd 325 10/24/19 12:49 PM

CHAPTER 8: Accounting for intangibles 325

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 8.8

REFERENCES AASB Agenda Paper 8.1, ‘Goodwill and Impairment’, June 2018,

accessed 3 April 2019 at www.aasb.gov.au/admin/file/ content102/c3/8.1_SP_Impairment_Testing_Summary_ Outreach_Responses_M165.pdf.

Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

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, vol. 44, no. 2, pp. 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, vol. 19, no. 4, pp. 326–36.

Dechow, P. & Sloan, R., 1991, ‘Executive Incentives and the Horizon Problem’, Journal of Accounting and Economics, vol. 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.

Hellman, N., Andersson, P. & Froberg, E., 2016, ‘The Impact of IFRS Goodwill Reporting on Financial Analysts’ Equity Valuation Judgements: Some Experimental Evidence’, Accounting and Finance, vol. 56, pp. 113–57.

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, vol. 8, no. 2, pp. 19–24.

Ji, K., 2013, ‘Better Late than Never: The Timing of Goodwill Impairment Testing in Australia’, Australian Accounting Review, vol. 23, no. 4, pp. 369–79.

KPMG, 2017, Key Audit Matters: Auditor’s Report Snapshot, 20 September 2017, KPMG, accessed 3 April 2019 at https:// assets.kpmg/content/dam/kpmg/au/pdf/2017/key-audit- matters-auditor-report-20-september-2017.pdf.

Lewellen, W., Loderer, C. & Martin, K., 1987, ‘Executive Compensation and Executive Incentive Problems’, Journal of Accounting and Economics, vol. 9, pp. 287–310.

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 Fair-Value Accounting’, unpublished working paper, accessed November 2015 at http://www.hbs.edu/faculty/ Publication%20Files/08-014.pdf.

Shalev, R., Zhang, I. & Zhang, Y., 2013, ‘CEO Compensation and Fair Value Accounting: Evidence from Purchase Price Allocation’, Journal of Accounting Research, vol. 51, pp. 819–54.

Sirower, M., 1997, The Synergy Trap – How Companies Lose the Acquisitions Game, Free Press, New York.

dee67382_ch08_283-326.indd 326 10/24/19 12:49 PM

dee67382_ch09_327-372.indd 327 10/23/19 10:08 AM

327

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

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 Explain the arguments for and against measuring heritage assets in financial/monetary terms. 9.3 Be able to provide arguments in respect of whether heritage assets satisfy the definition of assets in

terms of them possessing the potential to provide future economic benefits. 9.4 Be able to provide arguments about whether heritage assets satisfy the definition of assets in respect of

whether a reporting entity has control over the assets. 9.5 Be able to explain whether heritage assets can be measured in a way that satisfies the qualitative

requirement of being ‘representationally faithful’. 9.6 Be able to provide arguments about whether the financial quantification of heritage assets provides

information that satisfies the qualitative characteristic of ‘relevance’. 9.7 Be aware of some alternative approaches to measuring heritage assets. 9.8 Understand what constitutes a ‘biological asset’, and know some of the history and debate associated

with accounting for biological assets. 9.9 Understand the unique nature of biological assets and how they can be classified for financial reporting

purposes. 9.10 Be able to explain how biological assets shall be measured. 9.11 Be able to explain when and how revenue associated with biological assets shall be measured. 9.12 Know how to account for the harvested produce derived from an entity’s biological assets. 9.13 Be able to identify some non-financial disclosures that can be made with respect to biological assets. 9.14 Be aware of some of the arguments opposing the requirements of AASB 141 Agriculture.

C H A P T E R 9 Accounting for heritage assets and biological assets

dee67382_ch09_327-372.indd 328 10/23/19 10:08 AM

328 PART 3: Accounting for assets

LO 9.1

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is a heritage asset? LO 9.1 2. Is there general agreement within the ‘accounting community’ that heritage assets should be measured in

monetary terms? LO 9.2 3. Do heritage assets seem to comply with the definition of assets provided within the Conceptual Framework?

LO 9.3 4. What is a biological asset? LO 9.8 5. How shall biological assets be measured? LO 9.10 6. How shall the harvested produce from biological assets be measured? LO 9.12

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

13 Fair Value Measurement IFRS 13

101 Presentation of Financial Statements IAS 1

102 Inventories IAS 2

116 Property, Plant and Equipment IAS 16

141 Agriculture IAS 41

1049 Whole of Government and General Government Sector Financial Reporting –

9.1 Introduction to accounting for heritage assets and biological assets

In previous chapters we considered a number of accounting standards relating to specific types of assets, such as inventory (AASB 102) and intangible assets (AASB 138). We 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 heritage assets and biological assets. Various views will be provided on how to measure and disclose such assets. The chapter will also discuss the sorts of debate that are ongoing within the financial accounting domain. We start our discussion by focusing on heritage assets.

Definition of heritage assets: what are they? There is no single accepted definition of a heritage asset. In a paper released in 2006 by the UK Accounting Council/Financial Reporting Council 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 UK Accounting Council/Financial Reporting Council 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.

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.

dee67382_ch09_327-372.indd 329 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 329

The above definition is consistent with a definition of ‘heritage items’ provided more recently by the International Public Sector Accounting Standards Board (IPSASB) (2017):

Heritage items are items that are intended to be held indefinitely and preserved for the benefit of present and future generations because of their rarity and/or significance in relation, but not limited, to their archeological, architectural, agricultural, artistic, cultural, environmental, historical, natural, scientific or technological features.

According to IPSASB (2017), the special characteristics of ‘heritage items’ do not prevent them being considered as ‘assets’ for financial reporting purposes.

When we look at the above definitions, it appears that 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 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. 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 Council/Financial Reporting Council (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 Council/Financial Reporting Council (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.

dee67382_ch09_327-372.indd 330 10/23/19 10:08 AM

330 PART 3: Accounting for assets

9.2 Some arguments for and against recognising heritage assets in financial terms

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 the Conceptual Framework definition and recognition criteria of ‘assets’?

∙ Are the definition and recognition criteria of assets provided in the Conceptual Framework 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 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 of the Appendix to AASB 116:

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. (AASB 116)

Therefore, it is accepted by accounting standard-setters that ‘property, plant and equipment’ held by not-for-profit 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

LO 9.2

dee67382_ch09_327-372.indd 331 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 331

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, entities should consider whether the requirements of AASB 136 Impairment of Assets apply to such assets. (AASB 116)

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.

In the accounting standard released in the UK (June 2009)—this being FRS 30 Heritage Assets—the UK Accounting Council/Financial Reporting Council also took the view that heritage assets should be recognised for balance sheet purposes. Paragraph 11 of FRS 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, ASB (UK), IPSASB and IASB all argue 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 also 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. (MICALLEF, F. & PEIRSON, G., ‘Financial Reporting of Cultural, Heritage, Scientific and Community Collections’, Australian Accounting Review, vol. 7, no. 1, p 34 (c) 1997. Reproduced with permission of John Wiley & Sons Ltd.)

dee67382_ch09_327-372.indd 332 10/23/19 10:08 AM

332 PART 3: Accounting for assets

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/monetary value on all valuable resources. It is interesting to note that, in more recent times, the AASB appears to have also questioned various aspects associated with the reporting of heritage assets, particularly the reporting of information in financial terms. For example, the AASB (2018, pp. 3) states:

Public sector entities provide essential social, cultural, community, education, health, defence, transport and other social services, employing nearly 2 million people. The efficient functioning of the sector matters: any unnecessary red-tape diverts funds from essential services.

The financial reporting framework governing public sector entities has not been reviewed for many years. Public sector entities complain about financial reporting complexity, inconsistent requirements and that the reports do not focus on the needs of stakeholders. The cost of preparation (including valuation of non-financial assets) and audit of public sector financial statements, based on very rough estimates, is more than $1 billion annually.

Research Paper No. 6: Financial Reporting Requirements Applicable to Australian Public Sector entities (Research Report No. 6) identified the key question for the Australian public sector regarding financial reporting as:

Are the current Australian public sector financial reporting requirements—currently costing more than $1 billion per annum—necessary to adequately hold the public sector accountable for the use of taxpayers’ monies?

The four specific key issues derived from the findings of Research Report No. 6 were: 1. Significant costs of having every entity in the public sector prepare General Purpose Financial Statements

(GPFS) when it is unclear who the users are. 2. Inconsistency in reporting and assurance requirements across different jurisdictions in Australia. 3. Complex and technical requirements that are unique to Australia, including the use of Government Finance

Statistics (GFS) within financial reports, administered versus controlled items and fair valuing all non- financial assets.

4. Linkage of financial reports with performance reports, budget accountability reporting and fiscal sustainability reporting is unclear and inconsistent.

The AASB has therefore raised various questions about the role of general purpose financial reports in providing relevant information about heritage assets. Nevertheless, the AASB believes that some form of financial accountability is required from the managers of these organisations who have been given responsibility for looking after heritage assets. As the AASB (2018, p. 4) states:

It is difficult to argue that entities within the public sector receiving appropriations funded by taxpayers should not have some form of public financial accountability. However, it is possible to make the reporting requirements more proportionate and more focused on user needs.

The AASB (2018, p. 16) further states:

Accountability is often argued to be more complex and salient for governments than businesses since there is a need to be accountable for the use of public money. Governments and other public-sector entities raise resources from taxpayers, donors, lenders and other resource providers for use in the provision of services to citizens and other service recipients. These entities are accountable for their management and use of resources to those that provide them with resources and to those that depend on them to use those resources to deliver necessary services. Users and preparers agree that ‘accountability’ should be given importance over ‘decision-making’.

Therefore, the view that appears to be espoused in AASB (2018) is that it is difficult to argue that entities within the public sector receiving appropriations funded by taxpayers should not have some form of public financial accountability. However, it is possible to make the reporting requirements more proportionate and more focused on user needs. Of particular relevance might be the reporting of information that focuses more upon linking the budgeted use of funds relative to the actual use of funds.

The questioning of the relevance of much of the information about valuations of heritage assets is consistent with Aversano and Christiaens (2014) and Aversano et al. (2018), who argue that information about the financial value of heritage collections is of very little relevance to readers of reports, who tend to be more interested in the costs of preservation or descriptive information about the physical condition of various collections.

Reflecting the view that the preparers of the information also question its relevance, Ferri and Sidaway (2019, p. 8) report that the Australian Museum has stated within one of its annual reports that:

a financial valuation does not reflect what the Museum believes to be the true intrinsic worth of the collections. Their true value cannot be expressed in monetary terms but rather in terms of their cultural and scientific worth.

dee67382_ch09_327-372.indd 333 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 333

Ferri and Sidaway (2019, p. 11) further state:

The Australian Museum (AM) increased the value of its collection by 12% per year between 2009 and 2011, based on adjustments to the Consumer Price Index (CPI), which is traditionally used to measure changes in the costs of living. The rationale of this choice is peculiar as AM-stored species like echinoderms, amphipod crustaceans, and polychaetes are not usually goods a typical household would purchase. . . . Interestingly, blanket exclusions of particular assets types can be also observed. For example, the Queensland Museum stated that ‘culturally sensitive, secret and sacred objects and human remains were not valued or verified’. Similarly, the South Australian Museum reported that ‘Collections deemed to be culturally sensitive including human remains or secret and sacred to Aboriginal communities have not been included within the current valuation and are deemed to be at zero valuation. These collections are Human Biology, Secret Sacred, Archives, Palaeontology and Archaeology.’

Reflective of the potential arbitrary nature with which financial valuations were being made, Ferri and Sidaway (2019, p.12) explain:

Changes in the useful life are frequent in phase 2 (2003–2010) and while by 1999 National Gallery of Australia was recording depreciation using a useful life of 200 years, this changed to a range of 50 to 500 years in 2003, then 25 to 525 years in 2006, then 10 to 480 years in 2008 before settling at 20 to 480 years in 2009 and remaining so until 2015. National Museum of Australia started depreciating its collection in 2001, with a useful life ranging from 75 years to unlimited until 2003. The range was changed to 50 to 500 years in 2004, with the majority of items having a useful life of 200 or 300 years. Eventually, the maximum useful life was increased to 5000 years starting in 2005.

Again, the impression we get is that valuation approaches are constantly changing, reflecting a perspective that those in charge of measuring heritage assets are frequently not sure how they should measure such assets. In concluding their study, Ferri and Sidaway (2019, p. 15) state:

The findings of the present study confirm that the application of conventional accrual accounting techniques in the context of Australian public museums does not enhance the usefulness of financial information but rather has an adverse effect on the comparability of such information. This is owed largely in part to the arbitrary nature of attempting to assign financial values to assets that are primarily held for non-financial purposes including cultural, educational and scientific reasons. The level of subjectivity involved in this process is evidenced by the diverse array of accounting policies used across institutions coupled with frequent changes made to accounting policies within the institutions themselves along the three phases. For this reason, the reported financial information as it pertains to museum collections is problematic if one wishes to make comparisons either between or within museums. On the top of this, negative publicity and decreases in net operating results emerge as unexpected effects of heritage revaluation processes.

In November 2018, the Council of Australasian Museum Directors (CAMD) released the Australian Framework for the Valuation of Public Sector Collections for General Purpose Financial Reporting. In part, this framework was developed as a result of museum directors’ concerns about the inconsistency in valuations taking place across time, and between museums. A review of this framework, however, shows that there would still be a great deal of discretion in how collections would be valued in financial terms. The framework states (CAMD, 2018, p. 8) that:

for valuation purposes, collections can generally be separated into three classes summarised below and then discussed in detail hereunder:

(a) Highly Significant and Sensitive Collection Assets are those objects which because of uniqueness, sensitivity or legal frameworks need to be regarded as priceless or valueless;

(b) High Value Collection Assets are those where the value of the asset exceeds a predetermined threshold amount; and

(c) General Collection Assets are those where replacement value represents fair value through highest and best use.

In relation to ‘highly significant and sensitive collection assets’, for example, it is noted by CAMD (2018, p. 9) that a reliable value might not be possible in relation to those assets that are:

(a) Unique, irreplaceable (including in terms of their utility) and of significant cultural, social, historical or scientific value, with no data available to determine a market or replacement value; and/or

dee67382_ch09_327-372.indd 334 10/23/19 10:08 AM

334 PART 3: Accounting for assets

(b) Sensitive or legally defined Collection Assets—these include but are not restricted to: human remains; secret sacred objects; and objects acquired from a legal seizure under CITES, where the Museum determines, supported by independent expert evidence, that it is inappropriate to record value and/or there is an inability to reliably measure value. (COUNCIL OF AUSTRALIAN MUSEUM DIRECTORS, 2018, Australian framework for the valuation of public sector collections for general purpose financial reporting, CAMD, Manuka, ACT, November p 8.)

These assets should be recorded at nil value. Assets recorded at nil on this basis should be separately disclosed in the financial report.

Obviously, by excluding certain heritage assets from the valuation process this would again bring into question the relevance of any measure of the total monetary amount of the collection. So it is not clear that CAMD (2018) has greatly contributed to addressing key measurement problems.

In considering arguments for and against the recognition of heritage assets we can refer to 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 defines an asset as ‘a present economic resource controlled by the entity as a result of past events’. An ‘economic resource’ is further defined as ‘a right that has the potential to produce economic benefits’.

There are three fundamental characteristics that should therefore be present before something can be considered to be an asset:

1. The item (resource) must have the capacity 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 also necessarily 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 satisfies the definition of an asset (provided above), and (b) it can be measured in a way that achieves the qualitative characteristics expected of useful financial information.

That is, the information is relevant and faithfully represents the asset. For the information to be relevant requires consideration of factors such as existence uncertainty and the level of probability associated with the related inflows of economic benefits. A faithful representation relies upon consideration of factors such as measurement uncertainty.

Having considered the definition and recognition criteria of assets, we can try to determine whether heritage assets meet these criteria. In particular, we can consider the following questions:

∙ Do heritage assets have the capacity to 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. Worked Example 9.1 explores the issue of whether a museum should place a value on heritage assets.

WORKED EXAMPLE 9.1: Museums’ measurement of heritage assets

Within many countries there is a requirement that organisations such as museums place a financial value on their collections.

REQUIRED Should a museum be required to place a financial value on its collections?

SOLUTION As we should now understand, there are various arguments for and against measuring heritage assets in ways that are consistent with how profit-seeking organisations measure their property, plant and equipment. It really comes down to a judgement about whether such measures assist the managers to demonstrate their accountability in respect of the responsibilities that are reasonably assigned to them. If it is contended that museum managers are not responsible for issues associated with the financial value of its collections, then arguably it is inappropriate for them to expend resources coming up with various financial measures of the assets. The resources of such organisations could probably be better used in more worthwhile activities. Nevertheless, there are various reporting requirements that currently compel museums to place a monetary value on their collections.

dee67382_ch09_327-372.indd 335 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 335

9.3 Do heritage assets provide future economic benefits?

As we know, for the purposes of preparing a general purpose financial statement, if an object does not have the potential 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. This is consistent with the view espoused in IPSASB (2017, p. 32), where it is stated:

The special characteristics of heritage items, including an intention to preserve them for present and future generations, do not, of themselves, result in a present obligation such that an entity has little or no realistic alternative to avoid an outflow of resources. The entity should not therefore recognize a liability.

Heritage assets do provide ‘needed or desired services to beneficiaries’, but asset recognition under the Conceptual Framework relies upon potential economic benefits being generated for the benefit of the entity that controls the source 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. (CARNEGIE, G.D. & WOLNIZER, P.W., ‘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, p 18 (c) 1999. Reproduced with permission of John Wiley & Sons Ltd.)

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 cash-based accounting systems.

As government departments are required to prepare financial statements using accounting standards, 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 amount 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

LO 9.3

dee67382_ch09_327-372.indd 336 10/23/19 10:08 AM

336 PART 3: Accounting for assets

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. Central to this issue is whether all ‘assets’, whether held by for-profit or not-for-profit entities, should be defined in terms of their likelihood of generating future economic benefits. The UK Accounting Council/Financial Reporting Council 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 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 embraced in its recently revised Conceptual Framework for Financial Reporting, which was 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 was 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. In 2017 the IPSASB released a further Consultation Paper entitled ‘Financial Reporting for Heritage in the Public Sector’. In this document it was stated that:

1.7 Characteristics of heritage items include that: (a) They are often irreplaceable; (b) There are often ethical, legal and/or statutory restrictions or prohibitions that restrict or prevent sale,

transfer or destruction by the holder or owner; and (c) They are expected to have a long, possibly indefinite, useful life due to increasing rarity and/or significance.

dee67382_ch09_327-372.indd 337 11/07/19 11:56 AM

CHAPTER 9: Accounting for heritage assets and biological assets 337

1.8 These characteristics of heritage items may have consequences for financial reporting for heritage in the following areas:

(a) Measurement: Is it possible to measure heritage items in a way that reflects their service potential or their ability to generate economic benefits?

(b) Value: If assignment of monetary values does not convey the heritage significance of heritage items or their future claims on public resources, would users of GPFRs benefit more from non-financial information about heritage items, reported outside the financial statements?

(c) Preservation: If an entity’s responsibility is to preserve heritage items rather than to generate cash flows from them, are heritage items resources or obligations from the entity’s perspective?

(d) Restrictions on use: Given restrictions on entities’ ability to use, transfer or sell heritage items, should heritage items be shown as assets in the financial statements?

(e) Benefits to others: Can a reporting entity be said to control a heritage item for financial reporting purposes, when it is held for the benefit of current and future generations?

This text is an extract from ‘Financial Reporting for Heritage in the Public Sector’ of the IPSASB, published

by the International Federation of Accountants (IFAC) in 2017, and is used with permission of IFAC. Such

use of IFAC’s copyrighted material in no way represents an endorsement or promotion by IFAC. Any views

or opinions that may be included in Financial Accounting are solely those of McGraw-Hill Education and do not express the views and opinions of IFAC or any independent standard setting board associated with IFAC.

What is clear is that it is increasingly being questioned by different parties whether heritage assets should be treated like other assets for financial reporting purposes. This represents a movement away from earlier positions held by accounting standard-setters such as the Australian Accounting Standards Board, who 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 2006 IPSASB Consultation Paper:

The Boards agreed that the submissions to the IPSASB should 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.

Having considered the issue of whether heritage assets have the potential to generate future economic benefits, another important factor when it comes to recognising future economic benefits is that of who ‘controls’ those benefits. This issue is considered next.

9.4 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 Conceptual Framework, control is defined in the following terms:

4.20 An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it. Control includes the present ability to prevent other parties from directing the use of the economic resource and from obtaining the economic benefits that may flow from it. It follows that, if one party controls an economic resource, no other party controls that resource.

4.21 An entity has the present ability to direct the use of an economic resource if it has the right to deploy that economic resource in its activities, or to allow another party to deploy the economic resource in that other party’s activities.

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.

LO 9.4

dee67382_ch09_327-372.indd 338 11/07/19 10:57 AM

338 PART 3: Accounting for assets

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. (CARNEGIE, G.D. & WOLNIZER, P.W., (1999). Reproduced with permission of John Wiley & Sons Ltd.)

Such views would also be relevant to other types of heritage assets. The Accounting Council/Financial Reporting Council in the UK also addressed the matter of holders of heritage assets typically not being able to sell them. However, the Board 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 above discussion considered key elements in the definition of an asset and the problematic issues pertaining to how they can be applied to heritage assets. We now move to consider qualitative characteristics associated with recognising assets.

9.5 Faithful representation: 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. This is a key aspect of ‘faithful representation’. 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 example from a newspaper article entitled ‘WA Museum insurance too high’ (by Stephen Bevis in The West Australian, 6 November 2014, see https://thewest.com.au/news/australia/wa-museum-insurance-too-high-ng- ya-380369, accessed November 2019) in which it was reported that for five years the Western Australian Museum paid higher insurance premiums than it should have paid to insure its collection because of an accounting mistake made in 2009 when transcribing data from a working paper to a final report. This error overstated the value of the collection by almost 50 per cent, or almost $300 million. The error was only picked up five years later in 2014 when another valuer checked the report for the museum’s five-yearly valuation. The inflated value of $638.31 million was then revalued at $347.06 million, $291.25 million (46 per cent) less than in 2009, after applying different accounting assumptions. The museum’s director noted that the decrease did not affect the inherent value of the museum’s collection.

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. This point is further reflected in the study of Australian museums undertaken by Ferri

LO 9.5

dee67382_ch09_327-372.indd 339 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 339

and Sidaway (2019), who note how the valuations of museum collections changed dramatically across the years of their review (they reviewed monetary valuations undertaken by Australian museums during the period 1996–2015) as different assumptions and valuation techniques were used from year to year.

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 NZ $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 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!)

9.6 Is the information ‘relevant’? The actual demand for financial information about heritage assets

Determining whether there is a demand for financial information about heritage assets is a very important issue. If there is limited demand for certain information, resources are being wasted on providing such information, and recognition of the heritage assets would not meet the test for recognition within the Conceptual Framework, which, as we know, requires consideration of the qualitative characteristic of ‘relevance’. 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 Conceptual Framework notes (paragraph 2.39):

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.

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

LO 9.6

dee67382_ch09_327-372.indd 340 10/23/19 10:08 AM

340 PART 3: Accounting for assets

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. (CARNEGIE, G.D. & WOLNIZER, P.W., (1999). Reproduced with permission of John Wiley & Sons Ltd.)

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 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). (CARNEGIE, G.D. & WOLNIZER, P.W., (1999). Reproduced with permission of John Wiley & Sons Ltd.)

If we accept that what is actually reported should reflect what information is demanded or needed, 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.

The above discussion typically leads us back to basic and core considerations pertaining to what the responsibilities of an organisation are; how these responsibilities generate associated accountabilities; and, therefore, how these accountabilities relate to the ‘accounts’ that are being prepared. If an organisation is not considered as having a responsibility for generating financial returns, then it would not be perceived as having a responsibility for financial performance in terms of measures such as profits or return on assets. Therefore, it would not seem sensible at all to prepare financial statements that emphasise such measures. In the case of an organisation that has responsibility for heritage assets, there is much argument to support the view that monetary values either do not provide relevant information, or the information provided is not representationally faithful.

Worked Example 9.2 considers the ‘relevance’ of monetary values assigned to heritage assets.

WORKED EXAMPLE 9.2: The ‘need’ to measure resources in monetary terms

As we know, there is a general requirement that heritage assets under the ‘control’ of government departments have a financial value attributed to them.

REQUIRED Is an item in a museum collection more important if it has a high monetary value attributed to it?

dee67382_ch09_327-372.indd 341 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 341

SOLUTION There is no clear answer to such a question. The reason for posing the question is to again get us to question why we often think that all ‘resources’ should somehow be valued in monetary terms to enable us to determine the importance of an item. As accountants, and as other stakeholders, we have generally been ‘conditioned’ to believe that the importance, or ‘worth’, of something is best judged (and perhaps, can only be judged) when it has a financial valuation attached to it. However, to consider that the importance of most objects can be conflated to a financial measure seems rather simplistic. What do you think?

9.7 Measuring heritage assets in financial terms

As we have emphasised, one of the major purposes of financial reporting is to enable the management personnel of a reporting entity to demonstrate in financial terms, their accountability for the resources entrusted to them. 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, for example, at the Vision and Mission Statement of the National Museum of Australia (as provided on its website in 2019), we find the following:

Vision To be a trusted voice in the national conversation, and recognised as one of Australia’s premier cultural destinations exploring Australia’s past, illuminating the present and imagining the future.

Mission The National Museum of Australia’s mission is to bring the world’s cultures to Australia and present Australia’s history and culture to the world.

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 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.

LO 9.7

dee67382_ch09_327-372.indd 342 10/23/19 10:08 AM

342 PART 3: Accounting for assets

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. (From HONE, P., ‘The Financial Value of Cultural, Heritage and Scientific Collections: A Public Management Necessity’, Australian Accounting Review, vol. 7, no. 1, p 39 (c) 1997. Reproduced with permission of John Wiley & Sons Ltd.)

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. 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 (relevance). ∙ 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

dee67382_ch09_327-372.indd 343 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 343

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 Council/Financial Reporting Council (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. They would therefore not be in favour of the approach suggested in CAMD (2018), as discussed earlier.

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-for-like 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.

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.

dee67382_ch09_327-372.indd 344 10/23/19 10:08 AM

344 PART 3: Accounting for assets

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 non-capitalisation 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 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.

If heritage assets are to be capitalised, then there are various approaches to valuing the 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

dee67382_ch09_327-372.indd 345 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 345

of these are discussed in the following material. 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):

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. (HONE, P., (1997). Reproduced with permission of John Wiley & Sons Ltd.)

CVM has recently been applied by Parks Victoria, for example, to measure the value of certain ‘environmental amenities’ provided by parks under its control. 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? 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 in a report entitled Making economic valuation work for biodiversity conservation 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?

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.

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.

continued

dee67382_ch09_327-372.indd 346 10/23/19 10:08 AM

346 PART 3: Accounting for assets

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 million ($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

Exhibit 9.1 continued

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 (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 in a report entitled Making economic valuation work for biodiversity conservation released by Land and Water Australia in 2005.

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.

dee67382_ch09_327-372.indd 347 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 347

Exhibit 9.2 An illustration of the application of TCM

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.

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

Parks Victoria—the government organisation charged with looking after public parks in the state of Victoria to ‘ensure parks are healthy and resilient for current and future generations’—uses TCM to estimate the recreational values of particular sites by observing visitor travel patterns and the expenditure that people are willing to pay in order to enjoy a site.

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 2018 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.

Valuing land on such a basis is consistent with the requirements embodied within AASB 1049. 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.

dee67382_ch09_327-372.indd 348 10/23/19 10:08 AM

348 PART 3: Accounting for 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 bases 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 Exhibit 9.3. 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 Exhibit 9.4 describes how particular heritage assets might be valued.

Exhibit 9.3 Opposing the financial recognition of heritage assets

HERITAGE HANGS IN THE BALANCE 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.

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.

dee67382_ch09_327-372.indd 349 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 349

WHY DO I NEED TO KNOW ABOUT THE VARIOUS ISSUES AND DEBATES SURROUNDING THE FINANCIAL VALUATION (OR NOT) OF HERITAGE ASSETS?

Heritage assets are, by definition, extremely important for current and future generations. It is therefore extremely important that they are properly managed. Proper management requires appropriate levels of accountability by those charged with the responsibility of safeguarding heritage assets. Proper accountability requires that the ‘accounts’ prepared by the managers/custodians of heritage assets are relevant and representationally faithful.

By knowing about the various issues and debates we are better able ourselves to contribute to future discussion pertaining to accounting for heritage assets and for suggesting improvements thereto. We are also better placed to know about the pros and cons associated with various types of information currently being presented in respect of heritage assets.

9.8 An introduction to accounting for biological assets: what is a biological asset?

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. (AASB 141)

LO 9.8

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

Exhibit 9.4 How to value heritage assets

TRUE VALUES 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 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

dee67382_ch09_327-372.indd 350 10/23/19 10:08 AM

350 PART 3: Accounting for assets

A biological asset is defined as a living animal or plant. AASB 141, which was initially released in July 2004 (and subsequently amended 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 financial reporting issues.

As in the field of heritage assets, there had traditionally been a general lack of guidance on how to account for self-generating 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 Hagan (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).

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. (AASB 141)

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. 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. (AASB 141)

biological asset A living animal or plant.

SGARAs Self-generating and regenerating assets; that is, non-human-related living assets, including trees and animals.

dee67382_ch09_327-372.indd 351 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 351

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. (AASB 116)

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.

Paragraph 10 of AASB 141 requires:

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. (AASB 141)

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. We explored how to account for inventories in Chapter 7.

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

Biological assets Agricultural produce Products that are the result of processing

Sheep Wool Yarn, carpet

Trees in a timber plantation Felled trees Logs, timber

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

Table 9.1 Examples of biological assets, agricultural produce and products resulting from processing

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.

SOURCE: AASB 141 Agriculture

dee67382_ch09_327-372.indd 352 10/23/19 10:08 AM

352 PART 3: Accounting for assets

self-generating 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 that comparability—one of the four ‘enhancing qualitative characteristics’ (the others being verifiability, timeliness and understandability)—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?

9.9 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.

9.10 How should biological assets be classified, presented and measured 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

LO 9.9

LO 9.10

dee67382_ch09_327-372.indd 353 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 353

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 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. 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 require 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). (AASB 141)

dee67382_ch09_327-372.indd 354 10/23/19 10:08 AM

354 PART 3: Accounting for assets

Measuring biological assets Exhibit 9.5 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.

Exhibit 9.5 Some valuation policies adopted in relation to forestry assets (before AASB 1037 became operational)

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.

SOURCE: CSR, Auspine, Carter Holt Harvey, Amcor 1999 Annual Reports

A review of Exhibit 9.5 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;

dee67382_ch09_327-372.indd 355 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 355

∙ 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.

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?

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.

dee67382_ch09_327-372.indd 356 10/23/19 10:08 AM

356 PART 3: Accounting for assets

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, 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? (ROBERTS, D.L., 1988, ‘Agribusiness Livestock Trading and the Livestock Inventory Puzzle’, Charter, April, p 75, Chartered Accountants Australia and New Zealand)

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 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. (AASB 1037)

In considering the ‘new’ requirements of AASB 141, 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. (AASB 141)

‘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 paragraph 8 of 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. (AASB 141)

‘Costs to sell’ are defined in paragraph 5 of AASB 141 as:

The incremental costs directly attributable to the disposal of an asset, excluding finance costs and income taxes. (AASB 141)

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. (AASB 141)

For example, if an agricultural-based organisation has a number of new lambs born, and such lambs have a fair value of $10 000 and related costs to sell of $500, then the accounting journal entry would be:

Dr Biological assets—lambs 9 500

Cr Gain on recognition of biological assets—lambs (to recognise the existence of new lambs)

9 500

dee67382_ch09_327-372.indd 357 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 357

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 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. (AASB 141)

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. (AASB 141)

In relation to measuring agricultural produce, paragraph 32 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)

AASB 141 also provides guidance for situations where the value of the biological asset is not separate from other assets. Paragraph 25 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. (AASB 141)

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 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.

dee67382_ch09_327-372.indd 358 10/23/19 10:08 AM

358 PART 3: Accounting for assets

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.

As a further issue to consider in relation to ‘fair value’, and as we discussed in Chapter 4, consideration needs to be given to the three-level fair value hierarchy when determining the appropriate approach to determining fair value. As Chapter 4 explains, AASB 13 Fair Value Measurement establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. As paragraph 72 of AASB 13 states:

To increase consistency and comparability in fair value measurements and related disclosures, this Standard establishes a fair value hierarchy that categorises into three levels the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). (AASB 13)

Levels 1 and 2 in the hierarchy can be referred to as mark-to-market situations, with the highest level, Level 1 inputs, being quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date. Level 2 are directly observable inputs other than Level 1 market prices (Level 2 inputs could include market prices for similar assets or liabilities, or market prices for identical assets but that are observed in less active markets). As paragraph 81 states:

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. (AASB 13)

Level 3 inputs are mark-to-model situations where observable inputs are not available and risk-adjusted valuation models need to be used instead. Level 3 inputs are often used by organisations involved in agricultural activities to determine present values of future income streams which are in turn used as the basis for determining fair value. Level 3 inputs are unobservable inputs for the asset or liability. Paragraph 87 of AASB 13 states:

Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, ie an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. (AASB 13)

Reporting entities reporting information about the fair value of their biological assets are required to state whether fair values have been based on Level 1, 2 and/or 3 inputs (as Exhibit 9.6 demonstrates).

9.11 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

LO 9.11

dee67382_ch09_327-372.indd 359 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 359

(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 9.5 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.

A review of Exhibit 9.5 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 suggests 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. (ROBERTS, D.L., (1988), Chartered Accountants Australia and New Zealand)

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.

dee67382_ch09_327-372.indd 360 10/23/19 10:08 AM

360 PART 3: Accounting for assets

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, 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. (AASB 141)

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 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). (AASB 141)

9.12 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. 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. (AASB 141)

As we know from Chapter 7, AASB 102 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 applicable Standard. (AASB 141)

9.13 Non-financial disclosures

Although RSH deals predominantly with measurement issues associated with biological assets, it suggests 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. The authors 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

LO 9.12

LO 9.13

dee67382_ch09_327-372.indd 361 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 361

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. At this point we could suggest that an organisation involved in agricultural activities could provide ‘accounts’ of such things as:

∙ its use of water and its policies in respect of recycled water ∙ the types of waste it creates and how this waste is dealt with ∙ the use of transport and the efforts made to reduce the impacts associated with transportation ∙ the policies for the ethical treatment of animals, and the practices in place to assure that these policies are being

implemented.

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. (AASB 141)

Worked Example 9.3 provides an example of how to account for biological assets and agricultural produce. Exhibit 9.6 provides some of the disclosures made in the 2018 annual report of Elders Ltd in relation to its biological assets.

WORKED EXAMPLE 9.3: Accounting for biological assets and agricultural produce

In 2018, Tassie Orchard Ltd established and commenced operation of an apple orchard in New Norfolk. The trees were planted in 2018, and began producing saleable apples in 2022. In 2023, 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 2022 (the end of the previous reporting period) was $95 000, and at 30 June 2023, $109 000. During the reporting period ending 30 June 2023, 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.

continued

dee67382_ch09_327-372.indd 362 10/23/19 10:08 AM

362 PART 3: Accounting for assets

(a) Costs incurred in maintaining biological assets

30 June 2023

Dr Expenses (salaries, fertiliser, etc.) 40 000

Cr Cash/accounts payable (to recognise operating expenses relating to the apple trees)

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. (AASB 116)

(b) Harvesting of agricultural produce

30 June 2023

Dr Inventory—apples 120 000

Cr Gain arising on recognition of harvested apples (to recognise the harvesting of agricultural produce at fair value)

120 000

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. (AASB 141)

30 June 2023

Dr Picking and packing costs 30 000

Cr Cash (payment of expenses associated with the harvesting of apples)

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. (AASB 141)

(c) Sale of agricultural produce

30 June 2023

Dr Cash 96 000

Cr Sales revenue—apples (cash received from the sale of apples)

96 000

30 June 2023

Dr Cost of goods sold 96 000

Cr Inventory (recognition of the cost of the sold apples)

96 000

Because the inventory is sold at its fair value less costs to sell (80 per cent × $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 goods sold. As paragraph 13 of AASB 141 states:

WORKED EXAMPLE 9.3 continued

dee67382_ch09_327-372.indd 363 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 363

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. (AASB 141)

(d) Changes in fair value of the bearer plants between the ends of the reporting periods

30 June 2023

Dr Bearer plants—apple trees 14 000

Cr Gain in revaluation (included within OCI) (to recognise the revaluation of the value of the apple trees [bearer plants]. At the end of the accounting period the gain on revaluation would be transferred to the revaluation surplus account, which is part of equity. Taxation effects have been ignored)

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.

Exhibit 9.6 Note disclosure for biological assets as reported in the 2018 Annual Report of Elders Ltd

SOURCE: Elders Ltd 2018 Annual Report

dee67382_ch09_327-372.indd 364 10/23/19 10:08 AM

364 PART 3: Accounting for assets

9.14 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 was ‘Seeing wood beyond money trees’, by Leon Gettler (The Age, 3 July 2000, p. C3), an adaptation of which appears below. 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.

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.

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.

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!

LO 9.14

dee67382_ch09_327-372.indd 365 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 365

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 Hagan (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).

KEY TERMS

biological asset 350 contingent-valuation method (CVM) 345

heritage asset 328 SGARAs 350 travel-cost method (TCM) 346

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is a heritage asset? LO 9.1 A heritage asset can be 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.

2. Is there general agreement within the ‘accounting community’ that heritage assets should be measured in monetary terms? LO 9.2 No, there is not general agreement. As we learned in this chapter, there are many arguments raised in opposition to the measurement of heritage assets in monetary terms. It has been questioned whether measuring heritage assets in monetary terms makes a great deal of sense given the responsibilities that are typically assigned to managers of heritage assets.

WHY DO I NEED TO KNOW ABOUT HOW BIOLOGICAL ASSETS ARE TO BE ACCOUNTED FROM A FINANCIAL REPORTING PERSPECTIVE?

Knowledge of how biological assets are accounted for exposes us to various interesting accounting issues. The study of biological assets introduces us to a type of asset that can increase in value without any direct expenditure being incurred, as well as an asset that changes in physical form as time passes.

To understand the financial reports of an organisation involved with some form of agricultural activity it would be necessary for us to understand the material in this chapter pertaining to biological assets.

dee67382_ch09_327-372.indd 366 10/23/19 10:08 AM

366 PART 3: Accounting for assets

3. Do heritage assets seem to comply with the definition of assets provided within the Conceptual Framework? LO 9.3 The definition of assets relies upon considerations of the potential to generate future economic benefits and control (as well as there being a past event that led to the control). As we have discussed in this chapter, it is not at all clear that most heritage assets generate future economic benefits, or that the respective managers actually have control over the ‘assets’. Therefore, it is very questionable whether heritage assets actually satisfy the definition of assets.

4. What is a biological asset? LO 9.8 A biological asset is a living animal or plant and is generated through agricultural activity, which is the management by an entity of the biological transformation and harvesting of biological assets for sale or for conversion into agricultural produce or into additional biological assets.

5. How shall biological assets be measured? LO 9.10 AASB 141 requires that 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 cases where the fair value cannot be measured reliably.

6. How shall the harvested produce from biological assets be measured? LO 9.12 AASB 141 requires that an entity measures agricultural produce at the point of harvest at its fair value less costs to sell.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

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. What attributes of heritage assets would support the notion that they need to be accounted for differently from other

assets? LO 9.1 • 4. 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 9.3, 9.4 •••

5. 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 9.2, 9.6 ••

6. 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 ••

7. AASB 116 permits ‘heritage and cultural assets’ to be revalued. What would be some potential problems in revaluing heritage assets? LO 9.5 •

8. Do you think that we should have different asset definitions for not-for-profit organisations and for-profit organisations? Explain your answer. LO 9.4, 9.5, 9.6 ••

9. The Conceptual Framework for Financial Reporting 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 9.5, 9.6 ••

10. Would you consider that the accountability of managers of heritage assets is best demonstrated by requiring them to provide up-to-date valuations of the ‘assets’ under their control? Explain your answer. LO 9.2 ••

11. What is a biological asset? LO 9.8 • 12. What particular attributes of biological assets differentiate them from other assets? LO 9.8, 9.9 •• 13. What types of non-financial disclosures are required by AASB 141? LO 9.13 • 14. 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 9.10, 9.11, 9.12 •••

dee67382_ch09_327-372.indd 367 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 367

15. 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 Hagan (1995) for forest reserves held for the purposes of milling. LO 9.5, 9.6, 9.9, 9.10 •••

16. Roberts, Staunton and Hagan (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 9.10, 9.11 ••

17. Do you consider that lack of consistency across entities in the accounting treatment 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, 9.10 •••

18. Briefly explain how the method of valuation known as the travel-cost method is applied. LO 9.7 •

19. Briefly explain how the method of valuation known as the contingent-valuation method is applied. LO 9.7 •

CHALLENGING QUESTIONS

20. In an article that appeared in The Australian Financial Review on 15 December 2018 entitled ‘Australian Museum collection hits $1 billion mark’ (by Elouise Fowler, p. 3), it was reported that Kim McKay—who took up the position of director of the Australian Museum almost five years ago—was of the view that to be a genuine custodian of the museum she also needed to know how much it was worth and the cost of replacing objects should something go wrong. It was also reported that she said that ‘a true valuation was important to maintain and protect the museum’s collection and fund research’ and that such a valuation ‘assists our understanding of the most pressing environmental and social challenges facing our region: the loss of biodiversity, a changing climate and the search for cultural identity’.

REQUIRED Critically evaluate the view of Kim McKay. LO 9.6

21. 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, 9.2

22. Apart from the disclosures specifically required by AASB 141, what sustainability/environmentally-related disclosures would you suggest that a company with, for example, large herds of dairy cattle should make? LO 9.3

23. 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 9.7

24. Carnegie and Wolnizer (1995, ‘The Financial Value of Cultural, Heritage and Scientific Collections: An Accounting Fiction’, Australian Accounting Review, vol. 5, no. 1, pp. 31–47) 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 9.2

25. How would you value a museum collection of ancient Aboriginal artefacts? LO 9.7

26. It was reported within the chapter that some years ago the chairperson of Australia’s biggest wine producer, Southcorp Ltd, was critical of the requirements incorporated within AASB 141 because it would lead to the recognition of income in advance of when the company believed it should be reported. This could in turn cause some investors to question the dividends being paid on the basis that they were perceived to be too low. Critically evaluate this concern. LO 9.2, 9.14

dee67382_ch09_327-372.indd 368 11/07/19 10:57 AM

368 PART 3: Accounting for assets

27. Carnegie and West (Reprinted from CARNEGIE, G.D. & WEST, B.P., 2005, ‘Making Accounting Accountable in the Public Sector’, Critical Perspectives on Accounting, vol. 16, p 910, with permission from Elsevier.) 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 9.5, 9.6

28. 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.

REQUIRED Evaluate the above comment. LO 9.9, 9.10, 9.11

29. Corbett (1996, Australian Public Sector Management, 2nd edn, Allen and Unwin, Sydney. 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 9.1, 9.2

30. 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 9.7

31. Shoreham Vineyard Ltd grows grapes, which are sold to local wine producers. At 1 January 2022 Shoreham Vineyard Ltd’s grape vines had a fair value of $150 000. During the year ended 31 December 2022, $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 $4000 before they could be sold. At 31 December 2022, the fair value of Shoreham Vineyard 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 2022. LO 9.10, 9.11, 9.12

dee67382_ch09_327-372.indd 369 11/07/19 10:57 AM

CHAPTER 9: Accounting for heritage assets and biological assets 369

32. In 2016, Nambour Ltd established and commenced operation of a mango farm. The trees were planted in 2016 and began producing saleable mangoes in 2022. On 30 June 2023, 90 per cent of the mangoes are sold, one week after they were picked, for a sales price of $210 000. Selling costs were $3000. The remaining 10 per cent of the picked mangoes are recognised as inventories at the end of the reporting period, this being 30 June 2023.

The fair value of the mango trees at 30 June 2022 (the end of the previous reporting period) was $480 000 and, at 30 June 2023, $550 000. During the reporting period ending 30 June 2023, employee expenses, fertilisers, lease expenses and other expenses amounted to $50 000. The fair value less costs to sell 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 assets (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 9.10,

9.11, 9.12

33. Paragraph 9 of the Appendix to FRS 30 Heritage Assets, issued in the UK by the Accounting Council/Financial Reporting Council, 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 9.1, 9.2

34. In a newspaper article entitled ‘WA Museum insurance was too high’ (by Stephen Bevis in The West Australian, 6 November 2014, see https://thewest.com.au/news/australia/wa-museum-insurance-too-high-ng-ya-380369), it was reported that the Western Australian Museum paid higher premiums than it should have for a number of years to insure its collection because an accounting mistake some years earlier had overstated its value by almost $300 million.

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 the museum’s director that the decrease does not affect the intrinsic value of the museum’s collection or reflect or imply fewer items in the collection. LO 9.2, 9.5, 9.6

35. In a newspaper article by Rosemary Neill entitled ‘Museum’s assets take a $400m hit as insects lose their worth’ 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 9.6

dee67382_ch09_327-372.indd 370 10/23/19 10:08 AM

370 PART 3: Accounting for assets

36. Paragraph 11 of the Appendix to FRS 30 Heritage Assets, issued in the UK by the Accounting Council/Financial Reporting Council 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 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 9.3, 9.4

37. Paragraph 12 of the Appendix to FRS 30 Heritage Assets, issued in the UK by the Accounting Council/Financial Reporting Council, 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, 9.2, 9.4

38. 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 conservation 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 you should 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 9.2, 9.7

39. 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 9.2, 9.3, 9.4, 9.5, 9.6

REFERENCES Accounting Council/Financial Reporting Council 2006, Heritage

Assets: Can Accounting do Better?, Accounting Standards Board, London.

Australian Accounting Standards Board, 2018, AASB Discussion Paper: Improving Financial Reporting for Australian Public Sector, AASB, June, Melbourne.

Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

Aversano, N. & Christiaens, J., 2014, ‘Governmental Financial Reporting of Heritage Assets from a User Needs Perspective’, Financial Accountability & Management, vol. 30, no. 2, pp. 150–74.

Aversano, N., Christiaens, J. & Van Thielen, T., 2018, ‘Does IPSAS Meet Heritage Assets’ User Needs?’, International Journal of Public Administration, vol. 42, no. 4, pp. 279–88.

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

dee67382_ch09_327-372.indd 371 10/23/19 10:08 AM

CHAPTER 9: Accounting for heritage assets and biological assets 371

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.

Corbett, D., 1996, Australian Public Sector Management, 2nd edn, Allen and Unwin, Sydney.

Council of Australasian Museum Directors (CAMD), 2018, Australian Framework for the Valuation of Public Sector Collections for General Purpose Financial Reporting, CAMD, Manuka, ACT, November.

Ferri, P. & Sidaway, S., 2019, ‘Accounting for Heritage Assets in Australian Museums: A 20-Year Long Persisting Paradox’, Accounting and Financial Association of Australia and New Zealand Annual Conference, July, Brisbane.

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.

International Public Sector Accounting Standards Board, 2017, Proposed International Public Sector Accounting Standard: Financial Reporting for Heritage in the Public Sector, IPSASB, New York.

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 CPA Australia and Chartered Accountants Australia & New Zealand (CA ANZ))

dee67382_ch09_327-372.indd 372 10/23/19 10:08 AM

dee67382_ch10_373-408.indd 373 10/23/19 10:10 AM

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

dee67382_ch10_373-408.indd 374 10/23/19 10:10 AM

374

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 10.1 Know, and be able to apply, the definition of a liability as provided by the Conceptual

Framework for Financial Reporting. 10.2 Understand how to apply the recognition criteria for liabilities provided within the Conceptual

Framework for Financial Reporting. 10.3 Understand that liabilities can be disclosed on a current/non-current basis, or in order of liquidity. 10.4 Understand what constitutes a ‘provision’ and know how provisions shall be measured. 10.5 Understand the meaning of an ‘onerous contract’, and know how to disclose an onerous contract within

a financial report. 10.6 Understand how to calculate the issue price of securities such as bonds (debentures); know how to

apply the effective-interest method when accounting for liabilities such as bonds; and know how to account for any premium or discount that arises on the issue of bonds.

10.7 Understand what a ‘contingent liability’ represents, and understand how a contingent liability should be disclosed within the notes to a reporting entity’s financial statements.

10.8 Understand what a ‘contingent asset’ represents, and understand how it shall be disclosed. 10.9 Understand some of the reasons why managers would typically prefer to disclose a transaction as part

of equity, rather than as a liability. 10.10 Understand why, with certain transactions, professional judgement is required to determine whether

the transaction gives rise to a liability, or whether it should be recognised as part of equity. 10.11 Understand what a ‘hybrid’ security is, and understand how it shall be disclosed.

C H A P T E R 10 An overview of accounting for liabilities

dee67382_ch10_373-408.indd 375 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 375

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

9 Financial Instruments IFRS 9

13 Fair Value Measurement IFRS 13

101 Presentation of Financial Statements IAS 1

116 Property, Plant and Equipment IAS 16

132 Financial Instruments: Presentation IAS 32

137 Provisions, Contingent Liabilities and Contingent Assets IAS 37

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What are three key components of the definition of a liability? LO 10.1 2. What distinguishes a ‘provision’ from other liabilities? LO 10.1, 10.4 3. How are provisions to be measured? LO 10.4 4. What is an ‘onerous contract’, and how is such a contract to be represented within the financial statements?

LO 10.5 5. If an organisation issues some bonds (liabilities) to the public, and the coupon rate it offers on the bonds is less

than the market’s required rate of return, will the bonds be issued at a discount, or premium, relative to their face value? LO 10.6

6. What is a ‘contingent liability’, and how shall a contingent liability be disclosed within the financial reports? LO 10.7

LO 10.1 10.1 The definition of liabilities

Within the IASB Conceptual Framework for Financial Reporting, as amended in March 2018 (and which we discussed in depth in Chapter 2), a liability is defined as:

a present obligation of the entity to transfer an economic resource as a result of past events.

An ‘obligation’, as referred to in the above definition, is defined in the Conceptual Framework as:

a duty or responsibility that the entity has no practical ability to avoid.

Within Chapter 2, we learned that there are three key components to the above definition of a ‘liability’, these being:

1. a liability represents a present obligation of the entity 2. it creates an obligation to transfer economic resources away from the entity 3. it arises as a result of past events.

A present obligation In relation to the first criterion above, pertaining to there being a ‘present obligation’, paragraph 4.29 of the Conceptual Framework notes that for a liability to be recognised, the obligation must always be owed to another party (or parties) and the other party (or parties) could be a person or another entity, a group of people or other entities, or society at large. It is not necessary for the reporting entity to know the identity of the party (or parties) to whom the obligation is owed.

The recognition of liabilities is not to be restricted to situations where there is a legal obligation. Liabilities shall also be recognised in certain cases where equity or usual business practice dictates that obligations to external parties currently exist. As paragraph 4.31 of the Conceptual Framework states:

Many obligations are established by contract, legislation or similar means and are legally enforceable by the party (or parties) to whom they are owed. Obligations can also arise, however, from an entity’s customary practices,

dee67382_ch10_373-408.indd 376 10/23/19 10:10 AM

376 PART 4: Accounting for liabilities and owners’ equity

published policies or specific statements if the entity has no practical ability to act in a manner inconsistent with those practices, policies or statements. The obligation that arises in such situations is sometimes referred to as a ‘constructive obligation’.

So, the liabilities that appear within an entity’s statement of financial position (balance sheet) 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 may have no legal entitlement, they might have other sanctions to apply that leave the managers of the entity with no realistic alternative but to make future sacrifices of economic benefits. As indicated above, 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. AASB 137 Provisions, Contingent Liabilities and Contingent Assets provides a useful definition of a constructive obligation:

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. (AASB 137)

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 on remediating contaminated sites, 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 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 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.

Obligation to transfer resources Moving onto the second criterion required to be satisfied before a transaction or event satisfies the definition of a liability, we see from the material provided above that for a liability to exist there must be an obligation to transfer an economic resource away from the entity. According to paragraphs 4.37 and 4.38 of the Conceptual Framework:

4.37 To satisfy this criterion, the obligation must have the potential to require the entity to transfer an economic resource to another party (or parties). For that potential to exist, it does not need to be certain, or even likely, that the entity will be required to transfer an economic resource—the transfer may, for example, be required

dee67382_ch10_373-408.indd 377 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 377

only if a specified uncertain future event occurs. It is only necessary that the obligation already exists and that, in at least one circumstance, it would require the entity to transfer an economic resource.

4.38 An obligation can meet the definition of a liability even if the probability of a transfer of an economic resource is low. Nevertheless, that low probability might affect decisions about what information to provide about the liability and how to provide that information, including decisions about whether the liability is recognised (see paragraphs 5.15–5.17) and how it is measured.

As noted in Chapter 2, with the release of the revised Conceptual Framework in March 2018 by the IASB, the requirement that liabilities be recognised when future flows of economic benefits are deemed to be ‘probable’ was relaxed, with the criterion of ‘probable’ no longer being applied within the Conceptual Framework (rather, there is a requirement that there are ‘potential’ future flows of economic benefits). However, some accounting standards (such as AASB 137) still retain the criteria of ‘probable’ when prescribing whether certain liabilities shall be recognised. As we know, accounting standards take precedence over the Conceptual Framework.

The liability arises from ‘past events’ As noted above, the third criterion required to be satisfied before a transaction or event satisfies the definition of a liability is that a liability arises as a result of a ‘past event’. Therefore, if a future event needs to occur to create a liability, then a liability is not to be recognised until such time as the event occurs. However, a contingent liability note—to be discussed later in this chapter—might be required.

10.2 The recognition criteria for liabilities

To be recognised as a liability, and therefore to be included within an entity’s financial statements, the transaction or event must first satisfy the definition of a liability, as described above.

Apart from satisfying the definition of a liability, the recognition of a liability is also linked to professional judgements about whether the information to be disclosed would be relevant to the readers of the financial statements, and whether the information to be disclosed would faithfully represent the underlying obligation. If the information is not perceived to be relevant and/or representationally faithful, then the recognition of the liability shall not occur, pursuant to the Conceptual Framework. As paragraph 5.7 of the Conceptual Framework states:

An asset or liability is recognised only if recognition of that asset or liability and of any resulting income, expenses or changes in equity provides users of financial statements with information that is useful, ie with:

(a) relevant information about the asset or liability and about any resulting income, expenses or changes in equity; and

(b) a faithful representation of the asset or liability and of any resulting income, expenses or changes in equity.

Paragraph 5.8 of the Conceptual Framework also provides an additional factor to consider when recognising a liability (or an asset), and this is that a liability or asset is recognised only if the benefits of the information provided to users of financial statements by recognition are likely to justify the ‘costs’ of providing and using that information. Determining the cost and benefits of information obviously requires much professional judgement.

We will now consider the criteria of ‘relevance’ and ‘faithful representation’ further. As we should know, these are the two fundamental qualitative characteristics that useful financial information shall possess.

Relevance As discussed in Chapter 2, and consistent with the recognition criteria for assets, two important factors to consider when assessing the relevance of liability disclosure include:

∙ existence uncertainty ∙ assessments about the probabilities of an outflow of economic benefits.

For a liability to be recognised within the financial statements, it needs to be reasonably apparent that an obligation to an external party exists. This will be based on the available facts. If there is clearly little option for the managers of the reporting entity to avoid making a future transfer of economic benefits to another party, then the level of existence uncertainty might be considered to be low, and the recognition of a liability would, subject to other criteria, be appropriate. Conversely, if the level of existence uncertainty is high, then it might be inappropriate to recognise the liability in the financial statements.

LO 10.2

dee67382_ch10_373-408.indd 378 10/23/19 10:10 AM

378 PART 4: Accounting for liabilities and owners’ equity

As an example of a situation where there might be a high level of existence uncertainty, we could consider the situation wherein an organisation has been informed that it is being taken to court for some alleged wrongdoing. Before the court case is held, it might be very uncertain that an obligation exists, and therefore it might be inappropriate to recognise a liability.

In relation to considerations relating to the perceived probability of future outflows of economic benefits, the greater the uncertainties in terms of predicting the likelihood of future cash flows occurring, the less relevant would be the disclosure of information about a liability. For example, if an organisation has broken a particular law in terms of how it should be operating its business, but the managers are completely unable to determine the probability associated with whether they will have to pay a penalty, then no liability for the non-compliance would be recognised.

Faithful representation As Chapter 2 explained, another factor to consider when determining whether to recognise an asset, or a liability, is faithful representation. One factor to assess in relation to faithful representation is measurement uncertainty. If there is a high level of uncertainty with regards to the amount of future cash outflows likely to occur in relation to a particular liability—meaning that a faithful representation of the liability is potentially not possible—it might be inappropriate to recognise the liability in the financial statements. For example, if the organisation knows that it will be prosecuted for failure to comply with particular laws, but the managers are unable to reasonably determine the magnitude of the future fine even within broad ranges of possible outcomes, then because of the high level of ‘measurement uncertainty’, no liability would be recognised.

Given the above recognition criteria for liabilities, it is clear that recognition relies upon various professional judgements about the probability and measurability of expected future cash flows.

When the recognition criteria for a liability are not satisfied (that is, the future outflow has a low probability of occurrence and/or is not reliably measurable), the item should not be included within the statement of financial position (that is, a liability should not be recognised) and any related expenses should not be recognised within profit or loss. 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 (there is high measurement uncertainty), then while the item should not be disclosed in the statement of financial position because of problems associated with ‘faithful representation’, it would be appropriate to disclose information in the notes to the financial statements to the extent it is potentially material.

In the circumstances just described, where an obligation is dependent upon a future event (for example, a future court ruling pertaining to a claim already made against the reporting entity), or where the amount of the obligation cannot be measured reliably at a given point in time, the associated obligation is referred to as a contingent liability. We will consider contingent liabilities (and contingent assets) in greater depth later in this chapter.

contingent liability Obligations that are payable contingent upon a future event or obligations that are not probable (in terms of resource outflows) or are not measurable with sufficient reliability.

WHY DO I NEED TO KNOW ABOUT THE DEFINITION AND RECOGNITION CRITERIA FOR LIABILITIES?

The balance sheet is one of the most important financial statements that an organisation releases. It provides various insights into the financial position of an organisation and therefore provides various insights into such factors as the extent to which the total assets of the organisation have been funded by owners, or by lenders and creditors. The greater the proportional funding reliance on lenders and creditors, then, all things being equal, the greater the risk exposure of an organisation.

The balance sheet reports information about assets, liabilities and equity. To be able to properly understand the context of the balance sheet it is therefore important to understand the definition and recognition criteria for liabilities (and assets, and equity). It is also important to understand the various measurement rules for assets and liabilities, many of which will be explained throughout this book.

dee67382_ch10_373-408.indd 379 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 379

10.3 Classification of liabilities as ‘current’ or ‘non-current’

Having discussed how to define, and when to recognise, liabilities, another issue to consider is how to present information about these liabilities within the financial statements.

When presenting liabilities within the financial statements, a reporting entity has a choice, based on notions of relevance and reliability, to disclose liabilities either on the basis of a current/ non-current liability dichotomy, or on the basis of order of liquidity. Specifically, paragraph 60 of AASB 101 Presentation of Financial Statements states:

60. 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. (AASB 101)

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. In explaining the benefits of using the respective approaches to disclosing liabilities, paragraphs 62 and 63 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/non- current presentation because the entity does not supply goods or services within a clearly identifiable operating cycle. (AASB 101)

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 states:

69. 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. (AASB 101)

We see that a liability may 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 shall disclose, within the notes to the financial statements, the length of its operating cycle.

In explaining the use of the entity’s ‘operating cycle’, paragraphs 70 and 71 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. (AASB 101)

current liability Any liability that satisfies any of the four criteria provided by paragraph 69 of AASB 101.

non-current liability Any liability that does not pass the test provided within AASB 101 for a current liability.

LO 10.3

dee67382_ch10_373-408.indd 380 10/23/19 10:10 AM

380 PART 4: Accounting for liabilities and owners’ equity

10.4 Liability provisions

Liabilities will include such things 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 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 and should not be labelled as ‘provisions’. 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, as we have already noted, 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.

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. (AASB 137)

In relation to when provisions are to be recognised, paragraph 14 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. (AASB 137)

As we can see above, the recognition of a provision relies on a judgement being made that the outflow of resources is ‘probable’, which from the perspective of the standard means ‘more likely than not’. This recognition requirement is different from what is included with the Conceptual Framework as revised and released in March 2018. In this regard, a footnote to AASB 137 specifically notes that:

the definition of a liability in this Standard was not revised following the revision of the definition of a liability in the Conceptual Framework for Financial Reporting issued in 2018. (AASB 137)

Worked Example 10.1 explores how to determine whether an obligation shall be considered to create a ‘provision’.

LO 10.4

WORKED EXAMPLE 10.1: 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 2000 surfboards that were produced in overseas factories, about 20 per cent used defective fibreglass that will need to be replaced at an expected cost of about $250 per surfboard.

dee67382_ch10_373-408.indd 381 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 381

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. (AASB 137)

The ‘best estimate’, as referred to above, is the amount the entity would pay to settle this obligation at the end of the reporting period, or to transfer the obligation 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 that occur after the end of the reporting period provide further supplementary evidence for the existence of provisions as at the reporting date.

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 that 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 probabilities. This is known as the ‘expected-value’ method of estimation. Using this basis, the amount of the provision will depend on the probability of a loss. An example of this is provided in Worked Example 10.2.

• 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 also be recognised as liabilities, but not as ‘provisions’.

WORKED EXAMPLE 10.2: 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.

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.

continued

dee67382_ch10_373-408.indd 382 10/23/19 10:10 AM

382 PART 4: Accounting for liabilities and owners’ equity

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 possible outcomes. 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 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. (AASB 137)

As paragraph 46 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 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. (AASB 137)

The carrying amount of provisions is also required to be reviewed regularly. As paragraph 59 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. (AASB 137)

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 to be recognised as a borrowing cost. Worked Example 10.3 explores how to account for changes in the present value of a provision.

WORKED EXAMPLE 10.3: Accounting for a change in the present value of a provision

In 2023, 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 2023, the best estimate to remediate the site (in 2043) is $20 000 000.

One year later, on 30 June 2024, 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 2023 and 7 per cent as at 30 June 2024.

REQUIRED Provide the journal entries in relation to the above obligation for the years ending 30 June 2023 and 30 June 2024.

Dr Warranty expense 646 000

Cr Provision for warranty expense 646 000

(provision for warranty expense on toasters)

WORKED EXAMPLE 10.2 continued

dee67382_ch10_373-408.indd 383 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 383

Before we conclude our discussion on provisions, it is again stressed that the measurement of provisions relies upon a great deal of professional judgement, and consequently, opportunities exist for managers to take advantage of the apparent uncertainty, and subjectivity, to opportunistically manipulate the reported accounting numbers.

SOLUTION Provisions are to be recorded at present value, pursuant to paragraph 45 of AASB 137. Therefore, we first need to determine the present value of the liability as at 30 June 2023. 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 it an asset? As noted in Chapter 5, paragraph 16 of AASB 116 Property, Plant and Equipment 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. (AASB 116)

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. 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 2023 therefore would be:

Dr Power-generating plant 4 290 000

Cr Provision for restoration costs (to include the initial present value of the future restoration costs as part of the cost of the plant)

4 290 000

On 30 June 2024 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 2024 would be:

Dr Interest expense 1 240 000

Cr Provision for restoration costs (to recognise the increase in the present value of the provision)

1 240 000

WHY DO I NEED TO KNOW ABOUT THE NATURE OF A ‘PROVISION’?

A provision is unlike other liabilities. If a particular obligation is deemed to be a provision, then this signals that there is some uncertainty about the ultimate amount and/or timing of the payment to be made. The actual payment related to the obligation might be more, or less, than the recognised amount. The existence of the provision also indicates that the amount recognised has been subject to some amount of professional judgement and, therefore potentially, to some degree of ‘creative accounting’.

10.5 Onerous contracts

While there would be a general expectation that the business contracts that an organisation enters into will generate positive economic benefits for that organisation (for example, the sales revenue will exceed the associated costs), this will not always be the case. Perhaps, because of some mistakes, an organisation might enter into

LO 10.5

dee67382_ch10_373-408.indd 384 10/23/19 10:10 AM

384 PART 4: Accounting for liabilities and owners’ equity

a contractual arrangement only to subsequently learn that it will cost more to complete the contract than the revenue that will be earned on the contract. In such a situation an ‘onerous contract’ is deemed to exist.

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. (AASB 137)

AASB 137 further notes that the ‘unavoidable costs’ under a contract represent the least net cost of exiting from a contract, which is deemed to be the lower of:

∙ the cost of fulfilling the contract, and ∙ any compensation or penalties arising from the failure to fulfil it.

According to an Exposure Draft released by the IASB in December 2018 entitled ‘Onerous Contracts—Cost of Fulfilling a Contract’, examples of costs that directly relate to a contract to provide goods or services include direct labour, direct materials, allocations of costs that relate directly to contract activities, costs explicitly chargeable to the counterparty under the contract, and other costs incurred only because an entity entered into the contract.

Examples of situations where an onerous contract might exist include:

∙ When the managers of an organisation enter a contract to supply services for a given period and for an agreed price—for example, gardening services for the next year—only to find that the costs to be incurred are likely to exceed the contracted service revenues.

∙ When the managers of an organisation enter a contract to supply particular products at an agreed price only to find that the cost to manufacture the products is likely to exceed the contracted sales price.

∙ When an organisation has entered a non-cancellable lease of property, but the lessee has moved out of the site and is unable to sublet the property. In this case the organisation (the lessee) would expect to receive no further economic benefits from the property pursuant to the lease contract, but still has an obligation to pay future rentals.

If a contract can be cancelled at little or no cost to either party, then such contracts would not normally become ‘onerous’.

In the presence of an ‘onerous contract’, an expense and a related provision need to be recognised. However, prior to a provision being established, an organisation can recognise an impairment loss against an asset that is dedicated to the contract (such as inventory being manufactured as part of the contract). Worked Example 10.4 provides an illustration of how to account for an onerous contract.

WORKED EXAMPLE 10.4: An illustration of how to account for an onerous contract

Snapper Rocks Ltd enters a contract to supply Burleigh Barrels Ltd with 1000 office desks at a sales price of $890 each. The expected manufacturing cost of each desk is $640. The desks will be placed in the control of Burleigh Barrels Ltd once all 1000 have been completed.

When production commenced it became clear that an error had been made in determining the manufacturing cost, which was reassessed to actually be $1150 per desk.

REQUIRED

(a) Determine whether the contract for the supply of chairs constitutes an ‘onerous contract’. It is assumed that the contract is ‘non-cancellable’.

(b) Assume that at the end of the accounting period 600 desks had been completed, but not yet transferred to Burleigh Barrels Ltd. Burleigh Barrels Ltd expects Snapper Rocks Ltd to fully complete its obligations under the contract. The cost of the desks, which was included in ‘inventory’, was therefore $690 000 (600 × $1150). The loss on the contract has not yet been recognised. What is the accounting journal entry to recognise the existence of the ‘onerous contract’?

(c) Assume that at the end of the accounting period, no desks had been produced but Snapper Rocks Ltd was obliged to deliver the desks within the following six months or, alternatively, terminate the contract and pay a penalty to Burleigh Barrels Ltd of $100 000. What is the accounting journal entry to recognise the existence of the ‘onerous contract’?

dee67382_ch10_373-408.indd 385 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 385

10.6 Accounting for bonds (debentures)

A bond, or 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. Bond (debenture) liabilities are typically secured over the assets of the entity issuing the bonds. That is, if the entity issuing the bonds (the borrower) defaults on the agreement and does not make the agreed payments, the entity acquiring the bonds (the lender) can have the right to seize assets that were provided as security. Bonds may be issued at par, at a premium or at a discount.

Within Australia, corporations issue significant amounts—indeed in the hundreds of billions of dollars—of debt in the form of debentures/bonds. With the large amounts being issued, valuation is an important issue, since how debentures/bonds are valued will have direct implications for reported liabilities and expenses. In Australia, the federal government also issues bonds, and it is common for the government to issue tens of billions of dollars of bonds in a given year. In terms of the total amount of Australian government bonds on issue, this is believed to have been approximately $536 billion in 2019 according to information from the Australian Office of Financial Management (as accessed in May 2019).

Bonds issued at par The par (or face) value of a bond/debenture represents the amount that the bond holders will receive on maturity of the bonds. Investors will be prepared to pay the par value if they believe

SOLUTION

(a) 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’. Further, for the purposes of the accounting standard, the ‘unavoidable costs’ under a contract will reflect the least net cost of exiting a contract, which is the lower of the cost of fulfilling it, and any compensation or penalties arising from failure to fulfil it. In this case it does appear that, in net terms, this contract will cost Snapper Rocks Ltd more to complete than the economic benefits it expects to receive. Therefore, it is an onerous contract and shall be accounted for in accordance with AASB 137.

(b) To perform the accounting entries we need to determine the costs that Snapper Rocks Ltd cannot avoid because of the contract. On the basis of the available information, the total costs of the contract are $1 150 000 (1000 × $1150). The total amount expected to be received for the desks is $890 000 (1000 × $890). Therefore, the total expected loss on the contract is $260 000.

Rather than recognise a provision, the expected loss (an impairment loss) will be subtracted from the inventory account, which at the end of the accounting period would have had a balance of $690 000 before adjustment (600 × $690). The adjusting journal entry would be:

Dr Impairment loss on inventory 260 000

Cr Inventory (to recognise the total loss to be incurred on the contract)

260 000

(c) In this case, there is no amount residing within ‘inventory’ against which the foreseeable losses can be offset by way of an impairment loss. In this situation, a ‘provision’ shall therefore be recognised. The amount to be recognised, which is the lower of the cost of completing the contract (which would be a $260 000 net loss), or the penalty payable for failing to complete the contract (which would be $100 000), is therefore $100 000. The adjusting journal entry would be:

Dr Loss on production of inventory (onerous contract) 100 000

Cr Provision for loss on onerous contract (to recognise the loss on an onerous contract)

100 000

debenture A written promise to pay a principal amount at a specified time, as well as interest calculated at a specific rate.

par (or face) value The amount debenture holders receive on maturity of debentures.

LO 10.6

dee67382_ch10_373-408.indd 386 10/23/19 10:10 AM

386 PART 4: Accounting for liabilities and owners’ equity

that the rate of interest offered by the issuing company on the bonds—this would be written on the bond 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 bonds would, in this instance, be the same as the face value of the bonds. As will be indicated below, if the market believes that the firm is not offering a high enough rate of interest, investors 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. (AASB 13)

Conversely, if the market believes that the firm is offering a relatively high rate of interest, investors 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 10.5 provides an example of bonds/debentures being issued at par value.

WORKED EXAMPLE 10.5: Issue of bonds at par value

Company C issues $10 million of five-year, 10 per cent, semi-annual coupon corporate bonds to the public (which pay interest every six months). The market also requires a rate of return of 10 per cent. Assume that the moneys come in and the bonds are allotted on the same day: 30 June 2023.

REQUIRED Provide the accounting entries at 30 June 2023, 31 December 2023 and 30 June 2028 to record:

(a) the receipt of funds (b) the first payment of interest (c) the redemption of the bonds.

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 bonds.

30 June 2023

Dr Cash trust 10 000 000

Cr Application—bonds (to record the receipt of funds from the investors)

10 000 000

Dr Cash at bank 10 000 000

Cr Cash trust (to transfer funds to the entity’s operating account following the allocation of the bonds)

10 000 000

Dr Application—bonds 10 000 000

Cr Bonds (to record the allocation of the bonds, and to eliminate the ‘application’ account)

10 000 000

coupon rate The rate of interest specified on the face of a security.

dee67382_ch10_373-408.indd 387 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 387

Bonds 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 bonds not to be issued at par (face value). Remember, bonds 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 bond certificate (called the coupon rate). It should also be remembered that, regardless of what investors pay for the bond, they will receive the face value (or par value) on redemption; and the interest received will equal the rate written on the bond certificate, referred to as the coupon rate, multiplied by the par value of the security (regardless of the actual price paid for the 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 bonds, the issue price of the bonds 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—representing a rate of return equivalent to that required by the market. That is, the bonds 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, reducing the issue price of the bonds 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.

The application account is considered to be a liability, as are the bonds. When the bonds 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 2023

Dr Interest expense 500 000

Cr Cash at bank (interest expense for six months = $10m × 10% ÷ 2)

500 000

(c) When the bonds are redeemed on 30 June 2028, the entry to record the redemption would be:

30 June 2028

Dr Bonds 10 000 000

Cr Cash at bank (to recognise the repayment of the face value of the bonds)

10 000 000

dee67382_ch10_373-408.indd 388 10/23/19 10:10 AM

388 PART 4: Accounting for liabilities and owners’ equity

Worked Example 10.6 provides an illustration of bonds being issued at a discount.

WORKED EXAMPLE 10.6: Bonds issued at a discount

Assume that the market requires 12 per cent for the bonds considered in Worked Example 10.5.

REQUIRED Calculate the issue price of the bonds 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 seven decimal places).

Present value of interest payments $500 000 for 10 periods @ 6 per cent $500 000 × 7.360 086 6 = $3 680 043

Present value of principal repayment $10 000 000 in 10 periods @ 6 per cent $10 000 000 × 0.558 394 8 = $5 583 948

Present value of future cash flows $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 bonds would be:

30 June 2023

Dr Cash 9 263 991

Cr Bonds (to recognise the cash received on issue of bonds)

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 bond.

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 bond at the end of the bond’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.

As shown in Table 10.1, the amount of the change in the liability in 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 bond liability represents the present value of the liability throughout the bond term (adopting the market’s required rate of

effective-interest method Calculating the interest expense for a period by multiplying the opening present value of a liability by the appropriate market rate of interest.

dee67382_ch10_373-408.indd 389 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 389

return at the date the bonds were issued as the discount rate). Using the effective-interest method, the accounting entries would be:

31 December 2023

Dr Interest expense 555 839

Cr Bonds 55 839

Cr Cash (to recognise interest expense using the effective-interest method)

500 000

30 June 2024

Dr Interest expense 559 190

Cr Bonds 59 190

Cr Cash (to recognise interest expense using the effective-interest method)

500 000

31 December 2024

Dr Interest expense 562 741

Cr Bonds 62 741

Cr Cash (to recognise interest expense using the effective-interest method)

500 000

As we can see above, the interest expense increases across time as the present value of the liability increases.

Bonds issued at a premium If bonds 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 bonds, the effective rate of return on the bonds 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 10.7.

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.

Period Opening liability Effective interest @ 6 per cent Coupon rate Net liability

0 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 9 508 267.2 570 496.0 500 000 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

WORKED EXAMPLE 10.7: Bonds issued at a premium

The bond issue is the same as that in Worked Example 10.5, except this time the market demands 8 per cent per annum (or 4 per cent every six months) on such bonds.

REQUIRED Calculate the issue price (fair value) of the bonds and provide the accounting journal entries for 30 June 2023, 31 December 2023 and 30 June 2024.

continued

dee67382_ch10_373-408.indd 390 10/23/19 10:10 AM

390 PART 4: Accounting for liabilities and owners’ equity

10.7 Contingent liabilities

Earlier in this chapter we briefly discussed contingent liabilities and we noted that if the recognition criteria for liabilities—which are linked to considerations of relevance and faithful representation—are not satisfied, then

a contingent liability note might be required. In situations where, at the reporting date, there is either a low probability of a future flow of economic benefits

occurring, or no obligation that can be measured reliably, it would be inappropriate to include the related obligations 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. (AASB 137)

Worked Example 10.8 provides an illustration relating to when a contingent liability should be recognised.

SOLUTION

Present value of interest payments $500 000 for 10 periods @ 4 per cent $500 000 × 8.110 892 5 = $ 4 055 446

Present value of principal repayment $10 000 000 in 10 periods @ 4 per cent $10 000 000 × 0.675 564 3 = $ 6 755 643

Issue price = $10 811 089

Hence the issue price is $10 811 089. 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 bonds are to be disclosed at their fair value.

30 June 2023

Dr Cash 10 811 089

Cr Bonds (to recognise the issue price of the bonds)

10 811 089

31 December 2023

Dr Interest expense 432 444

Dr Bonds 67 556

Cr Cash (interest expense = 10 811 089 × 0.04 = 432 444)

500 000

30 June 2024

Dr Interest expense 429 741

Dr Bonds 70 259

Cr Cash (interest expense = [10 811 089 – 67 556] × 0.04 = 429 741)

500 000

LO 10.7

WORKED EXAMPLE 10.7 continued

dee67382_ch10_373-408.indd 391 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 391

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 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, this was supplied 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 2018 Annual Report of Orica Ltd stated in the notes to the financial statements (note 22, p. 103):

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 not provided for and 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.

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. (AASB 137)

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

WORKED EXAMPLE 10.8: Recognition of a contingent liability

During 2025, 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 2027, international trading conditions deteriorated to such an extent that Shawn Thomson Ltd incurred substantial losses. Finally, on 28 June 2027, Shawn Thomson Ltd was forced to file for bankruptcy.

REQUIRED How would Mark Richards Ltd report the guarantee provided to Shawn Thomson Ltd in its financial statements ending 30 June 2026 and 30 June 2027?

SOLUTION In this illustration, the obligating event is the provision of the guarantee, which gives rise to a legal obligation. At 30 June 2026, it is quite 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 2027, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and the amount can be measured reliably on the basis of the amount that was guaranteed. A provision—which is a liability that must be recognised within the financial statements—for the best estimate of the obligation must be recognised.

dee67382_ch10_373-408.indd 392 10/23/19 10:10 AM

392 PART 4: Accounting for liabilities and owners’ equity

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 2019 financial statements of Qantas Airways Ltd.

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

Present obligation as a result of an

obligating event?

Probable outflow?

Reliable estimate?

No

No Yes

No (rare)

Yes

Yes

Yes Yes

No

No

Start

Provide

Possible obligation?

Remote?

Disclose contingent

liability Do nothing

SOURCE: AASB 137, Appendix B. © Australian Accounting Standards Board (AASB)

Exhibit 10.1 Contingent liability note from the 2019 Annual Report of Qantas Airways Ltd

dee67382_ch10_373-408.indd 393 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 393

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 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).

In Worked Example 10.9 we put our new knowledge to use by determining whether a transaction or event creates a liability, a provision or a contingent liability.

SOURCE: Qantas Airways Ltd

WORKED EXAMPLE 10.9: 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 2022 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 2022 has subsequently taken legal action against the company, alleging wrongful dismissal and claiming damages of $1 000 000. Whites Beach Ltd’s solicitors are not sure of the likelihood that the former executive will be successful with the claim, but they think the probability is less than 25 per cent. The outcome of the action is expected to be settled by December 2022. 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 2022. This $30 000 is unpaid as at 30 June 2022.

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 2022 and, where appropriate, determine the required journal entries.

SOLUTION This scenario falls within the scope of AASB 137. 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 potential outflow of economic benefits that can be faithfully represented.

As the action has commenced before the end of the year, the ‘past event’ criterion is met. The solicitors are uncertain about the former executive’s chances of success but believe there is less than a 25 per cent likelihood of success. Therefore, there seem to be major uncertainties about whether the future flow of economic benefits will occur and therefore it would seem to be the case that the information does not pass the test of being ‘relevant’. 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 or less chance of being successful and which might result in the

continued

dee67382_ch10_373-408.indd 394 10/23/19 10:10 AM

394 PART 4: Accounting for liabilities and owners’ equity

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. Because the ultimate amount of the legal expenses is somewhat uncertain, it would be considered to represent a 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 Legal fees 30 000

Cr Legal fees payable (to recognise legal fees payable on services already provided)

30 000

Dr Legal fees 170 000

Cr Provision for future legal fees (to recognise the current obligation for future legal fees)

170 000

WHY DO I NEED TO KNOW ABOUT THE NATURE OF CONTINGENT LIABILITIES, AND THE WAY IN WHICH THEY ARE DISCLOSED?

It is important to understand that beyond the liabilities that are recognised and presented in the financial statements, there are also other obligations that are potentially very material, but which are not currently in the balance sheet. If we were to ignore the existence of contingent liabilities, we would be ignoring the full extent of obligations to which an organisation is potentially exposed. Should contingent liabilities ultimately become payable, the amounts involved could be material. Therefore, to properly understand the financial position of an organisation, we also need to know about the contingent liabilities of the organisation, and what circumstances will lead to an obligation being recognised.

10.8 Contingent assets

Apart from contingent liabilities, there is also 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. (AASB 137)

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 in the financial statements. 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, 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. (AASB 137)

LO 10.8

WORKED EXAMPLE 10.9 continued

dee67382_ch10_373-408.indd 395 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 395

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, paragraph 33 also requires that 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 tests 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 potential flows of economic benefits rather than the more difficult test of ‘virtually certain’). This is also not consistent with the recognition criteria for contingent liabilities. If the outflow of economic benefits associated with a contingent liability subsequently becomes ‘probable’ then a liability would be recognised within the financial statements.

10.9 Some implications of reporting liabilities

As we saw in Chapter 3, organisations commonly enter into contractual arrangements that are tied in part to the reported liabilities of the firm—for example, debt-to-assets constraints. Therefore, how an organisation accounts for its liabilities—which has been the focus of this chapter—can have direct implications on the future operations and viability of an organisation.

When the managers of an organisation use the organisation’s available funds to invest in risky projects, there is a possibility that either large gains, or large losses, will ultimately be made. Shareholders will gain in the presence of large gains (through capital gains and higher dividends), but they could lose their capital investment if the risky investments fail. Lenders, on the other hand have a fixed claim against the organisation (they do not share the profits), and therefore will not share in any ‘upside’ if the risky investments succeed. However, like shareholders, they might lose their investment in the organisation if the investment fails and the organisation subsequently is unable to repay amounts owed. Therefore, when a risky investment fails, the costs of failure are shared by shareholders with lenders and creditors (the shareholders do not bear the full cost), but any high gains (profits) are of benefit to shareholders and not shared with lenders and creditors.

Therefore, in general and in the presence of debt, shareholders have a greater preference for projects with higher risk relative to creditors and lenders. Lenders are aware of such managerial incentives to invest in risky projects and will attempt to limit managers’ investments in risky projects through the negotiation of debt covenants to be included within debt contracts.

Once debt covenants are in place, 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 interest-coverage 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 in terms of the contracts it has negotiated. For example, if a firm has determined that a transaction will not generate 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 interest-coverage ratio.

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 information included within a general-purpose financial statement should be relevant and should faithfully represent the underlying transactions. One aspect of ‘faithful representation’ is ‘neutrality’. ‘Creative accounting’ and ‘neutrality’ are mutually inconsistent.

The range of accounting policies being used by an organisation will influence managers’ ability to choose accounting methods that can potentially (and opportunistically) loosen restrictive debt covenants. For example, if

LO 10.9

dee67382_ch10_373-408.indd 396 10/23/19 10:10 AM

396 PART 4: Accounting for liabilities and owners’ equity

conservative accounting policies are being used by an organisation (which would, for example, tend to restrict the use of revaluations to fair value, or the early recognition of income), there is less ability to opportunistically manipulate accounting numbers in order to circumvent debt covenants. Also, in the presence of conservative accounting policies that restrict the recognition of income, there is less ability for managers to pay cash distributions (dividends) to owners, therefore retaining more resources within the organisation (and therefore increasing the pool of funds available to pay lenders and creditors). Further, if organisations are not revaluing their assets (thereby leaving them at the lower of their depreciated cost or their recoverable amount), then the measures reported for assets tend to be closer to or even lower than their realisable amount. In this regard, Sunder, Sunder and Zhang (2018) find that lenders generally insist on less restrictive covenant terms in debt contracts when negotiating with organisations that use relatively conservative accounting policies. Lenders were also found to generally charge lower rates of interest when borrowers use conservative accounting policies. This is also consistent with results generated by Callen, Chen, Dou and Xin (2016).

The view that managers will potentially adopt particular accounting methods to circumvent the 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. However, whether the lenders will be able to successfully take action in the event of a default of a debt covenant will be dependent upon the effectiveness of the legal enforcement mechanisms in place. That is, the actual effectiveness of debt covenants included within debt contracts depends upon the strength of a country’s law enforcement with respect to enforcing the contractual rights of lenders. As Hong, Hung and Zhang (2016) argue, weak enforcement regimes reduce the ability of lenders to enforce a contract in bankruptcy and therefore make debt covenants a less useful contracting mechanism. Consequently, there is an expectation that debt covenants are more effective and valuable in countries with relatively strong enforcement and where property rights are well-defined and covenant violations are effectively enforced. In this regard, research by Hong et al. (2016) finds that the use of debt covenants is indeed more prevalent in countries with stronger law enforcement. This is also consistent with research by Aghamolla and Li (2018), which showed that in the context of India, when certain measures were introduced into the law to strengthen the enforcement of lenders’ contractual rights, the use of debt covenants in lending agreements subsequently increased.

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; impose restrictions on the firm borrowing further funds; restrict the firm selling some of its assets; raise interest rates and so on. In this regard, when there is a breach of a debt covenant, managers might negotiate with lenders in an endeavour to persuade them not to require immediate repayment. Balsam, Gu and Mao (2018) show that some of this negotiation can result in total CEO compensation being reduced (thereby increasing available funds within the organisation), as well as the use of risk-taking incentives in remuneration plans plans being reduced following violation of debt contracts. Again, we see that how an organisation reports its liabilities—the topic of this chapter—can have implications for managers.

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. 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 requires the recognition of particular obligations (and related expenses) that were previously left off the balance sheet. 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—as noted above—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

dee67382_ch10_373-408.indd 397 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 397

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.

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 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.

Therefore, in concluding our discussion about the implications of recognising and reporting liabilities, we should understand that the decisions made with respect to the recognition, measurement and disclosure of liabilities can have various consequences for an organisation and the various stakeholders with an interest in the organisation (such as shareholders, lenders and managers).

10.10 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:

∙ 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.

LO 10.10

dividend A distribution of the profits of an entity to the owners of that entity, typically in the form of cash.

dee67382_ch10_373-408.indd 398 10/23/19 10:10 AM

398 PART 4: Accounting for liabilities and owners’ equity

In contrast with the former Schedule 5 treatment of preference shares, described above (which is no longer applicable), AASB 132 Financial Instruments: Presentation adopts a more logical substance-over-form approach. Paragraph 18 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. (AASB 132)

In further considering preference shares, paragraphs AG25 and AG26 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. (AASB 132)

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 10.10, the requirement to treat preference shares as debt can have significant implications for a firm’s debt-to-assets ratios.

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.

share capital The balance of owners’ equity within a company, which constitutes the capital contributions made by the owners.

WORKED EXAMPLE 10.10: Impact of classifying preference shares as debt, rather than equity

As at 30 June 2023 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 have voting rights.

REQUIRED Calculate the debt-to-assets ratio for Burridge Ltd as at 30 June 2023, assuming that:

(a) the preference shares are treated as equity (b) the preference shares are treated as debt.

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.

dee67382_ch10_373-408.indd 399 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 399

10.11 Hybrid securities

Although a more detailed description of financial instruments will be provided in Chapter 14, 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 have both debt and equity characteristics. Some companies also issue debt that allows conversion, at the debtholder’s option, into shares of the issuing company. That is, the securities may be converted 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 14, 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 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. (AASB 132)

LO 10.11

hybrid securities Securities exhibiting both debt and equity characteristics.

liability Defined in the Conceptual Framework as ‘a present obligation of the entity to transfer an economic resource as a result of past events’.

(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 debt-to-assets ratio, because the redemption is at the option of the shareholder the correct treatment would see the preference shares being treated as debt.

WHY DO I NEED TO KNOW ABOUT THE MOTIVATIONS THAT MIGHT INFLUENCE THE MANAGERS OF AN ORGANISATION TO DISCLOSE A TRANSACTION OR EVENT AS EQUITY, RATHER THAN DEBT?

By understanding such motivations, it instils within us a propensity to be somewhat cautious (or sceptical) rather than simply believing that managers will always account for particular transactions and events in an objective manner. We also need to understand that if managers disclose a transaction as equity, then the associated payments (dividends) will be accounted for as a distribution of profits, rather than as an expense. Where possible, we should always try to review the accounting policies/judgements being made by managers and their accountants, and consider whether we concur with how particular transactions and events have been accounted for.

dee67382_ch10_373-408.indd 400 10/23/19 10:10 AM

400 PART 4: Accounting for liabilities and owners’ equity

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 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 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. (AASB 132)

As mentioned previously, however, we will consider issues associated with convertible notes in more depth in Chapter 14.

SUMMARY

The chapter addressed general issues pertaining to liabilities. A liability is defined in the Conceptual Framework for Financial Reporting as a present obligation of the entity to transfer an economic resource as a result of past events. Liabilities are to be recognised when the related information is judged to be relevant to the readers of the financial statements, and when the information to be disclosed faithfully represents the underlying obligation.

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’.

‘Provisions’ were discussed, and it was explained that provisions are liabilities of uncertain timing and/or amount. It was stressed that, for a provision to be considered a liability, there must be a present obligation (legal, moral or constructive) to other entities that is probable, and that can be measured reliably at its ‘best estimate’ and at its present value. The chapter also explained the meaning of ‘onerous contracts’, as well as describing the accounting treatment required for onerous contracts.

Accounting for the issue of bonds was also discussed. Where the coupon rate of bonds is the same as the required market rate, bonds will be issued at their par or face value; where the required market rate of bonds is less than the coupon rate, bonds will be issued at a premium; and where the required market rate of bonds is greater than the coupon rate, bonds will be issued at a discount.

The meaning of ‘contingent liabilities’ was explained and the requirements in relation to disclosing information about contingent liabilities was described. It was emphasised that although contingent liabilities do not appear in the balance sheet, it is nevertheless very important to have knowledge about the contingent liabilities of an organisation.

This chapter also explored the motivations that may drive managers to prefer to treat a transaction or event as ‘equity’, rather than as a ‘liability’, as well as considering the accounting treatment of preference shares and convertible notes.

KEY TERMS

contingent liability 378 coupon rate 386 current liability 379 debenture 385 dividend 397

effective-interest method 388 hybrid security 399 liability 399 market rate of return 389 non-current liability 379

par (or face) value 385 preference shares 398 premium 389 share capital 398

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What are three key components of the definition of a liability? LO 10.1 There are three key components to the definition of a ‘liability’, these being:

1. a liability represents a present obligation of the entity 2. it creates an obligation to transfer economic resources away from the entity, and 3. it arises from past events.

dee67382_ch10_373-408.indd 401 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 401

2. What distinguishes a ‘provision’ from other liabilities? LO 10.1, 10.4 A provision is a liability of uncertain timing or amount.

3. How are provisions to be measured? LO 10.4 A provision shall be measured at the ‘best estimate’ of the expenditure required to settle the obligation, and the measurement will be based upon either the ‘most likely outcome’ or the ‘expected value’. Where the provision is expected to be paid beyond 12 months, it shall be measured at its present value.

4. What is an ‘onerous contract’, and how is such a contract to be represented within the financial statements? LO 10.5 An onerous contract is 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 represent the least net cost of exiting from a contract, which is deemed to be the lower of:

• the cost of fulfilling the contract, and • any compensation or penalties arising from failure to fulfil the contract.

In the presence of an ‘onerous contract’, an expense and a related provision need to be recognised. However, prior to a provision being established, an organisation can recognise an impairment loss against an asset that is dedicated to the contract (such as inventory being manufactured as part of the contract).

5. If an organisation issues some bonds (liabilities) to the public, and the coupon rate it offers on the bonds is less than the market’s required rate of return, will the bonds be issued at a discount, or premium, relative to their face value? LO 10.6 If the coupon rate being offered is less that the market’s required rate of return, the bonds will be issued below their face value (that is, at a discount). The issue price will be decreased to a point when the future cash flows effectively provide a rate of return that equates to the market’s required rate of return.

6. What is a ‘contingent liability’, and how shall a contingent liability be disclosed within the financial reports? LO 10.7 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. (AASB 137)

A contingent liability shall be disclosed in the notes to the financial statements. At the end of the reporting period, an entity shall disclose each class of contingent liability, together with a brief description of the nature of the contingent liability.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What attributes should an item or transaction exhibit in order to be classified a liability? LO 10.1, 10.2 • 2. What distinguishes a provision from other liabilities? LO 10.1, 10.2, 10.4 • 3. How shall provisions be measured? LO 10.4 • 4. What is a contingent liability and how should it be disclosed for financial reporting purposes? LO 10.7 • 5. 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, 10.4, 10.7 ••

6. 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 •

dee67382_ch10_373-408.indd 402 10/23/19 10:10 AM

402 PART 4: Accounting for liabilities and owners’ equity

7. 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 • 8. What factors may cause the price of a bond (also referred to as a ‘debenture’) at issue date to be different from its

face value? LO 10.6 • 9. What factors should an organisation consider when choosing between disclosing liabilities on a current/non-current

basis, or in order of liquidity? LO 10.3 • 10. What is an ‘onerous contract’ and how shall an onerous contract be presented within the financial statements?

LO 10.5 • 11. What is a ‘hybrid security’, and how should it be disclosed? LO 10.11 • 12. Which of the following would likely be considered to be a ‘provision’ as defined in AASB 137? (a) a warranty provided by a car retailer (b) an amount transferred from retained earnings to another account in anticipation of future repairs and

maintenance (c) an obligation to clean up a contaminated site (d) a bank loan LO 10.4 • 13. What is a constructive obligation, and can constructive obligations be recognised as liabilities? LO 10.1 • 14. How would you account for a possible obligation that has a remote likelihood of resulting in an outflow of economic

resources? LO 10.1, 10.2, 10.4, 10.7 • 15. How would you determine the discount or premium on a bond issue? LO 10.6, 10.7 • 16. 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 ••

17. 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, 10.2, 10.4 ••

18. Why would something be considered to be a contingent asset rather than an asset? LO 10.8 • 19. Rincon Ltd has been operating for a number of periods and has been selling jet-propelled surfboards. At the end of

the reporting period, available data suggests: • If small defects arise with all of the products that have been sold, the related repair costs would be $3. 5 million. • If significant defects arise with all of the products sold, the related costs would be $12 million. • Based upon past experience within Rincon Ltd, and within the industry, it is believed that 75 per cent of all

products will have no defects, 15 per cent will have small defects and 10 per cent will have significant defects.

REQUIRED What should the balance of the closing provision for warranty repairs be? LO 10.4 •• 20. Explain how the release of a new accounting standard could potentially cause a reporting entity to violate an existing

debt covenant. LO 10.1, 10.9 •• 21. 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 2043. As at 30 June 2023, the best estimate to clean up the site (in 2043) is $10 500 000.

dee67382_ch10_373-408.indd 403 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 403

One year later, on 30 June 2024, 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 2023 and 6 per cent as at 30 June 2024.

REQUIRED Provide the journal entries in relation to the above obligation for the years ending 30 June 2023 and 30 June 2024. LO 10.4 •••

22. Cactus Ltd issues some convertible notes in 2023. 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 2024. If the conversion option is not exercised, cash of $20 per note will be paid to the note holders. At 30 June 2024 the price of Cactus Ltd’s shares is $18.00. Would you disclose the notes as debt or as equity as at 30 June 2024? LO 10.10, 10.11 ••

23. On 1 July 2022 Michaela Ltd issues $1 million in five-year bonds 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 2022 (ii) 30 June 2023 (iii) 30 June 2024. LO 10.6 •• 24. On 1 July 2022 Bombo Ltd issues $2 million in six-year bonds that pay interest every 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 2022 (ii) 30 June 2023 (iii) 30 June 2024. LO 10.6 •• 25. On 1 July 2022 Rankin Ltd issues $1 million in 10-year bonds 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 2022 (ii) 30 June 2023 (iii) 30 June 2024. LO 10.6 •• 26. On 1 July 2022 Kiama Ltd issues $5 million in five-year bonds that pay interest every 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 2022 (ii) 30 June 2023 (iii) 30 June 2024. LO 10.6 ••

dee67382_ch10_373-408.indd 404 10/23/19 10:10 AM

404 PART 4: Accounting for liabilities and owners’ equity

27. On 1 July 2023, Kruger Ltd privately issues $1 million in six-year bonds, which pay interest every six months at a coupon rate of 6 per cent per annum (3 per cent every six 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 bonds are accounted for using the effective-interest method.

REQUIRED

(a) Determine the fair value of the bonds at the time of issue (which will also be their issue price). (b) Provide the journal entries at: (i) 1 July 2023 (ii) 31 December 2023 (iii) 30 June 2024. LO 10.6 •• 28. The following parts of this question relate to contingent assets. (a) What is a contingent asset? (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 10.8 ••

CHALLENGING QUESTIONS

29. How would you account for a liability that cannot be reliably measured? LO 10.1, 10.2, 10.4, 10.7

30. 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 10.9

31. 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 10.9

32. In a newspaper article of 3 May 2019 entitled ‘AMP facing $100m super class-action suit’ (in The Australian, by Ben Butler, p. 20) it was reported that the law firm Slater & Gordon had unveiled plans to lodge a class action against financial services group AMP worth more than $100 million, and which was to be lodged on behalf of holders of superannuation funds who were allegedly charged excessive fees and provided with poor investment returns. According to the article, a representative of Slater & Gordon said they had already identified more than 8000 potential members of the class action, but expected there would be tens of thousands of potential members. According to the article, Slater & Gordon claim to have undertaken an extensive review of fees across the superannuation industry and found AMP’s fees for its ‘MySuper’ product, which AMP claimed to be its low-cost option, were significantly higher than the rest of the industry.

REQUIRED Provide an opinion in respect of if, and how, AMP should disclose information about the possible action within either its financial statements or the notes thereto. LO 10.1, 10.2, 10.4, 10.7

33. Maroubra Ltd enters a contract to supply Lurline Bay Ltd with 20 Sandman panel vans at a sales price of $75 000 each. The expected manufacturing cost of each van is expected to be $60 000. The vans will be placed in the control of Lurline Bay Ltd once all 20 vans have been completed. When production commenced it became clear that an error had been made in determining the manufacturing cost, which was reassessed to actually be $90 000 per van.

REQUIRED

(a) Determine whether the contract for the supply of the vans constitutes an ‘onerous contract’. It is assumed that the contract is ‘non-cancellable’.

(b) Assume that at the end of the accounting period five vans had been completed, but not yet transferred to Lurline Bay Ltd. Lurline Bay Ltd expects Maroubra Ltd to fully complete its obligations under the contract. What is the accounting journal entry to recognise the existence of the ‘onerous contract’?

(c) Assume that at the end of the accounting period, no vans had been produced but Maroubra Ltd was obliged to deliver the vans within the following six months, or alternatively, terminate the contract and pay a penalty to Lurline Bay of $250 000. What is the accounting journal entry to recognise the existence of the ‘onerous contract’? LO 10.5

dee67382_ch10_373-408.indd 405 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 405

34. In a newspaper article of 1 May 2019 entitled ‘KPMG settles Discovery Metals class action’ (in The Australian Financial Review, by Edmond Tadros, p. 30) it was reported that the ‘Big 4’ consulting firm KPMG settled a class action with shareholders of an organisation known as Discovery Metals. The background to the action was that there had been a takeover offer in which the shareholders had been offered $1.70 a share. However, a valuation of the assets of Discovery Metals by KPMG led KPMG to advise the board of directors of Discovery Metals that the figure of $1.70 a share was ‘not fair and reasonable’ because the fair value for a Discovery Metals share was between $1.74 and $2.22. It was reported that the board subsequently advised shareholders to reject the offer, based on the advice of KPMG, and the offer lapsed a month later due to insufficient shareholder support. Discovery Metals subsequently went into liquidation in June 2015, leaving nothing for the shareholders. The shareholders are reported to have alleged that KPMG provided misleading advice to the board of directors by inflating the value of the company’s principal asset by as much as 40 per cent. The shareholders were also reported to have alleged that had KPMG not applied the faulty valuation, it would have advised the board that the takeover bid was fair and reasonable. According to the article, KPMG denied the allegations and agreed to the in-principle settlement ‘without any admission of liability’. The shareholders, in turn, agreed to release KPMG Advisory from all further related claims.

REQUIRED 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, 10.4, 10.7

35. All things being equal, the managers of an organisation would generally prefer to disclose a transaction as part of equity, rather than debt. Why? LO 10.9

36. Company X presents 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

37. 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, 10.4, 10.7

38. 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

39. In an article entitled ‘Berry nasty’ that appeared in the Courier Mail on 15 February 2015 (by Greg Stolz), it was reported that people who had eaten a well-known brand of frozen berries were warned to watch for symptoms of hepatitis A. This followed at least five cases of people contracting the illness after allegedly eating Nanna’s frozen mixed berries, which had been sourced from China and Chile. In response, Patties Foods ordered an urgent product recall of its product. 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’ discussed the potential financial implications of the product recall. In particular, it looked at the likelihood of a class action being taken and the implications of the product recall on the reputation of the organisation and its products. Subsequent to the product recall, Patties Foods’ shares fell in value by about 12 per cent.

REQUIRED

(a) In the light of the information, 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? LO 10.1, 10.2, 10.4, 10.7

dee67382_ch10_373-408.indd 406 10/23/19 10:10 AM

406 PART 4: Accounting for liabilities and owners’ equity

40. In a newspaper article of 8 November 2018 entitled ‘BHP faces $9b dam lawsuit’ (in The Australian Financial Review, by Will Willitts, p. 19), it was reported that BHP faces a £5 billion ($9 billion) lawsuit over the failure of the Samarco dam in Brazil in November 2015. Waste and sludge from the dam that collapsed flowed through the village of Bento Rodrigues, destroying homes, contaminating water and killing 19 people. The claim was being brought for damages by lawyers on behalf of 240 000 individuals who were victims of the disaster.

REQUIRED In the light of the brief information provided above, how do you believe that BHP should disclose information about this claim in its annual report? Further, given that the dam failed in 2015, and this particular action was taken in 2018, when is the earliest accounting period in which BHP should have made some form of disclosure about the dam collapse? LO 10.1, 10.2, 10.4, 10.7

41. 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.

Nearly a year after moving to oust chief executive Dov Charney, American Apparel continues to fight with its controversial founder on multiple fronts. 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 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.

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, 10.4, 10.7

42. 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 .  .  . ‘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, 10.4, 10.7

43. 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 . . .

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.’

dee67382_ch10_373-408.indd 407 10/23/19 10:10 AM

CHAPTER 10: An overview of accounting for liabilities 407

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.

REQUIRED 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, 10.7

44. 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 investors’ 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.

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, 10.7

REFERENCES Aghamolla, C. & Li, N., 2018, ‘Debt Contract Enforcement and

Conservatism: Evidence for a Natural Experiment’, Journal of Accounting Research, vol. 56, no. 5, pp. 1383–1416.

Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

Balsam, S., Gu, Y. & Mao, C., 2018, ‘Creditor Influence and CEO Compensation: Evidence from Debt Covenant Violations’, The Accounting Review, vol. 93, no. 5, pp. 23–50.

Callen, J., Chen, F., Dou, Y. & Xin, B., 2016, ‘Accounting Conservatism and Performance Covenants: A Signaling Approach’, Contemporary Accounting Research, vol. 33, no. 3, pp. 961—88.

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.

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.

Hong, H., Hung, M. & Zhang, J., 2016, ‘The Use of Debt Covenants Worldwide: Institutional Determinants and Implications on Financial Reporting’, Contemporary Accounting Research, vol. 33, no. 2, pp. 644–81.

International Accounting Standards Board, Exposure Draft ED/2018/2: Onerous Contracts—Cost of Fulfilling a Contract: Proposed amendments to IAS37, IFRS Foundation, 2018.

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.

Sunder, J., Sunder, S. & Zhang, J., 2018, ‘Balance Sheet Conservatism and Debt Contracting’, Contemporary Accounting Research, vol. 35, no. 1, pp. 494—524.

Watts, R.L. & Zimmerman, J.L., 1986, Positive Accounting Theory, Prentice Hall, Englewood Cliffs, NJ.

Watts, R.L. & Zimmerman, J.L., 1990, ‘Positive Accounting Theory: A Ten-year Perspective’, Accounting Review, January, pp. 131–56.

dee67382_ch10_373-408.indd 408 10/23/19 10:10 AM

dee67382_ch11_409-462.indd 409 10/25/19 02:54 PM

409

C H A P T E R 11 Accounting for leases

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

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 had for financial statements. 11.2 Understand the core principle and the scope of AASB 16 Leases. 11.3 Understand what a ‘lease’ represents from the perspective of AASB 16. 11.4 Understand when to recognise a lease. 11.5 Know how to account for the service component of a contract that includes both a lease and a service

component. 11.6 Know how to determine the ‘lease term’. 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 depreciation expense), and be able to prepare the related accounting journal entries.

11.8 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. Also 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.

11.9 Understand the implications that the requirements of AASB 16 have for various accounting-based contractual arrangements that a reporting entity might have negotiated.

dee67382_ch11_409-462.indd 410 10/25/19 02:54 PM

410 PART 4: Accounting for liabilities and owners’ equity

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following seven questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. For the purposes of AASB 16 Leases, what is a ‘lease’? LO 11.3 2. What is a ‘lessee’ and what is a ‘lessor’? LO 11.2, 11.3 3. At the commencement of a lease, is a lessee required to recognise an asset and/or a liability? LO 11.2, 11.4, 11.7 4. Are a lease liability and a right-of-use asset required to be recognised by a lessee at lease inception for all

leases? LO 11.2 5. How is a lease liability to be measured at lease inception? LO 11.7 6. How is a right-of-use asset measured at lease inception? LO 11.7 7. What expenses are typically recognised by a lessee throughout the term of a lease? LO 11.7

  11.1 An overview of recent developments in the accounting requirements pertaining to accounting for leases

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 accounting standard IAS 17 Leases), which excluded many lease assets, and associated liabilities, from being recorded on the balance sheets (statements of financial position) of lessees. Basically, under the former system, which was in place for about 30 years, if a lease contract was considered to transfer substantially all the ‘risks and rewards incidental to ownership of an asset’ to the lessee, then—and only then—was it classified as a ‘finance lease’, and a related lease asset and a lease liability were required to be recognised within the financial statements of the lessee—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 117) had required that the lease contract must have been non-cancellable and also have included one of the following elements:

(a) the lease ultimately transferred ownership of the asset to the lessee at the end of the lease term (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). (AASB 117)

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 lease liability, or lease asset, was recognised by the

LO 11.1

operating lease Lease in which the risks and rewards of ownership stay with the lessor.

lease An agreement conveying the right from a lessor to a lessee to use property for a stated period in return for a series of payments.

finance lease A lease in which the terms of the lease agreement transfer the risks and benefits of ownership from the lessor to the lessee.

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

16 Leases IFRS 16

112 Income Taxes IAS 12

116 Property, Plant and Equipment IAS 16

dee67382_ch11_409-462.indd 411 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 411

lessee, regardless of the fact that the organisation might have had a non-cancellable obligation to make lease payments for a number of years.

So if, for example, an organisation leased a building for five years and the lease contract did not 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 (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. 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 representational faithfulness 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 2023 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 up-front 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 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 up-front 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 Prepaid lease rentals—land 500 000

Cr Cash at bank (to recognise lease payments paid in advance)

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 Lease expense 500 000

Cr Prepaid lease rentals—land (to expense the previously recognised prepayment)

500 000

continued

dee67382_ch11_409-462.indd 412 10/25/19 02:54 PM

412 PART 4: Accounting for liabilities and owners’ equity

Worked Example 11.1 shows how, by comparison, many assets and liabilities were not recognised under the former accounting standard (thereby necessitating the need for a change), relative to AASB 16. The IASB also 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 on their balance sheets. Perhaps financial problems would have been predicted earlier, and possibly averted, 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 use accounting

TREATMENT OF THE LEASE UNDER THE ‘NEW’ REQUIREMENTS OF AASB 16 Under the new accounting standard released in February 2016—AASB 16 Leases—a lease asset (also referred to as a ‘right-of-use 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 sheets 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 Right-of-use asset—land 2 232 550

Cr Lease liability 1 732 550

Cr Cash at bank 500 000 (initial recognition of the right-of-use asset and associated lease liability)

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 depreciation 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 accounting treatment of leases as a result of the release of IFRS 16 and, subsequently, AASB 16). The accounting entry at the end of the first year would be:

Dr Interest expense 103 953

Cr Lease liability (interest expense equals the opening liability multiplied by the interest rate, which equals $1 732 550 × 6%)

103 953

Dr Depreciation expense 446 510

Cr Accumulated depreciation right-of-use asset—leased land (the depreciation of the right to use the land is undertaken on a straight-line basis unless another approach provides a better reflection of the use of the asset)

446 510

As we can see, there is quite a difference in the results generated under the ‘old’ accounting standard (AASB 117) and the ‘new’ accounting standard (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.

WORKED EXAMPLE 11.1 continued

dee67382_ch11_409-462.indd 413 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 413

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 was effective from 1 January 2020, although early adoption was permitted.

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 and 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

lease-related 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).

dee67382_ch11_409-462.indd 414 10/25/19 02:54 PM

414 PART 4: Accounting for liabilities and owners’ equity

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 non-cancellable, 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 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 present economic resource controlled by the entity as a result of past events. Further, an economic resource is a right that has the potential to produce economic benefits.

∙ A liability is a present obligation of the entity to transfer an economic resource as a result of past events.

Description of right Control Past event Future economic benefit Asset?

Right to use machinery during the lease term

Legally enforceable right established by the lease contract

Delivery following signing of the lease contract

Yes Yes

Table 11.1 Explanation of why a ‘right-of-use’ asset is an asset consistent with the Conceptual Framework

Description of obligation Present obligation Past event

Outflow of economic benefits Liability?

Obligation to pay rentals

Legally enforceable obligation established by the lease contract

Delivery following signing of the lease contract

Yes (cash payments) Yes

Table 11.2 Explanation of why an obligation to make lease payments is a liability consistent with the Conceptual Framework

dee67382_ch11_409-462.indd 415 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 415

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 the Conceptual Framework. The boards decided to develop a new approach to accounting for leases that would result in the recognition of the 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). In a newspaper article entitled ‘Retailers face hit from proposed lease accounting changes’ (by Sue Mitchell, The Australian Financial Review, 23 April 2015, p. 21) the likely future impacts on financial reports were discussed. Specifically, the impact on major Australian retailers were discussed. Such organisations typically are involved in a significant amount of leases with respect to their required retail space. It was reported in the newspaper article that: ∙ Myer had net reported debt of $340 million, but the net present value (NPV) of unrecognised lease liabilities was

$2.2 billion. Under the new accounting standard (AASB 16), reported debt would rise significantly to $2.5 billion. ∙ Woolworths had net reported debt of $3 billion, but the NPV of unrecognised leases was $15 billion. Reported

debt would rise about six times to $18 billion pursuant to the new accounting standard. ∙ Wesfarmers (Coles, Bunnings, Target, Officeworks) had net reported debt of $4 billion, with unrecognised NPV

of leases of $12 billion. Reported debt would also rise significantly.

In a more recent newspaper article in The Australian Financial Review of 21 March 2019 entitled ‘$100b of lease liabilities headed for balance sheets’ (by Vesna Poljak, p. 17), it was reported that:

New research estimating the impact of accounting standards that require leases to be brought on balance sheet finds that up to $100 billion of liabilities will be recognised for the top 100 companies, beginning this year. The findings underscore that the effect of the new standard amounts to the biggest shake-up to accounting standards since 2005.

WHY DO I NEED TO KNOW ABOUT THE BACKGROUND TO THE DEVELOPMENT OF THE NEW ACCOUNTING STANDARD FOR LEASING?

What is demonstrated by the development of the leasing accounting standard is that from time to time we can expect to see significant changes made to how certain assets and liabilities are recognised and measured. That is, although particular rules might have been in place for decades, major changes can be made, and these changes can have significant implications for financial reports in terms of reported profits, assets and liabilities.

What the experience with the development of AASB 16 also shows is that it can take many years for proposed changes to be made to accounting standards once it has been decided that major changes are necessary. For example, work on changing the standard for leases took almost a decade before a new accounting standard was released.

The experience with AASB 16 also reinforces the fact that financial reporting requirements can significantly change across time, therefore reinforcing the need for us to partake in ongoing professional education that keeps us up-to-date with respect to developments in financial reporting requirements.

11.2 The core principle and scope of AASB 16

As we now know, IFRS 16 was released in January 2016 (and AASB 16 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 AASB 16, 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. (AASB 16)

LO 11.2

dee67382_ch11_409-462.indd 416 10/25/19 02:54 PM

416 PART 4: Accounting for liabilities and owners’ equity

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 of AASB 16 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). (AASB 16)

Exemptions for leases of 12 months or less, and for low-value assets 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 and small items of office furniture), 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.

WORKED EXAMPLE 11.2: Example of accounting for a short-term lease

On 1 July 2023 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 Rental expense—machinery 20 000

Cr Cash 20 000 (recognition of lease expenses incurred on a short-term lease arrangement)

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.

dee67382_ch11_409-462.indd 417 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 417

11.3 What is a lease pursuant to AASB 16?

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 short-term leases, and leases of low-value assets). AASB 16 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. (AASB 16)

The ‘underlying asset’ referred to above is defined as:

An asset that is the subject of a lease, for which the right to use that asset has been provided by a lessor to a lessee. (AASB 16)

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 (AASB 16) 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). (AASB 16)

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 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.

LO 11.3

dee67382_ch11_409-462.indd 418 10/25/19 02:54 PM

418 PART 4: Accounting for liabilities and owners’ equity

Exhibit 11.1 Determination of whether a ‘lease’ exists

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).

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, 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

dee67382_ch11_409-462.indd 419 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 419

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.

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.

continued

dee67382_ch11_409-462.indd 420 10/25/19 02:54 PM

420 PART 4: Accounting for liabilities and owners’ equity

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 definitions of lessee and lessor as they appear within AASB 16. These terms are defined as follows:

Lessee: An entity that obtains the right to use an underlying asset for a period of time in exchange for consideration.

Lessor: An entity that provides the right to use an underlying asset for a period of time in exchange for consideration. (AASB 16)

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.

Exhibit 11.1 continued

11.4 When to recognise a lease

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 AASB 16 states:

At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability. (AASB 16)

The commencement date is defined in Appendix A of AASB 16 as:

The date on which a lessor makes an underlying asset available for use by a lessee. (AASB 16)

  11.5 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. AASB 16 requires that the lease component of the contract must be considered separately from the service contract. The customer does not obtain control of a resource as part of a service component. Rather, it commits to purchasing services that it will receive in the future and the supplier retains control of the use of any items needed to deliver the particular service. Therefore:

∙ with a lease, the customer controls the use of the item, and ∙ with a service, the supplier controls the use of the item delivering the service.

The general principle is that service contracts are not to be capitalised on the balance sheet. Because contracts often contain both a lease and a service component it is necessary for a lessee to separate the amounts for the lease of the asset 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. AASB 16 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 AASB 16 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).

LO 11.4

LO 11.5

dee67382_ch11_409-462.indd 421 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 421

Worked Example 11.3 explores how to determine which payments relate to a lease and which payments relate to a service component.

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.

11.6 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 AASB 16 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. (AASB 16)

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 Worked Example 11.4.

LO 11.6

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.

continued

dee67382_ch11_409-462.indd 422 10/25/19 02:54 PM

422 PART 4: Accounting for liabilities and owners’ equity

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.

WORKED EXAMPLE 11.4 continued

  11.7 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 AASB 16 requires:

At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability. (AASB 16)

In terms of the initial measurement of the lease liability, paragraph 26 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. (AASB 16)

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

LO 11.7

dee67382_ch11_409-462.indd 423 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 423

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. (AASB 16)

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 the lease payments. AASB 16 defines a ‘residual value guarantee’ as:

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. (AASB 16)

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.

residual value The actual or estimated net realisable value of a depreciable asset at the end of its useful life.

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, given the manner in which the asset is to be used, 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.

  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 component of this lease payment would be:

$15 000 × 0.6139 = $9209

As we saw above, paragraph 27 of AASB 16 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.

dee67382_ch11_409-462.indd 424 10/25/19 02:54 PM

424 PART 4: Accounting for liabilities and owners’ equity

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 AASB 16 as a ‘right-of-use asset’—paragraph 23 requires:

At the commencement date, a lessee shall measure the right-of-use asset at cost. (AASB 16)

The above requirement obviously necessitates that we 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; (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. (AASB 16)

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 AASB 16 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. (AASB 16)

Such costs would include commissions, legal fees and costs of preparing and processing documentation for new leases. Again, AASB 16 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.

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 $ 20 000

Periodic lease payments $15 000 × 3.5460 $ 53 190

Bargain purchase option $30 000 × 0.8227 $ 24 681

Lease liability to be recognised at the inception of the lease $ 97 871

dee67382_ch11_409-462.indd 425 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 425

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 AASB 16 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. (AASB 16)

The above requirement makes reference to the ‘unguaranteed residual’. This is defined 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. (AASB 16)

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. AASB 16 requires the lessor to disclose, within the notes to the financial statements, how it manages this risk.

Worked Example 11.7 explores how to determine the rate implicit in a lease.

WORKED EXAMPLE 11.7: Example of computing discount rate

McTavish Ltd decides to lease some machinery from Cornish Ltd on the following terms:

Duration of lease 10 years

Life of leased asset 11 years

Unguaranteed residual value $2000

Lease payments $4000 at lease inception, $3500 on 30 June each year (that is, 10 yearly payments in arrears of $3500 each)

Fair value of leased asset at date of lease inception $26 277

 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 at inception of lease $ 4 000

Present value of 10 yearly payments $ 21 506

Present value of unguaranteed residual $ 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.

dee67382_ch11_409-462.indd 426 10/25/19 02:54 PM

426 PART 4: Accounting for liabilities and owners’ equity

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 AASB 16 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. (AASB 16)

For a lessor (rather than the lessee), the interest rate to be used would be the rate that causes the sum of the present values 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 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 2022 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.

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 AASB 16. 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

dee67382_ch11_409-462.indd 427 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 427

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, AASB 16 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 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 AASB 16).

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.

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 Right-of-use asset—machinery 456 510

Cr Lease liability 346 510

Cr Cash at bank 110 000 (to recognise the lease-related asset and liability at the commencement of the lease)

Date Lease payment Interest expense Principal reduction Present value of lease liability

1 July 2022 346 510

30 June 2023 100 000 20 791 79 209 267 301

30 June 2024 100 000 16 038 83 962 183 339

30 June 2025 100 000 11 000 89 000 94 339

30 June 2026 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 depreciation 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 depreciation

dee67382_ch11_409-462.indd 428 10/25/19 02:54 PM

428 PART 4: Accounting for liabilities and owners’ equity

on the assumption that the economic benefits from the underlying asset are derived uniformly throughout the lease. This gives a depreciation expense of:

$456 510 ÷ 5 = $91 302

The accounting journal entry at 30 June 2023 to record the lease payment therefore is:

Dr Interest expense 20 791  

Dr Lease liability 79 209  

Dr Service expenses 15 000  

Cr Cash at bank   115 000 (to recognise the lease payment made on 30 June 2023)

In the above journal entry, the amount allocated to interest expense would typically be shown in the statement of cash flows as part of cash flows from operating activities (unless the organisation has elected to classify interest expenses as part of cash flows from financing activities), while the amount allocated to the lease liability (principal repayment) would be treated as part of cash flows from 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.

The accounting journal entry to record the period’s depreciation expense is:

Dr Depreciation expense 91 302  

Cr Accumulated depreciation—right-of-use asset—machinery   91 302 (to recognise the depreciation of the right-of-use asset)

We will now consider three more Worked 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 (Worked Example 11.9); how to account for a guaranteed residual payment (Worked Example 11.10); and how to account for a lease that ultimately transfers ownership of the underlying asset to the lessee (Worked Example 11.11).

WORKED EXAMPLE 11.9: Further example of accounting for a lease by a lessee

On 1 July 2022 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 2023. (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 (AASB 117).

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, AASB 16 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. (AASB 16)

dee67382_ch11_409-462.indd 429 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 429

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 up-front 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 up-front lease payment, is therefore $533 026 (which is $583 026 less $50 000). 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 Present value of

lease liability

1 July 2022 533 026

30 June 2023 130 000 37 312 92 688 440 338

30 June 2024 130 000 30 824 99 176 341 162

30 June 2025 130 000 23 881 106 119 235 043

30 June 2026 130 000 16 453 113 547 121 496

30 June 2027 130 000 8 504 121 496 0

The depreciation 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 a depreciation expense of:

$583 026 ÷ 5 = $116 605

The accounting journal entries for the year ending 30 June 2023 therefore are:

1 July 2022

Dr Right-of-use asset—trucks 583 026  

Cr Cash at bank 50 000

Cr Lease liability (to recognise the commencement of the lease)

533 026

30 June 2023

Dr Interest expense 37 312

Dr Lease liability 92 688

Dr Service expenses 20 000

Cr Cash at bank (to recognise the annual payment for the lease)

150 000

Dr Depreciation expense 116 605  

Cr Accumulated depreciation—right-of-use trucks (to recognise the amortisation/depreciation expense for the year)

116 605

continued

dee67382_ch11_409-462.indd 430 10/25/19 02:54 PM

430 PART 4: Accounting for liabilities and owners’ equity

(c) The following table summarises the total expenses associated with this lease.

Year ended Depreciation Interest

expense Service

expense Total

expenses Lease

payment

30 June 2023 116 605 37 312 20 000 173 917 50 000 + 150 000

30 June 2024 116 605 30 824 20 000 167 429 150 000

30 June 2025 116 605 23 881 20 000 160 486 150 000

30 June 2026 116 605 16 453 20 000 153 058 150 000

30 June 2027 116 605 8 505 20 000 145 110 150 000

800 000 800 000

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 AASB 16—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 depreciation for the lease assets (which would be common). If some form of accelerated depreciation was used (which recognises more depreciation 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, and kept them off the balance sheet, (which would be a contravention of AASB 16, but would be consistent with treating the lease as an ‘operating lease’— as was sometimes permitted by the former accounting standard, AASB 117), 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.

In terms of cash flows, as would be reported in a statement of cash flows, there would be no difference in the total 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 cash flows from operating activities. If the lease is now capitalised, the interest component would usually be shown as part of cash flows from operating activities, but the component of the payment that represents payment of part of the liability would be shown as a cash flow from financing activities. Therefore, the introduction of IFRS 16 (and, subsequently, AASB 16) has an effect on the presentation of cash flows—operating cash flows will reduce but there will be a corresponding increase in financing cash outflows.

WORKED EXAMPLE 11.9 continued

WORKED EXAMPLE 11.10: A further leasing example, with this example including a guaranteed residual payment

On 1 July 2022 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

Worked Example 11.10 provides a further example of accounting for a lease from the perspective of the lessee.

dee67382_ch11_409-462.indd 431 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 431

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 each of the years of the lease.

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) = $1 001 154

Present value of the amount that the asset is expected to be worth at the end of the lease term:

$380 000 × 0.8548 = $ 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 2022 901 154

30 June 2023 220 000 36 046 183 954 717 200

30 June 2024 220 000 28 688 191 312 525 888

30 June 2025 220 000 21 036 198 964 326 924

30 June 2026 340 000* 13 076 326 924 0

*Includes payment of $120 000 in relation to the residual value guarantee

The depreciation 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 a depreciation expense of:

$1 001 154 ÷ 4 = $250 288

continued

dee67382_ch11_409-462.indd 432 10/25/19 02:54 PM

432 PART 4: Accounting for liabilities and owners’ equity

WORKED EXAMPLE 11.10 continued

The accounting journal entries for each of the years of the lease therefore are:

1 July 2022

Dr Right-of-use asset—machinery 1 001 154

Cr Cash at bank 100 000

Cr Lease liability (to recognise the lease asset and liability at the inception of the lease)

901 154

30 June 2023

Dr Interest expense 36 046

Dr Lease liability 183 954

Dr Service expenses 30 000

Cr Cash at bank (to recognise the lease payment for the year)

250 000

Dr Depreciation expense 250 288

Cr Accumulated depreciation—right-of-use asset—machinery (to recognise the depreciation of the right-of-use asset)

250 288

30 June 2024

Dr Interest expense 28 688

Dr Lease liability 191 312

Dr Service expenses 30 000

Cr Cash at bank (to recognise the lease payment for the year)

250 000

Dr Depreciation expense 250 288

Cr Accumulated depreciation—right-of-use asset—machinery (to recognise the depreciation of the right-of-use asset)

250 288

30 June 2025

Dr Interest expense 21 036

Dr Lease liability 198 964

Dr Service expenses 30 000

Cr Cash at bank (to recognise the lease payment for the year)

250 000

Dr Depreciation expense 250 288

Cr Accumulated depreciation—right-of-use asset—machinery (to recognise the depreciation of the right-of-use asset)

250 288

30 June 2026

Dr Interest expense 13 076

Dr Lease liability 326 924

Dr Service expenses 30 000

Cr Cash at bank (to recognise the lease payment for the year)

370 000

dee67382_ch11_409-462.indd 433 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 433

Dr Depreciation expense 250 288

Cr Accumulated depreciation—right-of-use asset—machinery (to recognise the depreciation of the right-of-use asset)

250 288

Dr Accumulated depreciation—right-of-use asset— machinery

1 001 154

Cr Right-of-use asset—machinery (to eliminate the right-of-use asset and the accumulated depreciation at the end of the lease term. The leased asset is returned to the lessor)

1 001 154

Worked Example 11.11 provides another example of accounting for a lease. This time there is a bargain purchase option.

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 2023. 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 2024. 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 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 2024 and 30 June 2025. (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 2024 and 30 June 2025. (d) Prepare the journal entries for the year ending 30 June 2028 (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 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, AASB 16 requires that lease payments are to include ‘the exercise price of a purchase 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) = $90 000 × 3.6048 = $324 432

Present value of the bargain purchase option = $80 000 × 0.5674 = $ 45 392

$369 824

continued

dee67382_ch11_409-462.indd 434 10/25/19 02:54 PM

434 PART 4: Accounting for liabilities and owners’ equity

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)

Date

Lease payment (exclusive of

executory costs) Interest

expense Principal

reduction Outstanding

balance

1 July 2023 369 824

30 June 2024 90 000 44 379 45 621 324 203

30 June 2025 90 000 38 904 51 096 273 107

30 June 2026 90 000 32 773 57 227 215 880

30 June 2027 90 000 25 906 64 094 151 786

30 June 2028 170 000* 18 214 151 786 0

*Includes bargain purchase option

1 July 2023

Dr Right-of-use asset—machinery 369 824

Cr Lease liability (to record the leased asset and liability at the inception of the finance lease)

369 824

30 June 2024

Dr Service expenses 10 000

Dr Interest expense 44 379

Dr Lease liability 45 621

Cr Cash (to record the lease payment of $100 000)

100 000

Dr Lease depreciation expense 51 637

Cr Accumulated depreciation—right-of-use asset—machinery (to record depreciation expense [($369 824 – $60 000) ÷ 6])

51 637

As the lessee will most probably retain the right-of-use 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 2025

Dr Service expenses 10 000

Dr Interest expense 38 904

Dr Lease liability 51 096

Cr Cash (to record the lease payment of $100 000)

100 000

WORKED EXAMPLE 11.11 continued

dee67382_ch11_409-462.indd 435 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 435

Dr Lease depreciation expense 51 637

Cr Accumulated depreciation—right-of-use asset—machinery ($369 824 less $60 000 divided by six years)

51 637

(c) Portion of the statement of financial position for years ending 30 June 2024 and 30 June 2025

2024 ($) 2025 ($)

Assets

Right-of-use asset—machinery 369 824 369 824

less Accumulated depreciation 51 637 103 274

318 187 266 550

Current liabilities

Lease liability 51 096 57 227

Non-current liabilities

Lease liability 273 107 215 880

As at 30 June 2024, 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 2028

Dr Service expenses 10 000

Dr Interest expense 18 214

Dr Lease liability 151 786

Cr Cash (to record the final payment of $180 000)

180 000

Dr Lease depreciation expense 51 637

Cr Accumulated depreciation—right-of-use asset—machinery (to record depreciation expense [($369 824 – $60 000) ÷ 6])

51 637

At this point the lease liability will have a zero balance, and the right-of-use asset will have a carrying amount of $111 639, which is the original amount recognised on 1 July 2023 of $369 824 less accumulated depreciation of $258 185. 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 right-of-use asset account to the new account ‘Machinery’:

30 June 2028

Dr Machinery 111 639

Dr Accumulated depreciation—right-of-use asset—machinery 258 185

Cr Right-of-use asset—machinery (to transfer the balance in the right-of-use asset to the machinery account in recognition of the end of the lease term)

369 824

dee67382_ch11_409-462.indd 436 10/25/19 02:54 PM

436 PART 4: Accounting for liabilities and owners’ equity

11.8 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, AASB 16 now requires a lessor to disclose information about:

∙ assets subject to operating leases separately from owned assets held and used for other purposes by the lessor, and ∙ how it manages exposure to residual value risk.

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 AASB 16 requires:

A lessor shall classify each of its leases as either an operating lease or a finance lease. (AASB 16)

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 Appendix A as:

A lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset. (AASB 16)

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. (AASB 16)

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, the lessee’s risk exposure is basically what it would be if the lessee acquired the asset by way of a purchase transaction. Therefore, if the risks and rewards of ownership are transferred in substance to the lessee, the lessee’s risk exposure in relation to holding the asset is basically equivalent to what it would have been if the lessee had acquired the asset for cash or by way of a loan.

It is not always a straightforward exercise to determine whether the risks and rewards incidental to ownership have passed substantially to the lessee. Professional judgement might be required. As a result, the accounting standard (AASB 16) dedicates paragraphs 63 to 65 to assisting the

LO 11.8

WHY DO I NEED TO KNOW ABOUT THE FINANCIAL REPORTING REQUIREMENTS PERTAINING TO LEASES?

Leasing arrangements are very common and are often used by organisations as an alternative to purchasing the respective assets. Many reporting entities lease a very large amount of assets, thereby giving them access to very material amounts of assets, and creating very material obligations.

Because right-of-use assets and related lease liabilities can be very significant and can greatly impact measures such as the reported gearing of a reporting entity, it is essential to understand what these assets and liabilities represent, as well as when they are to be recognised, and how they shall be measured. It is also important to understand how the recognition of leases impacts the reported profits of a reporting entity. Lacking such an understanding would mean we would not really be able to understand the contents of a significant aspect of many organisations’ financial reports.

risks and rewards of ownership Risks include those associated with idle capacity and obsolescence and benefits include gains in realisable value.

dee67382_ch11_409-462.indd 437 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 437

determination of whether a lease is a finance lease or an operating lease. These paragraphs have been taken from the former accounting standard (AASB 117) 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 lessor does not transfer substantially all such risks and rewards. (AASB 16)

We will now further reflect upon some of the key considerations included in the above paragraphs.

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 (AASB 16) 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.

dee67382_ch11_409-462.indd 438 10/25/19 02:54 PM

438 PART 4: Accounting for liabilities and owners’ equity

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. As we have already noted, 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 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.

We can summarise some of the main factors that need to be considered when classifying a lease in Figure 11.1. 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 AASB 16) 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 ∙ 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 AASB 16 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;

dee67382_ch11_409-462.indd 439 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 439

(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. (AASB 16)

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 shall recognise the lease payments as lease income in profit or loss over the lease term, and no lease receivable would be recognised (that is, the underlying asset would not be substituted by a lease receivable).

While, from the perspective of the lessor, leases shall be classified as either finance or operating leases, finance leases can—as reflected in Figure 11.2—be further classified into either:

∙ direct-financing leases, or ∙ leases involving manufacturers or dealers (which have a profit or sale component).

These classifications are discussed further below.

Does the lease include a bargain

option?

Finance lease

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?

Yes

Yes

No

No

No

Operating lease

Is the lease term for the major part of the economic life of the asset?

No

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?

Yes

Yes

Yes

Figure 11.1 Factors to be considered by a lessor when classifying lease as an operating lease or a finance lease

dee67382_ch11_409-462.indd 440 10/25/19 02:54 PM

440 PART 4: Accounting for liabilities and owners’ equity

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 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 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 incremental costs that are directly attributable to negotiating and arranging a lease. Such costs would include commissions, legal fees and costs of preparing and processing documentation associated with new leases. Under a direct-financing lease, the initial direct costs are, if material, to be included as part of the lessor’s investment in the lease.

Amounts received by the lessor that represent a recovery of service costs, being those costs that are related specifically to the operation and maintenance of the leased property, including 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.

Worked Example 11.12 provides an illustration of how a lessor shall account for a direct finance lease.

Figure 11.2 Classification of leases by lessors

Finance leasesOperating 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

From the lessor’s perspective leases can

be subdivided into

direct-financing lease A lease that is not a lease involving a manufacturer or dealer in which the lessor acquires legal title to 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.

lease receivable A lessor’s right to receive lease payments arising from a lease, measured on a present value basis.

initial direct costs Costs that are directly attributable to negotiating and arranging a lease and would not have been incurred without entering into the lease.

dee67382_ch11_409-462.indd 441 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 441

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 in Worked Example 11.11, except this time we will do 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 2024 and 30 June 2025.

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

Lease payment (exclusive of

executory costs) Interest

revenue Principal

reduction Outstanding

balance

1 July 2023 369 824

30 June 2024 90 000 44 379 45 621 324 203

30 June 2025 90 000 38 904 51 096 273 107

30 June 2026 90 000 32 773 57 227 215 880

30 June 2027 90 000 25 906 64 094 151 786

30 June 2028 170 000 18 214 151 786 0

530 000 160 176 369 824

1 July 2023

Dr Machinery 369 824

Cr Cash (to recognise the initial acquisition of the machinery by the lessor)

369 824

Dr Lease receivable 369 824

Cr Machinery (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)

369 824

30 June 2024

Dr Cash 100 000

Cr Service expense recoupment (part of profit or loss) 10 000

Cr Interest revenue 44 379

Cr Lease receivable (to record the lease receipt of $100 000)

45 621

continued

dee67382_ch11_409-462.indd 442 10/25/19 02:54 PM

442 PART 4: Accounting for liabilities and owners’ equity

30 June 2025

Dr Cash 100 000

Cr Service expense recoupment (part of profit or loss) 10 000

Cr Interest revenue 38 904

Cr Lease receivable (to record the lease receipt of $100 000)

51 096

WORKED EXAMPLE 11.12 continued

We shall now consider Worked Example 11.13—which has a lease that includes an unguaranteed residual.

WORKED EXAMPLE 11.13: Lessor accounting for a direct-financing lease that has an unguaranteed residual

On 1 July 2023 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 are 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 2027), 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 2024.

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 $ 50 000

Present value of the lease component of the payments: $100 000 × 3.3121 = $331 210

Present value of the unguaranteed residual: $200 000 × 0.7350 = $147 000

Fair value of the machine at the commencement date of the lease $528 210

Because the present value of the lease payments plus the unguaranteed residual, discounted at 8 per cent, equals 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 2023

Dr Machinery 528 210

Cr Cash (to recognise the initial acquisition of the machinery by the lessor)

528 210

Dr Cash 50 000

Dr Lease receivable 331 210

dee67382_ch11_409-462.indd 443 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 443

Dr Residual asset—asset to be returned by the lessee 147 000

Cr Machinery (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)

528 210

30 June 2024

Dr Cash 110 000

Cr Service expense recoupment (part of profit or loss) 10 000

Cr Interest revenue ($331 210 × 8 per cent) 26 497

Cr Lease receivable (to recognise the receipt of the lease payment)

73 503

Dr Residual asset—asset to be returned by the lessee 11 760

Cr Interest revenue ($147 000 × 8 per cent) (to adjust the present value of the residual asset)

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 manufacturer- or dealer-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 AASB 16—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).

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 2023. 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.

continued

dee67382_ch11_409-462.indd 444 10/25/19 02:54 PM

444 PART 4: Accounting for liabilities and owners’ equity

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 2024. 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 2024 and 30 June 2025 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) $225 000 × 3.6048 = $811 080

The present value of the bargain purchase option = $200 000 × 0.5674 = $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

Lease payment (exclusive of

executory costs) Interest

revenue Principal

reduction Outstanding

balance

1 July 2023 924 560

30 June 2024 225 000 110 948 114 052 810 508

30 June 2025 225 000 97 261 127 739 682 769

30 June 2026 225 000 81 932 143 068 539 701

30 June 2027 225 000 64 764 160 236 379 465

30 June 2028   425 000   45 535 379 465 0

1 325 000 400 440 924 560

1 July 2023

Dr Lease receivable 924 560

Dr Cost of sales 800 000

Cr Inventory 800 000

Cr Sales (the lease receivable represents the present value of the lease payments, and the cost of goods sold represents the cost of the asset to the lessor)

924 560

WORKED EXAMPLE 11.14 continued

dee67382_ch11_409-462.indd 445 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 445

30 June 2024

Dr Cash 250 000

Cr Service expense recoupment (part of profit or loss) 25 000

Cr Interest revenue 110 948

Cr Lease receivable (to represent receipt of lease payment)

114 052

30 June 2025

Dr Cash 250 000

Cr Service expense recoupment (part of profit or loss) 25 000

Cr Interest revenue 97 261

Cr Lease receivable (to represent receipt of lease payment)

127 739

Again we notice that the lessor does not depreciate the underlying asset. It is the lessee that will depreciate the ‘right-of-use’ asset.

Worked Example 11.15 will use the knowledge we now have to account for a lease arrangement from the perspective of both the lessee and the lessor.

WORKED EXAMPLE 11.15: Accounting for a manufacturer-type lease from the perspective of both the lessee and lessor

The directors of Tubular Swells Ltd decide that due to low-cost surfboards now being imported from various countries, Tubular Swells Ltd will acquire some machinery that makes surfboards without human intervention, thereby replacing many skilled tradespeople who previously had handcrafted the surfboards. Tubular Swells Ltd needs to acquire some machinery from Industrialist Ltd, which designs and manufactures the machinery. To manufacture the equipment, which has an estimated economic life of eight years, costs Industrialist Ltd $200 000. Industrialist Ltd sells the equipment to parties such as Tubular Swells Ltd for $263 948.

Tubular Swells Ltd decides to lease the equipment from Industrialist Ltd for a period of seven years, by way of a non-cancellable lease. The lease commences on 1 July 2023. The lease payments are made at the end of each year and amount to $55 000. The lease payments include reimbursement of Industrialist 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. (b) Provide the journal entries in the books of Tubular Swells Ltd as at 1 July 2023 and 30 June 2024. (c) Provide the journal entries in the books of Industrialist Ltd as at 1 July 2023 and 30 June 2024.

SOLUTION

(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 $50 000 × 4.8684 = $243 420

Unguaranteed residual $40 000 × 0.5132 = $ 20 528

$263 948

continued

dee67382_ch11_409-462.indd 446 10/25/19 02:54 PM

446 PART 4: Accounting for liabilities and owners’ equity

WORKED EXAMPLE 11.15 continued

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 Tubular Swells Ltd

1 July 2023

Dr Right-of-use asset–machinery 243 420 

Cr Lease liability (to recognise the right-of-use 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)

243 420

30 June 2024

Dr Service costs 5 000 

Dr Interest expense 24 342

Dr Lease liability 25 658

Cr Cash (to recognise the first lease payment)

55 000

Dr Depreciation expense 34 774 

Cr Accumulated depreciation—right-of-use asset—machinery (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)

34 774

(c) Journal entries in the books of Industrialist Ltd

1 July 2023

Dr Lease receivable 243 420

Dr Residual asset 20 528

Dr Cost of goods sold 179 472

Cr Inventory 200 000

Cr Sales revenue (to recognise the sale of inventory to Tubular Swells Ltd and the related lease receivable and residual asset. The cost of goods sold represents the cost of the equipment to Industrialist 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. The lease is a manufacturer-type lease)

243 420

30 June 2024

Dr Cash 55 000

Cr Lease receivable 25 658

Cr Interest revenue 24 342

Cr Recoupment of service costs (to recognise the receipt of the periodic lease payment)

5 000

dee67382_ch11_409-462.indd 447 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 447

Dr Residual asset 2 053

Cr Interest revenue (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)

2 053

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 AASB 16 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. (AASB 16)

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 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. (AASB 16)

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 11.16 provides an illustration of how a lessor is to account for an operating lease.

WORKED EXAMPLE 11.16: Lessor accounting for a lease that is only for a minor part of the asset’s life

On 1 July 2023 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 2024 and 30 June 2025 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 2024.

SOLUTION The journal entries for the year ending 30 June 2024 would be:

1 July 2023

Dr Cash 100 000

Cr Rent received in advance (the initial payment would be treated as a liability labelled ‘Rent received in advance’)

100 000

continued

dee67382_ch11_409-462.indd 448 10/25/19 02:54 PM

448 PART 4: Accounting for liabilities and owners’ equity

30 June 2024

Dr Rent received in advance 100 000

Cr Rental income (as the rent has now been earned, we recognise revenue)

100 000

Dr Cash 100 000

Cr Rent received in advance (the payment made on 30 June 2024 represents rent received in advance for the next 12 months)

100 000

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, AASB 16 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 finance 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 AASB 16 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. (AASB 16)

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 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 AASB 16 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. (AASB 16)

WORKED EXAMPLE 11.16 continued

dee67382_ch11_409-462.indd 449 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 449

WORKED EXAMPLE 11.17: Accounting by the lessor for a lease involving land and buildings

On 1 July 2023, 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 2024. $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 2023 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 2024 and 30 June 2025 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 per cent (we eliminate the executory costs) = $70 000 × 4.8684 = $340 788

Present value of the unguaranteed residual = $200 000 × 0.5132 = $102 640

   $443 428

As the future 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 = 70 000 × (133 028 ÷ 443 428) = $21 000

Buildings = 70 000 × (310 400 ÷ 443 428) = $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.

continued

Accounting for a lease involving land and buildings is examined more closely in Worked Example 11.17.

dee67382_ch11_409-462.indd 450 10/25/19 02:54 PM

450 PART 4: Accounting for liabilities and owners’ equity

(c) Journal entries for the years ending 30 June 2024 and 30 June 2025

Date Lease payment

for building Interest

revenue Receivable

reduction Outstanding

balance

1 July 2023 238 551

30 June 2024 49 000 23 855 25 145 213 406

30 June 2025 49 000 21 341 27 659 185 747

30 June 2026 49 000 18 575 30 425 155 322

30 June 2027 49 000 15 532 33 468 121 854

30 June 2028 49 000 12 185 36 815 85 039

30 June 2029 49 000 8 504 40 496 44 543

30 June 2030   49 000     4 455   44 545 0*

343 000 104 447 238 553

*Note: There is a $2 rounding error due to the use of only 4 decimal places in the calculations.

1 July 2023

Dr Lease receivable 238 551

Dr Residual asset (140 000 × 0.51321) 71 849

Cr Building (to record the lease receivable and the residual asset, which replace the building in the accounts of Thom Ltd)

310 400

30 June 2024

Dr Cash 75 000

Cr Service expense recoupment (part of profit or loss) 5 000

Cr Interest revenue (see table above) 23 855

Cr Lease receivable 25 145

Cr Rental income—land (to record the lease receipt of $75 000)

21 000

Dr Residual asset 7 185

Cr Interest revenue (to record the increase in the present value of the residual asset, which is $71 849 × 10%)

7 185

30 June 2025

Dr Cash 75 000

Cr Service expense recoupment 5 000

Cr Interest revenue (see table above) 21 341

Cr Lease receivable 27 659

Cr Rental income—land (to record the lease receipt of $75 000)

21 000

Dr Residual asset 7 903

Cr Interest revenue (to record the increase in the present value of the residual asset, which is [71 849 + 7185] × 10%)

7 903

WORKED EXAMPLE 11.17 continued

dee67382_ch11_409-462.indd 451 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 451

11.9 Implications for accounting-based contracts

As we should now understand, there was a significant recent change in how lessees shall account for 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 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 penalties, such as the lenders having the immediate right to demand repayment of their funds or to seize certain assets over which the lenders have security). So, if more liabilities are to be recognised—perhaps as a result of capitalising more leases—then this can potentially trigger a default on lending agreements, which in turn would impact current operations, cash flows and, therefore, potentially the value of the firm.

For example, assume that a company has assets of $10 million and liabilities of $5.5 million. Also 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 assets and lease liabilities are not recognised (which, in certain circumstances, was permitted under the former accounting standard, AASB 117), debt and assets will not be affected, so the debt-to- asset ratio will not be affected. However, if the lease is recognised in accordance with the accounting standard (AASB 16), then the debt-to-asset ratio would become 0.609 (7 000 000 ÷ 11 500 000) and the company would be in technical default of the loan agreement—potentially a costly situation for the company. Of course, it might be possible that the borrowing agreement (contract) requires the use of the 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 ultimately within Australia by the AASB 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 that was available under AASB 16 (which was about three years from the time when the accounting standard was released to the time when it had to 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

LO 11.9

technical default When a borrowing entity has failed to comply with certain restrictive covenants that have been negotiated with lenders.

debt-to-asset constraint A restriction included in a debt agreement limiting the amount of debt an entity may have relative to its total assets.

dee67382_ch11_409-462.indd 452 10/25/19 02:54 PM

452 PART 4: Accounting for liabilities and owners’ equity

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. 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, AASB 117). Where restrictive debt covenants were in place (for example, debt-to-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 ‘finance’ 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 (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 AASB 16, lessees’ statements of financial position will incorporate right-of-use assets as well as the obligations to make lease payments (lease liabilities), 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 depreciation expenses related to the right-of-use asset.

Amortising the right-of-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 sheets 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.

dee67382_ch11_409-462.indd 453 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 453

SUMMARY

Table 11.3 provides a summary of the main points to consider in accounting for leases.

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 right-of-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 in-substance 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.

Table 11.3 A summary of some of the key requirements for lease accounting

continued

dee67382_ch11_409-462.indd 454 10/25/19 02:54 PM

454 PART 4: Accounting for liabilities and owners’ equity

Issue Required treatment

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 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 manufacturer- or dealer-type lease, the initial direct costs 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.

Depreciation of right-of-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:

(a) The lessor would recognise both a right to receive lease payments and a residual asset at the date of the commencement of the lease.

(b) 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.

(c) 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 in Appendix A to AASB 16 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. (AASB 16)

A lessee need not recognise lease assets or lease liabilities subject to a short-term 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 low-value items.

Table 11.3 continued

dee67382_ch11_409-462.indd 455 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 455

KEY TERMS

debt-to-asset constraint 451 direct-financing lease 440 finance lease 410 initial direct costs 440

lease 410 lease receivable 440 operating lease 410 residual value 423

risks and rewards of ownership 436 technical default 451

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following seven questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. For the purposes of AASB 16 Leases, what is a ‘lease’? LO 11.3 AASB 16 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. (AASB 16)

An ‘underlying asset’ is defined as:

An asset that is the subject of a lease, for which the right to use that asset has been provided by a lessor to a lessee. (AASB 16)

2. What is a ‘lessee’ and what is a ‘lessor’? LO 11.2, 11.3 According to AASB 16:

• A lessee is an entity that obtains the right to use an underlying asset for a period of time in exchange for consideration.

• A lessor is an entity that provides the right to use an underlying asset for a period of time in exchange for consideration.

3. At the commencement of a lease, is a lessee required to recognise an asset and/or a liability? LO 11.2, 11.4, 11.7 Yes (unless the exemptions in part 4 below apply). As paragraph 22 of AASB 16 states:

At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability. (AASB 16)

The ‘commencement date’ is defined in Appendix A of AASB 16 as:

The date on which a lessor makes an underlying asset available for use by a lessee. (AASB 16)

4. Are a lease liability and a right-of-use asset required to be recognised by a lessee at lease inception for all leases? LO 11.2 There are limited exemptions. Paragraph 5 of AASB 16 states that a lease liability, and a right-of-use asset, do not need to be recognised where the lease:

(a) Is a ‘short-term lease’, and (b) Is for an underlying asset of ‘low value’.

A short-term lease is defined in AASB 16 as a lease that, at the commencement date, has a lease term of 12 months or less. However, a lease that contains a purchase option is not a short-term lease. In terms of the value that items would have for them to be deemed to be of ‘low value’, the IASB suggests they would be in the order of magnitude of US$5000 or less.

5. How is a lease liability to be measured at lease inception? LO 11.7 Paragraph 26 of AASB 16 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. (AASB 16)

dee67382_ch11_409-462.indd 456 10/25/19 02:54 PM

456 PART 4: Accounting for liabilities and owners’ equity

The above requirement refers to ‘lease payments’. In this regard, 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, 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; (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; and (e) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an

option to terminate the lease. (AASB 16)

6. How is a right-of-use asset measured at lease inception? LO 11.7 Paragraph 23 of AASB 16 requires:

At the commencement date, a lessee shall measure the right-of-use asset at cost. (AASB 16)

The above requirement obviously necessitates that we 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; (b) any lease payments made at or before the commencement date, less any lease incentives received; (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. (AASB 16)

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 AASB 16 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. (AASB 16)

7. What expenses are typically recognised by a lessee throughout the term of a lease? LO 11.7 Throughout the term of a lease, a lessee will typically recognise:

• interest expenses • depreciation expenses pertaining to the right-of-use asset, and • service expenses associated with the right-of-use asset (including insurance expenses and repairs and

maintenance expenses associated with the use of the right-of-use asset).

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Provide an overview of how accounting for leases was changed as a result of the release of AASB 16. LO 11.1, 11.2 ••

2. What is a ‘lease’? LO 11.3 • 3. What is a ‘lease term’ and how is it determined? LO 11.3 • 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, 11.7 •• 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 11.2 • 7. What is the difference between a ‘direct-financing lease’ and a ‘manufacturer- (dealer-)type lease’? LO 11.8 •• 8. How do we account for service costs that are included within a contract to lease an asset? LO 11.5 •

dee67382_ch11_409-462.indd 457 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 457

9. When a lease transaction is to be capitalised, how do we determine the value of the leased asset, and the lease liability? LO 11.7 ••

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 11.6 •• 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, 11.8 • 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 11.2, 11.7, 11.8 ••• 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 2023. • 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 11.7 •• 17. Burt Ltd enters into a non-cancellable five-year lease agreement with Earnie Ltd on 1 July 2023. 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 2024. 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.

REQUIRED (a) Determine the rate of interest implicit in the lease and calculate the present value of the lease payments. (b) Prepare the journal entries in the books of Burt Ltd for the years ending 30 June 2024 and 30 June 2025. (c) Prepare the portion of the statement of financial position for the year ending 30 June 2025 relating to the lease

asset and lease liability. LO 11.2, 11.3, 11.4, 11.5, 11.6, 11.7 •••

dee67382_ch11_409-462.indd 458 10/25/19 02:54 PM

458 PART 4: Accounting for liabilities and owners’ equity

18. Gregory Ltd enters into a non-cancellable five-year lease agreement with Sanders Ltd on 1 July 2023. 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 2024. 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 2024 and 30 June 2025 in the books of: (a) Sanders Ltd (b) Gregory Ltd. LO 11.2, 11.3, 11.4, 11.5, 11.6, 11.7, 11.8 •••

CHALLENGING QUESTIONS

19. In a newspaper article that appeared in The Australian Financial Review on 21 March 2019 entitled ‘$100b of lease liabilities head for balance sheets’ (by Vesna Poljak, p. 17), it was reported that the large listed company Wesfarmers had assessed the impacts of applying the requirements of AASB 16 to be an estimated increase in reported assets (via right-of-use assets) of between $5.5 billion and $6.5 billion, and an increase in reported liabilities (leases) of between $6.3 billion and $7.3 billion.

REQUIRED How will this impact gearing ratios, and does it have potential implications for any debt covenants that the organisation might have already negotiated? LO 11.9

20. 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 on the IASB website 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 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

dee67382_ch11_409-462.indd 459 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 459

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’. (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’? (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? (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? (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, 11.2, 11.7, 11.9

21. 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 as to why this process took so long and why so many comment letters were received by the IASB. LO 11.1, 11.9

22. 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, 11.2

23. 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, 11.9

24. On 1 July 2023, 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 2024. Within each of these payments, $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 2023 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. (b) Provide the journal entries for the years ending 30 June 2024 and 30 June 2025 for Iselin Ltd. (c) Provide the journal entries for the years ending 30 June 2024 and 30 June 2025 for Weber Ltd. LO 11.2, 11.3,

11.4, 11.5, 11.6, 11.7

dee67382_ch11_409-462.indd 460 10/25/19 02:54 PM

460 PART 4: Accounting for liabilities and owners’ equity

25. 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. 

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). LO 11.2, 11.3, 11.4

26. 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, 11.2, 11.9

27. 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 future 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.

(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 future 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.

(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 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.

(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 lease payments is 70 per cent of the fair value of the plant. LO 11.8

28. Classic Malibu Ltd decides to lease some machinery from Noosaville Ltd on the following terms: • Date of entering lease: 1 July 2023. • 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 11.7

dee67382_ch11_409-462.indd 461 10/25/19 02:54 PM

CHAPTER 11: Accounting for leases 461

29. 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. (b) Mark Richards Ltd is not expected to get ownership of the asset at the end of the lease term. LO 11.6, 11.7

30. On 1 July 2023, 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 2023) and lease payments of $250 000 on 30 June each year (starting 30 June 2024). There is no residual payment required.

REQUIRED (a) Provide the journal entries for the lease in the books of Flyer Ltd as at 1 July 2023. (b) Provide the journal entries for the lease in the books of Finance Ltd as at 1 July 2023. (c) Provide the journal entries in the books of Flyer Ltd for the final year of the lease (that is, the entries in 20 years’

time). (d) Provide the journal entries in the books of Finance Ltd for the final year of the lease (that is, the entries in

20 years’ time). LO 11.3, 11.4, 11.5, 11.6, 11.7, 11.8

31. 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 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 2023. • 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. (b) Prepare the journal entries to account for the lease transaction in the books of the lessor, City Vans Ltd, at 1 July

2023 and 30 June 2024. (c) Prepare the journal entries to account for the lease transaction in the books of the lessee, Deliveries Ltd, at

1 July 2023 and 30 June 2024. (d) On 30 June 2027 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 2027 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, 11.8

dee67382_ch11_409-462.indd 462 10/25/19 02:54 PM

462 PART 4: Accounting for liabilities and owners’ equity

32. 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 2023. • 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 2023. • Lease expires: 1 July 2027. • 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 2023. (b) Prepare a schedule for the lease payments incorporating accrued interest expense. (c) Prepare the journal entries to account for the lease in the books of Hopeful Ltd at 1 July 2023, 30 June 2024

and 1 July 2024. (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 2027. LO 11.3, 11.4, 11.5, 11.6, 11.7, 11.8

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. 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.

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.

dee67382_ch12_463-494.indd 463 10/24/19 03:17 PM

463

LEARNING OBJECTIVES (LO) 12.1 Understand the various forms of benefits/entitlements that employees can receive from their

employers. 12.2 Understand whether particular employee entitlement obligations should be recorded at their nominal

value, or at their discounted present value. 12.3 Be able to account for employee benefits in the form of salaries and wages. 12.4 Be able to account for employee benefits in the form of annual leave. 12.5 Be able to account for sick leave, and in doing so, know the accounting implications associated with sick

leave that vests, relative to sick leave that does not vest. 12.6 Be able to account for long-service leave entitlements. 12.7 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 from the perspective of the employer.

12.8 Understand that even if an employee benefit-related obligation (provision) has been recognised, this does not ensure that employees will ultimately receive payment for their entitlements should the employer subsequently encounter financial difficulties.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important for your studies.

C H A P T E R 12 Accounting for employee benefits

dee67382_ch12_463-494.indd 464 10/24/19 03:17 PM

464 PART 4: Accounting for liabilities and owners’ equity

12.1 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. However, AASB 119 does not apply to share-based payments provided to employees (for example, shares or share options provided to employees as part of their remuneration package). Rather, AASB 2 Share-based Payments applies to share-based payments, including those that comprise part of employee benefits. Chapter 17 discusses share- based payments, including those paid to employees as part of their employment agreement.

‘Employee’ is not actually defined in AASB 119, but it does define ‘employee benefits’. Paragraph 8 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 Employees will typically be entitled to payments when they take various short-term absences. In this chapter, we will consider in some depth entitlements relating to annual leave, sick leave and long-service leave. Other forms of paid leave would include maternity leave, parental leave and carer’s leave.

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What are some of the various forms of employee benefits? LO 12.1 2. Shall obligations for employee benefits be measured at their present value? LO 12.2 3. What is long-service leave, and what are some of the factors that need to be considered when recognising an

organisation’s provision for long-service leave? LO 12.6 4. What are the two main categories of superannuation plans, and in which type does the employee bear

relatively more of the risk in terms of the amount ultimately to be received on their retirement? LO 12.7 5. Is it easier to account for an employer’s contributions and obligations to a defined benefit superannuation plan

or a defined contribution superannuation plan? LO 12.7 6. If an organisation collapses, but the organisation has already created a provision for annual leave, and a

provision for long-service leave, then there will be some cash available for employees after the organisation collapses. True or false? LO 12.8

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

2 Share-based Payments IFRS 2

116 Property, Plant and Equipment IAS 16

119 Employee Benefits IAS 19

1056 Superannuation Entities —

LO 12.1

dee67382_ch12_463-494.indd 465 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 465

In respect of 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 (in several countries it is two weeks). 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 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 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 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’ additional 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 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 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’, which at the time of writing is 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), with this rate currently set to continue until 1 July 2021, when it shall increase to 10 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

annual leave Number of weeks of paid leave to which full-time employees are entitled in a year.

sick leave Paid leave entitlement per year for when an employee is not fit for duties.

long-service leave Leave in addition to annual leave granted if an employee stays with an employer for a minimum number of periods.

superannuation Payments made to employees after their retirement, in a stream of periodic payments or a lump sum on termination.

dee67382_ch12_463-494.indd 466 10/24/19 03:17 PM

466 PART 4: Accounting for liabilities and owners’ equity

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 superannuation funds, or ‘plans’, would be classified as defined benefit funds. Alternatively, superannuation funds might pay benefits to employees that are based on the contributions made to the funds on behalf of those employees 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 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 part 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 future for a pre-specified price. These are known as share options. For example, an organisation might provide some of its employees with options to buy a specified number of shares in five years’ time for a price equal to the current market price of the organisation’s shares. If employees stay with the organisation and the share price increases—which might in part be a result of the efforts of the 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.

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.

12.2 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)

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.

share option Entitlement that gives the holder the right to buy shares at or before a future date at a specified price.

LO 12.2

dee67382_ch12_463-494.indd 467 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 467

∙ 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 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 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). (AASB 119)

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. An example of ‘high-quality corporate bonds’ would be the bonds (also called ‘debentures’) issued by leading ‘blue chip’ companies, and which have been assessed to have a very good credit rating (for example, at or above an AA or AAA rating by a ratings agency such as Standard & Poor’s).

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.

WHY DO I NEED TO KNOW ABOUT THE DIFFERENCES BETWEEN DIFFERENT CLASSES OF EMPLOYEE BENEFITS?

Different classes of employee benefits have different measurement rules, different timing in terms of ultimate payment, and create different risks for both the employee and the employer. For example, the amounts to be paid to employees for salaries and wages will typically be paid in the next week or two and will not be discounted to a present value. Being payable in the near term means there is generally limited risk that the amounts will not be paid.

For entitlements to benefits such as long-service leave, the measurement will be based upon various judgements and will be measured on the basis of present values. Whether the employee will actually receive any related payments depends on whether the employee stays for the stipulated minimum number of years— and whether the organisation has the necessary funding at the time when the related payments or leave are to be taken.

In relation to superannuation benefits, it is important that we know whether the superannuation plan is a ‘defined contribution plan’ or a ‘defined benefit plan’. If it is a defined contribution plan, there are minimal measurement issues and the amount to be paid to employees will be directly linked to the amount of contributions made by the employer and the earnings of the superannuation fund. The employer would be subject to minimal risk for additional payment at the time of the employees’ retirement. Conversely, for a defined benefit plan, there are many measurement requirements, and the risks associated with future payments are borne by the employer.

dee67382_ch12_463-494.indd 468 10/24/19 03:17 PM

468 PART 4: Accounting for liabilities and owners’ equity

12.3 Accounting for employee benefits in the form of 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.

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. Further, the amount to be paid to the employees is typically net of tax, which the employer will subsequently pay to the Australian Taxation Office (ATO) on behalf of the employees. Employers might also offer a service to employees by offering to pay third parties on employees’ behalf, such as for health insurance premiums, or union or sporting club membership fees.

In this example, Thruster Ltd retains $3000 per week to pay the ATO for pay-as-you-go (PAYG) tax on behalf of the employees. We have assumed a tax rate of 30 per cent for these 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 (which we have assumed are 5 per cent of salary).

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 8 000

Cr PAYG tax payable 2 400

Cr Oceanic MBF payable 400

Cr Wages and salaries payable (to recognise salaries expense incurred but not paid, where 8000 = 10 000 × 4/5)

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 (to recognise the wages and salaries paid to employees. $2000 represents one day’s salary, which would be included as an expense of the new financial period, out of which 30% is retained to pay the ATO and 5 per cent is retained to pay for medical insurance on behalf of the employees; the employees would receive the net amount after deduction of the PAYG tax and the medical fund contribution—that is, $10 000 less $3000, less $500)

6 500

When the amounts are paid to the ATO and the medical fund on Monday, the entry would be:

Dr PAYG tax payable 3 000

Dr Oceanic MBF payable 500

Cr Cash at bank (to recognise payments made to the ATO and the medical funds)

3 500

LO 12.3

dee67382_ch12_463-494.indd 469 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 469

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 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.

Employees frequently receive bonuses related to performance outcomes 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 as described above.

12.4 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.

LO 12.4

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 = $6327 (or $122 per week)

Therefore, the total amount paid to Fitzgerald each year would be:

For 48 weeks at normal pay rate 70 000 × 48 ÷ 52 = $64 615

For four weeks inclusive of loading 70 000 × 4 ÷ 52 × 1.175 = $ 6 327

Total salary and annual leave = $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 122

Cr Provision for annual leave (to recognise annual leave where122 = [70 000 × 4 ÷ 52 × 1.175] ÷ 52)

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 3163.50

Cr PAYG tax payable 1000.00

Cr Cash at bank (to recognise payment to employee while on annual leave: 3163.5 = 6327 ÷ 2)

2163.50

continued

dee67382_ch12_463-494.indd 470 10/24/19 03:17 PM

470 PART 4: Accounting for liabilities and owners’ equity

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 (that is, the maximum entitlement is two weeks 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

$100 000 × 1 × 0.2 = $ 20 000

$120 000

This would equate to $2308 per week. On this basis, Dion Ltd should recognise the following journal entry each week:

Dr Sick-leave expense 2 308

Cr Provision for sick leave (weekly entry to recognise the increased obligation for sick leave: 2308 = 120 000 ÷ 52)

2 308

Hot Buttered Ltd would also need to provide the usual weekly annual leave journal entry, even when Fitzgerald is on holidays:

Dr Annual leave expense 122

Cr Provision for annual leave (to recognise increased obligation for annual leave)

122

WORKED EXAMPLE 12.2 continued

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 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.

12.5 Sick leave

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).

LO 12.5

on-costs Costs other than salaries and wages incurred by an employer as a result of employing individuals.

dee67382_ch12_463-494.indd 471 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 471

12.6 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 2006 it was decided 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. (AASB 119)

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 as employees provide their 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

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 Provision for sick leave 240

Dr Salaries and wages 160

Cr PAYG tax payable 80

Cr Cash at bank (to recognise payment made to an employee who is sick for part of the week)

320

LO 12.6

dee67382_ch12_463-494.indd 472 10/24/19 03:17 PM

472 PART 4: Accounting for liabilities and owners’ equity

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.

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 $50 000 3 7 20%

1 $40 000 4 6 25%

1 $60 000 6 4 35%

1 $40 000 7 3 60%

1 $50 000 10 0 100%

1 $80 000 12 0 100%

6

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 long-service leave entitlements vest with them.

High-quality corporate bonds periods to maturity

Bond rate (%)

7 8.0

6 7.5

4 6.5

3 6.0

dee67382_ch12_463-494.indd 473 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 473

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 3 $61 494 $ 3 074 $ 1 794 20 $359

$40 000 4 $47 762 $ 3 184 $ 2 063 25 516

$60 000 6 $67 530 $ 6 753 $ 5 249 35 1 837

$40 000 7 $43 709 $ 5 099 $ 4 281 60 2 569

$50 000 10 $50 000 $ 8 333 $ 8 333 100 8 333

$80 000 12 $80 000 $16 000 $16 000 100 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 = $3074 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:

$3074 ÷ (1.08)7 = $1794 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:

$1794 × 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 $7314. This would represent the increase in the obligation that has occurred throughout the year.

continued

dee67382_ch12_463-494.indd 474 10/24/19 03:17 PM

474 PART 4: Accounting for liabilities and owners’ equity

Worked Example 12.5 provides another illustration of how to account for long-service leave.

(b) The accounting entry to recognise the long-service leave expense would be:

Dr Long-service leave expense 7 314

Cr Provision for long-service leave (to recognise long-service leave accrual for the year)

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 Provision for long-service leave X

Cr Cash at bank (to recognise a payment made to an employee for LSL)

X

In this chapter we are not considering the tax effects relating to employee benefits. That is, we are not considering the issue of whether the expenses being accrued are tax deductible for the employer. 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 ATO will generally give the deduction only when the amounts are actually paid to the employees. 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.

WORKED EXAMPLE 12.5: A further illustration of how to account for long-service leave

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 completing the 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 30 000 5 10

Jones 40 000 8 7

Johnson 40 000 10 5

Gunston 50 000 15 0

Billabong 40 000 18 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 7.0

7 6.2

5 6.0

WORKED EXAMPLE 12.4 continued

dee67382_ch12_463-494.indd 475 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 475

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 20

Jones 30

Johnson 60

Gunston 100

Billabong 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.

SOLUTION

(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.

Names Projected salary (1)

Accumulated LSL benefit (2)

Present value of LSL

obligation (3)

Probability that LSL will be paid (4) LSL liability

Smith 36 570 3 048 1 549 20% 310

Jones 45 947 6 126 4 021 30% 1 206

Johnson 44 163 7 361 5 501 60% 3 301

Gunston 50 000 12 500 12 500 100% 12 500

Billabong 40 000 12 000 12 000 100% 12 000

29 317

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. where n = number of years until LSL entitlement vests 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 = $3048

3 Present value of the long-service leave calculation Present value = accumulated LSL benefit ÷ (1 + appropriate corporate bond rate)n. For Smith, the calculation would be: 3048 ÷ (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: $1549 × 0.20 = $310

continued

dee67382_ch12_463-494.indd 476 10/24/19 03:17 PM

476 PART 4: Accounting for liabilities and owners’ equity

12.7 Superannuation contributions

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. 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, in this chapter we are restricting our discussion of superannuation to how to account for the employee entitlements paid/payable by the employer to such a fund 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 post- employment 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 superannuation fund (a pension), although in some funds there is an option to take a lump sum on retirement.

According to AASB 119, post-employment benefit plans are classified as either:

∙ defined contribution plans, or ∙ defined benefit plans.

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 $8417.

(b) The accounting entry to recognise the LSL expense for the current year would be:

Dr Long-service leave expense 8 417

Cr Provision for long-service leave (to recognise an accrual for long-service leave entitlements earned by employees in the accounting period)

8 417

WORKED EXAMPLE 12.5 continued

WHY DO I NEED TO KNOW ABOUT WHETHER, AND HOW, AN ORGANISATION HAS ACCOUNTED FOR ANY LONG-SERVICE LEAVE OBLIGATIONS?

Depending upon the number of employees, an organisation’s obligation for long-service leave can be significant. Therefore, it is important that an organisation has properly recognised this obligation. There are many judgements to be made when calculating the obligation for long-service leave, and thus it is an account that can be subject to some level of manipulation (‘creative accounting’). In the presence of a sizeable provision for long-service leave, it is important to ascertain that the organisation actually has sufficient cash available when the time comes for the related payments to be made.

LO 12.7

dee67382_ch12_463-494.indd 477 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 477

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 now.

Figure 12.1 Simple diagrammatic representation of fund flows to and from a superannuation fund

Employee

$$ salaryServices

$$ contributions

$$ superannuation payments on retirement

$$ contributions Superannuation

fund

Employer

WHY DO I NEED TO KNOW THE DIFFERENCE BETWEEN A DEFINED BENEFIT SUPERANNUATION PLAN AND A DEFINED CONTRIBUTION SUPERANNUATION PLAN?

The accounting treatment for a defined benefit superannuation plan and a defined contribution superannuation plan are very different. Therefore, it is important to clearly understand what type of fund is being accounted for.

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

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

dee67382_ch12_463-494.indd 478 10/24/19 03:17 PM

478 PART 4: Accounting for liabilities and owners’ equity

Defined contribution plans Most private-sector superannuation plans are defined contribution plans. Employers typically prefer these plans (as opposed to defined benefit plans) because the risk of having to make further contributions to the superannuation fund (perhaps because of inadequate earnings) is effectively removed. 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 the earnings generated by the superannuation fund on the contributions that have been made on behalf of employees. That is, the employer does not stipulate what the final payment on retirement to be made to the employee will be. The earnings to be made by a superannuation fund would include dividend and interest income on investments held by the fund, as well as the changing fair value of the investments. 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 post-employment 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. (AASB 119)

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.

The obligations shall be 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 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 Accounting Standard requires or permits the inclusion of the contribution in the cost of an asset.

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. (AASB 119)

Worked Example 12.6 requires accounting entries to be determined to recognise an employer’s obligation in relation to contributions to a defined contribution superannuation plan.

WORKED EXAMPLE 12.6: Accounting for contributions to a defined contribution plan

Point Leo Ltd has a defined contribution superannuation plan (also referred to as an ‘accumulation fund’) 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 the superannuation plan, which is managed by an external trustee. The salaries, and related contributions, are as follows:

Name Annual salary Contribution

Damien Hardman $125 000 $12 500

Barton Lynch $175 000 $17 500

$30 000

dee67382_ch12_463-494.indd 479 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 479

REQUIRED Provide the accounting entry necessary to recognise the superannuation obligation of Point Leo Ltd.

SOLUTION The accounting entry would be as follows:

Dr Employee benefits cost—superannuation 30 000

Cr Employee benefits payable (to recognise the employee benefits earned by the employees in the form of superannuation)

30 000

When the amount is ultimately paid there will be a reduction in the amount shown against employee benefits payable. That is:

Dr Employee benefits payable 30 000

Cr Cash (payment to superannuation fund)

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, as just discussed, 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 states:

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. (AASB 119)

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 (and not how the superannuation fund itself shall do its accounting). As paragraph 56 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. (AASB 119)

dee67382_ch12_463-494.indd 480 10/24/19 03:17 PM

480 PART 4: Accounting for liabilities and owners’ equity

Steps involved in accounting for defined benefit plans As paragraph 57 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. (AASB 119)

These steps can be summarised as follows:

Step 1: Use an actuarial technique to reliably estimate the ultimate cost to the entity in relation to the superannuation benefits that employees have earned in return for their services in the current and prior periods.

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.

dee67382_ch12_463-494.indd 481 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 481

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 periods 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, employers 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.

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 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

dee67382_ch12_463-494.indd 482 10/24/19 03:17 PM

482 PART 4: Accounting for liabilities and owners’ equity

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 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. (AASB 119)

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 is stipulated by AASB 119. Paragraph 83 notes:

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

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. (AASB 119)

In explaining the use of discount rates, paragraph 84 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. (AASB 119)

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

dee67382_ch12_463-494.indd 483 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 483

Year 1 2 3 4 5

Present values

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

*at present value using 7 per cent

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 (and it is assumed that the payment is made at the end of the year). 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 a further 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 further liabilities would exist. If the fair value exceeded the obligation an asset would exist. As paragraph 65 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. (AASB 119)

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 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. (AASB 119)

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 simply assume that the fair value of the plan assets at the end of each financial year is as follows. We will also assume that the following contributions have been paid into the fund (and the actual contributions made by the employer will not necessarily equal the period’s service cost):

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

dee67382_ch12_463-494.indd 484 10/24/19 03:17 PM

484 PART 4: Accounting for liabilities and owners’ equity

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). We will consider each of these in turn below.

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.

According to paragraph 108, 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). (AASB 119)

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 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).

dee67382_ch12_463-494.indd 485 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 485

Step 5: Determine the remeasurements on the net defined benefit liability (asset) to be recognised in other comprehensive income According to paragraph 127, 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). (AASB 119)

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:

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;

(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. (AASB 119)

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 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. (AASB 119)

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 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). (AASB 119)

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.

dee67382_ch12_463-494.indd 486 10/24/19 03:17 PM

486 PART 4: Accounting for liabilities and owners’ equity

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%

Using revised rates, the revised present value of the obligation at each year end is as follows:

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—from Step 1 16 105 32 210 48 315 64 420 80 525

Present values

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

Current service cost** 12 286 12 785 13 555 14 912 16 105

Actuarial (gain) loss on obligation (balancing figure)—included within OCI 0 (485) (759) 817 (596)

Closing present value of obligation*** 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

Contributions 11 500 11 500 11 500 12 000 12 000

Actuarial gain (loss) on plan assets (balancing figure)—included within OCI 0 1 350 2 450 3 220 1 000

Closing fair value of plan assets 11 500 25 500 42 000 61 000 80 100

* 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

Liability (asset) to be recognised in statement of financial position*

786 69 (1 334) (1 352) 425

Change in the balance of the liability (asset) 786 (717) (1 403) (18) 1 777

* 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.

dee67382_ch12_463-494.indd 487 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 487

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

Current service cost 12 286 12 785 13 555 14 912 16 105

Interest cost 0 983 2 301 3 253 5 368

Total expenses—included within profit or loss 12 286 13 768 15 856 18 165 21 473

Other comprehensive income (OCI)

Items that will not be reclassified to profit or loss

Remeasurements of defined benefit liability:

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)

Total to the statement of profit or loss and other comprehensive income 12 286 10 783 10 097 11 982 13 777

* 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 using the information from the above table would be:

Year 1

Dr Superannuation expense (profit or loss) 12 286

Cr Cash 11 500

Cr Liability on defined benefit plan (superannuation expense for the year)

786

Year 2

Dr Superannuation expense (profit or loss) 13 768

Dr Liability on defined benefit plan  717

Cr Superannuation gain (OCI) 2 985

Cr Cash (superannuation expense for the year)

11 500

Year 3

Dr Superannuation expense (profit or loss) 15 856

Dr Liability on defined benefit plan    69

Dr Asset on defined benefit plan   1 334

Cr Superannuation gain (OCI) 5 759

Cr Cash (superannuation expense for the year)

11 500

Remember that movements 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.

dee67382_ch12_463-494.indd 488 10/24/19 03:17 PM

488 PART 4: Accounting for liabilities and owners’ equity

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)

Amounts recognised in:

Profit or loss 12 286 13 768 15 856 18 165 21 473

Other comprehensive income 0 (2 985) (5 759) (6 183) (7 696)

Contributions paid (11 500) (11 500) (11 500) (12 000) (12 000)

Closing net liability (asset) 786 69 (1 334) (1 352) 425

Actual return on plan assets:

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

12.8 Employees’ accrued employee benefits and corporate collapses

In this chapter we have discussed how employers recognise accruals (and resulting provisions) for unpaid employee benefits. As we should appreciate, however, the act of making an accrual does nothing to ensure that any cash will actually be available to pay employees their accrued entitlements should the employer organisation become insolvent (that is, the act of creating or increasing the size of an employee benefit provision does not involve any actual movements in cash). Companies can have a vast amount ‘sitting’ in provisions and reserves accounts, but in fact have no cash. 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 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 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 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.

LO 12.8

dee67382_ch12_463-494.indd 489 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 489

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 for superannuation 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 465 defined benefit fund 466 defined contribution fund 466

long-service leave 465 on-costs 470 share option 466

sick leave 465 superannuation 465

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What are some of the various forms of employee benefits? LO 12.1 Employee benefits can include salaries and wages, annual leave, sick leave, long-service leave, superannuation entitlements, entitlements to shares in an organisation, and bonuses.

WHY DO I NEED TO KNOW THAT EVEN IF AN ORGANISATION HAS CREATED VARIOUS PROVISIONS AND RESERVES, THIS DOES NOT NECESSARILY MEAN THERE IS ANY CASH?

Employees expect to receive the entitlements they have earned. However, many people mistakenly believe that because an organisation has recognised various employee benefit expenses, and created related provisions, ultimately there will be cash available to pay employees. This is not true. It is important to realise that the creation of various provisions has nothing directly to do with movements in cash.

dee67382_ch12_463-494.indd 490 10/24/19 03:17 PM

490 PART 4: Accounting for liabilities and owners’ equity

2. Shall obligations for employee benefits be measured at their present value? LO 12.2 The general principle is that obligations for employee benefits that are due for payment beyond 12 months shall be discounted to their present value, with the discount rate to be based upon the yields being generated by high-quality corporate bonds.

3. What is long-service leave, and what are some of the factors that need to be considered when recognising an organisation’s provision for long-service leave? LO 12.6 Long-service leave is additional leave over and above annual leave, which some organisations provide to employees if they stay in the employment of the organisation for a certain extended period of time. Some of the factors that need to be considered when calculating the provision for long-service leave include projected salaries at the time the leave might be taken, probabilities that employees will remain within the organisation until such time that the leave vests, and the market yields on high-quality corporate bonds for discounting purposes.

4. What are the two main categories of superannuation plans, and in which type does the employee bear relatively more of the risk in terms of the amount ultimately to be received on their retirement? LO 12.7 The two main types of superannuation plans are defined contribution funds (also called accumulation funds) and defined benefit funds. With a defined benefit fund, it is the employer who bears the risk that there might be insufficient funds to pay the defined benefit as the employer will be required to make up any shortfall should the fund—which will typically be independent—not have sufficient funds. By contrast, with a defined contribution fund, the employer pays a set amount into the fund and the amount to ultimately be received by the employee will be dependent upon the earnings made by the fund, so in this type of fund the employee bears relatively more of the risk.

5. Is it easier to account for an employer’s contributions and obligations to a defined benefit superannuation plan or a defined contribution superannuation plan? LO 12.7 It is much easier to account for an employer’s contribution to a defined contribution fund, with the expense to be recognised being the amount actually contributed in a given year according to the arrangements negotiated with the employee. A liability will be accrued only to the extent that the required periodic payment has not been made to the superannuation fund. By contrast, for a defined benefit fund, many calculations must be made and these can be quite complicated.

6. If an organisation collapses, but the organisation has already created a provision for annual leave, and a provision for long-service leave, then there will be some cash available for employees after the organisation collapses. True or false? LO 12.8 False. Just because there are some provisions shown in the balance sheet that have a certain carrying amount does not mean there is any cash. For example, to establish a provision for long-service leave we debit long-service leave expense, and we credit provision for long-service leave. There is no transfer of cash. The payment of cash would occur only when the employee actually takes the leave. When an organisation collapses it usually does so because there is no cash, and whatever assets are in existence will generally be much less than the total debt.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is an ‘employee benefit’ and what are the various forms that these benefits can take? LO 12.1 • 2. When an organisation recognises a provision and related expense for annual leave, and a provision for long-service

leave for its employees, the risk to employees that they will not be paid these amounts that have been provided is effectively zero. Is this true or false? Why? LO 12.8 •

3. If an organisation would prefer to shift the risks associated with superannuation to its employees, the organisation would establish a defined benefit superannuation plan rather than a defined contribution superannuation plan. Is this true or false? Why? LO 12.7 •

4. Payments made by an organisation to its employees for work performed by employees shall always be treated as an expense. Is this true or false? Why? LO 12.1 •

5. Employee benefit expenses relating to annual leave should be recognised by the employer only when the annual leave is actually taken by the employee. True or false? Why? LO 12.4 •

6. According to AASB 119, how should an employer’s obligation for employee benefits be measured? LO 12.2 • 7. 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 12.2, 12.6, 12.7 •

dee67382_ch12_463-494.indd 491 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 491

8. According to AASB 119, when should the rates on government bonds be used to discount expected future payments back to their present value? LO 12.2, 12.6, 12.7 •

9. 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 12.2 •

10. Which employee benefits are required to be discounted in accordance with AASB 119? LO 12.2 • 11. When would payments made to employees be considered to be an asset? LO 12.1, 12.2 • 12. When would it be considered that income has arisen in relation to employee benefits? LO 12.2, 12.3 • 13. 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 12.7 • 14. 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 12.5 ••

15. 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 12.7 •

16. Why do some employers provide their employees with shares or options to buy shares in the organisation? LO 12.1 •

17. What is long-service leave and what is meant by: a preconditional period; a conditional period; and an unconditional period? LO 12.6 •

18. 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 (ATO) 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 •• 19. 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 $1200. LO 12.2, 12.4 ••

CHALLENGING QUESTIONS

20. 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 Current salary per employee

Years of service

Probability (%) that LSL will be paid

Periods to maturity

High-quality corporate

bond rate (%)

2 50 000 6 45 4 9

2 65 000 7 70 3 7

2 70 000 8 100 2 6

dee67382_ch12_463-494.indd 492 10/24/19 03:17 PM

492 PART 4: Accounting for liabilities and owners’ equity

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, 12.6

21. 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.

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 12.5

22. 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 40 000 2 10

Jan White 40 000 4 8

Noel Brown 50 000 6 6

Peter Green 60 000 8 4

Alvin Purple 70 000 10 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

Bond rate (%)

10 8.0

8 7.0

6 6.5

4 6.0

2 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 Probability (%)

that LSL will vest

Mike Black 15

Jan White 20

Noel Brown 50

Peter Green 70

Alvin Purple 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, 12.6

dee67382_ch12_463-494.indd 493 10/24/19 03:17 PM

CHAPTER 12: Accounting for employee benefits 493

23. Australasia Ltd started operating on 1 July 2021 with 12 employees. Three years later all of those employees were still with the company. On 1 July 2023 the company hired 15 more people but by 30 June 2024 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.

At 30 June 2024 Australasia Ltd estimates the following:

• the aggregate annual salaries of all employees hired on 1 July 2021 is now $600 000 • the aggregate annual salaries of all current employees hired on 1 July 2023 is now $400 000 • the probability that employees hired on 1 July 2021 will continue to be employed for the duration of the conditional

period is 40 per cent • the probability that employees hired on 1 July 2023 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:

1 July 2023 30 June 2024

Corporate bonds maturing in seven years 4% 6%

Corporate bonds maturing in eight years 5% 8%

Corporate bonds maturing in nine years 5% 8%

Corporate bonds maturing in ten years 6% 10%

At 30 June 2023 the provision for long-service leave was $6000.

REQUIRED

(a) Calculate the total accumulated long-service leave benefit as at 30 June 2024. (b) What amount should be reported for the long-service leave provision as at 30 June 2024 in accordance with

AASB 119? (c) Prepare the journal entry for the provision for long-service leave for 30 June 2024 in accordance with AASB 119.

LO 12.2, 12.6

24. 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 2023, 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 2023 and they are due to retire on 30 June 2026. The employees’ entitlement increases with the length of their employment. At 30 June 2022 they were entitled to receive three times their annual salary on retirement. By 30 June 2023 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 2023 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 2022.

The interest rate used to discount the defined benefit obligation was 7 per cent at 30 June 2022 and 30 June 2023.

The defined benefit plan assets had a fair value of $529 887 at 30 June 2022. For the year ended 30 June the contributions were $20 000 and the fair value of plan assets at 30 June 2023 was $585 000. The expected return on the plan assets was 8 per cent for the year ended 30 June 2023.

REQUIRED

(a) Prepare the journal entry to record Switches Ltd’s current superannuation obligation for the defined contribution plan as at 30 June 2023.

(b) Calculate the estimated benefits earned by employees in the defined benefit plan as at 30 June 2023. (c) Determine the present value of the defined benefit obligation as at 30 June 2023.

dee67382_ch12_463-494.indd 494 10/24/19 03:17 PM

494 PART 4: Accounting for liabilities and owners’ equity

(d) Calculate the interest cost of the defined benefit obligation for the year ended 30 June 2023 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 2023. LO 12.7

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. Lopez, G., 1999, ‘Company Collapses and Employee Entitlements’,

Australian CPA, August, pp. 30–1.

dee67382_ch13_495-526.indd 495 10/24/19 03:18 PM

495

LEARNING OBJECTIVES (LO) 13.1 Understand that the equity of an organisation can consist of several different accounts. 13.2 Understand how various equity accounts are created. 13.3 Understand that there can be various classes of shares, each affording different rights to holders, and

some having debt-like characteristics. 13.4 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 a public and a private issue of shares, as well as the costs associated with a share issue.

13.5 Be able to provide the journal entries necessary if partly paid shares are subsequently forfeited by their owners.

13.6 Be able to provide the journal entries necessary to account for ‘rights issues’ and issues of share options.

13.7 Understand what constitutes a ‘share split’ and a ‘bonus issue’ of shares, and know the accounting implications of both.

13.8 Be able to provide the journal entries to account for distributions to shareholders (dividends). 13.9 Be able to provide the journal entries necessary when a company buys back its ordinary shares, and

when preference shares are ‘redeemed’. 13.10 Know the disclosure requirements of AASB 101 Presentation of Financial Statements in relation to

share capital and reserves.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

C H A P T E R 13 Share capital and reserves

dee67382_ch13_495-526.indd 496 10/24/19 03:18 PM

496 PART 4: Accounting for liabilities and owners’ equity

13.1 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 (equity). That is, Assets = Liabilities plus Equity.

The 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 (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 definition of equity is directly a function of the definitions of assets and liabilities. Given that equity is the residual interest in the assets of the entity and given that the amount assigned to equity will always correspond to the excess of the amounts assigned to its assets over the amounts assigned to its liabilities, the criteria for the recognition of assets and liabilities effectively provide the criteria for the recognition of equity.

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: ∙ share capital relating to one class or several classes of shares—for example, ordinary shares plus various classes

of preference shares

equity Defined by the Conceptual Framework as ‘the residual interest in the assets of the entity after deducting all its liabilities’.

shareholders’ funds In a company, shareholders’ funds— which constitute ‘equity’— represent the difference between total assets and total liabilities.

OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is an ‘ordinary share’, what characteristics do ordinary shares have, and where are ordinary shares disclosed? LO 13.1, 13.3, 13.10

2. What is a ‘preference share’? LO 13.1, 13.3 3. Should preference shares be disclosed as ‘equity’ or as ‘debt’? LO 13.3 4. If ordinary shares are issued to the public (by a public company), can the issuing company use the cash

received from the issue as soon as the cash is received? LO 13.2, 13.4 5. What is a ‘share split’, and what accounting journal entries are required when an organisation performs a share

split? LO 13.7

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

2 Share-based Payments IFRS 2

9 Financial Instruments IFRS 9

101 Presentation of Financial Statements IAS 1

110 Events After the Reporting Period IAS 10

121 The Effects of Changes in Foreign Exchange Rates IAS 21

132 Financial Instruments: Presentation IAS 32

LO 13.1

dee67382_ch13_495-526.indd 497 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 497

∙ 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 as at 30 June 2019. Only the part of the statement of financial position that relates to equity is shown (figures are in US$ million; the bold column shows 2019 figures, while that on the right is for 2018).

Exhibit 13.1 Components of BHP’s equity as at 30 June 2019

SOURCE: BHP Group Ltd

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 16, for example, we find that the total Reserves balance of US$2285 million is comprised of various different accounts as shown in Exhibit 13.2.

Exhibit 13.2 An example of accounts that might comprise ‘reserves’—from the 2019 Annual Report of BHP

SOURCE: BHP Group Ltd

dee67382_ch13_495-526.indd 498 10/24/19 03:18 PM

498 PART 4: Accounting for liabilities and owners’ equity

13.2 Creating reserves

As we know, companies can have numerous types of reserves forming part of their shareholders’ funds (equity). In Chapter 6, 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 non-current 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 Land 150 000

Cr Gain on revaluation (part of OCI) 150 000

(to initially recognise the gain as part of other comprehensive income)

At the end of the accounting period, the gain on revaluation recognised within other comprehensive income would, in accordance with accounting standards, then be transferred to equity in the form of a transfer to the revaluation surplus account. Dr Gain on revaluation (part of OCI) 150 000

Cr Revaluation surplus 150 000

(to transfer the gain to revaluation surplus at the end of the accounting period)

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 Retained earnings 750 000

Cr General reserve 750 000

(to transfer an amount from retained earnings to the general reserve)

The net effect of the above entry on total shareholders’ funds (equity) is nil. The purpose of this entry might be that the directors wish 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 instance, particular accounting standards require the creation of reserves. As an example, and as is explained in Chapter 14,

As is the case for BHP, retained earnings often makes up a significant proportion of total shareholders’ funds (see Exhibit 13.1). For BHP, the retained earnings of $51 064 million represents about 84 per cent of total equity. 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.

LO 13.2

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.

WHY DO I NEED TO KNOW ABOUT THE DIFFERENT ACCOUNTS THAT CAN COMPRISE ‘EQUITY’?

The corporations law in different countries typically assigns different rights and obligations in respect of different components of equity. For example:

• shares might be both ordinary shares and preference shares. Preference shares have preferential rights over ordinary shares (in various aspects, as we will discuss shortly)

• retained earnings indicates the total balance that is potentially available to pay dividends (subject to there being available cash or cash equivalents)

• the revaluation surplus account relates to revaluation of non-current assets. This typically cannot be used for dividends, unless the balance is ultimately transferred to retained earnings (perhaps following the sale of a revalued non-current asset).

Other reserves, not discussed here, will also have different rights and obligations associated with them.

dee67382_ch13_495-526.indd 499 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 499

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’ (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.

13.3 Different classes of shares

Share capital forms part of the total equity of a company. Companies can have on issue various classes of shares. For example, many companies issue both ordinary shares and preference shares.

Ordinary shares An ordinary share represents a unit of ownership in a company, and these shares are generally transferable between parties without impacting the existence and operation of the company. The holders of ordinary shares are typically entitled to one vote per share (on various matters, such as the appointment of directors), except in certain circumstances, such as when the company is in financial distress. The extent to which ordinary shareholders can influence a company through their voting will depend on the ownership percentage that they have in the company.

An ordinary share also provides the shareholder with the right to receive a share of the company’s profits by way of dividends. However, these dividends will typically be received only if a company is earning profits, and if the directors have decided to declare dividends. That is, dividends in any accounting period are not assured. Failure to receive dividends in one year does not mean that a right to dividends will accrue until dividends are ultimately paid.

If a company is liquidated, ordinary shareholders rank last after creditors and preference shareholders in terms of receiving amounts from the liquidation of the company. Should a company collapse, ordinary shareholders have no obligations to make further payments other than perhaps in respect of unpaid amounts on their shares.

The total amount attributed to ordinary share capital might be composed of shares that were issued 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.

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.

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).

LO 13.3

ordinary shares A class of shares that typically ranks last in terms of any distribution of capital. Holders have voting rights, and will receive dividends at the discretion of the directors.

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.

dee67382_ch13_495-526.indd 500 10/24/19 03:18 PM

500 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 132)

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. (AASB 132)

13.4 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 for a new issue of shares. A company may elect to issue its shares at any price. However, the issue price of a company’s shares will depend on market demand.

Worked Example 13.1 considers the determination of share capital.

LO 13.4

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.

WORKED EXAMPLE 13.1: Determination of share capital

Coolum Ltd commenced its life by issuing 1 million ordinary shares at an issue price of $1.40 per share. Two years later it issued a further 500 000 ordinary shares at $2.00 each. Hence, Coolum Ltd received $2.4 million in total.

dee67382_ch13_495-526.indd 501 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 501

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 2023. Peregian Ltd subsequently issues 5 million shares on 1 August 2023. 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 2023

Dr Bank trust 10 500 000

Cr Application 10 500 000

(to recognise the aggregated receipt of application monies during July 2023)

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:

(1) 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.

(2) If the application money needs to be returned to an applicant, the person must return the money as soon as practicable.

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 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

REQUIRED Prepare the equity section of the statement of financial position immediately after the second issue of the shares. At that time the retained earnings was $600 000.

SOLUTION Following the issue, the shareholders’ equity section of the statement of financial position would be represented as:

Shareholders’ equity

Retained earnings  $ 600 000

Share capital: 1 500 000 ordinary shares $2 400 000

Total shareholders’ equity $3 000 000

continued

dee67382_ch13_495-526.indd 502 10/24/19 03:18 PM

502 PART 4: Accounting for liabilities and owners’ equity

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.

Returning to our example, to issue shares on 1 August 2023 the entry would be:

1 August 2023

Dr Application 10 500 000

Cr Share capital 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 2023

Dr Cash at bank 10 500 000

Cr Bank trust 10 500 000

(to recognise the transfer of cash from the trust account to the operating cash account following the issuance of shares)

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.

WORKED EXAMPLE 13.3: Issue of partly paid shares

Yeates Ltd commenced operations on 1 July 2023 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 2023 and a further $0.15 payable on 1 December 2023.

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, the future economic benefit can be faithfully represented (that is, there is minimal ‘measurement uncertainty’).

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 13.2 continued

dee67382_ch13_495-526.indd 503 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 503

REQUIRED Prepare the journal entries in the books of Yeates Ltd to account for the issue of the shares.

SOLUTION

1 July 2023

Dr Cash 15 000 000

Cr Share capital 15 000 000

(issuing of partly paid shares for cash)

1 July 2023

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 2023

Dr Cash 5 250 000

Cr First call 5 250 000

(receipt of cash for first call of $0.35 per share)

1 December 2023

Dr Cash 2 250 000

Cr Second call 2 250 000

(receipt of cash for second call of $0.15 per share)

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 AASB 13 Fair Value Measurement (paragraph 9) 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.

dee67382_ch13_495-526.indd 504 10/24/19 03:18 PM

504 PART 4: Accounting for liabilities and owners’ equity

WORKED EXAMPLE 13.4: Issue of shares other than for cash

On 1 December 2022, 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.

By 30 June 2023, 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 2023.

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 2022

Dr Cash 900 000

Dr Future consulting services receivable 850 000

Cr Share capital 1 750 000

(issuing of shares in exchange for cash and for future services)

30 June 2023

Dr Consulting fees expense (statement of profit or loss and other comprehensive income)

400 000

Cr Future consulting services receivable 400 000

(recording the portion of services received)

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.

WORKED EXAMPLE 13.5: Oversubscription for shares issued as partly paid

In July 2023, 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 2023. 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 2023.

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 2023

Dr Bank trust 6 000 000

Cr Application 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)

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.

dee67382_ch13_495-526.indd 505 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 505

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 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 2023

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

(to offset the balance of the application account [a liability] against the amount due on allotment of the shares)

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

(to transfer the cash in the trust account to the organisation’s operating account)

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 2023

Dr Cash at bank 3 000 000

Cr Allotment 3 000 000

(to recognise the receipt of amounts due on allotment)

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

continued

dee67382_ch13_495-526.indd 506 10/24/19 03:18 PM

506 PART 4: Accounting for liabilities and owners’ equity

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 equity to the extent that the costs are incremental costs and directly attributable to the equity transaction that otherwise would have been avoided. 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.

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 2023

Dr Cash at bank 3 000 000

Cr Call (to recognise the amount of cash received in relation to the call of $0.30 per share)

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.

WORKED EXAMPLE 13.6: Accounting for share issue costs

On 1 July 2023, 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

21 300

REQUIRED Prepare the journal entries necessary to account for the issue of the shares.

SOLUTION

Journal entries

1 July 2023

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)

WORKED EXAMPLE 13.5 continued

dee67382_ch13_495-526.indd 507 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 507

13.5 Forfeited shares

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 a member of the company. The shareholder may be entitled to a full or partial refund of the monies paid before the forfeiture of the shares. There are various possible outcomes:

∙ 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, the 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/equity 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 Share capital 200 000

Cr Call (a receivable) 100 000

Cr Forfeited shares account 100 000

(to reduce share capital, to eliminate the balance of the call account, and to create a forfeited shares account)

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.

Dr Cash at bank 2 500 000

Cr Bank trust 2 500 000

(to transfer cash to the organisation’s working bank account)

Dr Share capital 15 980

Dr Administration overheads (statement of comprehensive income) 5 320

Cr Cash 21 300

(allocating costs associated with the share issue)

The administration costs and costs associated with negotiating sources of finance are not deducted from the proceeds of the share issue. This is consistent with paragraph 37 of AASB 132.

LO 13.5

forfeited shares account An account reflecting the amounts paid by investors for partly paid shares and where those shares have been cancelled owing to the failure of investors to pay all amounts due.

forfeited shares reserve A reserve for non- refundable amounts paid by defaulting shareholders, shown as part of the shareholders’ funds of the company.

dee67382_ch13_495-526.indd 508 10/24/19 03:18 PM

508 PART 4: Accounting for liabilities and owners’ equity

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 $2500. The accounting entries would be:

Dr Cash at bank 160 000

Dr Forfeited shares account 40 000

Cr Share capital 200 000 (to recognise the cash received from the reissue of shares—an amount is transferred from the forfeited shares account to cover the shortfall between the original issue price and the subsequent issue price)

Dr Forfeited shares account 2500

Cr Cash at bank 2500 (to apply the funds in the forfeited shares account to pay for the reissue costs)

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 Forfeited shares account 57 500

Cr Cash at bank 57 500 (the balance remaining in the forfeited shares account is returned to the original shareholders)

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 the shareholders’ funds. Another illustration of share forfeiture is considered in Worked Example 13.7.

WORKED EXAMPLE 13.7: Forfeiture of shares

Torquay Ltd is listed on the Australian Securities Exchange. It makes a public offer of shares. On 1 July it receives $500 000 from people wanting to acquire shares. On 14 July 2023 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 2023, 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 2023 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 of 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 2023

Dr Bank Trust 500 000

Cr Application 500 000

(to record the receipt of cash and recognise an application account, which is a liability)

dee67382_ch13_495-526.indd 509 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 509

14 July 2023

Dr Application 500 000

Dr Call 500 000

Cr Share capital 1 000 000

(to record the issue of a call of $0.50 per share on 1 million shares, which is a receivable, and transfer the application to share capital)

Dr Cash at bank 500 000

Cr Cash trust 500 000

(to transfer the cash to the organisation’s operating cash account)

1 December 2023

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 100 000

Cr Call 50 000

Cr Forfeited shares account 50 000

(to record the forfeiture of 100 000 shares)

14 December 2023

Dr Cash at bank 70 000

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, which is calculated as the amount originally paid on the forfeited shares [$50 000] less the shortfall on the subsequent sale of the shares [$100 000 – $70 000 = $30 000], less the costs incurred to reissue the shares [$500])

Before concluding this section on forfeited shares we will consider one more comprehensive example relating to the issue of shares in Worked Example 13.8.

WORKED EXAMPLE 13.8: Issue of shares including the subsequent forfeiture of shares

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 2023.

continued

dee67382_ch13_495-526.indd 510 10/24/19 03:18 PM

510 PART 4: Accounting for liabilities and owners’ equity

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 2023, with the amounts being due by 31 December 2023. Holders of two million shares fail to pay the amount due on the call by the due date, and on 15 January 2024 these holders have their shares forfeited. The forfeited shares are auctioned on 15 February 2024. An amount of $0.70 per share is received. The cost of holding the auction is $5000. The shares are sold as ‘fully paid’.

REQUIRED Provide the accounting journal entries necessary to account for the above transactions and events.

SOLUTION The accounting entries to record the above transactions and events are as follows:

31 August 2023

Dr Cash trust 5 600 000

Cr Application 5 600 000

(to recognise the total amounts received on application for shares)

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 that will be due for an amount of $0.20 per share payable on 30 November 2023)

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 5 600 000

(to transfer the funds into the company’s operating account)

30 September 2023

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)

31 December 2023

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)

WORKED EXAMPLE 13.8 continued

dee67382_ch13_495-526.indd 511 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 511

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.

13.6 Rights issues and share options

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, while others may 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.

15 January 2024

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 2024

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 5000

Cr Cash at bank 5000

(to recognise the cost of the auction)

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)

LO 13.6

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 2023, 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 2023. In total, 10 million shares were on offer through the rights issue (meaning total subscriptions of $22 million).

By 1 September 2023, applications had been received for nine million shares, meaning that the underwriter was responsible for acquiring the remaining one million shares. The shares were issued on 7 September 2023, with this also being the date on which amounts due from the underwriter were received.

continued

dee67382_ch13_495-526.indd 512 10/24/19 03:18 PM

512 PART 4: Accounting for liabilities and owners’ equity

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 2023

Dr Bank trust 19 800 000

Cr Application 19 800 000

(to recognise the receipt of funds from share subscribers)

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

(to recognise the amount due from the underwriter for the undersubscribed shares)

7 September 2023

Dr Application 22 000 000

Cr Share capital 22 000 000

(to recognise the issue of shares and to close off the application account)

Dr Cash at bank 22 000 000

Cr Receivable—underwriter 2 200 000

Cr Bank trust 19 800 000

(to recognise the receipt of cash from the underwriter and the transfer of funds to the bank account from the bank trust)

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.

Share options 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 offered 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 they expire. Rights issues, by contrast, typically have quite short lives.

Once share options are issued, the actual options may or may not be exercised in the future. They will be exercised to the extent that 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 has been a particularly controversial topic—especially the aspect of placing a cost on share options 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 offered 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 2023 Caloundra Ltd provided a total of five 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 $5.00 each.

WORKED EXAMPLE 13.9 continued

dee67382_ch13_495-526.indd 513 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 513

The executives are not permitted to exercise the options before 30 June 2025, but they may then exercise them at any time between 1 July 2025 and 30 June 2026. The market price of the Caloundra Ltd shares on 1 July 2023 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 2025 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 2023

Dr Salaries expense 2 500 000

Cr Share options (part of share capital) 2 500 000

(to recognise the salaries expense paid by way of share options)

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 $5.00 throughout the period in which the right to exercise has vested—AASB 2 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. (AASB 2)

However, in this example the options are in fact exercised by the managers, which leads to the following entries:

31 December 2025

Dr Cash at bank 25 000 000

Cr Share capital 25 000 000

(to recognise the receipt of cash in relation to the share options)

Dr Share options 2 500 000

Cr Share capital 2 500 000

(to transfer the balance in share options to share capital)

As we can see from the above entry, the amount attributed to the options at the date of their issue (their fair value at the time) 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’.

13.7 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 the lower-priced shares will make the securities more marketable—but there is limited empirical research to support such a view.

LO 13.7

share split The subdivision of the company’s shares into shares of a smaller face value, resulting in no change to owners’ equity.

dee67382_ch13_495-526.indd 514 10/24/19 03:18 PM

514 PART 4: Accounting for liabilities and owners’ equity

When a share split occurs, there is no change to owners’ equity. The balance of the share capital remains the same. A share split does not require any accounting journal entries, but it does require the company to amend its share registers, which in itself will create some costs.

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 one 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 two 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’.

Companies can also issue bonus shares. When a bonus issue is made, existing shareholders 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 one 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 Retained earnings 1 000 000

Cr Share capital—ordinary shares (to recognise a bonus issue of shares funded from retained earnings)

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. Although shareholders typically feel as though they have gained from a bonus issue, what must be remembered is that their proportional share in the net assets of the business does not change. For example, if the company referred to above has total assets of $100 million, and liabilities of $23 million, the net asset backing per share would be $7.70 per share before the ‘one-for-ten’ bonus issue. This is calculated by dividing the net assets of the company by the number of shares on issue ($77 000 000 ÷ 10 000 000). Therefore, an individual holding of 10 000 shares 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 one 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, there is some evidence to suggest that the total market capitalisation of a company after a bonus issue tends, on average, to be greater than it was before the bonus issue. (The market capitalisation of a company is calculated by multiplying the number of shares on issue by their market price.) In part, this might be due to a signalling effect. Evidence, such as that provided in Ball, Brown and Finn (1977), suggests that the majority of share splits and bonus issues

are accompanied by increases 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.

A recent share split involved the mining company known as Galena Mining. In 2018 its share price had increased significantly. Some commentators in the news media noted that the high share price might have been a disincentive for some investors. Perhaps with this in mind, the company took the step of offering a one-for-five share split, which meant that the number of shares on issue rose from about 55.6 million to about 278 million. While the total resources of the company did not increase as a result of the share split (indeed, they would have decreased because of the costs associated with administering the share split, which for some companies can be as much as $1 million), the total market capitalisation following the share split rose.

13.8 Accounting for distributions

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

bonus shares Shares received from a bonus issue.

bonus share dividend A distribution to existing shareholders in the form of additional shares in the entity, normally on a pro rata basis and typically funded from retained earnings.

total market capitalisation Calculated by multiplying the number of issued shares in a company by their latest market price.

LO 13.8

dee67382_ch13_495-526.indd 515 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 515

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. Specifically, Section 254T of the Corporations Act requires:

(1) A company must not pay a dividend unless: (a) the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is

sufficient for the payment of the dividend; and (b) the payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and (c) the payment of the dividend does not materially prejudice the company’s ability to pay its creditors.

Note 1: As an example, the payment of a dividend would materially prejudice the company’s ability to pay its creditors if the company would become insolvent as a result of the payment.

Note 2: For a director’s duty to prevent insolvent trading on payment of dividends, see section 588G.

(2) Assets and liabilities are to be calculated for the purposes of this section in accordance with accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned).

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 Dividends paid XXX

Cr Cash (to recognise the payment of dividends)

XXX

At the end of the reporting period, the dividends paid will be closed off to equity.

Dr Retained earnings XXX

Cr Dividends paid (to offset the closing balance of ‘dividends paid’ against retained earnings)

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 Interim dividends XXX

Cr Cash (to recognise the payment of interim dividends)

XXX

dividend A distribution of the profits of an entity to the owners of that entity, typically in the form of cash.

dee67382_ch13_495-526.indd 516 10/24/19 03:18 PM

516 PART 4: Accounting for liabilities and owners’ equity

At the financial year end, the appropriation of interim dividends is closed to retained earnings.

Dr Retained earnings XXX

Cr Interim dividends (to offset the closing balance of ‘interim dividends’ against retained earnings)

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. 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 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 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 [see also IAS 1]. (AASB 110)

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 Final dividend declared XXX

Cr Dividend payable (to recognise the declaration of final dividends)

XXX

Dr Retained earnings XXX

Cr Final dividend declared (to offset the closing balance of ‘final dividends’ against retained earnings)

XXX

When the dividends are ultimately paid, the entries would be of the form:

Dr Dividend payable XXX

Cr Cash (to recognise the payment of the final dividend)

XXX

Dividends reinvestment plans Another way in which organisations might pay dividends is through a dividend reinvestment plan. Many organisations provide shareholders with a choice between receiving dividends in the form of cash (which we have just discussed) or receiving them in the form of shares in the organisation. These shares might be new shares to be issued by the organisation, or they might be existing shares that are acquired from the share market. If they are new shares, then this will tend to dilute the proportional ownership interest of those shareholders who do not participate in the dividend reinvestment plan. If they are existing shares, then the proportional interest of non-participating shareholders will not be diluted.

Exhibit 13.3 provides insight into the Commonwealth Bank of Australia’s ordinary share capital as reported in its 2019 Annual Report, and it shows that the bank does utilise a dividend reinvestment plan. Worked Example 13.11 provides an illustration of how to account for a divided reinvestment plan.

dee67382_ch13_495-526.indd 517 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 517

WORKED EXAMPLE 13.11: Accounting for a dividend reinvestment plan

For its interim dividend, Snapper Rocks Ltd offers ordinary shareholders choice between receiving cash dividends or participating in a dividend reinvestment plan. During the financial period, the company distributed $10 million in cash dividends, and $2 million by way of new shares issued by the company.

REQUIRED Provide the journal entries to account for the dividends.

SOLUTION When the directors pay an interim dividend, an appropriation is recorded in the records of the company.

Dr Interim dividends 12 000 000

Cr Cash 10 000 000

Cr Share capital (to recognise the interim dividends)

2 000 000

At the financial year end, the appropriation of interim dividends is closed to retained earnings.

Dr Retained earnings 12 000 000

Cr Interim dividends (to offset the interim dividends against retained earnings)

12 000 000

WHY DO I NEED TO KNOW ABOUT THE REQUIREMENTS RELATING TO ACCOUNTING FOR DISTRIBUTIONS?

Ultimately, returns to investors from investing in share capital (equity securities) generally come from two sources, these being through raising share prices (capital gains) and through distributions (dividends). Shareholders can also receive cash as a result of a share buyback, and may also receive bonus shares, share options or further shares as a result of ‘share splits’.

Exhibit 13.3 Disclosure pertaining to a dividend reinvestment plan

SOURCE: CBA Commonwealth Bank of Australia

continued

dee67382_ch13_495-526.indd 518 10/24/19 03:18 PM

518 PART 4: Accounting for liabilities and owners’ equity

13.9 ‘Buyback’ of ordinary shares, and redemption of preference shares

Companies will, from time to time, distribute funds to shareholders in ways that are not of the nature of periodic dividend payments. For example, a company might decide to pay cash to shareholders in exchange for those

shareholders selling some of their shares back to the company. We call these ‘share buybacks’ and we will consider them below. Further, if a company issues preference shares, it might have an obligation, or a right, to buy back those shares. Such shares would have been issued with this right or obligation. We typically refer to this as a redemption of preference shares (and to the shares as ‘redeemable preference shares’), and we will also discuss these below.

‘Buyback’ of ordinary shares ‘Share buybacks’ occur when a company buys back some of the ordinary shares held by existing shareholders. There are various reasons why a company might do so. Share buybacks can occur when the directors of a company believe they have surplus cash (and perhaps minimal investment opportunities) and see a share buyback as one way of distributing cash to all of the shareholders. If all of the shareholders accept a share buyback, then effectively their proportional interest in the company will not change. In some countries, favourable taxation treatment is given to those parties who receive cash from a share buyback, and this can be an incentive for an organisation to undertake such activity.

In Australia in 2019, Woolworths undertook a major share buyback of $1.7 billion, which was largely funded from the sale of its petrol station network. Another recent share buyback in 2019 was a $305 million share buyback by Qantas.

Interestingly, following a share buyback, the market price of the remaining shares often climbs. Linked to this, share buybacks are often contemplated because they typically create positive consequences for earnings per share—a performance indicator that attracts a lot of attention (we consider how to calculate earnings per share in Chapter 24). In this regard, in a newspaper article entitled ‘Domino’s set to buy back its own slices’ (Courier Mail, 22 December 2018, p. 55), the management of the company noted that a share buyback would have a positive consequence as the buyback was expected to boost earnings per share.

While share buybacks are permitted in many countries, there is typically a good deal of legislation that must be followed. In large part, this legislation is intended to protect the interests of creditors given that share buybacks use cash that might otherwise have been used to pay the amounts due by the company. Corporations law requirements in Australia also require the company to cancel any shares that have been bought back.

Paragraph 33 of AASB 132 requires that when a share buyback occurs those shares shall be deducted from equity. Paragraph 33 also requires that ‘no gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments’.

The typical accounting entry to account for a share buyback is:

Dr Share capital XX

Cr Cash at bank (to recognise a share buyback)

XX

Redemption of preference shares The Corporations Act imposes a number of requirements (in ss. 254J and 254K) in relation to the redemption of preference shares. As shown in Worked Example 13.12, where a company redeems (buys back) 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.

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:

LO 13.9

Certain accounts within equity can be used for various forms of distributions, whereas others cannot be used. Therefore, in order to understand the potential for future distributions, it is important to know the balances in various equity accounts, as well as understand how those accounts can be applied to various activities. For example, cash dividends would generally not be paid unless there are sufficient retained earnings and as long as other conditions are satisfied (as we described earlier).

dee67382_ch13_495-526.indd 519 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 519

Paragraph 99: Redeemable preference shares would normally be classified as a liability in accordance with accounting standard AASB 132 Financial Instruments: Presentation [see also IAS 32]. 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 X Cr Share capital (equity/liability)

(the issue of shares) X

Dr Share capital—redeemable preference shares (liability) X Cr Cash

(the redemption of the preference shares) 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. 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 X Cr Share capital (equity)

(to transfer retained earnings to share capital) X

Dr Share capital—redeemable preference shares (liability) X Cr Cash

(to redeem the preference shares) X

© Australian Securities & Investments Commission. Reproduced with permission

WORKED EXAMPLE 13.12: Redemption of preference shares

On 1 July 2023 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 2026. On 30 June 2026 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:

1 July 2023

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 2026

Dr Share capital—preference shares 30 000 000

Cr Capital redemption reserve 30 000 000

(to transfer the balance of the preference shares to capital redemption reserve)

continued

dee67382_ch13_495-526.indd 520 10/24/19 03:18 PM

520 PART 4: Accounting for liabilities and owners’ equity

13.10 Required disclosures for share capital and reserves

AASB 101 requires a number of disclosures to be made in relation to share capital and reserves. 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. (AASB 101)

Exhibit 13.4 provides an example of a disclosure note relating to share capital. It comes from the 2019 Annual Report of BHP. In terms of the description of equity (part (b) above), refer to Exhibit 13.2 for an example of the required note disclosure.

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 Retained earnings 30 000 000

Cr Cash 30 000 000

(to reduce both cash and retained earnings)

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 68 ‘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 Capital redemption reserve 30 000 000

Cr Share capital 30 000 000

(to increase share capital by the balance of the capital redemption reserve)

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.

LO 13.10

WORKED EXAMPLE 13.12 continued

dee67382_ch13_495-526.indd 521 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 521

Exhibit 13.4 Example of a disclosure note pertaining to share capital—from the 2019 Annual Report of BHP 

SOURCE: BHP Group Ltd

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.

dee67382_ch13_495-526.indd 522 10/24/19 03:18 PM

522 PART 4: Accounting for liabilities and owners’ equity

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, bonus issues, share buybacks and the redemption of preference shares 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 514 bonus shares 514 dividend 515 equity 496 forfeited shares account 507

forfeited shares reserve 507 general reserve 498 ordinary shares 499 par value 500 preference shares 499

share capital 500 share premium 500 share split 513 shareholders’ funds 496 total market capitalisation 514

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is an ‘ordinary share’, what characteristics do ordinary shares have, and where are ordinary shares disclosed? LO 13.1, 13.2, 13.10 An ordinary share represents a unit of ownership in a company, and these shares are generally transferable between parties without impacting the existence and operation of the company. The holders of ordinary shares are typically entitled to one vote per share (on various matters, such as the appointment of directors). The extent to which ordinary shareholders can influence a company through their voting will depend on the ownership percentage they have in the company. An ordinary share also provides the shareholder with the right to receive a share of the company’s profits by way of dividends. However, these dividends will typically be received only if a company is earning profits, and if the directors have decided to declare dividends. That is, dividends in any accounting period are not assured. If a company is liquidated, the holders of ordinary shares rank last after creditors and preference shareholders in receiving amounts from the liquidation of a company. Should a company collapse, ordinary shareholders have no obligations to make further payments other than perhaps in respect of the unpaid amounts on their shares. Ordinary shares will be disclosed in the balance sheet as part of equity, and various details about them will be disclosed within the notes to the financial statements.

2. What is a ‘preference share’? LO 13.1, 13.3 A preference share is another form of share capital. It provides the shareholder with ‘preferred treatment’ relative to the ordinary shareholders. For example, a preference shareholder might be entitled to fixed dividend payments (regardless of an organisation’s profitability) and those dividends might be received before the ordinary shareholders are entitled to any dividends. Preference shareholders might also be provided with priority over ordinary shareholders in terms of being repaid if the company becomes insolvent. Preference shares might also be redeemable.

3. Should preference shares be disclosed as ‘equity’ or as ‘debt’? LO 13.3 Some preference shares can take on the characteristics of equity, while others can take on the characteristics of debt. Where preference shares have the characteristics of debt, they must be disclosed as debt, and the related payments are to be considered as expenses rather than as a distribution of profits (that is, as an interest expense rather than as dividends). Normally, preference shares that are redeemable on a fixed date, or at the option of the shareholder, and which 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.

4. If ordinary shares are issued to the public (by a public company), can the issuing company use the cash received from the issue as soon as the cash is received? LO 13.2, 13.4 No. Until such time as the shares are actually issued to the subscribers, the cash must remain within a cash trust.

dee67382_ch13_495-526.indd 523 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 523

5. What is a ‘share split’, and what accounting journal entries are required when an organisation performs a share split? LO 13.7 A share split involves the subdivision of the company’s shares into more shares of a smaller value. When a share split occurs, there is no change to owners’ equity. The balance of the share capital remains the same. A share split does not require any accounting journal entries, but it does require the company to amend its share registers, which in itself will create some costs.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. In a company, what different accounts might we expect to find within ‘equity’? LO 13.1 • 2. Do we need to have specific recognition criteria for equity? LO 13.1 • 3. What are ‘share splits’ and what accounting entries are necessary when a share split is undertaken? LO 13.7 • 4. If a ‘general reserve’ is created, what would be the typical journal entries used? LO 13.2 • 5. Point Impossible Ltd has a dividend reinvestment plan in which it provides participating shareholders with dividends

amounting to $1 200 000. The shares are new shares issued by the company. What would the journal entry be? LO 13.8 •

6. Breamlea Ltd has a dividend reinvestment plan in which it provides participating shareholders with dividends amounting to $1 800 000. The shares are existing shares, which will be acquired from the capital market. What would the journal entry be? LO 13.8 •

7. What journal entries would be required to recognise an interim dividend? LO 13.8 • 8. Would you expect the total market capitalisation of an entity to increase following a share split? LO 13.7 • 9. What is a share buyback, and what would be the typical journal entries a company would use to recognise a share

buyback? LO 13.9 • 10. If the balance sheet shows that there is a large balance within retained earnings, then that company will have the

necessary resources to pay dividends to ordinary shareholders. Is this correct? LO 13.8 •• 11. 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 13.4 • 12. 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 13.7 • 13. 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 13.4 •• 14. Explain why equity is affected by the choice of particular asset and liability measurement practices. LO 13.1 •• 15. How do Australian Accounting Standards require preference shares to be disclosed? LO 13.3, 13.10 • 16. 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 13.3 ••

17. What forms of preferential treatment can the holders of preference shares receive over and above the rights of holders of ordinary shares? LO 13.3 ••

18. Are preference shares debt or equity? LO 13.3 • 19. What disclosures are required in relation to the reserves of a company? LO 13.10 • 20. What is the role of the statement of changes in equity? LO 13.10 • 21. 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 2023 and the shares are allotted on 4 August 2023. The share issue is made as a result of an offer being made to the public.

dee67382_ch13_495-526.indd 524 10/24/19 03:18 PM

524 PART 4: Accounting for liabilities and owners’ equity

REQUIRED Provide the journal entries to account for the receipt of the application monies and the subsequent allotment of the shares. LO 13.4 •

22. On 1 July 2022, 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 2023, 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 13.4 •• 23. On 1 July 2023, Coastalwatch Ltd issued 5 million shares at $5.00 each. All of the shares were subscribed for.

Coastalwatch Ltd incurred the following costs that were associated with the share issue:

$

Advertising of share issue and prospectus 10 000

Accounting fees associated with drafting of prospectus 4000

Legal expenses associated with share issue 5000

REQUIRED Prepare the journal entries necessary to account for the issue of the shares. LO 13.4 •• 24. On 1 July 2023 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 2025 but may then exercise them at any time between 1 July 2025 and 30 June 2026. The market price of the Cooloola Ltd shares on 1 July 2023 was $6.50. On 31 December 2025 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 13.6 ••

CHALLENGING QUESTIONS

25. 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 2023, with $1.00 being paid on application and a further $1.00 being payable within one month of allotment. By 15 July 2023 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 2023. Subsequently, holders of 1 million shares fail to make their payments due on allotment by 20 August 2023. 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 13.4, 13.5

26. Byron Ltd required additional equity funding and decided to issue a renounceable rights offer. To reduce the 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 2023 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 2023. The total shares on offer through the rights issue were 15 million. By 10 September 2023 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 2023, 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, 13.6

dee67382_ch13_495-526.indd 525 10/24/19 03:18 PM

CHAPTER 13: Share capital and reserves 525

27. 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 13.8

28. Tamarama Ltd issues 1 million redeemable preference shares of $2.00 each on 1 July 2023. 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 2025.

REQUIRED

(a) Would you classify these preference shares as debt or equity? Why? (b) Provide the journal entries necessary to record the issue and subsequent redemption of the shares. LO 13.3,

13.9

29. 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 2023. The directors allot 10 million shares on 5 August 2023. All applicants receive shares on a pro rata basis. The amounts payable on allotment are due by 5 September 2023. By 5 September 2023 the holders of 2 million shares have failed to pay the amounts due on allotment. The directors forfeit the shares on 10 September 2023. The shares are resold on 15 September 2023 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,

13.5

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May.

Ball, R., Brown, P. & Finn, F., 1977, ‘Share Capitalisation Changes, Information and the Australian Equity Market’, Australian Journal of Management, October, pp. 105–25.

dee67382_ch13_495-526.indd 526 10/24/19 03:18 PM

dee67382_ch14_527-598.indd 527 10/24/19 03:30 PM

527

LEARNING OBJECTIVES (LO) 14.1 Understand what a financial instrument is, and know when a financial instrument shall be

recognised. 14.2 Know what constitutes a financial asset, a financial liability and an equity instrument, and understand

the difference between a primary financial instrument and a derivative financial instrument. 14.3 Understand the factors that determine whether a financial instrument shall be presented as debt, or as

equity, in the financial statements of the issuing entity. 14.4 Understand what a ‘set-off’ represents, when one is permitted, and what benefits using a ‘set-off’

generates. 14.5 Understand how to measure financial assets on initial acquisition. 14.6 Understand the measurement rules to apply to financial assets subsequent to initial recognition. 14.7 Understand how to measure financial liabilities on initial acquisition. 14.8 Understand the measurement rules to apply to financial liabilities subsequent to initial recognition. 14.9 Understand the purpose of derivatives, and be able to explain their use with ‘hedging arrangements’. 14.10 Understand how to account for derivatives, as well as the other 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 what ‘options’ represent, and how to account for them. 14.13 Understand the meaning of a ‘foreign currency swap’ and an ‘interest rate swap’, and know how to

account for them. 14.14 Understand what a ‘compound financial instrument’ is and how the debt and equity components of a

compound financial instrument are to be determined. 14.15 Have a general understanding of the disclosure requirements embodied in AASB 7 Financial

Instruments: Disclosures.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

C H A P T E R 14 Accounting for financial instruments

dee67382_ch14_527-598.indd 528 10/24/19 03:30 PM

528 PART 4: Accounting for liabilities and owners’ equity

LO 14.1 14.1 Introduction to accounting for financial instruments

Financial instruments are held by all organisations. The financial instruments used within some organisations might be simple in nature (such as cash, accounts payable and accounts receivable), whereas in other

organisations they might be more complex in nature (for example, the organisation might use forward rate contracts, interest rate swaps or share options).

The nature and use of financial instruments is a key aspect associated with an organisation remaining as a going concern, given the relationship of financial instruments with future cash flows and the need for organisations to carefully manage their cash flows. Some financial instruments will have implications for cash flows in the short run, while others might have longer-term implications for cash flows. A review of the financial instruments existing within an organisation also provides insights into the ‘risk-taking’ attributes of managers, as some financial instruments are held either for speculative purposes, or for risk-reduction purposes.

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 three phases. These phases as applied to financial instruments were:

∙ Phase 1: Classification and measurement; ∙ Phase 2: Impairment methodology; and ∙ Phase 3: Hedge accounting.

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1. What is a ‘financial instrument’? LO 14.1 2. At the time of initial recognition, on what basis shall financial instruments be measured? LO 14.5, 14.7 3. If equity investments have been made in another entity (for example, shares have been acquired), and the

investments were made for trading purposes, how shall any gain or loss on the investments be treated? LO 14.5, 14.6

4. Which financial assets shall be measured at amortised cost? LO 14.5, 14.6 5. What is a ‘hedging arrangement’ and why might an organisation enter a hedging arrangement? LO 14.9 6. What is a ‘compound financial instrument’, and how is the debt component of a compound financial instrument

determined? LO 14.14

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

7 Financial Instruments: Disclosures IFRS 7

9 Financial Instruments IFRS 9

13 Fair Value Measurement IFRS 13

116 Property, Plant and Equipment IAS 16

121 The Effects of Changes in Foreign Exchange Rates IAS 21

123 Borrowing Costs IAS 23

132 Financial Instruments: Presentation IAS 32

139 Financial Instruments: Recognition and Measurement IAS 39

dee67382_ch14_527-598.indd 529 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 529

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 (24 July 2014) entitled IASB completes reform of financial instruments accounting, which in part said:

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.

Apart from AASB 9 Financial Instruments, another relevant accounting standard when discussing financial instruments is AASB 132 Financial Instruments: Presentation. AASB 132 acts as a companion to AASB 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. (AASB 132)

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. (AASB 7)

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 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, this being:

any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. (AASB 132)

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.

dee67382_ch14_527-598.indd 530 10/24/19 03:30 PM

530 PART 4: Accounting for liabilities and owners’ equity

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 an organisation, or hold a debt instrument that provides evidence of a claim against an organisation 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.

14.2 The definitions of financial assets, financial liabilities and equity instruments, and the difference between primary financial instruments and derivative financial instruments 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. (AASB 132)

‘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

LO 14.2

equity instrument Financial instrument that provides the holder with a residual interest in an entity after deduction of its liabilities.

dee67382_ch14_527-598.indd 531 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 531

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. (AASB 132)

‘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.

The above definitions also make reference to derivatives (also termed derivative financial instruments). Derivatives, such as share options, forward rate contracts, 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. (AASB 132)

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 ‘potentially favourable’ and ‘potentially 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 2023 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 (a third organisation) 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 2023.

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 point to be made here is that the future gain in value does not have to be certain or probable—but there has to be ‘potential’ for a gain to arise. The worst-case scenario for Buyer Ltd

continued

dee67382_ch14_527-598.indd 532 10/24/19 03:30 PM

532 PART 4: Accounting for liabilities and owners’ equity

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 expense 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 then 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. However, should the option lapse because the share price of Bells Ltd did not rise to at least $5.00 (thereby meaning that Buyer Ltd would not exercise the option), Seller Ltd would remove the liability and would then recognise the $1000 previously received as income. Again, it is the ‘potential’ to make a loss that is relevant when determining whether the arrangement creates a financial liability.

WORKED EXAMPLE 14.1 continued

Consistent with what is indicated within the solution to Worked Example 14.1, 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. (AASB 132)

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. (AASB 132)

dee67382_ch14_527-598.indd 533 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 533

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.

The difference between primary financial instruments and derivative financial instruments 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 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.

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 2023 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 is 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 2023 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, say, A$1 = US$1.02. This agreement means that if the exchange rate changes, McCoy Ltd will nevertheless 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. It is a ‘derivative’ because the receivable from the bank ‘derives’ its value from the exchange rate between US dollars and Australian dollars. 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 to the bank. From the perspective of McCoy Ltd, foreign exchange 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.

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

dee67382_ch14_527-598.indd 534 10/24/19 03:30 PM

534 PART 4: Accounting for liabilities and owners’ equity

instruments) are likely to be developed and used 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. (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 $10.50 per share in three years’ time. The options cost Company E $1.00 each to buy and were acquired when the market price of Company F’s shares was $10.00. 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 $10.50— 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 investment in an equity instrument of Company D. Company D would recognise the issue of 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 $10.50 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 Company F at a favourable price should the share price of Company F rise above the exercise price of $10.50. We do not consider the probability of the shares rising above $10.50 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.

WORKED EXAMPLE 14.4: Determining whether a financial instrument is a debt or equity instrument

Peter Ltd enters a contract with Drouyn Ltd in which it agrees to loan Drouyn Ltd $500 000. Because Peter has positive expectations about the future success of Drouyn Ltd, the terms of the loan agreement are that Drouyn Ltd will settle the loan in three years by providing Peter Ltd with 100 000 shares (equity instruments) in Drouyn Ltd. These shares were trading at $5 each at the time of the agreement.

Worked Example 14.4 provides a further illustration requiring us to classify a financial instrument as debt or equity.

dee67382_ch14_527-598.indd 535 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 535

REQUIRED

1. Does the instrument created through this loan agreement constitute a ‘financial instrument’? 2. If it is a financial instrument, how should both organisations classify the financial instrument?

SOLUTION

1. Yes, it is a financial instrument. It creates a financial asset for Peter Ltd, and an equity instrument for Drouyn Ltd.

2. It is a financial asset from Peter Ltd’s perspective and it would be classified as an equity instrument from Drouyn Ltd’s perspective as a given amount of debt is being settled by the issue of a fixed number of equity instruments. It is Peter Ltd that will be exposed to risks associated with changes in the fair value of the equity instruments. That is, if the share price falls to $3, then effectively Peter will be receiving $300 000 rather than $500 000.

However, it needs to be appreciated that, as paragraph 21 of AASB 132 states:

A contract is not an equity instrument solely because it may result in the receipt or delivery of an entity’s own equity instruments. (AASB 132)

If, by contrast, Drouyn Ltd was required to provide Peter Ltd with $500 000 worth of shares on an agreed date, then on settlement and with a share price fall to $3, this would have required Drouyn Ltd to issue 166 667 shares to Peter Ltd. The variable nature of the settlement (in terms of the number of shares) would have meant that such an arrangement would have constituted a financial liability. This is consistent with paragraph 21 of AASB 132, which also states that:

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. (AASB 132)

Again, the point to be emphasised is that if an agreement requires one party to issue a variable number of equity instruments to another party, then the issuing party has a financial liability.

WHY DO I NEED TO KNOW HOW TO DIFFERENTIATE BETWEEN FINANCIAL ASSETS, FINANCIAL LIABILITIES AND EQUITY INSTRUMENTS, AND TO ALSO KNOW THE DIFFERENCE BETWEEN PRIMARY FINANCIAL INSTRUMENTS AND DERIVATIVE FINANCIAL INSTRUMENTS?

The balance sheets of many organisations report material amounts of financial assets, financial liabilities and equity instruments. As readers of financial statements, we need to have a clear understanding of what these classifications represent. Further, there are different accounting rules in terms of recognition and measurement for different types of financial instruments. Therefore, as both preparers and users of financial statements, we need to appreciate that different rules apply to different forms of financial instruments, again necessitating the need to be able to differentiate between different types of financial instruments. Also, how we classify a financial instrument can in turn influence reported profits. For example, if a financial instrument is considered to be an equity instrument, then the related payments would be dividends (that do not impact profits), whereas if it is classified as a financial liability, then the associated payments (other than the repayment of principal) would represent interest expenses (which decrease reported profits).

Financial instruments can be classified as primary financial instruments or derivative financial instruments. In certain circumstances, derivative financial instruments can expose an organisation to significant financial risk. Therefore, as users of financial statements, it is important that we can identify the derivatives issued or held by an organisation as they potentially signal that the organisation is at higher risk.

dee67382_ch14_527-598.indd 536 10/24/19 03:30 PM

536 PART 4: Accounting for liabilities and owners’ equity

14.3 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 of the organisation. 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 (paragraph 15 of AASB 132).

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 (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. (AASB 132)

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, and as previously indicated in Worked Example 14.4, if an entity uses a variable number of its own equity instruments as a means to settle the contract, the contract does not evidence a residual interest in the entity’s assets after deducting all of its liabilities, and would therefore be considered to be a financial liability.

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 (this paragraph refers to preference shares—we covered these in depth in Chapter 13):

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

LO 14.3

dee67382_ch14_527-598.indd 537 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 537

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 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 those 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. (AASB 132)

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. (AASB 132)

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).

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.

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

dee67382_ch14_527-598.indd 538 10/24/19 03:30 PM

538 PART 4: Accounting for liabilities and owners’ equity

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 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.

Worked Example 14.5 explores the implications that follow as a result of classifying a financial instrument as debt or equity.

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.

WORKED EXAMPLE 14.5: The implications of classifying a financial instrument as debt rather than equity

Outa Reef Ltd has issued some preference shares to Big Gun Ltd. The managers of Outa Reef Ltd are looking at the characteristics of the preference shares to determine if they should be classified as equity instruments or financial liabilities.

REQUIRED What are the financial report consequences of the decision to classify the financial instrument as debt or equity?

SOLUTION If these preference shares are classified as debt, then:

• The periodic payments pertaining to the financial instruments shall be treated as a borrowing cost (as interest expense) rather than as dividends. This will have a negative impact on reported profits.

• The reported debt will rise. If the organisation has negotiated various debt covenants as part of borrowing agreements, there is a potential that the classification of the financial instruments as debt may lead to a breach of such covenants.

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. (AASB 132)

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

dee67382_ch14_527-598.indd 539 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 539

to the shareholder or to take any other specific action. It would be equity. 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 (see Chapter 2), for a liability to be recognised there is a requirement within the Conceptual Framework that:

∙ the definition be satisfied (the definition of a liability being a present obligation of the entity to transfer an economic resource as a result of past events), and that

∙ the information about the liability is considered both relevant (which requires consideration of factors such as ‘existence uncertainty’ and assessments about the probabilities of an outflow of economic benefits) and ‘representationally faithful’ (which requires consideration of ‘measurement uncertainty’).

With regard to considerations relating to the perceived probability of future outflows of economic benefits, the greater the uncertainties in terms of predicting the likelihood of future cash flows occurring, the less relevant from the perspective of the Conceptual Framework would be the disclosure of information about a liability.

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.

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. Also, we need to remember that the requirements within accounting standards take precedence over the guidance provided within the Conceptual Framework.

Since we know that the debt and equity components must be recognised separately we need to determine the respective amounts to be recognised if a financial instrument has both debt and equity components. 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. (AASB 132)

dee67382_ch14_527-598.indd 540 10/24/19 03:30 PM

540 PART 4: Accounting for liabilities and owners’ equity

WHY DO I NEED TO CLEARLY KNOW THE DIFFERENCE BETWEEN DEBT AND EQUITY?

The classification of a transaction or event as debt or equity has various implications. If something is classified as debt, then the related payments will at least in part constitute interest expense, which reduces profit. Debt constitutes an obligation to make future payments, whereas equity does not. Therefore, greater levels of debt create risks for an entity that we need to be aware of. Preparers of financial statements need to know that the payments made with respect to any financial instruments that are classified as debt have to be treated as interest expense (apart from amounts pertaining to the repayment of principal).

Larger organisations will typically have various contractual arrangements in place with debtholders which have some negotiated accounting-based covenants that are directly influenced by the amount of debt on issue—for example, debt to asset or debt to equity constraints, or particular interest coverage clauses (which will be impacted by the recognition of interest expenses). Therefore, as users or preparers of financial statements, we need to understand how the recognition of debt influences such contractual arrangements.

14.4 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.

The requirements relating to the set-off of assets and liabilities are incorporated in AASB 132. 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 (paragraph 42 of AASB 132).

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.

LO 14.4

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 $22.00 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:

Dr Cash 22 000 000  

Cr Loan   18 000 000

Cr Share options issued (in equity) (to recognise the issue of convertible notes and the respective debt and equity components)

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.

dee67382_ch14_527-598.indd 541 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 541

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. (AASB 132)

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. (AASB 132)

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 14.6.

WORKED EXAMPLE 14.6: Setting off debt

Assume that Grommet Ltd has the following statement of financial position before set-off:

Grommet Ltd Statement of financial position at 30 June 2023

  $

Assets  

Property, plant and equipment (net) 400 000

Loans receivable    600 000

  1 000 000

Liabilities  

Loans payable 500 000

Net assets 500 000

Shareholders’ funds  

Share capital 400 000

Retained earnings 100 000

  500 000

continued

dee67382_ch14_527-598.indd 542 10/24/19 03:30 PM

542 PART 4: Accounting for liabilities and owners’ equity

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 2023

  $

Assets  

Property, plant and equipment (net) 400 000

Loans receivable 400 000

  800 000

Liabilities  

Loans payable 300 000

Net assets 500 000

Shareholders’ funds  

Share capital 400 000

Retained earnings  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 reported 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.

WORKED EXAMPLE 14.6 continued

Having discussed various definitional and presentation issues, we will now consider issues associated with the recognition and measurement of financial instruments.

14.5 Recognition and measurement of financial instruments on acquisition

As stated previously, AASB 9 is the accounting standard that addresses how financial instruments are to be recognised and measured. As we also know, financial instruments can be either:

∙ 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’.

LO 14.5

dee67382_ch14_527-598.indd 543 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 543

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 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. (AASB 9)

Given that the initial measurement of financial assets and financial liabilities is to be at fair value (plus or minus 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. (AASB 13)

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). (AASB 13)

‘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.

As a further issue to consider in relation to ‘fair value’, and as we discussed within Chapter 4, consideration also needs to be given to the three-level fair value hierarchy when determining the appropriate approach to determining fair value. As Chapter 4 explains, AASB 13 establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an asset or liability. As paragraph 72 states:

To increase consistency and comparability in fair value measurements and related disclosures, this Standard establishes a fair value hierarchy that categorises into three levels the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs). (AASB 13)

We will not cover the fair value hierarchy again here, but we do just need to remember its relevance when discussing fair values. Where possible, priority should be given to using Level 1 inputs when determining fair value.

While fair value is the required basis of measurement when a financial instrument is originally recognised, the following discussion explains how financial instruments are to be measured subsequent to (following) the initial recognition.

14.6 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.

LO 14.6

dee67382_ch14_527-598.indd 544 10/24/19 03:30 PM

544 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 9)

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 model 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 (such as an investment in a government bond or a corporate bond) 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-by-instrument 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. (AASB 9)

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

dee67382_ch14_527-598.indd 545 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 545

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 sale 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 (government bonds can fluctuate in value as they are typically tradeable on capital markets), 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 14.7 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 14.7: Determining the amortised cost of a financial asset

On 1 July 2022 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 principal of $1 million on 30 June 2026. At the time the market only required a rate of return on 8 per cent on such bonds. We will assume that the market’s required rate of

continued

dee67382_ch14_527-598.indd 546 10/24/19 03:30 PM

546 PART 4: Accounting for liabilities and owners’ equity

return on these financial instruments remains at 8 per cent throughout the life of the bonds. Jack Ltd operates within a business model where 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 bonds at amortised cost. (c) Calculate the amortised cost of the bonds as at 30 June 2023, 2024, 2025 and 2026. (d) Provide the accounting journal entries for the years ending 30 June 2023, 2024, 2025 and 2026.

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 per cent return. As we explained in Chapter 10, 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 and a discount rate of 8 per cent (the market’s required rate of return for this security), 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 four years $100 000 × 3.312 126 4 = $ 331 213

Present value of the principal to be received in four years $1 000 000 × 0.735 029 7 = $ 735 029

Fair value at 1 July 2022   $ 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 bonds as:

∙ The 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 bonds give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

(c) All financial instruments shall initially be measured at fair value at acquisition. In this case, we calculated this to be $1 066 242. To determine the amortised cost of the financial asset following acquisition, 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 (2026), 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 Opening present

value Interest Principal

repayment Closing present

value

1 July 2022       1 066 242

30 June 2023 1 066 242 85 299 14 701 1 051 541

30 June 2024 1 051 541 84 123 15 877 1 035 664

30 June 2025 1 035 664 82 853 17 147 1 018 517

30 June 2026 1 018 517 81 483 1 018 517 0

WORKED EXAMPLE 14.7 continued

dee67382_ch14_527-598.indd 547 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 547

(d) If the bonds are being measured at amortised cost, then the accounting journal entries would be:

1 July 2022

Dr Investment in corporate bonds 1 066 242  

Cr Cash (to recognise the acquisition of corporate bonds at fair value. This is fair value as it represents the amount the market is prepared to pay for the bonds)

1 066 242

30 June 2023

Dr Cash 100 000  

Cr Investment in corporate bonds   14 701

Cr Interest income (to recognise the receipt of $100 000 from the corporate bonds, which is apportioned between interest income and a reduction in the value of the bonds)

85 299

30 June 2024

Dr Cash 100 000  

Cr Investment in corporate bonds   15 877

Cr Interest income (to recognise the receipt of $100 000 from the corporate bonds, which is apportioned between interest income and a reduction in the value of the bonds)

84 123

30 June 2025

Dr Cash 100 000  

Cr Investment in corporate bonds   17 147

Cr Interest income (to recognise the receipt of $100 000 from the corporate bonds, which is apportioned between interest income and a reduction in the value of the bonds)

82 853

30 June 2026

Dr Cash 100 000  

Cr Investment in corporate bonds   18 517

Cr Interest income (to recognise the receipt of $100 000 from the corporate bonds, which is apportioned between interest income and a reduction in the value of the bonds)

81 483

Dr Cash 1 000 000  

Cr Investment in corporate bonds (to recognise the redemption of the corporate bonds and the receipt of the amount receivable on redemption)

1 000 000

Worked Example 14.7 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 flows that the entity actually expects to receive (i.e. taking account of possible cash shortfalls), discounted at the original effective interest rate. The impairment loss can be offset directly against the asset (that is, by crediting the

dee67382_ch14_527-598.indd 548 10/24/19 03:30 PM

548 PART 4: Accounting for liabilities and owners’ equity

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 the impairment occurs.

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. (AASB 9)

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. (AASB 9)

The general principle applied in AASB 9 is that if it is considered 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 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 or decreasing 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 accounting standard AASB 116 Property, Plant and Equipment requires that the upward revaluation shall not be included within profit or loss, but will be included initially within OCI, and then, at the end of the accounting period, transferred to a reserve (which is part of equity) referred to as a ‘revaluation surplus’.

Turning our attention back to financial instruments, pursuant to AASB 9, fair value must be used as the basis of measurement after acquisition 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). Derivatives are also to be measured at fair value. 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 14.8 provides an example of how to account for a financial asset at fair value through profit or loss.

WORKED EXAMPLE 14.8: Accounting for a financial asset at fair value through profit or loss

On 1 July 2022 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 2023—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.

dee67382_ch14_527-598.indd 549 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 549

SOLUTION

1 July 2022 The financial asset would initially be recorded at fair value, which is the requirement for all financial instruments. If the financial asset is subsequently 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 Investment in Island Ltd 1 000 000  

Dr Brokerage fee expense 1 500  

Cr Cash (to recognise the acquisition of the investment in Island Ltd at fair value)

1 001 500

30 June 2023

Dr Investment in Island Ltd 200 000  

Cr Gain in fair value of equity investments (profit or loss) (to recognise the increase in fair value of the equity investment)

  200 000

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

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 financial assets in the form of 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. The election to include changes in the fair value of the equity investment in OCI rather than in profit or loss must be made on initial recognition of the equity investment.

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 investment in 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.

dee67382_ch14_527-598.indd 550 10/24/19 03:30 PM

550 PART 4: Accounting for liabilities and owners’ equity

Worked Example 14.9 provides an example of how to account for an equity instrument at fair value through other comprehensive income.

WORKED EXAMPLE 14.9: Accounting for a financial asset at fair value through other comprehensive income

The facts are the same as those in Worked Example 14.8 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 14.8, on 1 July 2022 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 2023 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 2022

The financial asset would initially be recorded at fair value. If the financial asset is measured at fair value through other comprehensive income, then the accounting standard requires that the transaction costs associated with the acquisition of the asset shall be included as part of the cost of the asset (and not treated as an expense 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 Investment in Island Ltd 1 001 500  

Cr Cash (to recognise the equity investment at fair value)

  1 001 500

30 June 2023

Dr Investment in Island Ltd 200 000  

Cr Gain in fair value (included within OCI) (to recognise the change in fair value of the equity investment)

  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’. At the end of the reporting period, the gains reported within OCI would be transferred to this equity account. 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:

∙ all financial instruments are initially measured at fair value (plus or minus, in some cases, related transaction costs)

∙ equity instruments are subsequently 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, after acquisition, 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 subsequently 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

dee67382_ch14_527-598.indd 551 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 551

∙ 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 on the debt instrument 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 required, AASB 7 identifies a number of related disclosures about such reclassifications.

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.

  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.

Table 14.1 Subsequent measurement of equity instruments

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

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

dee67382_ch14_527-598.indd 552 10/24/19 03:30 PM

552 PART 4: Accounting for liabilities and owners’ equity

Election to use fair value through profit or loss to address an ‘accounting mismatch’ As we now know, subject to certain requirements, reporting entities shall measure their financial assets (other than those held for trading) 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). (AASB 9)

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 AASB 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. (AASB 9)

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.

dee67382_ch14_527-598.indd 553 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 553

Figure 14.1 How to account for financial assets pursuant to AASB 9

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

Yes

Is the entity’s business model’s

objective achieved both by collecting

contractual cash flows as well as by selling the financial assets?

Equity instruments measured at fair value through OCI

• 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)

• 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

Fair value through profit or loss

• Changes in fair value will be included in profit or loss

• Interest and dividends (unless they are repayment of part of the cost of the investment) will be included in 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

Debt instruments fair value through OCI

Changes in fair value included within OCI

Interest revenue, expected credit losses, and foreign exchange gains and losses included within profit or loss

When the asset is derecognised (e.g. sold) the cumulative gain or loss recognised in OCI is reclassified from equity to profit or loss

No

Yes

Yes

Yes No

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

Yes

No

No

Is the financial asset an equity

investment?

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)?

No

No

Is the equity investment being held primarily for

trading?

Has the entity elected to present

changes in fair value within OCI?

No

We will now consider three Worked Examples. Worked Example 14.10 explores how to classify financial assets for subsequent measurement; Worked Example 14.11 demonstrates how different business models for a financial asset impact the basis of subsequent measurement; and Worked Example 14.12 addresses how we account for an interest- free loan provided to an employee.

dee67382_ch14_527-598.indd 554 10/24/19 03:30 PM

554 PART 4: Accounting for liabilities and owners’ equity

WHY DO I NEED TO KNOW THE MEASUREMENT REQUIREMENTS FOR DIFFERENT TYPES OF FINANCIAL ASSETS?

There is a requirement that different types of financial assets be measured differently. Further, the nature of the business model being applied with respect to the financial asset can also have implications for measurement of the financial asset, and the recognition of profit or loss.

Without some knowledge of the measurement rules available or required, and which have been applied, it will be difficult to understand the relevance of particular measures being reported within the financial statements. Knowledge of the rules/requirements will also allow us to better understand how particular accounting choices (such as the choice to recognise changes in fair value through OCI) will consequently impact reported profits or losses, and total comprehensive income or loss. This is important to enable us to understand the context of reported profits or losses.

WORKED EXAMPLE 14.10: 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 cent 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 per cent. 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 14.11: Different measurement requirements for government bonds depending upon the business model being applied

Lucky Break has acquired some government bonds on 1 July 2022. 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).

dee67382_ch14_527-598.indd 555 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 555

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 2023 (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 2022. (b) Provide the accounting journal entries for the government bonds for the years ending 30 June 2023

and 30 June 2024, 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 2023, 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.

(d) Provide the accounting entries for the government bonds for the year ending 30 June 2023 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, which at acquisition date was 5 per cent. 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 1 000 000 × 0.7835 = $ 783 500

Present value of interest to be received at the end of each of the following 5 years 100 000 × 4.3295 = $ 432 950

Issue price (fair value) of the government bonds on acquisition date   $ 1 216 450

In this case, the government bonds were issued above their face value of $1 000 000. This is because the coupon rate on the government bonds of 10 per cent was 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 is 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:

Date

Opening present value

($) Interest

($)

Principal repayment

($)

Closing present value

($)

1 July 2022       1 216 450

30 June 2023 1 216 450 60 823 39 177 1 177 273

30 June 2024 1 177 273 58 864 41 136 1 136 137

30 June 2025 1 136 137 56 807 43 193 1 092 944

30 June 2026 1 092 944 54 647 45 353 1 047 591

30 June 2027 1 047 591 52 380 1 047 591* 0

*rounding error

continued

dee67382_ch14_527-598.indd 556 10/24/19 03:30 PM

556 PART 4: Accounting for liabilities and owners’ equity

1 July 2022

Dr Government bonds 1 216 450  

Cr Cash (to recognise the acquisition of government bonds at fair value)

  1 216 450

30 June 2023

Dr Cash 100 000  

Cr Interest income   60 823

Cr Government bonds (to recognise the receipt of cash relating to the investment in government bonds) 

39 177

30 June 2024

Dr Cash 100 000  

Cr Interest income   58 864

Cr Government bonds (to recognise the receipt of cash relating to the investment in government bonds) 

41 136

(c) For parts (c) and (d) we also need to determine the fair value at 30 June 2023. 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 2023). This calculated amount would represent what the market would subsequently be prepared to pay for the bonds, and therefore represents their fair value.

Present value of the principal to be received in four years $1 000 000 × 0.8548 = $ 854 800

Present value of interest to be received at the end of each of the following four years $100 000 × 3.6299 = $ 362 990

Fair value of the government bonds as at 30 June 2023   $ 1 217 790

Carrying amount of government bonds prior to revaluation—see table presented earlier   $ 1 177 273

Increase in fair value   $ 40 517

1 July 2022

Dr Government bonds 1 216 450  

Cr Cash (to recognise the acquisition at fair value of government bonds) 

1 216 450

30 June 2023

Dr Cash 100 000  

Cr Interest income   60 823

Cr Government bonds (to recognise the cash received in relation to the government bonds) 

39 177

Dr Government bonds 40 517  

Cr Gain on financial asset (in equity and included within OCI) (to recognise the change in fair value of the government bonds)

40 517

WORKED EXAMPLE 14.11 continued

dee67382_ch14_527-598.indd 557 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 557

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. The amounts recorded in OCI will be transferred to an equity reserve at the end of each accounting period.

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. This would be a ‘reclassification adjustment’.

(d)

1 July 2022

Dr Government bonds 1 216 450  

Cr Cash (acquisition of government bonds at fair value)

  1 216 450

30 June 2023

Dr Cash 100 000  

Cr Interest income   60 823

Cr Government bonds (to recognise the cash received in relation to the government bonds)

39 177

Dr Government bonds 40 517  

Cr Fair value gain on government bond (included within profit or loss) (to recognise the change in fair value of the government bonds) 

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 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 14.12: Measurement of an interest-free loan provided to an employee

On 1 July 2022 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 2022 the market rate 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 2023.

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 AASB 13). However, if

continued

dee67382_ch14_527-598.indd 558 10/24/19 03:30 PM

558 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 9)

Using our present value tables, the present value of the interest free loan discounted at 6 per cent would equal: $1 000 000 × 0.8396 = $839 600.

The journal entries would be:

1 July 2022

Dr Loan receivable (employee loan) 839 600  

Dr Employee benefit expense 160 400

Cr Cash (to recognise a loan provided to an employee at fair value, with the difference between the fair value of the loan and the amount receivable provided to the employee representing an expense) 

1 000 000

30 June 2023

Dr Loan receivable 50 376  

Cr Interest revenue ($839 600 × 0.06 = $50 376) (to recognise the change in the present value of the loan provided to an employee. It is assumed that the market’s required rate of return on a financial instrument of this nature has not changed) 

50 376

WORKED EXAMPLE 14.12 continued

14.7 Initial recognition of financial liabilities

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’.

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 to be subsequently measured at fair value through profit or loss, any transaction costs directly attributable to the issue of the financial liability are deducted from the amount of the financial liability.

The requirements pertaining to the initial measurement of a financial liability are consistent with the requirements in respect of the initial measurement of financial assets, except that directly attributable transaction costs shall reduce rather than increase the carrying amount on initial recognition.

Worked Example 14.13 explores how to measure a loan at the date the loan is received.

LO 14.7

WORKED EXAMPLE 14.13: Initial measurement of a loan with associated transaction costs

Fishos Ltd borrows $800 000 from Front Beach Ltd for a period of three years. The rate of interest charged on the loan is 4 per cent, which equates to the market’s required rate of return. The legal costs associated with negotiating the loan were $10 000. These costs were incurred by Front Beach Ltd, but the terms of the loan agreement were that Fishos was to take responsibility for the costs.

dee67382_ch14_527-598.indd 559 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 559

REQUIRED You are to provide the accounting journal entries for the above loan.

SOLUTION

Dr Cash 790 000  

Cr Loan payable (to recognise the loan payable at fair value less the legal costs attributable to the loan) 

790 000

14.8 Subsequent measurements of financial liabilities

Most financial liabilities tend to be measured at amortised cost subsequent to initial recognition. However, some liabilities (such as those used as part of a hedging arrangement, or those that are traded) will be measured at fair value.

How to measure a financial liability at amortised cost is demonstrated in Worked Example 14.14.

LO 14.8

WORKED EXAMPLE 14.14: Financial liabilities other than those measured at fair value

On 1 July 2022, 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. It is assumed that the market’s required rate of return on such financial instruments remains at 12 per cent throughout the life of the bonds.

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 = $30 373

$100 000 × 0.6355 = $63 550

  $93 923

REQUIRED Prepare the journal entry to issue the bond at 1 July 2022, and the entry at 30 June 2023 to record the interest paid.

SOLUTION Table 14.3 demonstrates the amortised cost using the effective-interest method.

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

1 Year ended

2 Opening

bond payable

$

3 Payment

$

4 Interest at 12%

(column 2 × 12%) $

5 Increase in

bond payable (column 4 –

column 3) $

6 Amortised cost

of bond payable (column 2 +

column 5) $

30 June 2023 93 923 10 000 11 272 1272 95 195

30 June 2024 95 195 10 000 11 423 1423 96 618

30 June 2025 96 618 10 000 11 594 1594 98 212

30 June 2026 98 212 10 000 11 788* 1788 100 000

*small rounding error

Table 14.3 Determining amortised cost using the effective- interest method

continued

dee67382_ch14_527-598.indd 560 10/24/19 03:30 PM

560 PART 4: Accounting for liabilities and owners’ equity

increase in the carrying amount of the liability (which is measured at 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 2022

Dr Cash 93 923  

Cr Bond payable (issuing bonds for their fair value of $93 923)

  93 923

30 June 2023

Dr Interest expense 11 272  

Cr Bond payable   1 272

Cr Bank (interest payment and amortisation of bond payable using effective interest rate of 12%) 

10 000

WORKED EXAMPLE 14.14 continued

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 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 instrument is recognised in profit or loss.

14.9 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

LO 14.9

dee67382_ch14_527-598.indd 561 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 561

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. (AASB 9)

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’.

14.10 Accounting for 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 14.15.

hedge contract Arrangement with another party in which that other party accepts the risks associated with changing commodity prices, cash flows or exchange rates.

LO 14.10

WORKED EXAMPLE 14.15: Hedging arrangement

An Australian company, Mungo Ltd, orders some inventory from a US supplier, Barry Inc., on 1 May 2022 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 2022. As at 1 May 2022 the forward rate for the delivery of US dollars on 30 June 2022 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’. (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 2022, 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 Mungo Ltd could also enter into a forward exchange rate contract to buy US$200 000 on 30 June 2022 from another party (typically a bank) at a forward rate of, for example, A$1.00 = US$0.72.

(b) In this situation the amount to be paid by Mungo Ltd to Barry Inc. is the hedged item (that is, the item being hedged). This is the source of the original risk that Mungo Ltd wants to address. The forward rate arrangement negotiated 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.

continued

forward rate The exchange rate that is currently offered for the future acquisition or sale of a specific currency.

dee67382_ch14_527-598.indd 562 10/24/19 03:30 PM

562 PART 4: Accounting for liabilities and owners’ equity

(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’. Consistent with AASB 9, the forward rate contract is a derivative because it is a contract with three characteristics, these being:

1. The value of the contract changes as the value of an underlying item changes (this item being the exchange rates).

2. The contract requires no initial investment. 3. The contract is settled at a future date.

As we know, this forward rate contract could be entered into for speculative reasons or as a means of minimising the risks associated with changes in foreign exchange rates. In this case, it is the latter.

(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 2022. In the absence of a forward rate agreement (which we have designated the hedging instrument), the entity would have to 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.

WORKED EXAMPLE 14.15 continued

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. (AASB 9)

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 within 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 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. (AASB 9)

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. (AASB 9)

dee67382_ch14_527-598.indd 563 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 563

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, or 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. (AASB 9)

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 likely to be payable to a foreign supplier for a future purchase of an asset, 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 hedged 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 14.15.

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.

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

dee67382_ch14_527-598.indd 564 10/24/19 03:30 PM

564 PART 4: Accounting for liabilities and owners’ equity

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.

∙ 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 probable 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 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 hedging instrument to be valued at fair value, with any gains or losses owing to fair value adjustments to be treated as part of the period’s profit or loss. If the gains or losses on the hedged item are ‘perfectly hedged’ the gains or losses on the hedging instrument will offset the gains or losses on the hedged item so that the net effect on the period’s profit or loss would be $nil.

For a cash flow hedge, the gain or loss on measuring the hedged item at fair value is to be treated as part of the period’s profit or loss. The gain or loss on the hedging instrument is initially to be transferred to equity (and thereby included in ‘other comprehensive income’—remember, ‘other comprehensive income’ includes increases and decreases in a variety of equity accounts), but subsequently transferred to profit or loss as necessary to offset the gains or losses recorded on the hedged item. At the conclusion of the hedging arrangement, any amount still in equity relating 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.

We will now consider fair value hedges in more detail. This will then be followed by an analysis 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 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.

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 (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. (AASB 9)

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.

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.

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.

dee67382_ch14_527-598.indd 565 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 565

Worked Example 14.16 provides an example of a fair value hedge.

WORKED EXAMPLE 14.16: 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 2022, Goldblum Ltd enters into 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 2023. 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 2022 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 2023 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 2023.

SOLUTION

1 July 2022

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 2022 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 2022

Dr Loss on gold inventory (included in profit or loss) 120 000  

Cr Gold inventory (to recognise the fall in fair value of the gold, which is the hedged item)

120 000

Dr Forward contract—gold (an asset) 120 000  

Cr Gain on forward contract (included in profit or loss) (to recognise the increase in fair value of the forward contract, which is the hedging instrument)

120 000

30 June 2023

Dr Loss on gold inventory (included in profit or loss) 55 000  

Cr Gold inventory (to recognise the fall in fair value of the gold, which is the hedged item)

55 000

Dr Forward contract—gold 52 000  

Cr Gain on forward contract (included in profit or loss) (to recognise the increase in fair value of the forward contract, which is the hedging instrument)

52 000

Dr Cash at bank 172 000  

Cr Forward contract—gold (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)

172 000

dee67382_ch14_527-598.indd 566 10/24/19 03:30 PM

566 PART 4: Accounting for liabilities and owners’ equity

Worked Example 14.17 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 14.17: Fair value hedge of an unrecognised firm commitment

On 1 June 2022 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 2022 and payment will be made on that date. On 1 June 2022 Melbourne Ltd also enters a forward rate agreement with a bank for the delivery of US$2 000 000 on 1 August 2022. 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 Spot rate Forward rate for delivery

on 1 August

1 June 2022 US$1.00 = A$1.43 US$1.00 = A$1.45 30 June 2022 US$1.00 = A$1.45 US$1.00 = A$1.47 1 August 2022 US$1.00 = A$1.48 US$1.00 = A$1.48

REQUIRED Provide the journal entries to account for the hedged item and hedging instrument as required on 1 June 2022, 30 June 2022 and 1 August 2022.

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 2022, 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 Fair value of firm

commitment Gain/(loss) on firm

commitment Fair value of

forward contract Gain/(loss) on

forward contract

1 June 2022 2 900 000 – 2 900 000  –

30 June 2022 2 940 000 (40 000) 2 940 000 40 000

1 August 2022 2 960 000 (20 000) 2 960 000 20 000

Realised gain/(loss)   (60 000)   60 000

The accounting journal entries would be: 1 June 2022 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 2022

Dr Loss on unrecognised firm commitment (in profit or loss) 40 000  

Cr Unrecognised firm commitment (liability) (to recognise an increase in the value of the unrecognised firm commitment—which is the hedged item)

40 000

Dr Forward contract (asset) 40 000   Cr Gain on forward contract (in profit or loss)

(to recognise the increase in the fair value of the forward contract—which is the hedging instrument)

40 000

dee67382_ch14_527-598.indd 567 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 567

As we can see, after determining the respective fair values, the gain on the hedging instrument offsets the loss on the hedged item.

1 August 2022

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) (to recognise an increase in the amount of the unrecognised firm commitment)

20 000

Dr Forward contract (asset) 20 000  

Cr Gain on forward contract (in profit or loss) (to recognise an increase in the fair value of the forward contract)

  20 000

We then close out the forward contract, which in this case means that the bank will transfer to Melbourne Ltd the gain Melbourne Ltd has made on the forward contract:

Dr Cash at bank 60 000  

Cr Forward contract (asset) (receipt of the gain on the forward contract)

  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 Unrecognised firm commitment (liability) 60 000  

Dr Inventory 2 900 000  

Cr Cash at bank (to recognise the payment made to the supplier of the inventory)

  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 2022. 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 hedged 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 probable 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.

dee67382_ch14_527-598.indd 568 10/24/19 03:30 PM

568 PART 4: Accounting for liabilities and owners’ equity

∙ 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 probable forecast transaction, or an asset or liability that is currently recognised within the financial statements.

∙ 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.

∙ 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 14.18 provides an example of a cash flow hedge.

WORKED EXAMPLE 14.18: Cash flow hedge of a highly probable forecast transaction

Oz Ltd manufactures electric cars. On 15 June 2022 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 2022, 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 2022.

Because of concerns about movements in foreign exchange rates, on 15 June 2022 Oz Ltd entered into a forward rate contract on US dollars with a bank so as to receive US$2 000 000 on 30 August 2022 at a forward rate of A$1.00 = 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 2022 in the initial cost of the batteries.

The inventory was sold by Oz Ltd on 1 September 2022 for A$3 000 000.

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 2022, are also provided. It should be noted that on 30 August 2022, the last day of the forward rate contract, the spot rate and the forward rate will be the same.

Date Spot rate Forward rates for

30 August 2022 delivery of US$

15 June 2022 A$1.00 = US$0.83 A$1.00 = US$0.80

30 June 2022 A$1.00 = US$0.81 A$1.00 = US$0.78

30 August 2022 A$1.00 = US$0.76 A$1.00 = 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 2022.

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.

dee67382_ch14_527-598.indd 569 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 569

Gains/losses on the hedged item (the inventory purchase) are calculated as follows:

Date Spot rate Amount payable in A$ Foreign exchange gain/(loss)

15 June 2022 A$1.00 = US$0.83 –  

30 June 2022 A$1.00 = US$0.81 $2 469 136  

30 August 2022 A$1.00 = US$0.76 $2 631 579 (162 443)

Note: the purchase is not recognised until such time as the batteries are shipped on 30 June 2022 and control has been deemed to have passed to the purchaser.

Gains/losses on the hedging instrument (the forward rate contract) are calculated as follows:

Date

Fwd rate for delivery of US$ on

30 Aug 2022

Receivable on fwd

contract (a)

Amount payable in A$ on fwd

contract (b)

Fair value of fwd contract

(c)

Gain/(loss) on fwd contract

(d)

15 June 2022 A$1.00 = US$0.80 $2 500 000 $2 500 000 0

30 June 2022 A$1.00 = US$0.78 $2 564 103 $2 500 000 $64 103 $ 64 103

30 August 2022 A$1.00 = US$0.76 $2 631 579 $2 500 000 $131 579 $ 67 476

        $ 1 315 79

Notes to the above table

(a) Determined by dividing $2.0 million 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 contract on 30 June to receive US$2.0 million 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 $2.0 million 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 on the forward rate agreement) 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 2022 to any interested parties. Therefore, the contract itself has no fair value. However, if on 30 June 2022 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 the difference between ($2 000 000 ÷ 0.80) and ($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.

continued

dee67382_ch14_527-598.indd 570 10/24/19 03:30 PM

570 PART 4: Accounting for liabilities and owners’ equity

WORKED EXAMPLE 14.18 continued

(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 2022 it would have cost them A$2 564 103 for US$2 000 000 rather than the A$2 500 000 they were able to ‘lock in’ on 15 June 2022. 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 2022

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.

30 June 2022

Dr Forward rate contract (financial asset) 64 103  

Cr Cash flow hedge reserve (would be a gain recorded 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)

64 103

Dr Inventory 2 469 136  

Cr Foreign currency payable (to recognise the acquisition of inventory using the relevant spot rate)

2 469 136

Dr Cash flow hedge reserve (OCI) 64 103  

Cr Inventory (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 Presentation of Financial Statements, this is not a reclassification adjustment and hence it does not affect other comprehensive income)

64 103

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. When the amount due in regard to the inventory is paid, we can see from the above journal entries that the gain on the hedging instrument is reclassified from OCI to the hedged item, which is the inventory. Ultimately, this adjusted cost is reflected within cost of goods sold.

30 August 2022

Dr Forward rate contract (financial asset) 67 476  

Cr Gain on forward contract (to recognise the gain on the forward rate contract)

  67 476

Dr Foreign exchange loss 162 443  

Cr Foreign currency payable (to recognise the loss on the foreign currency payable—which is the obligation with the overseas supplier)

162 443

dee67382_ch14_527-598.indd 571 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 571

Dr Cash at bank 131 579  

Cr Forward rate contract (financial asset) (to recognise the receipt of the amount receivable in relation to the forward rate contract—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)

131 579

Dr Foreign currency payable 2 631 579  

Cr Cash at bank (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)

2 631 579

1 September 2022

Dr Accounts receivable 3 000 000  

Dr Cost of goods sold 2 405 033  

Cr Sales income   3 000 000

Cr Inventory (to recognise the sale of inventory and the associated cost of goods sold. The amount of the cost of goods sold equals the amount previously included in the cost of inventory, which from the above journal entries is $2 469 136 less $64 103)

2 405 033

Once the above journal entries are made, the net expenses recorded within profit or loss in relation to the inventory acquisition are represented by: Cost of goods sold ($2 405 033) Gain on forward contract after the date of inventory acquisition $ 67 476 Foreign exchange loss on purchase agreement with supplier ($ 162 443) ($2 500 000)

Under ‘hedge accounting’ we can see that the net amount reported for the total expenses associated with the acquisition of the inventory—including the gains and losses associated with changes in spot rates and forward rates—is $2 500 000. This reflects the hedge objective, which was to lock in the total costs associated with acquiring the inventory to $2 500 000.

We will consider, in what follows, some financial instruments that may (but need not) be used as hedging instruments.

WHY DO I NEED TO KNOW ABOUT HEDGING AS WELL AS HOW TO ACCOUNT FOR DIFFERENT TYPES OF HEDGING ARRANGEMENTS?

The appropriate use of hedging arrangements is an important strategy in reducing the risk that an organisation might be exposed to significant foreign currency losses. Therefore, it is important to understand how hedging arrangements work.

Hedging arrangements are commonly employed. Therefore, as preparers of financial statements, or as readers of financial statements, it is important for us to understand how hedging arrangements are accounted for and to appreciate that gains or losses on a hedging instrument will offset gains or losses on the hedged item.

dee67382_ch14_527-598.indd 572 10/24/19 03:30 PM

572 PART 4: Accounting for liabilities and owners’ equity

14.11 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 the 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 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 Group 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 US$7.14 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 14.19 provides an example of a futures contract.

hedging An action taken with the object of avoiding or minimising the possible adverse effects of movements in exchange rates or market prices.

futures contract A contract to buy or sell an agreed quantity of a particular item at an agreed price on a specific date.

mark to market Valuing assets according to their market prices.

LO 14.11

dee67382_ch14_527-598.indd 573 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 573

WORKED EXAMPLE 14.19: 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 Group 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 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?

SOLUTION Jill could enter a futures contract on BHP shares in which she takes a ‘sell position’ on 50 000 BHP shares. The price of BHP 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 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 Group 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 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 shares 50 000 × $3.00 ($150 000)

Gain on BHP futures 50 000 × $3.00 $150 000

Total net gain (loss)                  0

Share price index futures As another example of a share-related future we can consider Worked Example 14.20, 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 (there are similar indices in other countries). 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 are also ASX Property Trust Index Futures. In describing the development of share price index futures, Stoll and Whaley (1997, p. 140) state:

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 1 August 2019, the S&P/ASX 200 index was 6781. This means that the price of one

All Ordinaries Share Price Index Index that provides a measure of the movements in the share market within Australia.

dee67382_ch14_527-598.indd 574 10/24/19 03:30 PM

574 PART 4: Accounting for liabilities and owners’ equity

S&P/ASX 200 futures contract was $169 525 (6781 × $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 14.20 represents a futures trade where the trader in question has taken a buy position.

WORKED EXAMPLE 14.20: Futures trading taking a buy position

Johnny Risk believes that the share market is about to increase in value. On 1 March 2023 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 5 500 × $25.00 = $ 137 500

Value of SPI futures at date of position close 5 050 × $25.00 = $ 126 250

Loss on the futures contract   $ 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 14.21 provides another illustration of the use of SPI futures, including associated journal entries.

WORKED EXAMPLE 14.21: 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 2023 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.

dee67382_ch14_527-598.indd 575 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 575

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. (AASB 9)

(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 2023   $2 180 000  

Market price at 29 March 2023   $2 100 000 $80 000

Gain on SPI Futures—the hedging instrument      

Price on 1 March 2023 5550 × $25 × 16 units $2 220 000  

Price on 29 March 2023 5400 × $25 × 16 units $2 160 000 $60 000

Net loss     $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 2023 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 (recognition of a deposit on a futures contract—there is normally a requirement to make a percentage deposit with the futures broker)

100 000

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 financial 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

dee67382_ch14_527-598.indd 576 10/24/19 03:30 PM

576 PART 4: Accounting for liabilities and owners’ equity

(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 2023 Dr Loss on share portfolio 80 000   Cr Share portfolio

(to ‘mark to market’ the value of the organisation’s share portfolio and to treat the downward movement as a loss) 

80 000

Dr Deposit held by broker 60 000   Cr Gain on futures contract

(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)

60 000

(iii) If Boomtime Investments Ltd decides to sell its shares and close out its futures contract on 30 March 2023, 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 2023

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 (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)

60 000

Dr Cash at bank 220 000  

Cr Deposit held by broker (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)

220 000

Had the entity in Worked Example 14.21 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.

Foreign currency futures Apart from SPI futures, individuals may elect to transact in foreign currency futures. Worked Example 14.22 demonstrates the use of such futures.

WORKED EXAMPLE 14.22: Use of currency futures

On 1 July 2023 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 2023 is A$1 = US$0.7205, so that the value of the receivable converted to Australian dollars on 1 July 2023 is $1 387 925. The amount is due for receipt on 1 September 2023. Hedgy Ltd is aware that it is exposed to fluctuations in exchange rates, which could increase

WORKED EXAMPLE 14.21 continued

dee67382_ch14_527-598.indd 577 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 577

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 2023 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 2023, 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.

REQUIRED Provide the accounting entries for the sale made by Hedgy Ltd to the overseas organisation on 1 July 2023 and for the futures contract settled on 1 September 2023. 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 2023 Dr Accounts receivable 1 387 925   Dr Cost of goods sold 1 100 000   Cr Sales revenue   1 387 925 Cr Inventory

(to record the sale at the spot rate of A$1 = US$0.7205)   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 50 000  

Cr Cash at bank (to record the deposit made with the futures broker)

  50 000

1 September 2023 Dr Cash at bank 1 369 863   Dr Loss on foreign exchange 18 062   Cr Account receivable

(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)

1 387 925

Dr Deposit with futures broker 20 497   Cr Cash flow hedge reserve (gain included in other comprehensive income)

(the gain will equal the difference between the value of the futures contract on 1 July 2023 ($1 407 460) and its value on 1 September 2023 ($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)

20 497

continued

dee67382_ch14_527-598.indd 578 10/24/19 03:30 PM

578 PART 4: Accounting for liabilities and owners’ equity

14.12 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 marketplace, 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 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 $40.00 and the exercise price of the option is $38.50, we would expect the sale price of the option to be greater than $1.50 (which is $40.00 less $38.50). On 1 August 2019, the last sale price of 30  January 2020 $39.00 options was $2.175 (when the share price was $40.26). Investors would be prepared to pay a greater amount for an option than the current share price less the exercise price of the option, 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 14.23 provides an illustration of how to account for share options.

Dr Cash flow hedge reserve (transfer out of other comprehensive income) 20 497

 

Cr Gain on futures contract—in profit or loss (the gain is transferred from equity to offset the loss on the hedged item, which amounted to $18 062)

20 497

Dr Cash at bank 70 497  

Cr Deposit with futures broker (represents the addition of the original deposit made of $50 000 and the gains of $20 497 on the contract)

70 497

WORKED EXAMPLE 14.22 continued

LO 14.12

option 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 or other commodities related to the option.

strike price The price the holder of an option will pay to buy a company’s shares or other commodities related to the option.

dee67382_ch14_527-598.indd 579 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 579

14.13 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 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 would fall to A$200 000, which would represent a foreign currency gain of A$50 000. However, this gain would be fully offset by the reduction in the value of the receivable, which would also be valued at A$200 000. The net result is that no foreign currency exchange gain or loss would be incurred.

WORKED EXAMPLE 14.23: Valuation of options at net market price

On 1 December 2023 Trader Ltd acquires a parcel of 10 000 options in BHP Group 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 Group Ltd at any time in the next year for a price of $40.00. Trader Ltd’s reporting date is 30 June. At 30 June 2024 the value of BHP Group 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.

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 2023

Dr Investment in share options 4 000  

Cr Cash at bank (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; while not accounted for here, the organisation that issued/sold Trader Ltd the options would have a financial liability)

4 000

30 June 2024

Dr Investment in share options 4 500  

Cr Gain on share options (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)

4 500

swap agreement Agreement between borrowers to exchange aspects of their respective loan obligations.

foreign currency swap Agreement under which the obligation relating to a loan denominated in one currency is swapped for a loan denominated in another currency.

spot rate The exchange rate for immediate delivery of currencies to be exchanged.

LO 14.13

dee67382_ch14_527-598.indd 580 10/24/19 03:30 PM

580 PART 4: Accounting for liabilities and owners’ equity

WORKED EXAMPLE 14.24: Foreign currency swap

On 1 July 2022 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 2022.

Under the terms of the swap contract, Byron Ltd will take responsibility for 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 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 2022 A$1.00 = US$0.80 30 June 2024 A$1.00 = US$0.75

30 June 2023 A$1.00 = US$0.70 30 June 2025 A$1.00 = US$0.77

REQUIRED

(a) Provide the accounting entries in the books of Byron Ltd for the years ending 30 June 2023, 2024 and 2025.

(b) Provide the accounting entries in the books of Watego Ltd for the year ending 30 June 2023.

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

If an organisation has a number of receivables that are denominated in a foreign currency, changes in spot rates might 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 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 above. Such an organisation might seek out another entity that is prepared to swap its foreign currency loans for the organisation’s domestic loans.

When a swap is carried out, 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 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 14.24, which illustrates foreign currency swaps.

dee67382_ch14_527-598.indd 581 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 581

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 foreign currency receivable component of swap

Fair value of the

Australian payable

component of swap*

Fair value of swap

Gain/(loss) on hedge

1 July 2022 [(2 000 000 ÷ 0.8) × 0.12 × 2.401 831] + [(2 000 000 ÷ 0.8) × 0.7 117 801] = 2 500 000

2 500 000 – –

30 June 2023 [(2 000 000 ÷ 0.70) × 0.12 × 1.6 900 509] + [(2 000 000 ÷ 0.70) × 0.7 971 938] = 2 857 143

2 500 000 357 143 357 143

30 June 2024 [(2 000 000 ÷ 0.75) × 0.12 × 0.8 928 571] + [(2 000 000 ÷ 0.75) × 0.8 928 571] = 2 666 667

2 500 000 166 667 (190 476)

30 June 2025 2 000 000 ÷ 0.77 = 2 597 403 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.

We will account for the swap agreement and the overseas loan separately

1 July 2022

Dr Cash 2 500 000  

Cr Foreign loan (to recognise, at the 1 July 2022 spot rate, the initial loan received from the US company of $2 500 000 = $2 000 000 ÷ 0.80)

2 500 000

There is no entry on 1 July 2022 to recognise the swap as the fair value of the swap agreement is deemed to be zero on 1 July 2022 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 2023

Dr Foreign exchange loss 357 143  

Cr Foreign loan (to recognise the loss on the loan with the US corporation)

  357 143

Value of loan as at 1 July 2022 2 000 000 ÷ 0.80 = 2 500 000

Value of loan as at 30 June 2023 2 000 000 ÷ 0.70 = 2 857 143

Foreign exchange loss      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 2023 is $2 857 143).

continued

dee67382_ch14_527-598.indd 582 10/24/19 03:30 PM

582 PART 4: Accounting for liabilities and owners’ equity

Dr Swap asset 357 143  

Cr Gain on swap contract (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)

357 143

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 (to recognise the payment made to the US corporation of 342 857 = [2 000 000 × 0.12] ÷ 0.7)

342 857

Dr Cash 42 857  

Cr Interest expense (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 × .12] – [2 500 000 × 0.12] = 42 857)

42 857

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 2024

Dr Foreign loan 190 476  

Cr Foreign exchange gain (to recognise the loss on the loan with the US corporation)

190 476

Value of loan as at 1 July 2023 2 000 000 ÷ 0.70 = 2 857 143

Value of loan as at 30 June 2024 2 000 000 ÷ 0.75 = 2 666 667

Foreign exchange gain   190 476

Dr Loss on swap contract 190 476  

Cr Swap asset (to recognise the loss on the swap contract negotiated with Watego Ltd—see table provided earlier)

190 476

Dr Interest expense 320 000  

Cr Cash (to recognise the payment made to the US corporation of $320 000 = [2 000 000 × 0.12] ÷ 0.75)

320 000

WORKED EXAMPLE 14.24 continued

dee67382_ch14_527-598.indd 583 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 583

Dr Cash 20 000  

Cr Interest expense (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)

20 000

30 June 2025

Dr Foreign Loan 69 264  

Cr Foreign exchange gain (to recognise the loss on the loan with the US corporation)

69 264

Value of loan as at 1 July 2024 2 000 000 ÷ 0.75 = 2 666 667

Value of loan as at 30 June 2025 2 000 000 ÷ 0.77 = 2 597 403

Foreign exchange gain      69 264

Dr Loss on swap contract 69 264  

Cr Swap asset (to recognise the loss on the swap contract negotiated with Watego Ltd—see table provided earlier)

69 264

Dr Interest expense 311 688  

Cr Cash (to recognise the payment made to the US corporation of 311 688 = [2 000 000 × 0.12] ÷ 0.77)

311 688

Dr Cash 11 688  

Cr Interest expense (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)

11 688

Dr Loan 2 597 403  

Cr Cash (repayment of overseas loan)

2 597 403

Dr Cash 97 403  

Cr Swap asset (to recognise the completion of the swap contract and to record the amount paid to Byron Ltd by Watego Ltd)

97 403

(b) Accounting entries in the books of Watego Ltd

1 July 2022

Dr Cash 2 500 000  

Cr Loan (to recognise the domestic loan taken out by Watego Ltd)

2 500 000

continued

dee67382_ch14_527-598.indd 584 10/24/19 03:30 PM

584 PART 4: Accounting for liabilities and owners’ equity

There is no entry on 1 July 2022 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

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

1 July 2022 2 500 000 2 500 000 – – 30 June 2023 2 857 143 2 500 000 (357 143) (357 143) 30 June 2024 2 666 667 2 500 000 (166 667) 190 476 30 June 2025 2 597 403 2 500 000 (97 403) 69 264

30 June 2023 Dr Loss on swap contract 357 143   Cr Swap liability

(to recognise loss on swap contract)   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

(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 = $2 500 000 × 12 per cent)

300 000

Dr Interest expense 42 857   Cr Cash

(to recognise the additional interest paid to the other party to the swap contract)   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

$250 0000 × 12 per cent = $300 000

Cash flows associated with overseas loan (2 000 000 × 12 per cent) ÷ 0.70

= $342 857

Amount to be transferred to Byron Ltd from Watego Ltd $  42 857

WORKED EXAMPLE 14.24 continued

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 14.24. The contractual relationship between either company

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 borrowed funds 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

interest rate swap Occurs 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.

dee67382_ch14_527-598.indd 585 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 585

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 14.25.

WORKED EXAMPLE 14.25: 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 2022, 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 2023.

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 Bombi Ltd

Pays 12 per cent to primary lender Pays BBR + 0.5 per cent to primary lender

Pays BBR + 0.5 per cent to Bombi Ltd Pays 13 per cent to Beachmere Ltd

Receives 13 per cent from Bombi Ltd Receives BBR + 0.5 per cent from Beachmere Ltd

Net interest cost = BBR – 0.5 per cent 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 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 (i.e. a hedge of a future transaction in which the future cash flows being hedged are the future interest payments). (AASB 9)

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.

14.14 Compound financial instruments

As we have noted in our discussion of compound financial instruments earlier in this chapter, 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,

LO 14.14

dee67382_ch14_527-598.indd 586 10/24/19 03:30 PM

586 PART 4: Accounting for liabilities and owners’ equity

in all cases, the entity presents the liability and equity components separately in its statement of financial position. (AASB 132)

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. (AASB 132)

Worked Example 14.26 describes how to account for compound instruments.

WORKED EXAMPLE 14.26: Accounting for compound instruments

Grommett Ltd issues $10 million of convertible bonds on 1 July 2022. 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. For the purposes of this question, this required market rate for these financial instruments is assumed to remain at 8 per cent throughout the life of the bonds.

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.

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. (AASB 132)

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 states:

dee67382_ch14_527-598.indd 587 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 587

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. (AASB 132)

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 2022

Dr Cash at bank 10 000 000  

Cr Convertible bonds (liability)   9 337 568

Cr Convertible bonds (equity component) (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)

662 432

30 June 2023

Dr Interest expense 747 005  

Cr Cash   600 000

Cr Convertible bonds (liability) (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)

147 005

(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).

continued

dee67382_ch14_527-598.indd 588 10/24/19 03:30 PM

588 PART 4: Accounting for liabilities and owners’ equity

Date Payment Interest

expense Increase in

bond liability Bond liability

1 July 2022          9 337 568

30 June 2023 600 000 747 005 147 005    9 484 573

30 June 2024 600 000 758 766 158 766    9 643 339

30 June 2025 600 000 771 467 171 467    9 814 806

30 June 2026 600 000 785 194 185 194 10 000 000

(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 bonds (after receiving their interest payments), the entries in the third year would be:

30 June 2025

Dr Interest expense 771 467  

Cr Cash   600 000

Cr Convertible bonds (liability) (to recognise interest expense for the period)  

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

WORKED EXAMPLE 14.26 continued

Table 14.4 Stream of interest expenses over four- year life of bonds

14.15 Disclosure requirements pertaining to financial instruments

As its name would suggest, accounting standard AASB 7 Financial Instruments: Disclosures provides disclosure requirements relating to financial instruments. In explaining the rationale for the disclosure

requirements 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. (AASB 7)

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 2003–04. Such losses make investors wary and inclined to demand greater disclosures about such instruments.

LO 14.15

dee67382_ch14_527-598.indd 589 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 589

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. (AASB 7)

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 35 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.

Quantitative 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. (AASB 7)

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.

WHY DO I NEED TO KNOW ABOUT THE DISCLOSURE REQUIREMENTS PERTAINING TO FINANCIAL INSTRUMENTS?

Because financial instruments—particularly those in the form of derivatives, and unhedged foreign currency receivables and payables—can expose an organisation to various risks, it is important for readers of financial statements to know about such risks. Knowing the required disclosures enables us to understand what to look for in the financial reports, as organisations are required to make various useful disclosures—it is just a matter of the report reader finding them and then understanding the meaning of the disclosures (which in themselves are not always that easy to understand).

dee67382_ch14_527-598.indd 590 10/24/19 03:30 PM

590 PART 4: Accounting for liabilities and owners’ equity

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 initially 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 to transfer cash in the future. An equity instrument cannot involve such 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 573 call option 578 cash flow hedge 564 compound financial instrument 538

convertible note 538 derivative financial instrument 533 equity instrument 530 exercise price 578 fair value hedge 564

financial instrument 529 foreign currency swap 579 forward rate 561 futures contract 572 hedge contract 561 hedging 572

dee67382_ch14_527-598.indd 591 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 591

interest rate swap 584 mark to market 572 option 578

put option 578 set-off 540 spot rate 579

strike price 578 swap agreement 579

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is a ‘financial instrument’? LO 14.1 A financial instrument is defined in AASB 132 as:

any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. (AASB 132)

2. At the time of initial recognition, on what basis shall financial instruments be measured? LO 14.5, 14.7 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. (AASB 9)

3. If equity investments have been made in another entity (for example, shares have been acquired), and the investments were made for trading purposes, how shall any gain or loss on the investments be treated? LO 14.5, 14.6 If equity investments are held for trading purposes, they shall be measured at fair value through profit or loss.

4. Which financial assets shall be measured at amortised cost? LO 14.5, 14.6 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.

5. What is a ‘hedging arrangement’ and why might an organisation enter a hedging arrangement? LO 14.9 A hedging arrangement is said to exist in 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 a hedging arrangement that takes a position opposite to the original transaction, an entity can minimise its exposure to gains and losses on particular assets and liabilities.

6. What is a ‘compound financial instrument’, and how is the debt component of a compound financial instrument determined? LO 14.14 An entity might issue securities—such as convertible bonds—that have both equity and liability characteristics. Such securities are frequently classified as compound financial instruments, as they can include both equity instruments and financial liabilities. Paragraph AG 31 of AASB 132 requires that, 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.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Define ‘financial instrument’. LO 14.1 • 2. Define a financial asset, a financial liability and an equity instrument. LO 14.2 •

dee67382_ch14_527-598.indd 592 10/24/19 03:30 PM

592 PART 4: Accounting for liabilities and owners’ equity

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 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, 14.2 • 5. What is a derivative financial instrument? Provide some examples. LO 14.1, 14.2 • 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 14.9, 14.10 •• 7. What is a call option and what is a put option? LO 14.12 • 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 14.5, 14.6 •• 9. Should impairment testing be undertaken for financial instruments that are measured at amortised cost? LO 14.5,

14.6 •• 10. Would physical assets (such as inventories, property, plant and equipment) be considered to be financial assets?

Why? LO 14.1, 14.2 •• 11. How would you determine the debt component and the equity component of a compound financial instrument?

LO 14.14 •• 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 14.9 • 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 14.9, 14.10 ••

15. Would prepayments be considered to be financial instruments? Why? LO 14.2 • 16. What is a compound financial instrument? Provide some examples. LO 14.14 • 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 14.2, 14.3 ••• 18. What does mark to market mean? LO 14.6 • 19. Explain what a set-off of assets and liabilities is. LO 14.4 • 20. When does a ‘right of set-off’ exist? LO 14.4 • 21. Why would companies perform a set-off of assets and liabilities? LO 14.4 • 22. What disclosures must be made, pursuant to AASB 132, in the period following a set-off of assets and liabilities?

LO 14.4, 14.5 •• 23. Arthur Ltd has the following statement of financial position:

Statement of financial position before set-off

Loans payable 1 000 000 Loans receivable 1 200 000

Shareholders’ equity    1 000 000 Non-current assets      800 000

  $2 000 000   $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 14.4 •••

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 14.4 ••

dee67382_ch14_527-598.indd 593 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 593

25. On 1 July 2022 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 2023—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 14.5, 14.6 •••

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 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 ••

27. 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 measured? LO 14.6, 14.7 ••

28. 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 14.5, 14.7 •••

29. Explain how a currency swap operates. LO 14.13 •• 30. Explain how an interest rate swap operates. LO 14.13 •• 31. 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 •• 32. 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 14.9, 14.10, 14.11 •••

33. 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 14.2, 14.3 ••

34. 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 14.9, 14.11 •••

35. On 1 November 2022, Long Ltd enters a contract to buy inventory from an overseas supplier, with the inventory to be delivered in six months’ time. A sum of US$1 000 000 is payable on delivery of the inventory.

Long Ltd does not want to be exposed to potential losses associated with changes in the exchange rate. As a result, Long Ltd takes out a forward rate contract with Board Bank to purchase US$1 000 000 in six months’ time at an exchange rate of A$1.00 = US$0.70.

REQUIRED Explain who now bears the risks associated with changes in the exchange rate, and calculate how much Long Ltd will ultimately pay for the inventory. LO 14.9, 14.10 •••

36. On 1 July 2022, 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 Prepare the journal entry to issue the bonds at 1 July 2022, and the entry at 30 June 2023 to record the interest paid. LO 14.7, 14.8 ••

37. 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, 14.14 ••

38. Should interest on financial liabilities always be treated as an expense? LO 14.7, 14.8 ••

dee67382_ch14_527-598.indd 594 10/24/19 03:30 PM

594 PART 4: Accounting for liabilities and owners’ equity

39. Would it ever be appropriate to classify the distributions to holders of preference shares as interest expense rather than dividends? Explain your answer. LO 14.8 •

40. 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 14.14 ••

41. 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 14.3, 14.14 ••• 42. AASB 7 is concerned primarily with ensuring extensive disclosure of financial instruments. Why do you think this is

the case? LO 14.15 •• 43. 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? (b) Would it have been costly for companies to change how they disclose their convertible bonds? Explain your

answer. LO 14.14, 14.15 ••• 44. Lehman Ltd sells some printed material to an organisation in the United States on 1 July 2023. The price is

denominated in US dollars and is US$500 000. It is to be paid on 1 September 2023. 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. (b) How much money, in Australian dollars, will Lehman Ltd ultimately receive from the sale? LO 14.10, 14.11 ••

CHALLENGING QUESTIONS

45. 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

46. 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 perspectives 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 14.3, 14.12

47. On 1 July 2023 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.

dee67382_ch14_527-598.indd 595 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 595

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 rate on both loans is 6 per cent, and remains at 6 per cent throughout the terms of the loans. The relevant exchange rates are:

1 July 2023 A$1.00 = US$0.70

30 June 2024 A$1.00 = US$0.67

Provide the journal entries in the books of both Billy Ltd and Rip Ltd for 1 July 2023 and 30 June 2024. LO 14.13

48. On 1 July 2022 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 14.3, 14.14

49. (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 with ‘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 14.9, 14.10

50. On 1 June 2022 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 2022, 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 Sydney Ltd has designated the hedging arrangement as a ‘fair value hedge’. The relevant spot rates and forward rates are as follows:

Date Spot rate Forward rate

1 June 2022 US$1.00 = A$1.35 US$1.00 = A$1.40

30 June 2022 US$1.00 = A$1.27 US$1.00 = A$1.42

1 August 2022 US$1.00 = A$1.43 US$1.00 = A$1.43

REQUIRED Provide the journal entries to account for the hedged item and hedging instrument as required on 1 June 2022, 30 June 2022 and 1 August 2022. LO 14.9, 14.10

51. Brisbane Ltd manufactures cars. On 15 June 2022 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 2022, 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 2022.

Because of concerns about movements in foreign exchange rates, on 15 June 2022 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 2022 at a forward rate of A$1.00 = 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.

dee67382_ch14_527-598.indd 596 10/24/19 03:30 PM

596 PART 4: Accounting for liabilities and owners’ equity

Other information The respective spot rates are provided below. The forward rates offered on particular dates, for delivery of US dollars on 30 August 2022, are also provided.

Date Spot rate Forward rates for 30 August

delivery of US$

15 June 2022 A$1.00 = US$0.78 A$1.00 = US$0.75

30 June 2022 A$1.00 = US$0.76 A$1.00 = US$0.73

30 August 2022 A$1.00 = US$0.71 A$1.00 = 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 2022. LO 14.10, 14.11

52. On 1 July 2023 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 2023 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 2023 Busta Ltd decides to sell its portfolio of shares and to close out its futures contracts. 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 arrangement is not designated a cash flow hedge. LO 14.10, 14.11

53. Tea Tree Ltd has acquired some government bonds on 1 July 2022. 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 rate of return for these government bonds decreased to 5 per cent on 30 June 2023 (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 2022. (b) Provide the accounting journal entries for the government bonds for the years ending 30 June 2023 and 30

June 2024, 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 2023, 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 2023, assuming that the business model being used for government bonds focuses upon trading government bonds. LO 14.5, 14.6

54. On 1 July 2022 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 principal of $2 million on 30 June 2026. 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 2023, 2024, 2025 and 2026. (d) Provide the accounting journal entries for the years ending 30 June 2023, 2024, 2025 and 2026. LO 14.6, 14.7

dee67382_ch14_527-598.indd 597 10/24/19 03:30 PM

CHAPTER 14: Accounting for financial instruments 597

55. 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 14.13

56. Woodie Ltd issues $5 million in convertible bonds on 1 July 2023. 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 2024 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 2023 (b) recognise the interest payment on 30 June 2024, and (c) recognise the conversion of the bonds to ordinary shares on 1 July 2024. LO 14.8, 14.14

57. On 1 June 2023 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 2023 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 2023.

(b) If the bonds were acquired for speculative purposes, give the amount at which the bonds should be reported in the statement of financial position at 30 June 2023. If a change in fair value is recognised, where should it be recognised? LO 14.5, 14.6

58. On 1 November 2022 Sandy Ltd issued 10 000 convertible notes with the following features:

Face value $1000

Term Four years

Issue price At face value

Interest Coupon rate of 10 per cent payable annually in arrears

Conversion option Each note is convertible into 100 ordinary shares

Market interest rate 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 14.7, 14.14

59. Malibu Ltd issues $10 million of convertible bonds on 1 July 2022. 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 Malibu 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 bonds elect to convert the bonds to ordinary shares at the

end of the third year of the bonds. LO 14.8, 14.14

dee67382_ch14_527-598.indd 598 10/24/19 03:30 PM

598 PART 4: Accounting for liabilities and owners’ equity

60. Melbourne Ltd manufactures electric skateboards. On 4 June 2022 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 2022. The total contract price was US$3 000 000 and the full amount was due for payment on 30 August 2022.

Because of concerns about movements in foreign exchange rates, on 4 June 2022 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 2022 at a forward rate of A$1.00 = 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 2022, are also provided.

Date Spot rate Forward rates for 30 August 2022

delivery of US$

4 June 2022 A$1.00 = US$0.80 A$1.00 = US$0.78

30 June 2022 A$1.00 = US$0.78 A$1.00 = US$0.76

31 July 2022 A$1.00 = US$0.75 A$1.00 = US$0.74

30 August 2022 A$1.00 = US$0.72 A$1.00 = US$0.72

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 2022. LO 14.7, 14.8, 14.9, 14.10

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. 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.

dee67382_ch15_599-640.indd 599 10/24/19 03:35 PM

599

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

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 background to the release of AASB 15 Revenue from Contracts with Customers. 15.4 Know the scope of AASB 15. 15.5 Understand the five-step model derived from AASB 15 and used for determining the recognition of

revenue from contracts with customers. 15.6 Understand the importance to revenue recognition of identifying and understanding the terms of the

‘contracts’ negotiated with customers (Step 1 of the five-step model from AASB 15). 15.7 Understand the importance to revenue recognition of identifying the separate ‘performance

obligations’ in contracts negotiated with customers (Step 2 of the five-step model from AASB 15). 15.8 Know how to determine the ‘transaction price’ of a contract with a customer (Step 3 of the five-step

model from AASB 15) by knowing how to deal with variable consideration, financing components inherent in a contract, non-cash consideration, and any consideration payable to customers.

15.9 Understand how to allocate the transaction price to separate performance obligations identified within a contract with a customer (Step 4 of the five-step model from AASB 15).

15.10 Know how to recognise revenue as each performance obligation within a contract is satisfied (Step 5 of the five-step model from AASB 15).

15.11 Understand how to account for unearned revenue. 15.12 Understand how the existence of particular conditions included within a contract with a customer (such

as attached put and call options, or any right of return) will affect the timing of revenue recognition. 15.13 Understand how to account for revenues from long-term construction projects. 15.14 Understand how to account for dividend and interest revenue. 15.15 Understand the need to create an allowance for doubtful debts, and know how to do the associated

accounting journal entries.

C H A P T E R 15 Revenue recognition issues

dee67382_ch15_599-640.indd 600 10/24/19 03:35 PM

600 PART 4: Accounting for liabilities and owners’ equity

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

7 Financial Instruments: Disclosures IFRS 7

9 Financial Instruments IFRS 9

15 Revenue from Contracts with Customers IFRS 15

137 Provisions, Contingent Liabilities and Contingent Assets IAS 37

141 Agriculture IAS 41

OPENING QUESTIONS Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers. 1. ‘Income’ is often subdivided into ‘revenues’ and ‘gains’, but is there a difference between them? LO 15.1, 15.2 2. What is the general rule in terms of when revenue shall be recognised from contracts with customers?

LO 15.7, 15.10 3. If a customer pays for a product or service provided by an organisation with a payment that is not in the form

of cash, on what basis will that revenue be measured? LO 15.8 4. Organisations often sell products to customers with a ‘right of return’. What is a ‘right of return’, and how, if at

all, shall the right of return be accounted for at the point of sale? LO 15.12 5. If an organisation is constructing a building, and that building will take a number of years to complete, can

the organisation recognise revenue throughout the contract, or does the construction-based organisation have to wait until project completion before it recognises the revenue associated with the construction contract? LO 15.7, 15.10

6. AASB 15 identifies five steps that need to be taken when recognising revenue from contracts with customers. What are these steps? LO 15.5

15.1 The definition and recognition of income

In this chapter we will consider various accounting issues that arise in relation to the recognition and measurement of income. Apart from considering ‘income’ at its broader level, we will 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’.

While this chapter will mainly focus upon revenues from contracts with customers, to put our discussion within the context of ‘income’ generally, we will start here with a broader discussion of income.

As we know from previous chapters, the Conceptual Framework for Financial Reporting defines the element of accounting known as ‘income’ (the other elements being expenses, assets, liabilities and equity) as:

increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

Income arises from a variety of transactions or events, including the provision of goods and services to customers; from returns generated from investing in or lending to another entity; from holding and disposing of non-current assets; by receiving non-reciprocal transfers such as grants, donations and bequests; or where liabilities are forgiven. Hence, 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 as income because they do not result in an increase in equity.

We observe from the Conceptual Framework’s definition of income that there are two essential characteristics of income, these being:

1. an increase in assets, or a decrease in liabilities 2. a resulting increase in equity, other than as a result of contributions from owners.

LO 15.1

dee67382_ch15_599-640.indd 601 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 601

Following on from the definition of income above, unless we understand what assets and liabilities are, we will not be able to understand what ‘income’ is. The recognition of income is directly dependent upon the recognition of a change (increase) in assets and/or a change (decrease) in liabilities. We also know that the definition of an asset— which then directly ‘feeds into’ the definition and recognition of income—relies upon the reporting entity having ‘control’ over the related resource.

Revenue recognition points 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.

Figure 15.1 The earnings cycle

1. Devising an idea

3. Receipt of orders before commencing production

4. Commencing production 6. Completion of

production

7. Receipt of orders after completing production

8. Delivery of goods to customers

9. Receipt of cash

5. Progressively throughout production

2. Making purchases (e.g. of inventories)

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 Chartered Accountants Australia and New Zealand

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.

dee67382_ch15_599-640.indd 602 10/24/19 03:35 PM

602 PART 4: Accounting for liabilities and owners’ equity

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’.

Revenue recognition with respect to contracts with customers would, in practice, 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, transaction-based system of accounting. Income now tends 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 equity investments are frequently recognised as part of profit or loss, even in the absence of a transaction. Such a practice represents a departure from traditional historical-cost accounting, but it 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 asset 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. This means that when new accounting standards are issued that change how particular assets are measured, this will in turn have implications for the recognition and measurement of income.

As an example of how revenue is affected by a change in the rules governing the measurement of assets, we can consider 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. To put it 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 that involves ‘customers’, 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.

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 was 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 accounting standard AASB 15 Revenue from Contracts with Customers—which we shall discuss shortly—means that this practice ceased 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).

dee67382_ch15_599-640.indd 603 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 603

Where products require transportation, the revenues from manufacturing and selling activities are commonly recognised at the time of sale, normally determined by the shipping terms. That is, the time of sale is commonly interpreted as the time when the title passes. If the goods are shipped on terms referred to as f.o.b. shipping point (where f.o.b. stands for free on board), the title passes to the buyer when the seller delivers the goods to a common carrier (the ‘shipping point’), who acts as an agent for the buyer. Revenue would typically be recognised when the goods reach the carrier. If the goods are shipped f.o.b. destination, the title does not pass until the buyer receives the goods from the common carrier (that is, at the destination). In this case, 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.

15.2 Income as ‘revenues’ and ‘gains’

Income has traditionally been subdivided into ‘revenues’ and ‘gains’. Generally speaking, revenues relate to the ordinary income-generating activities of an entity—for example, from sales or rental receipts (and this traditional approach is consistent with AASB 15)—whereas gains relate to ‘other income’, which does not necessarily constitute part of the ordinary activities of an entity. For example, ‘gains’ might include those increases in equity arising on the disposal of non-current assets, or on the revaluation of non-current assets. When ‘gains’ are recognised in the income statement, they are often displayed separately because knowledge of them is useful for the purpose of making economic decisions. Gains are often also reported net of related expenses.

In respect of revenue, which is a component of income, AASB 15 defines revenue as:

Income arising in the course of an entity’s ordinary activities. (AASB 15)

Interestingly, AASB 15 does not actually define ‘ordinary activities’, hence there is some scope for professional judgement when determining whether the accounting standard applies to particular transactions or events.

While the former Conceptual Framework (as released by the IASB in 2010) subdivided income into ‘revenues’ and ‘gains’, this subdivision no longer exists in the revised Conceptual Framework released in 2018. Nevertheless, as we see above, the term ‘revenue’ is central to AASB 15.

15.3 Background to the release of the accounting standard on revenue recognition (AASB 15)

In late 2014, the accounting standard AASB 15 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. Given that the definition of income relies upon the definition of assets, ‘control’ is also therefore of direct importance to the definition and recognition of income.

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 the related 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, albeit that this represents an aspect of ‘control’). In the process leading to the development of the accounting standard, paragraph 6.7 of a Discussion Paper released by the IASB in 2008 (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.

LO 15.2

LO 15.3

f.o.b. shipping point An agreement whereby the price of a purchase typically includes the costs necessary to get the item to a certain transportation point, at which point title passes to the buyer.

f.o.b. destination An agreement whereby the price of a purchase typically includes the costs necessary to get the item to a certain destination, at which place title to the goods passes to the buyer.

dee67382_ch15_599-640.indd 604 10/24/19 03:35 PM

604 PART 4: Accounting for liabilities and owners’ equity

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. 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, and as noted above, 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 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. Further, because of the likely impact on financial statements of the new accounting standard, the date between release of the accounting standard and the date for implementation of the standard was relatively long. When issued in 2014, the accounting standard required implementation of the standard for reporting periods beginning on, or after, 1 January 2018.

15.4 Scope of AASB 15

In relation to the scope of AASB 15, paragraph 5 (the Scope section) states:

An entity shall apply this Standard to all contracts with customers, except the following: (a) lease contracts within the scope of AASB 16 Leases; (b) insurance contracts within the scope of AASB 4 Insurance Contracts; (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. (AASB 15)

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:

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. (AASB 15)

Because both the ‘objective’ and the ‘scope’ of AASB 15 make reference to ‘contracts’ with ‘customers’, it is useful to consider early in our discussion 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. (AASB 15)

LO 15.4

dee67382_ch15_599-640.indd 605 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 605

15.5 An overview of the five-step model for determining the recognition of revenue from contracts with customers

In relation to the recognition of revenue, AASB 15 identifies five important elements of a contract with a customer that need to be carefully reviewed by a reporting entity. We will refer to these elements as constituting a five-step model for revenue recognition. This is represented in Figure 15.2. Please take some time to look carefully at this five-step model and consider for yourself the sequential nature of these steps. That is, please try to understand how we must, on the basis of logic, complete each step before moving to the next step in the sequence.

These five steps must be applied to each contract with a customer in a sequential manner. We will consider each of these steps across the following pages, starting (logically) with Step 1.

LO 15.5

Figure 15.2 The five- step revenue recognition model reflecting the elements of a contract identified within AASB 15

Step 1: Identify the contract(s) with customers

Step 2: Identify the separate performance obligation(s) in the contract

Step 3: Determine the transaction price of the contract

Step 5: Recognise revenue when each performance obligation is satisfied

Step 4: Allocate the transaction price to each performance obligation

15.6 Step 1—identify the contract(s) with customers

As we can see from Figure 15.2, the first step is to identify the ‘contract’, which as we now know is an ‘agreement between two or more parties that creates enforceable rights and obligations’. While the contract could be written, it could also be verbal or implied by customary business practices. Obligations associated with contracts need to be interpreted within the context of the laws in place in the respective jurisdiction. As paragraph 10 of AASB 15 states:

The practices and processes for establishing contracts with customers vary across legal jurisdictions, industries and entities. In addition, they may vary within an entity (for example, they may depend on the class of customer or the nature of the promised goods or services). An entity shall consider those practices and processes in determining whether and when an agreement with a customer creates enforceable rights and obligations. (AASB 15)

Paragraph 9 of AASB 15 sets out the conditions that must be satisfied before a contract satisfies the requirements for application of the five-step model incorporated within AASB 15. This paragraph states:

An entity shall account for a contract with a customer that is within the scope of this Standard only when all of the following criteria are met:

(a) the parties to the contract have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations;

(b) the entity can identify each party’s rights regarding the goods or services to be transferred; (c) the entity can identify the payment terms for the goods or services to be transferred;

LO 15.6

dee67382_ch15_599-640.indd 606 10/24/19 03:35 PM

606 PART 4: Accounting for liabilities and owners’ equity

(d) the contract has commercial substance (ie the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract); and

(e) it is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession. (AASB 15)

Once we have identified the contract and understood the implications of the terms of the contract, the next step is to identify the separate performance obligations.

WHY DO I NEED TO IDENTIFY THE CONTRACTUAL ARRANGEMENTS WITH CUSTOMERS?

The contract will identify a number of important factors that are necessary for determining whether to recognise revenue, when to recognise it, and the amount of revenue to be recognised as particular performance obligations are satisfied. Therefore, this is a necessary first step in the process of recognising revenue.

WORKED EXAMPLE 15.1: Identification of performance obligations within a contract

Big Talk Ltd offers customers 24-month contracts for use on its 5G mobile network. The cost is $200 per month and includes providing the customer with a phone worth $900 at the beginning of the contract.

REQUIRED You are to identify the performance obligations within the contract.

SOLUTION We identify the performance obligations at the commencement of the contract. This requires us to identify each contractual promise to deliver goods and/or services to the customer. This is required so that we can subsequently allocate amounts of the ‘transaction price’ to each ‘performance obligation’ as it is satisfied. If distinct, each good or service promised to a customer creates a performance obligation. In this case there are two performance obligations that need to be accounted for separately, and Big Talk Ltd must allocate the total contract price between the mobile phone and the monthly service being provided.

15.7 Step 2—identify the performance obligation(s) in the contract

Once we have identified the contract (in Step 1), we then need to identify the ‘performance obligations’ within the contract. We do this at the beginning of the contract and this requires us to identify each contractual promise

to deliver, to a customer, goods or services. According to paragraph 22 of AASB 15, a performance obligation exists if it requires the transfer to the customer of either:

(a) a good or service (or a bundle of goods or services) that is distinct; or (b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer

to the customer. (AASB 15)

As long as it is ‘distinct’, any good or service promised to a customer as a result of a contract creates a ‘performance obligation’. Multiple performance obligations could be bundled within one contract. A distinct performance obligation can arise even if the related promise is incidental or part of a broader marketing campaign. An example would be the free mobile phones that are often provided to customers who sign up to a service plan offered by a telecommunications organisation. Worked Examples 15.1 and 15.2 provide insights into identifying performance obligations within contracts.

LO 15.7

dee67382_ch15_599-640.indd 607 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 607

WHY DO I NEED TO BE ABLE TO IDENTIFY THE SEPARATE PERFORMANCE OBLIGATIONS IN CONTRACTS WITH CUSTOMERS?

AASB 15 requires that an organisation shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. Therefore, it is a central requirement to recognising revenue that we are able to identify the separate performance obligations, and whether the obligations have been satisfied (at which point, the revenue is recognised).

WORKED EXAMPLE 15.2: A further example of identifying performance obligations within a contract

Consider the following two independent situations:

(a) Bobby Builder Corp agrees to construct a warehouse for a customer. As part of the contract, Bobby Builder Corp will: • provide engineering plans specific to the warehouse • clear the site of the pre-existing building • provide the labour and materials for the new warehouse, and • oversee the entire project management.

(b) Boffin Ltd has signed a contract to provide a customer with access to particular computer software, install the software within one of the customer’s sites (without modifying the software) and provide technical support for the software for the next two years. The software could be installed by a number of other organisations as well. Boffin Ltd also regularly sells each of these contractual components separately.

REQUIRED Identify the separate performance obligations in each of the above cases.

SOLUTION

(a) It is not clear that these services are distinct. The promise to deliver particular services does not appear to be separately identifiable. There seems to be a combined product, which is the warehouse. As such, there appears to be a single performance obligation and that is to construct a warehouse (see paragraph 29 of AASB 15).

(b) There does appear to be three separate promises, these being: • sell software to the customer • perform an installation service for the customer, and • provide ongoing technical support to the customer.

The software can be used without Boffin Ltd’s additional services (an alternative organisation could be contracted to install it), and the ongoing technical support is not essential to the use of the asset. As such, each of the services are ‘distinct’. The three services do seem to satisfy the criteria provided within paragraph 27 of AASB 15 for them to be treated as separate performance obligations, which states:

A good or service that is promised to a customer is distinct if both of the following criteria are met:

(i) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (ie the good or service is capable of being distinct); and

(ii) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (ie the promise to transfer the good or service is distinct within the context of the contract).

Therefore, there are three separate performance obligations to which the transaction price shall then be apportioned.

dee67382_ch15_599-640.indd 608 10/24/19 03:35 PM

608 PART 4: Accounting for liabilities and owners’ equity

Number of bikes returned Probability of outcome

0 15%

1 20%

2 28%

3 22%

4 15%

15.8 Step 3—determine the transaction price of the contract

Where revenue is to be recognised for the purposes of inclusion within financial statements, we obviously need to place a measurement on it. Determining the transaction price of a contract is a key component of the

five-step model derived from AASB 15, and represents Step 3 of the five-step model shown in Figure 15.2. Once we determine the total contract price, we will then allocate it between the separate performance obligations within the contract (which is Step 4, to be discussed shortly).

In relation to determining the transaction price (Step 3), 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. (AASB 15)

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 paragraph 47 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 (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both. (AASB 15)

Paragraph 48 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. (AASB 15)

We will now address, in turn, each of these five considerations pertaining to determining the transaction price.

Variable consideration 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 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.

(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). (AASB 15)

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):

LO 15.8

dee67382_ch15_599-640.indd 609 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 609

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.

Worked Example 15.3 provides another illustration of determining ‘variable consideration’.

WORKED EXAMPLE 15.3: Determining variable consideration

Surf Tech Company enters a contract with a customer to deliver 100 surfboards at a price of $800 per surfboard. The terms within the contract allow the customer to return any unsold surfboards within 40 days of acquisition and to receive a full refund. The contract is completed within the current reporting period. Using past experience, Surf Tech Company estimates the following probabilities of surfboards being returned:

Number of surfboards returned Probability of outcome

0 10%

1 15%

2 35%

3 25%

4 15%

REQUIRED You are to determine the transaction price using the ‘expected value method’.

SOLUTION The ‘transaction price’ would be considered to be a ‘variable amount’. The estimated variable consideration using the expected value method is $78 240, calculated as follows:

Number of surfboards returned Probability of outcome Entitlement to consideration

0 10% 100 × $800 × 0.10 = $ 8 000

1 15%  99 × $800 × 0.15 = $11 880

2 35%  98 × $800 × 0.35 = $27 440

3 25%  97 × $800 × 0.25 = $19 400

4 15%  96 × $800 × 0.15 = $11 520

    $78 240

probable More likely than less likely.

Constraining estimates of variable consideration This is the second consideration when determining the ‘transaction price’. Variable consideration is considered to be ‘constrained’ if there is a high level of uncertainty that the variable consideration will ultimately be collected/realised. If the variable consideration is considered to be too uncertain, then it should not be included within the calculation of the transaction price. Indeed, paragraph 56 of AASB 15 requires that an entity shall include in the transaction price some, or all, of an amount of variable consideration estimated in accordance with either ‘expected value’ or ‘most likely amount’ only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

Financing component A third issue to consider when determining the transaction price is the possible inclusion of a financing component within the contract with the customer. If it is clear that there is a financing component in the sale (for example, that

dee67382_ch15_599-640.indd 610 10/24/19 03:35 PM

610 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 15)

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.

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, 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). (AASB 15)

If a contract contains a significant financing component, then the contract effectively consists of two performance obligations that need to be accounted for separately, these being:

∙ one for the exchange of the goods or services ∙ one for the financing of those goods or services.

Worked Example 15.4 provides an example of a transaction with an interest component.

WORKED EXAMPLE 15.4: Receipt of a deferred payment for the provision of services

In June 2022 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 30 June 2022. The contract with Big Town Ltd requires it to make two deferred payments of $20 000 each to McTavish Ltd on 30 June 2023 and 30 June 2024. McTavish typically provides credit arrangements to such customers at a rate of 8 per cent. McTavish has a reporting period ending on 30 June.

REQUIRED Provide the journal entries for McTavish to account for the revenue to be received from the customer.

dee67382_ch15_599-640.indd 611 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 611

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 30 June 2023: $20 000 × 0.92593 = $18 519

PV of amount to be received on 30 June 2024: $20 000 × 0.85734 = $17 147

    $35 666

Effectively, when McTavish Ltd receives the payments it will be receiving the payments for the revenue earned in 2022 (and therefore already recognised) plus some interest revenue that it earns as a result of deferring the receipts of the payments. McTavish is effectively providing finance to Big Town Ltd. 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:

30 June 2022

Dr Accounts receivable 35 666  

Cr Revenue from surf lessons (to recognise the present value of earned revenue)

35 666

30 June 2023

Dr Cash at bank 20 000  

Cr Accounts receivable   17 147

Cr Interest revenue (to recognise the cash received from an account receivable and to recognise the interest earned with respect to the outstanding accounts receivable)

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 paragraph 64 of AASB 15 (reproduced above), after contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances.

30 June 2024

Dr Cash at bank 20 000  

Cr Accounts receivable   18 519

Cr Interest revenue (to recognise the cash received from an account receivable and to recognise the interest earned with respect to the outstanding accounts receivable) 

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 $1 481.

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 2022, 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 2023.

The difference 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.)

continued

dee67382_ch15_599-640.indd 612 10/24/19 03:35 PM

612 PART 4: Accounting for liabilities and owners’ equity

REQUIRED Provide the journal entries for Cassie Limited for the years ended 30 June 2023, 2024 and 2025.

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 revenue is calculated by multiplying the opening receivable for a period by the rate of interest implicit in the arrangement (in this case 12 per cent).

Date

Opening receivable

$

Interest revenue at 12%

$

Cash payment

$

Principal reduction

$

Outstanding balance

$

1 July 2022 12 009

30 June 2023 12 009  1 441  5 000  3 559 8 450

30 June 2024  8 450  1 014  5 000  3 986 4 464

30 June 2025  4 464    536  5 000  4 464 0

    2 991 15 000 12 009  

Interest revenue equals the outstanding receivable 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 referred to as the effective-interest method. The reduction in the receivable is calculated by subtracting the interest revenue from the cash payment.

The journal entries would be:

1 July 2022

Dr Note receivable 12 009  

Cr Sales   12 009

Dr Cost of sales 9 000  

Cr Inventory (to record the initial sale on 1 July 2022 and to separately recognise the financing component as reflected by the note receivable)

9 000

30 June 2023

Dr Cash 5 000  

Cr Note receivable   3 559

Cr Interest revenue (to record the receipt of $5000 on 30 June 2023)

  1 441

30 June 2024

Dr Cash 5 000  

Cr Note receivable   3 986

Cr Interest revenue (to record the receipt of $5000 on 30 June 2024)

  1 014

30 June 2025

Dr Cash 5 000  

Cr Note receivable   4 464

Cr Interest revenue (to record the receipt of $5000 on 30 June 2025)

  536

WORKED EXAMPLE 15.5 continued

dee67382_ch15_599-640.indd 613 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 613

WHY DO I NEED TO KNOW HOW TO DETERMINE THE TRANSACTION PRICE OF A CONTRACT?

It is the transaction price that will subsequently be allocated to each performance obligation, with the related allocated revenue being recognised as the respective performance obligation is satisfied. Therefore, clearly we need to know the total transaction price. Without knowing the transaction price, we will not be able to allocate revenue to the separate performance obligations within a contract.

LO 15.9

Non-cash consideration A fourth issue to consider when determining the ‘transaction price’ is the effects of non-cash consideration. If the contract price is cash, 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 15.6 provides an example of a transaction involving non-cash consideration.

WORKED EXAMPLE 15.6: 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 Machinery 60 000  

Cr Consulting revenue (to recognise consulting revenue at the fair value of the machinery received in lieu of cash) 

60 000

Consideration payable to a customer Our fifth and final issue to consider when determining the ‘transaction price’ is consideration payable to a customer as part of a contract. Consideration might be payable to a customer as an incentive to encourage the customer to purchase goods or services from the organisation. For example, organisations often offer their customers cash rebates for buying particular products or services. Such consideration is to be accounted for as a reduction of the transaction price to be paid to the organisation.

15.9 Step 4—allocate a transaction price to each performance obligation

Our fourth step in the five-step revenue recognition model is to allocate the transaction price of the contract— which was determined within Step 3—to the separate performance obligations within the contract. The objective of doing this is identified at paragraph 73 of AASB 15 and:

is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer. (AASB 15)

dee67382_ch15_599-640.indd 614 10/24/19 03:35 PM

614 PART 4: Accounting for liabilities and owners’ equity

If there is just a single performance obligation, then the allocation process is very easy as the entire transaction price would be assigned to that single performance obligation. However, if there is more than one performance obligation, we need to allocate the transaction price to each of the separate performance obligations.

As we discussed earlier in this chapter, each performance obligation relates to a distinct good or service. We allocate the transaction price to each performance obligation on the basis of the selling price of each distinct good or service. With knowledge of all of the stand-alone selling prices, the organisation can then allocate the transaction price in proportion to the respective stand-alone selling prices. When estimating the stand-alone selling prices, paragraph 78 of AASB 15 states:

an entity shall consider all information (including market conditions, entity-specific factors and information about the customer or class of customer) that is reasonably available to the entity. In doing so, an entity shall maximise the use of observable inputs and apply estimation methods consistently in similar circumstances. (AASB 15)

Paragraph 79 identifies methods by which a stand-alone price can be determined. These include: (a) Adjusted market assessment approach—an entity could evaluate the market in which it sells goods or services

and estimate the price that a customer in that market would be willing to pay for those goods or services. (b) Expected cost plus a margin approach—an entity could forecast its expected costs of satisfying a performance

obligation and then add an appropriate margin for that good or service. (c) Residual approach—an entity may estimate the stand-alone selling price by reference to the total transaction

price less the sum of the observable stand-alone selling prices of other goods or services promised in the contract. (AASB 15)

Worked Example 15.7 provides an example of allocating a transaction price to separate performance obligations.

WORKED EXAMPLE 15.7: Allocation of the transaction price to separate performance obligations

Sandman Ltd sells vans and also provides a national roadside service plan. Its vans can be sold for $40 000, and the roadside service plan is usually sold for $500 per year.

As part of a marketing strategy, Sandman Ltd has decided to offer a discounted package to customers. Each van sold will be bundled with one year of roadside service for a total price of $38 000.

REQUIRED You are required to allocate the transaction price of the contract to each of the separate performance obligations.

SOLUTION In this contract, there are two separate performance obligations, these being the delivery of the van and the provision of roadside service.

On the assumption that the discount relates to both performance obligations, then the discount shall be allocated to each performance obligation as follows:

Good or service Stand-alone price Discount allocation  Allocated amount

Van $40 000 40 000/40 500 × $2 500 = $2 469  $37 531

Roadside service $500 500/40 500 × $2 500 = $31 $469

  $40 500   $38 000

Therefore, when the van is delivered and control has passed to the customer, $37 531 will be recognised. The amount of $469 will initially be recognised as unearned income (which is a liability that we will discuss shortly), and will then be recognised as income as the service is subsequently provided to the customer.

WHY DO I NEED TO KNOW THE RULES PERTAINING TO ALLOCATING THE TRANSACTION PRICE TO EACH PERFORMANCE OBLIGATION?

Without knowing how to allocate the transaction price to each performance obligation, we would not be able to recognise any revenue as each performance obligation is satisfied.

dee67382_ch15_599-640.indd 615 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 615

15.10 Step 5—recognise revenue as each performance obligation is satisfied

Our final step in the five-step revenue recognition model is to actually recognise the revenue from the contract with the customer for inclusion within the financial statements. The amount allocated to each performance obligation (determined in Step 4) is recognised as revenue when the organisation satisfies the performance obligation. As AASB 15, paragraph 31, 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 that asset. (AASB 15)

Therefore, transfer of ‘control’ of the asset is a central requirement in the recognition of revenue under AASB 15. This requirement is consistent with the definition of assets and income provided earlier within this chapter. 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; (d) selling or exchanging the asset; (e) pledging the asset to secure a loan; and (f) holding the asset. (AASB 15)

Depending upon the nature of the activities of the reporting entity, and as indicated in earlier discussions within this chapter, revenue in relation to particular goods or services might be recognised at a point in time if the control of the promised good or service is transferred at a point in time. Alternatively, it might be recognised over a period of time if control of the good or service occurs over time (for example, in relation to a long-term construction contract, revenue might be recognised ‘over a period of time’). 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, occur 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) The entity has a present right to payment for the asset; (b) The customer has legal title to the asset; (c) The entity has transferred physical possession of the asset; (d) The customer has the significant risks and rewards of ownership of the asset; (e) The customer has accepted the asset. (AASB 15)

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 at a point in time), paragraph 35 of AASB 15 states:

An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognises revenue over time, if one of the following criteria is met:

(a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs

(b) 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

(c) 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. (AASB 15)

LO 15.10

dee67382_ch15_599-640.indd 616 10/24/19 03:35 PM

616 PART 4: Accounting for liabilities and owners’ equity

Paragraph 35(a) would apply to the supply of services, rather than to the supply of goods. Where services are provided to a customer, it is generally assumed that the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. Guidance on the application of paragraph 35(a) is provided in paragraphs B3 and B4 of AASB 15. Paragraph B3 states.

For some types of performance obligations, the assessment of whether a customer receives the benefits of an entity’s performance as the entity performs and simultaneously consumes those benefits as they are received will be straightforward. 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. (AASB 15)

In situations where it is not as clear whether ‘a customer simultaneously receives and consumes the benefits provided as the entity performs’, paragraph B4 notes:

a performance obligation is satisfied over time if an entity determines that another entity would not need to substantially re-perform the work that the entity has completed to date if that other entity were to fulfil the remaining performance obligation to the customer. (AASB 15)

In the situation where there is a transfer of a good, rather than a service, and where the reporting entity’s performance creates or enhances an asset that the customer controls while the asset is being created or enhanced, the reporting entity is permitted to recognise revenue over time. This is because the customer is in control of the work in progress and will benefit from the goods and services that are being provided to increase the value of the asset that represents the work in progress. For example, if a customer has control of a building that the reporting entity is constructing, then the customer has control of an asset that is increasing in value, and it is appropriate for the reporting entity to recognise revenue over time as the work is being performed.

For the situation referred to in paragraph 35(c) above, where 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, it will also to be appropriate to recognise revenue over time if the customer controls the asset and certain other conditions are satisfied. Specifically, if the contract:

∙ creates an asset with no alternative use, meaning there might be contractual or practical restrictions that mean the reporting entity could not easily direct the asset to an alternative use (perhaps the asset is very unique in nature in order to meet the customer’s requirements, or is located in an area that is otherwise difficult to access), and

∙ the entity creates an enforceable right for payment for performance completed to date

then it is appropriate to recognise revenue over time as work is performed. In relation to the right for payment, paragraph B9 of AASB 15 states:

In accordance with paragraph 37, an entity has a right to payment for performance completed to date if the entity would be entitled to an amount that at least compensates the entity for its performance completed to date in the event that the customer or another party terminates the contract for reasons other than the entity’s failure to perform as promised. An amount that would compensate an entity for performance completed to date would be an amount that approximates the selling price of the goods or services transferred to date (for example, recovery of the costs incurred by an entity in satisfying the performance obligation plus a reasonable profit margin) rather than compensation for only the entity’s potential loss of profit if the contract were to be terminated. (AASB 15)

WHY DO I NEED TO KNOW HOW TO DETERMINE WHETHER A PERFORMANCE OBLIGATION HAS BEEN SATISFIED?

This directly impacts when revenue is recognised. We shall not recognise revenue until such time as a performance obligation is satisfied, which generally is the time when control of the good or service is transferred to the customer. Without establishing that a performance obligation has been satisfied, no revenue from a contract with a customer shall be recognised. Instead, all amounts received would need to be recognised as a liability representing the obligation to provide goods or services to a customer at a future point in time. The related liability might be referred to as ‘unearned income’ or ‘revenue received in advance’ (something we consider in the next section).

dee67382_ch15_599-640.indd 617 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 617

15.11 Unearned revenue

It is not unusual for entities to receive funds for products or services in advance of actually satisfying particular performance obligations (for example, receiving payment before providing the related goods or services). Common examples would include rent or interest received in advance, the receipt of consulting fees in advance of the provision of services, or payments made in advance in relation to construction contracts. Since the services or resources have not been provided to the customer (and hence ‘control’ of the related good or service has not passed to the customer), the cash receipts have not been earned and the customer would not be deemed to be in control of the goods or services. In such a scenario, the receipts do not constitute revenue but instead are termed unearned revenue and considered liabilities. They represent obligations to customers to satisfy particular performance obligations. The entity would be under a present obligation to transfer future economic benefits at a future date (see paragraph 106 of AASB 15).

Worked Example 15.8 provides an example of the treatment of revenue received in advance.

LO 15.11

unearned revenue When assets are received by a business for services to be performed at a future date.

WORKED EXAMPLE 15.8: 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 2023. 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 2023

Dr Cash at bank 6 000  

Cr Rent received in advance (which is a liability) (to recognise the receipt of the rental payment; as the amount has been received in advance of satisfying a performance obligation, it is credited to the liability account ‘rent received in advance’) 

6 000

30 June 2023

Dr Rent received in advance 4 000  

Cr Rental income (to recognise two months’ rent earned in 2023 and to reduce the balance of the liability account rent received in advance; a balance of $2000 would remain in rent received in advance, representing the remaining performance obligation, and would be shown in the statement of financial position as a liability)

4 000

15.12 Accounting for sales with associated conditions—further considerations

We noted previously that Step 5 of the five-step revenue recognition model addresses whether performance obligations have been satisfied, thereby permitting a reporting entity to recognise revenue.

As an additional issue to consider in relation to when (or if) to recognise revenue (Step 5), 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

LO 15.12

dee67382_ch15_599-640.indd 618 10/24/19 03:35 PM

618 PART 4: Accounting for liabilities and owners’ equity

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, the right to return the assets, or a related leaseback. These all have implications for when revenue shall be recognised. We will consider each of these conditions below.

Call and put options As discussed in Chapter 14 in the discussion of financial instruments, a 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. The party that writes the call option agrees to deliver a particular asset to the call- option buyer, if that buyer instructs the other party to do so. A call option is considered to have value when the value of the underlying asset exceeds the option’s exercise price (when such an option is 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 fair value of the asset, the option has no value.

Therefore, if the fair value of the underlying asset exceeds the exercise price at the date of expiration of the option, the buyer of the option would typically exercise the option leading to the delivery of the underlying asset. If, by contrast, the fair value of the asset is below the exercise price

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 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 directly from the capital market at $28.

A put option, by contrast, operates in the reverse manner to a call option. Its holder has the right to sell an asset at a specified exercise price on or before a specified date. The writer (or seller) of the put option agrees to buy the asset at a future date for the exercise price if the put-option holder (buyer) should request it. The holder of the put option (who may also be in possession of the underlying asset) would typically exercise the option (that is, require the other party to buy the underlying asset) only if the exercise price is above the market price. A put option guarantees 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 a ‘sale’ to have occurred, the ‘control’ of the asset must pass to the customer as part of the contract.

For example, a reporting entity might require funds—say $2 million in cash. To provide security to the lender, it might sign a contract to transfer its land to the lender. This land might have a fair value of $3 million, with this fair value expected to increase across time. As part of the contract, the reporting entity might also be provided with a call option that provides it with a right to buy back the land at a future date for a specified price, say $2 300 000. This exercise price on the option would be well below what the expected fair value of the land will be. In this instance there would be an expectation—from the commencement of the transaction—that the reporting entity would exercise the option and buy back the land from the party to whom the land was previously transferred. In such a case, the transaction constitutes a financing arrangement with a total expected borrowing cost of $300 000, rather than a sale from the viewpoint of the vendor/borrower. It would not give rise to revenue. In these circumstances, the inflow of economic benefits to the vendor/borrower in the form of the $2 million in cash has resulted in an increase in liabilities, with the result that equity has not increased. This example emphasises the need to identify the contract with the customer and to carefully review the terms of the contract to determine if there are any performance obligations that would lead to the recognition of revenue.

Paragraphs B66 to B69 of AASB 15 provide guidance which 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

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.

put option Gives its holder the right to sell 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 designated asset.

dee67382_ch15_599-640.indd 619 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 619

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 AASB 16 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. (AASB 15)

Similarly, if a reporting entity sells an asset to another organisation and the other organisation (customer) has a put option that requires the reporting 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 15.9 provides an example of a transaction with an associated call option.

WORKED EXAMPLE 15.9: Sale of some land with an associated call option

Whites Beach Ltd is a property developer that has land throughout Australia. One parcel of undeveloped land has a fair value of $1 000 000. It requires some funds to expand its operations. With this in mind, on 1 July 2022 it agrees to sell the undeveloped 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 2025—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. There is an expectation that the fair value of the land will continue to increase over the coming years.

REQUIRED

(a) Determine whether Whites Beach Ltd should record sales revenue in relation to this agreement. (b) Prove that the rate of interest on this loan agreement is 5 per cent. (c) Provide the accounting entries for 1 July 2022, 30 June 2023, 30 June 2024, 30 June 2025 and 1 July 2025.

SOLUTION

(a) 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 in three years’ time. 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. It would be judged from the evidence that no ‘sale to a customer’ has occurred. Rather, it is a financing arrangement.

(b) The rate of interest can be shown to be 5 per cent as follows:

Date

Opening present value at 5%

($) Interest

($)

Closing present value

($)

1 July 2022     800 000

30 June 2023 800 000 40 000 840 000

30 June 2024 840 000 42 000 882 000

30 June 2025 882 000 44 100 926 100

continued

dee67382_ch15_599-640.indd 620 10/24/19 03:35 PM

620 PART 4: Accounting for liabilities and owners’ equity

(c) 1 July 2022

Dr Cash at bank 800 000  

Cr Contract liability—Big Bank Ltd (to recognise the receipt of cash and the associated liability. 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’) 

800 000

30 June 2023

Dr Interest expense 40 000  

Cr Contract liability—Big Bank Ltd (interest expense equals the opening liability multiplied by 5 per cent = $800 000 × 0.05) 

40 000

30 June 2024

Dr Interest expense 42 000  

Cr Contract liability—Big Bank Ltd (interest expense equals the opening liability multiplied by 5 per cent = $840 000 × 0.05) 

42 000

30 June 2025

Dr Interest expense 44 100  

Cr Contract liability—Big Bank Ltd (interest expense equals the opening liability multiplied by 5 per cent = $882 000 × 0.05) 

44 100

1 July 2025

Dr Contract liability—Big Bank Ltd 926 100  

Cr Cash at bank (being payment of the call option)

  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.

WORKED EXAMPLE 15.9 continued

Revenue recognition when right of return exists Another factor that we previously identified as relevant to the judgement about whether a performance obligation has been satisfied is the existence of a ‘right of return’.

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 the customer receives 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.

AASB 15 provides guidance in relation to rights of return. 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);

dee67382_ch15_599-640.indd 621 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 621

(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. (AASB 15)

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 shall be recognised.

Worked Example 15.10 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 15.10: 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 sales 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 to the customer (the point in time at which the performance obligation is satisfied), the entity would not recognise revenue for the three products that it expects to be returned. Consequently, the entity would recognise:

(a) cash received of $10 000 ($100 multiplied by the 100 units transferred) (b) revenue of $9700 ($100 × 97 products expected not to be returned) (c) a refund liability for $300 ($100 refund × 3 products expected to be returned) (d) a reduction in inventory of $6000 ($60 × 100 units) (e) cost of goods sold of $5820 ($60 × 97 units), and (f) an asset of $180 ($60 × 3 products) for its right to recover products from customers on settling the

refund liability.

The assets expected to be returned 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 at the time of sale would be:

Dr Cash 10 000  

Cr Revenue   9 700

Cr Refund liability (to recognise the initial sale and the related refund liability)

  300

Dr Cost of goods sold 5 820  

Dr Right to recover (which is an asset) 180  

Cr Inventory (to recognise the transfer of inventory to the customer)

  6 000

continued

dee67382_ch15_599-640.indd 622 10/24/19 03:35 PM

622 PART 4: Accounting for liabilities and owners’ equity

The accounting entries at the time the goods are returned (and to make this easier we have assumed that the expectations about the number of units to be returned have come to fruition):

Dr Refund liability 300  

Cr Cash (to recognise the refund provided to the customer when the goods are ultimately returned) 

300

Dr Inventory 180  

Cr Right to recover (to place the returned assets back into inventory when they are returned. It is assumed that the inventory is not damaged in any way) 

180

WORKED EXAMPLE 15.10 continued

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.

WHY DO I NEED TO KNOW HOW THE EXISTENCE OF ASSOCIATED CONDITIONS MIGHT IMPACT REVENUE RECOGNITION?

Profit or loss is obviously impacted by judgements about when revenue shall be recognised. Certain conditions associated with a contract—such as call or put options, right of return, or sale and leaseback—will affect judgements about the transaction price, as well as potentially impacting judgements about whether any performance obligations necessary for revenue recognition have been satisfied. Therefore, it is essential that we know about, and understand, the conditions associated with a contract with a customer.

15.13 Construction contracts—further consideration

Section 15.10 of this chapter addressed various issues associated with instances where performance obligations are satisfied over time, thereby necessitating the recognition of revenue over time (rather than at a point in time). We noted that construction contracts were an example of arrangements wherein performance obligations

are satisfied over time. In this section we provide further analysis of construction contracts. In accounting for construction contracts, individual construction contracts (for example,

different building sites) would be accounted for separately and the relevant accounting requirements would be applied separately to each contract. If a construction contract extends over a number of accounting periods, then there will be a need to determine the appropriate revenue and costs to be allocated to each accounting period.

AASB 15, paragraph 44, requires that an entity shall recognise revenue for a performance obligation satisfied over time—such as in the case of a long-term construction contract—only if

LO 15.13

construction contract Contract relating to the construction of an asset or a combination of assets that are closely interrelated in terms of design, technology, function or use.

dee67382_ch15_599-640.indd 623 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 623

the entity can reasonably measure its progress towards complete satisfaction of the performance obligation. Appropriate methods of measuring progress within each accounting period include ‘output methods’ and ‘input methods’. Output methods include methods such as surveys of performance completed to date, appraisals of results achieved, milestones reached, time elapsed and units produced or units delivered. By contrast, input methods recognise revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (for example, resources consumed, labour hours expended, costs incurred, time elapsed or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation. Paragraphs B15 to B19 of AASB 15 describe output and input measures of performance.

One input method traditionally used within the construction industry to account for construction contracts is the percentage-of-completion method. With the percentage-of-completion method (also referred to as the stage-of-completion method), revenue (and profit) on a construction contract is recognised in proportion to the work performed in each reporting period in which construction occurs, as reflected by costs incurred. This would reflect an ‘input measure’ of progress and would be acceptable under AASB 15.

Under the percentage-of-completion method, construction costs plus gross profit earned to date are accumulated in an account that might be identified as ‘construction in progress’. Pursuant to AASB 15, this would be considered to be a ‘contract asset’. When invoices are sent to the customer in accordance with the contract then part of the contract asset (construction in progress) account would be transferred to accounts receivable (that is, one asset would be substituted for another).

The general requirement that the customer has control of the asset throughout the construction is, as we have already learned, a requirement before any revenue shall be recognised. If the requirements of paragraph 35 of AASB 15 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.

Measuring performance obligations satisfied over time AASB 15 requires that 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. As already noted, 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

∙ input measures that recognise revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation.

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 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.

percentage-of- completion method (or stage-of- completion method) Where profits are recognised each period based upon the progress of construction. It represents an input method for measuring the progress towards completing a contract with a customer.

dee67382_ch15_599-640.indd 624 10/24/19 03:35 PM

624 PART 4: Accounting for liabilities and owners’ equity

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:

Percentage complete = Costs incurred to the end of current period

__________________________________ Most recent estimate of total costs

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 = × Percentage complete

− 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’) XXX  

Cr Materials, cash, payables, accumulated depreciation etc. (to record cost of construction)

  XXX

Dr Accounts receivable XXX  

Cr Construction in progress (Contract Asset) (to record progress billings; ‘accounts receivable’ replaces ‘construction in progress’)

XXX

Dr Cash XXX  

Cr Accounts receivable (to record collections of billings)

  XXX

dee67382_ch15_599-640.indd 625 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 625

Dr Construction in progress (Contract Asset) XXX  

Dr Construction expenses XXX  

Cr Revenue from long-term project (to recognise contract revenue and contract expenses)

  XXX

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 initially 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. (AASB 15)

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 15.11 and 15.12 describe the practical application of using an input measure, such as costs. We restrict our analysis to fixed-price contracts.

WORKED EXAMPLE 15.11: Percentage-of-completion method

MR Ltd commences construction of a wave-making machine on 1 July 2022 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 2025. 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:

  2023

($000) 2024

($000) 2025

($000)

Costs for the year 4 000 8 000 5 500

Costs incurred to date 4 000 12 000 17 500

Estimated costs to complete 12 000 5 000 –

Progress billings during the year 4 500 8 500 7 000

Cash collected during the year 3 500 7 500 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) Is the organisation permitted to recognise revenue over time? (b) Compute the gross profit to be recognised for each of the three years. (c) Prepare the journal entries for 2023. (d) Prepare the statement of financial position presentation for 2023 and 2024.

SOLUTION

(a) Yes, the organisation is permitted to recognise revenue over time to the extent that the customer has control of the asset and that one of the criteria in paragraph 35 of AASB 15 is met. The amount of revenue to be recognised can be based on the application of appropriate input or output measures. In

continued

dee67382_ch15_599-640.indd 626 10/24/19 03:35 PM

626 PART 4: Accounting for liabilities and owners’ equity

circumstances where the organisation is unable to reasonably measure the outcome of a performance obligation (for example, in the early stages of a contract), the organisation shall recognise revenue only to the extent of the costs incurred (meaning no profit is recognised in relation to the contract). In this example, we are assuming that such uncertainty does not exist.

(b) Computing the gross profit

  2023

($000) 2024

($000) 2025

($000)

Contract price 20 000 20 000 20 000

less Estimated cost:      

– Costs to date 4 000 12 000 17 500

– Estimated costs to complete 12 000 5 000 –

– Estimated total cost 16 000 17 000 17 500

Estimated total gross profit 4 000 3 000 2 500

Percentage complete (%) 25 70.6 100

  Gross profit recognised in:

$000 $000

2023 $4 million × 25 per cent $1 000  

2024 $3 million × 70.6 per cent $2 118  

  less Gross profit already recognised $1 000  

  Gross profit in 2024 $1 118  

2025 $2.5 million × 100 per cent   $2 500

  less Gross profit already recognised   $2 118

  Gross profit in 2025   $  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).

(c) Journal entries for 2023

Dr Construction in progress (Contract Asset) 4 000 000  

Cr Materials, cash, payables, accumulated depreciation, etc. (to recognise the costs associated with the contract)

  4 000 000

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) (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) 

5 000 000

Dr Accounts receivable 4 500 000  

Cr Construction in progress (Contract Asset) (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) 

4 500 000

WORKED EXAMPLE 15.11 continued

dee67382_ch15_599-640.indd 627 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 627

Dr Cash 3 500 000  

Cr Accounts receivable (amount received from customer)

  3 500 000

(d) Extract from the statement of financial position for 2023 and 2024

  2023

($000) 2024

($000)

Current assets    

Accounts receivable 1 000 2 000

Construction in progress (Contract Asset) 500 1 118

WORKED EXAMPLE 15.12: Construction contract where outcome cannot be reliably estimated

Assume the same facts as in Worked Example 15.11, 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 2023. (c) Prepare the statement of financial position presentation for 2023 and 2024.

SOLUTION

(a) Gross profit for the three years

  2023

($000) 2024

($000) 2025

($000)

Gross profit to be recognised – – 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 in accordance with paragraph 45 of AASB 15 (on the assumption that all expenses will be recouped).

(b) Journal entries for 2023

Dr Construction in progress (Contract Asset) 4 000 000  

Cr Materials, cash, payables, accumulated depreciation etc. (to recognise the costs associated with the contract)

  4 000 000

Dr Construction expenses 4 000 000  

Cr Revenue from long-term contract (because the progress on the performance obligation is not clear, revenue recognition is restricted to the amount of cost incurred) 

4 000 000

Dr Accounts receivable 4 500 000  

Cr Construction in progress (Contract Asset) (amount payable unconditionally by the customer)

  4 500 000

Dr Cash 3 500 000  

Cr Accounts receivable (amount received from customer)

  3 500 000

continued

dee67382_ch15_599-640.indd 628 10/24/19 03:35 PM

628 PART 4: Accounting for liabilities and owners’ equity

Dr Construction in progress (Contract Asset) 500 000  

Cr Contract liability—excess of the amount received, or receivable, from the 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. Prior to this entry the contract asset had a credit balance of $500 000)

500 000

(c) Extracts from the statement of financial position for 2023 and 2024

  2023

($000) 2024

($000)

Current assets    

Accounts receivable 1 000 2 000

Current liabilities    

Progress billings in excess of costs incurred on construction contracts (contract liability)

500 1 000

WORKED EXAMPLE 15.12 continued

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 loss-making 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’. We considered onerous contracts in detail in Chapter 10. 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. (AASB 137)

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 requires:

If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision. (AASB 137)

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.

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.

dee67382_ch15_599-640.indd 629 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 629

Worked Example 15.13 considers recognition of a loss using the percentage-of-completion method.

WORKED EXAMPLE 15.13: Percentage of completion with recognition of a loss

Assume the same facts as in Worked Example 15.11, except that, in this example, it becomes evident at the end of the 2024 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:

  2023

($000) 2024

($000) 2025

($000)

Costs for the year (fixed, rather than ‘cost plus’)

4 000 8 000 9 000

Costs incurred to date 4 000 12 000 21 000

Estimated costs to complete 12 000 9 000 –

Progress billings during the year 4 500 8 500 7 000

Cash collected during the year 3 500 7 500 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/(loss) to be recognised for each of the three years. (b) Provide the journal entries for 2023 and 2024.

SOLUTION

(a) Gross profit/(loss) for the three years

  2023

($000) 2024

($000) 2025

($000)

Contract price 20 000 20 000 20 000

less Estimated cost:      

– Costs to date 4 000 12 000 21 000

– Estimated costs to complete 12 000 9 000 –

– Estimated total cost 16 000 21 000 21 000

Estimated total gross profit/(loss) 4 000 (1 000) (1 000)

Percentage complete (%) 25 57.1 100

Gross profit /(loss) recognised in:

$000 $000 $000

2023 $4 million × 25 per cent $1 000    

2024 Expected loss   ($1 000)  

  less Profit already recognised in 2023   ($1 000)  

  Loss in 2024   ($2 000)  

2025 Expected loss     ($1 000)

  less Profit/(Loss) already recognised in previous years     ($1 000)

  Profit/(Loss) to be recognised in 2025           $nil

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 15.11 we know that as at the beginning

continued

dee67382_ch15_599-640.indd 630 10/24/19 03:35 PM

630 PART 4: Accounting for liabilities and owners’ equity

of 2023 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 2023 and 2024

(i) Journal entries for 2023 are the same as the 2023 journal entries in Worked Example 15.11(b), as the cost revision did not occur until 2024.

(ii) Journal entries for 2024

Dr Construction in progress (Contract Asset) 8 000 000  

Cr Materials, cash, payables, accumulated depreciation etc. (to recognise the cost of performing work on the contract)

  8 000 000

Dr Accounts receivable 8 500 000  

Cr Construction in progress (Contract Asset) (once the claim is made against the customer the contract asset becomes a receivable)

8 500 000

Dr Cash 7 500 000  

Cr Accounts receivable (receipt of cash from customer)

  7 500 000

Dr Construction expenses 1 000 000  

Cr Provision for loss on construction contract (a liability on an ‘onerous contract’ is recognised because the cost of settling the performance obligation [$21 million] is expected to exceed the amount of the transaction price allocated to that performance obligation [$20 million])

1 000 000

Dr Construction expenses 1 000 000  

Cr Construction in progress (Contract Asset) (reversal of profit recognised in the previous year)

  1 000 000

Dr Construction expenses 6 000 000  

Cr Revenue from long-term contract (recognition of revenues for 2023 and recognition of sexpenses for the same amount) 

6 000 000

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 2024, 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 2023. If the costs incurred in 2025 are $9 million as expected, in 2025 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 2025.

Following the above entries, at the end of 2024 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) 1 000 000  

Cr Contract liability (to reclassify the balance in the contract asset account to the contract liability account)

  1 000 000

WORKED EXAMPLE 15.13 continued

dee67382_ch15_599-640.indd 631 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 631

15.14 Interest and dividends

Two common forms of income are interest revenue and dividend revenue. Because these forms of income are common to most reporting entities it is worthwhile considering them, at least briefly, in this chapter. Interest revenue and dividend revenue would be derived from investments in financial assets, which are financial instruments. Financial instruments are not addressed within AASB 15. Rather, they are addressed in AASB 9 Financial Instruments.

Interest revenue The recognition of interest revenue is usually straightforward, with the revenue being recognised over time, as the borrower has the benefit of the borrowings and the lender establishes claims for interest earned. As Chapter 14 explains, financial investments that are held: ∙ within a business model whose objective is to hold them in order to collect contractual cash flows, and ∙ where the financial investment gives rise on specified dates to cash flows that are solely payments of principal and

interest on the principal amount outstanding shall be measured at amortised cost, and the interest revenue shall be measured using the effective-interest method. If the borrower prepays interest, the inflow of future economic benefits represented by the prepayment would

not constitute an item of revenue to the lender because the lender has a present obligation (a liability) to the borrower to provide finance for the period to which the prepayment relates. Interest received in advance would be considered to represent a liability.

Interest revenues might also be implicit in the terms of a contract with a customer. Where, for example, goods are sold on extended credit, the vendor is effectively financing the purchaser. The purchase consideration shall 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. This was addressed previously within this chapter.

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 by the board of directors or another governing body of the dividend-paying entity. 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).

When looking at 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.

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 dividends 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 pre- acquisition earnings, they shall be treated as a reduction in the cost of the investment rather than being treated as revenue.

15.15 Allowance for doubtful debts Up to this point of the chapter we have been discussing when revenue shall be recognised. As we know, under an accrual system of accounting, income is recognised when it is earned, rather than when the cash is actually received, consistent with AASB 15. This creates receivables for the reporting entity. Holding receivables exposes a reporting entity to ‘credit risk’, which is defined in AASB 7 Financial Instruments: Disclosures as:

The risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. (AASB 7)

LO 15.14

LO 15.15

interest revenue Revenue derived as a result of lending resources to another entity.

dee67382_ch15_599-640.indd 632 10/24/19 03:35 PM

632 PART 4: Accounting for liabilities and owners’ equity

When revenue is recognised in advance of the actual receipt of cash (or cash substitute), it is common for the entity to also recognise an allowance for doubtful debts. Logically, if goods are sold or services are provided on credit terms, and the revenue is recognised because the related performance obligations have been satisfied, then given the existence of credit risk, not all amounts due from the debtors will ultimately be collected. To ignore this fact would lead to an overstatement of receivables and, therefore, of assets in the statement of financial position. It would also lead to an overstatement of profit (or an understatement of losses).

When the first Exposure Draft Revenue from Contracts with Customers was released in June 2010, it was proposed that reporting entities should recognise revenue at the amount of consideration that the company expects to receive from the customer. 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 amount as revenue. This would have represented quite a departure from traditional accounting practice. However, when the second Exposure Draft was released in November 2011, the requirement was changed back to the traditional approach and this approach has been incorporated within AASB 15. That is, a reporting entity shall recognise revenue at the amount of consideration to which the entity considers it is ‘entitled’. An entity shall exclude expectations of collectability when determining the amount of the transaction price (and thus the amount to be recognised as revenue), albeit that paragraph 9 of AASB 15 requires that it must be assessed as ‘probable’ that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer before revenue shall be recognised. However, just because it was considered probable at the time when a performance obligation was satisfied—meaning that the revenue allocated to the respective performance obligation was recognised—this does not guarantee that all amounts recognised as revenue will ultimately be collected. Various difficulties could be encountered by customers between the time of a performance obligation being satisfied and the time when they are required to make a payment.

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 2022 and by the end of June 2022 it has receivables of $100 000. It is very unlikely that all amounts owing by the debtors (the receivables) will ultimately be received, and hence some allowance must be made for debts that might not be recovered. Various approaches may be adopted to calculate the allowance. For example, it may be assumed that, on average, 5 per cent of all debtors within that particular industry will fail to pay their debts. Alternatively, reliance may be placed on an aged debtors listing. For example, an analysis of the amounts owing might show that the debts can be

classified by age (see Table 15.1).

allowance for doubtful debts Account that provides an estimate of the amount of the accounts receivable that will ultimately not be received.

doubtful debts When it is considered to be doubtful that debtors will pay the amounts due, a doubtful debts expense is recognised.

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

Table 15.1 Outstanding debts classified by age

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 old; 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 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 2022 (the year end) would be:

Dr Doubtful debts expense 2 650  

Cr Allowance for doubtful debts (to recognise doubtful debts expense)

2 650

dee67382_ch15_599-640.indd 633 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 633

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 receivable 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 receivable control account, or the accounts receivable 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 Allowance for doubtful debts 500  

Cr Accounts receivable (to reduce allowance for doubtful debts in recognition of the write-off of a debtor)

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.

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 Bad debts expense 5 000  

Cr Accounts receivable (to recognise a bad debts expense)

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 (which provides detailed information about how much is owed by each individual debtor). 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.

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.

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.

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

Table 15.2 Calculation of allowance for doubtful debts

dee67382_ch15_599-640.indd 634 10/24/19 03:35 PM

634 PART 4: Accounting for liabilities and owners’ equity

SUMMARY

The chapter focused on various issues associated with ‘income’, with income being comprised of ‘revenues’ and ‘gains’. To the extent that a transaction does not involve a contribution from, or a distribution to, owners, the Conceptual Framework requires that the recognition of income occurs at the same time as:

• the initial recognition of an asset, or an increase in the carrying amount of an asset, or

• the derecognition of a liability, or a decrease in the carrying amount of a liability.

The definition and recognition of income (and expenses) is directly linked to the definition and recognition of assets and liabilities. An asset or liability is recognised only if recognition of that asset or liability and of any resulting income, expenses or changes in equity provides users of financial statements with information that is useful, that is, with:

• relevant information about the asset or liability and about any resulting income, expenses or changes in equity, and

• a faithful representation of the asset or liability and of any resulting income, expenses or changes in equity.

In relation to revenue from contracts with customers, we have also learned in this chapter that one key criterion emphasised in AASB 15 for 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. This is consistent with the guidance provided within the Conceptual Framework.

In discussing the process of recognising revenue from contracts with customers we utilised a five-step revenue recognition model based on the contents of AASB 15. Figure 15.3 summarises the five general steps that shall be applied in order to comply with AASB 15.

Figure 15.3 Steps to be taken when recognising revenue—a summary

Step 1: Identify the contract(s) with customers AASB 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.

Step 2: Identify the separate performance obligation(s) 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 of the contract 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 5: Recognise revenue when each performance obligation is satisfied Revenue is recognised as control of an asset 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.

Step 4: Allocate the transaction price to each performance obligation 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.

dee67382_ch15_599-640.indd 635 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 635

This chapter also noted that sales transactions are often made with associated conditions, such as call and put options, rights to return the assets, or a sale and leaseback arrangement. 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.

The chapter also considered how to account for long-term construction contracts. For a construction contract, revenue can be recognised over time if it transfers control of a good or service over time and, therefore, satisfies a performance obligation over time, and 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 either be based on input measures or on output measures.

KEY TERMS

accounts receivable 633 allowance for doubtful debts 632 bad debts 633 bad debts expense 633 call option 618 construction contract 622

contra asset 633 doubtful debts 632 exercise price 618 f.o.b. destination 603 f.o.b. shipping point 603 interest revenue 631

percentage-of-completion method 623 probable 609 put option 618 stage-of-completion method 623 unearned revenue 617

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. ‘Income’ is often subdivided into ‘revenues’ and ‘gains’, but is there a difference between them? LO 15.1,15.2 Traditionally, it has been considered that there is a difference. 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. This is consistent with how revenue is defined within AASB 15, which is ‘income arising in the course of an entity’s ordinary activities’.

2. What is the general rule in terms of when revenue shall be recognised from contracts with customers? LO 15.10 The general rule is stated at paragraph 31 of AASB 15:

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. (AASB 15)

Transfer of ‘control’ of the asset is a central requirement in the recognition of revenue under the accounting standard.

3. If a customer pays for a product or service provided by an organisation with a payment that is not in the form of cash, on what basis will that revenue be measured? LO 15.8 Where non-cash consideration is received, the consideration shall be measured at its fair value.

dee67382_ch15_599-640.indd 636 10/24/19 03:35 PM

636 PART 4: Accounting for liabilities and owners’ equity

4. Organisations often sell products to customers with a ‘right of return’. What is a ‘right of return’, and how, if at all, shall the right of return be accounted for at the point of sale? LO 15.12 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.

Where a sale with a right of return is provided to a customer, revenue, a refund liability and an asset relating to the right to recover the product will generally be recognised. The revenue to be recognised will be based on the sale of products that are not expected to be returned multiplied by their sales price, and the refund liability will be based on the products expected to be returned multiplied by their sale price.

5. If an organisation is constructing a building, and that building will take a number of years to complete, can the organisation recognise revenue throughout the contract, or does the construction-based organisation have to wait until project completion before it recognises the revenue associated with the construction contract? LO 15.10 Yes, as long as certain conditions are satisfied, the revenue can be recognised over a period of time. AASB 15, paragraph 31, 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 that asset. (AASB 15)

Therefore, transfer of ‘control’ of the asset is a central requirement in the recognition of revenue under the accounting standard. Revenue can be recognised over a period of time if transfer of control of the good or service occurs over time. Where performance obligations are satisfied over time and do not relate to a service, 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.

6. AASB 15 identifies five steps that need to be taken when recognising revenue from contracts with customers. What are these steps? LO 15.5 These five steps, which would be addressed sequentially, are:

1. Identify the contract(s) with customers. 2. Identify the performance obligation(s) in the contract. 3. Determine the transaction price of the contract. 4. Allocate the transaction price to each performance obligation. 5. Recognise revenue when each performance obligation is satisfied.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Would it be appropriate to recognise revenue at completion of production rather than at the point of sale? LO 15.10, 15.13 •

2. 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 15.1, 15.2, 15.10 ••

3. What is the difference between a bad debt and a doubtful debt? LO 15.15 • 4. 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 15.1, 15.10 • 5. Does AASB 15 apply to income derived from financial instruments? LO 15.4 • 6. Why is it important for a reporting entity to identify its contracts with customers and to fully understand the terms of

the contracts? LO 15.6 •

dee67382_ch15_599-640.indd 637 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 637

7. Identify the five steps that would be followed when recognising revenue from contracts with customers. LO 15.5 • 8. If a sale is made ‘f.o.b. destination’, when should the associated revenue be recognised? LO 15.1, 15.10 • 9. 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 15.8 • 10. 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, 15.15 ••

11. 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 15.8 ••

12. On what basis shall a reporting entity allocate a transaction price to separate performance obligations within a contract with a customer? LO 15.9 •

13. What does unearned revenue represent, and when shall it be recorded? LO 15.11 • 14. Is dividend revenue addressed within AASB 15? Would dividends received from pre-acquisition earnings from an

investee be recognised as income? LO 15.14 • 15. Can a contract with a customer contain multiple performance obligations, and if so, why is it important to identify

them? LO 15.7 • 16. Surfside Ltd is marketing a ‘surfing bundle’ in which, for $1100, it provides customers with a surfboard (which retails

separately for $850), a wetsuit (which retails separately for $250) and five lessons (which retail separately for $200). You are required to determine:

(a) Whether separate performance obligations exist, and to explain why you made this judgement. (b) How much of the transaction price to allocate to each performance obligation. LO 15.7, 15.8 •• 17. When amounts to be received from customers are to be discounted (for example, the amount to be received for a

sale of goods or services will be received beyond 12 months), what discount rate is to be applied? LO 15.8, 15.14 • 18. 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 15.10, 15.12 ••

19. 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 15.1, 15.10 ••

20. 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 •

21. 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 15.13 •

22. 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’), what are the alternative approaches to measuring the level of progress that depict the transfer of goods and services to the customer? LO 15.10, 15.13 ••

23. 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, 15.10 ••

CHALLENGING QUESTIONS

24. 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 15.3

dee67382_ch15_599-640.indd 638 10/24/19 03:35 PM

638 PART 4: Accounting for liabilities and owners’ equity

25. 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 15.1, 15.10

26. Big Construction Company signs a contract on 1 July 2023, 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:

2023 $2.5 million

2024 $4 million

2025 $1.5 million

The contract provides that Buyer Corporation Ltd will make payments on 31 December each year as follows:

2023 $2 million

2024 $5 million

2025 $3 million

The contract is completed and accepted on 31 December 2025. 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 2023, 2024 and 2025, assuming that: (a) the level of progress on the contract can be reliably estimated (b) the level of progress on the contract cannot be reliably estimated. LO 15.10, 15.13

27. Assume the same facts as in Challenging Question 26, except that in 2024 it becomes apparent that the costs to complete the contract will be $5.5 million in 2024 and $3 million in 2025.

REQUIRED Provide the journal entries for 2023, 2024 and 2025. LO 15.10, 15.13

28. XYZ signs a contract on 30 June 2023, 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 Cost

30 June 2024 $10 000 000

30 June 2025 $16 000 000

30 June 2026   $6 000 000

  $32 000 000

The contract provides that ABC will make payments on 30 June of each year as follows:

2024 $8 000 000

2025 $20 000 000

2026 $12 000 000

  $40 000 000

The contract is completed as expected on 30 June 2026. 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. (b) Provide the journal entries for each year, assuming extent of completion on the construction contract cannot be

reliably estimated. (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, 15.13

dee67382_ch15_599-640.indd 639 10/24/19 03:35 PM

CHAPTER 15: Revenue recognition issues 639

29. Assume the same facts as in Challenging Question 28, except that XYZ now estimates at the beginning of the 2025 financial year that construction costs will be as follows:

Year ending Cost

30 June 2024 $10 000 000

30 June 2025 $21 000 000

30 June 2026 $15 000 000

  $46 000 000

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, 15.13

30. 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. (b) A debt covenant that is approaching the point of being in technical default. LO 15.10

31. On 1 July 2023, 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 2024. 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. (b) Provide the journal entries for Bronzed Aussie Ltd for the years ending 30 June 2024 and 2025. LO 15.8, 15.14

32. 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 15.3

33. 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 15.8

34. 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.’

dee67382_ch15_599-640.indd 640 10/24/19 03:35 PM

640 PART 4: Accounting for liabilities and owners’ equity

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, 15.8

35. Sun City Ltd commences construction of a multi purpose water park on 1 July 2022 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 2025 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):

  2023 ($m)

2024 ($m)

2025 ($m)

Costs for the year 10 18 12

Costs incurred to date 10 28 40

Estimated costs to complete 28 12 –

Progress billings during the year 12 20 18

Cash collected during the year 11 19 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. (b) Prepare the journal entries for the 2023 financial year to recognise revenue on the assumption that the revenue

shall be recognised across the life of the construction contract. (c) Prepare the journal entries for the 2023 financial year, assuming that the measure of progress on the contract

cannot be reliably assessed. (d) Independently of the above three parts of this exercise, prepare the journal entries for the 2023 and 2024

financial years, assuming that the revised costing data, as shown below, indicates that, overall, the contract will make a loss of $2 million. The revision is due to the fact that, during the year ending 30 June 2024, 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 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 2023. LO 15.10, 15.13

  2024 ($m)

Costs for the year 18

Total costs incurred to date 28

Estimated costs to complete 24

Progress billings during the year 20

Cash collected during the year 19

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. Coombes, R.J. & Martin, C., 1982, The Definition and Recognition

of Revenue under Historic 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, IASB, London, December.

International Accounting Standards Board, 2011, Exposure Draft ED/2011/6 A revision of ED/2010/6 Revenue from Contracts with Customers, IASB, London, November.

dee67382_ch16_641-686.indd 641 10/17/19 08:20 PM

641

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 16.1 Understand the meaning of ‘profits’ and its relationship to income and expenses, and

appreciate that the determination of profit for a given period is dependent upon the particular asset and liability measurement model that has been adopted.

16.2 Appreciate that the determination of profits for a given period is dependent upon a variety of professional judgements.

16.3 Understand what ‘other comprehensive income’ and ‘total comprehensive income’ represent. 16.4 Be able to describe some of the components of ‘other comprehensive income’. 16.5 Be able to describe the format of the statement of profit or loss and other comprehensive income. 16.6 Be able to describe the nature of a ‘reclassification adjustment’, and how it shall be disclosed. 16.7 Know the disclosure requirements pertaining to the separate disclosure of ‘material items’ of profit or loss. 16.8 Understand how we account for changes in accounting estimates. 16.9 Understand that many accounting standards have specific requirements for the disclosure of

information about particular items of income and expense. 16.10 Understand what constitutes a ‘prior period error’, and know how to account for prior period errors. 16.11 Understand what constitutes a ‘change in accounting policy’, and know how to disclose information

about changes in accounting policies. 16.12 Understand the role of the statement of changes in equity. 16.13 Understand that reporting entities will also often construct and highlight measures of financial

performance that do not necessarily comply with accounting standards. 16.14 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.

C H A P T E R 16 The statement of profit or loss and other comprehensive income, and the statement of changes in equity

dee67382_ch16_641-686.indd 642 10/17/19 08:20 PM

642 PART 4: Accounting for liabilities and owners’ equity

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What does ‘other comprehensive income’ represent? LO 16.3 2. What does ‘total comprehensive income’ represent, and in which financial statement shall it be presented?

LO 16.3 3. Pursuant to AASB 101, the statement of profit or loss and other comprehensive income can be presented by

way of two alternative presentation formats. What are these formats? LO 16.5 4. What is a ‘reclassification adjustment’ as it relates to profit or loss and other comprehensive income? LO 16.6 5. If it is discovered that certain expenses that should have been recognised in a previous period were omitted

(there was a ‘prior period error’), should the correction of this prior period error be undertaken by adjusting the profit or loss of the current reporting period? LO 16.10

6. What is the role of the statement of changes in equity? LO 16.12

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

9 Financial Instruments IFRS 9

15 Revenue from Contracts with Customers IFRS 15

101 Presentation of Financial Statements IAS 1

102 Inventories IAS 2

108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8

116 Property, Plant and Equipment IAS 16

123 Borrowing Costs IAS 23

138 Intangible Assets IAS 38

16.1 Introduction to the statement of profit or loss and other comprehensive income

Profit is the difference between ‘income’ and ‘expenses’ and has the effect of increasing ‘equity’. As we know, income is defined in the Conceptual Framework for Financial Reporting as:

increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

As explained in Chapter 15, income is often further subdivided into revenues and gains with the general principle being that ‘revenues’ typically relate to the ordinary activities of the entity. This is confirmed in AASB 15 Revenue from Contracts with Customers, which defines revenue as:

Income arising in the course of an entity’s ordinary activities. (AASB 15)

‘Gains’ on the other hand relate to ‘other income’, which does not necessarily constitute part of the ordinary activities of an entity. For example, ‘gains’ might include those increases in equity arising on the disposal of non-current assets, or on the revaluation of non-current assets.

To determine the profit or loss of an entity, we also need a definition of ‘expenses’, as profit is derived by subtracting expenses from income. The Conceptual Framework does not include profit (or loss) as one of its elements of accounting, and given that profit is simply the difference between income and expenses, both of which are defined, there is no need for a separate definition or recognition criteria for profits. Expenses are defined in the Conceptual Framework as:

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

LO 16.1

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.

income Defined by the Conceptual Framework as ‘increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims’.

revenues A class of income typically relating to the ordinary activities of an entity.

dee67382_ch16_641-686.indd 643 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 643

Therefore, to the extent that a transaction does not involve a contribution from, or a distribution to, owners then the Conceptual Framework requires that the recognition of income occurs at the same time as:

(i) the initial recognition of an asset, or an increase in the carrying amount of an asset; or (ii) the derecognition of a liability, or a decrease in the carrying amount of a liability,

whilst the recognition of an expense arises at the same time as:

(i) the initial recognition of a liability, or an increase in the carrying amount of a liability; or (ii) the derecognition of an asset, or a decrease in the carrying amount of an asset,

The definition and recognition of income (and expenses) is therefore directly linked to the definition and recognition of assets and liabilities. As we know from previous chapters, for a transaction or event to be recognised within the financial statements there is a requirement within the Conceptual Framework that:

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

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

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

As indicated in Chapter 15 and elsewhere in this book, the determination of income and expenses will be influenced by which asset or liability measurement model is adopted. Different measurement models are based on historical cost, current cost, fair 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.

In relation to expenses, the judgement about whether or not to recognise assets will have a direct impact upon reported profits. At times, it might not be clear whether or not there is sufficient probability that future economic benefits sufficient to absorb the cost of the asset will be derived from an item of expenditure, and thus whether the item of expenditure should be recognised as an expense, or as an asset.

If there is doubt that sufficient future benefits will be derived, the expenditure will be expensed. The degree of probability and measurability attached to expectations regarding future economic benefits, and hence the recognition of an expense, will be a matter of professional judgement. As we know, accounting is not an exact science and so different teams of accountants would be unlikely to calculate the same profit or loss for an entity, even if they were given the same details about all the transactions and events that the entity has entered into, or encountered. Potentially, one team of accountants might report profits, while another team reports losses. This difference will be driven by differences in the assumptions made, and it is very possible that the alternative sets of results generated by the different teams might all be considered to be true and fair by the auditors of the reporting entity. For example, a judgement must be made about such things as how many periods should be used to fully depreciate an item of plant and equipment, or whether there has been an impairment loss on a particular asset (which in turn requires judgements to be made about the ‘recoverable amount’ of an asset).

16.2 Information about significant judgements made when compiling financial statements

It is obviously important for significant assumptions made by accountants to be clearly described in the notes to the financial statements. This is consistent with the requirements of paragraph 125 of AASB 101, Presentation of Financial Statements, 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

LO 16.2

asset Defined in the Conceptual Framework as ‘a present economic resource controlled by the entity as a result of past events’.

expenses Defined in the Conceptual Framework as ‘decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims’.

true and fair Disclosures are regarded as giving a true and fair view if they provide all relevant information that is representationally faithful and comply with applicable standards.

dee67382_ch16_641-686.indd 644 10/17/19 08:20 PM

644 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 101)

For example, in relation to some of the key assumptions that BHP Ltd makes in respect of some of its assets recognised in relation to mining activities, the 2019 Annual Report of BHP provides the following information (as shown in Exhibits 16.1 and 16.2).

Exhibit 16.2 A further example from the 2019 Annual Report of BHP Ltd of information about judgements made with respect to particular assets

SOURCE: BHP Group Ltd

Exhibit 16.1 An example from the 2019 Annual Report of BHP Ltd of information about judgements made with respect to particular assets

SOURCE: BHP Group Ltd

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:

dee67382_ch16_641-686.indd 645 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 645

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. (AASB 138)

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 contractual agreements in place that rely upon reported profit, for example dividend constraints, management bonus agreements and interest-coverage clauses incorporated within agreements negotiated between owners, 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 items of income (often referred to as ‘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 (such as those relating to the correction of prior period accounting errors) and certain gains (such as those relating to asset revaluations) are to be excluded from ‘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 ‘total comprehensive income’ (sometimes simply referred to as ‘comprehensive income’). As we will also learn in this chapter, ‘total comprehensive income’ includes both ‘profits or losses’ plus ‘other items of comprehensive income’. We will define what we mean by ‘other items of comprehensive income’ shortly.

WHY DO I NEED TO KNOW ABOUT THE KEY JUDGEMENTS AND ASSUMPTIONS MADE BY A REPORTING ENTITY WITH RESPECT TO THEIR FINANCIAL REPORTS?

The assets and liabilities, and therefore the income and expenses of an organisation, will be directly influenced by various assumptions and judgements that financial accountants make as part of the process of preparing financial reports. To place the reported financial information in context it is therefore important that a user is provided with a summary of these assumptions and judgements. Such information would be deemed to be ‘relevant’, which is one of the fundamental qualitative characteristics of financial accounting information.

16.3 The meaning of ‘total comprehensive income’ 

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.

AASB 101, paragraph 88, requires entities to recognise all items of income and expense that arise 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 also 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 referred to as ‘total comprehensive income’. As the name would suggest, total comprehensive income, which is comprised of profit or loss plus other gains and losses that are recorded in various equity accounts and which are referred to as being

LO 16.3

dee67382_ch16_641-686.indd 646 10/17/19 08:20 PM

646 PART 4: Accounting for liabilities and owners’ equity

components of ‘other comprehensive income’, is presented in a ‘statement of profit or loss and other comprehensive income’. That is:

Total comprehensive income = profit or loss (after tax) + other comprehensive income (after tax)

The format for disclosing an entity’s statement of profit or loss and other comprehensive income is prescribed within AASB 101. Reporting entities 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 of comprehensive income’, or they can separately provide both an income statement plus a statement of comprehensive income. As paragraph 10A 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. (AASB 101)

The only difference between the ‘single-statement approach’ and the ‘two-statement approach’ referred to above is that rather than showing both sections in one statement, there are two statements.

16.4 Components of other comprehensive income

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 within 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 or in another equity account, such as ‘revaluation surplus’). 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, it is a case of an expense being recognised directly in equity (by reducing retained earnings, which is an equity account). A number of other accounting standards also require certain income and expense items to be recorded within particular equity accounts (via recognition through ‘other comprehensive income’) rather than including them in a period’s profit or loss.

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. (AASB 101)

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 121 The

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

LO 16.4

dee67382_ch16_641-686.indd 647 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 647

(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). (AASB 101)

Hence if we were to look only at ‘profit or loss’ as 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 the income and expenses of a financial period.

The Conceptual Framework provides further discussion and insights into ‘other comprehensive income’. Paragraphs 7.15, 7.16 and 7.17 state:

7.15 Income and expenses are classified and included either: (a) in the statement of profit or loss; or (b) outside the statement of profit or loss, in other comprehensive income. 7.16 The statement of profit or loss is the primary source of information about an entity’s financial performance

for the reporting period. That statement contains a total for profit or loss that provides a highly summarised depiction of the entity’s financial performance for the period. Many users of financial statements incorporate that total in their analysis either as a starting point for that analysis or as the main indicator of the entity’s financial performance for the period. Nevertheless, understanding an entity’s financial performance for the period requires an analysis of all recognised income and expenses—including income and expenses included in other comprehensive income—as well as an analysis of other information included in the financial statements.

7.17 Because the statement of profit or loss is the primary source of information about an entity’s financial performance for the period, all income and expenses are, in principle, included in that statement. However, in developing Standards, the Board may decide in exceptional circumstances that income or expenses arising from a change in the current value of an asset or liability are to be included in other comprehensive income when doing so would result in the statement of profit or loss providing more relevant information, or providing a more faithful representation of the entity’s financial performance for that period.

While the Conceptual Framework does provide the above discussion of other comprehensive income, what does seem apparent at present is that there is no clear principles-based approach to determine or justify what is included within ‘other comprehensive income’, and what is not. The rules seem rather ad hoc, with standard-setters involved in developing particular accounting standards determining whether gains or losses are reported within other comprehensive income, or not. Nevertheless, research does seem to indicate that information about other comprehensive income and total comprehensive income is of relevance to particular stakeholders, such as investors (for example, see Khan, Bradbury and Courtenay 2018).

WHY DO I NEED TO KNOW THE DIFFERENCE BETWEEN ‘PROFIT OR LOSS’ AND ‘OTHER COMPREHENSIVE INCOME’?

Reporting entities are required to provide two measures of financial performance, these being ‘profit or loss’ and ‘other comprehensive income’. When these two amounts are added together, this gives us ‘total comprehensive income’. Because reporting entities disclose these figures, we obviously need to clearly understand what they represent—otherwise we really will not understand what the financial statements are telling us.

16.5 Format of the 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

LO 16.5

dee67382_ch16_641-686.indd 648 10/17/19 08:20 PM

648 PART 4: Accounting for liabilities and owners’ equity

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). (AASB 101)

In relation to the information to be presented with respect to 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. (AASB 101)

In addition to the above ‘line items’, an entity is allowed to include additional line items in respect of profit or loss and other comprehensive income if it is considered likely to assist users in gaining an understanding of an entity’s financial performance (see paragraph 85 of AASB 101).

As we can see, the requirements above refer to items that will be ‘reclassified’ from other comprehensive income 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 a consolidated statement of profit or loss and other comprehensive income to be disaggregated between the non-controlling interests, and the owners of the parent entity. In a business combination, where the parent entity owns less than 100 per cent of the shares of a subsidiary, the equity within the subsidiary that is not attributable to the parent is referred to as the ‘non-controlling interest’. 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 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. (AASB 101)

dee67382_ch16_641-686.indd 649 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 649

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. (AASB 101)

In explaining the alternative presentation formats, 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 X

Other income X

Changes in inventories of finished goods and work in progress X

Raw materials and consumables used X

Employee benefits expense X

Depreciation and amortisation expense X

Other expenses X

Total expenses (X)

Profit before tax 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 judgement. An example of a classification using the function of expense method is as follows:

Revenue X

Cost of sales (X)

Gross profit X

Other income X

Distribution costs (X)

Administrative expenses (X)

Other expenses (X)

Profit before tax X (AASB 101)

As an example, if expenses are classified on the basis of the ‘nature of expenses’, then employee benefit expenses would all be aggregated as one line item, perhaps referred to as ‘employee benefit expense’. By contrast, if expenses are classified on the basis of the ‘function of expenses’, then the employee benefits expenses would be allocated to their respective functions, such as cost of sales, selling expenses or administrative expenses. 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 judged 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

dee67382_ch16_641-686.indd 650 10/17/19 08:20 PM

650 PART 4: Accounting for liabilities and owners’ equity

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 expenses 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 16.3, 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 16.4. When reviewing the two formats, try to note the differences. At this stage it should also be noted that individual items of other comprehensive income can be disclosed either on an aggregated basis (Exhibit 16.3) or on a net-of-tax basis (Exhibit 16.4). Again, whichever format is chosen, it should be chosen on the basis of which format is considered by management to be more relevant and 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.

Exhibit 16.3 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 2023

2023 ($000)

2022 ($000)

Revenue 390 000 355 000

Cost of sales (245 000) (230 000)

Gross profit 145 000 125 000

Other income 20 667 11 300

Distribution costs (9 000) (8 700)

Administrative expenses (20 000) (21 000)

Other expenses (2 100) (1 200)

Finance costs (8 000) (7 500)

Share of profits of associates   35 100    30 100

Profit before tax 161 667 128 000

Income tax expense  (40 417)   (32 000)

Profit for the year from continuing operations 121 250 96 000

Loss for the year from discontinued operations              –   (30 500)

Profit for the year 121 250    65 500

Other comprehensive income:

Items that will not be reclassified to profit or loss:

Gains on property revaluation 933 3 367

Investments in equity instruments (24 000) 26 667

Remeasurements of defined benefit pension plans (667) 1 333

Share of other comprehensive income of associates 400 (700)

Income tax relating to items that will not be reclassified     5 834  (7 667)

(17 500) 23 000

dee67382_ch16_641-686.indd 651 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 651

2023 ($000)

2022 ($000)

Items that may be reclassified subsequently to profit or loss:

Exchange differences on translating foreign operations 5 334 10 667

Cash flow hedges (667) (4 000)

Income tax relating to items that may be reclassified (1 167) (1 667)

   3 500     5 000

Other comprehensive income for the year, net of tax (14 000) 28 000

Total comprehensive income for the year 107 250 93 500

Profit attributable to:

Owners of the parent 97 000 52 400

Non-controlling interests    24 250    13 100

121 250 65 500

Total comprehensive income attributable to:

Owners of the parent 85 800 74 800

Non-controlling interests   21 450   18 700

107 250 93 500

Earnings per share

Basic and diluted 46 cents 30 cents

SOURCE: IAS 1, 2014, Guidance on Implementing IAS 1 Presentation of Financial Statements

Exhibit 16.4 Two-statement format with expenses classified by nature

XYZ LTD Income statement for the year ended 31 December 2023

2023 ($000)

2022 ($000)

Revenue 390 000 355 000

Other income 20 667 11 300

Changes in inventories of finished goods and work in progress (115 100) (107 900)

Work performed by the entity and capitalised 16 000 15 000

Raw material and consumables used (96 000) (92 000)

Employee benefits expense (45 000) (43 000)

Depreciation and amortisation expense (19 000) (17 000)

Impairment of property, plant and equipment (4 000) –

Other expenses (6 000) (5 500)

Finance costs (15 000) (18 000)

Share of profit of associates    35 100    30 100

Profit before tax 161 667 128 000

Income tax expense   (40 417)  (32 000)

Profit for the year from continuing operations 121 250 96 000

Loss for the year from discontinued operations              –  (30 500)

Profit for the year  121 250    65 500

continued

dee67382_ch16_641-686.indd 652 10/17/19 08:20 PM

652 PART 4: Accounting for liabilities and owners’ equity

2023 ($000)

2022 ($000)

Profit attributable to:

Owners of the parent 97 000 52 400

Non-controlling interests    24 250    13 100

121 250    65 500

Earnings per share

Basic and diluted 46 cents 30 cents

XYZ LTD Statement of comprehensive income for the year ended 31 December 2023

2023 ($000)

2022 ($000)

Profit for the year 121 250 65 500

Other comprehensive income:

Items that will not be reclassified to profit or loss:

Gains on property revaluation 933 3 367

Investments in equity instruments (24 000) 26 667

Remeasurement of defined benefit pension plans (667) 1 333

Share of other comprehensive income of associates 400 (700)

Income tax relating to items that will not be reclassified 5 834 (7 667)

(17 500) 23 000

Items that may be reclassified subsequently to profit or loss:

Exchange differences on translating foreign operations 5 334 10 667

Cash flow hedge (667) (4 000)

Income tax relating to items that will not be reclassified (1 167) (1 667)

3 500 5 000

Other comprehensive income for the year (14 000) 28 000

Total comprehensive income for the year 107 250 93 500

Total comprehensive income attributable to:

Owners of the parent 85 800 74 800

Non-controlling interest 21 450 18 700

107 250 93 500

SOURCE: IAS 1, 2014, Guidance on Implementing IAS 1 Presentation of Financial Statements

Looking at the two formats just set out, one (expenses by function, Exhibit 16.3) separately identifies the cost of sales whereas the other (expenses by nature, Exhibit 16.4) 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

Exhibit 16.4 continued

dee67382_ch16_641-686.indd 653 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 653

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, which will be of interest to various stakeholders, are presented in the statement of changes in equity, which is discussed later in the chapter.

As we have indicated above, and as shown in Exhibit 16.3, ‘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. (AASB 101)

As indicated in Exhibit 16.3, 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 (with consequent adjustments to equity). For example, AASB 116 Property, Plant and Equipment does not require that all classes of property, plant and equipment shall be measured at fair value, even when the monetary value of the asset has increased significantly above its cost (and the Conceptual Framework would classify such increases in value as income if the increment in the carrying amount of the assets were recognised within the financial statements). This means that reported measures of financial performance are somewhat incomplete (that is, they are not truly ‘comprehensive’). Hence we 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.

16.6 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. 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. (AASB 101)

Pursuant to our accounting standards, there are only a relatively limited number of types of items of income and expense that will be ‘reclassified’. 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 Financial Instruments, and gains on hedging instruments associated with cash flow hedges that were initially recognised within a cash flow hedge reserve in accordance with AASB 9.

LO 16.6

dee67382_ch16_641-686.indd 654 10/17/19 08:20 PM

654 PART 4: Accounting for liabilities and owners’ equity

For example, consider a financial instrument in the form of a government bond (which is a ‘financial asset’ in the hands of the holder) 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 government bonds at fair value through other comprehensive income, meaning that any gains or losses go to other comprehensive income rather than directly to profit or loss. AASB 9 further requires that when the bonds are eventually sold, the sum of the gains previously recognised in other comprehensive income is then transferred to profit or loss with an equivalent amount being shown as a deduction from other comprehensive income (this is an example of a reclassification adjustment). That is, for certain items, 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).

A review of Exhibit 16.3 shows that within ‘other comprehensive income’ we should be able to see which items might subsequently be reclassified into profit or loss (reclassifications) and those items that will not be reclassified.

An illustration of a reclassification adjustment relating to financial assets measured at fair value through other comprehensive income is provided in Worked Example 16.1.

WORKED EXAMPLE 16.1: Reclassification adjustment

On 31 December 2022, Bombora Ltd purchased 10 000 government bonds at $12.40 per bond. On acquisition, Bombora 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 other comprehensive income until the item is derecognised (sold), at which point AASB 9 specifically requires the accumulated gain or loss will be transferred to profit or loss. At 31 December 2023, the fair value of the financial assets had increased to $18.60. At 31 December 2024, the fair value of the financial assets had increased to $21.70. All of the instruments were sold on 31 December 2024. 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 (we will discuss the statement of changes more fully later in this chapter), for the reporting period ending 31 December 2024 in which the reclassification adjustment for the government bonds is detailed.

SOLUTION Calculation of gains on government bonds

Before tax ($)

Income tax at 30% ($)

Net of tax ($)

Gains recognised in other comprehensive income:

Year ended 31 December 2023 62 000 (18 600) 43 400

Year ended 31 December 2024 31 000 (9 300) 21 700

Total gain 93 000 (27 900) 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 2024 as follows (and only numbers relating to the government bonds are presented below). As you can see, when the bonds are eventually sold, the gains previously recorded within other comprehensive income are treated as part of profit or loss, and a corresponding amount is deducted from other comprehensive income.

dee67382_ch16_641-686.indd 655 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 655

Bombora Ltd Statement of profit or loss and other comprehensive income for the year ended 31 December 2024

2024 ($)

2023 ($)

Profit or loss:

Gain on sale of financial assets (government bonds) 93 000 –

Income tax expense (27 900)       –

Net gain recognised in profit or loss 65 100       –

Other comprehensive income:

Gain on government bonds, net of tax 21 700 43 400

Reclassification adjustment, net of tax (65 100)           –

Net gain (loss) recognised in other comprehensive income (43 400) 43 400

Total comprehensive income for the year 21 700 43 400

Bombora Ltd Statement of changes in equity for the year ending 31 December 2024

Share capital

($)

Financial assets measured at

fair value through OCI

($)

Retained earnings

($)

Total equity

($)

Balance at 31 December 2022 500 000 – – 500 000

Changes in equity for 2023

Total comprehensive income for the year             –   43 400           –  43 400

Balance at 31 December 2023 500 000 43 400 – 543 400

Changes in equity for 2024

Total comprehensive income for the year             – 21 700 65 100  86 800

Reclassification adjustment for gain included in profit or loss

            – (65 100)           – (65 100)

Balance at 31 December 2024 500 000           – 65 100 565 100

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:

Bombora Ltd Statement of profit or loss and other comprehensive income for the year ended 31 December 2024

2024 ($)

2023 ($)

Profit or loss:

Gain on sale of instruments 93 000 –

Income tax expense (27 900)             –

Net gain recognised in profit or loss 65 100             –

Other comprehensive income:

Gain on financial assets measured at fair value through OCI 31 000 62 000

Reclassification adjustment (93 000) –

Income tax relating to other comprehensive income 18 600 (18 600)

Net gain (loss) recognised in other comprehensive income (43 400) 43 400

Total comprehensive income for the year 21 700 43 400

dee67382_ch16_641-686.indd 656 10/17/19 08:20 PM

656 PART 4: Accounting for liabilities and owners’ equity

Worked Example 16.2 provides another illustration relating to reclassification adjustments.

WHY DO I NEED TO KNOW WHAT A ‘RECLASSIFICATION ADJUSTMENT’ REPRESENTS?

A review of the financial statements of reporting entities will typically show that the statement of profit or loss and other comprehensive income includes amounts attributed to ‘reclassification adjustments’. These amounts can sometimes be very material in nature and will impact reported profit or loss. Therefore, it is important that we understand what these amounts represent. In doing so, we will learn that not all items that are included within other comprehensive income must subsequently be reclassified to profit or loss. We will also learn that certain gains that are included within other comprehensive income will never be included in profit or loss (for example, gains on asset revaluations and gains on equity investments that were measured at fair value through other comprehensive income).

WORKED EXAMPLE 16.2: Determining which gains or losses will require a subsequent reclassification adjustment

REQUIRED Determine whether the following items would result in a subsequent reclassification adjustment:

(a) A revaluation increment included within other comprehensive income (b) The gain on an equity investment where the equity investment is measured at fair value through other

comprehensive income (c) The gain on a financial asset in the form of a government bond where the bond is measured at fair value

through other comprehensive income

SOLUTION In attempting to answer this question, we can see that we need to know the requirements of specific and relevant accounting standards to in turn know whether gains or losses that are initially recorded within other comprehensive income shall be reclassified to profit or loss. That is, there is not a general rule or principle that has broad application to this issue.

(a) As Chapter 6 explains, unless the revaluation increment reverses a previous revaluation decrement, when assets are revalued, the credit entry is treated as part of other comprehensive income—perhaps referred to as a ‘gain on revaluation’—and the increase in the value of the asset will accumulate in an equity account known as a ‘revaluation surplus’ (or similar). Pursuant to paragraph 41 of AASB 116, the revaluation surplus included in equity can be transferred directly to retained earnings when the asset is derecognised (for example, sold). However, it is specifically noted within the accounting standard that transfers from revaluation surplus to retained earnings are not to be made through profit or loss. That is, reclassification adjustments are not permitted in relation to gains from revaluation of property, plant and equipment.

(b) As Chapter 14 explains, if equity investments are not held for trading, then an entity may irrevocably elect to present changes in fair value within other comprehensive income, and not in profit or loss. Where changes in fair value are included within other comprehensive income, AASB 9 specifically stipulates that such changes shall not be reclassified subsequently to profit or loss.

(c) As Chapter 14 explains, if the debt instrument is held within a business model whose objective is to both collect contractual cash flows and sell financial assets, then gains and losses on fair value can be included within other comprehensive income, and not in profit or loss. When the asset is derecognised (sold), AASB 9 specifically requires that the cumulative gain or loss recognised within other comprehensive income shall be reclassified from equity to profit or loss.

16.7 Separate disclosure of ‘material 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 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. (AASB 101)

LO 16.7

dee67382_ch16_641-686.indd 657 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 657

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 (when Australia used its own accounting standards that were developed 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, improved Australian financial reporting. However, the former requirement to disclose extraordinary items had been applied by many reporting entities in an opportunistic manner to move significant expenses—such as major asset write-downs—away from the measure of financial performance known as ‘profit or loss before extraordinary items’. This strategy is no longer available.

While AASB 101 prohibits the disclosure of extraordinary items, the following requirement at paragraph 97 could nevertheless 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. (AASB 101)

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:

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity.

Materiality depends on the nature or magnitude of information, or both. An entity assesses whether information, either individually or in combination with other information, is material in the context of its financial statements taken as a whole.

Information is obscured if it is communicated in a way that would have a similar effect for primary users of financial statements to omitting or misstating that information. The following are examples of circumstances that may result in material information being obscured:

(a) information regarding a material item, transaction or other event is disclosed in the financial statements but the language used is vague or unclear;

(b) information regarding a material item, transaction or other event is scattered throughout the financial statements;

(c) dissimilar items, transactions or other events are inappropriately aggregated; (d) similar items, transactions or other events are inappropriately disaggregated; and (e) the understandability of the financial statements is reduced as a result of material information being hidden by

immaterial information to the extent that a primary user is unable to determine what information is material. (AASB 101)

Assessing whether information could reasonably be expected to influence decisions made by the primary users of a specific reporting entity’s general purpose financial statements requires an entity to consider the characteristics of those users while also considering the entity’s own circumstances.

A review of the 2019 Annual Report of BHP Group 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 16.5 reproduces information from BHP Group Ltd’s 2019 Annual Report in respect of the exceptional items that arose in 2018, and which the organisation apparently believes are worthy of separate disclosure.

dee67382_ch16_641-686.indd 658 10/17/19 08:20 PM

658 PART 4: Accounting for liabilities and owners’ equity

Paragraph 98 of AASB 101 provides guidance about when separate disclosure of particular income or expense items would likely 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; (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. (AASB 101)

Exhibit 16.5 Example of disclosure of material items of income and expense

SOURCE: BHP Group Ltd

16.8 Changes in accounting estimates can impact profit or loss and other comprehensive income

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 states:

The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. (AASB 108)

LO 16.8

dee67382_ch16_641-686.indd 659 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 659

Many estimates must be made as part of the financial reporting process in relation to such things as bad debts, inventory obsolescence and the useful lives of various non-current 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 judgements 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. (AASB 108)

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. (AASB 108)

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 and events (‘faithful representation’ being one of the two fundamental qualitative characteristics of useful financial reporting information). The Conceptual Framework notes that financial information provides 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.

Because of new information or insights, changes in accounting estimates could be made with respect to various accounts, including, but not limited to changes in:

∙ the allowance for doubtful debts ∙ expected warranty costs on goods sold under guarantee ∙ the fair value of financial assets and financial liabilities ∙ the expected pattern of consumption of economic benefits of depreciable assets ∙ 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. 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

dee67382_ch16_641-686.indd 660 10/17/19 08:20 PM

660 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 108)

In relation to the disclosures required for changes in accounting estimates, paragraphs 39 and 40 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. (AASB 108)

Worked Example 16.3 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 16.3: Change in accounting estimate (changing the useful life of an asset)

On 30 June 2023, 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 years earlier on 1 July 2018 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 2023 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 Depreciation 50 000

Cr Accumulated depreciation—manufacturing equipment (to recognise depreciation for the year using a new estimate of useful life)

50 000

(b) Supporting note—change in accounting estimate

2023 ($)

2022 ($)

Profit before tax has been arrived at after taking into account:

Depreciation

Original 25 000 25 000

Change in accounting estimate 25 000           –

50 000 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 also increase by $25 000 for the remaining three years.

dee67382_ch16_641-686.indd 661 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 661

16.9 Other disclosures specifically required with respect to particular items of income and expense

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.

As already noted, many other accounting standards require the disclosure of information about various items of income and expense. For example, AASB 138 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 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 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). (AASB 15)

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.

WHY DO I NEED TO KNOW THAT THE PRODUCTION OF FINANCIAL REPORTS RELIES UPON MANY ACCOUNTING ESTIMATES?

The use of estimates is an essential part of preparing financial statements. Many estimates need to be made about such things as the useful life of assets, the amount of inventory that could be obsolete, the amount of accounts receivable that might ultimately not be collectable, and so forth. These estimates will directly impact measures of financial performance, such as profits or losses or other comprehensive income.

To properly understand the context of reported financial amounts, an appreciation of the role of estimates is necessary. It is also necessary to know that estimates (such as the life of a non-current asset) can be amended from period to period. This will have a direct impact on reported financial performance. Therefore, when there is a change in accounting estimate, it is relevant for a financial statement reader to understand how this has impacted reported profit relative to prior periods, and how it might impact future reporting periods.

LO 16.9

dee67382_ch16_641-686.indd 662 10/17/19 08:20 PM

662 PART 4: Accounting for liabilities and owners’ equity

16.10 Accounting for 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 with the required treatment now being stipulated within AASB 108. 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. (AASB 108)

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 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)

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. The impact on the financial statements in the current period will be reflected within the statement of changes in equity (to be discussed shortly) via adjustments to the opening balance of equity, typically retained earnings. For example, if in the year ended 30 June 2023 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 2023 would be:

Dr Retained earnings X

Cr Inventory (an adjustment to recognise a prior period error)

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 the managers of a reporting entity ‘forget’ to include an expense in one period and discover the omission in the next period, then that expense will not appear within profit or loss or other comprehensive income (because the subsequent recognition will be made by virtue of a direct 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?

The treatment of prior period errors is not really consistent with a ‘comprehensive approach’ to measurement of profit or loss. Corrections of prior period errors are not permitted by accounting standards to be a component of profit or loss, or a component of other comprehensive income. Therefore, the treatment of prior period errors is an exception to the comprehensive income approach to measuring profit or loss.

LO 16.10

dee67382_ch16_641-686.indd 663 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 663

As another point to again emphasise, 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. (AASB 108)

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 16.4.

WORKED EXAMPLE 16.4: 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 2023.

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 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 $8500, incurred in July 2021 and payable to a foreign supplier, was overlooked and not paid or provided for in the financial statements ending 30 June 2022. 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 accounting estimate. This will impact the current and future period’s profit or loss. Scenario 2 is a prior period error. It arose from a material amount not being included when the 2022 financial statements were prepared. The error will be recognised by directly adjusting opening retained earnings. No related expense will be recognised in the current reporting period. Comparative (prior period) figures will be adjusted.

In Worked Example 16.4 the increase in the amount recognised for doubtful debts results from a change in an accounting estimate. The estimate is the amount to be recognised 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 included in the allowance for doubtful debts at year end. However, the amount that was due to the foreign supplier and that was not paid or recognised in the financial statements ending 30 June 2022 was clearly an oversight or omission on the part of the company and, as such, meets the definition of a prior period error.

When to correct prior period errors Material prior period errors are corrected retrospectively in the first set of financial statements authorised for issue after their discovery. 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.

dee67382_ch16_641-686.indd 664 10/17/19 08:20 PM

664 PART 4: Accounting for liabilities and owners’ equity

Using the information contained in Worked Example 16.4, and assuming a tax rate of 30 per cent, the following journal entry would be necessary to correct the financial statements:

30 June 2023

Dr Retained earnings 5 950

Dr Income tax payable 2 550

Cr Accounts payable (to recognise a prior period error in relation to the previous non-recognition of cost of sales)

8 500

Disclosing prior period errors Paragraph 42 of AASB 108 specifically 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. (AASB 108)

In applying the above requirements of paragraph 42, paragraph 49 requires the following disclosures to be made:

An entity shall disclose the following: (a) the nature of the prior period error; (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. (AASB 108)

Worked Example 16.5 details how a prior period error should be accounted for and disclosed at the time the error is discovered.

WORKED EXAMPLE 16.5: 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 2022. 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 2021. 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 2022 would be:

Dr Opening retained earnings 78 000

Dr Accumulated depreciation—machinery 12 000

Cr Machinery (to recognise a prior period error wherein the loss on a derecognition of machinery had been omitted)

90 000

dee67382_ch16_641-686.indd 665 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 665

Apart from performing the above journal entry, the comparative figures shown within the financial statements would need to be adjusted.

16.11 Changes in accounting policy

One of the essential qualitative characteristics of general purpose financial statements is ‘comparability’, which is one of the four ‘enhancing qualitative characteristics’ of useful financial information. 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. (AASB 108)

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 16.6, 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 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.

LO 16.11

WORKED EXAMPLE 16.6: Identifying a change in accounting policy and an instance not considered to be a change in accounting policy

Scenario 1 Reef Ltd has previously not owned a depreciable building. During the reporting period ending 30 June 2023, a building was constructed. Depreciation was charged for the first time on the building from the 2023 reporting period.

Scenario 2 Reef Ltd has previously held land at cost. From the 2023 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.

dee67382_ch16_641-686.indd 666 10/17/19 08:20 PM

666 PART 4: Accounting for liabilities and owners’ equity

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 are 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. (AASB 108)

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 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. (AASB 108)

An example of a retrospective change in accounting policy is provided in Worked Example 16.7.

WORKED EXAMPLE 16.7: Retrospective change in accounting policy

During 2019, Kirra Ltd commenced the construction of a geothermal power station outside Canberra for its own use. During the reporting period ending 30 June 2023, 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, Kirra 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 Kirra 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 2023 are detailed below.

dee67382_ch16_641-686.indd 667 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 667

Kirra Ltd

Abridged statement of profit or loss and other comprehensive income for the year ended 30 June 2023

2023 ($)

2022 ($)

Profit before tax 29 200 28 400

Income tax expense (8 760) (8 520)

Profit for the year 20 440 19 880

Other comprehensive income          –          –

Total comprehensive income 20 440 19 880

Kirra Ltd

Abridged statement of changes in equity for the year ended 30 June 2023

Share capital

($)

Retained earnings

($) Total

($)

Balance at 1 July 2021 25 000 16 100 41 100

Profit for the year 19 880 19 880

Distributions to shareholders – (5 400) (5 400)

Balance at 30 June 2022 25 000 30 580 55 580

Profit for the year – 20 440 20 440

Distributions to shareholders – (7 400) (7 400)

Balance at 30 June 2023 25 000 43 620 68 620

Kirra Ltd

Statement of financial position (extract) at 30 June 2023

2023 ($)

2022 ($)

2021 ($)

Qualifying asset under construction 21 400 13 300 8 800

Other assets 47 220 42 280 32 300

68 620 55 580 41 100

Share capital 25 000 25 000 25 000

Retained earnings 43 620 30 580 16 100

68 620 55 580 41 100

Additional information

1. In 2023 interest of $2800 relating to the construction of the geothermal power station was expensed. Interest costs of $4200 were expensed in 2022, $5600 was expensed in 2021 and $3700 was expensed in reporting periods prior to 2021.

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.

continued

dee67382_ch16_641-686.indd 668 10/17/19 08:20 PM

668 PART 4: Accounting for liabilities and owners’ equity

SOLUTION

Kirra Ltd Abridged statement of profit or loss and other comprehensive income for the year ended 30 June 2023

2023 ($)

2022 ($)

Restated

Profit before tax 32 000 32 600

Income tax expense (9 600) (9 780)

Profit for the year 22 400 22 820

Other comprehensive income – –

Total comprehensive income 22 400 22 820

Kirra Ltd Abridged statement of changes in equity for the year ended 30 June 2023

Share capital

($)

Retained earnings

($) Total

($)

Balance at 1 July 2021 as previously reported 25 000 16 100 41 100

Change in accounting policy resulting from capitalising interest

– 6 510 6 510

Balance at 1 July 2021 as restated 25 000 22 610 47 610

Profit for the year (restated) 2022 – 22 820 22 820

Distributions to shareholders – (5 400) (5 400)

Balance at 30 June 2022 25 000 40 030 65 030

Profit for the year 2023 – 22 400 22 400

Distributions to shareholders – (7 400) (7 400)

Balance at 30 June 2023 25 000 55 030 80 030

Kirra Ltd Statement of financial position (extract) at 30 June 2023

2023 ($)

2022 ($)

2021 ($)

Qualifying asset under construction 37 700 26 800 18 100

Other assets 47 220 42 280 32 300

Taxation (deferred tax liability) (4 890) (4 050) (2 790)

80 030 65 030 47 610

Share capital 25 000 25 000 25 000

Retained earnings 55 030 40 030 22 610

80 030 65 030 47 610

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 now requires borrowing costs attributable to the construction of a qualifying asset to be capitalised as part of the cost of the asset. 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 2022 have been restated. The effect of the change on 2022 is shown below. Opening retained earnings for 2022 is increased by $9300 ($6510 after tax), which is the amount of the adjustment relating to periods prior to 2022.

WORKED EXAMPLE 16.7 continued

dee67382_ch16_641-686.indd 669 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 669

Effect on 2022

($)

Effect on periods prior to 2022

($)

Decrease in interest expense 4 200 9 300

(Increase) in income tax expense (1 260) (2 790)

Increase in profit 2 940 6 510

Increase in qualifying assets under construction 13 500 9 300

Increase in retained earnings at 30 June 2022 9 450 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 16.8.

WORKED EXAMPLE 16.8: Prospective change in accounting policy

During the reporting period ending June 2023, the directors of Currumbin Ltd decided to change the company’s accounting policy for depreciating property, plant and equipment to the components approach (which requires property, plant and equipment to be subdivided into smaller components, which are then separately depreciated) and, at the same time, adopt the revaluation model wherein particular classes of assets will be revalued to fair value. Prior to 2023, the details maintained in the assets register were not sufficiently detailed to apply the components approach fully.

During June 2022, 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 2022, the beginning of the 2023 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 2023 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 2023 reporting period.

For the purposes of this Worked Example we shall ignore taxation.

The following additional information is available: Property, plant and equipment at 30 June 2022 At cost 160 000

Accumulated depreciation (89 600)

Carrying amount 70 400

Depreciation expense based on a former valuation 9 600

The engineering survey established the following values: Property, plant and equipment—at fair value 108 800

Estimated residual value 19 200

Remaining asset life 5 years

Depreciation expense on new basis 17 920

REQUIRED Prepare the journal entries that would be made in the records of Currumbin Ltd at 30 June 2023, together with the note that would appear in the 2023 financial statements.

continued

dee67382_ch16_641-686.indd 670 10/17/19 08:20 PM

670 PART 4: Accounting for liabilities and owners’ equity

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 of financial reports 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.

Financial statements of subsequent periods need not repeat these disclosures.

SOLUTION

30 June 2023

Dr Accumulated depreciation 89 600

Cr Property, plant and equipment (to eliminate accumulated depreciation upon revaluation)

89 600

Dr Property, plant and equipment 38 400

Cr Gain on revaluation (in OCI) (revaluation of plant as per engineering survey. The gain will subsequently be transferred to an equity account, perhaps labelled ‘Revaluation surplus’.)

38 440

Dr Depreciation expense    8 320

Cr Accumulated depreciation (additional depreciation expense for the year on the assumption that depreciation expense based on previous valuations have already been recognised)

8 320

Notes to the 2023 financial statements

From the start of the 2023 reporting period, Currumbin 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 2023 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; create a revaluation surplus at the start of the year of $38 400; and increase depreciation expense by $8320.

WORKED EXAMPLE 16.8 continued

dee67382_ch16_641-686.indd 671 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 671

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. (AASB 108)

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 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.

As an example of the type of disclosures that might be made in relation to the possible impact of new accounting standards, BHP Group Ltd referred to a number of new accounting standards in its 2018 Annual Report. Exhibit 16.6 shows the new requirements in relation to leasing.

Exhibit 16.6 An example of information provided in relation to the potential impact of a new accounting standard

SOURCE: BHP Group Ltd

dee67382_ch16_641-686.indd 672 10/17/19 08:20 PM

672 PART 4: Accounting for liabilities and owners’ equity

WHY DO I NEED TO KNOW ABOUT, AND UNDERSTAND, ACCOUNTING POLICIES APPLIED BY AN ORGANISATION, TOGETHER WITH THE CHANGES THEREIN?

The accounting policies used by a reporting entity (for example, a policy to use the fair value model rather than the cost model to account for non-current assets) will have implications for reported assets, liabilities, income, expenses and equity. To properly understand the context of the financial numbers being reported, it is important to understand the accounting policies that have been applied. For example, if an organisation uses the fair value model for non-current assets then, in times of increasing prices, this would generally mean that the organisation would report higher assets and also higher depreciation expenses relative to an organisation that uses the cost model. Inappropriate comparisons could be made between entities if it is not understood that different accounting policies have been applied.

16.12 Statement of changes in equity

In addition to having to present a statement of financial position (which is explored in depth within Chapter 4), a statement of profit or loss and other comprehensive income (explained in this chapter), a statement of cash flows (which is explored in depth in Chapter 19), and supporting notes to the financial statements, an

entity is also required to produce a statement of changes in equity. In this chapter we have already made a number of references to the statement of changes in equity. As we have also 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. The two main sources of change in owners’ equity, and therefore in net assets (assets minus liabilities), are:

∙ transactions with owners in their capacity as owners ∙ the income and expenses of an organisation.

In relation to what is to be presented in the statement of changes in equity, paragraph 106 of AASB 101 requires: An entity shall present a statement of changes in equity as required by paragraph 10. 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 interests;

(b) for each component of equity, the effects of retrospective application or retrospective restatement recognised in accordance with AASB 108; and

(c) [deleted] (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. (AASB 101)

In relation to dividends, paragraph 107 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. (AASB 101)

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 16.7, a statement of changes in equity reconciles

LO 16.12

dee67382_ch16_641-686.indd 673 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 673

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 non-controlling 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.

Exhibit 16.7 Statement of changes in equity

XYZ LTD Statement of changes in equity for the year ended 31 December 2023

Share capital ($000)

Retained earnings

($000)

Translation of foreign

operations ($000)

Financial assets at fair value

through OCI

($000)

Cash flow

hedges ($000)

Revaluation surplus ($000)

Total ($000)

Non- controlling

interest ($000)

Total equity ($000)

Balance at 1 January 2022 600 000 118 100 (4 000) 1 600 2 000 – 717 700 29 800 747 500

Changes in accounting policy             –         400          –          –          –          –        400       100        500

Restated balance 600 000 118 500 (4 000) 1 600 2 000 – 718 100 29 900 748 000

Changes in equity for 2022

Dividends – (10 000) – – – – (10 000) – (10 000)

Total comprehensive Income for the year             –    53 200 6 400  16 000 (2 400) 1 600 74 800 18 700 93 500

Balance at 31 December 2022 600 000 161 700 2 400 17 600 (400) 1 600 782 900 48 600 831 500

Changes in equity for 2023

Issue of share capital 50 000 – – – – – 50 000 – 50 000

Dividends – (15 000) – – – – (15 000) – (15 000)

Total comprehensive income for the year – 96 600 3 200 (14 400) (400) 800 85 800 21 450 107 250

Transfer to retained earnings – 200 – – – (200) – – –

Balance at 31 December 2023 650 000 243 500 5 600    3 200    (800) 2 200 903 700 70 050 973 750

SOURCE: IAS 1, 2014, Guidance on Implementing IAS 1 Presentation of Financial Statements

dee67382_ch16_641-686.indd 674 10/17/19 08:20 PM

674 PART 4: Accounting for liabilities and owners’ equity

16.13 The reporting of alternative (non-complying) measures of ‘profits’

As Chapter 1 explains, within Australia, large proprietary companies and public companies (as well as other forms of ‘disclosing entities’ and some government departments) are required to comply with accounting

standards. This means that the financial statements shall present a measure of profits or losses and other comprehensive income that has been determined by applying accounting standards. As we learned in this chapter, profit (as determined by applying accounting standards) shall include all items of ‘income’ and ‘expense’, unless they are specifically excluded from being included within profit or loss by virtue of a requirement within an accounting standard.

As was also explained in Chapter 1, while organisations are required to measure and report profit or loss in accordance with accounting standards, it has also become quite common to find that many organisations also disclose alternative (additional) measures of profits that are derived in a way that is inconsistent with accounting standards, but which are argued by the managers of the organisation to provide a measure of performance that they believe is more representative of the organisation’s performance. The news media also often refer to these alternative measures of performance. Chapter 1 addresses this in some depth, but as this chapter is about reporting information about profit or loss, it is appropriate to revisit this issue here.

Evidence indicates that, when calculating these alternative measures of profits (and these alternative measures will not be presented within the financial statements themselves but in other commentary provided by managers), the most commonly excluded expenses are depreciation and amortisation, the costs assigned to share-based remuneration provided to managers, research and development costs, major impairments of assets including goodwill, restructuring and redundancy costs, and one-off tax expenses. When referring to these alternative measures of financial performance, organisations often refer to the alternative measure as ‘underlying profit’, ‘underlying earnings’, ‘cash earnings’ or ‘underlying profit after tax’ (CAANZ 2016). Research has shown that the majority of firms that report adjusted profit figures calculate an amount higher than the profit or loss for the period that has been calculated by applying accounting standards.

Even though we might think it is inappropriate to provide these alternative measures of profits in the same financial reports in which accounting standards must be followed, it is permitted unless the disclosures are considered to be misleading. If the alternative measures are reported in a way that is misleading, then within Australia, the Australian Securities and Investments Commission (ASIC) can take action against the directors of the company.

The motivations for providing these alternative measures of performance might come from a belief that the measures of performance derived by not complying with accounting standards provide a relatively superior indicator of the organisation’s underlying performance, and this measure is more useful to both the managers of the organisation, in terms of effectively managing the organisation, and the readers of the financial reports. Research by Brown and Sivakumar (2003) has indicated that these alternative measures of financial performance can potentially provide more accurate predictions of future earnings for investors. Bradshaw and Sloan (2002) also report evidence that these alternative measures of financial performance can have relevance and value for investors.

An alternative perspective, however, is that such measures of financial performance which do not comply with accounting standards might be reported opportunistically by managers in order to generate a result that managers think will provide some form of benefits to the organisation, or to themselves. The inclusion of this voluntary information also presents an opportunity for managers to exploit the existence of information asymmetry (where managers are privy to information about the organisation that is not available to others) opportunistically, and this is possible because these alternative disclosures are largely unregulated.

The financial performance of an organisation, and whether it has achieved previous forecasts of profitability, has been found to affect the propensity with which managers report these alternative measures of performance.

LO 16.13

WHY DO I NEED TO KNOW ABOUT THE ROLE OF THE STATEMENT OF CHANGES IN EQUITY?

There are four main financial statements, of which the statement of changes in equity is one. It provides a reconciliation of opening and closing equity and shows how and why the components of equity have changed. It also provides information that might not be readily available within other financial statements, such as transactions with owners in their capacity as owners, and adjustments to retained earnings as a result of the correction of prior period errors. Knowing the intended role of the statement of changes in equity, and the information it reports that is not available elsewhere, highlights the useful nature of the statement.

dee67382_ch16_641-686.indd 675 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 675

For example, Entwistle, Feltham and Mbagwu (2004) found that the use of these non-compliant measures of financial performance was less likely if profits determined in accordance with accounting standards were high, or if the reported amounts met analysts’ prior forecasts of profitability. It is generally considered that there are benefits to an organisation if it meets or exceeds analysts’ and managers’ profit targets and forecasts (Isidro & Marques 2013). This finding, that measures of profits which are non-compliant will be used strategically when a firm fails to reach particular profit benchmarks, is also supported within other research (e.g. Lougee & Marquardt 2004).

At this point in time, therefore, there is research and argument to suggest that an organisation might report non- compliant measures because it either believes it better reflects performance, or because managers are behaving opportunistically. Perhaps it might report these figures for both reasons. Indeed, Young (2014) argues that both motivations are likely to coexist in many organisations.

Therefore, the point to be appreciated here is that although organisations are required to comply with accounting standards, it is also becoming common to find that when they discuss their results they might tend to refer to alternative measures of ‘profits’ other than the profits that would be derived from following accounting standards, and which are reported within the financial statements. As a result, when we review financial reports we need to understand whether the financial results that are being emphasised and discussed by the senior management of the organisation are the same as the results that have been reported within their financial statements, and which have been subject to an independent financial audit—or whether the results are based upon non-compliant methods of accounting that have not been subject to an independent audit. If they have been derived from an accounting approach that does not comply with accounting standards, we perhaps need to determine whether we agree with managements’ assertions about the need for an alternative (additional) measure. We also need to consider whether there might be other motivations driving managers to report numbers that deviate from accounting standards. Also, we need to appreciate that the ability to compare the results of different organisations is undermined if organisations use different accounting methods.

WHY DO I NEED TO KNOW THAT PARTICULAR FINANCIAL RESULTS BEING EMPHASISED BY MANAGERS MIGHT NOT HAVE BEEN PREPARED/COMPILED IN ACCORDANCE WITH ACCOUNTING STANDARDS?

As we now know, managers of many organisations calculate alternative measures of financial performance that they then highlight within various media. It is important to know whether these figures have been developed in accordance with generally accepted accounting principles (GAAP), and have been subject to independent review by auditors—or alternatively, whether they are non-compliant measures that have not been audited.

If the reported information has not been prepared in accordance with accounting standards and other GAAP, there is always a chance that these numbers are being reported opportunistically and to generate benefits to the managers. Further, because these numbers are not based on GAAP, it would be unwise to compare these figures with other organisations (the methods used to generate the numbers might not be comparable).

The general principle to be applied is that once it becomes clear that the financial performance numbers being highlighted by managers do not comply with GAAP, then some scepticism is warranted. This is not to say the numbers might be produced in order to mislead readers, but care is necessary before simply relying upon such information.

LO 16.14

16.14 Profit as a guide to an organisation’s success

A central role of financial accounting is to determine the ‘profit or loss’ of an organisation (as well as identifying items 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.

Because profit or loss is a figure focused upon by many stakeholders, and because managers know this, managers often perform ‘earnings management’, which can be defined as action taken wherein accountants adopt particular accounting policies, or make particular accounting-based decisions, primarily to generate desired measures of profits/earnings. Earnings management can also occur when managers decide to undertake, or not undertake, certain transactions primarily because of the way those transactions will influence reported profits. Chapter 3 provides a detailed discussion of earnings management, so we shall not repeat that here.

dee67382_ch16_641-686.indd 676 10/17/19 08:20 PM

676 PART 4: Accounting for liabilities and owners’ equity

We must remember that profit is a measure of financial performance based upon the financial 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 32) are not directly incorporated into the calculation of profit or loss (or total 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, which would ultimately be expected to have negative implications for profits.

Also, newspaper articles about how a particular company’s profits have increased or decreased typically do not mention the accounting policies, estimates or judgements 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 news media articles is any mention typically made of the accounting policies employed by the respective company or of possible changes therein (any changes in accounting policies can lead to changes in accounting profits). As we know, and as we have emphasised in this chapter, 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 news 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, as we have previously stressed, makes it unlikely that different teams of accountants would calculate the same profit or loss for a particular entity for a given period.

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 an example, many casinos throughout the world generate large profits. However, at the same time, the activities of casinos create many adverse social effects for some community members, such as problem gamblers and their families (in recent times The Age newspaper has also been publishing articles that have uncovered the relationship between large Australian casinos and organised crime, associated money laundering and so forth). Again, these negative aspects of their performance are not reflected within their reported profits as the associated ‘costs’ are unrecognised from a financial reporting perspective. So they might be profitable, but are they ‘good’?

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:

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

The definition of expenses relies in turn on a definition of assets. An asset is defined in the Conceptual Framework as ‘a present economic resource controlled by the entity as a result of past events’. Consequently, if an object or resource is not ‘controlled’ (for example, the air or the ocean and waterways), it is excluded from asset recognition.

dee67382_ch16_641-686.indd 677 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 677

Therefore, if financial accounting practices are adopted in accordance with the Conceptual Framework, 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. Applying generally accepted accounting principles (GAAP), 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 within financial accounting and the reported assets/profits of the organisation would not be affected. Applying GAAP, 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. When we commend organisations for high profits we are, perhaps, putting the interests of the investors (the owners) 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 a newspaper article entitled ‘New NAB boss to ramp up cost-cutting’ that appeared in The Age on 20 July 2019 (by Sarah Danckert):

National Australia Bank’s incoming boss Ross McEwan has signaled plans to ramp up a massive transformation program that includes thousands of job cuts, which the troubled bank hopes will return it to success.

As we can see here, the newspaper article equates the slashing of thousands of jobs with ‘cost-cutting’ and ‘success’. Obviously, reducing available jobs would generate social costs—but such costs are ignored by financial accounting. Also, clearly the writer of the newspaper article equates ‘success’ with the level of ‘profitability’. No mention is made in the article of the hardship that could arise as a result of the removal of so many employment opportunities. Unfortunately, such a simplistic perspective is not uncommon.

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 that could be far reaching.

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). It would be available within the online journal subscriptions held by your university’s library.

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,

dee67382_ch16_641-686.indd 678 10/17/19 08:20 PM

678 PART 4: Accounting for liabilities and owners’ equity

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’.

WHY DO I NEED TO KNOW THAT MEASURES SUCH AS ‘PROFIT OR LOSS’ OR ‘TOTAL COMPREHENSIVE INCOME’ DO NOT REPRESENT A HOLISTIC MEASURE OF ORGANISATIONAL PERFORMANCE?

Arguably, it is just as important to understand what ‘profits or losses’ include as it is to understand what they do not include, or take account of. The view of the author of this book is that it is far too simplistic to believe that a ‘profitable company’ is a ‘good company’, or that it is a company that is performing to the benefit of a broad cross-section of stakeholders.

Profits as reported within a financial reporting system simply represent a number that is calculated by applying, with various assumptions, particular rules and principles—and those rules and principles frequently change. Such rules and principles tend to ignore many social and environmental impacts, in large part because of the way in which the elements of financial accounting are defined.

As such, it is important that apart from simply reviewing the financial reports of an organisation, we should also carefully review the social and environmental reports of the organisation (which we address in Chapter 32) before we decide whether or not to support a particular organisation.

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).

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 GAAP, typically ignore many social costs and social benefits attributable to an organisation’s operations.

KEY TERMS

asset 642 expensed 643 expenses 642

gains 642 income 642 revenues 642

true and fair 643

dee67382_ch16_641-686.indd 679 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 679

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What does ‘other comprehensive income’ represent? LO 16.3 Other comprehensive income comprises items of income and expense that are not recognised in profit or loss as required or permitted by Australian Accounting Standards

When accounting standards are developed by the IASB, the IASB occasionally decides that specific income or expenses arising from a change in the value of an asset or liability should be included in ‘other comprehensive income’ rather than in profit or loss. They make such a judgement on the basis of a view that it would result in the measure of profit or loss providing more relevant information, or providing a more faithful representation of the entity’s financial performance for that period. Where an item of income or expense is excluded from profit or loss, the related income or expense shall be included within other comprehensive income.

2. What does ‘total comprehensive income’ represent’, and in which financial statement shall it be presented? LO 16.3 Total comprehensive income represents the sum of ‘profit or loss’ and ‘other comprehensive income’. An entity may present a single statement of profit or loss and other comprehensive income, with ‘profit or loss’ and ‘other comprehensive income’ being presented in two sections.

Alternatively, 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.

Information about total comprehensive income shall also be reported within the statement of changes in equity. The statement of changes in equity shall show how different components of equity have been changed throughout the accounting period by profit or loss, and other comprehensive income.

3. Pursuant to AASB 101, the statement of profit or loss and other comprehensive income can be presented by way of two alternative presentation formats. What are these formats? LO 16.5 The two alternative presentation formats to be used will be based upon either the:

• nature of expenses being incurred, or • function of expenses.

As noted in the answer to Question 2 above, the profit or loss, and other comprehensive income, of an entity can also be presented by way of two financial statements, or one financial statement.

4. What is a ‘reclassification adjustment’ as it relates to profit or loss and other comprehensive income? LO 16.6 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. (AASB 101)

While some accounting standards require certain gains or losses that are initially recognised within other comprehensive income to be reclassified to profit or loss at a subsequent date (a reclassification adjustment), some other accounting standards ban certain gains or losses from being reclassified.

5. If it is discovered that certain expenses that should have been recognised in a previous period were omitted (there was a ‘prior period error’), should the correction of this prior period error be undertaken by adjusting the profit or loss of the current reporting period? LO 16.10 No, AASB 108 specifically prohibits the correction of a prior period error from being included as an adjustment to the profit or loss of the current period. The adjustment would be made to opening retained earnings. It would also not be shown as an adjustment to other comprehensive income. Prior period comparatives would, however, be amended to reflect the prior period error.

6. What is the role of the statement of changes in equity? LO 16.12 The statement of changes in equity provides a reconciliation of opening and closing equity and provides details of the various equity accounts impacted by total comprehensive income. It also provides information about the effects of transactions with owners in their capacity as owners (for example, payments of dividends or further direct investments in shares).

dee67382_ch16_641-686.indd 680 10/17/19 08:20 PM

680 PART 4: Accounting for liabilities and owners’ equity

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Within AASB 101 there is a prohibition on disclosing ‘extraordinary items’. Provide an assessment of the merits of this prohibition. LO 16.7 ••

2. Provide some examples of items that would be adjusted directly against equity, rather than being included as part of profit or loss. LO 16.3, 16.4 ••

3. If an entity were to discover that an expense of a prior period was omitted (perhaps as the 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 16.10 •

4. How is ‘profit’ defined for accounting purposes? LO 16.1, 16.2 • 5. 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 16.5 ••

6. What items must be recorded on the face of the statement of changes in equity? LO 16.12 • 7. When reviewing the financial statements and supporting notes of a reporting entity, is it possible to find out about all

of 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 16.7, 16.9, 16.14 •••

8. 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 16.4, 16.5, 16.6, 16.7, 16.9 •••

9. 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 16.5, 16.12 ••

10. 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 16.10, 16.11 ••

11. 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 16.5, 16.12 ••

12. 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 16.8, 16.11 ••

13. 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, 16.3 ••

14. On 30 June 2023, 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.

dee67382_ch16_641-686.indd 681 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 681

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 16.8 •• 15. On 30 June 2022, 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 2023, the fair value of the corporate bonds had increased to $14.00. At 30 June 2024 the fair value of the corporate bonds had decreased to $13.00. All of the corporate bonds were sold on 30 June 2024. At 30 June 2022, 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 2024 in which the reclassification adjustment for financial assets measured at fair value through other comprehensive income is detailed. LO 16.5, 16.6, 16.12 •••

16. On 30 June 2023, 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 $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 16.8 •• 17. The following two unrelated scenarios apply to Rabbit Ltd, whose financial year ends on 30 June 2023.

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 16.8, 16.10, 16.11 ••

CHALLENGING QUESTIONS

18. Do you consider financial reporting practices used by private-sector, profit-seeking entities to be applicable to government departments? Explain your answer. LO 16.1, 16.2, 16.14

19. 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 16.10

20. Do you agree with the view that a company which reports substantial profits within its statement of profit or loss and other comprehensive income is a ‘good company’? Clearly explain your answer. LO 16.14

21. Even though reporting entities are required to comply with accounting standards, are they also allowed to highlight and discuss other measures of ‘profits’ that are prepared in a way that is not in accordance with accounting standards? Why would they do this? LO 16.13

22. 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 publicly. Qantas is claiming

dee67382_ch16_641-686.indd 682 10/17/19 08:20 PM

682 PART 4: Accounting for liabilities and owners’ equity

damages from Rolls-Royce for problems associated with the airline’s A380 fleet due to engine failures. Rolls- Royce 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 the 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, 16.2, 16.3

23. On 30 June 2023, 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 2019 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 16.8

24. Noosa Ltd manufactures quality surf clothing. In the 2023 financial year, it reports a profit before tax of $500 000 and an income tax expense of $190 000.

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 2022, the tax rate increases, resulting in an additional expense to Noosa Ltd of $5000. (b) During recent years, Noosa Ltd has been developing a long-life wet-suit. The project has been in development

for the past five years, with total related expenditure of $400 000 being capitalised as at 30 June 2023. In June 2023 the wet-suits are finally tested. The results are not favourable. The wet-suits 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 wet-suits.

(c) On 1 July 2023 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 2023 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 2023. This has caused wages to increase from $80 000 in 2022 to $170 000 in 2023.

(e) In 2023 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 16.2, 16.3, 16.4, 16.8

25. 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 2023

2023 ($)

2022 ($)

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

dee67382_ch16_641-686.indd 683 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 683

Wedding Cake Island Ltd Statement of changes in equity for the year ended 30 June 2023

Share capital

($)

Retained earnings

($) Total

($)

Balance at 30 June 2021 3 000 3 040 6 040

Profit for the year ending 30 June 2022 – 16 520 16 520

Distributions         – (4 000) (4 000)

Balance at 30 June 2022 3 000 15 560 18 560

Profit for the year ending 30 June 2023 – 13 300 13 300

Dividends        – (4 000) (4 000)

Balance at 30 June 2023 3 000 24 860 27 860

The following additional information is available: During the preparation of the 2023 financial statements, it became apparent that electricity expenses of $3000 had been omitted when the 2022 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, 16.10

26. Fergie Ltd records the following expenses and income for the year ended 30 June 2023.

$000

Income

Interest revenue 200

Sales revenue 1 600

Expenses

Cost of goods sold 550

Administration salaries 170

Depreciation of office equipment 70

Major loss owing to insolvency of customer 110

Damage caused by ‘space junk’ re-entering atmosphere 65

Interest expense 25

Income tax expense 150

Opening equity 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 2022 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 2022 and 30 June 2023 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 16.3, 16.4, 16.5, 16.6, 16.7, 16.9, 16.11

dee67382_ch16_641-686.indd 684 10/17/19 08:20 PM

684 PART 4: Accounting for liabilities and owners’ equity

27. During 2020, Point Addis Ltd commenced the construction of a windfarm for its own use. During the reporting period ending 30 June 2023, 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. The unadjusted statement of profit or loss and other comprehensive income and statement of changes in equity for the reporting period ended 30 June 2023 are detailed below.

Point Addis Ltd Abridged statement of profit or loss and other comprehensive income for the year ended 30 June 2023

2023 ($)

2022 ($)

Profit before tax 14 600 14 200

Income tax expense (4 380) (4 260)

Profit for the year 10 220 9 940

Other comprehensive income         –     –

Total comprehensive income 10 220 9 940

Point Addis Ltd Abridged statement of changes in equity for the year ended 30 June 2023

Share capital

($)

Retained earnings

($) Total

($)

Balance at 1 July 2021 12 500 8 050 20 550

Profit for the year ended 30 June 2022 9 940 9 940

Distributions to shareholders – (2 700) (2 700)

Balance at 30 June 2022 12 500 15 290 27 790

Profit for the year ended 30 June 2023 – 10 220 10 220

Distributions to shareholders – (3 700) (3 700)

Balance at 30 June 2023 12 500 21 810 34 310

Point Addis Ltd Statement of financial position (extract) at 30 June 2023

2023 ($)

2022 ($)

2021 ($)

Qualifying asset under construction 10 700 6 650 4 400

Other assets 23 610 21 140 16 150

34 310 27 790 20 550

Share capital 12 500 12 500 12 500

Retained earnings 21 810 15 290 8 050

34 310 27 790 20 550

ADDITIONAL INFORMATION 1. In 2023, interest of $4000 relating to the construction of the windfarm was expensed. Interest costs of $3000 were

expensed in 2022, $3900 was expensed in 2021 and $2200 was expensed in reporting periods prior to 2021. 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, 16.5, 16.11

28. 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.

dee67382_ch16_641-686.indd 685 10/17/19 08:20 PM

CHAPTER 16: The statement of profit/loss, other comprehensive income, and changes in equity 685

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 16.14

29. 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 non-Australian 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 $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’.

Since 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 16.7

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. Bierman, H. & Davidson, S., 1969, ‘The Income Concept-Value

Increment of Earnings Predictor’, The Accounting Review, April.

Bradshaw, M.T. & Sloan, R.G., 2002, ‘GAAP Versus the Street: An Empirical Assessment of Two Alternative Definitions of Earnings’, Journal of Accounting Research, vol. 40, no. 1, pp. 41–66.

Brown, L.D. & Sivakumar, K., 2003, ‘Comparing the Value Relevance of Two Operating Income Measures’, Review of Accounting Studies, vol. 8, no. 4, pp. 561–72.

Chartered Accountants Australia and New Zealand, 2016, ‘The Rise and Rise of Non-GAAP Disclosure’, CAANZ, Sydney.

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, pp. 448–58.

Entwistle, G.M., Feltham, G.D. & Mbagwu, C., 2004, ‘Voluntary Disclosure Practices: The Use of Pro Forma Reporting’, Journal of Applied Corporate Finance, vol. 16, nos 2–3, pp. 73–80.

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.

Isidro, H. & Marques, A., 2013, ‘The Effects of Compensation and Board Quality on Non-GAAP Disclosures in Europe’, The International Journal of Accounting, vol. 48, no. 3, pp. 289–317.

dee67382_ch16_641-686.indd 686 10/17/19 08:20 PM

686 PART 4: Accounting for liabilities and owners’ equity

Khan, S., Bradbury, M. & Courtenay, S., 2018, ‘Value Relevance of Comprehensive Income’, Australian Accounting Review, vol. 28, no. 2, pp. 279–87.

Lougee, B.A. & Marquardt, C.A., 2004, ‘Earnings Informativeness and Strategic Disclosure: An Empirical Examination of “Pro Forma” Earnings’, The Accounting Review, vol. 79, no. 3, pp. 769–95.

Parker, C. & Porter, B., 2000, ‘Seeing the Big Picture’, Australian CPA, December, pp. 67–8.

Young, S., 2014, ‘The Drivers, Consequences and Policy Implications of Non-GAAP Earnings Reporting’, Accounting and Business Research, vol. 44, no. 4, pp. 444–65.

dee67382_ch17_687-722.indd 687 10/24/19 03:38 PM

687

LEARNING OBJECTIVES (LO) 17.1 Understand what a share-based payment represents, and know which share-based payments

are covered by AASB 2 Share-based Payment. 17.2 Understand the reasons that led to the development of AASB 2, understand that executive remuneration

can be comprised of various components some of which will be share-based payment transactions, and be able to explain the general recognition and measurement principles for share-based payment transactions.

17.3 Understand what is meant by an ‘equity-settled share-based payment transaction’, and know the main issues to consider when accounting for such a transaction.

17.4 Understand what is meant by a ‘cash-settled share-based payment transaction’, and know the main issues to consider when accounting for such a transaction.

17.5 Understand how to account for a ‘share-based payment transaction with cash alternatives’. 17.6 Explain some of the possible economic implications of AASB 2. 17.7 Describe the disclosure requirements of AASB 2.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important for your studies.

C H A P T E R 17 Accounting for share-based payments

dee67382_ch17_687-722.indd 688 10/24/19 03:38 PM

688 PART 4: Accounting for liabilities and owners’ equity

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

2 Share-based Payment IFRS 2

13 Fair Value Measurement IFRS 13

17.1 Introduction to accounting for share-based payments

In this chapter we discuss how to account for share-based payment transactions. AASB 2 Share-based Payment 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, for example, share options to their employees as part of their remuneration package (and this would be an example of a share-based payment transaction), yet not record any accompanying expense. Indeed, shareholders were often unaware of the issuance of various equity instruments and the potential dilutive effect such equity issues would have on their own shareholding. Pursuant to AASB 2, there is now 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 whether or not the transaction is ultimately settled with equity instruments or in cash.

A share-based payment transaction is defined in the Appendix to AASB 2 as an agreement between the entity and another party (including an employee) that entitles the other party to receive:

(a) cash or other assets of the entity 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, or

(b) equity instruments (including shares or share options) of the entity or another group entity . . . (AASB 2)

that is, provided the specified vesting conditions, if any, are met. 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 payment 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 by which the entity’s shares increase beyond $5.00 (this might be referred to as a ‘share 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’).

As paragraph 2 (the ‘Scope’ section of the standard) of AASB 2 states, the accounting standard details the 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);

LO 17.1

equity instrument Financial instrument that provides the holder with a residual interest in an entity after deduction of its liabilities.

share option Entitlement that gives the holder the right to buy shares at or before a future date at a specified price.

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is a ‘share-based payment transaction’? LO 17.1 2. What is an ‘equity-settled share-based payment transaction’? LO 17.3 3. For an equity-settled share-based payment transaction that involves the purchase of inventory, how should

the cost of the inventory be determined? LO 17.3 4. For an equity-settled share-based payment transaction with employees, how should the cost of the associated

employment benefits be determined? LO 17.3 5. What is a ‘cash-settled share-based payment transaction’? LO 17.4 6. Will a liability be recognised in relation to a cash-settled share-based payment transaction and, if so, does the

liability need to be remeasured at the end of each reporting period? LO 17.4

dee67382_ch17_687-722.indd 689 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 689

(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)

AASB 2 does not apply to a number of other share-based transactions that might also arise from time to time. For example, it does not apply when a share-based transaction is used to acquire goods as part of the net assets acquired in a ‘business combination’ to which AASB 3 Business Combinations applies.

17.2 Background to the release of AASB 2

Prior to the release of AASB 2 there was much debate about how some equity-based instruments were to be measured—in particular, share options provided to managers as part of their salary packages. A share option is defined in Appendix A of AASB 2 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. (AASB 2)

Senior managers or executives are often provided with options to buy shares in the organisation 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 service period. Options are often referred to as ‘golden hand-cuffs’ 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 be motivated to take action to increase the value of the entity’s shares, their own interests would be aligned with the owners’ interests. Chapter 3 provides some discussion of the role of equity instruments in motivating managers to maximise the value of an organisation.

An accounting issue that arises here is how to identify the expenses associated with providing managers or executives with options. The use of options is not limited to management of the entity. Some entities also issue 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 share 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 which he or she works for an exercise price of $1.20 per share, when the shares are actually trading on that date (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’. The ‘vesting period’ is defined in Appendix A of AASB 2 as:

the period during which all the specified vesting conditions of a share-based payment arrangement are to be satisfied. (AASB 2)

A vesting condition is defined in Appendix A of 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. (AASB 2)

LO 17.2

dee67382_ch17_687-722.indd 690 10/24/19 03:38 PM

690 PART 4: Accounting for liabilities and owners’ equity

As an example, a senior manager might be provided with 2 million share options in the company. The vesting condition might be that the manager must stay working for the organisation for three years. The exercise price of the options is $5.00 and the options are issued when the share price is $4.50 (so they are initially ‘out of the money’). Three years later the share price is $6.20. Effectively, the manager could then acquire the shares at $5.00, sell them for $6.20, and make a total gain of $2.4 million.

Determining the expense associated with the option 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. The standard 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. (AASB 2)

If the exercise price was greater than the fair value of the shares, then the options to buy shares 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, which ignored the time value associated with the option, 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 now 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. In general, companies are not permitted to provide employees with share options without recognising a corresponding cost.

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. There are many reported instances of senior executives earning many millions of dollars as a result of being granted shares and share options as part of their negotiated remuneration plan. Indeed, because of this practice, one Australian organisation known as the Macquarie Group has become known for several years as the ‘millionaires’ factory’. In a newspaper article of 3 May 2019 entitled ‘“Millionaires’ factory” chief’s pay packet leaves big four rivals in the shade’ (by Clancy Yeates, Sydney Morning Herald), it was reported that the Macquarie Group paid $17 million to its new Chief Executive Officer (CEO) in 2018, much of which was in the form of share-based payment transactions. The company’s former CEO was also reported to be eligible to receive $81.5 million over the next two years—mainly in deferred share-based rewards—awarded to him while CEO of Macquarie Group during the previous 10 years.

Despite the arguably excessive nature of some of these benefits being paid (see above), many people nevertheless 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.

Components of an executive’s total remuneration 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

dee67382_ch17_687-722.indd 691 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 691

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.

WHY DO I NEED TO KNOW ABOUT THE COMPONENTS OF REMUNERATION OFFERED TO SENIOR MANAGEMENT?

It is generally accepted that remuneration plans should be devised in a way that motivates managers to achieve particular outcomes, such as increasing the value of an organisation and/or achieving particular social and environmental outcomes. Therefore, in understanding what aspects of performance an organisation appears to be prioritising, it is useful to review how senior managers are being paid, and on what basis any bonuses will be paid.

As accountants, we need to know whether managers have been offered equity-settled or cash-settled share-based payment transactions, as different accounting treatments are required for each type of transaction.

To understand some of the likely future cash flows, we need to know about the existence of ‘cash-settled share-based payment transactions’. Also, to understand how the share ownership of existing shareholders might be diluted in terms of their proportional ownership of an organisation, we need to know about such things as share options that have been provided to managers and which might be exercised at a future date.

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 share-based 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. (AASB 2)

As already briefly indicated, the above objective represents a significant change from the 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).

AASB 2 requires different treatments depending upon whether share-based transactions are ultimately settled by the issue of shares (equity-settled share-based payment transactions) or the payment of cash (cash-settled share- based payment transactions). Equity-settled share-based payment transactions lead to the recognition of equity whereas cash-settled share-based payment transactions lead to the initial 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 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 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. (AASB 2)

Type of share-based payment transaction: Debit to: Credit to:

Equity-settled share-based payment transaction Asset or expense Equity

Cash-settled share-based payment transaction Asset or expense Liability

Table 17.1 Debt or equity?

dee67382_ch17_687-722.indd 692 10/24/19 03:38 PM

692 PART 4: Accounting for liabilities and owners’ equity

Recognition criteria AASB 2 separately considers recognition and measurement issues. In relation to when a share-based transaction is to be recognised, paragraph 7 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. (AASB 2)

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.

This 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 (to record a share-based transaction where the obligation will be settled by transferring equity in the reporting entity)

X

Dr Asset or expense X

Cr Liability (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 payment transaction)

X

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.

We will consider each of these types of share-based transactions in turn in what follows.

17.3 Equity-settled share-based payment transactions

As we now know, there are three broad categories of share-based payment transactions, of which equity-settled share-based payment transactions are one. 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 17.3

equity-settled share- based 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.

∙ 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 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.

dee67382_ch17_687-722.indd 693 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 693

In terms of how fair value is defined, paragraph 6A 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. (AASB 2)

As we might know from previous chapters, in AASB 13 Fair Value Measurement the definition of fair value (paragraph 9) is:

the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. (AASB 13)

For the purposes of AASB 2, however, ‘fair value’ is defined in Appendix A 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. (AASB 2)

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 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. (AASB 2)

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. (AASB 2)

The requirements of paragraphs 10 and 11 are summarised in Table 17.2.

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 could be exchanged between knowledgeable, willing parties in an arm’s length transaction’.

Nature of the transaction Amount at which the expense (or asset) and equity account are recognised

Transactions, other than with employees, 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

Table 17.2 Which fair values do we use?

dee67382_ch17_687-722.indd 694 10/24/19 03:38 PM

694 PART 4: Accounting for liabilities and owners’ equity

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 2022, Supplier X provides Margaret River Ltd with some inventory, which has a fair value of $140 000. In exchange for the inventory, Margaret River Ltd provides Supplier X with 10 000 shares in Margaret River 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 140 000

Cr Share capital (to recognise the acquisition of inventory and the issue of shares at the fair value of the inventory)

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 Margaret River 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 at the time the service is provided.

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—consistent with the requirements of paragraph 11 of AASB 2—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 15 000

Cr Employee share options (equity) (to recognise employee benefits expense at the fair value of issued options)

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 share-based 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, the standard defines ‘vest’ in Appendix A 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. (AASB 2)

dee67382_ch17_687-722.indd 695 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 695

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 defined in Appendix A 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. (AASB 2)

The above definition of a ‘vesting condition’ refers to ‘service conditions’ and ‘performance conditions’. 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 and 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 (a service condition) and to satisfy specified performance target(s) (for example, a specified increase in the entity’s profit over a specified period of time) while the counterparty is rendering the service. Some share-based payment transactions include both a service condition and a performance condition.

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 throughout the vesting period, thereby requiring the related expense to be recognised across a number of accounting periods. As paragraph 15 states:

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 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. (AASB 2)

The requirements just set out refer to ‘grant date’. A ‘grant date’ is defined in Appendix A of AASB 2 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 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. (AASB 2)

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

grant date Date at which the entity and the counterparty agree to a share-based payment arrangement, this being when the parties reach a shared understanding of the terms and conditions of the arrangement.

dee67382_ch17_687-722.indd 696 10/24/19 03:38 PM

696 PART 4: Accounting for liabilities and owners’ equity

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 each year, and an increase in equity as follows:

Dr Employee benefits expenses 20 000

Cr Employee share options (equity) (recognition of employee expenses based on an allocation of the grant date fair value of awarded options. This entry would be repeated for the following four years)

20 000

When the options are ultimately exercised, the balance in ‘Employee share options’ would be transferred to the ‘Share capital’ account.

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 at grant date (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

Remuneration expense

for period

Cumulative remuneration

expense

1 100 × 500 × 80% × $15 × 1 year/3 years $200 000 $200 000

2 100 × 500 × 80% × $15 × 2 years/3 years − $200 000 $200 000 $400 000

3 100 × 500 × 80% × $15 − $400 000 $200 000 $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 Employee benefits expense 200 000

Cr Employee share options (equity) (employee expense based on an allocation of the fair value of options provided to the employee)

200 000

It should be noted that pursuant to AASB 2, for equity-settled share-based payment transactions, the fair value of the equity instruments is based upon the fair value at grant date and not subsequently adjusted for any subsequent movements in fair value.

SCENARIO 2 In this alternative 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).

dee67382_ch17_687-722.indd 697 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 697

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,

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) 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.

Year 1 Year 2 Year 3

Number of employees at grant date 500 500 500

Actual resignations

Year 1 −20 −20 −20

Year 2 −22 −22

Year 3 −15

Expected resignations −55 −18 −

Total expected number of employees to vest 425 440 443

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

1 425 100 $15.00 1/3 $212 500 $212 500

2 440 100 $15.00 2/3 $227 500 $440 000

3 443 100 $15.00 3/3 $224 500 $664 500

The accounting entries would be:

End of year 1

Dr Employee benefits expense 212 500

Cr Employee share options (equity) (to recognise employee expense relating to equity-settled share-based payment transaction)

212 500

End of year 2

Dr Employee benefits expense 227 500

Cr Employee share options (equity) (to recognise employee expense relating to equity-settled share-based payment transaction)

227 500

End of year 3

Dr Employee benefits expense 224 500

Cr Employee share options (equity) (to recognise employee expense relating to equity-settled share-based payment transaction)

224 500

dee67382_ch17_687-722.indd 698 10/24/19 03:38 PM

698 PART 4: Accounting for liabilities and owners’ equity

with the award vesting immediately the target is reached. In such cases, the reporting entity is required at grant date to estimate the length of the vesting period. This is explained more fully in paragraph 15(b), which 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 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. (AASB 2)

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 2023, 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 2024 Point Ltd’s earnings have increased by more than 12 per cent • at 30 June 2025 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 2026 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 2023, 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 2024, 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 2024 earnings have increased by 11 per cent. It is expected that earnings will continue at a similar rate of increase for 2025. Point Ltd therefore expects the shares to vest on 30 June 2025.

By 30 June 2025, 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 2025 earnings increase by 7 per cent. Point Ltd expects that during the year ending 30 June 2026 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, thereby meaning that the employees will ultimately be awarded the shares.

At 30 June 2026, 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 2024, 2025 and 2026.

SOLUTION Employee turnover during the vesting period is calculated as follows:

30 June 2024 30 June 2025 30 June 2026

Number of employees at grant date 300 300 300

Actual resignations

Year to 30 June 2024 −20 −20 −20

Year to 30 June 2025 −25 −25

Year to 30 June 2026 −32

Expected future resignations −30 −25     −

250 230 223

dee67382_ch17_687-722.indd 699 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 699

Actual increase in earnings 11.0% 7.0% 9.0%

Average increase in earnings 11.0% 9.0% 9.0%

Expected average increase over vesting period 11.0% 8.0%

Year end

Expected number of

employees to vest

Shares per

employee

Fair value of equity

instruments

Expected portion of

vesting period

Cumulative remuneration

expense up to previous period

Cumulative remuneration

expense

Remuneration expense for

period

30 June 2024 250 200 $12.00 1/2 $300 000 $300 000

30 June 2025 230 200 $12.00 2/3 $300 000 $368 000 $68 000*

30 June 2026 223 200 $12.00 3/3 $368 000 $535 200 $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 2024 it was anticipated that the share entitlement would vest at the end of 2025.

The accounting journal entries for the years ending 30 June 2024, 2025 and 2026:

30 June 2024

Dr Employee benefits expense 300 000

Cr Employee share rights (equity) (to recognise employee expense relating to equity-settled share-based payment transaction)

300 000

30 June 2025

Dr Employee benefits expense 68 000

Cr Employee share rights (equity) (to recognise employee expense relating to equity-settled share-based payment transaction)

68 000

30 June 2026

Dr Employee benefits expense 167 200

Cr Employee share rights (equity) (to recognise employee expense relating to equity-settled share-based payment transaction)

167 200

Dr Employee share rights (equity) 535 200

Cr Share capital (equity) (to transfer the balance in the ‘Employee share rights’ account to ‘Share capital’ as the shares are allotted to the employees)

535 200

If, by contrast, the required performance conditions had not been satisfied, an adjusting journal entry would have been made to move the balance in the ‘Employee share rights’ account to another equity account—a reserve—other than ‘Share capital’.

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 shall simply be made to the quoted market

dee67382_ch17_687-722.indd 700 10/24/19 03:38 PM

700 PART 4: Accounting for liabilities and owners’ equity

price of the securities. If market prices are not available, estimates of fair value must be made. According to paragraph 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. (AASB 2)

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 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. (AASB 2)

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 (which is the principle we adopted in Worked Examples 17.3 and 17.4). 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.

dee67382_ch17_687-722.indd 701 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 701

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. (AASB 2)

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.

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.

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

Table 17.3 Market and other than market conditions

WORKED EXAMPLE 17.5: Options issued with market conditions

On 1 July 2022, Cactus Ltd grants each of its nine directors 50 000 share options conditional upon them completing their initial three-year contract (this is a ‘service condition’) under the terms that follow.

The share options cannot be exercised unless the share price increases from $5.50 at 1 July 2022 to more than $12.00 by 30 June 2025 (this is a ‘performance condition’). Should the share price be higher than $12.00 at 30 June 2025, the share options may be exercised at any time during the next three years; that is, by the end of 2028.

Cactus Ltd applies an option pricing model, which takes into account the possibility that:

• the share price will exceed $12.00 at 30 June 2025 (meaning the share options will become exercisable); and • the share price will not exceed $12.00 at 30 June 2025 (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. The fair value at grant date is the fair value used for the calculations of the related expenses (as required by AASB 2).

During the reporting period ending 30 June 2023, the share price increased to $8.00. At 30 June 2023, Cactus Ltd estimates the fair value of the share options with the market conditions to be $2.50 each. Applying an option pricing model, this fair value takes into account whether the market conditions will be satisfied by 30 June 2025.

During the reporting period ending 30 June 2024, the share price decreased to $7.20, but Cactus Ltd is still optimistic about meeting the share price target of $12.00. The fair value of the share options is estimated now to be $2.10, taking into account whether or not the share price will reach the targeted $12.00 per share.

continued

In Worked Example 17.5, the accounting treatment of an equity-settled share-based payment transaction with market conditions is described.

dee67382_ch17_687-722.indd 702 10/24/19 03:38 PM

702 PART 4: Accounting for liabilities and owners’ equity

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.

At 30 June 2025, 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 Cactus Ltd for the reporting periods ending 30 June 2023, 30 June 2024 and 30 June 2025.

SOLUTION

Year end

Expected number of

employees to vest Options per

employee Fair value of option

Portion of vesting period

Remuneration expense for

period

Cumulative remuneration

expense

30 June 2023 9 50 000 $1.00 1/3 $150 000 $150 000

30 June 2024 9 50 000 $1.00 2/3 $150 000 $300 000

30 June 2025 9 50 000 $1.00 3/3 $150 000 $450 000

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. (AASB 2) [emphasis added]

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 150 000

Cr Employee share options (equity) (recognising expense arising from equity-settled share- based payment transaction)

150 000

Had the employee share options ultimately been converted to shares, the carrying amount of the ‘Employee share option’ account would have been transferred to ‘Share capital’. In this case, however, the balance could be transferred to an equity reserve account, perhaps to a ‘general reserve’.

WORKED EXAMPLE 17.6: Award with market conditions and variable vesting period

On 1 July 2022, 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 an 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 2027.

WORKED EXAMPLE 17.5 continued

dee67382_ch17_687-722.indd 703 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 703

At 30 June 2023, no senior managers had left the company. However, Crash Test Dummy Ltd expects three executives to leave by 30 June 2027. The share price at 30 June 2023 was $6.20.

During the reporting period ending 30 June 2024, one senior manager left and the company expects three executives to leave by 30 June 2027.

During the year ending 30 June 2025, another senior manager had left and an additional three senior managers are expected to leave before 30 June 2027.

During the year ending 30 June 2026, two senior managers had left. By then no more managers are expected to leave before 30 June 2027.

Between 1 July 2023 and 30 June 2026, the share price increased to $10.40. During the reporting period ending 30 June 2027, no senior managers left Crash Test Dummy Ltd.

At 30 June 2027 the share price was $11.20. At 30 June 2028, 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 2027, the expected vesting period is five years. At 30 June 2027, the share price target was not met. However, the shares ultimately vest to the remaining executives in 2028, which is one year later than was initially expected.

Year end

Expected number of

employees to vest

Options per employee

Fair value of option

Portion of vesting period

Remuneration expense for

period

Cumulative remuneration

expense

30 June 2023 12 50 000 $1.00 1/5 $ 120 000 $120 000

30 June 2024 11 50 000 $1.00 2/5 $ 100 000 $220 000

30 June 2025 10 50 000 $1.00 3/5 $ 80 000 $300 000

30 June 2026 11 50 000 $1.00 4/5 $ 140 000 $440 000

30 June 2027 11 50 000 $1.00 5/5 $ 110 000 $550 000

30 June 2028 8 50 000 $1.00 $(150 000) $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 the grant date.

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’. Intrinsic value was defined earlier in this chapter.

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

dee67382_ch17_687-722.indd 704 10/24/19 03:38 PM

704 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 2)

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 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. (AASB 2)

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) 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. (AASB 2)

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 2023, 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 2023 the fair value of the share is deemed to be $8.00 and the fair value of each option is determined as being $6.00.

dee67382_ch17_687-722.indd 705 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 705

During the year ended 30 June 2024, 20 employees resign from the company. Janjuc Ltd estimates that a further 40 employees will leave before the options expire. At 30 June 2024 the company’s share price drops to $6.50 and, as a result, Janjuc decides on 1 July 2024 to reprice its options. The options will retain the same vesting date, this being 30 June 2026.

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 2025 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 2026.

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 2024, 2025 and 2026.

SOLUTION Employee turnover during the vesting period is calculated as follows:

30 June 2024 30 June 2025 30 June 2026

Number of employees at grant date 400 400 400

Actual resignations

30 June 2024 (20) (20) (20)

30 June 2025 (40) (40)

30 June 2026 (32)

Expected further resignations before vesting date  (40)  (25)     − Total expected number of employees at vesting date 340 315 308

Repricing of options

Fair value of share options (the revised fair value immediately prior to repricing) $4.00

Fair value of repriced options $5.50

Incremental fair value granted $1.50

Year ended

Expected number of

employees to vest

Share options

per employee

Fair value of equity

instruments

Expected portion of

vesting period

Cumulative remuneration

expense up to previous period

Cumulative remuneration

expense

Remuneration expense for

period

30 June 2024 340 200 $6.00 1/3 $136 000 $136 000

30 June 2025

Initial issue 315 200 $6.00 2/3 $136 000 $252 000 $116 000

Incremental fair value granted 315 200 $1.50 1/2 $ 47 250 $ 47 250

Total expense for 2025 $163 250*

30 June 2026

Initial issue 308 200 $6.00 3/3 $252 000 $369 600 $117 600

Incremental fair value granted 308 200 $1.50 2/2 $ 47 250 $ 92 400 $ 45 150

Total expense for 2026 $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.

continued

dee67382_ch17_687-722.indd 706 10/24/19 03:38 PM

706 PART 4: Accounting for liabilities and owners’ equity

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.

17.4 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 the fair value of an organisation’s shares. A cash-settled share- based payment transaction is defined in Appendix A of 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. (AASB 2)

With regard to the required accounting treatment (see Worked Example 17.8), paragraph 30 requires the following:

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. (AASB 2) [emphasis added]

WORKED EXAMPLE 17.7 continued

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.

The accounting entries would be:

30 June 2024

Dr Employee benefits expense 136 000

Cr Employee share options (equity) (recognition of employee expenses and the issue of share capital)

136 000

30 June 2025

Dr Employee benefits expense 163 250

Cr Employee share options (equity) (recognition of employee expenses and the issue of share capital)

163 250

30 June 2026

Dr Employee benefits expense 162 750

Cr Employee share options (equity) (recognition of employee expenses and the issue of share capital)

162 750

Dr Employee share options (equity) 462 000

Cr Share capital (equity) (to transfer the balance in the ‘Employee share options’ account to ‘Share capital’ as the shares are allotted to the employees)

462 000

cash-settled share- based 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.

LO 17.4

dee67382_ch17_687-722.indd 707 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 707

WORKED EXAMPLE 17.8: Accounting for share appreciation rights

On 1 July 2023 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 2024 is $3.00. • The share price at 30 June 2025 is $2.90. • The share price at 30 June 2026 is $4.10. • The managing director stays for three years and is paid the bonus on 1 July 2026.

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.

SOLUTION

Year end Calculation

Remuneration expense for

period

Cumulative remuneration

expense

30 June 2024 200 000 × ($3.00 − $2.50) $100 000 $100 000

30 June 2025 200 000 × ($2.90 − $2.50) − $100 000 ($ 20 000) $ 80 000

30 June 2026 200 000 × ($4.10 − $2.50) − $80 000 $240 000 $320 000

The accounting entries would be:

30 June 2024

Dr Employee benefits expense 100 000

Cr Accrued salaries payable (to recognise the employee expense and the associated liability)

100 000

30 June 2025

Dr Accrued salaries payable 20 000

Cr Employee benefits expense recouped (revenue) (to recognise the adjustment to the employee expense and the associated liability)

20 000

30 June 2026

Dr Employee benefits expense 240 000

Cr Accrued salaries payable (to recognise the employee expense and the associated liability)

240 000

1 July 2026

Dr Accrued salaries payable 320 000

Cr Bank (to recognise the ultimate payment of the employee-related liability)

320 000

Therefore, if the measurement of the liability is based upon the share price when the liability is settled, then changes in the share price will correspondingly lead to a change in the liability.

An example of a cash-settled share-based payment transaction is share appreciation rights (SARs). SARs are often 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.

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.

dee67382_ch17_687-722.indd 708 10/24/19 03:38 PM

708 PART 4: Accounting for liabilities and owners’ equity

In relation to cash-settled share-based transactions, paragraphs 31, 32 and 33 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. (AASB 2) [emphasis added]

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 the fair value of the equity instruments is ignored, whereas with cash-settled share-based transactions the related liabilities 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 payment 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 1 July 2022, 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 2025 and 30 June 2027.

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. The intrinsic value represents the amount the employee will receive for the share appreciation right on a particular date. The intrinsic value will be below the fair value, as the fair value also includes a ‘time value’ in addition to the intrinsic value. Because the share appreciation rights have a life that expires on 30 June 2027, there is a time value within the fair values. That is, the fair value of the rights will be above the intrinsic value (other than on the final date of the share appreciation rights when the time value will be zero and the fair value will therefore equal the intrinsic value).

The fair value of the rights at the grant date of 1 July 2022 was $5.40.

Additional information The fair value of the share appreciation rights at the end of each reporting period:

dee67382_ch17_687-722.indd 709 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 709

Year end Fair value

30 June 2023 $5.60

30 June 2024 $6.10

30 June 2025 $6.90

Employee turnover during the vesting period

30 June 2023 30 June 2024 30 June 2025

Number of employees at grant date 300 300 300

Actual resignations

30 June 2023 −18 −18 −18

30 June 2024 −22 −22

30 June 2025 −25

Expected resignations

30 June 2024 −15

30 June 2025 −15 −20 −

Total expected number of employees to vest 252 240 235

REQUIRED

(a) Calculate the liability at 30 June 2023, 30 June 2024 and 30 June 2025. (b) From the information arrived at in (a) above, prepare the journal entries that would appear at the end of

each reporting period assuming that none of the employees had exercised their rights. (c) Assume that on 30 June 2025, 95 employees exercise their rights, another 60 exercise their rights at

30 June 2026, and the remaining employees exercise their rights at 30 June 2027. The fair value and intrinsic value of the shares at the end of each of the reporting period dates are as follows:

Year end Fair value Intrinsic value

30 June 2025 $6.90 $5.90

30 June 2026 $7.50 $7.30

30 June 2027 $9.10 $9.10

Calculate the cash payments that would be made by Tickles at 30 June 2025, 30 June 2026 and 30 June 2027.

(d) From the information arrived at in (a) and (c) above, prepare the journal entries at 30 June 2025, 30 June 2026 and 30 June 2027.

SOLUTION

(a) The liability at the end of each reporting period can be calculated as follows:

Year end 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

30 June 2023 252 1 000 $5.60 1/3 $ 470 400

30 June 2024 240 1 000 $6.10 2/3 $ 976 000

30 June 2025 235 1 000 $6.90 3/3 $1 621 500

continued

dee67382_ch17_687-722.indd 710 10/24/19 03:38 PM

710 PART 4: Accounting for liabilities and owners’ equity

WORKED EXAMPLE 17.9 continued

(b) Journal entries

30 June 2023

Dr Employee benefits expense 470 400

Cr Accrued salaries payable (to recognise expense arising from cash-settled share-based payment transaction [share appreciation rights])

470 400

30 June 2024

Dr Employee benefits expense 505 600

Cr Accrued salaries payable (to recognise expense arising from cash-settled share-based payment transaction [share appreciation rights] where $505 600 = $976 000 − $470 400)

505 600

30 June 2025

Dr Employee benefits expense 645 500

Cr Accrued salaries payable (to recognise expense arising from cash-settled share-based payment transaction [share appreciation rights] where $645 500 = $1 621 500 − $976 000)

645 500

(c) Cash payment at date of exercise

Year end Number of employees exercising their rights

SARs per employee

Intrinsic value of SARs

Cash payment at the end of each reporting period

30 June 2025 95 1 000 $5.90 $560 500

30 June 2026 60 1 000 $7.30 $438 000

30 June 2027 80 1 000 $9.10 $728 000

235

(d) Journal entries

30 June 2025

Dr Employee benefits expense 550 500

Dr Accrued salaries payable 10 000

Cr Cash (to recognise the payment made in respect of some of the share appreciation rights that were exercised)

560 500

At 30 June 2025, 140 (235 − 95) employees still have to exercise their rights. The liability at 30 June 2025 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 2024 was $976 000, it must be adjusted by $10 000. It is assumed that the journal entry for 30 June 2025 in part (b) above has not already been made.

30 June 2026

Dr Accrued salaries payable 366 000

Dr Employee benefits expense 72 000

Cr Cash (to recognise the payment made in respect of some of the share appreciation rights that were exercised)

438 000

dee67382_ch17_687-722.indd 711 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 711

At 30 June 2026, 80 (140 − 60) employees still have to exercise their rights. The liability at 30 June 2026 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 2025 was $966 000 it must be adjusted downwards by $366 000.

30 June 2027

Dr Accrued salaries payable 600 000

Dr Employee benefits expense 128 000

Cr Cash (to recognise the payment made in respect of some of the share appreciation rights that were exercised)

728 000

At 30 June 2027, no employees still have to exercise their rights. The liability at 30 June 2027 based on the fair value of the share appreciation rights at that date would amount to $nil. As the liability at 30 June 2026 was $600 000, it must be reduced to $nil at 30 June 2027. $728 000 = $9.10 × 1000 × 80

WHY DO I NEED TO KNOW THE DIFFERENCE BETWEEN EQUITY-SETTLED SHARE-BASED PAYMENT TRANSACTIONS AND CASH-SETTLED SHARE-BASED PAYMENT TRANSACTIONS?

As accountants, we need to know the difference because the accounting treatment for both differs (as explained within this chapter).

We should also appreciate that cash-settled share-based payment transactions lead to the recognition of liabilities (whereas equity-settled share-based payment transactions do not). The recognition of liabilities creates future cash flow obligations for an organisation, and therefore effectively increases the organisation’s risk.

Also, because the liability associated with cash-settled share-based payment transactions must be adjusted at the end of each period, this tends to create greater volatility in profits relative to equity-settled share-based payment transactions, which do not need to be restated each period when the fair value of the equity instruments change.

17.5 Share-based payment transactions with cash alternatives

This is the third category of share-based transactions covered by AASB 2. According to this standard, 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 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. (AASB 2)

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

share-based payment transaction with cash alternative 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.

LO 17.5

dee67382_ch17_687-722.indd 712 10/24/19 03:38 PM

712 PART 4: Accounting for liabilities and owners’ equity

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.

WORKED EXAMPLE 17.10: Share-based payment transaction with a cash alternative

On 1 July 2023 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 2023 Winki Ltd’s share price was $16.00. The subsequent share prices were as follows:

30 June 2024 $13.00

30 June 2025 $18.00

30 June 2026 $22.00

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.

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 2023 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 2024, 2025 and 2026 to account for the

transaction.

SOLUTION

(a) The transaction is a share-based payment transaction 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 2024, 2025 and 2026

Fair value of debt component

Phantom shares 20 000 Share price at grant date $16.00 Fair value of cash alternative

$320 000

Fair value of compound instrument

Shares 25 000 Grant date fair value of share alternative

$12.00 Fair value of equity alternative $300 000

Fair value of equity component $ 20 000

A cost based on the following amounts is recognised: Equity component of employee benefits expense The equity component of the expense is based upon the fair value of the shares at grant date:

Year end Fair value of equity

components Vesting period

Cumulative expense

Expense for year

30 June 2024 $20 000 1/3 $6 666 $6 666

30 June 2025 $20 000 2/3 $13 333 $6 667

30 June 2026 $20 000 3/3 $20 000 $6 667

dee67382_ch17_687-722.indd 713 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 713

Debt component of employee benefits expense The debt component of the expense is based upon the fair value of the shares at each reporting date and remeasured accordingly:

Year end Phantom

shares Share price at reporting date

Vesting period

Cumulative expense

Expense for year

30 June 2024 20 000 $13.00 1/3 $86 667 $86 667

30 June 2025 20 000 $18.00 2/3 $240 000 $153 333

30 June 2026 20 000 $22.00 3/3 $440 000 $200 000

Journal entries

30 June 2024

Dr Employee benefits expense 93 333

Cr Liability for employee services 86 667

Cr Employee share right (equity)

(the combined expense is calculated by adding the equity component to the liability component represented by the phantom shares)

6 666

30 June 2025

Dr Employee benefits expense 160 000

Cr Liability for employee services 153 333

Cr Employee share right (equity)

(the combined expense is calculated by adding the equity component to the liability component represented by the phantom shares)

6 667

30 June 2026

Dr Employee benefits expense 206 667

Cr Liability for employee services 200 000

Cr Employee share right (equity)

(the combined expense is calculated by adding the equity component to the liability component represented by the phantom shares)

6 667

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 share-based transaction accordingly. Where the entity may choose to settle the share-based payment transaction either in cash or with an equity instrument, paragraph 41 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. (AASB 2)

If the entity has a present obligation to settle in cash, the transaction must be accounted for as a cash-settled share- based 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.

dee67382_ch17_687-722.indd 714 10/24/19 03:38 PM

714 PART 4: Accounting for liabilities and owners’ equity

17.6 Possible economic implications of AASB 2

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 share-

based payment 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 financial position had implications for the propensity of Australian organisations to undertake share-based payment 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 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 Payment 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

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.

Equity-settled share-based payment transaction—debt or equity?

Equity-settled share-based payment transactions are to be measured at fair value as at the grant date and disclosed as equity. The fair value of the equity is not remeasured at the end of the reporting period.

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.

Share-based payment transactions with cash alternatives—debt or equity?

Share-based payment transactions with cash alternatives will be measured at fair value with a debt and an equity component. The debt component will be remeasured at the end of each reporting period while the debt is outstanding.

Table 17.4 Summary of some of the main elements of AASB 2

LO 17.6

dee67382_ch17_687-722.indd 715 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 715

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.

(© Australian Investment Council)

In the periods subsequent to the release of AASB 2, there did appear to be some limited decline in the use of share options. However, in recent times it is clear that they are still being routinely used by large listed companies. When new accounting standards are issued it is common for different stakeholders to express their concerns about how a new accounting standard will create particular dysfunctional economic (and social) impacts.

17.7 Disclosure requirements

For many years, organisations were criticised for failing to be properly accountable for their share-based payment transactions. In part, the disclosure requirements of AASB 2 have reacted to such concerns. The standard 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 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;

LO 17.7

dee67382_ch17_687-722.indd 716 10/24/19 03:38 PM

716 PART 4: Accounting for liabilities and owners’ equity

(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. (AASB 2)

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, was 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 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. (AASB 2)

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 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

(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). (AASB 2)

Before concluding this chapter, it is interesting to look at some actual disclosures made by an organisation in relation to its remuneration policies. Such policies typically include share-based payment transactions, particularly

dee67382_ch17_687-722.indd 717 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 717

when remunerating senior executives. Exhibit 17.1 provides an extract of some of the disclosures that were made in the Remuneration Report of the large Australian retailer Woolworths Ltd, as reported in its 2018 Annual Report. In the Exhibit, reference is made to ‘performance rights’. In the case of Woolworths, each performance right provides a right to one fully paid ordinary share at a future date. The acronym TSR is also in use. This refers to ‘total shareholder returns’.

Exhibit 17.1 Basis of executive remuneration as disclosed in the 2018 Annual Report of Woolworths Ltd

continued

dee67382_ch17_687-722.indd 718 10/24/19 03:38 PM

718 PART 4: Accounting for liabilities and owners’ equity

Exhibit 17.1 continued

dee67382_ch17_687-722.indd 719 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 719

SUMMARY

The chapter considered how to account for share-based payment transactions. The accounting standard applicable to these transactions is AASB 2. 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 are 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 706 compound financial instrument 711 equity instrument 688

equity-settled share-based payment transaction 692 fair value 693 grant date 695 market conditions 701

share appreciation rights (SARs) 707 share-based payment transaction with cash alternative 711 share option 688

SOURCE: Woolworths Ltd Annual Report 2018

dee67382_ch17_687-722.indd 720 10/24/19 03:38 PM

720 PART 4: Accounting for liabilities and owners’ equity

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is a ‘share-based payment transaction’? LO 17.1 A share-based payment transaction is an agreement between the entity and another party (including an employee) that entitles the other party to receive cash or other assets of the entity 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, or equity instruments (including shares or share options) of the entity or another group entity, provided the specified vesting conditions, if any, are met.

2. What is an ‘equity-settled share-based payment transaction’? LO 17.3 An equity-settled share-based payment transaction is a transaction in which the entity receives goods or services as consideration for equity instruments of the entity (including shares or share options).

3. For an equity-settled share-based payment transaction that involves the purchase of inventory, how should the cost of the inventory be determined? LO 17.3 The cost of inventory would be determined as the fair value of the inventory received, unless that fair value cannot be determined (in which case reference would be made to the fair value of the equity instruments granted).

4. For an equity-settled share-based payment transaction with employees, how should the cost of the associated employment benefits be determined? LO 17.3 For transactions with employees providing employment services, the fair value of the services rendered will be determined by reference to the fair value of the equity instruments being granted to them.

5. What is a ‘cash-settled share-based payment transaction’? LO 17.4 A cash-settled share-based payment transaction is a transaction 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.

6. Will a liability be recognised in relation to a cash-settled share-based payment transaction and, if so, does the liability need to be remeasured at the end of each reporting period? LO 17.4 Yes, for a cash-settled share-based payment transaction, a liability will be recognised at the fair value of the liability (which in turn will be based upon the related equity instruments). Until such time that the liability is settled, the organisation shall remeasure the fair value of the liability at the end of each reporting period, with any changes being recognised within the profit or loss of that period.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

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, 17.3, 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, 17.3 • 4. How are share-based transactions to be measured? LO 17.2, 17.3, 17.4 • 5. What are three broad categories of disclosures required by AASB 2? LO 17.7 • 6. 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 17.1, 17.3, 17.4 •• 7. 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 17.2 •• 8. 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 17.3 •

dee67382_ch17_687-722.indd 721 10/24/19 03:38 PM

CHAPTER 17: Accounting for share-based payments 721

9. 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 17.3, 17.4 ••

10. 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 17.3 • 11. 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 17.2, 17.3, 17.4 •• 12. Prior to the release of AASB 2, many reporting entities failed to recognise the share options being provided to senior

executives. Why? LO 17.6 • 13. If an organisation has engaged in some equity-settled share-based payment transactions with senior managers,

and a number of share options are outstanding at the end of the reporting period, then pursuant to AASB 2, what disclosures shall be made in respect of those options? LO 17.7 ••

14. In what circumstances would equity instruments associated with a share-based payment transaction be measured at their intrinsic value? LO 17.2, 17.3, 17.4 •

15. 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 17.3, 17.4 •

16. Why could the release of AASB 2 have had an economic impact on reporting entities? LO 17.6 • 17. 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, 17.2, 17.6 ••

18. On 1 July 2023, 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 17.3 •

CHALLENGING QUESTIONS

19. On 1 July 2023, 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 2024 Rottnest Ltd’s earnings have increased by more than 14 per cent • at 30 June 2025, Rottnest Ltd’s earnings have increased by an average of 12 per cent or more over the two-year

period • at 30 June 2026, 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 2023, 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 2024, 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 2024 earnings have increased by 13 per cent. It is expected that earnings will continue at a similar rate of increase for 2025. Rottnest Ltd therefore expects the shares to vest on 30 June 2025.

By 30 June 2025, 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 2025 earnings increase by 10 per cent. Rottnest Ltd expects that during the year ending 30 June 2026 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.

dee67382_ch17_687-722.indd 722 10/24/19 03:38 PM

722 PART 4: Accounting for liabilities and owners’ equity

At 30 June 2026, 35 employees have left during the year, and Rottnest Ltd’s earnings have increased by 9 per cent during the year.

REQUIRED Prepare the accounting journal entries for the years ending 30 June 2024, 2025 and 2026. LO 17.3

20. On 1 July 2023, 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 2023 the fair value of the share price is expected to be $7.00. At 1 July 2023 the fair value of each option is determined as $5.00.

During the year ended 30 June 2024, 15 employees resign from the company. Coogee Ltd estimates that a further 30 employees will leave before the options expire. At 30 June 2024 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 2026.

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 2025 a further 30 employees had resigned and the company expects a further 20 employees to resign before the option entitlements vest. By 30 June 2026, a further 30 employees have resigned.

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 2024, 2025 and 2026. LO 17.3

21. On 1 July 2023 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 2024 is $4.00. • The share price at 30 June 2025 is $5.50. • The share price at 30 June 2026 is $6.00. • The managing director stays for three years and is paid the bonus on 1 July 2026.

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

22. On 1 July 2023 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 2023 Maroubra Ltd’s share price was $19.00. The subsequent share prices were as follows:

• 30 June 2024 $16.00

• 30 June 2025 $21.00

• 30 June 2026 $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 2023 was $15.00 per share.

REQUIRED Prepare the journal entries for the years ending 30 June 2024, 2025 and 2026 to account for the share-based transaction. LO 17.5

REFERENCE Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

dee67382_ch18_723-768.indd 723 10/24/19 03:40 PM

723

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 as calculated for taxation purposes. 18.2 Understand the ‘balance sheet approach’ to accounting for taxation that is to be applied for financial

reporting purposes, and understand that a difference between the carrying amount of an asset or a liability and its ‘tax base’ will lead to what is known as a ‘temporary difference’.

18.3 Understand the relationship between temporary differences and deferred tax assets and deferred tax liabilities, how and when ‘deferred tax assets’ and ‘deferred tax liabilities’ arise, how they are to be calculated, and how they impact ‘income tax expense’.

18.4 Know how to calculate the ‘tax base’ of assets and liabilities. 18.5 Understand how to account for taxation losses incurred by reporting entities and understand how, in

certain circumstances, taxation losses can lead to the recognition of assets in the form of deferred tax assets.

18.6 Be able to describe how, and explain why, the revaluation of non-current assets will lead to a deferred tax liability.

18.7 Understand the rules relating to offsetting deferred tax assets against deferred tax liabilities for the purpose of presentation in the statement of financial position.

18.8 Understand how changes in tax rates will impact existing deferred tax balances. 18.9 Be aware of the disclosures to be made in relation to accounting for taxation.

18.10 Be able to critically evaluate the balance sheet approach to accounting for taxation and the associated assets (deferred tax assets) and liabilities (deferred tax liabilities).

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important for your studies.

C H A P T E R 18 Accounting for income taxes

dee67382_ch18_723-768.indd 724 10/24/19 03:40 PM

724 PART 4: Accounting for liabilities and owners’ equity

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. On what basis is ‘income tax expense’ as reported in the statement of profit or loss and other comprehensive income determined? LO 18.2, 18.3

2. Will the ‘income tax expense’ for an accounting period be the same as the ‘income tax payable’ at the end of that accounting period? LO 18.1, 18.2, 18.3

3. Why would a profitable company potentially not have any income tax payable to the relevant taxation authority? LO 18.2, 18.3

4. What is a ‘deferred tax asset’, and when would it arise? LO 18.3 5. What is a ‘deferred tax liability’, and when would it arise? LO 18.3 6. Would incurring a loss for tax purposes lead to the recognition of a tax-related asset in the financial statements?

Why? LO 18.5

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

101 Presentation of Financial Statements IAS 1

107 Statement of Cash Flows IAS 7

112 Income Taxes IAS 12

116 Property, Plant and Equipment IAS 16

18.1 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.

Profit for taxation purposes, also known as taxable profit, is, however, determined in accordance with the rules embodied in income tax legislation and not from the application of the rules embodied in accounting standards. In Australia, and elsewhere, there are a number of differences between accounting principles of income and expense recognition and taxation principles of income and expense recognition.

Taxation rules can also show great variation between different countries. Tax rates applied in different countries will also vary. Therefore, although financial reporting requirements are effectively the same within countries applying IFRSs as issued by the IASB, taxation laws will show great variability between countries, meaning that a given set of transactions and events would create very different taxation obligations within reporting entities’ respective countries. Therefore, the point being made here 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 because tax will be payable on the basis of taxable profits, not on the basis of accounting profits. 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 profit 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 governs the accounting treatment of income taxes (its equivalent being IAS 12). AASB 112 applies what is known as ‘the balance sheet method’. It is called this because 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 tax obligations arising from the differences between

LO 18.1

accounting profit A measure of profit derived by applying generally accepted accounting principles and accounting standards.

dee67382_ch18_723-768.indd 725 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 725

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.

Several decades ago, and prior to the release of AASB 112 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 profit (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’—two items that we will discuss in this chapter.

In accounting for income tax, various events impacting on the reporting 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 in the Australian context (and elsewhere) 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 for 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. That is, the amount payable to the ATO is derived from what the ATO said the organisation earned based on the ATO’s rules.

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 and other generally accepted accounting principles and will be based on what the organisation earned from a financial accounting perspective. ‘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.

Therefore, it needs to be understood that 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.

18.2 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.

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’ arises. 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. (AASB 112)

Paragraph 5 of AASB 112 explains that temporary differences may be either:

(a) 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, or

LO 18.2

dee67382_ch18_723-768.indd 726 10/24/19 03:40 PM

726 PART 4: Accounting for liabilities and owners’ equity

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 2023:

Cash sales $100 000

Cost of goods sold $40 000

Amounts received in advance for services to be performed in August 2023 $10 000

Rent expense for year ended 30 June 2023 $10 000

Rent prepaid for two months to 31 August 2023 $1000

Doubtful debts expenses $1000

Amount provided in 2023 for employees’ long-service leave entitlements $6000

Goodwill impairment expense $6000

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 when cash paid

Many prepaid expenses (for example, prepaid rent, prepaid insurance)

Initially an asset—expensed when economic benefits used

Typically a tax deduction when cash paid

Revenue received in advance (for example, rental revenue)

Treated as a liability—recognised as revenue when subsequently earned

Typically taxed when cash received

Entertainment expenses 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 as ‘bad’ 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)

Interest expense Recognised as an expense when incurred (when it becomes payable)

Often not treated as deductible until actually paid

Interest revenue Recognised as income when earned (when it becomes receivable)

Often not treated as taxable until actually received

Table 18.1 Some of the differences between accounting rules and tax rules

(b) 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. (AASB 112)

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’. That is, you have the opportunity to compare what an accountant would say is the profit before tax with what the taxation authority says is the taxable profit.

dee67382_ch18_723-768.indd 727 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 727

REQUIRED Calculate ‘taxable profit’ and ‘accounting profit’ for the year ending 30 June 2023.

SOLUTION

Accounting profit

Taxable profit

Cash sales $100 000 $100 000

Cost of goods sold ($40 000) ($40 000)

Amounts received in advance by Big Kahuna Ltd for services to be performed in August 2023 – $10 000

Rent expense for year ended 30 June 2023 ($10 000) ($10 000)

Rent prepaid for two months to 31 August 2023 ($1 000)

Doubtful debts expense ($1 000) –

Amount provided in 2023 for employees’ long- service leave entitlements ($6 000) –

Goodwill impairment expense ($6 000)             –

$37 000 $59 000

18.3 Temporary differences lead to ‘deferred tax assets’ and/or ‘deferred tax liabilities’ and directly influence ‘income tax expense’

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 taxation purposes (applying the relevant tax legislation). In the sections that follow we will learn how to account for these differences.

Returning to paragraph 5 of AASB 112, 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 2023. 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 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

WHY DO I NEED TO KNOW THAT THERE ARE DIFFERENCES BETWEEN THE RULES USED TO DETERMINE TAXABLE PROFIT AND THE RULES USED TO CALCULATE PROFIT FOR FINANCIAL REPORTING PURPOSES?

Without knowing this, it would be very difficult to understand why income tax expense as presented in the statement of profit or loss and other comprehensive income (which is based upon the application of accounting standards and other generally accepted accounting principles) does not correspond in some way with income tax payable (which is based upon the application of taxation legislation). Income tax expense is typically a very material expense; therefore it seems sensible that we need to know what it represents. Knowing about the differences will also enable us to understand why a profitable company might, in particular accounting periods, have no income tax payable reported within its balance sheet, and pay no tax—meaning no payments for tax would be shown in the statement of cash flows.

LO 18.3

dee67382_ch18_723-768.indd 728 10/24/19 03:40 PM

728 PART 4: Accounting for liabilities and owners’ equity

by applying accounting standards and other generally accepted accounting principles, and which would be reported within the financial statements) and the tax base as follows (the determination of the difference between the tax base of a balance sheet item and its carrying amount is central to the balance sheet approach for accounting for taxes).

  Carrying amount Tax base

Cost $200 000 $200 000

less Accumulated depreciation $   80 000 $100 000

  $120 000 $100 000

In the above situation, what has effectively happened is that the ATO has given the entity a greater deduction relative to the accountant’s judgement about 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 taxation deduction will be given in the fifth year of the asset’s useful life, as the cost of the asset will have been fully claimed with the ATO by the end of year 4. Because no further deduction will be available for taxation purposes in year 5, the entity has effectively deferred the payment of some of the taxes to the fifth year—that is, the entity has a deferred tax liability. A deferred tax liability is defined at paragraph 5 of AASB 112 as:

the income taxes payable in future reporting periods in respect of taxable temporary differences. (AASB 112)

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 profit can be determined as follows:

  2023

($) 2024

($) 2025

($) 2026

($) 2027

($)

Accounting profit 500 000 600 000 650 000 700 000 800 000

add back Accounting depreciation 40 000 40 000 40 000 40 000 40 000

less Tax depreciation (50 000) (50 000) (50 000) (50 000)             –

Taxable profit 490 000 590 000 640 000 690 000 840 000

Tax payable (at 30%) 147 000 177 000 192 000 207 000 252 000

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 and other generally accepted accounting principles). 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 between accounting and taxation 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 shall 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 (which would have been calculated 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 reduces the taxes that have to be paid in those years, 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 therefore has a tax base of zero, so no further depreciation deductions are available), meaning that to determine taxable profit in the fifth year 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

dee67382_ch18_723-768.indd 729 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 729

be payable. As we can see, at the end of five years, the total depreciation for accounting purposes ($200 000) equals 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.

The underlying assumptions we use when accounting for tax as discussed above are:

∙ From the accountant’s perspective, the amount we are calculating for accounting profits is deemed to be the ‘correct amount’, and reflects the actual consumption of economic benefits throughout the accounting period. If additional taxation deductions are available over and above this amount, then managers will accept the higher deduction as it provides the organisation with a means of deferring tax payments until future periods. That is, the tax payment has been deferred to the future period when no further tax deductions are allowable, hence it is a ‘deferred’ tax liability.

∙ There is an underlying assumption that the organisation is a ‘going concern’ and will remain in business, and will pay taxes in future periods. Without such an assumption, the view that deferred tax payments will be paid in the future could not be held. Unless we assume taxable profits will be derived in the future, there would be no present obligation, and therefore no liability.

Worked Example 18.2 is 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 2020. 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 derived uniformly 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 accounting 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 2021 to 2024, and provide the necessary accounting journal entries.

SOLUTION

Year 1 (ending 30 June 2021)

 

Carrying amount

($) Tax base

($)

Temporary difference

($)

Fibreglassing machine: cost 600 000 600 000  

Accumulated depreciation (150 000) (200 000)

  450 000 400 000 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 will have higher tax deductions), but additional tax will need to be paid in year 4 when no deduction for depreciation will be available for taxation purposes. The tax payment is being deferred. The excess of the depreciation allowed for taxation 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 temporary difference of $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.

continued

dee67382_ch18_723-768.indd 730 10/24/19 03:40 PM

730 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 112)

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 remaining recoverable amount. That is, although the organisation expects to derive $450 000 in economic benefits over the remaining three years, for tax purposes the amount of tax deductions still available in relation to the machine is only $400 000. If the asset is sold for its anticipated recoverable amount (and ignoring any possible capitals gains tax concessions), this $50 000 would be assessable and $15 000 would consequently be payable ($50 000 × 30 per cent).

However, accepting that the asset has not been sold, the total tax on the company’s taxable profit would be determined as follows:

Accounting profit before tax $500 000

add back Accounting depreciation $150 000

less Depreciation for taxation purposes ($200 000)

Taxable profit $450 000

Income tax payable at 30 per cent $135 000

We can separately account for the tax expense relating to the deferred tax component (which in this example relates to the depreciation of the machine) and the tax expense to the current component of tax. The current component of tax relates to the amount currently due to the ATO (which is reflected within income tax payable). The journal entries at 30 June 2021 would therefore be:

Dr Income tax expense (deferred) 15 000  

Cr Deferred tax liability (to recognise the tax expense that relates to the temporary difference, which equals $50 000 × 0.30)

15 000

Dr Income tax expense (current) 135 000  

Cr Income tax payable (to recognise the tax expense that relates to the entity’s taxable profit, which equals $450 000 × 0.30)

135 000

While the above journal entries have separated the total tax expense of $150 000 into its current and deferred elements, the total tax expense for the accounting period will be the sum of the current and deferred tax expenses, and this is the amount that will be shown in the statement of profit or loss and other comprehensive income. That is, the income tax expense to be shown in the statement of profit or loss and other comprehensive income at the end of year 1 will be:

Current income tax expense $135 000

Deferred tax expense $ 15 000

Income tax expense $150 000

WORKED EXAMPLE 18.2 continued

dee67382_ch18_723-768.indd 731 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 731

Alternatively, we could have produced one combined journal entry, this being:

Dr Income tax expense 150 000  

Cr Income tax payable 135 000

Cr Deferred tax liability (to recognise income tax expense and related tax liabilities)

  15 000

As we can see, the tax expense above is equal to the accounting profit of $500 000 multiplied by the tax rate of 30 per cent. As can also 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. This is consistent with the definition of ‘tax expense’ provided within AASB 112, which is:

the aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax. (AASB 112)

Income tax payable is the amount that is generally expected to be paid within the next financial period. If the taxes payable method of accounting for tax was adopted, the tax expense in a given year simply equals the taxes that were directly payable as a result of that year’s operations. In this example, the tax expense under the taxes payable method would simply be $135 000. However, while the taxes payable method would be much easier to apply (and probably much easier to understand), it is not permitted in Australia and other countries applying IFRSs.

Year 2 (ending 30 June 2022)

 

Carrying amount

($) Tax base

($)

Temporary difference

($)

Fibreglassing machine: cost 600 000 600 000  

Accumulated depreciation (300 000) (400 000)

  300 000 200 000 100 000

The temporary difference at 30 June 2022 now 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 2021, an increase (or ‘top up’) of $15 000 is required.

The tax on the taxable profit would be determined as follows:

Accounting profit before tax $600 000

add back Accounting depreciation $150 000

less Depreciation for taxation purposes ($200 000)

Taxable profit  $550 000

Income tax payable at 30 per cent  $165 000

The journal entries at 30 June 2022 would be:

Dr Income tax expense (deferred) 15 000  

Cr Deferred tax liability (to recognise the tax expense that relates to the temporary difference)

15 000

Dr Income tax expense (current) 165 000  

Cr Income tax payable (to recognise the tax expense that relates to the entity’s taxable profit)

165 000

taxes payable method A method whereby the amount that is payable to the ATO is also treated as the tax expense of the organisation.

continued

dee67382_ch18_723-768.indd 732 10/24/19 03:40 PM

732 PART 4: Accounting for liabilities and owners’ equity

Year 3 (ending 30 June 2023)

 

Carrying amount

($) Tax base

($)

Temporary difference

($)

Fibreglassing machine: cost 600 000 600 000  

Accumulated depreciation (450 000) (600 000)

  150 000           0 150 000

The temporary difference at 30 June 2023 is now $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 aggregate for 2021 and 2022, an increase of $15 000 is required.

The tax on the taxable profit would be determined as follows:

Accounting profit before tax $700 000

add back Accounting depreciation $150 000

less Depreciation for taxation purposes ($200 000)

Taxable profit  $650 000

Income tax payable at 30 per cent  $195 000

The journal entries at 30 June 2023 would be:

Dr Income tax expense (deferred) 15 000  

Cr Deferred tax liability (to recognise the tax expense that relates to the temporary difference)

15 000

Dr Income tax expense (current) 195 000  

Cr Income tax payable (to recognise the tax expense that relates to the entity’s taxable profit)

195 000

Year 4 (ending 30 June 2024)

 

Carrying amount

($) Tax base

($)

Temporary difference

($)

Fibreglassing machine: cost 600 000 600 000  

Accumulated depreciation (600 000) (600 000)

              0             0     0

The temporary difference at 30 June 2024 would now be $nil, which means that at the end of the fourth and final year of the machine’s useful life 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 2024.

As we can see above, because the full amount of depreciation deductions has been claimed by the end of 2023, no further tax deductions are available in 2024 and thereafter. The tax on the taxable profit would be determined as follows:

Accounting profit before tax $800 000

add back Accounting depreciation $150 000

less Depreciation for taxation purposes 0

Taxable profit $950 000

Income tax payable at 30 per cent $285 000

WORKED EXAMPLE 18.2 continued

dee67382_ch18_723-768.indd 733 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 733

The journal entries at 30 June 2024 would be:

Dr Deferred tax liability 45 000  

Cr Income tax expense (deferred) (we credit tax expense because this $45 000 has already been recognised in previous years)

45 000

Dr Income tax expense (current) 285 000  

Cr Income tax payable (to recognise the tax expense that relates to the entity’s taxable profit)

285 000

A review of Worked Example 18.2 indicates that the balance sheet approach to accounting for income tax effectively ‘smooths’ the tax expenses across the four years, as indicated in Table 18.2.

  Year 1

($) Year 2

($) Year 3

($) Year 4

($) Total

($)

Tax expense based on taxable profit (as it would be calculated if the ‘taxes payable’ method was allowed—which it is not) 135 000 165 000 195 000 285 000 780 000

Adjustment for ‘temporary’ differences 15 000 15 000 15 000 (45 000)         – 

Total taxation expense to be reported in the statement of profit or loss and other comprehensive income (using the balance sheet method as required by AASB 112) 150 000 180 000 210 000 240 000 780 000

Table 18.2 The ‘smoothing effect’ of AASB 112

18.4 Calculating the tax base of assets and liabilities

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 taxation 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. (AASB 112)

In relation to the tax base of an asset, and accepting the above definition, the following formula can be applied: Tax base of an asset:

Carrying amount + Future amount deductible

for tax purposes

− Future taxable 

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:

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

economic benefits

=

Tax base

$450 000

+

$400 000

$450 000

=

$400 000

LO 18.4

dee67382_ch18_723-768.indd 734 10/24/19 03:40 PM

734 PART 4: Accounting for liabilities and owners’ equity

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 in future years).

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 (the asset cost $600 000, and $200 000 has already been claimed in year 1 as a tax deduction, meaning that only $400 000 in deductions remain in respect of this asset). 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 2022.

Machinery Acquired at a cost of $400 000 on 1 July 2020. At acquisition it was expected to have a useful life for accounting purposes of five years, and no expected salvage value. Its carrying amount at 30 June 2022 therefore is $240 000. For tax purposes it can be depreciated at 25 per cent of cost 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 profit.

REQUIRED Determine the respective tax bases of the above items as at 30 June 2022.

SOLUTION

Machinery Given the above details, the tax base of the asset at 30 June 2022 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:

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

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 amount of $240 000—the $240 000 (against which there will be

dee67382_ch18_723-768.indd 735 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 735

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 for financial reporting purposes would be $74 000, with an allowance for doubtful debts of $6000 being recognised.

For taxation purposes, the amount recognised for doubtful debts is not tax-deductible. It is deductible only when the account receivable is actually written off against specific debtors—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 organisation will receive a tax deduction in future periods—that is, a deferred tax asset exists. 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:

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

economic benefits

=

Tax base

$74 000

+

$6000

$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. (AASB 112)

If we also consider future taxable amounts, then:

Tax base of a liability:

Carrying amount − Future amount deductible

for tax purposes

+ Future taxable

economic benefits

= Tax base

deductions available of $200 000) 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:

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

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. Effectively, what is occurring here is that although the accountant believes the organisation has earned around $100 000 and therefore should pay tax of $30 000, the tax payable will be deferred until a future period (a deferred tax liability) in which the related cash is actually received and when the ATO then expects payment.

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:

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

economic benefits

=

Tax base

$80 000

+

$0

$0

=

$80 000

dee67382_ch18_723-768.indd 736 10/24/19 03:40 PM

736 PART 4: Accounting for liabilities and owners’ equity

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. (AASB 112)

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 2022.

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 amount of $40 000. The payment of the loan is not deductible.

REQUIRED Determine the tax base of Scott Dillon Ltd’s liabilities.

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. The revenue received in advance will create a deferred tax asset if it is taxed in the year in which it is received. From the accountant’s perspective, the organisation has not earned the income, yet it is paying the related tax. When it actually earns the income in a subsequent accounting period, no further tax will need to be paid as it has already been paid effectively in advance (thereby creating a deferred tax asset).

Hence the tax base of the interest received in advance is:

Carrying amount

Amount of revenue received in advance that will 

not be subject to tax in future periods

=

Tax base

$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:

Carrying amount

Future amount deductible

for tax purposes

+

Future taxable

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 profit, the tax base will be $40 000.

Carrying amount

Future amount deductible

for tax purposes

+

Future taxable

economic benefits

=

Tax base

$40 000

$0

+

$0

=

$40 000

As we have already stated, deferred tax assets and deferred tax liabilities occur because of temporary differences between the carrying amount of assets and liabilities in the balance sheet and the respective tax bases of the assets and liabilities. Whether a deferred tax asset or a deferred tax liability will arise is summarised in Table 18.3.

dee67382_ch18_723-768.indd 737 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 737

Deferred tax liability arises when: Deferred tax asset arises when:

Assets Carrying amount > tax base Carrying amount < tax base

Liabilities Carrying amount < tax base Carrying amount > tax base

Table 18.3 Overview of when a deferred tax liability or a deferred tax asset will arise

In the previous 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 deferred tax 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).

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

 temporary differences

× Tax rate = Deferred tax liabilities or

 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.

We can use the information in Table 18.3 along with that in the diagram above to generate a further table, which is Table 18.4. Review Table 18.4 to make sure you understand it, and then attempt Worked Example 18.5.

Leads to: Multiply by tax rate to give:

Asset

Carrying amount > tax base Taxable temporary difference Deferred tax liability

Carrying amount < tax base Deductible temporary difference Deferred tax asset

Liability

Carrying amount > tax base Deductible temporary difference Deferred tax asset

Carrying amount < tax base Taxable temporary difference Deferred tax liability

Table 18.4 The calculation of taxable temporary differences

WORKED EXAMPLE 18.5: Determining the deferred tax asset or deferred tax liability

REQUIRED Applying the contents of Table 18.4, determine whether there would be a deferred tax asset or a deferred tax liability, and calculate the balance for the following (the tax rate is 30 per cent):

(a) A depreciable asset with a carrying amount of $100 000 and a tax base of $70 000. (b) A provision for warranty repairs with a carrying amount of $70 000. No warranty expenses have actually

been paid as yet.

continued

dee67382_ch18_723-768.indd 738 10/24/19 03:40 PM

738 PART 4: Accounting for liabilities and owners’ equity

Worked Examples 18.6 and 18.7 further illustrate accounting for temporary differences.

SOLUTION

(a) The carrying amount of $100 000 is greater than the tax base of $70 000. This is considered to create a taxable temporary difference of $30 000. Multiplying this by the tax rate of 30 per cent gives us a deferred tax liability of $9000.

(b) The ATO would not recognise this liability, hence it would have a tax base of zero. As the carrying amount of the liability exceeds the tax base, this creates a deductible temporary difference of $70 000. Multiplying this by the tax rate of 30 per cent gives us a deferred tax asset of $21 000.

WORKED EXAMPLE 18.5 continued

WORKED EXAMPLE 18.6: 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 prior to the receipt of cash). The tax rate is 30 per cent.

REQUIRED Calculate Wingnut Ltd’s deferred tax liability and provide the relevant journal entries.

Carrying amount

($) Tax base

($)

Temporary difference

($)

Machinery cost 150 000 150 000

Accumulated depreciation (40 000) (60 000)

110 000   90 000 20 000

Interest receivable    15 000             0 15 000

35 000

SOLUTION The respective tax bases can also be confirmed as follows:

For machinery

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

economic benefits

=

Tax base

$110 000

+

$90 000

$110 000

=

$90 000

For the interest receivable

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

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 entry would be:

Dr Income tax expense (deferred) 10 500

Cr Deferred tax liability (to recognise a deferred tax liability in relation to temporary differences)

10 500

dee67382_ch18_723-768.indd 739 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 739

WORKED EXAMPLE 18.7: 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 the 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 the ATO will not have recognised the warranty expenses, and associated provision, of Farrelly Ltd, and the tax base is $nil.

 

Carrying amount

($) Tax base

($)

Temporary difference

($)

Accrued warranty expense 100 000 0 100 000

The tax base can be confirmed as follows:

Carrying amount

Future amount deductible

for tax purposes

+

Future taxable

economic benefits

=

Tax base

$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 profit 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 future economic benefit and is a deferred tax asset. The journal entry would be:

Dr Deferred tax asset 30 000

Cr Income tax expense (deferred) (to recognise the deferred tax effect associated with the provision for warranty repairs)

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.

As we have already noted, 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 profit will be derived in future years. The recognition criteria for deferred tax assets rely on the ‘probable’ test. That is, 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. (AASB 112)

dee67382_ch18_723-768.indd 740 10/24/19 03:40 PM

740 PART 4: Accounting for liabilities and owners’ equity

18.5 Unused tax losses

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, and many other countries, losses incurred in previous years can generally be carried forward to offset taxable profit derived in future years. That is, tax losses do not result in cash payments 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 profit of $100 000, the prior period tax loss can be used to offset the taxable profit 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 for 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. (AASB 112)

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.

WHY DO I NEED TO KNOW HOW `TAX EXPENSE’, AS SHOWN IN THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME, IS CALCULATED? AND WHY DO I NEED TO KNOW WHAT DEFERRED TAX ASSETS, DEFERRED TAX LIABILITIES AND INCOME TAX PAYABLE, AS SHOWN IN THE STATEMENT OF FINANCIAL POSITION, REPRESENT?

These amounts can be very material from a financial reporting perspective; therefore, to understand their context we need to understand how they are calculated. Profit after tax really would mean little if we didn’t understand what ‘tax expense’ actually represents. Similarly, if we do not understand what these assets and liabilities represent, it would be difficult to properly make sense of the total assets or total liabilities reported by a reporting entity.

LO 18.5

dee67382_ch18_723-768.indd 741 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 741

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. (AASB 112)

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. (AASB 112)

Worked Example 18.8 illustrates the utilisation of unused tax losses.

WORKED EXAMPLE 18.8: Utilisation of unused tax losses

Grommit Ltd commenced operations in 2023. In the year ending 30 June 2023 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 Profit before tax

2024 $300 000

2025 $400 000

2026 $600 000

It is assumed that there are no temporary differences between the carrying amounts 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

2023 Accepting that it is probable that the entity will be able to recoup the benefits associated with the tax loss, the entry in 2023 would be:

Dr Deferred tax asset 300 000  

Cr Income tax revenue (to recognise the deferred tax asset relating to a tax loss, which equals 1 000 000 × 30 per cent)

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

2024 In 2024 the entity generates a profit of $300 000. In the absence of a tax loss, $90 000 would be payable. We still recognise the 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 (to apply the deferred tax asset created by past tax losses against the tax that would otherwise be payable)

90 000

continued

dee67382_ch18_723-768.indd 742 10/24/19 03:40 PM

742 PART 4: Accounting for liabilities and owners’ equity

2025 In 2025 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 (to apply the deferred tax asset created by past tax losses against the tax that would otherwise be payable)

120 000

2026 In 2026 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 (to apply the remaining tax losses against the tax that would otherwise be payable, and to recognise the amount of tax that requires subsequent payment)

90 000

The statement of profit or loss and other comprehensive income for the four years is set out below:

  2026

($) 2025

($) 2024

($) 2023

($)

Profit/(loss) before tax 600 000 400 000 300 000 (1 000 000)

Tax revenue/(income tax expense) (180 000) (120 000) (90 000)    300 000

Profit/(loss) after tax 420 000 280 000 210 000   (700 000)

Statement of financial position extract for the four years as at 30 June

  2026

($) 2025

($) 2024

($) 2023

($)

Assets        

Deferred tax asset – 90 000 210 000 300 000

Liabilities        

Tax payable 90 000 – – –

WORKED EXAMPLE 18.8 continued

As we can see in Worked Example 18.8, the recognition of unused tax losses has the effect in the year of initial recognition of either reducing reported losses or increasing reported profits. If the unused tax losses are not recognised in one year because of concerns about the probability of utilising them in future years (that is, there could be uncertainties that the organisation will generate assessable profits in future years against which the unused tax losses could be offset to reduce required tax payments), the related deferred tax asset can subsequently be recognised if the related uncertainties of utilising them are later resolved (see paragraph 37 of AASB 112).

This potentially gives managers a potential for ‘earnings management’, which is something we discussed in some depth in Chapter 3. As we discussed then, ‘earnings management’ can be defined as action taken wherein accountants adopt particular accounting policies, or make particular accounting-based decisions, primarily to generate desired measures of profits/earnings.

dee67382_ch18_723-768.indd 743 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 743

While accountants should prepare financial statements objectively (which would increase the ‘representational faithfulness’ of the reported information), research has shown that managers have used the recognition of deferred tax assets associated with tax losses as part of a strategy of earnings management (for example, see Kasipillai & Mahenthiran 2013). Herbohn et al. (2010) also provide evidence to suggest that the managers’ timing of the recognition of previously unrecognised tax losses is influenced by whether their organisation is otherwise likely to report earnings that are below analysts’ previously publicised forecasts of profits.

However, while the above paragraphs suggest that managers might opportunistically choose when to recognise unused tax losses, there is also some argument that the recognition of unused tax losses provides important signals to the capital market about the likelihood that an organisation will generate future taxable profits. That is, the recognition of a deferred tax asset is a way in which managers can reassure the users of financial statements that the organisation believes it will generate profits in the future and therefore be able to utilise the tax benefits that the deferred tax asset represents (see Christensen et al. 2008). In this regard, it is also interesting to note that some research shows that the recognition of prior tax losses has positive implications for the capital market’s valuation of an organisation’s share capital (see Kager & Niemann 2013).

WHY DO I NEED TO KNOW HOW TO ACCOUNT FOR TAX LOSSES?

Subject to certain tests, tax losses can create deferred tax assets. In the process of recognising such assets, income will be recognised. This means that, effectively, the after-tax loss is not as great as the before-tax loss. Therefore, while, generally speaking, making a loss is not a great thing, we should appreciate that as long as an organisation is expected to return to profitability there are some economic benefits associated with making a loss.

18.6 Revaluation of non-current assets

As discussed in Chapter 6, reporting entities often revalue their non-current assets to fair value. This is an option available within AASB 116. As Chapter 6 explains, for an upward revaluation, the general requirement is to debit the relevant asset account, and to credit other comprehensive income (OCI). At the end of the accounting period this amount in OCI would then be credited to the revaluation surplus account, which is part of equity (unless the revaluation reverses a previous revaluation decrement). In our discussions of revaluations in Chapter 6, we did not discuss the tax implications of asset revaluations, so we will therefore consider them now. AASB 116, 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. (AASB 116)

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 (otherwise there would be great incentives for managers to recognise large asset revaluations so that they can subsequently claim greater depreciation deductions). However, any increase in the carrying amount 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 therefore 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. (AASB 112)

LO 18.6

dee67382_ch18_723-768.indd 744 10/24/19 03:40 PM

744 PART 4: Accounting for liabilities and owners’ equity

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 of the machine, the following journal entry would be made:

Dr Accumulated depreciation 400 000  

Cr Machinery   400 000

Dr Machinery 180 000  

Cr Gain on revaluation (in OCI) (to recognise a revaluation and the associated gain, which shall be recognised within other comprehensive income in accordance with AASB 116)

180 000

We can now consider the carrying amount of the asset after the revaluation, and its tax base.

 

Carrying amounts

($) Tax bases

($)

Fair value/cost 780 000 1 000 000

less Accumulated depreciation         ($nil) (400 000)

  780 000 600 000

Alternatively:

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

economic benefits

=

Tax base

$780 000

+

$600 000

$780 000

=

$600 000

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 18.3). 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 ‘other comprehensive income’ 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). (AASB 112)

The changes in the revaluation surplus account shall be included as part of other comprehensive income and then transferred to the equity account—revaluation surplus—at the end of the reporting period.

Continuing on from the above journal entries, the accounting entry to record the recognition of the deferred tax liability would therefore be:

Dr Income tax expense (in OCI) 54 000  

Cr Deferred tax liability (54 000 = 180 000 × 0.30. This amount will be recognised in other comprehensive income)

54 000

dee67382_ch18_723-768.indd 745 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 745

The amounts recognised within other comprehensive income (the gain on revaluation and the related tax effect) will be transferred to revaluation surplus at the end of the reporting period. AASB 116 does not permit the gain on revaluation to be reclassified to profit or loss

Dr Gain on revaluation (in OCI) 180 000  

Cr Income tax expense (in OCI)  54 000

Cr Revaluation surplus (at the end of the reporting period the amounts recognised in OCI in respect of the revaluation shall be transferred to an equity account known as ‘revaluation surplus’, or similar)

126 000

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 concessions, if available in particular countries, are typically provided when the asset is sold, not if it is being used within the organisation. The accounting entries to be made therefore will depend on the intended use of the revalued asset. As paragraph 51A of AASB 112 states:

In some jurisdictions, the manner in which an entity recovers (settles) the carrying amount of 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. (AASB 112)

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 per cent would apply if the asset were sold and a tax rate of 30 per cent 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 18.9 and 18.10 examine accounting for asset revaluations, and Worked Examples 18.11 and 18.12 give detailed examples of accounting for tax.

WORKED EXAMPLE 18.9: 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 assuming that the asset was acquired when the index for capital gains tax was 100, while the index at reporting date is 120.

continued

capital gains tax A tax that is payable on profits arising when an asset (typically a non- current asset) is sold at a price in excess of its cost.

dee67382_ch18_723-768.indd 746 10/24/19 03:40 PM

746 PART 4: Accounting for liabilities and owners’ equity

SOLUTION

(a) If the asset will be used within the organisation, the base can be determined as follows:

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

economic benefits

=

Tax base

$450 000

+

$276 000

$450 000

=

$276 000

(b) If the asset is expected to be sold, the base can be determined as follows:

Carrying amount

+

Future amount deductible

for tax purposes

Future taxable

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 continued

WORKED EXAMPLE 18.10: Accounting for a revaluation

Winter Swells Ltd acquired an item of plant with a ten-year useful life, on 1 July 2019, 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 2023, which is four years after it was acquired, the plant was revalued to $210 000. The remaining useful 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 2023, assuming the $210 000 is recovered through use.

(b) Assuming that Winter Swells Ltd continues to use the asset in subsequent reporting periods, how much depreciation will be recognised for the year ending 30 June 2024?

SOLUTION

(a) Determining the tax base and journal entries assuming the $210 000 will be recovered through use

On 30 June 2023, 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 2023

Dr Accumulated depreciation 80 000

Cr Plant and machinery (to eliminate accumulated depreciation on revaluation of asset)

80 000

Dr Plant and machinery 90 000

Cr Revaluation gain (in OCI) (to revalue the asset to fair value and recognise the gain as part of other comprehensive income in accordance with AASB 116)

90 000

dee67382_ch18_723-768.indd 747 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 747

Tax base

=

Future amount deductible

for tax purposes

Future taxable economic

benefits of asset

+

Carrying amount

$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 would already have 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:

Dr Income tax expense (in OCI) 27 000  

Cr Deferred tax liability (to recognise the deferred tax liability relating to the revaluation)

27 000

Dr Gain on revaluation (in OCI) 90 000  

Cr Income tax expense (in OCI)  27 000

Cr Revaluation surplus (at the end of the reporting period the amounts recognised in OCI in respect of the revaluation shall be transferred to an equity account known as revaluation surplus)

63 000

Deferred tax is recognised 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.

(b) As a result of the revaluation, depreciation in subsequent periods will be based on the increased revalued amount.

In this example, as the revalued amount is $210 000, and as there is a remaining useful life of six years, the depreciation expense for accounting purposes will be $35 000 (which is $210 000 divided by 6). For tax purposes, however, the asset will continue to be depreciated at its tax base of $40 000 over the remaining number of years available for tax depreciation, which in this case is one year. This gives a depreciation deduction of $40 000. One year after revaluation, when the asset will therefore have been fully depreciated for tax purposes, the carrying amount and tax base of the asset would therefore be:

Carrying amount Tax base

Cost/revalued amount $210 000 $200 000

less Accumulated depreciation ($ 35 000) ($200 000)

Carrying amount/tax base $175 000 $ 0

As at 30 June 2024, the taxable temporary difference would therefore be $175 000, leading to a deferred tax liability of $52 500 (which is 30 per cent of $175 000). As the deferred tax liability was $51 000 at 30 June 2023 (see above), there is a required increment of $1500.

Therefore, the journal entries for the depreciation and the increased deferred tax liability for the year ending 30 June 2024 are:

30 June 2024

Dr Depreciation expense 35 000  

Cr Accumulated depreciation (depreciation expense for the reporting period ending 30 June 2024 [$35 000 = $210 000 ÷ 6])

35 000

continued

dee67382_ch18_723-768.indd 748 10/24/19 03:40 PM

748 PART 4: Accounting for liabilities and owners’ equity

Worked Example 18.11 now provides a detailed example of accounting for tax.

Dr Income tax expense (deferred) 1500  

Cr Deferred tax liability (deferred tax on the excess of tax depreciation over accounting depreciation for the reporting period ending 30 June 2024. ($40 000 – $35 000) × 30 per cent = $1500)

1500

The total deferred tax liability will now be $52 500 ($24 000 + $27 000 + $1500). Over the next five years this deferred tax liability will decrease by $10 500 per year until 30 June 2029, when the balance of the deferred tax liability will then be zero, as will the carrying amount of the asset. In 2029 the tax base of the asset will also be zero, meaning that there would be no further temporary differences in relation to the asset.

WORKED EXAMPLE 18.10 continued

WORKED EXAMPLE 18.11: Detailed example of accounting for tax

First Point Ltd commences operations on 1 July 2022. One year later, on 30 June 2023, the entity prepares the following information, showing both the carrying amounts for accounting purposes, and tax bases of the respective assets and liabilities.

 

Extract from accounting balance sheet

($) Tax bases

($)

Assets    

Cash 50 000 50 000

Accounts receivable—net 35 000 40 000

Inventory 65 000 65 000

Plant—net 160 000 150 000

Land 400 000 400 000

  710 000 705 000

Liabilities    

Accounts payable 40 000 40 000

Provision for long-service leave 60 000 –

Provision for warranty 70 000 –

Loan payable 350 000 350 000

  520 000 390 000

Net assets 190 000 315 000

Other information

• Accounting profit before tax for 2023 was $275 000. • 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. • There is an allowance for doubtful debts of $5000. • An item of plant is purchased at a cost of $200 000 on 1 July 2022. 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.

• 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 Provide the accounting journal entries to account for taxation for the year ending 30 June 2023.

dee67382_ch18_723-768.indd 749 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 749

SOLUTION We can reconcile taxable profit to accounting profit as follows:

Accounting profit before tax $275 000

add

Depreciation for accounting purposes $ 40 000

Increase in provision for long service leave $ 60 000

Increase in provision for warranty $ 70 000

Increase in allowance for doubtful debts $ 5 000 $175 000

less

Depreciation allowed for tax purposes ($ 50 000)

Taxable profit $400 000

As demonstrated in the schedule below, given that First Point Ltd commences operations on 1 July 2022, 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, which in turn will lead to the recognition of deferred tax assets or deferred tax liabilities. Table 18.3 is useful for this purpose.

Extract from accounting

balance sheet

($)

Tax bases

($)

Deductible temporary

differences ($)

Taxable temporary

differences ($)

Tax expense

($)

Income tax

payable ($)

Assets

Cash 50 000 50 000

Accounts receivable—net 35 000 40 000 5 000 (5 000)

Inventory 65 000 65 000

Plant—net 160 000 150 000 10 000 10 000

Land 400 000 400 000

710 000 705 000

Liabilities

Accounts payable 40 000 40 000

Provision for long-service leave 60 000 – 60 000 (60 000)

Provision for warranty 70 000 – 70 000 (70 000)

Loan payment 350 000 350 000

520 000 390 000

Net assets 190 000 315 000

Temporary differences at period end 135 000 10 000 (125 000)

less Prior period amounts – – –

Movement for the period 135 000 10 000 (125 000)

Tax effected at 30% 40 500 3 000 (37 500)

Tax on taxable profit, 30% × $400 000  120 000 120 000

Income tax adjustments 40 500 3 000   82 500 120 000

continued

dee67382_ch18_723-768.indd 750 10/24/19 03:40 PM

750 PART 4: Accounting for liabilities and owners’ equity

WORKED EXAMPLE 18.11 continued

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.

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 profit is determined by calculating taxable profit 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 or subtract the tax effect of the temporary differences.

Taking the information from the table above, the accounting journal entries at 30 June 2023 would be:

Dr Income tax expense (current) 120 000  

Cr Income tax payable (to recognise the tax expense pertaining to taxable profit)

120 000

Dr Deferred tax asset 40 500  

Cr Deferred tax liability   3 000

Cr Income tax expense (deferred) (to recognise the effect on tax expense of the temporary differences)

37 500

The total tax expense to be reported within the statement of profit or loss and other comprehensive income therefore would be $82 500. 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 $3000 against the deferred tax asset. The entry on 30 June 2023 would therefore be:

Dr Deferred tax liability 3 000  

Cr Deferred tax asset (to set off the deferred tax liability against the deferred tax asset)

3 000

Worked Example 18.12 provides a further detailed example of accounting for tax.

WORKED EXAMPLE 18.12: A further detailed example of accounting for tax

Wounded Seagull Ltd commences operations on 1 July 2022 and presents its first statement of profit or loss and other comprehensive income and its first statement of financial position on 30 June 2023. 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 2023

($) ($)

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

dee67382_ch18_723-768.indd 751 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 751

Assets and liabilities as disclosed in the statement of financial position as at 30 June 2023

($) ($)

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

Provision for warranty expenses   15 000

Loan payable   154 000

Provision for long-service leave expenses   10 000

Total liabilities   229 000

Net assets   200 000

Other information

1. All administration and salaries expenses incurred have been paid as at year end. 2. None of the long-service leave expense has actually been paid. It is not deductible until it is actually paid. 3. 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.

4. 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.

5. Amounts received from sales, including those on credit terms, are taxed at the time the sale is made. 6. The plant is depreciated over four years for accounting purposes, but over three years for taxation purposes. 7. The tax rate is 30 per cent.

REQUIRED Provide the journal entries at 30 June 2023 to account for tax in accordance with AASB 112.

SOLUTION Our first step will be to determine taxable profit. We need to know this to determine income tax payable.

($) ($) ($)

Profit before tax 330 000

(adjust for differences between tax and accounting rules)

Long-service leave not yet deductible   10 000  

Warranty expenses 20 000    

Warranty expenses paid      (5 000) 15 000  

Accounting depreciation 75 000    

Tax depreciation (100 000) (25 000)

Insurance expense 10 000    

Insurance actually paid (14 000)    (4 000)    (4 000)

Taxable profit     326 000

continued

dee67382_ch18_723-768.indd 752 10/24/19 03:40 PM

752 PART 4: Accounting for liabilities and owners’ equity

Extract from accounting

balance sheet

($)

Tax bases

($)

Deductible temporary

differences ($)

Taxable temporary

differences ($)

Tax expense

($)

Current tax

payable ($)

Assets            

Cash 30 000 30 000        

Accounts receivable 90 000 90 000        

Inventory 80 000 80 000        

Prepaid insurance 4 000     4 000 4 000  

Plant—net of depreciation 225 000 200 000   25 000 25 000  

  429 000 400 000        

Liabilities            

Accounts payable 50 000 50 000        

Provision for warranty 15 000 – 15 000   (15 000)  

Provision for long-service leave 10 000 – 10 000   (10 000)  

Loan 154 000 154 000        

  229 000 204 000        

Net assets 200 000 196 000                        

Temporary differences at period end 25 000 29 000 4 000

less Prior period amounts             –         –         –  

Movement for the period     25 000 29 000 4 000  

Tax effected at 30%     7 500 8 700 1 200  

Tax on taxable profit, 30% × $326 000             –           – 97 800 97 800

Income tax adjustments       7 500   8 700 99 000 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 (current) 97 800  

Cr Income tax payable (to recognise the tax expense pertaining to taxable profit)

97 800

Dr Income tax expense (deferred) 1 200  

Dr Deferred tax asset 7 500  

Cr Deferred tax liability (to recognise the additional tax expense pertaining to the temporary differences)

8 700

The above entries have given rise to a deferred tax asset and a deferred tax liability. Assuming that the necessary conditions to perform a set-off are satisfied (including that the tax assets and tax liabilities all relate to

WORKED EXAMPLE 18.12 continued

dee67382_ch18_723-768.indd 753 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 753

18.7 Offsetting deferred tax liabilities and deferred tax assets

As indicated in Worked Examples 18.11 and 18.12, if the tax assets and tax liabilities relate to the same taxation 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. (AASB 112)

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. (AASB 112)

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. (AASB 112)

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 28), 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.

18.8 Change of tax rates

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.

the ATO), 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 Deferred tax liability 7 500  

Cr Deferred tax asset (to offset the deferred tax asset against the deferred tax liability)

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.

LO 18.7

LO 18.8

dee67382_ch18_723-768.indd 754 10/24/19 03:40 PM

754 PART 4: Accounting for liabilities and owners’ equity

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 Examples 18.13 and 18.14 provide examples of how to account for a change in tax rate.

WORKED EXAMPLE 18.13: Change in tax rates

As at 30 June 2022, the balance of the deferred tax liability account of Shannon Ltd was $660 000 credit. Assume that at 30 June 2023 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 2023.

SOLUTION The accounting entry at 30 June 2023 would be:

Dr Deferred tax liability 60 000  

Cr Income tax expense (reduction in tax expense resulting from a decrease in tax rate $660 000 − [$660 000/33 × 30] = $60 000)

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 2023 will be reported in the statement of profit or loss and other comprehensive income.

WORKED EXAMPLE 18.14: Impact of changing tax rates

Taxi Ltd has the following deferred tax balances as at 30 June 2023:

Deferred tax asset $500 000

Deferred tax liability $300 000

The above balances were calculated when the tax rate was 30 per cent. On 1 August 2023 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

  Balance at 30 June 2023 Balance at 1 August 2023 Change

Deferred tax asset $500 000 $500 000 × 25/30 = $416 667 ($83 333)

Deferred tax liability $300 000 $300 000 × 25/30 = $250 000 ($50 000)

dee67382_ch18_723-768.indd 755 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 755

18.9 Disclosures pertaining to tax expense and related assets and liabilities

Extensive disclosure requirements are included within AASB 112 (see paragraphs 79–88). These disclosure requirements are stipulated to allow readers of the financial statements to understand and evaluate the effects of current and deferred tax on the financial performance, and financial position, of a reporting entity. The required disclosures address issues such as:

∙ the major components of tax expense ∙ details of temporary differences that have given rise to deferred tax assets and deferred tax liabilities ∙ information about temporary differences, tax losses, and tax credits for which no deferred tax asset has been

recognised (for example, because the required probability criteria were not satisfied).

Paragraph 81 requires many disclosures, including the amount of income tax relating to each component of other comprehensive income. There is also a requirement to disclose a numerical reconciliation between income tax expense and the product of accounting profit multiplied by the applicable tax rate.

Other accounting standards also include a number of tax-related disclosures. For example:

∙ AASB 101 Presentation of Financial Statements requires that current tax assets and liabilities, and deferred tax assets and liabilities, shall be disclosed as separate line items within the statement of financial position.

∙ AASB 107 Statement of Cash Flows requires that cash flows from taxes on profit shall be separately disclosed, and shall be classified as part of cash flows from operating activities.

The following exhibit, Exhibit 18.1, provides extracts from the 2019 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, 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 assets 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. The related deferred tax assets in relation to unused tax losses can be recognised later, should related uncertainties subsequently be resolved. While not implying that CBA would do this, recognising unused tax losses at a future date can be a way of undertaking ‘earnings management’, as we discussed earlier in our discussion of accounting for unused tax losses.

Within the CBA financial statements, the total balance of deferred tax assets and deferred tax liabilities, before set-off, were $3369 million and $1694 million respectively (the net amount after set-off shown for the deferred tax

LO 18.9

The accounting entry at 1 August 2023 would be:

Dr Deferred tax liability 50 000  

Dr Income tax expense 33 333  

Cr Deferred tax asset (to adjust the balances of deferred tax assets and deferred tax liabilities as a result of a change in tax rate)

83 333

dee67382_ch18_723-768.indd 756 10/24/19 03:40 PM

756 PART 4: Accounting for liabilities and owners’ equity

asset was $1675 million). 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 profit, 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.

Exhibit 18.1 An example of disclosures made in relation to current and deferred taxes

dee67382_ch18_723-768.indd 757 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 757

The above statements of comprehensive income should be read in conjunction with the accompanying notes.

continued

dee67382_ch18_723-768.indd 758 10/24/19 03:40 PM

758 PART 4: Accounting for liabilities and owners’ equity

Exhibit 18.1 continued

dee67382_ch18_723-768.indd 759 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 759

SOURCE: CBA Commonwealth Bank of Australia

dee67382_ch18_723-768.indd 760 10/24/19 03:40 PM

760 PART 4: Accounting for liabilities and owners’ equity

18.10 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 ‘deferred tax assets’ or ‘deferred tax liabilities’ 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 present economic resource controlled by the entity as a result of past events’. 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 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 to transfer an economic resource as a result of past events’. 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.

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. Nevertheless, evidence exists to indicate that the capital market does take notice of the information generated through the application of the balance sheet method of accounting for tax. For example, when there have been instances where the corporate tax rate has fallen (meaning that future obligations associated with deferred tax liabilities would also consequently fall—as we have discussed earlier in this chapter), then the greater the magnitude of deferred tax liabilities reported by an organisation (and therefore the greater the economic benefits associated with a reduced corporate tax rate), the greater the positive movement in a company’s share price around the time that a reduction in tax rate is announced (see Givoly & Hayn 1992). This is consistent with a view that investors find information about deferred tax liabilities useful to their decision making.

LO 18.10

dee67382_ch18_723-768.indd 761 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 761

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 financial accounting are frequently different from those applied for taxation purposes.

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 of assets and liabilities 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 non- current asset are taken into account, the balance of the revaluation surplus account is reduced.

KEY TERMS accounting profit 724 capital gains tax 745 taxes payable method 731

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. On what basis is ‘income tax expense’ as reported in the statement of profit or loss and other comprehensive income determined? LO 18.2, 18.3 Tax expense is determined by applying the ‘balance sheet method’ as required by AASB 112. Income tax expense represents the sum of the tax attributable to the taxable profit (as assessed by the relevant taxation authority) plus or minus any adjustments relating to temporary differences (which result in deferred tax assets and deferred tax liabilities).

2. Will the ‘income tax expense’ for an accounting period be the same as the ‘income tax payable’ at the end of that accounting period? LO 18.1, 18.2, 18.3 No, not in the presence of ‘temporary differences’. Income tax expense as reported in the financial statements will be based upon accounting profit (accounting profit is determined by applying accounting standards and other generally accepted accounting principles), plus or minus adjustments relating to timing differences (which in themselves are based upon differences between the carrying amounts of assets and liabilities and their respective tax bases). By contrast, income tax payable is the amount of the obligation to the Australian Taxation Office (ATO), and this amount will be determined on the basis of the application of taxation legislation (and not accounting standards).

3. Why would a profitable company potentially not have any income tax payable to the relevant taxation authority? LO 18.2, 18.3 Income tax payable is based upon the application of taxation legislation. By contrast, accounting profit is based upon the application of accounting standards and other generally accepted accounting principles. As such, there will be differences between the calculated ‘accounting profit’ and ‘taxable profit’. This will lead to differences—which at times can be significant—between income tax expense (which is based upon accounting profits) and current income tax payable (which is based on taxable profit). The consequence of this is that organisations with high accounting profits could have low (or even no) taxable profit.

4. What is a ‘deferred tax asset’, and when would it arise? LO 18.3 Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:

(a) deductible temporary differences (b) the carry-forward of unused tax losses, and (c) the carry-forward of unused tax credits.

dee67382_ch18_723-768.indd 762 10/24/19 03:40 PM

762 PART 4: Accounting for liabilities and owners’ equity

Deferred tax assets arise when the carrying amount of an asset is less than its tax base, or where the carrying amount of a liability is greater than its tax base.

5. What is a ‘deferred tax liability’, and when would it arise? LO 18.3 Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary differences. Deferred tax liabilities arise when the carrying amount of an asset is greater than its tax base, or where the carrying amount of a liability is less than its tax base.

6. Would incurring a loss for tax purposes lead to the recognition of a tax-related asset in the financial statements? Why? LO 18.5 Yes, deferred tax assets can arise as a result of tax losses. In Australia, and many other countries, losses incurred in previous years can generally be carried forward to offset taxable profit derived in subsequent years. Hence, generating a taxable loss can produce 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.

However, there are specific requirements that need to be satisfied before a deferred tax asset relating to unused tax losses shall be recognised (see paragraphs 34–36 of AASB 112). Paragraph 36 of AASB 112 specifically requires:

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. (AASB 112)

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is a ‘temporary difference’ and why does it arise? LO 18.1, 18.2 • 2. How is the tax base of an asset determined? LO 18.2, 18.4 • 3. How is the tax base of a liability determined? LO 18.2, 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, 18.3, 18.4 • 6. What is the rationale for recognising a deferred tax asset or a deferred tax liability? LO 18.2, 18.3, 18.4 •• 7. What is the justification for recognising a deferred tax asset because an entity has unused tax losses? LO 18.5 •• 8. Explain why a temporary difference relating to employee benefits obligations for long-service leave creates a

deferred tax asset. LO 18.3, 18.4 •• 9. Will the existence of unused tax losses always lead to the recognition of a deferred tax asset? LO 18.5 • 10. How will a change in the tax rate impact 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 18.8 •• 11. Can deferred tax assets be offset against deferred tax liabilities? LO 18.7 • 12. Identify some disclosures that a reporting entity has to make with respect to the impacts of taxation on its financial

performance and financial position. LO 18.9 • 13. 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 2019 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 depreciated over two years. The tax rate is assumed to be 30 per cent.

dee67382_ch18_723-768.indd 763 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 763

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 2022? LO 18.2, 18.3,

18.4 •• 14. 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 18.2, 18.3, 18.4 • 15. 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 18.2, 18.3, 18.4 •• 16. 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 profit. 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 18.2, 18.3, 18.4 •• 17. 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 18.2, 18.3, 18.4 •• 18. A company has prepaid rent with a carrying amount 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? (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 18.2, 18.3, 18.4 •• 19. A company has a liability for employee benefits (relating to long-service leave) with a carrying amount of $50 000,

which will be deductible when the amounts are actually paid. The company has also accrued wages with a carrying amount 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 18.2, 18.3, 18.4 •• 20. A company has interest revenue received in advance with a carrying amount 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 18.2, 18.3, 18.4 ••

dee67382_ch18_723-768.indd 764 10/24/19 03:40 PM

764 PART 4: Accounting for liabilities and owners’ equity

21. 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 18.2, 18.3, 18.4 ••

22. Elwood Ltd has the following deferred tax balances as at 30 June 2023:

Deferred tax asset $1 000 000

Deferred tax liability $ 800 000

The above balances were calculated when the tax rate was 30 per cent. On 1 December 2023 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 18.8 ••

23. 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 18.6 ••

CHALLENGING QUESTIONS

24. Is it possible that the recognition of deferred tax assets associated with unused tax losses could be used as a means of ‘earnings management’? Explain your answer. LO 18.5, 18.10

25. Do the liabilities and assets that are generated by using the ‘balance sheet method’ of accounting for tax appear to be consistent with the definition and recognition criteria of assets and liabilities promulgated within the Conceptual Framework? LO 18.10

26. Boiling Pot Ltd commences operations on 1 July 2022. One year after the commencement of its operations (30 June 2023) the entity prepares the following information, showing both the carrying amounts for accounting purposes and the tax bases of the respective assets and liabilities.

  Carrying amounts

($) Tax bases

($)

Assets    

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

Land    600 000    400 000

   1 260 000  1 000 000

Liabilities    

Accounts payable      60 000      60 000

Provision for long-service leave      30 000 –

Provision for warranty      40 000 –

Loan payable    400 000    400 000

     530 000    460 000

Net assets    730 000    540 000

dee67382_ch18_723-768.indd 765 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 765

Other information

• After adjusting for differences between tax rules and accounting rules, it is determined that the taxable profit 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 2022. 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 18.1, 18.2, 18.3, 18.4, 18.6

27. MR Ltd commences operations on 1 July 2022 and presents its first statement of profit or loss and other comprehensive income and first statement of financial position on 30 June 2023. 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 2023

($) ($)

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

Assets and liabilities as disclosed in the statement of financial position as at 30 June 2023

($) ($)

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

dee67382_ch18_723-768.indd 766 10/24/19 03:40 PM

766 PART 4: Accounting for liabilities and owners’ equity

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 18.1, 18.2, 18.3, 18.4

28. At 30 June 2022, E-Surfboards Ltd had the following temporary differences:

Asset or liability Carrying amount

($000) Tax base

($000) Temporary difference

($000)

Computers at cost 300 300  

Accumulated depreciation  (60) (100)  

Computers—net 240  200 40

Accounts receivable 100 100  

Allowance for doubtful debts  (10)      0  

Accounts receivable—net   90  100 10

Provision for warranty costs 30 0 30

Provision for employee benefits (LSL) 20 0 20

The following information is available for the following year, the year ending 30 June 2023.

Statement of profit or loss and other comprehensive income for E-Surfboards Ltd for the year ending 30 June 2023    $000  

Revenue 4 000

Cost of goods sold expense (1 800)

Depreciation expense     (60)

Warranty expense     (90)

Bad and doubtful debts expense     (25)

Other expenses (1 375)

Profit before tax    650

Other comprehensive income       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 2023:

   $000

Assets  

Accounts receivable 120

Allowance for doubtful debts (20)

Liabilities  

Provision for warranty costs 50

Provision for employee benefits (LSL) 30

dee67382_ch18_723-768.indd 767 10/24/19 03:40 PM

CHAPTER 18: Accounting for income taxes 767

There was no acquisition of plant and equipment during the year. The tax rate as at 30 June 2022 and 30 June 2023 was 30 per cent.

REQUIRED (a) Calculate the amount of each of E-Surfboards’ temporary differences, if any, at 30 June 2022, 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 2022? (c) Calculate E-Surfboards’ taxable profit for the year ending 30 June 2023. (d) Prepare journal entries to record current tax and deferred tax for the year ending 30 June 2023. LO 18.1, 18.2,

18.3, 18.4

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. Christensen, T., Paik, G. & Stice, E., 2008, ‘Creating a Bigger Bath Using

the Deferred Tax Valuation Allowance’, Journal of Business Finance and Accounting, vol. 35, no. 5–6, pp. 601–25.

Givoly, D. & Hayn, C., 1992, ‘The Valuation of the Deferred Tax Liability: Evidence from the Stock Market’, The Accounting Review, April 1992, pp. 394–410.

Herbohn, K., Tuttucci, I. & Khor, P., 2010, ‘Changes in Unrecognised Deferred Tax Accruals from Carry-forward Losses: Earnings Management or Signalling?’, Journal of Business Finance and Accounting, vol. 37, no. 7–8, pp. 763–91.

Kager, R. & Niemann, R., 2013, ‘Income Determination for Corporate Tax Purposes Using IFRS as a Starting Point: Evidence for Listed Companies within Austria, Germany and the Netherlands’, Journal of Business and Economics, vol. 83, no. 5, pp. 427–70.

Kasipillai, J. & Mahenthiran, S., 2013, ‘Deferred Taxes, Earnings Management, and Corporate Governance: Malaysian Evidence’, Journal of Contemporary Accounting and Economics, vol. 9, pp. 1–18.

Westwood, M., 2000, Financial Accounting in New Zealand, Pearson, Auckland.

dee67382_ch18_723-768.indd 768 10/24/19 03:40 PM

dee67382_ch19_769-812.indd 769 10/25/19 11:39 AM

PART 5 Accounting for the

disclosure of cash flows

CHAPTER 19 The statement of cash flows

dee67382_ch19_769-812.indd 770 10/25/19 11:39 AM

770

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 19.1 Understand the role of the statement of cash flows relative to other financial statements. 19.2 Explain the reasons for differences between an organisation’s cash flows, and its profits as determined

under an accrual accounting system. 19.3 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’.

19.4 Understand the meaning of, and differences between, cash flows from operating activities, cash flows from investing, and cash flows from financing activities.

19.5 Be able to explain the format of the statement of cash flows as required by AASB 107. 19.6 Be aware of some supporting notes that shall accompany a statement of cash flows. 19.7 Be able to calculate cash flows from operating activities, cash flows from investing activities, and cash

flows from financing activities. 19.8 Understand how a statement of cash flows might be used by different stakeholders, and within different

contractual arrangements negotiated by an organisation.

C H A P T E R 19 The statement of cash flows

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is the role of the statement of cash flows? LO 19.1 2. The statement of cash flows provides information about movements in ‘cash’ and ‘cash equivalents’. What do

we mean by ‘cash equivalents’? LO 19.3 3. The statement of cash flows separates the total cash flows of a reporting entity into three classifications of

cash flows. What are these three classifications? LO 19.4 4. Would the cash flows from operating activities be greater if the balance of accounts receivable increases, or

decreases, across the reporting period? LO 19.7

dee67382_ch19_769-812.indd 771 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 771

19.1 Comparison with other financial statements

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. These other financial statements are the statement of financial position (balance sheet), 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 reconciliation of opening and closing equity as well as 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 (distributions and capital contributions). The statement of profit or loss and other comprehensive income shows the profit or loss as well as the ‘other comprehensive income’ that has been generated for a period of time, typically a year, adopting the process of accrual accounting.

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 three classifications of cash flows, these being cash flows from operating activities, cash flows from investing activities and cash flows from financing activities. The information provided in a statement of cash flows may assist different stakeholders to assess the ability of an organisation to:

∙ 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.

As we know, ‘profits’ or ‘losses’ are determined by the use of accrual accounting. Indeed, paragraph 27 of AASB 101 Presentation of Financial Statements specifically requires that ‘an entity shall prepare its financial statements, except for cash flow information, using the accrual basis of 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.

Share market analysts do focus a great deal on cash flows and, in particular, on cash flows from operating activities when assessing the performance and likely future of an organisation. A review of the news media indicates that the information derived from the statement of cash flows attracts a great deal of attention.

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’ judgements, whereas cash-flow data tends to be more ‘factual’ or ‘objective’. Indeed, paragraph 4 of AASB 107 Statement of Cash Flows states:

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. (AASB 107)

accrual profits/losses The profits or losses that would be disclosed as a result of applying accrual accounting techniques.

LO 19.1

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

101 Presentation of Financial Statements IAS 1

107 Statement of Cash Flows IAS 7

statement of cash flows A financial statement that provides a reconciliation of opening and closing ‘cash’, including cash on hand and cash equivalent.

accrual accounting A system of accounting in which revenues are recognised when earned and expenses are recognised when incurred, even in the absence of cash flows.

dee67382_ch19_769-812.indd 772 10/25/19 11:39 AM

772 PART 5: Accounting for the disclosure of cash flows

19.2 The difference between cash flows and profits

As we know, when an accountant determines the income and expenses (and therefore the profit) for an accounting period, it is necessary to make many professional judgements. Judgements have to be made about when to recognise income, and about the collectability of accounts receivable; judgements also have to be made about the useful life of a non-current asset, its residual value and the pattern of benefits to be derived from the asset when calculating depreciation expense. Many other examples could also be provided where professional judgement is required when determining income and expenses, but the point being made is that it is necessary, when accrual accounting is used, to make many judgements about when income is earned and when expenses are incurred. Sometimes these judgements might be made in a way that is not objective, and a level of bias could be introduced into the financial accounts.

By contrast, there is less ability to manipulate data reported within a statement of cash flows as the balance of opening and closing ‘cash and cash equivalents’ can be verified by reference to particular external records prepared by a third party—such as bank statements generated by a bank. Therefore, it is commonly argued that the data reported in a statement of cash flows is likely to be more reliable or representationally faithful than profit-related data.

The view that the statement of cash flows is a financial statement that is harder for managers to manipulate is one that has also been promoted within the news media. For example, within Australia, an article written in the popular newspaper the Daily Telegraph (on 25 August 2014 by David Koch and Libby Koch, and entitled ‘How to avoid the slide’) stressed that profit is an ‘accounting figure’ that is relatively easy to ‘push’ in a particular direction in order to generate a reported result that best suits the interests of management. The authors emphasise the importance to investors of the statement of cash flows because it is more difficult to ‘mask with financial trickery’ relative to the balance sheet and income statement. The authors of the article also note that if an organisation’s cash flows have decreased, but its profit has risen, this could be grounds to be suspicious that some form of ‘creative accounting’ has been applied, and it could therefore be worth ‘digging a little deeper’ to determine whether profit has actually been manipulated by managers.

In another newspaper article in another leading Australian newspaper (‘Insight comes from 30 minutes clocking value via a study of company reports’ by Nathan Bell, The Age, 14 August 2013), the author argues that the statement of cash flows should be the first financial statement that readers look at. The author also notes that the statement of cash flows is the financial statement that is the ‘hardest for management to manipulate’. Similar warnings were also provided in a newspaper article by Mark Cox in The Australian (entitled ‘What to do?’, 25 August 2010, p. 5) in which investors and other interested stakeholders were warned always to be sceptical of reported profits, given that companies can have substantial leeway in managing these. The advice was to focus upon the cash flows of the company because, while reported earnings can be manipulated, it is generally difficult to legally manipulate underlying cash flows. It was argued that a simple test is to compare cash flows from operating activities (from the statement of cash flows) with reported earnings over time—if cash flows from operating activities is continually much lower than reported earnings, find out why by looking at the ‘reconciliation of profit to cash flows from operating activities’ footnote. Any large figures from ‘esoteric-sounding items’ could be a warning sign.

While the material provided above supposes that the statement of cash flows is less likely to be manipulated than other financial statements, suggesting that any form of financial statement—be it a statement of cash flows or any other financial statement—is never likely to be subject to some form of ‘creative accounting’, or other error or manipulation, is quite naive. The opening balances, and the closing balances, of cash and cash equivalents as provided within the statement of cash flows should reconcile directly with particular amounts shown within the balance sheet, and with amounts that can be externally verified—for example, in an independently prepared bank statement. The reported sources of movements within cash and cash equivalents throughout the period are the amounts that are perhaps more easily manipulated. One highly publicised case of an inappropriately prepared statement of cash flows can be linked to the large international law firm Slater and Gordon. While this firm is often employed to investigate and take action against other organisations for inappropriate behaviour, it was found that an organisation directly related to Slater and Gordon was under government investigation as a result of being associated with reporting a questionable statement of cash flows.

Some of Slater and Gordon’s British operations are undertaken through an organisation known as Quindell. In a newspaper article entitled ‘More to come: warning for Slater and Gordon’ (by Sarah Thompson and reported in The Australian Financial Review, 30 June 2015), it was reported that the company acknowledged that within the statement of cash flows released by Quindell, the cash receipts were inflated, which occurred in conjunction with an inflation of cash payments. This allegedly allowed the organisation to project a view that it was more efficient at converting its amounts owed from customers into cash than was actually the case. The newspaper article noted that if managers manipulate cash receipts, they would also need to manipulate certain cash payments, otherwise the final balance

LO 19.2

dee67382_ch19_769-812.indd 773 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 773

of cash appearing in the statement of cash flows could not be confirmed (by auditors) back to the independently prepared bank statements. The newspaper article noted that it is very unusual to find an ‘accidental mis-statement in cash receipts from customers’ that by coincidence seems to be matched exactly by the same ‘mis-statement in the cash payments’.

Therefore, although the statement of cash flows is developed in a way that is less influenced by professional judgement (relative to accrual accounting), we always need to have a level of healthy scepticism when using information provided to us by managers of an organisation. The appointment of external auditors, whose role it is to provide an opinion on the reliability of the information contained within the financial statements, should provide financial statement readers with greater confidence that the financial statements have been properly prepared. By law, larger organisations, such as public companies, are required to have their financial statements audited by an independent external auditor prior to those financial statements being released to shareholders and other interested stakeholders.

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 Aus20.1 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

Exhibit 19.1 Reconciliation of cash flows from operating activities to operating profit after tax provided by Qantas Ltd in its 2019 Annual Report

SOURCE: Qantas Ltd 2019 Annual Report

dee67382_ch19_769-812.indd 774 10/25/19 11:39 AM

774 PART 5: Accounting for the disclosure of cash flows

flows from operating activities to its profits after tax for the year ended 30 June 2019. 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 operating activities.

19.3 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:

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)

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 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 2019 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.

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

SOURCE: Qantas Ltd 2019 Annual Report

LO 19.3

dee67382_ch19_769-812.indd 775 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 775

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. (AASB 107)

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’?

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.

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. Worked Example 19.1 explores the issue of what is, and what is not, a ‘cash equivalent’.

WORKED EXAMPLE 19.1: Determining the items that would be considered to be ‘cash equivalents’

REQUIRED Which of the following would be considered to be ‘cash equivalents’?

(a) Inventory (b) One-month money market deposit offering a fixed rate of return of 3 per cent (c) Accounts receivable (d) Deposit with a bank that is repayable to the company as soon as the company notifies the bank

SOLUTION As we now know, a ‘cash equivalent’ is a short-term, highly liquid investment that is readily convertible to a known amount of cash, and which is subject to an insignificant risk of change in value. Therefore: (a) Inventory: this does not satisfy the definition of a ‘cash equivalent’ as the inventory is not readily convertible

to cash (it needs to be sold and then the amount owed by a debtor needs to be paid), and there would be a risk that the value of inventory would change.

(b) One-month money market deposit offering a fixed rate of return: this does satisfy the definition of a ‘cash equivalent’ because the organisation would know how much it will receive in cash, and there would be limited chance of non-payment. Also, the time period fits within the 90-day rule identified within the accounting standard, which requires that cash equivalents must have a period to maturity of no more than 90 days.

(c) Accounts receivable: this would not be a cash equivalent as there is always a chance that the debtor might not pay cash, or that the debtor might pay the cash at a time that is beyond what was expected, or the debtor might pay only part of the amount outstanding.

(d) Bank deposit repayable to the company: this satisfies the definition of a ‘cash equivalent’ because the managers of the organisation would know how much the organisation will receive in cash, and there would be limited chance of non-payment.

19.4 Classification of cash flows

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.

operating activities Activities that relate to the provision of goods and services and other activities that are neither investing nor financing activities.

LO 19.4

dee67382_ch19_769-812.indd 776 10/25/19 11:39 AM

776 PART 5: Accounting for the disclosure of cash flows

∙ 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.

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.

We can diagrammatically depict some of the different types of cash flows that relate to the three classifications of activities we have identified; this representation is provided in Figure 19.1.

Figure 19.1 Examples of cash flows that would typically be included in the three classifications of cash flows

Inflows of cash Activities Outflows of cash

Cash receipts from sale of goods and provision of services to customers

Cash payments to suppliers of inventory

Operating activities

Cash payments to employees

Cash receipts in the form of royalties, dividends and

interest on investments

Interest paid

Taxes paid

Cash payments for other expenses relating

to operations Cash receipts from sale of property, plant and

equipment Cash payments relating to acquisition of property,

plant and equipmentCash receipts from sale of intangible assets

Investing activities

Cash payments relating to acquisition of intangible assetsCash receipts from

redemption/collection of loans relating to amounts

advanced to other organisations

Cash payments relating to equity investments in

other organisations

Cash receipts from sale of equity investments in

other organisations

Loans made to other organisations

Cash receipts from issue of shares or other equity

instruments of the organisation

Repayment of borrowed funds

Financing activities Payment of dividends

Cash receipts from loans from other organisations

Cash payments relating to buying back the

organisation’s shares

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.

dee67382_ch19_769-812.indd 777 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 777

19.5 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 operating activities be presented first, followed by cash flows from investing activities, and then by financing activities.

Items representing cash flows from investing and financing activities 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 can be treated as part of operating activity (although there is a choice, which we will discuss later in this chapter). 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

LO 19.5

Exhibit 19.3 Illustration of a statement of cash flows—from Appendix A to AASB 107

SOURCE: www.aasb.gov.au, Appendix A to AASB 107, p.25

dee67382_ch19_769-812.indd 778 10/25/19 11:39 AM

778 PART 5: Accounting for the disclosure of cash flows

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. (AASB 107)

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.

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 operating activities, 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 19.1 provides a sample of the types of items that might give rise to a difference between cash flows from operating activities, 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 operating activities and profits after tax.

Where items in Table 19.1 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.

As an illustration of the reconciliation of net profit to cash flows from operating activities, consider the following, fairly simple, example. As at the beginning of the financial year, Skipp Ltd had the following account balances:

  $

Cash at bank 100

Bank overdraft 20

Accounts receivable 60

Accounts payable 40

Accrued expenses 70

Inventory 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.

dee67382_ch19_769-812.indd 779 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 779

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 given that the opening balance was $50, then $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).

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 operating activities would equal:

Operating activities  

Profit/loss after tax XX

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 

Table 19.1 Adjustments required to reconcile net profit to cash flows from operating activities

Cash flows from operating activities ($) Cash receipts from customers 980

Cash paid to suppliers and employees (260)

Cash paid on other expenses (420)

  300

We can now reconcile net profit to cash flows from operating activities as follows:

Reconciliation of net cash provided by operating activities to net profit ($)

Net profit 330 (Increase) in inventories (30) (Increase) in accounts receivable (20) Increase in accounts payable 40 Decrease in accrued expenses (20) Net cash provided by operating activities 300

dee67382_ch19_769-812.indd 780 10/25/19 11:39 AM

780 PART 5: Accounting for the disclosure of cash flows

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.

19.6 Notes to accompany the statement of cash flows

The statement of cash flows will be accompanied by a number of other notes, which will appear in the notes to the financial statements. We will now consider some of these notes.

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. (AASB 107)

Examples of non-cash financing and investing transactions that should be included in a note supporting the statement of cash flows include:

(a) conversions of liabilities to equity; (b) conversion of preference shares to ordinary shares; (c) acquisitions of entities by means of an equity issue; (d) acquisitions of assets by assumption of directly related liabilities, such as a purchase of a building by incurring

a mortgage to the seller; (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 2019 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 $ nil (2018: $1 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. (AASB 107)

Exhibit 19.4 is a reproduction of the ‘financing facility’ note provided to the 2019 financial statements of BHP.

LO 19.6

dee67382_ch19_769-812.indd 781 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 781

19.7 Calculating cash inflows and outflows

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 operating activities, 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. The following material will help to reinforce our knowledge about the difference between profits derived using accrual accounting, and related cash flows.

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:

LO 19.7

Exhibit 19.4 Note relating to non-cash financing and investing activities of BHP

SOURCE: BHP Group Ltd

Sales Accounts receivable Allowance for doubtful debts

A/c rec. x Op. bal. x Bad debts x A/c rec. x Op. bal. x

    Sales x Allow. d.d. x Clos. bal. x D.d. exp. x

            Discounts x   x   x

            Cash x        

        Clos. bal. 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 19.2.

dee67382_ch19_769-812.indd 782 10/25/19 11:39 AM

782 PART 5: Accounting for the disclosure of cash flows

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. (AASB 107)

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 operating activities. 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

WORKED EXAMPLE 19.2: Calculating cash received from customers

Cottesloe Ltd provides you with the following information:

REQUIRED Determine how much cash was received from customers during the year.

SOLUTION We can use the t-account approach, or the equations approach. Using either method, the amount collected from customers was $567 000. Both of these approaches are shown below. The amounts shown in the t-accounts are in $000s.

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) − $8000 (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

Sales for the year (all on credit terms) $600 000

Discounts provided during the year to customers for early payment $15 000

Doubtful debts expense for the year $10 000

Opening balance of accounts receivable $100 000

Closing balance of accounts receivable $110 000

Opening balance of the allowance for doubtful debts $18 000

Closing balance of the allowance for doubtful debts $20 000

Sales Accounts receivable Allowance for doubtful debts

A/c rec. 600 Op. bal. 100     A/c rec. 8 Op. bal. 18

  Sales 600 Allow. d.d. 8   Clos. bal. 20 D.d. exp. 10

      Discounts 15     28   28

      Cash 567          

          Clos. bal. 110          

    700   700          

dee67382_ch19_769-812.indd 783 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 783

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. (AASB 107)

Later in this chapter we will consider some factors that might influence whether managers include expenses, such as interest expenses, in cash flows from operating activities, or whether they present them elsewhere in the statement of 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.

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 $1 000 000 × 0.6355 = $635 500

Present value of the interest revenue stream $100 000 × 3.0373 = $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 Debentures 939 230  

Cr Cash (to record the purchase of debentures)

  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 Interest receivable 100 000  

Dr Debentures 12 708  

Cr Interest revenue (to recognise interest revenue using the effective-interest method)

  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. x Debentures x

Interest rev. x Cash x

Debentures x Clos. bal. x

x x

dee67382_ch19_769-812.indd 784 10/25/19 11:39 AM

784 PART 5: Accounting for the disclosure of cash flows

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 x Op. bal. x

Cash x Decrease in bonds x

Clos. bal. x Interest expense x

x x

taxable profit The profit for a period determined in accordance with rules established by the taxation authorities, upon which income taxes are payable.

Pre-tax accounting income $100 000

Temporary differences

Increase in prepayments (prepayments are assumed to be deductible for tax purposes) ($20 000)

Increase in provision for long-service leave (increases in the provision are assumed not to be deductible for tax purposes)

$10 000

Taxable income $90 000

Dr Tax expense 30 000  

Dr Deferred tax asset 3 000  

Cr Deferred tax liability   6 000

Cr Income tax payable (to recognise tax expense and related assets and liabilities)

  27 000

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

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. (AASB 107)

With the adoption of tax-effect accounting (which is addressed in Chapter 18), 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 long- service 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). In this example, taxable income would be calculated as:

The accounting entry would be:

dee67382_ch19_769-812.indd 785 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 785

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 6 Op. bal. 0

Cash 0 Tax expense 30

Clos. bal. 27 Deferred tax asset 3

33 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 purchase 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 accounts payable and inventory accounts together.

Accounts payable Inventory

Disc. rev. x Op. bal. x Op. bal. x COGS x

Cash x Inventory x Accounts payable x Stock w/offs x

Clos. bal. x     Clos. bal. x

  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 19.3.

WORKED EXAMPLE 19.3: Calculating cash payments made to suppliers

Bogus Ltd has provided you with the following information:

Cost of goods sold for the year $190 000

Purchases for the year (on credit terms) $220 000

Discounts received for early payment to suppliers $7 000

Stock write-offs owing to water damage caused by global warming $14 000

Opening balance of accounts payable $50 000

Closing balance of accounts payable $60 000

Opening balance of inventory $20 000

Closing balance of inventory $36 000

continued

dee67382_ch19_769-812.indd 786 10/25/19 11:39 AM

786 PART 5: Accounting for the disclosure of cash flows

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).

Effectively, the amount reported for the cash flows from operating activities provides an insight into the ability of an organisation to generate cash flows from its ordinary, day-to-day activities. Such information is important as, in the long run, an organisation cannot rely upon the cash flows from financing activities and investing activities to support its operations. Significant changes in the cash flows from operating activities should be thoroughly investigated, as these cash flows are of vital importance to a business.

As already discussed, cash flows from operating activities will often be higher than the reported profits because of expenses such as depreciation expenses and impairments losses that reduce profits, but which do not involve a cash flow. As we indicated earlier (see Exhibit 19.1), if we look at the cash flow from operating activities of Qantas—which was $2807 million—we see that this is considerably higher than its profit of $891 million.

Organisations that sell goods will purchase inventory and will subsequently have to make the cash payment for that inventory as well as possible costs—perhaps payments to employees—in relation to the conversion of this inventory. They will then sell this inventory, often on credit terms, and then wait to receive the cash from the sale. These activities are all considered to relate to cash flows from operating activities. There can often be a significant time lag between acquiring the inventory from suppliers and receiving the cash from customers from the sale of the inventory.

Organisations will typically seek to minimise the time between when they need to make the payment to suppliers for the inventory and when they receive the cash from the subsequent sale of that inventory. This time period is often referred to as an organisation’s operating cycle, which accounting standards (such as AASB 101/IAS 1) define as ‘the time between the acquisition of assets for processing and their realisation in cash or cash equivalents’. The shorter the organisation’s operating cycle, the less the reliance on other funds, such as borrowings, and therefore the less the related interest expenses of the organisation. Organisations need controls to ensure that the operating cycle is kept as short as possible given the nature of the goods and services. Such controls are often referred to as ‘working capital controls’ (where ‘working capital’ refers to a measure of liquidity and includes cash, inventory, accounts receivable and accounts payable). Organisations that manufacture products will typically have a longer operating cycle than organisations that acquire and then sell finished goods (that is, retailers).

The operating cycle of a retailing organisation is diagrammatically depicted in Figure 19.2.

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 $000s):

Accounts payable Inventory

Disc. rev. 7 Op. bal. 50 Op. bal. 20 COGS 190

Cash 203 Inventory 220 Accounts payable 220 Stock w/offs 14

Clos. bal.  60                   Clos. bal.   36

  270   270   240   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) − $7000 (discounts given by suppliers) + $14 000 (stock write-offs) = $203 000

WORKED EXAMPLE 19.3 continued

dee67382_ch19_769-812.indd 787 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 787

Ideally, an organisation wants to delay paying suppliers for as long as possible, and to receive cash from customers as quickly as possible. In terms of Figure 19.2, managers would want to minimise the length of the time period between when they pay cash to suppliers (Point 3) and when they receive the cash from customers (Point 4). Ideally, the timing would match or, even better, the receipt from customers would come before the supplier needs to be paid—but this is often not possible. In organising the payment of suppliers, care must be taken not to damage the organisation’s reputation. Suppliers might not want to trade with an organisation that is known to unreasonably defer paying its debts.

In terms of delaying payments, strategies include using credit when it is made available by suppliers and not paying suppliers more quickly than is expected, or perhaps—particularly for smaller organisations—using credit cards for acquisitions, thereby receiving the period of time before related cash payments are due. Another strategy would be not to acquire more inventory than is necessary (while being careful not to run out of stock as this can also cause reputational damage for an organisation).

With regard to receiving amounts due from customers as quickly as possible, an organisation must ensure it sends out invoices quickly after the service has been performed or the goods have been delivered, and it must routinely follow up slow payments by sending reminders to customers. Managers might also consider offering customers a discount for early payment.

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).

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 and equipment 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:

Figure 19.2 Simple depiction of the ‘operating cycles’ of a retailing organisation that sells goods on credit terms

4. Receive cash from accounts receivable (customers)

3. Pay cash to accounts payable (suppliers)

1. Buy inventory and recognise accounts payable

2. Sell inventory and recognise accounts receivable

Non-current assets

Op. bal. x Disposal x

Revaluation res. x Accumulated deprec. x

Non-cash trans. x Clos. bal. x

Cash x

x x

dee67382_ch19_769-812.indd 788 10/25/19 11:39 AM

788 PART 5: Accounting for the disclosure of cash flows

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 19.4.

WORKED EXAMPLE 19.4: 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 (to eliminate existing accumulated depreciation in existence at time of revaluation)

30 000

Dr Plant and equipment 50 000  

Cr Gain on revaluation (part of OCI) (to revalue the plant and equipment to $150 000 with the gain being recognised within other comprehensive income)

50 000

As explained in Chapter 18, where there is an asset revaluation, the gain is to be recognised as part of other comprehensive income (and not as part of profit or loss). When there is a 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 Income tax expense (OCI) 15 000

Cr Deferred tax liability (to recognise the tax effect of the revaluation: 15 000 = 50 000 × 0.30)

15 000

At the end of the accounting period we would then transfer the net gain to the revaluation surplus account, which is part of equity. The entry would be:

Dr Gain on revaluation (OCI)  50 000

Cr Income tax expense (OCI) 15 000

Cr Revaluation surplus (to transfer the net gain on revaluation to equity at the end of the period)

35 000

dee67382_ch19_769-812.indd 789 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 789

financial structure Refers to how the resources of the entity have been funded, for example, how much debt there is relative to equity. Financial structure information can also describe the types of debt and types of equity in existence.

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:

Plant and equipment

Op. bal. 800 Disposal 130

Gain on revaluation 50 Accumulated deprec. 30

Non-cash trans. 60 Clos. bal. 780

Cash 30  

  940   940

Cash flows from financing activities The third category of cash flows that needs to be presented (other than cash flows from operating activities and cash flows from investing activities) are cash flows from financing activities. Financing activities relate to changing the size and composition of the financial structure of the entity, including equity and borrowings not falling within the definition of cash.

For many types of debt, it might be easy to determine the cash inflow. It might simply be the difference between the opening and closing liability. For items such as debentures (or bonds, as they are also called), however, we might need to consider whether financial assets were issued or acquired at a discount or premium to their ‘face value’. For example, assume that an entity raises funds by issuing debentures with a life of four years and a face value of $1 million (the ‘face value’ is 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 Interest expense 112 707

Cr Cash 100 000

Cr Debenture liability 12 707

(to recognise interest expense on debentures)

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 operating activities.

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

A final point to be made before considering the comprehensive illustration in Worked Example 19.5 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.

dee67382_ch19_769-812.indd 790 10/25/19 11:39 AM

790 PART 5: Accounting for the disclosure of cash flows

WORKED EXAMPLE 19.5: 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 2023

  2022 ($000)

2023 ($000)

Income    

Sales   700   885

Expenses        

Cost of goods sold 200   240  

Depreciation—buildings 20   20  

Depreciation—plant 60   70  

Doubtful debts 30   40  

Electricity and rates 20   45  

Income tax 76   84  

Interest expense 10   11  

Lease rentals 40   70  

Salaries 160 616 200 780

Net profit   84   105

Other comprehensive income:

Gain on revaluation (net of tax)   – 30

Total comprehensive income 84   135

Cashco Ltd Statement of financial position as at 30 June 2023

  2022

($000) 2023

($000)

Current assets    

Cash 176 239

Accounts receivable 220 280

Allowance for doubtful debts (30) (40)

Inventory    90 100

  456 579

Non-current assets    

Land 100 250

Buildings 400 400

Acc. depreciation—buildings (40) (60)

Plant and equipment 400 420

Acc. depreciation—P & E (40) (40)

Deferred tax asset         –         4

  820      974

Total assets 1 276 1 553

dee67382_ch19_769-812.indd 791 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 791

Current liabilities    

Accounts payable 80 70

Accrued expenses 10 20

Income tax payable        76       88

      166     178

Non-current liabilities    

Long-term loans 100 110

Deferred tax liability        –       20

     100     130

Shareholders’ funds    

Share capital 400 500

Revaluation surplus – 30

Retained earnings     610     715

  1 010 1 245

Total liabilities and shareholders’ funds 1 276 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 2023.

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 Accounts receivable 885 000  

Cr Sales (aggregated entry to recognise credit sales for the period)

  885 000

The entry to record the doubtful debts expense would be:

Dr Doubtful debts expense 40 000  

Cr Allowance for doubtful debts (to recognise doubtful debts for the period)

  40 000

continued

dee67382_ch19_769-812.indd 792 10/25/19 11:39 AM

792 PART 5: Accounting for the disclosure of cash flows

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:

Accounts receivable Allowance for doubtful debts

Op. bal. 220 Allow. d.d. 30 A/c rec. 30 Op. bal. 30

Sales 885 Cash 795        

  Clos. bal. 280 Clos. bal. 40 D.d exp. 40

  1105   1105   70   70

Alternatively, we can determine the cash flow as:

Cash flow = Sales + Opening accounts receivable − Transfer from allowance for doubtful 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 Accounts payable

Op. bal. 90 COGS 240 Cash 260 Op. bal. 80

Accounts payable

250 Clos. bal. 100 Clos. bal.   70 Inventory 250

  340   340   330   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.

Accrued expenses

Cash 260 Op. bal. 10

Clos. bal.   20 Sal. & leases 270

  280   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

WORKED EXAMPLE 19.5 continued

dee67382_ch19_769-812.indd 793 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 793

(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 Income tax expense 84 000  

Dr Deferred tax asset 4 000  

Cr Income tax payable (to recognise tax expense and related assets and liabilities)

88 000

A reconciliation of income taxes payable would show:

Income tax payable

Cash 76 Op. bal. 76

Clos. bal.   88 Tax/DTA   88

  164   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 operating activities as:

  $000

Receipts from customers 795

Payments to suppliers (260)

Payments for accrued expenses (260)

Interest payments (11)

Electricity and rates (45)

Taxation payments (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 Land 50 000  

Cr Gain on revaluation (OCI) (recognition of revaluation of land)

  50 000

Dr Income tax expense (OCI) 20 000  

Cr Deferred tax liability (recognition of the tax consequences of the revaluation)

  20 000

Dr Gain on revaluation (OCI)  50 000

Cr Income tax expense (OCI)   20 000

Cr Revaluation surplus   30 000

(to transfer the net gain on revaluation to equity at the end of the period)

continued

dee67382_ch19_769-812.indd 794 10/25/19 11:39 AM

794 PART 5: Accounting for the disclosure of cash flows

Dr Land 100 000  

Cr Share capital (acquisition of land by means of a share issue)

  100 000

Land

Op. bal. 100     Share capital 100     Gain on revaluation   50 Clos. bal. 250   250   250

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 Acc. depreciation—plant and equipment 70 000   Dr Cash 30 000   Cr Plant and equipment

(to record the disposal of plant and equipment)   100 000

As plant and equipment increases by $20 000, $120 000 must have been acquired during the period, as reconciled below.

Accumulated depreciation Plant and equipment

Disposal 70 Op. bal. 40 Op. bal. 400 Disposal 100 Clos. bal.   40 Deprec. exp.   70 Cash 120 Clos. bal. 420   110   110   520   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 (120)

Proceeds from sale of equipment      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 176

Cash from operations 143

Cash from investing (90)

Cash from financing   10

Closing cash balance 239

WORKED EXAMPLE 19.5 continued

dee67382_ch19_769-812.indd 795 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 795

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 2023

$000

Cash flows from operating activities

Receipts from customers 795

Payments to suppliers of goods and services, inclusive of labour (565)

Interest paid (11)

Income taxes paid (76)

Net cash provided from operating activities(1) 143

Cash flows from investing activities

Payment for property, plant and equipment(2) (120)

Proceeds from sale of plant     30

Net cash used in investing activities    (90)

Cash flows from financing activities

Proceeds from borrowings     10

Net cash from financing activities     10

Net increase in cash held 63

Cash at the beginning of the financial year 176

Cash at the end of the financial year 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 105

Depreciation 90

Increase in allowance for doubtful debts 10

Increase in income taxes payable 12

Increase in accounts receivable (60)

Increase in inventories (10)

Decrease in accounts payable (10)

Increase in accrued expenses 10

Increase in deferred tax asset    (4)

Net cash provided from operating activities 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.

Worked Example 19.6 provides a further example of the preparation of a statement of cash flows.

dee67382_ch19_769-812.indd 796 10/25/19 11:39 AM

796 PART 5: Accounting for the disclosure of cash flows

WORKED EXAMPLE 19.6: Comprehensive exercise—preparation of a statement of cash flows

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 2023 and 30 June 2024 are presented below.

2024 ($000)

2023 ($000)

Assets

Cash 480 –

Accounts receivable 180 300

Allowance for doubtful debts (60) (40)

Property, plant and equipment 780 600

Acc. depreciation—property, plant and equipment (180) (100)

Inventory   460 260

Total assets 1 660 1 020

Liabilities

Bank overdraft – 200

Accounts payable 300 300

Accrued wages 100 80

Provision for annual leave 40 60

Loans   300 –

Total liabilities 740    640

Net assets 920    380

Represented by:

Shareholders’ funds

Share capital 700 100

Revaluation surplus 140 40

Retained earnings     80 240

Total shareholders’ funds 920 380

The expenses and revenues of Crescent Ltd for the year ending 30 June 2024 are:

2024 ($000)

Revenues

Sales 300

Interest (no interest receivable at year end) 20

Gain on sale of property (which had a carrying amount of $100 000) 40

Expenses

Cost of goods sold (200)

Doubtful debts (40)

Depreciation (100)

Wages (100)

Employee entitlements—annual leave   (80)

dee67382_ch19_769-812.indd 797 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 797

Net loss for the year (160)

Other comprehensive income Gain on revaluation of property, plant and equipment 100

Total comprehensive income (60)

REQUIRED Prepare a statement of cash flows for Crescent Ltd for the year ending 30 June 2024. For the purposes of this exercise, taxation is ignored.

SOLUTION (a) Cash flows from operating activities (i) Cash receipts from customers

Accounts receivable

Op. bal. 300 Cash 400 Sales 300 Allow. for d.d. 20           Clos. bal. 180   600   600

Allowance for doubtful debts

Accounts receivable 20 Op. bal. 40 Clos. bal.   60 Expense   40   80   80

(ii) Cash payments for inventory

Inventory

Op. bal. 260 Cost of goods sold 200 Accounts payable 400 Clos. bal. 460   660   660

Accounts payable

Cash 400 Op. bal. 300 Clos. bal. 300 Inventory 400   700   700

(iii) Expense provisions/accrued expenses

Accrued wages

Cash 80 Op. bal. 80

Clos. bal. 100 Wages 100

  180   180

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 ($000)

From customers 400

Payments to employees (80 + 100) (180)

continued

dee67382_ch19_769-812.indd 798 10/25/19 11:39 AM

798 PART 5: Accounting for the disclosure of cash flows

Payments to suppliers (400)

Interest received     20

  (160)

(b) Cash flows from investing activities

Accumulated depreciation

Disposal 20 Opening bal. 100

Clos. bal. 180 Expense 100

  200   200

Property, plant and equipment

Op. bal. 600 Disposal 120

Revaluation reserve 100 Clos. bal. 780

Cash 200  

  900   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 $000

From sale of plant 140

Acquisition of plant (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 year ending 30 June 2024    

  $000 $000

Cash flows from operating activities    

Receipts from customers 400  

Payments to suppliers (400)  

Payments to employees (180)  

Interest received     20  

Net cash provided by operating activities(1)   (160)

Cash flows from investing activities    

Proceeds from sale of plant 140  

Acquisition of plant (200)  

Net cash from investing activities   (60)

WORKED EXAMPLE 19.6 continued

dee67382_ch19_769-812.indd 799 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 799

LO 19.8

Cash flows from financing activities    

Proceeds from share issue 600  

Proceeds from borrowings 300  

Net cash from financing activities   900

Net increase in cash held   680

Cash at the beginning of the year(2)   (200)

Cash at the end of the year   480

A number of supporting notes are required.

Note 1. Reconciliation of net cash provided by operating activities and net profit

  $000 $000

Operating profit after tax   (160)

Add/(subtract):    

Depreciation expense 100  

Decrease in receivables 120  

Profit on sale of property, plant and equipment (40)  

Increase in inventories (200)  

Decrease in annual leave provision (20)  

Increase in accrued expenses 20  

Increase in allowance for doubtful debts 20      0

Cash flows from operating activities   (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:

  2024

($000) 2023

($000)

Cash per statement of financial position 480 —

Bank overdraft per statement of financial position    — (200)

Cash at year end per statement of cash flows 480 (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.

19.8 The use of cash flow data by different stakeholders and within various contractual arrangements

Cash flows from operating activities (CFOA) would seem to provide a useful guide to the ability of a firm to service its debt obligations, 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 negotiated with providers of debt capital could require the net cash provided by operating activities to exceed total interest obligations by a specified number of times

dee67382_ch19_769-812.indd 800 10/25/19 11:39 AM

800 PART 5: Accounting for the disclosure of cash flows

(indeed, it is becoming more common to find such a requirement within debt contracts). 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, which is 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 CFOA divided by current debt might be a more appropriate measure of short-term liquidity. Sharma also proposes that retained cash flows from operating activities (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 capacity and its investment power without relying on borrowed funds or the sale of assets  .  .  .  Retained cash flows from operating activities 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, D., ‘Analysing the Statement of Cash Flows’, Australian Accounting Review, vol. 6, no. 2, p 40 (c) 1996. Reproduced with permission of John Wiley & Sons Ltd.)

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. (SHARMA, D., (1996). Reproduced with permission of John Wiley & Sons Ltd.)

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 CFOA 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, CFOA 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.

Recent evidence does show that information—such as CFOA—is being increasingly used within contracts negotiated by organisations. For example, Akono and Nwaeze (2018) offer evidence that, increasingly, senior managers are being provided with rewards (bonuses) that are directly tied to measures associated with CFOA. Further, they provide evidence that the more important management of working capital (which refers to managing such aspects of performance as accounts receivable turnover, inventory turnover and accounts payable turnover) is to a firm, the more likely that CFOA will be included within a senior executive bonus plan. In part, bonus plans incorporate this measure because of the inability of measures such as ‘profits’ to capture important managerial actions in the area of working capital management. Measures such as CFOA are considered better able to reflect the efficiency with which working capital is being internally managed.

As we noted earlier in this chapter, preparers of general purpose financial statements have a presentation choice in AASB 107 between including interest expenses within CFOA, or perhaps as part of the cash flows from financing activities. (While this choice is available within IFRSs, it is not available to US organisations, which are required to comply with accounting standards issued by the US Financial Accounting Standards Board. In the US, interest expenses shall be included with CFOA.)

As we also noted earlier in this chapter, CFOA is an important measure of performance, which many stakeholders, such as capital market analysts, specifically review when making decisions about an organisation. If an organisation

dee67382_ch19_769-812.indd 801 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 801

chooses not to include interest expense in CFOA activities, then it can effectively inflate its reported CFOA (Mulford & Comiskey 2005). Mulford and Comiskey (2005) emphasise that strong CFOA reflects an organisation’s sustainable and strong cash-generating capability, and captures an important measure of financial performance. They also emphasise—consistent with what we argued earlier in this chapter—that even though the closing balance of cash and cash equivalents is difficult to manipulate, the balances from operating, investing and financing activities are more susceptible to manipulation. Indeed, they provide an argument that there can be many incentives to positively manipulate cash flows from operating activities. Consistent with Mulford and Comiskey (2005), Lee (2012) provides evidence that firms do tend to manipulate CFOA by shifting items between the categories of cash flows, and also by timing transactions that can boost reported CFOA, such as delaying payments to creditors or accelerating collections from debtors.

Charitou, Karamanou and Kopita (2018) provide evidence that some organisations tend to present interest expense opportunistically with the statement of cash flows. While there is an abundance of proof that most organisations present interest expenses as part of CFOA, the authors offer evidence that firms that are reporting losses, and which have greater levels of debt, are less likely to disclose interest expense as part of CFOA. Rather, they tend to opportunistically disclose it as part of cash flows from financing activities, thereby inflating CFOA. The authors argue that as levels of debt get higher, this would reflect, on average, a greater likelihood of violating a contractual obligation with debtholders, and therefore greater increases in debt should—all things being equal—be positively related to the probability of not including interest paid in CFOA.

Charitou, Karamanou and Kopita (2018) also provide evidence that, increasingly, lending agreements include a debt covenant that is ‘debt to cash flows from operations’ (also referred to as the debt coverage ratio). By not treating interest expense as part of CFOA (thereby inflating CFOA), this can potentially help an organisation comply with contractual requirements that use CFOA.

Further, the authors supply evidence that firms that would otherwise not meet, or beat, analysts’ cash flow forecasts are more likely not to include interest expense as part of CFOA. They do this on the basis that firms beating analyst forecasts are positively favoured by the capital market. Therefore, organisations are perceived to opportunistically make the presentation choice because it can impact both investor and creditor perceptions without altering the final reported cash balance.

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.

dee67382_ch19_769-812.indd 802 10/25/19 11:39 AM

802 PART 5: Accounting for the disclosure of cash flows

When financial statements are presented to financial statement users, it is possible that cash flows from operating activities 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 operating activities. 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).

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.

KEY TERMS

accrual accounting 771 accrual profits/losses 771 financial structure 789

financing activities 776 investing activities 776 operating activities 775

statement of cash flows 771 taxable profit 784

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following four questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is the role of the statement of cash flows? LO 19.1 The statement of cash flows 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 three classifications of cash flows, these being cash flows from operating activities, cash flows from investing activities and cash flows from financing activities. The information provided in a statement of cash flows may assist different stakeholders to assess the ability of an organisation to: 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.

2. The statement of cash flows provides information about movements in ‘cash’ and ‘cash equivalents’. What do we mean by ‘cash equivalents’? LO 19.3 ‘Cash equivalents’ are 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’.

3. The statement of cash flows separates the total cash flows of a reporting entity into three classifications of cash flows. What are these three classifications? LO 19.4 The three classifications of cash flows are cash flows from operating activities, cash flows from investing activities and cash flows from financing activities.

4. Would the cash flows from operating activities be greater if the balance of accounts receivable increases, or decreases, across the reporting period? LO 19.7 If closing accounts receivable decreases relative to opening accounts receivable, and this decrease has not occurred because of the recognition of doubtful or bad debts, this means that the reduction in the debtors’ balance has occurred because the debtors have paid an amount during the accounting period that is greater than the sales that were made on credit terms during the accounting period. Therefore, cash flows from operating activities will be greater if accounts receivable decrease, relative to if they increase.

dee67382_ch19_769-812.indd 803 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 803

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

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, 19.4 •

2. Classify the following cash flows into the respective classifications of operating, financing or investing activity: (a) dividends received (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 19.4 • 3. Define ‘cash and cash equivalents’ for the purposes of a statement of cash flows. LO 19.3 • 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 19.3 • 5. Is cash-flow data more ‘reliable’ than profit-related data? Explain your answer. LO 19.1, 19.2 • 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, 19.2 •• 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, 19.2 •• 8. Why is a reconciliation of the profit for a year to the cash flows from operating activities often provided within the

notes that accompany an organisation’s financial statements? Why is it useful? LO 19.2, 19.6 •• 9. How is depreciation expense reported within the statement of cash flows? LO 19.2 • 10. Why is it often considered that the statement of cash flows is more difficult for managers and their accountants to

manipulate in comparison to information that is reported in the income statement and the balance sheet? LO 19.1, 19.2 •• 11. If the closing balance of accounts receivable is greater than the opening balance, will cash flows from customers be

greater or less than the reported sales revenue? LO 19.7 •• 12. An organisation might have generated significant profits for the past five years but nevertheless continue to report

negative cash flows from operations. How is this possible? LO 19.2 •• 13. The sales for an organisation within an accounting period were $340 000, opening accounts receivable was

$40 000, and closing accounts receivable was $15 000. There were no doubtful debts expenses for the period. All sales are made on credit terms, meaning there were no cash sales. How much cash was actually received from customers within the accounting period? LO 19.7 •

14. Sunshine Beach Ltd started the accounting period with a liability for accrued wages of $50 000. Wages expense for the year was $780 000 and the closing balance of accrued wages was $65 000. How much cash was paid to employees? LO 19.7 •

15. 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 19.6, 19.7 •

dee67382_ch19_769-812.indd 804 10/25/19 11:39 AM

804 PART 5: Accounting for the disclosure of cash flows

16. Pursuant to AASB 107, apart from the statement of cash flows, what other disclosures must be made? LO 19.7 • 17. Fremantle Ltd provides you with the following information:

Sales for the year $400 000

Discounts provided during the year to customers for early payment $10 000

Doubtful debts expense for the year $5 000

Opening balance of accounts receivable $90 000

Closing balance of accounts receivable $80 000

Opening balance of the allowance for doubtful debts $9 000

Closing balance of the allowance for doubtful debts $8 000

REQUIRED Determine how much cash has been received from customers during the year. LO 19.7 •

18. Rottnest Ltd has provided you with the following information:

Cost of goods sold for the year $60 000

Purchases for the year (on credit terms) $80 000

Discounts received for early payment to suppliers $2 000

Stock write-offs owing to water damage caused by melting ice in the Antarctic $5 000

Opening balance of accounts payable $40 000

Closing balance of accounts payable $35 000

Opening balance of inventory $10 000

Closing balance of inventory $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 19.7 •

19. Margaret River Ltd provides you with the following information about its property, plant and equipment:

Opening balance of property, plant and equipment $500 000

Closing balance of property, plant and equipment $650 000

Depreciation expense for the year $50 000

Opening balance of accumulated depreciation $200 000

Closing balance of accumulated depreciation $210 000

Gain on sale of property, plant and equipment $20 000

Carrying amount of property, plant and equipment that has been disposed of $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 19.7 ••

20. The balances in the accounts of XYZ at 30 June 2023 and 30 June 2024 are:

  2024

($000) 2023

($000)

Sales (all on credit) 250 350

Cost of goods sold 130 110

Doubtful debts expense 25 30

Interest expense 20 30

Salaries 30 25

dee67382_ch19_769-812.indd 805 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 805

Depreciation 10 15

Cash 144 139

Inventory 180 160

Accounts receivable 270 250

Allowance for doubtful debts 30 35

Land 150 150

Plant 100 90

Accumulated depreciation 20 30

Bank overdraft 20 19

Accounts payable 200 190

Accrued salaries 22 18

Long-term loan 90 70

Share capital 120 100

Opening retained earnings 307 187

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.

REQUIRED Prepare a statement of cash flows for XYZ Ltd for the year ending 30 June 2024. LO 19.4, 19.5, 19.7 ••

CHALLENGING QUESTIONS

21. Following are extracts from the accounting records of S Ltd at 30 June 2024:

S Ltd Statement of financial position as at 30 June 2024

  2024

($000) 2023

($000)

Current assets    

Cash 574 422

Inventory 240 216

Accounts receivable 672 528

Allowance for doubtful debts     (96)      (72)

  1 390 1 094

Non-current assets    

Land 600 240

Buildings 960 960

Accumulated depreciation—buildings (144) (96)

Plant and equipment 1 008 960

Accumulated depreciation—plant and equipment (96) (96)

Deferred tax asset       10         —

  2 338 1 968

Total assets 3 728 3 062

dee67382_ch19_769-812.indd 806 10/25/19 11:39 AM

806 PART 5: Accounting for the disclosure of cash flows

Current liabilities    

Accounts payable 168 192

Accrued expenses 30 24

Income tax payable     218     182

      416    398

Non-current liabilities    

Long-term loans 264 240

Deferred tax liability      48        —

      312    240

Shareholders’ funds    

Share capital 1 200 960

Retained earnings 1 728 1 464

Revaluation surplus      72        —

  3 000 2 424

Total liabilities and shareholders’ funds 3 728 3 062

S Ltd Statement of profit or loss and other comprehensive income for the year ending 30 June 2024

  2024

($000) 2023

($000)

Income

Sales 2 124 1 680

Expenses

Cost of sales 576 480

Doubtful debts 96 72

Depreciation

– Buildings 48 48

– Plant and equipment 168 144

Interest 26 24

Lease rental 168 96

Rates and electricity 90 48

Salaries 480 384

Income tax   208    182

1860 1 478

Net profit 264 202

Other comprehensive income:

Asset revaluation recognised in revaluation surplus      72       –

Total comprehensive income    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.

dee67382_ch19_769-812.indd 807 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 807

• 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 2024, in accordance with AASB 107 (comparative figures are not required). LO 19.4, 19.5, 19.6, 19.7

22. T Pty Ltd is a manufacturer of tennis equipment and fashion wear. The statement of financial position as at 30 June 2024 and details of expenses and revenues for the year ending 30 June 2024 are as follows:

Statement of financial position as at 30 June 2024

2024 ($000)

2023 ($000)

Current assets    

Cash 135 274

Inventory 2 774 2 486

Prepayments 115 0

Accounts receivable 2 897 2 654

Allowance for doubtful debts (150)   (120)

Total current assets 5 771 5 294

Non-current assets    

Investment—associated company 1 050 0

Investments 1 216 948

Land 1 500 1 750

Buildings 800 800

Accumulated depreciation—buildings (200) (160)

Plant and equipment 1 025 768

Accumulated depreciation—plant and equipment (100) (548)

Deferred tax asset     312 302

Total non-current assets 5 603 3 860

Total assets 11 374 9 154

Current liabilities    

Accounts payable 1 637 1 483

Accruals 1 575 1 110

Lease liability 5 0

Income tax payable 243 83

Provision for employee entitlements 205 298

Provision for deferred payment (relating to    

dee67382_ch19_769-812.indd 808 10/25/19 11:39 AM

808 PART 5: Accounting for the disclosure of cash flows

investment in Squash Pty Ltd) 50 0

Provision for warranty    314        0

Total current liabilities 4 029 2 974

Non-current liabilities    

Lease liability 15 0

Deferred tax liability 240 75

Borrowings 3 500 3 800

Total non-current liabilities 3 755 3 875

Total liabilities 7 784 6 849

Net assets 3 590 2 305

Shareholders’ equity    

Share capital 2 750 2 000

Retained earnings 280 130

Revaluation surplus    560    175

Total shareholders’ equity 3 590 2 305

Statement of profit or loss and other comprehensive income for the year ending 30 June 2024

2024 ($000)

2023 ($000)

Income    

Sales 31 394 27 346

Dividends income        51        47

Expenses    

Bad debts (90) (85)

Cost of sales (28 205) (24 611)

Doubtful debts (35) (40)

Inventory write-off (50) 0

Warranty expenses (taken to provision for warranty) (314) 0

Depreciation    

– Buildings (40) (40)

– Plant and equipment (100) (60)

Interest (315) (418)

Rent (600) (600)

Salaries and wages (1 324) (1 231)

Finance charges        (7)     (90)

Profit before tax 365 218

Income tax  (215)     (90)

Profit after tax 150 128

Other comprehensive income

Reduction in revaluation surplus as a result of reduction in fair value of land (175) –

Increase in revaluation surplus as a result of increase in fair value of plant and equipment 560    –

Total comprehensive income 535 128

dee67382_ch19_769-812.indd 809 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 809

Statement of changes in equity for the year ending 30 June 2024

 

Share capital ($000)

Retained earnings

($000)

Revaluation surplus ($000)

Total ($000)

Opening balance 1 July 2023 2 000 130 175 2 305

Statement of profit or loss and other comprehensive income

– 150 385 535

Issue of shares as part consideration for acquisition of associated company

    750      –      –     750

Balance 30 June 2024 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 2024. Comparatives are not required. LO 19.4, 19.5, 19.6, 19.7

23. Cabarita Ltd is involved in manufacturing swimming pool accessories. Cabarita Ltd’s statements of financial position for the years ending 30 June 2023 and 30 June 2024 are presented below.

  2024

($000) 2023

($000)

Assets    

Cash 96 –

Accounts receivable 36 60

Allowance for doubtful debts (12) (8)

Property, plant and equipment 156 120

Accumulated depreciation—property, plant and equipment (36) (20)

Inventory   92   52

Total assets 332 204

Liabilities    

Bank overdraft – 40

Accounts payable 60 60

Accrued wages 20 16

dee67382_ch19_769-812.indd 810 10/25/19 11:39 AM

810 PART 5: Accounting for the disclosure of cash flows

Provision for annual leave 8 12

Loans 60    –

Total liabilities 148 128

Net assets 184 76

Represented by:    

Shareholders’ funds    

Share capital (ordinary shares) 140 20

Revaluation surplus 28 8

Retained earnings   16    48

Total shareholders’ funds 184 76

Cabarita Ltd Statement of profit or loss of profit or loss and other comprehensive income (extract) of Cabarita Ltd for the year ending 30 June 2024:

  2024

($000)

Income  

Sales 60

Interest (no interest receivable at year end) 4

Profit on sale of property (which had a carrying amount of $20 000) 8

Expenses  

Cost of goods sold (40)

Doubtful debts (8)

Depreciation (20)

Wages (20)

Employee entitlements  (16)

Loss for the year (32)

Other comprehensive income:

Increase in revaluation surplus in recognition of increase in fair value of property, plant and equipment

20

Total comprehensive income/(loss) (12)

REQUIRED Prepare a statement of cash flows for Cabarita Ltd for the year ending 30 June 2024. Comparatives are not required. Ignore tax effects. LO 19.4, 19.5, 19.6, 19.7

24. In a newspaper article written by Carol Altmann and entitled ‘Cooking the books the Harris Scarfe way’ (The Australian, 7 August 2001, p. 1), the author discussed the collapse of the company known as Harris Scarfe. Specific commentary was given to how the senior accountant utilised ‘creative accounting’ to provide managers with profit figures that matched what they wanted to report even though the figures bore little relationship to the actual transactions and events. It was alleged that the company overstated its profits and had done so for a number of accounting periods. In this respect: (a) What does ‘creative accounting’ mean? (b) How would a reader of financial statements know if the books had been manipulated by ‘creative accounting’? (c) Is it likely that creative accounting was employed in relation to the statement of cash flows? Why or why not?

LO 19.1, 19.8

dee67382_ch19_769-812.indd 811 10/25/19 11:39 AM

CHAPTER 19: The statement of cash flows 811

25. What might motivate an organisation to present interest expense as part of cash flows from financing activities, rather than as part of operating activities? LO 19.8

26. In a newspaper article of 6 August 2018 entitled ‘FAANGs have lost their bite’, by Libby Koch and David Koch (in The Advertiser), it was stated that profit is an accounting number that managers can manipulate to suit management’s own interests. By contrast, the statement of cash flows is harder to mask with ‘financial trickery’ and therefore is more credible. What is the basis of this view, and do you agree with it? LO 19.2, 19.8

27. If cash flows from operations as reported by an organisation were, for the past five years, well above reported profits, would this be an issue of concern? LO 19.2, 19.8

REFERENCES Akona, H. & Nwaeze, E., 2018, ‘Why and How Firms Use Operating

Cash Flow in Compensation’, Accounting and Business Research, vol. 48, no. 4, pp. 400–26.

Charitou, A., Karamanou, I. & Kopita, A., 2018, ‘The Determinants and Valuation Effects of Classification Choice on the Statement of Cash Flows’, Accounting and Business Research, vol. 48, no. 6, pp. 613–50.

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.

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, L., 2012, ‘Incentives to Inflate Reported Cash from Operations Using Classification and Timing’, The Accounting Review, vol. 87, pp. 1–33.

Lee, T.A., 1981, ‘Reporting Cash Flows and Net Realisable Values’, Accounting and Business Research, Spring, pp. 163–70.

Mulford, C. & Comiskey, E., 2005, Creative cash flow reporting: Uncovering sustainable financial performance, John Wiley & Sons, Hoboken, NJ.

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.

dee67382_ch19_769-812.indd 812 10/25/19 11:39 AM

dee67382_ch20_813-852.indd 813 10/18/19 08:23 PM

CHAPTER 20 Accounting for the extractive industries

PART 6 Industry-specific

accounting issues

dee67382_ch20_813-852.indd 814 10/18/19 08:23 PM

814

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 20.1 Understand what constitutes the ‘extractive industries’, the various phases of operations of

entities involved in the extractive industries, and be aware that the extractive industries pose some unique accounting issues.

20.2 Understand the potential ways to account for exploration and evaluation expenditures, and specifically understand how to apply the ‘area-of-interest method’ as prescribed by AASB 6 Exploration for and Evaluation of Mineral Resources.

20.3 Know the required basis of measurement for exploration and evaluation expenditure. 20.4 Be able to provide the journal entries necessary for the amortisation and impairment of capitalised

exploration and evaluation expenditure. 20.5 Understand how and when to account for any restoration costs that might be incurred as a result of an

entity’s operations. 20.6 Understand issues associated with the recognition of revenue in the extractive industries. 20.7 Understand how to value inventory within the extractive industries. 20.8 Be aware of the disclosure requirements of AASB 6. 20.9 Be able to evaluate the relevance of the amount attributed in the balance sheet to mineral reserves. 20.10 Be aware of research explaining why entities elect to adopt particular methods to account for

exploration and evaluation expenditures. 20.11 Be aware that entities in the extractive industries will also make non-financial disclosures in relation to

such matters as their social and environmental performance. 20.12 Be aware of activities that have been undertaken towards developing a new accounting standard for

the extractive industries.

C H A P T E R 20 Accounting for the extractive industries

dee67382_ch20_813-852.indd 815 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 815

20.1 Overview of the extractive industries, and introductory comments about accounting for exploration and evaluation expenditures

In this chapter we focus on aspects of accounting as they relate to the extractive industries. According to the IASB (2010), extractive industries are those industries involved in exploring for and finding minerals, oil and natural gas deposits, developing those deposits and extracting the minerals, oil and natural gas. These resources would generally be considered to be non-renewable (or non-replaceable). For example, when energy is generated through the use of oil, coal or gas, that energy is generated through the consumption of non-renewable sources (with consequences in terms of various carbon-related emissions), whereas energy generated through sources such as solar, wind or hydro power is considered to come from renewable sources. As a result of global concerns about climate change, organisations involved in the search for, and extraction of, sources of energy such as coal and oil are likely to find the demand for their output somewhat curtailed in future years.

According to the website of the Minerals Council of Australia (MCA, see minerals.org.au), Australia has the world’s largest supply of economically recoverable reserves of mineral sands, brown coal, uranium, nickel, zinc and lead and ranks in the world’s top six for bauxite, black coal, copper, gold, iron ore and industrial diamonds. The export earnings of the minerals industry account for approximately half of all of Australia’s total exports of goods and services. In this regard, the website of the MCA states (as accessed October 2019):

Australia’s exports of goods and services surpassed $400 billion for the first time in 2017–18, due mainly to growth in resources exports which accounted for 55 per cent of total exports.

Resources exports—including minerals, metals, coal and petroleum—were a record high $220 billion in 2017– 18, up 11 per cent from the previous year due to rising exports of coal, gold, base metals and LNG.

Therefore, within the Australian context, the extractive industries appear very significant from an economic perspective. Hence, there will be many stakeholders with an interest in the reports being generated by entities in the extractive industries.

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What are the ‘extractive industries’? LO 20.1 2. What are the five broad phases of activities undertaken by organisations within the extractive industries?

LO 20.1 3. When can the costs incurred in the exploration and evaluation phases of operations be carried forward as

assets? LO 20.2, 20.3 4. Organisations within the extractive industries will ultimately generate inventory. Will the ‘costs of inventory’

include costs that were incurred in the initial exploration and evaluation phases of operations? LO 20.4, 20.7 5. Mining operations will typically create various forms of damage to the natural environment, and that

environment will need to be restored/rehabilitated at the cessation of the mining activities. When should the costs associated with the future restoration/rehabilitation be recognised by an entity? LO 20.5

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

6 Exploration for and Evaluation of Mineral Resources IFRS 6

15 Revenue from Contracts with Customers IFRS 15

102 Inventories IAS 2

108 Accounting Policies, Changes in Accounting Estimates and Errors IAS 8

116 Property, Plant and Equipment IAS 16

136 Impairment of Assets IAS 36

137 Provisions, Contingent Liabilities and Contingent Assets IAS 37

138 Intangible Assets IAS 38

LO 20.1

dee67382_ch20_813-852.indd 816 10/18/19 08:23 PM

816 PART 6: Industry-specific accounting issues

Until 2005, the relevant accounting standard in Australia for reporting entities 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 usefully 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 is 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,

prepared by the IASB, AASB 6 Exploration for and Evaluation of Mineral Resources, 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. (AASB 6)

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.

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.

In terms of the scope of AASB 6, paragraph 5 of AASB 6 states: 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)

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

dee67382_ch20_813-852.indd 817 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 817

industries was released in 2010 by the IASB, a review of the IASB website indicates that the project has been put on hold and no specific reactivation date has been nominated. 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 was undertaken as part of the process of developing a new accounting standard.

As we know, 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 cases exploration is unsuccessful and does not lead to future economic benefits, when an area is considered a commercially viable proposition, further expenditures are usually required before production is possible.

The period between the initial exploration of an area and production might be lengthy and a change in demand for the product during this period can result in the operation becoming uneconomical or less profitable than originally expected. Determining whether an asset has been created 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 be made about whether such expenditures result in an asset or an expense.

Economically recoverable reserves are the ultimate source of revenue for firms in the extractive industries. Economically recoverable reserves are defined in Appendix A of AASB 6 as:

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. (AASB 6)

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, with this amortisation/depreciation ultimately forming part of the cost of inventory. On the other hand, if these expenditures are not considered likely to lead to a successful project, the costs should be expensed 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

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 (when mineral reserves have been extracted and are available for sale)

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

Table 20.1 Some of the phases of activities in the extractive industries together with details of the respective accounting standard

extractive industries Firms in the extractive industries engage in the search for and extraction from the ground of natural substances of commercial value.

economically recoverable reserves Estimated quantity of product in an area expected to be profitably extracted, processed and sold in current and foreseeable economic conditions.

area of interest Individual geological area considered or proved to constitute a favourable environment for the presence of a mineral deposit or an oil or natural gas field.

dee67382_ch20_813-852.indd 818 10/18/19 08:23 PM

818 PART 6: Industry-specific accounting issues

20.2 Alternative methods to account for exploration and evaluation expenditure

The amounts that some organisations spend on exploration and evaluation can be in the hundreds of millions of dollars. Therefore, how these amounts are accounted for can have a profound impact on reported profits

and assets. In the absence of an accounting standard that 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. Prior to a relevant accounting standard, each of the following five methods of accounting had been applied to account for exploration and evaluation expenditure. 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. Within Australia, AASB 6 requires, as did AASB 1022, the use of the ‘area-of-interest method’ for exploration and evaluation expenditures. However, for organisations outside of Australia, the following five different methods are permissible.

Costs-written-off method Under the costs-written-off method, all exploration and evaluation costs are expensed (written off) as incurred regardless of whether economically recoverable reserves are discovered. As there is a low probability of success

from exploration and evaluation activities, advocates of this approach would argue that these costs should not be carried forward as an asset. This argument would seem to be consistent with the asset recognition criteria provided in the Conceptual Framework for Financial Reporting, which would require that assets be recognised only when there is a potential for future economic benefits and that the determination of the probability of the future benefits, and the measurement of the benefits, can be undertaken without high levels of uncertainty. No reinstatement of assets is permitted under this approach, even if economically recoverable reserves are subsequently found. The prohibition

on the reinstatement of assets—even if additional information becomes available which indicates that future economic benefits are probable—would not be consistent with the Conceptual Framework, which does allow resources to be recognised as assets if they subsequently meet the definition and recognition criteria for assets. Critics of this approach argue that this method fails to match costs with the benefit that flows from them. It is also argued that 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 when 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 meeting the recognition criteria (linked to recognition

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.

costs-written-off method Method whereby all exploration and evaluation costs are written off as incurred.

costs-written-off-and- 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.

WHY DO I NEED TO KNOW ABOUT THE REQUIREMENTS RELATING TO ACCOUNTING FOR EXPLORATION AND EVALUATION EXPENDITURE?

Organisations operating within the extractive industries are significantly important to the Australian economy. They also create various social and environmental impacts. Because of their significance, it is likely that, at some stage, you will review the financial statements of some organisations from the extractive industries. The source of the value generated by such organisations will be greatly influenced by the exploration and evaluation activities/expenditures undertaken by the entity. Therefore, when reviewing the financial statements of a mining or oil and gas organisation, their exploration and evaluation expenditures would be an aspect of operations in which we would be particularly interested. Further, to put the related amounts into context, we should understand the accounting rules pertaining to exploration and evaluation expenditures.

LO 20.2

dee67382_ch20_813-852.indd 819 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 819

criteria associated with ‘relevance’ and ‘faithful representation’), the Conceptual Framework suggests that an asset, and associated revenue, may be recognised, even if the related expenditure had previously been expensed.

While the Conceptual Framework requires that asset recognition shall occur when the related information satisfies various criteria associated with ‘relevance’ and ‘faithful representation’, 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, and the level of measurement uncertainty with respect to the related future economic benefits, the requirements of the Conceptual Framework would lead to greater initial write-offs (expensing) of exploration and evaluation expenditure than would the requirements of AASB 6.

Successful-efforts method 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 particular criteria associated with relevance and faithful representation are satisfied.

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. Where used, costs are typically accumulated and carried forward as an asset at a country level such that different countries become different cost centres. The exploration and evaluation costs carried forward are then amortised and treated as comprising part of the cost of inventory. 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. Nevertheless, at this point it is interesting to note that international research by Power, Cleary and Donnelly (2017) shows there is much diversity in the methods being used to account for exploration and evaluation expenditures, although they do note that oil and gas organisations outside of Australia typically use either the successful-efforts or full-cost methods. By contrast, the mining sector (that is, industries in the extractive industries other than the oil and gas sectors) either uses successful-efforts or the costs- written-off method to account for pre-production costs. Further, among oil and gas firms, the smaller firms tend to use the full-cost method, whereas in the mining sector the larger organisations tend to adopt the cost-written-off method.

Area-of-interest method It is the area-of-interest method that is used in Australia by virtue of Australian-specific requirements that have been added to IFRS 6 by the AASB. That is, unlike other countries, the Australian accounting standard-setter (AASB) has restricted the methods to be used in accounting for exploration and evaluation expenditure to just one. The area-of-interest method 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 oil or gas field. Nevertheless, AASB 6 does allow for some degree of management discretion in delimiting an area of interest.

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 pre- production 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.

dee67382_ch20_813-852.indd 820 10/18/19 08:23 PM

820 PART 6: Industry-specific accounting issues

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 (expensed) as incurred (like the ‘costs-written-off method’). 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. (AASB 6)

The notion of allowing an organisation to carry forward exploration and evaluation expenditure 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 consideration needs to be given to factors such as the probability and measurement uncertainty associated with the future economic benefits. 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 and that their value must be expected to exceed the measurement of the amounts that have been expended on the activities.

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 (and as discussed within Chapter 6).

As noted above, if specific conditions are satisfied, an organisation is permitted to carry forward as an asset some, or all, of its exploration and evaluation expenditures. The carry-forward expenditure might be classified as tangible

dee67382_ch20_813-852.indd 821 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 821

assets, or as intangible assets. Tangible assets might include special-purpose drilling rigs. Intangible assets might include amounts expended on exploration licences or geological surveys. As an example, the BHP 2019 Annual Report identifies that certain exploration expenses are capitalised and classified as intangible assets. In this regard, note 12 to the BHP financial statements, which pertains to intangible assets, notes that:

Initial payments for the acquisition of intangible mineral lease assets are capitalised and amortised over the term of the permit. A regular review is undertaken of each area of interest to determine the appropriateness of continuing to carry forward costs in relation to that area. Capitalised costs are only carried forward to the extent that they are expected to be recovered through the successful exploitation of the area of interest or alternatively by its sale. To the extent that capitalised expenditure is no longer expected to be recovered, it is charged to the income statement.

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. 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. (AASB 6)

Abandoning an area of interest For any area of interest, the exploration, evaluation, development and construction costs are carried forward as an asset 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. At times these impairment losses can be significant. For example, in the 2018 Annual Report of Origin Energy Ltd, an impairment of exploration and evaluation assets of $514 million was reported in relation to its ‘Ironbark’ mining site. The 2019 Annual Report of Origin Energy Ltd reported an impairment of $49 million on the Ironbark site. The revised valuation, and associated impairment loss, was based upon assessments of the fair values less costs of disposal of the tangible assets, valuations of minerals reserves, the future expected production levels, future expected commodity prices, expected operating costs and future development costs necessary to economically produce the reserves.

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, the useful life of the asset would not be tied to the life of the area of interest.

dee67382_ch20_813-852.indd 822 10/18/19 08:23 PM

822 PART 6: Industry-specific accounting issues

Accumulation of costs pertaining to exploration and evaluation activities As already noted, 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 expensed as 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 reporting 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.

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).

20.3 Basis for measurement of exploration and evaluation expenditures

AASB 6 provides the basis for measurement of the costs incurred in exploration and evaluation activities. Initially, such expenditures must 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 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.

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. (AASB 6)

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 or AASB 138 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. (AASB 6)

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 as ‘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 20.3

dee67382_ch20_813-852.indd 823 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 823

20.4 Subsequent 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 and included as part of the cost of inventory. Ultimately, they will then form part of the cost of goods sold, which will be matched 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 [see also IAS 36]. (AASB 6)

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 [see also IAS 36]. Any impairment loss is recognised as an expense in accordance with AASB 136 [see also IAS 36]. (AASB 6)

We can refer to AASB 136 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.

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

LO 20.4

dee67382_ch20_813-852.indd 824 10/18/19 08:23 PM

824 PART 6: Industry-specific accounting issues

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. (AASB 136)

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. 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 ∙ 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.

As we can see, there are many professional judgements that need to be made in respect of assets such as evaluation and expenditure assets. The way these judgements are made, and the nature of the evidence used to make

dee67382_ch20_813-852.indd 825 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 825

20.5 Accounting for 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. 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. (AASB 137)

Calculating future restoration costs is based upon a great deal of professional judgement given the many estimates that must be made. 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.

the judgements, will influence the relevance and representational faithfulness of the information being provided. In this regard, the Australian Securities and Investments Commission (ASIC) released a Media Release in January 2019 (19-014 MR—www.asic.gov.au/about-asic/news-centre/find-a-media-release/2019-releases/19-014mr-findings- from-30-june-2018-financial-reports/) in which it noted that the carrying amount of exploration and evaluation expenditure as reported by a number of Australian corporations was an issue creating a great deal of concern for ASIC. In the view of ASIC, the way organisations were forecasting future cash flows for the purpose of evaluating the assets did not appear reasonable and the estimates of future cash flows used in the calculations often exceeded the actual cash flows for a number of reported periods. ASIC also reported some entities as not having sufficient regard to impairment indicators, such as significant adverse changes in market conditions.

LO 20.5

WHY DO I NEED TO KNOW HOW THE COSTS INCURRED BY ORGANISATIONS IN THE EXTRACTIVE INDUSTRIES ARE ALLOCATED TO INVENTORY AND ULTIMATELY TO COST OF SALES?

The methods used to account for pre-production costs, including exploration and evaluation expenditure, will influence reported profits and assets. Because the accounting policy adopted will influence the recognition of profits, and reported assets, it is important, when reviewing the financial reports of an organisation, to identify what policy is used and understand how that policy impacts the financial position and financial performance. As we have learned, when the area-of-interest method is used, exploration and evaluation expenditure can be expensed as incurred, or it may be partially or fully capitalised to the extent that certain tests are satisfied. Whatever policy an organisation adopts will affect the financial statements and this impact could be quite significant. Therefore, to place the financial position and financial performance in context, it is necessary to understand the policy that managers have elected to adopt.

dee67382_ch20_813-852.indd 826 10/18/19 08:23 PM

826 PART 6: Industry-specific accounting issues

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. Costs related to required clean-up 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 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 (at present value). Therefore, the general form of the journal entry would be:

Dr Property, plant and equipment X  

Cr Cash/payables   X

Cr Provision for restoration (to recognise the cost of property, plant and equipment inclusive of future remediation costs, which are recognised at their present value)

  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.

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 subsequent 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 as the oil is subsequently extracted.

dee67382_ch20_813-852.indd 827 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 827

WORKED EXAMPLE 20.1: Accounting for a restoration provision

During the reporting period ending 30 June 2022, 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 2022. 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 2022, 30 June 2023 and 30 June 2024. Ignore depreciation.

SOLUTION

30 June 2022  

Dr Oil rig 113 792 582  

Cr Cash/accounts payable   99 500 000

Cr Provision for restoration costs (to account for the initial ‘cost’ of the rig, including an estimate of future site restoration costs)

  14 292 582

Discounting the future obligation for restoration creates interest costs for future years. The borrowing (interest) costs are allocated to specific years as follows:

Date Opening balance Interest at 4% Balance of site

restoration costs

1 July 2022 _ _  14 292 582

30 June 2023 14 292 582 571 703 14 864 285

30 June 2024 14 864 285 594 572 15 458 857

30 June 2025 15 458 857 618 354 16 077 211

30 June 2026 16 077 211 643 088 16 720 299

30 June 2027 16 720 299 668 812 17 389 111

The journal entries to recognise the periodic interest charges are:

30 June 2023

Dr Interest expense 571 703  

Cr Provision for restoration costs (to account for the increase in the present value of the restoration obligation)

  571 703

30 June 2024

Dr Interest expense 594 572  

Cr Provision for restoration costs (to account for the increase in the present value of the restoration obligation)

  594 572

continued

dee67382_ch20_813-852.indd 828 10/18/19 08:23 PM

828 PART 6: Industry-specific accounting issues

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 $17 389 111. This amount will then be eliminated when Nichol Ltd undertakes the actual restoration work. While not shown here, the cost of the oil rig ($113 792 582) would also be depreciated over the five-year life, and this depreciation expense would be included as part of the cost of the oil inventory. Ultimately, as the oil is sold, the various costs attributed to the inventory (including the depreciation) would be recognised as a cost, this being the cost of sales.

WORKED EXAMPLE 20.1 continued

WHY DO I NEED TO KNOW ABOUT THE RESTORATION PROVISIONS OF A MINING ORGANISATION?

The restoration costs associated with various activities in the extractive industries can be very significant and can greatly impact future cash flows. As such, it is important, if we have an interest/stake in a particular organisation, to understand what the future cash flows might be, and whether the available resources of the organisation appear sufficient to meet these important and necessary responsibilities/obligations.

20.6 Determining sales revenue

Refer to AASB 15 Revenue from Contracts with Customers for the requirements relating to the recognition of revenue in the extractive industries (see Chapter 15). Generally, sales revenue should not be brought to account

until such time as control of the resource has passed to the customer. 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. If the results of various tests of product quality/ quantity are completed after the end of the reporting period, but before the financial reports are authorised for issue (which would constitute an ‘event occurring after the end of the reporting period’ as discussed in Chapter 21), then the amount of the sales revenue for an accounting period would be adjusted in light of this information.

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’s 2019 Annual Report that relates to the recognition of sales revenue.

LO 20.6

Exhibit 20.2 BHP’s policy on recognising sales revenue, as reported in its 2019 Annual Report

dee67382_ch20_813-852.indd 829 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 829

20.7 Determining the measurement of inventory

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, 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.

As we know, when organisations in the extractive industries initially undertake exploration and evaluation activities, the related expenditure can be deferred to an asset account (subject to specific tests), and this account might be labelled ‘exploration and evaluation assets’. If economically recoverable reserves are discovered and the organisation seeks to move from the exploration and evaluation phases to subsequent phases of operations, then the amounts recorded as ‘exploration and evaluation assets’ will be transferred to another account, perhaps labelled ‘assets under construction’ (for the tangible assets), or ‘mineral assets’ (for the intangible assets). When inventory is ultimately extracted, that inventory will be allocated part of the cost of these tangible assets and intangible assets (through the process of depreciation/amortisation of the tangible and intangible assets), as well as other production costs.

20.8 Disclosure requirements

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. 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.

SOURCE: BHP Group Ltd

LO 20.7

LO 20.8

dee67382_ch20_813-852.indd 830 10/18/19 08:23 PM

830 PART 6: Industry-specific accounting issues

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. (AASB 6)

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, which includes requirements that are of relevance in relation to disclosing provisions for restoration. Specifically, paragraphs 26 and 27 require:

26. For each class of provision, an entity shall disclose: (a) the carrying amount at the beginning and end of the period; (b) additional provisions made in the period, including increases to existing provisions; (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. (AASB 137)

Exhibit 20.3 provides details of how BHP 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 are consistent with the requirements described in this chapter. The note from the 2019 Annual Report of BHP 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 2019 Annual Report of BHP 

dee67382_ch20_813-852.indd 831 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 831

continued

dee67382_ch20_813-852.indd 832 10/18/19 08:23 PM

832 PART 6: Industry-specific accounting issues

Exhibit 20.3 continued

dee67382_ch20_813-852.indd 833 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 833

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 in Australia pursuant to AASB 6) is contrasted with the full-cost method, which may be used in some other countries. Although the full-cost method is not permitted in Australia (albeit, it is permitted in other countries), this illustration shows how the adoption of alternative methods of accounting 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.

SOURCE: BHP Group Ltd

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 2021. During 2021, Fraser Island explores two areas and incurs the following costs.

Area Exploration and evaluation expenditure

($m)

A 17

B   8

  25

Other information

• In 2022 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 output basis) in 2022. 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 output basis.

• Development at Site B concludes at the beginning of 2022, and production also commences at Site B at the start of 2023.

• It is estimated that the amount of oil at Site B is 8 million barrels. The current sale price is $30 per barrel. • In 2023, 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

2021 $m $m

Dr Exploration and evaluation assets—Site A 17  

Dr Exploration and evaluation assets—Site B 8  

Cr Cash/payables etc.   25

continued

dee67382_ch20_813-852.indd 834 10/18/19 08:23 PM

834 PART 6: Industry-specific accounting issues

(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)

2022 $m $m

Dr Assets under construction—property, plant and equip. 5  

Dr Assets under construction—intangible assets 3  

Cr Exploration and evaluation assets—Site B   8

Dr Impairment loss—exploration and evaluation assets 17  

Cr Exploration and evaluation assets—Site A

(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)

17

Dr Assets under construction—property, plant and equip. 12  

Dr Assets under construction—intangible assets 8  

Cr Cash/payables/accumulated depreciation etc. (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)

20

2023 $m $m

Dr Property, plant and equipment—Site B 17  

Dr Intangible mineral assets 11  

Cr Assets under construction—property, plant and equip.   17

Cr Assets under construction—intangible assets (to reclassify the assets as a result of the movement from the pre-production phase to the production phase)

11

Dr Inventory of crude oil 4.2  

Cr Accumulated depreciation—property, plant and equip.—Site B   2.55

Cr Accumulated amortisation—intangible mineral assets—Site B

(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 barrel)

1.65

Dr Inventory of crude oil 3.6  

Cr Cash/payables/accumulated depreciation etc.

(to recognise the production costs that are treated as a cost of the inventory, rather than being written off directly)

3.6

Dr Cash/receivables 33  

Cr Sales revenue (to recognise sales made, where $33 million = 1.1 million barrels multiplied by $30 per barrel)

33

WORKED EXAMPLE 20.2 continued

dee67382_ch20_813-852.indd 835 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 835

Dr Cost of goods sold 7.15  

Cr Inventory of crude oil (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)

7.15

(b) Full-cost method

2021 $m $m

Dr Exploration and evaluation assets 25  

Cr Cash/payables etc.

(to account for the initial exploration and evaluation costs incurred at each site)

25

2022  $m $m

Dr Assets under construction—property, plant and equip. 17  

Dr Assets under construction—intangible assets 8  

Cr Exploration and evaluation assets (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)

25

Dr Assets under construction—property, plant and equip. 12  

Dr Assets under construction—intangible assets 8  

Cr Cash/payables/accumulated depreciation etc. (to recognise the development costs that are recorded in the depletable natural resources account)

20

2023 $m $m

Dr Property, plant and equipment 29  

Dr Intangible mineral assets 16  

Cr Assets under construction—property, plant and equip.   29

Cr Assets under construction—intangible assets   16

Dr Inventory of crude oil 6.75  

Cr Accumulated depreciation—property, plant and equip.   4.35

Cr Accumulated amortisation—intangible mineral assets (amortisation of costs carried forward; the amount is calculated as 1.2 million × $5.625, where $45 million ÷ 8 million = $5.625 per barrel)

2.40

Dr Inventory of crude oil 3.6  

Cr Cash/payables/accumulated depreciation etc. (to recognise the production costs, which are treated as a cost of the inventory rather than being written off directly)

3.6

Dr Cash/receivables 33  

Cr Sales revenue (to recognise sales made, where $33 million = 1.1 million barrels multiplied by $30 per barrel)

33

Dr Cost of goods sold 9.4875  

Cr Inventory of crude oil (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)

9.4875

dee67382_ch20_813-852.indd 836 10/18/19 08:23 PM

836 PART 6: Industry-specific accounting issues

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 2022. Production commenced in Tattersals at the beginning of September 2021. Two of the other locations, Newie and Pink, show promising geological formations. Club will be abandoned in 2022, 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 2022.

  $

Tattersals  

Mine development expenditures—intangible assets 250 000

Production costs (including royalties of $50 000) paid during production of oil 18 125 000

Construction of buildings 450 000

Construction of plant 1 125 000

Club  

Exploration and evaluation expenditure 875 000

Newie  

Exploration and evaluation expenditure 1 155 000

Pink  

Exploration and evaluation expenditure 1 342 500

At 30 June 2021 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)

1 800 000

• Assets under construction (this expenditure occurred in the development phase following the exploration and evaluation phase)

 

— intangible assets 875 000

— buildings 3 125 000

— plant 1 567 500

Club  

Exploration and evaluation expenditure 50 000

Newie  

Exploration and evaluation expenditure _

Pink  

Exploration and evaluation expenditure 50 000

dee67382_ch20_813-852.indd 837 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 837

Other information

(i) The non-current assets are to be depreciated as follows:

Buildings production-output basis

Plant 15 years

Intangible assets 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 2022.

(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 2021 carried-forward expenditure and the 2022 actual expenditure in the accounts as at 30 June 2022.

(b) Determine the appropriate valuation of Tattersals’ inventory at 30 June 2022. (c) Determine the result for the company for the year ending 30 June 2022. 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 2022

Club $

Exploration and evaluation assets carried forward at 30 June 2021 50 000

Incurred during the year ended 30 June 2022 875 000

Total 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 2021 _

Incurred during the year ended 30 June 2022 1 155 000

Total 1 155 000

The amount should be carried forward as an asset, since the area of interest looks promising and activities are continuing.

Pink $

Exploration and evaluation assets carried forward at 30 June 2021 50 000

Incurred during the year ended 30 June 2022 1 342 500

Total 1 392 500

The amount should be carried forward as an asset, since the area of interest looks promising and activities are continuing.

continued

dee67382_ch20_813-852.indd 838 10/18/19 08:23 PM

838 PART 6: Industry-specific accounting issues

Tattersals

Total pre-production costs $ $

Intangible assets    

Exploration and evaluation phase—2021 800 000  

Development phase—2021 875 000  

Mine development costs incurred (intangible assets) during the year ended 30 June 2022

   250 000 1 925 000

Buildings    

Development phase—2021 3 125 000  

Construction phase—2022    450 000 3 575 000

Plant    

Exploration and evaluation phase—2021 1 000 000  

Development phase—2021 1 567 500  

Construction phase—2022 1 125 000 3 692 500

Total pre-production costs—Tattersals site   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 pre-production 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 2022:   Plant ($3 692 500 ÷ 15) × (10 ÷ 12) = $205 139 Buildings ($3 575 000 ÷ 70 000 000) × 17 500 000 = $893 750 Intangible assets ($1 925 000 ÷ 70 000 000) × 17 500 000 = $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 $18 125 000

Amortisation of intangible assets $ 481 250

Depreciation of buildings $ 893 750

Depreciation of plant $ 205 139

Cost of goods manufactured $19 705 139

Cost per barrel (rounded) 19 705 139 ÷ 17 500 000 $ 1.126 Inventory value (500 000) × ($1.126) $ 563 000

(c) Operating result for the year

Profit for the year ended 30 June 2022  

Sales (17 000 000 × $9) $153 000 000 Cost of sales (17 000 000 × 1.126)   $19 142 000 Gross profit $133 858 000

Non-production expenses $5 500 000

Write-off of Club area of interest        $925 000

Profit before tax $127 433 000

WORKED EXAMPLE 20.3 continued

dee67382_ch20_813-852.indd 839 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 839

20.9 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 minerals or oil or gas reserves to be carried forward as an asset 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, 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 standards pertaining to revaluations (AASB 116 and AASB 138) prevent the credit 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.

20.10 Research on accounting regulation pertaining to exploration and evaluation expenditure

In the earlier discussion, we considered some research on how organisations account for their exploration and evaluation expenditure. 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 exploration and evaluation expenditure (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 exploration and evaluation expenditure would no longer have been permitted to carry forward expenditure

LO 20.9

LO 20.10

dee67382_ch20_813-852.indd 840 10/18/19 08:23 PM

840 PART 6: Industry-specific accounting issues

relating to ventures that did 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 full-cost 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 securities 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 area-of-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 for accounting for exploration and evaluation expenditure. Therefore, IFRS 6 effectively ‘codified existing industry practice, perpetuating the disparate methods of accounting for exploration and evaluation, and maintaining the status

dee67382_ch20_813-852.indd 841 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 841

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 extractive industries 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 carry-forward requirements. 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. Remember, where an organisation changes its accounting method

dee67382_ch20_813-852.indd 842 10/18/19 08:23 PM

842 PART 6: Industry-specific accounting issues

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?

20.11 Consideration of the social and environmental performance of organisations within the extractive industries

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 responsible and 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 various reports, approximately 60 million cubic metres of iron waste flowed into the Doce River. More than 600 people lost their homes, 19 people were killed, the sludge from the mine extended through the river system for 440 kilometres downstream, and the water supply for many thousands of people was interrupted and potentially polluted for future generations.

Another famous case of social and environmental damage being caused by an organisation in the extractive industries is the Deepwater Horizon oil spill, which involved a drilling rig belonging to the multinational oil company BP, and which occurred on 20 April 2010 in the Gulf of Mexico. It took approximately five months to seal the well after the rig exploded and sank, although there were reports that it continued to leak for some years after the event. Eleven people were killed when the oil platform exploded, and significant damage was caused to local marine and wildlife habitats, as well as to the fishing and tourism industries, as a result of the spill. The impacts of the disaster were ongoing for a number of years: dolphins and various species of fish continued to die in large numbers, and various forms of marine plant life over thousands of square kilometres were damaged or destroyed. It was a major environmental catastrophe.

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 triple-bottom- 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 32 provides a detailed investigation of social and environmental reporting and discusses such organisations as the Global Reporting Initiative. It also provides an

LO 20.11

dee67382_ch20_813-852.indd 843 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 843

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 ∙ 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, which produces the BHP Sustainability Report, available at www.bhp.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 Standards (although these have many shortcomings). There is, therefore, much variation in the disclosures made by individual companies in their social- and environmental- performance 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. Most of Australia’s larger companies in the extractive industries are signatories to the framework, including BHP, Rio Tinto and Energy Resources of Australia. 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 32.

20.12 The development of a new accounting standard for extractive activities

In 2004 the IASB set up an international project team comprising staff from the national accounting standard- setters of Australia, Canada, Norway and South Africa to research accounting for extractive activities. The release of IFRS 6 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

LO 20.12

dee67382_ch20_813-852.indd 844 10/18/19 08:23 PM

844 PART 6: Industry-specific accounting issues

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 would 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:

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 2019, 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 recognition, measurement (initial and subsequent measurement) and various disclosure issues.

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.

(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. 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

dee67382_ch20_813-852.indd 845 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 845

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 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 if, and when, another accounting standard is developed. 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

dee67382_ch20_813-852.indd 846 10/18/19 08:23 PM

846 PART 6: Industry-specific accounting issues

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.

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.

As this project has been paused and had not been restarted as of 2019 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 costs-written-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:

dee67382_ch20_813-852.indd 847 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 847

• 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 production-output basis would typically be used for depreciation/amortisation purposes 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 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 817 area-of-interest method 819 costs-written-off-and-reinstated method 818

costs-written-off method 818 economically recoverable reserves 817 extractive industries 817

full-cost method 819 successful-efforts method 819

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What are the ‘extractive industries’? LO 20.1 The extractive industries are those industries involved in exploring for and finding minerals, oil and natural gas deposits, developing those deposits and extracting the minerals, oil and natural gas.

2. What are the five broad phases of activities undertaken by organisations within the extractive industries? LO 20.1 The five phases can be identified as exploration, evaluation, development, construction and production.

3. When can the costs incurred in the exploration and evaluation phases of operations be carried forward as assets? LO 20.2, 20.3 Within Australia, and pursuant to AASB 6, the costs can be deferred to future periods to the extent that the rights to tenure of the area of interest are current, and if at least one of the following conditions is also met:

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

(ii) the exploration and evaluation activities in the area of interest have not at the end of the reporting period 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 of interest are continuing.

4. Organisations within the extractive industries will ultimately generate inventory. Will the ‘costs of inventory’ include costs that were incurred in the initial exploration and evaluation phases of operations? LO 20.4, 20.7 Organisations within the extractive industries have a choice between expensing the exploration and evaluation expenditure as incurred (meaning the cost would not ultimately be included within the cost of inventory) or partially or fully capitalising the expenditure as an exploration and evaluation asset if certain requirements are satisfied (see

dee67382_ch20_813-852.indd 848 10/18/19 08:23 PM

848 PART 6: Industry-specific accounting issues

above). An entity shall make this decision separately for each area of interest. Only those entities that capitalise the expenditure will include the exploration and evaluation expenditure within the cost of inventory. Once the exploration and evaluation phase of operations is complete, and economically recoverable reserves are found, then the costs would be reclassified into another asset before that asset would ultimately be amortised on a production or time basis, with the amortisation costs being treated as part of the cost of inventory.

5. Mining operations will typically create various forms of damage to the natural environment, and that environment will need to be restored/rehabilitated at the cessation of the mining activities. When should the costs associated with the future restoration/rehabilitation be recognised by an entity? LO 20.5 The costs associated with restoration/rehabilitation will be recognised in the form of a provision, and with an associated expense, as the damage to the environment occurs. The costs of future land restoration/rehabilitation associated with the construction of a particular item of plant or equipment shall be recognised as part of the initial ‘cost’ of the plant and equipment with a related provision also being recognised.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Define ‘area of interest’. LO 20.2, 20.3 • 2. According to the US experience, what would have motivated firms to lobby against the abolition of the full-cost

method? LO 20.2, 20.10 • 3. Generally speaking, when should an organisation in the extractive industries recognise revenue? LO 20.6 • 4. When should a company in the extractive industries start accounting for its restoration costs? LO 20.5 • 5. Is an entity in the extractive industries required to separately disclose information about exploration and evaluation

assets? LO 20.8 • 6. In respect of a provision for future restoration expenditure, what disclosures shall be made in the financial reports?

LO 20.8 • 7. If an organisation expenses all exploration and evaluation expenditure as incurred, would the related financial

reports provide ‘relevant’ information? LO 20.9 • 8. If an entity is considering revaluing its exploration and evaluation assets, would the revaluation increase the

‘relevance’ of the information from the perspective of the readers of the financial statements? LO 20.9 • 9. What sort of non-financial disclosures might organisations in the extractive industries make? LO 20.11 • 10. Would the choice between historical cost and fair value have implications for the potential volatility of reported profits

or losses? LO 20.12 • 11. Does the available evidence suggest that measuring various pre-production expenditures at current value/fair value

would provide information that satisfies the usual cost–benefit test? LO 20.12 •• 12. 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 20.3, 20.4 • 13. 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 20.5 •

14. Generally speaking, what costs should be included in the cost of inventory of an entity involved in the extractive industries? Explain your answer. LO 20.3, 20.4, 20.7 •

15. 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 20.2 ••

16. Once it is determined that it is technically feasible and commercially viable to extract resources, how shall the pre- existing exploration and evaluation expenditure be treated? LO 20.2, 20.3 •

17. Does AASB 6 address issues associated with how to account for expenditure once an organisation has moved beyond the exploration and evaluation phase? LO 20.2, 20.3 ••

dee67382_ch20_813-852.indd 849 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 849

18. What factors might indicate that exploration and evaluation assets have been impaired such that an associated impairment loss should be recognised? LO 20.4 ••

19. If circumstances suggest that carried forward (capitalised) exploration and evaluation expenditure exceeds their recoverable amount, what should be done? LO 20.4 •

20. When would you use time as the basis for amortising pre-production costs incurred in a mining venture? LO 20.4 • 21. 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 • 22. Would it be permissible for a company operating in the extractive industries to write off all exploration and evaluation

expenditure, regardless of the ultimate success of a site? LO 20.3, 20.4 ••

CHALLENGING QUESTIONS

23. ‘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 20.2, 20.3, 20.4

24. Extracto Ltd commences operations on 1 January 2021. During 2021 Extracto Ltd explores three areas and incurs the following costs:

Exploration and evaluation expenditure ($m)

Good 23

Bad 16

Indifferent 25

In 2022 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 2022 development costs of $27 million are incurred at Good Site (to be depreciated on a production output 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, 20.3, 20.4, 20.7

25. Surfcity Mining Ltd incurs the following exploration and evaluation costs at two sites, Ian and Eddie, over the years indicated:

Year Ian Eddie

2021 $1500 $2000

2022 $2000 $3000

2023 $3000 $4000

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 2023, 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 2024 at a cost of $2000. Portable buildings, with a life of 10 years, are also put in place. These buildings cost $500.

dee67382_ch20_813-852.indd 850 10/18/19 08:23 PM

850 PART 6: Industry-specific accounting issues

Production at Ian begins in 2024. 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 2024, 400 barrels are extracted, of which 250 are sold.

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 2021 to 2024 using:

(a) the area-of-interest method (b) the full-cost method. LO 20.2, 20.3, 20.7

26. Evaluate the following statement: ‘The Conceptual Framework would support the use of the costs expensed and reinstated method.’ LO 20.2

27. Should the costs that are capitalised prior to production be amortised on a time basis or on a production-output basis? LO 20.4

28. Would the full-cost method or the area-of-interest method of accounting for the extractive industries provide a greater volatility of earnings? Why? LO 20.2

29. 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? LO 20.3, 20.4

30. Kakadu Ltd commences mining operations on 1 July 2021. 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—intangible assets

($m) Total site costs

($m)

Green 3 6 9

Tree 6 4 10

Frog   3   7 10

  12 17 29

On 10 January 2022, uranium is discovered at Green. Because of damage continually being caused by angry goannas, it is decided in March 2022 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 2022, development costs of $12 million are incurred at Green (to be depreciated/amortised on a production output 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 2022, 5000 tonnes of uranium are extracted at a production cost of $2 million. In June 2022, 4000 tonnes are sold, with 1000 remaining on hand. The reporting date of Kakadu Ltd is 30 June 2022.

REQUIRED Provide the journal entries using the area-of-interest method. LO 20.2, 20.4, 20.5, 20.6, 20.7

31. 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 pre-production costs within AASB 6? LO 20.10

32. In a newspaper article of 21 March 2019 entitled ‘Buru set for renewed oil search in northern WA’ (by Matt Birney in Business News) it was reported that the ASX-listed company known as Buru Energy was:

dee67382_ch20_813-852.indd 851 10/18/19 08:23 PM

CHAPTER 20: Accounting for the extractive industries 851

(a) embarking on a multimillion-dollar search for oil in the Canning hydrocarbon basin in northern Western Australia. The company was preparing to drill up to four exploration wells to test some promising oil prospects in a relatively underexplored region.

(b) undertaking ongoing technical work on the Rafael prospect as part of the next potential exploration well. This technical work includes the reprocessing of existing seismic data over the structure and further quantification of the source, seal and reservoir parameters for the prospect.

REQUIRED You are required to describe how to account for the expenditure referred to in parts (a) and (b) above. LO 20.2, 20.3

33. In a newspaper article that appeared in Business News on 19 February 2019 it was reported that the organisation known as Sandfire Resources had recorded exploration and evaluation expenses of $24.4 million. Sandfire said these costs primarily related to a feasibility study and environmental impact statement for the Black Butte copper project in the US, and exploration at its Greater Doolgunna project.

REQUIRED Did the company comply with AASB 6 when it decided to immediately expense this expenditure? LO 20.2, 20.3

34. During the reporting period ending 30 June 2022, 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 2022. 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 2022, 30 June 2023 and 30 June 2024. Ignore depreciation. LO 20.4, 20.5

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May. 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.

King, R. & O’Keefe, T., 1986, ‘Lobbying Activities and Insider Trading’, Accounting Review, vol. 61, no. 1, pp. 76–9.

Larcker, D., Reder, R. & Simon, D., 1983, ‘Trades by Insiders and Mandated Accounting Standards’, Accounting Review, vol. 58, no. 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.

Power, S., Cleary, P. & Donnelly, R., 2017, ‘Accounting in the London Stock Exchange’s Extractive Industry: The Effect of Policy Diversity on the Value Relevance of Exploration- Related Disclosures’, The British Accounting Review, vol. 49, pp. 545–59.

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.

dee67382_ch20_813-852.indd 852 10/18/19 08:23 PM

dee67382_ch21_853-868.indd 853 10/24/19 03:42 PM

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

dee67382_ch21_853-868.indd 854 10/24/19 03:42 PM

854

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 21.1 Understand what constitutes an event occurring after the end of the reporting period. 21.2 Understand that financial statements are often not released for over two months after the end of the

reporting period, and to make them more ‘relevant’ there is a need to add notes giving additional information about material events that have occurred since the end of the reporting period.

21.3 Understand that events occurring after the end of the reporting period can be classified as either ‘adjusting events’, or ‘non-adjusting events’.

21.4 Understand which events after the reporting period will necessitate adjustments to the financial statements.

21.5 Understand which events after the reporting period will require disclosures within the notes to the financial statements, rather than adjustments to the financial statements.

21.6 Be aware of the specific disclosure requirements of AASB 110 Events After the Reporting Period.

C H A P T E R 21 Events occurring after the end of the reporting period

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following three questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. If an event occurs ‘after the reporting period’, then from the perspective of accounting standards, it is considered that the event has occurred between 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, within the notes to the financial statements, about material transactions and events that have occurred since the reporting date, but before the financial statements were authorised for issue? LO 21.2

3. Events after the reporting period 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 disclosure within the notes to the financial statements appropriate?) LO 21.3, 21.4, 21.5, 21.6

dee67382_ch21_853-868.indd 855 10/24/19 03:42 PM

CHAPTER 21: Events occurring after the end of the reporting period 855

AASB no. Title IFRS/IAS equivalent

110 Events After the Reporting Period IAS 10

AASB STANDARD REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENT

21.1 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. (AASB 110)

The end of the reporting period can also be defined as the end of the financial period to which the financial statements relate. It is therefore what we would traditionally have referred to as the balance sheet date or reporting date.

The date financial statements are authorised for issue will, according to AASB 110, vary depending upon the management structure, statutory requirements and procedures followed in preparing and finalising the financial statements. For example, the management of an entity might be required to issue its financial statements to a supervisory board (made up solely of non-executives) for approval. In such cases, the financial statements are deemed to be authorised for issue when the management authorises them for issue to the supervisory board.

For Australian corporate entities, the date the financial statements are authorised for issue is usually deemed to be the 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 Corporations Act has various requirements relating to the contents of the Directors’ Declaration, an important one being that the directors sign a statement that the entity can pay its debts as and when they fall due. Once the Directors’ Declaration is signed, the auditors sign the auditors’ report, at which point the reporting process is complete, except for distribution of the financial reports.

The signing of the Directors’ Declaration will occur a number of weeks after the ‘end of the reporting period’. For example, BHP Ltd has a reporting date of 30 June. Its 2019 Directors’ Declaration was not signed until 5 September 2019, and this date is deemed to be the date upon which the financial statements for the period ended 30 June 2019 were completed. Therefore, anything that occurred in the 67-day period between 30 June 2019 and 5 September 2019 would fall into the period covered by AASB 110—a period in which an event after the reporting period can occur.

For entities other than companies, the date the financial statements are authorised for issue is the date of final approval of the statements by the management or governing body of the entity, whichever is applicable.

Worked Example 21.1, based on an example provided in AASB 110, illustrates how the date the financial statements are authorised for issue is determined.

To sum up, what AASB 110 addresses is how to treat, for accounting purposes, those events or transactions that occur, or about which information becomes available,

between the end of the reporting period (typically 30 June in Australia) and when the financial statements are authorised for issue. This is summarised diagrammatically in Figure 21.1.

date financial statements are authorised for issue For companies, the date the Directors’ Declaration is signed, typically the last thing a company’s directors do before releasing the financial statements. For other entities it is the date of final approval of the report by the management or governing body of the entity.

event after the reporting period An event or circumstance that has arisen, or information that has become available, after the end of the reporting period (usually 30 June in Australia) but prior to the time when the financial statements are authorised for issue.

LO 21.1

reporting date Often referred to as ‘balance date’. The end of the financial period (typically 12 months). In Australia most companies have a reporting date of 30 June.

balance sheet date The end of the financial period (typically 12 months). Also referred to as ‘reporting date’ or ‘balance date’.

dee67382_ch21_853-868.indd 856 10/24/19 03:42 PM

856 PART 7: Other disclosure issues

WORKED EXAMPLE 21.1: Establishing the date the financial statements are authorised for issue

Surfersam Ltd, whose reporting period ends on 30 June 2023, completes its draft financial statements on 15 September 2023. On 30 September 2023, the board of directors reviews the financial statements, approves them and authorises their issue. Earnings announcements are made on 3 October 2023 and the financial statements are made available to shareholders on 12 October 2023. Surfersam Ltd’s annual general meeting is held on 24 October 2023 and the financial statements are filed with ASIC on 26 October 2023.

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 2023, 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’.

21.2 Why disclose information about events that have occurred after the end of the reporting period?

There is usually a time lag of many weeks or even months between the end of the financial period and the date that shareholders and other interested parties receive the financial statements. As such, the data is likely to be out of date by the time it reaches the financial statement users. Many material 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 date (for the statement of profit or loss and other comprehensive income, statement of changes in equity, and statement of cash flows) and it is not correct practice to change the financial statements because of events that have occurred after that date. The only exception to this requirement within the accounting standard—which we will discuss shortly—is the requirement that relates to after-reporting-period changes in the entity’s status as a going concern. Nevertheless, the information in the financial statements may be supplemented by notes to the financial statements that document and describe material events that have occurred after the end of the reporting period. Failure to disclose material events that arise after the end of the reporting period can, in effect, make the financial statements misleading. For example, the year-end statement of financial position of a reporting entity might show a value for buildings that are an integral part 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 in accompanying 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

Figure 21.1 Summary guidance in relation to the disclosure of events 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

Period of time in which an item or event is considered

an ‘event after the reporting period’ Reporting date

30 June for most companies in

Australia

LO 21.2

dee67382_ch21_853-868.indd 857 10/24/19 03:42 PM

CHAPTER 21: Events occurring after the end of the reporting period 857

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.

21.3 Types of events after the reporting period

There are generally two basic types of subsequent events (events after the reporting period) 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.

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). (AASB 110)

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.

Figure 21.2 Determining the treatment of an event occurring after the end of the reporting period

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).

Recognise by way of a note to the

financial statements

No disclosure required

No disclosure required

Does it create a new condition as distinct from any conditions that might have existed at the end of the reporting period?

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’?

Event occurring after the end of the reporting period

Yes Yes

Yes

Yes

No No

No

Does it provide evidence or further elucidate conditions

that existed at the end of the reporting period?

LO 21.3

dee67382_ch21_853-868.indd 858 10/24/19 03:42 PM

858 PART 7: Other disclosure issues

WHY DO I NEED TO KNOW ABOUT THE DISCLOSURE REQUIREMENTS PERTAINING TO EVENTS OCCURRING AFTER THE END OF THE REPORTING PERIOD?

There is typically a two- to three-month delay between the end of the reporting period and the date when an organisation’s financial statements are authorised for issue to stakeholders, such as shareholders. With this delay (which is necessary in order to collect, compile and audit the financial information), the information therefore starts to suffer from a lack of timeliness; it thus has reduced ‘relevance’. One way to address this problem is for managers to disclose information, within the notes to the financial statements, about material events—both positive and negative—that have occurred since the end of the reporting period, and which could conceivably have a significant impact on future financial performance and position. Once we know that this is a reporting requirement, we therefore know that the notes to the financial statements will include information that enhances the total relevance of the financial information being presented. This knowledge alerts us to the need to carefully read through the notes to the financial statements to find this information, which could have the potential to cause us to revise our opinions about how the organisation will perform in the future (and which would not necessarily be reflected in the financial statements).

21.4 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 in the period between the reporting date and when the financial statements were authorised for issue. With this information, the year-end provision for this liability could be more faithfully represented. Without the information, the potential obligation might be recorded in the notes to the financial statements as a contingent liability.

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. 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

LO 21.4

dee67382_ch21_853-868.indd 859 10/24/19 03:42 PM

CHAPTER 21: Events occurring after the end of the reporting period 859

(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; and

(e) the discovery of fraud or errors that show that the financial statements are incorrect. (AASB 110)

AASB 110 stipulates specific requirements for dividends and in relation to 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 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. (AASB 110)

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 2022, and the end of the reporting period was 30 June 2022, the dividends declared in July would actually be treated as part of liabilities as at 30 June 2022. The rationale for this treatment was that there would be an expectation that dividends would be paid from 2022 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.

WORKED EXAMPLE 21.2: Disclosure of declared dividends

On 18 August 2023, the directors of Alpha Ltd declared that a dividend of 20 cents per ordinary share be paid to shareholders registered on 30 June 2023, the financial year-end of the company. The financial statements were authorised for issue on 25 August 2023, while the payment of the dividends is likely to be made on 1 September 2023.

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 2023, the directors declared that a dividend of 20 cents per ordinary share be paid to shareholders registered on 30 June 2023.

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 Dividend declared (statement of changes in equity) XXX

Cr Dividend payable (statement of financial position) (to recognise dividends declared) XXX

dee67382_ch21_853-868.indd 860 10/24/19 03:42 PM

860 PART 7: Other disclosure issues

Breach of the going concern assumption As Chapter 2 explains, pursuant to the Conceptual Framework, there is a general presumption that financial statements are prepared in accordance with 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. (AASB 110)

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 (impairment of) 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 brought 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, 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 of the reporting period but before the date the financial statements are authorised for issue which shows that the going concern assumption is no longer appropriate, then management is required to go back and change the way the assets are measured as at the reporting date. 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 has now been abandoned in favour of a ‘blanket acceptance’ of the contents of standards released by the International Accounting Standards Board.

21.5 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

LO 21.5

dee67382_ch21_853-868.indd 861 10/24/19 03:42 PM

CHAPTER 21: Events occurring after the end of the reporting period 861

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. (AASB 110)

Again, all of the items listed above would be disclosed in the notes to the financial statements to the extent that the impacts on future financial statements are deemed to potentially be ‘material’. As we will discuss shortly, the disclosures within the notes should provide information about the nature of the respective event, and an estimate of its financial effect on future years’ operations (or if this cannot be quantified, a statement that such an estimate cannot be made). If any of the above events are extremely significant, then there could be a chance that the going concern assumption might be in doubt. In such an extreme case, where the going concern assumption seems no longer applicable, adjustments would need to be made to the financial statements (as discussed earlier).

Having discussed the difference between an adjusting and a non-adjusting event, we can now consider Worked Example 21.3.

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 as at 30 June 2023, which is the end of Lopez Ltd’s reporting period. On 26 July 2023, 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 2023 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 to account for the transaction. (c) Discuss how the answers to (a) and (b) would differ if a fire on 2 July 2023 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:

continued

dee67382_ch21_853-868.indd 862 10/24/19 03:42 PM

862 PART 7: Other disclosure issues

(c) As the fire that destroyed Lopez Ltd’s premises occurred on 2 July 2023, no adjustments to individual amounts in the financial statements of Lopez Ltd are required. That is, it would be considered to be a non-adjusting 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.

However, 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 2023 would have to be adjusted to reflect a liquidation basis of accounting. In this instance, the fire would be an ‘adjusting event’.

Dr Bad debts expense 85 000

Cr Accounts receivable 85 000

(to write down the amount owing by Gerry Ltd)

21.6 Disclosure requirements

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. (AASB 110)

As an example of the required disclosure, note 1 to the 2018 financial statements of Chartered Accountants Australia and New Zealand states:

The consolidated financial statements of Chartered Accountants Australia and New Zealand and its subsidiaries (together the “Group”) for the year ended 30 June 2018 were authorised for issue in accordance with a resolution of Directors on 11 October 2018.

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.

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. (AASB 110)

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 period note. It represents the note disclosures made by Myer Holdings Ltd in its annual report for the year ended 28 July 2018 (and which was authorised for issue on 11 September 2018).

LO 21.6

WORKED EXAMPLE 21.3 continued

dee67382_ch21_853-868.indd 863 10/24/19 03:42 PM

CHAPTER 21: Events occurring after the end of the reporting period 863

Exhibit 21.1 After-reporting-period event note from the 2018 Annual Report of Myer Holdings Ltd

SOURCE: Myer Holdings Ltd Annual Report 2018

Apart from the general requirements of AASB 110, it should be acknowledged that within Australia 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.

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.

Events after the reporting period 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 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 (useful) to financial statement users.

dee67382_ch21_853-868.indd 864 10/24/19 03:42 PM

864 PART 7: Other disclosure issues

KEY TERMS

balance sheet date 855 date financial statements are authorised for issue 855

event after the reporting period 855 reporting date 855

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following three questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. If an event occurs ‘after the reporting period’, then from the perspective of accounting standards, it is considered that the event has occurred between 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 The date financial statements are authorised for issue will, according to AASB 110, vary depending upon the management structure, statutory requirements and procedures followed in preparing and finalising the financial statements. For example, the management of an entity might be required to issue its financial statements to a supervisory board (made up solely of non-executives) for approval. In such cases, the financial statements are authorised for issue when the management authorises them for issue to the supervisory board. For Australian corporate entities, the date the financial statements are authorised for issue is usually deemed to be the date the Directors’ Declaration is signed, which is typically the last thing a company’s directors do before the financial statements are released.

2. What is the rationale for the inclusion of information, within the notes to the financial statements, about material transactions and events that have occurred since the reporting date, but before the financial statements were authorised for issue? LO 21.2 As there is usually a time lag of many weeks, or even months, between the end of the financial period and the date that shareholders and other interested parties receive the financial statements, the data is likely to be out of date by the time it reaches the financial statement users. Many material events could have occurred after the end of the reporting period, but before the financial statements are authorised for release to readers. The information in the financial statements may be supplemented by notes to the financial statements that document and describe material events occurring after the end of the reporting period. Failure to disclose material events that arise after the end of the reporting period can, in effect, make the financial statements misleading. For example, the year-end statement of financial position of a reporting entity might show a value for buildings that are an integral part 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 inclusion of this information in the notes to the financial statements helps to make the information more ‘timely’, and therefore, more ‘relevant’ to financial statement readers (‘timeliness’ is, according to the Conceptual Framework, a qualitative characteristic that ‘enhances’ the relevance of financial information).

3. Events after the reporting period 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 disclosure within the notes to the financial statements appropriate?) LO 21.3, 21.4, 21.5, 21.6

Adjusting events, both favourable and unfavourable, provide additional evidence of, or further elucidate, conditions that existed as at the end of the reporting period. For ‘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.

Therefore, an adjusting event 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 to the financial statements, if it relates to an item that would usually be recognised only by way of a note, such as a contingent liability.

dee67382_ch21_853-868.indd 865 10/24/19 03:42 PM

CHAPTER 21: Events occurring after the end of the reporting period 865

A non-adjusting event, on the other hand, relates to an event 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 (unless the event causes the organisation to no longer be considered a going concern, in which case the basis of valuation of the organisation’s assets and liabilities would need to be changed retrospectively). Non-adjusting 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.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What are the different types of events after the reporting date and how should they be disclosed? LO 21.1, 21.3, 21.4, 21.5, 21.6 •

2. If information relates to an event that occurs after the reporting period, when and why should it be detailed in the notes to the financial statements? LO 21.2, 21.5 •

3. The managers of an organisation are provided with an annual bonus which is 1 per cent of profits. The profit of the organisation is not determined until 2 months after the reporting date. Would the determination of profit result in the recognition of an ‘adjusting event’? Why? LO 21.3, 21.4 ••

4. An organisation sells a significant proportion of its inventory two weeks after the reporting date. The inventory had been on hand for four months. Would this constitute an ‘adjusting event’? Why? LO 21.3, 21.4 ••

5. An organisation has five factories. One of the factories burns down two weeks after the end of the reporting period. Would this constitute an ‘adjusting event’ or a ‘non-adjusting event’? Why? LO 21.3, 21.5 •

6. A major flood wipes out the principal place of operations of an organisation three weeks after the end of the reporting period. The flood loss is not covered by insurance. Would this be an ‘adjusting event’ or a ‘non-adjusting event’? Why? LO 21.3, 21.4, 21.5 •

7. What disclosures should an entity make in the notes to the financial statement in respect of each material category of non-adjusting event after the reporting period? LO 21.6 ••

8. 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. (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 21.1, 21.3, 21.4, 21.5, 21.6 •

9. Torquay Ltd’s financial year ended on 30 June 2023. 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 2023.

REQUIRED Classify the following events as either adjusting or non-adjusting events occurring after the reporting period, and indicate what sort of disclosure is required.

(a) 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.

(b) On 31 August 2023, the directors decided to restructure a loss-making division. LO 21.1, 21.2, 21.3, 21.5 ••

10. Indicate how Petersen Ltd should treat the following events in its financial statements for the year ending 30 June 2023. The financial statements were authorised for issue on 10 September 2023. You are not required to draft the financial statement notes.

(a) On 15 August 2023, 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.

dee67382_ch21_853-868.indd 866 10/24/19 03:42 PM

866 PART 7: Other disclosure issues

(b) On 30 June 2023, Lynch Ltd owed Petersen Ltd $234 900. On 24 July 2023, Petersen Ltd received notice that Lynch Ltd had become insolvent. It had ceased trading in May 2023.

(c) On 31 July 2023, 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 2023, Petersen Ltd settled a negligence claim lodged by one of its customers for $1 million. The claim arose on 7 March 2023. LO 21.1, 21.2, 21.3, 21.4, 21.5 ••

CHALLENGING QUESTIONS

11. You are finalising the 2022 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 2022. He has advised you of the following events:

(a) On 30 August 2022 an international convention agreed to increase the Saudi Arabian oil quota by 17 million barrels in 2022–2023. 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 2022 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.

(b) On 5 July 2022 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 2022 financial statements at a carrying amount of $15 million. The oil that the tanker was transporting had a carrying amount of $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 2022, 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 2022.

(d) For the year ended 30 June 2021, 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 2021 tax year. During 2022 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 2022, 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 2022 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 2022. No provision was recognised in the 30 June 2022 financial statements.

(f) At the August 2022 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 2022 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 2022. 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 carrying amount of the property as at 30 June 2022 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.

dee67382_ch21_853-868.indd 867 10/24/19 03:42 PM

CHAPTER 21: Events occurring after the end of the reporting period 867

• 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, 21.2, 21.3, 21.4, 21.5, 21.6

12. The 30 June 2022 financial statements of ABC Ltd have been prepared in draft form. However, the financial statements have not yet been authorised for issue. Subsequent to the end of the reporting period, the following events occur. Assume all amounts are material for financial statements purposes:

(a) A judgement is handed down in the Victorian Supreme Court on 15 July 2022 in relation to a 2021 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 2022 the Commonwealth government enacts legislation altering the company income tax rate from 30 per cent to 42 per cent for all income tax returns from 1 July 2022.

(c) On 28 July 2022 the company’s country warehouse is destroyed by fire. The total carrying amount of the warehouse, which was uninsured, is $350 000.

(d) On 2 August 2022 the financial cost of inventory shipped from overseas is determined. The inventory was received in June 2022 and the cost was estimated for accounting purposes. The revised cost is $900 000 greater than the prior estimate.

(e) On 16 July 2022 the company enters into a contract to purchase 25 per cent of the issued capital of a competitor XYZ Ltd for $750 000.

REQUIRED Discuss the appropriate accounting treatment of the above events. LO 21.1, 21.2, 21.3, 21.4, 21.5, 21.6

13. Lombok Ltd is an Australian entity that makes canoes and associated equipment. The end of its financial period is 30 June 2022. 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 authorised for issue, the following transactions and events come to light. Assume that each event or transaction is independent of the rest.

(a) On 30 July 2022 the directors recommend a final dividend of $2 per share. (b) At a directors’ meeting held in May 2022 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 2022 the directors become aware that the oars it has been selling since mid-July 2022 tend to fall apart when placed in water for more than 30 minutes. These oars were purchased by Lombok Ltd on 10 July 2022. By 7 August 2022 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 2022. 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 2022.

(e) In July 2022 an out-of-court settlement has finally been reached with one of Lombok Ltd’s 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 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 2022. LO 21.1, 21.2, 21.3, 21.4, 21.5

14. Gunnamatta Ltd has a financial period ending on 30 June 2022 and is expected to complete its financial statements on 10 September 2022. On 24 August 2022 it loses a major customer that has become insolvent. Also, owing to bad media publicity in August 2022 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 2022, this appears no longer to be the case.

dee67382_ch21_853-868.indd 868 10/24/19 03:42 PM

868 PART 7: Other disclosure issues

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 21.1, 21.2, 21.3, 21.4, 21.5

15. 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 2023. The company provides the following disclosures in the notes to the financial statements for the year ended 30 June 2023. The financial statements were issued on 31 August 2023:

(a) In July 2023 a warranty claim was made for a faulty brake system on 10 tractors sold to a large agricultural business in May 2023. 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 2023.

(b) A negligence lawsuit has been brought against Good Vehicles Ltd for damages sustained in July 2023 on account of the failure of the braking system in a tractor sold by the company in May 2023. 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.

(c) In August 2023 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 2023.

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 2023? LO 21.2, 21.3, 21.4, 21.5, 21.6

16. For each of the following material events after the reporting period, state whether adjustment or disclosure is required in the 30 June 2023 financial statements. If adjustment is required, state the nature of the adjustment on the financial statements.

(a) 2 July 2023: directors proposed a dividend of $10 000. (b) 3 July 2023: the executive directors approved the sale of an offshore agency to another entity for a profit of

$30 000. (c) 4 July 2023: 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 2023: 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 2023: 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 2023: the Australian Taxation Office (ATO) waived fines for the inclusion of incorrect information in the company’s 2021 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 2023: the government announced an increase in tax rates from 30 per cent to 33 per cent for the year commencing 1 July 2023; the deferred tax asset account is $90 000 and the deferred tax liability account is $60 000.

(h) 9 July 2023: the Remuneration Committee determined the CEO’s bonus for the year ended 30 June 2023 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 21.1, 21.3, 21.4, 21.5

dee67382_ch22_869-898.indd 869 10/23/19 06:58 AM

869

LEARNING OBJECTIVES (LO) 22.1 Understand that to enhance the usefulness of financial reports, the consolidated financial

statements (which provide a highly aggregated view of the financial performance and financial position of an organisation) need to be supplemented by additional disclosures pertaining to the various operating segments in which an organisation operates.

22.2 Understand the rationale behind the development of AASB 8 Operating Segments, and the reasons for the accounting standard’s requirement that the information to be disclosed shall be based upon the information used internally to manage the organisation.

22.3 Understand how ‘operating segments’ are defined. 22.4 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.

22.5 Understand how segment information is measured. 22.6 Be able to describe the disclosures required to be made about an operating segment’s financial

performance, assets, products and services, reliance on major customers, and the entity’s geographical dispersion.

22.7 Be able to critically evaluate whether the disclosure of information about operating segments creates competitive harm for a reporting entity.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

C H A P T E R 22 Segment reporting

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. We have an accounting standard that requires the disclosure of information about ‘operating segments’. What is an operating segment? LO 22.3

2. Why is it useful for financial statement readers to be provided with information about operating segments? LO 22.1, 22.2

3. How is it determined whether information about particular operating segments needs to be reported? LO 22.4 4. Is there a requirement to disclose any information about an organisation’s products or services, its major

customers or the geographic location of its operations? LO 22.6

dee67382_ch22_869-898.indd 870 10/23/19 06:58 AM

870 PART 7: Other disclosure issues

22.1 Advantages and disadvantages of segment reporting

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

(which bring together—or ‘consolidate’—the financial reports of a parent entity and its various subsidiaries) 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 2018 financial statements prepared by Westpac Banking Corporation Ltd and Commonwealth Bank Ltd. A review of the respective annual reports indicates that Westpac and Commonwealth Bank controlled 40 and 32 separate legal entities (subsidiaries) respectively. The consolidated financial statements presented to shareholders by each of these organisations combine/consolidate the financial statements of these many separate legal entities. Therefore, when we talk about Westpac Banking Corporation Ltd’s or Commonwealth Bank Ltd’s performance as a whole (as reflected in the consolidated financial statements), we are actually referring to the aggregated 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 statement of profit or loss and other comprehensive income provides an indication of the aggregated financial performance of many entities, some of which might be dissimilar, while the consolidated statement of financial position is derived from combining the statements of financial position of many organisations, all of which will typically have different financial structures. As a result of this aggregation process there is an obvious loss of information. Profitable or unprofitable subsidiaries or divisions are hidden in the aggregation process. Subsidiaries that could be considered high risk owing to excessive debt levels can also escape attention in the

consolidated financial statements as their assets and liabilities will be consolidated with those of the parent entity and all of the other subsidiaries. As an example of this problem, consider the data in Exhibit 22.1.

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

legal entity An entity that exists in its own right. Legal entities often combine to form an economic entity.

consolidated statement of financial position A statement of financial position that combines, with various eliminations and adjustments, the statements of financial position of the various entities within the economic entity.

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

8 Operating Segments IFRS 8

101 Presentation of Financial Statements IAS 1

LO 22.1

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.

  Farming

($000) Retail

($000) Entertainment

($000) Consolidated

data ($000)

Assets 500 400 600 1 500

Liabilities 200 200 500 900

Shareholders’ funds 300 200 100 600

Profit/(loss) for year 100 (50) 40 90

Return on assets 20% n/a 6.7% 6.0%

Return on shareholders’ funds 33.3% n/a 40% 15%

dee67382_ch22_869-898.indd 871 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 871

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.

Exhibit 22.2 provides details of the segment disclosure information by the Commonwealth Bank Ltd in its 2019 Annual Report (comparative information for 2018 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 Corporate Centre’), these being Retail Banking Services, Business and Private Banking, Institutional Banking and Markets, Wealth Management and New Zealand. You will also note that the Commonwealth Bank provides information on a geographical 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 2019 the ‘Business and Private Banking’ segment generated a return on assets of approximately 1.5 per cent, whereas at the other end, the components of the organisation that make up the ‘IFS and Corporate Centre’ segment generated a negative return. Interested stakeholders might like to undertake further investigation to understand why some segments appeared to provide minimal or negative returns. The segment data provided by Commonwealth Bank also allows us to know the income and non-current assets deployed in each geographical segment. Because different countries will have different levels of economic growth, political stability and so forth it is useful for financial statement readers to be aware of such geographically based information.

Reflective of the way that segment data is often used to evaluate the performance of different components of an organisation, in a newspaper article of 13 August 2018 entitled ‘How Domino’s could deliver both pleasure and pain’ (by James Thomson in The Australian Financial Review, p. 13), it was noted in relation to Domino’s Pizza that its Japanese geographical segment seemed to be particularly struggling and was the weakest segment within the organisation. This was noted as an issue of concern. The Japanese earnings were shown to be about a third of that in Australia and less than Europe. By contrast, the reported segment information indicated that the organisation had a limited presence in Germany and France and this was seen as providing an indication of future growth potential. Without segment data, such observations would not be possible.

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

Exhibit 22.2 Extract from the segment disclosure note provided in the 2019 Annual Report of Commonwealth Bank of Australia

continued

dee67382_ch22_869-898.indd 872 10/23/19 06:58 AM

872 PART 7: Other disclosure issues

SOURCE: Commonwealth Bank of Australia, Annual Report 2019.

Exhibit 22.2 continued

dee67382_ch22_869-898.indd 873 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 873

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 its 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 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

dee67382_ch22_869-898.indd 874 10/23/19 06:58 AM

874 PART 7: Other disclosure issues

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 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’.

WHY DO I NEED TO KNOW ABOUT OPERATING SEGMENTS?

As organisations get larger, they tend to become quite diversified. The overall (or consolidated) financial performance and financial position of the entire organisation might fail to represent the performance and position of different operating segments. Therefore, to more fully understand the performance and associated risks of an organisation, it would make sense to ‘drill down’ a bit and analyse data about how the different and sometimes independent components of an organisation are operating. This will provide a more thorough understanding of the performance of the organisation, its risks and its likely future performance.

22.2 An introduction to AASB 8

AASB 8 Operating Segments was initially released in 2007 and replaces AASB 114 Segment Reporting. AASB 8 features a number of significant departures from the requirements of the former accounting standard.

In the ‘Basis for Conclusions’ that accompanied the release of IFRS 8, the IASB supported the introduction of the new accounting standard 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;

LO 22.2

dee67382_ch22_869-898.indd 875 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 875

(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, it accompanied the standard with a press release. In it the IASB referred to the management approach adopted within AASB 8/IFRS 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. 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 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. (AASB 8)

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 the former accounting 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, the

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.

dee67382_ch22_869-898.indd 876 10/23/19 06:58 AM

876 PART 7: Other disclosure issues

former accounting standard 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, 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. (AASB 8)

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

∙ 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 former accounting standards, 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, and assets to the respective totals

provided for the entity ∙ other non-financial disclosures pertaining to operating segments.

22.3 Defining an operating segment

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 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

LO 22.3

dee67382_ch22_869-898.indd 877 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 877

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. (AASB 8)

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 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. (AASB 8)

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.

As already noted, AASB 8 is based largely on the United States accounting standard SFAS 131 ‘Disclosures about Segments of an Enterprise and Related Information’. Indeed, the standards are effectively the same. At the time when IFRS 8 was being developed, there was a project in place to converge the accounting standards being released in the US by the Financial Accounting Standards Board (FASB) with those being released by the IASB (this project subsequently lost momentum). 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 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. (c) Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, used with permission.

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. As we know, the Conceptual Framework identifies comparability as an enhancing qualitative characteristic of useful financial information. 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.

dee67382_ch22_869-898.indd 878 10/23/19 06:58 AM

878 PART 7: Other disclosure issues

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] (c) Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, used with permission.

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’.

22.4 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 requires:

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. (AASB 8)

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 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;

LO 22.4

reportable segment An operating segment for which segment information is required to be disclosed by virtue of AASB 8.

dee67382_ch22_869-898.indd 879 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 879

(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.

(AASB 8)

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. (c) Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, used with permission.

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:

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;

(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. (AASB 8)

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 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. (AASB 8)

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. (AASB 8)

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,

dee67382_ch22_869-898.indd 880 10/23/19 06:58 AM

880 PART 7: Other disclosure issues

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 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. (AASB 8)

The view taken when AASB 8 replaced AASB 114 was that the number of segments to be disclosed by reporting entities within the notes to the financial statements would increase. Evidence (for example, He et al. 2016) indicates that this did appear to occur. Arguably, this should enhance the ability of particular users—such as financial statement analysts—to make informed decisions about reporting entities given that managers’ ability to conceal segment information should be decreased, thereby improving analysts’ ability to correctly forecast future earnings. Nevertheless, in their research, He et al. (2016) showed that unlike research in the US, analysts’ earnings per share forecasts within Australia did not improve following the release of AASB 8. This was contrary to research published within the US. While we will not pursue this issue further in this chapter, it is important that research is undertaken to determine whether there are benefits to particular mandated disclosures that exceed the associated ‘costs’. If a great deal of research was produced to show that particular reporting requirements were not appearing to be beneficial to financial statement readers, then accounting standard-setters would need to consider making amendments to the accounting standards.

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.

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.

Business segment Segment revenue

($000) Profit or loss

($000) Segment assets

($000)

Mining 500 (55) 100

Manufacturing 125 (25) 20

Chemicals 100 5 10

Agriculture    800  100 150

Total 1 525    25 280

dee67382_ch22_869-898.indd 881 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 881

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 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. (AASB 8)

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 AASB 8 is 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 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

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. While ‘Chemicals’ is not deemed to be a ‘reportable segment’ for the purposes of the accounting standard, the organisation might nevertheless decide to disclose information about the segment. That is, the accounting standard provides rules for determining the minimum number of reportable segments, but managers can decide to report more segments.

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

dee67382_ch22_869-898.indd 882 10/23/19 06:58 AM

882 PART 7: Other disclosure issues

respondents’ concerns about competitive harm and proliferation of segments without fundamentally changing the management approach to segment definition. (c) Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA, used with permission.

22.5 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:

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. (AASB 8)

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.

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, the two fundamental qualitative characteristics of useful financial information are identified within the Conceptual Framework as 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;

LO 22.5

dee67382_ch22_869-898.indd 883 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 883

(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. (AASB 8)

WHY DO I NEED TO KNOW HOW SEGMENT ITEMS ARE MEASURED?

It is important because it enables us to understand the context of the numbers being reported. Because the managers of different organisations will perhaps use different measurement approaches, the information being presented about ‘measurement’ will help guide us as to whether, for example, it is appropriate to compare the operating segments of one organisation with those of another.

22.6 Required 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:

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 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 and rights arising under insurance contracts. (AASB 8)

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

LO 22.6

dee67382_ch22_869-898.indd 884 10/23/19 06:58 AM

884 PART 7: Other disclosure issues

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 AASB 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

The reconciling item to adjust expenditures for assets is the amount incurred for the corporate headquarters building, which is not included in segment information. None of the other adjustments is material.

Other material items Reportable segment

totals ($000) Adjustments

($000) Entity totals

($000)

Interest revenue 3 750 75  3 825

Interest expense 2 750 (50) 2 700

Net interest revenue (finance segment only)

1 000 – 1 000

Expenditures for assets 2 900 1 000  3 900

Depreciation and amortisation 2 950 –  2 950

Impairment of assets 200 –  200

Revenues $000

Total revenues for reportable segments 39 000

Other revenues 1 000

Elimination of inter-segment revenues (4 500)

Entity’s revenues as reported in the Income Statement 35 500

Profit or loss $000

Total profit or loss for reportable segments 3 970

Other profit or loss 100

Elimination of inter-segment profits (500)

Unallocated amounts:  

– Litigation settlement received 500

– Other corporate expenses (750)

– Adjustment to pension expense in consolidation  (250)

Income before income tax expense as reported in the Income Statement 3 070

Assets $000

Total assets for reportable segments 79 000

Other assets 2 000

Elimination of receivable from corporate headquarters (1 000)

Goodwill not allocated to reportable segments 4 000

Other unallocated amounts   1 000

Entity’s assets as reported in the Balance Sheet 85 000

dee67382_ch22_869-898.indd 885 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 885

Disclosure of information about products or services, major customers and geographical locations of operations Apart from financial disclosures, AASB 8 requires that other, entity-wide, non-financial information be disclosed. The standard 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, 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. (AASB 8)

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 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. (AASB 8)

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

(a) Revenues are attributed to countries on the basis of the customer’s location.

Geographical information Revenues (a)

($000) Non-current assets

($000)

Australia 8 000 9 000

United States 7 000 6 000

South Africa 4 800 5 100

Indonesia 2 200 –

Other countries   4 000   3 900

Total 26 000 24 000

dee67382_ch22_869-898.indd 886 10/23/19 06:58 AM

886 PART 7: Other disclosure issues

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. (AASB 8)

Refer to Exhibit 22.5 for an example of the form of disclosure that would satisfy the requirements of paragraph 34.

Exhibit 22.5 Information about major customers

NOTE X.

Revenues from one customer of World Surfing Ltd’s wetsuit segment represent 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.

WHY DO I NEED TO KNOW ABOUT AN ORGANISATION’S RELIANCE ON MAJOR CUSTOMERS, OR THE GEOGRAPHICAL REGIONS IN WHICH AN ENTITY OPERATES?

In relation to major customers, it is generally considered that the more an organisation relies upon particular customers, the greater the risk to the organisation. Ideally, an organisation would have a diversified group of customers in which no single customer dominates—although this is not always possible. To properly assess the performance and risk of an organisation, it is essential to know whether an organisation appears overly dependent upon a limited number of customers.

In relation to geographical details, different countries create different opportunities and different risks. Therefore, it is useful to have information about the different countries in which the organisation operates, the relative amount of assets held within those locations, and the revenues being derived. In the absence of such information, the risks and performance of an organisation cannot be properly assessed.

LO 22.7 22.7 Is there a case for competitive harm?

At the beginning of the chapter we pointed out that some organisations opposed detailed segment disclosures because 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

WORKED EXAMPLE 22.2: Comprehensive exercise on operating segments

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 of 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.

Financial information for the year for the respective segments as provided to the chief operating decision maker is as follows:

continued

dee67382_ch22_869-898.indd 887 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 887

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 AASB 8 is 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 enterprise-wide 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 than 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.

Worked Example 22.2 now provides a relatively comprehensive illustration pertaining to operating segments.

  Total sales

($000) Profit before tax

($000) Assets ($000)

Surfing equipment 700 65 8 000

Fashion 250 20 2 500

Toys 150 (10) 2 000

Building supplies 300 35 3 500

Information technology 30 6 300

Wave-pool construction      20 4     200

  1 450 120 16 500

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.

SOLUTION 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. As we know, 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; (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. (AASB 8) 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 six segments:

• Surfing equipment: sales total $700 000, therefore this segment passes the test. • Fashion: sales total $250 000, therefore this segment passes the test.

WORKED EXAMPLE 22.2 continued

dee67382_ch22_869-898.indd 888 10/23/19 06:58 AM

888 PART 7: Other disclosure issues

 

Depreciation and amortisation

($000)

Other non- cash expenses

($000) Liabilities

($000)

Capital acquisitions

($000)

Interest revenue

($000)

Interest expense

($000)

Surfing equipment 30 15 3 000 250 5 –

Fashion 15 10 1 500 50 – 3

Toys 25 15 1 000 100 – –

Building supplies 20 20 2 500 200 – –

Information technology 6 3 150 – – –

Wave-pool construction      4   2       50     –    –     –

  100 65 8 200 600    5    3

• 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

(b) Reconciliation of financial information provided in operating segment note to information provided in the financial statements

continued

dee67382_ch22_869-898.indd 889 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 889

 

Surfing equipment

($000) Fashion

($000) Toys

($000)

Building supplies

($000)

All other segments

($000) Total

($000)

Revenue from            

External sales 700 250 150 250 50 1 400

Inter-segment sales – –  – 50   50

Interest revenue 5         5

Interest expense   3       3

Depreciation and amortisation 30 15 25 20 10 100

Profit before tax 65 20 (10) 35 10 120

Segment assets 8 000 2 500 2 000 3 500 500 16 500

Segment liabilities 3 000 1 500 1 000 2 500 200 8 200

Acquisition of property, plant and equipment and intangible assets 250 50 100 200 – 600

Other non-cash expenses other than depreciation

15 10 15 20 5 65

Revenues $000

Total revenues from operating segments 1 450

Other revenues (received by head office) 10

Elimination of inter-segment revenues    (50)

Total revenue shown in statement of comprehensive income 1 410

dee67382_ch22_869-898.indd 890 10/23/19 06:58 AM

890 PART 7: Other disclosure issues

(c) Geographical information McTavish Ltd operates predominantly within Australia; however, some sales are made to customers in the United Kingdom.

(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.

WORKED EXAMPLE 22.2 continued

Profit or loss $000

Total profit or loss from operating segments 120

Elimination of inter-segment profits (5)

Unallocated corporate expenses (20)

Profit before income tax expense 95

Tax expense (30)

Profit after tax as shown in statement of comprehensive income 65

Assets $000

Total assets of operating segments 16 500

Goodwill not allocated to reportable segments 2 000

Other unallocated corporate assets        50

Total assets as shown in statement of financial position 18 550 

Liabilities $000

Total liabilities of operating segments 8 200

Unallocated liabilities    100

Total liabilities as shown in the statement of financial position 8 300

  Sales by geographical area

($000) Non-current assets

($000)

Australia 1 200 12 000

United Kingdom    250          –

  1 450 12 000

SUMMARY

The chapter addressed segment reporting. As a result of reading this chapter, it should now be apparent that it is important for readers of financial reports to seek out the notes to the financial statements that address operating segments, and to read them carefully. Segment reporting provides information about the performance and financial position of various sub- units 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.

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 enables 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

dee67382_ch22_869-898.indd 891 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 891

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 potential for profitable segments to attract unwelcome attention from government and interested groups.

The relevant accounting standard pertaining to segment disclosures is AASB 8 Operating Segments. 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 the 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 870

legal entity 870 operating segment 875

reportable segment 878

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following four questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. We have an accounting standard that requires the disclosure of information about ‘operating segments’. What is an operating segment? LO 22.3 According to AASB 8, 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 in order to make decisions about resources to be allocated to the segment and assess its performance, and

(c) for which discrete financial information is available. An operating segment may engage in business activities for which it has yet to earn revenues; for example, start-

up operations may be operating segments before earning revenues.

2. Why is it useful for financial statement readers to be provided with information about operating segments? LO 22.1, 22.2 The consolidated financial reports presented by organisations report the financial performance and financial position of organisations in a way that consolidates everything together, thereby making it difficult, or impossible, to determine how particular segments of an organisation have operated. To better understand the performance of, and risks associated with, an organisation, we need to have this information broken down into different operating segments. Different segments will be subjected to different levels of risk, and having segment information helps us to know better the level of investment in segments with different risks, as well as helping us to ascertain whether the returns being generated in particular operating segments are commensurate with the related risks. Such information should also enable us to make better predictions about the future. In addition, the production of segment data enables managers to demonstrate greater accountability in respect of the organisation.

dee67382_ch22_869-898.indd 892 10/23/19 06:58 AM

892 PART 7: Other disclosure issues

3. How is it determined whether information about particular operating segments needs to be reported? LO 22.4 There are a number of issues to consider here. First, 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. Therefore, the accounting standard takes a ‘management approach’ to defining reportable segments. Secondly, there are then specific quantitative thresholds that need to be met. In this regard, the accounting standard requires that an entity shall report separately information about an operating segment that meets any of the following quantitative thresholds:

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

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

(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.

The accounting standard also provides a quantitative threshold in respect of the total external revenue that is required to be reported by identified operating segments. Specifically, it is a requirement that 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.

4. Is there a requirement to disclose any information about an organisation’s products or services, its major customers or the geographic location of its operations? LO 22.6 Yes, there is. 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.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

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 22.7 • 3. Do you think that requiring organisations to provide segment data would stifle the introduction of new ideas or

approaches? LO 22.7 •• 4. Some people argue that providing segment data leads to a competitive disadvantage for firms that are operating

successfully. Evaluate this argument. LO 22.1, 22.7 •• 5. Evaluate the argument which holds that concerns about competitive disadvantage lead to lower-quality segment

disclosures. LO 22.1, 22.7 •• 6. ‘Providing segment data to financial statement users will enable management to demonstrate greater accountability.’

Discuss this statement. LO 22.1, 22.2 • 7. Do segment items, as disclosed in the operating segment note, need to be measured in accordance with accounting

standards? LO 22.5 • 8. What is a ‘reportable segment’? LO 22.4 • 9. How does an entity identify its operating segments for the purposes of applying AASB 8? LO 22.3,

22.4, 22.5 • 10. What is the basis of allocating revenue to particular segments? LO 22.6 • 11. What is the basis of allocating assets to particular segments? LO 22.6 • 12. 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 22.4, 22.5, 22.6 ••

dee67382_ch22_869-898.indd 893 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 893

13. Why disclose information about different geographical segments? LO 22.1, 22.2, 22.6 • 14. 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 •• 15. There are disclosures required by AASB 8 in respect of an entity’s reliance on major customers. Why should such

disclosures be made, and what are the required disclosures? LO 22.6 •• 16. If we initially prepare an operating segment note and we find that the total external revenue reported by the operating

segments constitutes less than 75 per cent of the entity’s total revenue, what are we to do? LO 22.4 • 17. The information to be disclosed about operating segments is to be based upon the information used internally by

managers and which might be compiled in a way that is not consistent with accounting standards. Does this help or impede the comparability of the information with respect to other reporting entities? Explain your answer. LO 22.1, 22.2, 22.5 ••

18. When are we permitted to combine the information for different segments when making a segment disclosure note? LO 22.4, 22.5, 22.6 •

19. 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 which fails to pass the tests the subsequent year? LO 22.4, 22.5, 22.6 ••

20. The following operating segment information is presented for Ocky Ltd.

  Segment revenue

($000) Segment profit

($000) Segment assets

($000)

Mining 700 100 1 000

Food 125 20 200

Chemicals 50 (35) 100

Clothing       90         5      90

Total    965      90 1 390

REQUIRED Determine which segments are reportable according to the guidelines provided in AASB 8. LO 22.4 • 21. The following operating segment information is presented for Rocky Ltd.

  Segment revenue

($000) Segment profit

($000) Segment assets

($000)

Timber 800 75 900

Steel 100 25 420

Cardboard    60 (15)    180

Total 960 85 1 500

REQUIRED Determine which segments are reportable according to the guidelines provided in AASB 8. LO 22.4 • 22. The following segment information is presented for Raging Bull Ltd.

  Segment revenue

($000) Segment profit

($000) Segment assets

($000)

Clothing 300 130 900

Travel 150 30 300

Agriculture 60 20 120

Motor vehicle manufacture   45 (15)      80

Total 555 165 1 400

REQUIRED Determine which segments are reportable according to the guidelines provided in AASB 8. LO 22.4 •

dee67382_ch22_869-898.indd 894 10/23/19 06:58 AM

894 PART 7: Other disclosure issues

REQUIRED Determine which segments are reportable according to the guidelines provided in AASB 8. LO 22.4 •

CHALLENGING QUESTIONS 24. The following information comes from the segment reporting note that was in the BHP 2019 Annual Report. As we

can see, more than half of the organisation’s revenue in 2019 came from China. Would this be a concern for you if you were a shareholder of BHP? If so, or not, why? LO 22.6

  Segment revenue

($000) Segment profit

($000) Segment assets

($000)

Food 330 100 800

Beverages 270 110 550

Hotels   50  (20)    150

Total 650 190 1 500

23. The following segment information is presented for Calm Cow Ltd.

25. In a newspaper article of 7 July 2017 entitled ‘Australia Post’s accounts a mess’ (by Tony Boyd, The Australian Financial Review, p. 40), it was noted that numerous restatements seemed to have been made in the financial accounts of Australia Post in recent years that did not impact the overall results of Australia Post, but which did change the reported financial performance of the different operating segments.

Specifically, it was reported that the restatements resulted in generally adverse outcomes for the earnings of the ‘letters’ segment, positive outcomes for the ‘parcels’ and ‘retail’ segments and large swings in the reported earnings for those parts of the business that were ‘unallocated’. The newspaper article then quoted an Australian university professor who noted that the apparent restatements made the performance of the ‘letters’ segment look worse and the performance of the ‘parcels’ segment look better. Further, according to the newspaper article, the various adjustments and restatements appeared to be occurring at the same time that Australia Post was campaigning for higher prices for posting letters, and for the introduction of a two-speed letter service.

The newspaper article also noted that the professor believed that this raised legitimate questions about whether the restatements were done purposely to make the performance of the ‘letters’ segment look worse.

REQUIRED Do you think it is realistic to believe that reporting entities might use segment data opportunistically to help them achieve desired outcomes? Further, why would making the performance of the ‘letters’ segment look worse than it should be in turn help Australia Post to get approval for a rise in the price of letters? LO 22.1, 22.2

SOURCE: BHP Group Ltd

dee67382_ch22_869-898.indd 895 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 895

  Depreciation

($000) Other non-cash

expenses ($000) Liabilities

($000) Capital acquisitions

($000)

Entertainment 20 10 200 50

Clothing 10 5 100 10

Food 15 10 150 20

Agriculture 25 15 100 10

General corporate items 20 20 250   –

Total 90 60 800 90

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 22.3, 22.4, 22.5, 22.6, 22.7

  Sales to outside customers

($000) Inter-segment sales

($000) Total sales

($000)

Entertainment 600 50 650

Clothing 80   80

Food 200   200

Agriculture   40 10   50

Total 920 60 980

Profit (loss) before income tax by operating segment $000

Entertainment 100

Clothing 20

Food (10)

Agriculture 20

General corporate expenses   (10)

Total 120

Identifiable assets by operating segment $000

Entertainment 800

Clothing 300

Food 100

Agriculture 110

General corporate assets      50

Total 1 360

26. 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.

dee67382_ch22_869-898.indd 896 10/23/19 06:58 AM

896 PART 7: Other disclosure issues

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 $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.

27. 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:

  Total sales

($000) Profit before tax

($000) Assets ($000)

Travel 1 750 162.5 20 000

Student accommodation 625 50 6 250

Entertainment 375   (25) 5 000

Consulting 750 87.5 8 750

Building 75 15 750

Sandmining      50 10      500

Total 3 625 300 41 250

 

Depreciation and

amortisation ($000)

Other non- cash

expenses ($000)

Liabilities ($000)

Capital acquisitions

($000)

Interest revenue

($000)

Interest expense

($000)

Travel 75  37.5  7 500 625 12.5 –

Student accommodation

37.5  25  3 750 125 – 7.5

Entertainment 62.5  37.5  2 500 250 – –

Consulting 50  50  6 250 500 – –

Building 15  7.5  375 – – –

Sandmining   10      5         125        –      –    –

Total 250  162.5 20 500 1 500 12.5 7.5

dee67382_ch22_869-898.indd 897 10/23/19 06:58 AM

CHAPTER 22: Segment reporting 897

• 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

REFERENCES Aitken, M., Hooper, C. & Pickering, J., 1997, ‘Determinants

of Voluntary Disclosure of Segment Information: A Re- examination of the Role of Diversification Strategy’, Accounting and Finance, vol. 37, pp. 89–109.

Association for Investment Management and Research, 1993, Financial Reporting in the 1990s and Beyond, Charlottesville VA.

Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

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.

He, L., Evans, E. & He, R., 2016, ‘The Impact of AASB 8 Operating Segments on Analysts’ Forecasts: Australian Evidence’, Australian Accounting Review, vol. 26, no. 4, pp. 330–40.

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.

dee67382_ch22_869-898.indd 898 10/23/19 06:58 AMdee67382_ch22_869-898.indd 898 10/23/19 06:58 AM

dee67382_ch23_899-916.indd 899 10/24/19 03:44 PM

899

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 23.1 Understand what a related party is and what is meant by a related party transaction. 23.2 Be aware of some of the risks and opportunities that accrue as a result of transactions with related

parties. 23.3 Understand the rationale behind disclosing extensive information about related party transactions. 23.4 Be aware of some of the categories of related parties. 23.5 Understand some of the various disclosure requirements included within the Corporations Act 2001

and AASB 124 Related Party Disclosures.

C H A P T E R 23 Related party disclosures

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. For accounting purposes, what is a ‘related party’, and what is a ‘related party transaction’? LO 23.1 2. It is often argued that to properly assess the performance of an organisation, knowledge of its related party

transactions is required. Why? LO 23.2, 23.3 3. What are some possible negative consequences of related party transactions? LO 23.2 4. Are related party transactions always a negative thing for an organisation? LO 23.2

dee67382_ch23_899-916.indd 900 10/24/19 03:44 PM

900 PART 7: Other disclosure issues

23.1 Introduction to related party disclosures

Transacting with related parties potentially creates certain risks for various stakeholders related to organisations and it is because of such risks that organisations are required to make fairly extensive related party disclosures.

Related party transactions also potentially create negative implications for the broader society. For example, as we will discuss later in the chapter, there are many instances where managers have been alleged to have structured their transactions with overseas related parties in a way that generates higher profits in countries that have lower tax rates, thereby assisting the organisation to pay less tax in the domestic country (and, as a result, providing a lower economic contribution to such societies).

Related party relationship defined 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. The relevant accounting standard for related party disclosures is AASB 124 Related Party Disclosures. According to paragraph 9:

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

(a) A person or a close member of that 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. (AASB 124)

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 as: ‘a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged’ (AASB 124).

Within Australia, Section 300A of the Corporations Act 2001 also contains a number of disclosure requirements regarding related parties. We will consider Section 300A towards the end of the chapter.

LO 23.1

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.

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

10 Consolidated Financial Statements IFRS 10

13 Fair Value Measurement IFRS 13

124 Related Party Disclosures IAS 24

dee67382_ch23_899-916.indd 901 10/24/19 03:44 PM

CHAPTER 23: Related party disclosures 901

23.2 Implications of related party transactions

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. (AASB 13)

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. Transactions between parties that are related and therefore not independent of each other 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 and increases the accountability that managers should demonstrate in relation to such transactions. 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 activities of a reporting entity.

In extreme cases, related party transactions might be undertaken to defraud other parties with a claim against the firm (including governments and broader societies). For example, a director might sell some of the firm’s assets to a related entity for a price materially below their market value. Directors might also use their position to pay themselves excessive salaries. In addition, there have been a number of high-profile cases where organisational resources have been diverted for use in the renovation of senior executives’ homes.

As already suggested, 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 to allow the transfer of profits to a related entity that has carry-forward tax losses, or which is operating in a country where tax rates are lower. Further, tax-deductible expenses could also be shifted to countries with a higher tax rate so as to receive a greater deduction relating to those expenses. Examples include the shifting of R&D expenditure, or interest expenses, to more highly taxed jurisdictions.

According to Kohlbeck and Mayhew (2017), for research purposes, related party transactions can usefully be divided into two main types. The first type are those transactions such as loans, guarantees and consulting arrangements that are negotiated with an organisation’s directors or other key management personnel. The other type are those that relate to purchases and sales of products central to the operations of the organisation and which commonly involve investees of the organisation. Kohlbeck and Mayhew (2017) provide evidence that the first category of related party transactions (directly involving senior executives) is the one that is more likely to create problems and which might be incorrectly recorded/accounted for in the first instance, thereby requiring a restatement of the accounts in subsequent years. Their view is that this first category of related party transactions is inherently more risky from an accounting and accountability perspective, and is more likely to be associated with managerial opportunism whereby managers effectively transact in a way that enables wealth transfers between the organisation and related parties that are detrimental to other stakeholders, such as shareholders.

Because of concerns about how Australian companies might structure their transactions so as to avoid making taxation payments, in 2015 the Australian government initiated a Senate Inquiry into Corporate Tax Avoidance. This inquiry investigated how some organisations tended to shift income to subsidiaries operating in various ‘tax havens’ while at the same time maximising the expenses being incurred (and related deductions being claimed) in more highly taxed countries—in particular, Australia. Ultimately, throughout 2017, 2018 and 2019, the Australian Taxation Office required several large Australian companies to pay many millions of dollars of additional taxes (sometimes hundreds of millions of dollars) that had otherwise been avoided. For example, in 2018 the Australian Taxation Office issued amended income tax assessments to ExxonMobil Australia in relation to interest that had been paid to related parties that were situated overseas. The Taxation Office was particularly interested in the interest rates that had been charged on loans from Exxon’s foreign subsidiaries. Similar actions were taken in 2017 against an organisation associated with the global oil company Chevron. And similar allegations were also made against the global company Shell. Hence, these concerns about related party transactions can refer to very large organisations, and the concerns could relate to transactions that constitute large financial amounts.

Apart from concerns about interest rates being charged by related parties, another concern recently raised by the Australian Taxation Office relates to those instances where some organisations manage their transactions to effectively

LO 23.2

related party transactions Transactions between related parties.

director Anyone who directs an entity in its financial and operating activities independently or with others or anyone occupying or acting in the position of director or directing someone in that position.

dee67382_ch23_899-916.indd 902 10/24/19 03:44 PM

902 PART 7: Other disclosure issues

shift profits to related organisations operating in countries with relatively low tax rates. That is, to shift the profits overseas. For example, sales transactions might be arranged in such a way that they are initiated by a related overseas organisation. In this regard, the Australian Taxation Office has investigated the practices of several large Australian mining companies.

As yet another example of concerns about related party transactions, in 2018 the Australian Prudential Regulation Authority released its review of related party arrangements for superannuation funds, with a particular focus on the use of consultants and fund managers (see www.apra.gov.au/sites/default/files/Pages/2018-2-insight.html#news1-ref1). The review of 14 superannuation funds was prompted by concerns that some funds’ management of commercial relationships with related parties was not in the best interest of their members.

As discussed in the sections that follow, and consistent with some of the instances referred to above, related parties disclosure is highly regulated in Australia and elsewhere. We might reasonably assume that the majority of transactions initiated within an organisation, whether or not with related parties, would be in the interests of the business and its owners. However, it is the risk that a minority of transactions might not be in the interests of the organisation (or the local community) that, arguably, has contributed to the extensive disclosure requirements now in place. Accountability is expected in relation to such transactions.

Considering what we read in the news media about related party transactions, we are often left feeling that there is something profoundly 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 associations involved. That is, there is not necessarily something wrong with all, or indeed perhaps most, related party transactions—but there is arguably something wrong with not disclosing information about them.

23.3 The rationale for requiring related party disclosures

If the performance of an entity and the potential impact thereon 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) 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. (AASB 124)

Paragraphs 5 to 8 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. (AASB 124)

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.

Applying the disclosure requirements for ‘related parties’ as detailed in AASB 124 obviously requires a definition of ‘related parties’. As we indicated earlier, AASB 124 provides a relatively broad definition of the term, tying it in

LO 23.3

dee67382_ch23_899-916.indd 903 10/24/19 03:44 PM

CHAPTER 23: Related party disclosures 903

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 (as has been the case in recent times for a number of Australian-based organisations). 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 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.

WHY DO I NEED TO KNOW ABOUT THE RELATED PARTY TRANSACTIONS BEING UNDERTAKEN BY AN ORGANISATION?

Related party transactions can create various risks and opportunities for an organisation and its various stakeholders and can potentially create material impacts upon the financial performance and financial position of an organisation. Therefore, to more fully understand the factors that have contributed to current performance, and which might impact future performance, it is necessary to know about the extent and nature of related party transactions undertaken by an organisation.

Figure 23.1 Example of some related party transactions

Director Key management

personnel

Salary

Bonuses Fees

Loan

LoansInventory

Inventory

Sales

Subsidiary A (Australia)

Subsidiary B (Singapore)

Parent Company (Australia)

dee67382_ch23_899-916.indd 904 10/24/19 03:44 PM

904 PART 7: Other disclosure issues

23.4 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. Appendix A to AASB 10 defines control as existing where 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. (AASB 10)

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.

Significant influence An entity that is significantly influenced by another entity is referred to as an associate. As indicated above, a related party relationship can also be established through the existence of significant influence by one entity over another.

Significant influence means the power to participate in the financial and operating policy decisions of an entity, but is not control or joint control of those policies. Significant influence is a relationship that falls short of control, but enables one party to substantially affect the policies of another. The most common form of relationship based on significant influence is that 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 (therefore meaning the investee is an ‘associate’ of the ‘investor’), 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.

control (organisations) With regards to related parties and other organisations within a group (economic entity), control means the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.

significant influence The capacity of an entity to affect substantially but not control either, or both, the financial and operating policies of another entity.

Figure 23.2 Example of related parties showing percentage of equity ownership

A Ltd

25%

100%

25%

100%

B Ltd

E LtdD Ltd

C Ltd

LO 23.4

dee67382_ch23_899-916.indd 905 10/24/19 03:44 PM

CHAPTER 23: Related party disclosures 905

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. (AASB 124)

An entity can also be deemed to be 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. (AASB 124)

We will now apply the definition of a related party provided in AASB 124 to the example given in Worked Example 23.1.

key management personnel Persons having authority and responsibility for planning, directing and controlling the activities of an entity, including any director of that entity.

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 Smith, Jones

Sunrise Ltd Green, Black

Peregian Ltd White, Sand

Marcoola Ltd Long, Board

Castaways Ltd Short, Wax

Sunshine Unit Trust 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.

continued

dee67382_ch23_899-916.indd 906 10/24/19 03:44 PM

906 PART 7: Other disclosure issues

(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 and therefore related.

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.

Figure 23.3 Structure of entities in an Australian group

Coolum Ltd

Marcoola Ltd

Sunshine Unit Trust

Peregian Ltd

Castaways Ltd

Sunrise Ltd

32% 40%

70%

55%11%

WORKED EXAMPLE 23.1 continued

dee67382_ch23_899-916.indd 907 10/24/19 03:44 PM

CHAPTER 23: Related party disclosures 907

23.5 Disclosure requirements for related parties

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 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. (AASB 124)

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. (AASB 124)

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.

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.

LO 23.5

dee67382_ch23_899-916.indd 908 10/24/19 03:44 PM

908 PART 7: Other disclosure issues

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 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. (AASB 124)

In relation to the disclosure of information about transactions between related parties, paragraph 18 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. (AASB 124)

The disclosures noted above must be classified by related party. As we have indicated, paragraph 19 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. (AASB 124)

Detailed disclosures of particular transactions with individual related parties would frequently be too voluminous to be easily understood. Accordingly, 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.

AASB 124 provides examples of related party transactions that should be disclosed. These include: ∙ purchases or sales of goods (finished or unfinished); ∙ purchases or sales of property and other assets; ∙ rendering or receiving of services; ∙ leases; ∙ transfers of research and development; ∙ transfers under licence agreements; ∙ transfers under finance arrangements (including loans and equity contributions in cash or in kind); ∙ provision of guarantees or collateral; ∙ commitments to do something if a particular event occurs or does not occur in the future, including executory

contracts (recognised and unrecognised); and ∙ settlement of liabilities on behalf of the entity or by the entity on behalf of that related party. (AASB 124)

Related party disclosures specifically required in relation to key management personnel Apart from the above disclosure requirements, which also relate to key management personnel, there are a number of additional 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:

dee67382_ch23_899-916.indd 909 10/24/19 03:44 PM

CHAPTER 23: Related party disclosures 909

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. (AASB 124)

Paragraph 17 just quoted refers to ‘compensation’. This word is often used interchangeably with ‘remuneration’. The categories of ‘compensation’ discussed in paragraph 17 are defined at paragraph 9 as follows:

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. (AASB 124)

As an example of some actual disclosures made in relation to key management personnel, consider Exhibit 23.1. The Exhibit reproduces some of the information disclosed in the 2019 Annual Report of Qantas in relation to key management personnel. There are many more pages of disclosure pertaining to payments/benefits provided to key management personnel in the Qantas Annual Report that are not reproduced here.

The rewards provided to corporate directors and executives, who are included among ‘key management personnel’, is a relatively sensitive issue and one in which many stakeholders take a keen interest. One issue that attracts a lot of attention is the magnitude of the payments, and the issue that these payments sometimes appear to lack a logical relationship to the performance of an organisation. For example, in a newspaper article of 2 March 2019, entitled ‘CEOs “ridiculously overpaid”: former Westpac boss’ (by Clancy Yeates, The Sydney Morning Herald, p. 10), it was noted by a former head of Westpac Bank that company chief executives are ‘ridiculously overpaid’ and that at $4.36 million, the pay of the typical ASX100 chief executive officer is about 52 times the average wage of $83 486.

As another example of a situation where payments to key management personnel attract significant attention, we can consider the high-profile example of the Shane Warne Foundation (established by the famous international cricketer Shane Warne). In an article entitled ‘Warne charity’s finances under investigation’ (by Chris Vedelago, Sun Herald, 15 November 2015, p. 11), it was noted that the Shane Warne Foundation raised $1.8 million in three years but donated an average of only 16¢ of every dollar to institutions that care for sick and underprivileged children. In part, the reason for the low payments to the charities was that the majority of funds were used to stage ‘glitzy celebrity events’ and employ a member of the cricketing great’s family. The article further noted that in one year Warne’s brother Jason drew a salary of nearly $80 000 but the fundraiser disbursed only $54 600 to beneficiaries. Perhaps such attention would not have been raised in relation to the payment if it had not been made to a related party, in this case, the brother of the person associated with establishing the foundation.

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.

dee67382_ch23_899-916.indd 910 10/24/19 03:44 PM

910 PART 7: Other disclosure issues

Exhibit 23.1 An example of some disclosures relating to key management personnel

SOURCE: Qantas 2019 Annual Report

Disclosures required by Section 300A of the Corporations Act 2001 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 and other key management personnel. 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 disclosure 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). ∙ 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.

dee67382_ch23_899-916.indd 911 10/24/19 03:44 PM

CHAPTER 23: Related party disclosures 911

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 (or at least, should 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 real 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 fixated 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 (which overwhelmingly were about ‘profits’).

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 non-binding vote, the relevant sections of the Corporations Act are ss. 250R(2) and (3) and 250SA. 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 250S.

While the vote on the remuneration report is non-binding, amendments were made to the Corporations Act in 2011—with the inclusion of Sections 250U to 250Y—and a mechanism that has become known as the ‘two-strikes policy’ was introduced in relation to the non-binding shareholder vote on a listed company’s remuneration report. The two strikes policy was introduced due to apparent concerns that the senior management of firms was effectively ignoring the shareholder votes (Clarkson et al. 2006). 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.

This reform was 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.

Research undertaken by Grosse, Kean and Scott (2017) shows that, on average, those firms that have had a strike do tend to decrease CEO bonuses relative to non-strike firms, thereby suggesting that a ‘strike’ will lead to a reduction in pay. Also, their evidence suggests that following a ‘strike’, the amount of disclosure (in pages) that is disclosed in relation to the remuneration report (presented within the annual report) increases in size relative to firms without a strike. This appears to indicate that firms receiving a strike do increase their levels of accountability in relation to executive remuneration. What is also interesting is that, on average, the amount of pay being received by CEOs at the

dee67382_ch23_899-916.indd 912 10/24/19 03:44 PM

912 PART 7: Other disclosure issues

time of receiving the strike was not found to be above that of the firms that did not receive a strike. The authors saw this as a possible indicator that the use of a ‘strike’ might be implemented by shareholders to indicate general dissent with the key management personnel, rather that specifically with the amounts of compensation being received.

As might be expected, the amendments to the Corporations Act were not overwhelmingly welcomed by company directors. However, the corporate law requirement reflected a widespread belief in the community that many senior executives are overpaid and that their pay often does not reflect the overall performance of the organisations they manage.

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 cross-references to the relevant details within the financial statements.

It is interesting to reflect on reactions to the CLERP 9 requirements (discussed above) and to compare how industry reacted with how shareholders and other stakeholders reacted. In November 2003 the Business Council of Australia (BCA) produced its ‘Submission to the Treasury on the Corporate Law Economic Reform Program’. In the submission, the BCA made a number of statements opposing the reporting requirements, including:

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 . . . 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.

A review of the entire submission of the BCA shows 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. (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 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 also speculated that the greater disclosures would lead to increases in salaries. This seems to be a fairly simplistic argument. In addition, the BCA promoted the view that 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 questioned the rights and ability of shareholders to evaluate directors’ and executives’ remuneration and held 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 (ASA) released a document in October 2003 entitled Pave the Way to Effective Disclosure in which the chairperson of the ASA stated that shareholder participation in executive remuneration is to be encouraged and that it is important for shareholders to take action to support management remuneration plans that encourage management to focus on the generation of long-term shareholder value.

Examples of related party disclosure notes Rather than providing you with numerous related party notes as they appear in annual reports, you should consider reviewing a number of annual reports of large public companies in which you are interested to see the extent of disclosures made with regard to related party transactions (available on corporate websites). 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 parties we can see that many pages of Australian annual reports are dedicated to providing information about transactions with related parties. As you will find if you review some actual disclosures, some of these disclosures can make for rather interesting reading.

dee67382_ch23_899-916.indd 913 10/24/19 03:44 PM

CHAPTER 23: Related party disclosures 913

SUMMARY

This chapter considers related party transactions. As demonstrated, related party transactions are subject to a great deal of disclosure regulation. The rationale for this is that dealings associated with related parties can expose a reporting entity, its shareholders and other stakeholders 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 related party transactions.

The accounting standard pertaining to disclosures of related parties and their transactions is AASB 124. Within Australia 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, large 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/standard-setters obviously consider these costs to be outweighed by the associated benefits.

KEY TERMS

control (organisations) 904 director 901

key management personnel 905 related parties 900

related party transactions 901 significant influence 904

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following four questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. For accounting purposes, what is a ‘related party’, and what is a ‘related party transaction’? LO 23.1 A related party is a person or entity that is related to the entity that is preparing its financial statements. 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 control of another party. Key management personnel are also related parties as are their close family members. A related party transaction is a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged.

2. It is often argued that to properly assess the performance of an organisation, knowledge of its related party transactions is required. Why? LO 23.2, 23.3 Related party transactions can expose an organisation, and its stakeholders, to various risks and opportunities. Related party transactions often occur on terms, and at prices, that would not occur with non-related parties. Therefore, to understand the context of an organisation’s operations, knowledge of related party transactions is required.

3. What are some possible negative consequences of related party transactions? LO 23.2 Some of the negative consequences of related party transactions are that they might be undertaken in a manner that advantages some of the organisation’s stakeholders, while disadvantaging others. For example, key management personnel might be able to arrange payments to themselves that are excessive and which therefore reduce the financial resources available for other stakeholders (such as shareholders and creditors). Managers might also structure transactions in a way that profits are earned by related entities operating overseas in low tax rate countries. This disadvantages communities in the local country because lower taxes are paid there and hence less money is available to provide services in that local country. The use of related parties might also create waste and inefficiency if contracts are negotiated with related organisations that are not as efficient as other independent organisations.

4. Are related party transactions always a negative thing for an organisation? LO 23.2 No. Many related party transactions are made on proper commercial terms and with organisations that are efficient providers of particular goods and services. Nevertheless, the existence of related party transactions always creates particular risks (and opportunities) that do not exist with other transactions. Therefore, disclosure of related party transactions is warranted in all cases.

dee67382_ch23_899-916.indd 914 10/24/19 03:44 PM

914 PART 7: Other disclosure issues

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is a ‘related party’? LO 23.1 • 2. What is a ‘related party transaction’? LO 23.1 • 3. What are some negative consequences that could arise as a result of related party transactions? LO 23.2 •• 4. What are some positive consequences of related party transactions? LO 23.2 • 5. Do you consider that disclosure of related party information is of value to financial statement users? Why? LO 23.3 •• 6. Do you consider that disclosure of related party information is of value to the organisations making the disclosures?

Why? LO 23.3, 23.5 •• 7. Do you think 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 23.3, 23.5 •• 8. What are the classes of related parties identified in AASB 124? LO 23.1, 23.4, 23.5 •• 9. How are ‘key management personnel’ defined in AASB 124? LO 23.1, 23.4, 23.5 • 10. Briefly identify the types of information that must be disclosed in relation to key management personnel-related

transactions. LO 23.5 • 11. 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 23.2, 23.5 •••

12. Review the key management personnel disclosures made by BHP in its most recent annual report (you will need to go to the BHP website) and identify which transactions would cause you concern. Explain why this is the case. LO 23.1, 23.2, 23.4, 23.5 •••

CHALLENGING QUESTIONS

13. Should the managers of an organisation be accountable for their related party transactions? Why? LO 23.2, 23.3

14. In November 2003, the Business Council of Australia made the following comments in 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’:

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.

You are required to evaluate these concerns, and consider whether such concerns are important enough to make us question whether related party disclosures should, to some extent, be curtailed. LO 23.2, 23.3

15. 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 23.4, 23.5

16. Review the related party note provided by BHP in its most recent annual report (find it at BHP’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

dee67382_ch23_899-916.indd 915 10/24/19 03:44 PM

CHAPTER 23: Related party disclosures 915

17. In a newspaper article entitled `Warne charity’s finances under investigation’ (by Chris Vedelago, Sun Herald, 5 November 2015, p. 11) it was reported that the Shane Warne Foundation raised $1.8 million in three years from various events and fundraisers but donated an average of only 16¢ of every dollar to charities. It was also reported that in one year, Shane Warne’s brother Jason, who was general manager of the organisation, drew a salary of nearly $80,000 but the fundraiser only disbursed $54,600 to its beneficiaries. LO 23.2, 23.3

REQUIRED Do you think it is an invasion of Shane and Jason Warne’s privacy for such information to be made publicly available, or do you think that stakeholders have a right to know about such transactions? Explain your answer. LO 23.2, 23.3

18. A review of BHP’s 2019 Annual Report shows that the compensation paid to the chief executive officer (CEO) is based on various aspects of performance. Some of these aspects of performance relate to measures of financial performance while some concern various social and environmental aspects. In relation to the social and environmental aspects of performance, some of the performance indicators used to pay the CEO are disclosed as being related to reported improvements in:

∙ fatalities, environmental and community incidents, and occupational illness ∙ health, environmental and community initiatives, community perceptions (including targets for reductions in

greenhouse gases, water usage and community complaints).

REQUIRED Why would a stakeholder need to know about the indicators used to compensate key management personnel, such as the CEO? Further, is it reasonable that large organisations such as BHP are required to make such disclosures? LO 23.3, 23.5

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.

Clarkson, P., Lammerts van Buren, A. & Walker, J., 2006, ‘Chief Executive Officer Remuneration Disclosure Quality: Corporate Responses to an Evolving Disclosure Environment’, Accounting and Finance, vol. 46, pp. 771–96.

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.

Grosse, M., Kean, S. & Scott, T., 2017, ‘Shareholder Say on Pay and CEO Compensation: Three Strikes and the Board is Out’, Accounting and Finance, vol. 57, pp. 701–25.

Kohlbeck, M. & Mayhew, B., 2017, ‘Are Related Party Transactions Red Flags?’, Contemporary Accounting Research, vol. 54, no. 2, pp. 900–28.

dee67382_ch23_899-916.indd 916 10/24/19 03:44 PMdee67382_ch23_899-916.indd 916 10/24/19 03:44 PM

dee67382_ch24_917-946.indd 917 10/22/19 12:56 PM

917

LEARNING OBJECTIVES (LO) 24.1 Understand the meaning of earnings per share, where it is disclosed, and how it is used by

different stakeholders. 24.2 Be able to define and calculate basic earnings per share and 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 how and why we calculate diluted earnings per share and be able to explain what potential

ordinary shares are, and be able to determine whether they are dilutive. 24.4 Know how to link earnings per share to other related indicators.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

C H A P T E R 24 Earnings per share

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What does earnings per share represent? LO 24.1 2. How do we calculate earnings per share? LO 24.2 3. How are ‘earnings’ and ‘number of shares’ determined for the purposes of calculating earnings per share?

LO 24.2 4. Where would the information about earnings per share be disclosed? LO 24.1

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

5 Non-current Assets Held for Sale and Discontinued Operations IFRS 5

133 Earnings per Share IAS 33

dee67382_ch24_917-946.indd 918 10/22/19 12:56 PM

918 PART 7: Other disclosure issues

24.1 Introduction to earnings per share

Earnings per share (EPS) is a ratio that is determined by dividing a company’s profit, or loss, as attributable to ordinary shareholders, by the weighted-average number of ordinary shares that an organisation has on issue during the accounting period.

AASB 133 Earnings per Share 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; and ∙ entities that voluntarily elect to disclose earnings per share.

An entity shall disclose earnings per share on the face of the statement of profit or 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 these 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 (profits), 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 about earnings per share. In this regard it should be noted that the financial press frequently provides summaries of listed companies’ earnings per share.

A review of the news media reflects a view that earnings per share is a measure of organisational performance that does attract a lot of attention from both corporate managers and other stakeholders, such as share market analysts. As some recent examples of this apparent focus on earnings per share, consider the following:

∙ In a newspaper article entitled ‘Westpac exit a small positive’ (The Australian, 21 March 2019, p. 23), an analyst from Morgan Stanley evaluated the decision by Westpac Bank to exit a certain business segment as being a positive choice because it was expected to be ‘earnings per share positive’ in the subsequent year.

∙ In a newspaper article ‘Investors win from BHP, Rio cash surge’ (The Australian Financial Review, 18 February 2019, p. 40), an analysis from Citi focused specifically upon how changing iron ore prices could impact earnings per share. Specifically, the analyst estimated that every US$1 move in the iron ore price lifts Rio’s earnings per share by 2 per cent; for BHP, every US$1 move in the iron ore price lifts EPS by 1 per cent; while for Fortescue Metals Group, every A$1 move adds 6 per cent to EPS.

∙ In a newspaper article entitled ‘CBA may be forced to cut its dividend’ (The Australian, 22 January 2019, p. 18), it was reported that in evaluating the merit of undertaking a share buyback, an analyst from Morgan Stanley specifically noted that such an action would help the bank ensure that earnings per share would not fall as much as they might in the absence of such a buyback.

∙ In a newspaper article entitled ‘Domino’s set to buy back its own slices’ (Courier Mail, 22 December 2018, p. 55), the management of the company noted that a share buyback would have a positive consequence as the buyback was expected to boost earnings per share.

Again, the purpose of briefly referring to the above newspaper articles is to demonstrate that earnings per share seems to be a rather high-profile measure of performance upon which different stakeholders often focus.

LO 24.1

dee67382_ch24_917-946.indd 919 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 919

24.2 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:

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 (and as we know, in the Conceptual Framework, ‘comparability’ is identified as an ‘enhancing qualitative characteristic’ of useful financial information). 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.

However, we must remember that there will continue to be differences in how firms calculate earnings owing to the numerous assumptions accountants must make throughout the accounting process. 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 factors such as probabilities, and measurement uncertainties). 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 affect 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). A change in accounting policy, or a change in various accounting estimates, can be a reason contributing to why EPS varies from one period to the next.

The standard requires that basic EPS and diluted EPS must be disclosed on the face of the statement of profit or loss and other comprehensive income. Where an income statement is prepared separately by an entity, the basic and diluted EPS shall be presented on the income statement.

Exhibit 24.1 shows the Consolidated Income Statement of BHP Group Ltd for the year ended 30 June 2019, as reported in BHP’s 2019 Annual Report. We can see the earnings per share disclosures made at the bottom of the income statement. Disclosures of EPS are required even when EPS is negative (that is, where there is a loss per share).

Determining earnings 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

LO 24.2

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.

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.

WHY DO I NEED TO KNOW ABOUT THE EARNINGS PER SHARE OF AN ORGANISATION?

As we have just indicated, earnings per share does seem to be a measure of performance upon which various participants in capital markets tend to focus. This would seem to indicate that negative movements in this measure will not be viewed favourably by capital market participants, thereby having potentially negative implications for the value of any investments you might have in particular organisations.

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.

dee67382_ch24_917-946.indd 920 10/22/19 12:56 PM

920 PART 7: Other disclosure issues

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 like 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 declared, 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:

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. (AASB 133)

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.

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.

Exhibit 24.1 Disclosure of earnings per share

SOURCE: BHP Group Ltd 2019 Annual Report

dee67382_ch24_917-946.indd 921 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 921

Determining the number of shares The calculation of basic EPS requires the earnings (adjusted as described above) to be divided by the weighted-average number of ordinary shares. An ordinary share is defined at paragraph 5 of AASB 133 as an equity instrument 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 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. (AASB 133)

For example, if a company has 1 000 000 ordinary shares issued at the beginning of the year (say, 1 July 2022) and it issues 200 000 fully paid shares on 1 March 2023, as well as buying back 100 000 shares on 1 April 2023, the weighted-average number of shares would be calculated as:

Period Proportion of year Number of shares outstanding Weighted average

Fully paid ordinary shares

1/7/22–28/2/23 243 ÷ 365 1 000 000 665 753

1/3/23–31/3/23 31 ÷ 365 1 200 000 101 918

1/4/23–30/6/23 91 ÷ 365 1 100 000 274 247

365   days

Total weighted-average number of ordinary shares 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) 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. (AASB 133)

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:

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. (AASB 133)

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.

ordinary shares A class of shares that typically ranks last in terms of any distribution of capital. Holders have voting rights, and will receive dividends at the discretion of the directors.

substance over form Events are accounted for and displayed in accordance with their economic substance, rather than their legal form.

dee67382_ch24_917-946.indd 922 10/22/19 12:56 PM

922 PART 7: Other disclosure issues

WORKED EXAMPLE 24.1: Calculation of basic EPS

For the year ending 30 June 2022, Kirra Ltd reports the following: • net profit after tax of $900 000.

As at 1 July 2021 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 2021 at the prevailing market price • 25 000 fully paid ordinary shares purchased back on 1 February 2022 at the prevailing market price • 70 000 partly paid ordinary shares issued on 1 April 2022 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 2022.

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 $ 900 000

less Preference share dividends ($100 000)

Earnings for basic EPS $ 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. (AASB 133)

Period Proportion of year Number of shares

outstanding Weighted average

Fully paid ordinary shares

1/7/21–31/8/21 62 ÷ 365 200 000 33 973

1/9/21–31/1/22 153 ÷ 365 300 000 125 753

1/2/22–30/6/22   150 ÷ 365 275 000 113 014

365   days

Partly paid ordinary shares

1/4/22–30/6/22 (91 ÷ 365) × ($1.30 ÷ $2.00) × 70 000   11 344

Total weighted-average number of ordinary shares 284 084

Basic EPS therefore is $800 000 ÷ 284 084 = $2.816

dee67382_ch24_917-946.indd 923 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 923

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 this standard 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. (AASB 5)

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.

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. (AASB 133)

Hence, AASB 133 requires the disclosure of two basic EPS figures (as well as two diluted EPS figures, as we will see later). Refer back to Exhibit 24.1 for an example of this disclosure.

The methods to be used to calculate the two basic EPS figures are:

Basic EPS

=

Basic earnings, based upon total profit

__________________________________ Basic weighted-average number of ordinary shares

Basic EPS

=

Basic earnings, based upon profit from continuing operations

_________________________________________ Basic weighted-average number of 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 2023 are as follows:

Keet Ltd and Keet Group Statements of profit or loss and other comprehensive income of for the year ended 30 June 2023

Keet Ltd $

Keet Ltd and its subsidiaries

$

Income 95 920 000 483 210 000

Expenses (excluding borrowing costs) (83 840 000) (352 890 000)

Borrowing costs   (2 730 000)   (52 470 000)

Profit before income tax expense 9 350 000 77 850 000

Income tax expense   (3 740 000)   (31 140 000)

Profit from continuing operations after income tax expense 5 610 000 46 710 000

Profit (loss) from discontinuing operations after related income tax        510 000     (1 230 000)

continued

dee67382_ch24_917-946.indd 924 10/22/19 12:56 PM

924 PART 7: Other disclosure issues

WORKED EXAMPLE 24.2 continued

Notes to and forming part of the financial statements

Profit after income tax 6 120 000 45 480 000

Other comprehensive income                0                   0

Total comprehensive income 6 120 000 45 480 000

Attributable to:

Owners of the parent 41 220 000

Non-controlling interests   4 260 000

45 480 000

Additional information

(i) On 30 June 2022, the share capital of Keet Ltd comprised:

Share class Number of

shares on issue Share capital

$

Ordinary 11 500 000 27 630 000

Preference  1 500 000 15 000 000

Total 13 000 000 42 630 000

(ii) During the financial year ending on 30 June 2023, Keet Ltd made the following share issues:

Date of share issue Class of share issue Details relating to share issue

15 September 2022 Ordinary 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 2024. The partly paid shares are entitled to participate in dividends from 15 March 2023. The partly paid shares will entitle shareholders to receive 30 per cent of the dividends received by fully paid ordinary shareholders.

27 November 2022 Ordinary 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.

12 April 2023 Ordinary Share buyback of 650 000 fully paid ordinary shares, purchased at the current share price at the time of purchase of $8.30.

Keet Ltd Keet Ltd and its

subsidiaries

Note X: Retained earnings

Retained earnings—1 July 2022 5 160 000 50 940 000

Profit after income tax 6 120 000

Profit attributable to members of the parent entity 41 220 000

Interim Dividend—ordinary shares (1 520 000) (1 520 000)

Final Dividend—ordinary shares (1 640 000) (1 640 000)

Dividends—preference shares (paid 30 September 2022)     (900 000)     (900 000)

Retained earnings—30 June 2023   7 220 000 88 100 000

dee67382_ch24_917-946.indd 925 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 925

(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 2023 was not paid.

REQUIRED Calculate basic earnings per share for the financial year ended 30 June 2023, in accordance with the requirements of AASB 133.

SOLUTION

Calculation of basic earnings

Profit attributable to members of the parent entity 41 220 000

less Preference share dividends—30 September 2022 900 000

less Cumulative preference dividends not paid or provided for—31 March 2023

($15 000 000 × 0.06)       900 000

Basic earnings, based upon total profit 39 420 000

add Loss from discontinuing operations after related income tax   1 230 000

Basic earnings, based upon profit from continuing operations 40 650 000

Period Proportion

of year

Number of shares

outstanding Weighted average

Fully paid ordinary shares

1/7/22–26/11/22 (shares in place at beginning of year) 149 ÷ 365 11 500 000 4 694 521

27/11/22–11/4/23 (share issue) 136 ÷ 365 13 500 000 5 030 137

12/4/23–30/6/23 (share buyback)   80 ÷ 365 12 850 000 2 816 438

365   days

Partly paid ordinary shares

15/3/23–30/6/23 (108 ÷ 365) × 0.30 1 200 000      106 520

Total weighted-average number of ordinary shares 12 647 616

Calculation of basic EPS, based upon profit from continuing operations

Basic EPS

=

Basic earnings, based upon profit from continuing operations

_________________________________________ Basic weighted-average number of ordinary shares

=

40 650 000 _________ 12 647 616

= $3.21 per share

Calculation of basic EPS, based upon total profit

Basic EPS

=

Basic earnings, based upon total profit

__________________________________ Basic weighted-average number of ordinary shares

=

39 420 000 _________ 12 647 616

= $3.12 per share

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.

dee67382_ch24_917-946.indd 926 10/22/19 12:56 PM

926 PART 7: Other disclosure issues

Adjustment for the bonus element in an issue of ordinary shares A bonus issue occurs when ordinary shares are issued to existing shareholders for no required payment. 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 2023 Greenmount Ltd has earnings after tax of $500 000. On 1 July 2022 the company has 400 000 shares on issue and on 1 June 2023 it gives a one-for-four bonus issue, funded out of retained earnings. That is, for every four shares held, the shareholder receives one share more at no cost. The last sale price of the shares prior to the bonus issue is $3.50.

The bonus issue does not change total shareholders’ funds. It simply involves a transfer from retained earnings to share capital (assuming that the bonus share issue is funded from retained earnings). That is, for bonus shares that are issued out of/funded by retained earnings, we would

simply debit retained earnings and credit share capital by the aggregate amount of the share issue. There would be no change in total equity, or in assets or liabilities.

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. (AASB 133)

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 24.2. 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 o × N o ) + P r ________

N o + 1

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.

WHY DO I NEED TO KNOW HOW EARNINGS PER SHARE IS CALCULATED?

Earnings per share is, as we have discussed, a measure of performance upon which various stakeholder groups focus. However, it can be influenced by various factors linked to how ‘earnings’ are determined, and also by how the number of shares is determined. Different accounting policy decisions will impact earnings, and therefore earnings per share. Whether an organisation issues more shares or buys back some of its shares during an accounting period will also impact the number of shares, and therefore earnings per share. It is important that people focusing upon earnings per share understand how this number is influenced (or manipulated) by different managerial choices.

dee67382_ch24_917-946.indd 927 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 927

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

_________ 4 + 1

= $2.80

Exhibit 24.2 Adjustment factor for EPS in respect of the bonus element in an issue of ordinary shares

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

Px = theoretical ex-rights price

= ( P o × N o ) + P r ________

N o + 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

immediately prior to exercise of rights ] + [

Proceeds from the

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 $105 000 (which is 30 000 × $3.50). Following the issue, Rob Greenmount would have held 37 500 shares (which is 30 000 × 5 ÷ 4). The value of Rob’s holding using the theoretical price would have been 37 500 multiplied by $2.80, or $105 000. That is, it is the same as it was before the bonus issue. In terms of the total market capitalisation of the firm, which is calculated by multiplying the total number of issued shares by their market price, a bonus issue should, according to the formula, have no effect. That is, if there were 400 000 shares on issue before the bonus issue, the market capitalisation should be $1.4 million (400 000 × $3.50). After the bonus issue of one additional share for each four shares held, there would 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.

market capitalisation The total value of a firm’s securities computed by multiplying the current market value of each security by the number of securities issued by the entity.

dee67382_ch24_917-946.indd 928 10/22/19 12:56 PM

928 PART 7: Other disclosure issues

There is some evidence, however, that the total market capitalisation of a firm (its current share price multiplied by the number of issued shares) 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 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 weighted- average number of ordinary 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 2023, 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 2022 the company issued a further 100 000 fully paid ordinary shares (these were not bonus shares). On 1 May 2023 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 2022 was $2.10.

REQUIRED Compute the basic EPS amount for 2023 and provide the adjusted comparative EPS for 2022.

SOLUTION Earnings calculation

Profit after tax $700 000

less Preference share dividends ($ 20 000)

Profit after tax less preference dividends $680 000

Theoretical ex-bonus price

=

( $4.00 ) ( 6 ) + 0

_________ 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 Proportion

of year

Multiply by number of shares

outstanding Divide by

adjustment factor Weighted average

Fully paid ordinary shares

1/7/22–31/8/22 62 ÷ 365 500 000 0.8571 99 092

1/9/22–30/4/23 242 ÷ 365 600 000 0.8571 464 133

1/5/23–30/6/23 61 ÷ 365 700 000 116 986

680 211

dee67382_ch24_917-946.indd 929 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 929

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 o × N o ) + P r ________

N o + 1

and the theoretical price would be:

( $1.00 × 3 ) + 0.80

___________ 3 + 1

= $0.95

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.

As we can see above, the number of shares held before the bonus issue are adjusted in a way that implies that the bonus issue was in place for the entire year. Basic earnings per share for 2023 would be:

$680 000 ÷ 680 211 = $0.9997

The comparative figures for 2022 would be adjusted for the bonus issue using the adjustment factor that we calculated. 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. Again, note that for the current periods in which the bonus issue is made, we adjust the weighted-average 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.

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.

WORKED EXAMPLE 24.4: Calculation of EPS in the presence of a rights issue with a bonus element

For the year ending 30 June 2023, 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 2022 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 previous year ended 30 June 2022 was $1.95.

REQUIRED Compute the basic EPS amount for 2023, and provide the adjusted comparative EPS for 2022.

SOLUTION Earnings calculation

Profit after tax $500 000

less Preference share dividends ($ 10 000)

Profit after tax less preference dividends $490 000

continued

dee67382_ch24_917-946.indd 930 10/22/19 12:56 PM

930 PART 7: Other disclosure issues

Theoretical ex-bonus price

=

($2.00) (4) + $1.50

___________ 4 + 1

= $1.90 Adjustment factor

=

1.90 ÷ 2.00

=

0.95

Calculation of the weighted-average number of ordinary shares and ordinary share equivalents

Period Proportion

of year

Number of shares

outstanding Adjustment

factor Weighted average

Fully paid ordinary shares

1/7/22–31/8/22 62 ÷ 365 800 000 0.95 143 043

1/9/22–30/6/23 303 ÷ 365 1 000 000 830 137

973 180

Basic earnings per share for 2023 would be:

$490 000 ÷ 973 180 = $0.5035

The comparative figures for 2022 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.

24.3 Diluted earnings per share

AASB 133 also requires that diluted EPS should be calculated and disclosed, together with basic EPS, on the face of the statement of profit or loss and other comprehensive income. Please refer back to Exhibit 24.1 for an

example of this disclosure. 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 states:

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. (AASB 133)

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 ‘a financial instrument or other contract that may entitle its holder to ordinary shares’ (AASB 133). 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

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.

WORKED EXAMPLE 24.4 continued

LO 24.3

dee67382_ch24_917-946.indd 931 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 931

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 negatively affected in the future.

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. (AASB 133)

As paragraph 32 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. (AASB 133)

The conversion of potential ordinary shares might also have a number of flow-on effects. As paragraph 35 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 profit-sharing 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. (AASB 133)

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.

dee67382_ch24_917-946.indd 932 10/22/19 12:56 PM

932 PART 7: Other disclosure issues

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. (AASB 133)

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 $2000, and receive 1000 shares. The number of shares that they would have acquired for $2000 if they had paid the market price of $2.50 would be 800. Effectively, the number of shares issued for no consideration is therefore 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 $2000 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. (AASB 133)

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 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 states:

dee67382_ch24_917-946.indd 933 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 933

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. (AASB 133)

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 2023, 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 2022 there were 500 000 fully paid ordinary shares. There were no additional share issues during the year.

As at 1 July 2022 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 2021 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 $1 050 000

less Preference dividends ($ 200 000)

Profit after tax and preference dividends $ 850 000

Basic EPS

=

$850 000 ÷ 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).

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

continued

dee67382_ch24_917-946.indd 934 10/22/19 12:56 PM

934 PART 7: Other disclosure issues

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 20 000

Number of shares that would be issued at market price for the actual proceeds of $40 000 = $40 000 ÷ $5

8 000

Number of shares deemed issued for no consideration 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 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. (AASB 133)

In this example, the order from most dilutive to least dilutive is:

Increase in shares

Earnings per incremental share

Options 12 000 $ nil

Convertible debentures 125 000 $0.134

Convertible preference shares 120 000 $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.

WORKED EXAMPLE 24.5 continued

dee67382_ch24_917-946.indd 935 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 935

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 $850 000

less Adjustments $           nil

Net profit from continuing operations for the trigger test $850 000

$850 000 ÷ 500 000 = $1.70

As previously noted, AASB 133 requires that diluted EPS be presented on the face of the statement of profit or 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 EPS Dilutive?

Net profit from continuing operations $ 850 000 500 000 $ 1.70  

Options $              nil    12 000    

  $ 850 000 512 000 $1.6602 Yes

Convertible debentures $      16 750  125 000    

  $   866 750 637 000 $1.3607 Yes

Convertible preference shares $   200 000 120 000    

$1 066 750 757 000 $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.

Profit Ordinary shares

As reported for basic EPS $850 000 500 000

Options $ nil 12 000

Convertible debentures $   16 750 125 000

$866 750 637 000

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.

dee67382_ch24_917-946.indd 936 10/22/19 12:56 PM

936 PART 7: Other disclosure issues

24.4 Linking earnings per share to other indicators

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 expected to 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) Calculate 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 × 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 is 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.

LO 24.4

dee67382_ch24_917-946.indd 937 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 937

Tea Tree Bay Ltd Basic EPS = ($90m – $3m) ÷ [(50m × 0.5) + (60m × 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) Earnings per share is a number that is widely used by investment analysts and is seen as an important indicator of the performance of an organisation over time. It also provides an indicator of likely future dividend payments. 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, the reality is that comparing earnings per share of one company with another is not appropriate as different companies divide their share capital into different numbers of shares that were issued at different amounts per share.

When we consider the price earnings ratio we see that the price earnings ratio of Tea Tree Bay Ltd of 25.28 is almost two times that of Granite Bay Ltd (which is 13.81). That is, the market is prepared to pay many more times current earnings per share for Tea Tree Bay Ltd. Again, we would probably want further information so as to put this information into context.

For listed companies, a price earnings ratio in the range of 20–25 is quite common. The price earnings ratio provides an indication of how many times the earnings the share market is prepared to pay for a share. A higher number relative to similar organisations indicates greater market acceptance of the organisation. The market might believe that the organisation with the higher price earnings ratio has relatively lower risk and/or it has good growth prospects—so a higher number seems to be a good thing. A low price earnings ratio might indicate that investors believe the organisation is relatively risky, or that its earnings are expected to fall in the future. However, a low price earnings ratio is also consistent with the possibility that the price of an organisation’s shares is currently undervalued and that they represent a potentially good investment opportunity—care would need to be taken, though, before immediately accepting this as an explanation for a low price earnings ratio.

The industry to which an organisation belongs will impact the price earnings ratio, and therefore it can be inappropriate to compare the price earnings ratio of companies in different industries.

Price earnings ratios can sometimes get very high to the point where they seem to defy explanation, potentially indicating an ‘overheated market’ and that a market adjustment (at the extreme, a ‘market crash’) is imminent. For example, prior to the ‘global financial crisis’ of 2009, many leading companies’ price earnings ratios had climbed to above 40. Within months, many of these had dropped to around 20, and massive losses were incurred by many investors.

In relation to the dividend payout ratio we can see that the dividend payout ratio of Tea Tree Bay Ltd is slightly more 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).

WORKED EXAMPLE 24.7: Further comprehensive illustration of calculating earnings per share and diluted earnings per share

For the year ending 30 June 2024, 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. $1 million of 10 per cent debentures (bonds) issued on 1 August 2023. The debentures have a life of five years and give holders the right to convert the debentures into 400 000 fully paid ordinary shares.

continued

Worked Example 24.7 provides a further comprehensive example of calculating earnings per share.

dee67382_ch24_917-946.indd 938 10/22/19 12:56 PM

938 PART 7: Other disclosure issues

2. In 2022, 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.

3. In 2022 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

• The 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 2024 of Green Island Ltd’s:

(a) basic earnings per share (b) diluted earnings per share.

SOLUTION

(a) Basic earnings per share for Green Island Ltd

Profit after tax $1 800 000

less Preference share dividends ($     20 000)

Profit after tax less preference dividends $1 780 000

Determining the weighted-average number of ordinary shares

Period Proportion of

year Number of shares

outstanding Weighted average

Fully paid ordinary shares 1/7/23–30/6/24 365 ÷ 365 500 000 500 000

Partly paid ordinary shares 1/7/23–30/6/24 365 ÷ 365 100 000 ($0.90 ÷ $2.00)   45 000

Total weighted-average number of ordinary shares     545 000

Basic earnings per share therefore is $1 780 000 ÷ 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 55 000

Number of shares that would be issued with the proceeds given the average market price (100 000) ($1.10) ÷ $2.50 44 000

Number of shares deemed issued for no consideration 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 (bonds)

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.

WORKED EXAMPLE 24.7 continued

dee67382_ch24_917-946.indd 939 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 939

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 250 000

Number of shares that would be issued with the proceeds given the average market price (250 000) ($2.30) ÷ $2.50 230 000

Number of shares deemed issued for no consideration 20 000

There is no adjustment to earnings for the capital inflow associated with the options, 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 are:

$20 000 ÷ 100 000 = $0.20

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

Options 20 000 $nil

Partly paid shares 11 000 $nil

Convertible debentures 366 027 $0.1500

Convertible preference shares 100 000 $0.2000

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 $1 780 000

add Adjustments $               nil

Net profit from continuing operations to be used for the purpose of the trigger test $1 780 000

continued

dee67382_ch24_917-946.indd 940 10/22/19 12:56 PM

940 PART 7: Other disclosure issues

SUMMARY

In this chapter we considered various aspects of the calculation and disclosure of earnings per share (EPS). Organisations with shares listed on a securities exchange 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 or 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 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.

Step 4: Perform the trigger test

Profit and adjustments ($)

Ordinary shares ($)

EPS ($) Dilutive?

Net profit from continuing operations 1 780 000 545 000 3.2661  

Options            Nil     20 000    

  1 780 000 565 000 3.1504 Yes

Partly paid shares            Nil     11 000    

  1 780 000 576 000 3.0903 Yes

Convertible debentures       54 904   366 027    

  1 834 904 942 027 1.9478 Yes

Convertible preference shares     20 000     100 000    

  1 854 904 1 042 027 1.7801 Yes

Step 5: Compute diluted earnings per share

  Profit

($) Ordinary shares

($)

As reported for basic EPS 1 780 000 545 000

Options 0 20 000

Convertible debentures 54 904 366 027

Convertible preference shares 20 000 100 000

Partly paid shares                0       11 000

  1 854 904 1 042 027

Diluted EPS = $1 854 904 ÷ 1 042 027 = $1.7801

WORKED EXAMPLE 24.7 continued

dee67382_ch24_917-946.indd 941 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 941

KEY TERMS

basic EPS 919 bonus issue 926 cumulative dividend preference shares 920 diluted EPS 919

earnings per share 919 market capitalisation 927 ordinary shares 921 potential ordinary shares 930 rights issue 929

substance over form 921 weighted-average number of shares 919

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following four questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What does earnings per share represent? LO 24.1 Earnings per share is a measure of performance that indicates how much earnings/profits are being generated in respect of each ordinary share that a company has on issue.

2. How do we calculate earnings per share? LO 24.2 Earnings per share is a ratio that is determined by dividing a company’s profit, or loss, for an accounting period that is attributable to ordinary shareholders by the weighted-average number of ordinary shares that an organisation has on issue during that accounting period.

3. How are ‘earnings’ and ‘number of shares’ determined for the purposes of calculating earnings per share? LO 24.2 To determine earnings per share, reliance is placed upon the measure of profit shown in the financial statements. Preference share dividends declared throughout the period are deducted from profits. This is done because earnings are being calculated from the perspective of the owners of the ordinary shares.

The number of shares (the denominator of the ratio) will be based on the weighted-average number of ordinary shares on issue throughout the accounting period. The weighted-average number of shares also needs to take account of any partly paid ordinary shares. Such shares would be included in the measure to the extent that they carry rights to participate in dividends relative to an ordinary share. The weighted-average number of shares would also include ‘mandatorily convertible securities’. Adjustments to the weighted-average number of ordinary shares would also need to take into account the presence of any bonus issue, or rights issue, of ordinary shares. In the presence of potential ordinary shares that are dilutive, then a dilutive EPS measure shall also be calculated and disclosed.

4. Where would the information about earnings per share be disclosed? LO 24.1 The information about earnings per share would be disclosed on the face of the statement of profit or loss and other comprehensive income. If a separate income statement is presented by an entity, then the information would generally be presented in the body of the income statement.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. How do we determine: (a) basic earnings per share? (b) diluted earnings per share? LO 24.1, 24.2, 24.3 • 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, 24.2, 24.3 • 5. In a newspaper article entitled ‘Domino’s set to buy back its own slices’ (Courier Mail, 22 December 2018, p. 55) it

was reported that the pizza company Domino’s would buy back some shares at such times and in such circumstances as are considered by management to be beneficial to the efficient capital management of the company. The article also noted that Domino’s said the buyback is expected to boost earnings per share.

REQUIRED Why would the proposed share buyback boost earnings per share? LO 24.1, 24.2, 24.3 ••

dee67382_ch24_917-946.indd 942 10/22/19 12:56 PM

942 PART 7: Other disclosure issues

6. If a company issues bonus shares to shareholders, what will be the subsequent impact on earnings per share? LO 24.2 •

7. What is the price earnings ratio, and how does it relate to earnings per share? LO 24.4 •

8. What would a low price earnings ratio indicate? LO 24.4 •

9. If one organisation has a higher earnings per share than another organisation, does this indicate that it is being better managed? Further, is it actually appropriate to compare the EPS of one organisation with that of another? LO 24.1, 24.2, 24.3, 24.4 ••

10. 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 ••

11. If an entity has issued mandatorily convertible instruments, can they be ignored when we are calculating basic earnings per share? LO 24.2, 24.3 •

12. All things being equal, will a higher EPS lead to a higher or lower dividend payout ratio? LO 24.4 •

13. For the year ending 30 June 2024, 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 2023 at the prevailing market price • purchased back 50 000 fully paid ordinary shares on 1 March 2024 at the prevailing market price • issued 100 000 partly paid ordinary shares on 1 June 2024 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 2024. LO 24.1, 24.2 ••

14. For the year ending 30 June 2023, 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 2022 the company issued another 150 000 fully paid ordinary shares. On 1 May 2023 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 2022 was $2.30.

REQUIRED Compute the basic earnings per share amount for 2023 and provide the adjusted comparative EPS for 2022. LO 24.1, 24.2 •

15. X Ltd has earnings for the year ending 30 June 2023 of $410 million. Outstanding ordinary shares as at 1 July 2022 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 $2.00

Paid $0.50

Closing date 31 May 2023

REQUIRED Calculate the basic earnings per share for the year ending 30 June 2023. LO 24.1, 24.2 •

16. You are given the following information for Y Ltd for the year ending 30 June 2023.

Net profit before tax $1 455 000

Income tax expense ($ 655 000)

Profit after tax $ 800 000

Non-controlling interest ($ 100 000)

dee67382_ch24_917-946.indd 943 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 943

Dividends:  

— Preference ($100 000)

— Ordinary ($300 000)

Increase in retained earnings $300 000

The company has 2.4 million fully paid ordinary shares on issue at July 2022 and 2 million, 5 per cent, $1.00 preference shares.

On 1 January 2023 the company issued a further 600 000 ordinary shares at full market price and on 1 May 2023 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 2023. LO 24.1, 24.2 •• 17. 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 2024.

Profit after income tax $290 000

Dividends:  

— Ordinary ($160 000)

— Preference ($ 20 000)

Increase in retained earnings  $110 000

REQUIRED Calculate the diluted earnings per share for Z Ltd for the year ending 30 June 2024. LO 24.3 • 18. 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, 24.2, 24.3 •• 19. P Ltd is an Australian listed company. Its results for the financial year ending 30 June 2023 have exceeded

expectations—profit before tax is $5.597 million and income tax expense is $1.847 million. As at 30 June 2022, there were 9.75 million ordinary shares on issue. On 11 May 2023, 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 2023. LO 24.1, 24.2 • 20. C Ltd is an Australian listed company.

Results for the year are as follows:

6 months ended 31/12/22 12 months ended 30/6/23

Profit $7 035 800 $17 500 000

Income tax expense $1 756 000 $5 500 000

Year-end price of the shares is $2.40. Shares

Number of fully paid ordinary shares

At 1/7/22 5 000 000

At 30/6/23 5 000 000

Ten million options were issued by the company on 15 September 2022. These are exercisable by the holder at $2.50 per option on or before 22 November 2025.

One million options were also issued by the company on 15 March 2023. These are exercisable by the holder at $2 per option on or before 11 May 2027.

dee67382_ch24_917-946.indd 944 10/22/19 12:56 PM

944 PART 7: Other disclosure issues

Other information

Average share price for the year $2.20

Company tax rate 33 per cent

REQUIRED Calculate the basic earnings per share and diluted earnings per share for C Ltd for the year ending 30 June 2023. LO 24.1, 24.2, 24.3 ••

CHALLENGING QUESTIONS

21. 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 2023 10 000 000

Earnings (profit after tax) for six months ended 30 June 2024 13 000 000

23 000 000

Fully paid ordinary shares as at 30 June 2023

90 000 000

Outstanding partly paid shares as at 30 June 2023

— Number 10 000 000

— Issue price $2.00

— Paid to $1.00

These shares were issued on 1 January 2023 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 2024. The company will mail the dividend on 15 April 2024.’

• Call of partly paid shares during the year:

— Previously paid to $1.00

— Call of $0.50

— Closing date 28 February 2024

• 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 2022, exercisable at $2.60 on or before 31 December 2026. • Ten million options were issued on 30 June 2022, exercisable at $2.10 on or before 30 June 2025. • The company income tax rate is 40 per cent.

REQUIRED Calculate basic earnings per share and diluted earnings per share as at 30 June 2024. LO 24.2, 24.3

22. You are given the following information in respect of XYZ Ltd for the year ending 30 June 2022.

Earnings for the year ending 30 June 2022 $70 000 000

Fully paid ordinary shares at 1 July 2021 75 000 000

Ten million options are issued on 30 June 2020, exercisable at $2.00 per option on or before 30 June 2024. The holder of each option has the right to purchase one share.

At July 2021, 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 2024 and 1 May 2025.

dee67382_ch24_917-946.indd 945 10/22/19 12:56 PM

CHAPTER 24: Earnings per share 945

On 1 May 2022, 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 2022. LO 24.2, 24.3

23. The statements of comprehensive income of PK Ltd, and PK Group (comprising PK Ltd and its subsidiaries), for the financial year ending 30 June 2023 are as follows: Statements of comprehensive income of PK Ltd and PK Group for the year ended 30 June 2023

  PK Ltd

($) PK Ltd and its subsidiaries

($)

Income 38 368 000 193 284 000 

Expenses (excluding borrowing costs) (33 536 000) (141 156 000)

Borrowing costs   (1 092 000) (20 988 000)

Profit before income tax expense 3 740 000 31 140 000

Income tax expense   (1 496 000)   (12 456 000)

Profit from continuing operations after income tax expense

2 244 000 18 684 000 

Profit (loss) from discontinuing operations after related income tax

       204 000        (492 000)

Profit after income tax 2 448 000 18 192 000 

Other comprehensive income              0               0 

Total comprehensive income     2 448 000     18 192 000 

Profit attributable to non-controlling interest       1 704 000 

Profit attributable to members of the parent entity   16 488 000 

Notes to and forming part of the financial statements

PK Ltd ($)

PK Ltd and its subsidiaries ($)

Note X: Retained earnings

Retained earnings—1 July 2022 2 064 000 20 376 000

Profit after income tax 2 448 000

Profit attributable to members of the parent entity

16 488 000

Interim dividend—ordinary shares (608 000) (608 000)

Final dividend—ordinary shares (656 000) (656 000)

Dividends—preference shares  (360 000)   (360 000)

Retained earnings—30 June 2023 2 888 000 35 240 000

Additional information (i) On 30 June 2022, the share capital of PK Ltd comprised:

Share class Number of shares on issue Share capital

($)

Ordinary 4 600 000 11 052 000

Preference 600 000 6 000 000

Total 5 200 000 17 052 000

dee67382_ch24_917-946.indd 946 10/22/19 12:56 PM

946 PART 7: Other disclosure issues

(ii) During the financial year ending 30 June 2023, PK Ltd made the following share issues:

Date of share issue Class of share issue Details relating to share issue

1 October 2022 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 2024. The partly paid shares rank for (are entitled to participate in) dividends from 1 April 2023. The partly paid shares will entitle shareholders to receive 30 per cent of the dividends received by fully paid ordinary shareholders.

1 December 2022 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 2023 Preference Private placement of 320 000 fully paid shares, issued at the current share price at the time of issue.

1 May 2023 Ordinary Share buyback of 260 000 fully paid ordinary shares, purchased at the current share price at the time of purchase of $3.32.

(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 2023 was not paid.

REQUIRED Calculate basic earnings per share for the financial year ended 30 June 2023 in accordance with the requirements of AASB 133. LO 24.1, 24.2

24. 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). • Had 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 24.4

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May.

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.

dee67382_ch25_0947-1004.indd 947 10/25/19 11:45 AM

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

CHAPTER 28 Further consolidation issues III: accounting for indirect ownership interests

CHAPTER 29 Accounting for investments in associates and joint ventures

dee67382_ch25_0947-1004.indd 948 10/25/19 11:45 AM

948

LEARNING OBJECTIVES (LO) 25.1 Understand what it means to ‘consolidate’ the financial statements of a group of entities,

and what the rationale is for doing so. 25.2 Be aware of some of the history behind the development of Australian accounting standards

pertaining to consolidated financial statements. 25.3 Be aware that if an organisation is considered to be an ‘investment entity’ then it does not need to

consolidate those entities over which it has a potentially controlling ownership interest. 25.4 Understand the alternative consolidation concepts. 25.5 Understand that control is the criterion for determining whether or not to consolidate the accounts of

a legal entity within the ‘group accounts’, and be able to explain what control means, and what factors should be considered in determining the existence of control.

25.6 Be able to differentiate between direct and indirect control. 25.7 Understand the basics involved in preparing consolidated financial statements and, in doing so, be able

to use a ‘consolidation worksheet’ to perform relatively simple consolidations, including those that lead to the recognition of goodwill.

25.8 Understand what a ‘gain on bargain purchase’ represents, and how it shall be accounted for. 25.9 Know how to perform a consolidation when the subsidiary’s assets are not recorded at fair value prior

to consolidation. 25.10 Know how to perform a consolidation when the subsidiary’s accounts, at the time of acquisition,

exclude identifiable intangible assets that the subsidiary controls. 25.11 Know how to perform a consolidation in a period subsequent to the initial acquisition of a subsidiary. 25.12 Be aware of some of the disclosure requirements of AASB 12. 25.13 Understand the relative meanings of ‘control’, ‘joint control’ and ‘significant influence’.

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

C H A P T E R 25 Accounting for group structures

dee67382_ch25_0947-1004.indd 949 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 949

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is a ‘parent entity’, and what is a ‘subsidiary’? LO 25.1, 25.7 2. What are ‘consolidated financial statements’? LO 25.1 3. What does ‘control’ mean in the context of consolidation accounting, and of what relevance is ‘control’ to the

decision to include, or exclude, the financial accounts of an entity within the consolidated financial statements? LO 25.5

4. What is ‘goodwill’, and how is it determined? LO 25.7 5. If some intangible assets were not recognised by a subsidiary because they were internally developed, can

those same intangible assets be recognised in the consolidated financial statements? LO 25.10 6. Will the retained earnings and equity reserves of a subsidiary be included within the consolidated financial

statements? LO 25.7

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

3 Business Combinations IFRS 3

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

112 Income Taxes IAS 12

116 Property, Plant and Equipment IAS 16

127 Separate Financial Statements IAS 27

128 Investments in Associates and Joint Ventures IAS 28

136 Impairment of Assets IAS 36

137 Provisions, Contingent Liabilities and Contingent Assets IAS 37

138 Intangible Assets IAS 38

25.1 The meaning of ‘consolidated financial statements’, and the rationale for consolidating the financial statements of different legal entities

In this and the next four 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.

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 its subsidiaries). Where a reporting entity controls another entity, AASB 10 Consolidated Financial Statements requires that consolidated financial statements be prepared. In this chapter we will consider issues relating to the consolidation process, including:

∙ 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.

LO 25.1

group Typically, a group of entities comprising the parent entity and each of its subsidiaries.

consolidation The aggregation of the accounts of a number of separate legal entities.

dee67382_ch25_0947-1004.indd 950 10/25/19 11:45 AM

950 PART 8: Accounting for equity interests in other entities

Rationale for consolidating the financial statements of different legal entities Virtually every company listed on a securities exchange has subsidiaries. Therefore, investors in a parent entity (which has control over the subsidiaries) have effectively invested in the group comprising the parent entity and its subsidiaries. Many public companies have subsidiaries that can number in the hundreds. Often, people do not appreciate that when we talk about the results of large organisations listed on a securities exchange, we are actually talking about the combined (consolidated) results and financial positions of many entities all consolidated together. Therefore, when we are talking about a large organisation’s performance as a whole (as reflected in the consolidated financial statements), we are aggregating the results of a large number of different (but controlled) legal entities, some of which might have done very well, and some very poorly.

If investors in a large organisation 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

Chapters 26, 27 and 28 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 four chapters. In defining these key terms we will rely upon definitions provided in AASB 10. 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, paragraph 5, 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’.

As we can see from the above definitions, an entity must ‘control’ an organisation before that 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 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.

control over 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.

Figure 25.1 A simple parent and subsidiary relationship

Company A (parent)

Company B (subsidiary)

100%

Economic entity

Separate legal

entities

dee67382_ch25_0947-1004.indd 951 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 951

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. (AASB 10)

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. As we will see in this and the next three chapters, the process of aggregating items will also often involve undertaking various eliminations and adjustments. As will be stressed in this and in Chapter 26, the consolidation process does not involve any adjustments to the financial accounts 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.

25.2 History of Australian accounting standards that govern the preparation of consolidated financial statements

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. It 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. We will discuss this practice below.

Prior to the original issue of an accounting standard pertaining to consolidations (AAS 24), companies had a great deal of freedom in how they accounted for their subsidiaries, and many companies used this freedom opportunistically, or ‘creatively’, to present financial statements in the best possible light. Sullivan (1985) identified examples of companies using unit trusts to keep debt off the consolidated statement of financial position (balance sheet). As shown by Sullivan, the consolidation of the trust itself might not greatly alter the entity’s 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 or loss and other comprehensive income of the various entities within the economic entity.

LO 25.2

consolidated statement of financial position A statement of financial position that combines, with various eliminations and adjustments, the statements of financial position of the various entities within the economic entity.

dee67382_ch25_0947-1004.indd 952 10/25/19 11:45 AM

952 PART 8: Accounting for equity interests in other entities

but consolidation of the entities below the trust might have considerable effects. Sullivan showed how, by interposing a unit trust into a group’s structure, an organisation could effectively keep both the debt incurred by the trust and the 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).

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.

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)

dee67382_ch25_0947-1004.indd 953 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 953

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. (From SULLIVAN, G., ‘Accounting and Legal Implications of the Interposed Unit Trust Agreement’, Abacus, 21(2), p 182 (c) 1985. Reproduced with permission of John Wiley & Sons Ltd.)

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 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. (SULLIVAN, G., (1985). Reproduced with permission of John Wiley & Sons Ltd.)

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. (SULLIVAN, G., (1985). Reproduced with permission of John Wiley & Sons Ltd.)

Figure 25.3 Illustration of an interposed unit trust arrangement

Joint venture

DPPL

DAF

CSR WPAC

Lenders

CSRI*

CSRI* = CSR Investments Pty Limited

dee67382_ch25_0947-1004.indd 954 10/25/19 11:45 AM

954 PART 8: Accounting for equity interests in other entities

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.

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 requires that a parent shall prepare consolidated financial statements. A parent is defined 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’. Consolidated financial statements are defined in Appendix A 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. (AASB 10)

The above definition in turn refers to subsidiaries. A subsidiary is defined 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 to ‘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 only to the parent entity.

consolidated entity A combined entity constituted by a parent entity and its controlled entities.

dee67382_ch25_0947-1004.indd 955 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 955

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 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.

WHY DO I NEED TO KNOW THE MEANING OF ‘CONSOLIDATED FINANCIAL STATEMENTS’?

When the results of a large organisation are released by the directors of an organisation, or are being discussed in the news media, it is the group, or consolidated, results that are being discussed and not the results of the parent entity alone. Therefore, to grasp the focus of the discussion, and to make sense of what the numbers being discussed actually represent, it is important that we understand the nature of consolidated financial statements. Further, to understand the contents and context of consolidated financial statements, we need to comprehend the rules that determine which entities are included in the group accounts (that is, we need to know what a ‘parent’ is and what a ‘subsidiary’ is), as well as the accounting requirements pertaining to the types of eliminations and adjustments that occur in respect of the financial statements of the separate legal entities (the parent entity and the subsidiaries’ financial statements) that are included within the consolidated financial statements.

25.3 ‘Investment entities’: exception to consolidation

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.

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)

The standard 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).

LO 25.3

dee67382_ch25_0947-1004.indd 956 10/25/19 11:45 AM

956 PART 8: Accounting for equity interests in other entities

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. (AASB 10)

With limited exceptions, investment entities are not required to consolidate subsidiaries, or apply AASB 3 Business Combinations 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. (AASB 10)

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 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.

25.4 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 Separate Financial Statements 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.

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.

LO 25.4

dee67382_ch25_0947-1004.indd 957 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 957

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 BCZ157 to BCZ159 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 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, which was subsequently revised in 2018).

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 non- controlling 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.

25.5 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 consolidation of an investee shall begin from the date the investor obtains control of the investee, and shall 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. (AASB 10)

Further, a ‘parent’ is defined as:

an entity that controls one or more entities. (AASB 10)

LO 25.5

dee67382_ch25_0947-1004.indd 958 10/25/19 11:45 AM

958 PART 8: Accounting for equity interests in other 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 Appendix A of 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. (AASB 10) [emphasis added]

The three elements of control are explained in some detail throughout AASB 10 and in the associated Application Guidance that accompanies the standard. For control to be deemed to exist, all three elements just identified must be present.

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 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. (AASB 10)

Determining the existence of ‘power’ will not always be a straightforward exercise. As paragraph 11 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. (AASB 10)

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 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. (AASB 10)

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:

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. (AASB 10)

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 Joint Arrangements—needs to be applied (and this standard—which is discussed in Chapter 29—does not allow consolidation for jointly controlled entities).

dee67382_ch25_0947-1004.indd 959 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 959

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.

WHY DO I NEED TO KNOW THE MEANING OF ‘CONTROL’?

Control is the fundamental issue in deciding whether the accounts of a separate legal entity are to be included within the consolidated financial statements. Therefore, to understand the contents of consolidated financial statements we need to understand the definition of control (including the difference between ‘direct control’ and ‘indirect control’), and how that definition is applied.

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 of 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 if it does not hold the majority of the voting rights. As paragraphs BC99, BC107 and BC108 of the Basis for Conclusions to IFRS 10 state:

BC99 The Board decided that in Exposure Draft 10 (which preceded the release of the Accounting Standard) 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.

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

dee67382_ch25_0947-1004.indd 960 10/25/19 11:45 AM

960 PART 8: Accounting for equity interests in other entities

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, convertible bonds or preference shares, which 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 BC120, BC121 and BC124 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.

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’s and C Ltd’s interests are reduced to 20 per cent each.

dee67382_ch25_0947-1004.indd 961 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 961

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.

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.

dee67382_ch25_0947-1004.indd 962 10/25/19 11:45 AM

962 PART 8: Accounting for equity interests in other entities

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. (AASB 10)

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, meaning that the investor’s returns from its involvement have the potential to vary as a result of the investee’s performance.

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.

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.

25.6 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 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

controlled entity An organisation that is controlled by another entity; often called a subsidiary.

LO 25.6

dee67382_ch25_0947-1004.indd 963 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 963

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

Company A

Non-controlling interests

Company B

70%

30%

Figure 25.4 An example of direct control

Figure 25.5 An example of indirect controlCompany A

Company B

75%

60%

40%

25%

Company C

Non-controlling interests

Non-controlling interests

Company A

Company B

65%

25% Company C

35%35%

40%Non-controlling interests

Non-controlling interests

Figure 25.6 Situation where control is established through a mix of direct and indirect ownership interests

dee67382_ch25_0947-1004.indd 964 10/25/19 11:45 AM

964 PART 8: Accounting for equity interests in other entities

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.

25.7 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. We consolidate another entity when the parent entity is effectively combining the acquired business (a ‘business combination’) with that of the parent entity and its other subsidiaries.

According to AASB 3 Business Combinations, a ‘business combination’ is a transaction or other event in which an acquirer obtains control of one or more businesses.

AASB 3 and AASB 10 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 standard 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 standard 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 businesses being acquired. This requires that the assets acquired, and liabilities assumed, constitute a ‘business’. A ‘business’ is defined in AASB 3 as ‘an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest), or generating other income from ordinary activities’.

Guidance on what constitutes a business is provided in the Application Guidance accompanying AASB 3. According to paragraph B7:

A business consists of inputs and processes applied to those inputs that have the ability to contribute to the creation of outputs. The three elements of a business are defined as follows:

(a) Input: Any economic resource that creates outputs, or has the ability to contribute to the creation of 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 outputs or has the ability to contribute to the creation of outputs. Examples include strategic management processes, operational processes and resource management processes. These processes typically are documented, but the intellectual capacity of an 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 goods or services to customers, generate investment income (such as dividends or interest), or generate other income from ordinary activities. (AASB 3)

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. If we are not acquiring a business then we would not recognise goodwill.

LO 25.7

dee67382_ch25_0947-1004.indd 965 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 965

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.

WHY DO I NEED TO KNOW THE DIFFERENCE BETWEEN A BUSINESS ACQUISITION AND THE ACQUISITION OF A GROUP OF ASSETS?

When we prepare consolidated financial statements, we consolidate the accounts of a business with those of the parent entity; in doing so, we recognise goodwill (or in rare cases, a bargain purchase on acquisition). If the parent entity is acquiring a business, then, as accountants, we need to know that it is a requirement to apply AASB 10 and AASB 3.

By contrast, if an organisation is simply acquiring a group of assets, then no goodwill (or bargain purchase on acquisition) arises, and the acquired assets are simply included within the financial statements of the parent entity. In such an instance, AASB 10 and AASB 3 do not apply. Rather, accounting standards such as AASB 116 and AASB 138 apply.

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.

dee67382_ch25_0947-1004.indd 966 10/25/19 11:45 AM

966 PART 8: Accounting for equity interests in other entities

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.

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, 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 states:

Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets. (AASB 138)

However, should another entity (the acquirer, or investor) subsequently acquire the business of another entity (the acquiree, or the investee), 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 Appendix A to 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. (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. (AASB 3)

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. (AASB 137)

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 as:

An asset representing the future economic benefits arising from assets acquired in a business combination that are not individually identified and separately recognised. (AASB 3)

In the context of business combinations, 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);

dee67382_ch25_0947-1004.indd 967 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 967

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

(iii) in a business combination achieved in stages (see paragraphs 41 and 42), the acquisition-date fair value of the 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. (AASB 3)

This can be simplified as follows:

FAIR VALUE OF CONSIDERATION TRANSFERRED XXX

plus Amount of non-controlling interest XXX

plus Fair value of any previously held equity interest in the acquiree XXX

XXX

less Fair value of identifiable assets acquired and liabilities assumed (XXX)

GOODWILL ON ACQUISITION DATE 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’.

According to the Basis for Conclusions in IAS 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. 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. (AASB 3)

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 2023, 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:

Carrying amount ($)

Fair value ($)

Cash 15 000 15 000

Accounts receivable 68 000 68 000

Inventory 112 000 131 000

Land 360 000 420 000

continued

dee67382_ch25_0947-1004.indd 968 10/25/19 11:45 AM

968 PART 8: Accounting for equity interests in other entities

Plant 220 000 240 000

Loans payable (170 000) (170 000)

Accounts payable (58 000) (58 000)

Contingent liabilities – (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 650 000

less Fair value of identifiable assets acquired and  liabilities assumed

Cash 15 000

Accounts receivable 68 000

Inventory 131 000

Land 420 000

Plant 240 000

Loans payable (170 000)

Accounts payable (58 000)

Contingent liabilities   (46 000)

Total fair value of net assets acquired 600 000

Goodwill on acquisition date   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 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, Ying (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 subsequently 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 Impairment of Assets, 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

WORKED EXAMPLE 25.2 continued

dee67382_ch25_0947-1004.indd 969 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 969

financial statements. However, where the parent does not acquire all of 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 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.

While very sophisticated accounting packages exist that allow us to prepare consolidated financial statements, we will demonstrate, in this chapter and the following chapters, how a manual accounting system can be used to perform consolidations. This allows us to explain how consolidated financial statements are prepared and what they represent. The way we shall be performing consolidation adjustments is consistent with how various computerised accounting information systems would do it—it just takes us a lot longer to do it manually. In a real-life situation, and given the fact that thousands of consolidation adjustments and eliminations would potentially need to be made every year, a manual accounting system would be severely impractical.

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.

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 that is shown in the balance sheet of the parent entity 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 losses may indicate an impairment that requires recognition in the consolidated financial statements.

dee67382_ch25_0947-1004.indd 970 10/25/19 11:45 AM

970 PART 8: Accounting for equity interests in other entities

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. (AASB 10)

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 2023. The statements of financial position of both entities immediately following the purchase are:

Parent Ltd ($000)

Subsidiary Ltd ($000)

Current assets

Cash 10 5

Accounts receivable 150 55

Non-current assets

Plant 800 500

Land 200 100

Investment in Subsidiary Ltd    500      –

1 660 660

Parent Ltd ($000)

Subsidiary Ltd ($000)

Current liabilities

Accounts payable 60 30

Non-current liabilities

Loans 400 150

Shareholders’ equity

Share capital 1 000 200

Retained earnings    200 280

1 660 660

REQUIRED Provide the consolidated statement of financial position for Parent Ltd and Subsidiary Ltd as at 30 June 2023.

SOLUTION We will provide the answers 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. (AASB 3)

dee67382_ch25_0947-1004.indd 971 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 971

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. Chapter 4 provides extensive discussion of various issues associated with determining and accounting for the fair value of assets. Hence, this will not be repeated here. Fair value is defined in AASB 13 Fair Value Measurement, and therefore also within other relevant accounting 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. (AASB 13)

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.

As already noted, 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 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 500 000

(to eliminate the investment in Subsidiary Ltd and to recognise the goodwill on acquisition)

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 legal 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

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.

dee67382_ch25_0947-1004.indd 972 10/25/19 11:45 AM

972 PART 8: Accounting for equity interests in other entities

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 2023

Eliminations and adjustments

Parent Ltd ($000)

Subsidiary Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Current assets

Cash 10 5 15

Accounts receivable 150 55 205

Non-current assets

Plant 800 500 1 300

Land 200 100 300

Investment in Subsidiary Ltd 500 – 500 –

Goodwill on acquisition        –     – 20     20

1 660 660 1 840

Current liabilities

Accounts payable 60 30 90

Non-current liabilities

Loans 400 150 550

Shareholders’ equity

Share capital 1 000 200 200 1 000

Retained earnings     200 280 280     200

1 660 660 500 500 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 2023

Parent entity ($000)

Group ($000)

Current assets

Cash 10 15

Accounts receivable    150    205

   160    220

dee67382_ch25_0947-1004.indd 973 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 973

Parent entity ($000)

Group ($000)

Non-current assets

Plant 800 1 300

Land 200 300

Investment in Subsidiary Ltd 500 –

Goodwill        –      20

1 500 1 620

Total assets 1 660 1 840

Current liabilities

Accounts payable      60      90

Non-current liabilities

Loans    400    550

Total liabilities    460    640

Net assets 1 200 1 200

Represented by:

Shareholders’ equity

Share capital 1 000 1 000

Retained earnings    200    200

1 200 1 200

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.

WHY DO I NEED TO KNOW WHAT GOODWILL REPRESENTS, AND HOW IT SHALL BE ACCOUNTED FOR?

The goodwill acquired in a business acquisition, and presented within the consolidated balance sheet, can sometimes amount to many millions, or even billions, of dollars. Therefore, it can be a very material asset and it is thus important to understand what it represents, and how it is calculated. To understand ‘goodwill’, it is also important to understand that only purchased goodwill can be recognised, and to understand the requirements in relation to ongoing impairment testing of goodwill.

25.8 Gain on bargain purchase

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

LO 25.8

dee67382_ch25_0947-1004.indd 974 10/25/19 11:45 AM

974 PART 8: Accounting for equity interests in other entities

amount of any non-controlling interest in the acquiree plus the acquisition-date fair value of the acquirer’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. (AASB 3)

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 $400 000

Fair value of net assets acquired $480 000

Gain on bargain purchase   $80 000

REQUIRED Provide the consolidation worksheet for Parent Ltd and its controlled entity for the year ending 30 June 2023.

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)

Consolidation worksheet for Parent Ltd and its controlled entity for the year ending 30 June 2023

Eliminations and adjustments

Parent Ltd ($000)

Subsidiary Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Current assets

Cash 110 5 115

dee67382_ch25_0947-1004.indd 975 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 975

Eliminations and adjustments

Parent Ltd ($000)

Subsidiary Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Accounts receivable 150 55 205

Non-current assets

Plant 800 500 1 300

Land 200 100 300

Investment in

Subsidiary Ltd    400      – 400      –

1 660 660 1 920

Current liabilities

Accounts payable 60 30 90

Non-current liabilities

Loans 400 150 550

Shareholders’ equity

Share capital 1 000 200 200 1 000

Retained earnings 200 280 280    80   280

1 660 660 480 480 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.

25.9 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 acquisition- date 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, or if revaluations are used, they might not be up-to-date), 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 the date of 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 and AASB 138. 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 Income Taxes. 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 before we subsequently use

LO 25.9

dee67382_ch25_0947-1004.indd 976 10/25/19 11:45 AM

976 PART 8: Accounting for equity interests in other entities

consolidation journal entries to eliminate the parent entity’s investment in the subsidiary against the pre-acquisition share capital and reserves of the subsidiary. This would require the following 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 Gain on revaluation (on OCI) XX

(revaluing assets to their fair value and recognising the gain in other comprehensive income in compliance with AASB 116)

Dr Income tax expense (in OCI) XX  

Cr Deferred tax liability XX

(recognising the deferred tax consequences of the revaluation in accordance with AASB 112, as we explained in Chapter 18)

Dr Gain on revaluation (in OCI) XX  

Cr Income tax expense (in OCI) XX

Cr Revaluation surplus XX

(transferring the net gain on revaluation to the revaluation surplus at the end of the accounting period in accordance with AASB 116)

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 entries 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 (eliminating the investment in subsidiary, as well as the revaluation surplus created in the previous entry)

XX

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 2023, 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 (you may need to go back and read Chapter 18 if you have forgotten the requirements of tax-effect accounting). The revaluation creates a

dee67382_ch25_0947-1004.indd 977 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 977

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 2023

Dr Land 30 000

Cr Gain on revaluation (in OCI) 30 000

(to revalue the asset to fair value and recognise the associated gain in other comprehensive income)

Dr Income tax expense (in OCI) 9 000

Cr Deferred tax liability 9 000

(to recognise the deferred tax effect associated with the revaluation)

Dr Gain on revaluation (in OCI) 30 000

Cr Income tax expense (in OCI) 9 000

Cr Revaluation surplus 21 000

(closing entry at the end of the accounting period to transfer the net gain on revaluation to the revaluation surplus account, which is part of equity)

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 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 2023

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

(to eliminate the investment in the subsidiary against the subsidiary’s pre-acquisition share capital and reserves)

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.

dee67382_ch25_0947-1004.indd 978 10/25/19 11:45 AM

978 PART 8: Accounting for equity interests in other entities

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 2023 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 $2 500 000

Retained earnings $    900 000

Total share capital and reserves $3 400 000

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)

Current assets

Cash 15 6

Accounts receivable    175       64

   190       70

Non-current assets

Land 2 890 2 700

Plant and equipment 1 905 900

Investment in Surfer Ltd 3 920        –

8 715 3 600

Total assets 8 905 3 670

Current liabilities

Accounts payable    140     55

Non-current liabilities

Loans 1 145    215

Total liabilities 1 285    270

Net assets 7 620 3 400

Shareholders’ equity

Share capital 5 500 2 500

Retained earnings 2 120    900

7 620 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:

dee67382_ch25_0947-1004.indd 979 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 979

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 2023, 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 2024 to account for the depreciation.

SOLUTION

(i) Consolidation journal entries

30 June 2023

(a) Dr Land 500 000

Cr Revaluation surplus recognised on consolidation 350 000

Cr Deferred tax liability 150 000

(to revalue the land held by the subsidiary)

(b) Dr Accumulated depreciation 2 800 000

Cr Plant 2 800 000

(to eliminate the accumulated depreciation at the date of revaluation)

(c) Dr Plant 400 000

Cr Revaluation surplus recognised on consolidation 280 000

Cr Deferred tax liability 120 000

(to revalue the plant held by the subsidiary)

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 2 500 000

Retained earnings 900 000

Revaluation surplus recognised on consolidation    630 000

Total pre-acquisition capital and reserves 4 030 000

Cost of investment in Surfer Ltd 3 920 000

Gain on bargain purchase    110 000

(d) Dr Share capital 2 500 000

Dr Retained earnings 900 000

Dr Revaluation surplus recognised on consolidation 630 000

Cr Gain on bargain purchase of Surfer Ltd 110 000

Cr Investment in Surfer Ltd 3 920 000

(to eliminate the investment in the subsidiary against the subsidiary’s pre-acquisition share capital and reserves)

continued

dee67382_ch25_0947-1004.indd 980 10/25/19 11:45 AM

980 PART 8: Accounting for equity interests in other entities

As we can see from the above journal entries, the entire fair value adjustment on consolidation that was created in entries (a) and (c) above is then eliminated in entry (d). The fair value adjustment 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. We have used the account ‘Revaluation surplus recognised on consolidation’ to highlight that this is a revaluation undertaken as part of the consolidation process, which will subsequently be eliminated when determining goodwill.

Consolidation worksheet for Kite Ltd and its controlled entity for the period ending 30 June 2023

Eliminations and adjustments

Kite Ltd ($000)

Surfer Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

of financial position

($000)

Retained earnings 2 120 900 900(d) 110(d) 2 230

Share capital 5 500 2 500 2 500(d) 5 500

Revaluation surplus recognised on consolidation 630(d) 350(a), 280(c) –

Current liabilities

Accounts payable 140 55 195

Non-current liabilities

Deferred tax liability 150(a), 120(c) 270

Loans 1 145     215 1 360

8 905 3 670 9 555

Current assets

Cash 15 6 21

Accounts receivable 175 64 239

Non-current assets

Plant 4 000 3 700 400(c) 2 800(b) 5 300

Accumulated depreciation (2 095) (2 800) 2 800(b) (2 095)

Land 2 890 2 700 500(a) 6 090

Investment in Surfer Ltd 3 920        – 3 920(d)        –

8 905 3 670 7 730 7 730     9 555

(ii) Additional depreciation expense adjustment at 30 June 2024 (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 $1 300 000

Carrying amount of plant in accounting records of Surfer Ltd $900 000

Additional depreciation to be recognised in total over next 4 years $400 000

Additional depreciation per year ($400 000 ÷ 4) $100 000

WORKED EXAMPLE 25.6 continued

dee67382_ch25_0947-1004.indd 981 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 981

30 June 2024—consolidation journal entries to recognise additional depreciation expense

Dr Depreciation expense 100 000

Cr Accumulated depreciation—plant 100 000

Dr Deferred tax liability 30 000

Cr Income tax expense 30 000

(to recognise the increased depreciation expense and related tax effects)

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 2023, 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 consolidation journal entries performed in 2023 would also need to be repeated in 2024.

25.10 Previously unrecognised identifiable intangible assets

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 by virtue of AASB 138. 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. (AASB 138)

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. (AASB 3)

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 also notes that the acquirer shall recognise a deferred tax liability, or asset, arising from assets acquired in a business combination when those assets were not recognised in the financial statements of the acquiree. A deferred tax liability will arise on recognition of the previously unrecognised identifiable intangible asset because the carrying amount of the asset will change, while the tax base will not change, which leads to an increase in taxable temporary differences in the form of a deferred tax liability.

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.

LO 25.10

dee67382_ch25_0947-1004.indd 982 10/25/19 11:45 AM

982 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 25.7: Recognition on consolidation of previously unrecognised identifiable intangible assets

On 30 June 2023 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 $3 000 000

Retained earnings    $400 000

Total share capital and reserves $3 400 000

At the date of acquisition, the statements of financial position of Larry Ltd and Blair Ltd were as follows:

Larry Ltd ($000)

Blair Ltd ($000)

Current assets

Cash 100 25

Accounts receivable    200       45

   300       70

Non-current assets

Land 3 500 3 000

Plant and equipment 1 700 600

Investment in Blair Ltd 4 000        –

9 200 3 600

Total assets 9 500 3 670

Current liabilities

Accounts payable    100       50

Non-current liabilities

Loans 1 400     220

Total liabilities 1 500     270

Net assets 8 000 3 400

Shareholders’ equity

Share capital 5 500 3 000

Retained earnings 2 500     400

8 000 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 2023, but which had

been internally developed and therefore was not recognised in its statement of financial position. • The tax rate is 30 per cent.

REQUIRED Prepare the consolidation journal entries necessary to consolidate Larry Ltd and Blair Ltd at 30 June 2023. Prepare the consolidated statement of financial position.

SOLUTION Determination of goodwill

Share capital 3 000 000

Retained earnings    400 000

Total pre-acquisition capital and reserves 3 400 000

Cost of investment in Surfer Ltd 4 000 000

600 000

less Fair value of publishing title (net of associated deferred tax liability of $120 000, which equals $400 000 × 0.30)

   280 000

Goodwill    320 000

dee67382_ch25_0947-1004.indd 983 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 983

Consolidation journal entries

(a) to recognise the previously unrecognised publishing title

Dr Publishing title 400 000

Cr Deferred tax liability 120 000

Cr Revaluation surplus recognised on consolidation 280 000

(to recognise previously unrecognised publishing title)

(b) elimination of investment in subsidiary

Dr Share capital 3 000 000

Dr Retained earnings 400 000

Dr Revaluation surplus recognised on consolidation 280 000

Dr Goodwill 320 000

Cr Investment in Blair Ltd 4 000 000

(to eliminate the investment in the subsidiary against the subsidiary’s pre-acquisition capital and reserves)

Consolidation worksheet for Larry Ltd and its controlled entity for the period ending 30 June 2023

Eliminations and adjustments

Larry Ltd ($000)

Blair Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement of financial position

($000)

Retained earnings 2 500 400 400(b) 2 500

Share capital 5 500 3 000 3 000(b) 5 500

Revaluation surplus recognised on consolidation 280(b) 280(a) –

Current liabilities

Accounts payable 100 50 150

Non-current liabilities

Deferred tax liability 120(a) 120

Loans 1 400    220 1 620

9 500 3 670 9 890

Current assets

Cash 100 25 125

Accounts receivable 200 45 245

Non-current assets

Plant 1 700 600 2 300

Land 3 500 3 000 6 500

Publishing title 400(a) 400

Goodwill 320(b) 320

Investment in Surfer Ltd 4 000         – 4 000(b)         –

9 500 3 670 4 400 4 400 9 890

dee67382_ch25_0947-1004.indd 984 10/25/19 11:45 AM

984 PART 8: Accounting for equity interests in other entities

25.11 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, the efforts of the management team of the parent entity, they should be reflected in the results of the economic entity. That is, unlike pre-acquisition earnings, post-acquisition earnings of the subsidiary are considered to be part of the earnings of the economic entity (the group of entities) and are not eliminated on consolidation. Accounting post-acquisition is examined more closely in Worked Example 25.8.

LO 25.11

pre-acquisition shareholders’ funds Shareholders’ funds that were in existence in an organisation before an entity acquired an 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 2023, leading to goodwill of $20 000 being recognised. We will assume that there is no tax to be paid.

The accounts for Parent Ltd and Subsidiary Ltd at 30 June 2024 (one year after acquisition) are provided here.

Reconciliation of opening and closing retained earnings

Parent Ltd ($000)

Subsidiary Ltd ($000)

Sales revenue 300 100

Cost of goods sold (100) (40)

Other expenses   (60)   (30)

Profit 140 30

Retained earnings opening balance   200  280

Retained earnings—30 June 2024  340  310

Statements of financial position as at 30 June 2024

Parent Ltd ($000)

Subsidiary Ltd ($000)

Shareholders’ equity

Retained earnings 340 310

Share capital 1 000 200

Current liabilities

Accounts payable 60 40

Non-current liabilities

Loans    600 250

2 000 800

Current assets

Cash 50 25

Accounts receivable 250 75

dee67382_ch25_0947-1004.indd 985 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 985

Non-current assets

Land 200 100

Plant 1 000 600

Investment in Subsidiary Ltd    500     –

2 000 800

Additional information Directors have determined that goodwill acquired in 2023 has been impaired by $5000, so that its value at 30 June 2024 is $15 000. There are no intragroup transactions.

REQUIRED Prepare the consolidation worksheet for Parent Ltd and its controlled entity as at 30 June 2024.

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 therefore 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 against the subsidiary’s pre- acquisition capital and reserve, 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 5000

Cr Accumulated impairment—goodwill 5000

(to recognise the impairment loss for 2024)

(c) Preparation of worksheet

Consolidation worksheet for Parent Ltd and its controlled entity for the period ending 30 June 2024

Eliminations and adjustments

Parent Ltd ($000)

Subsidiary Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Reconciliation of opening and closing retained earnings

Sales revenue 300 100 400

Cost of goods sold (100) (40) (140)

Other expenses    (60)     (30) 5(b)   (95)

Profit 140 30 165

continued

dee67382_ch25_0947-1004.indd 986 10/25/19 11:45 AM

986 PART 8: Accounting for equity interests in other entities

Eliminations and adjustments

Parent Ltd ($000)

Subsidiary Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Retained earnings opening balance    200     280 280(a)    200

Retained earnings closing balance    340     310    365

Statements of financial position

Retained earnings—30 June 2024 340 310 365

Share capital 1 000 200 200(a) 1 000

Current liabilities

Accounts payable 60 40 100

Non-current liabilities

Loans    600    250    850

2 000     800 2 315

Current assets

Cash 50 25 75

Accounts receivable 250 75 325

Non-current assets

Plant 1 000 600 1 600

Land 200 100 300

Investment in Subsidiary Ltd 500 – 500(a) –

Goodwill on acquisition – – 20(a) 20

Accum. impairment—goodwill        –          –   –   5(b)    (5)

2 000     800 505 505 2 315

As can be seen from the above worksheet, the consolidated retained earnings balance at the end of the 2024 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.

In Worked Example 25.9 we consider a further consolidation example. In this illustration, we consider a situation where the subsidiary’s assets are not recorded at fair value, and the consolidation is undertaken in the year subsequent to initial acquisition.

WORKED EXAMPLE 25.9: Consolidation in the year subsequent to acquisition, and with a fair value adjustment

Stubbs Ltd acquires all of the shares in Billa Ltd on 30 June 2022. The financial statements for Stubbs Ltd and Billa Ltd at 30 June 2023 (one year after acquisition) are provided below.

Reconciliation of opening and closing retained earnings

Stubbs Ltd ($000)

Billa Ltd ($000)

Sales revenue 2 000 610

Cost of goods sold (800) (240)

WORKED EXAMPLE 25.8 continued

dee67382_ch25_0947-1004.indd 987 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 987

Stubbs Ltd ($000)

Billa Ltd ($000)

Other expenses   (300)   (70)

Profit 900 300

Retained earnings opening balance 1 100 500

Retained earnings at 30 June 2023 2 000 800

Statements of financial position

Stubbs Ltd ($000)

Billa Ltd ($000)

Shareholders’ equity

Retained earnings 2 000 800

Share capital 1 100 350

Current liabilities

Accounts payable 700 150

Non-current liabilities

Loans 1 100    700

4 900 2 000

Current assets

Cash 150 200

Accounts receivable 450 250

Non-current assets

Land 1 200 750

Plant 2 600 1 000

Accumulated depreciation—plant (600) (200)

Investment in Billa Ltd 1 100         –

4 900 2 000

Additional information

1. Stubbs Ltd acquires Billa Ltd on 30 June 2022 for $1.1 million in cash. 2. The directors of Stubbs Ltd consider that in the year to 30 June 2023 the value of goodwill has been

impaired by an amount of $20 000. 3. There are no intragroup transactions. 4. Billa Ltd did not issue any shares during 2023. 5. The tax rate is 30 per cent. 6. 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)

Cash 150 150

Accounts receivable 200 200

Land 750 800

Plant (cost of $1 000 000, accumulated depreciation of $200 000)    800    900

1 900 2 050

continued

dee67382_ch25_0947-1004.indd 988 10/25/19 11:45 AM

988 PART 8: Accounting for equity interests in other entities

7. No revaluations are undertaken in Billa Ltd’s accounts before consolidation. 8. At the date of acquisition of Billa Ltd, Billa Ltd’s liabilities amount to $1.050 million and there are no contingent

liabilities. 9. The plant in Billa Ltd is expected to have a remaining useful life of 10 years from 30 June 2022, and no

residual value.

REQUIRED Provide the consolidated accounts of Stubbs Ltd and Billa Ltd as at 30 June 2023.

SOLUTION 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 $1 100 000

Carrying amount of net assets acquired:

Carrying amount of assets $1 900 000

Carrying amount of liabilities $1 050 000 $850 000

Fair value adjustment:

Excess of fair value of land over carrying amount $50 000

Excess of fair value of plant over carrying amount $100 000

$150 000

Tax effect of revaluation (deferred tax liability) $150 000 × 0.30   ($45 000) $105 000 Fair value of net assets acquired $955 000

Goodwill acquired $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 Land 50 000

Cr Revaluation surplus recognised on consolidation 35 000

Cr Deferred tax liability 15 000

(to recognise the fair value adjustment of land and the consequent deferred tax liability)

Dr Accumulated depreciation 200 000

Cr Plant 200 000

(to eliminate the existing accumulated depreciation of the plant as part of the fair value adjustment of plant)

Dr Plant 100 000

Cr Revaluation surplus recognised on consolidation 70 000

Cr Deferred tax liability 30 000

(to recognise the fair value adjustment of plant and the consequent deferred tax liability)

(b) To eliminate the investment in Billa Ltd and the pre-acquisition capital and reserves of Billa Ltd

Dr Share capital 350 000

Dr Retained earnings 500 000

Dr Revaluation surplus recognised on consolidation 105 000

Dr Goodwill 145 000

Cr Investment in Billa Ltd 1 100 000

(to eliminate the pre-acquisition share capital and reserves of Billa Ltd)

WORKED EXAMPLE 25.9 continued

dee67382_ch25_0947-1004.indd 989 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 989

continued

(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 Impairment loss—goodwill 20 000

Cr Accumulated impairment—goodwill 20 000

(to recognise the subsequent impairment of goodwill)

(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 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

(to adjust depreciation due to the fair value adjustment on consolidation)

Consolidation worksheet for Stubbs Ltd and its controlled entity for the period ending 30 June 2023

Eliminations and adjustments

Stubbs Ltd ($000)

Billa Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Reconciliation of opening and closing retained earnings

Sales revenue 2 000 610 2 610

Cost of goods sold (800) (240) (1 040)

Other expenses   (300)      (70) 10(d), 20(c) 3(d)   (397)

Profit 900 300 1 173

Retained earnings—30 June 2022 1 100    500 500(b) – 1 100

Retained earnings—30 June 2023 2 000    800 2 273

Statements of financial position

Shareholders’ equity

Retained earnings 2 000 800 2 273

Share capital 1 100 350 350(b) 1 100

Revaluation surplus recognised on consolidation

– – 105(b) 70(a), 35(a) –

Current liabilities

Accounts payable 700 150 850

Non-current liabilities

Loans 1 100 700 1 800

Deferred tax liability                       3(d) 15(a), 30(b)       42

4 900 2 000 6 065

dee67382_ch25_0947-1004.indd 990 10/25/19 11:45 AM

990 PART 8: Accounting for equity interests in other entities

Eliminations and adjustments

Stubbs Ltd ($000)

Billa Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Current assets

Cash 150 200 350

Accounts receivable 450 250 700

Non-current assets

Land 1 200 750 50(a) 2000

Plant 2 600 1 000 100(a) 200(a) 3 500

Accumulated depreciation (600) (200) 200(a) 10(d) (610)

Goodwill 145(b) 145

Accumulated impairment— goodwill

20(c) (20)

Investment in Billa Ltd 1 100         –            1 100(b)         –

4 900 2 000 1 483 1 483 6 065

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 2023

Stubbs Ltd ($000)

Group ($000)

Current assets

Cash 150 350

Accounts receivable 450 700

600 1 050

Non-current assets

Land 1 200 2 000

Plant 2 600 3 500

Accumulated depreciation (600) (610)

Goodwill – 145

Accumulated impairment—goodwill – (20)

Investment in Billa Ltd 1 100         –

4 300 5 015

Total assets 4 900 6 065

Current liabilities

Accounts payable    700    850

Non-current liabilities

Loans 1 100 1 800

Deferred tax liability        –       42

1 100 1 842

WORKED EXAMPLE 25.9 continued

dee67382_ch25_0947-1004.indd 991 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 991

25.12 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 this standard 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.

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)

Stubbs Ltd ($000)

Group ($000)

Total liabilities 1 800 2 692

Net assets 3 100 3 373

Represented by:

Shareholders’ equity

Retained earnings 2 000 2 273

Share capital 1 100 1 100

3 100 3 373

LO 25.12

dee67382_ch25_0947-1004.indd 992 10/25/19 11:45 AM

992 PART 8: Accounting for equity interests in other entities

AASB 12 also stipulates a number of disclosure requirements in relation to:

∙ the nature and extent of significant restrictions on management’s ability to access or use the assets and settle the liabilities of the group (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).

25.13 Control, joint control and significant influence

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 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 29 of this book. As Chapter 29 explains, joint arrangements are classified as

LO 25.13

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

Account for assets, liabilities, revenues and expenses.

Disclose in accordance with AASB 12 Disclosure of

Interests in Other Entities

Apply AASB 9 Financial

Instruments

Is there joint control?

Is there significant influence?

Account for an investment in accordance with AASB 128

Investments in Associates and Joint Ventures and provide

disclosures in accordance with AASB 12

Define type of joint arrangement in accordance

with AASB 11 Joint Arrangements

Does the investor control the investee?

Yes No

Joint operation Joint venture

Yes

NoYes

No

Figure 25.7 Accounting for investments in which the investee has control, joint control, or significant influence over the investee

dee67382_ch25_0947-1004.indd 993 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 993

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 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. (AASB 11)

By contrast, a joint venture is defined at paragraph 16 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. (AASB 11)

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 investor’s financial statements and also 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 29—is to be used to account for the investment. As paragraphs 21 and 24 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.

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. (AASB 11)

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 29 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. AASB 9 is considered in depth in Chapter 14.

SUMMARY

This chapter introduces the four 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 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 AASB 136. If a bargain on purchase is calculated on consolidation, the bargain is to be accounted for as a gain in the consolidated financial statements.

dee67382_ch25_0947-1004.indd 994 10/25/19 11:45 AM

994 PART 8: Accounting for equity interests in other entities

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 954 consolidated statement of financial position 951 consolidated statement of profit or loss and other comprehensive income 951

consolidation 949 controlled entity 962 control over an investee 950 group 949 internally generated goodwill 971

pre-acquisition shareholders’ funds 984 purchased goodwill 971

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is a ‘parent entity’, and what is a ‘subsidiary’? LO 25.1, 25.7 A parent entity is an entity that controls one or more entities, and a subsidiary is an entity that is controlled by another entity.

2. What are ‘consolidated financial statements’? LO 25.1 Consolidated financial statements are the financial statements of a group presented as those of a single economic entity. Consolidated financial statements combine like items of assets, liabilities, equity, income, expenses and cash flows of the parent with those of its subsidiaries.

3. What does ‘control’ mean in the context of consolidation accounting, and of what relevance is ‘control’ to the decision to include, or exclude, the financial accounts of an entity within the consolidated financial statements? LO 25.5 An investor (parent entity) shall consolidate the accounts of those entities that it controls (subsidiaries). In this context, control is deemed to exist 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.

4. What is ‘goodwill’, and how is it determined? LO 25.7 Goodwill is an asset representing the future economic benefits arising from assets acquired in a business combination that are not individually identified and separately recognised. Goodwill effectively reflects the fair value of the consideration paid to acquire a business less the fair value of the net assets acquired in the acquisition.

5. If some intangible assets were not recognised by a subsidiary because they were internally developed, can those same intangible assets be recognised in the consolidated financial statements? LO 25.10 Yes, they can be recognised. As part of the consolidation process it is a requirement that all of the identifiable assets of a subsidiary are identified and recognised at fair value as part of the initial consolidation journal entries. A failure to recognise identifiable intangible assets would lead to an overstatement of the purchased goodwill.

6. Will the retained earnings and equity reserves of a subsidiary be included within the consolidated financial statements? LO 25.7 Only the post-acquisition movements in the retained earnings and equity reserves of a subsidiary shall be included within the consolidated financial statements. As part of the process of compiling consolidated financial statements, we shall eliminate the parent entity’s investment in each subsidiary against the parent entity’s interest in the pre- acquisition share capital and reserves of the subsidiary.

dee67382_ch25_0947-1004.indd 995 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 995

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is the role of consolidated financial statements? LO 25.1 •

2. In a newspaper article entitled ‘Pay for big four bosses in the shade of an even bigger one’ that appeared in The Sydney Morning Herald on 4 May 2019 it was reported that the Chief Executive Officer (CEO) of Macquarie Group received $17 million in remuneration at the time when the Macquarie Group reported a profit of $2.99 billion. In another newspaper article entitled ‘Coca-Cola’s top pay loses its fizz’ that appeared in The Financial Review on 11 April 2019 it was reported that the CEO of Coca-Cola Amatil received $4.1 million in remuneration at the time when Coca-Cola Amatil reported a profit of $401 million.

REQUIRED

Would the profits referred to above relate to the profit derived by the parent entity (company) or by the group of companies in the respective group? LO 25.1, 25.7 ••

3. 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 25.1, 25.3, 25.7 ••

4. 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 25.1, 25.7 •

5. 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 25.7 •

6. Define: (a) a legal entity (b) an economic entity (c) a parent entity (d) a subsidiary. LO 25.1 •

7. On consolidation, how is the goodwill on acquisition or the bargain gain on purchase determined? LO 25.7, 25.8 ••

8. 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 ••

9. What is ‘fair value’ and why is it relevant to consolidation accounting? LO 25.7, 25.8 •

10. Briefly explain the differences between the entity, proprietary and parent-entity consolidation concepts and identify which concept is to be applied in Australia. LO 25.4 •

11. 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 25.7, 25.8, 25.9 ••

dee67382_ch25_0947-1004.indd 996 10/25/19 11:45 AM

996 PART 8: Accounting for equity interests in other entities

12. Can a subsidiary be controlled by two different entities? LO 25.13 • 13. Do we consolidate an entity over which we have joint control? LO 25.13 •

14. What is a non-controlling interest, and what disclosures about the non-controlling interests in the group shall be made pursuant to AASB 12? LO 25.12 ••

15. On consolidation we need to eliminate the investments in controlled entities. Against which accounts do we eliminate these investments? LO 25.7 •

16. What is the primary criterion for determining whether or not to consolidate an entity? LO 25.1, 25.5 •

17. 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 •

18. 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 25.5 •

19. If there are non-controlling interests, will all of the goodwill of the subsidiary be recognised in the consolidated statements of financial position? LO 25.5, 25.7 ••

20. Would it be possible for an organisation to be required to consolidate another entity in which it has no equity interest? Explain why. LO 25.5 ••

21. 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 25.7, 25.11 ••

22. 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 25.1, 25.2, 25.4, 25.5 ••

23. What forms of entities may be consolidated (for example, partnerships, trusts, companies)? Has this requirement changed across the years? LO 25.2 •

24. 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 25.1, 25.7 ••

25. According to AASB 3, how should a bargain gain on purchase arising on consolidation be treated? LO 25.8 •

26. 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 25.1, 25.2 ••

27. Biggin Ltd acquires 100 per cent of the shares of Smallin Ltd on 1 July 2022 for a consideration of $730 000. The share capital and reserves of Smallin Ltd at the date of acquisition are:

Share capital $200 000

Retained earnings $100 000

Revaluation surplus $150 000

$450 000

dee67382_ch25_0947-1004.indd 997 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 997

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 2023 (one year after acquisition) are:

Biggin Ltd ($000)

Smallin Ltd ($000)

Reconciliation of opening and closing retained earnings

Profit before tax 300 100

Tax    (100) (30)

Profit after tax 200 70

Retained earnings—1 July 2022     200 100

Retained earnings—30 June 2023     400 170

Statements of financial position

Shareholders’ equity

Retained earnings 400 170

Share capital 1 000 200

Revaluation surplus 300 200

Current liabilities

Accounts payable 60 40

Non-current liabilities

Loans   600 250

2 360 860

Current assets

Cash 80 45

Accounts receivable 350 95

Non-current assets

Land 200 120

Plant 1 000 600

Investment in Smallin Ltd   730      –

2 360 860

REQUIRED Prepare the consolidated financial statements for Biggin Ltd and Smallin Ltd as at 30 June 2023. LO 25.7 ••

28. Michael Ltd acquires all of the issued capital of Petersen Ltd for a cash payment of $600 000 on 30 June 2023. The statements of financial position of both entities immediately following the purchase are:

Michael Ltd ($000)

Petersen Ltd ($000)

Current assets

Cash 10 5

Accounts receivable 150 55

Non-current assets

Plant 700 500

Land 200 100

Investment in Petersen Ltd   600     –

1 660 660

dee67382_ch25_0947-1004.indd 998 10/25/19 11:45 AM

998 PART 8: Accounting for equity interests in other entities

Michael Ltd ($000)

Petersen Ltd ($000)

Current liabilities

Accounts payable 60 30

Non-current liabilities

Loans 400 150

Shareholders’ equity

Share capital 1 000 200

Retained earnings   200 280

1 660 660

Additional information

• All assets of Petersen appearing in the 30 June 2023 statement of financial position are fairly valued. • At 30 June 2023 Petersen had two internally developed identifiable intangible assets with the following fair

values:

Fair value ($000)

Patent 100

Publishing title 25

REQUIRED Provide the consolidated statement of financial position for Michael Ltd and Petersen Ltd as at 30 June 2023. LO 25.7, 25.10 •••

29. Largey Ltd acquires 100 per cent of the shares of Smalley Ltd on 1 July 2022 for a consideration of $650 000. The share capital and reserves of Smalley Ltd at the date of acquisition are:

Share capital $300 000

Retained earnings $150 000

Revaluation surplus $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 2023 (one year after acquisition) are:

Largey Ltd ($000)

Smalley Ltd ($000)

Reconciliation of opening and closing retained earnings

Profit before tax 300 150

Tax   (100)     (50)

Profit after tax 200 100

Retained earnings—1 July 2022     400     150

Retained earnings—30 June 2023     600     250

Statements of financial position

Shareholders’ equity

Retained earnings 600 250

Share capital 1 200 300

Revaluation surplus 300 200

Current liabilities

Accounts payable 100 100

dee67382_ch25_0947-1004.indd 999 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 999

continued

Largey Ltd ($000)

Smalley Ltd ($000)

Non-current liabilities

Loans     600     250

2 800 1 100

Current assets

Cash 100 145

Accounts receivable 350 155

Non-current assets

Land 700 200

Plant 1 000 600

Investment in Smalley Ltd    650        –

2 800 1 100

REQUIRED Prepare the consolidated accounts for Largey Ltd and Smalley Ltd at 30 June 2023. LO 25.7, 25.8 ••

30. Whopper Ltd acquires 100 per cent of the shares of Weenie Ltd on 1 July 2022 for a consideration of $1.25 million. The share capital and reserves of Weenie Ltd at the date of acquisition are:

Share capital $750 000

Retained earnings $375 000

Revaluation surplus  $375 000

$1 500 000

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 2023. The financial statements of Whopper Ltd and Weenie Ltd at 30 June 2023 (one year after acquisition) are:

Whopper Ltd ($000)

Weenie Ltd ($000)

Reconciliation of opening and closing retained earnings

Profit before tax 750 375

Tax   (250)   (125)

Profit after tax 500 250

Retained earnings at 30 June 2022 1 000    375

Retained earnings at 30 June 2023 1 500    625

Statements of financial position

Shareholders’ equity

Retained earnings 1 500 625

Share capital 3 000 750

Revaluation surplus 750 500

Current liabilities

Accounts payable 250 250

Non-current liabilities

Loans 1 500    625

7 000 2 750

dee67382_ch25_0947-1004.indd 1000 10/25/19 11:45 AM

1000 PART 8: Accounting for equity interests in other entities

Whopper Ltd ($000)

Weenie Ltd ($000)

Current assets

Cash 250 200

Accounts receivable 875 300

Non-current assets

Land 1 750 750

Plant 2 875 1 500

Investment in Weenie Ltd 1 250         –

7 000 2 750

REQUIRED Prepare the consolidated accounts for Whopper Ltd and Weenie Ltd as at 30 June 2023. LO 25.7, 25.11 ••

CHALLENGING QUESTIONS

31. 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

32. 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.

dee67382_ch25_0947-1004.indd 1001 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 1001

(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 70

Mrs X 20

Mr L 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

33. 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.

(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 non- executive 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. 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

34. On 30 June 2022, 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 2022. The statement of financial position of Winkipop at 30 June 2022 was as follows:

dee67382_ch25_0947-1004.indd 1002 10/25/19 11:45 AM

1002 PART 8: Accounting for equity interests in other entities

Balance sheet of Winkipop Ltd as at 30 June 2022

$000

Current assets

Cash 50

Accounts receivable 40

Inventory 110

Non-current assets

Plant and equipment 720

Accumulated depreciation—plant and equipment (120)

Land     800

1 600

Current liabilities

Accounts payable 100

Non-current liabilities

Loan     500

    600

Share capital and reserves

Share capital 700

Retained earnings 200

Revaluation surplus     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

35. On 30 June 2022 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)

Cash 100 50

Accounts receivable 130 90

Inventory 200 110

Property, plant and equipment 400 350

Accumulated depreciation (120) (90)

Land 300 100

Investment in Lorne Ltd 500 –

Accounts payable 110 70

Loans 200 190

Share capital 900 200

Retained earnings 300 150

dee67382_ch25_0947-1004.indd 1003 10/25/19 11:45 AM

CHAPTER 25: Accounting for group structures 1003

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, consolidation worksheet and consolidated statement of financial position for the above entities. LO 25.4, 25.5, 25.8, 25.10

36. 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

37. Sandy Ltd acquired 100 per cent of the issued capital of Beach Ltd on 30 June 2022 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 2022

$000 $000

Assets Liabilities

Accounts receivable 70 Loan 300

Inventory 100

Land 400 Shareholders’ equity

Property, plant and equip. 700 Share capital 500

Accumulated depreciation   (270) Retained earnings    200

1 000 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. • Beach Ltd declared a dividend of $40 000 on 10 July 2022, with the dividends being paid from pre-acquisition

retained earnings. • The statements of financial position and details of opening and closing retained earnings 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 2023

Sandy Ltd ($000)

Beach Ltd ($000)

Assets

Cash 80 40

Accounts receivable 50 50

Inventory 140 123

Land 600 400

Property, plant and equipment 900 700

Accumulated depreciation (300) (313)

Investment in Beach Ltd     900         –

Total assets 2 370 1 000

continued

dee67382_ch25_0947-1004.indd 1004 10/25/19 11:45 AM

1004 PART 8: Accounting for equity interests in other entities

Sandy Ltd ($000)

Beach Ltd ($000)

Liabilities

Accounts payable 100 10

Dividends payable 100 50

Loan 670 140

Shareholders’ equity

Share capital 1 000 500

Retained earnings    500    300

2 370 1 000

Reconciliation of opening and closing retained earnings

Profit after tax 400 190

Retained earnings—30 June 2022 300 200

Interim dividend (90) (40)

Final dividend   (110)     (50)

Retained earnings—30 June 2023    500    300

REQUIRED Prepare the consolidated statement of financial position for the above entities as at 30 June 2023. LO 25.4, 25.5, 25.8, 25.10

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May.

Sullivan, G., 1985, ‘Accounting and Legal Implications of the Interposed Unit Trust Agreement’, Abacus, vol. 21, no. 2, pp. 174–96.

dee67382_ch26_1005-1054.indd 1005 10/25/19 11:50 AM

1005

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

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 post-acquisition

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.

C H A P T E R 26 Further consolidation issues I: accounting for intragroup transactions

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is an intragroup transaction, and do the effects of intragroup transactions have to be eliminated in full? LO 26.1

2. Following consolidation, should dividends paid to the parent entity by its subsidiaries be shown in the economic entity’s financial statements? LO 26.2

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? Further, will adjustments be required to restate the balance of opening inventory as at the beginning of the next financial period? LO 26.3

4. If one organisation within a group sells a non-current asset to another member of the group at a profit, will this lead to a deferred tax asset on consolidation? Why or why not? LO 26.4

5. If management fees are paid from one organisation to another within an economic entity, does this transaction need to be reversed on consolidation? Further, will the transaction lead to a deferred tax asset on consolidation? LO 26.1

dee67382_ch26_1005-1054.indd 1006 10/25/19 11:50 AM

1006 PART 8: Accounting for equity interests in other entities

26.1 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 of the subsidiary. As paragraph B86(c) of AASB 10 Consolidated Financial Statements 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. (AASB 10)

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.

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 that were 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.

intragroup transaction Transaction undertaken between separate legal entities within an economic entity.

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

3 Business Combinations IFRS 3

9 Financial Instruments IFRS 9

10 Consolidated Financial Statements IFRS 10

102 Inventories IAS 2

116 Property, Plant and Equipment IAS 16

136 Impairment of Assets IAS 36

LO 26.1

WHY DO I NEED TO KNOW WHAT AN INTRAGROUP TRANSACTION REPRESENTS?

The effects of all intragroup transactions must be eliminated as part of the process of preparing consolidated financial statements. Therefore, as accountants, we need to understand what they represent so that we can subsequently identify them for the purpose of eliminating them. We also need to understand that intragroup transactions can take a variety of forms.

LO 26.2 26.2 Dividend payments from pre- and post-acquisition earnings

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

dee67382_ch26_1005-1054.indd 1007 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1007

Figure 26.1 Dividends paid by members of an economic entity

Parent Entity

Shareholders of Parent Entity

Subsidiary

$4000 dividends

$1000 dividends

Economic entity

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 2022 at a cost of $800 000. The share capital and reserves of Company B on the date of acquisition are:

$

Share capital 500 000

Retained earnings 300 000

800 000

Dividends of $50 000 paid by Company B come from profits earned since 1 July 2022 (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, given that the fair value of the acquired net assets happens to equal the fair value of the consideration paid, there is no goodwill to be recognised on consolidation. Company A recognises dividend

to be shown when we consider the group as a single economic entity. That is, you cannot pay ‘dividends’ to yourself. Further, from the group’s perspective, when dividends have been declared and are payable from one legal entity within the group to another legal entity within the group, there is no obligation to an external entity, and therefore from the group’s perspective there is actually no liability (and therefore, no related receivable).

The only dividends that should be shown in the consolidated financial statements would be dividends paid or payable to parties external to the group, that is, to the shareholders of the parent entity and to the non-controlling interests. We will discuss non-controlling 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 $1000 in dividends to Parent Entity, and Parent Entity pays $4000 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 $4000 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.

continued

dee67382_ch26_1005-1054.indd 1008 10/25/19 11:50 AM

1008 PART 8: Accounting for equity interests in other entities

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 2023 reveal the following:

Company A ($000)

Company B ($000)

Reconciliation of opening and closing retained earnings

Profit before tax 200 100

Tax expense (50) (40)

Profit after tax 150 60

Opening retained earnings—1 July 2022 400 300

550 360

less Dividends proposed (70) (50)

Closing retained earnings—30 June 2023 480 310

Statement of financial position

Shareholders’ funds

Retained earnings 480 310

Share capital 500 500

Liabilities

Accounts payable 1 000 100

Dividends payable 70 50

2 050 960

Assets

Cash 100 70

Accounts receivable 50 130

Dividends receivable 50 –

Inventory 200 160

Plant and equipment 850 600

Investment in Company B 800 –

2 050 960

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 Dividend declared (statement of changes in equity) 50 000

Cr Dividend payable (statement of financial position) 50 000

(to recognise dividends declared, which reduces retained earnings, and the accompanying obligation to make the dividend payment)

As Company A recognises dividend income when the dividend is declared by the investee, it would have the following entry in its own accounts:

WORKED EXAMPLE 26.1 continued

dee67382_ch26_1005-1054.indd 1009 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1009

Dr Dividend receivable (statement of financial position) 50 000

Cr Dividend income (statement of profit or loss and other comprehensive income)

50 000

(to recognise dividend income and the associated receivable)

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) Preparation of the 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 need to be eliminated. 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) 50 000

Cr Dividend declared (statement of changes in equity) 50 000

(to reverse the entry made by Company A in respect of the declaration of dividends)

Elimination entry for dividends receivable by Company A

(ii) Dr Dividend income (statement of profit or loss and other comprehensive income)

50 000

Cr Dividend receivable (statement of financial position) 50 000

(to reverse the entry made by Company A in respect of the dividend to be received from Company B)

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. There are no taxation consequences in relation to these adjustments.

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 500 000

Dr Retained earnings 1/7/2022 300 000

Cr Investment in Company B 800 000

(to eliminate Company A’s investment in Company B against the pre-acquisition capital and reserves of Company B)

The consolidation worksheet can now be presented as follows:

Consolidation worksheet for Company A and its controlled entity

Eliminations and adjustments

Company A ($000)

Company B ($000)

Dr ($000)

Cr ($000)

Consolidated statements

($000)

Reconciliation of opening and closing retained earnings

Profit before tax 200 100 50(ii) 250

Tax expense  (50) (40)    90

Profit after tax 150 60 160

Opening retained earnings 400 300 300(iii) 400

continued

dee67382_ch26_1005-1054.indd 1010 10/25/19 11:50 AM

1010 PART 8: Accounting for equity interests in other entities

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 Financial Instruments, which notes that while 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.

Eliminations and adjustments

Company A ($000)

Company B ($000)

Dr ($000)

Cr ($000)

Consolidated statements

($000)

550 360 560

less Dividends declared  70 50 50(i)    70

Closing retained earnings 480 310 490

Statement of financial position

Shareholders’ funds

Retained earnings 480 310 490

Share capital 500 500 500(iii) 500

Liabilities

Accounts payable 1 000 100 1 100

Dividends payable  70 50 50(i)    70

2 050 960 2 160

Assets

Cash 100 70 170

Accounts receivable 50 130 180

Dividends receivable 50 – 50(ii) –

Inventory 200 160 360

Plant and equipment 850 600 1 450

Investment in Company B 800  –         800(iii) –

2 050 960 900 900 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 2023. 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).

WORKED EXAMPLE 26.1 continued

dee67382_ch26_1005-1054.indd 1011 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1011

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 profits generated 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 Shares in subsidiary 19 000 000

Dr Dividend receivable 1 000 000

Cr Cash 20 000 000

(to recognise the acquisition of shares in a subsidiary that come with a right to dividend payments)

When the dividend is subsequently received, the entry in the parent entity’s accounts would be:

Dr Cash 1 000 000

Cr Dividend receivable 1 000 000

(to recognise the cash receipt pertaining to the previously acquired dividend entitlement)

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 2023. 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:

Sunshine Ltd ($000)

Sunrise Ltd ($000)

Current assets

Cash 20 15

Accounts receivable 300 45

Dividend receivable 200 –

Non-current assets

Plant 1 480 600

Investment in Sunrise Ltd 300

2 300 660

Current liabilities

Accounts payable 100 30

Dividend payable 200

continued

dee67382_ch26_1005-1054.indd 1012 10/25/19 11:50 AM

1012 PART 8: Accounting for equity interests in other entities

Sunshine Ltd ($000)

Sunrise Ltd ($000)

Non-current liabilities

Loans 800 180

Shareholders’ equity

Share capital 1 000 200

Retained earnings 400 50

2 300 660

It is assumed that the assets of Sunrise are fairly valued at the date of acquisition. 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 2023.

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 Dividend declared (reduces retained earnings) 200 000

Cr Dividend payable 200 000

(to recognise the declaration of a dividend)

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 Dividend receivable 200 000

Dr Investment in Sunrise Ltd 300 000

Cr Cash 500 000

(to recognise the dividend receivable and the investment in Sunrise that were acquired at a combined cost of $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 now turn our attention to the required consolidation journal entries. We need to eliminate the intragroup payables and receivables as, from the group perspective, the group cannot owe itself any money.

(a) Dr Dividend payable 200 000

Cr Dividend receivable 200 000

(to eliminate the intercompany receivable and payable)

WORKED EXAMPLE 26.2 continued

dee67382_ch26_1005-1054.indd 1013 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1013

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 200 000

Retained earnings of Sunrise Ltd at acquisition 50 000

250 000

Cost of investment in Sunrise Ltd 300 000

Goodwill 50 000

(b) Dr Share capital 200 000

  Dr Retained earnings 50 000

  Dr Goodwill 50 000

  Cr Investment in Sunrise Ltd 300 000

(to eliminate the investment in Sunrise Ltd against Sunrise Ltd’s pre-acquisition share capital and reserves)

The consolidation worksheet can then be prepared as follows:

Consolidation worksheet for Sunshine Ltd and its controlled entity for the period ending 30 June 2023

Eliminations and adjustments

Sunshine Ltd ($000)

Sunrise Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statements

($000)

Current assets

Cash 20 15 35

Accounts receivable 300 45 345

Dividend receivable 200 200(a) –

Non-current assets

Plant 1 480 600 2 080

Investment in Sunrise Ltd 300 – 300(b) –

Goodwill – – 50(b)   50

2 300 660 2 510

Current liabilities

Accounts payable 100 30 130

Dividend payable 200 200(a) –

Non-current liabilities

Loans 800 180 980

Shareholders’ equity

Share capital 1 000 200 200(b) 1 000

Retained earnings 400 50 50(b) 400

2 300 660 500 500 2 510

continued

dee67382_ch26_1005-1054.indd 1014 10/25/19 11:50 AM

1014 PART 8: Accounting for equity interests in other entities

The consolidated statement of financial position would be as follows:

Consolidated statement of financial position of Sunshine Ltd and its controlled entity as at 30 June 2023

Sunshine Ltd ($000)

Economic entity ($000)

Current assets

Cash 20 35

Accounts receivable 300 345

Dividend receivable 200 –

520  380

Non-current assets

Plant 1 480 2 080

Investment in Sunrise Ltd (net) 300 –

Goodwill – 50

1 780 2 130

Total assets 2 300 2 510

Current liabilities

Accounts payable 100 130

Non-current liabilities

Loans 800  980

Total liabilities 900 1 110

Net assets 1 400 1 400

Represented by:

Shareholders’ equity

Share capital 1 000 1 000

Retained earnings 400  400

1 400 1 400

WORKED EXAMPLE 26.2 continued

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 now 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.

LO 26.3

dee67382_ch26_1005-1054.indd 1015 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1015

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 actually cost the group only $35 000 to manufacture. As we know, pursuant to accounting 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 subsequently 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

Company A

Outside entity Company B

$100 000

$150 000

Economic entity

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 2022 for $1 million when the shareholders’ funds of Little Ltd are:

Share capital $500 000

Retained earnings $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 2023 the value of goodwill has been impaired by an amount of $10 000.

During the 2023 financial year, which is the first year after which the subsidiary was acquired, 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 2023 half of the stock is still on hand with Big Ltd. The tax rate is assumed to be 33 per cent.

continued

dee67382_ch26_1005-1054.indd 1016 10/25/19 11:50 AM

1016 PART 8: Accounting for equity interests in other entities

The financial statements of Big Ltd and Little Ltd at 30 June 2023 are as follows:

Big Ltd ($000)

Little Ltd ($000)

Reconciliation of opening and closing retained earnings

Sales revenue 1 200 400

less Cost of goods sold (500) (140)

less Other expenses (60) (30)

Other revenue 70 25

Profit 710 255

Tax expense 200 100

Profit after tax 510  155

Retained earnings—30 June 2022 1 000 400

1 510 555

Dividends paid 200 40

Retained earnings—30 June 2023 1 310 515

Statement of financial position

Shareholders’ equity

Retained earnings 1 310 515

Share capital 4 000 500

Current liabilities

Accounts payable 100 85

Non-current liabilities

Loans 600 250

6 010 1 350

Current assets

Cash 250 25

Accounts receivable 150 175

Inventory 600 300

Non-current assets

Land 1 440 400

Plant 2 470 400

Investment in Little Ltd 1 000 –

Deferred tax asset   100     50

6 010 1 350

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 2023.

WORKED EXAMPLE 26.3 continued

dee67382_ch26_1005-1054.indd 1017 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1017

SOLUTION Determination of goodwill

At date of acquisition:

Share capital of Little Ltd 500 000

Retained earnings  400 000

900 000

Cost of investment in Little Ltd 1 000 000

Goodwill on acquisition 100 000

Consolidation journal entries Elimination of investment in controlled entity

(a) Dr Share capital 500 000

Dr Retained earnings—1 July 2022 400 000

Dr Goodwill 100 000

Cr Investment in Little Ltd 1 000 000

(to eliminate the investment in Little Ltd against the pre-acquisition share capital and reserves of Little Ltd)

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, the standard requires 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. The journal entry to record the impairment of goodwill would be:

(b) Dr Impairment loss—goodwill 10 000

Cr Accumulated impairment losses—goodwill 10 000

(to recognise the current year’s goodwill impairment expense)

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. (AASB 3)

With regard to operationalising the requirements of paragraph 61 just quoted, paragraph B67(d) requires:

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.

(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.

continued

dee67382_ch26_1005-1054.indd 1018 10/25/19 11:50 AM

1018 PART 8: Accounting for equity interests in other entities

(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. (AASB 3)

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 Sales 200 000

Cr Cost of goods sold 200 000

(to eliminate the intragroup sales)

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 the unrealised profit amounts to $40 000. In accordance with AASB 102 Inventories, we must measure 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 included within inventory).

(d) Dr Cost of goods sold 40 000

Cr Inventory 40 000

(to adjust inventory so that it represents the cost incurred by the economic entity)

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 of tax. (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 13 200

Cr Income tax expense 13 200

(tax effect of the unrealised profit in inventory. $40 000 × 33 per cent)

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 Dividend income 40 000

Cr Dividends paid 40 000

(to eliminate the intragroup dividend payment)

WORKED EXAMPLE 26.3 continued

dee67382_ch26_1005-1054.indd 1019 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1019

Having prepared the consolidation journal entries, we now need to post these journal entries to the consolidation worksheet.

Consolidation worksheet for Big Ltd and its controlled entity for the year ending 30 June 2023

Eliminations and adjustments

Big Ltd ($000)

Little Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statements

($000)

Reconciliation of opening and closing retained earnings

Sales revenue 1 200 400 200(c) 1 400

less Cost of goods sold (500) (140) 40(d) 200(c) (480)

less Other expenses (60) (30) 10(b) (100)

Other revenue 70 25 40(f) 55

Profit 710 255 875

Tax expense (200) (100) 13.2(e) (286.8)

Profit after tax 510 155 588.2

Retained earnings—1 July 2022 1 000 400 400(a) 1 000

1 510 555 1 588.2

Dividends paid (200) (40) 40(f) (200)

Statement of financial position

Shareholders’ equity

Retained earnings—30 June 2023 1 310 515 1 388.2

Share capital 4 000 500 500(a) 4 000

Current liabilities

Accounts payable 100 85 185

Non-current liabilities

Loans 600 250 850

6 010 1 350 6 423.2

Current assets

Cash 250 25 275

Accounts receivable 150 175 325

Inventory 600 300 40(d) 860

Non-current assets

Land 1 440 400 1 840

Plant 2 470 400 2 870

Investment in Little Ltd 1 000 – 1 000(a) –

Deferred tax asset 100 50 13.2(e) 163.2

Goodwill – – 100(a) 100

Accumulated impairment loss                                      10(b)       (10)

6 010 1 350 1 303.2 1 303.2 6 423.2

continued

dee67382_ch26_1005-1054.indd 1020 10/25/19 11:50 AM

1020 PART 8: Accounting for equity interests in other entities

Big Ltd and its controlled entity Consolidated statement of profit or loss and other comprehensive income entity for the year ended 30 June 2023

The Group ($)

Big Ltd ($)

Sales 1 400 000 1 200 000

Cost of goods sold (480 000) (500 000)

Gross profit 920 000 700 000

Other revenue 55 000 70 000

Other expenses (100 000) (60 000)

Profit before tax 875 000 710 000

Income tax expense (286 800) (200 000)

Profit for the year 588 200 510 000

Other comprehensive income – –

Total comprehensive income for the year 588 200 510 000

Big Ltd and its controlled entity Consolidated statement of changes in equity for the year ended 30 June 2023

Share capital ($)

Group retained earnings ($)

Group total equity ($)

Balance at 1 July 2022 4 000 000 1 000 000 5 000 000

Total comprehensive income for the year 588 200 588 200

Distributions—dividends   (200 000)   (200 000)

Balance at 30 June 2023 4 000 000 1 388 200 5 388 200

Big Ltd Statement of changes in equity for the year ended 30 June 2023

Share capital ($)

Retained earnings ($)

Total equity ($)

Balance at 1 July 2022 4 000 000 1 000 000 5 000 000

Total comprehensive income for the year 510 000 510 000

Distributions—dividends (200 000) (200 000)

Balance at 30 June 2023 4 000 000 1 310 000 5 310 000

Consolidated statement of financial position of Big Ltd and its controlled entity as at 30 June 2023

The Group ($)

Big Ltd ($)

Current assets

Cash 275 000 250 000

Accounts receivable 325 000 150 000

Inventory   860 000   600 000

1 460 000 1 000 000

WORKED EXAMPLE 26.3 continued

dee67382_ch26_1005-1054.indd 1021 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1021

Unrealised profit in opening inventory Given that there were unrealised profits in the closing inventory of Big Ltd at 30 June 2023, 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 within the group, to the current 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 2024—would be:

Dr Opening retained earnings—1 July 2023 40 000

Cr Cost of goods sold 40 000

(to shift the income from the sale of inventory from the previous period to the current period)

Remember that reducing the value of opening inventory will reduce cost of goods sold. The above entry will effectively shift the income from 2023 to 2024 (and 2024 is 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.

The Group ($)

Big Ltd ($)

Non-current assets

Land 1 840 000 1 440 000

Plant and equipment 2 870 000 2 470 000

Investment in Little Ltd 1 000 000

Goodwill 100 000 –

less Accumulated impairment loss (10 000) –

Deferred tax asset 163 200 100 000

4 963 200 5 010 000

Total assets 6 423 200 6 010 000

Current liabilities

Accounts payable 185 000 100 000

Non-current liabilities

Loans  850 000   600 000

Total liabilities 1 035 000 700 000

Shareholders’ equity

Share capital 4 000 000 4 000 000

Retained earnings 1 388 200 1 310 000

Total shareholders’ equity 5 388 200 5 310 000

Total of liabilities and shareholders’ equity 6 423 200 6 010 000

dee67382_ch26_1005-1054.indd 1022 10/25/19 11:50 AM

1022 PART 8: Accounting for equity interests in other entities

Dr Income tax expense 13 200

Cr Opening retained earnings—1 July 2023 13 200

(to recognise the additional tax expense relating to the increased profit brought about by the reduced cost of goods sold)

Any profits in closing inventory in 2024 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 2024 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.

WORKED EXAMPLE 26.4: Unrealised profit in opening inventory

This Worked Example is a continuation of Worked Example 26.3. During the 2024 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 2024, 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 2024 goodwill has been impaired by a further $20 000.

The financial statements of Big Ltd and Little Ltd at 30 June 2024 are as follows:

Big Ltd ($000)

Little Ltd ($000)

Reconciliation of opening and closing retained earnings

Sales revenue 1 500 550

less Cost of goods sold (800) (180)

less Other expenses (70) (40)

Other revenue 90 30

Profit 720 360

Tax expense (320) (130)

Profit after tax 400 230

Retained earnings—1 July 2023 1 310 515

1 710 745

Dividends paid (200) (50)

Retained earnings—30 June 2024 1 510 695

Statement of financial position

Shareholders’ equity

Retained earnings 1 510 695

Share capital 4 000 500

Current liabilities

Accounts payable 140 90

Non-current liabilities

Loans   590   240

6 240 1 525

Current assets

Cash 270 35

dee67382_ch26_1005-1054.indd 1023 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1023

Big Ltd ($000)

Little Ltd ($000)

Accounts receivable 220 190

Inventory 750 455

Non-current assets

Land 1 440 400

Plant 2 450 390

Investment in Little Ltd 1 000 –

Deferred tax asset   110 55

6 240 1 525

REQUIRED Provide the consolidation worksheet for Big Ltd and its controlled entity for the year ended 30 June 2024.

SOLUTION Elimination of investment in controlled entity

(a) Dr Share capital 500 000

Dr Retained earnings—1 July 2023 400 000

Dr Goodwill 100 000

Cr Investment in Little Ltd 1 000 000

(elimination of the investment in Little Ltd, and the recognition of associated goodwill as at the date of the original acquisition)

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 Impairment loss—goodwill 20 000

Dr Retained earnings—1 July 2023 10 000

Cr Accumulated impairment losses—goodwill 30 000

(recognition of previous period, and current period, impairments of goodwill)

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 in relation to that inventory, which is still on hand within the group. This will ensure that we do not overstate the turnover of the economic entity.

(c) Dr Sales 220 000

Cr Cost of goods sold 220 000

(elimination of intragroup sales)

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. (Again, 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

continued

dee67382_ch26_1005-1054.indd 1024 10/25/19 11:50 AM

1024 PART 8: Accounting for equity interests in other entities

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 Retained earnings—1 July 2023 40 000

Cr Cost of goods sold 40 000

(to shift the profit from the previous period to the current period in relation to unrealised profit on opening inventory)

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 profit from 2023 to 2024 (the period in which the sale to an external party actually occurs). Higher profits will lead to a higher tax expense. As we know, tax expense is based upon accounting profits with the adoption of tax-effect accounting.

(e) Dr Income tax expense 13 200

Cr Retained earnings—1 July 2023 13 200

(to recognise the increased tax expense due to the higher profit as a result of the reduction in this period’s cost of goods sold)

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 at the end of the accounting period, this amount has not been fully earned. In this case, the unrealised profit amounts to $15 000. In accordance with AASB 102, we must measure 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

(to eliminate the unrealised profit in closing inventory)

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 $4950 (33 per cent of $15 000). 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.

(g) Dr Deferred tax asset 4950

Cr Income tax expense 4950

(recognition of the reduced tax expense as a result of the reduced accounting profit of the group. $15 000 × 33 per cent)

Elimination of intercompany dividends As we know, any intragroup dividends must be eliminated on consolidation (as an entity cannot pay itself a dividend).

WORKED EXAMPLE 26.4 continued

dee67382_ch26_1005-1054.indd 1025 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1025

(h) Dr Dividend income (statement of profit or loss and other comprehensive income)

50 000

Cr Dividends paid (statement of changes in equity) 50 000

(elimination of the intragroup dividend income)

As the above dividend has actually been paid, there are no associated receivables or payables to eliminate on consolidation.

Having prepared the consolidation journal entries, we now need to post these journal entries to the consolidation worksheet.

Consolidation worksheet for Big Ltd and its controlled entity for the year ending 30 June 2024

Eliminations and adjustments

Big Ltd ($000)

Little Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statements

($000)

Reconciliation of opening and closing retained earnings

Sales revenue 1 500 550 220(c) 1 830

less Cost of goods sold (800) (180) 15(f) 40(d)

220(c) (735)

less Other expenses (70) (40) 20(b) (130)

Other revenue 90   30 50(h) 70

Profit before tax 720 360 1 035

Tax expense (320) (130) 13.2(e) 4.95(g) (458.25)

Profit after tax 400 230 576.75

Retained earnings—1 July 2023 1 310 515 400(a) 13.2(e)

10(b)

40(d) 1 388.2

1 710 745 1 964.95

Dividends paid (200) (50) 50(h) (200)

Statement of financial position

Shareholders’ equity

Retained earnings—30 June 2024 1 510 695 1 764.95

Share capital 4 000 500 500(a) 4 000

Current liabilities

Accounts payable 140 90 230

Non-current liabilities

Loans   590   240 830

6 240 1 525 6 824.95

Current assets

Cash 270 35 305

Accounts receivable 220 190 410

continued

dee67382_ch26_1005-1054.indd 1026 10/25/19 11:50 AM

1026 PART 8: Accounting for equity interests in other entities

LO 26.4

Eliminations and adjustments

Big Ltd ($000)

Little Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statements

($000)

Inventory 750 455 15(f) 1 190

Non-current assets

Land 1 440 400 1 840

Plant 2 450 390 2 840

Investment in Little Ltd 1 000 – 1 000(a) –

Deferred tax asset 110 55 4.95(g) 169.95

Goodwill – – 100(a) 100

Accumulated impairment loss                               30(b) (30)

6 240 1 525 1 373.15 1 373.15 6 824.95

26.4 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 also 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 intragroup 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 26.4 continued

WORKED EXAMPLE 26.5: Intragroup sale of a non-current asset

On 1 July 2022 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 $500 000

Retained earnings $300 000

$800 000

All assets of Sandy Ltd were fairly stated at acquisition date. On 1 July 2022, and immediately following the acquisition of Sandy Ltd, 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, there is expected to be no residual value, and it is depreciated using the straight-line method. The tax rate is 30 per cent.

dee67382_ch26_1005-1054.indd 1027 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1027

At 30 June 2023 it was estimated that goodwill acquired in Sandy Ltd had been impaired by $5000. 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 2023 provided the following information:

Eddie Ltd ($000)

Sandy Ltd ($000)

Reconciliation of opening and closing retained earnings

Sales revenue 2 000  900 

less Cost of goods sold (1 400) (350)

Gross profit 600  550 

Other income

Gain on sale of fixed asset 180  – 

Expenses

Depreciation –  (130)

Other expenses (280) (100)

Profit before tax 500  320 

Tax expense (150) (96)

Profit after tax 350  224 

Retained earnings—1 July 2022 400 300

Retained earnings—30 June 2023 750 524

Statement of financial position

Shareholders’ equity

Retained earnings 750 524

Share capital 1 000 500

Current liabilities

Tax payable 150 96

Non-current liabilities

Loans   400 250

2 300 1 370

Current assets

Accounts receivable 300 180

Inventory 420 220

Non-current assets

Land 730 320

Plant, at cost – 780

Plant—accumulated depreciation – (130)

Investment in Sandy Ltd  850 –

2 300 1 370

REQUIRED Provide the consolidation worksheet of Eddie Ltd and its controlled entity for the year ended 30 June 2023.

continued

dee67382_ch26_1005-1054.indd 1028 10/25/19 11:50 AM

1028 PART 8: Accounting for equity interests in other entities

SOLUTION Consolidated financial statements for 2023

Elimination of investment in controlled entity

(a) Dr Share capital 500 000

Dr Retained earnings—1 July 2022 300 000

Dr Goodwill 50 000

Cr Investment in Sandy Ltd 850 000

(to eliminate the investment in Sandy Ltd, and to recognise the associated goodwill on acquisition)

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 are 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

(to eliminate the gain on sale and to reinstate the cost and accumulated depreciation of the plant)

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 expensed 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 the 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 of Eddie 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 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

(to reduce tax expense for the group in consequence of the elimination of the profit on sale of the plant)

Reinstating accumulated depreciation in the statement of financial position Sandy Ltd would be depreciating the asset on the basis of the cost it incurred as a separate legal entity 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,

WORKED EXAMPLE 26.5 continued

dee67382_ch26_1005-1054.indd 1029 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1029

giving a depreciation charge of $600 000 ÷ 6 = $100 000. An adjustment of $30 000 is therefore required (we have assumed that the life of the asset for tax purposes is the same as the useful life of the asset, and that the amount of $100 000 per year is deductible for taxation purposes).

(d) Dr Accumulated depreciation 30 000

Cr Depreciation expense 30 000

(to reduce the depreciation expense to the amount it would have been had there been no intragroup sale of the plant)

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 $9000, which is $30 000 × 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

(to recognise the increased tax expense as a result of the reduced depreciation expense)

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

(to recognise goodwill impairment expense)

Having prepared the consolidation journal entries, we now need to post these journal entries to the consolidation worksheet.

Eliminations and adjustments

Eddie Ltd ($000)

Sandy Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Detailed reconciliation of opening and closing retained earnings

Sales revenue 2 000 900 2 900

less Cost of goods sold (1 400) (350) (1 750)

Gross profit 600 550 1 150

Other income

Gain on sale of fixed asset 180 – 180(b) –

Total income 780 550 1150

Expenses

Depreciation – (130) 30(d) (100)

Other expenses (280) (100) 5(f) (385)

Profit before tax 500 320 665

Tax expense (150) (96) 9(e) 54(c) (201)

Profit after tax 350 224 464

Retained earnings—1 July 2022 400 300 300(a)   400

Retained earnings—30 June 2023 750 524   864

continued

dee67382_ch26_1005-1054.indd 1030 10/25/19 11:50 AM

1030 PART 8: Accounting for equity interests in other entities

Eliminations and adjustments

Eddie Ltd ($000)

Sandy Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Statement of financial position

Shareholders’ equity

Retained earnings 750 524 864

Share capital 1 000 500 500(a) 1 000

Current liabilities

Tax payable 150 96 246

Non-current liabilities

Loans   400   250 650

2 300 1 370 2 760

Current assets

Accounts receivable 300 180 480

Inventory 420 220 640

Non-current assets

Land 730 320 1 050

Plant, at cost – 780 220(b) 1 000

Plant—accumulated depreciation – (130) 30(d) 400(b) (500)

Investment in Sandy Ltd 850 – 850(a) –

Deferred tax asset – – 54(c) 9(e) 45

Goodwill—at cost – – 50(a) 50

Goodwill—accum. impairment loss      –     –             5(f)      (5)

2 300 1 370 1 348 1 348 2 760

WORKED EXAMPLE 26.5 continued

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 2024— that is, two years after control of the subsidiary was established.

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 2024 are as follows:

Eddie Ltd ($000)

Sandy Ltd ($000)

Detailed reconciliation of opening and closing retained earnings

Sales revenue 2 700 1 100

less Cost of goods sold (1 550) (440)

Gross profit 1 150 660

dee67382_ch26_1005-1054.indd 1031 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1031

continued

Eddie Ltd ($000)

Sandy Ltd ($000)

Expenses

Depreciation – 130

Other expenses 410 120

Profit before tax 740 410

Tax expense 222 123

Profit after tax 518 287

Retained earnings—1 July 2023    750    524

Retained earnings—30 June 2024 1 268 811

Statement of financial position

Shareholders’ equity

Retained earnings 1 268 811

Share capital 1 000 500

Current liabilities

Tax payable 222 123

Non-current liabilities

Loans    390    245

2 880 1 679

Current assets

Accounts receivable 300 280

Inventory 820 559

Non-current assets

Land 910 320

Plant, at cost – 780

Plant—accumulated depreciation – (260)

Investment in Sandy Ltd    850         –

2 880 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 2024, assuming that the directors believe that goodwill on acquisition has been impaired by a further $5000.

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 Share capital 500 000

Dr Retained earnings—1 July 2023 300 000

Dr Goodwill 50 000

Cr Investment in Sandy Ltd 850 000

(to eliminate the investment in Sandy Ltd, and to recognise purchased goodwill)

Reversal of gain recognised in prior period on sale of asset and reinstatement of cost and accumulated depreciation

dee67382_ch26_1005-1054.indd 1032 10/25/19 11:50 AM

1032 PART 8: Accounting for equity interests in other entities

(b) Dr Retained earnings—1 July 2023 126 000

Dr Deferred tax asset 54 000 Dr Plant 220 000 Cr Accumulated depreciation 400 000

(to remove the effects of an intragroup sale of plant that occurred in a previous financial year)

Reinstating accumulated depreciation in the statement of financial position

(c) Dr Accumulated depreciation 60 000

Cr Depreciation expense 30 000 Cr Retained earnings—1 July 2023 30 000

(to adjust current and previous period depreciation so that the depreciation would be based upon the cost of the asset to the group)

Consideration of the tax effect of current and previous period’s depreciation adjustments

(d) Dr Income tax expense 9000

Dr Retained earnings—1 July 2023 9000 Cr Deferred tax asset 18 000

(to increase the tax expense recognised in this period, and the previous period, to reflect the increased profit as a result of the reduced depreciation expense)

Recognition of the impairment of goodwill in current and previous period

(e) Dr Impairment loss—goodwill 5000

Dr Retained earnings—1 July 2023 5000 Cr Accumulated impairment losses—goodwill 10 000

(to recognise the current and previous periods’ impairment of goodwill)

The consolidated financial statements can be prepared from the following worksheet:

Eliminations and adjustments

Eddie Ltd ($000)

Sandy Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Detailed reconciliation of opening and closing retained earnings

Sales revenue 2 700 1 100 3 800

less Cost of goods sold (1 550) (440) 1 990

Gross profit 1 150 660 1 810

Expenses

Depreciation – (130) 30(c) (100)

Other expenses (410) (120) 5(e) (535)

Profit before tax 740 410 1 175

Tax expense (222) (123) 9(d) (354)

Profit after tax 518 287 821

WORKED EXAMPLE 26.6 continued

dee67382_ch26_1005-1054.indd 1033 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1033

Eliminations and adjustments

Eddie Ltd ($000)

Sandy Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Retained earnings—1 July 2023 750 524 300(a) 30(c)

126(b)

9(d)

5(e)   864

Retained earnings—30 June 2024 1 268 811 1685

Statement of financial position

Shareholders’ equity

Retained earnings 1 268 811 1 685

Share capital 1 000 500 500(a) 1 000

Current liabilities

Tax payable 222 123 345

Non-current liabilities

Loans    390    245    635

2 880 1 679 3 665

Current assets

Accounts receivable 300 280 580

Inventory 820 559 1 379

Non-current assets

Land 910 320 1 230

Plant, at cost – 780 220(b) 1 000

Plant—accumulated depreciation – (260) 60(c) 400(b) (600)

Investment in Sandy Ltd 850 – 850(a) –

Deferred tax asset – – 54(b) 18(d) 36

Goodwill—at cost – – 50(a) 50

Goodwill—accum. impairment loss         –        –  10(e) (10)

2 880 1 679 1 338 1 338   3 665

Consolidated statement of profit or loss and other comprehensive income of Eddie Ltd and its controlled entity for the year ended 30 June 2024

The Group ($) Eddie Ltd ($)

Sales 3 800 000 2 700 000

Cost of goods sold (1 990 000) (1 550 000)

Gross profit 1 810 000 1 150 000

Depreciation (100 000) –

Other expenses (535 000) (410 000)

continued

dee67382_ch26_1005-1054.indd 1034 10/25/19 11:50 AM

1034 PART 8: Accounting for equity interests in other entities

The Group ($) Eddie Ltd ($)

Profit before tax 1 175 000 740 000

Income tax expense      354 000   (222 000)

Profit after tax      821 000      518 000

Other comprehensive income                –                –

Total comprehensive income for the year     821 000     518 000

Eddie Ltd and its controlled entity Statement of changes in equity for the year ended 30 June 2024

Share capital ($)

Group retained earnings ($)

Group total equity ($)

Balance at 1 July 2023 1 000 000 864 000 1 864 000

Total comprehensive income for the year 821 000 821 000

Distributions—dividends                                –              –

Balance at 30 June 2024 1 000 000 1 685 000 2 685 000

Eddie Ltd Statement of changes in equity for the year ended 30 June 2024

Share capital ($)

Retained earnings ($)

Total equity ($)

Balance at 1 July 2023 1 000 000 750 000 1 750 000

Total comprehensive income for the year 518 000 518 000

Distributions—dividends                                –                –

Balance at 30 June 2024 1 000 000 1 268 000 2 268 000

Consolidated statement of financial position of Eddie Ltd and its controlled entity as at 30 June 2024

The Group ($)

Eddie Ltd ($)

Current assets

Accounts receivable 580 000 300 000

Inventory 1 379 000    820 000

1 959 000 1 120 000

Non-current assets

Land 1 230 000 910 000

Plant and equipment 1 000 000 –

Accumulated depreciation (600 000) –

Investment in Sandy Ltd 850 000

Deferred tax asset 36 000 –

Goodwill 50 000 –

less Accumulated impairment loss     (10 000)                –

1 706 000 1 760 000

WORKED EXAMPLE 26.6 continued

dee67382_ch26_1005-1054.indd 1035 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1035

Total assets 3 665 000 2 880 000

Current liabilities

Tax payable 345 000 222 000

Non-current liabilities

Loan 635 000    390 000

Total liabilities 980 000 612 000

Shareholders’ equity

Share capital 1 000 000 1 000 000

Retained earnings 1 685 000 1 268 000

Total shareholders’ equity 2 685 000 2 268 000

Total liabilities and shareholders’ equity 3 665 000 2 880 000

Before concluding this chapter we will do one more Worked Example. Worked Example 26.7 will address:

∙ intragroup sales of inventory ∙ intragroup sales of non-current assets ∙ goodwill impairments ∙ payment of management fees.

The following financial statements of Mungo Ltd and its subsidiary Barry Ltd have been extracted from their financial records at 30 June 2023.

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)

Gross profit 452 684

Dividends received from Barry Ltd 186 –

Management fee revenue 53 –

Gain on sale of plant 70 –

Expenses

Administrative expenses (98.8) (77.4)

Depreciation (49) (113.6)

Management fee expense – (53)

Other expenses (202.2) (154) 

Profit before tax 411   286

WORKED EXAMPLE 26.7: A further consolidation example incorporating different types of intragroup transactions

continued

dee67382_ch26_1005-1054.indd 1036 10/25/19 11:50 AM

1036 PART 8: Accounting for equity interests in other entities

Mungo Ltd ($000)

Barry Ltd ($000)

Tax expense 123 84.4

Profit for the year 288 201.6

Retained earnings—1 July 2022 638.8 478.4

926.8 680

Dividends paid (274.8) (186)

Retained earnings—30 June 2023 652 494

Mungo Ltd ($000)

Barry Ltd ($000)

Statement of financial position Shareholders’ equity

Retained earnings 652 494

Share capital 700 400

Current liabilities

Accounts payable 109.4 92.6

Tax payable 82.6 50

Non-current liabilities

Loans 347 232

1 891 1 268.6

Current assets

Accounts receivable 118.8 124.6

Inventory 184 58

Non-current assets

Land and buildings 448 652

Plant—at cost 599.7 711.6

Accumulated depreciation (171.5) (277.6)

Investment in Barry Ltd 712 –

1 891 1 268.6

Other information • Mungo Ltd acquired its 100 per cent interest in Barry Ltd for $712 000 on 1 July 2019, that is, four years

earlier. At that date the capital and reserves of Barry Ltd were:

Share capital $400 000

Retained earnings $250 000

$650 000

At the date of acquisition all assets were considered to be fairly valued.

• During the current 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 2022 included inventory acquired from Barry Ltd for $84 000 that had cost Barry Ltd $70 000 to produce.

WORKED EXAMPLE 26.7 continued

dee67382_ch26_1005-1054.indd 1037 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1037

• 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 $5000 in the current financial year. Previous impairments of goodwill amounted to $10 000.

• On 1 July 2022 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’, and of depreciating its non-current assets using the straight-line depreciation method.

• Barry Ltd paid $20 000 in management fees to Mungo Ltd. • The tax rate is 30 per cent.

REQUIRED Provide the consolidated financial statements of Mungo Ltd and Barry Ltd as at 30 June 2023.

SOLUTION

Elimination of the investment in Barry Ltd and the recognition of goodwill on consolidation

Barry Ltd ($)

Share capital at acquisition date—1 July 2019 400 000

Retained earnings at acquisition date—1 July 2019 250 000

650 000

Investment in Barry Ltd 712 000

Goodwill on consolidation 62 000

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 in its subsidiary is:

(a) Dr Share capital 400 000

Dr Retained earnings—1 July 2022 250 000

Dr Goodwill 62 000

Cr Investment in Barry Ltd 712 000

(to eliminate the investment in Barry Ltd and to recognise purchased goodwill)

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 104 000

Cr Cost of goods sold 104 000

(to eliminate intragroup sales)

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.)

continued

dee67382_ch26_1005-1054.indd 1038 10/25/19 11:50 AM

1038 PART 8: Accounting for equity interests in other entities

Elimination of the unrealised profit in the closing inventory of Mungo Ltd

In this case, the unrealised profit in closing inventory amounts to $15 200. In accordance with AASB 102, we must measure 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

(to eliminate the unrealised profit in closing inventory)

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 $4560 (30 per cent of $15 200). 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 Barry Ltd is obliged to pay the tax.

(d) Dr Deferred tax asset 4 560

Cr Income tax expense 4 560

(to reduce tax expense as a result of the elimination of the unrealised profit in closing inventory. $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 $4800.

(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 $4800. In accordance with AASB 102, the inventory must be measured 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, $4800 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 $1440, which is 30 per cent of $4800. 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.

WORKED EXAMPLE 26.7 continued

dee67382_ch26_1005-1054.indd 1039 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1039

(g) Dr Deferred tax asset 1 440

Cr Income tax expense 1 440

(reduced tax expense as a result of the reduced income brought about by the elimination of unrealised profit in closing inventory. $4800 × 30 per cent)

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. Assuming that the inventory has been sold to an external party in the current period, and therefore that the profit is now realised from the group’s perspective, there is no need to adjust the closing balance of inventory in relation to the intragroup sale.

(h) Dr Retained earnings—1 July 2022 9 800

Dr Income tax expense 4 200

Cr Cost of sales 14 000

(to recognise the net effect of the elimination of the profit in opening inventory and to effectively shift the profit from the previous year to the current year)

Adjustments for intragroup sale of plant

On 1 July 2022 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 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 Gain on sale of plant 20 000

Dr Plant 20 000

Cr Accumulated depreciation 40 000

(to eliminate the effects of the intragroup sale of plant)

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, $6000 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 asset must 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 (the benefits of which will be derived by Barry Ltd in the form of higher depreciation expenses claimed for tax purposes in each of the next six years—$16 667 in depreciation, rather than $13 333, which is a difference of $3334).

continued

dee67382_ch26_1005-1054.indd 1040 10/25/19 11:50 AM

1040 PART 8: Accounting for equity interests in other entities

( j) Dr Deferred tax asset 6 000

Cr Income tax expense 6 000

(to reduce the tax expense related to the sale of the item of plant within the group)

Reinstating accumulated depreciation in the statement of financial position

Barry 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 $3334 is therefore required.

(k) Dr Accumulated depreciation 3 334

Cr Depreciation expense 3 334

(to adjust depreciation expense to take it to what it would have been had no intragroup sale occurred)

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 $1000, which is $3334 × 30 per cent. This entry represents a partial reversal of the deferred tax asset of $6000 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 Income tax expense 1 000

Cr Deferred tax asset 1 000

(to increase tax expense to reflect the higher profit derived as a result of the decreased depreciation expense. $3334 × 0.3 = $1000)

Impairment of goodwill

(m) Dr Retained earnings—1 July 2022 10 000

Dr Impairment loss—goodwill 5000

Cr Accumulated impairment losses— goodwill

15 000

(to recognise current and previous period impairments of goodwill)

Elimination of intragroup transactions—management fees

All of the management fees paid within the group will need to be eliminated on consolidation. This is just another kind of intragroup transaction that requires elimination.

(n) Dr Management fee revenue 20 000

Cr Management fee expense 20 000

(to eliminate the intragroup transaction)

Because the above transaction would have created an amount that was taxable by one legal entity, and assessable by the other legal entity, the net effect on taxation is zero. Therefore, the above elimination creates no tax effect.

Dividends paid

We eliminate dividends paid within the group. Only dividends paid to parties outside the entity (non-controlling interests) are to be shown in the consolidated accounts.

WORKED EXAMPLE 26.7 continued

dee67382_ch26_1005-1054.indd 1041 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1041

(o) Dr Dividend revenue 186 000

Cr Dividend paid 186 000

(to eliminate the intragroup dividend payment)

We can now post the consolidation journal entries to the consolidation worksheet, after which we can construct consolidated financial statements.

Eliminations and adjustments

Mungo Ltd ($000)

Barry Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Detailed reconciliation of opening and closing retained earnings

Sales revenue 1 380 1 160 104(b) 2 306

130(e)

Cost of goods sold (928) (476) 15.2(c) 104(b) 1 176

4.8(f) 130(e)

14(h)

Gross profit 452 684 1 130

Other revenue –

Dividends received from Barry Ltd 186 – 186(o) –

Management fee revenue 53 20(n) 33

Gain on sale of plant 70 20(i) 50

Expenses

Administrative expenses (98.8) (77.4) (176.2)

Depreciation (49) (113.6) 3.334(k) (159.266)

Management fee expense – (53) 20(n) (33)

Other expenses (202.2) (154) 5(m) (361.2)

Profit before tax 411 286 483.334

Tax expense 123    84.4 4.2(h) 4.56(d) 200.6

1(l) 1.44(g)

6( j)

Profit for the year 288 201.6 282.734

Retained earnings—1 July 2022 638.8 478.4 250(a) 847.4

9.8(h)

10(m)

926.8 680 1 130.134

Dividends paid (274.8) (186) 186(o) (274.8)

Retained earnings—30 June 2023 652 494 855.334

Statement of financial position

Shareholders’ equity

Retained earnings 652 494 855.334

Share capital 700 400 400(a) 700

continued

dee67382_ch26_1005-1054.indd 1042 10/25/19 11:50 AM

1042 PART 8: Accounting for equity interests in other entities

Eliminations and adjustments

Mungo Ltd ($000)

Barry Ltd ($000)

Dr ($000)

Cr ($000)

Consolidated statement

($000)

Current liabilities

Accounts payable 109.4 92.6 202

Tax payable 82.6 50 132.6

Non-current liabilities

Loans 347 232 579

1 891 1 268.6 2 468.934

Current assets

Accounts receivable 118.8 124.6 243.4

Inventory 184 58 15.2(c) 222

4.8(f)

Non-current assets

Deferred tax asset 4.56(d) 1(l) 11

1.44(g)

6( j)

Land and buildings 448 652  1 100

Plant—at cost 599.7 711.6 20(i) 1 331.3

Accumulated depreciation (171.5) (277.6) 3.334(k) 40(i) (485.766)

Investment in Barry Ltd 712 – 712(a) –

Goodwill – – 62(a) 62

Accumulated impairment loss – – 15(m) (15)  

1 891 1 268.6 1 257.334 1 257.334 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 2023

The Group ($)

Mungo Ltd ($)

Sales 2 306 000  1 380 000 

Cost of goods sold (1 176 000) (928 000)

Gross profit 1 130 000  452 000 

Dividend income –  186 000 

Management fee revenue 33 000  53 000 

Gain on sale of plant 50 000  70 000 

Administrative expenses (176 200) (98 800)

Depreciation (159 266) (49 000)

WORKED EXAMPLE 26.7 continued

dee67382_ch26_1005-1054.indd 1043 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1043

The Group ($)

Mungo Ltd ($)

Impairment loss—goodwill (5 000) –

Management fee expense (33 000) –

Other expenses (356 200) (202 200)

Profit before income tax expense 483 334  411 000

Income tax expense (200 600) (123 000)

Profit after tax 282 734  288 000

Other comprehensive income              –               –

Total comprehensive income 282 734  288 000

Mungo Ltd and its controlled entity

Statement of changes in equity for the year ended 30 June 2023

Share capital ($)

Group retained earnings ($)

Group total equity ($)

Balance at 1 July 2022 700 000 847 400  1 547 400 

Total comprehensive income for the year 282 734  282 734 

Distributions—dividends                (274 800)   (274 800)

Balance at 30 June 2023 700 000 855 334  1 555 334 

Mungo Ltd

Statement of changes in equity for the year ended 30 June 2023

Share capital ($)

Retained earnings ($)

Total equity ($)

Balance at 1 July 2022 700 000 638 800  1 338 800 

Total comprehensive income for the year 288 000  288 000 

Distributions—dividends (274 800)  (274 800)

Balance at 30 June 2023 700 000  652 000  1 352 000 

Consolidated statement of financial position of Mungo Ltd and its subsidiaries as at 30 June 2023

The Group ($)

Mungo Ltd ($)

Current assets

Accounts receivable 243 400 118 800

Inventory 222 000 184 000

465 400 302 800

Non-current assets

Land and buildings 1 100 000 448 000

Plant and equipment 1 331 300 599 700

less Accumulated depreciation (485 766) (171 500)

Investment in Barry Ltd 712 000

Goodwill 62 000 –

less Accumulated impairment loss (15 000) –

continued

dee67382_ch26_1005-1054.indd 1044 10/25/19 11:50 AM

1044 PART 8: Accounting for equity interests in other entities

The Group ($)

Mungo Ltd ($)

Deferred tax asset 11 000              –

2 003 534 1 588 200

Total assets 2 468 934 1 891 000

Current liabilities

Accounts payable 202 000 109 400

Tax payable 132 600 82 600

334 600 192 000

Non-current liabilities

Loan 579 000 347 000

Total liabilities 913 600 539 000

Shareholders’ equity

Share capital 700 000 700 000

Retained earnings 855 334 652 000

Total shareholders’ equity 1 555 334 1 352 000

Total of liabilities and shareholders’ equity 2 468 934 1 891 000

WORKED EXAMPLE 26.7 continued

WHY DO I NEED TO KNOW WHEN, AND HOW, TO ELIMINATE INTRAGROUP TRANSACTIONS?

As accountants, when preparing consolidated financial statements, it is necessary to properly eliminate intragroup transactions. Failure to do so would mean that the consolidated financial statements would not represent the financial performance and financial position of the group as a combined economic entity. Further, if we do not understand how the process of consolidation is performed, we will not really understand what the consolidated financial statements actually represent.

SUMMARY

This chapter considered the consolidation process and, in particular, how to account for intragroup transactions—that is, intragroup dividend payments, sales of inventory, management fees 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.

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 of inventory, 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).

dee67382_ch26_1005-1054.indd 1045 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1045

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 1006

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is an intragroup transaction, and do the effects of intragroup transactions have to be eliminated in full? LO 26.1 An ‘intragroup transaction’ is a transaction between separate legal entities within an economic entity (‘intra’ means ‘within’). The effects of all intragroup transactions need to be eliminated so that the consolidated financial statements shall only represent the effects of transactions with entities that are external to the group (economic entity).

2. Following consolidation, should dividends paid to the parent entity by its subsidiaries be shown in the economic entity’s financial statements? LO 26.2 Dividends paid to the parent entity by a subsidiary shall not be shown within the consolidated financial statements. Such payments would represent an intragroup transaction and should be eliminated in full as part of the consolidation process.

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? Further, will adjustments be required to restate the balance of opening inventory as at the beginning of the next financial period? LO 26.3 When preparing consolidated financial statements, we must prepare them in conformity with accounting standards. AASB 102 requires that inventory shall be measured at the lower of cost and net realisable value. Therefore, at the end of the reporting period, adjustments need to be made to ensure that any inventory on hand is reported at ‘cost’ to the group, which means that any ‘mark-ups’ (profits) that have been included within the cost of closing inventory need to be removed (reversed). Further, if we reduce the measure of inventory at the end of one period through the use of consolidation adjustments, we need to correspondingly reduce the measure of opening inventory at the beginning of the next reporting period through consolidation adjustments undertaken at the beginning of the next reporting period. Reducing opening inventory in the new reporting period acts to shift profits from the previous reporting period to the current reporting period.

4. If one organisation within a group sells a non-current asset to another member of the group at a profit, will this lead to a deferred tax asset on consolidation? Why or why not? LO 26.4 Yes, it will. From the individual legal entity perspective, the selling organisation has made a profit on sale and will need to pay tax on this gain. However, from the group’s perspective, a profit has not been made, and therefore there should be no tax expense recognised from the perspective of the group. The payment of tax by the individual legal entity—which cannot be avoided—is considered from the group’s perspective to represent a prepayment of tax in the form of a deferred tax asset. The group will be able to utilise this deferred tax asset over the remaining useful life of the asset because the separate legal entity that acquired the non-current asset will be able to obtain a higher tax deduction (and therefore the group will also obtain the deduction) based upon the higher cost of the non-current asset.

5. If management fees are paid from one organisation to another within an economic entity, does this transaction need to be reversed on consolidation? Further, will the transaction lead to a deferred tax asset on consolidation? LO 26.1 Yes, it needs to be reversed on consolidation. The consolidation adjustment would debit the management fees income, and credit the management fees expense. Because the related benefits would be considered to be fully realised, there would be no related tax adjustment.

dee67382_ch26_1005-1054.indd 1046 10/25/19 11:50 AM

1046 PART 8: Accounting for equity interests in other entities

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

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. If there has been an intragroup sale of inventory within a reporting period, and all of the related inventory has been sold

to external parties, which accounts need to be debited and credited as part of the consolidation process? LO 26.3 • 4. If there has been an intragroup sale of inventory within a reporting period, and not all of the related inventory

has been sold to external parties, which accounts need to be debited and credited as part of the consolidation process? LO 26.3 ••

5. If goodwill has been acquired in a previous period, what consolidation journal entries would be used in the current period to account for prior period, and current period, impairments of goodwill? LO 26.1 •

6. If there has been an intragroup payment of management fees within a reporting period, which accounts need to be debited and credited as part of the consolidation process? LO 26.1 •

7. In the consolidated financial statements, which dividends are to be shown as paid, declared, payable and receivable? LO 26.2 •

8. 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 •

9. 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 ••

10. 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 ••

11. 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 •• 12. 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 2022 for a cost of $2000. All assets are fairly stated at acquisition date. The share capital and reserves of Small Company on the date of acquisition are:

$

Share capital 1 250

Retained earnings    750

2 000

The reconciliation of retained earnings and statements of financial position of Big Company and Small Company, as at 30 June 2023, are as follows:

Big Company ($)

Small Company ($)

Reconciliation of opening and closing retained earnings

Profit before tax 500 250

Tax (125) (100)

Profit after tax 375 150

Opening retained earnings 1 000 750

dee67382_ch26_1005-1054.indd 1047 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1047

Big Company ($)

Small Company ($)

1 375 900

less Dividends declared (175) (125)

Closing retained earnings 1 200 775

Statement of financial position

Shareholders’ funds

Retained earnings 1 200 775

Share capital 1 250 1 250

Liabilities

Accounts payable 2 500 250

Dividends payable    175    125

5 125 2 400

Assets

Cash 250 175

Accounts receivable 125 325

Dividends receivable 250 –

Inventory 375 400

Plant and equipment 2 125 1 500

Investment in Small Company 2 000         –

5 125 2 400

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 2023. LO 26.1, 26.2 ••

13. Bernie Boffin Ltd owns 100 per cent of Computer Ltd. On 1 July 2021 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 2022 and 30 June 2023 to adjust for the above sale. LO 26.4 ••

14. Bigger Company owns all of the issued capital of Smaller Company. The financial statements of Bigger Company and Smaller Company at 30 June 2023 are as follows:

Bigger Company ($)

Smaller Company ($)

Reconciliation of opening and closing retained earnings

Profit before tax 500 500

Tax (125) (200)

Profit after tax 375 300

Opening retained earnings 4 000 1 500

4 375 1 800

less Dividends proposed (175) (250)

Closing retained earnings 4 200 1 550

dee67382_ch26_1005-1054.indd 1048 10/25/19 11:50 AM

1048 PART 8: Accounting for equity interests in other entities

Bigger Company ($)

Smaller Company ($)

Statement of financial position

Shareholders’ funds

Retained earnings 4 200 1 550

Share capital 1 250 2 500

Liabilities

Accounts payable 2 500 500

Dividends payable     175    250

8 125 4 800

Assets

Cash 250 350

Accounts receivable 125 650

Dividends receivable 250 –

Inventory 375 800

Plant and equipment 2 125 3 000

Investment in Smaller Company 5 000        –

8 125 4 800

Bigger Company acquired its 100 per cent interest in Smaller Company on 1 July 2022 for a cost of $5000. The share capital and reserves of Smaller Company on the date of acquisition are:

$

Share capital 2500

Retained earnings 1500

4000

The directors believe that goodwill has been impaired by 20 per cent in the year to 30 June 2023.

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 2023. LO 26.1, 26.2 ••

15. Nat Ltd acquires all of the issued capital of Midget Ltd for a cash payment of $1.5 million on 30 June 2023. The statements of financial position of both entities immediately following the purchase are:

Nat Ltd ($000)

Midget Ltd ($000)

Current assets

Cash 60 45

Accounts receivable 900 135

Non-current assets

Plant 4 440 1 800

Investment in Midget Ltd 1 500       –

6 900 1 980

Current liabilities

Accounts payable 300 90

Non-current liabilities

Loans 2 400 540

dee67382_ch26_1005-1054.indd 1049 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1049

Nat Ltd ($000)

Midget Ltd ($000)

Shareholders’ equity

Share capital 3 000 600

Retained earnings 1 200  750

6 900 1 980

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 2023. LO 26.1, 26.2 ••

CHALLENGING QUESTIONS

16. Jacko Ltd owns 100 per cent of the shares of Jackson Ltd, acquired on 1 July 2022 for $3.5 million when the shareholders’ funds of Jackson Ltd were:

$

Share capital 1 750 000

Retained earnings 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 2023.

During the 2023 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 2023, half of the inventory is still on hand with Jacko Ltd. The tax rate is 33 per cent.

The financial statements of Jacko Ltd and Jackson Ltd at 30 June 2023 are as follows:

Jacko Ltd ($000)

Jackson Ltd ($000)

Reconciliation of opening and closing retained earnings

Sales revenue 4 200 1 400  

less Cost of goods sold (1 750) (490)  

less Other expenses (210) (105)  

Other revenue   245   87.5

Profit 2 485 892.5

Tax expense (700) (350)  

Profit after tax 1 785 542.5

Retained earnings—1 July 2022 3 500 1 400

5 285 1 942.5

Dividends paid (700) (140)

Retained earnings—30 June 2023 4 585 1 802.5

Statement of financial position

Shareholders’ equity

Retained earnings   4 585 1 802.5

Share capital 14 000 1 750

dee67382_ch26_1005-1054.indd 1050 10/25/19 11:50 AM

1050 PART 8: Accounting for equity interests in other entities

Jacko Ltd ($000)

Jackson Ltd ($000)

Current liabilities   

Accounts payable 350 297.5

Non-current liabilities   

Loans    2 100 875

21 035 4 725

Current assets   

Cash 875 87.5

Accounts receivable 525 612.5

Inventory 2 100 1 050

Non-current assets

Land 5 040 1 400  

Plant 8 645 1 400  

Investment in Jackson Ltd 3 500 –   

Future income tax benefit 350 175  

Goodwill           – –

21 035 4 725

REQUIRED Provide the consolidated financial statements for Jacko Ltd and its controlled entity for 2023. LO 26.2, 26.3

17. The following financial statements of Andy Ltd and its subsidiary Irons Ltd have been extracted from their financial records at 30 June 2023.

Andy Ltd ($)

Irons Ltd ($)

Reconciliation of opening and closing retained earnings

Sales revenue 839 250 725 000

Cost of goods sold (580 000) (297 500)

Gross profit 259 250 427 500

Dividends received from Irons Ltd 116 250 –

Management fee revenue 33 125

Gain on sale of plant 43 750

Expenses

Administrative expenses (38 500) (48 375)

Depreciation (30 625) (71 000)

Management fee expense – (33 125)

Other expenses (126 375) (96 250)

Profit before tax 256 875 178 750

Tax expense (76 875) (52 750)

Profit for the year 180 000 126 000

Retained earnings—1 July 2022 399 250 299 000

579 250 425 000

Dividends paid   (171 750) (116 250)

Retained earnings—30 June 2023 407 500 308 750

dee67382_ch26_1005-1054.indd 1051 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1051

Andy Ltd ($)

Irons Ltd ($)

Statement of financial position Shareholders’ equity

Retained earnings 407 500 308 750

Share capital 437 500 250 000

Current liabilities

Accounts payable – 57 875

Tax payable 100 000 31 250

Non-current liabilities

Loans    236 000   145 000

1 181 000 792 875

Current assets

Accounts receivable 74 250 77 875

Inventory 115 000 36 250

Non-current assets

Land and buildings 198 750 407 500

Plant—at cost 400 000 444 750

Accumulated depreciation (107 000) (173 500)

Investment in Irons Ltd    500 000               –

1 181 000 792 875

Other information • Andy Ltd acquired its 100 per cent interest in Irons Ltd on 1 July 2016—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

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 2022 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 $3750 in the current financial year. Previous impairments of goodwill amounted to $20 000.

• On 1 July 2022 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’. The group uses the straight-line method of depreciation.

• Irons Ltd paid $33 125 in management fees to Andy 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 2023. Also provide a statement of changes in equity. LO 26.2, 26.3, 26.4

dee67382_ch26_1005-1054.indd 1052 10/25/19 11:50 AM

1052 PART 8: Accounting for equity interests in other entities

18. The following financial statements of Joel Ltd and its subsidiary Parko Ltd have been extracted from their financial records at 30 June 2023.

Joel Ltd ($000)

Parko Ltd ($000)

Reconciliation of opening and closing retained earnings

Sales revenue 671.4 540  

Cost of goods sold (464) (238)

Gross profit 207.4 302  

Dividends received from Parko Ltd 93 –

Management fee revenue 26.5

Gain on sale of plant 40 35  

Expenses

Administrative expenses (30.8) (38.7)

Depreciation (29.5) (56.8)

Management fee expense – (26.5)

Other expenses (101.1) (72)

Profit before tax 205.5 143  

Tax expense (61.5) (42.2)

Profit for the year 144 100.8

Retained earnings—30 June 2022 319.4 239.2

463.4 340  

Dividends paid (137.4) (93)

Retained earnings—30 June 2023 326 247

Joel Ltd ($000)

Parko Ltd ($000)

Statement of financial position

Shareholders’ equity

Retained earnings 326   247  

Share capital 350   200  

Current liabilities

Accounts payable 54.7 46.3

Tax payable 41.3 25  

Non-current liabilities

Loans 173.5 116

945.5 634.3

Current assets

Accounts receivable 59.4 62.3

Inventory 92 29  

Non-current assets

Land and buildings 224 326  

Plant—at cost 299.85 355.8

Accumulated depreciation (85.75) (138.8)

Investment in Parko Ltd 356 –

945.5 634.3

dee67382_ch26_1005-1054.indd 1053 10/25/19 11:50 AM

CHAPTER 26: Further consolidation issues I: accounting for intragroup transactions 1053

Other information • Joel Ltd acquired its 100 per cent interest in Parko Ltd on 1 July 2018, 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 2022 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 2022 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’. The group uses the straight-line method of depreciation.

• 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 2023. LO 26.2, 26.3, 26.4

dee67382_ch26_1005-1054.indd 1054 10/25/19 11:50 AM

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 27.1 Understand the meaning and nature of non-controlling interests. 27.2 Know how to disclose non-controlling interests in the consolidated financial statements. 27.3 Know how to calculate the non-controlling interests’ share in the share capital and in the

reserves, and the current period profit or loss and other comprehensive income of the subsidiary. 27.4 Know how to adjust for intragroup transactions in the presence of non-controlling interests.

C H A P T E R 27 Further consolidation issues II: accounting for non-controlling interests

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following four questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is a non-controlling interest, and how should it be disclosed within the consolidated financial statements? LO 27.1, 27.2

2. Is the non-controlling interest considered to be debt, or equity, within the consolidated financial statements? LO 27.1, 27.2

3. If there is a purchase transaction between the parent entity and a 60 per cent-owned subsidiary that 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 27.4

4. 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 27.3

1055

dee67382_ch27_1055-1102.indd 1055 10/25/19 03:12 PM

dee67382_ch27_1055-1102.indd 1056 10/25/19 03:12 PM

1056 PART 8: Accounting for equity interests in other entities

27.1 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 (in superseded/ replaced accounting standards they were previously referred to as minority interests or outside equity interests).

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 as it would be expected to control the majority of the voting rights with respect to Little Company. The remaining 25 per cent is held by investors who are not part of the economic entity. These outside investors—who could be many in number—are called ‘non- controlling interests’. A non-controlling interest exists when a subsidiary is partly owned by the

parent entity. Accounting 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 non-controlling 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. However, this shareholding might be dispersed among a large number of shareholders, many of whom may never attend any company meetings and/or vote on any motions raised at general meetings.

Figure 27.1 Simple group structure that includes a non- controlling interest

Big Company

Little Company Non-controlling

interests

75%

25%

parent entity An entity that controls another legal entity.

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

3 Business Combinations IFRS 3

10 Consolidated Financial Statements IFRS 10

101 Presentation of Financial Statements IAS 1

102 Inventories IAS 2

136 Impairment of Assets IAS 36

LO 27.1

dee67382_ch27_1055-1102.indd 1057 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1057

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.

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 subsidiary’s 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, and will be attributed, within equity, to the non-controlling interests.

∙ 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, and therefore which will be paid to entities/individuals that are external to the group, 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 liabilities (as are the dividends payable by the parent entity to its shareholders).

WHY DO I NEED TO KNOW WHAT A ‘NON-CONTROLLING INTEREST’ REPRESENTS?

In our future careers we will most likely read, at some stage, the financial statements prepared by various large business organisations. Because most large organisations constitute a ‘group’ of legal entities (or, as it is also called, an ‘economic entity’) in which there is a parent entity and various subsidiaries, and because not all subsidiaries will typically be 100 per cent owned, there will typically be ‘non-controlling interests’. These non- controlling interests will be measured and the attributed measures will appear within the financial statements. At times, these amounts might be very significant (for example, in the 2019 Annual Report of BHP Group Ltd, non- controlling interests amount to US$4564 million, or approximately 8.9 per cent of the total equity of the group).

Therefore, given the magnitude of the financial measures involved, it would be important for us to understand what the non-controlling interests actually represent.

27.2 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:

LO 27.2

dee67382_ch27_1055-1102.indd 1058 10/25/19 03:12 PM

1058 PART 8: Accounting for equity interests in other entities

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. (AASB 10)

Non-controlling interests have a share in the profit or loss and other comprehensive income of the group. Paragraph B94 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 10)

AASB 101 Presentation of Financial Statements includes a number of disclosure requirements relating to non- controlling interests. These are consistent with the requirements of AASB 10. Paragraph 81B 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 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; and (b) comprehensive income for the period attributable to: (i) non-controlling interests; and (ii) owners of the parent. (AASB 101)

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 the accounting standard was re-released, these disclosure examples 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’).

Exhibit 27.1 Non-controlling interest disclosures in the statement of financial position

XYZ Group Ltd Statement of financial position as at 30 June 2023 (extract)

The Group Parent

2023 ($000)

2022 ($000)

2023 ($000)

2022 ($000)

EQUITY

Share capital X X X X

Other reserves X X X X

Retained earnings X X X X

Total equity X X X X

Parent interest X X X X

Non-controlling interest X X – –

Total equity X X X X

dee67382_ch27_1055-1102.indd 1059 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1059

Exhibit 27.2 provides 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.

Exhibit 27.3 Non-controlling interest disclosures in the statement of changes in equity

XYZ Group Ltd Statement of changes in equity for the year ended 30 June 2023

Attributable to owners of the parent

Share capital ($000)

Retained earnings

($000)

Translation of foreign

operations ($000)

Revaluation surplus ($000)

Total ($000)

Non- controlling

interest ($000)

Total equity ($000)

Balance at 1 July 2022 XXX XXX (XXX) XXX XXX XXX XXX

Changes in accounting policy – XXX – – XXX XXX XXX

Restated balance XXX XXX (XXX) XXX XXX XXX XXX

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 2023

The Group Parent

2023 ($000)

2022 ($000)

2023 ($000)

2022 ($000)

Revenue XXX XXX XXX XXX

Expenses (XXX) (XXX) (XXX) (XXX)

Profit before income tax XXX XXX XXX XXX

Income tax expense (XXX) (XXX) (XXX) (XXX)

Profit for the period XXX XXX XXX XXX

Other comprehensive income:

Exchange differences on translating foreign operations

XXX XXX XXX XXX

Gains on property revaluation XXX XXX XXX XXX

Other comprehensive income for the year XXX XXX XXX XXX

Total comprehensive income for the year XXX XXX XXX XXX

Profit attributable to:

Owners of the parent entity X X X X

Non-controlling interest X X – –

X X X X

Total comprehensive income attributable to:

Owners of the parent entity X X X X

Non-controlling entity X X – –

X X X X

continued

dee67382_ch27_1055-1102.indd 1060 10/25/19 03:12 PM

1060 PART 8: Accounting for equity interests in other entities

27.3 Calculating non-controlling interests

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. (AASB 10)

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 expenses 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.

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 between the acquisition date and the commencement of the current accounting period. This is achieved through calculating the non-controlling interests’ share of the post- acquisition movements in retained earnings and reserves.

Attributable to owners of the parent

Share capital ($000)

Retained earnings

($000)

Translation of foreign

operations ($000)

Revaluation surplus ($000)

Total ($000)

Non- controlling

interest ($000)

Total equity ($000)

Changes in equity for 2023

Issue of share capital XXX XXX XXX

Dividends – (XXX) – – (XXX) (XXX) (XXX)

Total comprehensive income for the year

– XXX XXX XXX XXX XXX XXX

Transfer to retained earnings – XXX – (XXX) – – –

Balance at 30 June 2023 XXX XXX XXX XXX XXX XXX XXX

LO 27.3

Exhibit 27.3 continued

dee67382_ch27_1055-1102.indd 1061 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1061

3. Non-controlling interests’ share in the profit or loss and other comprehensive income, and movements in the reserves, of the subsidiaries in the current period.

Apart from the above calculations, AASB 3 Business Combinations 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 that we allocate to the non-controlling interests. According to paragraph 19, 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 non-controlling interests’ share of goodwill). Specifically, paragraphs 18 and 19 state:

18. The acquirer shall measure the identifiable assets acquired and the liabilities assumed at their acquisition- date fair values.

19. For each business combination, the acquirer shall measure at the acquisition date components of non- controlling 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. (AASB 3)

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. The choice will impact the amount of goodwill reported in the consolidated financial statements, as well as the amount that is attributed to the non-controlling interests.

If the non-controlling interests are calculated on the basis of the fair value of the subsidiary as at the date that the parent entity acquires the subsidiary, then an amount representing the non-controlling interests’ 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 International Accounting Standards Board (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 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 IFRS 3. Paragraphs BC209 and BC210 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

dee67382_ch27_1055-1102.indd 1062 10/25/19 03:12 PM

1062 PART 8: Accounting for equity interests in other entities

[the ‘full goodwill method’]. 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 to measure non-controlling interests, 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 non- controlling 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 in Chapters 25 and 26. 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—which is an instance of an intragroup transaction—are eliminated against the parent’s share of the subsidiary’s dividend distributions. However, 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 equity interest in the net assets of the subsidiary.

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, all 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.

dee67382_ch27_1055-1102.indd 1063 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1063

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. (AASB 3)

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 (the ‘full goodwill method’) for one business combination and the proportionate share of the acquiree’s net identifiable assets (the ‘partial goodwill method’) 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.

Shareholders of parent entity

Non-controlling interests

Parent entity

Subsidiary

Dividends distributed to parent entity’s

shareholders

Shareholders’ investment in

parent

Dividends paid to parent

Non-controlling interests’

shareholding

Dividends paid to

non-controlling interests

Parent entity’s shareholding in

subsidiary

Economic entity

Figure 27.2 A diagrammatic representation of equity investments and dividend flows within an economic entity in the presence of non- controlling interests

WORKED EXAMPLE 27.1: Non-controlling interest in pre-acquisition capital and reserves where the non-controlling interest is measured at the proportionate share of the acquiree’s identifiable net assets

On 1 July 2023, 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 $ 700 000

Revaluation surplus $ 200 000

Retained earnings $ 100 000

$1 000 000

continued

dee67382_ch27_1055-1102.indd 1064 10/25/19 03:12 PM

1064 PART 8: Accounting for equity interests in other entities

All assets of Subsidiary Ltd were recorded at fair value at the 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:

Elimination of investment in Subsidiary Ltd

Subsidiary Ltd ($)

Parent Entity’s 70% interest

($)

30% Non- controlling

interest ($)

Fair value of consideration transferred 800 000

less Fair value of identifiable assets acquired and liabilities assumed:

Share capital on acquisition date 700 000 490 000 210 000

Revaluation surplus on acquisition date 200 000 140 000 60 000

Retained earnings on acquisition date 100 000 70 000 30 000

Fair value adjustment ($50 000 × (1 – tax rate)) 35 000 24 500 10 500

1 035 000 724 500

Goodwill on acquisition date 75 500 –

Non-controlling interest 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 $1 000 000

Fair value adjustment (after tax) $ 35 000

$1 035 000

Proportional interest at 70 per cent $ 724 500

Cost of investment $ 800 000

Goodwill acquired $ 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 parent entity’s 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 non-controlling 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 as at acquisition date.

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 (to close off accumulated depreciation in accordance with the net method of asset revaluation)

180 000

WORKED EXAMPLE 27.1 continued

dee67382_ch27_1055-1102.indd 1065 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1065

continued

WORKED EXAMPLE 27.2: Non-controlling interest in Subsidiary Ltd, when the non-controlling interest is measured at fair value

Assume the same information as in Worked Example 27.1, except this time we will apply the other option available within the accounting standard, and we value the non-controlling interest in the acquiree at fair value (that is, we will be applying the ‘full goodwill method’).

REQUIRED Prepare the consolidation journal entry to recognise the non-controlling interest in the pre-acquisition capital and reserves of Subsidiary Ltd, assuming that the non-controlling interest is measured at fair value.

SOLUTION The recognition of goodwill on acquisition and its allocation between Parent Entity and Subsidiary Ltd can be calculated as follows:

Elimination of investment in Subsidiary Ltd

Subsidiary Ltd ($)

Parent Entity’s 70% interest

($)

30% Non- controlling

interest ($)

Fair value of consideration transferred 800 000 800 000

add Non-controlling interest measured at fair value ($800 000 × 30/70) 342 857 342 857

1 142 857

Dr Plant 50 000

Cr Revaluation surplus recognised on consolidation 35 000

Cr Deferred tax liability (to recognise, as part of the consolidation process, the revaluation increment after tax)

15 000

Dr Share capital (70% of 700 000) 490 000

Dr Revaluation reserve (70% of 200 000) 140 000

Dr Revaluation surplus recognised on consolidation (70% of 35 000) 24 500

Dr Retained earnings (70% of 100 000) 70 000

Dr Goodwill 75 500

Cr Investment in Subsidiary Ltd (to recognise the goodwill acquired by Parent Entity and to eliminate the parent’s interest in the pre-acquisition capital and reserves of the subsidiary. We separately account for the pre-existing revaluation surplus, and the revaluation surplus recognised as part of the fair value adjustment on consolidation)

800 000

Dr Share capital (30% of $700 000) 210 000

Dr Revaluation surplus (30% of $200 000) 60 000

Dr Revaluation surplus recognised on consolidation (30% of $35 000) 10 500

Dr Retained earnings (30% of $100 000) 30 000

Cr Non-controlling interest (to recognise the non-controlling interest in contributed equity and reserves at date of acquisition, including the amount attributed to the fair value adjustment. 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 within the consolidated statement of financial position)

310 500

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.

dee67382_ch27_1055-1102.indd 1066 10/25/19 03:12 PM

1066 PART 8: Accounting for equity interests in other entities

Elimination of investment in Subsidiary Ltd

Subsidiary Ltd ($)

Parent Entity’s 70% interest

($)

30% Non- controlling

interest ($)

less Fair value of identifiable assets acquired and liabilities assumed

Share capital on acquisition date 700 000 490 000 210 000

Revaluation surplus on acquisition date 200 000 140 000 60 000

Retained earnings on acquisition date 100 000 70 000 30 000

Fair value adjustment ($50 000 × (1 – tax rate)) 35 000 24 500 10 500 1 035 000 724 500 310 500

Goodwill on acquisition date 107 857 75 500 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.

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 (to close off accumulated depreciation in accordance with the net method of asset revaluation)

180 000

Dr Plant 50 000

Cr Revaluation surplus recognised on consolidation 35 000

Cr Deferred tax liability (to recognise, as part of the consolidation process, the revaluation increment after tax)

15 000

Dr Share capital (30% of 700 000) 210 000

Dr Revaluation surplus (30% of 200 000) 60 000

Dr Revaluation surplus recognised on consolidation (30% of 35 000) 10 500

Dr Retained earnings (30% of 100 000) 30 000

Dr Goodwill 32 357

Cr Non-controlling interest (to recognise non-controlling interest in contributed equity, reserves and goodwill at date of acquisition. This consolidation entry is the same as the entry in Worked Example 27.1, except this time we allocate some goodwill to the non-controlling interest)

342 857

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 200 000) 140 000

Dr Revaluation surplus recognised on consolidation (70% of 35 000) 24 500

WORKED EXAMPLE 27.2 continued

dee67382_ch27_1055-1102.indd 1067 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1067

27.4 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 represent a flow of resources away from the group, as indicated in Figure 27.2.

The dividends distributed to the non-controlling interests will also 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 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 as such dividends would constitute an intragroup transaction that requires elimination).

For example, let us assume that Subsidiary Ltd declares a dividend of $1000 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 Dividend income—statement of profit or loss and other comprehensive income 700

Cr Dividend receivable—statement of financial position 700

Dr Dividend payable—statement of financial position 700

Cr Dividend declared—statement of changes in equity (consolidation entries to eliminate the effects of intragroup dividends)

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.

WHY DO I NEED TO KNOW HOW NON-CONTROLLING INTERESTS ARE CALCULATED?

Because the amount attributed to non-controlling interests can be very material (for example, as we indicated previously, they constituted 8.9 per cent of the total equity of the BHP Group in 2019), it would seem sensible, if we will be reviewing financial statements in our future career, to have some appreciation about how this potentially large number is actually derived. Further, if we end up in the role of financial accountant, then we might actually need to make these adjustments—hence we would need to have this knowledge.

LO 27.4

Dr Retained earnings (70% of 100 000) 70 000

Dr Goodwill 75 500

Cr Investment in Subsidiary Ltd (to recognise the goodwill acquired by Parent Entity and to eliminate Parent Entity’s interest in pre-acquisition capital and reserves)

800 000

dee67382_ch27_1055-1102.indd 1068 10/25/19 03:12 PM

1068 PART 8: Accounting for equity interests in other entities

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 Entity for $1000 when Subsidiary Ltd had a related cost of sales of $700. Let us further assume that Parent Entity then sold all of the inventory to an external customer for $1500. Subsidiary Ltd would record a profit on sale of $300 and Parent Entity would record a profit on sale of $500 in their individual accounts. The total profit to the economic entity would be $800 ($1500 less $700) and therefore all profits would be realised. An adjustment to remove an element of profit 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 $1000 and if that asset is to be depreciated on a straight-line basis 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 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 at the end of the reporting period (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. The general principles are:

dee67382_ch27_1055-1102.indd 1069 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1069

∙ We need to make adjustments to non-controlling interests’ share of profits only 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 option 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 2022 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 $1 500 000

Retained earnings $ 700 000

$2 200 000

As at 30 June 2024 (that is, two years after the date of acquisition) the financial statements of the two companies are as follows:

Bells Ltd ($000)

Torquay Ltd ($000)

Detailed reconciliation of opening and closing retained earnings

Sales revenue 480 115

Cost of goods sold (100) (40)

Other expenses (80) (15)

Other revenue 70 25

Profit before tax 370 85

Tax expense (60) (30)

Profit for the year 310 55

Retained earnings—1 July 2023 1 000 800

1 310 855

Dividends paid (160) (30)

Dividend declared (40) (10)

Retained earnings—30 June 2024 1 110  815

continued

dee67382_ch27_1055-1102.indd 1070 10/25/19 03:12 PM

1070 PART 8: Accounting for equity interests in other entities

Statement of financial position

Shareholders’ equity

Retained earnings 1 110 815

Share capital 4 000 1 500

Current liabilities

Accounts payable 20 30

Dividends payable 40 10

Non-current liabilities

Loans 600 250

Total of liabilities and equity 5 770 2 605

Current assets

Cash 150 25

Accounts receivable 242 175

Dividends receivable 8 –

Inventory 500 300

Non-current assets

Land 1 400 1 105

Plant 1 870 1 300

Accumulated depreciation (400) (300)

Investment in Torquay Ltd 2 000 –

Total assets 5 770 2 605

Other information • The management of Bells Ltd values any non-controlling interest in Torquay Ltd at fair value. • It is assumed that all assets of Torquay Ltd are recorded at fair value at the date of acquisition. • 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 interest in the profits of Torquay Ltd.)

• 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 interest in the profits of 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 $8000 to produce. At 30 June 2023, 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 interest in the profits of 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 2023, and by a further $12 000 in the year to 30 June 2024. (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 the profits of Torquay Ltd.)

• On 1 July 2023 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 using the straight-line method of depreciation, with

WORKED EXAMPLE 27.3 continued

dee67382_ch27_1055-1102.indd 1071 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1071

continued

no expected residual value. (Hint: as this unrealised profit relates to a sale of plant made by Torquay Ltd, adjustments will be necessary when calculating non-controlling interest in the profits of Torquay Ltd as a result of the adjustment to depreciation expense.)

• On 30 June 2024, 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 the profits of 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 2024.

SOLUTION Workings to eliminate the investment in the subsidiary and recognise goodwill on acquisition date

Elimination of the investment in Torquay Ltd and recognition of goodwill on acquisition date

Elimination of investment in Torquay Ltd

Torquay Ltd ($)

Bells Ltd’s 80% interest

($)

20% Non- controlling interest ($)

Fair value of consideration transferred 2 000 000 2 000 000

add Non-controlling interest at fair value ($2 000 000 × 20/80) 500 000 500 000

2 500 000

less Fair value of identifiable assets acquired and liabilities assumed

Share capital on acquisition date 1 500 000 1 200 000 300 000

Retained earnings on acquisition date 700 000 560 000 140 000

2 200 000 1 760 000 440 000

Goodwill on acquisition date 300 000 240 000 60 000

The entry to eliminate Bells Ltd’s investment in Torquay Ltd at acquisition date is:

(a)

Dr Share capital 1 200 000

Dr Retained earnings—1 July 2023 560 000

Dr Goodwill 240 000

Cr Investment in Torquay Ltd (to eliminate investment in Torquay Ltd and recognising goodwill on acquisition)

2 000 000

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

(b)

Dr Sales 20 000

Cr Cost of goods sold (to eliminate intragroup sales of inventory)

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

dee67382_ch27_1055-1102.indd 1072 10/25/19 03:12 PM

1072 PART 8: Accounting for equity interests in other entities

We are told that the total profit earned by Torquay Ltd on the sale of the inventory is $6000. 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 $6000 × 0.4, which equals $2400. 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.

(c)

Dr Cost of goods sold 2 400

Cr Inventory (to eliminate unrealised profit included in closing inventory)

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, $2400 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 $2400). 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 Deferred tax asset 720

Cr Income tax expense (to recognise the reduction in tax expense as a result of the elimination of profit in closing inventory—$2400 × 30 per cent)

720

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:

(e)

Dr Sales 30 000

Cr Cost of goods sold (to eliminate intragroup sales of inventory)

30 000

Elimination of unrealised profit in closing inventory The total profit earned by Bells Ltd on the sale of the inventory is $8000. 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 $8000 × 50 per cent, which equals $4000. In accordance with AASB 102, 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 Cost of goods sold 4 000

Cr Inventory (to eliminate the profit that was included within closing inventory)

4 000

WORKED EXAMPLE 27.3 continued

dee67382_ch27_1055-1102.indd 1073 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1073

continued

Consideration of the tax paid or payable on the sale of inventory that is still held within the group From the group’s perspective, $4000 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 $1200 (30 per cent of $4000). 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 Deferred tax asset 1 200

Cr Income tax expense (to reduce tax expense as a result of the elimination of the profit in closing inventory—$4000 × 30 per cent)

1 200

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 accounts 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 $8000 to produce. At the beginning of the financial year (1 July 2023), 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 – $8000) × 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 2023 and reducing income tax expense for the 2023 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 Retained earnings—1 July 2023 420

Dr Income tax expense 180

Cr Cost of goods sold (to eliminate the profit in opening inventory and to transfer the profits and related tax expense to the current reporting period)

600

Adjustments for intragroup sale of plant and associated depreciation adjustments On 1 July 2023 Torquay Ltd sold an item of plant to Bells Ltd for $45 000 when its carrying amount 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 using the straight-line depreciation method, 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.

(i)

Dr Gain on sale of plant 20 000

Dr Plant 5 000

Cr Accumulated depreciation (to eliminate the effects of the intragroup sale of a non-current asset)

25 000

dee67382_ch27_1055-1102.indd 1074 10/25/19 03:12 PM

1074 PART 8: Accounting for equity interests in other entities

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, $6000 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 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 Deferred tax asset 6 000

Cr Income tax expense (to reduce tax expense as a result of eliminating the gain on the intragroup sale of a non-current asset)

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 expense per year would be $45 000 divided by 10, which equals $4500. From the economic entity’s perspective, the asset had a carrying amount of $25 000, which was to be allocated over the next 10 years using the straight-line method of depreciation, giving a depreciation charge of $25 000 divided by 10, which equals $2500. An adjustment of $2000 is therefore required.

(k)

Dr Accumulated depreciation 2 000

Cr Depreciation expense (to reduce depreciation expense following the elimination of the gain on the intragroup sale of a non-current asset)

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 $2000 × 30 per cent. This entry represents a partial reversal of the deferred tax asset of $6000 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.

(l)

Dr Income tax expense 600

Cr Deferred tax asset (profits rise as a result of decreasing depreciation expense, and this increases tax expense)

600

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, and the ‘full goodwill method’ is applied, paragraph 6 of Appendix C to AASB 136 Impairment of Assets 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 $2400 (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 non-controlling interest at the proportionate share of Torquay Ltd’s identifiable net

WORKED EXAMPLE 27.3 continued

dee67382_ch27_1055-1102.indd 1075 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1075

continued

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.

(m)

Dr Retained earnings—1 July 2023 12 000

Dr Other expenses—impairment goodwill 12 000

Cr Accumulated impairment losses—goodwill (to recognise current and previous years’ impairment of goodwill)

24 000

Elimination of intragroup transactions—management fees All of the management fees paid within the group will need to be eliminated on consolidation.

(n)

Dr Management fee revenue 10 000

Cr Management fee expense (to eliminate of intragroup management fees)

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 fully 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.

(o)

Dr Dividend revenue 24 000

Cr Dividend paid (to eliminate of the intragroup dividends paid)

24 000

Dividend declared

(p)

Dr Dividend payable 8 000

Cr Dividend declared (to eliminate the effects of dividends declared)

8 000

(q)

Dr Dividend revenue 8 000

Cr Dividend receivable (to eliminate the effects of dividends declared)

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.

dee67382_ch27_1055-1102.indd 1076 10/25/19 03:12 PM

1076 PART 8: Accounting for equity interests in other entities

Earlier in the chapter some possible formats for the disclosure of non-controlling interests (see Exhibits 27.1, 27.2 and 27.3) were provided.

Calculation of non-controlling interests in Torquay Ltd

Torquay Ltd ($)

20% Non- controlling

interest ($)

(i) Non-controlling interests and goodwill on acquisition date

Share capital 1 500 000 300 000

Retained earnings—on acquisition 700 000 140 000

Goodwill on acquisition 60 000

2 200 000 500 000

(ii) 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) 100 000

less Unrealised profit in inventory—1 July 2023 (600)

Tax effect on unrealised profit 180

Goodwill impairment—2023 (12 000)

87 580 17 516

(iii) Non-controlling interest in the current period’s profit and movements in reserves in the current period

Profit for the year 55 000

add Unrealised profit in inventory—1 July 2023 now realised 600

Tax effect on unrealised profit now realised (180)

less Unrealised profit in inventory—30 June 2024 (2 400)

Tax effect on unrealised profit 720

less Unrealised profit on sale of non-current asset (20 000)

Tax effect on unrealised profit 6 000

add Depreciation 2 000

Tax effect on depreciation (600)

Goodwill impairment—2024 (12 000)

Profit Torquay contributed to the economic entity 29 140 5 828

Dividends paid by Torquay Ltd (30 000) (6 000)

Dividends declared by Torquay Ltd (10 000) (2 000)

515 344

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. (AASB 10)

WORKED EXAMPLE 27.3 continued

dee67382_ch27_1055-1102.indd 1077 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1077

continued

(r)

Dr Share capital 300 000

Dr Retained earnings—1 July 2023 140 000

Dr Goodwill 60 000

Cr Non-controlling interest (to recognise non-controlling interest on the date the subsidiary was acquired applying the ‘full goodwill method’)

500 000

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 2023 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 2023 goodwill impairment allocated to the non-controlling interest needs to be made. The 20 per cent non-controlling interest in movements in contributed equity, reserves and for goodwill 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.

(s)

Dr Retained earnings—1 July 2023 17 516

Cr Non-controlling interest (non-controlling interest’s share of movements in retained earnings of the subsidiary for the period from the acquisition of the subsidiary to the end of the previous reporting period)

17 516

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 2023 now realised At 1 July 2023 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 2024 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 2024 amounted to $2400. The reduction in profits will lead to a lower tax expense. At a tax rate of 30 per cent an adjustment of $720 ($2400 × 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 $6000 ($20 000 × 30 per cent) must be reversed.

dee67382_ch27_1055-1102.indd 1078 10/25/19 03:12 PM

1078 PART 8: Accounting for equity interests in other entities

As the depreciation expense charged by Bells Ltd would be greater than that charged by Torquay Ltd, the additional depreciation charge of $2000 ($4500 – $2500) should be adjusted for. The decrease in depreciation results in an increase in profits. This would lead to an increase in tax of $600 ($2000 × 30 per cent).

An adjustment for the 2024 goodwill impairment allocated to the non-controlling interest must be made. This amounts to $12 000 for 2024.

The 20 per cent non-controlling interest in the current period’s profit and movements in reserves in the current period amounted to $5828, as shown in the calculations provided earlier.

(t)

Dr Non-controlling interest in earnings 5 828

Cr Non-controlling interest (to recognise non-controlling interest in the current period’s profit and movements in reserves in the current period)

5 828

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.

(u)

Dr Non-controlling interest 8 000

Cr Dividends paid 6 000

Cr Dividends declared (dividends attributable to non-controlling interest—acts to reduce the non-controlling interests’ share in the equity of the subsidiary)

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 + $5828 – $8000, and which is the total amount shown in the table provided earlier).

Bells Ltd and its controlled entity

Eliminations and adjustments

Bells Ltd

($000)

Torquay Ltd

($000) Dr

($000) Cr

($000)

Consolidated statements

($000)

Reconciliation of opening and closing retained earnings

Revenue 480 115 20(b) 545

30(e)

Cost of goods sold (100) (40) 2.4(c) 20(b) (95.8)

4(f) 30(e)

0.6(h)

Other expenses (80) (15) 12(m) 2(k) (95)

10(n)

Other income 70 25 20(i) 33

10(n)

24(o)

8(q)  

Profit before tax 370 85 387.2

WORKED EXAMPLE 27.3 continued

dee67382_ch27_1055-1102.indd 1079 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1079

continued

Eliminations and adjustments

Bells Ltd

($000)

Torquay Ltd

($000) Dr

($000) Cr

($000)

Consolidated statements

($000)

Income tax expense (60) (30) 0.18(h) 0.72(d) (82.86)

0.6(l) 1.2(g)

6( j)

Profit for the year 310 55 304.34

Non-controlling interest in earnings 5.828(t) (5.828)

Retained earnings—1 July 2023 1 000 800 560(a) 1 070.064

0.42(h)

12(m)

140(r)

17.516(s)

1 310 855 1 368.576

Dividends paid (160) (30) 24(o) (160)

6(u)

Dividend declared (40) (10) 8(p) (40)

2(u)

Retained earnings—30 June 2024 1 110 815 1 168.576

Statement of financial position

Equity

Share capital 4 000 1 500 1 200(a) 4 000

300(r)

Retained earnings b/d 1 110 815 1 168.576

Non-controlling interest 500(r) 515.344

8(u) 17.516(s)

5.828(t)

Current liabilities

Accounts payable 20 30 50

Dividends payable 40 10 8(p) 42

Non-current liabilities

Loans 600 250 850

5 770 2 605 6 625.92

Current assets

Cash 150 25 175

Accounts receivable 242 175 417

Dividend receivable 8 – 8(q) –

Inventory 500 300 2.4(c) 793.6

4(f)

dee67382_ch27_1055-1102.indd 1080 10/25/19 03:12 PM

1080 PART 8: Accounting for equity interests in other entities

Non-current assets

Deferred tax asset 0.72(d) 0.6(l) 7.32

1.2(g)

6( j)

Land 1 400 1 105 2 505

Plant 1 870 1 300 5(i) 3 175

Accumulated depreciation (400) (300) 2(k) 25(i) (723)

Investment in Torquay Ltd 2 000 – 2 000(a) –

Goodwill – – 240(a) 300

60(r)

Accumulated impairment loss—goodwill 24(m) (24)

5 770 2 605 2 697.864 2 697.864 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 paid and 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 2024

Group ($)

Bells Ltd ($)

Revenue 545 000 480 000

Cost of goods sold (95 800) (100 000)

Gross profit 449 200 380 000

Other income 33 000 70 000

482 200 450 000

Other expenses (95 000) (80 000)

Profit before tax 387 200 370 000

Income tax expense (82 860) (60 000)

Profit for the year 304 340 310 000

Other comprehensive income – –

Total comprehensive income 304 340 310 000

Profit attributable to:

Owners of the parent 298 512 310 000

Non-controlling interest 5 828 –

304 340 310 000

Total comprehensive income attributable to:

Owners of the parent 298 512 310 000

Non-controlling interest 5 828 –

304 340 310 000

WORKED EXAMPLE 27.3 continued

dee67382_ch27_1055-1102.indd 1081 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1081

continued

Bells Ltd and its controlled entity Consolidated statement of changes in equity for the year ended 30 June 2024

Attributable to owners of the parent

Share capital

($)

Retained earnings

($) Total

($)

Non- controlling

interest ($)

Total equity

($)

Balance at 1 July 2023 4 000 000 1 070 064 5 070 064 517 516 5 587 580

Total comprehensive income for the year 298 512 298 512 5 828 304 340

Dividends (200 000)  (200 000) (8 000) (208 000)

Balance at 30 June 2024 4 000 000 1 168 576 5 168 576 515 344 5 683 920

Bells Ltd Statement of changes in equity for the year ended 30 June 2024

Share capital

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2023 4 000 000 1 000 000 5 000 000

Total comprehensive income for the year 310 000 310 000

Distributions (200 000) (200 000)

Balance at 30 June 2024 4 000 000 1 110 000 5 110 000

Bells Ltd and its controlled entity Consolidated statement of financial position at 30 June 2024

Group ($)

Bells Ltd ($)

Assets

Current assets

Inventory 793 600 500 000

Accounts receivable 417 000 242 000

Dividends receivable – 8 000

Cash 175 000 150 000

Total current assets 1 385 600 900 000

Non-current assets

Land 2 505 000 1 400 000

Plant and equipment 3 175 000 1 870 000

Accumulated depreciation (723 000) (400 000)

Goodwill 300 000 –

Accumulated impairment loss (24 000) –

Investment in Torquay Ltd – 2 000 000

Deferred tax asset 7 320 –

Total non-current assets 5 240 320 4 870 000

Total assets 6 625 920 5 770 000

dee67382_ch27_1055-1102.indd 1082 10/25/19 03:12 PM

1082 PART 8: Accounting for equity interests in other entities

Current liabilities

Accounts payable 50 000 20 000

Dividends payable 42 000 40 000

Total current liabilities 92 000 60 000

Non-current liabilities

Loans 850 000 600 000

Total non-current liabilities 850 000 600 000

Total liabilities 942 000 660 000

Net assets 5 683 920 5 110 000

Equity

Share capital 4 000 000 4 000 000

Retained earnings 1 168 576 1 110 000

5 168 576 5 110 000

Non-controlling interest 515 344 –

Total of liabilities and equity 5 683 920 5 110 000

WORKED EXAMPLE 27.4: Consolidated financial statement presentation in the presence of non-controlling interests—application of the ‘partial goodwill method’

The following financial statements of Hogwarts Ltd and its subsidiary Gryffindor Ltd have been extracted from their financial records at 30 June 2024.

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

Dividends received—from Gryffindor 74.4 –

Management fee revenue 26.5 –

Profit on sale of plant 35 –

Expenses

Administrative expenses (30.8) (38.7)

Depreciation (24.5) (56.8)

Management fee expense – (26.5)

Other expenses (101.1) (77)

Profit before tax 205.5 143

Tax expense (61.5) (42.2)

Profit for the year 144 100.8

Worked Example 27.4 provides another illustration of how to determine the non-controlling interest in the equity of a subsidiary. In this Worked Example we will measure the non-controlling interest by reference to the proportionate share in the recognised amounts of the acquiree’s identifiable net assets (also referred to as the ‘partial goodwill method’).

WORKED EXAMPLE 27.3 continued

dee67382_ch27_1055-1102.indd 1083 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1083

continued

Hogwarts Ltd ($000)

Gryffindor Ltd ($000)

Retained earnings—1 July 2023 319.4 239.2

463.4 340

Dividends paid (137.4) (93)

Retained earnings—30 June 2024 326 247

Statement of financial position

Shareholders’ equity

Retained earnings 326 247

Share capital 350 200

Current liabilities

Accounts payable 54.7 46.3

Tax payable 41.3 25

Non-current liabilities

Loans 173.5 116

945.5 634.3

Current assets

Accounts receivable 59.4 62.3

Inventory 92 29

Non-current assets

Land and buildings 224 326

Plant—at cost 299.85 355.8

Accumulated depreciation (85.75) (138.8)

Investment in Gryffindor Ltd 356 –

945.5 634.3

Other information

• Hogwarts Ltd had acquired its 80 per cent interest in Gryffindor Ltd on 1 July 2015, that is, nine years earlier. At that date the capital and reserves of Gryffindor Ltd were:

Share capital $200 000

Retained earnings $170 000

$370 000

At the date of acquisition all assets were considered to be fairly valued.

• The management of Hogwarts Ltd measures 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 2023 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.

dee67382_ch27_1055-1102.indd 1084 10/25/19 03:12 PM

1084 PART 8: Accounting for equity interests in other entities

• The closing inventory of Gryffindor Ltd includes inventory acquired from Hogwarts Ltd at a cost of $12 000. This cost Hogwarts Ltd $9600 to produce.

• The management of Hogwarts Ltd believe that goodwill acquired was impaired by $3000 in the current financial year. Previous impairments of goodwill amounted to $22 500.

• On 1 July 2023 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 Hogwarts 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 2024.

SOLUTION

Eliminating the investment in Gryffindor Ltd and recognising goodwill on acquisition date

Elimination of investment in Gryffindor Ltd

Gryffindor Ltd ($)

Hogwarts Ltd’s 80% interest

($)

20% Non- controlling

interest ($)

Fair value of consideration transferred 356 000

less Fair value of identifiable assets acquired and liabilities assumed

Share capital on acquisition date 200 000 160 000 40 000

Retained earnings on acquisition date 170 000 136 000 34 000

370 000 296 000

Goodwill on acquisition date 60 000 –

Non-controlling interest at date of acquisition 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. As we also know, if we measure the non- controlling interest at the proportionate share of Gryffindor Ltd’s identifiable net assets, then the goodwill to be recognised on consolidation will be restricted to the goodwill acquired by the parent.

The consolidation entry to eliminate the investment is:

(a)

Dr Share capital 160 000

Dr Retained earnings—1 July 2023 136 000

Dr Goodwill 60 000

Cr Investment in Gryffindor Ltd (to eliminate the investment in the subsidiary against the parent entity’s proportionate share of the capital and reserves of the subsidiary at the date of acquisition)

356 000

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

WORKED EXAMPLE 27.4 continued

dee67382_ch27_1055-1102.indd 1085 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1085

continued

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

(b)

Dr Sales 52 000

Cr Cost of goods sold (to eliminate intragroup sale of inventory)

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 $5600. In accordance with AASB 102, we must measure 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.

(c)

Dr Cost of goods sold 5 600

Cr Inventory (to eliminate the intragroup profit included in the closing inventory)

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, $5600 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 $1680 (30 per cent of $5600). 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 1 680

Cr Income tax expense (to reduce the group’s tax expense as a result of the elimination of the intragroup profit in closing inventory—$5600 × 30 per cent)

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 $9600 to produce.

(e)

Dr Sales 65 000

Cr Cost of goods sold (to eliminate intragroup sale of inventory)

65 000

dee67382_ch27_1055-1102.indd 1086 10/25/19 03:12 PM

1086 PART 8: Accounting for equity interests in other entities

Unrealised profit in closing inventory held by Gryffindor Ltd

In this case, the unrealised profit in closing inventory amounts to $2400 ($12 000 × 25 ÷ 125). In accordance with AASB 102, the inventory must be measured 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.

(f)

Dr Cost of goods sold 2 400

Cr Inventory (to eliminate the intragroup profit included in the closing inventory)

2 400

Tax attributable to unrealised profit in closing inventory held by Gryffindor Ltd From the group’s perspective, $2400 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 ($2400 × 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.

(g)

Dr Deferred tax asset 720

Cr Income tax expense (to reduce the group’s tax expense as a result of the elimination of the intragroup profit in closing inventory—$2400 × 30 per cent)

720

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 Retained earnings—1 July 2023 4 900

Dr Income tax expense 2 100

Cr Cost of goods sold (to eliminate the profit in opening inventory and to transfer the related profit to the current reporting period)

7 000

Adjustments for intragroup sale of plant On 1 July 2023 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 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.

WORKED EXAMPLE 27.4 continued

dee67382_ch27_1055-1102.indd 1087 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1087

continued

(i)

Dr Gain on sale of plant 35 000

Dr Plant 19 000

Cr Accumulated depreciation (to eliminate the effects of the intragroup sale of a non-current asset)

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 Hogwarts 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.

( j)

Dr Deferred tax asset 10 500

Cr Income tax expense (to reduce the tax expense of the group as a result of eliminating the intragroup profit in respect of the sale of a non-current asset)

10 500

Reinstating accumulated depreciation in the statement of financial position Gryffindor 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 amount 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 $5833 is therefore required.

(k)

Dr Accumulated depreciation 5 833

Cr Depreciation expense (to reduce the depreciation expense as a result of reducing the amount attributed to the depreciable asset)

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 $1750, which is $5833 × 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.

(l)

Dr Income tax expense 1 750

Cr Deferred tax asset (to recognise the increased tax expense as a result of the reduction in depreciation expenses)

1 750

Impairment of goodwill The total impairment of goodwill amounts to $25 500. Of this amount $3000 must be recognised in the current period, with $22 500 relating to a previous period’s impairment being offset against opening retained earnings.

dee67382_ch27_1055-1102.indd 1088 10/25/19 03:12 PM

1088 PART 8: Accounting for equity interests in other entities

(m)

Dr Retained earnings—1 July 2023 22 500

Dr Impairment loss—goodwill 3 000

Cr Accumulated impairment losses—goodwill (to recognise the current period and prior period impairment of goodwill)

25 500

As Hogwarts Ltd values the non-controlling interest at the proportionate share of Gryffindor Ltd’s identifiable net assets, there is no necessity to allocate any goodwill impairment expense between the parent and the non-controlling 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 Management fee revenue 26 500

Cr Management fee expense (to eliminate the intragroup management fees)

26 500

Implications for non-controlling interests: intragroup payment of management fees It is not necessary to make any adjustments to non-controlling interest in profits as the profits associated with the management fees are deemed to be fully realised.

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 financial statements.

(o)

Dr Dividend revenue 74 400

Cr Dividend paid (to eliminate intragroup dividend payment)

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. We need to determine:

(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.

Calculation of non-controlling interest in Gryffindor Ltd

Gryffindor Ltd ($)

20% Non- controlling

interest ($)

(i) Non-controlling interests on acquisition date

Share capital 200 000 40 000

Retained earnings—on acquisition 170 000 34 000

370 000 74 000

WORKED EXAMPLE 27.4 continued

dee67382_ch27_1055-1102.indd 1089 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1089

continued

Calculation of non-controlling interest in Gryffindor Ltd

Gryffindor Ltd ($)

20% Non- controlling

interest ($)

(ii) 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) 69 200

less Unrealised profit in inventory—1 July 2023 (7 000)

Tax effect on unrealised profits 2 100

64 300 12 860

(iii) Non-controlling interest in the current period’s profit and movements in reserves in the current period

Profit for the year 100 800

add Unrealised profit in inventory—1 July 2023—now realised 7 000

Tax effect on unrealised profit now realised (2 100)

less Unrealised profit in inventory—30 June 2024 (5 600)

Tax effect on unrealised profit 1 680

Profit Gryffindor contributed to the economic entity 101 780 20 356

Dividends paid by Gryffindor Ltd (93 000) (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 net assets. It would therefore be inappropriate to allocate any goodwill impairment expense against the profits of the subsidiary.

Non-controlling interests on acquisition date The non-controlling interest in contributed equity and reserves is transferred to the non-controlling interests.

(p)

Dr Share capital 40 000

Dr Retained earnings—1 July 2023 34 000

Cr Non-controlling interest (to recognise non-controlling interests on acquisition date. Given that the non-controlling interest is being measured at the proportionate share of Gryffindor Ltd’s identifiable net assets, no goodwill is attributed to the non-controlling interest)

74 000

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.

dee67382_ch27_1055-1102.indd 1090 10/25/19 03:12 PM

1090 PART 8: Accounting for equity interests in other entities

In this Worked Example, the unrealised profit on the sale of inventory at 1 July 2023 amounted to $7000. The reduction in profits will lead to a lower tax expense. At a tax rate of 30 per cent, an adjustment of $2100 ($7000 × 30 per cent), the tax effect on the unrealised profits, must be made. The 20 per cent 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 amounted to $12 860.

(q)

Dr Retained earnings—1 July 2023 12 860

Cr Non-controlling interest (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)

12 860

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 2023 now realised

At 1 July 2023 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 2024

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 2024 amounted to $5600. The reduction in profits will lead to a lower tax expense. At a tax rate of 30 per cent an adjustment of $1680 ($5600 × 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.

(r)

Dr Non-controlling interest in earnings 20 356

Cr Non-controlling interest (recognising non-controlling interest in the current period’s profit and movements in reserves in the current period)

20 356

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.

(s)

Dr Non-controlling interest 18 600

Cr Dividends paid (recognising reduction of non-controlling interest due to dividends paid by Gryffindor Ltd)

18 600

WORKED EXAMPLE 27.4 continued

dee67382_ch27_1055-1102.indd 1091 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1091

continued

Eliminations and adjustments

Hogwarts Ltd

($000)

Gryffindor Ltd

($000) Dr

($000) Cr

($000)

Consolidated statements

($000)

Detailed reconciliation of opening and closing retained earnings

Sales revenue 690 580 52(b) 1 153

65(e)

Cost of goods sold (464) (238) 5.6(c) 52(b) (586)

2.4(f) 65(e)

7(h)

Gross profit 226 342 567

Other revenue –

Dividends received—from Gryffindor 74.4 – 74.4(o) –

Management fee revenue 26.5 26.5(n) –

Gain on sale of plant 35 35(i) –

Expenses

Administrative expenses (30.8) (38.7) (69.5)

Depreciation (24.5) (56.8) 5.833(k) (75.467)

Management fee expense – (26.5) 26.5(n) –

Other expenses (101.1) (77) 3(m) (181.1)

Profit before tax 205.5 143 240.933

Tax expense (61.5) (42.2) 2.1(h) 1.68(d) (94.65)

1.75(l) 0.72(g)

10.5( j)

Profit for the year 144 100.8 1 46.283

Non-controlling interest in profit after tax 20.356(r) (20.356)

Parent entity interest in profit after tax 125.927

Retained earnings—1 July 2023 319.4 239.2 136(a) 348.34

463.4 340 4.9(h) 474.267

22.5(m)

34(p)

12.86(q)

Dividends paid (137.4) (93) 74.4(o) 18.6(s)

(137.4)

Retained earnings—30 June 2024 326 247 336.867

Now we can post the consolidation journal entries to the consolidation worksheet.

dee67382_ch27_1055-1102.indd 1092 10/25/19 03:12 PM

1092 PART 8: Accounting for equity interests in other entities

Eliminations and adjustments

Hogwarts Ltd

($000)

Gryffindor Ltd

($000) Dr

($000) Cr

($000)

Consolidated statements

($000)

Statement of financial position

Shareholders’ equity

Retained earnings 326 247 336.867

Share capital 350 200 160(a) 40(p)

350

Non-controlling interest 18.6(s) 74(p) 12.86(q)

88.616

20.356(r)

Current liabilities

Accounts payable 54.7 46.3 101

Tax payable 41.30 25 66.3

Non-current liabilities

Loans 173.5 116 289.5

945.5 634.3 1 232.283

Current assets

Accounts receivable 59.4 62.3 121.7

Inventory 92 29 5.6(c) 113

2.4(f)

Non-current assets

Deferred tax asset 1.68(d) 1.75(l) 11.15

0.72(g)

10.5( j)

Land and buildings 224 326 550

Plant—at cost 299.85 355.8 19(i) 674.65

Accumulated depreciation (85.75) (138.8) 5.833(k) 54(i) (272.717)

Investment in Gryffindor Ltd 356 – 356(a) –

Goodwill – – 60(a) 60

Accumulated impairment loss – – 25.5(m) (25.5)

945.5 634.3 814.699 814.699 1 232.283

Summary of non-controlling interest

20% Non-controlling interest

Profit

Profit of Gryffindor Ltd 100 800 20 160

Adjustments

Unrealised profit in opening inventory 4 900 980

WORKED EXAMPLE 27.4 continued

dee67382_ch27_1055-1102.indd 1093 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1093

continued

20% Non-controlling interest

Unrealised profit in closing inventory (3 920) (784) 20 356

Opening retained earnings

Opening retained earnings of Gryffindor Ltd 239 200 47 840

Unrealised profit in opening inventory (4 900) (980) 46 860

Dividends

Paid by Gryffindor Ltd (93 000) (18 600) (18 600)

Non-controlling interest in closing retained earnings

48 616

Non-controlling interest in share capital 200 000 40 000 40 000

Total non-controlling interest 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 2024

The Group ($)

Hogwarts Ltd ($)

Sales 1 153 000 690 000

Cost of goods sold (586 000) (464 000)

Gross profit 567 000 226 000

Dividend revenue 74 400

Management fee revenue 26 500

Gain on sale of plant 35 000

Administrative expenses (69 500) (30 800)

Depreciation (75 467) (24 500)

Other expenses (181 100) (101 100)

Profit before income tax expense 240 933 205 500

Income tax expense (94 650) (61 500)

Profit after income tax expense 146 283 144 000

Other comprehensive income – –

Total comprehensive income 146 283 144 000

Profit after income tax attributable to:

Owners of the parent 125 927 144 000

Non-controlling interest 20 356 –

146 283 144 000

Total comprehensive income attributable to:

Owners of the parent 125 927 144 000

Non-controlling interest 20 356 –

146 283 144 000

dee67382_ch27_1055-1102.indd 1094 10/25/19 03:12 PM

1094 PART 8: Accounting for equity interests in other entities

Consolidated statement of financial position of Hogwarts Ltd and its subsidiaries as at 30 June 2024

The Group ($)

Hogwarts Ltd ($)

Current assets

Accounts receivable 121 700 59 400

Inventory 113 000 92 000

234 700 151 400

Non-current assets

Land and buildings 550 000 224 000

Plant and equipment 674 650 299 850

less Accumulated depreciation (272 717) (85 750)

Goodwill 60 000 –

less Accumulated impairment loss (25 500) –

Investment in Gryffindor Ltd – 356 000

Deferred tax asset 11 150 –

997 583 794 100

Total assets 1 232 283 945 500

Current liabilities

Accounts payable 101 000 54 700

Tax payable 66 300 41 300

167 300 96 000

Non-current liabilities

Loan 289 500 173 500

Total liabilities 456 800 269 500

Shareholders’ equity

Share capital 350 000 350 000

Retained earnings 336 867 326 000

Total parent entity interest in equity 686 867 676 000

Non-controlling interest in equity 88 616 –

Total equity 775 483 676 000

1 232 283 945 500

Hogwarts Ltd and its controlled entity Consolidated statement of changes in equity for the year ended 30 June 2024

Attributable to owners of the parent

Share capital

($)

Retained earnings

($) Total

($)

Non- controlling

interest ($)

Total equity

($)

Balance at 1 July 2023 350 000 348 340 698 340 86 860 785 200

Total comprehensive income for the year 125 927 125 927 20 356 146 283

Distributions (137 400) (137 400) (18 600) (156 000)

Balance at 30 June 2024 350 000 336 867 686 867 88 616 775 483

WORKED EXAMPLE 27.4 continued

dee67382_ch27_1055-1102.indd 1095 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1095

Hogwarts Ltd Statement of changes in equity for the year ended 30 June 2024

Share capital

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2023 350 000 319 400 669 400

Total comprehensive income for the year 144 000 144 000

Distributions (137 400) (137 400)

Balance at 30 June 2024 350 000 326 000 676 000

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, being intragroup transactions, 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, the parent entity’s share of post-acquisition movements in the retained earnings and reserve of the subsidiary, as well as the share capital and reserves of the subsidiary that are attributable to the non-controlling interest. The parent entity’s interest in the pre-acquisition share capital and reserves will be eliminated on consolidation.

KEY TERM

parent entity 1056

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following four questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is a non-controlling interest, and how should it be disclosed within the consolidated financial statements? LO 27.1, 27.2 Non-controlling interests are the equity interests in the subsidiary that are not held by the parent entity. Non-controlling interests exist when a subsidiary is partly owned by a parent entity. The non-controlling interests would be measured each period and the total amount attributed to the non-controlling interests will be shown separately within the equity

dee67382_ch27_1055-1102.indd 1096 10/25/19 03:12 PM

1096 PART 8: Accounting for equity interests in other entities

(shareholders’ funds) section of the balance sheet. Also, within the statement of profit or loss and other comprehensive income, the consolidated financial statements shall disclose the profit or loss for the period attributable to non- controlling interests, as well as the total comprehensive income attributable to the non-controlling interests.

2. Is the non-controlling interest considered to be debt, or equity, within the consolidated financial statements? LO 27.1, 27.2 Following on from the above answer, the non-controlling interests would be considered as part of the equity of the group. The non-controlling interests have an ownership interest in the group.

3. If there is a purchase transaction between the parent entity and a 60 per cent-owned subsidiary that 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 27.4 There is a requirement to eliminate, in full, the effects of intragroup transactions. This requirement is maintained whether or not there are non-controlling interests in the subsidiaries.

4. 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 27.3 Consistent with the answer above, all of the assets and liabilities of a subsidiary (subject to eliminations in respect of intragroup transactions) shall be included within the consolidated financial statements, regardless of whether there are non-controlling interests in the subsidiary.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

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 27.1, 27.3 •

2. If the assets of a subsidiary are reported at below fair value in the balance sheet at the date of acquisition, and a fair value adjustment is not undertaken as part of the consolidation process, will goodwill be overstated? Why or why not? LO 27.3 •

3. What is a non-controlling interest, and how should it be disclosed? LO 27.1, 27.2 • 4. There are two approaches to measuring non-controlling interests, each of which will lead to a different amount being

attributed to reported goodwill. Will the choice of either method of accounting for non-controlling interests impact any goodwill impairment expenses that might subsequently be recognised? LO 27.3 •

5. Why does AASB 3 provide a choice in how to measure non-controlling interests? LO 27.3 • 6. Do we make adjustments to the non-controlling interests’ share of profit when an intragroup transaction affects the

subsidiary’s profit or loss, or the parent entity’s profit or loss, or both? LO 27.1, 27.4 • 7. In the presence of non-controlling interests, if dividends are declared by a subsidiary and by a parent entity, which

dividends payable will be shown in the consolidated balance sheet? LO 27.1, 27.4 • 8. Do dividends declared and paid by a partly owned subsidiary reduce the non-controlling interest in that subsidiary?

LO 27.3 • 9. Could the non-controlling interests control, in total, more than 50 per cent of the total shareholding of a subsidiary?

LO 27.1 • 10. How are non-controlling interests affected by intragroup transactions? LO 27.1, 27.4 • 11. 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 27.3, 27.4 •• 12. 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 $ 8 million

Retained earnings $ 2 million

$10 million

dee67382_ch27_1055-1102.indd 1097 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1097

(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 acquiree is measured at fair value?

(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 acquiree is measured at the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets?

(c) What are some of the implications of allowing the group to have two options in accounting for goodwill on consolidation? LO 27.3 ••

13. Backbeach Ltd acquired a 70 per cent interest in another entity, Frontbeach Ltd, in 2019 for a cost of $5 million. There was no goodwill or bargain gain on purchase. The consolidation worksheet for Backbeach Ltd and its controlled entity as at 30 June 2023 included the following:

Parent ($000)

Consolidated ($000)

Revenue 2 000 5 000

Cost of goods sold 400 1 500

Dividend revenue 1 000 200

Interest expense 50 100

Depreciation expense 100 50

Other expenses 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. LO 27.2, 27.3, 27.4 ••

14. Kelly Ltd acquired 70 per cent of the share capital of Slater Ltd on 1 July 2022 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 180 000

Retained earnings 50 000

Revaluation surplus 60 000

290 000

On 15 August 2022 Slater Ltd paid a $50 000 dividend out of pre-acquisition earnings to all shareholders that held shares at 10 July 2022. Non-controlling interest in the acquiree is measured at fair value.

REQUIRED Using the above information, prepare the consolidation adjustments and eliminations required for the year ended 30 June 2023. LO 27.3, 27.4 ••

15. Layne Ltd acquired 90 per cent of the share capital of Beachly Ltd on 1 July 2022 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 2022 were:

$

Share capital 350 000

Retained earnings 100 000

450 000

Additional information • The management of Layne Ltd values any non-controlling interest at the proportionate share of Beachly Ltd’s

identifiable net assets. • Beachly Ltd had a profit after tax of $70 000 for the year ended 30 June 2023. • During the financial year to 30 June 2023 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 2023.

dee67382_ch27_1055-1102.indd 1098 10/25/19 03:12 PM

1098 PART 8: Accounting for equity interests in other entities

• During the year Beachly Ltd paid $10 000 in management fees to Layne Ltd. • On 1 July 2022 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 2023 and, based on the information provided above, calculate the non-controlling interests in the 2023 profits. LO 27.3, 27.4 •••

16. On 1 July 2021 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 $3 000 000

Retained earnings $1 400 000

$4 400 000

As at 30 June 2023 (two years after the date of acquisition) the financial statements of the two companies are as follows:

Anderson Ltd ($000)

Thruster Ltd ($000)

Detailed reconciliation of opening and closing retained earnings

Sales revenue 800 200

Cost of goods sold (200) (80)

Other expenses (120) (60)

Other revenue 310 85

Profit 790 145

Tax (170) (35)

Profit after tax 620 110

Retained earnings—1 July 2022 2 000 1 600

2 620 1 710

Dividends paid (400) (80)

Retained earnings—30 June 2023 2 220 1 630

Statement of financial position

Shareholders’ equity

Retained earnings 2 220 1 630

Share capital 8 000 3 000

Current liabilities

Accounts payable 120 80

Non-current liabilities

Loans 1 200 500

11 540 5 210

Current assets

Cash 300 50

Accounts receivable 500 350

Inventory 1 000 600

dee67382_ch27_1055-1102.indd 1099 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1099

continued

Anderson Ltd ($000)

Thruster Ltd ($000)

Non-current assets

Land 2 800 2 210

Plant 2 940 2 000

Investment in Thruster Ltd 4 000 –

11 540 5 210

Additional information • The management of Anderson Ltd measures any non-controlling interest in Thruster Ltd at fair value. • During the 2023 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

17. On 1 July 2021 Borris Ltd purchased 80 per cent of the shares of Natasha Ltd for $8 million. On 1 July 2021 the shareholders’ funds of Natasha Ltd were:

Share capital $5 500 000

Retained earnings $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 carrying amount. • On 30 June 2023 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 2023 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 2023, half of this inventory had been sold by Borris Ltd.

• On 1 July 2022 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 and is depreciated using the straight-line method of depreciation.

• 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 2023

Borris Ltd ($)

Natasha Ltd ($)

Sales 5 200 000 1 550 000

Cost of goods sold (3 000 000) (500 000)

Gross profit 2 200 000 1 050 000

Other revenues 200 000 150 000

Other expenses (400 000) (200 000)

dee67382_ch27_1055-1102.indd 1100 10/25/19 03:12 PM

1100 PART 8: Accounting for equity interests in other entities

Borris Ltd ($)

Natasha Ltd ($)

Profit before income tax expense 2 000 000 1 000 000

Income tax expense (500 000) (350 000)

Profit after income tax expense 1 500 000 650 000

Statement of financial position of Borris Ltd and Natasha Ltd as at 30 June 2023

Borris Ltd ($)

Natasha Ltd ($)

Current assets

Cash 250 000 300 000

Accounts receivable 650 000 250 000

Dividends receivable 40 000 –

Inventory 2 800 000 1 200 000

Non-current assets

Land 4 910 000 3 450 000

Plant 7 500 000 5 000 000

Accumulated depreciation (1 500 000) (1 000 000)

Investment in Natasha Ltd 8 000 000 –

Deferred tax assets 250 000 1 100 000

Total assets 22 900 000 10 300 000

Current liabilities

Accounts payable 250 000 100 000

Dividends payable – 50 000

Non-current liabilities

Loans 650 000 150 000

Total liabilities 900 000 300 000

Shareholders’ equity

Share capital 15 000 000 5 500 000

Retained earnings 7 000 000 4 500 000

Total equity 22 000 000 10 000 000

22 900 000 10 300 000

Borris Ltd Statement of changes in equity for the year ended 30 June 2023

Share capital ($)

Retained earnings

($) Total

($)

Balance at 1 July 2022 15 000 000 6 000 000 21 000 000

Total comprehensive income for the year 1 500 000 1 500 000

Distributions—interim (500 000) (500 000)

Balance at 30 June 2023 15 000 000 7 000 000 22 000 000

dee67382_ch27_1055-1102.indd 1101 10/25/19 03:12 PM

CHAPTER 27: Further consolidation issues II: accounting for non-controlling interests 1101

Natasha Ltd Statement of changes in equity for the year ended 30 June 2023

Share capital ($)

Retained earnings ($)

Total ($)

Balance at 1 July 2022 5 500 000 4 000 000 9 500 000

Total comprehensive income for the year 650 000 650 000

Distributions—interim (100 000) (100 000)

Distributions—final (50 000) (50 000)

Balance at 30 June 2023 5 500 000 4 500 000 10 000 000

REQUIRED (a) Prepare the consolidation worksheet journal entries for Borris Ltd and its controlled entity as at 30 June 2023

and post them to a consolidation worksheet. (b) Calculate the non-controlling interest in profit and equity as at 30 June 2023. (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 27.2, 27.3, 27.4

18. The following financial statements of Mark Ltd and its subsidiary Richards Ltd have been extracted from their financial records at 30 June 2023.

Mark Ltd ($)

Richards Ltd ($)

Detailed reconciliation of opening and closing retained earnings

Sales revenue 1 725 000 1 450 000

Cost of goods sold (1 160 000) (595 000)

Gross profit 565 000 855 000

Dividend revenue—from Richards Ltd 186 000 –

Management fee revenue 66 250 –

Profit on sale of plant 87 500 –

Expenses

Administrative expenses (77 000) (96 750)

Depreciation (61 250) (142 000)

Management fee expense – (66 250)

Other expenses (252 750) (192 500)

Profit before tax 513 750 357 500

Tax expense (153 750) (105 500)

Profit for the year 360 000 252 000

Retained earnings—1 July 2022 798 500 598 000

1 158 500 850 000

Dividends paid (343 500) (232 500)

Retained earnings—30 June 2023 815 000 617 500

Statement of financial position

Shareholders’ equity

Retained earnings 815 000 617 500

Share capital 875 000 500 000

continued

dee67382_ch27_1055-1102.indd 1102 10/25/19 03:12 PM

1102 PART 8: Accounting for equity interests in other entities

Mark Ltd ($)

Richards Ltd ($)

Current liabilities

Accounts payable 136 750 115 750

Tax payable 103 250 62 500

Non-current liabilities

Loans 433 750 290 000

2 363 750 1 585 750

Current assets

Accounts receivable 148 500 155 750

Inventory 230 000 72 500

Non-current assets

Land and buildings 560 000 815 000

Plant—at cost 749 625 889 500

Accumulated depreciation (214 375) (347 000)

Investment in Richards Ltd 890 000 –

2 363 750 1 585 750

Other information • Mark Ltd had acquired its 80 per cent interest in Richards Ltd on 1 July 2014, that is, nine years earlier. At that date

the capital and reserves of Richards Ltd were:

Share capital $500 000

Retained earnings $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 2022 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 $7500 in the current financial year. Previous impairments of goodwill amounted to $56 250.

• On 1 July 2022 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 2023. LO 27.2, 27.3, 27.4

dee67382_ch28_1103-1154.indd 1103 10/25/19 12:11 PM

1103

LEARNING OBJECTIVES (LO) 28.1 Understand what direct and indirect ownership interests represent, and understand that

the determination of the total parent and non-controlling interest in a subsidiary must take account of both direct and indirect ownership interests.

28.2 Understand how to calculate the parent entity interest and the non-controlling interest in a subsidiary when there are both direct and indirect ownership interests, and where multiple subsidiaries were acquired on the same date.

28.3 Understand how to calculate the parent entity interest and the non-controlling interest in a subsidiary when there are both direct and indirect ownership interests, and where multiple subsidiaries were acquired on different dates (for example, where the parent entity acquires the ownership interest in an intermediate subsidiary before, or after, the intermediate subsidiary acquires an ownership interest in another subsidiary).

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

C H A P T E R 28 Further consolidation issues III: accounting for indirect ownership interests

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. If the indirect ownership interests of a parent entity in a subsidiary are being discussed, what is this discussion referring to? LO 28.1

2. What is an indirect non-controlling interest in a subsidiary? LO 28.1 3. Can an entity be considered a controlled entity (that is, a subsidiary) of another entity (the parent) even if that

other entity (the parent) has no direct ownership interest in the subsidiary? LO 28.1 4. On consolidation, when we eliminate the parent entity’s investment in the subsidiary against the pre-acquisition

capital and reserves of the subsidiary, do we take account of only the direct ownership interests of the parent entity, or both the direct and indirect ownership interests? LO 28.1, 28.2

5. On consolidation, post-acquisition movements in the reserves, retained earnings and profits of a subsidiary will be included in the consolidated financial statements. However, they will need to be apportioned between the parent entity’s interest and the non-controlling interests. In undertaking this apportionment, should we take account of only the direct ownership interests, or both the direct and indirect ownership interests? LO 28.2, 28.3

dee67382_ch28_1103-1154.indd 1104 10/25/19 12:11 PM

1104 PART 8: Accounting for equity interests in other entities

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

10 Consolidated Financial Statements IFRS 10

102 Inventories IAS 2

112 Income Taxes IAS 12

28.1 Introduction to accounting for indirect ownership interests

In the previous chapters we have explored the process of consolidation where there are only two organisations within the economic entity. In Chapters 25 and 26 we considered how to account for a parent entity having

100 per cent ownership of a subsidiary. Chapter 26 explored how to account for various intragroup transactions. In Chapter 27 we continued to examine group structures comprising only two separate entities—a parent and a subsidiary— however, we reduced the parent entity’s ownership interest to less than 100 per cent and thereby introduced the concept of non-controlling interests. We showed how to calculate and disclose these direct non-controlling interests and how to account for intragroup transactions in the presence of non-controlling interests.

In this chapter we look at economic entities with more than one subsidiary and create situations in which a parent entity controls a subsidiary indirectly; in other words, we consider situations in which a parent entity controls another entity by virtue of its control of an intermediate subsidiary. As we will see, if a subsidiary that is controlled by the parent entity in turn has ownership interests in another entity, this creates what we will refer to as ‘indirect ownership interests’. These ownership interests are held by parent entities as well as by non-controlling interests. So in this chapter we consider not only how to consolidate the financial statements of more than two separate entities within an economic entity, but also how to calculate parent entity interests and non-controlling interests in the presence of both direct and indirect ownership interests.

Indirect ownership interests As we know, consolidated financial statements are defined in AASB 10 Consolidated Financial Statements. The standard defines them 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. (AASB 10)

In turn, a subsidiary is defined as ‘an entity that is controlled by another entity’. In terms of when an investee is required to be consolidated and therefore be designated as a subsidiary, paragraph 20 of AASB 10 requires:

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. (AASB 10)

As we also know from previous chapters, and as we can see above, ‘control’ is the criterion for determining whether an entity is a subsidiary. According to paragraphs 6 and 7 of AASB 10:

6. An investor controls an investee when it 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.

7. Thus, an investor controls an investee if and only if the investor has all the following:

LO 28.1

control (organisations) With regards to related parties and other organisations within a group (economic entity), control means the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.

(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). (AASB 10)

‘Control’ can be exercised even in the absence of any direct ownership interest—it can arise through indirect ownership interests. That is, if an entity has a controlling ownership in one entity, it effectively has control over the other entities controlled by that entity. That is, it is possible for one entity to control another entity without any direct ownership interest.

dee67382_ch28_1103-1154.indd 1105 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1105

For example, in Figure 28.1 the parent entity controls A Ltd as a result of a direct ownership interest of 70 per cent. Through its control of A Ltd, the parent entity can, in turn, control B Ltd, even though no investments have been made directly by the parent entity in B Ltd. The control is exercised through an indirect ownership interest (that is, via its direct ownership interest in A Ltd). In Figure 28.1 the indirect interests are depicted by broken-line arrows, and the direct ownership interests by solid-line arrows.

In this example, the parent entity’s indirect interest in B Ltd would be 42 per cent; that is, 70 per cent of 60 per cent. This means that if B Ltd pays a dividend of $1000, $600 would be paid to A Ltd and $400 would be paid to the direct non-controlling interests in B Ltd. If A Ltd receives the $600 and decides in turn to pay out the entire receipts as dividends, 70 per cent ($420) of the $600 would find its way to the parent entity (or 42 per cent of the original $1000 dividend payment made by B Ltd). The remaining $180 would go to the non-controlling interests of A Ltd. That is, the non-controlling interests in A have an indirect ownership interest (indirect non-controlling interest) in B Ltd of 18 per cent. The ownership interests are summarised in Table 28.1.

It is also possible to hold both direct and indirect interests in a particular entity. In the example shown in Figure 28.2, the parent entity has direct ownership interests of 70 per cent and 60 per cent in Subsidiary 1 and Subsidiary 3, respectively. In the absence of evidence to the contrary, this should be sufficient to control both subsidiaries. Through its control of Subsidiary 1, the parent entity would also be able to control Subsidiary 2—although the control would be indirect as the parent entity has no direct ownership interest in Subsidiary 2.

As was done in Figure 28.1, the direct and indirect ownership interests in Subsidiary 1, Subsidiary 2 and Subsidiary 3 are indicated by solid and broken arrows, respectively. You should see whether you understand how the various percentages next to each of the arrows has been calculated. The interests that we need to know for the purposes of the consolidated financial statements are the parent entity’s interests (direct and indirect) and the non-controlling interests (direct and indirect).

To obtain the direct and indirect ownership interests of the parent entity we would add together the percentages shown against each of the arrows emanating from the parent entity. For example, the total direct ownership interest in

Figure 28.1 Example of control being exercised through an indirect interest

18%

Parent entity

A Limited

B Limited

70%

60%

42%

40%

30%

Non-controlling interest

Non-controlling interest

non-controlling interests That portion of the profit or loss and net assets of a subsidiary attributable to equity interests that are not owned by the parent.

A Ltd (% interest) B Ltd (% interest)

Parent entity interest

Direct 70 –

Indirect – 42

Non-controlling interest

Direct   30   40

Indirect     –   18

100 100

Table 28.1 Ownership interests in A and B Ltd

dee67382_ch28_1103-1154.indd 1106 10/25/19 12:11 PM

1106 PART 8: Accounting for equity interests in other entities

Subsidiary 3 would be 60 per cent, whereas the parent entity’s indirect ownership interest in Subsidiary 3 would be 16.8 per cent. This 16.8 per cent is calculated by multiplying the parent entity’s ownership interest in Subsidiary 1 by the ownership interest Subsidiary 1 has in Subsidiary 2, by the ownership interest Subsidiary 2 has in Subsidiary 3, which is 70 per cent × 60 per cent × 40 per cent, which equals 16.8 per cent.

When considering the non-controlling interests we see that the direct non-controlling interests in Subsidiary 1 has an indirect interest in Subsidiary 2 and Subsidiary 3. The direct non-controlling interest in Subsidiary 2 has an indirect non-controlling interest in Subsidiary 3 (again, direct ownership interests are depicted by solid lines). The respective parent entity and non-controlling interests are summarised in Table 28.2.

As we can see in Figure 28.2, the direct ownership interests (which include the direct parent entity interests and the direct non-controlling interests)—represented by solid lines—add up to 100 per cent for all the subsidiaries. As stated above, to determine the parent entity interest in all subsidiaries we only look at the arrows emanating from the parent entity box. So, looking at Subsidiary 2, we can see that the parent entity interest is indirect and is 42 per cent. The non-controlling interest will be direct (40 per cent) and indirect (18 per cent), giving a total non-controlling interest of 58 per cent. Adding the total parent entity interest (direct and indirect) to the total non-controlling interest (direct and indirect) must give 100 per cent.

Similarly, for Subsidiary 3, the parent entity has a mixture of both direct and indirect ownership interests, which add up to 76.8 per cent in total, while the non-controlling interests, also a mix of direct and indirect interests, total 23.2 per cent.

Figure 28.2 Where a parent entity holds both a direct and an indirect interest in a subsidiary

Parent entity

Subsidiary 1

70%

60%

30%

7.2%

18%

16%

40%

40%

42%

60%

16.8%

Subsidiary 2

Subsidiary 3 Non-controlling

interest

Non-controlling interest

Subsidiary 1 (% interest)

Subsidiary 2 (% interest)

Subsidiary 3 (% interest)

Parent entity interest

Direct 70 – 60

Indirect – 42 16.8*

Non-controlling interest

Direct 30 40 –

Indirect      –    18    23.2**

100 100 100

Table 28.2 Direct and indirect interests in a subsidiary

*16.8 = 100 × 0.7 × 0.6 × 0.4 **23.2 = 100 × [(0.3 × 0.6 × 0.4) + (0.4 × 0.4)]

dee67382_ch28_1103-1154.indd 1107 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1107

28.2 Calculating the parent entity interest, and the non-controlling interest, in the presence of indirect interests

But why are we spending all this time working out:

∙ direct and indirect parent entity interests, and ∙ direct and indirect non-controlling interests?

After all, it does seem to require a lot of effort. As we will see, we need to have these details to determine the non-controlling interests in profits and capital and reserves, which will need to be disclosed in the economic entity’s financial statements (as we explained in Chapter 27). For example, as we will learn shortly:

∙ the elimination of the parent entity’s investment in a subsidiary will be done by eliminating the investment against the parent entity’s direct ownership interest in pre-acquisition share capital and reserves

∙ the parent entity interest in post-acquisition profits and post-acquisition movements in reserves will be based on the combined total of the parent entity’s direct and indirect interests

∙ the non-controlling interest in pre-acquisition capital and reserves will be based on the direct non-controlling interest only

∙ the non-controlling interest in post-acquisition movement in reserves and post-acquisition profits will be based on the combined sum of both direct non-controlling interest and indirect non-controlling interest.

In Worked Example 28.1, we will consider, in more detail, the consolidation process in the presence of indirect interests.

WHY DO I NEED TO KNOW WHAT AN INDIRECT OWNERSHIP INTEREST REPRESENTS?

In our professional lives we will be exposed to consolidated financial statements. The ultimate parent entity will not always have any direct ownership interest in some organisations, yet as a result of indirect control exercised through another organisation, these organisations will be deemed to be subsidiaries and will therefore be included within the group. To understand the meaning of the group, or economic entity, we therefore need to understand this. To understand the context of the consolidated financial statements we need to understand, too, that the consolidated financial statements will also include the assets and liabilities and post-acquisition movements in reserves of subsidiaries in which the ultimate parent of the group has no direct ownership interest.

LO 28.2

WORKED EXAMPLE 28.1: Consolidation in the presence of indirect interests

Assume that on 1 July 2022, Burridge Ltd acquires 70 per cent of the issued capital of Anderson Ltd and, on the same date, Anderson Ltd acquires 60 per cent of the issued capital of Menser Ltd. The group’s structure would appear as shown in Figure 28.3.

Burridge Ltd has no direct ownership interest in Menser Ltd. Burridge Ltd’s ownership interest (indirect) in Menser Ltd would be 42 per cent (70 per cent of 60 per cent). Because we have assumed that Anderson Ltd’s 60 per cent direct ownership of Menser Ltd allows Anderson Ltd to control Menser Ltd, Burridge Ltd controls Menser Ltd indirectly through its control of Anderson Ltd. That is, even in the absence of direct shareholding, Menser Ltd would be considered a subsidiary of Burridge Ltd. This is consistent with the definition of ‘subsidiary’ provided earlier. Burridge Ltd would be described as the ultimate parent entity of the group, as well as the immediate parent entity of Anderson Ltd. Anderson Ltd would be described as the immediate parent entity of Menser Ltd.

The direct and indirect interests in Anderson Ltd and Menser Ltd can be represented as in Table 28.3. Note that the indirect non-controlling interest in Menser Ltd of 18 per cent is derived by multiplying the 30 per

cent non-controlling interest in Anderson Ltd by the ownership interest Anderson Ltd has in Menser Ltd (60 per cent). There is a choice between two methods when performing the consolidation. The first method is the

sequential-consolidation approach, which, if there are numerous subsidiaries, would be time consuming and rather messy as consolidation of each separate legal entity with its controlled entities would be performed

continued

dee67382_ch28_1103-1154.indd 1108 10/25/19 12:11 PM

1108 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.1 continued

sequentially. Adopting the sequential-consolidation method, it would be necessary first to consolidate Anderson Ltd with Menser Ltd, and then sequentially consolidate Burridge Ltd with the Anderson–Menser group (working backwards from the most distant subsidiary).

Alternatively, we could adopt a multiple-consolidation approach, which is the method advocated in this book. When using the multiple-consolidation approach, the following general principles should be followed:

• In eliminating the investments held by the immediate parent entities (the investments as they would appear in the separate legal entities’ financial statements), only direct ownership interests are taken into account.

• Post-acquisition movements in the subsidiaries’ shareholders’ equity are allocated to the ultimate parent entity on the basis of the sum of the direct and indirect ownership interests.

Hence, indirect interests are relevant only for apportioning post-acquisition movements in shareholders’ equity. Any pre-acquisition allocations or distributions are to be apportioned to the parent and to the non- controlling interest on the basis of direct ownership interests only.

We will assume that Burridge Ltd acquires the 70 per cent interest in Anderson Ltd on 1 July 2022 for a cost of $1 million representing the fair value of consideration transferred. All assets are assumed to be fairly valued in the books of Anderson Ltd. The share capital and reserves of Anderson Ltd at the date of acquisition are:

Share capital $ 1 000 000

Retained earnings $ 300 000

$ 1 300 000

Figure 28.3 Group structure of Burridge Ltd and its controlled entities

Burridge Ltd

Anderson Ltd

70%

60%

42%

Menser Ltd

40%

30%

18%

Non-controlling interest

Non-controlling interest

in Anderson Ltd (% interest) in Menser Ltd (% interest)

Burridge Ltd’s interest

Direct 70 –

Indirect – 42

Non-controlling interest

Direct 30 40

Indirect      –   18

100 100

Table 28.3 Direct and indirect interests in Anderson Ltd and Menser Ltd

dee67382_ch28_1103-1154.indd 1109 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1109

The management of Burridge Ltd values any non-controlling interest at the proportionate share of Anderson Ltd’s identifiable net assets.

Anderson acquires the 60 per cent interest in Menser Ltd on 1 July 2022 for $800 000 representing the fair value of consideration transferred. All assets are assumed to be fairly valued in the books of Menser Ltd. The share capital and reserves of Menser Ltd at the date of acquisition are:

Share capital $ 800 000

Retained earnings $ 400 000

$ 1 200 000

The non-controlling interest in Menser Ltd is valued at fair value. As noted above, in the consolidation process the elimination of the investment will be based on the direct

ownership interests of the immediate parent entity, whereas the allocation of post-acquisition profits and movements in reserves will be based on the ultimate parent entity’s direct and indirect interests.

Similarly, the non-controlling interest in pre-acquisition capital and reserves will be based on the non- controlling interest’s direct ownership interest, whereas the allocation of the non-controlling interest’s share in post-acquisition profits and movements in reserves will be based on the total of the direct and indirect non- controlling interests.

It must be remembered that preparers of financial statements have the choice about how to measure the non-controlling interests at acquisition in each business combination. For example, and as we have already indicated in previous chapters, reporting entities can use fair value for one business combination and the proportionate share of the acquiree’s net identifiable assets for another business combination. As the information in this Worked Example has already indicated:

• The non-controlling interest in Anderson Ltd at acquisition is to be measured at the non-controlling interest’s proportionate share of Anderson Ltd’s identifiable net assets.

• The non-controlling interest in Menser Ltd at acquisition is to be measured at fair value.

As we know from Chapter 27, the choice of how to account for non-controlling interests at acquisition will have direct implications for the amount of goodwill recognised on consolidation and how any subsequent goodwill impairment expenses will be allocated among the separate legal entities. Where non-controlling interests are valued at fair value at acquisition date this means that total goodwill on consolidation will include an amount that has been allocated to the non-controlling interests (that is, the goodwill will be increased beyond the amount purchased by the acquirer). Further, for the purposes of determining non-controlling interests in profits or losses, any subsequent goodwill impairment expense will be apportioned to the non-controlling interest.

Conversely, where non-controlling interests are valued at the proportionate share of the acquiree’s identifiable net assets at acquisition date, this means that total goodwill on consolidation will include only the amount purchased by the parent. Also, for the purposes of determining non-controlling interests in profits or losses, any subsequent goodwill impairment expense will not be apportioned to the non-controlling interests if non-controlling interests are valued at the proportionate share of the acquiree’s identifiable net assets at acquisition date.

An extract of the statements of profit or loss and other comprehensive income, statements of changes in equity and statements of financial position of the entities at 30 June 2023 (one year after the acquisition) are as follows:

continued

Burridge Ltd ($000)

Anderson Ltd ($000)

Menser Ltd ($000)

Extract from statement of profit or loss and other comprehensive income Profit before tax 500 80 100 Tax (270) (25) (40) Profit after tax 230 55 60

dee67382_ch28_1103-1154.indd 1110 10/25/19 12:11 PM

1110 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.1 continued

Additional information It is assumed that in the year to 30 June 2023 there have been impairment losses in relation to the goodwill acquired in Anderson Ltd. The goodwill has been deemed to have been impaired by an amount of 10 per cent of its original balance. Similarly, the goodwill in Menser Ltd is considered to have been impaired by $13 333 in the year to 30 June 2023. All dividends were declared on 30 June 2023 and the decision to pay them communicated to shareholders on that date.

For the purposes of this illustration we will assume that apart from the dividends, there are no other intragroup transactions (this assumption will not apply in the next Worked Example).

REQUIRED Present 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 Burridge Ltd and its controlled entities as at 30 June 2023.

SOLUTION

Elimination of the cost of the investment and recognition of goodwill When eliminating the investment against the pre-acquisition capital and reserves of the subsidiaries, we consider only direct ownership interests.

Burridge Ltd ($000)

Anderson Ltd ($000)

Menser Ltd ($000)

Statement of changes in equity (extract) Retained earnings—1 July 2022 1 000 300 400 Profit after tax 230 55 60

1 230 355 460 Dividends declared (200) (50) (30) Retained earnings—30 June 2023 1 030 305 430

Statement of financial position Shareholders’ equity Retained earnings 1 030 305 430 Share capital 4 000 1 000 800 Current liabilities Accounts payable 170 40 – Dividends payable 200 50 30 Non-current liabilities Loans 400 250 –

5 800 1 645 1 260 Current assets Cash 165 37 100 Accounts receivable 250 175 200 Dividends receivable 35 18 – Inventory 500 300 400 Non-current assets Land 2 350 – 200 Plant 1 500 315 360 Investment in Anderson Ltd 1 000 – – Investment in Menser Ltd – 800 –

5 800 1 645 1 260

dee67382_ch28_1103-1154.indd 1111 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1111

Again, it should be noted that the approach to determining goodwill on acquisition will depend upon whether: • the non-controlling interest at acquisition date is measured at the non-controlling interest’s proportionate share

of the acquiree’s identifiable net assets (which means no goodwill will be attributed to the non-controlling interest, as in the case of Burridge’s investment in Anderson Ltd above, as it was decided by management that the non-controlling interest in Anderson Ltd would be measured at the non-controlling interest’s proportionate share of Anderson Ltd’s identifiable net assets), or

• the non-controlling interest at acquisition date is measured at fair value (which means goodwill will be attributed to the non-controlling interest, as in the case of Anderson’s investment in Menser Ltd above, as it was decided by management that the non-controlling interest in Menser Ltd would be measured at fair value at acquisition date).

Consolidation worksheet journal entries

(a) To eliminate Burridge Ltd’s investment in Anderson Ltd

continued

Elimination of investment in Anderson Ltd

Anderson Ltd ($)

Burridge Ltd’s 70% interest

($)

30% Non- controlling

interest ($)

Fair value of consideration transferred less Fair value of identifiable assets acquired and liabilities assumed

1 000 000

Share capital on acquisition date 1 000 000 700 000 300 000

Retained earnings on acquisition date 300 000 210 000 90 000

1 300 000 910 000

Goodwill on acquisition date 90 000 –

Non-controlling interest at date of acquisition 390 000

Elimination of investment in Menser Ltd Menser Ltd

($)

Anderson Ltd’s 60% interest

($)

40% Non- controlling

interest ($)

Fair value of consideration transferred 800 000 800 000

plus Non-controlling interest at fair value ($800 000 × 40/60) 533 333 533 333

1 333 333

less Fair value of identifiable assets acquired and liabilities assumed

Share capital on acquisition date 800 000 480 000 320 000

Retained earnings on acquisition date 400 000 240 000 160 000

1 200 000 720 000 480 000

Goodwill on acquisition date 133 333 80 000 53 333

Dr Share capital 700 000

Dr Retained earnings—1 July 2022 210 000

Dr Goodwill 90 000

Cr Investment in Anderson Ltd (to eliminate Burridge Ltd’s investment in Anderson Ltd. The elimination is based upon the parent entity’s direct ownership interest in the subsidiary)

1 000 000

dee67382_ch28_1103-1154.indd 1112 10/25/19 12:11 PM

1112 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.1 continued

(b) To eliminate Anderson Ltd’s investment in Menser Ltd

Dr Share capital 480 000

Dr Retained earnings—1 July 2022 240 000

Dr Goodwill 80 000

Cr Investment in Menser Ltd (to eliminate Anderson Ltd’s investment in Menser Ltd using Anderson Ltd’s direct ownership interest in Menser Ltd)

800 000

As we can see in the tables above, the total goodwill in Menser Ltd of $133 333 also includes an amount attributed to the non-controlling interest, this being $53 333. This amount will be recognised later in this Worked Example when we recognise the non-controlling interest in the net assets of Menser Ltd. At this stage we are only recognising the parent entity’s share of goodwill at acquisition date.

Goodwill impairment (c) Impairment of the goodwill associated with the acquisition of Anderson Ltd

Dr Impairment expense—goodwill 9 000

Cr Accumulated impairment losses—goodwill (to recognise goodwill impairment)

9 000

(d) Impairment of the goodwill associated with the acquisition of Menser Ltd

Dr Impairment expense—goodwill 13 333

Cr Accumulated impairment losses—goodwill (to recognise goodwill impairment)

13 333

It should be noted that the above impairment losses relate to the total amount of goodwill recognised on acquisition (see the previous tables).

An issue we will need to address subsequently is that, when we later calculate the non-controlling interest in profits or losses, to which entities will we attribute any goodwill impairments? Possible treatments would be to: 1. attribute the goodwill impairment losses to the ultimate parent entity in the Group (in this case, Burridge

Ltd) 2. attribute the goodwill impairment losses to the immediate parent entity of the subsidiary (in this case,

Anderson would be the immediate parent entity of Menser Ltd), or 3. attribute the goodwill impairment losses to the subsidiary itself.

While the accounting standards do not provide any clear guidelines, a choice between the three options must be made. It is the opinion of the author that the appropriate treatment of goodwill impairment losses relating to an investment in a subsidiary depends upon how the non-controlling interest is measured. From Chapter 27 we know there are two options in terms of how the non-controlling interest can be measured.

If it has been decided to adopt the option that allows the acquirer to measure any non-controlling interest in the acquiree (the subsidiary) at the acquisition-date fair values then: • As we know, the goodwill acquired by the acquirer (the immediate parent), as well as the direct non-

controlling interests’ share of goodwill at acquisition will be recognised (referred to as the ‘full goodwill method’).

• Therefore, if events have occurred which have created an impairment in goodwill then both the immediate parent’s share of goodwill, and the direct non-controlling interests’ share of goodwill will be impacted.

dee67382_ch28_1103-1154.indd 1113 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1113

• As such, when working out the non-controlling interests’ share of the profit or loss of the subsidiary, the amount of the impairment should be subtracted from the subsidiary’s profit or loss before the non-controlling interests’ share of profit is determined. This impairment will then be proportionally allocated to both the direct parent entity and the non-controlling interest on the basis of the respective ownership interests. This will have the effect of reducing the non-controlling interest in the subsidiary’s profits. If it has been decided to adopt the other option that allows the acquirer (the immediate parent entity) to

measure the non-controlling interest in the subsidiary at the non-controlling interest’s proportionate share of the subsidiary’s identifiable net assets then: • As we know, only the goodwill acquired by the acquirer (the immediate parent) will be recognised (referred

to as the ‘partial goodwill method’, as explained in Chapter 27). No goodwill will be recognised in relation to the non-controlling interest.

• Therefore, if events have occurred which have created an impairment in the value of goodwill then it is only the immediate parent’s share of goodwill that will be impacted.

• As such, when working out the non-controlling interests’ share of the profit or loss of the subsidiary no adjustment is necessary in relation to goodwill impairment. Any impairment in goodwill will only relate to goodwill that has been attributed to the immediate parent entity’s interest in the subsidiary. As such, any goodwill impairment will be recognised as a consolidation adjustment, but will not be considered when determining the non-controlling interest in the subsidiary’s profit or loss.

Elimination of intercompany dividends As discussed in previous chapters, all intragroup dividends should be eliminated on consolidation.

(e) To eliminate dividends payable and receivable within the group (an intragroup transaction)

Dr Dividend payable (statement of financial position) 35 000

Cr Dividend receivable (statement of financial position) 35 000 (to take account of Burridge Ltd’s direct interest of 70 per cent in Anderson Ltd’s dividends of $50 000)

To eliminate dividend income and dividends declared within the group (an intragroup transaction):

(f) Dr Dividend revenue 35 000

Cr Dividend declared (statement of changes in equity) 35 000 (to eliminate of Burridge Ltd’s interest in the dividends declared by Anderson Ltd)

(g) Dr Dividend payable (statement of financial position) 18 000

Cr Dividend receivable (statement of financial position) 18 000 (to take account of Anderson Ltd’s direct interest of 60 per cent in Menser Ltd’s dividends of $30 000)

(h) Dr Dividend revenue 18 000

Cr Dividend declared (statement of changes in equity) 18 000 (to eliminate Anderson Ltd’s interest in the dividends declared by Menser Ltd)

Up to this point we have not introduced any journal entries that were not already explained in the previous chapters on consolidation. Even in the presence of indirect interests we still eliminate the pre-acquisition capital and reserves against the direct investment and we eliminate all the intragroup transactions before we construct the consolidated financial statements. As we will see shortly, the indirect interests affect how we apportion the total consolidated shareholder equity and consolidated profits between the parent and non-controlling interests.

continued

dee67382_ch28_1103-1154.indd 1114 10/25/19 12:11 PM

1114 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.1 continued

Recognising non-controlling interest in share capital, reserves and earnings Non-controlling interest in Anderson Ltd

Calculation of non-controlling interests in Anderson Ltd Anderson Ltd

($)

30% Non- controlling interest

($)

Non-controlling interests and goodwill on acquisition date

Share capital 1 000 000 300 000

Retained earnings—on acquisition 300 000 90 000

1 300 000 390 000

Non-controlling interest in the current period’s profit and movements in reserves in the current period

Profit for the year 55 000

less Dividends received from entity within group* (18 000)

less Impairment of goodwill in Menser Ltd* –

37 000 11 100

less Dividends paid by Anderson Ltd (50 000) (15 000)

386 100

*Explanations for these adjustments are provided below

(i) Dr Share capital 300 000

Dr Retained earnings—1 July 2022 90 000

Dr Non-controlling interest in profits 11 100

Cr Dividend declared 15 000

Cr Non-controlling interest 386 100 (to recognise non-controlling interest in the pre-acquisition capital and reserves and non-controlling interest in profits of Anderson Ltd since acquisition)

Explanation for adjustments If the above calculations of the non-controlling interest in current period profits are reviewed, it is apparent that adjustments for the intragroup dividends have been made, but no adjustments have been made for any goodwill impairment. Why?

First, in relation to dividends, of the dividends declared by Menser Ltd, which totalled $30 000, $18 000 (60 per cent) went to Anderson Ltd and $12 000 (40 per cent) went to the direct non-controlling interests in Menser Ltd. The dividend paid to Anderson Ltd will be included in Anderson Ltd’s profits, in which the direct non- controlling interests (30 per cent) will have a share. The indirect non-controlling interests in Menser Ltd—who are the same parties as the direct non-controlling interests in Anderson Ltd (see Figure 28.3)—will be allocated a share in the profits of Menser Ltd (through their 18 per cent indirect interest).

The dividends paid by Menser Ltd to Anderson Ltd represent a distribution of these profits. The non- controlling interests in Anderson Ltd (who are the same investors as the indirect non-controlling interests in Menser Ltd) should not get a share of these profits yet again (it would be double counting), so before the non-controlling interest in the profits of Anderson Ltd are calculated, the dividends paid to Anderson Ltd by Menser Ltd are subtracted. The general rule here is that intragroup dividends paid to an ‘intermediate parent’ from a subsidiary are subtracted from the profits of that intermediate parent before the non-controlling interest in profits of that organisation is calculated.

In relation to why neither the impairment of Menser Ltd’s goodwill nor Anderson Ltd’s goodwill impairment is deducted from Anderson Ltd’s profit before the non-controlling interest is determined, we can refer back to the general principles provided earlier, these being:

dee67382_ch28_1103-1154.indd 1115 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1115

• If the non-controlling interest is valued at fair value at acquisition date, the goodwill impairment loss relating to the purchase of a subsidiary should be attributed to that subsidiary.

• If the non-controlling interest is valued at the non-controlling interest’s proportionate share of the subsidiary’s identifiable net assets at acquisition date, then the goodwill impairment loss relating to the purchase of a subsidiary should be attributed to the immediate parent entity of the subsidiary because it is only the immediate parent entity’s share of goodwill which has been recognised.

Because the non-controlling interest in Menser at acquisition date was determined on the basis of fair value, then the goodwill impairment will be attributed to Menser Ltd (see below). Further, as the non- controlling interest in Anderson Ltd at acquisition date was determined on the basis of the non-controlling interest’s proportionate share of the identifiable net assets of the subsidiary at acquisition date, then the impairment of the goodwill in Anderson Ltd will be attributed to Burridge Ltd. Hence, for Anderson Ltd, there are no goodwill impairment adjustments when calculating the non-controlling interest in current period profits.

Direct non-controlling interest in Menser Ltd

Calculation of direct non-controlling interests in Menser Ltd Menser Ltd

($)

40% Non-controlling interest

($)

Non-controlling interests and goodwill on acquisition date

Share capital 800 000 320 000

Retained earnings—on acquisition 400 000 160 000

Goodwill on acquisition 53 333

1 200 000 533 333

Non-controlling interest in the current period’s profit and movements in reserves in the current period

Profit for the year 60 000

less Goodwill impairment (13 333)

46 667 18 667

less Dividend declared by Menser Ltd (30 000) (12 000)

540 000

( j) Dr Share capital 320 000 Dr Retained earnings—1 July 2022 160 000 Dr Goodwill 53 333 Dr Non-controlling interest in earnings 18 667 Cr Dividend declared 12 000 Cr Non-controlling interest 540 000

(to recognise non-controlling interest in the pre-acquisition capital and reserves and non-controlling interest in profits of Menser Ltd since acquisition)

Indirect non-controlling interest in Menser Ltd

Calculation of indirect non-controlling interest in Menser Ltd Menser Ltd

($)

18% Indirect non-controlling

interest ($)

Profit for the year 60 000

Impairment of goodwill acquired in Menser Ltd 13 333

46 667 8 400

continued

dee67382_ch28_1103-1154.indd 1116 10/25/19 12:11 PM

1116 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.1 continued

(k) Dr Non-controlling interest in earnings 8 400

Cr Non-controlling interest (to recognise indirect non-controlling interest in profits of Menser Ltd)

8 400

The above consolidation journal entries can now be posted to the consolidation worksheet. Burridge Ltd and its controlled entities Consolidation worksheet for the year ending 30 June 2023

Eliminations and adjustments

Burridge Ltd

($000)

Anderson Ltd

($000)

Menser Ltd

($000) Dr

($000) Cr

($000)

Consolidated statements

($000)

Abbreviated statement of profit or loss and other comprehensive income

Profit before tax 500 80 100 9(c) 604.667

13.333(d)

35(f)

18(h)

Tax expense (270) (25)  (40) (335)

Profit after tax 230 55  60 269.667

Non-controlling interest in earnings 11.1(i) (38.167)

18.667( j)

8.4(k)

Statement of changes in equity

Profit after tax 230 55 60

Retained earnings—1 July 2022 1 000 300 400 210(a)

90(i)

1 230 355 460 240(b) 1000

160( j)

1231.5

Dividends declared (200) (50)  (30) 18(h)

15(i)

35(f) (200)

12( j)

Retained earnings—30 June 2023 1 030 305 430 1031.5

Statement of financial position

Shareholders’ equity

Retained earnings 1 030 305 430 1031.5

Share capital 4 000 1 000 800 700(a)

480(b) 4000

300(i)

320( j)

dee67382_ch28_1103-1154.indd 1117 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1117

Before the consolidated statement of financial position, the consolidated statement of changes in equity and the consolidated statement of profit or loss and other comprehensive income can be presented, the non- controlling interest needs to be considered. As was established in Chapter 27, the non-controlling interest must be disclosed separately within the financial statements. As AASB 10, paragraph 22, 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. (AASB 10)

Non-controlling interests in the profit or loss of the group shall also be separately disclosed (as per paragraph B94 of AASB 10).

Exhibits 27.1, 27.2 and 27.3 (in Chapter 27) show the suggested disclosures for non-controlling interests in the equity component of the statement of financial position, the statement of profit or loss and other comprehensive income and statement of changes in equity.

Eliminations and adjustments

Burridge Ltd

($000)

Anderson Ltd

($000)

Menser Ltd

($000) Dr

($000) Cr

($000)

Consolidated statements

($000)

Non-controlling interest – – – 386.1(i) 934.5

540( j)

8.4(k)

5 966

Current liabilities

Accounts payable 170 40 – 210

Dividends payable 200 50 30 35(e)

18(g) 227

Non-current liabilities

Loans 400 250 – 650

5 800 1 645 1 260 7 053

Current assets

Cash 165 37 100 302

Accounts receivable 250 175 200 625

Dividends receivable 35 18 – 35(e)

18(g) –

Inventory 500 300 400 1200

Non-current assets

Land 2 350 – 200 2550

Plant 1 500 315 360 2175

Investment in Anderson Ltd 1 000 – – 1 000(a) –

Investment in Menser Ltd – 800 – 800(b) –

Goodwill 90(a)

– – – 80(b) 223.333

53.333( j)

Accumulated impairment 9(c)

losses—goodwill – – – 13.333(d) (22.333)

5 800 1 645 1 260 2 889.833 2 889.833 7 053

continued

dee67382_ch28_1103-1154.indd 1118 10/25/19 12:11 PM

1118 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.1 continued

Burridge Ltd and its controlled entities

Consolidated statement of profit or loss and other comprehensive income for the year ending 30 June 2023

The Group ($)

Burridge Ltd ($)

Profit before tax 604 667 500 000

Income tax expense (335 000) (270 000)

Profit for the year 269 667 230 000

Other comprehensive income            –            –

Total comprehensive income 269 667 230 000

Attributable to:

Owners of the parent 231 500 –

Non-controlling interest 38 167 –

269 667 –

Burridge Ltd and its controlled entities

Consolidated statement of changes in equity for the year ending 30 June 2023

Share capital

($)

Retained earnings

($) Total

($)

Non- controlling

interest ($)

Total equity

($)

Balance at 1 July 2022 4 000 000 1 000 000 5 000 000 923 333 5 923 333

Total comprehensive income for the year – 231 500 231 500 38 167 269 667

Dividends – (200 000) (200 000) (27 000) (227 000)

Balance at 30 June 2023 4 000 000 1 031 500 5 031 500 934 500 5 966 000

Burridge Ltd

Statement of changes in equity for the year ending 30 June 2023

Share capital ($)

Retained earnings

($) Total equity

($)

Balance at 1 July 2022 4 000 000 1 000 000 5 000 000

Total comprehensive income for the year – 230 000 230 000

Dividends            –   (200 000)   (200 000)

Balance at 30 June 2023 4 000 000 1 030 000 5 030 000

dee67382_ch28_1103-1154.indd 1119 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1119

Burridge Ltd and its controlled entities

Consolidated statement of financial position at 30 June 2023

The Group ($)

Burridge Ltd ($)

Assets

Non-current assets

Property, plant and equipment 4 725 000 3 850 000

Goodwill 223 333 –

Accumulated impairment losses (22 333)

Investment in Anderson Ltd         – 1 000 000

Total non-current assets 4 926 000 4 850 000

Current assets

Inventories 1 200 000 500 000

Accounts receivable 625 000 250 000

Dividends receivable – 35 000

Cash 302 000   165 000

Total current assets 2 127 000   950 000

Total assets 7 053 000 5 800 000

Liabilities

Non-current liabilities

Loans 650 000   400 000

Total non-current liabilities 650 000   400 000

Current liabilities

Accounts payable 210 000 170 000

Dividends payable 227 000   200 000

Total current liabilities 437 000   370 000

Total liabilities 1 087 000   770 000

Net assets 5 966 000 5 030 000

Equity

Capital and reserves

Share capital 4 000 000 4 000 000

Retained earnings 1 031 500 1 030 000

5 031 500 5 030 000

Non-controlling interest 934 500            –

Total equity 5 966 000 5 030 000

WORKED EXAMPLE 28.2: Consolidation in the presence of indirect ownership interests and intragroup transactions

On 30 June 2019, Big Ltd purchased 70 per cent of the shares of Medium Ltd for $660 000 cash. On the same date, Medium Ltd purchased 60 per cent of the shares of Small Ltd for $420 000 cash.

The statements of financial position of Medium Ltd and Small Ltd immediately before the investments were as follows:

In Worked Example 28.2 we now introduce intragroup transactions into the consolidation process.

continued

dee67382_ch28_1103-1154.indd 1120 10/25/19 12:11 PM

1120 PART 8: Accounting for equity interests in other entities

Medium Ltd and Small Ltd

Statements of financial position as at 30 June 2019

Medium Ltd ($)

Small Ltd ($)

Assets

Cash 465 000 30 000

Accounts receivable 180 000 80 000

Inventory 200 000 130 000

Land 105 000 210 000

Factory buildings 1 000 000 360 000

Accumulated depreciation   (700 000) (72 000)

Total assets 1 250 000 738 000

Liabilities

Accounts payable 450 000 258 000

Shareholders’ equity

Share capital 560 000 160 000

Retained earnings   240 000 320 000

Total liabilities and shareholders’ equity 1 250 000 738 000

Additional information

(i) The non-controlling interest in Medium Ltd is measured at fair value, while the non-controlling interest in Small Ltd is measured at the proportionate share of its identifiable net assets. (Hint: as we should now appreciate, the choice of either of these two options for measuring the non- controlling interest at acquisition will have implications for the amount of goodwill recognised on acquisition and how any goodwill impairment expenses will be allocated between the parent entity and the non-controlling interests.)

(ii) At the date of investment, all the identifiable net assets of Medium Ltd and Small Ltd were considered to be recorded at fair value in the respective statements of financial position of Medium Ltd and Small Ltd, except Small Ltd’s factory buildings, which had a fair value of $416 000, and a carrying amount of $288 000 (cost of $360 000, accumulated depreciation of $72 000). Small Ltd did not revalue its buildings at the date of investments. At 30 June 2019, the factory buildings had a remaining useful life of 16 years.

(iii) On 1 July 2022 the recoverable amount of the goodwill relating to the purchase of Small Ltd by Medium Ltd was assessed to be $40 000 (an accumulated impairment loss of $38 240, as we will see shortly). This impairment loss of $38 240 was recognised in the first year following acquisition, that is, in the year to 30 June 2020. During the year to 30 June 2023 it was considered that the goodwill in Small Ltd had been further impaired by an amount of $5000, to provide a recoverable amount at 30 June 2023 of $35 000.

(iv) On 30 June 2023, the recoverable amount of the goodwill relating to the purchase of Medium Ltd by Big Ltd was assessed to be $110 000 and it was considered that all the impairment occurred in the 2023 financial year.

(v) During the 2023 financial year Small Ltd sold goods to Big Ltd for $2 000 000. These goods had originally cost Small Ltd $1 600 000. On 30 June 2023, 35 per cent of these goods remained in Big Ltd’s closing inventory.

(vi) Small Ltd’s opening inventory for the reporting period included goods purchased from Medium Ltd for $570 000. These goods had originally cost Medium Ltd $490 000.

(vii) On 30 June 2023 Big Ltd sold a factory building to Medium Ltd for $800 000. Big Ltd had originally purchased the factory building for $900 000, on 1 July 2017. The original estimated useful life of the factory building was 20 years.

WORKED EXAMPLE 28.2 continued

dee67382_ch28_1103-1154.indd 1121 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1121

(viii) On 31 November 2022, Big Ltd paid an interim dividend of $125 000 while Small Ltd paid an interim dividend of $110 000.

(ix) On 30 June 2023, Big Ltd declared a final dividend of $260 000 while Medium Ltd declared a final dividend of $90 000. The decision to pay these dividends was communicated to shareholders on this date.

(x) The income tax rate is 30 per cent. (xi) The financial statements of Big Ltd, Medium Ltd and Small Ltd revealed the following balances as at

30 June 2023.

Big Ltd, Medium Ltd and Small Ltd,

Statements of profit or loss and other comprehensive income for the year ending 30 June 2023

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Sales 7 500 000 4 000 000 3 500 000

Cost of goods sold (6 100 000) (3 260 000) (2 900 000)

Gross profit 1 400 000 740 000 600 000

Depreciation expense (130 000) (50 000) (18 000)

Other expenses (743 000) (476 000) (262 000)

Dividend revenue 63 000 66 000 –

Gain on sale of factory building   170 000            –            –

Profit before income tax expense 760 000 280 000 320 000

Income tax expense   (304 000)   (112 000)   (128 000)

Profit after income tax expense 456 000 168 000 192 000

Other comprehensive income            –            –            –

Total comprehensive income   456 000   168 000   192 000

Big Ltd, Medium Ltd and Small Ltd

Statements of financial position as at 30 June 2023

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Assets

Cash 76 000 6 000 37 000

Accounts receivable 172 000 52 000 68 000

Dividends receivable 63 000 – –

Inventory 1 100 000 440 000 700 000

Land 720 000 105 000 210 000

Factory buildings 2 600 000 1 800 000 360 000

Accumulated depreciation (130 000) (900 000) (144 000)

Investment in Medium Ltd 660 000 – –

Investment in Small Ltd           – 420 000           –

Total assets 5 261 000 1 923 000 1 231 000

Liabilities

Accounts payable 910 000 715 000 319 000

Dividends payable 260 000 90 000 –

continued

dee67382_ch28_1103-1154.indd 1122 10/25/19 12:11 PM

1122 PART 8: Accounting for equity interests in other entities

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Shareholders’ equity

Share capital 3 300 000 560 000 160 000

Retained earnings   791 000   558 000   752 000

Total of liabilities and shareholders’ equity 5 261 000 1 923 000 1 231 000

Big Ltd

Statement of changes in equity for the year ending 30 June 2023

Share capital

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2022 3 300 000 720 000 4 020 000

Total comprehensive income for the year – 456 000 456 000

Dividends paid and declared            – (385 000) (385 000)

Balance at 30 June 2023 3 300 000 791 000 4 091 000

Medium Ltd

Statement of changes in equity for the year ending 30 June 2023

Share capital

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2022 560 000 480 000 1 040 000

Total comprehensive income for the year – 168 000 168 000

Dividends paid and declared            –   (90 000)      (90 000)

Balance at 30 June 2023 560 000 558 000 1 118 000

Small Ltd

Statement of changes in equity for the year ending 30 June 2023

Contributed equity

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2022 160 000 670 000 830 000

Total comprehensive income for the year – 192 000 192 000

Dividends paid and declared            – (110 000) (110 000)

Balance at 30 June 2023 160 000 752 000 912 000

REQUIRED Prepare a consolidated statement of profit or loss and other comprehensive income, a consolidated statement of financial position and a consolidated statement of changes in equity for the year ending 30 June 2023.

SOLUTION As we know from previous chapters, there are a number of steps to take. We need to:

1. provide the consolidation worksheet journal entries 2. calculate non-controlling interests

WORKED EXAMPLE 28.2 continued

dee67382_ch28_1103-1154.indd 1123 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1123

3. post the consolidation journal entries to the worksheet 4. prepare the consolidated financial statements from the consolidation worksheet and utilise the

calculation of non-controlling interests to disclose the non-controlling interests, contribution to profits and the non-controlling interests in share capital and reserves.

Consolidation worksheet journal entries Recognition of the fair value adjustment At the date of Medium Ltd’s acquisition of Small Ltd the carrying amount of the factory buildings was less than their fair value. So that we can correctly calculate goodwill on acquisition we must put through a revaluation adjustment as at the date of acquisition before we eliminate the investment against the pre-acquisition capital and reserves of the acquired subsidiary. As we explained in Chapter 18, when an entity revalues its non-current assets a tax effect is created, which needs to be recognised in accordance with AASB 112 Income Taxes.

(a) Dr Factory buildings ($416 000 – $360 000) 56 000 Dr Accumulated depreciation (to close off balance before

revaluation) 72 000

Cr Revaluation surplus recognised on consolidation 128 000 (to recognise a fair value adjustment as at acquisition date for the factory buildings held by a subsidiary)

(b) Dr Revaluation surplus recognised on consolidation 38 400

Cr Deferred tax liability (128 000 × 0.3) 38 400 (to recognise the tax effect of the asset revaluation)

Adjusting the carrying amount of the buildings will have implications for depreciation expense. The depreciation expense will be based on the adjusted fair value. Because the subsidiary was acquired four years ago, and the fair value adjustment was initially made four years ago, then four years’ adjustment to depreciation must be made. Three years’ depreciation will be adjusted against opening retained earnings.

(c) Dr Depreciation expense ($128 000/16 for the current year) 8 000

Dr Retained earnings—1 July 2022 ($128 000/16 × 3 for the previous three years)

24 000

Cr Accumulated depreciation ($128 000/16 × 4 years) 32 000 (to recognise the impacts of the fair value adjustment on current and prior period depreciation expense)

(d) Dr Deferred tax liability ($32 000 × 0.3) 9 600 Cr Income tax expense ($8 000 × 0.3 for the current year) 2 400 Cr Retained earnings—1 July 2022 7 200

($24 000 × 0.3 for the previous three years) (to adjust deferred tax liability following current and prior period depreciation expense adjustments)

Elimination of the fair value of consideration transferred and recognition of goodwill Because the non-controlling interest in Medium Ltd at acquisition is to be measured at fair value, this means goodwill will be attributed to the non-controlling interest in Medium Ltd.

Elimination of investment in Medium Ltd Medium Ltd

($)

Big Ltd’s 70% interest

($)

30% Non- controlling

interest ($)

Fair value of consideration transferred 660 000 660 000

plus Non-controlling interest at fair value ($660 000 × 30/70) 282 857 942 857

continued

dee67382_ch28_1103-1154.indd 1124 10/25/19 12:11 PM

1124 PART 8: Accounting for equity interests in other entities

Elimination of investment in Medium Ltd Medium Ltd

($)

Big Ltd’s 70% interest

($)

30% Non- controlling

interest ($)

less Fair value of identifiable assets acquired and liabilities assumed

Share capital on acquisition date 560 000 392 000 168 000

Retained earnings on acquisition date 240 000 168 000 72 000

800 000 560 000

Goodwill on acquisition date 142 857 100 000 42 857

Non-controlling interest on acquisition date 282 857

Elimination of investment in Small Ltd Because the non-controlling interest in Small Ltd at acquisition is to be measured at the proportionate share of the fair value of the identifiable net assets of Small Ltd this means no goodwill will be attributed to the non- controlling interest in Small Ltd.

Small Ltd ($)

Medium Ltd’s 60% interest

($)

40% Non- controlling interest ($)

Fair value of consideration transferred 420 000

less Fair value of identifiable assets acquired and liabilities assumed

Share capital on acquisition date 160 000 96 000 64 000

Retained earnings on acquisition date 320 000 192 000 128 000

Revaluation surplus created as a result of fair value adjustment 89 600 53 760 35 840

569 600 341 760

Goodwill on acquisition date 78 240 –

Non-controlling interest at date of acquisition 227 840

(e) Dr Share capital 392 000

Dr Retained earnings—1 July 2022 168 000

Dr Goodwill 100 000

Cr Investment in Medium Ltd 660 000 (to eliminate Big Ltd’s investment in Medium Ltd)

(f) Dr Share capital 96 000

Dr Retained earnings—1 July 2022 192 000

Dr Revaluation surplus recognised on consolidation 53 760

Dr Goodwill 78 240

Cr Investment in Small Ltd 420 000 (to eliminate Medium Ltd’s investment in Small Ltd)

Impairment of goodwill (relating to purchase of Small Ltd by Medium Ltd)

(g) Dr Retained earnings—1 July 2022 (previous years’ accumulated impairment)

38 240

Cr Accumulated impairment losses—goodwill 38 240 (to recognise prior period impairment of goodwill)

WORKED EXAMPLE 28.2 continued

dee67382_ch28_1103-1154.indd 1125 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1125

(h) Dr Impairment loss—goodwill (the impairment loss recognised in 2023) 5 000

Cr Accumulated impairment losses—goodwill 5 000 (to recognise current period impairment of goodwill)

Impairment of goodwill in 2023 (relating to purchase of Medium Ltd by Big Ltd)

(i) Dr Impairment loss—goodwill ($142 857 — $110 000) 32 857

Cr Accumulated impairment losses—goodwill 32 857 (to recognise current period impairment of goodwill)

Elimination of intercompany sales As part of the consolidation adjustments and eliminations 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. All intragroup transactions are eliminated in full and the presence of direct and indirect non-controlling interests does not alter this requirement.

Sale of inventory from Small Ltd to Big Ltd

( j) Dr Sales 2 000 000

Cr Cost of goods sold 2 000 000 (to eliminate intragroup sales)

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, hence 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 $140 000, which represents the profit on the total sales multiplied by the proportion of sales still on hand, that is ($2 000 000 − $1 600 000) × 35 per cent. 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.

(k) Dr Cost of goods sold 140 000

Cr Inventory 140 000 (to eliminate profit included within closing inventory)

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. 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, $140 000 has not been earned. However, from Small 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 Small Ltd’s accounts of $42 000 (30 per cent of $140 000). 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 Small Ltd is obliged to pay the tax.

(l) Dr Deferred tax asset 42 000

Cr Income tax expense 42 000 (to recognise the tax implications of the elimination of the profit in closing inventory—$140 000 × 30 per cent)

Unrealised profit in opening inventory At the end of the preceding financial year, Small Ltd had $570 000 of inventory on hand, which had been purchased from Medium Ltd. The inventory had cost Medium Ltd $490 000 to produce.

continued

dee67382_ch28_1103-1154.indd 1126 10/25/19 12:11 PM

1126 PART 8: Accounting for equity interests in other entities

(m) Dr Retained earnings—1 July 2022 56 000

Dr Income tax expense 24 000

Cr Cost of sales 80 000 (to recognise the current period effect of the unrealised profit in opening inventory. This adjustment effectively shifts the after-tax effect of the sales from the previous period to the current period)

Adjustments for intragroup sale of factory building On 30 June 2023, Big Ltd sold a factory building to Medium Ltd for $800 000 when its carrying amount in Big Ltd’s accounts was $630 000 (cost of $900 000, accumulated depreciation of $270 000). The building was being depreciated over a further 14 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 factory building to Medium Ltd is that the profit of $170 000—the difference between the sales proceeds of $800 000 and the carrying amount of $630 000—will be shown in Big Ltd’s financial statements. However, from the economic entity’s perspective there has been no sale (it is an intragroup transaction) 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 applied had the intragroup sale not occurred.

(n) Dr Gain on sale of building 170 000

Dr Building 100 000

Cr Accumulated depreciation 270 000 (to eliminate the effects of an intragroup transaction relating to the sale of a building)

The result of this entry is that the intragroup profit is removed and the asset and accumulated depreciation account reverts to reflecting no sales transaction. The profit of $170 000 will be recognised progressively in the consolidated financial statements of the economic entity by adjustments to the amounts of depreciation charged by Medium Ltd in its accounts. As the service potential or economic benefits embodied in the asset are consumed, the $170 000 profit will be progressively recognised from the economic entity’s perspective.

Impact of tax on gain on sale of factory building From Big Ltd’s individual perspective it would have made a profit of $170 000 on the sale of the building and this gain would have been taxable. At a tax rate of 30 per cent, $51 000 would be payable by Big 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 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.

(o) Dr Deferred tax asset 51 000

Cr Income tax expense 51 000 (to recognise the tax effect of the intragroup sale of the building)

As the sale of the factory building occurred on consolidation date, there are no consolidation worksheet journal entries required to adjust the depreciation of the factory building.

Dividends paid and declared We eliminate the dividends paid and payable within the group. Only the dividends paid and payable to parties outside the entity (to the investors in the parent entity and to the direct non-controlling interests) are to be shown in the consolidated financial statements.

WORKED EXAMPLE 28.2 continued

dee67382_ch28_1103-1154.indd 1127 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1127

Elimination of interim dividend (paid by Small Ltd to Medium Ltd)

(p) Dr Dividend revenue ($110 000 × 0.6) 66 000 Cr Interim dividend 66 000

(to eliminate intragroup dividend)

Elimination of final dividend (declared by Medium Ltd to Big Ltd)

(q) Dr Dividend revenue ($90 000 × 0.7) 63 000 Cr Final dividend 63 000

(to eliminate intragroup dividend)

Elimination of intragroup debt: Big Ltd’s share of Medium Ltd’s declared final dividend

(r) Dr Dividend payable ($90 000 × 0.7) 63 000 Cr Dividend receivable 63 000

(to eliminate an intragroup receivable and payable)

Having completed the consolidation adjustments and eliminations, we can now calculate the non- controlling interests in the current period’s profits and in share capital and reserves. We will need to consider direct and indirect ownership interests. These are reflected in Figure 28.4 and then summarised in Table 28.4.

continued

Medium Ltd Small Ltd

Parent entity interest

Direct 70%

Indirect [0.7 × 0.6] 42%

Non-controlling interest

Direct 30% 40%

Indirect [0.3 × 0.6] 18%

100% 100%

Table 28.4 Calculation of direct and indirect interests in Medium Ltd and Small Ltd

Figure 28.4 Group structure of Big Ltd and its controlled entities

Big Ltd

Medium Ltd

70%

60%

42%

Small Ltd

40%

30%

18%

Non-controlling interest

Non-controlling interest

dee67382_ch28_1103-1154.indd 1128 10/25/19 12:11 PM

1128 PART 8: Accounting for equity interests in other entities

Recognising non-controlling interest in share capital, reserves and earnings It must be remembered that in order to recognise the non-controlling interest’s share in share capital 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, the gains and losses of the subsidiary that are unrealised from the economic entity’s perspective will need to be adjusted for.

As we also know, where the non-controlling interest at acquisition date is to be valued at fair value, then goodwill will be attributed to the non-controlling interest. We also need to apply the general rules about which legal entity should be allocated amounts attributable to any goodwill impairment. As we learned earlier in this chapter, if the non-controlling interest is valued at fair value at acquisition date then goodwill impairment losses relating to the purchase of a particular entity should be attributed to the parent entity and the non-controlling interest. Conversely, if the non-controlling interests at acquisition date are valued at the non-controlling interests’ proportional share of the fair value of the net identifiable assets at acquisition date, then no goodwill will be attributed to the non- controlling interests and any impairment of goodwill will be attributed as an expense of the acquirer (investor).

Calculation of direct non-controlling interests in Medium Ltd and Small Ltd

Medium Ltd ($)

30% Non- controlling

interest ($)

Small Ltd ($)

40% Non- controlling

interest ($)

(i) Non-controlling interests on acquisition date

Share capital on acquisition date 560 000 168 000 160 000 64 000

Retained earnings on acquisition date 240 000 72 000 320 000 128 000

800 000

Revaluation surplus created as a result of fair value adjustment – – 89 600 35 840

Goodwill 42 857     –     –

282 857 569 600 227 840

(ii) 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

Retained earnings—since acquisition

Medium Ltd ($480 000 — $240 000) 240 000

Small Ltd ($670 000 — $320 000) 350 000

less Depreciation adjustment due to revaluing factory building to fair value (in relation to the previous three years) (24 000)

Tax effect of depreciation adjustment due to revaluing factory buildings 7 200

less Impairment loss—goodwill (relating to purchase of Small Ltd by Medium Ltd) (38 240) –

less Unrealised profit in opening inventory (last year’s closing inventory) (80 000) –

Tax effect of unrealised profit in opening inventory 24 000        –   

Adjusted post-investment retained earnings—1 July 2022 145 760 43 728 333 200 133 280

WORKED EXAMPLE 28.2 continued

dee67382_ch28_1103-1154.indd 1129 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1129

Calculation of direct non-controlling interests in Medium Ltd and Small Ltd

Medium Ltd ($)

30% Non- controlling

interest ($)

Small Ltd ($)

40% Non- controlling

interest ($)

(iii) Non-controlling interest in the current period’s profit and movements in reserves in the current period

Profit for the year 168 000 192 000

Adjustment relating to inventory

Unrealised profit in opening inventory 80 000

less Tax effect of unrealised profit in opening inventory (24 000)

less Unrealised profit in closing inventory (140 000)

Tax effect of unrealised profit in closing inventory 42 000

Fair value adjustment

less Depreciation adjustment due to revaluing factory building to fair value (8 000)

Tax effect of depreciation adjustment due to revaluing factory buildings 2 400

Intragroup dividends

less Dividend revenue from within the group (paid by Small Ltd to Medium Ltd) (66 000)

less Goodwill impairment in organisation controlled by intermediate subsidiary (5 000) –

less Goodwill impairment—2023 (32 857)      

Adjusted profit for the year 120 143 36 043  88 400 35 360

Dividends paid and declared (90 000) (27 000) (110 000) (44 000)

335 628 352 480

Recognising direct non-controlling interest in share capital and reserves at acquisition date, non-controlling interest in movements in reserves to the beginning of the current year, and direct non-controlling interests in current period profits of Medium Ltd

(s) Dr Share capital 168 000 Dr Retained earnings—1 July 2022 ($72 000 + $43 728) 115 728 Dr Goodwill 42 857 Dr Non-controlling interest in earnings 36 043 Cr Final dividend 27 000 Cr Non-controlling interest 335 628

(to recognise direct non-controlling interests in Medium Ltd as at 30 June 2023)

Recognising direct non-controlling interest in share capital and reserves at acquisition date, non-controlling interest in movements in reserves to the beginning of the current year, and direct non-controlling interests in current period profits of Small Ltd

(t) Dr Share capital 64 000

Dr Retained earnings—1 July 2022 ($128 000 + $133 280) 261 280 Dr Revaluation surplus recognised on consolidation 35 840

Dr Non-controlling interest in earnings 35 360

Cr Interim dividend 44 000

Cr Non-controlling interest 352 480 (to recognise direct non-controlling interests in Small Ltd as at 30 June 2023)

continued

dee67382_ch28_1103-1154.indd 1130 10/25/19 12:11 PM

1130 PART 8: Accounting for equity interests in other entities

Recognising indirect non-controlling interest in Small Ltd

Calculation of indirect non-controlling interest in Small Ltd Small Ltd

($)

18% Indirect non-controlling

interest ($)

Indirect 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

333 200 59 976

Indirect non-controlling interest in the current period’s profit for the year 88 400 15 912

421 600 75 888

(u) Dr Retained earnings—1 July 2022 59 976

Dr Non-controlling interest in earnings 15 912

Cr Non-controlling interest 75 888 (to recognise indirect non-controlling interest in earnings of Small Ltd. This is added to direct non-controlling interests in Small Ltd to give total non- controlling interest in Small Ltd)

Looking at the above calculations, it can be seen that they are the same form of adjustments made in Chapter 27, which concentrated on non-controlling interests. The only difference is that an adjustment has been made for the dividends received by Medium Ltd from Small Ltd, and adjustments have also been made for the impairment loss pertaining to the goodwill acquired in Small Ltd (which is adjusted against the profits of Medium Ltd, as Medium Ltd acquired the goodwill in Small Ltd). Explanations for these adjustments were provided in Worked Example 27.3.

A review of the above calculations reinforces the following: • Pre-acquisition balances of reserves (in this example, retained earnings and revaluation surplus) are

allocated on the basis of direct ownership interests only. • Post-acquisition movements in reserves are allocated on the basis of the sum of direct and indirect

ownership interests. • Current period profits are allocated using the sum of direct and indirect ownership interests. • Dividends are allocated on the basis of direct ownership interests only.

Consolidation worksheet as at 30 June 2023

Eliminations and adjustments

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Dr ($)

Cr ($)

Consolidated ($)

Sales 7 500 000 4 000 000 3 500 000 2 000 000( j) 13 000 000

Cost of goods sold (6 100 000) (3 260 000) (2 900 000) 140 000(k) 2 000 000( j) (10 320 000)

80 000(m)

Gross profit 1 400 000 740 000 600 000 2 680 000

Depreciation expense (130 000) (50 000) (18 000) 8 000(c) (206 000)

Impairment loss— goodwill – – – 5 000(h) (37 857)

32 857(i)

Other expenses (743 000) (476 000) (262 000) (1 481 000)

Dividend revenue 63 000 66 000 – 66 000(p) –

63 000(q)

WORKED EXAMPLE 28.2 continued

dee67382_ch28_1103-1154.indd 1131 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1131

continued

Eliminations and adjustments

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Dr ($)

Cr ($)

Consolidated ($)

Gain on sale of factory   170 000            –            – 170 000(n)            –

Profit before tax 760 000 280 000 320 000 955 143

Income tax expense   (304 000)   (112 000) (128 000) 24 000(m) 2 400(d) (472 600)

42 000(l)

51 000(o)

Profit after tax 456 000 168 000 192 000 482 543

Non-controlling interest in earnings 36 043(s) (87 315)

35 360(t)

15 912(u)

Retained earnings— 1 July 2022 720 000 480 000 670 000 24 000(c) 7 200(d)   961 976

192 000(f)

38 240(g)

168 000(e)

56 000(m)

115 728(s)

261 280(t)

59 976(u)

1 357 204

Interim dividend (125 000) – (110 000) 66 000(p) (125 000)

44 000(t)

Final dividend   (260 000)   (90 000)            – 63 000(q) (260 000)

27 000(s)

Retained earnings— 30 June 2023 791 000 558 000 752 000 972 204

Share capital 3 300 000 560 000 160 000 96 000(f) 3 300 000

392 000(e)

168 000(s)

64 000(t)

Revaluation surplus            –            –            – 38 400(b) 128 000(a)            –

53 760(f)

35 840(t)

Non-controlling interest 335 628(s)   763 996

352 480(t)

75 888(u)

Total shareholders’ equity 4 091 000 1 118 000 912 000 5 036 200

dee67382_ch28_1103-1154.indd 1132 10/25/19 12:11 PM

1132 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.2 continued

Eliminations and adjustments

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Dr ($)

Cr ($)

Consolidated ($)

Accounts payable 910 000 715 000 319 000 1 944 000

Dividends payable 260 000 90 000 – 63 000(r) 287 000

Deferred tax liability            –            –            – 9 600(d) 38 400(b)   28 800

Total of equity and liabilities 5 261 000 1 923 000 1 231 000 7 296 000

Cash 76 000 6 000 37 000 119 000

Accounts receivable 172 000 52 000 68 000 292 000

Dividends receivable 63 000 – – 63 000(r) –

Inventory 1 100 000 440 000 700 000 140 000(k) 2 100 000

Land 720 000 105 000 210 000 1 035 000

Factory buildings 2 600 000 1 800 000 360 000 56 000(a) 4 916 000

100 000(n)

Accum. depreciation (130 000) (900 000) (144 000) 72 000(a) 32 000(c) (1 404 000)

270 000(n)

Investment in Medium Ltd 660 000 – – 660 000(e) –

Investment in Small Ltd – 420 000 – 420 000(f) –

Goodwill – – – 78 240(f) 221 097

100 000(e)

42 857(s)

Accum. impairment loss 38 240(g) (76 097)

5 000(h)

32 857(i)

Deferred tax asset – – – 42 000(l) 93 000

            51 000(o)        

Total assets 5 261 000 1 923 000 1 231 000 4 974 093 4 974 093 7 296 000

We can now prepare the consolidated financial statements.

Big Ltd and its subsidiaries

Consolidated statement of profit or loss and other comprehensive income of for the year ending 30 June 2023

The Group ($)

Big Ltd ($)

Sales 13 000 000 7 500 000

Cost of goods sold (10 320 000) (6 100 000)

Gross profit 2 680 000 1 400 000

Depreciation expense (206 000) (130 000)

Impairment loss-goodwill (37 857) –

Dividend revenue – 63 000

Gain on sale of factory – 170 000

dee67382_ch28_1103-1154.indd 1133 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1133

continued

The Group ($)

Big Ltd ($)

Other expenses (1 481 000) (743 000)

Profit before income tax expense 955 143 760 000

Income tax expense (472 600) (304 000)

Profit after income tax expense 482 543 456 000

Other comprehensive income – –

Total comprehensive income 482 543 456 000

Profit after income tax attributable to non-controlling interest 87 315 –

Profit after income tax attributable to parent entity interest 395 228 –

482 543 –

Big Ltd and its controlled entities

Consolidated statement of changes in equity for the year ending 30 June 2023

Attributable to owners of the parent

Share capital

($)

Retained earnings

($) Total

($)

Non- controlling

interest ($)

Total equity

($)

Balance at 1 July 2022 3 300 000 961 976 4 261 976 747 681 5 009 657

Total comprehensive income for the year – 395 228 395 228 87 315 482 543

Dividends           – (385 000) (385 000) (71 000) (456 000)

Balance at 30 June 2023 3 300 000 972 204 4 272 204 763 996 5 036 200

Big Ltd

Statement of changes in equity for the year ending 30 June 2023

Share capital

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2022 3 300 000 720 000 4 020 000

Total comprehensive income for the year – 456 000 456 000

Distributions—interim dividend – (125 000) (125 000)

Distributions—final dividend           –  (260 000)  (260 000)

Balance at 30 June 2023 3 300 000  791 000  4 091 000

Big Ltd and its subsidiaries

Consolidated statement of financial position of as at 30 June 2023

The Group ($)

Big Ltd ($)

Current assets

Cash 119 000 76 000

Accounts receivable 292 000 172 000

dee67382_ch28_1103-1154.indd 1134 10/25/19 12:11 PM

1134 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.2 continued

The Group ($)

Big Ltd ($)

Dividends receivable 63 000

Inventory 2 100 000 1 100 000

Total current assets 2 511 000 1 411 000

Non-current assets

Land 1 035 000 720 000

Factory buildings 4 916 000 2 600 000

less Accumulated depreciation (1 404 000) (130 000)

Goodwill 221 097 –

less Accumulated impairment losses (76 097) –

Investment in Medium Ltd 660 000

Deferred tax asset   93 000           –

Total non-current assets 4 785 000  3 850 000

Total assets 7 296 000  5 261 000

Current liabilities

Accounts payable 1 944 000 910 000

Dividends payable  287 000  260 000

2 231 000 1 170 000

Non-current liabilities

Deferred tax liability   28 800             –

Total liabilities 2 259 800 1 170 000

Net assets 5 036 200 4 091 000

Equity

Share capital 3 300 000 3 300 000

Retained earnings   972 204   791 000

Parent entity interest 4 272 204 4 091 000

Non-controlling interest  763 996           –

Total of liabilities and shareholders’ equity 5 036 200 4 091 000

In the examples provided so far in this chapter the acquisitions have all occurred on the same date. That is, the ultimate parent entity acquired the intermediate subsidiary at the same time as the intermediate subsidiary acquired the controlling interest in the other entity. The next section will consider the situation where the acquisitions occur on different dates.

28.3 Sequential and non-sequential acquisitions

Although up to now it has suited our purposes to confine our examples to cases in which all acquisitions occur on the same date, this will not always be the case in practice. Acquisitions could also occur in the following ways:

LO 28.3

dee67382_ch28_1103-1154.indd 1135 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1135

Figure 28.5 Sequential acquisition of ownership interests

Organisation A

Organisation B

1st acquisition

Organisation C

2nd acquisition

Organisation A

Organisation B

1st acquisition

Organisation C

2nd acquisition

B Group

Figure 28.6 Non-sequential acquisition of ownership interests

∙ The parent acquires its interest in the intermediate subsidiary before the intermediate subsidiary acquires its interest in the other subsidiary (this is referred to as sequential acquisition and is represented in Figure 28.5).

∙ The parent acquires its interest in the intermediate subsidiary after the intermediate subsidiary acquires its interest in the other subsidiary (this is referred to as non-sequential acquisition and is represented in Figure 28.6).

In a sequential acquisition, as depicted in Figure 28.5, the consolidated financial statements will be accounted for in the same manner as when acquisitions occur simultaneously. Since we have considered simultaneous acquisitions up to now in this text, we will have no trouble accounting for sequential transactions.

Figure 28.6 depicts a non-sequential acquisition—the situation where the parent entity acquires its control of the intermediate subsidiary after the intermediate subsidiary acquired its interest in another subsidiary. Effectively, what is happening is that the ultimate parent entity—which we will refer to as Organisation A—is acquiring an interest in the B Group, rather than solely in Organisation B. Hence, in determining the fair value of the assets acquired in Organisation B, which is necessary for our consolidation entry that eliminates the investment in Organisation B against the pre-acquisition capital and reserves of Organisation B, we need to consider the value of both Organisation B and Organisation C. The value of Organisation B’s investment in Organisation C will be affected by post-acquisition profits and reserve movements in Organisation C. Therefore, Organisation A’s investment in Organisation B must be

dee67382_ch28_1103-1154.indd 1136 10/25/19 12:11 PM

1136 PART 8: Accounting for equity interests in other entities

eliminated against Organisation A’s share of the owners’ equity of the B Group (Organisation B plus Organisation C) as at the date of Organisation A’s investment. The profits earned by Organisation C, after Organisation B acquired its interest in Organisation C, but prior to Organisation A’s acquisition of the B Group are treated as part of pre- acquisition reserves, and therefore eliminated on consolidation.

WHY DO I NEED TO KNOW ABOUT THE DIFFERENCE BETWEEN A SEQUENTIAL AND A NON-SEQUENTIAL ACQUISITION OF OWNERSHIP INTERESTS?

We need to understand the difference between a sequential and non-sequential acquisition because we need to identify, for each acquisition, which type of acquisition it is. As we have just learned, the nature of the acquisition will impact how we calculate goodwill and how we calculate total non-controlling interests.

In Worked Example 28.3 we will consider how to account for non-sequential acquisitions. We will use the same information as we did in Worked Example 28.2, except we will change the acquisition dates so that Big Ltd acquires Medium Ltd after Medium Ltd has already acquired Small Ltd.

WORKED EXAMPLE 28.3: Example of a non-sequential acquisition

Assume the same facts as for Worked Example 28.2, except that the acquisition dates are altered as follows:

• On 30 June 2019 Medium Ltd acquired 60 per cent of the shares of Small Ltd for $420 000 when the share capital and reserves of Small Ltd were:

Small Ltd ($)

Share capital 160 000

Retained earnings 320 000

480 000

• On 30 June 2020 (one year later) Big Ltd acquired a 70 per cent interest in Medium Ltd for $660 000.

At 30 June 2020 the share capital and reserves of Medium Ltd and Small Ltd were as follows:

Medium Ltd ($)

Small Ltd ($)

Share capital 560 000 160 000

Retained Earnings 340 000 370 000

900 000 530 000

The amounts paid for the equity in Big Ltd and Medium Ltd represented the fair value of consideration transferred. The remaining information below is the same as that in Worked Example 28.2.

(i) Any non-controlling interest in Medium Ltd is measured at fair value, while the non-controlling interest in Small Ltd is measured at the proportionate share of its identifiable net assets.

(ii) At the date of investment, all the identifiable net assets of Medium Ltd and Small Ltd were considered to be recorded at fair value in the respective statements of financial position of Medium Ltd and Small Ltd, except Small Ltd’s factory buildings, which had a fair value of $416 000, and a carrying amount of $288 000 (cost of $360 000, accumulated depreciation of $72 000). Small Ltd did not revalue its factory buildings at the date of investment. At 30 June 2019, the factory buildings had a remaining useful life of 16 years.

(iii) On 1 June 2022, the recoverable amount of the goodwill relating to the purchase of Small Ltd by Medium Ltd was assessed to be $40 000 (an accumulated impairment loss of $38 240, as will be

dee67382_ch28_1103-1154.indd 1137 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1137

seen shortly). This impairment loss of $38 240 was recognised in the first year following acquisition; that is, in the reporting period to 30 June 2020. During the reporting period to 30 June 2023 it was considered that the goodwill in Small Ltd had been further impaired by an amount of $5000, to provide a recoverable amount at 30 June 2023 of $35 000.

(iv) On 30 June 2023, the recoverable amount of the goodwill relating to the purchase of Medium Ltd by Big Ltd was assessed to be $110 000.

(v) During the 2023 reporting period Small Ltd sold goods to Big Ltd for $2 000 000. These goods had originally cost Small Ltd $1 600 000. On 30 June 2023, 35 per cent of these goods remained in Big Ltd’s closing inventory.

(vi) Small Ltd’s opening inventory included goods purchased from Medium Ltd for $570 000. These goods had originally cost Medium Ltd $490 000.

(vii) On 30 June 2023, Big Ltd sold a factory building to Medium Ltd for $800 000. Big Ltd had originally purchased the factory building for $900 000, on 1 July 2017. The original estimated useful life of the factory building was 20 years. It was not expected to have any residual value.

(viii) On 31 December 2022, Big Ltd paid an interim dividend of $125 000, while Small Ltd paid an interim dividend of $110 000.

(ix) On 30 June 2023, Big Ltd declared a final dividend of $260 000, while Medium Ltd declared a final dividend of $90 000. The decision to pay the dividends was communicated to shareholders on that date.

(x) The income tax rate is 30 per cent. (xi) The financial statements of Big Ltd, Medium Ltd and Small Ltd revealed the following balances at 30

June 2023.

Big Ltd, Medium Ltd and Small Ltd Statements of profit or loss and other comprehensive income for the year ending 30 June 2023

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Sales 7 500 000 4 000 000 3 500 000

Cost of goods sold (6 100 000) (3 260 000) (2 900 000)

Gross profit 1 400 000 740 000 600 000

Depreciation expense (130 000) (50 000) (18 000)

Other expenses (743 000) (476 000) (262 000)

Dividend revenue 63 000 66 000 –

Gain on sale of factory building  170 000            –            –

Profit before tax 760 000 280 000 320 000

Income tax expense   (304 000)   (112 000)   (128 000)

Profit for the year 456 000 168 000 192 000

Other comprehensive income            –            –            –

Total comprehensive income   456 000   168 000   192 000

Big Ltd, Medium Ltd and Small Ltd Statements of financial position at 30 June 2023

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Assets

Cash 76 000 6 000 37 000

Accounts receivable 172 000 52 000 68 000

Dividends receivable 63 000 – –

Inventory 1 100 000 440 000 700 000

continued

dee67382_ch28_1103-1154.indd 1138 10/25/19 12:11 PM

1138 PART 8: Accounting for equity interests in other entities

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Land 720 000 105 000 210 000

Factory buildings 2 600 000 1 800 000 360 000

Accumulated depreciation (130 000) (900 000) (144 000)

Investment in Medium Ltd 660 000 – –

Investment in Small Ltd           –  420 000           –

Total assets 5 261 000 1 923 000 1 231 000

Liabilities

Accounts payable 910 000 715 000 319 000

Dividends payable 260 000 90 000 –

Equity

Share capital 3 300 000 560 000 160 000

Retained earnings  791 000  558 000  752 000

Total of liabilities and shareholders’ equity 5 261 000 1 923 000 1 231 000

Big Ltd Statement of changes in equity for the year ending 30 June 2023

Share capital

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2022 3 300 000 720 000 4 020 000

Total comprehensive income for the year – 456 000 456 000

Distributions paid and declared           – (385 000)  (385 000)

Balance at 30 June 2023 3 300 000  791 000 4 091 000

Medium Ltd Statement of changes in equity for the year ending 30 June 2023

Share capital

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2022 560 000 480 000 1 040 000

Total comprehensive income for the year – 168 000 168 000

Distributions paid and declared           –  (90 000)  (90 000)

Balance at 30 June 2023 560 000  558 000  1 118 000

Small Ltd Statement of changes in equity for the year ending 30 June 2023

Contributed equity

($)

Retained earnings

($)

Total equity

($)

Balance at 1 July 2022 160 000 670 000 830 000

Total comprehensive income for the year – 192 000 192 000

Distributions paid and declared           –  (110 000) (110 000)

Balance at 30 June 2023  160 000  752 000 912 000

WORKED EXAMPLE 28.3 continued

dee67382_ch28_1103-1154.indd 1139 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1139

continued

REQUIRED Prepare a consolidated statement of profit or loss and other comprehensive income, a consolidated statement of financial position, and a consolidated statement of changes in equity for Big Ltd and its controlled entities as at 30 June 2023.

SOLUTION The consolidation journal entries required to revalue the building of Small Ltd at the date of Medium Ltd’s acquisition (the same date as that used in Worked Example 28.2) will be the same as those provided at entries (a) to (d). The consolidation journal entry required to eliminate Medium Ltd’s investment in Small Ltd is the same as provided in entry (f), while the entry to recognise the impairment loss will be the same as provided in entries (m) and (n). As a number of entries are the same as those in Worked Example 28.2, the explanations are not repeated here. However, explanations are provided in relation to the elimination of Big Ltd’s investment in Medium Ltd.

Revaluation of factory balance to fair value

(a) Dr Factory buildings ($416 000 – $360 000) 56 000

Dr Accumulated depreciation (to close off balance before revaluation) 72 000

Cr Revaluation surplus recognised on consolidation 128 000 (to recognise fair value adjustment for factory building)

Deferred tax liability arising on revaluation of factory building

(b) Dr Revaluation surplus recognised on consolidation 38 400

Cr Deferred tax liability ($128 000 × 0.3) 38 400 (to recognise deferred tax liability arising on fair value adjustment of factory building)

Recognition of additional depreciation expense for the current reporting period and accumulated depreciation for previous three reporting periods

(c) Dr Depreciation expense ($128 000/16 for the current year) 8 000

Dr Retained earnings—1 July 2022 ($128 000/16 × 3 for the previous 3 years)

24 000

Cr Accumulated depreciation ($128 000/16 × 4 years) 32 000 (to recognise of additional depreciation expense for the current and previous three reporting periods)

Adjustments to current tax expense and deferred tax liability arising from additional depreciation expense

(d) Dr Deferred tax liability ($32 000 × 0.3) 9 600

Cr Income tax expense ($8 000 × 0.3 for the current year) 2 400

Cr Retained earnings—1 July 2022 ($24 000 × 0.3 for the previous 3 years)

7 200

(to recognise decrease in deferred tax liability and income tax expense from additional depreciation expense in current and previous three reporting periods)

Eliminate investment in Medium Ltd against Big Ltd’s share of Medium Ltd’s owners’ equity on acquisition date

Of critical importance in this Worked Example is how any goodwill or bargain purchase on acquisition is measured in relation to Big Ltd’s acquisition of the economic entity Medium Ltd and its controlled entity (Small Ltd). It should be noted that in calculating the goodwill or the bargain gain on the purchase associated with Big Ltd’s acquisition of Medium Ltd and its subsidiary, Big Ltd has acquired interests in the net assets of the whole economic entity, not only of Medium Ltd. In other words, Big Ltd has acquired an interest in the net assets of the economic entity attributable to the owners of Medium Ltd.

dee67382_ch28_1103-1154.indd 1140 10/25/19 12:11 PM

1140 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.3 continued

Big Ltd’s acquisition of the economic entity (Medium Ltd and its controlled entity, Small Ltd) comprises:

• seventy per cent of the equity (contributed capital and reserves) of Medium Ltd • sixty per cent of the post-acquisition reserves of Small Ltd from the date of Medium Ltd’s acquisition of Small

Ltd to the date of Big Ltd’s acquisition of Medium Ltd.

Calculation of non-controlling interest in Medium Ltd

Medium Ltd ($)

Big Ltd’s 70% interest

($)

30% Non— controlling

interest ($)

Fair value of consideration transferred 660 000 660 000

plus Non-controlling interest at fair value ($660 000 × 30/70) 282 857 942 857

less Fair value of identifiable assets acquired and liabilities assumed

Share capital on acquisition date 560 000 392 000 168 000

Retained earnings on acquisition date 340 000 238 000 102 000

900 000 630 000

Share of post-acquisition retained earnings of Small Ltd attributable to Medium Ltd prior to Big Ltd’s acquisition of Medium Ltd

Increase in retained earnings of Small Ltd from 30 June 2019 to 30 June 2020 = ($370 000 – $320 000) × 60 per cent

30 000 21 000 9 000

Goodwill impairment in Small Ltd to 30 June 2020  (38 240)  (26 768)  (11 472)

891 760 624 232 267 528

Goodwill on acquisition date 51 097 35 768 15 329

Non-controlling interest on acquisition date 282 857

Eliminating Big Ltd’s investment in Medium Ltd and recognition of goodwill

(e) Dr Share capital 392 000

Dr Retained earnings (Medium Ltd)—1 July 2022 238 000

Dr Goodwill 35 768

Cr Retained earnings (Small Ltd)—1 July 2022 5 768

Cr Investment in Medium Ltd 660 000 (to eliminate Big Ltd’s investment in Medium Ltd and recognition of goodwill on acquisition)

Eliminating Medium Ltd’s investment in Small Ltd and recognition of goodwill

(f) Dr Share capital 96 000

Dr Retained earnings—1 July 2022 192 000

Dr Revaluation surplus recognised on consolidation 53 760

Dr Goodwill 78 240

Cr Investment in Small Ltd 420 000 (eliminating investment in Small Ltd and recognition of goodwill on acquisition)

Elimination of intragroup sales inventory from Small Ltd to Big Ltd

(g) Dr Sales 2 000 000

Cr Cost of goods sold 2 000 000 (to eliminate intragroup sales of inventory)

dee67382_ch28_1103-1154.indd 1141 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1141

Elimination of unrealised profit in closing inventory

(h) Dr Cost of goods sold 140 000

Cr Inventory (statement of financial position) 140 000 (to eliminate unrealised profit in closing inventory)

Consideration of the tax paid or payable on the sale of inventory that is still held within the group

(i) Dr Deferred tax asset 42 000

Cr Income tax expense 42 000 (to recognise tax effect on unrealised profit in closing inventory—$140 000 × 0.30 per cent)

Unrealised profit in opening inventory

( j) Dr Retained earnings—1 July 2022 56 000

Dr Income tax expense 24 000

Cr Cost of goods sold 80 000 (to eliminate unrealised profit in opening inventory)

Eliminating intragroup sale of non-current asset and associated depreciation adjustments Reversal of gain recognised on sale of asset and reinstatement of cost and accumulated depreciation

(k) Dr Gain on sale of building 170 000

Dr Factory building 100 000

Cr Accumulated depreciation 270 000 (to reverse gain recognised in Big Ltd’s financial statements and reinstatement of accumulated depreciation)

Impact of tax on gain on sale of factory building

(l) Dr Deferred tax asset 51 000

Cr Income tax expense 51 000 (to reduce related tax expense on intragroup sale of factory building)

Recognise impairment of goodwill (relating to purchase of Small Ltd by Medium Ltd)

Impairment of goodwill in prior periods

(m) Dr Retained earnings—1 July 2022 (previous years’ accumulated impairment)

38 240

Cr Accumulated impairment loss—goodwill 38 240 (to recognise goodwill impairment loss from previous periods)

Impairment of goodwill in current period

(n) Dr Impairment loss—goodwill (the impairment loss recognised in 2023)

5 000

Cr Accumulated impairment loss—goodwill 5 000 (to recognise goodwill impairment loss in current period)

As Medium Ltd valued the non-controlling interest at the proportionate share of Small Ltd’s identifiable net assets, there is no necessity to allocate any goodwill impairment expense between the parent and the non-controlling interest either in the current or previous reporting periods.

In Worked Example 28.2 an impairment loss on the goodwill acquired by Big Ltd in Medium Ltd was recognised because the carrying amount of goodwill was greater than its recoverable amount. However, in this example, because the recoverable amount of goodwill at 30 June 2023 is deemed to be $110 000, which is greater than its carrying amount, no consolidation entry is required to recognise an impairment loss.

continued

dee67382_ch28_1103-1154.indd 1142 10/25/19 12:11 PM

1142 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.3 continued

Dividends paid and declared

Elimination of interim dividend (paid by Small Ltd to Medium Ltd)

(o) Dr Dividend revenue ($110 000 × 0.6) 66 000 Cr Interim dividend 66 000

(to reverse interim dividend paid by Small Ltd to Medium Ltd)

Elimination of final dividend (declared by Medium Ltd to Big Ltd)

(p) Dr Dividend revenue ($90 000 × 0.7) 63 000 Cr Final dividend 63 000

(to eliminate final dividend declared by Medium Ltd and recognised by Big Ltd)

Elimination of intragroup debt: Big Ltd’s share of Medium Ltd’s declared final dividend

(q) Dr Dividend payable ($90 000 × 0.7) 63 000 Cr Dividend receivable 63 000

(to reverse intragroup dividends payable and receivable)

Recognising non-controlling interest in contributed equity, reserves and earnings

As was established earlier, it is necessary to calculate the non-controlling interest’s share in profits and capital and reserves. The calculations undertaken in Worked Example 28.2 for the non-controlling interest’s share of current period’s profits, contributed equity and dividends apply equally here. However, the non-controlling interests’ share of retained earnings at 1 July 2023 (that is, opening retained earnings) will need to be recalculated.

Calculation of non-controlling interests in Medium Ltd and Small Ltd

Medium Ltd ($)

30% Non- controlling

interest ($)

Small Ltd ($)

40% Non- controlling

interest ($)

(i) Non-controlling interests on acquisition date

Share capital on acquisition date 560 000 168 000 160 000 64 000

Retained earnings on acquisition date 340 000 102 000 320 000 128 000

Post-acquisition retained earnings Small Ltd (370 000 – 320 000) × 0.6 30 000 less Impairment loss—goodwill (relating to purchase of Small by Medium Ltd), being 78 240 – 40 000 (38 240)

  (8 240) (2 472)

Revaluation surplus on acquisition date (128 000 – 38 400)  −  − 89 600 35 840

891 760 267 528

Goodwill (see calculation provided earlier)  15 329    

282 857 569 600 227 840

(ii) 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

Retained earnings—since acquisition

Medium Ltd ($480 000 – $340 000) 140 000

Small Ltd ($670 000 – $320 000) 350 000

less Depreciation adjustment due to revaluing factory building to fair value (in relation to the previous three years) (24 000)

dee67382_ch28_1103-1154.indd 1143 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1143

Calculation of non-controlling interests in Medium Ltd and Small Ltd

Medium Ltd ($)

30% Non- controlling

interest ($)

Small Ltd ($)

40% Non- controlling

interest ($)

Tax effect of depreciation adjustment due to revaluing factory buildings 7 200

less Unrealised profit in opening inventory (last year’s closing inventory) (80 000)

Tax effect of unrealised profit in opening inventory 24 000    −  

Adjusted post-investment retained earnings—1 July 2022   84 000 25 200 333 200 133 280

(iii) Non-controlling interest in the current period’s profit and movements in reserves in the current period

Profit for the year 168 000 192 000

Adjustment relating to inventory

Unrealised profit in opening inventory 80 000

less Tax effect of unrealised profit in opening inventory (24 000)

less Unrealised profit in closing inventory (140 000)

Tax effect of unrealised profit in closing inventory 42 000

Fair value adjustment

less Depreciation adjustment due to revaluing factory buildings to fair value (8 000)

Tax effect of depreciation adjustment due to revaluing factory buildings 2 400

Intragroup dividends

less Dividend revenue from within the group (paid by Small Ltd to Medium Ltd) (66 000)

less Goodwill impairment in organisation controlled by intermediate subsidiary  (5 000)    −  

Adjusted profit for the year  153 000 45 900 88 400 35 360

Dividends paid and declared   (90 000) (27 000) (110 000) (44 000)

326 957 352 480

Recognising non-controlling interest in contributed equity, reserves and earnings in Medium Ltd

(r) Dr Share capital 168 000 Dr Retained earnings (Medium Ltd)

—1 July 2022 ($102 000 + $25 200) 127 200

Dr Goodwill 15 329 Dr Non-controlling interest in earnings 45 900 Cr Retained earnings (Small Ltd)—1 July 2022 2 472 Cr Final dividend 27 000 Cr Non-controlling interest 326 957

(to recognise non-controlling interests in Medium Ltd and non-controlling interests in earnings in Medium Ltd on acquisition date)

Recognising non-controlling interest in contributed equity, reserves and earnings in Small Ltd

(s) Dr Share capital 64 000 Dr Retained earnings—1 July 2022 (128 000 + 133 280) 261 280

continued

dee67382_ch28_1103-1154.indd 1144 10/25/19 12:11 PM

1144 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.3 continued

Dr Revaluation surplus recognised on consolidation 35 840 Dr Non-controlling interest in earnings 35 360 Cr Interim dividend 44 000 Cr Non-controlling interest 352 480

(to recognise non-controlling interests in Small Ltd and non-controlling interests in earnings in Small Ltd on acquisition date)

Indirect non-controlling interest in Small Ltd

Calculation of indirect non-controlling interest in Small Ltd

Small Ltd ($)

18% Indirect non-controlling

interest ($)

Indirect 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 333 200 59 976

Indirect non-controlling interest in the current period’s profit for the year  88 400  15 912

421 600 75 888

(t) Dr Retained earnings—1 July 2022 59 976

Dr Non-controlling interest in earnings 15 912

Cr Non-controlling interest 75 888 (to recognise indirect non-controlling interest in earnings of Small Ltd)

Consolidation worksheet as at 30 June 2023

Eliminations and adjustments

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Dr ($)

Cr ($)

Consolidated statements

($)

Sales 7 500 000 4 000 000 3 500 000 2 000 000(g) 13 000 000

Cost of goods sold (6 100 000) (3 260 000) (2 900 000) 140 000(h) 2 000 000(g) (10 320 000)

80 000( j)

Gross profit 1 400 000 740 000 600 000 2 680 000

Depreciation expense (130 000) (50 000) (18 000) 8 000(c) (206 000)

Impairment loss—goodwill – – – 5 000(n) (5 000)

Other expenses (743 000) (476 000) (262 000) (1 481 000)

Dividend revenue 63 000 66 000 – 66 000(o)

63 000(p) –

Gain on sale of factory   170 000            –            – 170 000(k)            –

Profit before tax 760 000 280 000 320 000 988 000

Income tax expense   (304 000) (112 000) (128 000) 24 000( j) 2 400(d) (472 600)

42 000(i)

51 000(l)

Profit for the year 456 000 168 000 192 000 515 400

Non-controlling interest in earnings. 45 900(r) (97 172)

35 360(s)

15 912(t)

dee67382_ch28_1103-1154.indd 1145 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1145

Eliminations and adjustments

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Dr ($)

Cr ($)

Consolidated statements

($)

Retained earnings —1 July 2022 720 000 480 000 670 000 24 000(c) 7 200(d) 888 744

238 000(e) 5 768(e)

192 000(f) 2 472(r)

56 000( j)

38 240(m)

127 200(r)

261 280(s)

59 976(t)

Interim dividend (125 000) – (110 000) 66 000(o) (125 000)

44 000(s)

Final dividend   (260 000)   (90 000)            – 63 000(p)   (260 000)

27 000(r)

Retained earnings —30 June 2023 791 000 558 000 752 000 921 972

Share capital 3 300 000 560 000 160 000 392 000(e) 3 300 000

96 000(f)

168 000(r)

64 000(s)

Revaluation surplus recognised on consolidation            –             –            – 38 400(b) 128 000(a) –

53 760(f)

35 840(s)

Non-controlling interest 326 957(r) 755 325

352 480(s)

      75 888(t)  

Total equity 4 091 000 1 118 000 912 000 4 977 297

Accounts payable 910 000 715 000 319 000 1 944 000

Dividends payable 260 000 90 000 – 63 000(q) 287 000

Deferred tax liability           –           –           – 9 600(d) 38 400(b)  28 800

Total of equity and liabilities 5 261 000 1 923 000 1 231 000 7 237 097

Cash 76 000 6 000 37 000 119 000

Accounts receivable 172 000 52 000 68 000 292 000

Dividends receivable 63 000 – – 63 000(q) –

Inventory 1 100 000 440 000 700 000 140 000(h) 2 100 000

Land 720 000 105 000 210 000 1 035 000

Factory buildings 2 600 000 1 800 000 360 000 56 000(a) 4 916 000

100 000(k)

Accumulated depreciation (130 000) (900 000) (144 000) 72 000(a) 32 000(c) (1 404 000)

270 000(k)

Investment—Medium Ltd 660 000 – – 660 000(e) –

Investment—Small Ltd – 420 000 – 420 000(f) –

continued

dee67382_ch28_1103-1154.indd 1146 10/25/19 12:11 PM

1146 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 28.3 continued

Eliminations and adjustments

Big Ltd ($)

Medium Ltd ($)

Small Ltd ($)

Dr ($)

Cr ($)

Consolidated statements

($)

Goodwill – – – 35 768(e) 129 337 78 240(f) 15 329(r)

Accumulated impairment loss 38 240(m) (43 240) 5 000(n)

Deferred tax asset – – – 42 000(i) 93 000         51 000(l)    

Total assets 5 261 000 1 923 000 1 231 000 4 940 805 4 940 805 7 237 097

Big Ltd and its controlled entities Consolidated statement of profit or loss and other comprehensive income for the year ending 30 June 2023

The Group ($)

Big Ltd ($)

Sales 13 000 000 7 500 000

Cost of goods sold (10 320 000) (6 100 000)

Gross profit 2 680 000 1 400 000

Dividend revenue – 63 000

Gain on sale of factory – 170 000

Depreciation expense (206 000) (130 000)

Impairment loss—goodwill (5 000) –

Other expenses   (1 481 000)   (743 000)

Profit before tax 988 000 760 000

Income tax expense (472 600)   (304 000)

Profit for the year 515 400 456 000

Other comprehensive income           –           –

Total comprehensive income   515 400   456 000

Attributable to:

Owners of the parent 418 228 –

Non-controlling interest  97 172 –

  515 400 –

Big Ltd and its controlled entities Consolidated statement of changes in equity for the year ending 30 June 2023

Attributable to owners of the parent

Share capital

($)

Retained earnings

($) Total

($)

Non- controlling

interest ($)

Total equity

($)

Balance—1 July 2022 3 300 000 888 744 4 188 744 729 153 4 917 897 Comprehensive income for the year – 418 228 418 228 97 172 515 400 Dividends           – (385 000) (385 000) (71 000) (456 000) Balance—30 June 2023 3 300 000 921 972 4 221 972 755 325 4 977 297

dee67382_ch28_1103-1154.indd 1147 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1147

Big Ltd Statement of changes in equity for the year ending 30 June 2023

Share capital

($)

Retained earnings

($)

Total equity

($)

Balance—1 July 2022 3 300 000 720 000 4 020 000 Comprehensive income for the year – 456 000 456 000 Dividends           – (385 000)  (385 000) Balance—30 June 2023 3 300 000 791 000 4 091 000

Big Ltd and its controlled entities Consolidated statement of financial position at 30 June 2023

The Group ($)

Big Ltd ($)

Assets

Current assets

Inventory 2 100 000 1 100 000

Accounts receivable 292 000 172 000

Dividend receivable – 63 000

Cash 119 000 76 000

Total current assets 2 511 000 1 411 000

Non-current assets

Land 1 035 000 720 000

Factory buildings 4 916 000 2 600 000

less Accumulated depreciation (1 404 000) (130 000)

Goodwill 129 337 –

less Accumulated impairment losses (43 240) –

Investment in Medium Ltd – 660 000

Deferred tax asset  93 000           –

Total non-current assets 4 726 097 3 850 000

Total assets 7 237 097 5 261 000

Liabilities

Non-current liabilities

Deferred tax liability   28 800            –

Total non-current liabilities   28 800            –

Current liabilities

Accounts payable 1 944 000 910 000

Dividends payable  287 000  260 000

Total current liabilities 2 231 000 1 170 000

Total liabilities 2 259 800 1 170 000

Net assets 4 977 297 4 091 000

Equity

Capital and reserves

Share capital 3 300 000 3 300 000

Retained earnings   921 972  791 000

4 221 972 4 091 000

Non-controlling interest  755 325           –

Total equity 4 977 297 4 091 000

dee67382_ch28_1103-1154.indd 1148 10/25/19 12:11 PM

1148 PART 8: Accounting for equity interests in other entities

SUMMARY

This chapter, as did Chapters 25, 26 and 27, considered issues associated with preparing consolidated financial statements. This chapter specifically focused upon how to account for indirect ownership interests.

The chapter showed that it is possible to control another entity—and therefore be required to consolidate it—without necessarily having any direct ownership in that separate legal entity. The control can be established through an indirect ownership interest, that is, through an interest established by controlling another entity that in turn controls the entity in question.

When consolidating in the presence of indirect interests, the elimination of the investments held by the immediate parent entities is to be undertaken on the basis of the direct ownership interest. The economic entity’s interest in the post-acquisition profits of subsidiaries, however, will be based on the sum of both the direct ownership interests and the indirect ownership interests.

KEY TERMS

control (organisations) 1104 non-controlling interests 1105

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. If the indirect ownership interests of a parent entity in a subsidiary are being discussed, what is this discussion referring to? LO 28.1 This would be referring to a situation where a parent entity has shares in a subsidiary and that subsidiary in turn has shares in another subsidiary.

2. What is an indirect non-controlling interest in a subsidiary? LO 28.1 If a subsidiary is partly owned, there will be direct non-controlling interests in that subsidiary. If that subsidiary in turn has an equity interest in another subsidiary, the non-controlling interests in the first subsidiary will then have indirect interests in the second subsidiary.

3. Can an entity be considered a controlled entity (that is, a subsidiary) of another entity (the parent) even if that other entity (the parent) has no direct ownership interest in the subsidiary? LO 28.1 Yes, a parent entity can have a subsidiary in which it has no direct ownership interest. If one organisation (the parent) controls another organisation (a subsidiary)—which we might refer to as an intermediate subsidiary—then the parent effectively also controls the organisations that are controlled by the intermediate organisation.

4. On consolidation, when we eliminate the parent entity’s investment in the subsidiary against the pre-acquisition capital and reserves of the subsidiary, do we take account of only the direct ownership interests of the parent entity, or both the direct and indirect ownership interests? LO 28.2, 28.2 When we eliminate the parent entity’s investment in a subsidiary, we eliminate the pre-acquisition capital and reserves on the basis of the direct ownership interests held by the immediate parent entity in that subsidiary.

5. On consolidation, post-acquisition movements in the reserves, retained earnings and profits of a subsidiary will be included in the consolidated financial statements. However, they will need to be apportioned between the parent entity’s interest and the non-controlling interests. In undertaking this apportionment, should we take account of only the direct ownership interests, or both the direct and indirect ownership interests? LO 28.2, 28.3 When allocating the post-acquisition movements in the reserves and retained earnings, and post-acquisition profits, to the parent entity and the non-controlling interests, we base this allocation on the total of direct and indirect ownership interests.

dee67382_ch28_1103-1154.indd 1149 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1149

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is a direct ownership interest and what is an indirect ownership interest? LO 28.1 • 2. Why do we need to know which part of a non-controlling interest is direct, and which part is indirect? LO 28.1 • 3. Can a parent entity have a subsidiary in which it has no direct ownership interest? LO 28.1 • 4. Where in the statement of financial position would indirect non-controlling interests be disclosed? LO 28.1 • 5. What is the difference in the consolidation accounting approach used for sequential and non-sequential acquisitions?

LO 28.2, 28.3 •• 6. When calculating the non-controlling interest in the post-acquisition profits of a subsidiary, is the calculation based

upon the non-controlling interests’ direct ownership interests? LO 28.2 • 7. If an intermediate parent acquires a subsidiary and, in doing so, purchases goodwill, then how will any impairment

of that goodwill be treated when working out the non-controlling interest in profits and retained earnings? LO 28.2, 28.3 ••

8. A Ltd has a 60 per cent interest in B Ltd and B Ltd has an 80 per cent interest in C Ltd. Both acquisitions were made in 2020. During the financial year ending 30 June 2023, A Ltd paid a dividend of $300 000, B Ltd paid a dividend of $200 000 and C Ltd paid a dividend of $100 000. What amount of dividends paid would be shown in the consolidated financial statements of A Ltd and its controlled entities for the year ending 30 June 2023? LO 28.2 •

9. Consider the example in Figure 28.7 and assume that ownership interest (the percentages shown) is representative of the capacity to control the various entities.

REQUIRED Determine which of the entities would constitute the economic entity. LO 28.1 •

Figure 28.7 Structure of the entity in Review Question 9

B

A

C

ED

F

70% 60%

20% 30%

70% 50%

10. Maroubra Ltd holds 70 per cent of the ownership equity of Coogee Ltd and Coogee Ltd holds 80 per cent of the ownership equity of Clovelly Ltd. During the financial year the following dividends are paid by the respective companies:

Maroubra Ltd $ 120 000

Coogee Ltd $ 80 000

Clovelly Ltd $ 60 000

REQUIRED What amount of dividend payments would be shown in the consolidated financial statements? LO 28.2 ••

11. When eliminating the investment in a subsidiary against the pre-acquisition capital and reserves of a subsidiary for the purposes of presenting consolidated financial statements, should both direct and indirect ownership interests be considered? LO 28.1 ••

dee67382_ch28_1103-1154.indd 1150 10/25/19 12:11 PM

1150 PART 8: Accounting for equity interests in other entities

13. A Ltd acquires a 60 per cent interest in B Ltd on 1 July 2022 for a cost of $2 million representing the fair value of consideration transferred. The management of A Ltd values any non-controlling interest at acquisition date at the proportionate share of B Ltd’s net identifiable assets at acquisition date. All assets are assumed to be fairly valued in the books of B Ltd. The share capital and reserves of B Ltd at the date of acquisition are:

Share capital $ 2 000 000

Retained earnings $ 600 000

$ 2 600 000

B Ltd acquires a 60 per cent interest in C Ltd on 1 July 2022 for $1.6 million representing the fair value of consideration transferred. Any non-controlling interest in C Ltd at acquisition date is based on fair value. The share capital and reserves of C Ltd at the date of acquisition are:

Share capital $ 1 600 000

Retained earnings $ 800 000

$ 2 400 000

The statements of comprehensive income and statements of financial position of the entities at 30 June 2023 (one year after the acquisitions) are as follows:

A Ltd ($000)

B Ltd ($000)

C Ltd ($000)

Abbreviated statement of profit or loss and other comprehensive income

Retained earnings

Profit before tax 1 000 160 200

Tax expense (540) (50) (80)

Profit after tax 460 110 120

Statement of changes in equity

Profit after tax (extract) 460 110 120

Retained earnings—1 July 2022 2 000 600 800

2 460 710 920

Dividends declared (400) (100) (60)

Retained earnings—30 June 2023 2 060 610 860

Statement of financial position

Shareholders’ equity

Retained earnings 2 060 610 860

Share capital 8 000 2 000 1 600

12. Consider the corporate structure represented in Figure 28.8.

REQUIRED Determine A Ltd’s interest (direct and indirect) and the non-controlling interest (direct and indirect) in the separate legal entities under the control of A Ltd. LO 28.1 ••

Figure 28.8 Corporate structure referred to in Review Question 12

B Ltd

A Ltd

C Ltd

E Ltd

D Ltd

60% 70%

60%

80% 10%

dee67382_ch28_1103-1154.indd 1151 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1151

A Ltd ($000)

B Ltd ($000)

C Ltd ($000)

Current liabilities

Accounts payable 340 80 − Dividends payable 400 100 60

Non-current liabilities

Loans 800 500 − 11 600 3 290 2 520

Current assets

Cash 590 74 200

Accounts receivable 250 350 400

Dividends receivable 60 36 − Inventory 1 000 600 800

Non-current assets

Land 4 700 − 400 Plant 3 000 630 720

Investment in B Ltd 2 000 − Investment in C Ltd − 1 600 −

11 600 3 290 2 520

Additional information It is assumed that goodwill acquired has been subject to an impairment loss of 20 per cent of the original goodwill value.

REQUIRED Present consolidated financial statements for A Ltd and its controlled entities as at 30 June 2023. LO 28.2 ••

CHALLENGING QUESTIONS

14. On 1 July 2020 Anglesea acquired a 70 per cent interest in Bells Ltd at a cost of $1 000 000, and Bells Ltd acquired an 80 per cent interest in Torquay Ltd at a cost of $750 000. Both payments represent the fair value of consideration transferred. All assets are assumed to be recorded at their fair value. At the date of acquisition the share capital and reserves of Bells Ltd and Torquay Ltd were as follows:

Bells Ltd ($)

Torquay Ltd ($)

Share capital 500 000 400 000

Revaluation surplus 150 000 100 000

Retained earnings 250 000 100 000

900 000 600 000

For the year ending 30 June 2023, Bells Ltd and Torquay Ltd generated the following results:

Bells Ltd ($)

Torquay Ltd ($)

Profit before tax 250 000 100 000

Tax expense (100 000)   (40 000)

Profit after tax 150 000 60 000

Retained earnings—1 July 2022 280 000 130 000

430 000 190 000

Dividends paid   (30 000)   (10 000)

Retained earnings—30 June 2023 400 000 180 000

dee67382_ch28_1103-1154.indd 1152 10/25/19 12:11 PM

1152 PART 8: Accounting for equity interests in other entities

Non-controlling interests are measured at the non-controlling interest’s proportionate share of the acquiree’s identifiable net assets. In relation to goodwill, the recoverable amount of the goodwill acquired in Bells Ltd was assessed as being $250 000 at 30 June 2023, with $15 000 of the accumulated impairment occurring in the 2023 financial year. The goodwill acquired in Torquay Ltd was assessed as having a recoverable amount of $150 000 as at 30 June 2023 with $10 000 of the total impairment occurring in the year ending 30 June 2023.

REQUIRED Determine the total non-controlling interest in closing retained earnings as at 30 June 2023. LO 28.2

15. On 30 June 2019, Maroubra Ltd purchased 70 per cent of the shares of Clovelly Ltd for $2 640 000 cash. On the same date, Clovelly Ltd purchased 60 per cent of the shares of Bronte Ltd for $1 680 000 cash. Any non-controlling interest is valued at fair value.

The statements of financial position of Clovelly Ltd and Bronte Ltd immediately before the investments were as follows:

Clovelly Ltd and Bronte Ltd Statements of financial position as at 30 June 2019

Clovelly Ltd ($)

Bronte Ltd ($)

Assets

Cash 1 860 000 120 000

Accounts receivable 720 000 320 000

Inventory 800 000 520 000

Land 420 000 840 000

Plant and machinery 4 000 000 1 440 000

Accumulated depreciation (2 800 000) (288 000)

Total assets 5 000 000 2 952 000

Liabilities

Accounts payable 1 800 000 1 032 000

Shareholders’ equity

Share capital 2 240 000 640 000

Retained earnings 960 000 1 280 000

Total of liabilities and shareholders’ equity 5 000 000 2 952 000

Additional information (i) At the date of investment, all the identifiable net assets of Clovelly Ltd and Bronte Ltd were considered to be

recorded at fair value in the respective statements of financial position of Clovelly Ltd and Bronte Ltd, except Bronte Ltd’s plant and machinery, which had a fair value of $1 664 000, and a carrying amount of $1 152 000 (cost of $1 440 000, accumulated depreciation of $288 000). At 30 June 2019, the plant and machinery had a remaining useful life of 16 years.

(ii) It is assumed that there has been no impairment in any goodwill acquired. (iii) During the 2023 financial year Bronte Ltd sold goods to Maroubra Ltd for $8 000 000. These goods originally cost

Bronte Ltd $6 400 000. On 30 June 2023, 30 per cent of these goods remained in Maroubra Ltd’s closing inventory. (iv) Bronte Ltd’s opening inventory included goods purchased from Clovelly Ltd for $1 280 000. These goods

originally cost Clovelly Ltd $1 960 000. (v) On 30 June 2023 Maroubra Ltd sold plant and machinery to Clovelly Ltd for $3 200 000. Maroubra Ltd originally

purchased the plant and machinery for $3 600 000, on 1 July 2017. The original estimated useful life of the plant and machinery was 20 years. The expected residual value is $nil.

(vi) The income tax rate is 30 per cent. (vii) The accounts of Maroubra Ltd, Clovelly Ltd and Bronte Ltd revealed the following balances as at 30 June 2023.

dee67382_ch28_1103-1154.indd 1153 10/25/19 12:11 PM

CHAPTER 28: Further consolidation issues III: accounting for indirect ownership interests 1153

Maroubra Ltd, Clovelly Ltd, and Bronte Ltd Statements of profit or loss and other comprehensive income for the year ended 30 June 2023

Maroubra Ltd ($)

Clovelly Ltd ($)

Bronte Ltd ($)

Sales 30 000 000 16 000 000 14 000 000

Cost of goods sold (24 400 000) (13 040 000) (11 600 000)

Gross profit 5 600 000 2 960 000 2 400 000

Depreciation expense (520 000) (200 000) (72 000)

Other expenses (2 972 000) (1 904 000) (1 048 000)

Dividend revenue 252 000 264 000 −

Gain on sale of plant and machinery 680 000           –           –

Profit before income tax expense 3 040 000 1 120 000 1 280 000

Income tax expense (1 216 000) (448 000) (512 000)

Profit after income tax expense 1 824 000 672 000 768 000

Other comprehensive income           –           –           –

Total comprehensive income 1 824 000 672 000 768 000

Maroubra Ltd, Clovelly Ltd and Bronte Ltd Statements of financial position of as at 30 June 2023

Maroubra Ltd ($)

Clovelly Ltd ($)

Bronte Ltd ($)

Assets

Cash 304 000 24 000 148 000

Accounts receivable 688 000 208 000 272 000

Dividends receivable 252 000 – –

Inventory 4 400 000 1 760 000 2 800 000

Land 2 880 000 420 000 840 000

Plant and machinery 10 400 000 7 200 000 1 440 000

Accumulated depreciation (520 000) (3 600 000) (576 000)

Investment in Clovelly Ltd 2 640 000 – –

Investment in Bronte Ltd           – 1 680 000           –

Total assets 21 044 000 7 692 000 4 924 000

Liabilities

Accounts payable 3 640 000 2 860 000 1 276 000

Dividends payable 1 040 000 360 000 –

Shareholders’ equity

Share capital 13 200 000 2 240 000 640 000

Retained earnings 3 164 000 2 232 000 3 008 000

Total of liabilities and shareholders’ equity 21 044 000 7 692 000 4 924 000

dee67382_ch28_1103-1154.indd 1154 10/25/19 12:11 PM

1154 PART 8: Accounting for equity interests in other entities

Maroubra Ltd Statement of changes in equity for the year ending 30 June 2023

Share capital ($)

Retained earnings

($) Total

($)

Balance at 1 July 2022 13 200 000 2 880 000 16 080 000

Total comprehensive income for the year – 1 824 000 1 824 000

Dividend—interim dividend – (500 000) (500 000)

Dividend—final dividend           – (1 040 000) (1 040 000)

Balance at 30 June 2023 13 200 000 3 164 000 16 364 000

Clovelly Ltd Statement of changes in equity for the year ending 30 June 2023

Share capital ($)

Retained earnings

($) Total

($)

Balance at 1 July 2022 2 240 000 1 920 000 4 160 000

Total comprehensive income for the year – 672 000 672 000

Dividend—final dividend           – (360 000) (360 000)

Balance at 30 June 2023 2 240 000 2 232 000 4 472 000

Bronte Ltd Statement of changes in equity for the year ending 30 June 2023

Share capital ($)

Retained earnings

($) Total

($)

Balance at 1 July 2022 640 000 2 680 000 3 320 000

Total comprehensive income for the year – 768 000 768 000

Dividend—interim dividend           –  (440 000)  (440 000)

Balance at 30 June 2023 640 000 3 008 000 3 648 000

REQUIRED Prepare a consolidated statement of profit or loss and other comprehensive income, a consolidated statement of changes in equity, and a consolidated statement of financial position for Maroubra Ltd and its controlled entities for the year ended 30 June 2023, disclosing separately the parent entity interest and non-controlling interest. LO 28.2

16. Use the same information as in Challenging Question 15, except that the acquisition dates are as follows: • On 30 June 2019 Clovelly Ltd acquired 60 percent of the shares of Bronte Ltd for $1 680 000 (same date as in

Challenging Question 15). • On 30 June 2020 (one year later) Maroubra Ltd acquired a 70 per cent interest in Clovelly Ltd for $2 640 000.

Both amounts represent the fair value of consideration transferred. Any non-controlling interests are measured at fair value. At 30 June 2020 the share capital and reserves of Clovelly Ltd and Bronte Ltd were as follows:

Clovelly Ltd ($)

Bronte Ltd ($)

Share capital 2 240 000 640 000

Retained earnings 1 360 000 1 480 000

3 600 000 2 120 000

REQUIRED Prepare a consolidated statement of profit or loss and other comprehensive income, a consolidated statement of changes in equity, and a consolidated statement of financial position for Maroubra Ltd and its controlled entities as at 30 June 2023. You should also provide details of the non-controlling interests as required by AASB 10. LO 28.3

dee67382_ch29_1155-1204.indd 1155 10/25/19 12:17 PM

1155

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 29.1 Be aware that investments in ‘associates’ must be accounted for using the ‘equity method of

accounting’, and know the principles of this method of accounting. 29.2 Understand that an ‘associate’ is an investee over which the investor has significant influence and be

aware of tests that can be applied to determine the existence of significant influence. 29.3 Understand how to apply the equity method of accounting through appropriate journal entries either in

the investor’s own accounts or as part of the consolidation process. 29.4 Understand how to apply the equity method of accounting in the presence of inter-entity transactions. 29.5 Understand how to apply the equity method of accounting when the associate incurs losses. 29.6 Be aware of the disclosure requirements pertaining to investments in associates. 29.7 Be aware of what a joint arrangement represents and its relationship to ‘joint control’, and be aware that

a joint arrangement can be classified as either a ‘joint venture’ or a ‘joint operation’. 29.8 Understand the meaning of a ‘joint venture’ and know how to account for the interests in a joint venture. 29.9 Understand the meaning of a ‘joint operation’ and know how to account for the interests in a joint

operation.

C H A P T E R 29 Accounting for investments in associates and joint ventures

dee67382_ch29_1155-1204.indd 1156 10/25/19 12:17 PM

1156 PART 8: Accounting for equity interests in other entities

29.1 Introduction to the equity method of accounting

In this chapter we will consider how to account for equity investments in which the investor entity does not exert control over the investee’s financial and operating policies—that is, where the investee is not a subsidiary.

In Chapters 25, 26, 27 and 28 we considered the consolidation process and learned that consolidation is required where one entity controls another entity either on a temporary or long-term basis (and where the exception available for parent entities that are ‘investment entities’ is not invoked). We also learned that during the consolidation process the investment in the subsidiary, as shown in the accounts of the parent entity, is eliminated against the pre-acquisition capital and reserves of the subsidiary (after any required fair value adjustments have been undertaken), with any difference being of the nature of either goodwill, or gain on a bargain purchase. As also indicated in the previous chapters devoted to consolidation issues, the consolidated economic entity can comprise various forms of entities, for example, companies, partnerships and trusts.

Where an organisation holds an ownership interest in another organisation, the investment in the separate accounts of the investor will generally be measured at fair value in accordance with AASB 9 Financial Instruments, and increases or decreases in the fair value of the investment would typically be included in the parent entity’s profit or loss. However, if the investment is in a subsidiary (or ‘associate’ or ‘joint venture’—we will explain what these are later in this chapter), then the parent entity can elect to measure its investment in a subsidiary—as reported in the parent entity’s own individual financial statements—at cost (rather than fair value). That is, while AASB 9 does have a general requirement that equity investments must be measured at fair value, there are

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. If an entity has shares in another organisation, when would that other organisation be considered to be an ‘associate’? LO 29.1, 29.2

2. If an investee is deemed to be an associate, does the equity method of accounting need to be applied when accounting for the investor’s investment in that associate? LO 29.1, 29.2

3. Will the accounting adjustments required by the equity method of accounting be performed in the investor’s own separate accounts, or by way of consolidation adjustments within a consolidation worksheet? LO 29.3

4. What is a ‘joint arrangement’, and what are the two broad types of joint arrangements? LO 29.7 5. Is the equity method of accounting to be used to account for interests in both types of joint arrangements?

LO 29.8, 29.9

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

6 Exploration for and Evaluation of Mineral Resources IFRS 6

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

112 Income Taxes IAS 12

127 Separate Financial Statements IAS 27

128 Investments in Associates and Joint Ventures IAS 28

LO 29.1

equity investment Usually shares in an organisation, giving the investor an ownership interest and therefore a share in the organisation’s profits.

economic entity When used from the perspective of a group of organisations, an economic entity comprises the parent entity and the entities (subsidiaries) under the control of the parent entity.

dee67382_ch29_1155-1204.indd 1157 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1157

investor An entity/person that has an ownership interest in another entity (the investee).

investee An entity in which another party (the investor) has an ownership interest.

associate An entity over which the investor has significant influence.

significant influence The power to participate in the financial and operating policy decisions of the entity, but not have control or joint control over those policies.

equity method of accounting Under equity accounting, the investment in an associate or joint venture is increased by any post- acquisition movements in the associate’s or joint venture’s earnings and reserves.

exceptions available where the investment is in a subsidiary, joint venture or associate. As paragraph 10 of AASB 127 Separate Financial Statements states:

When an entity prepares separate financial statements, it shall account for investments in subsidiaries, joint ventures and associates either:

(a) at cost; (b) in accordance with AASB 9; or (c) using the equity method as described in AASB 128.

The entity shall apply the same accounting for each category of investments. (AASB 127)

The ‘separate financial statements’ referred to above would be the financial statements of the parent entity that have not been consolidated with the subsidiaries. As we know, when a parent entity prepares its financial statements, for each year being reported upon it will present two columns of data—one for the parent entity separately and one column for the group. Chapter 14 addressed, in some depth, how to account for financial instruments, including equity investments, so we will not repeat that material here.

As we have already explained in earlier chapters, where an investor has control of an investee, then the investee is considered to be a ‘subsidiary’ and the accounts of the subsidiary are to be consolidated with those of the investor (parent). If an investor has ‘joint control’ over another organisation, then it will not consolidate that organisation, but will be required to adopt another approach to recognising its interest in the joint arrangement (we will cover joint arrangements later in this chapter).

Further, an organisation might have ‘significant influence’ over another entity. Significant influence is weaker than both control and joint control. An entity that is subject to ‘significant influence’ is referred to as an ‘associate’ of the investor. We will now turn our attention to accounting for associates. Later in this chapter we will consider how to account for ‘joint arrangements’ that arise when one entity has joint control over another.

Accounting for investments in associates is regulated by an accounting standard devoted to ‘associates’ and to ‘joint ventures’ (we will discuss ‘joint ventures’ later in this chapter). An associate is defined as an entity over which an investor has significant influence. According to Accounting Standard AASB 128 Investments in Associates and Joint Ventures, an investor has significant influence over another entity when it has the power to participate in the financial and operating policy decisions of the investee but is not in control or joint control of those policies.

Accounting Standard AASB 128 requires that, where an investor does significantly influence an investee, the investor must adopt the equity method of accounting. Therefore, at this stage you should be aware that the extent of ownership interest can affect how an investor accounts for its equity investments.

An accounting standard requiring the use of the equity method of accounting (a method of accounting to be described below) was first released within Australia in 1989. When initially released, AASB 1016 Accounting for Investments in Associates (which has since been withdrawn) restricted the use of the equity method of accounting to investments that were of a corporate form, thus excluding the use of the equity method of accounting for investments of a non-corporate form such as trusts. Further, the standard restricted the use of the equity method of accounting to the notes to the financial statements alone—rather than allowing the equity method of accounting to be used for the purposes of the financial statements themselves. A revised version of AASB 1016 was released in 1998 and required the equity method of accounting to be applied in the financial statements (rather than the notes to the financial statements), and extended the application of the equity method of accounting beyond companies.

AASB 128 Investments in Associates was initially released in July 2004, replacing AASB 1016. As with AASB 1016, AASB 128 required the use of the equity method of accounting within the financial statements rather than the notes, and the application of the equity method of accounting was to include investments that are of a corporate form as well as those that are not of a corporate form. AASB 128 Investment in Associates and Joint Ventures was revised and re-released in August 2011 and its coverage extended to include joint ventures.

Equity accounting is an approach to accounting to be adopted for those investments over which the investor has significant influence. Where an investor has significant influence over an investee, the investee is referred to as an ‘associate’ of the investor. Paragraph 3 of AASB 128 defines an associate as being:

an entity over which the investor has significant influence. (AASB 128)

dee67382_ch29_1155-1204.indd 1158 10/25/19 12:17 PM

1158 PART 8: Accounting for equity interests in other entities

29.2 Significant influence

We can see from the above definition that significant influence is the criterion to be applied in determining whether the equity method of accounting is to be applied in relation to an equity investment. That is, the equity

method of accounting is to be used for investments in associates (and joint ventures as we will see later in this chapter), and whether an investee is classified as an associate depends upon the existence of significant influence. As we have already noted, significant influence is defined at paragraph 3 of AASB 128 as the power to participate in the financial and operating policy decisions of the investee but it is not control or joint control over those policies.

As indicated in the above definition, significant influence falls short of control. ‘Control’ is the criterion for determining whether an entity is a subsidiary of an investor.

The commentary to AASB 128 further explains the notion of significant influence. It states that significant influence normally stems from the investor’s voting power in the investee. Voting power is directly related to the voting rights attaching to equity interests of an associate, but excludes voting rights that apply only in special or contingent circumstances.

In deciding whether the investor’s voting power gives rise to significant influence over the investee, it might be necessary to consider the distribution of the balance of the voting power. For example, if the equity interests are widely dispersed, with investors typically having a small ownership (and voting) interest, then holding less than 20 per cent of the voting interests might

be enough to provide the investor with the power to participate in the financial and operating policy decisions of the investee.

Where an investor holds 20 per cent or more of the voting power of the investee, it is normally assumed that significant influence exists, unless there is evidence to the contrary. Twenty per cent is not intended as an absolute cut-off point, however, and significant influence may exist with an equity holding below this rather arbitrary amount of voting power. Paragraph 5 of AASB 128 states:

If an entity holds, directly or indirectly (e.g. through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly (e.g. through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence. (AASB 128)

Paragraph 6 of AASB 128 lists factors that, singly or in combination, should be considered in determining the existence of significant influence, even if the investor’s voting power is less than 20 per cent. It is emphasised that determining the existence of significant influence will not always be straightforward and will call for the exercise of professional judgement. Factors to consider in determining whether one entity has significant influence over another entity include:

∙ representation on the board of directors or equivalent governing body of the investee ∙ participation in policy-making processes, including participation in decisions about dividends or other distributions ∙ material transactions between the investor and the investee ∙ interchange of managerial personnel ∙ provision of essential technical information.

The above discussion is consistent with how BHP Ltd, for example, defines its associates. Exhibit 29.1 reproduces material from the 2019 Annual Report of BHP Group Ltd (p. 174).

In relation to the possibility that an entity might subsequently lose its ability to significantly influence its investee, paragraph 9 of AASB 128 states:

An entity loses significant influence over an investee when it loses the power to participate in the financial and operating policy decisions of that investee. The loss of significant influence can occur with or without a change in absolute or relative ownership levels. It could occur, for example, when an associate becomes subject to the control of a government, court, administrator or regulator. It could also occur as a result of a contractual arrangement. (AASB 128)

LO 29.2

voting power Determined by considering the voting rights attaching to equity interests in an investee, excluding contingent voting rights.

dee67382_ch29_1155-1204.indd 1159 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1159

Exhibit 29.1 Description of ‘associates’ from the 2019 Annual Report of BHP Group Ltd

SOURCE: BHP Group Ltd 2019 Annual Report

If an entity subsequently loses its ability to significantly influence an investee it must cease using the equity method of accounting in relation to that investee. In this regard, paragraph 22 of AASB 128 states:

An entity shall discontinue the use of the equity method from the date that it ceases to be an associate or joint venture as follows:

(a) If the investment becomes a subsidiary, the entity shall account for its investment in accordance with AASB 3 Business Combinations and AASB 10.

(b) If the retained interest in the former associate or joint venture is a financial asset, the entity shall measure the retained interest at fair value. The fair value of the retained interest shall be regarded as its fair value on initial recognition as a financial asset in accordance with AASB 9. The entity shall recognise in profit or loss any difference between:

(i) the fair value of any retained interest and any proceeds from disposing of a part interest in the associate or joint venture; and

(ii) the carrying amount of the investment at the date the equity method was discontinued. (c) When an entity discontinues the use of the equity method, the entity shall account for all amounts previously

recognised in other comprehensive income in relation to that investment on the same basis as would have been required if the investee had directly disposed of the related assets or liabilities. (AASB 128)

WHY DO I NEED TO KNOW WHAT AN INVESTMENT IN AN ‘ASSOCIATE’ REPRESENTS?

When we look at the financial statements of large organisations we will find that the balance sheet and the statement of profit or loss and other comprehensive income typically refer to investments in associates and share of profit or loss from those associates. Therefore, it would seem important that we know what this actually means. The amounts can be quite material. For example, if we review the consolidated balance sheet of BHP Group Ltd for the year ending 30 June 2019 we find that ‘Investments accounted for using the equity method of accounting’ (this method of accounting is discussed in this chapter) amount to US$2569 million. The consolidated income statement of BHP Group Ltd for the year ending 30 June 2019 also shows that profit/(loss) from equity-accounted investments, after related impairments and expenses, amounted to US$(546) million in 2019, but was a loss as high as US$2104 million in 2016. Therefore, the amounts assigned to investments in associates are potentially quite material, thereby emphasising the idea that we should have some knowledge of what the amounts actually represent.

dee67382_ch29_1155-1204.indd 1160 10/25/19 12:17 PM

1160 PART 8: Accounting for equity interests in other entities

LO 29.3

materiality A threshold concept concerning the relevance of an event or transaction to financial statement users.

29.3 Application of the equity method of accounting

So far we have discussed when the equity method of accounting shall be applied. We have learned that it must be applied when an investor has significant influence over an investee. We also know what ‘significant

influence’ means, but how do we actually perform the equity method of accounting? AASB 128 provides guidance on how to apply the equity method of accounting. As with most

other accounting standards, the principle of materiality is applied within AASB 128. Where the information resulting from the application of the standard is not considered to be material, the investor is not required to comply with the standard.

In applying the equity method of accounting, the investment is adjusted to take account of the investor’s share of the profits and other comprehensive income of the associate—and in this regard it needs to be appreciated that the investor’s share of profits is not necessarily the

same as the dividends that have been paid to (or are payable to) the investor by the associate. There might actually be little relationship between the profits earned within a period by an entity and the dividends that it pays or declares. Paragraph 10 of AASB 128 provides the following explanation of the application of the equity method of accounting:

Under the equity method, on initial recognition the investment in an associate or a joint venture is recognised at cost, and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition. The investor’s share of the profit or loss of the investee is recognised in the investor’s profit or loss. Distributions (for example, dividends) received from an investee reduce the carrying amount of the investment. Adjustments to the carrying amount of the investment in the associate may also be necessary for changes in the investor’s proportionate interest in the investee’s other comprehensive income. Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences. The investor’s share of those changes is recognised in the investor’s other comprehensive income. (AASB 128)

Where the equity method of accounting is implemented will be directly influenced by whether or not the investor prepares consolidated financial statements. When an investor is required to prepare consolidated financial statements (that is, when it has at least one subsidiary), it must recognise its investment in an associate by applying the equity method of accounting in its consolidated financial statements (that is, in the consolidation worksheet), and by applying either the fair-value method (pursuant to AASB 9) or cost to the investment in its own individual financial statements (that is, in its own journals and ledgers).

If the investor does not prepare consolidated financial statements (that is, it does not have a subsidiary), the equity method of accounting is to be applied in the investor’s own separate financial statements. This requirement is summarised in Figure 29.1. Again, it is emphasised that while AASB 9 has a general requirement that all equity investments shall be measured at fair value in the accounts of the investor, there is a specific exception in the case of investments in subsidiaries, joint ventures or associates.

As indicated above, under the equity method of accounting the investment is initially recorded at the cost of acquisition. At the time of acquisition, the carrying amounts of the identifiable assets and liabilities of the associate are notionally adjusted to fair values. The difference between the investor’s share of the adjusted values of the investee’s

Figure 29.1 Does the investor prepare consolidated financial statements?

1. In investor’s separate financial statements Investment in associate to be recorded at cost or fair value

Does the investor prepare consolidated financial statements?

1. In investor’s separate financial statements Investment in associate to be accounted for using the equity method

2. In consolidated financial statements Investment in associate is to be accounted for by the equity method

NoYes

dee67382_ch29_1155-1204.indd 1161 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1161

net assets and the cost of the investment is regarded as goodwill, or as an excess on acquisition. The accounting standard does not require the goodwill (or excess on acquisition) relating to the associate to be disclosed separately in the consolidated financial statements. Nor does it permit the calculated goodwill to be subject to periodic amortisation. Nevertheless, if the goodwill of the associate is impaired in future periods, appropriate adjustments to the investor’s share of the associate’s profits or losses after acquisition will need to be made for the impairment losses associated with the goodwill acquired as part of the investment in the associate. As paragraph 32 of AASB 128 states:

An investment is accounted for using the equity method from the date on which it becomes an associate or a joint venture. On acquisition of the investment, any difference between the cost of the investment and the investor’s share of the net fair value of the investee’s identifiable assets and liabilities is accounted for as follows:

(a) Goodwill relating to an associate or a joint venture is included in the carrying amount of the investment. Amortisation of that goodwill is not permitted;

(b) Any excess of the investor’s share of the net fair value of the associate’s identifiable assets and liabilities over the cost of the investment is included as income in the determination of the entity’s share of the associate’s or joint venture’s profit or loss in the period in which the investment is acquired.

Appropriate adjustments to the investor’s share of the associate’s or joint venture’s profit or loss after acquisition are made in order to account, for example, for depreciation of the depreciable assets based on their fair values at the acquisition date. Similarly, appropriate adjustments to the entity’s share of the associate’s or joint venture’s profit or loss after acquisition are made for impairment such as for goodwill or property, plant and equipment. (AASB 128)

When recognising the investor’s share of the post-acquisition profits of the associate, adjustments need to be made to that profit share so as to take into account the depreciation that would be determined based upon the fair values of the assets of the associate.

Note that in the above discussion we have used the term ‘entity’s share’. This term means the investor’s ownership interest in the associate. This can be quite different from the investor’s voting power in the associate. Voting power is used to determine the existence of significant influence. For example, it is possible for an investor to hold 60 per cent of all the issued shares of a company, but to have voting power of only 30 per cent, owing to the existence of non- voting equity shares. At face value, it could appear that the investor has control of an entity because it holds more than 50 per cent of the issued shares. However, its voting power might be much lower than this.

The rationale for adopting the equity method of accounting is that the stream of dividend receipts, reported as income under the cost method, might provide a reasonably inaccurate guide to the performance and value of the investee. As we have already indicated, the investee might actually pay dividends in periods when losses are incurred. Alternatively, an entity might be generating significant profits, but elect to retain those profits for continuing expansion. The cost method would not reflect the increasing value of the investment. As a result, the cost of the investment might be a poor guide to the underlying value of the investment.

Incorporating post-acquisition movements in the associate’s reserves into the value of the investment is argued by many to provide a better indication of the underlying worth of the investment. Again, it is emphasised that, when applying the equity method of accounting, the profits recorded by the investor will include the proportional share of the profits of the associate, even though some or all of those profits might have been retained by the associate (and therefore not currently be paid out as dividends). In justifying the use of the equity method of accounting, as opposed to the cost method, for investments in associates and joint ventures (and under the cost method, the investor would include in its own profits only the dividends received or receivable from the investee), paragraph 11 of AASB 128 states:

The recognition of income on the basis of distributions received may not be an adequate measure of the income earned by an investor on an investment in an associate or joint venture because the distributions received may bear little relation to the performance of the associate or joint venture. Because the investor has joint control of, or significant influence over the investee, the investor has an interest in the associate’s or joint venture’s performance and, as a result, the return on its investment. The investor accounts for this interest by extending the scope of its financial statements to include its share of profits or losses of such an investee. As a result, application of the equity method provides more informative reporting of the investor’s net assets and profit or loss. (AASB 128)

Opponents of the equity method have criticised it on the basis that it breaches the realisation principle, which tends to be tied to the traditional notion of conservatism. They argue that the investor reports its share of the investee’s profits in the statement of profit or loss and other comprehensive income, even though no dividends have been paid, and might not be paid for some time. The other point to be made is that when the equity method of accounting

dee67382_ch29_1155-1204.indd 1162 10/25/19 12:17 PM

1162 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 29.1: Comparison of the cost method and the equity method of accounting

This example compares the following methods to account for an investment in an associate:

(a) the cost method (b) the equity method, assuming the investor is a parent entity (c) the equity method, assuming the investor is not a parent entity.

Let us assume that on 1 July 2022 Cassie Ltd acquires a 30 per cent interest in Joy Ltd for a cash consideration of $540 000. On the date of the acquisition, the assets of Joy Ltd are reported at their fair value. The total share capital and reserves of Joy Ltd (which, as we know, equate to the net assets of the entity) as at the date of the acquisition are:

Share capital $1 320 000

Retained earnings $ 480 000

Total shareholders’ funds $1 800 000

Additional information

• For the year ending 30 June 2023, Joy Ltd records an after-tax profit of $100 000. A dividend of $40 000 is declared and ratified by Joy Ltd on 30 June 2023, with the dividend coming from profits earned in the 2022–23 financial year.

• In October 2023 Joy Ltd pays the $40 000 dividend provided for on 30 June 2023. • For the year ending 30 June 2024, Joy Ltd records an after-tax loss of $50 000. On 30 June 2024 Joy Ltd

declares dividends of $20 000, to be paid out of the profits earned in the 2023 financial year. • On 30 June 2024 Joy Ltd revalues its land upwards by an amount of $400 000. • Cassie Ltd recognises dividends as revenue when the investee declares the dividends (that is, Cassie Ltd also

recognises a dividend receivable). • The corporate tax rate is 30 per cent.

REQUIRED

(a) Prepare the journal entries for the years ending 30 June 2023 and 30 June 2024 to account for the investment in Joy Ltd using the cost method of accounting.

(b) Prepare the journal entries for the years ending 30 June 2023 and 30 June 2024 to account for the investment in Joy Ltd using the equity method of accounting and assuming that Cassie Ltd is a parent entity (and therefore prepares consolidated financial statements).

(c) Prepare the journal entries for the years ending 30 June 2023 and 30 June 2024 to account for the investment in Joy Ltd using the equity method of accounting and assuming that Cassie Ltd is not a parent entity (and therefore does not prepare consolidated financial statements).

SOLUTION

(a) Journal entries using the cost method in the accounts of Cassie Ltd

Year ending 30 June 2023

July 2022

Dr Investment in Joy Ltd 540 000

Cr Cash at bank 540 000

(to recognise the initial acquisition of shares in Joy Ltd)

is applied, the account balance of the investment in the associate is neither ‘cost’ nor ‘fair value’. It is cost plus adjustments for post-acquisition movements in profits and reserves.

Having discussed the equity accounting requirements of AASB 128, it is now appropriate to consider a numerical illustration in Worked Example 29.1.

dee67382_ch29_1155-1204.indd 1163 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1163

June 2023

Dr Dividend receivable 12 000

Cr Dividend revenue 12 000

(to recognise the share of dividends provided by Joy Ltd: $12 000 = $40 000 × 30%)

Year ending 30 June 2024

October 2023

Dr Cash at bank 12 000

Cr Dividend receivable 12 000

(the receipt of the dividend that is declared by Joy Ltd and recognised as revenue by Cassie Ltd in the preceding accounting period)

June 2024

Dr Dividend receivable 6 000

Cr Dividend revenue 6 000

(to recognise Cassie Ltd’s share of dividends declared from profits earned in the 2022–23 financial year: $6000 = $20 000 × 30%)

Note that the cost method recognises revenue in the 2024 financial year (relating to the dividends declared by Joy Ltd) despite the fact that the associate made a loss in that year. This is considered by some to be a major limitation of the cost method.

(b) Journal entries using the equity method in the consolidated accounts of Cassie Ltd (a parent entity)

Year ending 30 June 2023

Cassie Ltd is a ‘parent entity’ because it has ‘subsidiaries’, so it must prepare consolidated financial statements. Pursuant to AASB 128, the equity method of accounting will be applied within the consolidation worksheet. (Remember that the entries in (a) above would already have been made by the parent entity in its own individual accounts, and hence would be incorporated in the account balances shown for the parent entity prior to the consolidation.) Where the equity method of accounting is used, it is necessary to determine whether any goodwill, or bargain purchase on acquisition, has arisen on acquisition of the investment.

Determination of goodwill (or discount)

Identifiable net assets of associate at 1 July 2022 $1 800 000

Adjustment to fair values 0

Fair value of identifiable net assets $1 800 000

Cassie Ltd’s equity ownership × 30% Fair value of net assets acquired by Cassie Ltd $ 540 000

As the cost of acquisition is equal to Cassie Ltd’s ownership interest in the fair value of the net assets of Joy Ltd, there is no notional goodwill on acquisition, and hence no need to consider any subsequent impairments of purchased goodwill. If there had been some calculated goodwill, and if this was subsequently impaired, the investor’s proportional share of this impairment would be accounted for by reducing both the investor’s share of the investee’s profits and the value of the investment in the associate by the investor’s proportional share in the impairment loss. Because the assets in the accounts of Joy Ltd are deemed already to be recognised at fair value, there is also no need to make adjustments in relation to depreciation expense.

continued

dee67382_ch29_1155-1204.indd 1164 10/25/19 12:17 PM

1164 PART 8: Accounting for equity interests in other entities

Initial acquisition adjustments As indicated above, given that the carrying amount and fair value of the associate’s assets and liabilities are the same, no other adjustments (such as depreciation adjustments) are required.

Share of current year profit/loss

Associate’s profit for the 2022–23 financial year $100 000

Cassie Ltd’s equity interest × 30% Cassie Ltd’s share of Joy Ltd’s 2022–23 profit $ 30 000

It is important to remember that the cost method has been utilised in the investor’s own separate accounts. We need to give effect to incremental entries in the consolidation worksheet so as to arrive at the results that would be generated by applying the equity method of accounting.

The adoption of the equity method of accounting requires the investor to recognise as part of profits its share in the post-acquisition profits of the associate, with a corresponding increase in the investment. The consolidation adjustment entry would be:

30 June 2023 (for the consolidation worksheet)

Dr Investment in Joy Ltd 30 000

Cr Share of associate’s profit 30 000

(to recognise the investor’s share of the associate’s profits)

When the equity method of accounting is adopted, AASB 128 requires dividends recognised as income by the investor to be deducted from the carrying amount of the investment in the associate. The dividend received in June 2023 is recorded as a receivable and recognised as revenue in Cassie Ltd’s accounts.

Under the equity method of accounting, it is the share of the associate’s profit or loss that is included in the profits of the investor, and not the dividends paid by the associate. These dividends have already been recognised as revenue using the cost method; hence, to avoid double counting, they must be reversed. The entry in the consolidation worksheet would be:

Dr Dividend revenue 12 000

Cr Investment in Joy Ltd 12 000

(to reduce the investment in the associate by the dividends received)

It should be noted that we do not eliminate any dividends receivable from an associate when applying the equity method of accounting as the dividend payment does not represent an ‘intragroup transaction’.

Year ending 30 June 2024 Determination of the initial adjustment to retained earnings and reserves to be recorded in the worksheet This step is necessary as the 2024 financial year will be the second year in which the equity method has been in use. The reason for this entry is that the 2023 entries are made in the consolidation worksheet and are therefore not carried forward in the balances of any ledger accounts of the separate organisations. In each year following the adoption of the equity method of accounting, we will need to record an initial adjusting entry in the consolidation worksheet (to both retained earnings and reserves, as well as to the investment) to give effect to the equity accounting adjustments made in all the previous years. Remember that in this example the cost method is utilised in the investor’s accounts and the carrying amount of the investment has not been affected by the equity method. The initial entry at 30 June 2024 would therefore be:

30 June 2024 (for the consolidation worksheet)

Dr Investment in Joy Ltd 18 000

Cr Retained earnings—30 June 2023 18 000

(Prior share of profits recognised ($30 000), less the share of dividends payments ($12 000))

WORKED EXAMPLE 29.1 continued

dee67382_ch29_1155-1204.indd 1165 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1165

Calculation of share of current year profit and loss of Joy Ltd

Joy Ltd’s profit/(loss) for the year ending 30 June 2024 ($50 000)

Cassie Ltd’s equity interest in Joy Ltd × 30% Cassie Ltd’s share of the profits/(losses) of Joy Ltd ($15 000)

June 2024 (for the consolidation worksheet)

Dr Share of associate’s profit/loss 15 000

Cr Investment in Joy Ltd 15 000

(the investment in Joy Ltd is reduced to reflect the investor’s share of the current period’s loss made by Joy Ltd)

The dividends received and recognised under the cost method are also reversed out.

June 2024 (for the consolidation worksheet)

Dr Dividend revenue 6 000

Cr Investment in Joy Ltd 6 000

(to reduce the investment in the associate by the dividend received)

Calculation of share of current year reserve movements The change in reserves relates to a revaluation undertaken by Joy Ltd. As we explained in Chapter 18, when an entity revalues its non-current assets a tax effect is created, which needs to be recognised in accordance with AASB 112 Income Taxes (you might 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. According to paragraph 20 of AASB 112:

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. (AASB 112)

As Joy Ltd revalued its land, the journal entries in its own separate accounts would have resulted in a debit to land of $400 000 and a credit to other comprehensive income (OCI) of $400 000. The related tax implications would also need to be recognised, which would lead to a debit to other comprehensive income of $120 000 and a credit entry to the deferred tax liability account. The net effect would be an increase in other comprehensive income of $280 000 (which is $400 000 × [1 − tax rate]). At the end of the accounting period, this amount of $280 000 would be transferred by Joy Ltd to the equity account known as the revaluation surplus account. Cassie Ltd’s share of the post-acquisition increase in revaluation surplus would be calculated as:

Increase in other comprehensive income as a result of the revaluation within Joy Ltd

$280 000

Cassie Ltd’s equity interest × 30%

Cassie Ltd’s share of the movement in Joy Ltd’s OCI $ 84 000

June 2024 (for the consolidation worksheet)

Dr Investment in Joy Ltd 84 000

Cr Share of associate’s other comprehensive income 84 000

(to recognise Cassie Ltd’s share of Joy Ltd’s other comprehensive income)

continued

dee67382_ch29_1155-1204.indd 1166 10/25/19 12:17 PM

1166 PART 8: Accounting for equity interests in other entities

Following on from the above journal entry, a consolidation entry would subsequently transfer the $84 000 above to the consolidated asset revaluation reserve. That is, we would also expect the following entry to be made in the consolidated financial statements:

June 2024 (for the consolidation worksheet)

Dr Share of associate’s other comprehensive income 84 000

Cr Revaluation surplus 84 000

(closing entry to transfer the net amount in OCI relating to the revaluation to the revaluation surplus account)

(c) Journal entries using the equity method in the accounts of Cassie Ltd (and where Cassie is not a parent entity) As Cassie Ltd is now not assumed to be a parent entity, it will not prepare consolidated financial statements. Pursuant to AASB 128, the equity method of accounting is therefore to be applied in the separate accounts of the investor. Apart from this difference, the equity accounting journal entries will be similar to those made in (b). However, they will be made in the ledger accounts of Cassie Ltd, rather than in a consolidation worksheet.

Year ending 30 June 2023

July 2022

Dr Investment in Joy Ltd 540 000

Cr Cash at bank 540 000

(to recognise the initial acquisition of shares in Joy Ltd)

Share of current year profit/loss The calculations are the same as those provided in (b) above, except that this time the entry is made in the accounts of Cassie Ltd rather than in a consolidation worksheet.

30 June 2023

Dr Investment in Joy Ltd 30 000

Cr Share of associate’s profit 30 000

Dr Dividend receivable 12 000

Cr Investment in Joy Ltd 12 000

(increase in the carrying amount of the investment in the associate by the share of an associate’s profit. The dividend from the associate is not treated as revenue but as a reduction in the carrying amount of the investment in the associate)

This journal entry above that debits dividends receivable assumes that a journal entry debiting dividends receivable and crediting dividend revenue (as would be used under the cost method) has not already been made in the accounts of Cassie Ltd at the time the dividends were declared by Joy Ltd. Had such a journal entry been made the second journal entry above would instead have been a debit to dividends revenue and a credit to investment in Joy Ltd.

Year ending 30 June 2024

October 2023

Dr Cash at bank 12 000

Cr Dividend receivable 12 000

(the receipt of the dividend that is declared by Joy Ltd and recognised as revenue by Cassie Ltd in the preceding accounting period)

WORKED EXAMPLE 29.1 continued

dee67382_ch29_1155-1204.indd 1167 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1167

30 June 2024 Initial adjustment to retained earnings to recognise share of associate’s profits that were recognised by the investor in previous periods Unlike the corresponding entry in (b) above, no adjustment is required here as the effects of prior-period equity accounting entries will carry forward, given that the entries were made in the accounts of the investor and not in the consolidation worksheet.

Calculation of share of current year profit/(loss) of Joy Ltd The calculations are the same as those provided in (b) above, except that this time the entry is made in the accounts of Cassie Ltd rather than in a consolidation worksheet.

Dr Share of associate’s profit/loss 15 000

Cr Investment in Joy Ltd 15 000

Dr Dividend receivable 6 000

Cr Investment in Joy Ltd 6 000

(decrease in the carrying amount of the investment in the associate by the share of an associate’s loss. The dividend from the associate is not treated as revenue but as a reduction in the carrying amount of the investment in the associate)

Calculation of share of current year reserve movements The calculations are the same as those provided in (b) above, except this time the entry is made in the accounts of Cassie Ltd rather than in a consolidation worksheet.

Dr Investment in Joy Ltd 84 000

Cr Share of associate’s other comprehensive income 84 000

(to recognise Cassie Ltd’s share of Joy Ltd’s other comprehensive income)

Dr Share of associate’s other comprehensive income 84 000

Cr Revaluation surplus 84 000

(closing entry to transfer the net amount in OCI relating to the revaluation to the revaluation surplus account)

The solution to Worked Example 29.1 has been tabulated in Table 29.1. This has been done in this case simply to allow for a side-by-side comparison of the entries required when using the cost method of accounting; the equity method of accounting in consolidated accounts or; the equity method of accounting in the accounts of the investor.

Table 29.2 provides a comparison of the final balances of the investment account derived by applying the cost method and the equity method of accounting.

Note that in Worked Example 29.1 the cost method of accounting actually reports the highest accumulated amount of profit over the two years. However, the equity method of accounting would report the higher ‘total comprehensive income’ given the asset revaluation undertaken by the associate in 2024. The cost method would also have reported the highest carrying amount for the associate had the associate not revalued its land. In summary, when the equity method of accounting is adopted:

(a) the investment in the associate must initially be recognised at cost (b) the carrying amount of the investment in the associate must subsequently be increased (decreased) by the investor’s

share of the profit (or loss) of the associate after adjustments for such items as revisions in depreciation expenses, impairment of goodwill, dissimilar accounting policies and certain inter-entity transactions

(c) the carrying amount of the investment must be decreased by the amount of dividends recognised by the investor from the associate (either on a cash or accruals basis)

dee67382_ch29_1155-1204.indd 1168 10/25/19 12:17 PM

1168 PART 8: Accounting for equity interests in other entities

(a) Journal entries in Cassie Ltd’s accounts using the cost method

(b) Accounting in the consolidated accounts assuming Cassie Ltd is a parent entity

(c) Accounting for investment in Joy Ltd assuming Cassie Ltd is not a parent entity

Using the cost method Year ending 30 June 2023

July 2022

Dr Investment in Joy Ltd 540 000

Cr Cash at bank 540 000

(to recognise acquisition of investment in Joy Ltd)

30 June 2023

Dr Div. receivable 12 000

Cr Dividend revenue 12 000

(dividends paid out of post-acquisition profits, which are recognised as income under the cost method)

Year ending 30 June 2024

October 2023

Dr Cash at bank 12 000

Cr Dividend receivable 12 000

(receipt of cash relating to dividends declared in previous period)

Converting from the cost to the equity method Year ending 30 June 2023 No entry is needed here as the investment has already been recognised in the separate accounts of Cassie Ltd. Remember, if the investor is producing consolidated financial statements, in its own accounts it would already have accounted for the investment in accordance with the cost method. The following consolidation adjustments are made to adjust the carrying amount of the investment to provide a value consistent with the application of equity accounting.

30 June 2023

Dr Investment in Joy Ltd 30 000

Cr Share of associate’s profit

30 000

(recognition of share of associate’s profit in accordance with the equity method of accounting)

Dr Dividend revenue 12 000

Cr Investment in Joy Ltd 12 000

(to eliminate dividend revenue previously recognised under the cost model)

Year ending 30 June 2024 No entry is needed here as the cash received has already been recognised in the separate accounts of Cassie Ltd.

30 June 2024

Dr Investment in Joy Ltd 18 000

Cr Retained earnings 18 000

(This entry records the accumulated adjustments in previous consolidated accounts. As we know, consolidation adjustments are undertaken in a consolidation worksheet and do not carry forward automatically to the next period. Hence in each period we need to take through an adjustment to recognise prior period consolidation adjustments.)

Using the equity method Year ending 30 June 2023

July 2022

Dr Investment in Joy Ltd 540 000

Cr Cash 540 000

(if the investor does not prepare consolidated accounts, it will use the equity method, and not the cost method, in its own accounts to account for the investment)

30 June 2023

Dr Investment in Joy Ltd 30 000

Cr Share of associate’s profit

30 000

(recognition of share of associate’s profit in accordance with the equity method of accounting)

Dr Dividend receivable 12 000

Cr Investment in Joy Ltd 12 000

(dividends paid out of post-acquisition profits, which, under the equity method, are deducted from the carrying value of the investment in the associate)

Year ending 30 June 2024

October 2023

Dr Cash at bank 12 000

Cr Dividend receivable 12 000

(receipt of cash relating to dividends declared in previous period)

No entry is needed here as the previous entries to recognise the share of profits of the associate have been recorded in the accounts of Cassie Ltd and not in the consolidation journal.

30 June 2024

Dr Dividend receivable 6 000

Cr Dividend revenue 6 000

(to record dividends paid out of post-acquisition

profits)

Dr Share of associate’s loss 15 000

Cr Investment in Joy Ltd 15 000

(to record share of associate’s loss)

Dr Dividend revenue 6 000

Cr Investment in Joy Ltd 6 000

(to eliminate dividend revenue recognised under the cost model)

Dr Investment in Joy Ltd 84 000

Cr Share of associate’s other comprehensive income

84 000

(share of associate’s increase in reserves)

Dr Share of associate’s OCI 84 000

Cr Revaluation surplus 84 000

(to transfer the net effect in OCI to the revaluation surplus account at the end of the accounting period)

30 June 2024

Dr Share of assoc.’s loss 15 000

Cr Investment in Joy Ltd 15 000

(to record share of associate’s loss)

Dr Dividend receivable 6 000

Cr Investment in Joy Ltd 6 000

(dividends paid out of post-acquisition profits)

Dr Investment in Joy Ltd 84 000

Cr Share of associate’s other comprehensive income

84 000

(share of associate’s increase in reserves)

Dr Share of associate’s OCI 84 000

Cr Revaluation surplus 84 000

(to transfer the net effect in OCI to the revaluation surplus account at the end of the accounting period)

Table 29.1 Solution to Worked Example 29.1 presented in table form to aid comparison of accounting treatments

dee67382_ch29_1155-1204.indd 1169 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1169

Cost method ($)

Equity method ($)

Amount recognised in profit or loss in 2023 12 000 30 000

Amount recognised in profit or loss in 2024 6 000 (15 000)

Amount recognised within other comprehensive income in 2024 (due to revaluation)

0 84 000

Carrying amount of associate as at 30 June 2023 540 000 558 000

Carrying amount of associate as at 30 June 2024 540 000 621 000

The above carrying amounts were determined as follows:

Acquisition costs 540 000

less Dividend income recognised by Cassie Ltd in 2023 ($40 000 × 30%) (12 000)

plus Cassie Ltd’s share of associate’s 2023 profit ($100 000 × 30%) 30 000

Carrying amount as at 30 June 2023 according to the equity method of accounting

558 000

less Dividend income recognised by Cassie Ltd in 2024 ($20 000 × 30%) (6 000)

less Cassie Ltd’s share of associate’s 2024 loss ($50 000 × 30%) (15 000)

plus Share of the revaluation of associate’s land [$400 000 × (1 − 30%) × 0.3]

84 000

Carrying amount as at 30 June 2024 according to the equity method of accounting

621 000

Table 29.2 Comparison of the final balances generated by the cost and equity methods of accounting using the data supplied in Worked Example 29.1

(d) adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the investee arising from changes in the investee’s other comprehensive income. Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences. The investor’s share of those changes is recognised in the investor’s other comprehensive income.

According to paragraph 40 of AASB 128:

After application of the equity method, including recognising the associate’s or joint venture’s losses in accordance with paragraph 38, the entity applies paragraphs 41A–41C to determine whether there is any objective evidence that its net investment in the associate or joint venture is impaired. (AASB 128)

An impairment loss needs to be recognised when the carrying amount of an asset exceeds its recoverable amount. In the event that the carrying amount of an investment in an associate exceeds its recoverable amount, the carrying

amount must be written down to its recoverable amount, with the write-down recognised within profit or loss. In the event that the recoverable amount subsequently increases to an amount greater than the carrying amount, a reversal is required up to a maximum of the previous write-down(s). The amount of the reversal must be recognised in profit or loss. The maximum amount to be shown for the investment in the associate is the carrying amount of the investment calculated by applying the equity method of accounting.

In Worked Example 29.1 the carrying amount of the associate’s identifiable assets and liabilities is equal to their fair value at the date of acquisition. This greatly simplifies the equity accounting adjustments that are necessary. In practice, however, these circumstances will rarely arise. As previously noted, AASB 128 requires the investor’s share of the associate’s profit/loss to be adjusted for any depreciation differences caused as a result of reassessing the values of the investor’s assets to fair value at the time of the investment acquisition.

In Worked Example 29.1 we also accounted for the revaluation of Joy Ltd’s land, with the whole amount of the revaluation being attributed to the post-acquisition period. Where there is a difference between the carrying amount of an asset and its fair value as at the date of the acquisition of the equity interest in the associate, any subsequent revaluation of the asset will reflect that fact. Accounting Standard AASB 128 requires the carrying amount of the investment to be adjusted by post-acquisition increments or decrements in the associate’s total reserves, except to the extent that the movements have already been reflected in the statement of financial position of the investor or in the carrying amount of the investment.

Worked Example 29.2 considers the case where there is goodwill on acquisition and where there is a difference on acquisition date between the fair value of the investee’s depreciable assets and the associated carrying amounts. This means that additional depreciation charges are necessary when the equity method of accounting is adopted.

dee67382_ch29_1155-1204.indd 1170 10/25/19 12:17 PM

1170 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 29.2: Adoption of the equity method of accounting in the presence of a difference between the fair values and carrying amounts of depreciable assets; and in the presence of a post-acquisition asset revaluation

On 1 July 2021 Rankin Ltd, a parent entity (which therefore produces consolidated financial statements and applies the equity method of accounting in the consolidation worksheet) acquires a 25 per cent interest in the issued capital of Coombes Ltd for a cash consideration of $80 000. At the date of acquisition, the shareholders’ equity of Coombes Ltd is $225 000, represented by:

Share capital $165 000

Retained earnings $ 60 000

Total shareholders’ equity $225 000

Additional information

• On the date of acquisition, land and buildings have carrying amounts in the books of Coombes Ltd of $200 000 and $400 000 respectively. The fair value of the land at the time is $225 000, and the buildings’ fair value is $450 000. The buildings have a remaining expected useful life from 1 July 2021 of 20 years.

• For the year ending 30 June 2022 Coombes Ltd reported an after-tax profit of $50 000 from which it declared a dividend of $20 000.

• For the year ending 30 June 2023, Coombes Ltd reports an after-tax profit of $100 000, from which it declared a dividend of $50 000. Coombes Ltd revalues its land to $250 000 in June 2023.

• Rankin Ltd recognises dividends as revenue on receipt of the dividends (rather than recognising dividends as they are declared by the investee).

• It is assumed that any goodwill acquired has not subsequently been impaired. • The tax rate is 30 per cent.

REQUIRED Calculate the amount of goodwill acquired at the date of the acquisition and, using the equity method of accounting, prepare the accounting journal entries that would be required in the consolidation worksheet for the year ending 30 June 2023 (that is, two years after the initial acquisition).

SOLUTION Since it has subsidiaries, Rankin Ltd is a parent entity and so must prepare a consolidation worksheet. The equity method of accounting will therefore be applied in the consolidated financial statements. That is, the equity accounting entries will not be recorded in the ledger accounts of Rankin Ltd.

Determination of goodwill

Identifiable net assets of the associate as at 1 July 2021 $225 000

Adjustment to fair value for land after related tax effect (25 000 × 0.7) $ 17 500

Adjustment to fair value for buildings after related tax effect (50 000 × 0.7) $ 35 000

Fair value of Coombes Ltd’s identifiable net assets as at 1 July 2021 $277 500

Rankin Ltd’s equity interest × 25%

Fair value of assets acquired by Rankin Ltd as at 1 July 2021 $ 69 375

Acquisition cost $ 80 000

Goodwill acquired $ 10 625

Adjustments to recognise additional depreciation expenses

Extra depreciation expense pertaining to buildings: ($50 000 ÷ life of the buildings) × Rankin Ltd’s ownership interest = ($50 000 ÷ 20) × 25% = $625. The after-tax effect of this is $625 × (1 − 0.30) = $437.50.

dee67382_ch29_1155-1204.indd 1171 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1171

Initial adjustment to retained earnings to be recorded in the consolidation worksheet

Associate’s profit for the year ending 30 June 2022 $ 50 000

Rankin Ltd’s equity interest in Coombes Ltd × 25% $ 12 500

less Building depreciation adjustment (see above) (437.50)

Rankin Ltd’s share of Coombes Ltd’s adjusted profit $12 062.50

As Rankin Ltd’s policy is to recognise dividends as revenue only as they are received, the dividend declared by Coombes in the 2022 financial year, but unpaid at year end, will not be recognised in calculating Rankin’s share of the associate’s profits (because Rankin Ltd has not recognised the dividend in its own accounts as a separate legal entity). The consolidation worksheet journal entry would therefore be:

June 2022 (for the consolidation worksheet)

Dr Investment in Coombes Ltd 12 062.50

Cr Retained earnings as at 30 June 2022 12 062.50

(to recognise prior period share of profits in the associate)

Calculation of Rankin Ltd’s share of the current year profits of Coombes Ltd

Associate’s profit for the year ending 30 June 2023 $ 100 000

Rankin Ltd’s equity interest × 25% $ 25 000

less Additional building depreciation expense ($ 437.50)

Rankin Ltd’s share of associate’s adjusted profit $24 562.50

The accounting entry to recognise Rankin Ltd’s share of the current year’s profits would be:

June 2023 (for the consolidation worksheet)

Dr Investment in Coombes Ltd 24 562.50

Cr Share of associate’s profit 24 562.50

(share of associate’s profit)

The entry to reverse the dividend that would have been recognised under the cost method (under the cost method the dividends would have been recognised in the individual accounts of Rankin Ltd) would be:

June 2023 (for the consolidation worksheet)

Dr Dividend revenue 5 000

Cr Investment in Coombes Ltd 5 000

(to reduce the investment in the associate by the dividend received from the associate, and to eliminate dividend revenue pertaining to the dividend 5000 = 20 000 × 25%)

Calculation of the current year reserve movements While the amount of the revaluation recognised by the associate is $50 000 in 2023, the first $25 000 is recognised in the carrying amount of the investment at the time of the investment acquisition (and used to determine the amount of goodwill acquired). At this point it should again be noted that although AASB 128 requires a notional amount to be attributed to goodwill, it does not permit the goodwill to be amortised. Nevertheless, the goodwill needs to be subject to annual impairment testing. Therefore we only increase the investment account for the share in the post-acquisition movement in the revaluation surplus, after tax, which is

continued

dee67382_ch29_1155-1204.indd 1172 10/25/19 12:17 PM

1172 PART 8: Accounting for equity interests in other entities

29.4 The equity method of accounting in the presence of inter-entity transactions

Paragraph 22 of AASB 128 requires the elimination of inter-entity transactions before the share of the associate’s profits is calculated. That is, in applying the equity method of accounting, the carrying amount of the investment in the associate must be increased or decreased by the amount of the investor’s share of the post-acquisition profit or loss of the associate after adjustments for certain inter-entity transactions.

The investor is required to adjust its share of the associate’s profit or loss for its share of any unrealised gains or losses owing to transactions between:

(a) the associate and the investor, or any of its controlled entities (subsidiaries), and (b) the associate and any other associate of the investor.

Profits or losses are realised to the extent that assets that have been purchased or sold between related entities have subsequently been sold to unrelated entities or, alternatively, have been used by the end of the reporting period.

In point (a) above, where the transaction is between the associate and the parent or subsidiary, the proportion of unrealised profits or losses to be eliminated in the equity accounting process is the investor’s ownership interest in the associate.

In point (b) above, where the transaction is between two associates of the investor, the proportion of unrealised profits or losses to be eliminated in the equity accounting process is the product of the investor’s ownership interest in each of the associates. For example, where an associate in which a 25 per cent ownership interest is held transacts with an associate in which a 40 per cent ownership interest is held, 10 per cent (0.25 × 0.4) of the unrealised profit or unrealised loss is to be eliminated before the investor’s share of the associate’s profits can be determined.

The accounting treatment required to eliminate unrealised profits or losses under the equity method of accounting can be contrasted with the adjustments required when consolidating controlled entities (subsidiaries), where the full amount of the unrealised profit or loss is eliminated in the consolidation process.

Let us consider the information about Investor Company and its subsidiaries and associates given in Figure 29.2 and the information that follows about the transactions between Investor Company’s subsidiaries and associates.

Transaction 1 Associate A sells goods to Subsidiary A and makes a profit on the transaction of $10 000. At the end of the reporting period, Subsidiary A still has 50 per cent of the goods on hand.

The amount of the unrealised gain therefore is 50 per cent of $10 000, which equals $5000. The amount to be eliminated (following the rules provided for point (a) above) is 40 per cent of the unrealised gain, which is $2000 (40 per cent of $5000).

LO 29.4

calculated as ($250 000 − $225 000) × (1 − tax rate) × 25% = $4375. The consolidation worksheet entry would therefore be:

June 2023 (for the consolidation worksheet)

Dr Investment in Coombes Ltd 4 375

Cr Share of associate’s other comprehensive income 4 375

(to recognise Rankin Ltd’s share of Coombes Ltd’s other comprehensive income)

June 2023 (for the consolidation worksheet)

Dr Share of associate’s other comprehensive income 4 375

Cr Revaluation surplus 4 375

(closing entry to transfer the net amount in OCI relating to the revaluation to the revaluation surplus account)

It should be noted that had the goodwill of Coombes Ltd been impaired, then the proportional interest in the goodwill impairment would need to have been deducted from Rankin Ltd’s share of Coombes Ltd’s profit.

WORKED EXAMPLE 29.2 continued

dee67382_ch29_1155-1204.indd 1173 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1173

Transaction 2 Assume the same circumstances as in Transaction 1 above, except this time the goods are sold by Associate A to Subsidiary B. The same amount would be eliminated, even though Subsidiary B is only 80 per cent held.

Transaction 3 Associate A sells goods to Associate B, making a profit of $20 000. At the end of the reporting period, 75 per cent of the goods have not been sold by Associate B and therefore are still on hand.

The amount of the unrealised gain is therefore 75 per cent of $20 000, which equals $15 000. The amount to be eliminated (following the rules provided for point (b) above) is 12 per cent (0.40 × 0.30) of the unrealised gain, which is $1800 (12 per cent of $15 000).

In all three situations described here the inventory is sold by an associate, either to an entity within the economic entity (which includes the parent entity and its subsidiaries) or to an associate of the investor. In each situation, part of the profit recognised in the accounts of Associate A is said to be unrealised—that is, the unrealised gain resides in Associate A. An interesting question arises. Should we also eliminate inter-entity transactions where the assets are being sold by the investor or one of the investor’s subsidiaries to an associate of the investor? In this situation we would say that the unrealised gain or loss on the sale resides in the economic entity. Does it make sense to adjust the investor’s share of the associate’s profit or loss for an unrealised gain or loss of the investor?

The wording of AASB 128 does not specify which inter-entity transactions are to be eliminated. To further muddy the waters, AASB 128 states that the investor’s share of the associate’s profit or loss must be adjusted for certain inter- entity transactions. Recall that the purpose of AASB 128 is to determine the carrying amount of the investment in the associate. That is, AASB 128 provides guidance about a measurement technique and not a consolidation technique. Further, the definition of an economic entity under AASB 10 Consolidated Financial Statements excludes associates, and therefore any transaction between associates and entities within the economic entity is, by definition, not an intragroup transaction. Hence, arguably, any unrealised profit resulting from a transaction between the investor and the associate, to the extent it resides in the investor, does not have to be eliminated.

In relation to a further issue involving the transactions of associates, it should be stressed that elimination of the respective amounts will only be possible if the information is known. Miller and Leo (1997) highlight the problems of obtaining the information necessary to perform the eliminations. In the analysis of the submissions made in reaction to ED 71 Accounting for Investments in Associates by the Equity Method, they highlighted submissions made by the ASC (now ASIC) and WMC Ltd, which drew attention to the fact that, in practice, the investor cannot demand the necessary accounting information from the associate, as it does not have control of the associate. In its submission, the ASC pointed out that some adjustments required to the investor’s share of profit or loss of the associate are inappropriate and possibly illegal. The adjustments referred to are those required in relation to notional depreciation, dissimilar accounting policies and the elimination of inter-entity transactions. According to Miller and Leo (p. 10), the adjustments are possibly illegal ‘because the investor is not entitled to the information necessary to make the adjustments in preference to all other shareholders’.

As we can see, there are unresolved issues in relation to adjusting an associate’s profit or loss. Perhaps these problems will be resolved in the future. If not, comparing the results of similar entities that apply the equity method of accounting might be a difficult and potentially misleading exercise.

In Worked Example 29.3 we will consider how to account for the sale of inventory and a depreciable asset from an associate to an investor. As any unrealised profits will reside with the associate, such profits will need to be eliminated—if they had been held by the investor the case would not be so clear, as indicated in the foregoing discussion. We will assume that the investor has access to the required information held by the associate. (Again, consider the argument provided by Miller and Leo, summarised above, pointing out that this information is not always accessible.)

Figure 29.2 Investor Company and its subsidiaries and associates

Investor Company

Subsidiary A 100% owned

Associate A 40% owned

Subsidiary B 80% owned

Associate B 30% owned

dee67382_ch29_1155-1204.indd 1174 10/25/19 12:17 PM

1174 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 29.3: Sale of inventory and a depreciable asset from the associate to the investor

Iselin Ltd, a parent entity, acquires 25 per cent of the shares of Lambert Ltd on 1 July 2021 for a cash consideration of $165 000. At the time of the acquisition, all of the assets of Lambert Ltd are recorded at fair value, with the exception of land that has a fair value $30 000 above its carrying amount.

The equity balances of Lambert Ltd as at the date of acquisition are:

Share capital $400 000

Revaluation surplus $ 60 000

Retained earnings $120 000

Total shareholders’ equity $580 000

Additional information

• Lambert Ltd does not pay interim dividends, and no dividend is provided for in the 2021 financial statements. Dividends that have been declared are paid within 15 weeks of the end of the financial year.

• During the financial year ending 30 June 2022, Lambert Ltd makes a profit before tax of $80 000, and an after-tax profit of $50 000 and declared a dividend of $10 000.

• During the financial year ending 30 June 2023, Lambert Ltd makes a profit before tax of $65 000 and an after- tax profit of $41 000 and declared a dividend of $8000 to be paid in August 2023. The after-tax profit includes a sale of some inventory to Nathan Ltd (another associate of Iselin Ltd) for $15 000 (which cost Lambert Ltd $10 000 to produce), and a profit of $5000 on the disposal of a printing press that is sold to Windsor Ltd, a subsidiary of Iselin Ltd. At 30 June 2023 Nathan Ltd has $3000 of the above-mentioned inventory still on hand, which cost Lambert Ltd $2000 to produce.

• The printing press referred to above is sold by Lambert Ltd on 1 July 2022 for a price of $30 000. The printing press has a remaining expected useful life of 10 years.

• Iselin Ltd holds 40 per cent of the shares of Nathan Ltd. • The company tax rate is assumed to be 36 per cent. • Iselin Ltd recognises dividends when they are actually received.

REQUIRED Prepare the accounting entries, as required by AASB 128, for Iselin Ltd for the year ending 30 June 2023 to account for Iselin Ltd’s interest in the associate Lambert Ltd.

SOLUTION As Iselin Ltd is a parent entity, the following equity accounting entries will be applied in the consolidation worksheet.

Determination of the goodwill acquired (if any)

Identifiable net assets of the associate at 1 July 2021 $580 000

Adjustment for the after-tax effect of the fair value adjustment of the land ($30 000 × [1.00 − 0.36])

$ 19 200

Fair value of identifiable net assets at 1 July 2021 $599 200

Iselin Ltd’s equity interest in the associate × 25%

Fair value of the net assets acquired by Iselin $149 800

Consideration $165 000

Goodwill included in the carrying amount of the investment $ 15 200

We calculate the value of goodwill because if there is a subsequent impairment of goodwill then this impairment would need to be recognised by reducing the investor’s share of the associate’s profit. The goodwill relating to the associate is not included within the financial statements.

Initial adjustments required There is no adjustment for land, as land is not a depreciable asset.

dee67382_ch29_1155-1204.indd 1175 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1175

Calculation of initial adjustment to retained earnings

Associate’s profit for the year ending 30 June 2022 $50 000

Iselin Ltd’s equity interest × 25%

Share of associate’s 2022 profit $12 500

As the equity accounting entries are being performed for the year ending 30 June 2023, the investor’s share of the associate’s 2022 profit (calculated above) is to be credited to opening retained earnings. No dividends were recognised in 2022. Iselin Ltd recognises dividends only when they are received.

30 June 2023

Dr Investment in Lambert Ltd 12 500

Cr Retained earnings at 1 July 2022 (to increase the carrying amount of the investment in the associate by the investor’s share of the associate’s prior period’s profits)

12 500

Calculation of investor’s share of the associate’s current year profit or loss

Associate’s profit for the year ending 30 June 2023 $41 000

Iselin Ltd’s equity interest in associate × 25%

$10 250

less Elimination of unrealised profit on inter-entity transactions (see below) (64)

less Adjustment for gain on disposal of printing press (see below) (720)

Investor’s share of associate’s adjusted profit $ 9 466

As the investor in this instance recognises the dividends in the associate only as they are received, the equity accounting entries will eliminate only dividends that have been paid throughout the year. Iselin Ltd would receive the dividend declared in the 2022 financial statements 15 weeks after the end of the 2022 financial year. The amount received would be $10 000 × 25 per cent.

Lambert Ltd sells goods to Nathan Ltd, with 20 per cent of the goods remaining unsold (by Nathan Ltd) at year end. The profit before tax on the total transaction is $5000. Therefore, assuming a tax rate of 36 per cent, the after-tax profit on the unrealised component is calculated as $5000 × 20 per cent × (1 − 0.36), which equals $640. As the sale is between two associates, the amount of the profit to be eliminated will be based on the product of the investor’s ownership interest in each associate. Therefore the adjustment to the associate’s profit will be: $640 × 0.4 × 0.25 = $64.

Lambert Ltd makes a gain of $5000 on the sale of a printing press to a subsidiary of Iselin Ltd. The printing press will be depreciated in the subsidiary’s accounts over a 10-year period. As Windsor Ltd is a subsidiary and therefore part of the economic entity, the gain can be considered to be unrealised. The gain will be realised as the economic benefits of the asset are consumed. The adjustment required is calculated as:

Amount of gain included in the associate’s profit $5 000

less Applicable tax at 36 per cent ($1 800)

After-tax gain $3 200

Accumulated amount realised to 30 June 2023 in the form of higher depreciation ($ 320)

$2 880

Investor’s share × 25%

Adjustment required $ 720

continued

dee67382_ch29_1155-1204.indd 1176 10/25/19 12:17 PM

1176 PART 8: Accounting for equity interests in other entities

To record the adjustment necessary to record the investor’s share of the profits of Lambert Ltd (after the above adjustments), the consolidation worksheet journal entries would be: 30 June 2023

Dr Investment in Lambert Ltd 9 466

Cr Share of associate’s profit 9 466

Dr Dividend revenue 2 500

Cr Investment in Lambert Ltd 2 500

(to increase the carrying amount of the investment in the associate by the investor’s share of the associate’s current period profits, and to reduce the carrying amount by the investor’s share of dividends)

Before moving our attention to associates that generate a loss, in Worked Example 29.4 we will consider addressing investments in associates where the associates are generating profits.

WORKED EXAMPLE 29.4: A further example of accounting for an investment in an associate

On 1 July 2022 Lopez Ltd acquires 25 per cent of the ordinary issued capital of Lightning Bolt Ltd for $750 000. Upon acquisition of this financial interest in Lightning Bolt Ltd, Lopez Ltd appoints two directors to the eight-seat board of directors of Lightning Bolt Ltd.

All of the identifiable net assets of Lightning Bolt Ltd are stated at fair value, except for the following:

Carrying amount ($000)

Fair value ($000)

Difference ($000)

Land 1 500 2 000 500

Depreciable assets 1 280 1 400 120

The depreciable assets are considered to have a further useful life of five years. The share capital and reserves of Lightning Bolt Ltd at 1 July 2022 were:

$000

Share capital 800

General reserve 150

Retained earnings 550

1 500

Extracts from the financial statements of Lopez Ltd and Lightning Bolt Ltd as at 30 June 2023 show:

Lopez Ltd ($)

Lightning Bolt Ltd ($)

Reconciliation of opening and closing retained earnings

Profit before tax 1 000 000 910 000

Income tax expense (390 000) (370 000)

Profit after tax 610 000 540 000

Retained earnings—opening 520 000 550 000

1 130 000 1 090 000

Transfer to reserves – (50 000)

Dividends paid (60 000) (180 000)

WORKED EXAMPLE 29.3 continued

dee67382_ch29_1155-1204.indd 1177 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1177

Lopez Ltd ($)

Lightning Bolt Ltd ($)

Dividends proposed (140 000) (60 000)

Retained earnings—closing 930 000 800 000

Statements of financial position

Current assets

Inventory 2 850 000 1 350 000

Cash 1 740 000 240 000

4 590 000 1 590 000

Non-current assets

Investments in associate 750 000 –

Property, plant and equipment 4 500 000 2 524 000

5 250 000 2 524 000

Total assets 9 840 000 4 114 000

Liabilities (4 768 000) (2 314 000)

Net assets 5 072 000 1 800 000

Shareholders’ funds

Share capital 2 000 000 800 000

General reserve 1 500 000 200 000

Revaluation surplus 642 000 –

Retained earnings 930 000 800 000

5 072 000 1 800 000

Additional information • Lopez Ltd recognises dividends only when received. • On 30 June 2023 Lopez Ltd holds inventory sold to it by Lightning Bolt Ltd at a profit of $15 000. This

inventory was sold to Lopez Ltd for $20 000. • Lightning Bolt Ltd has a policy of paying dividends out of current year profits before utilising previous years’

profits. • Assume that the tax rate applicable for the year ending 30 June 2023 is 39 per cent. • Lightning Bolt has a number of subsidiaries.

REQUIRED Prepare the relevant equity accounting entries for Lopez Ltd and its associate Lightning Bolt Ltd for the year ending 30 June 2023 in accordance with AASB 128.

SOLUTION First we can determine the goodwill acquired at acquisition date, as follows:

Identifiable net assets $1 500 000

Fair value adjustments

Land—after-tax increase (500 000 × [1.00 − 0.39]) $ 305 000

Depreciable assets—after-tax increase (120 000 × [1.00 − 0.39]) $ 73 200

Fair value of identifiable net assets at 1 July 2022 $1 878 200

Lopez Ltd’s equity interest in Lightning Bolt Ltd × 25%

Fair value of identifiable net assets acquired $ 469 550

Purchase consideration $ 750 000

Purchased goodwill therefore is: $ 280 450

continued

dee67382_ch29_1155-1204.indd 1178 10/25/19 12:17 PM

1178 PART 8: Accounting for equity interests in other entities

We calculate goodwill at acquisition so that we have a basis upon which we can subsequently apportion any impairment of goodwill.

The following entries would be recorded in the ledger accounts of Lopez Ltd (using the cost method):

1 July 2022

Dr Investment in Lightning Bolt Ltd 750 000

Cr Cash 750 000

(to recognise the initial investment in Lightning Bolt Ltd using the cost method)

Dr Cash 45 000

Cr Dividend revenue 45 000

(only dividends actually received are recognised by Lopez Ltd—$180 000 × 0.25 = $45 000)

The following entries represent the equity accounting entries. These entries would be recorded in the consolidation worksheet.

Calculation of Lopez Ltd’s share of the current year profits of Lightning Bolt Ltd

Associate’s profit for the year ending 30 June 2023 $540 000

Lopez Ltd’s equity interest × 25%

$135 000

less Additional depreciation expense ($ 3 660)

less Elimination of inter-entity transactions ($ 2 287)

Lopez Ltd’s share of associate’s adjusted profit $129 053

Explanations for the adjustments shown above: Depreciation adjustment

The depreciation adjustment is determined by dividing the investor’s share in the difference between the carrying amount and fair value of the depreciable assets by the expected remaining useful life of the assets:

($120 000 × 0.25) ÷ 5 = $6000. The after-tax effect of this is $6000 × (1.00 − 0.39) = $3660.

Adjustment for inter-entity transactions

Lightning Bolt Ltd sells goods to Lopez Ltd. The profit before tax in relation to the inventory still on hand at the reporting date is $15 000. Therefore, assuming a tax rate of 39 per cent, the after-tax profit on the unrealised component is calculated as:

$15 000 × (1 − 0.39) = $9150

As the sale is made by the associate, the amount of the profit to be eliminated will be based on the ownership interest in the associate. Therefore the adjustment to the associate’s profit will be:

$9150 × 0.25 = $2287.50

The accounting entry to recognise Lopez Ltd’s share of the current year’s profits would therefore be:

June 2023 (for the consolidation worksheet)

Dr Investment in Lightning Bolt Ltd 129 053

Cr Share of associate’s profit 129 053

(to recognise the investor’s share of the associate’s profit)

WORKED EXAMPLE 29.4 continued

dee67382_ch29_1155-1204.indd 1179 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1179

The entry to adjust the investment account for the dividends received would be:

30 June 2023 (for the consolidation worksheet)

Dr Dividend revenue 45 000

Cr Investment in Lightning Bolt Ltd 45 000

(to decrease the carrying amount of the investment in the associate by the investor’s share of the dividend from the associate)

The carrying amount of the investment in the separate financial statements of Lopez Ltd (using the cost method) would be $750 000. The carrying amount of the investment in the associate (adopting the equity method of accounting) as shown in the consolidated financial statements would be $834 053, which would be the original cost of the investment plus the share of the associate’s profit less Lopez Ltd’s proportional interest in the dividend payments made by Lightning Bolt Ltd.

29.5 Application of the equity method of accounting when losses have been incurred by an associate

AASB 128 requires the equity method of accounting to be discontinued when the effect of equity accounting losses or revaluation decrements causes the carrying amount of the investment to fall below zero. The carrying amount of the investment in the associate is not to be reduced below zero. When the equity-accounted value of the investment in the associate falls to zero and losses continue, the use of the equity method of accounting should be suspended (paragraph 38 of AASB 128).

It is possible that the associate will generate accounting profits or recognise revaluation increments in a subsequent period. The investment in the associate should be increased only by the investor’s share of the profits or revaluation increments (and the revaluation increments would be part of other comprehensive income), when such increases offset the losses and revaluation decrements that were not recognised following the suspension of the equity method. According to paragraph 39 of AASB 128, if the associate or joint venture subsequently reports profits, the investor resumes recognising its share of those profits only after its share of the profits equals the share of losses not recognised.

We will now consider in Worked Example 29.5 how to account for an associate that generates a loss.

LO 29.5

WORKED EXAMPLE 29.5: Accounting for an associate that is generating losses

On 1 July 2021 Mick Ltd acquired 25 per cent of the issued shares of Fanning Ltd for $500 000. The total shareholders’ equity of Fanning Ltd was $2 000 000 on the date of acquisition, and all identifiable assets and liabilities of Fanning Ltd were reported at their fair value. Mick Ltd has a number of subsidiaries and therefore prepares consolidated financial statements. Fanning has not paid or declared dividends between 2022 and 2026.

The profits or losses of Fanning Ltd for the five years following acquisition are as follows:

Year ending Profit/(loss)

$ Share of profit/(loss)

$ Cumulative share

$ Carrying amount of

investment $ Unrecognised

losses $

30 June 2022 100 000 25 000 25 000 525 000 0

30 June 2023 (300 000) (75 000) (50 000) 450 000 0

30 June 2024 (2 000 000) (500 000) (550 000) 0 50 000

30 June 2025 100 000 25 000 (525 000) 0 25 000

30 June 2026 1 000 000 250 000 (275 000) 225 000 0

REQUIRED Prepare the related journal entries that would be required to generate consolidated financial statements for each of the respective years.

continued

dee67382_ch29_1155-1204.indd 1180 10/25/19 12:17 PM

1180 PART 8: Accounting for equity interests in other entities

SOLUTION

30 June 2022 (for the consolidation worksheet)

Dr Investment in associate—Fanning Ltd 25 000

Cr Share of profits of associate 25 000

(to increase the investment in the associate by the investor’s share of the associate’s profits)

30 June 2023 (for the consolidation worksheet)

Dr Share of losses of associate 75 000

Cr Retained earnings—1 July 2022 25 000

Cr Investment in associate—Fanning Ltd 50 000

(to reduce the carrying amount of the investment by the share of the associate’s losses. As these are the journal entries that are posted to the consolidation worksheet, the net effect of the previous entries applying the equity method of accounting must form part of the journal entries)

30 June 2024 (for the consolidation worksheet)

Dr Share of losses of associate 450 000

Dr Retained earnings—1 July 2023 50 000

Cr Investment in associate—Fanning Ltd 500 000

(to reduce the value of the investment to zero due to losses of associate. It must be remembered that the amount attributed to the investment account in the separate accounts of Mick Ltd would be $500 000 and would not have been directly adjusted by the previous consolidation adjustments)

30 June 2025 (for the consolidation worksheet)

Dr Retained earnings—1 July 2024 500 000

Cr Investment in associate—Fanning Ltd 500 000

(as the share of losses of the associate has already taken the carrying amount in the consolidated financial statements to zero, no further losses are recognised within the consolidated financial statements)

30 June 2026 (for the consolidation worksheet)

Dr Retained earnings—1 July 2025 500 000

Cr Share of profits of associate 225 000

Cr Investment in associate—Fanning Ltd 275 000

(to recognise the investor’s share of the profits of the associate. Although 25 per cent of the associate’s profits amounts to $250 000, the requirement is that the investment in the associate should be increased only by the investor’s share of the profits when such increases offset the losses and revaluation decrements that were not recognised following the  suspension of the equity method)

WORKED EXAMPLE 29.5 continued

dee67382_ch29_1155-1204.indd 1181 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1181

29.6 Disclosure requirements

To find the disclosure requirements pertaining to interests in associates and joint arrangements we need to go to yet another accounting standard, this being AASB 12 Disclosure of Interests in Other Entities. The relevant paragraphs are paragraphs 20 to 23, and these state:

20. An entity shall disclose information that enables users of its financial statements to evaluate: (a) the nature, extent and financial effects of its interests in joint arrangements and associates, including

the nature and effects of its contractual relationship with the other investors with joint control of, or significant influence over, joint arrangements and associates (paragraphs 21 and 22); and

(b) the nature of, and changes in, the risks associated with its interests in joint ventures and associates (paragraph 23).

Nature, extent and financial effects of an entity’s interests in joint arrangements and associates 21. An entity shall disclose: (a) for each joint arrangement and associate that is material to the reporting entity: (i) the name of the joint arrangement or associate. (ii) the nature of the entity’s relationship with the joint arrangement or associate (by, for example,

describing the nature of the activities of the joint arrangement or associate and whether they are strategic to the entity’s activities).

(iii) the principal place of business (and country of incorporation, if applicable and different from the principal place of business) of the joint arrangement or associate.

(iv) the proportion of ownership interest or participating share held by the entity and, if different, the proportion of voting rights held (if applicable).

(b) for each joint venture and associate that is material to the reporting entity: (i) whether the investment in the joint venture or associate is measured using the equity method or at fair value. (ii) summarised financial information about the joint venture or associate as specified in paragraphs

B12 and B13. (iii) if the joint venture or associate is accounted for using the equity method, the fair value of its

investment in the joint venture or associate, if there is a quoted market price for the investment. (c) financial information as specified in paragraph B16 about the entity’s investments in joint ventures and

associates that are not individually material: (i) in aggregate for all individually immaterial joint ventures and, separately, (ii) in aggregate for all individually immaterial associates. 22. An entity shall also disclose: (a) the nature and extent of any significant restrictions (eg resulting from borrowing arrangements, regulatory

requirements or contractual arrangements between investors with joint control of or significant influence over a joint venture or an associate) on the ability of joint ventures or associates to transfer funds to the entity in the form of cash dividends, or to repay loans or advances made by the entity.

(b) when the financial statements of a joint venture or associate used in applying the equity method are as of a date or for a period that is different from that of the entity:

(i) the date of the end of the reporting period of the financial statements of that joint venture or associate; and (ii) the reason for using a different date or period. (c) the unrecognised share of losses of a joint venture or associate, both for the reporting period and

cumulatively, if the entity has stopped recognising its share of losses of the joint venture or associate when applying the equity method.

Risks associated with an entity’s interests in joint ventures and associates 23. An entity shall disclose: (a) commitments that it has relating to its joint ventures separately from the amount of other commitments

as specified in paragraphs B18–B20. (b) in accordance with AASB 137 Provisions, Contingent Liabilities and Contingent Assets, unless the

probability of loss is remote, contingent liabilities incurred relating to its interests in joint ventures or associates (including its share of contingent liabilities incurred jointly with other investors with joint control of, or significant influence over, the joint ventures or associates), separately from the amount of other contingent liabilities. (AASB 12)

LO 29.6

dee67382_ch29_1155-1204.indd 1182 10/25/19 12:17 PM

1182 PART 8: Accounting for equity interests in other entities

As we can see from the above paragraphs, the disclosure requirements relating to associates also apply to joint arrangements. We now turn our attention to joint arrangements.

29.7 Introduction to accounting for interests in joint arrangements

Having considered how to account for interests in associates we will now consider how to account for interests held in joint arrangements. In doing so, we will need to refer to AASB 11 Joint Arrangements. We will

also need to refer to AASB 128, which we have just been discussing in relation to investments in associates.

Joint arrangements are particularly common in the mining industry and in the real estate development and construction industries, and have been for several decades. For companies involved in mining, joint arrangements typically require the venturers to contribute resources for joint use with a view to a share of the production output. In a property development joint venture,

one venturer might contribute expertise and the other financial capital, with both parties having a share in the final construction.

Joint arrangements can take many different forms and structures, such as partnerships, trusts and incorporated entities. Joint arrangements can also exist even when a separate vehicle has not been established. In such a situation, the joint arrangement can simply involve the shared use of assets, other resources and expertise of the parties. Further, some joint arrangements involve the joint control by the parties of one or more assets contributed to the joint arrangement. As we will see, the accounting treatment required for interests in a joint arrangement will depend upon

the type of joint arrangement involved. A joint arrangement is defined in AASB 11 as an arrangement of which two or more parties

have joint control. Paragraph 6 states that a joint arrangement is either a joint operation or a joint venture. How we account for the joint arrangement will be dependent upon how the joint arrangement is classified—that is, whether it is a

∙ joint venture or ∙ joint operation.

Joint control—which is essential for an arrangement to be considered a joint arrangement—is defined in paragraph 7 of AASB 11 as:

The contractually agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. (AASB 11)

Because joint arrangements—which we now know shall be classified as either joint operations or joint ventures—are subject to joint control (which is stronger than ‘significant influence’, which

is a defining characteristic relating to investments in associates, but weaker than ‘control’), then no one entity has control of the joint arrangement and consequently the arrangements are not considered to be subsidiaries of a parent entity. Therefore, we do not consolidate interests in joint arrangements with the accounts of the investor.

Neither AASB 11 nor AASB 128 addresses how the joint venture or joint operation itself should prepare its own financial statements. Rather, the accounting standards address how the investor should account for its interests in the joint arrangements. Further, there is no direct statutory or professional requirement for a joint venture or joint operation to prepare financial statements. However, if a joint arrangement is deemed to be a reporting entity, general- purpose financial statements might need to be prepared. (You will recall that general-purpose financial statements are financial statements that comply with relevant accounting standards.)

We will discuss the requirements relating to joint ventures and joint operations respectively below. As paragraph 14 of AASB 11 requires:

An entity shall determine the type of joint arrangement in which it is involved. The classification of a joint arrangement as a joint operation or a joint venture depends upon the rights and obligations of the parties to the arrangement. (AASB 11)

A deal of professional judgement is required in determining whether a joint arrangement is a joint venture, or a joint operation. As paragraphs 17 and 18 of AASB 11 state:

17. An entity applies judgement when assessing whether a joint arrangement is a joint operation or a joint venture. An entity shall determine the type of joint arrangement in which it is involved by considering its rights and

joint arrangement An arrangement in which two or more parties have joint control.

joint operation A joint arrangement whereby the parties that have joint control have rights to the assets, and obligations for the liabilities, relating to the arrangement.

joint venture A joint arrangement whereby the parties that have joint control have rights to the net assets of the arrangement.

LO 29.7

dee67382_ch29_1155-1204.indd 1183 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1183

obligations arising from the arrangement. An entity assesses its rights and obligations by considering the structure and legal form of the arrangement, the terms agreed by the parties in the contractual arrangement and, when relevant, other facts and circumstances (see paragraphs B12–B33).

18. Sometimes the parties are bound by a framework agreement that sets up the general contractual terms for undertaking one or more activities. The framework agreement might set out that the parties establish different joint arrangements to deal with specific activities that form part of the agreement. Even though those joint arrangements are related to the same framework agreement, their type might be different if the parties’ rights and obligations differ when undertaking the different activities dealt with in the framework agreement. Consequently, joint operations and joint ventures can coexist when the parties undertake different activities that form part of the same framework agreement. (AASB 11)

As paragraph B19 also explains:

A joint arrangement in which the assets and liabilities relating to the arrangement are held in a separate vehicle can be either a joint venture or a joint operation. (AASB 11)

Whether a party is a joint operator or a joint venturer depends on the party’s rights to the assets (and obligations for the liabilities) relating to the arrangement that are held in the separate vehicle. As will be explained in the material that follows, when the parties to a joint arrangement have structured the joint arrangement in a separate entity, the parties need to assess whether the legal form of the separate entity, the terms of the contractual arrangement and, when relevant, any other facts and circumstances give them:

(a) rights to the assets, and obligations for the liabilities, relating to the arrangement (in which case the arrangement would be considered to be a joint operation), or

(b) rights to the net assets of the arrangement (in which case the arrangement would be considered to be a joint venture).

We will now consider joint ventures and joint operations respectively. We will commence our discussion with joint ventures.

29.8 Joint ventures

A joint venture is defined in both AASB 128 and 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.

Paragraph B23 of AASB 11 further explains:

For example, the parties might conduct the joint arrangement through a separate vehicle, whose legal form causes the separate vehicle to be considered in its own right (ie the assets and liabilities held in the separate vehicle are the assets and liabilities of the separate vehicle and not the assets and liabilities of the parties). In such a case, the assessment of the rights and obligations conferred upon the parties by the legal form of the separate vehicle indicates that the arrangement is a joint venture. (AASB 11)

The parties to a joint venture are called joint venturers. In summarising some of the above discussion, if a party has joint control of an entity, and the party (joint venturer)

has no claim against specific assets, and no obligation for specific liabilities—but rather has a claim to, or responsibility for, the net assets—then the joint arrangement would be considered to be a joint venture. In terms of the required accounting treatment, paragraph 24 of AASB 11 requires that:

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. (AASB 11)

Therefore, unless the limited exemptions identified at paragraphs 17 to 19 of AASB 128 apply, then the investor shall use the equity method of accounting to account for its interest in a joint venture. We have already explained the application of the equity method of accounting earlier in this chapter when we discussed investments in associates, therefore we will not repeat that explanation. The same accounting procedures shall be applied.

LO 29.8

dee67382_ch29_1155-1204.indd 1184 10/25/19 12:17 PM

1184 PART 8: Accounting for equity interests in other entities

If the joint venturer prepares consolidated financial statements then the equity method will be used in the consolidated financial statements. In the separate financial statements of the joint venturer, the joint venturer shall, in accordance with paragraph 26 of AASB 11:

account for its interest in a joint venture in accordance with paragraph 10 of AASB 127 Separate Financial Statements. (AASB 11)

A review of paragraph 10 of AASB 127 shows:

When an entity prepares separate financial statements, it shall account for investments in subsidiaries, joint ventures and associates either:

(a) at cost; (b) in accordance with AASB 9; or (c) using the equity method as described in AASB 128. (AASB 127)

The above requirement effectively means that the joint venturer will choose between measuring its investment in the joint venture at either cost or fair value in its own separate financial statements, and apply the equity method of accounting in its consolidated financial statements. We will now turn our attention to the second category of joint arrangements, this being joint operations. We are not to use the equity method of accounting to account for interests in joint operations.

29.9 Joint operations

Paragraph 15 of AASB 11 defines a joint operation 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. (AASB 11)

A joint operation might, or might not be, structured through a separate vehicle. If a joint arrangement does not involve a separate vehicle, then it is a joint operation. As paragraph B16 of AASB 11 states:

A joint arrangement that is not structured through a separate vehicle is a joint operation. In such cases, the contractual arrangement establishes the parties’ rights to the assets, and obligations for the liabilities, relating to the arrangement, and the parties’ rights to the corresponding revenues and obligations for the corresponding expenses. (AASB 11)

If an arrangement does involve the establishment of a separate entity then it may, or may not be, a joint operation. As paragraphs B19 to B21 of AASB 11 state:

B19 A joint arrangement in which the assets and liabilities relating to the arrangement are held in a separate vehicle can be either a joint venture or a joint operation.

B20 Whether a party is a joint operator or a joint venturer depends on the party’s rights to the assets, and obligations for the liabilities, relating to the arrangement that are held in the separate vehicle.

B21 As stated in paragraph B15, when the parties have structured a joint arrangement in a separate vehicle, the parties need to assess whether the legal form of the separate vehicle, the terms of the contractual arrangement and, when relevant, any other facts and circumstances give them:

(a) rights to the assets, and obligations for the liabilities, relating to the arrangement (ie the arrangement is a joint operation); or

(b) rights to the net assets of the arrangement (ie the arrangement is a joint venture). (AASB 11)

Paragraph B24 of AASB 11 further states:

The assessment of the rights and obligations conferred upon the parties by the legal form of the separate vehicle is sufficient to conclude that the arrangement is a joint operation only if the parties conduct the joint arrangement in a separate vehicle whose legal form does not confer separation between the parties and the separate vehicle (ie the assets and liabilities held in the separate vehicle are the parties’ assets and liabilities). (AASB 11)

An example of a joint operation is when two or more joint operators combine their operations, resources and expertise to manufacture, market and distribute jointly a particular product, such as an aircraft. Different parts of the

LO 29.9

dee67382_ch29_1155-1204.indd 1185 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1185

manufacturing process are carried out by each of the joint operators. Each joint operator bears its own costs and takes a share of the revenue from the sale of the aircraft, such share being determined in accordance with the contractual arrangement.

As we have noted, a joint operation does not necessarily require the establishment of a corporation, partnership, other form of entity or a financial structure that is separate from the joint operators themselves. It may simply involve the shared use of assets and other resources of the joint operators.

Where a joint operation exists, as described above, the joint operator must recognise the assets it jointly controls, liabilities and expenses it incurs, and revenues from its share of the output of the joint operation. The interests in joint operations must be recognised in the joint operator’s own separate financial statements.

Figure 29.3 summarises some of our discussion in terms of determining whether a joint arrangement is a joint venture (in which case the equity method of accounting must be applied), or whether it is a joint operation. As Figure 29.3 indicates, it is a necessary requirement that a joint venture must be structured through a separate vehicle, whereas a joint operation might, or might not be, structured through a separate vehicle. Table 29.3 also provides a summary of some issues to consider in determining whether an arrangement is a joint operation or a joint venture.

In relation to the accounting treatment required by the joint operator with an interest in a joint operation, paragraph 20 of AASB 11 requires that:

A joint operator shall recognise in relation to its interest in a joint operation: (a) its assets, including its share of any assets held jointly; (b) its liabilities, including its share of any liabilities incurred jointly; (c) its revenue from the sale of its share of the output arising from the joint operation; (d) its share of the revenue from the sale of the output by the joint operation; and (e) its expenses, including its share of any expenses incurred jointly. (AASB 11)

Paragraph 21 further requires:

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. (AASB 11)

Because the assets, liabilities, income and expenses are recognised in the financial statements of the joint operator, no adjustments or other consolidation procedures are required in respect of these items when the joint operator presents consolidated financial statements.

Assets arising from a joint operator’s share in the items employed in a joint operation are normally included in the joint operator’s statement of financial position with other assets that have a similar nature or function. For example,

Figure 29.3 Classification of a joint arrangement: assessment of the parties’ rights and obligations arising from the arrangement (adapted from AASB 11)

Structure of the joint arrangement

An entity shall consider: (i) the legal form of the separate vehicle (ii) the terms of the contractual arrangement and (iii) when relevant, other facts and circumstances

Not structured through a separate vehicle

Structured through a separate vehicle

Joint ventureJoint operation

dee67382_ch29_1155-1204.indd 1186 10/25/19 12:17 PM

1186 PART 8: Accounting for equity interests in other entities

Table 29.3 Differentiating between a joint venture and a joint operation

Assessing the terms of the contractual arrangement

Joint operation Joint venture

The terms of the contractual arrangement

The contractual arrangement provides the parties to the joint arrangement with rights to the assets, and obligations for the liabilities, relating to the arrangement.

The contractual arrangement provides the parties to the joint arrangement with rights to the net assets of the arrangement (i.e. it is the separate vehicle, not the parties, that has rights to the assets, and obligations for the liabilities, relating to the arrangement).

Rights to assets

The contractual arrangement establishes that the parties to the joint arrangement share all interests (e.g. rights, title or ownership) in the assets relating to the arrangement in a specified proportion (e.g. in proportion to the parties’ ownership interest in the arrangement or in proportion to the activity carried out through the arrangement that is directly attributed to them).

The contractual arrangement establishes that the assets brought into the arrangement or subsequently acquired by the joint arrangement are the arrangement’s assets. The parties have no interests (i.e. no rights, title or ownership) in the individual assets of the arrangement.

Obligations for liabilities

The contractual arrangement establishes that the parties to the joint arrangement share all liabilities, obligations, costs and expenses in a specified proportion (e.g. in proportion to the parties’ ownership interest in the arrangement or in proportion to the activity carried out through the arrangement that is directly attributed to them).

The contractual arrangement establishes that the parties to the joint arrangement are liable for claims raised by third parties.

The contractual arrangement establishes that the joint arrangement is liable for the debts and obligations of the arrangement.

The contractual arrangement establishes that the parties to the joint arrangement are liable to the arrangement only to the extent of their respective investments in the arrangement or to their respective obligations to contribute any unpaid or additional capital to the arrangement, or both.

The contractual arrangement states that creditors of the joint arrangement do not have rights of recourse against any party with respect to debts or obligations of the arrangement.

Revenues, expenses, profit or loss

The contractual arrangement establishes the allocation of revenues and expenses on the basis of the relative performance of each party to the joint arrangement. For example, the contractual arrangement might establish that revenues and expenses are allocated on the basis of the capacity that each party uses in a plant operated jointly, which could differ from their ownership interest in the joint arrangement. In other instances, the parties might have agreed to share the profit or loss relating to the arrangement on the basis of a specified proportion such as the parties’ ownership interest in the arrangement. This would not prevent the arrangement from being a joint operation if the parties have rights to the assets, and obligations for the liabilities, relating to the arrangement.

The contractual arrangement establishes each party’s share in the profit or loss relating to the activities of the arrangement.

a share in an oil pipeline is aggregated with other plant and equipment controlled by the joint operator. Liabilities incurred by a joint operator as a result of its interest in a joint operation are included with other liabilities of the joint operator that have a similar nature.

The method described above is frequently referred to as the line-by-line method. Applying this method will result in the assets in the statement of financial position including both the assets controlled by the entity—and remember that the control test that applies to asset recognition might not coincide with legal ownership—and those that have been

dee67382_ch29_1155-1204.indd 1187 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1187

contributed to the joint operation. The assets held in the joint operation would not typically be as ‘controllable’ as those held by the reporting entity—the assets in the joint operation would be under joint control. This issue has been raised by some people in opposition to the requirements of the joint arrangement accounting standard, which requires that the entity’s assets held within the organisation (and subject to control) should be included with those residing in the joint operation (and under joint control). Hence the approach to asset recognition adopted within AASB 11 could arguably represent a departure from the recommendations made in the Conceptual Framework for Financial Reporting in terms of the definition and recognition criteria for assets, which relies upon control.

An alternative way of accounting for an interest in a joint operation—not permitted by AASB 11—would simply be to record the net interest in the joint operation as a single amount. This method is commonly referred to as the one-line method.

Exhibit 29.2 shows how BHP accounts for its interests in joint arrangements as disclosed in the 2019 Annual Report of BHP Group Ltd.

Exhibit 29.2 An example of how an organisation accounts for its joint arrangements

SOURCE: BHP Group Ltd 2019 Annual Report

WHY DO I NEED TO KNOW WHAT A JOINT ARRANGEMENT REPRESENTS, AND THE FORMS THAT JOINT ARRANGEMENTS CAN TAKE?

As was the case with investments in associates, when we look at the financial statements of large organisations— particularly some of those in the mining, information technology and property development sectors—we will find that the balance sheet and the statement of profit or loss and other comprehensive income will typically refer to investments in joint arrangements. The amounts attributed to interests in joint arrangements can sometimes be very material. Therefore, it would seem important that we know what joint arrangements represent, and the accounting requirements that relate to joint arrangements.

dee67382_ch29_1155-1204.indd 1188 10/25/19 12:17 PM

1188 PART 8: Accounting for equity interests in other entities

See Worked Example 29.6 for an illustration of how to account for a joint operation.

WORKED EXAMPLE 29.6: Accounting for a joint operation

On 1 July 2022 Lets Ltd, Do Ltd and It Ltd decide to contractually form a joint operation to pursue mineral exploration and production activity. They acquire a parcel of land by the river in St Lucia and obtain the relevant permits to begin mining. They expect to continue mining for 10 years.

The companies contractually commit themselves to contribute the following amounts to the joint operation:

Lets Ltd $ 8 000 000 (40%)

Do Ltd $10 000 000 (50%)

It Ltd $ 2 000 000 (10%)

$20 000 000 (100%)

Funds are initially used to acquire some machinery at a cost of $10 million, and some land at a cost of $6 million. It is assumed that these assets are acquired on 1 July 2022. The assets are held by the joint operators as tenants in common in proportion to their agreed contributions (provided above). The balance of the contracted contribution (a total of $4 million) will be called by the joint operation’s manager as required.

To finance their contributions, Lets Ltd and Do Ltd have had to borrow $3 million and $4 million respectively. For the year ending 30 June 2023, the joint operation’s manager prepares the following statement of

financial position, statement of cash flows and statement of production costs. (You will notice that there is no joint operation statement of profit or loss and other comprehensive income, as it is assumed in this case that the joint operators share in outputs not profits—this is quite common. If the joint operators were to share in income then a statement of profit or loss and other comprehensive income would be produced.)

As at 30 June 2023, no minerals have been removed, although the joint operators do consider that economically recoverable reserves exist and extraction will commence shortly. All pre-production costs (other than the expenditure relating to the land and buildings acquired on 1 July 2022) are considered to be equally distributed between intangible assets and machinery. The intangible assets relate to expenditure incurred in exploring and evaluating the mine site. The pre-production expenditures (which would initially have been referred to as exploration and evaluation assets) have been transferred to property, plant and equipment and an asset labelled intangible mining assets has also been recognised. These assets would be amortised when production commences. Such amortisation would typically be on a production output basis.

Statement of costs of pre-production for year ending 30 June 2023

$000

Direct costs

– Wages 300

– Materials 500

– Management fees 300

– Other 300

Total costs of pre-production 1 400

Statement of cash flows for year ending 30 June 2023

$000 $000

Cash flows from operations

Payments

– Wages 300

– Materials 400

– Management fees 300

– Other 200 (1 200)

dee67382_ch29_1155-1204.indd 1189 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1189

$000 $000

Cash flows from financing activities

Receipts from joint operators

– Lets Ltd 800

– Do Ltd 1 000

– It Ltd 200 2 000

Cash on hand 30 June 2023 800

Joint operation statement of financial position as at 30 June 2023

$000

Current assets

Cash on hand 800

Non-current assets

Machinery ($10 000 000 + $1 400 000/2) 10 700 Land 6 000

Intangible mining assets 700

17 400

Total assets 18 200

less Current liabilities

Accounts payable 200

Net assets 18 000

Represented by:

Interests of participants

Lets Ltd 7 200

Do Ltd 9 000

It Ltd 1 800

18 000

REQUIRED

(a) Prepare the journal entries that would appear in the joint operators’ own journals to record the establishment of the joint operation on 1 July 2022.

(b) Prepare the journal entries that would appear in the joint operators’ own journals to record the transactions for the year to 30 June 2023.

SOLUTION

(a) Journal entries to record the establishment of the joint operation 1 July 2022

Lets Ltd ($000)

Do Ltd ($000)

It Ltd ($000)

Dr Machinery in joint operation (JO) 4 000 5 000 1 000

Dr Land in JO 2 400 3 000 6 00

Cr Cash 3 400 4 000 1 600

Cr Borrowings 3 000 4 000

continued

dee67382_ch29_1155-1204.indd 1190 10/25/19 12:17 PM

1190 PART 8: Accounting for equity interests in other entities

Note that in recording the above transactions the joint operators’ interest in the machinery and land is based on the operators’ initial agreement relating to their total contribution. Assets held within the joint operation (JO) are distinguished from the other assets controlled by the joint operators. For example, by using an account entitled ‘machinery in joint operation’, this indicates that the machinery is under joint control and not separately controlled by the respective organisations.

Where joint operators make contributions of assets to the joint operation, the value of the contribution is assessed at fair value. The transfer of assets is typically treated as a sale of the ownership proportion of the assets given up. Where there is a difference between the carrying amount and the fair value of the asset, this difference will typically be treated as a profit or loss on sale. In relation to determining the magnitude of this profit or loss, paragraphs B34 and B35 of AASB 11 state that:

B34 When an entity enters into a transaction with a joint operation in which it is a joint operator, such as a sale or contribution of assets, it is conducting the transaction with the other parties to the joint operation and, as such, the joint operator shall recognise gains and losses resulting from such a transaction only to the extent of the other parties’ interests in the joint operation.

B35 When such transactions provide evidence of a reduction in the net realisable value of the assets to be sold or contributed to the joint operation, or of an impairment loss of those assets, those losses shall be recognised fully by the joint operator. (AASB 11)

(b) Journal entries to record the transactions for the year to 30 June 2023

Lets Ltd ($000)

Do Ltd ($000)

It Ltd ($000)

Dr Advance to joint operation 800 1 000 200

Cr Cash 800 1 000 200

The above advances have been made on the basis of the agreed contribution ratio of 40:50:10. As at the end of the year, joint operators bring to account their:

• respective interests in each of the individual assets employed in the joint operation • proportional interest in the liabilities incurred by the joint operator in relation to the joint operation, and • proportional share of the expenses incurred and the share of income earned (if any) by the operator in relation

to the joint operation.

So we will need to offset these proportional interests against the advance to the joint operation account we created above. To eliminate the account, the following entries would be made:

30 June 2023

Lets Ltd ($000)

Do Ltd ($000)

It Ltd ($000)

Dr Cash in JO 320 400 80

Dr Machinery in JO 280 350 70

Dr Intangible mining assets in JO 280 350 70

Cr Accounts payable in JO 80 100 20

Cr Advance to joint operation 800 1 000 200

The above entries also recognise the outstanding liabilities of the joint operation as a liability in the joint operators’ own accounts. These relate to the excess of the pre-production costs incurred ($1 400 000) over the actual payments of $1 200 000 made for these costs.

The individual joint operators will depreciate the individual assets in their own accounts in a manner consistent with their own accounting policies.

For an illustration of how to account for situations where the carrying amount differs from the fair value of assets initially contributed to a joint operation, consider Worked Example 29.7.

WORKED EXAMPLE 29.6 continued

dee67382_ch29_1155-1204.indd 1191 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1191

WORKED EXAMPLE 29.7: Transfer of assets to a joint operation where the carrying amount and fair value differ

On 1 July 2022 Mineral Ltd enters into a joint arrangement with Ore Ltd. Both parties commit themselves to a contractual arrangement in which Mineral Ltd contributes machinery and Ore Ltd contributes cash of $2.5 million. The joint arrangement is not undertaken through a separate entity and is considered to be a joint operation (as opposed to a joint venture).

The machinery contributed by Mineral Ltd has a carrying amount of $2 million (cost of $2.2 million, and accumulated depreciation of $200 000) and a fair value of $2.5 million.

All current and future contributions are to be based on a 50:50 split, as are the future distributions of output. The relevant tax rate is 30 per cent.

REQUIRED Provide the journal entries to account for the joint operators’ contributions.

SOLUTION

Journal entries in the books of Mineral Ltd

1 July 2022

Dr Cash in JO 1 250 000

Dr Machinery in JO 1 100 000

Dr Accumulated depreciation 200 000

Cr Gain on sale of machinery 250 000

Cr Machinery 2 200 000

Cr Accumulated depreciation—Machinery in JO 100 000

(to recognise the assets that are in the joint operation and to recognise the gain on sale of the machinery)

The $1.25 million cash in the joint operation represents a half-share in the cash provided by Ore Ltd. Mineral Ltd will also reduce the carrying amount of the machinery, as it now has only a 50 per cent share in the machinery it has provided to the joint operation. The gain is the difference between the fair value of the machinery at the date of the transfer and the carrying amount, multiplied by 50 per cent. That is, ($2 500 000 – [$2 200 000 – $200 000]) × 0.5 = $250 000.

Because Mineral Ltd uses the cost model, its proportional interest in the machinery within the joint operation will continue to be measured at cost. The machinery account and the associated accumulated depreciation is removed from Mineral Ltd’s accounts, and it is replaced with ‘machinery in JO’, which indicates that the machinery is now within the joint operation and is therefore subject to joint control.

Journal entries in the books of Ore Ltd

1 July 2022

Dr Cash in JO 1 250 000

Dr Machinery in JO 1 250 000

Cr Cash 2 500 000

(to recognise the full amount of cash contributed to the joint operation and to recognise the share in the assets contributed to the joint operation. The machinery in the joint operation is measured at its fair value at the date the asset is contributed)

The debit entry above to machinery represents the half-share in the machinery provided by Mineral Ltd. The credit to cash represents 50 per cent of the amount of cash contributed to the joint operation. We can see that Ore Ltd’s proportional interest in the machinery is recognised at the fair value of the asset when Mineral Ltd contributed the asset. This can be contrasted with how Mineral Ltd measures the asset, which is at cost.

We will conclude this section on joint operations with one more Worked Example, this being Worked Example 29.8.

dee67382_ch29_1155-1204.indd 1192 10/25/19 12:17 PM

1192 PART 8: Accounting for equity interests in other entities

WORKED EXAMPLE 29.8: A further example of accounting for joint arrangements in the form of a joint operation

On 1 July 2022 Blue Ltd enters into a joint arrangement to form a joint operation with Sky Ltd. Both joint operators commit themselves to a contractual arrangement in which Blue Ltd contributes plant and machinery with a fair value of $10 million and Sky Ltd contributes cash of $10 million. The contributed cash is partly used to acquire, at a cost of $6 million, some land that is considered to be rich in minerals, with the balance of the cash on hand to meet operational requirements.

Additional information • The plant and machinery contributed by Blue Ltd has a carrying amount of $7 million (cost of $10 million and

accumulated depreciation of $3 million) and a fair value of $10 million. • All current and future contributions are to be based on a 50:50 split, as are the future distributions of output. • The tax rate is 30 per cent.

For the year ending 30 June 2023, the joint operation’s manager prepares the following statement of financial position, statement of cash flows and statement of production costs. To date, no minerals have been removed, although the joint operators consider that economically recoverable reserves exist.

Of the total pre-production costs of $2 000 000 incurred in 2023 (see below), $300 000 relates to expenditure on developing machinery, and the balance represents expenditures incurred in exploring and evaluating the mine site. Such expenditure, which amounts to $1 700 000, is to be classified as an intangible asset and will be labelled ‘intangible mineral assets’. Because the operations are no longer in the exploration and development phase, all amounts incurred in the exploration and evaluation phase (the $2 000 000) have been transferred out of the account ‘exploration and evaluation assets’ in accordance with AASB 6 Exploration for and Evaluation of Mineral Resources. (This is explained in Chapter 20, but, to recap briefly, when an entity is in the exploration and evaluation phase of operations, AASB 6 requires the expenditure to be accumulated in an account entitled ‘exploration and evaluation asset’, or the like. However, once this phase of operation is complete, the related assets are to be transferred to another account, with the expenditure being classified as either intangible or tangible assets.)

Statement of costs of production for year ending 30 June 2023

$000

Direct costs

– Wages 500

– Materials 700

– Management fees 700

– Other   100

2 000

Statement of cash flows for year ending 30 June 2023

$000 $000

Cash flows from operations

Payments

– Wages 500

– Materials 500

– Management fees 500

– Other  100 (1 600)

Cash flows from investing activities

Acquisition of land (6 000)

Cash flows from financing activities

From joint operator Sky Ltd  10 000

Cash on hand—30 June 2023   2 400

dee67382_ch29_1155-1204.indd 1193 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1193

Joint operation statement of financial position as at 30 June 2023

$000

Current assets

Cash on hand 2 400

Non-current assets

Plant and machinery 10 300

Land 6 000

Intangible mineral assets 1 700

Total assets 20 400

less Current liabilities

Accounts payable 400

Net assets 20 000

Represented by:

Interests of participants

Blue Ltd 10 000

Sky Ltd 10 000

20 000

REQUIRED

(a) Prepare the journal entries that would appear in the joint operators’ own journals to record the establishment of the joint operation on 1 July 2022.

(b) Prepare the journal entries that would appear in the joint operators’ own journals to record the joint operation’s transactions for the year to 30 June 2023.

SOLUTION

(a) Journal entries to record the establishment of the joint operation

1 July 2022

Blue Ltd’s accounts

Dr Cash in JO 5 000 000

Dr Machinery in JO 5 000 000

Dr Accumulated depreciation 3 000 000

Cr Machinery 10 000 000

Cr Accumulated depreciation in JO 1 500 000

Cr Profit on sale of machinery 1 500 000

(to recognise Blue Ltd’s share in the cash contributed by Sky Ltd, and to remove the machinery and the associated accumulated depreciation from Blue Ltd’s accounts and replace it with a 50 per cent share in machinery in the joint operation and the associated accumulated depreciation. The profit to be recognised is the difference between the fair value of the machinery and its carrying amount at the time the asset was contributed to the joint operation, multiplied by 50 per cent)

continued

dee67382_ch29_1155-1204.indd 1194 10/25/19 12:17 PM

1194 PART 8: Accounting for equity interests in other entities

Paragraphs 20 to 23 of AASB 12 include a number of disclosure requirements in relation to interests in associates and joint arrangements. We considered these disclosure requirements earlier in this chapter when we were discussing associates, so we will not repeat that material here.

Dr Land in JO 3 000 000

Cr Cash in JO 3 000 000

(to recognise Blue Ltd’s proportional interest in the acquisition of the land)

Sky Ltd’s accounts

Dr Cash in JO 5 000 000

Dr Machinery in JO 5 000 000

Cr Cash 10 000 000

(to recognise Sky Ltd’s contribution of cash—$10 million was contributed, of which Sky Ltd has a 50 per cent interest in the cash in the joint operation—and to recognise Sky Ltd’s proportional interest [50 per cent] in the machinery contributed by Blue Ltd [at a fair value of $10 million])

Dr Land in JO 3 000 000

Cr Cash in JO 3 000 000

(to recognise Sky Ltd’s proportional interest in the acquisition of the land)

(b) Journal entries to record the joint operation’s transactions for the year to 30 June 2023 As at the end of the year, the joint operators need to bring to account their:

• respective interests in each of the individual assets employed in the joint operation • proportional interest in the liabilities incurred by the operators in relation to the joint

operation • proportional share of the expenses incurred by the joint operation.

Therefore, using information from the financial statements shown earlier, the following entries would appear in both Blue Ltd’s and Sky Ltd’s accounts:

30 June 2023

Dr Machinery in JO 150 000

Dr Intangible mineral assets in JO 850 000

Cr Cash in JO 800 000

Cr Accounts payable in JO 200 000

(to recognise joint operator’s interests in assets and liabilities of joint operation)

The above entries recognise, as a liability in each joint operator’s own accounts, the outstanding liabilities of the joint operation (which relate to the excess of the production costs incurred [$2 million] over the actual payments of $1.6 million made for these costs).

The individual operators will depreciate the machinery and the intangible mineral assets in their own accounts in a manner consistent with their own accounting policies.

Because it is assumed that the mine has proceeded past the exploration and evaluation phase, no ‘exploration and evaluation assets’ are recognised in the joint operators’ accounts. Rather, they recognise the related machinery and the intangible mineral assets. These assets would then typically be amortised in the individual accounts of the operators and form part of cost of goods sold on a production output basis.

dee67382_ch29_1155-1204.indd 1195 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1195

SUMMARY

The chapter considered a number of issues relating to the valuation and disclosure of equity investments. Organisations that hold equity investments are required to apply the requirements of AASB 9. However, exceptions to the requirement for an investor to measure equity investments at fair value in its own individual accounts are provided where the investment is in a subsidiary, associate or joint venture.

The chapter emphasises that the degree of influence exerted by the investor over the investee will affect the choice of accounting treatment. Consistent with Chapters 25, 26, 27 and 28, it is explained that if the investor has the capacity to control the financing and operating decisions of the investee, the investee will be considered a subsidiary of the investor, and therefore the investee’s accounts must form part of the consolidated financial statements.

Where an investor is deemed to have the power to participate in the financial and operating policy decisions of the investee, but does not have control or joint control over those policies (referred to as having ‘significant influence’), the investee is considered to be an associate (and associates can include companies as well as entities other than companies) and the equity method of accounting must be used to account for the investor’s interest in the associate. The equity method of accounting must be applied in the consolidated financial statements of the investor if it is a parent entity; otherwise it is to be applied in the accounts of the investor itself. When consolidated financial statements are prepared, an investor can account for an investment in an associate by applying the cost method in the investor’s own separate accounts.

In this chapter we also considered a number of issues associated with accounting for interests in joint arrangements. Joint arrangements can be classified as either joint operations or joint ventures. Different accounting approaches are to be adopted for accounting for interests in joint arrangements, with the approach to be adopted depending on the classification of the joint arrangement.

Joint operations are defined as joint arrangements whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement. A joint venture is a joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement.

Where an entity has an interest in a joint operation, the joint operator must recognise the assets within the joint operation that it jointly controls, the liabilities and expenses it incurs in relation to the joint operation, and revenues from its share of the output of the joint operation.

If the arrangement is a joint venture then the equity method of accounting is to be applied in the consolidated financial statements of the parent entity and the cost method, or fair value, applied in the parent entity’s own separate financial statements or, if the joint venturer does not prepare consolidated financial statements, the equity method is to be used in the financial statements of the joint venturer itself.

KEY TERMS

associate 1157 economic entity 1156 equity investment 1156 equity method of accounting 1157

investee 1157 investor 1157 joint arrangement 1182 joint operation 1182

joint venture 1182 materiality 1160 significant influence 1157 voting power 1158

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. If an entity has shares in another organisation, when would that other organisation be considered to be an ‘associate’? LO 29.1, 29.2 It would be an ‘associate’ if the other organisation has significant influence over the investee.

2. If an investee is deemed to be an associate, does the equity method of accounting need to be applied when accounting for the investor’s investment in that associate? LO 29.1, 29.2 Yes, the equity method of accounting shall be used to account for investments in associates.

3. Will the accounting adjustments required by the equity method of accounting be performed in the investor’s own separate accounts, or by way of consolidation adjustments within a consolidation worksheet? LO 29.3

dee67382_ch29_1155-1204.indd 1196 10/25/19 12:17 PM

1196 PART 8: Accounting for equity interests in other entities

If the investor is a parent entity with subsidiaries and therefore required to prepare consolidated financial statements, the equity method of accounting shall be applied within the consolidation worksheet. If the investor does not have control of any subsidiaries, and therefore does not prepare consolidated financial statements, the equity method of accounting shall be applied in the investor’s own individual accounts.

4. What is a ‘joint arrangement’, and what are the two broad types of joint arrangements? LO 29.7 A joint arrangement is an arrangement in which two or more parties have joint control over a particular venture or operation. Joint control represents the agreed sharing of control of an arrangement, which exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. A joint arrangement will typically be classified as either a ‘joint venture’ or a ‘joint operation’.

5. Is the equity method of accounting to be used to account for interests in both types of joint arrangements? LO 29.8, 29.9 No, the equity method of accounting shall be used for interests in joint ventures only.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. If equity investments are held as current assets, how can they be measured? LO 29.1 • 2. Explain the cost method and the fair value method of accounting. LO 29.1 • 3. If a dividend is received from pre-acquisition earnings of an investee, how would this dividend be treated if: (a) the cost method is used by the investor? (b) the fair value method is used by the investor? LO 29.1 •• 4. Do you believe that the cost method or the fair value method is more appropriate for measuring equity securities?

Explain your answer. LO 29.1 •• 5. When is it a requirement that the equity method of accounting be applied? LO 29.2 • 6. What is the difference between significant influence and control, and what are the implications of establishing either?

LO 29.4 • 7. Discuss the factors you would consider when deciding whether an investor has significant influence rather than

control over an entity. LO 29.4 • 8. When an investor acquires an interest in an associate: (a) how is goodwill on acquisition calculated? (b) why is goodwill on acquisition calculated? (c) how is goodwill on acquisition of the associate disclosed? LO 29.3 •• 9. How are post-acquisition movements in the reserves of an associate to be treated when the equity method of

accounting is applied? LO 29.3 •• 10. What is a joint arrangement and what are the two main classifications of joint arrangements? LO 29.6 • 11. What is the difference between a joint venture and a joint operation? LO 29.6 • 12. Does the required accounting treatment for an interest in a joint operation differ from the requirements for an interest

in a joint venture and, if so, how do these requirements differ? LO 29.7, 29.8, 29.9 •• 13. How should the joint operators’ share of assets in the joint operation be disclosed? LO 29.7, 29.9 • 14. How should the joint venturers’ share of assets in the joint venture be disclosed? LO 29.7, 29.8 • 15. Do you think it is appropriate for a joint operator to ‘mix’ its proportional share of net assets in with its other assets

for the purpose of presentation in the statement of financial position? Explain your answer. LO 29.7, 29.9 •• 16. Assume that an investor has two associates, which are both 20 per cent owned. During the year, one associate sells

some inventory to the other associate at a profit of $50 000. At the end of the year, this inventory is still on hand with the associate that has bought the inventory. In determining the investor’s share of the associates’ profits, what adjustments would be necessary as a result of this transaction? LO 29.3 •••

dee67382_ch29_1155-1204.indd 1197 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1197

17. Simon Ltd has acquired a mining lease in Torquay that the managing director Simon believes contains valuable oil reserves. However, Simon is a surfer and has no knowledge of oil exploration and development. As a result, Simon Ltd enters a joint arrangement with Anderson Ltd pursuant to which Anderson Ltd will perform the exploration, evaluation and development of the Torquay site for which Anderson Ltd will receive a 50 per cent interest in the mining lease and a 50 per cent share of any oil produced. The contractual terms of the arrangement require both Simon Ltd and Anderson Ltd to jointly make all decisions in relation to the joint arrangement.

(a) How should Simon Ltd classify its joint arrangement with Anderson Ltd in accordance with AASB 11? (b) How should Simon Ltd account for its investment in the joint arrangement in accordance with AASB 11?

LO 29.6, 29.7, 29.8, 29.9 •• 18. On 1 July 2022 Ma Ltd acquires a 25 per cent interest in Pa Ltd for a cash consideration of $375 000. On the date

of the acquisition, the assets of Pa Ltd are reported at fair value. The share capital and reserves of Pa Ltd at the date of acquisition are:

Share capital $1 000 000

Retained earnings $ 500 000

Total shareholders’ equity $1 500 000

Additional information • For the year ending 30 June 2023, Pa Ltd records an after-tax profit of $80 000, from which it pays a dividend of

$30 000. • For the year ending 30 June 2024, Pa Ltd records an after-tax profit of $100 000, from which it pays a dividend

of $50 000. • On 30 June 2024, Pa Ltd revalues its land upwards by $70 000. • The tax rate is 30 per cent. • Ma Ltd has a number of subsidiaries.

REQUIRED Prepare the journal entries under both the cost and the equity method of accounting for the investment in Pa Ltd for the year ending 30 June 2024 (that is, two years after acquisition). LO 29.7 ••

19. Zimmer Ltd holds a 25 per cent interest in Finn Ltd. During the year ending 30 June 2023, Zimmer Ltd acquires $500 000 of inventory from Finn Ltd. This inventory cost Finn Ltd $300 000 to produce. All of the inventory is still on hand with Zimmer Ltd at year end. It is expected to be fully sold in the following year. Assume that the tax rate is 33 per cent.

REQUIRED Provide the equity accounting entries to account for the unrealised profit in inventory sold from the associated company to Zimmer Ltd. LO 29.3 ••

CHALLENGING QUESTIONS

20. Would there be situations where the directors of a company would prefer to classify an investee as an associate rather than as a subsidiary? If so, when would you expect these circumstances to arise? LO 29.2

21. On 1 July 2022 Stokes Ltd acquires 25 per cent of the issued capital of Cotter Ltd for a cash consideration of $120 000. At the date of acquisition, the shareholders’ equity of Cotter Ltd is:

Share capital $150 000

Retained earnings $100 000

Total shareholders’ equity $250 000

Additional information • On the date of acquisition, the buildings have a carrying amount in the accounts of Cotter Ltd of $80 000 and a

fair value of $100 000. The buildings have an estimated useful life of 10 years after 1 July 2022. • For the year ending 30 June 2023 Cotter Ltd records an after-tax profit of $30 000, from which it pays a dividend

of $10 000.

dee67382_ch29_1155-1204.indd 1198 10/25/19 12:17 PM

1198 PART 8: Accounting for equity interests in other entities

• For the year ending 30 June 2024 Cotter Ltd records an after-tax profit of $100 000, from which it pays a dividend of $50 000.

• Stokes Ltd has a number of subsidiaries. • The tax rate equals 30 per cent.

REQUIRED Calculate the amount of goodwill at the date of acquisition, and prepare the journal entries for the years ending 30 June 2023 and 30 June 2024, applying the equity method of accounting. LO 29.3

22. On 1 July 2022 Larry Ltd acquires 25 per cent of the ordinary issued capital of Blaire Ltd for $187 500. Upon acquisition of this financial interest in Blaire Ltd, Larry Ltd appoints two directors to the eight-seat board of directors of Blaire Ltd.

All of the identifiable net assets of Blaire Ltd are stated at fair value, except for the following:

Carrying amount ($)

Fair value ($)

Difference ($)

Land 375 000 500 000 125 000

Depreciable assets 320 000 350 000 30 000

The depreciable assets are considered to have a further useful life of 10 years. The share capital and reserves of Blaire Ltd at 1 July 2022 are:

$

Share capital 200 000

General reserve 37 500

Retained earnings 137 500

375 000

The financial statements of Larry Ltd and Blaire Ltd as at 30 June 2023 show:

Reconciliation of opening and closing retained earnings for the year ending 30 June 2023

Larry Ltd ($)

Blaire Ltd ($)

Profit before tax 250 000 227 500

Income tax expense (97 500) (92 500)

Profit after tax 152 500 135 000

Retained earnings—opening 130 000 137 500

282 500 272 500

Transfer to reserves – (12 500)

Dividends paid (15 000) (45 000)

Dividends proposed (35 000) (15 000)

Retained earnings—closing 232 500 200 000

Statements of financial position as at 30 June 2023

Larry Ltd ($)

Blaire Ltd ($)

Current assets

Inventory 712 500 337 500

Cash 435 000 60 000

1 147 500 397 500

dee67382_ch29_1155-1204.indd 1199 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1199

Larry Ltd ($)

Blaire Ltd ($)

Non-current assets

Investments in associate 187 500 –

Property, plant and equipment 1 125 000 631 000

1 312 500 631 000

Total assets 2 460 000 1 028 500

Liabilities (1 192 000) (578 500)

Net assets 1 268 000 450 000

Shareholders’ funds

Share capital 500 000 200 000

General reserve 375 000 50 000

Revaluation surplus 160 500 –

Retained earnings 232 500 200 000

Shareholders’ equity 1 268 000 450 000

Additional information • Larry Ltd recognises dividends only when received. • On 30 June 2023 Larry Ltd holds inventory sold to it by Blaire Ltd at a profit of $3750. This inventory is sold to

Larry Ltd for $5000. • Blaire Ltd has a policy of paying dividends out of current year profits before utilising previous years’ profits. • The tax rate applicable for the year ending 30 June 2023 is 39 per cent. • Larry Ltd has a number of subsidiaries.

REQUIRED Prepare the relevant equity accounting entries for Larry Ltd and its associate Blaire Ltd for the year ending 30 June 2023, in accordance with AASB 128. LO 29.3

23. ABC Ltd (ABC) sells wooden furniture. It has a 40 per cent interest in DEF Ltd (DEF), which sells timber. Financial information for each company for the year ending 30 June 2022 is as follows: Abbreviated statements of profit or loss and other comprehensive income and reconciliations of opening and closing retained earnings

ABC ($)

DEF ($)

Sales 3 265 000 1 288 500

Cost of goods sold (2 775 250) (1 030 800)

Gross margin 489 750 257 700

Other income 32 000 0

Selling and distribution expenses (91 830) (58 300)

Administration expenses (97 720) (73 250)

Finance expenses (51 270) (37 650)

Profit before tax 280 930 88 500

Income tax expense (99 307) (33 500)

Net profit after tax 181 623 55 000

Opening retained earnings 57 227 40 000

Total available for appropriation 238 850 95 000

Dividends paid (100 000) (80 000)

Closing retained earnings 138 850 15 000

dee67382_ch29_1155-1204.indd 1200 10/25/19 12:17 PM

1200 PART 8: Accounting for equity interests in other entities

Statements of financial position as at 30 June 2022

ABC ($)

DEF ($)

Current assets

Cash 130 500 62 600

Receivables 310 250 122 440

Inventory 408 125 193 275

Other 16 300 8 385

865 175 386 700

Non-current assets

Property, plant and equipment 552 700 225 300

Investment in DEF 50 000 0

Other 25 305 8 000

628 005 233 300

Total assets 1 493 180 620 000

Current liabilities

Creditors and borrowings 289 088 118 522

Provisions 125 012 70 028

414 100 188 550

Non-current liabilities

Creditors and borrowings 400 000 300 000

Provisions 5 900 16 450

405 900 316 450

Total liabilities 820 000 505 000

Net assets 673 180 115 000

Shareholders’ funds

Share capital 300 000 100 000

Reserves 234 330 0

Retained earnings 138 850 15 000

Shareholders’ equity 673 180 115 000

Additional information

• ABC buys its interest on 1 July 2021 after its due-diligence work finds no material adjustments to DEF’s accounts. • DEF has issued no new capital since incorporation in 1997. • DEF’s policy is to pay dividends out of current year profits first. • ABC Ltd has a number of subsidiaries.

REQUIRED Assuming the existence of significant influence but not control, provide the necessary journal entries for ABC to equity-account for its interest in DEF. LO 29.3

24. On 1 July 2021 Peet Ltd purchased 40 per cent of the ordinary shares of Keet Ltd for $3 250 000. The remaining 60 per cent of the ordinary shares of Keet Ltd are owned by two shareholders, Radio Ltd, which owns 40 per cent of the shares, and Birdman Unit Trust, which owns 20 per cent of the shares.

Keet 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. Keet Ltd’s five-member board of directors consists of:

dee67382_ch29_1155-1204.indd 1201 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1201

• two representatives of Peet Ltd • two representatives of Radio Ltd • one representative of Birdman Unit Trust.

Each member of Keet Ltd’s board of directors is entitled to one vote on issues/resolutions being considered by the board of directors.

The statement of financial position of Keet Ltd immediately before the investment was as follows:

Keet Ltd Statement of financial position as at 1 July 2021

Assets Liabilities

Cash 110 000 Accounts payable 875 000

Accounts receivable 575 000 Bank loans 3 875 000

Inventory 1 100 000 Deferred tax liability 1 250 000

Land 2 750 000

Buildings 8 100 000 Shareholders’ equity

(Accumulated depreciation) (1 350 000) Share capital 4 500 000

Plant and equipment 2 300 000 Revaluation surplus 1 875 000

(Accumulated depreciation) (460 000) Retained earnings 750 000

Total assets 13 125 000 Total equities 13 125 000

Additional information

• On 1 July 2021, all of the identifiable net assets of Keet Ltd were considered to be recorded at fair value in Keet Ltd’s statement of financial position, except land, which had a fair value of $3 375 000 on 1 July 2021.

• On 30 June 2022, the recoverable amount of goodwill acquired in Keet Ltd by Peet Ltd was assessed to be $225 000.

• On 14 July 2021, Keet Ltd declared and paid an interim dividend of $200 000, out of profits earned during the 2020–21 financial year.

• During 2021–22, Keet Ltd earned a profit after income tax expense of $725 000, from which it paid a final dividend of $325 000.

• During 2022–23, Keet Ltd earned a profit after income tax expense of $850 000, from which it declared a final dividend of $400 000.

• On 30 June 2023, Keet Ltd revalued its land (to fair value as at that date) to $3 625 000. • The income tax rate is 40 per cent.

REQUIRED

(a) Explain how Peet Ltd should classify its investment in Keet Ltd, in accordance with accounting standards. (b) Prepare the journal entries to account for Peet Ltd’s investment in Keet Ltd, in Peet Ltd’s individual accounts,

for the financial years ending 30 June 2022 and 30 June 2023, in accordance with AASB 128, assuming that Peet Ltd is a parent entity.

(c) Prepare the journal entries to account for Peet Ltd’s investment in Keet Ltd, in Peet Ltd’s individual accounts, for the financial years ending 30 June 2022 and 30 June 2023, in accordance with AASB 128, assuming that Peet Ltd is not a parent entity.

(d) Prepare the consolidation worksheet journal entries to account for Peet Ltd’s investment in Keet Ltd, for the financial years ending 30 June 2022 and 30 June 2023, in accordance with AASB 128, assuming that Peet Ltd is a parent entity. LO 29.3, 29.4

25. On 1 July 2022 Oiley Ltd enters into a joint arrangement with Goldey Ltd. Both parties commit themselves to a contractual arrangement in which Oiley Ltd contributes plant and machinery, and Goldey Ltd contributes cash of $8 million.

The machinery contributed by Oiley Ltd has a carrying amount of $6 million and a fair value of $8 million. All current and future contributions are to be based on a 50:50 split, as are the future distributions of output.

REQUIRED Provide the journal entries to account for the joint operators’ contributions to the joint operation. LO 29.7, 29.9

dee67382_ch29_1155-1204.indd 1202 10/25/19 12:17 PM

1202 PART 8: Accounting for equity interests in other entities

26. On 1 July 2022 Toxic Ltd enters into a joint arrangement with Sludge Ltd. Both parties commit themselves to a contractual arrangement in which Toxic Ltd contributes plant and machinery with a fair value of $20 million; Sludge Ltd contributes cash of $10 million and land with a fair value of $10 million, which is considered to be a good site for the extraction of minerals. The cash that is contributed is used partly to acquire some additional machinery at a cost of $7 million, with the balance of the cash on hand to meet operational requirements.

Additional information • The machinery contributed by Toxic Ltd has a carrying amount of $21 million (cost $30 million; accumulated

depreciation $9 million) and a fair value of $20 million. • The land contributed by Sludge Ltd has a carrying amount of $8 million and a fair value of $10 million. • All current and future contributions are to be based on a 50:50 split, as are the future distributions of output.

For the year ending 30 June 2023, the joint operation’s manager prepares the following statement of financial position, cash flow statement and statement of pre-production costs. To date, no minerals have been removed, although the joint operators do consider that economically recoverable reserves exist. All production costs have been transferred to an asset account called ‘mining assets under construction’ in anticipation of amortising the asset as production commences.

Statement of costs of production for year ending 30 June 2023

$000

Direct costs

– Wages 800

– Materials 600

– Management fees 600

– Other 200

2 200

Statement of cash flows for year ending 30 June 2023

$000 $000

Cash flows from operations

Payments

– Wages 700

– Materials 500

– Management fees 200

– Other 200 (1 600)

Cash flows from investing activities

Acquisition of machinery (7 000)

Cash flows from financing activities

From joint operator Sludge Ltd 10 000

Cash on hand at 30 June 2023 1 400

Joint operation statement of financial position as at 30 June 2023

$000

Current assets

Cash on hand 1 400

Non-current assets

Mining assets under construction 2 200

Plant and machinery 27 000

Land 10 000

dee67382_ch29_1155-1204.indd 1203 10/25/19 12:17 PM

CHAPTER 29: Accounting for investments in associates and joint ventures 1203

$000

Total assets 40 600

less Current liabilities

Accounts payable 600

Net assets 40 000

Represented by:

Interests of participants

Toxic Ltd 20 000

Sludge Ltd 20 000

40 000

REQUIRED

(a) Prepare the journal entries that would appear in the joint operators’ own journals to record the establishment of the joint operation on 1 July 2022.

(b) Prepare the journal entries that would appear in the joint operators’ own journals to record the joint operation’s transactions for the year to 30 June 2023. LO 29.7, 29.9

27. On 1 July 2021 Sally Ltd acquired 25 per cent of the issued shares of Fitz Ltd for $1 000 000. The shareholders’ equity of Fitz Ltd was $4 000 000 on the date of acquisition and all identifiable assets and liabilities of Fitz Ltd were reported at fair value. Sally Ltd prepares consolidated financial statements. Fitz Ltd has not paid or declared dividends between 2022 and 2025. The profit or losses of Fitz Ltd for the four years following acquisition are as follows:

Year ending

Profit/(loss) ($)

Share of profit/loss

($)

Cumulative share

($)

Carrying amount of investment

($)

Unrecognised losses

($)

30 June 2022 200 000 50 000 50 000 1 050 000 0

30 June 2023 (1 600 000) (400 000) (350 000) 650 000 0

30 June 2024 (8 000 000) (2 000 000) (2 350 000) 0 1 350 000

30 June 2025 3 600 000 900 000 (950 000) 50 000 0

REQUIRED Prepare the related journal entries that would be required to generate consolidated financial statements for each of the respective years. LO 29.5

REFERENCES Australian Accounting Standards Board, 2019, Conceptual

Framework for Financial Reporting, AASB, Melbourne, May.

Miller, M.C. & Leo, K., 1997, ‘The Downside of Harmonisation Haste: The Equity Accounting Experience’, Australian Accounting Review, vol. 7, no. 2, October, pp. 2–15.

dee67382_ch29_1155-1204.indd 1204 10/25/19 12:17 PM

dee67382_ch30_1205-1226.indd 1205 10/25/19 12:19 PM

PART 9 Foreign currency

CHAPTER 30 Accounting for foreign currency transactions

CHAPTER 31 Translating the financial statements of foreign operations

dee67382_ch30_1205-1226.indd 1206 10/25/19 12:19 PM

1206

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 30.1 Understand the nature of foreign currency transactions, and why it is necessary to translate

those transactions that are denominated in foreign currencies. 30.2 Understand that all transactions denominated in foreign 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’.

30.3 Understand that at the end of the reporting period all foreign currency monetary items must be translated at the reporting date spot rate.

30.4 Understand the difference between a ‘functional currency’ and a ‘presentation currency’. 30.5 Know how to account for foreign currency exchange gains or losses on monetary items such as

receivables, payables and cash deposits that are denominated in a foreign currency. 30.6 Understand what a ‘qualifying asset’ is, and be able to provide the appropriate accounting entries

relating to a qualifying asset. 30.7 Understand the nature of, and the reason for entering, a hedging arrangement. 30.8 Understand what a ‘foreign currency swap’ is and why one might be undertaken.

C H A P T E R 30 Accounting for foreign currency transactions

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following five questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is a foreign currency transaction? LO 30.1 2. What is a ‘spot rate’? LO 30.1, 30.2, 30.3 3. If a payable, or receivable, is denominated in a foreign currency, does its carrying amount have to be adjusted

at the end of the reporting period? LO 30.3 4. If an amount owing to an overseas supplier for the purchase of inventory increases because of an adverse

movement in the foreign exchange rate, is such an increase to be accounted for as part of the cost of the inventory? LO 30.2, 30.3, 30.5

5. If an organisation has a five-year loan that is denominated in a foreign currency, does the carrying amount of the loan have to be adjusted at the end of each reporting period to reflect any changes in exchange rates? LO 30.5

dee67382_ch30_1205-1226.indd 1207 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1207

30.1 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.

A foreign currency transaction is a transaction with another entity wherein the price or cost assigned to the transaction is denominated in a currency other than the organisation’s functional currency (the functional currency being the currency used in the primary, or main, economic environment in which the organisation operates).

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 31.

AASB 121 defines an exchange rate as ‘the ratio of 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 example, the exchange rate for the Australian dollar greatly dropped in 2016 relative to currencies such as the British pound and the US dollar. Relative to the US dollar, the exchange rate fell to approximately A$1.00 = US$0.69 in December 2016. That is, for every Australian dollar we would receive about 69 US cents. This compared with one year earlier when one Australian dollar would buy US$0.92 (and US$1.10 in 2011). More recently, the Australian dollar would buy US$0.81 in early 2018, but then only US$0.68 in October 2019.

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, thereby stimulating exports. Parties that had borrowed funds from 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, or receivables, 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 for a number of decades is the Big Mac index, which was invented by The Economist (the index is also referred to as ‘burgernomics’). 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.

exchange rate The rate at which one currency can be exchanged for another.

AASB no. Title IFRS/IAS equivalent

9 Financial Instruments IFRS 9

121 The Effects of Changes in Foreign Exchange Rates IAS 21

123 Borrowing Costs IAS 23

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

LO 30.1

dee67382_ch30_1205-1226.indd 1208 10/25/19 12:19 PM

1208 PART 9: Foreign currency

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’.

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.

In January 2019 the Big Mac cost US$4.35 in Australia, while it was US$5.58 in the US, which was seen as indicating that the Australian dollar (which was trading at US$0.70) was undervalued. We will not pay any further attention to considering whether exchange rates are appropriate, or how they are determined (or the merit of ‘burgernomics’). 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 30.1.

WORKED EXAMPLE 30.1: Acquisition of goods from a foreign supplier where the transaction is denominated in a foreign currency

On 1 June 2022 Michaela Ltd acquires goods on credit from a supplier in Northern Ireland. The goods are shipped FOB Belfast on 1 June 2022. (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 2022.

On 1 June 2022 the exchange rate is A$1.00 = UK£0.48. On 30 June 2022 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 2022 (b) 30 June 2022.

SOLUTION

(a) As at 1 June 2022, 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. The cost of inventory would also be considered to be A$208 333.

(b) As at 30 June 2022, 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.

translation of foreign currency transactions Translation of transactions denominated or requiring settlement in a currency other than the functional currency of the entity.

In Worked Example 30.1, 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—which has a functional currency of Australian dollars—is better off.

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, instead, 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

dee67382_ch30_1205-1226.indd 1209 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1209

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 30.1, should be treated as part of the profit or loss of the financial period.

WHY DO I NEED TO KNOW ABOUT THE NATURE OF FOREIGN CURRENCY TRANSACTIONS, AND THE RISKS TO WHICH THEY CAN EXPOSE AN ORGANISATION?

It is very common for organisations (and individuals) to transact with organisations in currencies that are different from the domestic currency. We need to understand how exchange rates work so that we can determine the actual amounts or obligations associated with such transactions. Once we understand how exchange rates work, and how much they can fluctuate, we can then understand that having amounts that are payable, or receivable, and which are denominated in a foreign currency will expose us (or our organisation) to various risks and opportunities.

LO 30.2 30.2 Accounting entry at the date of the original transaction

Paragraph 21 of AASB 121 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. (AASB 121)

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 states:

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). (AASB 121)

Should the functional currency not be apparent even after considering the above factors, paragraph 10 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. (AASB 121)

functional currency The currency of the primary economic environment in which the entity operates.

dee67382_ch30_1205-1226.indd 1210 10/25/19 12:19 PM

1210 PART 9: Foreign currency

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 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. (AASB 121)

In situations where the functional currency is not obvious, 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 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. (AASB 121)

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’ 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 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. (AASB 121)

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 Group 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 2019 Annual Report of BHP Group 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. (BHP Group Ltd)

Returning to Worked Example 30.1, for Michaela Ltd the initial entry on 1 June 2022 would be:

Dr Inventory 208 333 Cr Accounts payable

(to recognise the purchase of inventory at the spot rate when control of the inventory was transferred)

208 333

presentation currency The currency in which the financial statements are presented.

dee67382_ch30_1205-1226.indd 1211 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1211

30.3 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’. 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. To the extent that monetary items are denominated in a foreign currency, they shall be adjusted at the end of the reporting period to reflect the exchange rate in place at the end of the reporting period (the ‘closing rate’). In the case of Michaela Ltd this would mean that the obligation would need to be restated to $192 308.

From the perspective of Australian dollars (which is the functional currency of Michaela Ltd), 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 discuss towards the end of this chapter, 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 (foreign exchange gains or losses) 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 121, which states:

Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements shall be recognised in profit or loss in the period in which they arise, except as described in paragraph 32. (AASB 121)

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 adjusting journal entry on 30 June 2022 would be:

LO 30.3

Dr Accounts payable 16 025 Cr Foreign exchange gain

(to recognise the decrease in the amount of the account payable by applying the closing rate)

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.

The above example referred to the acquisition of inventory. Applying the principles so far discussed in this chapter, Worked Example 30.2 illustrates how to account for the sale of products that are denominated in a foreign currency.

WORKED EXAMPLE 30.2: Sale of goods to an overseas customer when the sale price is denominated in a foreign currency

On 1 June 2023 Ochy Ltd makes a sale of US$1 million of inventory to an overseas organisation known as Luppo Inc. The item cost Ochy Ltd A$1.1 million to manufacture. The spot rate on 1 June 2023 is A$1 = US$0.7205, so the value of the receivable converted to Australian dollars on 1 June 2023 is $1 387 925. The amount owing is due for payment on 1 September 2023.

Luppo Inc. does pay the amount owed on 1 September 2023, when the value of the Australian dollar has increased, with the spot rate on 1 September being A$1 = US$0.7300. The spot rate on 30 June 2023 was A$1 = US$0.7210. The reporting date of Ochy Ltd is 30 June.

continued

dee67382_ch30_1205-1226.indd 1212 10/25/19 12:19 PM

1212 PART 9: Foreign currency

WORKED EXAMPLE 30.2 continued

REQUIRED Provide the accounting entries for the sale made by Ochy Ltd to Luppo Inc., as well as any subsequent adjusting journal entries.

SOLUTION

30 June 2023

(to recognise the decrease in the amount of the account receivable by applying the closing rate)

1 September 2023

1 September 2023

1 June 2023

Dr Accounts receivable 1 387 925 Dr Cost of goods sold 1 100 000 Cr Sales revenue 1 387 925 Cr Inventory 1 100 000

(to record the sale at the spot rate of A$1= US$0.7205, where 1 000 000÷0.7205 = 1 387 925)

Dr Foreign exchange loss 962 Cr Accounts receivable 962

Balance of receivable at 1 June 2023: 1 000 000 ÷ 0.7205 1 387 925 Balance of receivable at 30 June 2023: 1 000 000 ÷ 0.7210 1 386 963 Decrease in receivable 962

Balance of receivable at 30 June 2023: 1 000 000 ÷ 0.7210 1 386 963 Balance of receivable at 1 September 2023: 1 000 000 ÷ 0.7300 1 369 863 Decrease in receivable 17 100

Dr Foreign exchange loss 17 100 Cr Accounts receivable 17 100

(to adjust the balance of accounts receivable on the date the related cash is received)

Dr Cash at bank 1 369 863 Cr Accounts receivable 1 369 863

(Ochy 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)

30.4 Determination of the presentation currency

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. As already noted, paragraph 9 of AASB 121 provides a number of factors to consider in determining the functional currency.

LO 30.4

dee67382_ch30_1205-1226.indd 1213 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1213

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 30.3.

WORKED EXAMPLE 30.3: 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. 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  31, 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.

dee67382_ch30_1205-1226.indd 1214 10/25/19 12:19 PM

1214 PART 9: Foreign currency

30.5 The translation of longer-term receivables, payables and cash deposits

The transactions of Michaela Ltd, introduced in Worked Example 30.1, led to the recognition of a short-term payable (an ‘account payable’). Reporting entities can also have long-term monetary items, many of which might be denominated in a foreign currency. According to AASB 121, at the end of the reporting period, all monetary items must be translated using the reporting-date spot rates. The exchange gain or loss that results from translating both current and non-current payables and 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 constantly fluctuates 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 30.4, we consider the translation of a non-current liability from a foreign currency into Australian dollars.

WHY DO I NEED TO KNOW THE MEANINGS OF FUNCTIONAL CURRENCY AND PRESENTATION CURRENCY?

The functional currency is the currency of the primary economic environment in which an organisation operates. Different nations’ currencies will tend to have different risks in terms of fluctuating exchange rates. Therefore, it is important to be aware of which underlying functional currency is being used as this will indicate, to some extent, the degree to which the assets and liabilities of the organisation (particularly the monetary items) might be subject to ongoing fluctuations in value brought about by changing exchange rates.

Financial statements are presented in a particular currency—the presentation currency—which may or may not be the same as the functional currency. The choice of presentation currency will impact a reserve known as the foreign currency translation reserve, which is explored in the next chapter.

LO 30.5

spot rate The exchange rate for immediate delivery of currencies to be exchanged.

WORKED EXAMPLE 30.4: Translation of a non-current liability

On 1 July 2022 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:

REQUIRED Provide the journal entries in the books of Noosa Ltd for the year ending 30 June 2023 to account for the above transaction.

SOLUTION

1 July 2022

(to recognise the foreign currency loan at the 1 July 2022 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)

Dr Cash 1 000 000 Cr Loan payable 1 000 000

1 July 2022 A$1.00 = £0.50 30 June 2023 A$1.00 = £0.40

dee67382_ch30_1205-1226.indd 1215 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1215

Translation of other monetary assets such as cash deposits In Worked Example 30.4 we translated a foreign currency payable. The same principles apply to other monetary items that are denominated in a foreign currency, such as cash, money market deposits and the like, as we will see in Worked Example 30.5.

30 June 2023

(to recognise year-end interest payment of 125 000 = (500 000 × 10 per cent) ÷ 0.40)

(to recognise the effect of retranslation of the loan at the 30 June 2023 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)

Dr Foreign exchange loss 250 000 Cr Loan payable 250 000

Dr Interest expense 125 000 Cr Cash 125 000

Balance of payable at 1 July 2022: £500 000 ÷ 0.50 $1 000 000 Balance of payable at 30 June 2023: £500 000 ÷ 0.40 $1 250 000 Increase in loan payable $  250 000

WORKED EXAMPLE 30.5: Translation of cash denominated in a foreign currency

On 1 July 2022 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 2022. 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:

REQUIRED Provide the journal entries in the books of Peregian Ltd for the year ending 30 June 2023 to account for the above transaction.

SOLUTION The accounting entries in the books of Peregian Ltd would be:

1 July 2022

(to recognise consulting revenue at the 1 July 2022 spot rate: 533 000 = 400 000 ÷ 0.75)

30 June 2023

(to recognise the interest revenue at the 30 June 2023 spot rate: 60 000 = (400 000 × 12 per cent) ÷ 0.80)

Dr Cash 533 333 Cr Consulting revenue 533 333

1 July 2022 A$1.00 = US$0.75 30 June 2023 A$1.00 = US$0.80

Dr Cash 60 000 Cr Interest revenue 60 000

continued

dee67382_ch30_1205-1226.indd 1216 10/25/19 12:19 PM

1216 PART 9: Foreign currency

30.6 Qualifying assets

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. 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.

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 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. (AASB 123)

In relation to the borrowing costs, AASB 123 provides their accounting treatment. Paragraph 8 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. (AASB 123)

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. (AASB 123)

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 states:

LO 30.6

qualifying asset Asset under construction or otherwise being made ready for future productive use of the organisation or for the use of another entity under a contract, which necessarily takes a substantial period of time to get ready for its intended use or sale.

(to adjust for the change in the Australian dollar equivalent of the overseas bank deposit using the 30 June 2023 spot rates)

Dr Foreign exchange loss 33 333 Cr Cash 33 333

Balance of cash at 1 July 2022: US$400 000 ÷ 0.75 A$533 333 Balance of cash at 30 June 2023: US$400 000 ÷ 0.80 A$500 000 Reduction in cash A$ 33 333

WORKED EXAMPLE 30.5 continued

dee67382_ch30_1205-1226.indd 1217 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1217

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. (AASB 123)

Worked Example 30.6 provides an illustration of how to account for exchange differences that arise while an asset is considered to be a qualifying asset.

WORKED EXAMPLE 30.6: Foreign currency transaction relating to a qualifying asset

On 1 March 2021 Greenough Ltd enters into a binding agreement with a Singapore company to construct an item of machinery that manufactures spoons. The machinery is under the control of Greenough Ltd throughout construction and the cost of the machinery is S$250 000. The construction of the machinery is completed on 1 June 2022 and shipped FOB Singapore on that date. The debt is unpaid at 30 June 2022. Greenough Ltd’s end of reporting period is 30 June. The exchange rates at the relevant dates are:

REQUIRED Provide the required journal entries for the years ending 30 June 2021 and 30 June 2022. 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 2021 to 1 June 2022. Therefore, the movement in exchange rates to 1 June 2022 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 2021

(to recognise the cost of the asset on 1 March 2021: 250 000 ÷ 1.10)

30 June 2021

(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)

1 June 2022

(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)

1 March 2021 A$1.00 = S$1.10 30 June 2021 A$1.00 = S$1.05 1 June 2022 A$1.00 = S$1.02 30 June 2022 A$1.00 = S$1.00

continued

Dr Machinery under construction 227 273 Cr Accounts payable 227 273

Dr Machinery under construction 10 822 Cr Accounts payable 10 822

Balance of accounts payable at 1 March 2021: S$250 000 ÷ 1.10 A$227 273 Balance of accounts payable at 30 June 2021: S$250 000 ÷ 1.05 A$238 095 Increase in accounts payable A$ 10 822

Dr Machinery under construction 7 003 Cr Accounts payable 7 003

dee67382_ch30_1205-1226.indd 1218 10/25/19 12:19 PM

1218 PART 9: Foreign currency

(once the construction has been completed, the balance of ‘machinery under construction’ is transferred to the ‘machinery’ account)

30 June 2022

(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)

Dr Foreign exchange loss 4 902 Cr Accounts payable 4 902

Balance of accounts payable at 1 June 2022: S$250 000 ÷ 1.02 A$245 098 Balance of accounts payable at 30 June 2022: S$250 000 ÷ 1.00 A$250 000 Increase in accounts payable A$ 4 902

Balance of accounts payable at 30 June 2021: S$250 000 ÷ 1.05 A$238 095 Balance of accounts payable at 1 June 2022: S$250 000 ÷ 1.02 A$245 098 Increase in accounts payable A$ 7 003 Dr Machinery 245 098 Cr Machinery under construction 245 098

WORKED EXAMPLE 30.6 continued

30.7 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, or a ‘hedging arrangement’ as it is also referred to. By entering into an agreement that assumes a position opposite to the original transaction, an entity can minimise its exposure to foreign currency movements. Although AASB 121 relates to foreign currency transactions, it does not address foreign currency hedges.

For foreign currency hedges we must refer to AASB 9 (again, as indicated earlier, this means that 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 contract or otherwise, with the objective of avoiding or mitigating possible adverse financial effects of movements in exchange rates.

To illustrate a hedge agreement, let us assume that an Australian company orders some inventory from a US supplier on 1 May 2022 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 2022. 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 2022 from another party (typically a bank) at a forward rate of A$1.00 = US$0.72.

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. With this forward rate

agreement, the entity has locked in the price of the goods to A$277 778 (which is 200 000 ÷ 0.72). 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’.

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 2022. In the absence of a forward rate agreement, the entity would have to pay the US supplier

hedge contract Arrangement with another party in which that other party accepts the risks associated with changing commodity prices, cash flows or exchange rates.

hedge Action taken to minimise possible adverse financial effects of movements in exchange rates or other market values.

forward rate The exchange rate that is currently offered for the future acquisition or sale of a specific currency.

LO 30.7

dee67382_ch30_1205-1226.indd 1219 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1219

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 that has been negotiated with the bank, the entity can obtain US$200 000 from the bank at an agreed cost of A$277 778. The supplier of the US currency (which we have assumed is a bank) is a different party from the overseas inventory supplier and, as the other party to the forward rate agreement (the bank) 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 (for example, a bank) 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.

To illustrate a ‘sell hedge’, let us assume that an entity agrees on 1 January 2022 to sell some plant (to be constructed) to a UK company at a price of UK£500 000, payable on 30 June 2022. The exchange rate on 1 January 2022 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 the same UK£500 000 to the bank at an agreed forward rate of A$1.00 = UK£0.48. The bank charges a premium, in this case equal to the difference between the spot rate at the date of entering the agreement and the agreed forward rate, and in this case it is equal to A$45 290 [(500 000 ÷ 0.46) – (500 000 ÷ 0.48)]. This amount of A$45 290 compensates the bank 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 the 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 therefore 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 if the exchange rate moves downwards. 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 hedging arrangement negotiated with the bank) 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.

WHY DO I NEED TO KNOW ABOUT THE NATURE OF HEDGING?

As should be clear from reading this chapter, if an organisation has receivables or payables denominated in a foreign currency, then potentially large losses (or gains) will be made when foreign currency exchange rates change, as they typically do. If the magnitude of the change is great enough, the associated losses might be significant enough to wipe out an organisation. The sensible use of hedging arrangements, which typically involve a third party and the use of a ‘hedging instrument’, can mitigate these potential losses (or gains). Therefore, if we are in business, it is essential to understand how hedging works, particularly if we are buying or selling products or services that are priced in a foreign currency. Further, if we are trying to assess the risk of another organisation, and if that organisation has monetary assets that are denominated in a foreign currency, then it is important to determine whether hedging has been employed by the managers of that organisation (unless, of course, the payables and receivables are of a similar amount and in the same currency, in which case the gains or losses on one would be offset by the gains or losses on the other).

dee67382_ch30_1205-1226.indd 1220 10/25/19 12:19 PM

1220 PART 9: Foreign currency

Accounting for hedging transactions As we already know, hedge accounting is addressed within AASB 9. 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. In that chapter we discuss 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. Chapter 14 also includes a number of review questions at the end of the chapter that relate to the use of hedging arrangements used to mitigate risks associated with fluctuations in foreign currency exchange rates.

30.8 Foreign currency swaps

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 briefly revisit issues associated with foreign currency swaps.

Swaps occur when borrowers exchange aspects of their respective loan obligations. Commonly used swaps are:

LO 30.8

foreign currency swap Agreement under which the obligation relating to a loan denominated in one currency is swapped for a loan denominated in another currency.

∙ interest-rate swaps (typically a fixed-interest-rate obligation is swapped for a variable-rate obligation—also covered in 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).

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 monetary item (perhaps the foreign currency payable) will be offset by gains on the other monetary item (perhaps the foreign currency receivable). For example, assume that at 20 June 2022, when the exchange rate was A$1.00 = US$0.70, we had an accounts payable of US$1 million and we also had an accounts receivable of US$1 million. If on 30 June 2022 the exchange rate falls to A$1.00 = US$0.65, then the movements in the foreign currency monetary amounts would be:

Balance of accounts payable at 20 June 2022: US$1 000 000 ÷ 0.70  1 428 571 Balance of accounts payable at 30 June 2022: US$1 000 000 ÷ 0.65 1 538 462 Foreign currency loss on accounts payable   (109 891) Balance of accounts receivable at 20 June 2022: US$1 000 000 ÷ 0.70 1 428 571 Balance of accounts receivable at 30 June 2022: US$1 000 000 ÷ 0.65 1 538 462 Foreign currency gain on accounts receivable 109 891 Net gain/loss 0

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 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. Chapter 14 also includes a number of review questions at the end of the chapter that relate to the use of foreign currency swaps.

dee67382_ch30_1205-1226.indd 1221 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1221

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, AASB 123 and AASB 9.

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 profit or loss, whether or not the amounts have been realised.

• Gains or losses on foreign currency receivables and payables are, with limited exceptions, 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 profit or loss.

• The use of hedging arrangements can be undertaken to reduce the risks associated with changes in foreign currency exchange rates.

• Foreign currency swaps may also be undertaken as a form of hedging.

KEY TERMS

exchange rate 1207 foreign currency swap 1220 forward rate 1218 functional currency 1209

hedge 1218 hedge contract 1218 presentation currency 1210 qualifying asset 1216

spot rate 1214 translation of foreign currency transactions 1208

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following five questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is a foreign currency transaction? LO 30.1 A foreign currency transaction is a transaction that is undertaken with another entity in a currency that is different from the organisation’s functional currency.

2. What is a ‘spot rate’? LO 30.1, 30.2, 30.3 The ‘spot rate’ is the exchange rate that would apply for the immediate delivery of a currency.

3. If a payable, or receivable, is denominated in a foreign currency, does its carrying amount have to be adjusted at the end of the reporting period? LO 30.3 Yes, its carrying amount does have to be adjusted at the end of the reporting period. Specifically, at the end of the reporting period, foreign currency monetary amounts must be translated using the ‘closing rate’, which is the spot exchange rate at the end of the reporting period.

4. If an amount owing to an overseas supplier for the purchase of inventory increases because of an adverse movement in the foreign exchange rate, is such an increase to be accounted for as part of the cost of the inventory? LO 30.2, 30.3, 30.5 The general principle is that the subsequent gain or loss on the amount owing is not to be treated as part of the cost of the inventory. Rather, it is to be recognised as a foreign exchange loss, which is to be included within profit or loss. However, if the asset being acquired is a ‘qualifying asset’, then the gains or losses can be included within the cost of the asset while it remains a qualifying asset. Inventory shall be considered to be a qualifying asset only

dee67382_ch30_1205-1226.indd 1222 10/25/19 12:19 PM

1222 PART 9: Foreign currency

to the extent that it necessarily took a substantial period of time to construct. Most items of inventory would not be qualifying assets.

5. If an organisation has a five-year loan that is denominated in a foreign currency, does the carrying amount of the loan have to be adjusted at the end of each reporting period to reflect any changes in exchange rates? LO 30.5 Yes it does. It would need to be adjusted using the ‘closing rate’ and any gain or loss would be included within profit or loss.

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is a foreign currency exchange rate? LO 30.1 • 2. What is a foreign currency transaction? LO 30.1 • 3. What is a functional currency and what is a presentation currency? LO 30.4 • 4. Explain why it is necessary to translate foreign currency transactions into Australian dollars. LO 30.1 • 5. 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? Further, how should any adjustments (if necessary) be treated within the statement of profit or loss and other comprehensive income? LO 30.3 ••

6. 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 30.2 •

7. Some inventory is acquired from an overseas supplier with the debt denominated in a foreign currency. In the absence of a hedging 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 30.3, 30.5 ••

8. 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 30.2, 30.6 ••

9. What is a hedging arrangement and how does it reduce foreign currency risk exposure? LO 30.7 • 10. When is a foreign currency monetary item considered to be hedged? LO 30.7 • 11. What are foreign currency swaps and why are they undertaken? LO 30.8 • 12. On 5 June 2022 Perth Ltd acquires goods on credit from a supplier in London. The goods are shipped FOB London on

5 June 2022. The cost of the goods is UK£250 000 and the debt remains unpaid at 30 June 2022. On 5 June 2022 the exchange rate is A$1.00 = UK£0.46. On 30 June 2022 it is A$1.00 = UK£0.44. 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 2022. LO 30.2, 30.3, 30.5 •

13. On 1 July 2022 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 2022 A$1.00 = UK£0.48 30 June 2023 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 2023. LO 30.3, 30.5 •

14. On 10 July 2022 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 2022. 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 2022 A$1.00 = US$0.78 30 June 2023 A$1.00 = US$0.75

dee67382_ch30_1205-1226.indd 1223 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1223

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 2023. LO 30.3, 30.5 •

15. On 1 March 2021 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 2022 and shipped FOB Auckland on that date. The debt is unpaid at 30 June 2022, which is also Drouyn Ltd’s reporting date.

The exchange rates at the relevant dates are:

1 March 2021 A$1.00 = NZ$1.20 30 June 2021 A$1.00 = NZ$1.15 1 June 2022 A$1.00 = NZ$1.30 30 June 2022 A$1.00 = NZ$1.25

REQUIRED Provide the required journal entries of Drouyn Ltd for the years ending 30 June 2021 and 30 June 2022. LO 30.3, 30.5, 30.6 ••

16. On 1 March 2022 Possum Ltd, an Australian entity, purchases US$1.5 million of inventory from Lincoln Inc., a US entity. The amount is paid on 1 August 2022. Possum Ltd has a 30 June financial year end.

Additional information

Date Spot rate

1 March 2022 A$1.00 = US$0.70 30 June 2022 A$1.00 = US$0.72 1 August 2022 A$1.00 = US$0.70

REQUIRED Prepare the journal entries for Possum Ltd to account for the above transaction. LO 30.2, 30.3, 30.5 ••

17. On 1 March 2022 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. The goods are shipped on 1 June 2022, at which point they are considered to be in the control of Kanga Ltd, and are paid for on 1 August 2022. The organisation has a 30 June year end.

Additional information

Date Spot rate

1 March 2022 A$1.00 = £0.45 1 June 2022 A$1.00 = £0.43 30 June 2022 A$1.00 = £0.39 1 August 2022 A$1.00 = £0.41

REQUIRED Provide the necessary journal entries for Kanga Ltd to account for the purchase transaction with Ferrett plc. Also, would you recommend that the organisation consider entering a hedging arrangement with respect to this transaction? LO 30.2, 30.3, 30.5, 30.7 ••

18. 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 2022, FOB Sydney. The amount is due for payment by Harlom Inc. on 1 September 2022. Platypus Ltd’s reporting date is 30 June.

Additional information

Date Spot rate

1 May 2022 A$1.00 = US$0.84 30 June 2022 A$1.00 = US$0.85 1 September 2022 A$1.00 = US$0.86

REQUIRED Prepare the journal entries for Platypus Ltd to account for the above transaction. LO 30.2, 30.3, 30.5

dee67382_ch30_1205-1226.indd 1224 10/25/19 12:19 PM

1224 PART 9: Foreign currency

CHALLENGING QUESTIONS

19. 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. 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 2022, with delivery due by 30 April 2022. 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 31 May 2022, 30 June 2022 and a final payment on 31 July 2022. The following exchange rates are applicable:

22 April 2022 HK$8.00 = A$1.00 30 April 2022 HK$8.50 = A$1.00 31 May 2022 HK$8.56 = A$1.00 30 June 2022 HK$8.59 = A$1.00 31 July 2022 HK$8.94 = A$1.00

(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 2021 for a fixed price of ¥5 million. The equipment is delivered on 31 May 2022, 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 2022. The following exchange rates are applicable:

30 April 2021 ¥160 = A$1.00 30 June 2021 ¥160 = A$1.00 31 May 2022 ¥240 = A$1.00 30 June 2022 ¥245 = A$1.00 31 July 2022 ¥260 = A$1.00

(c) The company arranges a US-dollar interest-only loan on 1 January 2022 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. The following exchange rates are applicable:

Date Spot rate

1 January 2022 A$1.00 = US$0.69 30 June 2022 A$1.00 = US$0.64

(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 2022. The contract price is established at £350 000 and delivery takes place on 31 May 2022, as agreed. Payment is due in respect of these vehicles on 31 August 2022. The following exchange rates are applicable:

Date Spot rate

31 January 2022 £0.49 = A$1.00 31 May 2022 £0.47 = A$1.00 30 June 2022 £0.43 = A$1.00 31 August 2022 £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. Also, how important would it be for this organisation to consider entering hedging arrangements? LO 30.2, 30.3, 30.5, 30.6, 30.7

dee67382_ch30_1205-1226.indd 1225 10/25/19 12:19 PM

CHAPTER 30: Accounting for foreign currency transactions 1225

20. 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 2022 Orders £300 000 of inventory A$1.00 = 37p 11 May 2022 Purchase takes place as inventory shipped to ABC Ltd (FOB) A$1.00 = 41p 30 June 2022 End of financial year A$1.00 = 43p 02 July 2022 Inventory arrives at warehouse A$1.00 = 42p 14 August 2022 Payment of £300 000 to supplier A$1.00 = 39p

REQUIRED

(a) Prepare appropriate journal entries for each relevant event. (b) Assume that, instead of inventory, the purchase is plant and equipment, which is installed ready for use on

15 July 2022 when the rate is still A$1.00 = 42p. Prepare appropriate journal entries for each relevant event. (c) Concerned about the risks associated with fluctuations in exchange rates, the organisation is considering

entering a foreign currency swap. Explain how this would be done by ABC Pty Ltd. LO 30.2, 30.3, 30.5, 30.8

21. URS Ltd is an Australian manufacturer of televisions. The financial year of URS Ltd ends on 30 June. 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.

The machinery is purchased (and in the control of the organisation) on 30 April 2022 at a price of US$250 000. The amount is payable in two instalments, on 31 July 2022, and on delivery on 31 August 2022.

The machinery is to be depreciated from the date it is delivered and ready for use (31 August 2022) at a rate of 10 per cent per annum.

The exchange rates applicable at the above dates are as follows:

30 April 2022 A$1.00 = US$0.76 30 June 2022 A$1.00 = US$0.74 31 July 2022 A$1.00 = US$0.72 31 August 2022 A$1.00 = US$0.74

The company also purchases S$500 000 worth of spare parts from a Singapore company on 30 May 2022. As URS Ltd has three-month interest-free terms, the amount is payable in full on 31 August 2022. URS Ltd obtains title to the goods when they leave the Singapore factory. The exchange rates applicable at the above dates are as follows:

Date Spot rate

30 May 2022 A$1.00 = S$1.40 30 June 2022 A$1.00 = S$1.25 31 August 2022 A$1.00 = S$1.15

REQUIRED Prepare the journal entries to account for the above transactions. LO 30.2, 30.3, 30.5, 30.6

REFERENCE Australian Accounting Standards Board, 2019, Conceptual Framework for Financial Reporting, AASB, Melbourne, May.

dee67382_ch30_1205-1226.indd 1226 10/25/19 12:19 PM

dee67382_ch31_1227-1248.indd 1227 10/25/19 12:20 PM

1227

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 31.1 Understand why it is necessary to translate the accounts of foreign subsidiaries to a specific

presentation currency before the consolidation process is performed. 31.2 Be able to translate the financial statements of a foreign operation into a particular functional currency. 31.3 Be able to translate the financial statements of a foreign operation into a particular presentation

currency. 31.4 Understand how to perform a consolidation subsequent to the translation of a foreign subsidiary’s

financial statements.

C H A P T E R 31 Translating the financial statements of foreign operations

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following six questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is a functional currency, and what is a presentation currency? LO 31.2, 31.3 2. If we consolidate the financial statements of the parent entity with its subsidiaries, do all of the different

entities’ financial statements have to be in the same presentation currency prior to consolidation? Why? LO 31.2

3. When translating the financial statements of a foreign operation, do we first translate the accounts into the functional currency and then into the presentation currency, or vice versa? LO 31.2, 31.3

4. For a foreign operation, will the functional currency necessarily be the same as the local/domestic currency? LO 31.2, 31.3

5. When translating a foreign operation’s financial statements into a functional currency, what rate do we apply to monetary assets? LO 31.2

6. When translating a foreign operation’s financial statements from a functional currency into the presentation currency, what rate do we apply to the various income and expenses? LO 31.3

dee67382_ch31_1227-1248.indd 1228 10/25/19 12:20 PM

1228 PART 9: Foreign currency

31.1 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 Consolidated Financial Statements 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), 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 presented in different currencies. As paragraph 38 of AASB 121 The Effects of Changes in Foreign Exchange Rates 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. (AASB 121)

The accounting standard pertaining to the translation of foreign subsidiaries is AASB 121. As we saw in Chapter 30, 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 subsequently 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: the currency of the primary economic environment in which the entity operates. ∙ Presentation currency: 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 30. We now consider how to translate the accounts of a foreign operation in accordance with the requirements of AASB 121.

31.2 Reporting foreign currency transactions in the functional currency

In this chapter we will consider two situations. First, we will consider translating the financial statements of an entity into a particular functional currency. Then, 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

entity’s functional currency. If the functional currency is the same as the local currency, then there will be no need to translate the financial statements of the foreign operation into the functional currency, as the financial statements prepared in the local currency will already have been prepared in the 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’. Management uses its judgement to determine the functional

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

10 Consolidated Financial Statements IFRS 10

116 Property, Plant and Equipment IAS 16

121 The Effects of Changes in Foreign Exchange Rates IAS 21

LO 31.1

LO 31.2

foreign currency A currency other than the local currency of the entity.

dee67382_ch31_1227-1248.indd 1229 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1229

currency that most faithfully represents the economic effects of the underlying transactions, events and conditions. Paragraph 12 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. (AASB 121)

Paragraphs 9, 10 and 11 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. (AASB 121)

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.

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

dee67382_ch31_1227-1248.indd 1230 10/25/19 12:20 PM

1230 PART 9: Foreign currency

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 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. (AASB 121)

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 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. (AASB 121)

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 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. (AASB 121)

The above paragraph makes reference to monetary items. Monetary items are defined in paragraph 8 as:

units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. (AASB 121)

In relation to monetary assets, paragraph 16 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. (AASB 121)

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.

The rates to be used to translate financial statements into a given functional currency are now summarised in Table 31.1.

Applying the rates in Table 31.1 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

dee67382_ch31_1227-1248.indd 1231 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1231

Category Rate

Assets

Monetary Translate at the spot exchange rate at reporting date (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 in the foreign operation was acquired

Reserves—at acquisition Translated at the rate when the investment in the foreign operation 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 in the foreign operation 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

Table 31.1 Summary of rates used when translating financial statements into the functional currency

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. (AASB 121)

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 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 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. (AASB 121)

The translation from a foreign currency into a functional currency is explored in Worked Example 31.1.

dee67382_ch31_1227-1248.indd 1232 10/25/19 12:20 PM

1232 PART 9: Foreign currency

WORKED EXAMPLE 31.1: Translation from a foreign currency into a functional currency

On 1 July 2022, 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 2023 are shown below.

1 July 2022 UK£1 = NZ$3.00 Average rate for the year UK£1 = NZ$3.10 Ending inventory (acquired before year end) UK£1 = NZ$3.20 30 June 2023 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 2023

UK£000

Sales 2 500

Cost of sales:

– Inventory—1 July 2022 (500)

– Purchases (2 000)

– Inventory—30 June 2023 450

Administration expenses (75)

Depreciation expense (100)

Profit before tax 275

Income tax expense (125)

Profit for the year 150

Other comprehensive income   –

Total comprehensive income   150

Bulldog plc Statement of changes in equity for the year ending 30 June 2023

Share capital (UK£000)

Retained earnings (UK£000)

Balance at 30 June 2022 500 150

From statement of profit or loss and other comprehensive income     − 150

Balance at 30 June 2023 500 300

Bulldog plc Statement of financial position as at 30 June 2023

1 July 2022 (UK£000)

30 June 2023 (UK£000)

Assets

Property, plant and equipment 1 050 950

Cash and debtors 100 800

Inventory     500    450

Total assets 1 650 2 200

dee67382_ch31_1227-1248.indd 1233 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1233

1 July 2022 (UK£000)

30 June 2023 (UK£000)

Liabilities

Bank loan 1 000 1 000

Trade creditors        −    400

Total liabilities 1 000 1 400

Net assets    650    800

Equity

Share capital 500 500

Retained earnings     150    300

   650    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 2023

UK£000 Exchange rate NZ$000

Sales 2 500 3.10 7 750.0

Cost of sales:

– Inventory—1 July 2022 (500) 3.00 (1 500.0)

– Purchases (2 000) 3.10 (6 200.0)

– Inventory—30 June 2023 450 3.20 1 440.0

Administration expenses (75) 3.10 (232.5)

Depreciation expense (100) 3.00 (300.0)

Foreign exchange loss        − (210.0)*

Profit before tax 275 747.5

Income tax expense    (125) 3.10   (387.5)

Profit for the year 150 360.0

Other comprehensive income   −    −

Total comprehensive income 150 360

(* Explained below. See asterisk near the end of this Worked Example)

Bulldog plc

Statement of financial position as at 30 June 2023

UK£000 Exchange rate NZ$000

Assets

Property, plant and equipment 950 3.00 2 850

Cash and debtors 800 3.30 2 640

Inventory    450 3.20 1 440

Total assets 2 200 6 930

continued

dee67382_ch31_1227-1248.indd 1234 10/25/19 12:20 PM

1234 PART 9: Foreign currency

UK£000 Exchange rate NZ$000

Liabilities

Bank loan 1 000 3.30 3 300

Trade creditors   400 3.30 1 320

Total liabilities 1 400 4 620

Net assets    800 2 310

Equity

Share capital 500 3.00 1 500

Retained earnings

Opening balance 150 3.00    450

From statement of profit or loss and OCI   150   360

   800 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.

UK£000 UK£000 Current rate less

rate applied (NZ$) NZ$000

gain/(loss)

Net monetary assets at 1 July 2022

– Bank loan     (1 000)

– Cash and debtors      100    (900) (3.30 − 3.00) (270)

Movements during the year

Increases in monetary assets—sales 2 500 (3.30 − 3.10) 500

Decreases in monetary assets resulting from:

– Purchases (2 000) (3.30 − 3.10) (400)

– Cash expenses (75) (3.30 − 3.10) (15)

– Income tax expense    (125) (3.30 − 3.10)   (25)

Net monetary assets (liabilities) at 30 June 2023   (600) (210)*

Reconciled to net monetary items at 30 June 2023 as follows:

Bank loan (1 000 000)

Creditors (400 000)

Cash and debtors   800 000

 (600 000)

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.

WORKED EXAMPLE 31.1 continued

dee67382_ch31_1227-1248.indd 1235 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1235

31.3 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 from their respective functional currencies into the presentation currency of the parent entity. That is, we will need to ensure that prior to consolidation, all of the financial statements of the entities within the group are presented in the one currency, which will be the group’s presentation currency.

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 considered to occur uniformly throughout the period, average rates may be used. Any resulting translation gains or losses are taken directly to reserves (rather than to profit or loss, which was the case when we translated the financial statements from a local currency to the functional currency). Specifically, paragraph 39 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. (AASB 121)

Note from (c) above that the exchange differences created as part of the process of converting the financial statements to a particular presentation currency are not to be treated as part of profit or loss. Rather, they are to be included within other comprehensive income. At the end of the accounting period they would then be transferred to a reserve—a foreign currency translation reserve.

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 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. (AASB 121)

With regard to the requirement at paragraph 39(c) above that all exchange differences are to go to other comprehensive income, rather than be included as part of the profit or loss of the accounting period, paragraph 41 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. (AASB 121)

To illustrate simplistically the use of the required method for translating foreign operation financial statements, 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 included in other

spot rate The exchange rate for immediate delivery of currencies to be exchanged.

exchange rate The rate at which one currency can be exchanged for another.

LO 31.3

dee67382_ch31_1227-1248.indd 1236 10/25/19 12:20 PM

1236 PART 9: Foreign currency

comprehensive income (and then transferred to a foreign currency translation reserve at the end of the accounting period) 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 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 by the parent entity, including in the case of a corporation, share capital at

acquisition and pre-acquisition 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 31.2 summarises the approach to translating the accounts of a foreign subsidiary.

Item 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

Post-acquisition retained earnings Amount determined from translating the statement of profit or loss and other comprehensive income

Table 31.2 Summary of the method to be applied for translating financial statements from a given functional currency to a specific presentation currency

dee67382_ch31_1227-1248.indd 1237 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1237

Worked Example 31.2 provides an illustration of the translation of a foreign subsidiary’s financial statements.

WORKED EXAMPLE 31.2: Translation of a foreign operation’s financial statements from a functional currency into a presentation currency

On 1 July 2022 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 2023 are as follows:

1 July 2022 £1.00 = A$2.00

Average rate for year £1.00 = A$2.10

Ending inventory acquired (before year end) £1.00 = A$2.20

30 June 2023 £1.00 = A$2.30

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.

Nigel plc

Abbreviated statement of profit or loss and other comprehensive income for the year ending 30 June 2023

UK£000

Sales 2 500

Cost of sales

– Inventory—1 July 2022 (500)

– Purchases (2 000)

– Inventory—30 June 2023 450

Administration expense (75)

Depreciation expense (100)

Profit 275

Income tax expense   (125)

Profit after tax 150

Other comprehensive income −

Comprehensive income 150

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

continued

dee67382_ch31_1227-1248.indd 1238 10/25/19 12:20 PM

1238 PART 9: Foreign currency

Nigel plc

Statement of changes in equity for the year ending 30 June 2023

Share capital (UK£000)

Retained earnings (UK£000)

Balance at 30 June 2022 500 150

From statement of profit or loss and other comprehensive income   − 150 Balance at 30 June 2023 500 300

Nigel plc

Statement of financial position as at 30 June 2023

1 July 2022 (UK£000)

30 June 2023 (UK£000)

Assets

Plant and equipment 1 050 950

Cash and debtors 100 800

Inventory     500    450

Total assets 1 650 2 200

Liabilities

Bank loan 1 000 1 000

Trade creditors        –    400

Total liabilities 1 000 1 400

Net assets   650    800

Represented by:

Shareholders’ funds

Share capital 500 500

Retained earnings    150    300

   650    800

REQUIRED Translate the financial statements of the foreign operation from the functional 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 31.2.

Nigel plc

Statement of profit or loss and other comprehensive income for the year ending 30 June 2023

(UK£000) Rate (A$000)

Sales 2 500 2.10 5 250

Cost of sales

– Inventory—1 July 2022 (500) 2.00 (1 000)

– Purchases (2 000) 2.10 (4 200)

– Inventory—30 June 2023 450 2.20 990

Administration expense (75) 2.10 (157.5)

Depreciation expense   (100) 2.10  (210)

Profit 275 672.5

Income tax expense   (125) 2.10  (262.5)

WORKED EXAMPLE 31.2 continued

dee67382_ch31_1227-1248.indd 1239 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1239

(UK£000) Rate (A$000)

Profit after tax 150 410

Other comprehensive income

Increase in foreign currency translation reserve   − 130* Total comprehensive income 150 540

*See calculation provided below

Nigel plc

Statement of changes in equity for the year ending 30 June 2023

Share capital

(UK£000)

Retained earnings

(UK£000)

Foreign currency translation reserve

(UK£000)

Balance at 30 June 2022 1 000* 300** − From statement of profit or loss and other comprehensive income      − 410 130 Balance at 30 June 2023 1 000 710 130

*£500 000 × 2 where 2 is the opening exchange rate on 1 July 2022 **$150 000 × 2.00 where 2.00 is the opening exchange rate on 1 July 2022

Nigel plc

Statement of financial position as at 30 June 2023

1 July 2022 (UK£000)

30 June 2023 (UK£000) Rate (A$000)

Assets

Plant and equipment 1 050 950 2.30 2 185

Cash and debtors 100 800 2.30 1 840

Inventory   500    450 2.30 1 035

1 650 2 200 5 060

Liabilities

Bank loan 1 000 1 000 2.30 2 300

Trade creditors         −     400 2.30    920 1 000 1 400 3 220

Net assets   650   800 1 840

Represented by:

Shareholders’ funds

Share capital 500 500 2.00 1 000

Foreign currency translation reserve 130*

Retained earnings    150    300 710

  650   800 1 840

*See calculation provided at the end of this Worked Example

Foreign currency translation reserve As we have noted, when translating the financial statements from the functional currency to the presentation currency, 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 in the foreign operation was acquired. Retained earnings will be the balance provided from the

continued

dee67382_ch31_1227-1248.indd 1240 10/25/19 12:20 PM

1240 PART 9: Foreign currency

Note that the exchange rate has moved against the Australian dollar in Worked Example 31.2. 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.

Worked Example 31.3 provides another illustration of translating the financial statements of a foreign operation from a particular functional currency into a different presentation currency.

WORKED EXAMPLE 31.3: Further Worked Example of the translation of a foreign operation’s financial statements from a functional currency into a presentation currency

On 1 July 2022, 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 2023 are as follows:

1 July 2022 US$1.00 = A$1.40

Average rate for year US$1.00 = A$1.50

Ending inventory acquired (before year end) US$1.00 = A$1.55

30 June 2023 US$1.00 = A$1.60

The statement of profit or loss and other comprehensive income, and the 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.

Chuck Inc.

Statement of profit or loss and other comprehensive income for the year ending 30 June 2023

US$000

Sales 5 000

Cost of sales

– Inventory—1 July 2022 (1 000)

– Purchases (4 000)

– Inventory—30 June 2023 900

Administration expense (150)

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 (foreign currency translation reserve) 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 retained earnings.

The increase in the foreign currency translation reserve, which is treated as part of other comprehensive income, is determined as follows:

Net assets at 30 June 2023 at closing rate (800 × $2.30) $1840

less Components of net assets at their historical rates

− Share capital 500 × $2.00 ($1000)

− Retained earnings ($   710)

Translation gain—to foreign currency translation reserve $   130

WORKED EXAMPLE 31.2 continued

dee67382_ch31_1227-1248.indd 1241 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1241

US$000

Depreciation expense (200)

Profit 550

Income tax expense (250)

Profit after tax 300

Other comprehensive income    –

Comprehensive income 300

Chuck Inc.

Statement of financial position as at 30 June 2023

1 July 2022 (US$000)

30 June 2023 (US$000)

Share capital 1 000 1 000

Retained earnings 300 600

Bank loan 2 000 2 000

Trade creditors         –    800

3 300 4 400

Plant and equipment 2 100 1 900

Cash and debtors 200 1 600

Inventory 1 000    900

3 300 4 400

REQUIRED Translate the financial statements of Chuck Inc. into Australian dollars.

SOLUTION We can refer to Table 31.2 for a summary of which rates to use for the various items.

Chuck Inc.

Statement of profit or loss and other comprehensive income for the year ending 30 June 2023

US$000 Rate A$000

Sales 5 000 1.50 7 500

Cost of sales

– Inventory—1 July 2022 (1 000) 1.40 (1 400)

– Purchases (4 000) 1.50 (6 000)

– Inventory—30 June 2023 900 1.55 1 395

Administration expense (150) 1.50 (225)

Depreciation expense (200) 1.50   (300)

Profit 550 970

Income tax expense (250) 1.50  (375)

Profit after tax 300 595

Other comprehensive income

Increase in foreign currency translation reserve*   –    145

Total comprehensive income      300 740

*see below

continued

dee67382_ch31_1227-1248.indd 1242 10/25/19 12:20 PM

1242 PART 9: Foreign currency

Chuck Inc.

Statement of financial position as at 30 June 2023

1 July 2022 (US$000)

30 June 2023 (US$000) Rate A$000

Share capital 1 000 1 000 1.40 1 400

Foreign currency translation reserve 145*

Retained earnings 300 600 1 015**

Bank loan 2 000 2 000 1.60 3 200

Trade creditors         –    800 1.60 1 280

3 300 4 400 7 040

Plant and equipment 2 100 1 900 1.60 3 040

Cash and debtors 200 1 600 1.60 2 560

Inventory 1 000    900 1.60 1 440

3 300 4 400 7 040

*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:

A$000

Net assets at 30 June 2023 at closing rate (1600 × $1.60) $2 560

less Components of net assets at their historical rates: share capital (1000 × $1.40) ($1 400)

Retained earnings ($1 015)

Translation gain—to foreign currency translation reserve $    145

WORKED EXAMPLE 31.3 continued

WHY DO I NEED TO KNOW ABOUT THE PROCESSES INVOLVED IN TRANSLATING THE FINANCIAL STATEMENTS OF A FOREIGN OPERATION?

When the financial statements of a foreign operation are translated into a functional currency, gains or losses will be recognised that will be included within consolidated profit or loss. Arguably, to therefore understand consolidated profit or loss, we need to understand how such gains or losses arise, and this chapter provides some insight.

When the financial statements are then translated from a functional currency into a presentation currency, this can lead to a gain or loss that is recognised within other comprehensive income, which will then be transferred to the foreign currency translation reserve at the end of the accounting period. Because consolidated financial statements will typically include a foreign currency translation reserve within the balance sheet, it is arguably necessary to understand how and why these balances originate.

31.4 Consolidation subsequent to translation

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, 27 and 28). AASB 121, paragraph 45, however, explains that intragroup monetary items, assets or liabilities cannot be eliminated

LO 31.4

dee67382_ch31_1227-1248.indd 1243 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1243

against the corresponding intragroup asset or liability without the result of the currency fluctuations being shown in the financial statements. 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. (AASB 121)

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 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. (AASB 121)

The above requirement means that the related asset, such as goodwill, must be translated at the closing rate at the end of the reporting period. This can create an adjustment to any foreign currency translation reserve that has been created. How this should occur is detailed in Worked Example 31.4.

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 31.4: Accounting treatment of goodwill arising on acquisition

On 1 July 2021, 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 4 800 000

Retained earnings    800 000

5 600 000

*ZAR = South African rands

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)

Land 2 800 000 3 400 000

The relevant exchange rates are as follows:

1 July 2021      A$1 = ZAR 4 30 June 2022   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.

continued

dee67382_ch31_1227-1248.indd 1244 10/25/19 12:20 PM

1244 PART 9: Foreign currency

REQUIRED Prepare the consolidation journal entries at 1 July 2021 and 30 June 2022.

SOLUTION Elimination of investment in Jeffreys Bay Ltd

Jeffreys Bay Ltd (A$)

Eliminate parent 100% (A$)

Share capital (4 800 000 ÷ 4) 1 200 000 1 200 000

Retained earnings—at acquisition (800 000 ÷ 4) 200 000 200 000

Revaluation surplus (600 000 ÷ 4 = $150 000 net of deferred tax at 40% of $60 000)      90 000     90 000

1 490 000

Investment in Jeffreys Bay Ltd 1 550 000

Goodwill on acquisition      60 000

From the above workings, the consolidation entry to eliminate the investment in Jeffreys Bay Ltd would be:

1 July 2021

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 Ltd (eliminating the investment in Jeffreys Bay Ltd and recognising goodwill at date of acquisition)

1 550 000

At 30 June 2022, the exchange rate had moved to A$1 = ZAR 5. The revaluation surplus and other equity items are translated at the rate at original acquisition, while goodwill is translated at the closing rate at the end of each reporting period. The following additional entry should be made at 30 June 2022.

30 June 2022

Dr Foreign currency translation reserve 12 000

Cr Goodwill on acquisition (recognising decrease in value of goodwill resulting from movements in exchange rate)

12 000

At 1 July 2021, goodwill expressed in the South African rand amounted to ZAR 240 000 ($60 000 × 4). At 30 June 2022, 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.

WORKED EXAMPLE 31.4 continued

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 also 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 Foreign currency translation reserve X

Cr Inventory X

dee67382_ch31_1227-1248.indd 1245 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1245

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. We also learned that where the financial statements of the foreign operation are then translated from its functional currency into the presentation currency, the net exchange difference on translation is treated as part of equity (the foreign currency translation reserve), with the related gain or loss being treated as part of other comprehensive income. 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 1235 foreign currency 1228 spot rate 1235

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following six questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is a functional currency, and what is a presentation currency? LO 31.2, 31.3 The functional currency is the currency of the primary economic environment in which the entity operates, and the presentation currency is the currency in which the financial statements are presented.

2. If we consolidate the financial statements of the parent entity with its subsidiaries, do all of the different entities’ financial statements have to be in the same presentation currency prior to consolidation? Why? LO 31.2 Yes, they do. It would not make sense to combine/consolidate financial statements that were individually presented in different currencies. The combined totals would be relatively meaningless.

3. When translating the financial statements of a foreign operation, do we first translate the accounts into the functional currency and then into the presentation currency, or vice versa? LO 31.2, 31.3 We first translate the financial statements into the functional currency. Table 31.1 in this chapter provides a summary of the rates to be used when translating financial statements into the functional currency. We then translate the financial statements of the foreign operation from the functional currency into the presentation currency. Table 31.2 provides a summary of the rates to be applied for translating financial statements from a given functional currency into a specific presentation currency.

4. For a foreign operation, will the functional currency necessarily be the same as the local/domestic currency? LO 31.2, 31.3 No, not necessarily. This chapter gives the example of an Australian parent entity with a subsidiary that is in New Zealand. If 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, then the functional currency of the subsidiary is Australian dollars. Perhaps the entity acquires products directly from the parent entity and sells the products at prices based on the Australian dollar. 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, which would be New Zealand dollars.

5. When translating a foreign operation’s financial statements into a functional currency, what rate do we apply to monetary assets? LO 31.2 As Table 31.1 shows, we use the spot exchange rate at reporting date (that is, we use the ‘closing rate’).

dee67382_ch31_1227-1248.indd 1246 10/25/19 12:20 PM

1246 PART 9: Foreign currency

6. When translating a foreign operation’s financial statements from a functional currency into the presentation currency, what rate do we apply to the various income and expenses? LO 31.3 As Table 31.2 shows, we use the rate in place at the time of the transaction. For practical reasons, however, it is acceptable to use a rate that approximates to the rate in place when the transactions took place (for example, to use an average rate for the year).

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. Why do we need to translate the financial statements of a foreign operation? LO 31.1 • 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 included within other comprehensive income and then transferred to an equity account referred to as the foreign currency translation reserve. LO 31.3 ••

3. What is the difference between the presentation currency and the functional currency and how would an organisation determine the appropriate presentation currency? LO 31.2, 31.3 •

4. On consolidation, will any non-controlling interests be allocated a share of any foreign currency translation reserve? LO 31.4 •

5. At the end of the reporting period, when consolidation adjustments are made, will goodwill on acquisition of a foreign operation be adjusted to reflect any changes in exchange rates? LO 31.4 ••

6. 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 31.3 •

7. 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 31.3, 31.4 •

CHALLENGING QUESTIONS

8. On 1 July 2022 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 2023 are as follows:

1 July 2022 £1.00 = A$2.00

Average rate for year £1.00 = A$2.10

Ending inventory acquired (before year end) £1.00 = A$2.20

30 June 2023 £1.00 = A$2.30

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£.

Felicity plc

Statement of profit or loss and other comprehensive income for the year ending 30 June 2023

UK£

Sales 5 000

Cost of sales

– Inventory—1 July 2022 (1 000)

– Purchases (4 000)

– Inventory—30 June 2023 900

Administration expense (150)

Depreciation expense (200)

dee67382_ch31_1227-1248.indd 1247 10/25/19 12:20 PM

CHAPTER 31: Translating the financial statements of foreign operations 1247

UK£

Profit 550

Income tax expense (250)

Profit after tax 300

Other comprehensive income     − Total comprehensive income 300

Felicity plc

Statement of financial position as at 30 June 2023

1 July 2022 (UK£)

30 June 2023 (UK£)

Share capital 1 000 1 000

Retained earnings 300 600

Bank loan 2 000 2 000

Accounts payable    −    800 3 300 4 400

Plant and equipment 2 100 1 900

Cash and debtors 200 1 600

Inventory  1 000    900

3 300 4 400

REQUIRED Translate the financial statements of the foreign operation, assuming:

(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 functional currency of Felicity plc and the Australian dollar is the presentation currency of the group. LO 31.2, 31.3

9. Bazza Ltd, an Australian company, acquires all of the shares of Chan Ltd, a Hong Kong company, on 1 July 2022. Chan Ltd had a $nil balance in retained earnings as at the date of acquisition. The financial statements for Chan Ltd are presented below:

Chan Ltd

Statement of profit or loss and other comprehensive income for the year ending 30 June 2023

HK$ HK$

Sales 250 000

Cost of sales

– Inventory—1 July 2022 (25 000)

– Cost of goods manufactured (152 500)

– Inventory—30 June 2023 27 500 (150 000)

Gross profit 100 000

Selling and administrative expenses (20 000)

Depreciation (30 000)

Profit before tax 50 000

Income tax expense (20 per cent) (10 000)

Profit after tax 40 000

Other comprehensive income        − Total comprehensive income 40 000

dee67382_ch31_1227-1248.indd 1248 10/25/19 12:20 PM

1248 PART 9: Foreign currency

Chan Ltd

Statement of financial position as at 30 June 2023

HK$

Cash 34 000

Accounts receivable 46 000

Inventory (cost) 27 500

Plant and equipment 125 000

less Accumulated depreciation (30 000)

Land   50 000

Total assets 252 500

Share capital 150 000

Retained earnings 30 000

Current liabilities

Accounts payable 12 500

Dividends payable 10 000

Non-current liabilities

Long-term bonds 50 000

Total shareholders’ equity and liabilities 252 500

Additional information

• Relevant exchange rates are:

1 July 2022 A$1.00 = HK$4.00

Plant, equipment and inventory acquired A$1.00 = HK$4.00

Long-term bonds issued A$1.00 = HK$3.50

Land acquired A$1.00 = HK$3.50

Average rate for 2023 financial year A$1.00 = HK$3.00

Average rate for June 2023 quarter A$1.00 = HK$2.25

30 June 2023 A$1.00 = HK$2.00

• Plant, equipment and inventory are acquired on 1 July 2022. There were no monetary assets or liabilities at the commencement of business.

• Long-term bonds are issued on 1 August 2022, 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 2023 quarter. • All revenue and expense items are incurred evenly throughout the year.

REQUIRED Translate the financial statements of Chan Ltd into Australian dollars in preparation for group consolidation in accordance with AASB 121, assuming that HK dollars are the functional currency of Chan Ltd and the Australian dollar is the presentation currency of the group. LO 31.2, 31.3

dee67382_ch32_1249-1332.indd 1249 10/25/19 01:46 PM

CHAPTER 32 Accounting for corporate social responsibility

PART 10 Corporate social-

responsibility reporting

dee67382_ch32_1249-1332.indd 1250 10/25/19 01:46 PM

1250

Before reading this chapter, watch the accompanying video of Craig Deegan explaining why this topic is important

for your studies.

LEARNING OBJECTIVES (LO) 32.1 Know what ‘social-responsibility reporting’ is, and what its components—social reporting and

environmental reporting—represent. 32.2 Understand the meaning of ‘sustainability’. 32.3 Be aware of different perceptions about the ‘responsibilities’ of business organisations, of how perceptions of

responsibilities in turn influence perceptions about ‘accountability’, and of how perceptions of ‘accountability’ in turn impact decisions about the ‘accounts’ that should be prepared.

32.4 Understand the extent to which organisations currently disclose information about their social and environmental performance.

32.5 Be aware of an ‘accountability model’ and understand how that model can be applied to explain or inform organisational reporting.

32.6 Be aware of various perspectives about ‘why’ organisations present social and environmental information. 32.7 Be aware of various considerations that influence decisions about ‘to whom’ organisations present social and

environmental information. 32.8 Be aware of various considerations that influence decisions about ‘what’ information organisations will report to

their various stakeholders. 32.9 Understand some of the different ways in which social and environmental information can be reported and, in doing

so, appreciate some of the limitations of conventional financial accounting in relation to the recognition of social and environmental costs and benefits, and be aware of some of the various frameworks for social-performance and environmental performance reporting (such as the frameworks of the Global Reporting Initiative, International Integrated Reporting Council, Sustainability Accounting Standards Board and the Financial Stability Board).

32.10 Be aware of the United Nations’ Sustainable Development Goals, and understand how they are influencing organisational policies, inclusive of reporting.

32.11 Understand the meaning of ‘externalities’ and how to account for them through such processes as ‘full cost accounting’. 32.12 Understand the nature of ‘counter accounts’ and how such accounts can assist an organisation to present different

stakeholders’ perspectives about the performance of an organisation. 32.13 Understand the critical nature of climate change, and be aware of some reporting implications associated with

climate change. 32.14 Aside from the notion of corporate social responsibility, appreciate the central importance of ‘personal social

responsibility’.

C H A P T E R 32 Accounting for corporate social responsibility

dee67382_ch32_1249-1332.indd 1251 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1251

32.1 Introduction to social-responsibility reporting

Throughout this book we have been considering numerous financial reporting standards and other generally accepted accounting principles. 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 many points in this book we have emphasised that financial measures of performance—such as ‘profits’—fail to reflect many of the positive and negative social and environmental impacts, or externalities, caused by organisations). In this chapter we will consider a number of issues associated with corporate social and environmental reporting, as well as sustainability reporting.

Prior to recent decades, 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 of stakeholders (those with a financial interest in the organisation—such as investors/ owners) over and above the interests of other stakeholders. However, such views have changed somewhat, and it has become more widely accepted—but not universally accepted (unfortunately)— that business organisations have responsibilities to a broader group of stakeholders beyond their shareholders (this broader group of stakeholders might include local communities, customers, suppliers, employees, workers within supply chains, 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 statement that appeared in the BHP Group’s 2018 Sustainability Report (p. 10):

Sustainability is one of BHP’s core values. It means putting health and safety first, being environmentally responsible and supporting our communities. The wellbeing of our people, the community and the environment is considered in everything that we do. (BHP Group Ltd)

LO 32.1

externality An impact that an entity has on parties external to the organisation. Externalities can be viewed as positive externalities (benefits) or negative externalities (costs).

stakeholder Any group or individual that can affect or is affected by the achievement of an organisation’s objectives.

OPENING QUESTIONS

Before reading this chapter, please consider how you would answer the following seven questions. We will return to these questions at the end of the chapter, where we suggest some answers.

1. What is ‘corporate social responsibility’? LO 32.1, 32.3 2. What is ‘corporate social-responsibility reporting’? LO 32.1 3. What does ‘sustainable development’ mean? LO 32.2 4. What is the relationship, if any, between perceptions of organisational ‘responsibilities’ and ‘accounting’?

LO 32.3, 32.5 5. What is the Global Reporting Initiative? LO 32.9 6. What is an ‘externality’, and does financial reporting typically account for the externalities being generated by

an organisation? LO 32.11 7. What is ‘integrated reporting’? LO 32.9

AASB STANDARDS REFERRED TO IN THIS CHAPTER AND IFRS/IAS EQUIVALENTS

AASB no. Title IFRS/IAS equivalent

116 Property, Plant and Equipment IAS 16

137 Provisions, Contingent Liabilities and Contingent Assets IAS 37

dee67382_ch32_1249-1332.indd 1252 10/25/19 01:46 PM

1252 PART 10: Corporate social-responsibility reporting

Of course, whether such public statements or commitments made by company executives, 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 internally 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.

We will see that existing generally accepted accounting principles, as embodied within accounting standards and the Conceptual Framework typically act to exclude from measurement many social and environmental costs and benefits generated by organisations. Hence, moves to provide social and environmental information require an entity to go outside conventional financial reporting practices. We will specifically consider the limitations of generally accepted financial accounting principles with respect to providing information about an entity’s social and environmental performance. As we will see, generally accepted accounting principles typically treat ‘environmental goods’ (for example, air and water) as being in infinite supply and free, with the consequence that the use or abuse

of the environment is not reflected in accounting performance indicators such as ‘profits’ (unless fines or other penalties have been imposed). Also, financial accounting practices have tended to ignore the social costs that an entity might have imposed upon the societies with which it interacts. For example, while retrenching thousands of people from a workforce can have positive effects on accounting profits (as has been the case for many large companies in recent years as they replaced people with various labour-saving technologies), there are associated social costs that are ignored by the organisation when calculating ‘profits’.

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

provided in stand-alone social and environmental reports—often quite extensive in length and available on corporate websites (frequently in the form of interactive reports). As there is a general lack of regulation in this area of reporting, there is much variation in how the reporting is being done.

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 a discussion of various issues associated with the vital 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 (although it is increasing). 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 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 organisations providing unbiased ‘accounts’ of their social and environmental performance and related impacts.

Social and environmental reporting defined 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 social-responsibility 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’ (CSR)? 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

social-responsibility reporting The provision of information about the performance of an organisation with regard to its interaction with its physical and social environment.

social costs Costs 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.

dee67382_ch32_1249-1332.indd 1253 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1253

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 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.

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.

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. Environmental reporting could include documenting an organisation’s impact on living and non-living natural systems, including its impacts on land, air, water and ecosystems.

In the mid to late 1990s, more and more corporations throughout the world started discussing aspects of what had 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.

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.

dee67382_ch32_1249-1332.indd 1254 10/25/19 01:46 PM

1254 PART 10: Corporate social-responsibility reporting

32.2 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 few organisations’ operations that we know of are actually ‘sustainable’ (or anywhere remotely close to it).

Corporate social-responsibility 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 2018 Sustainability Report (p. 10) provides an insight into how Shell publicly promotes sustainability as meaning:

.  .  .  providing more and cleaner energy solutions in a responsible manner—in a way that balances short- and long-term interests, and that integrates economic, environmental and social considerations into decision-making. Sustainability is integrated across our business on three levels:

∙ in Shell company operations—by running a safe, efficient, responsible and profitable business; ∙ for our customers—by helping to shape a more sustainable energy future; and ∙ with communities and wider society—by sharing benefits where we operate and making a positive contribution.

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 Standards 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 (GRI) states.

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. (GRI, ‘About sustainability reporting’, https://www.globalreporting.org/information/sustainability- reporting/Pages/default.aspx, accessed 4 October 2019).

LO 32.2

dee67382_ch32_1249-1332.indd 1255 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1255

Now we will examine some perspectives about the responsibilities of business and whether these responsibilities can reasonably be expected to extend to providing information about corporate social and environmental performance.

WHY DO I NEED TO KNOW ABOUT THE MEANING OF SUSTAINABILITY AND UNDERSTAND THAT LARGE ORGANISATIONS TYPICALLY REPORT SUSTAINABILITY-RELATED INFORMATION?

‘Sustainability’ is a term that is increasingly being used within the community and by business organisations. It is therefore a concept that we all need to understand. Increasingly, various stakeholders of organisations expect the managers of organisations to incorporate issues associated with sustainability into their operations. The support afforded to organisations by various stakeholders will be influenced by the information organisations report in terms of how they interpret and operationalise sustainability-related considerations. Given that sustainability-related disclosures have the potential to influence the success of an organisation, as accountants we should be aware of the different ways in which organisations can report with respect to sustainability.

32.3 What are the responsibilities of business (to whom and for what)?

The issue of corporate social responsibility is very topical. For example, at an international level, there has been much media attention directed at the clothing trade being operated within various developing countries. Over time, there have been many deaths and injuries in factories within developing countries such as Bangladesh, Pakistan, India and Indonesia. Many such factories manufacture clothes that are then sold by major international clothing brands to Western consumers. For example, in a newspaper article entitled ‘Fast fashion’s human cost still too high’ (by Keren Adams, The Age, 24 April 2018, p. 19), it was reported that:

Five years ago today, the eight-storey Rana Plaza building in Bangladesh came crashing down, burying factory workers inside. In the weeks that followed, the scale of the disaster became clear—1134 workers, mainly young women, were dead and over 2000 others injured.

Rana Plaza is often described as the garment industry’s ‘worst industrial accident’, but the industry practices that led to it were far from accidental. Western brands, including many from Australia, flocked to Bangladesh because of its rock-bottom prices. Low prices reinforced low wages and discouraged investment in factory safety.

The newspaper article went on to say that wages in the garment industry remain too low, and forced and child labour are widespread in many countries from which Australia, and other Western countries, source their clothes. The newspaper article also stressed that Australian and other Western consumers need to understand where their clothes are made, and how they are made, so they can use their purchasing power to encourage ethical sourcing. This can occur only, though, if retailers provide information on where they are sourcing their clothing from. However, the newspaper article claims that five years after the Rana Plaza disaster, ‘many Australian retailers still won’t reveal the names and locations of their suppliers’. At issue here is whether they should reveal such information.

With this newspaper article in mind, please reflect again upon your own views about corporate responsibilities and associated accountabilities. 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 production requirements? Should they provide a publicly available ‘account’ of what they are doing to ensure workers within their supply chain are treated ethically? The issue of how far corporate responsibilities should extend is a very subjective issue and people’s views on this will vary.

While in the past many corporate managers might have given little direct consideration to stakeholders other than shareholders, this seems to have changed. For example, in a 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 2019), 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

LO 32.3

dee67382_ch32_1249-1332.indd 1256 10/25/19 01:46 PM

1256 PART 10: Corporate social-responsibility reporting

∙ 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’. This is reflected in Figure 32.1.

Referring to Figure 32.1, 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), then 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 perspective on the responsibilities of organisations, 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

Figure 32.1 The relationship between organisational responsibility, accountability and accounts

SOURCE: Deegan (2020a).

dee67382_ch32_1249-1332.indd 1257 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1257

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. On page 61 of the report, BHP 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 2018 BHP Sustainability Report it is stated (p. 15):

We conduct a materiality assessment every year to identify the sustainability issues that are most critical to our business and to our stakeholders. This process assists us to both track ongoing issues and identify emerging ones. This analysis informs our sustainability strategies and enables us to provide transparent coverage of key topics in line with Global Reporting Initiative (GRI) principles. As part of this assessment, we analyse our risk registers and other inputs and engage with internal and external stakeholders to identify the issues of most concern to them. (BHP Group Ltd)

This would imply that BHP 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 that in a famous debate in the 1930s (p. 19):

Professor Adolf Berle . . . supporting the ‘shareholder primacy’ view, argued that the powers and duties given to directors . . . should be exercisable only for the benefit of, and to maximise the profits for, 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 as reflected in Figure 32.1. 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’. Worked Example 32.1 indicates how the managers’ own views and expectations influence the nature of the accounts they prepare.

WORKED EXAMPLE 32.1: Making a judgement about organisational accountability

Assume that you are the general manager of an organisation that sells clothing. You outsource some of the manufacturing of these clothes to suppliers in Bangladesh.

REQUIRED Do you have any responsibility and related accountability for what happens to workers in the supply factories?

SOLUTION The answer to this is a matter of judgement, which is impacted by our own values and morals. If we accept we have a responsibility to ensure safe, fair and healthy conditions for workers throughout our supply chains, this means we believe that we have an accountability to report whether the factories are working in accordance with these responsibilities. If, by contrast, we do not believe we have any responsibilities to these foreign workers, we would not seek to monitor conditions in the factories there, and we would provide no accounts of what we are doing to ensure safe, fair and healthy work environments.

dee67382_ch32_1249-1332.indd 1258 10/25/19 01:46 PM

1258 PART 10: Corporate social-responsibility reporting

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.

However, not all segments of the community embrace broad perspectives on corporate responsibility. For example, we could be excused for thinking that many individuals working within the contemporary financial press hold the same view as Friedman (a restricted view of responsibilities, as noted above). The financial press continues to praise companies

for increased profitability and to criticise companies who are subject to falling profitability. They often do this with little or no regard to the social costs or social benefits (which are not directly incorporated within reported profit) generated by the operations of the entities concerned.

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 within the introductory accounting syllabus. 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’ (see Deegan 2020a for a different approach to the teaching of introductory accounting). 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 responsibility

and accountability. This linkage should always be considered. If we accept that an entity has a responsibility for its social and environmental performance, we, as accountants, should accept a duty to provide an ‘account’ of an organisation’s social and environmental performance. If we don’t accept this, then we won’t feel obliged to provide such an account.

At this point it would be useful to consider a definition of accountability. One commonly accepted definition of accountability is that 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.

As we can see, the linkage between ‘responsibilities’ and ‘accounting’ is explicit. The above definition of accountability is consistent with the definitions also provided by other researchers, for example:

∙ Accountability, as we use the term, implies that some actors have the right to hold other actors to a set of standards, to judge whether they have fulfilled their responsibilities in light of these standards, and to impose sanctions if they determine that these responsibilities have not been met (Grant and Keohane 2005, p. 29)

∙ The concept of accountability is a pervasive one  .  .  .  The notions underlying it are those of accounting for, reporting on, explaining and justifying activities, and accepting responsibility for the outcomes. Accountability involves an obligation to answer for one’s decisions and actions when authority to act on behalf of one party (the principal) is transferred to another (the agent) . . . Accountability requires openness, transparency and the provision of information, and the acceptance of responsibility for one’s actions (Barton 2006, pp. 257–8).

Consistent with the above definitions, according to Gray, Adams and Owen (2014), 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 definitions, 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 non-financial

social benefits Benefits generated by an entity for society, or a segment thereof, such as provision of education, clean water, safe products and health care.

accountability The duty to provide an account or reckoning of those actions for which one can be held responsible.

dee67382_ch32_1249-1332.indd 1259 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1259

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.

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 benefit of the owners, or in the ‘best interests’ of the company. For example, within Australia, the major guiding principle 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.

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. As an example, the prioritisation of profits is reflected in a newspaper article entitled ‘Social “purpose” must align with returns’ (James Eyers, The Australian Financial Review, 23 May 2019, p. 18), in which it was reported that Elizabeth Bryan, chairperson of IAG and Virgin Australia, believed that the consideration of a broader corporate purpose beyond profitability could ‘backfire’ if it was not linked to the main profit-making operations of an organisation. The article stated:

Ms Bryan said delivering strong shareholder returns should remain paramount. ‘You have to deliver to shareholders, you have to deliver the returns they expect. But you have got to do something on top of it—that is what society is saying to us. So, you have to find something that makes those two things reinforcing.’

Amid discussion on whether directors’ duties needed to change to make boards more accountable to employees and the wider community, Ms Bryan backed the positions of ANZ Bank chairman David Gonski and Westpac chairman Lindsay Maxsted that no change to the law was needed. Boards should ‘focus on profit, but you focus on long-term profit, not short-term profit,’ she said, which incorporated consideration of broad stakeholders.

You should perhaps reflect on the above comments from Bryan and consider whether corporate focus on profits (even ‘long-term profits’) will lead us on a path towards appropriately addressing the critical and immediate threats posed by problems such as climate change.

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 regardless of the implications for ‘long-term profits’? If sustainability is embraced, our current production patterns should not compromise the ability of future generations to satisfy their own needs. Such a view is being publicly embraced throughout the world by many organisations.

WHY DO I NEED TO KNOW ABOUT THE RELATIONSHIP BETWEEN ORGANISATIONS’ RESPONSIBILITIES, ACCOUNTABILITIES AND ACCOUNTING?

This is important as it helps us understand why managers of some organisations might report particular information, whereas others might not. The absence of particular accounts being reported potentially indicates to us that the managers do not believe they have an ‘accountability’ for particular aspects of performance, and this could be due to a belief by managers that they have no ‘responsibility’ with respect to particular aspects of social and environmental performance. Knowing about this relationship between responsibilities, accountabilities and accounting allows us to understand the context of particular corporate disclosures.

dee67382_ch32_1249-1332.indd 1260 10/25/19 01:46 PM

1260 PART 10: Corporate social-responsibility reporting

32.4 Evidence of public social and environmental reporting

Since the early 1990s, many Australian companies have increased their public disclosure of information about 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 social-responsibility 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.

One organisation that performs a regular survey of CSR reporting is the global accounting firm KPMG. The latest available survey results were released in 2017 (KPMG 2017). KPMG used two broad samples for its research. It surveyed the reporting practices of a global sample of 4900 companies, which was made up of the top 100 companies from 49 different countries (referred to as the N100 companies). It also surveyed the reporting practices of the world’s largest companies by revenue based on the Fortune 500 ranking of companies (referred to as the G250 companies). KPMG reports that 93 per cent of G250 companies and 75 per cent of N100 companies produce CSR reports. The leading countries are the United Kingdom, Japan, India, Malaysia, France, Denmark, South Africa and the United States, with reporting rates for the N100 companies in these countries ranging from 92 per cent to 99 per cent. Australia was ranked 27th, with a reporting rate of 77 per cent. For the minority of large companies that do not report, KPMG warns:

The one quarter of N100 companies in this year’s survey that are not reporting ignore sustainability at their peril. If they want to remain in business in the long term, they need to start thinking about it immediately. The first step is to start reporting internally. By considering the issues we’re facing globally and understanding how they could affect business models—both positively and negatively—these companies can adapt accordingly. If they don’t act, it’s unlikely they will remain in business. (KPMG 2017, p. 10)

Other findings within the KPMG 2017 survey reveal the following:

∙ Some industries have higher rates of reporting than others. For example, at the higher end of reporting, 81 per cent of N100 companies in the oil and gas and also chemicals sectors produce CSR reports, as do 80 per cent of N100 companies in the mining sector.

∙ The assurance of reports by independent third parties has increased in recent years. Sixty-seven per cent of G250 companies have their reports assured by independent third parties, while 45 per cent of N100 companies have their CSR reports assured.

∙ In terms of the most commonly used reporting framework, it was the GRI standards that were most commonly used. Seventy-five per cent of the G250 companies and 63 per cent of the N100 companies use the GRI standards as the basis of their reporting.

∙ Many of the companies—43 per cent of G250 companies and 39 per cent of N100 companies—link their CSR activities to the UN’s Sustainable Development Goals, which we will discuss later in this chapter.

∙ In relation to targets pertaining to climate change, the majority of G250 companies (67 per cent) disclose targets to cut their carbon emissions; 50 per cent of N100 companies also disclose these targets. We will discuss the important issue of climate change in more depth later in this chapter.

∙ Aside from producing information about carbon and other greenhouse gas (GHG) emissions, information about the business risks of climate change is also described as useful. In this regard, only 28 per cent of N100 companies and 48 per cent of G250 companies acknowledge this risk in their reports, something that is seen as somewhat disappointing by the authors of the report.

The KPMG report also highlights that, internationally, governments and securities exchanges are looking at increasing the regulation of CSR-related disclosures, and this will have obvious implications for increasing the amount of disclosures being made. Therefore, the evidence is clear. This focus of reporting is here to stay, and thus accountants and managers need to be very well aware of it!

LO 32.4

dee67382_ch32_1249-1332.indd 1261 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1261

32.5 The application of an ‘accountability model’

Having discussed the relationship between corporate responsibility, accountability and accounting (see Figure 32.1), we will now examine, in turn, what might be considered as a four-stage ‘accountability model’. As Deegan (2020a) explains, this linkage between responsibilities/values and accountability, and ultimately ‘accounting’, can be tied to the following four issues:

∙ Why provide an ‘account’? ∙ To whom is an ‘account’ to be provided? ∙ What is to be included in an ‘account’? ∙ How should an ‘account’ be prepared/presented?

Deegan (2020a, p. 20) provides a simple representation of this relationship, which is reproduced as Figure 32.2. For example, and applying the above four steps, if a judgement (grounded in certain ‘values’) is made from

a neoclassical economic perspective (for example, a ‘Friedmanite-type’ perspective), that ‘accounts’ of particular aspects of performance should be prepared only to the extent that the activity of preparing the accounts increases corporate profitability (the why? question), then the target audience of those reports might be those stakeholders with the power to influence the economic value of the organisation (the to whom? question)—for example, shareholders and providers of debt capital. In terms of what aspects of performance should be reflected in the ‘accounts’, in this scenario it would be likely that measures of economic/financial performance would be prioritised (the what to report? question), and the information would be supplied in financial reports prepared in accordance with a financial reporting

LO 32.5

Figure 32.2 A diagrammatic representation of a four-step accountability model

SOURCE: Deegan (2020a).

dee67382_ch32_1249-1332.indd 1262 10/25/19 01:46 PM

1262 PART 10: Corporate social-responsibility reporting

framework, such as that provided by the International Accounting Standards Board (in answer to the final how to report? question).

By contrast, if a contrary judgement is made that an organisation has a responsibility and associated accountability to a broader group of stakeholders in relation to economic, social and environmental performance (the why? report issue), then the audience of the reports would tend to be those stakeholders that are most affected (economically and/ or socially and/or environmentally) by the operations of the entity (the to whom? question), or the stakeholders that work/act in the interests of the affected stakeholders (for example, NGOs). Issues of stakeholder power would not be particularly pertinent in this ‘view of the world’. Continuing this example, in terms of the aspects of performance that would be reported within the accounts (the what to report? question), the information would tend to be prioritised in terms of the perceived (subjectively determined) importance of the various social, environmental and economic impacts. The information would be provided by virtue of frameworks beyond financial reporting, and which would enable impacts to be reported in a way (the how to report? question) that promotes further dialogue and improvement in an organisation’s social and environmental performance.

What is being demonstrated here, it is hoped, is that although we are applying the same four-step accountability model in both scenarios, and therefore the same four broad ‘steps’ in our decision making, we can nevertheless arrive at very different normative prescriptions about how an organisation should ‘account’ for its operations as a result of the different ‘world views’ that we might possess.

In the material that follows, we will structure our discussion around these four stages of the accountability model.

WHY DO I NEED TO KNOW ABOUT THE LOGIC BEHIND THE FOUR-STAGE ‘ACCOUNTABILITY MODEL’?

It is a simple model, but it does emphasise the factors that ultimately influence the decisions managers make with respect to reporting. For example, an organisation might fail to provide a report/account in relation to a particular facet of performance because managers believe they do not have a ‘responsibility’ to particular stakeholders with respect to that aspect of performance. In such a scenario, perhaps the decision to report information voluntarily is based on the goal of maximising the economic value of an organisation (this being the answer to the ‘why report?’ question), and therefore the information needs of low-power stakeholders will be ignored (which relates to the questions of ‘to whom to report?’ and ‘what to report?’).

32.6 Why report?

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

LO 32.6

dee67382_ch32_1249-1332.indd 1263 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1263

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. To answer the question of ‘why’ organisations might report, 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 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 legal 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 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. (AASB 116)

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 32.1.

AASB 137 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

dee67382_ch32_1249-1332.indd 1264 10/25/19 01:46 PM

1264 PART 10: Corporate social-responsibility reporting

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. (AASB 137)

Exhibit 32.1 Example of how AASB 137 is applied to environment-related 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.

SOURCE: AASB 137, Appendix C

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 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 32.2 provides the required disclosure from the Directors’ Report appearing in the 2019 Annual Report of BHP Group Ltd.

Exhibit 32.2 Example of disclosure required pursuant to Section 299(1)(f)—from the 2019 Annual Report of BHP Group Ltd

dee67382_ch32_1249-1332.indd 1265 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1265

Sections 1013A to 1013F 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

∙ 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 (released by ASIC) 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.

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.

Modern Slavery Act

At a national level, one very interesting and important development within Australia was the introduction of the Modern Slavery Act in 2018. This followed the introduction of similar legislation in 2015 within the United Kingdom.

‘Modern slavery’ refers to the use of human trafficking or forced labour that amounts to slavery, or slavery- like practices. According to the International Labour Organization (ILO) Forced Labour Convention, 1930 (No. 29), ‘forced or compulsory labour’ is all work or service that is exacted from any person under the threat of a penalty and for which the person has not offered himself or herself voluntarily.

SOURCE: BHP Group Ltd

dee67382_ch32_1249-1332.indd 1266 10/25/19 01:46 PM

1266 PART 10: Corporate social-responsibility reporting

Many Australian organisations source materials and products from the Asia-Pacific region, which is accepted as a high-risk area in terms of the use of forced labour and human trafficking. Indeed, estimates by the ILO suggest there are at least 12 million victims of forced labour in the Asia-Pacific region. The ILO also estimates that US$150 billion in illegal profits are generated annually through the use of ‘modern slaves’.

Apart from the immoral nature of such activity, there are many risks (which we might refer to as ‘reputational risks’) to an organisation if it is found to be associated with forced labour. For example, we can consider the vast amount of negative publicity the leading surf company Rip Curl received back in 2016. In one related newspaper article entitled ‘Surf clothing label Rip Curl using “slave labour” to manufacture clothes in North Korea’ (by Nick McKenzie and Richard Baker, Sydney Morning Herald, 20 February 2016), it was noted:

In a major embarrassment that raises serious questions about Rip Curl’s garment sourcing practices, a Fairfax Media investigation can reveal that workers at the Taedonggang Clothing Factory near the North Korean capital Pyongyang were contracted to make some of Rip Curl’s 2015 winter range of clothing. Workers in North Korea are routinely exploited. North Korean defectors have told investigators from NGOs, including Human Rights Watch, that employees are forced to work long hours with minimal or sometimes no pay. Workers who do not obey orders are imprisoned in work camps. After Fairfax Media sent Rip Curl photos of its garments being made in North Korea, the company’s chief financial officer Tony Roberts released a statement that said the firm ‘takes its social compliance obligations seriously’. ‘We were aware of this issue, which related to our Winter 2015 Mountain-wear range, but only became aware of it after the production was complete and had been shipped to our retail customers.’

Such publicity would have been extremely detrimental to the organisation’s reputation (which is effectively based on a healthy sporting image) and this would likely have had an impact on its profitability. That is, consumers and the market would have potentially punished the company for its apparent link to forced labour—which is the rationale for the government introducing the Modern Slavery Act. The Act aims, through corporate disclosures, to necessarily create awareness within organisations about where they are sourcing their goods from, and how employees in those supply chains are being treated (thereby hopefully averting situations like that in which Rip Curl got embroiled), as well as informing consumers and the public more widely about an organisation’s sourcing policies.

Within Australia, the Modern Slavery Act applies to larger organisations, specifically those with annual consolidated revenue of $100 million or more. It requires organisations to report annually—by way of a ‘Modern Slavery Statement’—on the steps they are taking, across their supply chains, to address and monitor the risk that modern slavery is present within their supply chains. Specifically, paragraph Section 16 of the Act requires:

This Part requires modern slavery statements to be given annually to the Minister, describing the risks of modern slavery in the operations and supply chains of reporting entities and entities owned or controlled by those entities.

The statements must also include information about actions taken to address those risks. Mandatory criteria for modern slavery statements

(1) A modern slavery statement must, in relation to each reporting entity covered by the statement: (a) identify the reporting entity; and (b) describe the structure, operations and supply chains of the reporting entity; and (c) describe the risks of modern slavery practices in the operations and supply chains of the reporting entity,

and any entities that the reporting entity owns or controls; and (d) describe the actions taken by the reporting entity and any entity that the reporting entity owns or controls,

to assess and address those risks, including due diligence and remediation processes; and (e) describe how the reporting entity assesses the effectiveness of such actions; and (f) describe the process of consultation with: (i) any entities that the reporting entity owns or controls; and (ii) in the case of a reporting entity covered by a statement under section 14—the entity giving the

statement; and (g) include any other information that the reporting entity, or the entity giving the statement, considers

relevant. Example: For paragraph (d), actions taken by an entity may include the development of policies and processes to address modern slavery risks, and providing training for staff about modern slavery.

(Sourced from the Federal Register of Legislation at September 2019. For the latest information on Australian Government law please go to https://www.legislation.gov.au.)

The ‘modern slavery statement’ must be signed off by a nominated person in the peak governing body of the entity (such as the Board of Directors), thereby ensuring that the information is directly brought to the attention of the most

dee67382_ch32_1249-1332.indd 1267 11/01/19 12:40 PM

CHAPTER 32: Accounting for corporate social responsibility 1267

senior people within an organisation. The Act does not apply any penalties to organisations for information uncovered and disclosed as a result of the audits of their supply chains. As already noted, the intention is to leave it to ‘the market’ and consumers to punish perceived poor behaviour. However, this relies upon key assumptions that:

∙ consumers actually want to be aware of such information, and ∙ they will then act negatively towards organisations that are associated with modern slavery.

That is, the intended impacts of the Act rely on concerns managers have about their ‘reputational risk’—wherein reputational risk can be considered to relate to the potential of negative publicity, or negative public perceptions, to create adverse impacts on a company’s reputation, thereby affecting its revenue streams, and therefore its profitability. The further assumption here is that managers, being concerned about their reputational risk, will take actions to ensure that elements of modern slavery are not in existence within their supply chains and this ultimately will lead to a reduced incidence of modern slavery throughout the world.

Because Australia imports many products from high-risk areas, the central tenet of the Australian Government’s initiative is that the buying power of Australian organisations is sufficiently large that it can be utilised to create positive social change. However, it is not always obvious that this ‘reputational risk’ exists for all organisations. That is, it is not at all clear that all organisations are subject to the same levels of reputational risk, and some organisations are likely to be more reliant on their reputation and image than others. For example, throughout 2019 there were many newspaper and television stories about Australian casinos allegedly being linked to organised crime (with some of the associated people being linked to forced labour) and money laundering, but there was no clear impact on their profitability.

All modern slavery statements are to be submitted to a government-backed repository, meaning that the publicly available reports shall all be accessible at one place.

According to CPA Australia (2019, p. 12), some of the consequences of the new modern slavery laws would include:

∙ managers revising their governance policies and developing revised policies and action plans, including updating or initiating supplier codes of conduct

∙ implementing systematic reviews of human rights issues in procurement processes, tender processes and contractual terms (including supplier pre-qualification processes)

∙ establishing targets and key performance indicators, internal awareness raising and training in the firm and with key or high-risk suppliers.

The legislation does not actually define ‘supply chains’ and it has effectively been left to organisations to self-define their ‘supply chain’. Research reported in CPA (2019) reveals that the majority of firms appear to be interpreting it very narrowly to mean suppliers with which they have a ‘direct payment relationship’. It is hoped that this interpretation will broaden over time, but nevertheless it does require self-analysis by organisations in terms of what they consider to be their ‘supply chain’.

The effectiveness of the Act relies upon firms organising or commissioning appropriate auditing and monitoring processes throughout supply chains. For example, organisations will need to arrange audits within suppliers’ factories throughout various developing countries and to report the results of such audits. However, legislators and others need to be aware of the available evidence, which casts significant doubt over the robustness or objectivity of such audits, before, perhaps naively, simply believing the information being produced by apparently independent third- party auditors/assurance providers. In an in-depth investigation of compliance audits undertaken of the supply chains of multinational corporations (MNCs) in the context of the Bangladesh garments industry, Islam, Deegan and Gray (2018, p. 214) report:

What seems to have emerged is a complex interplay of motives, assumptions and influences. The actual conduct of a social compliance audit is predominantly a requirement instituted by the MNC as a pre-condition of the supply contract. There is very little evidence that, all things being equal, the MNCs exert much in the way of resources or effort to assess the reliability of these audits which appear to have a symbolic role and allow the MNC to continue to make claims that appear to play well with western consumers . . . Consequently, the audits are generally of a cursory nature and we found little evidence that they make much constructive impact on the lives of workers and communities. Such accountability as is owed to the relatively powerless workers and communities remains largely undischarged . . . Thus, a social compliance audit becomes a ritualistic practice that supports MNCs’ maintenance of legitimacy to the wider community rather than creating real accountability. (ISLAM, M.A., DEEGAN, C. & GRAY, R., (2018) Reprinted by permission of the publisher, Taylor & Francis Ltd, http://www.tandfonline.com)

Hence, as with all reported information, we must always be careful not to necessarily be naive and believe everything we read. We must consider the reputation of the parties involved in gathering and reporting the information, as well as the potential motivations for introducing an element of bias into the reported information.

dee67382_ch32_1249-1332.indd 1268 10/25/19 01:46 PM

1268 PART 10: Corporate social-responsibility reporting

National Pollutant Inventory

At a national level within Australia 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. Again, this is very similar to the rationale behind the development of the Modern Slavery Act, as just discussed. 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 Energy Data Officer may choose to publish such information for each member or business unit of the group. According to the website (www.cleanenergyregulator.gov.au, accessed October 2019):

The National Greenhouse and Energy Reporting (NGER) scheme, established by the National Greenhouse and Energy Reporting Act 2007 (NGER Act), is a single national framework for reporting and disseminating company information about greenhouse gas emissions, energy production, energy consumption and other information specified under NGER legislation.

The objectives of the NGER scheme are to: ∙ inform government policy ∙ inform the Australian public ∙ help meet Australia’s international reporting obligations ∙ assist Commonwealth, state and territory government programmes and activities, and ∙ avoid duplication of similar reporting requirements in the states and territories.

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?).

dee67382_ch32_1249-1332.indd 1269 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1269

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, 4th edition (released February 2019). 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 ASX 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 environmental or social 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 environmental and social 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, 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.

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. It should be noted that there are some countries that have been a lot more proactive in mandating greater amounts of public social and environmental reporting (for example, France, Denmark, Norway, South Africa). However, 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. 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

dee67382_ch32_1249-1332.indd 1270 10/25/19 01:46 PM

1270 PART 10: Corporate social-responsibility reporting

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 thought that ‘enlightened self-interest’ is the panacea for improving social and environmental performance 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 Continuing our discussion of ‘why’ organisations might report, 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 the Code of Environmental 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 organisation 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 (which for many years has been the dominant theory in social and environmental accounting—see Deegan 2020b), 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.

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’s Sustainability Report 2018 states (p. 4):

Transparency and accountability are fundamental to trust. It is trust that underpins the social contract in which corporations, governments and communities agree to work together for our mutual best interest. Without transparency, there cannot be accountability for sharing the proceeds of wealth and fair distribution of taxes.

social contract Considered to be an implied contract constituted by the expectations that society holds about the conduct of an organisation.

dee67382_ch32_1249-1332.indd 1271 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1271

Similarly, the 2018 Shell Sustainability Report (p. 77) notes:

Shell aims to work with contractors and suppliers that behave in an economically, environmentally and socially responsible manner. Our approach to suppliers and contractors is clearly set out in our Shell General Business Principles and Shell Supplier Principles. These principles cover requirements such as business integrity, health and safety, and human rights. Working with suppliers and contractors in this way is central to maintaining a strong societal licence to operate.

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. Legitimacy Theory posits that the organisation must appear to consider the rights of the public at large, not merely those of its investors.

Consequently, organisations 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 organisations 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.

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

dee67382_ch32_1249-1332.indd 1272 10/25/19 01:46 PM

1272 PART 10: Corporate social-responsibility reporting

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 news 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 news 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 news 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 news media do shape community expectations and that corporate disclosures of environmental performance information are one way to correct ‘misperceptions’ held or presented by the news 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.

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 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 news media attention devoted to particular issues) functions to elicit particular disclosure reactions from the company. The underlying proposition was that changes in society’s 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 news 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 news media in influencing corporate disclosure policies and underline the dilemma that unless community concerns are somehow raised (perhaps by the news 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 news 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.

And in a study of the social disclosures of Australian companies involved in the gambling industry, Loh, Deegan and Inglis (2015) showed that the disclosures appeared to react to increasing community concerns about ‘problem gambling’. Specifically, in periods in which there were major government inquiries into problem gambling and greater

dee67382_ch32_1249-1332.indd 1273 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1273

attention was therefore being focused on it, it was found that the companies’ social disclosures increased across a variety of social responsibility-related issues other than just problem gambling. They state (p. 816):

We surmise that this is potentially part of a corporate strategy to deflect attention away from problem gambling— which was the major focus of the inquiries and the related submissions—and towards other social issues with which the companies could be favourably portrayed. As the disclosures seemed to increase across the same period in which government scrutiny of gambling was increasing, and because of the predominantly positive nature of the disclosures, we believe the disclosures have little to do with demonstrating accountability, but more to do with securing corporate legitimacy.

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 Another reason why managers might voluntarily disclose information is that it might be a way of managing or controlling particular stakeholders. 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) 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.

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

dee67382_ch32_1249-1332.indd 1274 10/25/19 01:46 PM

1274 PART 10: Corporate social-responsibility reporting

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. More specifically, 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

dee67382_ch32_1249-1332.indd 1275 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1275

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 self-interest 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 has an accountability 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.

WHY DO I NEED TO KNOW ABOUT SOME OF THE POTENTIAL REASONS THAT MIGHT BE DRIVING AN ORGANISATION TO DISCLOSE SOCIAL AND ENVIRONMENTAL INFORMATION?

This is important because it allows us to understand the context of the disclosures. If, for example, we believe that the managers of an organisation are disclosing information simply to improve the image and profitability of an organisation, we might be less inclined to believe such disclosures.

32.7 To whom will the organisation report?

As Figure 32.2 shows, 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 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

LO 32.7

social audit A process whereby an enterprise can account for its performance against its social objectives and report on that performance to evaluate observance of the principles of accountability.

dee67382_ch32_1249-1332.indd 1276 10/25/19 01:46 PM

1276 PART 10: Corporate social-responsibility reporting

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.

32.8 What information shall be reported?

As we have just learned, in determining what information to produce (which is the third stage in the accountability model—see Figure 32.2), we have to consider ‘to whom’ we are going to direct the disclosures (which is stage

2 in the accountability model). 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 is to review share price reactions to particular disclosures. That is, to undertake capital markets research. The underlying theory used in such research is based upon the use of the efficient-markets hypothesis, which proposes that the information content of news announcements, if relevant to the marketplace (investors), will be immediately and unbiasedly impounded within share prices. That is, if an item of information about an organisation can be associated with a change in the share price of that organisation, it is assumed that the information is of importance to investors and they have reacted to the disclosure of the information (with the reaction being reflected by the change in share price). For example, in a study that explored the capital market’s reactions to greenhouse gas disclosures, Griffin, Lont and Sun (2017) provided evidence which indicated that share prices react negatively to greenhouse gas emission disclosures, with greater levels of emissions being linked to greater levels of negative movements in share prices. Numerous other studies (for example, Ingram 1978; Anderson & Frankle 1980; Belkaoui 1976; Jaggi & Freedman 1982; Griffin & Sun

2012; Brooks & Oikonomou 2018) have also shown that investors do react to the release of corporate social and environmental performance information. Hence, as a group, investors appear to find such information ‘useful’.

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.

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

LO 32.8

efficient-markets hypothesis A hypothesis holding that the market price of a particular security is directly affected by all relevant information that is publicly available to the market. The hypothesis assumes that the market is efficient in disseminating information.

dee67382_ch32_1249-1332.indd 1277 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1277

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 & Unerman 2009). However, as Unerman & Bennett (2004) have contended, because access to the internet 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

dee67382_ch32_1249-1332.indd 1278 10/25/19 01:46 PM

1278 PART 10: Corporate social-responsibility reporting

(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.

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. 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.

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. 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, and as discussed earlier, many organisations are also now demanding that suppliers provide them with details of their social and environmental performance prior to entering supply arrangements.

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.

32.9 How (and where) will the information be presented?

The next and final step in our four-stage accountability model (see Figure 32.2) is the issue of ‘how to report?’ social and environmental information. 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 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, such as the Global Reporting Initiative’s Sustainability Reporting Standards.

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

LO 32.9

dee67382_ch32_1249-1332.indd 1279 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1279

limitations of generally accepted accounting principles, which act 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 at paragraph 1.2 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 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 contribute to such social costs.

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

dee67382_ch32_1249-1332.indd 1280 10/25/19 01:46 PM

1280 PART 10: Corporate social-responsibility reporting

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, expenses are defined as follows:

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

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

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

The recognition of assets therefore relies upon control. Environmental resources such as air and water are shared and not controlled by the organisation and hence cannot be considered to be ‘assets’. Therefore, their use and/or abuse are not considered expenses. As we know, the recognition of an expense arises at the same time as:

1. the initial recognition of a liability, or an increase in the carrying amount of a liability, or 2. the derecognition of an asset, or a decrease in the carrying amount of an asset.

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. Consider the following extract from a newspaper article by Sarah Danckert entitled ‘New NAB boss to ramp up cost- cutting’ that appeared in The Age on 20 July 2019:

National Australia Bank’s incoming boss Ross McEwan has signaled plans to ramp up a massive transformation program than includes thousands of job cuts, which the troubled bank hopes will return it to success.

As we can see here, the newspaper article equates the slashing of thousands of jobs with ‘cost-cutting’ and ‘success’. 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.

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 (ETS) (such as the ‘cap and trade’ approach that we will discuss later in the chapter) and carbon taxes in some countries will mean that carbon emissions will be priced, typically, on the basis of tonnes of

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.

dee67382_ch32_1249-1332.indd 1281 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1281

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.

Worked Example 32.2 considers how the release of chemicals by an organisation might have no impact on reported profits.

WORKED EXAMPLE 32.2: The recognition of social and environmental costs

Organisations have for many years been emitting numerous chemicals into the atmosphere and this has created various negative environmental impacts, including climate change.

REQUIRED Does the release of the chemicals impact the emitting organisation’s profits? If not, why not?

SOLUTION The release of chemicals into the atmosphere has no direct impact on the organisation’s financial reports (although, in the longer run, a heavily polluting company might lose demand for its goods and services and this might ultimately affect profits). This is because of the way we define the elements of accounting. The atmosphere is not controlled, and therefore it is not an ‘asset’ of the organisation. An expense occurs when an asset declines in value. While the environment might be negatively impacted, it is not an asset, and thus no ‘expense’ is recognised and ‘profit’ is not directly impacted.

The recognition criteria of ‘measurability’ and ‘probability’ The Conceptual Framework also provides recognition criteria for the elements of financial reporting. As we know from previous chapters, for a transaction or event to be recognised within the financial statements there is a requirement within the Conceptual Framework that:

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

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

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

Hence, for all the five elements of financial accounting, both probability and measurability are key considerations. Evidence suggests that many 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.

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 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. (AASB 137)

dee67382_ch32_1249-1332.indd 1282 10/25/19 01:46 PM

1282 PART 10: Corporate social-responsibility reporting

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. (AASB 137)

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 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.

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 news 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 organisation 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).

dee67382_ch32_1249-1332.indd 1283 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1283

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 AASB 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. (AASB 137)

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. 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.

dee67382_ch32_1249-1332.indd 1284 10/25/19 01:46 PM

1284 PART 10: Corporate social-responsibility reporting

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 as it is currently practised 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, in considering the fourth step of the accountability model represented in Figure 32.2—this being ‘how’ to report—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 and in the balance of this chapter we will consider some alternative frameworks/approaches to reporting social and environmental information.

WHY DO I NEED TO KNOW ABOUT THE LIMITATIONS THAT GENERALLY ACCEPTED FINANCIAL REPORTING PRINCIPLES HAVE WITH RESPECT TO ACCOUNTING FOR THE SOCIAL AND ENVIRONMENTAL IMPACTS OF AN ORGANISATION?

The most visible performance measure of an organisation is its ‘profits’, and this is a measure that, for larger organisations, is frequently referred to in the news media as an indicator of ‘success’, or as a rationale for organisations to pursue particular strategies (such as job cuts in times of low ‘profits’). However, ‘profits’ do not take account of many of the social and environmental ‘costs’ (or benefits) generated by organisations. Therefore, once we know this we will be more cautious about interpreting the meaning of ‘profits’ in terms of it being an indicator of organisational ‘success’.

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

dee67382_ch32_1249-1332.indd 1285 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1285

has taken a dominant position in the social and environmental (and sustainability) reporting domain is the Global Reporting Initiative’s Sustainability Reporting Standards*.

GRI has been releasing new/revised guidance for over 20 years. Its most recent guidance (at the time of writing) is the Sustainability Reporting Standards. These are freely available on the GRI website. You can also watch a video on YouTube that introduces the standards (visit youtube.com/watch?v=AGqE4OO0_7g).

According to the GRI website (see globalreporting.org as accessed in October 2019): the GRI Standards enable all organizations to report publicly on their economic, environmental and social impacts— and show how they contribute towards sustainable development. The GRI Standards are also a trusted reference for policy makers and regulators, and have a modular structure so they can be kept up-to-date and relevant.

In relation to use of its reporting standards, the GRI website further states: Sustainability reports are released by companies and organizations of all types, sizes and sectors, from every corner of the world. Thousands of companies across all sectors have published reports that reference GRI’s Sustainability Reporting Guidelines. Public authorities and non-profits are also big reporters. GRI’s Sustainability Disclosure Database features all known GRI-based reports.

The GRI standards identify a number of reporting principles that organisations should embrace, together with the disclosures that organisations are expected to make. In terms of the format of the disclosures, the GRI website notes:

A report in accordance with the GRI Standards can be produced as a stand-alone sustainability report, or can reference information disclosed in a variety of locations and formats (e.g., electronic or paper-based). Any report prepared in accordance with the GRI Standards is required to include a GRI content index, which is presented in one location and includes the page number or URL for all disclosures reported.

The GRI standards are generally accepted by many people (but not all people) as representing current ‘best practice’ for sustainability reporting. They are structured as a set of interrelated standards. An overview of the GRI standards is presented in Exhibit 32.3.

Exhibit 32.3 The structure of the GRI standards framework

SOURCE: Global Reporting Initiative (2016). GRI 101: Foundation 2016, p 3. www.globalreporting.org/standards/media/1036/ gri-101-foundation-2016.pdf, accessed September 2019.

*Global Reporting Initiative (GRI) is the independent international organisation—headquartered in Amsterdam with regional offices around the world—that helps businesses, governments and other organisations understand and communicate their sustainability impacts.

dee67382_ch32_1249-1332.indd 1286 10/25/19 01:46 PM

1286 PART 10: Corporate social-responsibility reporting

Referring to Exhibit 32.3, we can see that the GRI 101: Foundation standards are the starting point for using the full set of GRI standards. GRI 101 includes the principles that need to be adopted by reporters in relation to report content and quality. These reporting principles are fundamental to achieving high-quality sustainability reporting. According to the GRI website:

The Reporting Principles for defining report content help organizations decide which content to include in the report. This involves considering the organization’s activities, impacts, and the substantive expectations and interests of its stakeholders.

The Reporting Principles for defining report quality guide choices on ensuring the quality of information in a sustainability report, including its proper presentation. The quality of information is important for enabling stakeholders to make sound and reasonable assessments of an organization, and to take appropriate actions.

The principles are divided into two groups: principles for defining report content, and principles for defining report quality. These are summarised in Table 32.1.

Reporting principles for defining report content  In relation to the principles for defining report content identified above, we can summarise these as follows (remember that the following information, when included within a sustainability report, will help to put in context the rest of the information being provided by an organisation):

∙ Stakeholder inclusiveness—The organisation shall describe the stakeholders to whom it believes it is accountable, together with information about how it identified the stakeholders, and their respective views and expectations (as we noted earlier in this chapter, identifying ‘who’ the identified stakeholders are is also an important element of our ‘accountability model’).

∙ Sustainability context—The organisation shall explain how it interprets the concept of sustainable development for the purposes of its operations, and will describe its performance in the context of the environments and societies in which it operates, as well as within the context of national and/or international social and environmental goals. The organisation shall be clear about how its operations can, and do, influence/affect the communities/environments within which it operates.

∙ Materiality—This  is the principle that determines which topics are sufficiently important for it to be essential that the organisation reports on them. The organisation shall clearly identify why it has decided to report the information it reports. That is, the organisation is to explain the process by which it determined the priority of the topics that are reported. The determination of materiality, and therefore the decision to report particular information, will be influenced by a variety of factors, including the organisation’s mission, competitive strategy, stakeholder concerns, and international standards and agreements.

∙ Completeness—The goal is to provide a balanced and reasonable representation of the organisation’s economic, environmental and social impacts. The topics covered in the report are expected to be sufficient to reflect the organisation’s significant economic, environmental and/or social impacts, and to enable stakeholders to assess and evaluate the organisation. In determining whether the information in the report is sufficient, the organisation considers both the results of stakeholder engagement processes and broad-based societal expectations that are not identified directly through stakeholder engagement processes. An organisation preparing a report in accordance with the GRI standards is expected to report not only on the impacts it causes, but also on the impacts it contributes to, and the impacts that are directly linked to its activities, products or services through a business relationship.

The concept of materiality referred to above is very important. As we have indicated elsewhere in this book, information is considered to be material if it is likely to impact the decisions that stakeholders make about an

Reporting principles for defining report content Reporting principles for defining report quality

Stakeholder inclusiveness Accuracy

Sustainability context Balance

Materiality Clarity

Completeness Comparability

Reliability

Timeliness

SOURCE: Global Reporting Initiative (2016). GRI 101: Foundation 2016, p 7. (www.globalreporting.org/standards/ media/1036/gri-101-foundation-2016.pdf, accessed September 2019.)

Table 32.1 An overview of the GRI reporting principles

dee67382_ch32_1249-1332.indd 1287 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1287

organisation. That is, it is relevant. Determining whether particular items of information might be important to stakeholders requires an organisation to engage with stakeholders to determine what information they would prefer the organisation to disclose. This process is often referred to as a ‘materiality determination process’ (see Worked Example 32.3).

Apart from the reporting principles for defining report content, GRI 101 also identifies a number of reporting principles for defining report quality—these are also summarised in Table 32.1. The quality of information is considered important in that it enables stakeholders to make sound and reasonable assessments of an organisation, and to take appropriate actions. Table 32.2 provides an additional explanation of the qualitative characteristics that are expected to be satisfied if information is going to prove useful to its readers.

WORKED EXAMPLE 32.3: The importance of disclosing information about the materiality determination process

Information about the ‘materiality determination process’ within an organisation outlines the processes that the managers of an organisation establish to determine which items of information are considered important enough to disclose and, conversely, why other information is excluded from reports.

REQUIRED What are the benefits to report readers of knowing about the materiality determination process utilised by an organisation?

SOLUTION Where the disclosure of information is predominantly voluntary—as is the case with much social and environmental information—it would be reasonable for readers to question the logic, or merit, of why particular information was, or was not, disclosed. If managers are able to provide a clear, overall rationale for why particular information was deemed important enough to disclose, then even though readers might not agree with the materiality determination processes that the managers have employed, the disclosure about the processes should enable the readers to better understand the context for why some information is reported and other information is not, and this should increase the understandability of the report.

Principle Description

Accuracy The reported information shall be sufficiently accurate and detailed for stakeholders to assess the reporting organisation’s performance.

Balance The reported information shall reflect positive and negative aspects of the reporting organisation’s performance to enable a reasoned assessment of overall performance.

Clarity The reporting organisation shall make information available in a manner that is understandable and accessible to stakeholders using that information.

Comparability The reporting organisation shall select, compile and report information consistently. The reported information shall be presented in a manner that enables stakeholders to analyse changes in the organisation’s performance over time, and that could support analysis relative to other organisations.

Reliability The reporting organisation shall gather, record, compile, analyse and report information and processes used in the preparation of the report in such a way that they can be subject to examination, and that establishes the quality and materiality of the information.

Timeliness The reporting organisation shall report on a regular schedule so that information is available in time for stakeholders to make informed decisions.

SOURCE: Global Reporting Initiative (2016). GRI 101: Foundation 2016, p 13-16. (www.globalreporting.org/standards/ media/1036/gri-101-foundation-2016.pdf, accessed 4 October 2019.)

Table 32.2 Principles for defining report quality as per the GRI

If we look at the attributes (or qualitative characteristics) that the GRI suggests the sustainability-related information should have, we will see that these are similar to the qualitative characteristics identified in the Conceptual Framework for Financial Reporting as discussed in Chapter 2. That is, the principles and qualitative characteristics described in Table 32.2 are very similar to the qualitative characteristics that are typically promoted in relation to financial reporting.

dee67382_ch32_1249-1332.indd 1288 10/25/19 01:46 PM

1288 PART 10: Corporate social-responsibility reporting

A review of Exhibit 32.3 shows that, once we have considered GRI 101, we then need to consider GRI 102 and GRI 103. We will not cover these two standards in depth (for interested readers, these two standards are freely accessible on the GRI website), but briefly:

∙ GRI 102: General Disclosures is used to report contextual information about an organisation and its sustainability reporting practices. This includes information about an organisation’s profile, strategy, ethics and integrity, governance, stakeholder engagement practices and reporting process.

∙ GRI 103: Management Approach is used to report information about how an organisation manages a material topic. It is designed to be used for each material topic in a sustainability report, including those covered by the topic-specific GRI standards (series 200, 300 and 400) and other material topics.

The GRI 200, 300 and 400 series include numerous topic-specific standards. These are used to report information on an organisation’s impacts related to economic, environmental and social topics.

Tables 32.3, 32.4 and 32.5 summarise the various GRI standards, and the respective disclosures of economic, social or environmental information required by them. The standards to be applied by an organisation will be determined by whether the managers believe that the respective topics are material in the context of the organisation’s operations. Review these tables and consider whether you believe the various items of information would be relevant to you if you wanted to assess the ‘performance’ of an organisation.

GRI standards Topic-specific disclosures

GRI 201—Economic performance

Disclosure 201-1: Direct economic value generated and distributed Disclosure 201-2: Financial implications and other risks and opportunities due to

climate change Disclosure 201-3: Defined benefit plan obligations and other retirement plans Disclosure 201-4: Financial assistance received from government

GRI 202—Market presence

Disclosure 202-1: Ratios of standard entry-level wage by gender compared with local minimum wage

Disclosure 202-2: Proportion of senior management hired from the local community

GRI 203—Indirect economic impacts

Disclosure 203-1: Infrastructure investments and services supported Disclosure 203-2: Significant indirect economic impacts

GRI 204—Procurement practices

Disclosure 204-1: Proportion of spending on local suppliers

GRI 205—Anti- corruption

Disclosure 205-1: Operations assessed for risks related to corruption Disclosure 205-2: Communication and training about anti-corruption policies and

procedures Disclosure 205-3: Confirmed incidents of corruption and actions taken

GRI 206—Anti- competitive behaviour

Disclosure 206-1: Legal actions for anti-competitive behaviour, anti-trust and monopoly practices

SOURCE: Global Reporting Initiative, 2018, GRI Standards Glossary, p. 2 (www.globalreporting.org/standards/media/1913/ gri-standards-glossary.pdf accessed September 2019.)

Table 32.3 Topic-specific standards: GRI 200—economic

GRI standards Topic-specific disclosures

GRI 301—Materials Disclosure 301-1: Materials used by weight or volume Disclosure 301-2: Recycled input materials used Disclosure 301-3: Reclaimed products and their packaging materials

GRI 302—Energy Disclosure 302-1: Energy consumption within the organisation Disclosure 302-2: Energy consumption outside of the organisation Disclosure 302-3: Energy intensity Disclosure 302-4: Reduction of energy consumption Disclosure 302-5: Reduction in energy requirements of products and services

GRI 303—Water Disclosure 303-1: Interactions with water as a shared resource Disclosure 303-2: Management of water discharge-related impacts Disclosure 303-3: Water withdrawal

Table 32.4 Topic-specific standards: GRI 300—environmental

dee67382_ch32_1249-1332.indd 1289 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1289

GRI standards Topic-specific disclosures

GRI 304—Biodiversity Disclosure 304-1: Operational sites owned, leased, managed in, or adjacent to, protected areas and areas of high biodiversity value outside protected areas

Disclosure 304-2: Significant impacts of activities, products and services on biodiversity

Disclosure 304-3: Habitats protected or restored Disclosure 304-4: IUCN Red List species and national conservation list species with

habitats in areas affected by operations

GRI 305—Emissions Disclosure 305-1: Direct (Scope 1) GHG emissions Disclosure 305-2: Energy indirect (Scope 2) GHG emissions Disclosure 305-3: Other indirect (Scope 3) GHG emissions Disclosure 305-4: GHG emissions intensity Disclosure 305-5: Reduction of GHG emissions Disclosure 305-6: Emissions of ozone-depleting substances Disclosure 305-7: Nitrogen oxides (NOX), sulfur oxides (SOX) and other significant

air emissions

GRI 306—Effluents and wastes

Disclosure 306-1: Water discharge by quality and destination Disclosure 306-2: Waste by type and disposal method Disclosure 306-3: Significant spills Disclosure 306-4: Transport of hazardous waste Disclosure 306-5: Water bodies affected by water discharges and/or run-off

GRI 307— Environmental compliance

Disclosure 307-1: Non-compliance with environmental laws and regulations

GRI 308—Supplier environmental assessment

Disclosure 308-1: New suppliers that were screened using environmental criteria Disclosure 308-2: Negative environmental impacts in the supply chain and

actions taken

SOURCE: Global Reporting Initiative, 2018, GRI Standards Glossary, p. 2 (www.globalreporting.org/standards/media/1913/ gri-standards-glossary.pdf accessed September 2019.)

GRI standards Topic-specific disclosures

GRI 401—Employment Disclosure 401-1: New employee hires and employee turnover Disclosure 401-2: Benefits provided to full-time employees that are not provided to

temporary or part-time employees Disclosure 401-3: Parental leave

GRI 402—Labour/ management relations

Disclosure 402-1: Minimum notice periods regarding operational changes

GRI 403— Occupational health and safety

Disclosure 403-1: Occupational health and safety management system Disclosure 403-2: Hazard identification, risk assessment, and incident investigation Disclosure 403-3: Occupational health services Disclosure 403-4: Worker participation, consultation, and communication on

occupational health and safety

GRI 404—Training and education

Disclosure 404-1: Average hours of training per year per employee Disclosure 404-2: Programs for upgrading employee skills and transition assistance

programs Disclosure 404-3: Percentage of employees receiving regular performance and

career development reviews

GRI 405—Diversity and equal opportunity

Disclosure 405-1: Diversity of governance bodies and employees Disclosure 405-2: Ratio of basic salary and remuneration of women to men

GRI 406—Non- discrimination

Disclosure 406-1: Incidents of discrimination and corrective actions taken

Table 32.5 Topic-specific standards: GRI 400—social

continued

dee67382_ch32_1249-1332.indd 1290 10/25/19 01:46 PM

1290 PART 10: Corporate social-responsibility reporting

GRI standards Topic-specific disclosures

GRI 407—Freedom of association and collective bargaining

Disclosure 407-1: Operations and suppliers in which the right to freedom of association and collective bargaining may be at risk

GRI 408—Child labour Disclosure 408-1: Operations and suppliers at significant risk for incidents of child labour

GRI 409—Forced or compulsory labour

Disclosure 409-1: Operations and suppliers at significant risk for incidents of forced or compulsory labour

GRI 410—Security practices

Disclosure 410-1: Security personnel trained in human rights policies or procedures

GRI 411—Rights of indigenous people

Disclosure 411-1: Incidents of violations involving rights of indigenous peoples

GRI 412—Human rights assessment

Disclosure 412-1: Operations that have been subject to human rights reviews or impact assessments

Disclosure 412-2: Employee training on human rights policies or procedures Disclosure 412-3: Significant investment agreements and contracts that include

human rights clauses or that underwent human rights screening

GRI 413—Local communities

Disclosure 413-1: Operations with local community engagement, impact assessments and development programs

Disclosure 413-2: Operations with significant actual and potential negative impacts on local communities

GRI 414—Supplier social assessment

Disclosure 414-1: New suppliers that were screened using social criteria Disclosure 414-2: Negative social impacts in the supply chain and actions taken

GRI 415—Public policy Disclosure 415-1: Political contributions

GRI 416—Customer health and safety

Disclosure 416-1: Service categories Disclosure 416-2: Incidents of non-compliance concerning the health and safety

impacts of products and services

GRI 417—Marketing and labelling

Disclosure 417-1: Requirements for product and service information and labelling Disclosure 417-2: Incidents of non-compliance concerning product and service

information and labelling Disclosure 417-3: Incidents of non-compliance concerning marketing

communications

GRI 418—Customer privacy

Disclosure 418-1: Substantiated complaints concerning breaches of customer privacy and loss of customer data

GRI 419— Socioeconomic compliance

Disclosure 419-1: Non-compliance with laws and regulations in the social and economic area

SOURCE: Global Reporting Initiative, 2018, GRI Standards Glossary, p. 2 (www.globalreporting.org/standards/media/1913/ gri-standards-glossary.pdf accessed September 2019.)

Apart from the above disclosure items, which could arguably apply to most industries, the GRI provides additional guidance—referred to as ‘sector supplements’—for organisations operating within particular industry sectors. Sector supplements have been prepared for:

∙ airport operators ∙ construction and real estate ∙ electric utilities ∙ event organisers ∙ financial services ∙ food processing ∙ media ∙ mining and metals ∙ NGOs ∙ oil and gas.

Table 32.5 continued

dee67382_ch32_1249-1332.indd 1291 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1291

Interested students are encouraged to visit the website of the GRI to review the sustainability standards, and sector supplements, for themselves. Again, the GRI standards are applied by many large organisations throughout the world so we should have some awareness of them.

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 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 sources of 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.

WHY DO I NEED TO KNOW ABOUT THE ROLE OF THE GRI SUSTAINABILITY REPORTING STANDARDS?

In the area of social and environmental (and sustainability) reporting, the standards of the GRI represent the most commonly used framework. As the larger organisations report information using the GRI standards, it is arguably important that we understand the role of the GRI and its standards.

Integrated reporting Another approach to corporate social-responsibility reporting that is attracting a great deal of attention is ‘integrated reporting’, a term that is becoming widely used within business. Integrated reporting can take a variety of forms and can be defined in a number of ways, but it would generally be perceived as involving the generation of reports that integrate information about the social, economic/financial and environmental implications/impacts of an organisation’s operations.

The International Integrated Reporting Council (IIRC) is a major organisation associated with promoting a particular approach to integrated reporting. It was created in August 2010 and was a joint initiative of The Prince’s Accounting for Sustainability Project (A4S; which in itself was an organisation initially established to develop what was then known as ‘Connected Reporting’) and the GRI.

According to the website of the IIRC (see www.integratedreporting.org), IIRC’s 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.

One important issue the IIRC has sought to address is the lack of integration in the different reports that organisations typically release. Most larger organisations produce an annual report that includes a number of financial statements and associated note disclosures, as required by financial accounting standards, corporations law and securities exchange listing requirements. The same organisations also often release a quite separate CSR or sustainability report. However, there is often little or no link between the separate reports (and they are often prepared by different people), and this has led to calls for a form of reporting—integrated reporting—in which various types of information necessary for assessing and evaluating a company’s performance are reported in a comprehensive fashion within an integrated report.

The IIRC Framework The IIRC released its International Integrated Reporting Framework, also referred to as the International <IR> Framework, in December 2013, with revisions expected. It is a principles-based framework, rather than one that stipulates lists of required disclosures, so it is quite different from the GRI standards previously discussed. As stated in the framework document (IIRC, 2013, p. 4):

The International <IR> Framework (the Framework) takes a principles-based approach. The intent is to strike an appropriate balance between flexibility and prescription that recognizes the wide variation in individual

dee67382_ch32_1249-1332.indd 1292 10/25/19 01:46 PM

1292 PART 10: Corporate social-responsibility reporting

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.

The framework provides ‘guiding principles’ and ‘content elements’ that are to be used to govern the overall content of an integrated report, and to explain the fundamental concepts that underpin the report. These principles and elements are reproduced in Exhibit 32.4. Reading through them, you will probably agree that they seem to be logical and, if applied properly, would assist an organisation to produce reports that are relatively more useful to external stakeholders (relative to reports that are prepared without following such principles). You should also be able to see that there is some degree of overlap between these guiding principles and the principles for defining report quality included within the GRI standards (and the Conceptual Framework for Financial Reporting), as previously discussed. This should not be unexpected, as such principles are generally relevant to any information that an organisation produces for the use of different stakeholders, whether it relates to social, environmental or financial performance.

A more in-depth review of the framework reveals a number of other interesting (and some concerning) aspects of the guidelines, some of which are discussed below. In our review of the framework, we will apply some of the knowledge we have already gained in this book to evaluate whether the framework appears to be one that can assist stakeholders to assess how managers of an organisation have acted in respect of the responsibilities they should have embraced. And we will be particularly interested in assessing whether the framework will realistically assist us in evaluating an organisation’s accountability with regard to its social and environmental performance.

Exhibit 32.4 Guiding principles and content elements

GUIDING PRINCIPLES The following Guiding Principles underpin the preparation of an integrated report, informing the content of the report and how information is presented:

• Strategic focus and future orientation: An integrated report should provide insight into the organisation’s strategy, and how it relates to the organisation’s ability to create value in the short, medium and long term, and to its use of and effects on the capitals.

• Connectivity of information: An integrated report should show a holistic picture of the combination, interrelatedness and dependencies between the factors that affect the organisation’s ability to create value over time.

• Stakeholder relationships: An integrated report should provide insight into the nature and quality of the organisation’s relationships with its key stakeholders, including how and to what extent the organisation understands, takes into account and responds to their legitimate needs and interests.

• Materiality: An integrated report should disclose information about matters that substantively affect the organisation’s ability to create value over the short, medium and long term.

• Conciseness: An integrated report should be concise. • Reliability and completeness: An integrated report should include all material matters, both positive and

negative, in a balanced way and without material error. • Consistency and comparability: The information in an integrated report should be presented: (a) on a basis

that is consistent over time; and (b) in a way that enables comparison with other organisations to the extent it is material to the organisation’s own ability to create value over time.

CONTENT ELEMENTS An integrated report includes eight Content Elements that are fundamentally linked to each other and are not mutually exclusive:

• Organisational overview and external environment: What does the organisation do and what are the circumstances under which it operates?

• Governance: How does the organisation’s governance structure support its ability to create value in the short, medium and long term?

• Business model: What is the organisation’s business model?

dee67382_ch32_1249-1332.indd 1293 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1293

The IIRC’s focus on ‘value creation’ rather than ‘accountability’

Accountability itself is referred to at the start of the framework. Specifically, it is stated (IIRC 2013, p. 2) that:

<IR> aims to enhance accountability and stewardship for the broad base of capitals (financial, manufactured, intellectual, social and relationship, and natural) and promote understanding of their interdependencies.

Unfortunately, ‘accountability’ is not further discussed or defined within the framework, despite its obvious importance. As we have emphasised already, accountability is a central and logical component of accounting, and hence any reporting framework needs to be clear about accountability in terms of why an organisation should report, to whom the organisation should report, what it should report, and how it should report.

According to the framework, integrated reporting is defined as (IIRC 2013, p. 33):

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 of this framework is on ‘value creation’, rather than on ‘accountability’. This was of concern to the many people who had hoped that the emphasis of integrated reporting would be to increase the transparency of organisations in regard to a broad group of interested stakeholders, many of whom are not directly interested in value creation. This is not to say that a focus on value creation is wrong. Rather, perhaps the goal of demonstrating a high level of accountability should also be strongly prioritised.

The application of ‘materiality’ within the IIRC Framework

The IIRC also emphasises the centrality of ‘materiality’ to the reporting process. This is important, as assessments of materiality/significance are central to any reporting framework. That is, as we have emphasised already in this chapter, it needs to be made very clear why an organisation elects to report certain information, but not report other information. In terms of the guiding principle of materiality, we know from Exhibit 32.4 that it states: ‘An integrated report should disclose information about matters that substantively affect the organisation’s ability to create value over the short, medium and long term’. The framework document further states (IIRC 2013, p. 18):

To be most effective, the materiality determination process is integrated into the organisation’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.

This provides a very narrow view of materiality, and therefore, if applied by managers, it could greatly impede the accountability that organisations might demonstrate. When we then review the framework to see the perspective adopted with respect to the ‘primary purpose’ of an integrated report, we find (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, this restricted definition of the perceived users of integrated reports is extremely disappointing. This perspective, in which shareholders are seen as the focal stakeholders of an organisation, is often referred to as the ‘shareholder primacy perspective’. This acts to limit the usefulness of a reporting framework to provide accountability to a broader group of stakeholders beyond shareholders. What perhaps needed to be accepted, or understood, by the IIRC is that an organisation—which operates within society, and effectively with the permission to operate being given by that society—has a responsibility, and therefore an accountability, to a broad group

• Risks and opportunities: What are the specific risks and opportunities that affect the organisation’s ability to create value over the short, medium and long term, and how is the organisation dealing with them?

• Strategy and resource allocation: Where does the organisation want to go and how does it intend to get there?

• Performance: To what extent has the organisation achieved its strategic objectives for the period and what are its outcomes in terms of effects on the capitals?

• Outlook: What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy, and what are the potential implications for its business model and future performance?

• Basis of presentation: How does the organisation determine what matters to include in the integrated report and how are such matters quantified or evaluated?

SOURCE: International Integrated Reporting Council 2013, pp. 16–32

dee67382_ch32_1249-1332.indd 1294 10/25/19 01:46 PM

1294 PART 10: Corporate social-responsibility reporting

of stakeholders and not just to those parties that provide financial capital. Nevertheless, the restricted view of accountability apparently embraced by the IIRC does reflect the views of many people in business (but not all people!). The pity is that such people, with this heavily restricted view of accountability, seem to have captured the standard-setting processes within the IIRC, which is unfortunate as the IIRC has established a great deal of support globally. As Rowbottom and Locke (2016) also stress, once a framework such as the IIRC <IR> Framework becomes dominant, it has the potential to become the ‘taken for granted’ approach to reporting and to shape broader reporting practices.

Rowbottom and Locke (2016, p. 100) also suggest that there was a view held by many people who were active in the development of the IIRC Framework that if a broader stakeholder perspective had been embraced, as many had hoped, then the resulting reports would have been very long and segmented—and hence, from a pragmatic perspective, focusing on the needs of just the capital providers allowed a ‘less cluttered, less complex yet more communicative report’, albeit one that departed from the original stakeholder perspective. Rowbottom and Locke (2016, p. 101) further note that ‘due to broad philosophical differences between the shareholder and stakeholder perspective, there was a contest to influence the interests inscribed in the IIRC Framework’. In support of the extremely narrow ‘shareholder primacy’ view of accountability, Rowbottom and Locke (2016, p. 101) report:

The International Corporate Governance Network explicitly set out guidance from a ‘shareholder and investor perspective’ and warned against a ‘wild profusion of peripheral, trivial or irrelevant measures’. The UK Financial Reporting Council and Accounting Standards Board also specifically advocated a shareholder-based interpretation by warning that integrated reporting could ‘run the risk of being captured by particular stakeholder groups and the reporting of issues that are not material to the needs of long-term investors’ while guarding against ‘increasing the length and complexity of the annual report’.

Rowbottom and Locke (2016) also report that there were also many alternate views that a broader ‘stakeholder perspective’ should be adopted within the framework. However, the broader stakeholder perspectives were over ridden such that the way in which the IIRC ultimately identified the key users of integrated reports—being investors— represented a ‘key detour’ from early views about what integrated reporting would or should represent. In doing so, this created the potential to alienate the interests of stakeholders who had participated in the integrated reporting project at its inception. According to La Torre et al. (2020, p. 1):

The IIRC was born out of a necessity to create a reporting model that can tackle the sustainability challenges of the 21st century. But arguably, the <IR> Framework abandoned the original ideology of its promoters in favour of a capitalist ideology aligned with stock market capitalism.

Furthermore, the way in which ‘materiality’ is described in the framework tends—perhaps expectedly—to emphasise the risks and opportunities for the reporting organisation, and how it can mitigate or capitalise on those risks and opportunities. If materiality was considered from a broader sustainability perspective (one of the focuses of this chapter), then perhaps more consideration would be explicitly given to an organisation’s impacts on the ‘outside world’.

The approach adopted by the IIRC with respect to integrated reporting can be contrasted with the approach taken within South Africa, where integrated reporting has been required for certain organisations for several years. The approach adopted within South Africa embraces a broader ‘stakeholder-inclusive’ approach to integrated reporting. That is, while integrated reporting is mandated for certain organisations within South Africa, there is no requirement that the IIRC Framework must be applied (rather, there is a requirement that information is provided about specific corporate governance principles that have been identified in what is known as the King IV Report).

The ‘capitals’ as used within the IIRC Framework

A particularly interesting aspect of the IIRC Framework is that it makes reference to ‘capitals’, in particular to six different capitals. The framework document notes (IIRC 2013, p. 4) that:

An integrated report aims to provide insight about the resources and relationships used and affected by an organization—these are collectively referred to as ‘the capitals’ in this Framework. It also seeks to explain how the organization interacts with the external environment and the capitals to create value over the short, medium and long term.

The capitals are stocks of value that are increased, decreased or transformed through the activities and outputs of the organization. They are categorized in this Framework as financial, manufactured, intellectual, human, social and relationship, and natural capital, although organizations preparing an integrated report are not required to adopt this categorization or to structure their report along the lines of the capitals.

dee67382_ch32_1249-1332.indd 1295 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1295

Therefore, for the purposes of the framework, the value being created by an organisation resides in capitals. According to IIRC (2013, paragraphs 2.10 and 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 . . .

2.12 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 in the framework (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 32.3 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 of how it supports the ‘past, current or future prosperity’ of an organisation. We might question whether the environment should be considered in such an organisation-centric manner. Is this not 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 utilised and degraded in exchange for economic gains is a major contributory factor to our current global problems.

Figure 32.3 The value creation process as depicted in the IIRC’s International <IR> Framework

SOURCE: IIRC 2013

dee67382_ch32_1249-1332.indd 1296 10/25/19 01:46 PM

1296 PART 10: Corporate social-responsibility reporting

The other point to be made here is that given that the main audience of integrated reports are deemed to be the providers of investment capital, notions of value will be determined from the investors’ perspective—and investors, in general, are notoriously short term in orientation and tend to focus on financial gains, rather than considering social and environmental costs and benefits. Therefore, it is difficult from a logical perspective to understand how this focus on value creation from the perspective of investors (which has little to do with broader notions of ‘accountability’) can help the long-term sustainability of business operations, or provide any real hope in addressing problems such as climate change. Surely there is a high degree of incompatibility between value creation from the perspective of shareholders, and environmental and social sustainability? From a practical perspective, there is also an absence of guidance in the framework about how value, and changes therein, are actually measured.

In relation to the various trade-offs, the framework states (IIRC 2013, p. 13):

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 organisation 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, there should be no ‘trade-off’.

Some strengths of the IIRC Framework

It is not at all clear that the IIRC Framework provides much hope in terms of extending the accountability of organisations in regard to the various non-financial aspects of their operations. By discussing this framework in the manner we have, it should demonstrate to you that people have dissenting views about the worth of different reporting frameworks. As ‘thinking people’, we should challenge things we do not agree with—but hopefully do so in a way that is constructive. Obviously, the author of this book, who has a great deal of experience in the area, is not a supporter of this framework. Challenging such frameworks—if we see problems—is a way for us to try to move forward the accountability of organisations.

However, while a number of negative aspects of the framework have been identified, we should also—for balance—acknowledge some of its positive aspects (just as we previously noted that the principles were logical and helpful). These include that the framework:

∙ specifically encourages ‘integrated thinking’, which is defined in the framework as ‘the active consideration by an organisation of the relationships between its various operating and functional units and the capitals that the organisation uses or affects’. Integrated thinking leads to integrated decision making and actions that consider the creation of value over the short, medium and long term

∙ requires consideration of connectivity/interdependencies within an organisation. When we consider how different operations/activities within an organisation influence one another, this can lead to important changes and cost savings. For example, we might even terminate some products/processes that otherwise looked profitable in isolation

∙ requires explicit consideration of the context within which the organisation operates ∙ requires explicit commentary on why particular items are reported—that is, why they are ‘material’—which

arguably helps the credibility of reports ∙ requires an explanation of how the reporting boundary has been identified ∙ requires explicit consideration of the social, environmental and economic challenges/risks confronting the

organisation ∙ encourages information to be disclosed about how remuneration and incentives are linked to value creation in the

short, medium and long term, including how they are linked to the organisation’s use of, and effects on, the capitals ∙ encourages diagrams of inputs, business activities and outputs, all of which can assist in increasing people’s

understanding of what is being reported ∙ requires answers to ‘Where does the organisation want to go and how does it intend to get there?’ ∙ requires the identification of significant frameworks and methods used to quantify or evaluate material matters

included within the report ∙ emphasises there is no set time dimension for reporting ∙ requires the organisation to note how its governance structure supports the organisation’s ability to create value in

the short, medium and long term.

dee67382_ch32_1249-1332.indd 1297 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1297

The Sustainability Accounting Standards Board The Sustainability Accounting Standards Board (SASB) is a US non-profit organisation that was established in 2011 to develop and disseminate sustainability accounting standards, primarily with US corporations in mind. The SASB aims to integrate its standards into documents—specifically, in a form known as a Form 10-K, but with relevance to other forms known in the US as Form 10-Q, Form S-1 and Form 8-K—that must be filed by US public companies, and by foreign public companies in the US, in their annual filings with the US Securities and Exchange Commission (SEC). These disclosures are accessible by the public.

While the SASB’s focus is primarily on the US—and many companies there are electing to apply the standards— the SASB standards are becoming voluntarily applied as guidance documents throughout the world by various large organisations. Like the IIRC Framework, the standards have been developed primarily with investors in mind, to assist them to understand the sustainability-related risks and opportunities confronting organisations, which are likely ultimately to impact an organisation’s financial performance. Adopters of the standards are not precluded from providing information to other stakeholders.

Within the US, corporations legislation (specifically, Regulation S-K, which sets forth certain disclosure requirements associated with Form 10-K and other required SEC filings) requires companies, in a document known as the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of Form 10-K, to describe, among other things:

any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.

In addition to the above, further requirements in US law (Instructions to Item 303) state that the MD&A:

shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.

The SASB standards were developed to assist organisations to meet the above requirements, with specific focus being applied to those risks of a social and environmental/sustainability nature. While the standards are useful for satisfying this purpose, both the SEC and the Financial Accounting Standards Board (the body responsible for developing financial accounting standards within the United States) do not explicitly require compliance with the SASB standards.

The SASB standards were developed on the basis that different industries are exposed to different social and environmental risks and opportunities, and so specific disclosure guidance for different industries was needed. The SASB arranged industries into a classification system, which it referred to as its Sustainable Industry Classification System, or SICS, based on the similarity of companies’ sustainability challenges and opportunities. The SASB then identified the sustainability topics that it believes are particularly relevant to investors in those companies within each respective SICS industry code. Seventy-nine industries were identified, each seen as belonging to one of 11 sectors:

∙ health care ∙ financials ∙ technology and communications ∙ non-renewable resources ∙ transportation ∙ services ∙ resource transformation ∙ consumption I ∙ consumption II ∙ renewable resources and alternative energy ∙ infrastructure.

WHY DO I NEED TO KNOW ABOUT THE NATURE OF INTEGRATED REPORTING?

‘Integrated reporting’ is a term that is increasingly being used globally. Therefore, it is important for us to understand what it means—and it is also important for us to understand that there are many variations of integrated reporting, of which the IIRC Framework represents one approach.

dee67382_ch32_1249-1332.indd 1298 10/25/19 01:46 PM

1298 PART 10: Corporate social-responsibility reporting

Within the transportation sector, for example, sustainability accounting standards were developed for the following industries: ∙ automobiles ∙ auto parts ∙ car rental and leasing ∙ airlines ∙ air freight and logistics ∙ marine transportation ∙ rail transportation ∙ road transportation.

Exhibits 32.5 and 32.6 reproduce tables that appear in the Automobiles Sustainability Accounting Standard and the Airlines Sustainability Accounting Standard, respectively. The accounting standards (accessible at www.sasb.org) provide further written advice on each of the ‘accounting metrics’ identified within the following tables.

Review Exhibits 32.5 and 32.6 and consider whether you agree that the respective accounting metrics provide information that would likely be of interest to investors who have interests in the companies operating in the automobile and airline industries. Furthermore, you could also consider whether you believe the information would be of interest to stakeholders other than investors (and, perhaps, why it would be of interest).

Again, unlike the GRI standards that we discussed earlier in this chapter, and which are designed to provide guidance to a wide variety of stakeholders, the SASB standards are designed with investors’ needs in mind—they focus on issues that are considered likely to eventually create risks and opportunities that could impact financial performance. The management of the respective companies is ultimately responsible for determining which information is material

Exhibit 32.5 Extract from the SASB Automobiles Sustainability Accounting Standard

SOURCE: Sustainability Accounting Standards Board, Automobiles, 2018

dee67382_ch32_1249-1332.indd 1299 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1299

Exhibit 32.6 Extract from the SASB Airlines Sustainability Accounting Standard

SOURCE: Sustainability Accounting Standards Board, Airlines (2018)

and is therefore required to be included in the disclosures made to the SEC. Hence, as is often the case with accounting disclosures, managers need to determine whether the information is likely to impact decisions being made by the users of those reports. If it is considered likely, then disclosures should be made. The SASB acknowledges that establishing what is material in relation to information that is fundamentally non-financial can be a rather complex task.

Another source of guidance that is attracting a lot of attention globally is a guide developed by the Financial Stability Board, which we shall now consider.

The CEO Guide to Climate-Related Financial Disclosures The development of the CEO Guide to Climate-Related Financial Disclosures (www.wbcsd.org/Overview/Resources/ General/CEO-Guide-to-climate-related-financial-disclosures) was driven by an organisation known as the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system (Task Force on Climate-related Financial Disclosures 2017, p. 7):

In April 2015, at the request of G20 Finance Ministers and Central Bank Governors, the Financial Stability Board (FSB) convened representatives of the private and public sector to review how the financial sector could take account of climate-related issues. The conclusion was that financial markets need better, more comparable and complete information about climate change. In response, the FSB established the Task Force on Climate-related Financial Disclosures (TCFD) in December 2015.

The TCFD encourages companies with annual revenue exceeding US$1 billion or equivalent to disclose against all recommendations and to conduct robust analyses to assess the resilience of their strategies against a range of climate-related scenarios. Generally, disclosures are to be made in companies’ public annual financial filings. The TCFD believes that climate-related issues are, or could be, material for many organizations and that its recommendations are therefore useful in complying with existing disclosure obligations.

We will return to the important issue of climate change later in this chapter, but it is becoming increasingly obvious that there is an expectation that organisations are accountable for their actions in alleviating, or contributing to, climate change. They are also increasingly being held accountable for providing information about the risks and opportunities climate change creates for their organisation.

Exhibit 32.7 reproduces a table from the CEO Guide that summarises the recommendations and supporting recommended disclosures. Again, review these disclosures and consider whether you agree that they would be useful for you in assessing the climate change-related risks to which an organisation might be exposed.

dee67382_ch32_1249-1332.indd 1300 10/25/19 01:46 PM

1300 PART 10: Corporate social-responsibility reporting

Exhibit 32.7 Recommended disclosures pertaining to the risks and opportunities associated with climate change

SOURCE: Task Force on Climate-related Financial Disclosures (2017). World Business Council for Sustainable Development, https://docs.wbcsd.org/2017/12/CEO_Guide_to_climate-related_financial_disclosure.pdf

Reflecting its use within Australia, the 2019 Sustainability Report of Woolworths devotes a number of pages to addressing the recommendations of the TCFD. A part of those disclosures is reproduced in Exhibit 32.8.

Exhibit 32.8 Disclosures pertaining to climate risks and opportunities

dee67382_ch32_1249-1332.indd 1301 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1301

SOURCE: 2019 Sustainability Report, Woolworths

We will now turn our attention to another international initiative that will impact corporate social and environmental reporting, this being the United Nations and its Sustainable Development Goals.

32.10 United Nations’ Sustainable Development Goals

Addressing sustainability at the individual organisational level is problematic. Sustainable development is a big concept that involves the consideration of larger environments and societal requirements, something that is beyond the confines of any single organisation. The quest for sustainable development requires the coordinated actions of all organisations, governments and communities. Regardless of these concerns about the appropriateness, or otherwise, of single organisations producing sustainability reports, an increasing number of organisations now report against the 17 Sustainable Development Goals (SDGs) of the United Nations (UN; see www.undp.org/content/undp/ en/home/sustainable-development-goals.html). These goals are shown in Exhibit 32.9.

LO 32.10

Exhibit 32.9 The 17 Sustainable Development Goals

SOURCE: www.undp.org/content/undp/en/home/sustainable-development-goals.html

dee67382_ch32_1249-1332.indd 1302 10/25/19 01:46 PM

1302 PART 10: Corporate social-responsibility reporting

The 17 SDGs have been developed by the UN as part of a resolution in 2015 entitled ‘Transforming Our World: The 2030 Agenda for Sustainable Development’, which was agreed to by all member states of the United Nations. The aim is to provide guidelines and targets for countries to adopt in accordance with their own priorities and the social and environmental challenges of the world at large. The UN SDGs provide a ‘common lens’ through which organisations can review and report their progress towards sustainable development. Each SDG is supported by various components of documentation and guidance. The 17 goals are supported by 169 underlying targets, with 232 indicators (see https:// unstats.un.org/sdgs/indicators/indicators-list/). Organisations are encouraged to focus upon those goals on which their activities are most likely to have significant impacts.

The view taken by the UN is that addressing the SDGs requires a partnership of governments, the private sector, civil society and citizens in order to leave a better planet for future generations to enjoy. As an example of an organisation that publicly refers to the SDGs, the Commonwealth Bank states in its 2017 Sustainability Report (p. 17):

We actively consider key developments such as the Sustainable Development Goals (SDGs) to evolve and refine our approach to corporate responsibility. We have again this year mapped our existing programs of work to the SDGs. The relevant SDGs are identified against each of the eight Opportunity Initiatives. In future years we will continue to review our strategy and programs of work in light of the SDGs. As a major financial services organisation, our approach to supporting the SDGs is to focus on those areas where our impact is most material.

As another example, the 2016 Sustainability Report of global shipping company A.P. Moller—Maersk notes (p. 7):

The United Nations’ Sustainable Development Goals (SDGs) have been applied in our materiality assessment this year as an expression of the expectations of the global stakeholder community. Corresponding to our current strategic sustainability priorities, we see the greatest potential for positive impact at scale through our business on Goals number 8: decent work and economic growth, 9: industry, innovation, and infrastructure, and 13: climate action.

When engaging in global value chains and energy production, our business touches on all 17 SDGs, either directly or indirectly. Many of the goals and targets cover issues that are already core to our sustainability efforts, including anti-corruption, labour rights, responsible procurement, diversity & inclusion, safety and environment. In each of the following chapters, we mark the relationship between the topic at hand and the SDGs. Our full analysis, comparing our current business and sustainability priorities with the 17 Goals and 169 targets, can be viewed online at www.maersk.com/about/sustainability.

A joint study by RMIT University and Global Compact Network Australia of the disclosures made by the top Australian Securities Exchange companies (ASX 150) in their respective 2018 annual reports and sustainability reports (RMIT & GCNA 2019) revealed:

∙ 37 per cent of the companies mentioned the SDGs in their reports ∙ 25 per cent of the companies reported how they prioritise the SDGs, with the three most commonly prioritised

SDGs being: Climate Action (SDG 13); Responsible Consumption and Production (SDG 12); and Decent Work and Economic Growth (SDG 8). Exhibit 32.10 shows how Woolworths links its business priorities to the SDGs in its 2019 Sustainability Report

∙ 27 companies reported how they had embedded SDGs into their materiality analysis (a materiality analysis involves engaging stakeholders to determine what issues are of most importance/relevance to them). Exhibit 32.11 provides an example of how ANZ Banking Group reported within its 2018 Sustainability Review on linking the SDGs to its materiality analysis

∙ nine companies aligned business performance targets and indicators with SDGs. Exhibit 32.12 shows how, within its 2018 Sustainability Report, National Australia Bank reports information about SDGs and organisational targets.

The above findings reflect the relevance that the UN SDGs are now having within Australia (and elsewhere).

dee67382_ch32_1249-1332.indd 1303 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1303

Exhibit 32.10 Linking business priorities to the SDGs

SOURCE: Woolworths 2019 Sustainability Report

dee67382_ch32_1249-1332.indd 1304 10/25/19 01:46 PM

1304 PART 10: Corporate social-responsibility reporting

Exhibit 32.11 Linking materiality analysis to the SDGs

SOURCE: ANZ Banking Group 2018 Sustainability Review

dee67382_ch32_1249-1332.indd 1305 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1305

Exhibit 32.12 Linking organisational targets to the SDGs

SOURCE: National Australia Bank 2018 Sustainability Report

It is expected that in the coming years the UN SDGs will play an increasing role in influencing the perceived responsibilities and accountabilities of organisations globally. Therefore, as accountants, they are something we need to be aware of.

WHY DO I NEED TO KNOW ABOUT THE NATURE OF THE UN SDGs?

The UN SDGs are gaining a great deal of publicity and traction worldwide and are influencing the operational and reporting policies of larger organisations globally. Therefore, it is important that we understand their role and the reason for their creation.

Apart from the reporting models developed by organisations such as the Global Reporting Initiative, International Integrated Reporting Council, Sustainability Accounting Standards Board, Financial Stability Board and the United Nations, there are a number of other approaches to reporting, some of which are quite imaginative and innovative and that have been debated and developed by researchers. Two such approaches are full cost accounting and the construction of ‘counter accounts’—we will consider these in turn now.

dee67382_ch32_1249-1332.indd 1306 10/25/19 01:46 PM

1306 PART 10: Corporate social-responsibility reporting

32.11 Accounting for externalities and ‘full cost accounting’

The UN SDGs just discussed have brought greater attention to the externalities being generated by organisations. One complementary approach to accounting for social and environmental impacts is to place

a financial cost on the externalities generated by the organisation and then potentially to 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. As Unerman, Bebbington and O’Dwyer (2018, p. 498) state:

As externalities are a product of market failures, and as financial prices from market transactions underlie most financial reporting data, financial reporting information will be flawed and incomplete in the most inevitable presence of externalities. Accordingly, for financial reporting to provide a representationally faithful portrayal of an entity’s performance and position, additional information needs to be provided about material externalities that are not reflected in financial reporting’s market-derived financial data.

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 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.

There are various ‘costs’ that go into products that are often ignored. For example, let us consider the everyday hamburger. What resources are actually consumed as part of making a hamburger? It has been reported (Harvey 2015; see www.businessinsider.com.au/one-hamburg-erenvironment-resources-2015-2) that the creation of each McDonald’s hamburger requires about 660 litres of water—this relates to factors such as the consumption of water by the cow, and the water used to grow the pasture. In addition, each burger requires 6 kilograms of animal feed, which relies upon the farming of 6 square metres of land. In all, one Quarter Pounder burger also has a carbon footprint of almost 2 kilograms. Yet we pay only a few dollars for the burger. So, are the externalities being accounted for in terms of the price being charged for a hamburger? The direct financial cost of feeding the cattle and looking after the land would be included in the price of the meat going into the hamburger—these would be considered the private costs that are captured within the price of the burger. But the externalities, including the water used, are not being fully accounted for, as most of the water is being treated as a free good. Methane emissions and the carbon footprint are also likely to be unaccounted for, as they do not constitute an immediate private cost either. However, as water scarcity increases in some areas, it is likely that the amount of water being used to generate the final product will tend to be accounted for more fully.

So, are these hamburgers generating a profit? From a financial accounting perspective, McDonald’s is generating a financial profit, given that the water being used is probably being sourced at no, or very little, cost. If McDonald’s was to develop a more holistic notion of profit and treated the water as a real cost, as well as considering the impact of a hamburger’s production on climate change, habitat and so forth, then it would become arguable as to whether McDonald’s is generating a true profit at all. ‘Full cost’ accounting would address such costs. Similar conclusions could also be made in relation to the goods and services provided by many other organisations (and indeed, perhaps by most organisations).

As another example, let us consider the broader ‘costs’ of using coal. The use of coal is often promoted on the basis of it being a low-cost method of generating power. But the generation of ‘cheap’ power through the use of coal

LO 32.11

dee67382_ch32_1249-1332.indd 1307 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1307

is not really cheap once we consider the various social costs associated with the burning of coal. If organisations had had to account for these social and environmental costs, there might have been a greater shift towards cleaner energy sources. In an article entitled ‘The hidden cost of Hazelwood’ (by Tom Arup and Adam Morton, Sunday Age, 19 April 2015, p. 12), it was reported that two Harvard researchers 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 was estimated at $900 million. The estimate is based on damage from global warming on the agricultural sector, on property, and on health because of the reduced air quality. According to the researchers, renewable or clean energy sources could compete on an equal footing with polluters such as 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.

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 ETS 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.

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, if full cost accounting was employed, then a notional financial cost would be attributed to this social impact.

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 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

dee67382_ch32_1249-1332.indd 1308 10/25/19 01:46 PM

1308 PART 10: Corporate social-responsibility reporting

‘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. The methodology relies heavily upon the use of various estimation techniques. As part of the process, PUMA allocates a financial cost to products—such as shoes—for greenhouse gas, water, waste, air pollution, land use and other environmental costs.

The French-based organisation Kering is another company to produce an environmental profit or loss. 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’.

Another interesting approach to full cost accounting is provided by the UK organisation known as the Crown Estate. The Crown Estate uses an approach it refers to as its ‘Total Contribution’ methodology (see www.thecrown estate.co.uk/en-gb/our-business/sustainability/total-contribution/). In its report entitled Total Contribution Report 2017—Everything is Connected, the Crown Estate notes:

dee67382_ch32_1249-1332.indd 1309 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1309

Our Total Contribution methodology provides us with information and insight on the effect of our actions, enhancing our decision-making and enabling us to report the broader value of what we do. It plays a critical role in helping us to think in a wider, deeper and increasingly integrated way about the impact of our actions. It demonstrates how everything is connected . . . Working with colleagues across our business and in conjunction with advisors at Route2, we developed a framework based on the capitals we draw on and impact. The framework reflects the positive and negative flows of our business activities. Having evaluated other options, we put economic values on indicators for each capital. By introducing a common unit of measurement we can compare and aggregate performance across different metrics . . . We recognise that putting economic values on non-financial indicators isn’t always a perfect solution and that figures aren’t absolute. However, it is a starting point and focus for discussion.

The Crown Estate identifies six different ‘capitals’ that it relies upon. One of the capitals is identified as ‘natural resources’, against which it has identified eight indicators that are the focus for monetary measures. See Exhibit 32.13.

Exhibit 32.13 Indicators used by the Crown Estate to measure impact on natural resources

SOURCE: The Crown Estate, Total Contribution Report 2017—Everything is Connected, 2017

In relation to the different indicators, information is provided about how the amounts were determined. For example, in relation to placing a cost on greenhouse gases emitted and greenhouse gas emissions avoided, see Exhibit 32.14, which shows the indicators that were assigned to ‘natural resources’.

Exhibit 32.14 Approaches used to attribute a financial cost to particular indicators

Total contribution value associated with the indicator, based on the average of three years’ data (2013/14–2015/16)

continued

dee67382_ch32_1249-1332.indd 1310 10/25/19 01:46 PM

1310 PART 10: Corporate social-responsibility reporting

Another interesting illustration of ‘full cost accounting’ was provided by Davies and Dunk (2015). They considered issues associated with the UK higher education sector. Specifically, they sought to determine the externalities associated with the carbon emissions relating to overseas students going to the UK, together with those generated by friends and family visiting them while they were studying.

We now turn to Worked Example 32.4, which requires us to consider some factors we might consider if we were to apply full cost accounting to a casino.

SOURCE: The Crown Estate, Total Contribution Report 2017—Everything is Connected, 2017

Exhibit 32.14 continued

WORKED EXAMPLE 32.4: Application of full cost accounting

Assume that you are the general manager of Tiara Casino.

REQUIRED You have considered the possibility of doing some form of ‘full cost accounting’. What are some of the factors you would need to consider in undertaking such a task?

SOLUTION You would need to first determine the key social and environmental impacts of the organisation and then determine the costs that would notionally be incurred to remedy the negative impacts created. A monetary value would also necessarily be assigned to the positive social and environmental impacts (if any can be determined).

Some of the negative social impacts would include the social harm done to problem gamblers and their families; the damage caused by patrons to surrounding areas; the crime that might occur because of undesirable people being attracted to the casino from overseas; waste generated by the casino; and the energy and water consumption of the casino. The costs that would be incurred to notionally remedy all of these social and environmental impacts would then be calculated using particular forms of financial modelling. These costs might then be deducted from calculated profit to see if any form of ‘real profit’ has been generated by the casino.

This would be a very interesting exercise to do. Many people would predict that if the full social impacts associated with a casino were somehow attributed a cost, then casinos would always be running at a loss.

dee67382_ch32_1249-1332.indd 1311 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1311

In concluding our look at full cost accounting, it is again emphasised that only very few organisations internationally employ some form of this method of accounting. Nevertheless, our discussion does show how different forms of ‘accounting’ can be used to measure and report an organisation’s social and environmental impacts—be they positive or negative.

Another interesting approach to addressing ‘how’ we might report social and environmental information (stage 4 of Figure 32.2) is the production of ‘counter accounts’. We will now consider ‘counter accounts’ before turning our attention to an important area of corporate responsibility, this being climate change.

WHY DO I NEED TO KNOW ABOUT THE NATURE OF ‘EXTERNALITIES’ AND HOW ACCOUNTING ADDRESSES THEM?

Organisations can generate a variety of externalities. The types of externalities generated by an organisation will influence the support an organisation receives from different stakeholders. If we are trying to more fully understand the ‘performance’ of an organisation, and because externalities will not generally be recognised when determining an organisation’s profits, we need additional information generated through non-financial reporting frameworks.

32.12 Counter (shadow) accounts

All forms of accounting typically involve an element of judgement by those making the disclosures, and this is even more so when the form of reporting is largely unregulated, as is the case with much social and environmental/sustainability reporting. Therefore, the managers of an organisation might—through their disclosures— provide a particular perspective of their organisation’s performance (potentially a partisan perspective), but such perspectives of performance might not be shared by other stakeholder groups. Realistically, there could be an element of bias to the reporting being undertaken.

Apart from managers, stakeholder groups with an interest in an organisation—which may include particular employee groups, consumer groups or environmental groups—might have access to particular information about that organisation and be able to provide ‘alternative accounts’ about how an organisation has performed. That is, they might produce accounts that challenge, or contest, the accounts released by managers. These accounts, produced by stakeholders other than managers, are often referred to as counter accounts or shadow accounts. Such accounts are often developed from different philosophical and political standpoints and can contradict the accounts prepared by managers.

Typically, these counter accounts, if prepared, are released independently by the respective stakeholder group. However, there is some argument that when organisations prepare their CSR/ sustainability reports, and particularly where there are contested perspectives about performance (that is, where different stakeholders do not share the same view as management about how well the organisation is performing), then the alternative views held by other stakeholders should arguably also be included within the reports being released by the organisation. For example, if an organisation produces social information relating to how it has advanced the interests of its employees, possibly through implementing various educational or training initiatives, or by introducing policies that assist in the employment of people with disabilities, it might also be useful to provide the views of particular labour union officials about whether they also believe that the organisation has been successful in promoting the interests of employees.

Brown (2009) provides an insightful discussion of this possibility, referring to the concept of dialogic accounting and focusing on the sustainability area for illustrative purposes. By dialogic accounting, Brown is referring to a situation in which there is typically more than one ‘logic’ that could be employed to assess organisational performance, and these different logics (based on different perspectives about what aspects of performance are important, or otherwise) could be used to develop different accounts. Producing dialogic accounts encourages debate and enhances possibilities for revisions in how managers manage the organisation. Brown’s perspective of dialogic accounting is consistent with what we have referred to as the production of counter accounts.

Brown provides an interesting comparison of dialogical accounting with monologic accounting—monologic accounts represent only one view or logic, this being that of the managers.

LO 32.12

counter accounts Accounts or reports prepared by stakeholders other than management that provide an alternative perspective to managers about a particular aspect of organisational performance.

dialogic accounting Where different and alternative logics (world views) are used to provide alternative perspectives or measures of a particular aspect, or aspects, of performance.

monologic accounting Where an account of performance is produced based on only one logic (world view), this being that of the management of the organisation.

dee67382_ch32_1249-1332.indd 1312 10/25/19 01:46 PM

1312 PART 10: Corporate social-responsibility reporting

As she explains, monologic accounting reflects the accounting traditions currently in place, wherein only the manager’s perspective of performance is reported to external stakeholders. This is the approach to reporting to which we are accustomed. However, according to Brown, the non-reporting of other stakeholders’ perspectives inevitably provides bias in situations where there are conceivably alternative viewpoints.

According to Brown (2009, p. 317), dialogic accounting, in recognising the existence of different views of organisational performance, allows for a situation where different and sometimes conflicting views are allowed to coexist. Pursuant to this view, corporate reporting could become a vehicle to foster democratic interaction. The aim of dialogic accounting is not necessarily to replace one dominant form of accounting with another, but rather to encourage the development and use of more multidimensional accounting and accountability systems, capable of engaging a variety of perspectives and facilitating wide-ranging discussion and debate about organisational matters. This is a very interesting suggestion, one that runs counter to the views often proffered by many accounting practitioners and researchers, wherein there is presumed to be only one view of the world that can be captured by managers and objectively reflected within accounting reports. As Brown (2009, p. 318) states:

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.

According to Brown, a form of accounting that embraces a dialogic approach will have considerable transformative potential in areas such as sustainable development. Again, the views embodied by Brown (2009) would seem to be of great value in informing debate to extend corporate accountability, and to project different views about corporate performance and success. However, despite its merits, it is probably unlikely that the current monologic practices, which tend to dominate reporting practices, will be displaced any time soon by dialogic approaches.

For more on the inclusion of alternative views in organisational reporting, see Worked Example 32.5.

WORKED EXAMPLE 32.5: The incorporation of different stakeholders’ perspectives within corporate reports

Let us consider the suggestion from Brown (2009) that the alternative views held by different stakeholders should also be included within the reports being released by an organisation.

REQUIRED

(a) Would the introduction of counter accounts within corporate reports be useful to readers of the reports? (b) Could the introduction of dialogic accounting increase the possibility that organisational practices will

change? (c) Is such an approach likely to be implemented by managers?

SOLUTION

(a) The introduction of counter accounts would potentially be useful to readers of organisational reports. Traditional practice is that organisational reports reflect only the managers’ views of performance. This could include an element of bias—either intentionally or unintentionally introduced. Because different perspectives can be taken of social and environmental performance, it can be useful to know about other stakeholders’ views, but we would also need to determine how reliable those views are and whether they are intentionally biased.

(b) The argument is that reporting different stakeholders’ views of performance can stimulate debate about whether managers might be seeing or prioritising aspects of performance differently from the way in which others see or prioritise them. This could lead to further analysis, which in turn could lead to changes in the way the organisation conducts its operations and how performance is reported. It could also lead to the discovery of new opportunities, or reveal potential risks that need to be addressed. Furthermore, if managers know that a counter (dialogic) account will be published alongside their account, they might

dee67382_ch32_1249-1332.indd 1313 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1313

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 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. (Reprinted from Cooper, C., Coulson, A. & Taylor, P., 2011, ‘Accounting for Human Rights: Doxic Health and Safety Practices—The Accounting Lesson from ICL’. Critical Perspectives on Accounting, vol. 22, no. 8. p. 755, with permission from Elsevier)

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’, make this a potentially very exciting area in which to work.

The balance of this chapter will consider the very important issue of climate change.

be more proactive in reporting negative information in order to pre-empt the counter account. Knowing that they will need to report this information, they may then be more proactive in actually addressing the issues associated with such negative information in order to avoid their occurrence in the first place.

(c) It is unusual for the reports released by organisations to include the opinions of other stakeholders, other than perhaps auditors/assurance providers. It is not certain that this will change in the future, despite the potential benefits.

32.13 The critical problem of climate change

An environmental crisis that is increasingly being seen as likely to have severe and potentially catastrophic 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. The greater the concentration of these greenhouse gases (GHGs), the less heat that can escape. The ‘greenhouse effect’ is portrayed in Figure 32.4.

Human actions are increasing the concentrations of GHGs, which is causing changes in the earth’s climate— changes that are projected to intensify as GHG emissions continue to rise. One important GHG is carbon dioxide, which is believed to represent approximately 75 per cent of Australia’s GHG 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

LO 32.13

dee67382_ch32_1249-1332.indd 1314 10/25/19 01:46 PM

1314 PART 10: Corporate social-responsibility reporting

Academy’s website and is called The Science of Climate Change: Questions and Answers (see www.science.org.au/ learning/general-audience/science-booklets-0/science-climate-change, accessed October 2019). 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.

As the report emphasises, such temperature rises will have dramatic economic, environmental and social impacts. In part, and as discussed in our previous discussion of externalities and full cost accounting, 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. 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. 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.

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.

It is not unreasonable to expect that organisations would accept climate change as a key problem to be addressed as part of their responsibilities; we would also expect them to embrace some accountability in this regard, particularly those organisations in carbon-intensive industries, or in industries significantly exposed to climate change-related risks and opportunities. As KPMG (2017, p. 36) states:

In the coming years, we can expect to see a sharp increase in reporting on the financial risks from climate change, building on the rates demonstrated in this year’s survey. Climate change is introducing greater risk and uncertainty

Figure 32.4 A simple representation of the greenhouse effect

SOURCE: Shutterstock/Siberian Art

dee67382_ch32_1249-1332.indd 1315 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1315

into the financial system, both by causing physical damage to companies’ assets, infrastructure and supply chains, and by catalyzing market transformations that threaten to make some traditional business models obsolete and create opportunities for others. As a result, investors and central banks are pushing for greater disclosure.

KPMG also emphasises that organisations should not only disclose information about their actual emissions of GHGs, but should also disclose information about the risks and opportunities climate change creates for them (KPMG 2017, p. 36):

Climate-related risk disclosure is very different from reporting carbon emissions or environmental impacts. It’s about turning the telescope around, understanding the impact of a changing climate on the company and asking searching questions. Does the company need to move its operations? Is its supply chain vulnerable to weather events? Will it be able to take out insurance in future? Should it change its business model entirely?

This change in reporting approach will also require a change in roles and responsibilities. Traditionally, thinking about climate change has been the function of corporate responsibility or sustainability teams, but now the responsibility needs to sit with the executive who has the best understanding of a company’s financial risks and opportunities—namely the Chief Financial Officer.

For companies that have just begun the process of reporting on climate-related financial risks, or have not yet started at all, a qualitative approach is a good foundation and the TCFD’s guidelines are helpful here. Companies should bring together the main stakeholders from around the business to look at the potential financial risks and opportunities presented by climate change, and then carry out qualitative scenario analysis. For example, if you are a brewing corporation, what would happen if you ran out of water in critical production locations or if the costs of water rise dramatically? If you’re an oil company, will you still have a market for your products in 10 or 20 years’ time? After that, companies can start building sophisticated models that properly project the full gamut of financial risks and opportunities associated with climate change, eventually integrating these models into their decision making and adapting the business strategy accordingly.

Some of the risks and opportunities that climate change creates for organisations have been identified by the Task Force on Climate-related Financial Disclosures—an initiative that we have already discussed briefly in this chapter (see Table 32.6).

An important organisation in relation to identifying and measuring climate change is the Intergovernmental Panel on Climate Change (IPCC). In its Fifth Assessment Report (2014)—the IPCC was finalising its Sixth Assessment Report at the time of writing this chapter—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

Risks Opportunities

• Increased costs associated with generating GHG emissions

• Regulated restrictions to be enforced in relation to existing products and services

• Increasing possibility of litigation against the organisation

• Changing customer behaviour • Increased costs of some materials • Damage created by increased severity of

weather events, including those related to rising sea levels and rising temperatures

• Changing supplies of necessary resources, such as water

• Costs incurred in transition to lower emission practices

• Encourage recycling • More energy-efficient plant and equipment to be

used • More efficient transportation options • Reduced water and energy consumption • Government incentives for cleaner technologies • Use of carbon markets • Development of low-emission goods and

services • Increased returns by being reactive to changing

consumer demands • Resource substitution/diversification

SOURCE: Adapted from Task Force on Climate-related Financial Disclosures (2017). World Business Council for Sustainable Development, https://docs.wbcsd.org/2017/12/CEO_Guide_to_climate-related_financial_disclosure.pdf

Table 32.6 Risks and opportunities for business from climate change

dee67382_ch32_1249-1332.indd 1316 10/25/19 01:46 PM

1316 PART 10: Corporate social-responsibility reporting

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’ (as accessed on the McKinsey & Company website, October 2019, 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 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). Organisations 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.

Woolworths Ltd is one of many companies to recognise the importance of climate change. In its 2019 Sustainability Report it devotes several pages to climate change. Exhibit 32.15 reproduces information from just one of these, (page 36). You should read this page to understand how serious some organisations, such as Woolworths, consider climate change to be.

In this chapter we have already discussed various sources of guidance in relation to climate change-related disclosures. For example, we have discussed guidance from the Task Force on Climate-related Financial Disclosures; the Sustainability Accounting Standards Board; and the Global Reporting Initiative.

Academic research also provides useful disclosure insights. For example, Haque, Deegan and Inglis (2016) note that to understand how organisations are addressing the risks associated with climate change, readers of reports need information about whether an organisation does, or does not, have particular climate change-related governance policies in place. This is also consistent with a report from the Australian Securities and Investments Commission (ASIC 2018) in which the ASIC states (p. 12) that:

Transparency is one of the fundamental tenets of strong corporate governance. When climate risk is material, consideration should be given to disclosing the company’s governance and risk management practices around climate risk.

As a result of an extensive review of various guidance documents, as well as engaging various stakeholder groups, Haque, Deegan and Inglis (2016) developed a ‘best practice disclosure’ list of items that organisations should disclose in order to allow interested readers to know the extent to which an organisation is addressing climate change and the risks related thereto. This best practice disclosure index is shown in Table 32.7. Haque, Deegan and Inglis (2016) reviewed the annual reports and sustainability reports of a sample of Australia’s most highly carbon-intensive companies. Unfortunately, they found that very few of the items in Table 32.7 were disclosed by the companies. This is consistent with the results reported within ASIC (2018), in which ASIC found that companies generally disclosed very little information about their climate change-related governance policies. Haque, Deegan and Inglis (2016) also undertook a series of interviews with corporate managers to understand the reasons behind the low levels of climate change-related corporate governance disclosure, and in this regard they note (p. 620) that:

dee67382_ch32_1249-1332.indd 1317 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1317

Interview results indicate that the low levels of disclosure by Australian companies may be due to a number of factors. A lack of proactive stakeholder engagement and an apparent preoccupation with financial performance and advancing shareholders’ interest, coupled with a failure by managers to accept accountability, seems to go a long way towards explaining low levels of disclosure.

Exhibit 32.15 Woolworths 2019 Sustainability Report

SOURCE: Woolworths 2019 Sustainability Report, p. 36

dee67382_ch32_1249-1332.indd 1318 10/25/19 01:46 PM

1318 PART 10: Corporate social-responsibility reporting

You should review Table 32.7 and, in doing so, consider how knowledge about the existence, or absence, of the respective governance policy would influence your judgement regarding whether an organisation is seriously addressing the issues and risks associated with climate change.

General categories Specific issues

Board oversight (1) Organisation has/does not have a board committee with explicit oversight responsibility for environmental affairs.

(2) Organisation has/does not have a specific board committee for climate change and GHG affairs.

(3) The Board conducts/does not conduct periodic reviews of climate change performance.

(4) Organisation discloses the potential financial implications of any climate change policy affecting the organisation.

Senior management engagement and responsibility

(5) Chairperson/CEO articulates the organisation’s views on the issue of climate change through publicly available documents such as annual reports, sustainability reports, and websites.

(6) Organisation has/does not have an executive risk management team, dealing specifically with GHG issues.

(7) Whether senior executives have specific responsibility for relationships with government, the media and the community with a specific focus on climate change issues.

(8) An organisation has/does not have a performance assessment tool to identify current gaps in GHG management.

(9) The executive officers’ and/or senior managers’ compensation is/is not linked to attainment of environmental goals.

(10) The executive officers’ and/or senior managers’ compensation is/is not linked to attainment of GHG targets.

Emissions accounting

(11) Organisation conducts/does not conduct annual inventory of total direct/indirect GHG emissions from operations.

(12) Organisation calculates/does not calculate GHG emissions savings and offsets from its projects.

(13) Organisation has/has not set an emissions baseline year by which to estimate future GHG emissions trends.

(14) Organisation sets/does not set absolute GHG emission reduction targets for facilities and products.

(15) Organisation has/does not have third-party verification processes for GHG emissions data.

(16) Organisation has/does not have a specific policy to purchase and/or develop renewable energy sources.

(17) Organisation has/does not have specific requirements for suppliers to reduce GHG emissions associated with their operations.

(18) Organisation has/does not have a policy of providing product information including emissions reduction information to the customers through product labelling.

(19) Organisation has/does not have an accredited labelling standard for providing information about the environmental impacts of the products.

Research and development

(20) Organisation has/does not have a specific policy to develop energy efficiency by utilising/acquiring low-emission technologies.

(21) Organisation has/does not have a policy of investment to accelerate the research and development of low-emissions technologies and support energy-efficient projects.

Potential liability reduction

(22) Organisation pursues/does not pursue strategies to minimise exposure to potential regulatory risks and/or physical threats to assets relating to climate change.

(23) Organisation pursues/does not pursue strategies to minimise the possibility of litigation being brought against it for its impact on climate change.

Table 32.7 ‘Best practice’ climate change- related corporate governance disclosure items

dee67382_ch32_1249-1332.indd 1319 11/01/19 10:35 AM

CHAPTER 32: Accounting for corporate social responsibility 1319

Accounting professional bodies are also increasingly starting to release guidance/requirements in relation to climate change-related disclosures. For example, in March 2019 the AASB released a report entitled Climate-Related and Other Emerging Risks Disclosures: Assessing Financial Statement Materiality Using AASB/IASB Practice Statement 2 (see www.aasb.gov.au/admin/file/content102/c3/AASB_AUASB_Joint_Bulletin_Finished.pdf). In the report it is noted that, in accordance with AASB/IASB Practice Statement 2 Making Materiality Judgements (APS/PS 2), various factors may make climate-related risks ‘material’ to readers of financial reports and thereby warrant related disclosures when preparing financial statements, regardless of their numerical impact.

The report notes (AASB 2019, p. 4) that entities preparing financial statements should consider the needs of report readers particularly in regard to their requirement to know how climate-related risks have influenced various asset and liability valuations made within the organisation, as well as other operational decisions being made within the organisation. According to AASB (2019, p. 11), the potential financial implications arising from climate-related and other emerging risks may include, but are not limited to:

∙ asset impairment ∙ changes in the useful life of assets ∙ changes in the fair valuation of assets due to climate-related and emerging risks ∙ increased costs and/or reduced demand for products and services affecting impairment calculations and/or

requiring recognition of provisions for onerous contracts ∙ potential provisions and contingent liabilities arising from fines and penalties, and ∙ changes in expected credit losses for loans and other financial assets.

Therefore, the report by the AASB makes it very clear that climate change-related risks are now an important issue to consider when preparing financial statements.

The Australian Securities and Investments Commission (ASIC) is also releasing guidance in relation to climate change. For example, in August 2019 ASIC released Regulatory Guide 247: Effective Disclosure in an Operating and Financial Review. As we explained in Chapter 1, companies with securities listed on the ASX must present an operating and financial review (OFR), also known as a ‘management commentary’ or a ‘management discussion and analysis’, which provides an overview that better enables shareholders to understand an entity’s business performance and the factors underlying its financial position. The ASIC regulatory guide (paragraph 64) notes that an OFR:

should include a discussion of environmental, social and governance risks where those risks could affect the entity’s achievement of its financial performance or outcomes disclosed, taking into account the nature and business of the entity and its business strategy

General categories Specific issues

Reporting/ benchmarking

(24) Organisation has/does not have specific frameworks to benchmark its GHG emissions against other companies and competitors.

(25) Organisation employs/does not employ industry benchmarking standards for reducing GHG emissions.

(26) Organisation has/does not have a policy of compliance with GRI Guidelines or a comparable Triple-Bottom-Line format (e.g. GHG Protocol) to report its GHG emissions and trends.

Carbon pricing and emission trading

(27) Organisation has/does not have a policy for trading in regional and/or international emission trading schemes.

(28) Organisation has/does not have a policy to assist government and other stakeholders on the design of effective climate change policies such as carbon pricing and/or National Emission Trading Scheme.

External affairs (29) Organisation has/does not have a public policy to support collaborative solutions (e.g. work with the government and other organisations in voluntary emission reduction projects) for climate change.

(30) Organisation has/does not have a policy to promote climate friendly behaviour within the community by raising awareness through environmental sustainability education.

(31) Disclosure of policy about climate change-related political lobbying

SOURCE: Adapted from Haque, S., Deegan, C. & Inglis, R., 2016, ‘Demand for, and Impediments to, the Disclosure of Information about Climate Change-Related Corporate Governance Practices’, Accounting and Business Research, Vol. 46, no. 6, p. 620 (Reprinted with permission of the publisher, Taylor & Francis Ltd http://www.tandfonline)

dee67382_ch32_1249-1332.indd 1320 10/25/19 01:46 PM

1320 PART 10: Corporate social-responsibility reporting

In relation specifically to climate change, paragraph 66 of the ASIC guide further states:

Climate change is a systemic risk that could have a material impact on the future financial position, performance or prospects of entities. Examples of other risks that could have a material impact for particular entities may include digital disruption, new technologies, geopolitical risks and cyber security. Directors may also consider whether it would be worthwhile to disclose additional information that would be relevant under integrated reporting, sustainability reporting or the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), where that information is not already required for the OFR.

Therefore, corporate regulators are clearly expecting increased disclosure in relation to issues associated with climate change, again reinforcing the point that accountants need to understand the relevance of climate change to corporate reporting.

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 ETS 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.

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 organisations, through a broker, or on an exchange. Excess allowances can be ‘banked’ and used to satisfy compliance requirements in subsequent years. It is argued that cap-and-trade programs provide organisations with added flexibility to choose the most cost-effective way to manage their emissions.

The introduction of an ETS in some countries 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.

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 Emissions Trading Scheme—which is an example of a cap-and-trade scheme where pollution rights are traded within a specifically

dee67382_ch32_1249-1332.indd 1321 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1321

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.

The Greenhouse Gas Protocol One approach to measuring greenhouse gas emissions is provided by the Greenhouse Gas Protocol. According to the GHG Protocol website (GHG Protocol; www.ghgprotocol.org/corporate-standard, accessed October 2019):

The GHG Protocol Corporate Accounting and Reporting Standard provides requirements and guidance for companies and other organizations preparing a corporate-level GHG emissions inventory. The standard covers the accounting and reporting of seven greenhouse gases covered by the Kyoto Protocol—carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), sulphur hexafluoride (SF6) and nitrogen trifluoride (NF3). It was updated in 2015 with Scope 2 Guidance, which allows companies to credibly measure and report emissions from purchased or acquired electricity, steam, heat and cooling.

The GHG Protocol is one of the most widely used international accounting tools for quantifying greenhouse gas emissions. Pursuant to the GHG Protocol, emissions can be divided into three categories: Scope 1, Scope 2 and Scope 3:

∙ Scope 1—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 – fugitive emissions.

Fugitive emissions, referred to above, result from the intentional or unintentional release of GHGs (for example, the leakage of hydrofluorocarbons from refrigeration and air-conditioning equipment).

∙ Scope 2— emissions generated in the production of electricity consumed by an organisation, where that electricity is generated outside of the organisation’s measurement boundary (that is, the electricity is generated by a different entity, namely an electricity generator).

∙ Scope 3—all of the other indirect emissions that are a consequence of the activities of an organisation, but which occur from sources not owned or controlled by the organisation, such as:

– commuting – air travel for work-related activities – waste disposal – embodied emissions from the extraction, production and transportation of purchased goods – outsourced activities – contractor-owned vehicles – line loss from electricity transmission and distribution.

The requirement to report information about different ‘scopes’ reflects the fact that some emissions (Scope 1) are considered easier to monitor and control than others. Different countries have different requirements in relation to reporting GHG emissions. 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 Australian National Greenhouse and Energy Reporting Act (NGER), and the GHG Protocol is considered an appropriate framework to measure these emissions.

dee67382_ch32_1249-1332.indd 1322 10/25/19 01:46 PM

1322 PART 10: Corporate social-responsibility reporting

32.14 Personal social responsibility

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.

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!

WHY DO I NEED TO KNOW ABOUT CLIMATE CHANGE AND UNDERSTAND SOME OF THE WAYS IN WHICH ORGANISATIONS CAN REPORT INFORMATION ABOUT THEIR PERFORMANCE AND INITIATIVES IN RELATION TO CLIMATE CHANGE?

As future business leaders, it is essential that we understand the global crisis represented by climate change. It is important that we comprehend the necessity for all people and organisations—including those we will work for—to address climate change and to develop policies to reduce or ideally eliminate their carbon-related emissions. Because of the responsibility that all organisations have with respect to climate change, managers need to understand the various frameworks that are available to demonstrate their accountability with respect to climate change. We have also learned that even from a ‘traditional’ financial reporting perspective, climate change-related risks also have implications for how amounts are attributed to assets and liabilities within the financial statements (see AASB 2019).

LO 32.14

dee67382_ch32_1249-1332.indd 1323 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1323

environmental accounting An approach to external reporting that incorporates the impacts of the organisation on its physical surroundings.

Concluding remarks

What has happened in recent decades 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 and environmental reporting as part of the duties of accountants, and (hopefully) to incorporate social and environmental accounting issues in their educational programs in a meaningful way. While some universities already have entire units devoted to social and environmental accounting, they are currently in the minority. It is expected that to reflect the role that accountants can play in the provision of social and environmental information, more universities will develop social and environmental accounting and reporting units, thereby recognising the fact that organisations are accountable beyond their financial performance.

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 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.

dee67382_ch32_1249-1332.indd 1324 10/25/19 01:46 PM

1324 PART 10: Corporate social-responsibility reporting

KEY TERMS

accountability 1258 counter accounts 1311 dialogic accounting 1311 efficient-markets hypothesis 1276 environmental accounting 1323 externality 1251 monologic accounting 1311

social audit 1275 social benefits 1258 social contract 1270 social cost 1252 social-responsibility reporting 1252 stakeholder 1251

sustainable development 1253 traditional financial accounting 1280 triple-bottom-line reporting 1253

ANSWERS TO OPENING QUESTIONS

At the beginning of this chapter we asked the following seven questions. As a result of reading this chapter, you should now be able to provide informed answers to these questions—ours are shown below.

1. What is ‘corporate social responsibility’? LO 32.1, 32.3 As the chapter discussed, there are various definitions of corporate social responsibility. The definition provided in Section 32.1 from the Commission of European Communities is an accepted definition.

2. What is ‘corporate social-responsibility reporting’? LO 32.1 Corporate social-responsibility reporting provides information about how an organisation has addressed its social responsibilities, and involves the disclosure of information about the performance of an organisation in relation to its interaction with its physical and social environment.

3. What does ‘sustainable development’ mean? LO 32.2 A commonly accepted definition is ‘development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’. Such a definition emphasises the need to consider both intragenerational equity (that all people throughout the world be treated equitably) and intergenerational equity (that the obligation to future generations is considered). The reason why ‘intragenerational equity’ is important to sustainable development is that current-day social inequities are a cause of environmental degradation because poverty reduces people’s ability to choose whether or not to be environmentally focused in their activities.

4. What is the relationship, if any, between perceptions of organisational ‘responsibilities’ and ‘accounting’? LO 32.3, 32.5 There is a direct relationship, as represented in Figure 32.1, which shows that perceptions of organisational responsibilities directly impact judgements about the accountabilities managers should demonstrate, which in turn directly influences their decisions on what form of ‘accounts’ they will provide to stakeholders.

5. What is the Global Reporting Initiative? LO 32.9 The Global Reporting Initiative is an organisation that has been generating sustainability reporting guidance for over two decades. The GRI standards are the most commonly used standards for CSR/sustainability reporting.

6. What is an ‘externality’, and does financial reporting typically account for the externalities being generated by an organisation? LO 32.11 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. Financial reporting typically ignores many of the externalities generated by an organisation.

7. What is ‘integrated reporting’? LO 32.9 Integrated reporting can take on a variety of forms and can be defined in a number of ways, but it would generally be perceived as involving the generation of reports that integrate information about the social, economic/financial and environmental implications/impacts of an organisation’s operations.

dee67382_ch32_1249-1332.indd 1325 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1325

REVIEW QUESTIONS (KEY: Easy • Medium •• Hard •••)

1. What is social-responsibility reporting? LO 32.1 • 2. What is meant by the term ‘accountability’? LO 32.3 • 3. What is the relationship between ‘accountability’ and ‘accounting’? LO 32.3, 32.5 • 4. What would you consider to be the social responsibilities of business? LO 32.1, 32.3 • 5. What is the Sustainability Accounting Standards Board? LO 32.9 • 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 32.6 •• 7. What are some of the central premises of Legitimacy Theory? LO 32.6 • 8. According to Legitimacy Theory, what are the implications for an organisation that fails to comply with the expectations

held by society? LO 32.6 • 9. What is the IPCC? LO 32.13 • 10. In relation to schemes aimed at reducing carbon emissions, briefly explain how a ‘cap-and-trade’ system operates.

LO 32.13 • 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 32.6, 32.7 •• 12. Do the majority of large companies actually disclose information about their social and environmental performance?

LO 32.4 • 13. Does an organisation have a responsibility to future generations? LO 32.2 • 14. What is sustainable development? LO 32.2 • 15. From the perspective of sustainable development, why is it important to consider both intergenerational and

intragenerational equity? LO 32.2 •• 16. Does AASB 116 have any requirements in relation to restoring land? If so, what are the requirements? LO 32.8 • 17. According to the GRI, what are the six principles for defining report quality, and are they similar to the qualitative

characteristics identified in the Conceptual Framework for Financial Reporting? LO 32.8, 32.9 • 18. What is the role of the United Nations’ Sustainable Development Goals? LO 32.10 • 19. In relation to the issue of ‘biodiversity’, what types of disclosures are suggested by GRI 304? LO 32.9 • 20. Explain the apparent rationale behind the Australian Government introducing the Modern Slavery Act. LO 32.6, 32.9 •• 21. What do ‘counter accounts’ represent, and would the incorporation of ‘counter accounts’ within corporate reports

enhance the usefulness of corporate reports? LO 32.12 •• 22. What are some of the motivations that might drive corporate managers to voluntarily disclose social and environmental

performance information? LO 32.6 •• 23. What is an externality and do reported profits incorporate a measure of the externalities generated by a reporting

entity? LO 32.11 •• 24. As used within this chapter, what does ‘full cost accounting’ involve? LO 32.11 • 25. What is personal social responsibility and what is the role of business educators in instilling the idea of personal

social responsibility within students? LO 32.14 •• 26. The following appeared in the 2018 Sustainability Report of BHP (p. 10):

Our social licence is an informal set of enabling relationships that exist between BHP and our local, regional and global stakeholders. Our social licence is built on and sustained by the quality of our relationships, our operational and environmental performance, our social impacts and the lasting benefits we create.

REQUIRED Can you explain the nature of this ‘social licence’? For example, is it a written contract? LO 32.6, 32.8 •

dee67382_ch32_1249-1332.indd 1326 10/25/19 01:46 PM

1326 PART 10: Corporate social-responsibility reporting

27. In a newspaper article entitled ‘NAB slashes to brace for digital threat’ (by Clancy Yeates, The Age, 3 November 2017, p. 20), it was reported that:

National Australia Bank chief executive Andrew Thorburn is unleashing a $1 billion cost-cutting drive he says is needed to prepare the bank for a world of tougher competition and economic conditions. Mr Thorburn said up to 6000 jobs would be lost over the next three years as part of a plan to slash expenses while investing in new technology, including by using automation to replace work done by people.

REQUIRED The slashing of so many jobs will likely cause various social impacts. Referring to the definitions of the elements of financial accounting, why are such social costs not considered to represent ‘expenses’? LO 32.9 •

28. What is climate change and what are some of the accounting issues associated with climate change? LO 32.13 •• 29. 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 32.8 •• 30. In this chapter it was stated:

When we then review the Framework to see the perspective adopted with respect to the primary purpose of an integrated report we find (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 32.3, 32.9 ••• 31. 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 32.6 •••

32. Evaluate the following statement: ‘The annual report issued to the public is a very important document of the organisation from a strategic perspective’. LO 32.6 ••

33. Brown and Deegan (1999) provided results which showed that companies operating within industries that are subject to higher levels of news 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 32.6, 32.8 •••

34. On page 73 of the Rio Tinto 2018 Sustainable Development Report, the following statement is made under the heading ‘Our Stakeholders’:

Our stakeholders are vital to our success. What we learn from them helps us to create value for everyone. We consider any person or organisation with an interest in our activities a Rio Tinto stakeholder. This includes people potentially affected by our activities and those who influence our business decisions.

REQUIRED 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 32.3 •••

35. In a newspaper article entitled ‘Even regulators now factor in climate risks’ (by Richard Gluyas, The Australian, 20 August 2019, p. 21), it was reported that:

Last April, Bank of England executive director Sarah Breeden gave an eye-popping speech in which she estimated the transition cost to a low-carbon global economy would be up to $US20 trillion ($29.5 trillion).

This reflected the impact on the financial system of stranded assets that turn out to be worth less than expected—probably zero, in her words, in the case of unburnable carbon.

The estimated losses in the fossil fuels segment alone were between $US1 trillion and $US4 trillion. The latter figures are highly relevant for Australia, which counts iron ore, coal, natural gas, aluminium ores and crude petroleum among its top 10 export earners.

REQUIRED Explain why concern about climate change might require some organisations to recognise large impairment losses on some of their (‘stranded’) assets. LO 32.13 •••

dee67382_ch32_1249-1332.indd 1327 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1327

CHALLENGING QUESTIONS

36. In a newspaper article entitled ‘Huawei exec grilled by hostile MPs’ (by Latika Bourke, The Age, 12 June 2019, p. 14), it was reported that John Suffolk, Huawei’s vice-president and global cyber security and privacy officer, appeared before a UK parliamentary committee. He was asked about a report published by the Australian Policy and Strategic Institute that highlighted the organisation’s potential role in enabling China’s surveillance, repression and persecution of Uighurs and other Muslim ethnic minority communities in Xinjiang province. It was reported that he was specifically asked whether the United Kingdom should do business with a company that is complicit in such human rights abuses. It was reported that:

Suffolk said: ‘I think you should do business with all companies that stick to the law.’ Earlier, Suffolk said it was Huawei’s job to work within the law of the 170 countries in which it operates, regardless of the sort of government that set the laws. ‘It is the government’s role to set the law whether it is in the east or the west. It is our job as a supplier to work within that law, so it doesn’t matter to us what is the name of the country—it is whether it is lawful,’ Suffolk said. ‘We don’t make judgments whether laws are right or wrong, that’s for others to make those judgments.’

REQUIRED Is this response consistent with our definition of corporate social responsibility provided within this chapter? Further, do you think such a statement would impact the perceived ‘legitimacy’ of the organisation? LO 32.1, 32.3

37. 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 32.7, 32.8

38. 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 32.1, 32.3

39. How does the decision about ‘what’ and ‘to whom’ to report relate to considerations of ‘why’ report? LO 32.5

40. 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:

(a) how and why the way we define assets and expenses tends to exclude the recognition of social and environmental impacts

(b) why the ‘entity principle’ is inconsistent with the principle of sustainable development (c) why the recognition criteria for the elements of accounting can lead to organisations not recognising environment-

related obligations and associated costs (d) why periodic (12-month) reporting can act to discourage a business organisation from taking a longer-term view

of its operations. LO 32.9

41. 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.

REQUIRED Critically evaluate Gray and Bebbington’s statement. LO 32.9

42. 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;

dee67382_ch32_1249-1332.indd 1328 10/25/19 01:46 PM

1328 PART 10: Corporate social-responsibility reporting

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 32.1, 32.3

43. 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 32.1, 32.3

44. 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?

REQUIRED Critically evaluate the above quotation and provide an opinion on the ‘true or false’ question. LO 32.1

45. 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 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.

REQUIRED Explain and evaluate what Brown is saying in the above quote. LO 32.12

46. Assume that you are the chief financial officer of a company that provides printing services. The company supplies the customer with a choice of recycled or non-recycled paper for use in printing jobs. Chemicals used in the production printing process are disposed of in compliance with environmental regulations, but a low level of land, air and noise pollution is incurred. The company provides regional employment in a large country town. The chief executive officer has asked you to make a recommendation on the nature and extent of social and environmental reporting, if any, that the company should undertake.

In your reply, consider the costs and benefits to the company and various stakeholders. If recommending social or environmental reporting, suggest the form it should take and how, and to whom, the report should be disseminated. LO 32.1, 32.3, 32.5, 32.6, 32.7, 32.8

47. In this chapter it was stated:

Because different teams of managers will have different views about corporate social responsibilities and associated accountability, they will inevitably provide different sets of ‘accounts’.

REQUIRED Explain the meaning of the above quote. LO 32.3, 32.5

48. In an article entitled ‘Business and society in the coming decades’, which was available on the website of McKinsey & Company (accessed in October 2015), the following three quotes appeared. (a) Long-term capitalism takes a deeper view of business’s role in society, recognizing that, in the long run,

the interests of stakeholders converge with the interests of the broader community. (b) There are compelling reasons companies should seize the initiative to drive social and business benefits.

First, in an interconnected world facing unprecedented environmental and social challenges, society will demand it. Increasingly, a basic expectation among customers, governments, and communities will be that the companies they do business with provide a significant net positive return for society at large, not just for investors. This will be part of the implicit contract or license to operate.

dee67382_ch32_1249-1332.indd 1329 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1329

(c) While it is important to operate the core business in a way that delivers value for society and the business, a healthy, high-performing company can and must go further. The world faces social, environmental, and financial challenges of unprecedented magnitude and complexity. No one actor can resolve these issues single-handedly. Governments and civil society are increasingly calling business to the table.

REQUIRED You are to read each quote and explain in your own words what you believe the quote is saying, and whether you believe there is logic in the argument. LO 32.1, 32.3

REFERENCES Adams, C.A., 2004, ‘The Ethical, Social and Environmental

Reporting—Performance Portrayal Gap’, Accounting, Auditing and Accountability Journal, vol. 17, no. 5, pp. 731–57.

Ader, C.R., 1995, ‘A Longitudinal Study of Agenda Setting For the Issues of Environmental Pollution’, Journalism and Mass Communication Quarterly, vol. 72, no. 2, pp. 300–11.

Anderson, J.C. & Frankle, A.W., 1980, ‘Voluntary Social Reporting: An Iso-beta Portfolio Analysis’, The Accounting Review, vol. 55, no. 3, pp. 467–79.

ASX Corporate Governance Council, 2019, Corporate Governance Principles and Recommendations, 4th edition, ASX, Sydney.

Australian Academy of Science, 2015, The Science of Climate Change: Questions and Answers, Australian Academy of Science, Wollongong.

Australian Accounting Standards Board, 2019, Climate-Related and Other Emerging Risks Disclosures: Assessing Financial Statement Materiality Using AASB/IASB Practice Statement 2, AASB, March, see https://aasb.gov.au/admin/file/ content102/c3/AASB_AUASB_Joint_Bulletin_Finished.pdf

Australian Corporations and Markets Advisory Committee, 2006, The Social Responsibility of Corporations, Australian Government, Canberra.

Australian Securities and Investments Commission, 2018, Climate Risk Disclosure by Australia’s Listed Companies, ASIC Report 593, September.

Australian Securities and Investments Commission, 2019, Regulatory Guide 247: Effective Disclosure in an Operating and Financial Review, ASIC, August.

Barton, A., 2006, ‘Public Sector Accountability and Commercial-in- Confidence Outsourcing Contracts’, Accounting, Auditing and Accountability Journal, vol. 19, no. 2, pp. 256–71.

Bebbington, J. & Gray, R., 2001, ‘An Account of Sustainability: Failure, Success and a Reconceptualisation’, Critical Perspectives on Accounting, vol. 12, no. 5, pp. 557–605.

Belkaoui, A., 1976, ‘The Impact of the Disclosure of the Environmental Effects of Organizational Behavior on the Market’, Financial Management, Winter, pp. 26–31.

Boiral, O., 2013, ‘Sustainability Reports as Simulacra? A Counter- account of A and A+ GRI Reports’, Accounting, Auditing and Accountability Journal, vol. 26, no. 7, pp. 1036–71.

Brooks, C. & Oikonomou, J., 2018, ‘The Effects of Environmental, Social and Governance Disclosures and Performance on Firm Value: A Review of the Literature in Accounting and Finance’, The British Accounting Review, vol. 50, pp. 1–15.

Brown, J., 2009, ‘Democracy, Sustainability and Dialogic Accounting Technologies: Taking Pluralism Seriously’, Critical Perspectives on Accounting, vol. 20, pp. 313–42.

Brown, N. & Deegan, C., 1999, ‘The Public Disclosure of Environmental Performance Information—A Dual Test of Media Agenda-setting Theory and Legitimacy Theory’, Accounting and Business Research, vol. 29, no. 1.

Chandler, D., 2010, ‘What Does Business Owe the World? Why Aren’t We Stressing Stakeholder Responsibility?’ Harvard Business Review, Blog Network, 28 April, http://blogs.hbr. org/what-business-owes-the-worl/2010/04/why-arent-we- stressing-stakeho.html

Cicutto, F., 2002, ‘Banks and their Corporate Social Responsibility’, Journal of Banking and Financial Services, December, pp. 16–19.

Commission Of European Communities, 2001, Promoting a European Framework for Corporate Social Responsibility, Green Paper, Brussels: Commission of European Communities.

Cooper, C., Coulson, A. & Taylor, P., 2011, ‘Accounting for Human Rights: Doxic Health and Safety Practices—The Accounting Lesson from ICL’, Critical Perspectives on Accounting, vol. 22, no. 8, pp. 738–58.

Corporations and Markets Advisory Committee, 2006, The Social Responsibilities of Corporations, CMAC, Sydney, December.

CPA Australia, 2019, ‘Regulating Transparency and Disclosure on Modern Slavery in Global Supply Chains: A Conversation Starter or a Tick-Box Exercise?’, CPA Australia, Melbourne, March.

Davies, J. & Dunk, R., 2015, ‘Flying along the Supply Chain: Accounting for Emissions from Student Air Travel in the Higher Education Sector’, Carbon Management, vol. 6, no. 5–6, pp. 233–46.

Deegan, C., 1996, ‘A Review of Mandated Environmental Reporting Requirements for Australian Corporations Together with an Analysis of Contemporary Australian and Overseas Environmental Reporting Practices’, Environmental and Planning Law Journal, vol. 13, no. 2, April, pp. 120–32.

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, pp. 448–58.

Deegan, C., 2014, Financial Accounting Theory, 4th edition, McGraw-Hill, Sydney.

Deegan, C., 2020a, An Introduction to Accounting: Accountability in Organisations and Society, Cengage Learning Australia, South Melbourne.

Deegan, C., 2020b, ‘Legitimacy Theory: Despite Its Enduring Popularity and Contribution, Time is Right for a Necessary

dee67382_ch32_1249-1332.indd 1330 10/25/19 01:46 PM

1330 PART 10: Corporate social-responsibility reporting

Makeover’, Accounting, Auditing and Accountability Journal, forthcoming.

Deegan, C. & Blomquist, C., 2006, ‘Stakeholder Influence on Corporate Reporting: An Exploration of the Interaction Between the World Wide Fund for Nature and the Australian Minerals Industry’, Accounting, Organizations and Society, vol. 31, no. 4/5, pp. 343–72.

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. & Rankin, M., 1996, ‘Do Australian Companies Objectively Report Environmental News? An Analysis of Environmental Disclosures by Firms Successfully Prosecuted by the Environmental Protection Authority’, Accounting, Auditing and Accountability Journal, vol. 9, no. 2, pp. 52–69.

Deegan, C. & Rankin, M., 1997, ‘The Materiality of Environmental Information to Users of Accounting Reports’, Accounting, Auditing and Accountability Journal, vol. 10, no. 4, pp. 562–83.

Deegan, C., Rankin, M. & Tobin, J., 2002, ‘An Examination of the Corporate Social and Environmental Disclosures of BHP from 1983–1997: A Test of Legitimacy Theory’, Accounting, Auditing and Accountability Journal, vol. 15, no. 3, pp. 312–43.

Deegan, C. & Shelly, M., 2014, ‘Corporate Social Responsibilities: Alternative Perspectives about the Need to Regulate’, Journal of Business Ethics, vol. 121, no. 4, pp. 499–526.

Dowling, J. & Pfeffer, J., 1975, ‘Organizational Legitimacy: Social Values and Organizational Behavior’, Pacific Sociological Review, vol. 18, no. 1, pp. 122–36.

Elkington, J., 1997, Cannibals with Forks: The Triple Bottom Line of 21st Century Business, Capstone, Oxford.

Environmental Accounting And Auditing Reporter, 2000, ‘Accounting for the Environment—the Interface Experiment’, Informa, UK, September.

Freeman, R., 1984, Strategic Management: A Stakeholder Approach, Pitman, Marshall, MA.

Freeman, R. & Reed, D., 1983, ‘Stockholders and Stakeholders: A New Perspective on Corporate Governance’, Californian Management Review, vol. 25, no. 2, pp. 88–106.

Friedman, M., 1962, Capitalism and Freedom, University of Chicago Press, Chicago.

Global Reporting Initiative, 2016, GRI 101: Foundation 2016, www.globalreporting.org/standards/media/1036/gri-101- foundation-2016.pdf

Global Reporting Initiative, 2018, GRI Standards Glossary, p. 2, www.globalreporting.org/standards/media/1913/ gri-standards-glossary.pdf

Grant, R. & Keohane, R., 2005, ‘Accountability and Abuses of Power in World Politics’, American Political Science Review, vol. 99, no. 1, pp. 29–43.

Gray, R., 2013, ‘Back to Basics: What Do We Mean by Environmental (and Social) Accounting and What Is It For?–A Reaction to Thornton’, Critical Perspectives on Accounting, vol. 24, no. 6, pp. 459–68.

Gray, R., Adams, C. & Owen, D., 2014, Accountability, Social Responsibility and Sustainability, Pearson Education, London.

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., Collison, D., Kouhy, R., Lyon, B., Reid, C., Russell, A. & Stevenson, L., 1998, The Valuation of Assets and Liabilities: Environmental Law and the Impact of the Environmental Agenda for Business, Institute of Chartered Accountants in Scotland, Edinburgh.

Gray, R. & Laughlin, R., 2012, ‘It Was 20 Years Ago Today’, Accounting, Auditing and Accountability Journal, vol. 25, no. 2, pp. 228–55.

Gray, R., Owen, D. & Adams, C., 1996, Accounting and Accountability: Changes and Challenges in Corporate and Social Reporting, Prentice Hall, London.

Gray, R., Owen, D. & Maunders, K.T., 1991, ‘Accountability, Corporate Social Reporting and the External Social Audits’, Advances in Public Interest Accounting, vol. 4, pp. 1–21.

Griffin, P., Lont, D. & Sun, Y., 2017, ‘The Relevance to Investors of Greenhouse Gas Emission Disclosures’, Contemporary Accounting Research, vol. 34, no. 2, pp. 1265–97.

Griffin, P. & Sun, Y., 2012, ‘Going Green: Market Reaction to CSR Newswire Releases’, Capital Markets: Market Efficiency eJournal, University of California, Davis, Graduate School of Management.

Haque, S., Deegan, C. & Inglis, R., 2016, ‘Demand for, and impediments to, the Disclosure of Information about Climate Change- Related Corporate Governance Practices’, Accounting and Business Research, vol. 46, no. 6, pp. 620–64.

Harvey, C., 2015, ‘We are killing the environment one hamburger at a time’, Business Insider Australia, 6 March, www. businessinsider.com.au/one-hamburger-environment- resources-2015-2

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.

Ingram, R.W., 1978, ‘Investigation of the Information Content of Certain Social Responsibility Disclosures’, Journal of Accounting Research, vol. 16, no. 2, pp. 270–85.

Institute Of Chartered Accountants in England and Wales, 1975, The Corporate Report, ICAEW, London.

Intergovernmental Panel on Climate Change, 2014, Climate Change 2014: Synthesis Report. Contribution of Working Groups I, II and III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change [Core writing team: R.K. Pachauri & L.A. Meyer (eds)], IPCC, Geneva, Switzerland.

International Integrated Reporting Council, 2013, The International <IR> Framework, available at www.theiirc.org.

Islam, M.A. & Deegan, C., 2008, ‘Motivations for Organisations within Developing Countries to Report Social Responsibility Information: Evidence from Bangladesh’, Accounting, Auditing and Accountability Journal, vol. 21, no. 6, pp. 850–74.

Islam, M.A. & 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.

Islam, M.A., Deegan, C. & Gray, R., 2018, ‘Social Compliance Audits and Multinational Corporation Supply Chains: Evidence

dee67382_ch32_1249-1332.indd 1331 10/25/19 01:46 PM

CHAPTER 32: Accounting for corporate social responsibility 1331

from a Study of Rituals of Social Audits’, Accounting and Business Research, vol. 48, no. 2, pp. 190–224.

Jaggi, B. & Freedman, M., 1982, ‘An Analysis of the Information Content of Pollution Disclosures’, Financial Review, vol. 19, no. 5, pp. 142–52.

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.

Kering, 2015, ‘Kering Environmental Profit & Loss’, Kering, Paris, available at https://www.kering.com/en/news/open- sources-environmental-profit-loss-account-methodology- catalyse-corporate-natural-capital-accounting

KPMG, 2017, KPMG Survey of Corporate Responsibility Reporting, Amsterdam.

La Torre, M., Dumay, J., Rea, M. & Abhayawansa, S., 2020, ‘A Journey Towards a Safe Harbor: The Rhetorical Process of the International Integrated Reporting Council’, The British Accounting Review, forthcoming.

Lehman, G., 1995, ‘A Legitimate Concern for Environmental Accounting’, Critical Perspectives on Accounting, vol. 6, no. 6, pp. 393–412.

Lindblom, C.K., 1994, ‘The Implications of Organisational Legitimacy for Corporate Social Performance and Disclosure’, Paper presented at the Critical Perspectives on Accounting Conference, New York.

Loh, C., Deegan, C. & Inglis, R., 2015, ‘The Changing Trends of Corporate Social and Environmental Disclosure within the Australian Gambling Industry’, Accounting and Finance, vol. 55, pp. 783–823.

O’Donovan, G., 1999, ‘Managing Legitimacy through Increased Corporate Environmental Reporting: An Exploratory Study’, Interdisciplinary Environmental Review, vol. 1, no. 1, pp. 63–99.

O’Dwyer, B., 2005, ‘The Construction of a Social Account: A Case Study in an Overseas Aid Agency’, Accounting, Organizations and Society, vol. 30, no. 3, pp. 279–96.

Oxford University Press, 2009, Oxford Dictionary of Proverbs, 5th edition, John Simpson and Jennifer Speake (eds), Oxford University Press, London.

Parliamentary Joint Committee on Corporations and Financial Services, 2006, Corporate Responsibility: Managing Risk and Creating Value, Commonwealth of Australia, Canberra, June.

Perks, R.W., 1993, Accounting & Society, Chapman & Hall, London. Rinaldi, L. & Unerman, J., 2009, ‘Stakeholder Engagement and

Dialogue Initiatives of UK FTSE100 Companies over the Internet: An Empirical Analysis’, Interdisciplinary Perspectives on Accounting Conference, Innsbruck.

RMIT University & Global Compact Network Australia, 2019, SDG Measurement and Disclosure by ASX 150: Executive Summary Report, RMIT, Melbourne.

Rowbottom, N. & Locke, J., 2016, ‘The Emergence of <IR>’, Accounting and Business Research, vol. 46, no. 1, pp. 83–115.

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, CA, pp. 67–80.

Sustainability Accounting Standards Board, 2018a, Automobiles: Sustainability Accounting Standard, www.sasb.org/wp- content/uploads/2018/11/Automobiles_Standard_2018. pdf

Sustainability Accounting Standards Board, 2018b, Airlines: Sustainability Accounting Standard, www.sasb.org/wp- content/uploads/2018/11/Airlines_Standard_2018.pdf

Task Force on Climate-related Financial Disclosures, 2017, CEO Guide to Climate-Related Financial Disclosures, World Business Council for Sustainable Development, https://docs.wbcsd.org/2017/12/CEO_Guide_to_climate- related_financial_disclosure.pdf

The Crown Estate, 2017, Total Contribution Report 2017— Everything is Connected, The Crown Estate, London.

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., 2007, ‘Stakeholder Engagement and Dialogue’, in Unerman, J., Bebbington, J. & O’Dwyer, B. (eds), Sustainability Accounting and Accountability, Routledge, Abingdon, pp. 86–103.

Unerman, J., Bebbington, J. & O’Dwyer, B., 2018, ‘Corporate Reporting and Accounting for Externalities’, Accounting and Business Research, vol. 48, no. 5, pp. 497–522.

Unerman, J. & Bennett, M., 2004, ‘Increased Stakeholder Dialogue and the Internet: Towards Greater Corporate Accountability or Reinforcing Capitalist Hegemony?’, Accounting, Organizations and Society, vol. 29, no. 7, pp. 685–707.

US Securities and Exchange Commission, 2002, ‘Commission Statement about Management’s Discussion and Analysis of Financial Condition and Results of Operations’, www.sec. gov/rules/other/33-8056.htm

US Securities and Exchange Commission, 2008, ‘Topic 9: Management’s Discussion and Analysis of Financial Position and Results of Operations (MD&A)’, www.sec.gov/ corpfin/cf-manual/topic-9

Weng, Z., Mudd, G., Martin, T. & Boyle, C., 2012, ‘Pollutant Loads from Coal Mining in Australia: Discerning Trends from the National Pollutant Inventory (NPI)’, Environmental Science & Policy, vols 19–20, May–June, pp. 78–89.

World Commission on Environment and Development, 1987, Our Common Future (The Brundtland Report), Oxford University Press.

Yankelovich, D., 1972, Corporate Priorities: A Continuing Study of the New Demands on Business, Daniel Yankelovich Inc., Stamford, Connecticut.

dee67382_ch32_1249-1332.indd 1332 10/25/19 01:46 PM

dee67382_app_1333-1340.indd 1333 10/25/19 02:36 PM

Appendices Glossary Index

dee67382_app_1333-1340.indd 1334 10/25/19 02:36 PM

1334

APPENDIX A

Present value of $1 in n periods = 1/(1 + k)n, where k is the discount rate.

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12%

1 .9901 .9804 .9709 .9615 .9524 .9434 .9346 .9259 .9174 .9091 .8929 2 .9803 .9612 .9426 .9246 .9070 .8900 .8734 .8573 .8417 .8264 .7972 3 .9706 .9423 .9151 .8890 .8638 .8396 .8163 .7938 .7722 .7513 .7118 4 .9610 .9238 .8885 .8548 .8227 .7921 .7629 .7350 .7084 .6830 .6355 5 .9515 .9057 .8626 .8219 .7835 .7473 .7130 .6806 .6499 .6209 .5674 6 .9420 .8880 .8375 .7903 .7462 .7050 .6663 .6302 .5963 .5645 .5066 7 .9327 .8706 .8131 .7599 .7107 .6651 .6227 .5835 .5470 .5132 .4523 8 .9235 .8535 .7894 .7307 .6768 .6274 .5820 .5403 .5019 .4665 .4039 9 .9143 .8368 .7664 .7026 .6446 .5919 .5439 .5002 .4604 .4241 .3606

10 .9053 .8203 .7441 .6756 .6139 .5584 .5083 .4632 .4224 .3855 .3220 11 .8963 .8043 .7224 .6496 .5847 .5268 .4751 .4289 .3875 .3505 .2875 12 .8874 .7885 .7014 .6246 .5568 .4970 .4440 .3971 .3555 .3186 .2567 13 .8787 .7730 .6810 .6006 .5303 .4688 .4150 .3677 .3262 .2897 .2292 14 .8700 .7579 .6611 .5775 .5051 .4423 .3878 .3405 .2992 .2633 .2046 15 .8613 .7430 .6419 .5553 .4810 .4173 .3624 .3152 .2745 .2394 .1827 16 .8528 .7284 .6232 .5339 .4581 .3936 .3387 .2919 .2519 .2176 .1631 17 .8444 .7142 .6050 .5134 .4363 .3714 .3166 .2703 .2311 .1978 .1456 18 .8360 .7002 .5874 .4936 .4155 .3503 .2959 .2502 .2120 .1799 .1300 19 .8277 .6864 .5703 .4746 .3957 .3305 .2765 .2317 .1945 .1635 .1161 20 .8195 .6730 .5537 .4564 .3769 .3118 .2584 .2145 .1784 .1486 .1037 25 .7798 .6095 .4776 .3751 .2953 .2330 .1842 .1460 .1160 .0923 .0588 30 .7419 .5521 .4120 .3083 .2314 .1741 .1314 .0994 .0754 .0573 .0334 40 .6717 .4529 .3066 .2083 .1420 .0972 .0668 .0460 .0318 .0221 .0107 50 .6080 .3715 .2281 .1407 .0872 .0543 .0339 .0213 .0134 .0085 .0035 60 .5504 .3048 .1697 .0951 .0535 .0303 .0173 .0099 .0057 .0033 .0011

dee67382_app_1333-1340.indd 1335 10/25/19 02:36 PM

1335

Period 14% 15% 16% 18% 20% 24% 28% 32% 36%

1 .8772 .8696 .8621 .8475 .8333 .8065 .7813 .7576 .7353 2 .7695 .7561 .7432 .7182 .6944 .6504 .6104 .5739 .5407 3 .6750 .6575 .6407 .6086 .5787 .5245 .4768 .4348 .3975 4 .5921 .5718 .5523 .5158 .4823 .4230 .3725 .3294 .2923 5 .5194 .4972 .4761 .4371 .4019 .3411 .2910 .2495 .2149 6 .4556 .4323 .4104 .3704 .3349 .2751 .2274 .1890 .1580 7 .3996 .3759 .3538 .3139 .2791 .2218 .1776 .1432 .1162 8 .3506 .3269 .3050 .2660 .2326 .1789 .1388 .1085 .0854 9 .3075 .2843 .2630 .2255 .1938 .1443 .1084 .0822 .0628

10 .2697 .2472 .2267 .1911 .1615 .1164 .0847 .0623 .0462 11 .2366 .2149 .1954 .1619 .1346 .0938 .0662 .0472 .0340 12 .2076 .1869 .1685 .1372 .1122 .0757 .0517 .0357 .0250 13 .1821 .1625 .1452 .1163 .0935 .0610 .0404 .0271 .0184 14 .1597 .1413 .1252 .0985 .0779 .0492 .0316 .0205 .0135 15 .1401 .1229 .1079 .0835 .0649 .0397 .0247 .0155 .0099 16 .1229 .1069 .0930 .0708 .0541 .0320 .0193 .0118 .0073 17 .1078 .0929 .0802 .0600 .0451 .0258 .0150 .0089 .0054 18 .0946 .0808 .0691 .0508 .0376 .0208 .0118 .0068 .0039 19 .0829 .0703 .0596 .0431 .0313 .0168 .0092 .0051 .0029 20 .0728 .0611 .0514 .0365 .0261 .0135 .0072 .0039 .0021 25 .0378 .0304 .0245 .0160 .0105 .0046 .0021 .0010 .0005 30 .0196 .0151 .0116 .0070 .0042 .0016 .0006 .0002 .0001 40 .0053 .0037 .0026 .0013 .0007 .0002 .0001        *        * 50 .0014 .0009 .0006 .0003 .0001     *        *       *       * 60 .0004 .0002 .0001

*The factor is zero to four decimal places

dee67382_app_1333-1340.indd 1336 10/25/19 02:36 PM

1336

APPENDIX B

Present value of an annuity of $1 per period for n periods

= Σ t =1

n

1 _____ (1 + k) t

= 1 − 1 / ( 1 + k ) n

_______ k

No. of payments 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12%

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.8929 2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.6901 3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4018 4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.0373 5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6048 6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.1114 7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.5638 8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 4.9676 9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.3282

10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.6502 11 0.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 5.9377 12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.3561 7.1607 6.8137 6.1944 13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.4235 14 13.0037 12.10621 1.29611 0.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.6282 15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6101 6.8109 16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 6.9740 17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.1196 18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.2497 19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.3658 20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.4694 25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 7.8431 30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269 8.0552 40 32.8347 27.3555 23.1148 19.7928 17.1591 15.0463 13.3317 11.9246 10.7574 9.7791 8.2438 50 39.1961 31.4236 25.7298 21.4822 18.2559 15.7619 13.8007 12.2335 10.9617 9.9148 8.3045 60 44.9550 34.7609 27.6756 22.6235 18.9293 16.1614 14.0392 12.3766 11.0480 9.9672 8.3240

dee67382_app_1333-1340.indd 1337 10/25/19 02:36 PM

1337

No. of payments 14% 15% 16% 18% 20% 24% 28% 32%

   1 0.8772 0.8696 0.8621 0.8475 0.8333 0.8065 0.7813 0.7576    2 1.6467 1.6257 1.6052 1.5656 1.5278 1.4568 1.3916 1.3315    3 2.3216 2.2832 2.2459 2.1743 2.1065 1.9813 1.8684 1.7663    4 2.9137 2.8550 2.7982 2.6901 2.5887 2.4043 2.2410 2.0957    5 3.4331 3.3522 3.2743 3.1272 2.9906 2.7454 2.5320 2.3452    6 3.8887 3.7845 3.6847 3.4976 3.3255 3.0205 2.7594 2.5342    7 4.2883 4.1604 4.0386 3.8115 3.6046 3.2423 2.9370 2.6775    8 4.6389 4.4873 4.3436 4.0776 3.8372 3.4212 3.0758 2.7860    9 4.9464 4.7716 4.6065 4.3030 4.0310 3.5655 3.1842 2.8681  10 5.2161 5.0188 4.8332 4.4941 4.1925 3.6819 3.2689 2.93041  11 5.4527 5.2337 5.0286 4.6560 4.3271 3.7757 3.3351 2.9776  12 5.6603 5.4206 5.1971 4.7932 4.4392 3.8514 3.3868 3.0133  13 5.8424 5.5831 5.3423 4.9095 4.5327 3.9124 3.4272 3.0404  14 6.0021 5.7245 5.4675 5.0081 4.6106 3.9616 3.4587 3.0609  15 6.1422 5.8474 5.5755 5.0916 4.6755 4.0013 3.4834 3.0764  16 6.2651 5.9542 5.6685 5.1624 4.7296 4.0333 3.5026 3.0882  17 6.3729 6.0472 5.7487 5.2223 4.7746 4.0591 3.5177 3.0971  18 6.4674 6.1280 5.8178 5.2732 4.8122 4.0799 3.5294 3.1039  19 6.5504 6.1982 5.8775 5.3162 4.8435 4.0967 3.5386 3.1090  20 6.6231 6.2593 5.9288 5.3527 4.8696 4.1103 3.5458 3.1129  25 6.8729 6.4641 6.0971 5.4669 4.9476 4.1474 3.5640 3.1220  30 7.0027 6.5660 6.1772 5.5168 4.9789 4.1601 3.5693 3.1242  40 7.1050 6.6418 6.2335 5.5482 4.9966 4.1659 3.5712 3.1250  50 7.1327 6.6605 6.2463 5.5541 4.9995 4.1666 3.5714 3.1250  60 7.1401 6.6651 6.2402 5.5553 4.9999 4.1667 3.5714 3.1250

dee67382_app_1333-1340.indd 1338 10/25/19 02:36 PM

1338

APPENDIX C

Calculating present values In financial accounting there are a number of approaches to measuring the cash flows associated with assets and liabilities. One approach is to value the cash flows at their present values. In this appendix we will provide a very basic overview of calculating present values. For a more thorough understanding, reference should be had to appropriate mathematics or economics texts.

The idea underlying present values is that a unit of currency, such as a dollar, is worth more now than the same amount received in the future. That is, the present value of a dollar received today is more than a dollar received at a future date. The extent of the difference will depend upon the discount (or interest) rate being applied. Many factors will affect the choice of discount rate, including the expected risk associated with the future cash flow, current inflation rates, earnings available on alternative investments, and a preference for having money now (and, perhaps, consuming now), as opposed to waiting until a future period.

For example, if we assume that Money Ltd has agreed to pay us $1 in one year’s time, how much would that be worth today? That is, what is its present value? To determine this, we must decide on the appropriate discount rate (which we can also refer to as the interest rate). Let us assume that, given the risk associated with Money Ltd, as well as other factors associated with our preference for holding cash, and other investment alternatives, we believe that we should expect to be able to earn a rate of return of 10 per cent from Money Ltd. Therefore, if Money Ltd has agreed to pay us $1 in one year’s time, and we expect a rate of return of 10 per cent, then the present value of the $1 to be received in one year (that is, what it is worth today) is $0.9091. That is, $0.9091 invested today to earn 10 per cent per annum (our required rate of return) will equal $1.00 in one year’s time. This can be confirmed as follows:

$0.9091 × (1 + interest rate) = $0.9091 × 1.10 = $1.00

What if Money Ltd is going to pay us $1.00 in two years’ time? What would this $1 be worth today? Another way of asking this is to say that if we can earn 10 per cent per year, how much would we need to invest today to have a total of $1.00 in two years’ time? The answer, using the interest rate of 10 per cent, is $0.8264. We can prove this is correct by doing the following calculations. In the first year we would earn 10 per cent, giving us a total of

$0.8264 × 1.10 = $0.9091

This $0.9091 would then earn 10 per cent in the second year, giving us a total of

$0.9091 × 1.10 = $1.00

What we are showing is that, if we expect a rate of return of 10 per cent, then the present value (that is, today’s value) of $1.00 to be received in two years’ time is $0.8264. If the discount rate is correctly assessed as 10 per cent, then we are assumed to be indifferent to whether we receive $0.8264 now, or $1.00 in two years’ time—from our perspective, both amounts are worth the same.

Rather than performing calculations to work out the interest earned each year, we can use the following formula to calculate present values:

Present value = (Amount to be received) ÷ (1 + interest rate)n

where n = number of periods

dee67382_app_1333-1340.indd 1339 10/25/19 02:36 PM

1339

APPeNdix C 1339

For example, if we expect to receive $500 in four years’ time, and we expect a rate of return (also referred to as the interest rate, or discount rate) of 8 per cent, then the present value of the $500 is:

$500 ÷ (1.08)4 = $367.50

To verify this, we can do the calculation ‘long-hand’ and consider the interest earned each year.

Year 1 $367.50 × 1.08 = $ 396.90 Year 2 $ 396.90 × 1.08 = $ 428.65 Year 3 $ 428.65 × 1.08 = $ 462.94 Year 4 $ 462.94 × 1.08 = $500.00

In these calculations, we assume that we do not withdraw the interest earned each year, but instead allow the interest to accumulate and contribute to future earnings. As an alternative way to calculate the present values, we can use the table in Appendix A. We can look down the left-hand-column (‘Period’) of the table until we reach the row relating to four periods. If we then go across this row of the table until we reach the 8% column, this gives us the present value factor of 0.7350. If we multiply $500.00 by 0.7350, we get $367.50, which is the present value of $500 to be received in four years’ time (as calculated above).

We can now extend the analysis to calculate the present value of a stream of payments (or receipts). A series of payments or receipts of the same value is known as an annuity. For example, we might be going to receive $10.00 at the end of each of the next five years—that is, a total of $50.00 over five years. What is the present value of this annuity? If we assume a discount rate of 10 per cent, then using the formula provided above the present value of each of the $10 amounts can be calculated as follows:

Year 1 $10.00 ÷ (1.10)   = $ 9.091 Year 2 $10.00 ÷ (1.10)2  = $ 8.264 Year 3 $10.00 ÷ (1.10)3 = $ 7.514 Year 4 $10.00 ÷ (1.10)4 = $ 6.830 Year 5 $10.00 ÷ (1.10)5 = $ 6.209

$37.908

That is, the present value of a $10.00 annuity to be received at the end of each of the next five years, using a discount rate of 10 per cent, is $37.91. This means that, if 10 per cent is deemed to be the appropriate discount rate, we would be indifferent to whether we receive $37.908 now, or $10.00 at the end of each of the next five years.

To make the calculation of present values of an annuity easier we can refer to Appendix B. If we look down the left column to 5 payments, and go across the row until we reach 10%, then we will find that the present value factor is 3.7908. If we multiply this by $10.00, we will get the same number that we calculated above—$37.908. However, if we use the table in Appendix B, we can find the answer much more easily and more quickly.

We can now combine the above discussion relating to the present value of a discrete amount and the present value of an annuity by considering the following example. Let us assume that we are a company that has sold a building to another company. This company will pay us $100 000 at the end of each of the next five years (which is an annuity), and a final amount of $1 million dollars at the end of year 6. While we are going to receive $1 500 000 in total for the building, the present value of the receipts will be somewhat less. If we assume a discount rate of 5 per cent, then, using the tables in Appendix A and Appendix B, we can calculate the present value as:

$1 million × 0.7462 = $ 746 200 $100 000 × 4.3295 = $ 432 950

   $1 179 150

That is, the present value of the future cash flows associated with selling the building total $1 179 150. It should be noted that, as we increase the discount rate, the present value of the future cash flows will fall.

dee67382_app_1333-1340.indd 1340 10/25/19 02:36 PM

dee67382_glo_1341-1352.indd 1341 10/24/19 04:51 PM

1341

GLOSSARY

absorption costing Where the cost of inventory includes variable production costs and fixed production costs. Often referred to as ‘full costing’.

accountability The duty to provide an account or reckoning of those actions for which one can be held responsible.

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

accounting profit A measure of profit derived by applying generally accepted accounting principles and accounting standards.

accounting-based bonus scheme Employee remuneration scheme where employees receive a bonus tied to accounting numbers.

accounts receivable Amounts owed to an entity by external parties generally as a result of the entity providing goods or services.

accrual accounting A system of accounting in which revenues are recognised when earned and expenses are recognised when incurred, even in the absence of cash flows.

accrual profits/losses The profits or losses that would be disclosed as a result of applying accrual accounting techniques.

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.

accumulated impairment losses Total amount of impairment losses 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.

agency relationship Involving the delegation of decision making from the principal to an agent.

All Ordinaries Share Price Index Index that provides a measure of the movements in the share market within Australia.

allowance for doubtful debts Account that provides an estimate of the amount of the accounts receivable that will ultimately not be received.

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. The terms can also be used interchangeably, though.

annual leave Number of weeks of paid leave to which full-time employees are entitled in a year.

area of interest Individual geological area considered or proved to constitute a favourable environment for the presence of a mineral deposit or an oil or natural gas field.

area-of-interest method Method whereby pre- production 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.

asset Defined in the Conceptual Framework as ‘a present economic resource controlled by the entity as a result of past events’.

asset Resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

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

associate An entity over which the investor has significant influence.

Australian Accounting Standards Board (AASB) Body charged with developing a 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.

Australian Securities and Investments Commission (ASIC) Body 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.

Australian Securities Exchange (ASX) Body that sets uniform trading rules, ethical standards and listing requirements.

dee67382_glo_1341-1352.indd 1342 10/24/19 04:51 PM

1342 GLOSSARY

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.

bad debts expense The amount of expense recognised by writing off an amount that was receivable from a debtor.

balance sheet date The end of the financial period (typically 12 months). Also referred to as ‘reporting date’ or ‘balance date’.

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.

biological asset A living animal or plant.

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.

bonus scheme Where the manager receives a bonus that is tied to the performance of the organisation.

bonus share dividend A distribution to existing shareholders in the form of additional shares in the entity, normally on a pro rata basis and typically funded from retained earnings.

bonus shares Shares received from a bonus issue.

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.

capacity to adapt A measure, promoted by Chambers, tied to the cash that could be obtained if an entity sold its assets.

capital gains tax A tax that is payable on profits arising when an asset (typically a non-current asset) is sold at a price in excess of its cost.

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.

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.

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.

cash-settled share-based 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.

charge A form of security for a debt taken by a creditor over company assets. A mortgage is a type of charge.

committee of creditors A small group of creditors, or their representatives, often appointed by the creditors of a company at the first meeting in a voluntary administration. The committee’s role is to consult with and to receive and consider reports by the voluntary administrator. The committee may be called upon to approve the voluntary administrator’s fees. The voluntary administrator must report to the committee when it reasonably requires.

committee of inspection A small group of creditors and shareholders, or their representatives, often appointed by the creditors and shareholders of a company in liquidation to assist the liquidator. The committee is often called on to approve the liquidator’s fees and sometimes to approve the compromise of debts or the entry of the liquidator into contracts extending beyond three months.

compound financial instrument Financial instrument with both a liability and an equity component.

Conceptual Framework A framework that describes the objective of, and the concepts for, general purpose financial reporting.

conservative accounting policies Policies that tend to understate the value of an entity’s net assets; a bias towards understating the carrying amount of assets and overstating the carrying amount of liabilities.

consolidated entity A combined entity constituted by a parent entity and its controlled entities.

consolidated statement of financial position A statement of financial position that combines, with various eliminations and adjustments, the statements of financial position of the various entities within the economic entity.

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.

consolidation The aggregation of the accounts of a number of separate legal entities.

construction contract Contract relating to the construction of an asset or a combination of assets that are closely interrelated in terms of design, technology, function or use.

contingent liability Obligations that are payable contingent upon a future event or obligations that are not probable (in terms of resource outflows) or are not measurable with sufficient reliability.

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

dee67382_glo_1341-1352.indd 1343 10/24/19 04:51 PM

GLOSSARY 1343

asked how much they would be willing to pay to retain a particular resource.

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.

contra asset Account that typically accumulates data from one period to the next, which is shown as a deduction from another related account.

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.

control (organisations) With regards to related parties and other organisations within a group (economic entity), control means the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.

control over 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.

controlled entity An organisation that is controlled by another entity; often called a subsidiary.

controller A person appointed by a secured creditor to deal with assets subject to a charge: includes a receiver, and receiver and manager.

convertible note Debt that gives the holder the right to convert securities into ordinary shares of the issuer.

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.

costs-written-off method Method whereby all exploration and evaluation costs are written off as incurred.

costs-written-off-and-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.

coupon rate The rate of interest specified on the face of a security.

court-ordered liquidation A liquidation that starts as a result of a court order, made after an application to the court, usually by a creditor of the company.

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

creditor A person who is owed money.

creditors’ voluntary liquidation A liquidation for insolvent companies, initiated by the company. Creditors

may replace the liquidator appointed by the company in this type of liquidation.

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.

current assets 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 12 months after the reporting period; or (d) the asset is cash or a cash equivalent (as defined in AASB 107/IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least 12 months after the reporting period.

current cash equivalents Represented by the amount that would be expected to be generated by selling an asset.

current liability Any liability that satisfies any of the four criteria provided by paragraph 69 of AASB 101.

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

current replacement cost A valuation method based on the current replacement cost of an item rather than its historical cost.

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

date financial statements are authorised for issue For companies, the date the Directors’ Declaration is signed, typically the last thing a company’s directors do before releasing the financial statements. For other entities it is the date of final approval of the report by the management or governing body of the entity.

debenture A written promise to pay a principal amount at a specified time, as well as interest calculated at a specific rate.

debt An amount owed.

debt covenant Restriction within a trust deed/debt contract on the operations of a borrowing entity.

debt-to-asset constraint A restriction included in a debt agreement limiting the amount of debt an entity may have relative to its total assets.

debt-to-assets ratio Derived by dividing the total liabilities of an organisation by its total assets.

debtholder External party with a claim against an organisation for the repayment of funds previously advanced.

declining-balance method Method of depreciation to be used when the economic benefits to be derived from

dee67382_glo_1341-1352.indd 1344 10/24/19 04:51 PM

1344 GLOSSARY

a depreciable asset are expected to be greater in the earlier years relative to the later years.

deed administrator The external administrator appointed to oversee a deed of company arrangement.

deed of company arrangement A binding arrangement between a company and its creditors governing how the company’s affairs will be dealt with, which may be agreed to as a result of the company entering voluntary administration. It aims to maximise the chances of the company, or as much as possible of its business, continuing, or to provide a better return for creditors than an immediate winding up of the company, or both.

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.

depreciable amount 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.

depreciable asset A non-current asset having a limited useful life.

depreciation Allocation of the cost of an asset, or its revalued amount, over the periods in which benefits are expected to be derived.

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.

diluted EPS Shows the extent to which basic EPS would be diluted if potential ordinary shares were actually converted to ordinary shares.

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.

direct-financing lease A lease that is not a lease involving a manufacturer or dealer in which the lessor acquires legal title to 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.

director Anyone who directs an entity in its financial and operating activities independently or with others or anyone occupying or acting in the position of director or directing someone in that position.

dividend A distribution of the profits of an entity to the owners of that entity, typically in the form of cash.

doubtful debts When it is considered to be doubtful that debtors will pay the amounts due, a doubtful debts expense is recognised.

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.

economic entity When used from the perspective of a group of organisations, an economic entity comprises the parent entity and the entities (subsidiaries) under the control of the parent entity.

economically recoverable reserves Estimated quantity of product in an area expected to be profitably extracted, processed and sold in current and foreseeable economic conditions.

effective-interest method Calculating the interest expense for a period by multiplying the opening present value of a liability by the appropriate market rate of interest.

efficient-markets hypothesis A hypothesis holding that the market price of a particular security is directly affected by all relevant information that is publicly available to the market. The hypothesis assumes that the market is efficient in disseminating information.

environmental accounting An approach to external reporting that incorporates the impacts of the organisation on its physical surroundings.

equity Defined by the Conceptual Framework as ‘the residual interest in the assets of the entity after deducting all its liabilities’.

equity instrument Financial instrument that provides the holder with a residual interest in an entity after deduction of its liabilities.

equity instrument A contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

equity investment Usually shares in an organisation, giving the investor an ownership interest and therefore a share in the organisation’s profits.

equity method of accounting Under equity accounting, the investment in an associate or joint venture is increased by any post-acquisition movements in the associate’s or joint venture’s earnings and reserves.

equity-settled share-based 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.

event after the reporting period An event or circumstance that has arisen, or information that has become available, after the end of the reporting period (usually 30 June in Australia) but prior to the time when the financial statements are authorised for issue.

dee67382_glo_1341-1352.indd 1345 10/24/19 04:51 PM

GLOSSARY 1345

exchange rate The rate at which one currency can be exchanged for another.

excluded employee An employee who has also been a director of the company, or a relative of a director, at any time in the 12 months before the appointment of an external administrator. Excluded employees are entitled to only limited priority for repayment of their outstanding entitlements.

exercise price The price the holder of an option will pay to buy a company’s shares or other commodities related to the option.

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.

expensed Something is expensed if it is written off.

expenses Defined in the Conceptual Framework as ‘decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims’.

external administrator A general term for an external person formally appointed to a company or its property: includes provisional liquidator, liquidator, voluntary administrator, deed administrator, controller, receiver, and receiver and manager. Other than a liquidator for a members’ voluntary liquidation and a controller who is not a receiver or receiver and manager, an external administrator is required to be registered by ASIC. An external administrator is sometimes also referred to as an insolvency practitioner.

externality An impact that an entity has on parties external to the organisation. Externalities can be viewed as positive externalities (benefits) or negative externalities (costs).

extractive industries Firms in the extractive industries engage in the search for and extraction from the ground of natural substances of commercial value.

f.o.b. destination An agreement whereby the price of a purchase typically includes the costs necessary to get the item to a certain destination, at which place title to the goods passes to the buyer.

f.o.b. shipping point An agreement whereby the price of a purchase typically includes the costs necessary to get the item to a certain transportation point, at which point title passes to the buyer.

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 could be exchanged between knowledgeable, willing parties in an arm’s length transaction’.

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.

finance lease A lease in which the terms of the lease agreement transfer the risks and benefits of ownership from the lessor to the lessee.

financial asset An asset that is cash or a contractual right to receive cash from or exchange financial instruments with another entity.

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 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.

Financial Reporting Council (FRC) Body that oversees the activities of the AASB and the AUASB.

financial structure Refers to how the resources of the entity have been funded, for example, how much debt there is relative to equity. Financial structure information can also describe the types of debt and types of equity in existence.

financing activities Activities that relate to changing the size and/or composition of the financial structure of the entity.

first-in, first-out (FIFO) cost-flow method Method of assigning costs to inventory where it is assumed that the first inventory that enters an organisation’s stock is the first inventory that is sold.

fixed charge A charge taken by a lender over particular assets of a company. The company may not dispose of these assets without the consent of the lender.

fixed costs Costs that do not fluctuate (at least in the shorter term) as levels of production/activity change.

fixed production costs Costs of production that are not expected to fluctuate as levels of production change.

floating charge A charge taken by a lender over general assets of a company. The company is usually able to use and dispose of these assets (e.g. stock, debtors) in the ordinary course of business without the secured creditor’s consent. A floating charge converts to a fixed charge over those assets if certain events listed in the charge document occur. These usually include the appointment of a liquidator or other external administrator.

foreign currency A currency other than the local currency of the entity.

foreign currency swap Agreement under which the obligation relating to a loan denominated in one currency is swapped for a loan denominated in another currency.

forfeited shares account An account reflecting the amounts paid by investors for partly paid shares and

dee67382_glo_1341-1352.indd 1346 10/24/19 04:51 PM

1346 GLOSSARY

where those shares have been cancelled owing to the failure of investors to pay all amounts due.

forfeited shares reserve A reserve for non-refundable amounts paid by defaulting shareholders, shown as part of the shareholders’ funds of the company.

forward rate The exchange rate that is currently offered for the future acquisition or sale of a specific currency.

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.

functional currency The currency of the primary economic environment in which the entity operates.

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.

futures contract A contract to buy or sell an agreed quantity of a particular item at an agreed price on a specific date.

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.

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 of their information needs.

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.

generally accepted accounting principles Body of conventions, rules and procedures that are generally applied by accountants.

goodwill An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised. These ‘other assets’ would include the future economic benefits associated with an existing customer base, efficient management, reliable suppliers and the like.

grant date Date at which the entity and the counterparty agree to a share-based payment arrangement, this being when the parties reach a shared understanding of the terms and conditions of the arrangement.

group Typically, a group of entities comprising the parent entity and each of its subsidiaries.

hedge Action taken to minimise possible adverse financial effects of movements in exchange rates or other market values.

hedge contract Arrangement with another party in which that other party accepts the risks associated with changing commodity prices, cash flows or exchange rates.

hedging An action taken with the object of avoiding or minimising the possible adverse effects of movements in exchange rates or market prices.

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.

heritage assets Variously defined. For example: ‘non- current assets that a government intends to preserve indefinitely because of their unique historical, cultural or environmental attributes’ (Auditor-General of NSW).

hybrid securities Securities exhibiting both debt and equity characteristics.

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.

income Defined by the Conceptual Framework as ‘increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims’.

independent valuation For non-current assets, a valuation made by an expert in valuations of that class of assets whose pecuniary or other interests could not be capable of affecting that person’s ability to give an unbiased opinion on that valuation.

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

initial direct costs Costs that are directly attributable to negotiating and arranging a lease and would not have been incurred without entering into the lease.

insolvent Unable to pay all debts when they fall due for payment.

Institutional Theory Theory that considers the forms organisations assume and explains why organisations within particular ‘organisational fields’ tend to take on similar characteristics and forms.

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

interest rate swap Occurs 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.

interest revenue Revenue derived as a result of lending resources to another entity.

dee67382_glo_1341-1352.indd 1347 10/24/19 04:51 PM

GLOSSARY 1347

internally generated goodwill Goodwill that is generated by the reporting entity itself, not purchased from an external entity.

intragroup transaction Transaction undertaken between separate legal entities within an economic entity.

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.

investee An entity in which another party (the investor) has an ownership interest.

investing activities Activities that relate to the acquisition and/or disposal of non-current assets.

investor An entity/person that has an ownership interest in another entity (the investee).

joint arrangement An arrangement in which two or more parties have joint control.

joint operation A joint arrangement whereby the parties that have joint control have rights to the assets, and obligations for the liabilities, relating to the arrangement.

joint venture A joint arrangement whereby the parties that have joint control have rights to the net assets of the arrangement.

key management personnel Persons having authority and responsibility for planning, directing and controlling the activities of an entity, including any director of that entity.

last-in, first-out (LIFO) cost-flow method Method of assigning costs to inventory where it is assumed that the last inventory item that enters an organisation’s stock is the first inventory that is sold.

lease An agreement conveying the right from a lessor to a lessee to use property for a stated period in return for a series of payments.

lease receivable A lessor’s right to receive lease payments arising from a lease, measured on a present value basis.

legal entity An entity that exists in its own right. Legal entities often combine to form an economic entity.

Legitimacy Theory Theory which proposes that organisations always seek to ensure that they operate within the bounds and norms of their societies.

leverage (gearing) Measure of the amount of debt issued by an entity. The greater the use of debt the greater the gearing.

liability Defined in the Conceptual Framework as ‘a present obligation of the entity to transfer an economic resource as a result of past events’.

liquidation The orderly winding up of a company’s affairs. It involves realising the company’s assets, cessation or sale of its operations, distributing the proceeds of

realisation among its creditors and distributing any surplus among its shareholders. The three types of liquidation are: court-ordered, creditors’ voluntary and members’ voluntary.

liquidator A natural person appointed to administer the liquidation of a company.

long-service leave Leave in addition to annual leave granted if an employee stays with an employer for a minimum number of periods.

lower of cost and net realisable value A rule for the measurement of inventory that requires the cost and net realisable value to be calculated for different items of inventory and that the lower of the two amounts be chosen to measure inventory. Should the net realisable value be lower than cost, then inventory write-down expenses would be recognised.

mark to market Valuing assets according to their market prices.

market capitalisation The total value of a firm’s securities computed by multiplying the current market value of each security by the number of securities issued by the entity.

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.

market rate of return The rate of return that the market, typically the capital market, requires from a particular investment.

materiality A threshold concept concerning the relevance of an event or transaction to financial statement users.

member (of a company) A shareholder.

members’ voluntary liquidation A liquidation for solvent companies, initiated by the company.

monitoring cost Cost incurred monitoring the performance of others.

net present value The difference between the present value of the future cash inflows and the present value of the future cash outflows relating to a particular project or object.

net selling price The selling price of an item less the costs that are incidental to making the sale.

non-controlling interests That portion of the profit or loss and net assets of a subsidiary attributable to equity interests that are not owned by the parent.

non-current liability Any liability that does not pass the test provided within AASB 101 for a current liability.

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

officer (of a company) A director, secretary or external administrator (in most cases) of the company.

dee67382_glo_1341-1352.indd 1348 10/24/19 04:51 PM

1348 GLOSSARY

on-costs Costs other than salaries and wages incurred by an employer as a result of employing individuals.

operating activities Activities that relate to the provision of goods and services and other activities that are neither investing nor financing activities.

operating lease Lease in which the risks and rewards of ownership stay with the lessor.

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.

option Entitles the holder to buy assets at a future time at a prespecified price.

ordinary shares A class of shares that typically ranks last in terms of any distribution of capital. Holders have voting rights, and will receive dividends at the discretion of the directors.

par (or face) value The amount debenture holders receive on maturity of debentures.

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.

parent entity An entity that controls another legal entity.

percentage-of-completion method (or stage-of- completion method) Where profits are recognised each period based upon the progress of construction. It represents an input method for measuring the progress towards completing a contract with a customer.

period costs Costs that are expensed 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.

periodic inventory system Also known as the physical inventory method, this is a method of accounting for inventory where inventory is counted periodically and then priced.

perpetual inventory system Also known as the continuous method, this is a method of accounting for inventory where a running total is kept of the units on hand by recording all increases and decreases in inventory as they occur.

perquisite consumption Consumption by employees of non-salary benefits.

political costs Costs that groups external to the firm might be able to impose on the firm as a result of political actions.

poll (of creditors) A voting procedure where both the number of creditors voting a particular way and the value

of their debts is considered in deciding if a resolution is approved or not.

Positive Accounting Theory (PAT) Theory that seeks to explain and predict accounting practice.

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.

pre-acquisition shareholders’ funds Shareholders’ funds that were in existence in an organisation before an entity acquired an ownership interest in that organisation.

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.

premium The amount paid per debenture in excess of the par or face value.

present value The value of an item to be received or paid for in the future expressed in terms of its value today.

presentation currency The currency in which the financial statements are presented.

priorities The order set down by the Corporations Act 2001 for the payment of the unsecured creditors of an insolvent company by an external administrator.

priority creditor An unsecured creditor entitled to be paid ahead of other creditors (e.g. employees).

probable More likely than less likely.

proof of debt A prescribed form to be completed by creditors at the liquidator’s request, setting out details of their claim against the company, including how the debt arose and the amount claimed.

provisional liquidator A liquidator appointed by the court to preserve a company’s assets until a winding-up application is decided.

proxy A person appointed by another person to represent them at a meeting. A proxy is usually entitled to attend and vote on behalf of the person who appointed them. In an external administration, the appointer is usually a creditor or shareholder.

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.

put option Gives its holder the right to sell an asset, at a specified exercise price, on or before a specified date.

qualifying asset Asset under construction or otherwise being made ready for future productive use of the organisation or for the use of another entity under a contract, which necessarily takes a substantial period of time to get ready for its intended use or sale.

dee67382_glo_1341-1352.indd 1349 10/24/19 04:51 PM

GLOSSARY 1349

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

receiver An external administrator appointed by a secured creditor to realise enough of the assets subject to the charge to repay the secured debt. Less commonly, a receiver may also be appointed by a court to protect the company’s assets or to carry out specific tasks.

receiver and manager A receiver who has, under the terms of their appointment, the power to manage the company’s affairs.

receivership An insolvency procedure where a receiver, or receiver and manager, is appointed over some or all of the company’s assets.

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 the costs of disposal, and its value in use.

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.

related party transactions Transactions between related parties.

report as to affairs A prescribed form required to be completed by the directors and secretary of a company in liquidation or receivership, giving details of the company’s assets and liabilities, and the identities of the creditors and debtors.

reportable segment An operating segment for which segment information is required to be disclosed by virtue of AASB 8.

reporting date Often referred to as ‘balance date’. The end of the financial period (typically 12 months). In Australia most companies have a reporting date of 30 June.

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.

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.

residual value The actual or estimated net realisable value of a depreciable asset at the end of its useful life.

revaluation decrement When an asset is revalued downwards, the revaluation decrement represents the difference between the carrying amount of the asset and its fair value at the date of revaluation.

revaluation increment When an asset is revalued upwards, the revaluation increment represents the difference between the carrying amount of the asset and its fair value at the date of revaluation.

revenues A class of income typically relating to the ordinary activities of an entity.

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.

risks and rewards of ownership Risks include those associated with idle capacity and obsolescence and benefits include gains in realisable value.

secured creditor A creditor who has a security (e.g. charge or mortgage) over some or all of a company’s property.

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.

SGARAs Self-generating and regenerating assets; that is, non-human-related living assets, including trees and animals.

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.

share capital The balance of owners’ equity within a company, which constitutes the capital contributions made by the owners.

share option Entitlement that gives the holder the right to buy shares at or before a future date at a specified price.

share premium The difference between the issue price of a share and the par value of that share.

share split The subdivision of the company’s shares into shares of a smaller face value, resulting in no change to owners’ equity.

share-based payment transaction with cash alternative 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.

shareholders’ funds In a company, shareholders’ funds—which constitute ‘equity’—represent the difference between total assets and total liabilities.

sick leave Paid leave entitlement per year for when an employee is not fit for duties.

significant influence The capacity of an entity to affect substantially but not control either, or both, the financial and operating policies of another entity.

dee67382_glo_1341-1352.indd 1350 10/24/19 04:51 PM

1350 GLOSSARY

significant influence The power to participate in the financial and operating policy decisions of the entity, but not have control or joint control over those policies.

social auditing A process whereby an enterprise can account for its performance against its social objectives and report on that performance to evaluate observance of the principles of accountability.

social benefits Benefits generated by an entity for society, or a segment thereof, such as provision of education, clean water, safe products and health care.

social contract Considered to be an implied contract constituted by the expectations that society holds about the conduct of an organisation.

social costs Costs 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.

social-responsibility disclosures Disclosures of information about the interaction of an organisation with its physical and social environment.

social-responsibility reporting The provision of information about the performance of an organisation with regard to its interaction with its physical and social environment.

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.

specific-identification method Method of accounting for the cost flow of inventory. Significant dollar value items are often accounted for in this way, particularly where they have a unique characteristic such as a unique product number.

spot rate The exchange rate for immediate delivery of currencies to be exchanged.

stage-of-completion method Where profits are recognised each period based upon the progress of construction. It represents an input method for measuring the progress towards completing a contract with a customer.

stakeholder Any group or individual that can affect or is affected by the achievement of an firm’s objectives.

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

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.

statement of cash flows A financial statement that provides a reconciliation of opening and closing ‘cash’, including cash on hand and cash equivalent.

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.

strike price The price the holder of an option will pay to buy a company’s shares or other commodities related to the option.

substance over form Events are accounted for and displayed in accordance with their economic substances, rather than their legal form.

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.

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

superannuation Payments made to employees after their retirement, in a stream of periodic payments or a lump sum on termination.

sustainable development Development that meets the needs of the present world without compromising the ability of future generations to meet their own needs.

swap agreement Agreement between borrowers to exchange aspects of their respective loan obligations.

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.

taxable profit The profit for a period determined in accordance with rules established by the taxation authorities, upon which income taxes are payable.

taxes payable method A method whereby the amount that is payable to the ATO is also treated as the tax expense of the organisation.

technical default When a borrowing entity has failed to comply with certain restrictive covenants that have been negotiated with lenders.

theory Coherent set of hypothetical, conceptual and pragmatic principles forming the frame of reference for a field of inquiry.

total market capitalisation Calculated by multiplying the number of issued shares in a company by their latest market price.

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.

dee67382_glo_1341-1352.indd 1351 10/24/19 04:51 PM

GLOSSARY 1351

translation of foreign currency transactions Translation of transactions denominated or requiring settlement in a currency other than the functional currency of the entity.

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.

triple-bottom-line reporting Reporting that provides information about the economic, environmental and social performance of an entity.

true and fair Disclosures are regarded as giving a true and fair view if they provide all relevant information that is representationally faithful and comply with applicable standards.

unearned revenue When assets are received by a business for services to be performed at a future date.

unidentifiable intangible assets Intangible assets that cannot be separately sold, such as loyal customers and established reputation. Goodwill is an example of an unidentifiable intangible asset.

unsecured creditor A creditor who does not hold a security over a company’s property.

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.

voluntary administration An insolvency procedure whereby the directors of a financially troubled company or a secured creditor with a charge over most of the

company’s assets appoint an external administrator called a ‘voluntary administrator’. The role of the voluntary administrator is to investigate the company’s affairs, to report to creditors and to recommend to creditors whether the company should enter into a deed of company arrangement, go into liquidation or be returned to the directors.

voluntary administrator An external administrator appointed to carry out the voluntary administration of a company.

voting power Determined by considering the voting rights attaching to equity interests in an investee, excluding contingent voting rights.

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.

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.

winding-up order A court order for the winding up of a company. The first step in a court-ordered liquidation. Usually made after an application by a creditor.

write-down Reducing the carrying value of an asset.

dee67382_glo_1341-1352.indd 1352 10/24/19 04:51 PM

dee67382_idx_1353-1366.indd 1353 10/24/19 04:29 PM

1353

Note: Page numbers in bold refer to definitions of terms in margins of text.

12-month test, 178, 379

AAS 24 Consolidated Financial Statements, 951

AASB see Australian Accounting Standards Board

AASB 2 Share-Based Payments, 688–719

background to, 689–92 disclosure requirements, 715–19 economic implications, 714–15 requirements of, 691–2 on share options, 512 summary of, 719

AASB 3 Business Combinations, 956, 964–7

on bargain purchase, 974 on goodwill, 286, 304–5, 966–7,

970–3, 976–7 on intangible assets, 288, 304 on non-controlling interests, 1061,

1069 or business combinations, 964 on subsidiary’s assets, 975

AASB 5 Non-current Assets Held for Sale and Discontinued Operations, 182, 211, 258, 923

AASB 6 Exploration for and Evaluation of Mineral Resources, 816–46, 1192

AASB 7 Financial Instruments: Disclosures, 529, 588–9

AASB 8 Operating Segments, 40, 873–91

introduction to, 874–6 AASB 9 Financial Instruments, 588, 993

on amortised cost, 544 on debentures, 388 on dividends, 631, 1010 equity method of accounting, 1156,

1160 on financial liabilities, 558–9 on foreign currency hedges, 1218 on hedging instruments, 520, 560–71,

1220 on impairment, 548 on measurement, 548–51, 653 on recognition, 542–3 on reserves, 520

AASB 10 Consolidated Financial Statements, 949–93, 1228

on concept of control, 957–62, 992 equity method of accounting, 1157,

1173 on foreign currency, 1228 indirect ownership interests, 1104,

1117 for intragroup transactions, 1006, 1067

for non-controlling interests, 1056, 1057, 1072, 1086

AASB 11 Joint Arrangements on concept of control, 958, 993 equity method of accounting,

1182–4, 1187 AASB 12 Disclosure of Interests in Other

Entities disclosure requirements, 1181 interests in subsidiaries, 991

AASB 13 Fair Value Measurement accounting standards, 171–4 in business combinations, 971 of debentures, 386 for equity-settled share-based

payments transactions, 693 of financial instruments, 543 on related party disclosures, 901 use of, 226, 292

AASB 15 Revenue from Contracts with Customers, 416, 602, 642, 828

scope of, 604 AASB 16 Leases, 410, 412, 415–21

core principles and scope, 415 AASB 101 Presentation of Financial

Statements, 7, 178–80, 755 on accounting policy, 119, 643–4 on biological assets, 353 on current assets, 178–9 on current liabilities, 179 on equity, 520 future changes to, 672 on general purpose financial

statements, 7 on intangible assets, 284 on liabilities, 379 on non-controlling interests, 1058–9 profit or loss disclosure, 647–53 on reserves, 520 on share capital, 520 on specific disclosures, 180–1 true and fair view requirements, 15

AASB 102 Inventories, 258–67 accounting methods, 119 on biological assets, 350 disclosure, 661 in extractive industries, 816, 817, 829 intragroup sale of inventory, 1018, 1024

AASB 107 Statement of Cash Flows, 178, 755, 771–801

AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors

on accounting policy, 120, 665–72 on changes in accounting estimates,

210, 658–61 disclosure requirements, 670–2 makes Conceptual Framework

mandatory, 62 on materiality, 10 on prior period errors, 646, 662–5

AASB 110 Events After the Reporting Period, 516, 855–63

AASB 111 Construction Contracts, 603 AASB 112 Income Taxes, 724–61

equity method of accounting, 1165 on evaluation of assets and

liabilities, 760 indirect ownership interests, 1123 for intragroup transactions, 1006 on lease payments, 426

AASB 114 Segment Reporting, 873–6, 880, 882

AASB 116 Property, Plant and Equipment, 182–9, 193, 653, 964

components approach to cost allocation, 187–8, 208

on depreciation, 202–7 disclosure requirements, 215–16, 250 on disposition of depreciable asset,

212–13 on employee benefits, 469 extractive industries, 816, 817, 821,

822, 824, 826, 829 on heritage assets, 330 on revaluations, 224–50, 743, 975 in social and environmental reporting,

1263 AASB 117 Leases, 410–52 AASB 118 Revenue, 603 AASB 119 Employee Benefits, 465

on long service leave, 471–6 AASB 121 The Effects of Changes in

Foreign Exchange Rates, 520, 564, 1228–31, 1235, 1236, 1242, 1243

AASB 123 Borrowing Costs, 191 on financial instruments, 538 on inventory, 263, 266 on property, plant and equipment,

190–3 on qualifying assets, 1216–18

AASB 124 Related Party Disclosures, 900–12

on categories of related parties, 904–7

on close family members, 905 disclosure requirements, 907–12 implications of, 901–2 on key management personnel, 900,

905, 909 rationale for, 902–3 on employee benefits, 909

AASB 127 Separate Financial Statements equity method of accounting, 1157 in group structures accounting, 956

AASB 128 Investments in Associates and Joint Ventures

equity method of accounting, 1157–61, 1169, 1172, 1173, 1179, 1183

on joint ventures, 993

INDEX

dee67382_idx_1353-1366.indd 1354 10/24/19 04:29 PM

1354 INDEX

AASB 132 Financial Instruments: Presentation, 529

on compound financial instruments, 585–8

on disclosure requirements, 588–9 on hybrid securities, 399 on preference shares, 398, 500 on share issue costs, 506

AASB 133 Earnings per Share, 40, 918–40

AASB 136 Impairment of Assets on amortisation of deferred

development costs, 298 in business combinations, 968 disclosure requirements, 250 on goodwill impairment, 305–7 on non-current assets, 224–50 on property, plant and equipment, 184 on recognition of impairment loss, 169,

239–43, 823–5, 1017 on reversal of impairment loss, 163–4,

239–40 AASB 137 Provisions, Contingent

Liabilities and Contingent Assets in business combinations, 966 on contingent assets, 394–5 on contingent liabilities, 375–6, 378 extractive industries, 816, 817, 825–6 on onerous contracts, 383–4, 628 on property, plant and equipment,

184, 185 on provision accounts, 1281 on restoration costs, 825–6 in social and environmental reporting,

1263, 1283 AASB 138 Intangible Assets, 284–314

on advertising costs, 170 on amortisation, 211 in business combinations, 964 cost of assets, 170 disclosure requirements, 661 extractive industries, 816, 817, 822 on goodwill, 303 on identifiable intangible assets, 981 on internally-generated goodwill,

966, 968 introduction of IFRS (2005), 313–14 on reinstatement of assets, 81 on research and development,

295–303, 644–5 on revaluations, 224, 975

AASB 139 Financial Instruments: Recognition and Measurement, 528

on fair value hedge, 564 on measurement, 548

AASB 140 Investment Properties, 246–7 AASB 141 Agriculture, 602

on agricultural produce, 360 on biological assets, 167, 349–50, 602 disclosure requirements, 363 fair value, 351 on measurement, 351 opposition to, 364 scope of, 350

AASB 1002 [superceded], 860 AASB 1012 [superceded], 1236 AASB 1013 Accounting for Goodwill, 305 AASB 1016 Accounting for Investments

in Associates equity method of accounting, 1157

AASB 1018 [superceded], 657, 662 AASB 1022 Accounting for Extractive

Industries, 816 AASB 1023 General Insurance Contracts

objections to, 147 AASB 1024 Consolidated Accounts, 873,

951, 956 AASB 1026, 775 AASB 1027 Earnings Per Share

(replaced), 918 AASB 1037 Self-generating and

Regenerating Assets, 349–50 objections to, 364

AASB 1041 Revaluation of Non-current Assets, 238

AASB 1048 Interpretation of Standards, 37

AASB 1049 Whole of Government and General Government Sector Financial Reporting, 7, 330–1, 335

AASB 1053 Application Tiers of Australian Accounting Standards, 38–41, 64

AASB 1056 Superannuation Entities, 476 AASB Conceptual Framework see

Conceptual Framework for Financial Reporting

ability to pay, 645 absorption costing, 261 accountability, 3, 66, 341, 342

social and environmental, 1257, 1258, 1271, 1292

accounting-based bonus schemes, 108 accounting methods and standards

for agricultural produce, 360 Australian history of, 38–41, 951–5 Australian release of, 26 for biological assets, 360 for business combinations, 964–73 changes across time, 38 for climate change, 1314 Corporations Act 2001 and, 18, 23, 30 cost-benefit analysis of standards,

22–3 cultural differences and, 44–5 debt contracting and, 112 differential reporting, 38–41 disclosure requirement reductions,

39–40 for equity accounting, 496–521 equity method of, 993, 1156, 1157 for externalities, 1306–11 for extractive industries, 816–46 functions of, 1271 for goodwill, 303–13 in government, 7, 338, 354 harmonisation of, 27, 30 for heritage assets, 335, 339–40 IAS/IFRS equivalents, 25–6 for intangible assets, 284–314 introduction of, 144–5 for leases, 410–15 for loss-making construction contracts,

628–30 ‘making’ and ‘formulating’ standards,

18 metrics, 1298 model, 1261–2 numbering system, 26–31 ‘pending’ standards, 23

profits, alternative measures of, 48–52 accounting mismatch, 552–8, 560 accounting performance measures, 108 accounting policy

in business combinations, 964–73 changes in, 120, 665–72 conservative, 44–5 creative accounting, 120–1, 238,

311, 395 disclosure requirements, 670–2 qualifying asset, 266 selection and disclosure, 119–20

accounting policy notes, 120, 276 Accounting Principles Board (US), 92 accounting profit, 724, 726–7, 728 Accounting Standards Advisory

Forum, 36 Accounting Standards Board (UK), 329,

336, 337, 339, 350, 364 Accounting Standards Review Board,

18, 145 Accounting Standards Steering

Committee, 66, 90 accounts payable, 785, 1211 accounts receivable, 633, 781, 1211 accrual accounting, 74, 771, 781 accrual-based earnings management,

116–17 accrual profits/losses, 771 accruals, 379 accumulated depreciation, 228–9 accumulation fund, 466 acquisition method, 965 acquisitions

acquirer, identity of, 965 consolidation after, 984–91 cost of assets, 170 date of, 965, 975–81

active market, 290–2, 822 adjusting events after reporting period,

857–62 advertising expenditure, 169–70 agency costs of debt, 110, 112 agency costs of equity, 104 agency relationship, 104, 961–2 agricultural produce, 349–50 see also

biological assets Airbnb, 154 airline industry, 214 see also Qantas Alfredson, Keith, 32 all-inclusive profit or loss, 662 All Ordinaries Share Price Index, 573 allowance for doubtful debts, 631–3, 632 Amazon, 284 Amcor Ltd, 352, 354 American Institute of Certified

Practising Accountants Special Committee, 877

American Institute of Certified Public Accountants, 92

American Petroleum Institute, 841 amortisation, 169, 211

depreciable life and, 211 in extractive industries, 823–5 of financial assets, 545–7 of goodwill, 305–11 of intangible assets, 290–2 of purchased goodwill, 304–11 of research and development costs,

296–7

dee67382_idx_1353-1366.indd 1355 10/24/19 04:29 PM

INDEX 1355

Anglian Water, 1308 annual leave, 464–5, 469–70 annual reports, 12–14, 954 see also

Directors’ Reports; financial reporting antidilutive, 931 ANZ Bank, 153, 775, 1259 Apple, 284 APRA, 39 area of interest, 817, 821 area-of-interest method, 818, 819–21,

836–8 arts institutions, 335, 339, 340 see also

heritage assets ASC see Australian Securities

Commission ASIC see Australian Securities and

Investments Commission ASRB see Accounting Standards Review

Board assembly costs, 183 asset and liability view, 75 asset/liability approach, 75 asset revaluation, 224 assets, 75, 161–2, 642

acquired at no cost, 193–4 acquisition cost, 170 biological assets, 167, 349–52, 602 classes of, 167 in Conceptual Framework, 1280 contingent assets, 394–5 current assets, 178–9 deferred payments, 189–90 deferred tax assets, 725, 727–33, 753 disposal of, 188, 194, 213, 234–5, 293 in financial statements, 180–4 in foreign currency transactions, 1230 future economic benefits of, 168–70, 414 held by subsidiaries, 975–81 heritage assets, 167, 328–9 measurement of, 87–90, 165–70 non-current, sale of, 1026–44 property, plant and equipment, 188–9 qualifying assets, 191, 266 on qualifying assets, 1216–18 recognition of, 75–81, 162–70 set-off of, 540–2 tax base of, 733–40 see also

amortisation; depreciation; financial assets; impairment losses; intangible assets; non- current assets; revaluations; valuations

associates, 1156, 1157, 1159 and investor, 1172

Association for Investment Management and Research (US), 870

AstraZeneca, 43 ASX see Australian Securities Exchange ATO see Australian Taxation Office AUASB see Auditing and Assurance

Standards Board Auditing and Assurance Standards Board,

31–2 Auditor-General NSW, 347 auditors, 15, 41–2, 113 audit reports, 41–2, 112 Auspine Ltd, 354, 359 Australia

accounting standards history in, 38–41, 951–5

accounting standards release in, 26 climate change in, 1313 corporate social responsibility in, 1255 differential reporting in, 38–41 emissions targets, 1318 extractive industry, 839, 841, 842 financial futures in, 572 futures contracts in, 572–8 harmonisation process in, 27 international standards adopted by,

24–6, 41 Australian Academy of Science, 1313 Australian Accounting Research

Foundation, 331, 951 Australian Accounting Standards Board,

18–31 adoption of international standards,

24–6, 41 critical review of proposed releases, 41 Financial Reporting Council, 19, 31–2 functions of, 18–19 IASB and, 40–1, 292 IPSASB and, 329 numbering, 26–31 organisational structure, 19 removal of Australian Guidance, 465 on true and fair view requirements, 18

see also AASB Australian Competition and Consumer

Commission, 145 Australian Conceptual Framework see

Conceptual Framework for Financial Reporting

Australian Conservation Foundation, 1270 Australian Corporations and Markets

Advisory Committee, 1252 Australian dollar, 1218, 1219, 1228–30,

1235, 1236 Australian Financial Review, The, 145 Australian Minerals Code for

Environmental Management, 843, 1270

Australian National Museum, 167 Australian Office of Financial

Management, 385 Australian Prudential Regulation Authority,

22, 39 Australian Securities and Investments

Commission, 7–18, 145 on amortisation of intangible assets,

292 ASX and, 32 Class Orders, 41, 912 policy statements, 14 on preference shares, 518 regulatory capture of, 144–5 regulatory guides, 14 regulatory role of, 8–9

Australian Securities and Investments Commission Act 2001 (Cth), 8, 31

Australian Securities Commission, 7 see also Australian Securities and Investments Commission

Australian Securities Commission Act 1989 (Cth), 7

Australian Securities Exchange, 32–4, 41 corporate governance principles, 33,

1269–70 disclosure of earnings per share to,

918

on Financial Reporting Council, 19, 24, 28, 31

forfeited shares and, 507–11 Index Futures, 574 Property Trust Index Futures, 573 view on adoption of international

standards, 26–31 Australian Shareholders’ Association, 912 Australian Stock Exchange see Australian

Securities Exchange Australian Taxation Office, 725, 728 Australian Venture Capital Association

Ltd, 714

bad debts, 633 bad debts expense, 633 balance sheet approach, 725–7, 760 balance sheet date, 855 balance sheets, 9 see also statements of

financial position Ballarat, City of, 339 Bangladesh, 1255, 1274 Bangladesh Garment Manufacturers and

Exporters Association, 1274 banking industry

corporate social responsibility in, 1278 interest rate charges, 114 presentation of financial statements,

180 in rural areas, 134 social and environmental reporting

by, 1278 see also ANZ Bank; Commonwealth Bank; National Australia Bank; Westpac

bargain purchase option, 411, 423, 424, 438

bargain purchases, gains on, 973–5, 978–81

Barings plc, 572, 588 basic earnings per share, 919–30

determining earnings, 919–20 determining the number of shares,

921–2 discontinued operation, 923–5

Baxter International Inc., 1308 beneficial interest, 962 Berle, Adolf, 1257 best estimate of provision for liabilities,

381 BHP Billiton Ltd, 202, 842

accounting policies, 830–3 assets of, 167 bonds issued at discount, 387 reporting date, 855 sales revenue report, 828–9 social and environmental disclosure

policies, 1264–5, 1272 sustainability reports, 1251

BHP Group Ltd, 12–15, 49 exceptional items, 657 significant judgements, financial

statements, 644 Big Mac index, 1207 Billabong Ltd, 113 biological assets, 167, 349–52

accounting for, 349–50 disclosure requirements, 360 measurement, 354–8 revenue, 602 unique nature of, 352

dee67382_idx_1353-1366.indd 1356 10/24/19 04:29 PM

1356 INDEX

Black-Scholes Option Pricing Model, 690, 700

blanket rule, 645 board of directors see directors Bombora Ltd, 536 bonding cost, 105 bonds, 385–8 see also debentures bonus issue, 926 see also bonus shares bonus scheme, 107, 123, 466

accounting-based, 107–8 market-based, 109–10

bonus share dividend, 514 bonus shares, 514

impact on earnings per share, 926–9 borrowing costs

core principle, 191 of financial instruments, 538 of foreign currency transactions,

1216–18 of inventory, 263, 266 of property, plant and equipment,

190–3 on qualifying assets, 1216–18

brand names as intangible assets, 284 Britain see United Kingdom Brundtland Report (1987), 1254, 1275 BSO/Origin, 1307 buildings, 71

accounting for land and, 210–11 depreciation of, 214, 260 as heritage assets, 328–9 impairment of goodwill for, 305 as investment properties, 246–7 leases involving, 448–50 measuring at cost or fair value, 224–5 recognition of, 163, 167 see also

construction contracts; property, plant and equipment

business combinations, 169, 286, 288–9, 292, 304, 306–7, 964–73

Business Council of Australia, 912 businesses

accountability in, 90 business model test, 545 impacts of, 66 social responsibilities of, 1255–9

buy hedge, 562

CAC-40 index futures, 573 call options, 532, 578, 618–20 Canada, 819, 843

heritage assets, 340 Canadian Institute of Chartered

Accountants, 92 capacity to adapt, 126 ‘cap and trade’ system, 1320–1 capital gains tax, 745 capitalise, 170, 184

borrowing costs, 191–2 expenditure on intangible assets, 289 heritage assets, 343 lease payments, 430 research on interest capitalisation, 192–3

Capitalism and Freedom, 1256 capture theory, 144–6, 841 carbon dioxide, 1307, 1313 carbon taxes, 1280 Carnegie, Garry, 348 carrying amount, 74, 163, 211, 225, 239

balance sheet approach to taxation accounting, 725–7

depreciation included in, 203 carrying value see carrying amount Carter Holt Harvey Ltd, 354, 359 cash

cash-generating unit, 239, 243 definition, 774–5 paid as dividends, 516

cash deposits, 1214–16 cash equivalents, defined, 774–5 cash-flow hedges, 563, 564, 567–71,

1220 cash flows

calculating inflows and outflows, 781–99 classification of, 775–6 definition, 774 direct method of reporting, 778 indirect method of reporting, 778 retained from operations, 789 see also

statements of cash flows stakeholders and contractual

arrangements, 799–801 cash flows from operating activities

(CFOA), 799–801 cash-settled share-based payments

transaction, 689, 691, 706–11 CEO see chief executive officer CEO Guide to Climate-Related Financial

Disclosures, 1299–301 Certified General Accountants

Association (Canada), 92 CFO see chief financial officer Chambers, Raymond, 103, 126–8 changes in accounting estimates, 658–61,

665–72 changes in accounting policy, 665–72 charitable donations, 1269 Chartered Accountants Australia and New

Zealand, 22, 49 Financial Reporting Council and, 31

chief executive officer, 14–18, 23 effect on goodwill impairment losses,

311 remuneration for, 909

chief financial officer, 11, 12, 14–18, 23 chief operating decision, 882, 883 chief operating decision maker, 875 Cicutto, Frank, 1269 Citigroup, 151 Civil Aviation Safety Authority, 145 claim dilution, 110 classification

of biological assets, 351 of cash flows, 775–6 of convertible instruments, 538, 585 of expenses by function, 650 of expenses by nature, 650 of financial instruments, 528, 539 of liabilities, 379 reclassification adjustments, 653–6

see also recognition climate change, 1252, 1280, 1313–20 Clime Asset Management, 214 closing rate, 1211 coal-generated electricity, 1307 coal mining, 1306–7 CoCoA see Continuously Contemporary

Accounting Coca-Cola Amatil, 284 coercive isomorphism, 138–41 Commission of European Communities,

1253

commodity, 147 Commonwealth Bank, 14, 15–17, 115,

180, 870, 871, 1302 financial statements, 755

Commonwealth government, 42 bonds, 385–6 pending accounting standards and, 23

Commonwealth Parliament, 23 community licence to operate, 1254,

1270 companies see businesses comparability, of financial information,

68, 72 compensation, in related-party

transactions, 909 competitive harm, 886–90 compiled standards, 27 complementary effect, 116 complete depiction, 70 completeness, 70 components approach to cost allocation,

187–8, 208 compound financial instrument, 538,

585–8, 711 Conceptual Framework for Financial

Reporting, 6, 60, 692 on assets, 334 background to, 60–1 benefits of, 61 components of, 63 on compound financial instruments,

586 critical review of, 90–2 on depreciation, 202 development of, 92 on equity, 87 on expenses, 85, 642, 1280 on gains, 603 on general purpose financial

statements, 6–7 goals of, 60 on heritage assets, 334 on income, 86–7, 642 on income and revenue recognition,

600–3 on income taxes, 725 on lease accounting, 410–52 on liabilities, 81–5, 375 on materiality, 10, 68 measurement principles, 87–90 as normative theory, 93, 101, 124 on objectives of general purpose

financial reporting, 67 on qualitative characteristics of

financial information, 68–74 reclassification of instruments, 539 on reliability, 71 on reporting entities, 64–5 revision of, 61–3 on social and environmental costs,

1254 on true and fair view requirements,

14–18 on users of general purpose financial

statements, 65–6 confirmatory value of financial reporting,

68 conservative accounting policies, 44, 264 consideration, 188, 967–9 see also

assets; fair value consolidated accounts

dee67382_idx_1353-1366.indd 1357 10/24/19 04:29 PM

INDEX 1357

accounting policy for, 964–73 after date of acquisition, 984–91 alternative concepts of, 1062–4 Australian Accounting Standards

history of, 951–5 disclosure requirements, 991–2 for foreign operations, 1242–4 for group structures, 949–93 for intragroup transactions, 951, 1057,

1060, 1062, 1067–95 to intragroup transactions, 1006–44 for non-controlling interests, 1056–95 rationale for, 950–1

consolidated entity, 954 consolidated financial statements,

949–51 see also consolidated statement of financial position

consolidated statement of cash flows, 951

consolidated statement of changes in equity, 951, 1059–60

consolidated statement of comprehensive income, 951, 1058

consolidated statement of financial position, 105, 870, 951

accounting standards governing, 951–5

group structures accounting, 949, 951, 955

non-controlling interests, 1057–62, 1069–82

consolidated statement of profit and loss and other comprehensive income, 951, 951

consolidation, 45, 753, 949 after date of acquisition, 984–91 alternative concepts of, 956–7 worksheets, 951, 969, 972, 1062,

1067 construction contracts, 191, 622–30 construction, mineral resources, 816 constructive obligations, 83, 376 Consumer Price Index (CPI), 826 contaminated sites, 376, 391, 1281 contingent assets, 394–5 contingent liability, 378, 966 see also

liability contingently issuable shares, 932–3 contingent-valuation method, 345 Continuously Contemporary Accounting,

126–8, 143, 305 contra asset, 633 contract, 604 contract asset, 623–5 contractual cash flow characteristics

test, 544 contractual rights and obligations

accounting methods and, 301 building depreciation and, 214 construction contracts, 191 financial instruments and, 530 futures contracts, 560, 572–8 lease accounting and, 451–2 for loss-making contracts, 628–30

contributed equity, 500 control (assets), 76, 162

recognition of revenue, 603 control (by the customer), 417 control (organisations), 24, 904, 1104 control (resources), 1280 controlled entity, 962

controlling corporation, 1268 control of joint arrangement, 1182 control over an investee, 950, 957–62,

992–3 conventional financial reporting practices

see accounting methods and standards; generally accepted accounting principles

Convergence Project, 30 convertible notes, 399, 538, 585 Coombes and Martin, 601–2 Cooper, Coulson and Taylor, 1313 corporate art, 329 corporate bond market, 387 corporate collapses, 488 corporate governance

ASX corporate governance principles, 32–4, 1269–70

executive remuneration and, 911 model of, 66 responsibilities of business, 1255–9

Corporate Governance Council (ASX), 32–4 Corporate Governance Principles and

Recommendations, 33 Corporate Law Economic Reform

Program (CLERP 1), 18, 27 Corporate Law Economic Reform

Program Act 1999 (Cth), 18 Corporate Law Economic Reform Program

(Audit Reform and Corporate Disclosure) Bill 2003 (CLERP 9), 910, 912

The Corporate Report, 66, 90 corporate social responsibility, 1251–323

reporting, 1253 corporations see The Corporations Law;

businesses Corporations Act 2001

on accounting standards, 23, 27, 38–41

ASIC role defined in, 8, 18 ASX and, 32 on declaration by CEO and CFO,

14–18, 23 on Directors’ Declaration, 11, 12–14,

855 on Directors’ Report, 14 on disclosing entities, 41 on financial statements, 7 on preference shares, 398, 518–19 on related party disclosures, 901–2,

910–12 on reporting entity, 65 on share capital, 500 on share splits, 513–14 on ‘small’ proprietary companies, 23–4,

65 on social and environmental reporting,

1259, 1264–5 on true and fair view requirements,

9–10, 14–18 Corporations and Markets Advisory

Committee, 1257 The Corporations Law, 500, 952 see also

Corporations Act 2001 cost-benefit analysis

of financial reporting, 71 of heritage asset information, 343 of standards, 22–3

cost-flow assumptions, inventory valuation, 267–75

cost method of accounting, 1162–7 cost model of asset revaluation, 182–4,

224–5 cost of goods sold, 258, 785 cost of sales method, 649, 650 costs

of construction contracts, 623–4 of convergence, 42 of conversion, 260–1 of exploration and evaluation, 822 of intangible assets, 288–90 of inventories, 260–7 monitoring, 105 of property, plant and equipment,

182–9 of purchase, 260 of research and development, 296–7 of revaluation, 247–9 of share issue, 506

costs-written-off-and-reinstated method, 818–19

costs-written-off method, 818 counter accounts, 1311–13 counterparty, 695, 711 coupon rate, 387 CPA Australia, 22, 53, 313, 364 creative accounting, 120–1, 238, 311,

395 see also accounting methods and standards

credit card profits, 153 credit derivatives, 152 credit losses, 547 credit risk, 589, 631 credit watch, 117 CSR Ltd, 352–4, 952–3 cultural differences, 44–5 ‘cum div,’ 1010 cumulative dividend preference shares,

920 Cunningham, Glen, 364 currency risk, 589 currency swaps see foreign currency

swaps current assets, 178–9 current cash equivalents, 127 current-cost accounting, 126, 143 current liabilities, 179, 379 current market value, 355, 356, 358 current-rate method, 1236 current ratio, 111, 179 current replacement cost, 128 customer, 604 CVM see contingent-valuation method

Daily Telegraph, 772 Darwin, Charles, 339 date financial statements are authorised

for issue, 855–6 David Jones, 153 DAX index futures, 573 dealers of leased asset, 443–7 debentures, 385–90

coupon rate, 387 issued at a discount, 388 issued at a premium, 389–90 issued at par, 386–7

debt contracting of, 110–14 doubtful, 632 equity vs., 397–8, 536–40 setting off, 541–2

dee67382_idx_1353-1366.indd 1358 10/24/19 04:29 PM

1358 INDEX

debt covenants, 113, 154, 395 debtholder, 110–11, 113 debt hypothesis, 123, 269, 839 debt-to-assets constraint, 395 debt-to-assets ratio, 247, 398 decision-makers emphasis, 127 decision-models approach, 127 decision usefulness, 67 declining-balance method, 205 decoupling, 138, 141, 143, 1252 deductible temporary difference, 726,

737, 739 deferral of research and development,

295 deferred development balances, 301–2 deferred development costs, 297–8 deferred payments on property, plant and

equipment, 189–90 deferred sale proceeds, 213 deferred tax asset, 725, 727–33, 753 deferred tax liability, 727–33, 743, 744,

753 defined benefit fund, 466 defined benefit plan, 480–8 defined contribution fund, 466 defined contribution plan, 478 The Definition and Recognition of

Revenue under Historic Cost Accounting, 601

delegated power (agency relationships), 104, 961–2

Delhi Australia Fund, 952–3 Delhi Petroleum Pty Ltd, 952–3 Denmark, 1269 Department of Justice (US), 116 depreciable amount, 204 depreciable asset, 202 depreciable life, 210–12 depreciation, 202

disclosure requirements, 215–16 of land and buildings, 210–11 of leased assets, 424, 427, 447 method of cost apportionment, 205 of non-current assets, 743–5 on property, plant and equipment,

202–7 revision, 210 of separate components, 208 when to start, 209 see also

amortisation deprival-value accounting, 127–8, 143 derecognition of assets, 234–5 see also

recognition derivative financial instruments, 530–2,

533–5, 560–1, 588 used within a hedging arrangement,

560–1 designated hedged items, 560 destination, 603 devaluation see revaluations; valuations development of mineral resources, 816

see also research and development costs

dialogic accounting, 131–2, 1311, 1312 differential reporting, 38–41 diluted earnings per share, 920, 930–5 dilutive see diluted earnings per share direct control, 962–4 direct costing, 261 direct-financing lease, 440

directly attributable costs, 182 direct method of reporting cash flows,

778 direct non-controlling interests, 1105 directors, 901

compliance with accounting standards, 12, 14

true and fair view disclosure requirements, 14–18 see also corporate governance; managers

Directors’ Declaration, 11, 12–14, 855 Directors’ Reports, 14, 910, 912 see also

annual reports disclosing entities, 41 disclosure

about contaminated sites, 378 about major customers, 885, 886 of accounting policies, 119–20 agricultural produce, 360–1 in biological asset accounting, 360–1 changes in accounting policy, 120,

670–2 climate risks and opportunities,

1300–1 consolidated accounts, 991–2 for contingent liabilities, 391 depreciation, 215–16 of event after the reporting period,

858, 860–2 in extractive industries, 829–38 for financial instruments, 588–9 for financing facilities, 780 geographical information, 885, 886 in heritage asset accounting, 344 for intangible assets, 294 in inventory, 275 in lease accounting, 436 non-controlling interests, 1057–8 non-financial disclosures, 360–1 prior period errors, 662–5 products or services, 885 reduced, 39–40 in relation to related parties, 907–12 requirements, 1181–2 revaluation of non-current assets, 250 in segment reporting, 883–6 share-based payment transactions,

715–19 share capital, 520 social and environmental reporting,

135 on social and environmental reporting,

1264–9, 1271–2 discontinued operation, 923–5, 930 discounting

of debentures, 382 for early payment, 260, 263 practice for liabilities, 1283–4

discount rates, 239 for lease payments, 424–5 for superannuation payments, 482

Discussion Papers (DPs), 22 disposal of assets, 188, 194, 202, 212–13,

234–5 see also derecognition of assets

diverse stakeholders, 131–2 dividends, 397, 515

as cash flows, 782–3, 789 consolidated financial statements,

1006–14

cumulative dividend preference shares, 920

declaration after reporting period, 859 disclosure requirements, 520 distributions to owners, 514–18 final, 516 interim, 515–16 intragroup transactions involving,

1006–14, 1067 to non-controlling interests,

1057, 1062 out of post-acquisition profits, 1007–10 out of pre-acquisition profits, 1010–14 payment of, 515 revenue from, 631

Dodd, Merrick, 1257 doubtful debts, 631, 632–633 downside, 111 dumping, 117

earnings cycle, 601 earnings management, 116–18, 675, 742 earnings per share, 918–40, 919

basic, 919–30 diluted, 920, 930–5 linked to other performance indicators,

936–40 economically recoverable reserves, 817 economic entity, 950, 1156 economic implications

of AASB 2, 714–15 of asset revaluations, 247–9 of goodwill amortisation, 311–13

Economic Interest Group Theory of Regulation, 146–8

economic resource, 81, 82, 161 economic substance, 62, 437, 536 ED see Exposure Draft (Australian) ED 10, 959 ED 40 Consolidated Financial

Statements, 951 ED 76 Events Occurring After Reporting

Date, 860 ED 83 Self-generating and Regenerating

Assets, 353 effective-interest method, 388–9, 545,

560, 631 efficiency perspective, 72, 105–6, 108,

111, 119 efficient-markets hypothesis, 1276 electricity industry, 1283, 1307 elements of financial statements, 74–87 emissions trading schemes, 1280 employee benefits, 464–88

corporate collapse and, 488 long-term, 467 post-employment, 467, 476 short-term, 467 termination, 467

employee render service, 708 employee share options, 466, 512, 688

see also share-based payment transactions

Energy Resources of Australia, 843 Enron, 43 entity, 1186 entity assumption, 1279, 1284 entity concept of consolidation, 956,

1056–7 see also reporting entity entity’s share, 1161

dee67382_idx_1353-1366.indd 1359 10/24/19 04:29 PM

INDEX 1359

environmental accounting, 1252, 1258, 1308, 1323

Environmental Profit & Loss (E P&L), 1308 Environmental Protection Authorities,

135, 1272 environmental reporting see social and

environmental reporting; social responsibility reporting; sustainability

EPA see Environmental Protection Authorities

EPS see earnings per share equation approach, 784, 788, 790 equitable obligations, 83, 376

accounting methods, 496–521 debt vs, 397–8, 536–40, 585–6 equity, 83, 87, 496 see also

statements of changes in equity pre-acquisition share capital, 1063–7

equity, 83, 87 equity instruments, 500, 530, 532,

536–40, 688 modification of terms and conditions,

704–6 equity investments, 1156 equity method of accounting, 993, 1157

application of, 1160–72 associate generating losses, 1179–80 vs. cost method, 1162–7 of inter-entity transactions, 1172–9

equity-settled share-based payments transaction, 688, 691, 692–706

Ernst & Young, 151 errors, prior period, 662–5 estimates see changes in accounting

estimates ethical investment market, 873 Eureka Flag, 339 European Union

‘cap and trade’ system, 1320–1 Emissions Trading Scheme, 1320 ‘single market objective,’ 24

evaluation phase, extractive industries accounting, 816

event after the reporting period, 855–63 evidence of public social and

environmental reporting, 1260 ex ante perspective, 105 exceptional items, 657 exchange rate, 1207–9, 1211, 1214,

1216, 1218–20, 1235 see also foreign currency transactions

executives see chief executive officer; chief financial officer; managers

executive salaries, 690 exercise price, 578, 618, 689 existence uncertainty, 643 exit-price accounting, 126–7, 148–9 exit-price theory, 126, 143 expected loss model, 548 expected-value method, 381, 609 expensed, 643 expenses, 85, 642

excluding social and environmental costs, 1280

recognition of, 85–6 exploration and evaluation activities

AASB 6 and, 816 accumulation of costs, 822 alternative methods of accounting for,

818–21

exploration and evaluation expenditure accounting for, 818–22 accounting regulation research,

839–42 ex post perspective, 106 Exposure Draft (Australian), 21, 62

on heritage assets, 350 on liabilities, 384 on reporting entity, 62, 64, 65, 88 on users of general purpose financial

statements, 65–6 see also ED exposure to variable returns, 958, 962 externality, 1251, 1280, 1306–11 extractive industries, 815–46, 1316

definition, 817 extraordinary items, 656–7 Exxon Valdez, 135

Facebook, 284 face (par) value, 385, 500 fair value, 88, 165–7, 643, 693

of biological assets, 351 class, 174 concerns, 177–8 consideration of, 171–8 of consideration transferred, 967–9 of debentures, 386 of derivatives, 560 of equity instruments, 700–1 in extractive industries, 839, 844–5 of financial assets, 539, 548–51 incremental, 704 of leases, 437–8 of property, plant and equipment,

188–9, 224–5 in related party disclosures, 902 of share-based transactions, 693–4 subsidiary’s assets not recorded at,

975–81 unable to be determined, 703–4 vesting conditions influence on,

700–3 see also fair value hedges; valuations

fair value hedges, 563–7, 1220 faithful representation, 68, 70–1, 124,

395 family members, in related-party

disclosures, 905 FASB see Financial Accounting Standards

Board (US) federal government see Commonwealth

government Federal Register of Legislation, 7 Federal Trade Commission (US),

investigations by, 116 feedback value, 68 FIFO see first-in, first-out cost-flow method finance lease, 410, 436 financial accounting, 5 see also

accounting methods and standards; financial reporting

Financial Accounting Standards Board (US)

adopting IFRSs, 30 conceptual framework, 61–2, 86 exposure draft on SFAS 19, 840 on heritage assets, adopting IFRSs,

339 on measurement attributes, 88

financial assets, 530–6

measurement, 544–51, 575 set-off of, 540–2

financial futures, 572 financial instruments, 528–90, 1220

convertible notes, 399 debt equity debate, 397–8 definition, 529–30 disclosure requirements, 588–9

financial lease, 439 financial liabilities, 530–5

measurement of, 559–60, 575 set-off of, 540–2

financial performance, 842, 1251, 1252, 1257, 1279, 1323

financial position, 75 financial press, 91 financial reporting see also accounting

methods and standards; statements of cash flows; statements of changes in equity; statements of comprehensive income; statements of financial position

definition of, 62–4 excluding social and environmental

costs, 1279 objectives of, 60–1 short-term results, 1282 users’ demand for, 6–7, 12, 45, 46

Financial Reporting Council, 31 adoption of international standards,

24–6 control of AASB, 19, 23, 146 functions and powers, 7, 31–2 membership of, 31–2

financial risk see risk Financial Stability Board, 1299 financial statements

credibility of, 46, 105 date authorised for issue, 855–6 reconciliation of segment information

to, 876, 883–5 translating, of foreign operations,

1228–45 see also statements of financial position

financial structure, 789 financing activities, 776

cash flows from, 789–99 financing facilities, disclosure of, 780 finite life, 211 firm commitment, 563–4 first-in, first-out cost-flow method, 267,

268 five-step revenue recognition model,

605 fixed assets see non-current assets fixed costs, 261 fixed production costs, 260 floating GAAP, 112, 451 f.o.b. destination, 603 f.o.b. shipping point, 603 forecast transaction, 564, 568–71 foreign currency, 1228 foreign currency futures, 576–8 foreign currency hedges, 1218 foreign currency swaps, 579–84, 1220 foreign currency transactions, 1206–21,

1228–45 foreign currency translation reserve,

1239–40 foreign investment, 27

dee67382_idx_1353-1366.indd 1360 10/24/19 04:29 PM

1360 INDEX

foreign operations, financial statements of, 1228–45

consolidation subsequent to translation, 1242–4

reporting in functional currency, 1228–34

translating accounts into presentation currency, 1235–42

forestry assets, 350 forfeited shares account, 507–11 forfeited shares reserve, 507–11 form-over-substance approach, 397 for-profit private sector entities, 39 forward rate, 561 forward rate agreement, 561, 1218,

1219 Foster’s Brewing Ltd, 353, 356 Framework for the Preparation

and Presentation of Financial Statements, 93 see also Conceptual Framework for Financial Reporting

France, 1269 FRC see Financial Reporting Council freedom from error, 70–1 free economy, 1256 free from error, 70 free goods, 352, 1306 ‘free-market’ perspective, 45–7 free on board (f.o.b.), 603 free-riders, 47 Friedman, Milton, 1256, 1258 frozen GAAP, 112, 451 FRS 30 Heritage Assets, 328, 331, 336,

338, 344, 345 Fuld, Richard, Jr, 151 full-cost accounting

for social and environmental reporting, 1306–11

full-cost method, 819, 833–5, 839–40 full goodwill method, 1061, 1112 functional currency, 1207–8, 1209,

1213, 1228–34 function of expense method, 649 future contracts, 560, 572–8 future economic benefits, 76–7, 162,

167, 643 of heritage assets, 167, 335–7 leases, 414 sources, 168–70

GAAP see generally accepted accounting principles

gains, 642 on bargain purchases, 973–5, 978–81 on derecognition, 213 on disposal of assets, 188, 194 on disposal of revalued non-current

asset, 234–5 on financial assets measured at fair

value, 549–51 on financial liabilities, 560 from intragroup transactions, 1068 revenue compared with, 603

gearing ratio, 154, 953 see also leverage (gearing)

general insurers, 166 generally accepted accounting principles,

108, 112, 396, 675, 677 Australian GAAP, 15 IFRS differences with, 30–1, 43 institutional theory and, 141

legitimacy and, 135–6 rolling principles, 452 on social and environmental costs,

1252 US GAAP, 44, 141

general price level accounting, 147 general purpose financial statements,

6–7, 38, 39 definition of, 64–5 objectives, 67 special purpose financial statement

vs., 64 users’ demand for, 6–7, 10, 41–2 users of, 65–6

general reserve, 498 geographical segments, 871, 873 Global Compact, 1302 global financial crisis, 92 globalisation, 30 Global Reporting Initiative, 842, 1254,

1278, 1283, 1284–91 global warming, 1307 going concern, 74, 96, 226

breach of assumption, 860 golden hand-cuffs, 689 Goodman Fielder Wattie Ltd, 353 goodwill, 11, 127, 147, 286

accounting for, 303–13 amortisation of, 305–11 in business combinations, 970–3 full goodwill method, 1061 impairment of, 305–11, 1112 internally generated, 284, 968, 971 non-controlling interests and, 1061 partial goodwill method, 1061, 1063 purchased, 304, 968, 971 see also

intangible assets Google, 284 governance see corporate governance government

accounting methods for, 677 accounting standards for, 7, 19, 338,

354 bonds, 654–5 costs on using resources, 1307 related party transactions state government, 42 valuating land and roads, 347

Government Accounting Standards Board (US), 141

grant date, 695–6 Greenhouse and Energy Data Officer,

1268 greenhouse effect, 1313 greenhouse gas (GHG) emissions, 911,

1265, 1313, 1315 categories of emissions, 1321

Greenhouse Gas Protocol, 1321–2 gross method, 230–31 group (economic entity), 949 Group of 100 Inc., 166, 364, 1265 group structures accounting, 949–93 see

also consolidated accounts guaranteed residual, 423

Hang Seng Index futures, 573 harmonisation of accounting standards,

44–5 see also international standards

Harvey Norman, 153 Hawker, Michael, 134

Hazelwood power station, 1307 hedge, 560, 1218–20

cash-flow, 563, 564, 567–71, 1220 fair-value, 563–7, 1220

hedge contract, 561, 1218 hedged items, 563–4 hedging, 572

effectiveness of, 560, 562 in foreign operations, 563, 1218–20 instruments, 1220

hedging instruments, 520, 560–71 derivatives as, 560–1

held for trading, 549–52 Hennes & Mauritz, 136, 1272, 1274 heritage assets, 167, 328–49

actual demand for financial information, 339–41

control of, 337–8 future economic benefits, 335–7 inalienability, 338 measurement of, 338–9, 341–9 valuation approaches, 345–9

historical-cost accounting, 125, 166, 204, 214, 224, 329, 331, 602

in extractive industries, 843–6 Hobbes, Thomas, 134 horizon problem, 299 Howie, Craig, 115 hybrid securities, 399

IAS 1 Presentation of Financial Statements, 650

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, 841

IAS 14 Segment Reporting, 874 IAS 17 Leases, 410, 412–15, 436 IAS 26 Accounting and Reporting by

Retirement Benefit Plans, 476 IAS 27 Consolidated Financial

Statements, 957 IAS 32 Financial Instruments:

Presentation, 529 IAS 37 Provisions, Contingent Liabilities

and Contingent Assets, 600 IAS 38 Intangible Assets, 286 IAS 39 Financial Instruments: Recognition

and Measurement, 548 IAS 41 Agriculture, 357, 600 IASB see International Accounting

Standards Board IASB 2008, 603–4 IASB Framework for Financial Reporting,

93 IBM, 1308 identifiable intangible assets, 284, 288,

313, 981–3 identifiable net assets, 1111 IFRS see International Financial Reporting

Standards IFRS 3 Business Combinations, 286,

1061 IFRS 6 Exploration for and Evaluation of

Mineral Resources, 840–1 IFRS 7 Financial Instruments: Disclosures,

600 IFRS 8 Operating Segments, 874, 875,

877 IFRS 9 Financial Instruments, 528, 600 IFRS 10 Consolidated Financial

Statements, 957

dee67382_idx_1353-1366.indd 1361 10/24/19 04:29 PM

INDEX 1361

IFRS 15 Revenue from Contracts with Customers, 108, 112, 600

IFRS 16 Leases, 410, 413, 415, 436, 452

core principle and scope, 415 IFRS Foundation, 34–5, 36 IFRS Interpretation Committee, 20, 34,

36–7 Interpretations, 34

IIRC see International Integrated Reporting Committee

Ilyk, Peter, 145 impairment losses

costs carried forward, 823–5 deferred development costs as, 297–8 of financial assets, 547–8 goodwill impairment, 305–14 in non-current assets, 224 recognition of, 169, 226, 239–44 reversal of, 163–4, 239–40

implicit interest rate, 454 inalienability, 338 incentives to manipulate accounting

numbers, 108–9 income, 86, 642

income-decreasing accounting methods, 115

recognition of, 86–7 revenue recognition points, 601–2 revenues and gains, 603

income statement, 9, 646 income taxes, 650–2, 724–61, 784–5 incremental borrowing rate, 454 incremental fair value granted, 704 indefinite useful life, 211, 291 independent valuation, 248 indirect control, 962–4 indirect method of reporting cash flows,

778 indirect ownership interests, 1104–7

calculating, 1107–34 inflation, 125 information asymmetry, 107 initial direct costs, 440 initial public offering (IPO), 501 input, 964 inside information, 874 insider trading, 397 insolvency, 488 see also going concern installation and assembly costs, 183 Institute of Chartered Accountants in

Australia on executive remuneration, 714 on introduction of AASB 2, 714

Institute of Chartered Accountants in England and Wales, 66, 90, 1279

Institute of Public Accountants, 22, 53 Institutional Theory, 104, 128, 137–44,

142 insurance

social and environmental reporting in, 1278

intangible assets, 38, 44, 165, 179 accounting for, 284–314 active market for, 165 amortisation of, 290–92 classes of, 294 cost of, 170 identifiable, 284, 288, 292, 981–3 introduction of IFRS, 313–14 legal life of, 204

research and development, 295–303 revaluations, 292–3 social and environmental reporting

impact on, 1320 types of, 204, 211 see also goodwill useful life, 290–2, 295, 297

integrated reporting, 1291–7 Interbrand, 284 interest

capitalisation of, 192–3 as cash flows, 782–3 cash payment of, 784 interest coverage clauses, 111, 165,

299 in intragroup transactions, 1068 lease payments and, 424–5 rate risk, 589

interest rate swaps, 584–5, 1220 interest revenue, 631 Interface Europe, 1308 Intergovernmental Panel on Climate

Change, 1315 internally generated goodwill, 285, 968,

971 International Accounting Standards

Board, 6, 9, 34–7, 60 AASB equivalents, 25–6 AASB numbering system, 26–31 Conceptual Framework see

Conceptual Framework for Financial Reporting

Discussion Paper ‘Extractive Activities’ (2010), 844–6

European Union and IAS, 24–6 on extractive industry standards, 840 introduction of IFRS, 528–30 on non-controlling interests, 1061 on retail leases, 153–4 on small and medium enterprises, 40 on social and environmental reporting,

1251 structure of, 34–7 see also IAS; IFRS

International Accounting Standards Committee, 24, 26, 34, 61, 358

on extractive industry standards, 840 Foundation, 34 on revenue recognition, 600

International Financial Reporting Standards, 34–7, 44, 60

AASB equivalents, 25–6 AASB numbering system, 26–31 Australian adoption of, 24–6 Australian equivalents, 20 benefits of adopting, 42–4 convergence with US GAAP, 44 differential reporting, 38–41 Foundation, 34–5 Interpretations Committee, 20, 34,

36–7 for Small and Medium-sized

Entities, 40 International Integrated Reporting

Council, 1291–7 International Integrated Reporting

Framework, 1291–7 International Organization of Securities

Commissions, 43 International Public Sector Accounting

Standards Board, 41, 329 international standards

Australian adoption of, 18, 24–6

Australian input into, 841 Australian Interpretations, 20, 36–7 financial instruments, 528–9, 1220 proposed adoption of, 30

International Trade Commission, investigations by, 116

Interpretations (IFRS), 36–7 Interpretations advisory panels (AASB), 20 in the money, 512 intragroup transactions, 951, 1006–44,

1057, 1062 adjustments for, 1067–95

intrinsic value, 690, 703 inventory, 258

cost-flow assumptions, 267–74 in extractive industries, 829 intragroup sale of, 1014–26, 1068 valuation of, 259–67

investee, 1157 control over, 950, 957–62, 992–3

investing activities, 776 cash flows from, 787–9 non-cash financing and, 780

investment properties, 246–7 investor, 955, 1157

power of, 958, 961–2, 992–3 voting rights of, 959

Invitations to Comment (ITCs), 22 IOSCO see International Organization of

Securities Commissions IPCC see Intergovernmental Panel on

Climate Change IPO see initial public offering IPSASB see International Public Sector

Accounting Standards Board ISO see International Organization for

Standardization isomorphism, 138–41, 143

Japan, 139 JB Hi-Fi, 153 joint arrangements, 187, 992–3,

1182–3 joint control, 992–3, 1187 joint operations, 993, 1182, 1184–94

joint ventures vs., 1186 joint ventures, 993, 1156, 1182–4

vs. joint operation, 1186 journal entries for construction contract

accounting, 624–8 JPMorgan Chase, 151

Kakadu conservation zone, 345 Kehoe, John, 145 Kering, 1308 key management personnel (KMP), 900,

901, 905, 909 see also managers key performance indicators (KPIs), 911,

1292, 1306 KPMG, 154, 1260

land and buildings building depreciation, contractual

implications of, 214 depreciation of, 210–11 leases of, 448–50

Landcare Ltd (NZ), 1308 land under roads, 348 large proprietary companies, 23, 24 last-in, first-out cost-flow method, 268–9 lease receivable, 440

dee67382_idx_1353-1366.indd 1362 10/24/19 04:29 PM

1362 INDEX

leases, 410–52 accounting-based contracts and,

451–2 accounting standards, 415 asset of specialised nature, 438–40 bargain purchase option, 423, 424,

427, 433, 438 capitalised lease payments, 430, 452 definition, 417–20 economic life of, 437 exemptions, 416 finance leases, 410, 436, 439 for land and buildings, 448–50 lease term, 421–2 measurement of lease liabilities, 422–4,

427–36 non-cancellability, 437 operating see operating lease ownership, 410, 433–4 residual value guarantee, 423 retailer accounting rules, 153–4 revenue and, 622 right-of-use asset, 412, 414–16, 420,

424, 426–7 sale and leaseback transactions, 622 service arrangement, 420 short-term lease exclusions, 454 see

also lessees; lessors legal entity, 870, 949–51 see also entity

concept of consolidation legal form, 62, 536–7 legal ownership, 1186 legislation see government; regulation Legislation Review Board, 15 legitimacy gap, 135 Legitimacy Theory, 104, 128, 133–7, 143

corporate social responsibility and, 1263, 1270–3

Lehman Brothers, 151 lessees, 422–36

disclosure requirements, 436 interest rates on lease payments,

424–7 operating leases, 428 see also leases

lessors, 436–50 classifying a lease, 438, 439 direct-financing leases, 440–3 disclosure requirements, 436 initial direct costs, 440 manufacturers or dealers of leased

asset, 443–7 operating leases, 410–12 recognition of residual assets, 454 risks and rewards of ownership, 436

see also leases leverage (gearing), 113, 536, 540, 572 liabilities, 375

contingent, 378 current, 379 debt equity debate, 397–9 deferred tax liability, 727–33, 743,

744, 753 definition of, 70, 81, 375 discounting, 1283–4 measurement of, 87–90 non-current, 379 provisions for, 380–3 recognition of, 81–5 reporting implications, 395–7

tax base of, 733–40 LIFO, 268–9 line-by-line method, 1186 liquidity format, 179–81 liquidity risk, 589 Listing Rules (ASX), 32, 1269 livestock assets, 353 see also biological

assets local currency, 1228 local government, 39, 337 Locke, John, 134 long-service leave, 465, 471–6 losses

disclosure, 648 loss-making contracts, 628–30 unused tax losses, 740–3

lower of cost and net realisable value, 259–60, 263–5, 267, 275

management accounting, 5 managers

owner-manager contracting, 106–7 R&D expenditure, 299–300 wealth of, 1274–5 see also corporate

governance; related party transactions

manufacturers of leased asset, 443–7 margin call, 572 marked to market, 572 market-based bonus schemes,

109–10 market capitalisation, 514, 927 market conditions, 701–3 market participants, 543, 901, 966, 971 market rate of return, 389 market risk, 589 mark to market, 572 Marsal, Bryan, 152 Masel, Leigh, 146 material items, disclosure of, 656–8 materiality, 210, 1160

definitions of, 10, 69–70, 657 determining, 68, 69, 94 equity method of accounting, 1160 in social and environmental reporting,

1283, 1293 MCA see Minerals Council of Australia McDade, Herbert, 152 McDonald’s, 284 McFarlane, John, 153 measurability, 84, 643, 1281–2 measurement

in accounting for share capital, 496, 500–1

of assets, 87–90, 165–70, 965–6 of biological assets, 354–8 in construction contracts, 623–4 in exploration and evaluation, 822 of financial assets, 543–58 of financial instruments, 529 of financial liabilities, 559–60 of goodwill, 304–5 of heritage assets, 338–9 of intangible assets, 288–90 of inventory, 259–67 of liabilities, 87–90, 965–6 of property, plant and equipment, 182,

224–5 of provisions, 381–3

of segment items, 882–3 of share-based transactions, 692 in social and environmental reporting,

1281–2 see also revaluations; valuations

uncertainty, 643 mechanistic hypothesis, 300 media, 1272

social disclosure in, 136, 1255, 1272 Media Agenda-Setting Theory, 1272 Melbourne, City of, 348 Mercedes Benz, 284 Metallgesellschaft AG, 572 Microsoft, 284 mimetic isomorphism, 138, 139–40 Minerals Council of Australia, 815, 843,

1270 mining industries see extractive industries minority interests see non-controlling

interests mixed attribute accounting model, 88 modelling, 139 Modern Slavery Act, 1265–8 monetary assets, 286 monetary items from foreign currency

transactions, 1230 monitoring cost, 105 monologic accounting, 131, 1311–12 Montgomery, Roger, 214 Morgan Stanley, 154, 572 mortgage profits, 153 motivations for social and environmental

reporting, 1256, 1262, 1269, 1274 multiple accounts, 131–2 Murray, David, 115 Museum of New Zealand, 339 museums, 339, 343, 347 see also

heritage assets Myer, 153

National Australia Bank, 572, 588, 1269 National Companies and Securities

Commission, 7, 146 National Consumer Credit Protection Act

2009 (Cth), 8 National Greenhouse and Energy

Reporting Act 2007 (Cth) (NGER Act), 1268, 1321

National Museum of Australia, 333, 338 National Pollutant Inventory, 1268 nature of expense method, 649 NCSC see National Companies and

Securities Commission negative credit watch, 117 net-amount method, 228–9 net asset backing per share, 163–4 net assets, 1183 net basis, 213 net investment in a foreign operation, 564 net market value, 356, 359, 364 net present value, 109 net-present-value method, 355 net realisable value, 259, 263–4 net selling price, 128 net value added, 1307 neutral depiction, 70 neutrality, 70 New York State government accounting

procedures, 135

dee67382_idx_1353-1366.indd 1363 10/24/19 04:29 PM

INDEX 1363

New Zealand, 339, 340 New Zealand Post, 115 Nike, 136, 1272, 1274 Nikkei 225 futures, 573 nominal valuations, 348 non-adjusting events after reporting

period, 857, 860–2 non-cancellability of leases, 437 non-capitalisation approach, 343 non-cash consideration, 188–9, 613 non-cash financing, 780 non-controlling interests, 648, 956–7,

962, 969, 1105, 1107–34 accounting for, 1056–95 calculating, 1060–7 pre-acquisition shares and reserves,

1063–7 non-current assets, 202

depreciation, temporary differences caused by, 743–5

impairment testing of, 224 intragroup sale of, 1026–44, 1068 modifying, 212 revaluations of, 224–50, 743–53 useful life expectation, 210

non-current liability, 379, 1214–15 non-monetary items from foreign currency

transactions, 1230 non-recurring items, 657 non-sequential acquisitions

of ownership interests, 1134–47 non-vesting sick leave, 465 normal operating cycle, 178–9 normative accounting theories, 101–3,

124–8 Conceptual Framework Project as, 93,

102, 124 current-cost accounting, 126, 143 deprival-value accounting, 127–8, 143 exit-price accounting, 126–7

normative isomorphism, 138, 140, 141 North Broken Hill Peko Ltd, 353 Norway, 843, 1269 notes (examples)

to cash flow statements, 780 disclosures for heritage assets, 343 financial reporting by segments, 871–2 to financial statements, 643, 653, 659,

672 geographical information, 886 related party disclosures, 912 statement of significant accounting

policies, 830–3 Not-for-Profit (Private Sector) Focus

Group, 19 not-for-profit sector, 193, 259, 330 notional value, 500 NPV see net-present-value method

Ocean Grove Ltd, 65 offsetting

of deferred tax liabilities and assets, 753

oil companies, 115, 135, 184–5, 1264 see also Shell

Oil Industry Accounting Committee (UK), 841

on-costs, 470 one-line method, 1187

onerous performance obligation, 628 operating activities, 775

cash flows from, 781–7 operating cycle, 379 operating lease, 410

disclosure requirements, 436 lessee accounting for, 430 lessor accounting for, 447–8 liabilities, 410

operating segments, 875–8 opportunistic perspective, 105–6, 119,

121 options (derivative financial instrument),

578–9 see also share option orderly transaction, 543, 966, 971 ordinary shares, 499, 921 organisational legitimacy, 1271 organisation fields, 137 Orica Ltd, 284, 391 other comprehensive income, 549–51,

646–53, 743, 1058 other price risk, 589 out of the money, 689 output, 964 output methods, 623 outside equity interests see non-

controlling interests overseas requirements, 1269 owner-manager contracting, 106–7 owners’ equity see equity ownership, 24

of leases, 410, 433–6, 448 risks and rewards of, 436 see also

control; equity ownership interests

accounting for indirect, 1104–47 non-sequential acquisitions of, 1134–

47 sequential acquisitions of, 1134–47

parent entity, 949–51, 954–5, 968–9, 1056, 1057, 1068

in foreign operations, 1228–9, 1235 interest, 1107–34

Parker, Colin, 314, 364 Parliamentary Joint Committee on

Corporations and Financial Services, 1269

partial goodwill method, 1061, 1063, 1113

partially hedged, 1219 partition effect, 952 par (or face) value, 385, 500 PAT see Positive Accounting Theory Paulson, Henry, Jr, 151 payables in foreign currency transactions,

1214–16 percentage-of-completion method, 623,

625–7, 629–30 perfectly hedged, 564, 1219 performance conditions

for key management personnel, 911 vesting conditions, 695

performance obligations, 603–4, 606–7, 623

period costs, 261 periodic inventory system, 269 perpetual inventory system, 269 perquisite consumption, 106

personal social responsibility, 1322 petroleum industry see oil companies Phar Lap, 167, 339, 349 Pioneer Sugar Mills Ltd, 356, 359 plant see property, plant and equipment political costs, 114–18, 123, 248, 841 politicians, 115, 147 Positive Accounting Theory, 72, 93, 103,

104–5, 119, 143, 193, 1274 bonus schemes and, 107–10 building depreciation in, 214 criticisms of, 122–4 debt contracting, 110–14 efficiency perspective of, 105–6 interest capitalisation, 192–3 liabilities, 395–6 opportunistic perspective of, 105–6 owner-manager contracting in, 106–7 political costs, 114–18

positive research, 104 post-acquisition earnings, dividends from,

1007–10, 1056, 1063 post-employment benefits, 466, 476 potential ordinary shares, 930–1 power

delegated, 961–2 over investee, 958, 992

pre-acquisition earnings, dividends from, 1010–14

pre-acquisition shareholders’ funds, 984 predictive value of financial reporting, 68 preference share, 398, 499–500

redemption of, 518–19 Preliminary Views on Revenue

Recognition in Contracts with Customers, 604

Premier Investments, 153 premium, 389 prescriptive theory see normative

accounting theories presentation currency, 1210, 1213,

1228, 1235–42 Presentation of Financial Statements, 7 present obligations, 81–3 present value, 128 present-value accounting

for lease payments, 422 for non-current assets, 239, 244–5

primary financial instrument, 533–5 primary users, 6 Prince’s Accounting for Sustainability

Project, 1291 prior period adjustments, 1030–1 prior period errors, 662–5 private companies see businesses private debt issues, 111 private interests, 147 Private Interest Theory of Regulation, 146 probability, 71, 74, 78, 79, 84, 288, 378,

608, 643, 1281–2 probable, 609, 740, 818 process, in a business, 964–5 production output, 824 production overheads, 261 production phase, extractive industries

accounting, 816, 824 profit or loss

disclosure, 647–53 before extraordinary items, 657

dee67382_idx_1353-1366.indd 1364 10/24/19 04:29 PM

1364 INDEX

profits accounting vs. taxable, 724 alternative measures of, 48–52 asset revaluation and, 246–7 cash flows vs., 772–4 conceptual framework on, 75 non-controlling interests and, 1068–9 reporting of alternative (non-complying)

measures of, 674–5 social and environmental performance

and, 675–8 unrealised, in opening inventory,

1021–6 with and without revaluation, 238

project advisory panels, 19 promissory notes, 503 property, plant and equipment, 182–9,

224–5 cost allocation, 187 deferred payments, 189–90 with non-cash consideration, 188–9

proprietary concept of consolidation, 957, 1057

‘pro-regulation’ perspective, 47–8 provision accounts, 380–3, 1281 public accountability, 39, 40, 65 public debt issues, 111 public interest, 144, 146, 147 Public Interest Theory, 144 public issue of shares, 501–2 PUMA, 1308 purchase, cost of, 260 purchased goodwill, 304, 968, 971 put options, 532, 578, 618

Qantas, 392, 773, 774, 780 qualifying asset, 191, 266, 1216–18 qualitative characteristics of financial

information, 64, 68–74

rational economic person assumption, 106, 1274–5

R&D see research and development real earnings management, 116 receipts from customers, 781–2 receivables, 631, 632, 781, 1214–16 reclassification adjustments, 653–6

of heritage assets, 335–7 of impairment loss, 169, 239–44 of income, 86–7 of intangible assets, 287–9 of liabilities, 81–5, 965–6

recognised asset/liability, 563–4 recognition

of assets, 75–81, 162–70, 965–6 criteria for, 77 of expenses, 85 of financial assets, 543–58

recoverable amount, 163, 169, 224, 239, 643

recycling, 645, 676 reduced disclosure requirements, 39–40 Reebok, 1274 regulation

regulator as interest group, 146–8 for social and environmental reporting,

1252, 1262, 1263, 1278 theories of, 144–8

regulatory capture, 144–6, 154 regulatory guides, 14 reinstatement of assets, 81

related parties, 901, 904–12 categories of, 904–5

related party disclosures, 900–12 annual report notes examples, 912 close family members, 905 Corporations Act 2001, s. 300A,

910–11 disclosure requirements, 907–12 key management personnel, 905, 909 in social and environmental reporting,

911 related party transactions, 900, 901–2 relevance criterion, 60, 66, 68, 71–2, 94,

179, 314, 377–8, 882 reliability, 71, 179, 882 remediation see contaminated sites remuneration

corporate governance and, 911 in Corporations Act 2001, 910–12 for executives, 690–1, 714, 912

renounceable rights, 511 repairs and maintenance, 380 reportable segment, 878–82 reporting see financial reporting; social

and environmental reporting reporting date, 855–6 reporting entity, 40, 64–5, 901, 1187

definition of, 64 IASB Exposure Draft, 62, 88

reporting period, events occurring after, 855–63

adjusting events, 857–62 disclose information, 856–7 disclosure requirements, 862–3 non-adjusting events, 857, 860–2

representational faithfulness, 60, 71–2, 92, 124–5, 378, 882

representationally faithful, 643 repurchase agreements, 152 required disclosure see disclosure research and development costs, 108–9,

284, 295–303, 314 amortisation of, 297–9 empirical research on, 299–303

Reserve Bank of Australia, 151 reserves, 496, 498–9

general reserve, 498 non-controlling interests and, 1063–7 valuation by area-of interest method,

839 residual value, 204, 291, 423

guarantees, 423 Resource Assessment Commission, 345 restoration costs, 825–8 retained cash flows from operating

activities (RCFFO), 800 retained cash flows from operations, 789 retained earnings, 497, 498, 514 revaluation decrement, 228–9

reversal of, 233–4 revaluation increment, 226–7, 232 revaluation model, 182, 224–8, 331,

669, 822 revaluations

area-of-interest method, 818, 819–21, 839

costs of, 247–9 economic implications of, 247–8 of intangible assets, 292–3 of non-current assets, 224–50, 743–53

see also valuations

revaluation surplus, 646 revenue, 599–635, 642

from biological assets, 358–60 at completion of production, 602 from contracts with customers, 608 gains compared with, 603 from major customers, 886 recognition criteria, 603 at time of sale, 602–3 unearned, 617 when right of return exists, 620–2

revenue and expense view, 75 revenue/expense approach, 75 Revenue from Contracts with Customers,

604 reversal

of impairment loss, 163–4, 239–40 of inventory write-downs, 275 of revaluation decrements and

increments, 232–4 reverse acquisitions, 965 rewards of ownership, 410, 436 right of ownership, 76 right of return, revenue recognition and,

620–2 right-of-use asset, 412, 414–16, 419,

422, 424, 426–7 rights issue, 511, 929–30 Rio Tinto, 843 risks, 382

disclosure requirements associated with, 588–9

of ownership, 410, 436 and rewards of ownership, 603, 604 in social and environmental reporting,

1269 Roberts, Staunton and Hagen, 359 Rocky Outcrop Ltd, 536 Rodden, Michael, 145 rolling GAAP, 112 rolling principles, 452 Rousseau, Jean-Jacques, 134

SAC 1 Definition of the Reporting Entity, 60

salaries, 464, 468–9 executive, 690 see also employee

benefits; remuneration sales

of assets, 213 with associated conditions, 617–22 of inventory, intragroup, 1014–26 and leaseback transaction, 622 of non-current assets, intragroup,

1026–44, 1068 proceeds deferred from, 213 revenue from extractive industries,

828–9 Samsung, 284 Samuel, Graeme, 145 Sandilands Committee (UK), 128 Sarbanes-Oxley Act 2002 (US), 146 secondary financial instrument see

derivative financial instruments secondary users, 6 securities, 397 Securities and Exchange Commission

(US), 30, 413, 840 segment reporting, 870–91

reconciliation for financial statements, 876, 883–4

dee67382_idx_1353-1366.indd 1365 10/24/19 04:29 PM

INDEX 1365

self-generating and regenerating assets, 350–1

classification, 351 measurement of, 356 see also

biological assets self-interest, 104–5, 107, 123, 125,

1263, 1270, 1274 sell hedge, 1219 senior executives see chief executive

officer; chief financial officer; managers

separable assets, 286, 287, 303 service component in lease, 420

sequential acquisitions, 1134–47 service payments, intragroup, 1068 set-off, 540–2 SFAC 1 Objectives of Financial Reporting

by Business Enterprises, 61 SFAS 2 Accounting for Research and

Development Costs, 299, 300 SFAS 13 Leases, 452 SFAS 19 Development Stage Accounting,

840 SFAS 131 Disclosures about Segments

of an Enterprise and Related Information, 874, 879, 881, 882, 887

SFAS 141 Business Combinations, 1061 SGARAs see self-generating and

regenerating assets shadow accounts, 1311–13 share appreciation rights (SARs), 707–11 share-based payment transactions,

688–719 with cash alternatives, 711–14

share capital, 398, 500–7 accounting for issue of, 500–7 disclosure requirements, 520 in non-controlling interests, 1063–7

see also equity shareholders, 23

disclosure of executive remuneration to, 911–12

funds, 496, 507 share options, 466, 512, 531, 688 share premium, 500 share price, 109, 1276 share price index (SPI) futures, 563,

573–6 shares

bonus issues, 513–14, 926–9 classes of, 499–500 contingently issuable shares, 932–3 entitlements to, 464 forfeited, 507–11 issued for no consideration, 932 issue of, 500–7, 932–3 oversubscribed, 504 partly paid, 502–3 rights issue, 511–13, 929–30

share split, 513–14 see also dividends; equity; investing activities; share options

Shell, 1251, 1254 shipping point, 603 sick leave, 465, 470–71 significant influence, 904–5, 992–3,

1157–9, 1182 single economic entity, 1007 small and medium enterprises, 23, 40, 65 Small APRA Funds, 39 small proprietary companies, 23–4

SMEs, 23, 40, 65 social accounting, 1258–9, 1323 social and environmental reporting,

1251–3 costs of, 1280–1 disclosure requirements on, 135,

1264–9, 1272 evidence of, 1260 full-cost accounting, 1306–11 integrated reporting, 1291–7 legal requirements, 1263–70 limitations of traditional financial

accounting, 1278–84 motivations for, 1256, 1262, 1269,

1274 profit and, 675–8, 843 regulation for, 1252, 1262, 1263 reporting guidance documents, 1254,

1268 restoration costs, 825–8 stakeholder demands for, 1273–4 see

also Global Reporting Initiative; International Integrated Reporting Framework; social responsibility reporting; sustainability

social auditing, 1275 social benefits, 1258 social contract, 133, 1270 social costs, 676–8, 1252, 1258,

1280–1 socially responsible investments (SRIs),

1278 social performance, 675–8, 842–3,

1251 social responsibility disclosures,

129, 135 social responsibility reporting, 1252–323

see also social and environmental reporting

Société Générale, 572 South Africa, 843, 1269 Southcorp Ltd, 364 S&P 500 futures, 573 S&P/ASX 200 index, 573 special purpose financial statement, 6, 64 Specialty Fashion, 153 specific-identification method, 268 Spencer, Ken, 364 spill resolution, 911 spot rate, 579, 1214, 1235 stage-of-completion method, 623 stakeholders, 645, 647, 677, 1251,

1258 information needs of, 1279 primacy view, 1269, 1293 and social responsibilities, 1256

Stakeholder Theory, 104, 128, 129–33, 143, 1273–4

Stanbroke Pastoral Company, 359 standard costs, 261 statements of cash flows, 771–801

comparison with other financial statements, 771

format of, 777–80 notes to, 780 preparation of, 790–9 see also cash

flows vs. profits, 772–4

statements of changes in equity, 520, 672–4

consolidated, 951, 1060

statements of comprehensive income, 9, 226, 269, 499, 641–78

other comprehensive income, 549–51, 646–7, 1058

profit or loss disclosure, 647–53 Statements of Financial Accounting

Concept, 61 statements of financial position, 9, 269

assets, 179–84 current/non-current format, 180 disclosures, 180–1 for foreign operations, 1228–45 intangible assets, 287 leases recognised in, 411 liquidity format, 179–81

statements of profit or loss and other comprehensive income, 641–78

consolidated, 951, 1057–8 Stebbens, Patricia, 154 stewardship, 67 stock, 348 see also inventory; shares stocktake, 274 Storey, Simon, 349 straight-line method, 205, 290, 298–9 Streaky Bay Ltd, 870 strike price, 578, 689 subsidiaries

acquisition of, 975–6 assets not recorded at fair value,

975–81 consolidated financial statements,

949–51, 956–7 control of, 962 definition, 957–8 eliminating parent’s investment in,

969–70 foreign, translation of financial

statements, 1236–7 goodwill of, 968–9, 971–3 loss of control, 962

substance-over-form test, 536, 921 successful-efforts method, 819, 839 sufficient regularity, 226 sum-of-digits method, 205 superannuation, 465, 476–7

plans, 476–7 supply chains, 1253, 1272, 1278 sustainability, 1254–5, 1275

Global Reporting Initiative, 1284–91 integrated reporting, 1291–7 reporting for, 1251, 1254–5, 1262,

1268, 1306, 1323 social and environmental performance,

842–3 sustainable cost, 1280, 1307 sustainable development, 1253, 1254,

1275, 1282 Sustainable Development Goals,

1301–5 sustainable profit, 1280 see also social

and environmental reporting Sustainability Accounting Standards

Board, 1297–9 Sustainability Reporting Guidelines, 842,

1278, 1283 swap agreement, 579 swaps

foreign currency swaps, 579–84, 1220

interest rate swaps, 579, 584–5, 1220 systems-oriented theories, 128

dee67382_idx_1353-1366.indd 1366 10/24/19 04:29 PM

1366 INDEX

t-account approach, 781 ‘taking a bath,’ 108 Task Force on Climate-related Financial

Disclosures, 1299 Tasmania, 154 taxable profit, 724–7, 785 taxable temporary difference, 727,

737, 740 taxation

balance sheet approach, 725–7, 755 changing tax rates, 753–5 of consolidated entity, 1015 expenses of, 724, 725 income taxes, 724–5 tax-effect accounting, 725

tax base in AASB 112, 725 of assets and liabilities, 733–40

taxes payable method, 731 tax expense, 725

and related assets and liabilities, 755–9

tax-related disclosures, 755–9 technical default, 451 temporary difference, 727–33, 736,

739–1, 743 theories, 102

of accounting, 101–19 of regulation, 144–8

timeliness criterion, 68, 72 time of sale, 602–3 time period, 824 time value, 689 tobacco manufacturers, 1279 total comprehensive income, 645, 647,

648, 672, 676, 1167 total market capitalisation, 514 total shareholder returns, 717 Tourism Council (Tas), 154 Toyota, 284 trade payables, 379, 380 traditional financial accounting practices,

1280 see also accounting methods and standards; generally accepted accounting principles

transaction price, 606, 608–14 transfer

of consideration, 967–9 of ownership of leases, 410, 433–5

translating financial statements of foreign operations, 1228–45

into functional currency, 1231–4 into presentation currency, 1235–42

translation of cash deposits in foreign currency, 1214–16

translation of foreign currency transactions, 1208, 1214–16

travel-cost method (TCM), 346–7 tree valuation, 167, 348 trigger test in AASB 133, 935 triple-bottom-line reporting, 1253, 1254 true and fair view, 9, 14–18, 643

in consolidated financial statements, 953, 954

Corporations Act 2001, 9–10 disputes over, 14–18

truing up, 697 Trustees Act 1925, 953 Tully, Joseph, 145 Tweedie, David, 413 two-strikes policy, 911

UBS, 572 ultimate parent entity, 1107, 1134–5 unavoidable costs, 628 underlying, 561, 575 understandability criterion, 68, 72 unearned revenue, 617 unguaranteed residuals, 425 unidentifiable intangible assets, 284–6,

303 United Kingdom

Barings plc, 572, 588 extractive industries in, 841 Japanese modelling of, 139 R&D, accounting for, 300 segment disclosures in, 874 on social and environmental reporting

in, 1265 United Nations’ Sustainable Development

Goals, 1301–5 United States

accounting firms in, 145 conceptual framework in, 60–1 exploration and evaluation expenditure,

839–40 extractive industries in, 839–40 FASB see Financial Accounting

Standards Board (US) heritage assets in, 339 LIFO in, 268 R&D costs, 299–300 use of GAAP, 141

United States’ generally accepted accounting principles (US GAAP), 30

units-of-production method, 207

unit trusts, 951–3 unrealised profit or loss, 1015 unrecognised firm commitment, 564 unused tax losses, 740–3 upside, 111 useful life, 169, 204, 214

depreciable life, 210–11 intangible assets, 290–2, 294, 297

User Focus Group, 19 users

of financial reports, 6–7, 10, 1293 of general purpose financial

statements, 6–7, 65–6 primary, 6 secondary, 6

valuations of heritage assets, 345–9 of inventory, 259–67 of research and development, 295 of reserves in extractive industries, 839

see also fair value; measurement; revaluations

value creation, 1256 value-in-use, 76, 169, 239 Valukas, Anton, 151 verifiability criterion, 68, 72 vesting

conditions, 689, 695, 700–3 of entitlements, 694–9 grant date, 695–6 period, 689 sick leave, 465, 470–1

Victorian power plants, 1307 ‘virtually certain,’ 395 voting power, 1158 voting rights, 959–61

wages and salaries, 464, 468–9 see also employee benefits; remuneration

weighted-average approach, 268 weighted-average number of shares,

919, 931–5 well-offness, 676 Wesfarmers Ltd, 153, 258, 276 Wessex Water, 1308 Westpac, 134, 1259 Westpac Banking Corporation Ltd, 870 wine industry, 364 Wolnizer, Peter, 348 Woolworths Ltd, 153, 717–19, 1316 write-down, 266, 275

Yeates, Clancy, 690

  • 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 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 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
    • Chapter 28 Further consolidation issues III: accounting for indirect ownership interests
    • Chapter 29 Accounting for investments in associates and joint ventures
  • PART 9 FOREIGN CURRENCY
    • Chapter 30 Accounting for foreign currency transactions
    • Chapter 31 Translating the financial statements of foreign operations
  • PART 10 CORPORATE SOCIAL-RESPONSIBILITY REPORTING
    • Chapter 32 Accounting for corporate social responsibility
  • Appendices
  • Glossary
  • Index